California reinstates insurance company DRD.

California Assembly Bill 263 (AB 263), Stats. 2004, ch. 868, signed into law in September 2004, resolved the controversy that followed the California Court of Appeal's decision in Ceridian Corp. v. Franchise Tax Board (FTB), 85 Cal. App. 4th 875 (2000), by reinstating an insurance company dividends-received deduction (DRD) and providing an election to take it retroactively for open years ending on or after Dec. 1, 1997, as computed under the new provisions. AB 263 establishes very complex rules and formulas to compute the DRD on "qualified dividends" and grants the FTB the authority to include a portion of an insurance company's earnings and profits (E&P) in its shareholders' income as a "deemed dividend."

Background

In Ceridian, the court held that Cal. Rev. & Tax. Code (CRTC) [section]24410 provisions that limited a deduction for dividends received from subsidiaries engaged in the insurance business to corporations "commercially domiciled" in California, and to insurance company dividends paid from "income from California sources," violated the Commerce Clause. For tax years ending on or after Dec. 1, 1997 (years subsequent to the tax years at issue in Ceridian), the FTB had taken the position that as a result of Ceridian, CRTC [section]24410 was wholly inoperable, so that no DRD was permitted for dividends received from an insurance company; see Departmental Policy on Section 24410 Insurance Dividend Deductions, FTB Multistate Audit Program Mem. (4/26/02).

Certain taxpayers in the insurance industry took the position that the (1) portions of prior CRTC [section]24410 that related to commercial domicile and limited the deduction to insurance company dividends paid from California-source income were severable from the statute; and (2) remaining portions of pre-AB 263 CRTC [section]24410 provided for a 100% deduction for dividends received from an 80%-owned insurance company. Conversely, the FTB issued proposed assessments of additional tax and interest to all taxpayers who claimed the CRTC [section]24410 deduction in years ending after Dec. 1, 1997, based on the FTB's argument that CRTC [section]24410 was wholly inoperable.

New Law

AB 263 reinstated an insurance company DAD of 80% of "qualified dividends" and provides an election to retroactively take it for open years ending on or alter Dec. 1, 1997. However, AB 263 also establishes very complex rules and formulas as to the amount of the dividends qualifying for the DRD; disallows for the future certain deductions for expenses paid by a corporation to an insurance company affiliate; limits the nonrecognition rules on reorganizations and transfers of assets to insurance companies; and grants the FTB authority to include a portion of an insurance company's E&P in its shareholders' income as a "deemed dividend." Due to the complexity of these rules, the new law merits careful review when dealing with an insurance company affiliate and before implementing any restructuring or transfer of assets involving such affiliate.

The key provisions of AB 263 are summarized in the exhibit above.

Exhibit: Summary of AB 263's key provisions

* For years beginning after 2003, an 80% DRD is allowed for "qualified dividends" from an insurance company subsidiary. The DRD increases ta 85% for years beginning after 2007 (CRTC [section]24410(a)).

* The DRD is reduced if the ratio of income from the conduct of the insurance business to total insurance company income is below 60% (increasing to 70% for tax years after 2007) (CRTC [section]24410(c)).

* E&P from the conduct of an insurance business means net premium income, rather than income from insurance company activities (CRTC [section]24410(c)). AB 263 provides detailed rules for calculating this income.

* Net premium income does not include income attributable to premiums paid by members of a commonly controlled group (CRTC [section]24410(d)(2)).

* Taxpayers may elect to take a DRD as computed under the new rules for any open tax year ending on or after Dec. 1, 1997 (CRTC [section]24410(b)(1)). This election is made by filing amended returns by March 28, 2005; see CRTC [section]24410(b)(4)(B) and FTB Notice 2004- 6. FTB Notice 2004-6 also provides detailed instructions on making the election. Further, if a retroactive election is made, it must apply to all years open under the statute of limitations (CRTC [section]24410(b)(5)).

* Interest and other expenses paid to an insurance company in a commonly controlled group are also either disallowed or severely limited (CRTC [section]24425(b)).

* For purposes of the various nonrecognition provisions contained in Internal Revenue Code (IRC) subchapter C, transactions with an insurance company are not covered by the nonrecognition provisions in specified situations (CRTC [section]24465).

* In the case of an IRC Sec. 332 liquidation of an insurance company into a noninsurance company, the latter is treated as receiving a dividend subject to the applicable DRD on "qualified dividends" (CRTC [section]24465(h)(2)).

* Under specified circumstances, the FTB can treat a taxpayer's pro-rata share of investment (non-premium) income of any current-year E&P of an insurance company in a commonly controlled group as a "deemed dividend" received by the noninsurance company affiliate (CRTC [section]24900).