Federal consolidated return principles create confusion in California combined reports.

California recently opened a new chapter in its ongoing struggle with the use of Federal consolidated return principles in the California combined report. A pair of rulings illustrates the conflict and confusion created by simultaneously rejecting and embracing such principles.

Appeal of Rapid-American Corp.

In Appeal of Rapid-American Corp. (10/10/96), the State Board of Equalization (SBE) declined to apply Federal consolidated return principles to calculate the stock basis for California franchise tax purposes of a subsidiary owned by a member of the same combined group. Under Regs. Sec. 1.1502-32, a parent's basis in a consolidated subsidiary's stock is generally increased by that subsidiary's undistributed taxable income. In contrast, the SBE held that, for California franchise tax purposes, a parent's stock basis in its subsidiary may not be increased to reflect that subsidiary's undistributed earnings.

The taxpayer, which filed a California combined report with its subsidiaries, realized substantial capital gains from the sale of several subsidiaries. The taxpayer reduced the gains to reflect increases in its stock basis attributable to the undistributed earnings of each of the disposed subsidiaries. The taxpayer contended that the increases were necessary to prevent double taxation of the subsidiaries' retained earnings, which already had been reported as income in previous California combined reports. In disallowing the adjustment, the SBE held that the lack of an upward basis adjustment did not result in impermissible double taxation; although the subsidiary's earnings had been taxed as the income was earned, those earnings had not been previously subjected to tax at the shareholder level. Even though an upward basis adjustment is allowed under Regs. Sec. 1.1502-32, there was no California statute, regulation or case allowing a similar adjustment for members of the same California combined report. Accordingly, the SBE declined to allow the taxpayer to exclude the gain that would have been eliminated if the stock basis had been adjusted.

The SBE rejected concerns that denying the upward basis adjustment may open the door to manipulation. The taxpayer noted that the state could be "whipsawed" by this holding. As an example, the taxpayer stated that a parent corporation planning a divestiture could have the subsidiary declare a dividend of all its earnings and profits (E&P) prior to the sale. This intercompany dividend generally would be eliminated in the combined report. The selling price of the subsidiary would be reduced by the dividend, thus reducing any potential capital gain. Nevertheless, the SBE deferred to the California legislature to address any potential problems.

The SBE's decision also did not address the treatment of a loss that could be incurred when the stock of a subsidiary with historical losses (whether or not used to offset the combined group's taxable income) is sold for much less than the original stock basis. Will California allow taxpayers to claim the additional loss that resulted from the lack of downward stock basis adjustments for the historical losses? Under the reasoning of Rapid-American, it appears that the SBE does not have the authority to invoke Federal consolidated return principles to disallow such a loss.

FTB Notice 97-2

California has long had an informal policy of deferral for intragroup transactions involving fixed assets and inventory, and more recently for transactions involving intangible assets. The Franchise Tax Board (FTB) has based this position on the theory that intercompany transaction income should not be taxed while the members remain in the group, provided the income does not enhance the economic position of the combined group as a whole. Four months after the Rapid-American decision, FTB Notice 97-2 (2/21/97) extended this Federal consolidated return principle to nondividend distributions that exceed a parent's stock basis in the distributing unitary subsidiary.

Under both California and Federal tax law, a distribution is treated as a dividend to the extent of the distributing corporation's current or accumulated E&P; any excess reduces the recipient's basis in the distributing corporation's stock. The portion of the distribution that exceeds any available stock basis is treated as income from the sale of property under Sec. 301(c)(3) and Cal. Rev. & Tax. Code Section 24451. If both the recipient and distributing corporations are members of the same Federal consolidated group, however, recognition of the income is deferred for Federal tax purposes by creating an excess loss account (i.e., establishing a negative basis for the stock) (Regs. Secs. 1.1502-13 and-19).

California currently has no rules that allow for a deferral of the excess distribution income. The FTB indicated, however, that it is in the process of drafting regulations that would prospectively provice for such treatment. FTB Notice 97-2 advises taxpayers to request a closing agreement for all open years in order to defer the recognition of income created in such circumstances.

Conclusion

As illustrated by these two rulings, California's piecemeal approach to adopting Federal consolidated return principles can create a confusing road for taxpayers to travel. Ideally, the members of a combined group should be treated as a single economic unit for all California tax purposes, not just for income or loss deferral. If the FTB chooses to apply such principles uniformly, the anxiously awaited regulations will alleviate the confusion and establish a consistent tax policy.

From Scott A. Salmon, CPA, MAcc., Washington, D.C.