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Dividend deductions; Farmer Bros. ruling: Rev. and Tax Code Sec. 24402 unconstitutional.

In Farmer Bros. Co. v. Franchise Tax Board, the Court of Appeal [(2003) 108 Cal.App. 4th 936, 134 Cal.Rptr.2d 390] held that the California Revenue and Taxation Code Sec. 24402 dividend deduction is unconstitutional. The following outlines how the Franchise Tax Board will apply the Farmer Bros. decision to other taxpayers.

FTB Policy

1. For tax years ending on or after Dec. 1, 1999, the FTB will disallow all Sec. 24402 deductions. To the extent that a taxpayer added back to income expenses related to the Sec. 24402 deduction because the dividends were not in the measure of tax as provided by Sec. 24425, that state adjustment should be reversed.

2. For tax years ending prior to Dec. 1, 1999, all dividends received from noninsurance corporations are deductible, subject to the ownership limitations of Sec. 24402(b).

3. Dividends from an insurance company that do not qualify for a deduction under Sec. 24410 for tax years ending on or after Dec. 1, 1997 are not allowable as a Sec. 24402 dividend deduction.

4. Sec. 24411(a) provides for a deduction of 75 percent of qualified dividends in the case of a water's-edge election. The dividends in question are generally from foreign subsidiaries that are not included in the water's-edge combined report. In most instances, the dividends described in Sec. 24411 are fully deductible as Sec. 24402 dividends in accordance with the Farmer Bros. decision for tax years ending prior to Dec. 1, 1999. Therefore, there is no Sec. 24411 dividend deduction in these years.

5. Sec. 24344(c), the foreign investment interest offset, will not be applicable in most cases for tax years ending prior to Dec. 1, 1999.

6. For tax years ending prior to Dec. 1, 1999, the FTB will apply Sec. 24425 to deny expenses to earn income not in the measure of tax under Sec. 24402. Sec. 24425 applies to the dividends described in Sec. 24411 that are now deductible as Sec. 24402 dividends for tax years ending prior to Dec. 1, 1999.

FTB Analysis of Court Decision

The Farmer Bros. case held that Rev. & Tax Code Sec. 24402(a)--which provides for a dividend-received deduction to the extent that the dividend payor was subject to California corporate income or franchise tax--is unconstitutional because the dividend-received deduction discriminated against interstate commerce, which violates the U.S. Constitution.

A statute that is declared unconstitutional is void and ceases to operate (See Kopp v. Fair Political Practices Commission [(1995) 11 Cal.4th 607, citing with approval, Jawish v. Molet (1952) 86 A.2d. 96)].

Sec. 24402(a) authorizes a deduction, but a deduction is not available if the underlying statute is void and ceases to operate. Sec. 19393 provides that if a deduction, credit or exclusion is determined to be invalid or discriminatory under the Constitution, the tax for taxpayers who received the benefit of the deduction is to be recomputed by disallowing the deduction.

The Court of Appeal in Ceridian v. FTB, [(2001) 85 Cal.App. 4th 875 (as modified 86 Cal.App.4th 383)] held that Sec. 24410 is unconstitutional. Sec. 24410 provided for a dividend-received deduction for dividends paid by an 80 percent or more owned insurance corporation to the extent that the insurance corporation was subject to the California gross premiums tax.

The court in Ceridian did not apply Sec. 19393 because retroactive tax collection was not possible for the years involved since the statute of limitations was not open for all taxpayers who took the deduction for such that they could be treated similarly. The FTB has interpreted Sec. 19393 to apply to all years open under the normal four-year statute of limitations.

The statute of limitations for issuing assessments for tax years ending before Dec. 1, 1999 has expired for some taxpayers, so it is not possible to treat all taxpayers comparably by disallowing the Sec. 24402 deduction. Therefore, taxpayers will be allowed to take a 100 percent dividend deduction for dividends received from noninsurance corporations subject to the ownership requirements of Sec. 24402(b).

Refunds will be allowed if claims are, or have been, filed within the statute of limitations.

For tax years ending on or after Dec. 1, 1999, the statute of limitations for issuing assessments was open for all taxpayers when notices of proposed assessment were issued pursuit to the FTB's March 4, 2004 message on interim procedures for implementing the Farmer Bros. decision. Therefore, Sec. 19393 is applicable and the Sec. 24402 dividend deduction should be disallowed for all taxpayers.

Sec. 24402(b) Ownership Limitations

The Farmer Bros. court did not rule on Sec. 24402(b), which limits the deduction computed in Sec. 24402(a) based on ownership.

The corporation receives a dividend-received deduction of 100 percent of the deductible dividend percentage computed in accordance with Sec. 24402(a) if the corporation owns more than 50 percent of the stock of the dividend-paying corporation.

If the corporation owns between 20 percent and 50 percent of the dividend-paying corporation, the percentage computed in Sec. 24402(a) is limited to 80 percent. The limitation is 70 percent if the corporation owns less than 20 percent of the dividend-paying corporation.

In seeking its claim for refund, Farmer Bros. applied the limitations of Sec. 24402(b). Therefore, the Sec. 24402(b) limitation continues to apply for tax years ending before Dec. 1, 1999.

For example, presume a taxpayer received a $1,000 dividend in 1988 from a corporation in which they held a 10 percent ownership interest.

The payor corporation had a 15 percent California dividend-received deduction percentage.

Applying Sec. 24402 prior to the Farmer Bros. decision, the taxpayer should have taken a dividend-received deduction of $105. [Computed as $1,000 multiplied by 15 percent--as under Sec. 24402(a)--and then multiplied by the 70 percent limitation of Sec. 24402(b)].

After Farmer Bros., the taxpayer will be allowed a deduction of $700 [$1,000 under Sec. 24402(a) multiplied by the 70 percent limitation of Sec. 24402(b)].

Sec. 24402 Not Applicable to Insurance Company Dividends

The FTB anticipates that taxpayers who receive dividends from insurance corporations will take the position that those dividends should receive similar treatment as Sec. 24402 dividends. Sec. 24402 cannot be used to provide a dividend-received deduction for dividends received from an insurance company for the following reasons:

* Legislative history and case law (see Burton E. Green Inv. Co. v. McColgan (1943) 60 Cal.App. 2d 224) make it clear that Sec. 24402 was never intended to apply to dividends received from insurance companies. There would have been no need for Sec. 24410 if Sec. 24402 applied.

* Sec. 24402(a) provides for a dividend-received deduction to the extent that the dividend-paying corporation paid the dividend out of income that was included in the measure of tax imposed by the corporate franchise or income tax. Insurance companies are subject to the gross premiums tax and not the corporate franchise or income tax.

Water's-Edge Dividend Deduction Under Sec. 24411

Generally, Sec. 24411(a) provides for a deduction of 75 percent of the dividends received from foreign subsidiaries in a water's-edge election. The deduction is applied to "qualifying dividends to the extent not otherwise allowed as a deduction or eliminated from income."

For tax years ending prior to Dec. 1, 1999, the dividends that would otherwise qualify for Sec. 24411(a) treatment are now generally deductible under Sec. 24402(a) due to Farmer Bros.

Assuming that the entity receiving the dividend owns more than 50 percent of the dividend payor, 100 percent of the dividends would be deductible under Sec. 24402(a).

If the dividend-receiving corporation owns 50 percent or less of the entity paying the dividend, then the Sec. 24402 deduction is limited by 24402(b), and the remainder of the qualifying dividend may be deductible under Sec. 24411 if the ownership requirements of that section are met.

For Sec. 24411 to be operative, the domestic unitary group must own more than 50 percent of the foreign subsidiary. However, Sec. 24402 only looks at the ownership relationship of the entity receiving the dividend.

For example, P owns 60 percent of CFC. P's subsidiary, S1, owns 40 percent of CFC, CFC pays a total dividend of $1,000. For tax years ending prior to Dec. 1, 1999, all of P's $600 dividend qualifies for Sec. 24402 deduction. But only $320 of S1's $400 dividend qualifies as a Sec. 24402 deduction because Sec. 24402(b) limits the amount of the deduction to 80 percent for ownership between 20 percent and 50 percent of the dividend-paying corporation.

The remaining $80 dividend would qualify for Sec. 24411 treatment because CFC is more than 50 percent owned by the group.

For tax years ending on or after Dec. 1, 1999, the Sec. 24411 dividend deduction would still apply to the entire dividend since no deduction is allowable under Sec. 24402.

Foreign Investment Interest Offset Under Sec. 24344(c)

Sec. 24344(c) is the foreign investment interest offset, which disallows part of the overall interest deduction that is related to the water's-edge dividends not included in the measure of tax under Sec. 24411. (Reg. Sec. 24344(c)(2)(F) limits the dividends to which the interest offset applies to the amount deducted under Sec. 24411, not the amount of qualifying dividends).

Because most dividends will be deducted under Sec. 24402, there will be almost no Sec. 24411 deductions for tax years ending prior to Dec. 1, 1999. To the extent that there are no Sec. 24411 deductions, there will be no Sec. 24344(c) adjustment. For tax years ending on or after Dec. 1, 1999, the regular foreign investment interest offset under Sec. 24344(c) still applies.

Expenses Related to Income Not in the Measure of Tax

Sec. 24425 disallows expenses incurred to earn income not in the measure of tax. The court in Great Western Financial Corp. v. FTB, (1971) 4 Cal. 3d 1, held that expenses allocated to earning dividend income deductible under Sec. 24402 were not allowable deductions, because the deductible dividend was in a class of income not included in the measure of tax. Sec. 24425 should be used to disallow expenses related to the Sec. 24402 deduction.

For tax years ending before Dec. 1, 1999, where the Sec. 24411 deduction has been replaced by a Sec. 24402 deduction, the interest disallowance under Sec. 24425 would operate instead of the foreign investment interest offset under Sec. 24344(c).

The amount of interest expense to disallow in accordance with Sec. 24425 may be approximate to the interest disallowed by Sec. 24344(c) depending on the taxpayer's facts and circumstances. The main difference between the two provisions deals with direct tracing.

Sec. 24344(c) and the related regulations provide detail of how direct tracing of interest expense is accomplished for foreign investment offset purposes.

The State Board of Equalization in the Appeal of Zenith National Corporation (98 SBE 001-A, June 25, 1998, order denying the petition and clarifying the decision at 98-SBE-001, Jan. 8, 1998), explained the methodology for direct tracing in accordance with Sec. 24425.

This report is courtesy of the Franchise Tax Board. For more information, visit www.www.ftb.ca.gov.
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Title Annotation:CaliforniaTax
Publication:California CPA
Geographic Code:1U9CA
Date:Aug 1, 2004
Words:1865
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