Did a California partnership's long-term notes secured by California real estate produce California-source income requiring withholding for its nonresident partner?

Plain-English summary

California Chief Counsel Ruling 20-0531 concluded that a California partnership's income from long-term notes secured by California real estate was not California-source income to its nonresident partner.

The notes were qualifying debt securities, and the partnership qualified as an investment partnership under Revenue and Taxation Code section 17955.

Because the income came from the notes rather than the real estate collateral, FTB said no California nonresident withholding was required.

The partnership's investments

The nonresident taxpayer was a partner in a California general partnership.

All partnership assets were notes acquired from third parties and secured by California real estate. Another California entity serviced the loans.

The partnership had never owned the real estate, did not engage in lending, and held the notes as long-term investments.

The partner's distributive share consisted of interest and possible gain or loss from disposition or worthlessness of the notes, reduced by partnership expenses.

Section 17955 investment-partnership rules

Section 17955 treated a nonresident partner's income from qualifying investment securities as non-California-source income even when the partnership had a usual place of business in California.

The ruling described an investment partnership as one meeting both a 90-percent qualifying-asset test and a 90-percent qualifying-income test.

Qualifying investment securities included debt securities, and FTB treated the notes as debt securities even though California real estate secured them.

Why the California collateral did not control

FTB said the notes produced the income; the real estate merely secured the debt.

The partnership did not make real estate loans regularly or systematically and did not buy and sell notes as an ongoing business.

Its California organization also did not change the result.

FTB explained that income produced by the real estate itself would have been sourced differently, but that was not the transaction presented.

Loan servicing remained investment activity

FTB concluded that the loan-servicing activity was insufficient to become more than investment activity, regardless of whether agency law attributed it to the partnership.

Section 17955 allowed activities related to acquiring, managing, and disposing of qualifying investment securities without destroying investment-partnership treatment.

Holding

Because the notes were the partnership's sole assets, FTB concluded that the partnership qualified as an investment partnership and its income was from qualifying investment securities.

The nonresident partner's distributive share was not California-source income, and no withholding was required.

The ruling conditioned that conclusion on the investment activity not being interrelated with a separate California trade or business of the partner or an entity in which the partner owned an interest.

What this means for you

Investment partnerships

Document the qualifying-asset and qualifying-income tests, acquisition history, holding period, servicing arrangement, and absence of a regular lending or note-trading business.

Nonresident partners

California formation, administration, or collateral did not alone establish California-source income under these facts. The income-producing asset and the partnership's activities mattered.

Tax professionals

Test separately whether investment activity is interrelated with another California business. That condition was essential to FTB's no-withholding conclusion.

Common questions

Q: Did California real estate collateral make the note income California-source?

A: No. FTB said the notes, not the collateral, produced the income.

Q: Were the notes qualifying investment securities?

A: Yes. FTB treated them as debt securities under section 17955.

Q: Did California loan servicing destroy investment-partnership status?

A: No. On the submitted facts, it remained investment activity.

Q: Did organizing the partnership in California change the result?

A: No. FTB said the partnership's California organization was not important to the determination.

Q: Was the no-withholding conclusion unconditional?

A: No. It depended on the investment activity not being interrelated with a separate California trade or business of the partner or a related entity.

Key source language

• Debt-security conclusion: “The notes held by the partnership are debt securities within the meaning of Revenue and Taxation Code section 17955 because the term "securities" is broad enough to include notes secured by real estate.”
• Collateral: “The fact that the notes are secured by California real estate is of no importance since the income is produced by the notes, not the real estate.”
• Holding: “Because the notes are the sole assets of the partnership, the partnership qualifies as an investment partnership within the meaning of Revenue and Taxation Code section 17955, and the income therefrom as income from qualifying investment securities.”
• Result: “Accordingly, no withholding of tax is required.”

Citations and references

• Cal. Rev. & Tax. Code §§ 17851, 17955, 18662, and 21012(a)(1)
• Cal. Code Regs., tit. 18, § 17951-3
• I.R.C. § 702(b)
• Appeal of H. F. Ahmanson & Co. (Cal. St. Bd. of Equal., Apr. 5, 1965)
• Appeal of Pick (Cal. St. Bd. of Equal., June 25, 1985)
• Appeal of Bass, 89-SBE-004
• Appeal of Bills (Cal. St. Bd. of Equal., Apr. 5, 1965)

Source

• Landing page: Chief Counsel Ruling index
• Official ruling: Chief Counsel Ruling 20-0531

Original ruling text

STATE OF CALIFORNIA
KATHLEEN CONNELL
FRANCHISE TAX BOARD
Chair
Legal Branch
DEAN ANDAL
PO Box 1720
Member
Rancho Cordova, CA 95741-1720
(916) 845-5316 Fax (916) 845-3648
B. TIMOTHY GAGE
Member

December 28, 2000
Chief Counsel Ruling
20-0531

Dear ***,

In your letter dated **, you questioned whether ** distributive share of partnership income from **. constitutes income from qualifying investment securities within the meaning of Revenue and Taxation Code section 17955 such that **** is not subject to California withholding.

*** is a nonresident partner in **., a California general partnership. All of assets consist of notes it acquired secured by California real estate. The loans are serviced by another California entity, ***. .
** distributive share of income consists of interest from the notes and possibly gain or loss from the disposition or worthlessness of the notes, offset by expenses paid to . In our telephone conversation and confirming letter dated
***, you stated that the partnership never owned the real estate which is the security for the loans and does not engage in lending activities, but acquired the notes from third parties. You also indicated that the notes are being held on a long-term basis. 1

Revenue and Taxation Code section 18662 and the regulations thereunder require persons to withhold tax from payments to nonresidents which constitute income from California sources.

Generally, partnership income has a source where the partnership property is located and where the operations are carried on. (Appeal of H. F. Ahmanson & Co., Cal. St. Bd. of Equal., April 5, 1965; Appeal of Pick, Cal. St. Bd. of Equal., June 25, 1985.)

However, in Appeal of Bass, 89-SBE-004, the Board of Equalization held that a nonresident's distributive share of income from a California partnership that maintained an office in California, employed individuals in California and owned tangible property in California was not income from California sources because the income was from

1
In Appeal of Bass, supra, for example, securities held an average of 5.78 years were considered to be held on a long-term basis.

Page 2

December 28, 2000
Control Number 20-0531
Page 2

investments and the activities were related solely to monitoring and servicing the investments.

In addition, Revenue and Taxation Code section 17955 provides that partnership income of a nonresident which constitutes income from qualifying investment securities is not income from California sources even if the partnership has a usual place of business in this state. (Subd. (a)(2).) To qualify under this section, the partnership must be an investment partnership, meaning that at least 90% of its total assets consist of qualifying investment securities and that at least 90% of its gross income consists of interest, dividends, and gains from the sale of qualifying investment securities. (Subds. (c)(1)(A), (B).)

This section does not apply, however, to income derived from investment activity that is interrelated with any trade or business activity in this state separate and distinct from the acts of acquiring, managing and disposing of qualified investment securities. (Subd. (b).)

Income from qualifying investment securities is defined to include interest and gains from qualifying investment securities. Qualifying investment securities includes, among other items, debt securities. (Subd. (c)(3)(A)(ii).) A security is defined broadly to include evidences of obligations to pay money. (Black's Law Dict., Fifth Ed., 1979, p. 1215.)

The notes held by the partnership are debt securities within the meaning of Revenue and Taxation Code section 17955 because the term "securities" is broad enough to include notes secured by real estate. Critical to our determination is that the partnership acquired the notes in question and is holding them on a long-term basis. Based upon your representations, this is not a situation where a commercial lender is making real estate loans on a regular and systematic basis nor a situation where an entity is buying and selling notes as part of an ongoing business activity. The fact that the notes are secured by California real estate is of no importance since the income is produced by the notes, not the real estate. (Appeal of Bills, Cal. St. Bd. of Equal., April 5, 1965.) 2 The fact that the partnership was organized in California is likewise not important to this determination.

Whether or not the servicing of the loans by ** is attributable to ** under agency law, such activity is insufficient under either the Appeal of Bass, supra, or Revenue and Taxation Code section 17955 to constitute more than investment activity. The language of section 17955 dealing with place of business in this state contemplates that the partnership may conduct some degree of activity without losing investment partnership status. In addition, subdivision (b) permits a partnership to engage in activities relating to the acquisition, management and disposition of qualified investment securities

2
If the income were produced by the real estate, the income would have a source in California because the source of such income is where the real estate is located. (Title 18 California Code of Regulations section 17951-3.)

Page 3

December 28, 2000
Control Number 20-0531
Page 3

without disturbing the character of the income as that from qualified investment activity. In the Appeal of Bass, supra, the partnership maintained an office and employees in California and monitored the investments as well.

Because the notes are the sole assets of the partnership, the partnership qualifies as an investment partnership within the meaning of Revenue and Taxation Code section 17955, and the income therefrom as income from qualifying investment securities. 3 The income also qualifies as investment income within the meaning of the Appeal of Bass, supra. Accordingly, no withholding of tax is required.

This ruling is conditioned on the premise that the investment activity of the partnership is not interrelated with any trade or business activity of *** or an entity in which
***** owns an interest in this state.

Please be advised that the tax consequences expressed in this Chief Counsel Ruling are applicable only to the named taxpayer and are based upon and limited to the facts you have submitted. In the event of a change in relevant legislation, or judicial or administrative case law, a change in federal interpretation of federal law in cases where our opinion is based upon such an interpretation, or a change in the material facts or circumstances relating to your request upon which this opinion is based, this opinion may no longer be applicable. It is your responsibility to be aware of these changes should they occur. This letter is a legal ruling by the Franchise Tax Board Chief Counsel within the meaning of Revenue and Taxation Code section 21012(a)(1). Please attach a copy of this letter and your request to the back of the appropriate return(s) (if any) when filed or any notices or inquiries which might be issued.

Very truly yours,

Richard Gould
Senior Tax Counsel

3
The income from the notes is properly characterized as either interest or gain or loss from the disposition or worthlessness of the notes under the partnership characterization rule of Internal Revenue Code section 702(b), to which California conforms. (Revenue and Taxation Code section 17851.)