Were dividends passed from controlled foreign corporations through domestic parents to the ultimate parent eliminated under section 25106 when every entity was fully included in a worldwide California combined report?

Plain-English summary

California Chief Counsel Ruling 2006-0001 addressed dividends moving from controlled foreign corporations through domestic parent corporations to the publicly traded ultimate parent of a worldwide unitary group.

FTB ruled that the dividends created unitary income at each tier and qualified for elimination under Revenue and Taxation Code section 25106. The same cash could retain its unitary character as it moved up the ownership chain even though the dividend was eliminated from the recipient's taxable income at an earlier tier.

FTB also confirmed California's E&P ordering rule: current E&P first, followed by accumulated annual layers in reverse chronological, last-in-first-out order.

The worldwide combined group

The redacted ultimate parent owned many domestic and foreign corporations, with as many as seven ownership tiers between a lower entity and the parent.

The parent and its unitary affiliates filed a single worldwide California combined report. In the distribution year, lower-tier CFCs paid dividends to their domestic parents, and the domestic parents immediately paid dividends of the same amounts to the ultimate parent.

Every dividend payor and recipient was included in the worldwide combined report. Each CFC had always been included in a California combined report with the domestic parent receiving its dividend, and the CFC E&P had accumulated during that combined-report relationship.

All the dividends were reported as business income on the California corporation return.

Why section 25106 applied at every tier

Section 25106 eliminates a dividend between corporations whose tax is determined with reference to each other's income and apportionment factors, to the extent the dividend is paid from the unitary business's income.

FTB reasoned that an eliminated intercompany dividend remained income and E&P in the recipient for purposes of a later distribution. Receiving the CFC dividend increased the domestic parent's E&P, creating a pool from which it could immediately pay the ultimate parent.

Because the CFC dividend would have been apportionable business income to the domestic parent but for section 25106, the domestic parent's next dividend was paid from income determined with reference to the income and factors of both corporations.

The distributions consequently created unitary income in each recipient and were eliminated as they passed to the ultimate parent.

Fully included worldwide reporting was essential

The holding depended on all payors and recipients being fully included in the worldwide combined report.

FTB distinguished the right to include an item in the unitary apportionment calculation from the actual imposition of tax on that item. A statutory elimination did not destroy the item's unitary-income character when the relevant entities and their income and factors were otherwise fully included.

The ruling did not extend to a domestic parent's own older E&P that accumulated before that parent was included in a combined report with the ultimate parent. A dividend paid from such a separate layer would not be eliminated under section 25106.

Earnings-and-profits ordering

California applied the ordering rules incorporated through I.R.C. section 316:

1. Current E&P funds a dividend first.
2. Accumulated E&P is then used from the most recent annual layer backward on a LIFO basis.
3. If a dividend consumes only part of one year's E&P, it is drawn proportionately from all classes of E&P in that annual layer, without regard to the exact date during the year when each income item arose.

The proportional rule applied if an E&P pool contained both apportionable unitary business income eligible for section 25106 and nonbusiness income receiving different treatment.

Holding

FTB held that the CFC dividends to the domestic parents and the immediate dividends from those parents to the ultimate parent created unitary income and were eliminated under section 25106.

It also held that California uses current-first and then LIFO E&P ordering in applying section 25106.

What this means for you

Multinational groups

The worldwide combined-report election and full inclusion of foreign subsidiaries were central to this holding. Do not assume the same result for a water's-edge group or a partially included foreign corporation.

Corporate tax departments

Maintain entity-by-entity E&P histories, unitary and combined-report dates, CFC-to-parent ownership chains, annual E&P composition, dividend timing, and proof that each payment was made from a qualifying layer.

Multitier structures

Test every link. A domestic parent can pass unitary E&P upward after receiving an eliminated dividend, but a separate historic E&P layer may produce a different result under the ordering rules.

Common questions

Q: Did the first section 25106 elimination prevent the domestic parent from having E&P?

A: No. FTB treated the received dividend as increasing the domestic parent's E&P even though it was eliminated from income.

Q: Why did the final dividend to the ultimate parent qualify?

A: The domestic parent's dividend was paid from unitary E&P created by the CFC dividend while all relevant entities were fully included in the worldwide combined report.

Q: Did the ruling cover a domestic parent's own older E&P?

A: No. It expressly excluded older E&P that had not been included in a combined report with the ultimate parent.

Q: Which E&P is used first?

A: Current E&P first, then accumulated E&P from the most recent year backward on a LIFO basis.

Q: Does this ruling establish the result for a water's-edge filer?

A: No. The ruling involved a fully included worldwide combined group.

Citations and references

• Cal. Rev. & Tax. Code §§ 24271, 24451, 24452, 25106, 25110, and 25120(a)
• I.R.C. §§ 61, 312, and 316
• Treas. Reg. §§ 1.312-1, 1.312-6(b), and 1.316-2(b)-(c)
• Cal. Code Regs., tit. 18, §§ 25120(a) and 25120(c)(4)
• Willamette Industries, Inc. v. Franchise Tax Board, 33 Cal. App. 4th 1242 (1995)
• Rosemary Properties v. McColgan, 29 Cal. 2d 677 (1947)
• Safeway Stores, Inc. v. Franchise Tax Board, 3 Cal. 3d 745 (1970)
• Henry C. Beck Co. v. Commissioner, 52 T.C. 1 (1969), aff'd, 433 F.2d 309 (5th Cir. 1970)
• Appeal of CTI Holdings, Inc., 96-SBE-004 (Feb. 22, 1996)
• FTB Legal Ruling 376 (Aug. 5, 1974)

Source

• Landing page: Chief Counsel Ruling index
• Official ruling: Chief Counsel Ruling 2006-0001

Original ruling text

STATE OF CALIFORNIA
STEVE WESTLY
FRANCHISE TAX BOARD
Chair
PO Box 1720
Rancho Cordova, CA 95741-1720
JOHN CHIANG
Telephone (212) 575-1613
Member
FAX (916) 843-6033
MICHAEL C. GENEST
Member

February 28, 2006

Chief Counsel Ruling 2006-0001

Re: ***********

Dear *****:

This Chief Counsel Ruling is issued in response to your request for a legal opinion dated ***. In general, the request asks for an opinion as to the applicability of California Revenue and Taxation Code ("CRTC") section 25106 1 to certain dividend transactions as well as the proper earnings and profits ("E & P") ordering rule for dividend payments. We conclude that, subject to audit verification of the factual representations made in the request for ruling and as more fully described below, the dividends passing up the corporate chain from lower tier subsidiaries to the ultimate parent, ***., are properly eliminated under section 25106. We also conclude that California follows an E & P ordering rule for dividend payments similar to federal treatment, where dividends are deemed paid out of current E & P first and are then "layered back" on a last-in first-out ("LIFO") basis.

FACTS

******* is a publicly traded corporation that is the ultimate parent of a substantial number of domestic and foreign corporations, with up to seven tiers of ownership between a particular entity and **. **
** and its unitary affiliates filed a single, worldwide unitary California franchise tax return for the fiscal year ended ***. A single, worldwide unitary return will also be filed for the fiscal year ending ******.

During the fiscal year ending ***, a significant number of dividend payments were made among the members of the * unitary group; however,
** was the ultimate recipient of these dividend payments. The dividend payments in question originated from lower tier subsidiaries ("CFCs") and involved subsequent dividend payments of the same amount up the chain of ownership until the

1
Hereinafter all references to section numbers shall refer to the California Revenue and Taxation Code unless otherwise indicated.

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dividend reached its final destination via a dividend to *** from its first tier subsidiaries ("Domestic Parents").

All dividend payors and recipients were included in a single, worldwide unitary California franchise tax return for the fiscal year ended ***, and will also be included in a single worldwide unitary California franchise tax return that will be filed for the fiscal year ending ****. All of the dividends will be reported on Form 100 California Franchise or Income Tax Return as business income.

Each CFC that distributed a dividend to a Domestic Parent has always been included in a California combined report with the Domestic Parent to which the CFC paid the dividend. As such, the earnings and profits of each CFC accumulated during and prior to the fiscal year * were accumulated while those CFCs were included in a California combined report that included the Domestic Parent to which the CFC paid a dividend. Prior to the taxable year, **filed its combined report with one or more of the Domestic Parents. Beginning in * and each year thereafter, ** combined report included all CFCs and Domestic Parents.

**, in turn, received dividends from Domestic Parents attributable to the dividends received by Domestic Parents from CFCs in fiscal year . Each Domestic Parent is included with **and all dividend distributing CFCs in a California combined report.

The CFCs paid dividends to their respective Domestic Parents (all of whom have always been included with their respective CFCs in a California combined report), and then these Domestic Parents paid dividends to the ultimate parent, ***, immediately after receiving the dividends from CFCs.

RULINGS REQUESTED

1. Dividends paid to the Domestic Parents by the CFCs and the subsequent dividends
   paid to the ultimate parent **from the Domestic Parents in fiscal year create "unitary income" within the meaning of section 25106 for **and the Domestic Parents, respectively, such that all such dividends qualify for elimination under section 25106 (i.e., "paid out of the unitary business").

2. California follows an E & P ordering rule for dividend payments similar to federal
   treatment, whereby dividends are deemed paid out of current E & P first and then are "layered" back on a most recently accumulated or LIFO basis.

HOLDING

1. Dividends paid to the Domestic Parents by the CFCs and the subsequent dividends
   paid to the ultimate parent **from the Domestic Parents in fiscal year create "unitary income" within the meaning of section 25106 for **and the

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Domestic Parents, respectively, so that all such dividends qualify for elimination under section 25106.

2. In the application of section 25106, California follows the federal earnings and profits
   ordering rules on a LIFO basis.

LAW AND ANALYSIS

Question 1:

Section 25106 provides:

In any case in which the tax of a corporation is or has been determined under this chapter with reference to the income and apportionment factors of another corporation with which it is doing or has done a unitary business, all dividends paid by one to another of those corporations shall, to the extent those dividends are paid out of the income previously described of the unitary business, be eliminated from the income of the recipient and, except for purposes of applying Section 24345, shall not be taken into account under Section 24344 or in any other manner in determining the tax of any member of the unitary group.

To qualify for elimination under Section 25106, a dividend must be paid from "income" of a unitary business, and that "income" must have been determined by reference to the income and apportionment factors of both the dividend payor and the dividend recipient. (Id.; Willamette Industries, Inc. v. Franchise Tax Bd. (1995) 33 Cal.App.4th 1242.) However, Internal Revenue Code (IRC) section 316 (incorporated into the Revenue and Taxation Code by reference under Section 24451) defines a dividend as a distribution by a corporation out of its earnings and profits. This requires an analysis of both the concept of "earnings and profits" and the term "income" as it is used in Section 25106.

Although "earnings and profits" is not precisely defined by statute, the meaning of the term has generally evolved by administrative practice of the Internal Revenue Service, by regulations, case law, and as prescribed by adjustments required under IRC section 312 2 (see Bitker and Eustice, Federal Income Taxation of Corporations and Shareholders, 6th Ed. ¶8.03[1]). In practice, earnings and profits are determined by using taxable income as a starting point, and by making a series of positive and negative adjustments thereto (Id., ¶8.03[2]). For the most part, by incorporation of IRC sections 312 and 316, California follows the federal adjustments to arrive at earnings and profits. However, California does not adopt the adjustments to earnings and profits prescribed by the federal consolidated return regulations adopted under IRC section 1501 (in a similar context, see Appeal of Rapid American, 96-SBE-19, Oct. 10, 1996,

2
Also incorporated by reference into the Revenue and Taxation Code by Section 24451.

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pet. for reh. den. 96-SBE-19A, May 8, 1997, in which the State Board of Equalization held that the consolidated return investment stock basis adjustments required under Treasury Regulation section 1.1502-32 do not apply for combined report purposes).

Under California law, for purposes of determining the amount of earnings and profits of a corporation, unitary attributes of a corporation are disregarded, and earnings and profits are determined on a separate entity basis (Appeal of Young's Market Company, 86-SBE-199, Nov. 19, 1986). This rule applies even if the amount of income apportioned to a taxpayer member of a unitary group under Chapter 17 of the Corporation Tax Law exceeds the separate entity earnings and profits of that member (see, generally, Safeway Stores, Inc. v. Franchise Tax Bd. (1970) 3 Cal.3d 745, in which the court authorized a special rule [often described as the "Safeway fomula"] in the application of Section 24402 to deal with that eventuality).

Section 25106 allows the "elimination" of a dividend paid out of certain unitary "income." Yet, the item entitled to relief under that section (i.e., a "dividend") is itself described by IRC section 316, which refers to an amount paid out of "earnings and profits." However, as noted above, the terms "income" (i.e., "taxable income") and "earnings and profits" are not synonymous.

To reconcile the difference, it is instructive to look to the analogous application of a similar phrase contained in Section 24402. Under that section, dividends are deductible if "declared from income" that has been included in the measure of franchise tax (chapter 2), the alternative minimum tax (chapter 2.5), or the income tax (chapter 3). In the cases of Burton E. Green Investment Co. v. McColgan (1943) 60 Cal.App.2d 224, and Rosemary Properties v. McColgan (1947) 29 Cal.2d 677, because of the effects of percentage depletion, the dividend payor's earnings and profits were substantially larger than the amount of net income upon which the dividend payor actually paid tax. The taxpayer received a dividend larger than the amount of the payor's net income, but sought a dividend-received deduction under Section 8(h) of the Bank and Corporation Franchise Tax Act (a predecessor to Section 24402) for the entirety of its dividend.

The Franchise Tax Commissioner argued that the term "income" in that section meant something different than "earnings and profits." Because only a fraction of the income associated with the taxpayer's earnings and profits was subject to tax, the Commissioner argued that the taxpayer was entitled to a deduction only in the ratio of its net income subject to tax to its total earnings and profits. The court of appeal and the California Supreme Court, respectively, disagreed, holding that the term "income," as used in Section 8(h), did not mean "net income" subject to tax. Instead, in the words of the Rosemary Properties court, "any dividend paid from "earnings and profits"—an item of gross income entering, like the authorized deductions, into the determination of net income—would be a dividend paid out of income included in the measure of the tax." (Rosemary Properties, supra, at 682. Emphasis added.)

In Legal Ruling 376, August 5, 1974, a similar issue was presented with respect to a dividend that was deducted under Section 24402 in arriving at net income. The ruling

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held that the dividend was "income included in the measure of the tax" for purpose of Section 24402, despite the fact that the dividend was not an item of statutory "net income" to the dividend recipient, and "tax" is not literally imposed on such a dividend. Thus, the earnings and profits attributable to receipt of such a dividend was considered to be "income included in the measure of the tax" as the dividend is passed up a chain of ownership of corporations subject to California taxation (Legal Ruling 376, supra, questions one and two).

Thus, for example, if a dividend is paid from a lower-tier subsidiary to an intermediate- tier subsidiary, and then to a parent corporation (assuming that all of the corporations are California taxpayers and none of the above are members of a unitary group), the dividend paid by the middle-tier subsidiary, to the extent attributable to the income of the bottom-tier subsidiary, is eligible for a Section 24402 deduction, even though the middle tier subsidiary did not pay tax on that amount. The ruling relied on Rosemary Properties, supra, for that proposition ("It follows that dividends which are included in California gross income attributable to California sources is 'included in the measure of the taxes' of the recipient corporation even if such dividends are subsequently deducted under either Section 24402 or Section 24110.") Thus, the premise for this treatment, as in Rosemary Properties, supra, was that, although deductible, a dividend eligible for Section 24402 treatment was nevertheless "income" within the meaning of Section 24402 when "declared" as a dividend, on the basis that, had it chosen to do so, California could have subjected the dividend to taxation.

Thus, the meaning of "income" in the context of Section 24402 is broad enough to include all earnings and profits that the state had the right to tax as income from a California source, whether or not it chose to do so (see Safeway Stores, Inc. v. Franchise Tax Bd. (1970) 3 Cal.3d 745, 750-751, describing the deduction as relating to "all income, including earnings and profits, attributable to California sources…." (emphasis in the original).)

The parallel phrasing in both Section 24402 and Section 25106 ("dividends . . . declared from income" and "dividends . . . paid out of . . . income," respectively) suggests that the term "income" in Section 25106 also means something other than statutory "net income" as defined in the Revenue and Taxation Code, and that, as in Section 24402, the term should be more broadly construed.

However, the scope of the term "income" in Section 24402 is not the same as in Section 25106. The latter section describes "income" that is taken into account by reference to "income and apportionment factors" of a unitary corporation. The description of the "income" as relating to the "apportionment factors" of another member of the unitary group indicates that "income" means both (1) business income, as defined by Section 25120(a), that is included in a combined report, 3 and (2) income before apportionment

3
Because "income" includes only income taken into account by reference to income and apportionment factors of another unitary entity, and because the unitary business principle can only reach income

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(i.e., "unitary business income from whatever source"). That is demonstrated by the phrase "income previously described of the unitary business," which indicates that the term "income" referred to the entire income of the unitary business as a whole. 4

Nevertheless, if the term "income" in Section 25106 were construed as broadly as the court in Rosemary Properties construed the term in Section 24402 (i.e., income "entering . . . into the determination of" income subject to apportionment), that section would describe earnings and profits that California would have treated as combined report business income under Section 25120(a), without consideration as to whether the business "income" was otherwise beneficially treated. Thus, "income" would be eligible for elimination under Section 25106 even if the amount of business income included a deduction (like depletion) that exceeded cost basis, or income that was excluded from the computation of the income tax base, but would have been business income but for the exclusion (e.g., dividends deductible under Section 24411 that would constitute business income if subject to taxation).

A key portion of the analysis requires a determination as to whether "income" as described in Section 25106 includes earnings and profits attributable to dividends received from another corporation, where the dividends were themselves eliminated from the "income" of the dividend payor under Section 25106. In the absence of Section 25106, the court in Safeway Stores v. Franchise Tax Board, supra, clearly treated an intercompany dividend as an item of "gross income" within the meaning of the California equivalent of IRC section 61 (now incorporated by reference by Section 24271), even though the dividend was paid between members of a unitary group. Thus, if the Legislature had not enacted Section 25106, an intercompany dividend would clearly be "income." If the broad application of the term "income" utilized in the context of Section 24402 were to be analogously applied to Section 25106, that application would suggest that intercompany dividends that would constitute "income," but for the Section 25106 elimination, would be properly considered "income" in the hands of the recipient.

However, Legal Ruling 376, August 5, 1974, held that a dividend described by Section 25106 could not be considered as "income included in the measure of the tax" for purposes of Section 24402, thereby potentially preventing such a dividend from being deducted under Section 24402. In so holding, the ruling cited a federal consolidated return case (Oscar E. Baan (1965) 45 T.C. 71, 93) for the proposition that the term "eliminated" is to be used in the sense of "nonrecognition." It further cited dictum in Pacific Telephone and Telegraph v. Franchise Tax Board (1972) 7 Cal.3d 544, 558, that

subject to apportionment, the term "income" as described in Section 25106 can include only "business income" as defined in Section 25120(a). (See Cal. Code Regs., tit. 18, § 25120(a).) 4 A similar use of the phrase "income and apportionment factors" occurs in Section 25110, which given the context in which it operates to exclude the income and apportionment factors of certain foreign entities from a combined report, clearly shows that the phrase refers to income that would have been combined report business income before apportionment, but for the effects of the water's edge election.

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stated "Section 25106 provides that intercompany dividends are not income. . . ." The ruling then stated that "[i]n any event it is clear that dividends eliminated from the income of the recipient are not required to be reported in California gross income." (Emphasis added.) The legal ruling then concluded, ". . . Section 25106 dividends are not included in the 'measure of the taxes' within the meaning of Section 24402 as construed by Rosemary."

The citations to Oscar Baan and Pacific Telephone for the proposition that Section 25106 dividends are not "recognized income" and not "gross income," and are therefore not "included in the measure of the taxes," indicates that the ruling was based on the premise that Section 25106 dividends are not "income" for purposes of Section 24402. Given the parallel construction of dividends paid "from income," this analysis could suggest that a Section 25106 dividend might likewise not be considered "income" for purposes of whether the elimination provisions of Section 25106 applied to a dividend paid by a middle-tier corporation to its parent.

Such a suggestion, of course, is contrary to that portion of the legal ruling that clearly held that a dividend passing through a chain of unitary entities that had always been unitary would at least retain Section 25106 character as the dividend passed from one unitary tier to another. From that holding, it could be concluded that such a dividend might be considered "income" for purposes of Section 25106, even though the dividend might not be considered "income" for purposes of Section 24402.

However, the theoretical underpinnings of Legal Ruling 376 may, in fact, have been flawed. The court in Oscar Baan did not deal with intercompany dividends. Rather, the issue in that case was whether intercompany transaction gain was properly considered "not recognized," for purposes of IRC section 355, because it was subsequently "eliminated" in a consolidated return (reflecting the consolidated return regulations in effect prior to 1966). The IRS argued that the "income" at issue in the case was "income" that was "recognized" under the Code for purposes of IRC section 355, despite later being eliminated in consolidated return income. The Oscar Baan court held that intercompany transaction income was "not recognized." The holding in Oscar Baan was rendered moot by a decision of the court of appeal, reversing the tax court, that held that the transaction did not qualify for IRC section 355 treatment for other reasons (Comm'r v. Oscar Baan (9th Cir. 1967) 382 Fd.2d 485).

Whatever the force and effect of the tax court's opinion in Oscar Baan, however, that case's holding was considerably narrowed by Henry C. Beck Co. v. Comm'r (1969) 52 T.C. 1, aff'd (5th Cir. 1970) 433 F.2d 309, in which the court held that intercompany transaction book income was properly considered earnings and profits with respect to a distribution from that company to its parent, despite the fact that the income from the intercompany sale was "eliminated" for purposes of computing income considered in a consolidated return. 5 Thus, even though "eliminated" intercompany gain might be

5
The tax court, relying upon Bangor & Aroostook Railroad Co. (1951) 16 T.C. 578, aff'd (1st Cir. 1951) 193 F.2d 827, distinguished income resulting from an intercompany sale from nonrecognized income that

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characterized as "nonrecognized income" for purposes of IRC section 355, the court characterized the eliminated gain from an intercompany transaction as more of an "economic concept which the tax law has utilized 'to approximate a corporation's power to make distributions that are more than just a return of investment.'" (Id., at 6, quoting Albrecht, "Dividends and Earnings or Profits," 7 Tax L. Rev. 157, 183.) The eliminated intercompany income was nevertheless a "sum which [the intercompany seller], upon receipt, could distribute to its shareholders without impairing its investment." (Henry C. Beck Co., 52 T.C. at 6.)

Thus, the fact that a dividend is "eliminated" from income does not mean that the dividend is not "income" for purposes of earnings and profits. As noted, a dividend is by definition a payment from earnings and profits, and is by definition an amount more than "just a return of [the shareholder's capital] investment." (Id., quoting Albrecht, "Dividends and Earnings or Profits," 7 Tax L. Rev. 157, 183.) To the extent a dividend is paid, the payor's earnings and profits are decreased (Treas. Reg., § 1.312-1), and the payee's earnings and profits are correspondingly increased. An item is "income" in the accounting sense of earnings and profits, even if the item is exempt from taxation (see Treas. Reg., § 1.312-6(b)).

The dictum in Pacific Telephone, supra, cited in Legal Ruling 376, is not particularly significant to the analysis, and should not have had any bearing on the legal ruling's outcome. In that opinion, the court was merely pointing out that Section 25106 both provided that intercompany transaction income was excluded from "income," and that the dividend was removed from the calculation of the interest offset provided by Section 24344(b). The casual observation of the court was merely descriptive of the immediate tax effect of Section 25106 (i.e., exclusion of formerly taxable dividends from the tax base), and not a substantive inquiry as to whether a dividend eliminated under Section 25106 was nevertheless "income" (either gross or net) for any other purpose, including the operation of Section 24402. Thus, the court was not really concerned about whether a dividend eliminated under Section 25106 was income in the first instance, and then eliminated, or whether the dividend was never income to begin with.

Thus, despite the ruling's reservation about characterizing a dividend "eliminated" from income under Section 25106 as "income" for purposes of Section 24402, that conclusion was unnecessary, and perhaps inappropriate. The ruling appeared to have been based on a concern that Section 25106 might be read as displacing the effects of Section 24402, thereby defeating the object of relieving multiple entity taxation as a dividend passed up a chain of unitary entities. However, as seen, the ruling need not have found a conflict between Section 24402 and Section 25106, but instead could

represented merely a deferral of tax reflected in tax basis after a tax deferred exchange. In that case, income will eventually be recognized to the party to the exchange, making it appropriate to delay the effect on earnings and profits until the income is taken into account as taxable income at a later date. Conversely, in the case of an intercompany sale, the seller would never again recognize income from that intercompany transaction, because the "eliminated income" would be reflected in the basis of the intercompany purchaser, not the intercompany seller.

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have seen the sections operating simultaneously, giving effect to both, subject, of course, to the general rule proscribing a double deduction for the same item (see Treas. Reg., § 1.161-1). Accordingly, neither Oscar Baan nor Pacific Telephone affects the analysis that a dividend passing from one unitary entity to another is "paid from the income previously described of the unitary business."

The analysis that a dividend eligible for elimination under Section 25106 is nevertheless "income" is consistent with the Board of Equalization's opinion in Appeal of CTI Holdings, Inc. 96-SBE-004, Feb. 22, 1996. In that opinion, the Board held that a dividend eliminated under Section 25106 was properly considered "income" within the meaning Section 24345. That meant that a foreign tax paid on such dividend was properly considered to have been a tax "on or according to or measured by income or profits" for purposes of the latter section. The Board rejected the taxpayer's argument that Pacific Telephone, supra, stood as authority that such a dividend was not "income."

Turning to the facts of the ruling request, as dividends pass up a chain of unitary entities, to be eligible for elimination under §25106 at each step, each dividend must then be considered "paid out of the income previously described of the unitary business." If the dividend distributions are made from E & P accumulated prior to * by a payor which was not included in **'s combined report, in order for the dividends paid to ***to be eligible for elimination, those dividends must have been considered to have been paid from apportionable unitary income of the ***, Domestic Parents, CFC group during the combined report period during which the CFC dividends were received by the Domestic Parents. 6 Thus, to be eligible for elimination, dividends from the bottom tier subsidiaries must be considered apportionable business income with respect to the Domestic Parents, notwithstanding the elimination of the dividends from the Domestic Parents' income.

As noted, intercompany dividends would be considered gross income under IRC
§61, adopted in California through §24271. With the enactment of UDITPA (as later interpreted by the Appeal of Standard Oil of California, 83-SBE-068, March 2, 1983, and Times Mirror v. Franchise Tax Board (1980) 102 Cal.App.3d 872), dividends and gains on the sale of stock are no longer treated as generally allocable to commercial domicile under the rule of mobilia sequuntur personam (Southern Pacific Corp. v. McColgan (1945) 68 Cal.App.2d 48). Presently, dividends are business income subject to apportionment if the dividend arises from stock that satisfies the conditions of §25120(a) (Cal. Code Regs., tit. 18,
§25120(c)(4)) at the time the dividend is paid. Thus, if a dividend were to be paid between two presently unitary entities, but for the effects of §25106, the dividend would ordinarily be in the apportionable business income of a combined reporting group that consists of both the dividend payor and payee because the functional

6
As noted above, that is necessary because §25106 requires that the "income" from which the dividend was paid must be paid out of combined report business income that is determined "with respect to the "income and apportionment factors" of both the dividend payor and the dividend payee.

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test of the statute would ordinarily be satisfied (see generally, Hoechst Celanese v. Franchise Tax Board (2001) 24 Cal. 4th 508). If that were the case, the tax of the parent member of the unitary group would have been determined by reference to the income and apportionment factors of the dividend payor, and the dividend would have been paid out of the income subject to apportionment.

As discussed above, Legal Ruling 376 construed §24402 to allow a dividend deductible under that section to be considered "income" eligible for another
§24402 dividend when that dividend is paid to a higher tier parent, notwithstanding that the dividend was deductible to the middle tier recipient and was not again "taxed." The theory is that the dividend would have been taxed, but for operation of §24402, to the middle tier, and thus properly considered "gross income" under Rosemary Properties, supra. Given the similarity of the phrase "declared from income" and "paid out of the income," and the fact that dividends are not normally considered paid out of "net income," but are paid with respect to earnings and profits, the construction of the term "income" in §25106 can be reasonably construed more broadly than the term "net income" as defined by §24341. Thus, if an item would have been unitary business income subject to apportionment between members of a combined reporting group but for its exclusion, exemption, deduction, or "elimination" by statutory rule, that item should properly be considered unitary income for purposes of §25106. That is because, with respect to the dividend payor, a new pool of unitary earnings and profits has been created, from which the dividend to the parent is paid.

Note, however, that §25106 would not apply to earnings and profits earned by a member of the unitary group if that member is excluded from the combined reporting group as a result of a water's-edge election under §25110, et seq., notwithstanding that such income "would be" in a combined report, but for the water's edge election. Section 25106 is conditioned upon both the existence of a unitary relationship and having income and apportionment factors being taken into account with respect to both the payee and payor in the computation of tax under chapter 17. Because both income and factors are excluded from a combined report in a water's-edge election, that essential element in §25106 is not satisfied. The same analysis would apply to a partially-included entity, such as a foreign entity with U.S. income and factors (§25110(a)(4)), and a controlled foreign corporation with subpart F income (§25110(a)(6).) To the extent that otherwise unitary income and associated factors are excluded from a combined report, §25106 is not satisfied, and a dividend from that "income" is not eligible for elimination.

One last item deserves consideration. In order to be eligible for elimination under
§25106, "tax" must have been determined under chapter 17 with reference to the income and apportionment factors of a unitary member. This raises the question as to whether tax must actually have been imposed on an apportioned part of that income. If an actual tax were required to be paid on a specific income amount, then, for example, a dividend paid from earnings and profits attributable

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to items that had been excluded or deducted from income under such sections as §24384.5, §24402, §24404, §24406, §24410, or §24411, the dividend would not be eligible for elimination under §25106, even if it would have been apportionable business income in a unitary combined report, because "tax" was not paid on the business income excluded by those sections.

However, with respect to the operation of §24402 under Rosemary Properties, supra, at 682 (including items "entering, like the authorized deductions, into the determination of net income. . . ." (emphasis added), and Legal Ruling 376, a dividend is considered as having been paid from income subject to the "measure of the tax," even if no tax is actually paid with respect to that income, so long as California had the right to tax that income had it chosen to do so. By comparable analysis, "tax . . . determined under this chapter" refers to an amount that, if it were not exempted, would have been part of the determination of business income included in a combined report, and thus would have been apportionable to this state under chapter 17. That construction is consistent with Legal Ruling 376 in that the ruling clearly contemplated that a dividend passing through tiers of unitary corporations would retain its character as paid out of "unitary income" even though the dividend received by the middle tier entity was itself eliminated under §25106, and thus would not itself be subjected to an actual imposition of "tax" in the application of chapter 17.

Thus, "tax . . . determined under this chapter" appears to relate to income subject to the application of the apportionment methodology of Chapter 17, and not to income actually subject to the imposition of tax.

Because the dividends received from the CFCs would have been apportionable business income to the Domestic Parents, but for the operation of §25106, the dividends paid by the Domestic Parents are properly considered paid from "income" determined by reference to the apportionment factors of the CFCs and the Domestic Parents, and thus constitute "income previously described of the unitary business" when that amount is paid as a dividend to **in fiscal year ***.

Consequently, the distributions create "unitary income" within the meaning of section 25106 to each distributee and are properly eliminated under that section. 7

Question 2:

Under Section 24452, California incorporates IRC section 316. That section provides that every distribution is made out of earnings and profits, to the extent thereof, and

7
It should be noted that this ruling addresses only the situation of CFC dividends passing up the ownership chain to ***, the ultimate parent. If one or more of the Domestic Parents paid dividends out of their own pre- E & P which had not been included in a combined report with *
**, the dividends would not be eliminated under section 25106.

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from the most recently accumulated earnings and profits. Thus, earnings and profits are drawn first from current earnings and profits, and then from each year's layer of earnings and profits in reverse order of accumulation (i.e., on a last-in, first-out basis). This principle is a general rule of dividend distributions, and applies to all earnings and profits regardless of character or source. (See generally, Treas. Reg., § 1.316-2(b) and (c), which treat current earnings and profits as evenly earned throughout the year, without regard to the possibility that the specific date that an item of current earnings and profits is earned occurs after the date of a mid-year distribution in that current year.) If dividends are drawn from earnings and profits of a specific year, but are insufficient to consume all of the earnings and profits for that year, earnings and profits are drawn on a pro rata basis from all classes of earnings and profits earned during the year, without regard to the specific date on which an income item giving rise to earnings and profits was realized. (See Safeway Stores, 3 Cal.3d 745 at 753. See also, Treas. Reg., § 1.245-1, subdivision (c)(4), which applies the last-in, first-out principle, and subdivision (d), Example (3), of that regulation, which illustrates application of the ratio principle, without regard to the specific date in a given year that an item of U.S. source income is earned.)

Thus, if a dividend is paid from a pool of earnings and profits that consists of earnings and profits from apportionable business income of a unitary group (eligible for Section 25106 treatment) and nonbusiness income (eligible, if at all, only for Section 24402 treatment 8 ), the dividend is considered ratably drawn from each component of the pool, without regard to the specific date during the year when a given item of income was earned. 9

Please be advised that the tax consequences expressed in this Chief Counsel Ruling are applicable only to the taxpayer (and to the taxpayer members of its combined report group as set forth in Exhibit A attached to your ruling request) and are based upon and limited to the facts you have submitted. All representations of fact, including representations of unitary relationships, are subject to verification by audit examination. 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's Chief Counsel within the meaning of paragraph (1) of subdivision (a) of section 21012 of the Revenue and Taxation Code. Please attach a copy of this letter and your request to the appropriate

8
Although the court in Farmer Bros. Co. v. Franchise Tax Board (2003) 108 Cal. App. 4th 976 held that Section 24402 violated the Commerce Clause of the United States Constitution by discriminating against corporations engaged in interstate commerce, that holding does not impact the principle of proration discussed here. 9 The holding in Fujitsu It Holdings v. Franchise Tax Board, (2004) 120 Cal. App.4th 459, 15 Ca. Rptr. 3d 473 does not address the situation presented here where all members of the unitary group are and have been fully included in the combined report.

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return(s) (if any) when filed or in response to any notices or inquiries which might be issued.

Very truly yours,

Claudia Land
Tax Counsel IV