Does income from an activity that national banks cannot conduct count as financial income merely because it is interest or gain resembling income earned by a bank?

Plain-English summary

California Chief Counsel Ruling 2007-1 held that income classification for the section 23183 financial-corporation test follows the activity that generated the income, not simply the income's label or form.

The taxpayer's disregarded broker-dealer earned income from certain intangible-asset activities that the taxpayer represented national banks were not allowed to conduct.

Even if those activities produced interest income or gains resembling income earned by a bank, FTB treated the income as non-financial because the underlying activities were outside the permitted business of national banks.

The entity structure

The redacted taxpayer was a holding company whose only asset was its interest in a single-member limited liability company.

That LLC was disregarded for federal and California tax purposes, so its income and activities were reported by the holding company. The holding company had no other material income or activities.

The LLC was a registered broker-dealer, exchange member, introducing broker, and primary dealer in U.S. government securities. It underwrote or dealt in multiple kinds of securities and financial instruments and provided brokerage, margin lending, investment banking, and financial advisory services.

The narrow issue

The ruling did not classify every activity of the broker-dealer.

The taxpayer identified particular intangible-asset activities that a national bank was not permitted to conduct and treated them as general or non-financial activities under Regulation 23183.

It asked whether income from those non-financial activities could nonetheless count as financial income merely because it had the same character as bank income, such as interest or gains on sales of intangibles.

The financial-corporation rule

Regulation 23183(a) defined a financial corporation as a corporation that predominantly dealt in money or moneyed capital in substantial competition with national banks, subject to the statutory exceptions.

Subsection (b)(5) defined the business of national banks by the businesses in which national banks were permitted to operate.

Subsection (b)(4) stated that a corporation's activities did not need to be identical to a national bank's activities; competition with some phases of national banking could be enough.

Both provisions focused on business activities rather than on the character of a particular receipt.

Holding

FTB concluded that earning income that looked like bank income did not convert a non-financial activity into an activity conducted in substantial competition with national banks.

Income associated with the represented non-permissible national-bank activities was therefore non-financial income for the gross-income measurement test used to determine financial-corporation status.

The ruling did not determine the taxpayer's ultimate status on facts beyond the specified activities and income classification.

What this means for you

Broker-dealers and financial-services companies

Classify receipts by identifying the exact activity that generated them and whether a national bank may conduct that activity. Do not rely solely on labels such as interest, gain, fee, or securities income.

Corporate tax departments

Maintain activity-level revenue mapping, licenses and registrations, governing agreements, descriptions of each product or service, and authority on whether national banks may conduct each activity.

Disregarded entities

The disregarded entity's activities and income flow to its owner for this analysis. Entity classification did not erase the need to classify the underlying activities.

Common questions

Q: Is all interest income financial income under section 23183?

A: No. The ruling held that the activity producing the income controls, not the income's form alone.

Q: Did the broker-dealer's financial-services registrations decide the issue?

A: No. FTB focused on whether the particular activities at issue were businesses national banks were permitted to conduct.

Q: Can an activity compete with national banks without being identical to bank activity?

A: Yes. The regulation said competition with some phases of national-bank business may be sufficient.

Q: Did FTB independently decide whether national banks could conduct the activities?

A: The ruling proceeded on the taxpayer's representation that they could not.

Q: Did FTB determine the corporation's overall financial-corporation status?

A: The determination addressed how the specified income entered the gross-income measurement test, not every fact bearing on final status.

Citations and references

• Cal. Rev. & Tax. Code § 23183
• Cal. Code Regs., tit. 18, § 23183(a) and (b)(4)-(5)

Source

• Landing page: Chief Counsel Ruling index
• Official ruling: Chief Counsel Ruling 2007-1

Original ruling text

STATE OF CALIFORNIA
JOHN CHIANG
FRANCHISE TAX BOARD – Legal Department
Chair
PO Box 1720
Rancho Cordova, CA 95741-1720
BETTY T. YEE
Telephone (916) 845-5151
Member
TAX (916) 845-3648
MICHAEL C. GENEST
Member

March 12, 2007
**** Chief Counsel Ruling 2007-1

Re: Request for Chief Counsel Ruling on Behalf of ****

Dear Mr. ***,

In your correspondence dated ***, you requested advice concerning the application of the test for determining whether a corporation will be treated as a "financial corporation" under Revenue and Taxation Code Section 23183 and its regulations.

FACTS

** is a broker-dealer entity that is a single-member limited liability company. * is wholly owned by ***. For federal income tax and California franchise/income tax purposes, * is a disregarded entity. As such, 's income and activities are reported by , which has no other material income or activities. is a 'holding company' whose only asset is its interest in ***.

** is registered as a "broker-dealer" with the Securities and Exchange Commission ("SEC') and is a member of * and other exchanges. is also registered as an introducing broker with the , is a primary dealer in U.S. Government securities, and underwrites and/or deals in equity securities, corporate debt securities, mortgage and other asset-backed securities, U.S. Government agency obligations, state and municipal securities, money market instruments, and other financial instruments. also provides brokerage services, margin loans, and various investment banking and financial advisory services in connection with public offerings, mutual fund offerings, mergers and acquisitions, restructurings, private placements, loan syndications, loan trading, derivative product arrangements, and project financings. *** can also offer mutual fund investments and margin loans.

Page 2

March 12, 2007
Chief Counsel Ruling 2007-1
Page 2

In regards to the specific activities at issue in this ruling request, you have represented that ** is conducting activities involving certain intangible assets that a national bank is not permitted to conduct and, as such, these activities would be considered "general" or "non-financial" activities under the test set forth in California Code of Regulations (CCR) Section 23183.

ISSUE

Whether **s income from non-financial activities can give rise to "financial income" for purposes of applying the gross income measurement test in determining "financial corporation" status because the activities produce income that is of the same character (e.g. interest income and gains on sales of intangibles) as income earned by a bank.

LAW AND ANALYSIS

CCR Section 23183 (a) sets forth that a "financial corporation" means a corporation, except as provided in subdivision (b) of California Revenue and Taxation Code Section 23183, which predominantly deals in money or moneyed capital in substantial competition with the business of national banks.

Section (b) of the regulation provides definitions for the various requirements set forth in section (a). In pertinent part, subsection (b)(5) sets forth that the "business of national banks" means the businesses in which national banks are permitted to operate.

Because the "business of national banks" is defined in terms of the operation of a business, rather than simply the characterization of income, it is reasonable to conclude that simply earning income of the same character as a bank is not enough to have the activity that gave rise to the income deemed an activity in substantial competition with the business of national banks.

Further support for this interpretation is found in subsection (b)(4) which defines "substantial competition". This section, in part, provides that:

The activities of a corporation need not be identical to those performed by a national bank in order to constitute substantial competition, it is sufficient if there is competition with some, but not all, phases of the business of national banks…

(emphasis added)

This subsection provides further support for the conclusion that it is activities of the business that are determined to be financial in nature, not the character of the income.

Page 3

March 12, 2007
Chief Counsel Ruling 2007-1
Page 3

DETERMINATION

**'s income associated with non-financial activities (the non-permissible national bank activities conducted by ****) should be considered non-financial income for purposes of applying the gross income measurement test for determining financial corporation status under regulation 23183.

Please be advised that the tax consequences expressed in this Chief Counsel Ruling are applicable only to the named taxpayer and are **ed 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 *ed upon such an interpretation, or a change in the material facts or circumstances relating to your request upon which this opinion is ***ed, 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 return(s) (if any) when filed or in response to any notices or inquiries which might be issued.

Very truly yours,

Carl A. Joseph
Tax Counsel III