Can same-year dividends passed through several fully included members of a California unitary group be eliminated under section 25106, and which earnings-and-profits layers fund the dividends first?

Plain-English summary

California Chief Counsel Ruling 2007-5 addressed a sequence of cash dividends moving from lower-tier subsidiaries through intermediate corporations to the ultimate parent of a California combined unitary group.

FTB ruled that each same-year dividend created unitary income in the recipient and qualified for elimination under Revenue and Taxation Code section 25106. The fact that a dividend was eliminated at one tier did not stop it from being income or earnings and profits when it was passed to the next tier.

FTB also confirmed California's ordering rule: dividends come first from current earnings and profits, then from the most recently accumulated annual E&P layer and backward on a last-in, first-out basis.

The dividend chain

The redacted taxpayer was a publicly traded parent with operating subsidiaries. It had acquired another corporation and that corporation's subsidiaries in 1998.

The group planned three immediate cash distributions in the same tax year:

1. A lower-tier subsidiary would distribute cash to its parent.
2. That recipient would immediately distribute the same cash to the next corporation in the ownership chain.
3. The first-tier subsidiary would immediately distribute the cash to the ultimate parent.

Every dividend payor and recipient had been included in the California combined reports since 1998 and would remain included during the distribution year. The requested ruling also stated that each recipient would treat the cash dividend as business income.

Why section 25106 eliminated each dividend

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 still increases the recipient's earnings and profits and remains income for purposes of a later dividend. Otherwise, the statute's protection against multiple taxation would fail when the same cash moved through several fully included unitary corporations.

Because the dividends would have been apportionable business income but for section 25106, each recipient created a new pool of unitary E&P from which it could pay the next dividend. The three distributions therefore qualified for elimination as they moved up the chain.

Important limits

The ruling did not extend section 25106 to every E&P layer in the group.

• If the first-tier subsidiary paid a dividend from its own pre-1998 E&P, accumulated before it was combined with the ultimate parent, that dividend would not be eliminated under section 25106.
• Income and factors excluded by a water's-edge election do not satisfy section 25106's combined-report requirement.
• The same limitation applies to the excluded portion of a partially included foreign entity or controlled foreign corporation.

FTB distinguished whether income was included in the apportionment process from whether California actually imposed tax on that specific item. An exclusion, deduction, exemption, or prior section 25106 elimination did not by itself prevent the item from being unitary income when the state otherwise had the right to include it in the combined-report business-income calculation.

Earnings-and-profits ordering

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

1. Current E&P funds the dividend first.
2. Accumulated E&P is then used year by year, starting with the most recent year and moving backward on a LIFO basis.
3. If one year's E&P pool contains multiple classes or sources, a dividend that does not consume the entire layer is drawn proportionately from those components, without regard to when during that year a particular item arose.

This proportional rule matters when a single annual layer contains both apportionable unitary business income eligible for section 25106 and nonbusiness income that may receive different treatment.

Holding

FTB held that the described same-year dividends to the intermediate subsidiaries and ultimate parent created unitary income and were eliminated under section 25106.

It also held that California applies current-E&P-first and then LIFO ordering when identifying which earnings-and-profits layers fund a dividend.

What this means for you

Combined reporting groups

Track the history of each E&P layer and the years in which each payor and recipient were fully included together in California combined reports. A cash payment's path alone does not establish section 25106 eligibility.

Corporate tax departments

For a tiered distribution, document each step, the same-year timing, each entity's unitary and combined-report status, whether the stock produced business income, and the source-year composition of the payor's E&P.

Water's-edge groups

Do not assume a unitary relationship is enough. Section 25106 also requires the relevant income and apportionment factors to have been taken into account in the combined report.

Common questions

Q: Does a dividend stop being income after section 25106 eliminates it?

A: No. FTB concluded that it still increases the recipient's E&P and can be unitary income supporting the next dividend in the chain.

Q: Must California have actually taxed the exact income item?

A: No. FTB focused on whether the item would have entered the combined-report apportionment calculation but for a statutory exclusion, deduction, exemption, or elimination.

Q: Which E&P is used first?

A: Current E&P first, followed by accumulated E&P on a most-recent-year-first, LIFO basis.

Q: What if one year's E&P includes both unitary business and nonbusiness income?

A: A dividend drawn from that annual layer is allocated proportionately across the layer's components.

Q: Did the ruling cover the first-tier subsidiary's older pre-1998 E&P?

A: No. The ruling expressly said a dividend from that separate pre-combination E&P would not be eliminated under section 25106.

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 2007-5

Original ruling text

STATE OF CALIFORNIA
JOHN CHIANG
FRANCHISE TAX BOARD – Legal Division
Chair
1415 Louisiana Street, Suite 1515
Houston, TX 77002-7351
BETTY T. YEE
Telephone (713) 853-4604
Member
FAX (916) 843-6107
MICHAEL C. GENEST
Member

February 22, 2008

Chief Counsel Ruling 2007-5

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

Dear *****:

This Chief Counsel Ruling is issued in response to your request for a legal opinion as to the applicability of California Revenue and Taxation Code section 251061 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 parent corporation of a federal consolidated group (*) with operating subsidiaries
**********. In 1998, * acquired 100 percent of the stock of ***** (), a corporation with numerous subsidiaries operating ** in various states. *** also wholly owned
**, a holding company, which in turn wholly owned ** (.) Prior to the acquisition by , *** and all of its subsidiaries (**) have always been a unitary group included in the same combined report in California.

1
All statutory references are to the California Revenue and Taxation Code unless otherwise noted. All regulatory references are to Title 18 of the California Code of Regulations unless otherwise noted.

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** and its subsidiaries are contemplating several cash distributions among the members of the * unitary group; however, will be the ultimate recipient of these distributions. The payments will originate from a lower tier subsidiary () and will involve subsequent immediate dividend payments of the same amount up the chain of ownership until the dividend reaches its final destination via a dividend to * from its first tier subsidiary, . Specifically, there will be three steps involved: (1) will make a cash distribution to ; (2) Immediately following the receipt of the distribution from * will distribute the cash to ; and (3) *** will then immediately distribute the cash to the ultimate parent, *.

All dividend payors and recipients have been included in the ** group's combined reports in California since 1998 and will continue to be so included in the year of the distribution. The cash distributions will be treated as business income of each recipient.

Each lower tier subsidiary that will distribute payments has always been included in a California combined report with the parent to which the lower tier subsidiary will pay the dividend. As such, E and P of each lower tier subsidiary was and is accumulated during and prior to the year of distribution while the lower tier subsidiary was and is included in a California combined report that includes the parent to which the dividend will be paid.

**, in turn, will receive dividends from its first tier subsidiary attributable to the dividends received by the first tier subsidiary in the tax year of the distribution. The first tier subsidiary will be included with **** (and the dividend distributing entity) in a California combined report for that same tax year.

RULINGS REQUESTED

1. A ruling is requested that the dividends paid in Steps 1 through 3 will
   create "unitary income" in its entirety within the meaning of section 25106
   for each payee respectively so that all such dividends qualify for
   elimination under section 25106 (i.e., "paid out of the income of the unitary
   business").

2. A ruling is also requested that 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 E & P, i.e., "last-in-first-out" ("LIFO") basis.

HOLDINGS

1. Dividends paid to the middle and upper tier subsidiaries, ** and ,
   respectively, and the subsequent dividends paid to the ultimate parent,
   * in the same tax year will create "unitary income" within the meaning
   of section 25106, so that all such dividends qualify for elimination under
   section 25106.

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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.2 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 concepts 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 312.3 In practice, earnings and profits are determined by using taxable income as a starting point, and making a series of positive and negative adjustments thereto.4 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 section1501 (in a similar context, see Appeal of

2
Willamette Industries, Inc. v. Franchise Tax Board (1995) 33 Cal.App.4th 1242.
3
Also incorporated by reference into the Revenue and Taxation Code by section 24451. See Bitker and Eustice, Federal Income Taxation of Corporations and Shareholders 6th Ed. ¶8.03[1]. 4 Bitker and Eustice, supra, ¶8.03[2]

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Rapid American5, which held that the consolidated return investment stock basis adjustments required under Treasury Regulation section 1.1502-32 do not apply for consolidated return 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.6 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.7

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 ordinary meaning of the terms "income" (i.e., "taxable income") and "earnings and profits" are not synonymous.

Although the court in Farmers Bros. Co. v. Franchise Tax Board8 held that section 24402 violated the United States Constitution by discriminating against corporations engaged in interstate commerce; nevertheless, it remains instructive to look to the analogous application of a similar phrase "declared from income" contained in section 24402 to reconcile the difference between the terms "income" and "earnings and profits."9 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. McColgan10 and Rosemary Properties v. McColgan,11 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

5
96-SBE-19, Oct. 10, 1996, pet. for reh. den. 96-SBE-19A, May 8, 1997.
6
Appeal of Young's Market Company, 86-SBE-199, Nov. 19, 1986.
7
See, generally, Safeway Stores, Inc. v. Franchise Tax Board (1970) 3 Cal.3d 745, which authorized a special rule (often described as the "Safeway formula") in the application of section 24402 to deal with that eventuality. 8 (2003) 120 Cal.App.4th 976
9
The holding in Farmers Bros., supra, does not impact the application of the phrase "declared from income" discussed here. 10 (1943) 60 Cal.App.2d 224.
11
(1947) 29 Cal.2d 677.

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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 from "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,12 emphasis added.)

In Legal Ruling 376, dated 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 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.13

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 are '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

12
Supra, at 682.
13
Legal Ruling 376, supra, questions one and two.

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California source, whether or not it chose to do so (see Safeway Stores, Inc. v. Franchise Tax Board,14 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 sections 24402 and 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 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,15 and 2) income before apportionment (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.16

Nevertheless, if the term "income" in section 25106 were construed as broadly as 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

14
(1970) 3 Cal.3d 745, 750-751.
15
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 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, section 25120(a).) 16 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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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, 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 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 the latter section. In so holding, the ruling cited a federal consolidated return case (Oscar E. Baan17) 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 Board18 that 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 might 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 holding 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

17
(1965) 45 T.C. 71, 93.
18
(1972) 7 Cal.3d 544, 558.

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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. Oscar Baan did not deal with intercompany dividends. 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. v. Oscar Baan.19)

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 Company v. Comm.,20 which 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.21 Thus, even though "eliminated" intercompany gain might be 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…to approximate a corporation's power to make distributions that are more than just a return of investment."22 The eliminated intercompany income was nevertheless a "sum which the

19
(9th Cir., 1967) 382 Fd.2d 485.
20
(1969) 52 T.C.1, aff'd (5th Cir.,1970) 433 F.2d 309.
21
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 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. However, 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. 22 Id., at 6, quoting Albrecht, "Dividends and Earnings or profits," 7 Tax L. Rev. 157, 183.

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[intercompany seller], upon receipt could distribute to its shareholders without impairing its investment."23

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."24 To the extent a dividend is paid, the payor's earnings and profits are decreased,25 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.26

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 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.27 Accordingly, neither Oscar Baan nor Pacific Telephone affects the analysis that a dividend passing from one

23
Id. at 6.
24
Id., quoting Albrecht, "Dividends and Earnings or profits," 7 Tax L. Rev. 157, 183.
25
Treas. Reg. section 1.312-1.
26
See Treas. Reg. section 1.312-6(b).
27
See, Treas. Reg. section 1.161-1.

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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.28 That opinion held that a dividend eliminated under section 25106 was properly considered "income" within the meaning of 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 section 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 1998 by a payor which was not included in * combined report, in order for the dividends to be paid to * to be eligible for elimination, those dividends must be considered to be paid from apportionable unitary income of the * – ** during the combined report period during which the dividends are to be received by the * parents.29 Thus to be eligible for elimination, dividends from the bottom tier subsidiaries must be considered apportionable business income with respect to the middle tier parents, notwithstanding the elimination of the dividends from the middle tier parents' income.

As noted, intercompany dividends would be considered gross income under IRC section 61, adopted in California through section 24271. With the enactment of UDITPA (as later interpreted by the Appeal of Standard Oil of California,30 and Times Mirror v. Franchise Tax Board,31 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.32 Presently, dividends are business income subject to apportionment if the

28
96-SBE-004, Feb. 22, 1996.
29
As noted above, that is necessary because section 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. 30 83-SBE-068, March 2, 1983.
31
(1980) 102 Cal.App.3d 872.
32
Southern Pacific Corp. v. McColgan (1945) 68 Cal.App.2d 48.

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dividend arises from stock that satisfies the conditions of section 25120(a)33 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 section 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 test of the statute would ordinarily be satisfied.34 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 section 24402 to allow a dividend deductible under that section to be considered "income" eligible for another section 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 section 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 section 25106 can be reasonably construed more broadly than the term "net income" as defined by section 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 section 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 section 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 section 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 section 25106 is not satisfied. The same analysis would apply to a partially-included entity, such as a foreign entity with U.S. income and factors35 and a controlled foreign corporation with subpart F income.36 To

33
Cal. Code Regs., tit. 18, section 25120(c)(4).
34
See generally, Hoechst Celanese v. Franchise Tax Board (2001) 24 Cal. 4th 508.
35
Section 25110(a)(4).
36
Section 25110(a)(6).

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February 22, 2008
Chief Counsel Ruling
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the extent that otherwise unitary income and associated factors are excluded from a combined report, section 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 section 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 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 section 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 section 24402 under Rosemary Properties,37 (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 section 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 * and would be apportionable business income to and , respectively, but for the operation of section 25106, the dividends to be paid by *** will properly be considered paid from "income" determined by reference to the apportionment factors of the *, and thus constitute "income previously described of the unitary business" when that amount is paid as a dividend to
****.

37 supra, at 682.

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February 22, 2008
Chief Counsel Ruling
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Therefore, the distributions create "unitary income" within the meaning of section 25106 to each distributee and are properly eliminated under that section.38

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 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.39 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.40

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 treatment41), the dividend is considered ratably drawn from each component of the pool, without regard to the specific date that a given item of income was earned.42

38
It should be noted that this ruling addresses only the situation of * dividends passing up the ownership chain to *, the ultimate parent. If *** pays dividends out of its own pre-1998 E & P, which had not been included in a combined report with ***, the dividends will not be eliminated under section 25106. 39 See generally, Treas. Reg., section 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. 40 See Safeway Stores, 3 Cal.3d. 745 at 753. See also Treas. Reg., section 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. 41 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.

The holding in Fujitsu IT Holdings v. Franchise Tax Board (2004) 120 Cal.App.4th 459 42

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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February 22, 2008
Chief Counsel Ruling
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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'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,

Cynthia D. Kent
Tax Counsel