Did a registered broker-dealer include return of capital in sales-factor receipts from principal securities trades, and could intrastate effects alone support alternative apportionment?

Plain-English summary

California Chief Counsel Ruling 2012-01 held that a registered broker-dealer included the entire sales price from its principal securities trades in the sales factor, including return of capital.

The ruling also held that a change in how California-source income was divided among members of the combined group was an intrastate-apportionment issue. That effect, by itself, did not establish the interstate distortion required for relief under Revenue and Taxation Code section 25137.

FTB expressly did not decide whether other aspects of the taxpayer's facts justified alternative apportionment; a separate statutory and regulatory process governed that question.

The broker-dealer's trades

The combined group included a national banking association and its wholly owned registered broker-dealer. The broker-dealer was not treated as a financial corporation under the cited California regulation.

The broker-dealer made two types of transactions:

• Principal trades, in which it bought and sold securities for the company's own account and earned gain or loss.
• Agency trades, in which it bought and sold securities for customers and earned a fee or commission.

Historically, its California sales factor included net gains, but not less than zero, from principal trades; interest and dividends from securities held for sale; and agency-trade commissions.

Effect of including full principal-trade proceeds

The broker-dealer's greater cost of performance occurred in California, so the stated receipts were included in the California numerator and everywhere denominator.

For the years illustrated in the ruling, adding return of capital to principal-trade receipts increased both the broker-dealer's sales factor and the combined group's California apportionment factor.

The taxpayer asked whether that full amount belonged in the standard sales factor and whether the change in income assigned among California members supported section 25137 relief.

Why return of capital was included

For years beginning on or after January 1, 2011, section 25120(f) generally defined sales as gross receipts not allocated under sections 25123 through 25127.

The statute excluded transactions in intangible assets held in a unitary business's treasury function. But it said a taxpayer principally engaged in buying and selling those types of intangible assets—such as a registered broker-dealer—was not performing a treasury function with respect to that income.

Accordingly, the broker-dealer included the entire amount received from its principal securities sales, not merely net gain, under the standard formula.

Interstate versus intrastate apportionment

Section 25137 addressed whether the standard allocation and apportionment rules fairly represented the extent of the taxpayer's activities in California compared with activity outside California.

Intrastate apportionment did something different: it divided the group's already-apportioned California business income among the taxpayer members according to their relative California factors.

Because that member-by-member allocation did not compare California activity with out-of-state activity, its change was not a proper section 25137 distortion analysis by itself.

Holding

Under section 25120(f)'s general rules, the registered broker-dealer included the full sales price from principal trades—including return of capital—in its sales factors.

The resulting intrastate shift among combined-group members did not, by itself, establish distortion sufficient to apply section 25137.

FTB took no position in the ruling on whether the taxpayer otherwise qualified for alternative apportionment or whether FTB might require an alternative formula through the separate applicable procedure.

What this means for you

Broker-dealers

Distinguish securities held as part of the dealer business from intangible assets held in a treasury function. The gross-receipts rule can include principal returned on disposition.

Combined reporting groups

Model both interstate apportionment and the later intrastate allocation among California taxpayers. A shift between members is not automatically evidence that the interstate formula is distortive.

Tax controversy teams

Present section 25137 issues through the designated alternative-apportionment process and ground the claim in how the standard formula represents California versus out-of-state activity.

Common questions

Q: Did the broker-dealer include only its trading gain?

A: No. Under the general rule, it included the entire principal-trade sales price, including return of capital.

Q: Why did the treasury-function exclusion not apply?

A: The statute treated a registered broker-dealer principally engaged in buying and selling those intangible assets as not performing a treasury function for that income.

Q: Did the ruling approve or deny alternative apportionment overall?

A: Neither. It held only that intrastate effects were not a proper section 25137 basis by themselves and expressly took no position on the broader application of section 25137.

Q: What years did the ruling cover?

A: The ruling stated that it applied to the named taxpayer for taxable years ending on or after December 31, 2011.

Citations and references

• 12 U.S.C. § 21 et seq.
• Cal. Rev. & Tax. Code §§ 25120-25139, including §§ 25120, 25128, 25134, 25136, and 25137
• Cal. Code Regs., tit. 18, §§ 23183 and 25106.5(c)(7)
• Appeal of CTI Holdings, Inc., 96-SBE-003 (Feb. 22, 1996)

Source

• Landing page: Chief Counsel Ruling index
• Official ruling: Chief Counsel Ruling 2012-01

Original ruling text

chair John Chiang | member Jerome E. Horton | member Ana J. Matosantos

Legal Division MS L17
300 S. Spring Street, Suite 5704
Los Angeles, CA 90013-1265
tel: (213) 897-5233 fax: (916) 843-0287
[email protected]

04.30.12

Chief Counsel Ruling 2012-01

Subject: Chief Counsel Ruling Request for ****

Dear Mr. *:

You requested by letter dated July 29, 2011, a Chief Counsel Ruling concerning the application of Revenue and Taxation Code (“RTC”) sections 25120 and 25137 to **
****(“Company”). Specifically, you requested a Chief Counsel Ruling advising whether the standard apportionment formula, contained in RTC sections 25120 through 25136, would result in the entire sales price received from certain trades being included in the sales factors of **** pursuant to RTC section 25120(f) and, if so, whether the effect of this inclusion on intrastate apportionment would allow Company to use an alternative method of apportionment under the authority of RTC section 25137.

FACTS

Company consists of *** which is the holding company for *
*, * and various other non-banking subsidiaries. ** is a national banking association, as provided by the National Bank Act,1 and conducts business in California, Nevada, and New York, among other states.

*, a wholly-owned subsidiary of , is a registered broker-dealer and a member of the National Association of Securities Dealers. is not a financial corporation as defined under California Code of Regulations, title 18, section 23183 and does not generate gross business receipts from banking and financial business activity pursuant to RTC section 25128. *** engages primarily in two types of transactions:

1. Principal Trades — * buys and sells securities from the Company’s own account
   and generates gain or loss on the sale of the securities; and

2. Agency Trades — * buys and sells securities to third parties on behalf of its
   customers and collects a fee or commission for each transaction.
   Pursuant to RTC section 25136, the greater cost of performance of *** transactions

1 12 USCS § 21 et seq.

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occurred in California; therefore, receipts from Principal Trades and Agency Trades are included in * California sales factor numerator and denominator. Historically, *** included net gains (not less than zero) from Principal Trades, interest and dividends from securities held for sale, and commissions generated from Agency Trades in the California sales factor.

With * sales factor computed on this basis, Company’s California sales factors for taxable years ended (“TYE”) 12/31/2005 through 12/31/2009 averaged 93.66 percent. If, for example, *** includes the entire amount received from Principal Trades (i.e., net gain plus return of capital) in its California sales factors, Company’s California sales factors for the TYE 12/31/2005 through 12/31/2009 would increase to an average of 97.66 percent (a change of 4 percent and an increase in the factor of approximately 4.3 percent).2

ISSUES

1. Under the standard method of apportionment, should * include the entire sales
   price received from Principal Trades in its sales factors, including return of capital?

2. If return of capital is included in * sales factors under standard method
   apportionment, does this lead to apportionment that, for purposes of RTC section 25137, does not fairly represent the extent of the unitary business’ California business activities because it effects the intrastate apportionment between *** and the financial corporation members of the combined reporting group?

HOLDINGS

1. Under the general rules of RTC section 25120(f), * would include the entire sales
   price received from Principal Trades in its sales factors, including return of capital.

2. Intrastate apportionment is not a proper subject for analysis under RTC section 25137.
   Therefore, the change in intrastate apportionment by including gross receipts from Principal Trades does not, by itself, establish distortion adequate to apply the provisions of RTC section 25137.

LAW AND ANALYSIS

Standard Apportionment

RTC section 25120(f)(1) provides that for taxable years beginning on or after January 1, 2011, sales, for sales factor purposes, is defined as all gross receipts not allocated under RTC sections 25123 through 25127. RTC section 25120(f)(2)(K) provides gross receipts exclude “[a]mounts received from transactions in intangible assets held in

2 Company’s average combined California apportionment factor for TYE 12/31/2005 through

12/31/2009 averaged 93.6820 percent. If * included the entire amount received from Principal Trades in its California sales factors, Company’s combined California apportionment factor for TYE 12/31/2005 through 12/31/2009 would increase to an average of 95.6767 percent.

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connection with a treasury function of the taxpayer’s unitary business and the gross receipts and overall net gains from the maturity, redemption, sale, exchange, or other disposition of those intangible assets.” However, RTC section 25120(f)(2)(K) goes on to state that a “taxpayer principally engaged in the trade or business of purchasing and selling intangible assets of the type typically held in a taxpayer’s treasury function, such as a registered broker-dealer, is not performing a treasury function, for purposes of this subparagraph, with respect to income so produced.” Hence, upon sale of a marketable security, broker-dealers may include the entire sales price in the sales factor, including return of capital, unless such inclusion gives rise to apportionment that unfairly represents the extent of a taxpayer’s activity in California such that the Franchise Tax Board requires an alternative formula under the authority of RTC section 25137.3

Here, * engages in Principal Trades but only includes the net gain or loss from the disposition of these securities. Under RTC section 25120(f)(2)(K), ***, a registered broker-dealer, may include the entire amount received from the sale, including the return of capital, in the sales factor under the standard apportionment formula pursuant to RTC sections 25120 and 25134.

Intrastate Apportionment and RTC Section 25137

RTC section 25137 provides that an alternate apportionment method may be used if the standard method does not fairly represent the extent of the taxpayer’s business in the state. In contrast, intrastate apportionment is not part of the Uniform Division of Income for Tax Purposes Act (UDITPA) (codified in RTC sections 25120 through 25139), but rather is a method to determine the individual California tax liabilities of the taxpayer members of a combined reporting group. The applicable rules for intrastate apportionment are set forth in California Code of Regulations, title 18 (“Regulation”), 25106.5. In general, combined California business income is divided among taxpayer members having activities in California in accordance with the ratio that the California factors of each taxpayer member bears to the total California factors of the group. The specific steps to arrive at each taxpayer member’s California business income are set forth in Regulation section 25106.5(c)(7).

It is well established that RTC section 25137 relief is limited to correcting unfair reflections of activity resulting from the application of the standard allocation and apportionment provisions of UDITPA. (Appeal of CTI Holdings, Inc, 96-SBE-003, Feb. 22, 1996.)

Furthermore, RTC section 25137 by its terms may be invoked only when the standard

3 Franchise Tax Board takes no position in this Chief Counsel Ruling regarding the application of RTC

section 25137 to the facts set forth herein. Chief Counsel Rulings are not an appropriate venue for the analysis of whether or not RTC section 25137 applies in a specific fact pattern. RTC section 25137 and the regulations thereunder provide a separate mechanism whereby a taxpayer may request, or Franchise Tax Board may impose, an alternative apportionment methodology. The determination of the staff of Franchise Tax Board may be reviewed by the three-member Franchise Tax Board itself as set forth in the regulations promulgated under the statute.

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apportionment formula does not fairly represent the extent of a taxpayer’s activities in this state. In other words, RTC section 25137 requires a comparison of a taxpayer’s activity in California to the California activities reflected in the apportionment formula. In contrast, intrastate apportionment involves the assignment of California source apportioned income amongst the California taxpayer members of a unitary group. Income is assigned to the California taxpayer members according to the relative weight of each member’s California factors. Thus, intrastate apportionment is not concerned with in-state versus out-of-state activities or the geographic sourcing of income; it is concerned with the relative weight of the California taxpayer’s in-state activities. Therefore, intrastate apportionment is not a proper subject for analysis under RTC section 25137.

Please be advised that the tax consequences expressed in this Chief Counsel Ruling are applicable only to the named taxpayer for future years4 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,

Shail Shah
Tax Counsel

4 Taxable years ending on or after 12/31/2011.