When did a taxable business-income dividend enter the recipient's California sales factor rather than being excluded as mere stock holding?

Plain-English summary

Legal Ruling 2003-3 says a dividend already classified as taxable business income was not automatically included in the recipient's California sales factor. The recipient also needed income-producing activity connected to the dividend.

Participation in the dividend payor's management or operations was enough. Merely holding the stock was not. FTB also said ordinary shareholder actions—voting the shares, reviewing materials normally sent to shareholders, and recording the dividend—did not rise to the required level.

The ruling applied that distinction to one corporation whose officers or employees served on the payor's board and another corporation that had no management or operational role.

Situation 1: Active management participation

Corporation A received a wholly taxable business-income dividend from Corporation B. A and B were not in the same combined-reporting group, but A's officers or employees were active members of B's board and participated in B's business decisions.

FTB held that A engaged in income-producing activity with respect to the dividend because it participated in B's management and operations. The dividend was therefore included in A's sales factor.

Situation 2: Mere stock holding

Corporation C received a wholly taxable business-income dividend from Corporation S. C had no representative on S's board and did not assist S's operations. Any sales between C and S occurred on the same terms as sales to other buyers.

FTB held that C did not engage in income-producing activity with respect to the dividend. The dividend was excluded from C's sales factor.

Why business-income classification was not enough

The ruling explains that gross receipts producing business income generally fell within the statutory definition of sales. Dividends treated as business income could therefore be sales-factor receipts.

But the regulation stated that merely holding intangible property was not itself an income-producing activity. It also required business income from intangible property to be excluded from the sales factor when the income could not readily be attributed to a particular income-producing activity.

FTB reconciled those rules by asking whether the shareholder did more than hold the stock. Active management or operational participation supplied the missing activity; ordinary incidents of ownership did not.

Activities that did and did not count

Counted as income-producing activity

• Officers or employees serving actively on the dividend payor's board.

• Participation in the payor's business decisions.

• Other involvement in the payor's management or operations.

Did not count by themselves

• Exercising voting rights that came with stock ownership.

• Receiving and reviewing ordinary shareholder materials.

• Accounting for receipt of the dividend.

• Conducting ordinary buyer-seller transactions on the same terms offered to others.

What this means for you

Corporate shareholders reviewing historical factors

Do not stop after classifying a dividend as business income. Under this ruling, inclusion in the sales factor also depended on identifiable activity by the recipient connected to managing or operating the payor.

Minority or passive investments

Ownership rights alone did not create the required activity. Board participation and substantive business involvement were the facts that changed the result.

Tax departments documenting dividends

Keep records showing the recipient's actual role: board seats, management decisions, operational assistance, and the nature of intercompany dealings. The ruling's two outcomes turned on that evidence.

Common questions

Q: Was every taxable business-income dividend included in the sales factor?

A: No. The recipient needed income-producing activity beyond mere holding of the stock.

Q: Did board participation count?

A: Yes. Active board service and participation in business decisions supported inclusion.

Q: Was voting the shares enough?

A: No. FTB treated ordinary voting rights as an incident of ownership, not management or operational activity.

Q: Did ordinary sales between the shareholder and payor establish the required activity?

A: Not in Situation 2, where those sales occurred in the same manner as sales to any other buyer and C did not assist S's operations.

Q: What happened when the recipient merely held the stock?

A: The dividend was excluded from both numerator and denominator of the sales factor under the ruling's analysis.

Q: Does this ruling state today's California dividend sourcing rule?

A: No. It summarizes the 2003 ruling and the law then cited; current law must be checked independently.

Citations and references

• Cal. Rev. & Tax. Code §§ 25120, 25123 through 25127, 25134, and 25136
• Cal. Code Regs., tit. 18, §§ 25134(a)(1)-(2), 25136(b), and 25137(c)(1)(C)

Source

• Landing page: California FTB Legal Rulings
• Official PDF: Legal Ruling 2003-3

Original ruling text

STATE OF CALIFORNIA
STEVE WESTLY
FRANCHISE TAX BOARD - Legal Branch
Chair
PO Box 1720
CAROLE MIGDEN
Rancho Cordova CA 95741-1720
Member
(916) 845-3309 Fax (916) 845-3648
DONNA ARDUIN
Member

December 4, 2003

LEGAL RULING 2003- 3

SUBJECT: Inclusion of Business Income Dividends in the Recipient's Sales Factor

ISSUE

When does income-producing activity exist with respect to a business income dividend so that the dividend is includible in the recipient's sales factor?

FACTS

Situation 1: Corporation A receives a wholly taxable dividend from Corporation B. Assume the stock of B is a business asset in the hands of A, and the dividend is business income, but that A and B are not members of a common combined reporting group. Officers or employees of A are active members of the board of directors of B and participate in the business decisions of B.

Situation 2: Corporation C receives a wholly taxable dividend from Corporation S. The stock of S is a business asset in the hands of C, and the dividend it receives from S is business income. However, C does not have representation on S's board nor does it assist S with its operations in any manner. All sales between S and C are transacted in the same manner as with any other buyer of S's or C’s products.

LAW

Revenue and Taxation Code section 251341 states that the sales factor of California's apportionment formula is computed using a numerator consisting of sales in California and a denominator consisting of total sales everywhere. Section 25120, subdivision (e), defines "sales" as all gross receipts of the taxpayer except those subject to allocation by sections 25123 through 25127. Sections 25123 through 25127 provide rules for the allocation of various items of nonbusiness income. Section 25120, subdivision (d), defines nonbusiness income as "all income other than business income." Therefore, the term "sales" includes all gross receipts from activities that give rise to business income. Regulation section 25134, subsection (a)(1), which states that "the term 'sales' means all gross receipts derived by the taxpayer from transactions and activity in the regular course of . . . [the taxpayer's] trade or business," is consistent.

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All further section references are to the Revenue and Taxation Code, and all references to regulations are to title 18 of the California Code of Regulations, unless otherwise specifically noted.

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Section 25120 defines "business income" as "income arising from transactions and activity in the regular course of the taxpayer's trade or business and includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer's regular trade or business operations." Dividends that are business income fall within the meaning of the term "sales" for purposes of section 25134.

Because the dividends constitute a sale "other than a sale of tangible personal property," they are includible in the sales factor according to the rules set forth in section 25136 and the regulations thereunder. Section 25136 provides that such sales will be sourced for sales factor purposes to the state in which the income-producing activity took place. If the income-producing activity took place in more than one state, the sale is assigned to the state in which the greater cost of performance occurred. Regulation section 25136 further specifies that if income-producing activity occurs in more than one state, the relative amounts of income-producing activity will be measured by ascertaining and comparing the direct cost of such activity in each state.

Regulation section 25134, subsection (a)(2), states that "[i]n some cases certain gross receipts should be disregarded in determining the sales factor in order that the apportionment formula will operate fairly to apportion to this state the income of the taxpayer's trade or business." Regulation section 25136, subsection (b), expressly states that "[t]he mere holding of intangible personal property is not, of itself, an income producing activity." Regulation section 25137, subsection (c)(1)(C), provides that "[w]here business income from intangible property cannot readily be attributed to any particular income producing activity of the taxpayer," such income must be excluded from the numerator and denominator of the taxpayer's sales factor. This regulation section contains the following example: "[W]here business income in the form of dividends received on stock . . . results from the mere holding of the intangible . . . such dividends . . . shall be excluded from the denominator of the sales factor."

DISCUSSION

Based on the language of the Revenue and Taxation Code and its concomitant regulations, business income dividends constitute gross receipts that are generally includible in the sales factor. However, because the "mere holding" of intangible property does not constitute income-producing activity, dividends are includible in the sales factor only when the holder engages in an activity that constitutes more than mere holding. Income-producing activity with respect to a dividend exists when there is participation in the management and/or operations of the dividend payor. However, the exercise of voting rights conferred by ownership of stock, the receipt and review of material normally supplied to a stockholder, and accounting for the receipt of dividend income do not constitute participation in the management and/or operations of the dividend payor and, therefore, do not amount to income-producing activity with respect to a dividend.

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HOLDING

Situation 1: Because A participates in the management and operations of B, it engages in income-producing activity with respect to the dividend so that the dividend is includible in A's sales factor.

Situation 2: Because C does not participate in the management and/or operations of S, it does not engage in income-producing activity with respect to the dividend, and the dividend is not includible in C's sales factor.

CONTACT INFORMATION

For further information regarding this ruling, please contact Carl Joseph at the Franchise Tax Board, Legal Department, P.O. Box 1720, Rancho Cordova, CA 95741-1720.