United States: Favorable Guidance for Water’s-Edge Taxpayers in California

On October 20, 2004, the California Supreme Court denied petitions for review and depublication in Fujitsu IT Holdings, Inc. v. Franchise Tax Board (2004 Cal. LEXIS 10228, 2004 D.A.R. 12885 (Cal. Oct. 20, 2004)). (Until reaching the California Supreme Court, the case name was Amdahl Corp. v. Franchise Tax Board). This decision leaves undisturbed a First District Court of Appeal case (120 Cal. App. 4th 459) that provides generally favorable guidance for taxpayers who have elected to file a water’s-edge combined report in California.

The Court of Appeal held for the taxpayer on three of the four issues before the court. The issues with particular significance for California taxpayers are whether dividends paid out of unitary income of lower-tier subsidiaries that are partially included entities in the water's-edge group should be excluded from both the numerator and denominator of the recipient's inclusion ratio and the proper ordering rules for California's dividends-received deduction (DRD) provisions.

Under the provision that describes the entities that will be includible in a water’s-edge group (Cal. Rev. & Tax. Code section 25110), a controlled foreign corporation (CFC) must be included in the water’s-edge combined report if some portion of its income is Subpart F income as defined in Section 952 of the Internal Revenue Code (IRC). The income and apportionment factors of the CFC are included in the water’s-edge combined report on the basis of a ratio, the numerator of which is the CFC’s Subpart F income and the denominator of which is the CFC’s earnings and profits (the inclusion ratio).

The IRC’s Subpart F provisions require the U.S. shareholder of a CFC to take into account certain CFC income when it is earned by the CFC, rather than when it is distributed. When an actual distribution is made from the CFC, however, the U.S. shareholder will not be required to include such distribution in its income to the extent that it is considered previously taxed income (PTI). The PTI exclusion is particularly important where dividends are distributed from a lower-tier CFC to a first-tier CFC. In these circumstances, the PTI rules prevent the U.S. shareholder from including the amount as Subpart F income twice — once when it is earned by the lower-tier CFC and again when it is received as a dividend by the first-tier CFC.

For purposes of computing the inclusion ratio, the Franchise Tax Board’s (FTB) position was that California adopted only IRC section 952’s definition of Subpart F income. As such, the fact the federal PTI rules operate to exclude certain dividends from a U.S. shareholder’s income is irrelevant for purposes of the California inclusion ratio because the excluded dividends nevertheless meet the federal definition of "Subpart F income" under IRC section 952.

The Court of Appeal affirmed the trial court’s holding that when a CFC receives a dividend that was paid by a lower-tier CFC out of earnings wholly included in the combined income of the water’s edge group such dividend is excluded from the income and inclusion ratio of the recipient. The Court of Appeal based its holding on two grounds. First, in adopting the federal definition of "Subpart F income," absent clear statutory language to the contrary, California adopted into its definition the federal exclusions, including for PTI distributions. Second, Cal. Rev. & Tax. Code section 25106 requires that dividends paid out of unitary income be "eliminated from the income of the recipient and . . . shall not be taken into account under Section 24344 [the provision that addresses interest expense disallowance] or in any other manner in determining the tax of any such corporation."

The Court of Appeal also addressed how dividends received by the unitary group from a CFC should be treated where only a portion of the payor CFC’s income is included in the water’s-edge combined report. The taxpayer argued that the dividends should be treated as being paid first out of unitary income. The FTB asserted the dividend should be prorated between earnings included in the income of the water’s-edge group and earnings that have not been included.

The distinction between these two arguments arises from California’s statutory provisions addressing the deduction of dividends. As noted above, Cal. Rev. & Tax. Code section 25106 provides for the complete elimination of dividends paid out of income of the unitary business. Cal. Rev. & Tax. Code section 24411, on the other hand, provides for only a 75 percent deduction of dividends received by the water’s-edge group (whether or not the dividend was paid from the income of the unitary business).

Siding with the taxpayer, the Court of Appeal held dividends would be deemed to be paid first out of the already taxed income of the unitary group and, therefore, should be completely eliminated from the income of the recipient to the extent of such unitary income. If the dividend exceeded the amount of CFC income included in the water’s -edge combined report, Cal. Rev. & Tax. Code section 24411 would operate to provide a 75 percent exclusion for the excess.

Taxpayers following prior FTB guidance for calculating the income of the water’s-edge group, both with regard to calculating inclusion ratios and eliminating dividends, should consider filing refund claims for any open years. Be forewarned, however, that the FTB is likely to utilize expense disallowance provisions (contained in Cal. Rev. & Tax. Code Sections 24425 and 24344(c)) to diminish the benefit of the 75 percent deduction for dividends received by the water’s-edge group.

In addition to the impact this holding has for water’s-edge taxpayers faced with computing inclusion ratios for CFCs, the underlying analysis of the Court of Appeal’s reliance on federal PTI exclusions may have broader implications. Prior to this decision, there has been little guidance in California on whether California’s adoption of an IRC provision (Provision 1) which, in turn, incorporates another IRC section (in the text of the federal statute itself or in treasury regulations) (Provision 2) means California also incorporates Provision 2. This decision would appear to indicate that, at least in some circumstances, Provision 2 will be given some effect for California tax purposes, even though not specifically incorporated into the Revenue and Taxation Code.