United States: California Clarifies Post-Apportioned Excluded Cancellation-Of-Debt Income Used To Reduce Tax Attributes

The California Franchise Tax Board (FTB) has issued a technical advice memorandum (TAM) addressing the reduction of certain tax attributes in instances when cancellation-of-debt-income (CODI) is excluded from gross income for California purposes.¹ The guidance clarifies that post-apportioned, rather than pre-apportioned, excluded CODI should be used to reduce the tax attributes.

Federal Treatment of CODI

The general definition of gross income provided by Internal Revenue Code (IRC) Section 61 specifically includes "income from discharge of indebtedness," which is another term for CODI.² For example, if a creditor no longer pursues a debtor for an outstanding debt, or if a creditor cancels a debt in exchange for the performance of services, the debtor must treat the forgiven debt as an item of income on its federal return.³

However, IRC Section 108(a)(1) provides a few exceptions to the recognition of CODI as income. Specifically, CODI is not included in gross income if the debt is discharged in specific instances such as Title 11 bankruptcy⁴ or insolvency.⁵ Further, IRC Section 108(b)(1) requires that certain tax attributes be reduced to the extent CODI was excluded from gross income. IRC Section 108(b)(2) specifies that certain tax attributes, including the following, must be reduced by the amount of CODI excluded from gross income in the order listed: (i) net operating losses (NOLs);⁶ (ii) certain tax credits;⁷ (iii) capital loss carryovers;⁸ and (iv) basis reductions.⁹

California Treatment of CODI

California law incorporates the provisions of IRC Sections 61 and 108 by reference, but lists certain exceptions.¹⁰ Also, California law requires that taxpayers that derive income from sources within and outside California use apportionment to determine the portion of federal modified taxable income attributable to the state.¹¹ The FTB's TAM addresses whether the tax attributes should be reduced by pre-apportioned or post-apportioned excluded CODI. In instances where IRC Section 61 is applicable without the provisions of IRC Section 108 such as bankruptcy or insolvency, CODI would be included in the California apportionable base, which would then be apportioned to arrive at the California state taxable income. Therefore, the FTB concluded that CODI should be apportioned along with the rest of the income items when computing the California state tax liability.

As discussed above, IRC Section 108(b)(1) requires that certain tax attributes be reduced to the extent CODI was excluded from gross income. Therefore, for California purposes, the FTB's guidance clarifies that CODI excluded under IRC Section 108 should also be excluded for California purposes on a post-apportioned basis, and should then reduce the post-apportioned California tax attributes specifically enumerated by California law.¹²

Commentary

The guidance provided by the FTB is useful because it clarifies an issue often faced by taxpayers, concluding that tax attributes should be reduced with post-apportioned, rather than pre-apportioned, excluded CODI. As explained by the FTB, because CODI is apportioned generally, it follows that post-apportioned excluded CODI should be applied to reduce tax attributes. Furthermore, certain tax attributes that must be reduced, such as NOL carryovers and capital loss carryovers, are post-apportioned amounts. Therefore, using post-apportioned excluded CODI to reduce NOL carryovers and capital loss carryovers provides a consistent approach.

While the approach may be consistent, it may not be favorable for all taxpayers. Using post-apportioned amounts raises the possibility that in certain instances, taxpayers will reduce their state tax attributes in a manner that is materially different from their federal tax attributes. For example, in some cases, a CODI reduction of attributes for federal income tax purposes may only require a reduction of a portion of the federal NOL, while the CODI reduction of attributes for California corporation franchise tax purposes may require elimination of the entire California NOL and California tax credits.

It should be noted that many states do not provide specific guidance on reducing tax attributes with excluded CODI, leaving taxpayers without an ironclad method of performing the calculation that would be immune from challenge by state tax authorities. The California TAM can serve as useful reference when considering the reduction of tax attributes by excluded CODI items in other states that have similar apportionment provisions. Also, this guidance can be used when evaluating the tax treatment of CODI for financial statement purposes.

Footnotes

1. Technical Advice Memorandum 2015-02, California Franchise Tax Board, Dec. 22, 2015.

2. IRC § 61(a)(12).

3. Treas. Reg. § 1.61-12.

4. IRC § 108(a)(1)(A).

5. IRC § 108(a)(1)(B).

6. IRC § 108(b)(2)(A).

7. IRC § 108(b)(2)(B), (C).

8. IRC § 108(b)(2)(D).

9. IRC § 108(b)(2)(E).

10. CAL. REV. & TAX. CODE §§ 24271(a); 24307(a). For example, California specifically decouples from IRC § 108(i), which provides for the temporary deferral and ratable inclusion of income arising from business indebtedness discharged by the reacquisition of a debt instrument. CAL. REV. & TAX. CODE § 24307(i).

11. CAL. REV. & TAX. CODE § 25101.

12. See CAL. REV. & TAX. CODE § 24307(a).

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