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FTB Notice 2000-9

letseal.gif (14667 bytes) STATE OF CALIFORNIA
FRANCHISE TAX BOARD - Legal Branch
PO Box 1720
Rancho Cordova CA 95741-1720
(916) 845-3309 Fax (916) 845-3648

KATHLEEN CONNELL
CHAIR

DEAN ANDAL
MEMBER

B. TIMOTHY GAGE
MEMBER

December 19, 2000

FTB NOTICE 2000-9

SUBJECT: At its meeting on September 19, 2000, the Franchise Tax Board adopted a policy regarding the application of section 24344, subdivision (b), of the California Revenue and Taxation Code in light of the United States Supreme Court's decision in Hunt-Wesson, Inc. v. Franchise Tax Board, 120 S. Ct. 1022 (2000).  The policy provides:

  1. For all taxpayers subject to Division 2, Part 11 of the Revenue and Taxation Code ("Bank and Corporation Tax Law"), Staff will continue to apply Rev. & Tax. Code § 24344(b) (the "interest offset" rule).
  2. For all tax years beginning on or after February 22, 2000, and for prior periods if the taxpayer asserts a constitutional violation by the application of Rev. & Tax. Code § 24344(b) based upon Hunt-Wesson, Inc. v. Franchise Tax Board, 120 S. Ct. 1022 (2000), no interest expense deduction will be disallowed through application of Rev. & Tax. Code § 24344(b) as an offset against interest and/or dividend income not subject to apportionment by formula and not allocable to California (i.e., interest and/or dividend income allocable outside of California).

Section 24344 is a general rule dealing with the deductibility of interest expense. Like all general rules of deductibility, this section is a deduction in arriving at net income.  "Net income," by definition, is net income from all sources, before allocation and apportionment.[1]  Most general deduction rules do not affect sourcing principles.  Sourcing is done after net income from all sources has been determined.  Thus, except to the extent provided in subdivisions (b) and (c) of section 24344, section 24344 does not differentiate between business and nonbusiness interest expense.  Regulation section 25120(d) classifies general "allowable deductions" as business or nonbusiness, without exclusion of interest expense.  This is part of the sourcing process, separating business income from nonbusiness income that reside in the general pool of "net income." 

Section 24344, subdivision (a), generally allows a deduction for interest expense, "except as otherwise provided."  Thus, this statute is subject to provisions of the California Revenue and Taxation Code that operate to defer, deny, or capitalize interest expense, including provisions that conform to section 163 of the Internal Revenue Code.  Interest expense attributable to foreign investments must then be offset against dividends deductible under section 24411 (section 24344, subdivision (c), which by its terms supercedes the provisions of section 24344, subdivision (b)).

The remaining interest expense is subject to any limitations contained in section 24344, subdivision (b).  The first sentence of that subdivision provides that for apportioning corporations, interest expense (otherwise deductible under the Revenue and Taxation Code) shall be allowed as a deduction to the extent of business interest income, plus the amount by which the remaining interest expense exceeds interest and dividends not apportionable by formula (i.e., nonbusiness interest and dividends).  The amount disallowed under the first sentence is directly offset against nonbusiness interest and dividends.  In Hunt-Wesson v. Franchise Tax Board, 120 S. Ct. 1022 (2000), the U.S. Supreme Court held with respect to a corporation domiciled outside of California, that because the provisions of section 24344, subdivision (b), unreasonably assigned interest expense on a dollar-for-dollar basis to nonbusiness interest and dividends, the method prescribed by that subdivision resulted in taxation of extraterritorial income in violation of both the Commerce Clause and the Due Process Clause of the Fourteenth Amendment of the United States Constitution.

In response to Hunt-Wesson, the Franchise Tax Board has determined that --

  1. because the Court did not consider the first clause of the interest offset (allowing a deduction to the extent of business interest income), the Franchise Tax Board will continue to apply that portion of section 24344, subdivision (b), to all taxpayers;
  2. because the Hunt-Wesson Court did not reach the constitutionality of section 24344, subdivision (b), as it applies to nonbusiness interest income and nonbusiness dividend income that are allocable to California, the Franchise Tax Board will continue to apply section 24344, subdivision (b), in those circumstances; and,
  3. because the Hunt-Wesson Court held that to the extent that section 24344, subdivision (b), would assign interest expense to nonbusiness interest and dividends allocable to another state it is unconstitutional, such interest expense is to be taken into account in determining net business income.

Regulation section 25120(d) is used to assign interest expense between business and nonbusiness income that is not described in section 24344, subdivision (b).  Regulation section 25120(d) will continue to be applied to the extent there is interest expense in excess of that assigned to business interest income and nonbusiness interest and nonbusiness dividend income.

Because section 24344, subdivision (b), speaks specifically to the assignment of interest expense to business interest income, nonbusiness dividend income and nonbusiness interest income, Regulation section 25120(d) will not be applied to assign interest expense to such items of income or to assets that would have the potential to give rise to such income.

The Franchise Tax Board's policy deals only with the treatment of interest expense that section 24344, subdivision (b), assigned to business interest income and to nonbusiness interest income and nonbusiness dividend income.  Except as may be modified by this notice, all other provisions of law relating to the deductibility of interest expense shall continue to be applied as they were before the decision in Hunt-Wesson was rendered.  

This Notice is illustrated by the following Examples:

Assumptions:      $400 Total Interest Expense
                                $200 Interest expense directly traceable to nonbusiness stock
                                $  50 Interest expense directly traceable to a
                                        nonbusiness mortgage assigned to California
                                $100 Business interest income
                                $100 Nonbusiness dividend income

The only nonbusiness items are the nonbusiness stock and property securing the mortgage.

                    California Apportionment Percentage - 50%

                                        Non-California Domiciliary

Interest Assignment

Business Assigned

Nonbusiness Assigned

Unassigned Interest

Total Interest Expense

   

$400

Business Interest Income

$100

 

$300

Nonbusiness Dividends & Interest

$100

 

$200

Mortgage 25120(d)

 

$50 (California)

$150

Residue

$150

 

0

Total

$350

$50 (California)

 

Total Deduction attributable to California  ($350 X 50%) + 50  = $225

                                           California Domiciliary

Interest Assignment

Business Assigned

Nonbusiness Assigned

Unassigned Interest

Total Interest Expense

   

$400

Business Interest Income

$100

 

$300

Nonbusiness Dividends & Interest

 

$100 (California)

$200

Mortgage 25120(d)

 

$50 (California)

$150

Residue

$150

 

0

Total

$250

$150 (California)

 

Total Deduction Attributable to California ($250 X 50%) + $150 = $275

[1]  Under section 24341 of the Revenue and Taxation Code, "net income" is defined as "gross income, computed under Chapter 6 (commencing with section 24271), less the deductions allowed under this article and Article 2 (commencing with section 24401)."  Under section 24271, "gross income" has the meaning provided by section 61 of the Internal Revenue Code.  Section 61 of the Internal Revenue Code, in turn, provides that "gross income" includes "all income from whatever source derived."  Only after net income has been determined do the apportionment and allocation provisions apply.  Section 25101 provides that if a taxpayer has income from sources within and without the state, "the tax shall be measured by the net income derived from or attributable to sources within the state in accordance with the provisions of Article 2 (commencing with section 25120)."