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Explanation of the Discussion Draft of the Section 25106.5 Regulation -- Mechanics of Combined Reporting

Attached is a discussion draft of the Section 25106.5 regulations. If adopted, these regulations would provide specific rules to describe the general mechanics of combined reporting, currently reflected in Publication 1061, Guidelines for Corporations Filing a Combined Report.

Because of the continued controversy surrounding Appeal of Finnigan (Cal. St. Bd. of Equal., 88-SBE-022, Aug. 28, 1988, pet. reh. den. 88-SBE-022A, Jan. 25, 1990), Appeal of NutraSweet (Cal. St. Bd. of Equal., 92-SBE-024, October 29, 1992), and FTB Notice 90-3, there are two versions of the regulation attached, one of which adopts the method of California apportionment prescribed by FTB Notice 90-3 (Finnigan/NutraSweet) and the other of which adopts the department's pre-Finnigan approach, reflected in Legal Ruling 234. The later is shown in add-and-strike-out version to show the effects of the revision.

The regulations attached are actually a series of regulations, which would eventually become a main combined reporting regulation, followed by numbered regulations under Section 25106.5 (e.g., Reg. §25106.5-1, §25106.5-2, etc.). The existing regulation §25106.5-3 (foreign combination), would be integrated into this series and renumbered. The dashed series was introduced to avoid encumbering the regulation with exceptional circumstances which will not affect all taxpayers (e.g., accounting method issues, fiscalization, foreign combination). In general, the appearance order of the regulation dashed series is roughly the order referred to in the main regulation. However, because the sequencing of the regulations has yet to be finally determined, and there is a possibility for new items to be introduced, this discussion draft regulation package uses alphabetical sequencing. When and if the regulation is finally noticed, dashed numbering will replace the alphabetical sequencing.

In general, the Finnigan version of the regulation provides that combined reporting is accomplished in a series of steps:

1) Unless provided by rule to the contrary, the separate accounting income of each of the members is first determined under the Revenue and Taxation Code without regard to the income of the other members. Each member's methods of accounting and elections are determined independently of the others, except that all combined reports that include that member's income must treat that income consistently.

2) Income from intercompany transactions is then either deferred or restored. The rules for treatment of intercompany transactions will be a dashed series regulation, and a discussion draft regulation on the subject will be released to the public soon.

3) Capital, Section 1231 and involuntary gains and losses are removed from separate accounting income and dealt with under special rules.

4) Nonbusiness income and loss items are removed. They are accounted for by each member after apportionment is complete at step 11) below.

5) The resulting apportionable business income is then fiscalized (if applicable) to the common accounting period of the "principal member," as defined, and combined. Supplemental rules are provided which deal with the details of fiscalization.

6) The interest offset is applied, if applicable, to remove a portion of the interest expense from combined income.

7) Combined income is apportioned to California using the appropriate apportionment percentage of the group, determined under Section 25128. The regulation specifically applies the rule of Appeal of NutraSweet, i.e., that California sales of an entity exempt from taxation in the state are nevertheless assigned to the state for purposes of apportionment of income of the group, if any member of the group is a taxpayer in this state.

8) California source combined income of the group is intrastate apportioned to the respective taxpayer members, using the member's intrastate apportionment percentage. That percentage is determined by the relative weight of the taxpayer member's California apportionment percentage (as defined) to all taxpayer member's California apportionment percentages.

9) If applicable, the taxpayer member then realigns (refiscalizes) its California source combined reporting income back to its own income year.

10) The taxpayer member then applies its California source income from any other (e.g., nonunitary) combined reporting groups, its California source nonbusiness income, and the interest offset deduction.

11) California source net operating losses (apportioned from the preceding income years), is applied as a deduction against other California source income.

12) The taxpayer member then computes its regular tax liability based on aggregate of its California source income from all activity, and applies any credits which it had earned against the tax so computed.

13) If applicable, the taxpayer member recomputes its income under the same procedures for purposes of the alternative minimum tax. Special rules will be developed to deal with the such issues as adjusted current earnings.

The special rules for capital, etc. gain or loss generally prescribe that netting between classes of income (e.g., Section 1231 gains and capital losses) is not done until after apportionment and allocation is complete. This rule prevents business capital losses from being isolated in the separate account of an individual member, when other members have business capital gains which could offset such losses. The rules are generally consistent with the rules which apply to the sourcing of net operating loss carryover.

There are also special rules to deal with accounting method and other elections when a member of the combined reporting group has been erroneously excluded. For the first period in which an erroneously excluded member is brought into the combined reporting group, if that member has not already committed to an election or method of accounting on a federal return, the taxpayer members may generally make elections on behalf of the excluded member, even though such an elections are normally required with the filing of a timely return. Taxpayers are allowed to make protective accounting elections contingent on the outcome of a dispute as to whether or not an affiliate is properly in the combined reporting group. In that case, taxpayers are permitted to defer the substantiation that is often required with respect to making such an election until the dispute is resolved.

The second version with pre-Finnigan rules (Legal Ruling 234) is substantially the same, except that steps 9) and 10) above are merged in a single step intrastate apportionment, and there is a rule which treats sales of goods by an exempt entity as thrown back to the state of origin, even if the group has an entity taxable in the state of destination.

Although the department's practice is to apply the interest offset on a combined basis under Pacific Telephone and Telegraph v. Franchise Tax Board, (1972) 7 Cal. 3d 544, further regulatory work is expected with respect to the interest offset issue. Thus, the portion of the regulation dealing with interest offset is reserved. The department is also studying whether the Pacific Telephone holding should also apply to the application of Section 24425 to combined reporting groups.

The grouping of the discussion draft regulations, subject to change, is follows.

Main Regulation §25106.5.

-A. Intercompany Transactions.

-B. Capital, etc. gains and losses.

-C. Accounting Methods and Elections.

-D. Fiscalization.

-E. Interest Offset. (Reserved).

-F. California Source Carryover Items. (Reserved).

-G. Charitable Contributions Adjustment. (Reserved).

-H. AMT. (Reserved).

-I. Partial Period Combination.

-J. Foreign Combination. (Current Reg. 25106.5-3, not attached, subject to amendment).

-K. Group Returns (i.e., Schedule R, Sch. R-7 rules). (Reserved).

These discussion draft regulations are preliminary and are offered to the public to provide interested parties with an opportunity to review and provide comment prior to formal public notice. The staff has taken the unusual step of offering alternative regulations, reflecting the Appeal of Finnigan and Appeal of NutraSweet on the one hand and the pre-Finnigan, Legal Ruling 234 methodology on the other, in the hope of stimulating an active discourse on the appropriateness of the respective methods. If there is sufficient interest, the department will hold a public meeting or symposium on the draft regulations prior to commencing the formal notice process. Written comments should be addressed to: Beverly Moore, Franchise Tax Board Legal Division, P.O. Box 1720, Rancho Cordova, CA 95741-1720 or faxed at (916) 845-3648. For further information, you may call Michael Brownell at (916) 845-5245. Please submit any comments by December 1, 1997.