Legal Ruling 1958-13

Dividend Income: Parent Subsidiary

From the facts presented, the net difference between the amount of tax computed by the parent corporation on consolidated returns and that amount computed separately by the subsidiaries and remitted to the parent corporation is to be treated as dividend income under section 24402 of the Bank and Corporation Tax Law.

The parent files consolidated returns for Federal purposes only, and thereby affects a considerable Federal tax saving.  However, none of this tax saving is passed along to the subsidiaries as each subsidiary computes its Federal tax liability separately (nonconsolidated) and remits this sum to the parent company pursuant to a written agreement to that effect.  The parent then computes the proportionate part of the consolidated Federal tax liability allocable to the subsidiary and the net difference is treated as dividend income. The subsidiaries treated the item as an unallowable deduction.

A number of the subsidiaries do their entire business in California and all of the earnings and profits would be included in the measure of the franchise tax of the subsidiary which has enabled the parent annually to claim a large deduction under the provisions of section 24402.

Advice is requested as to whether the net difference is to be treated as dividend income to the parent and as dividends for the purposes of the provisions of section 24402.

There are numerous cases which hold that a distribution out of earnings and profits may be taxable to the shareholders as dividends even though (1) they purport to be based upon a consideration and are not designated as dividends, (2) they are not in proportion to the stockholdings, or (3) there is no formal declaration of a dividend.

A more difficult question arises as to whether the amounts may be treated as dividends for the purposes of the deduction provisions of section 24402. That section provides for a deduction to the recipient of dividends declared from income which has been included in the measure of the tax upon the declaring corporation. Here the dividends were not declared as such, and if the above section is literally construed, the deduction would be denied.

The intent and purpose of the deduction is to avoid double taxation of dividend income which has already been included in the measure of the franchise tax (Corp. of America v Johnson (1936) 7 C2d 295). If this purpose is to be fulfilled in the instant case the deduction should be allowed.

The section should not be literally and technically construed as limited to formally declared dividends. The cases reveal many legitimate dividend payments which were not formally declared as such. The particular wording of the statute was apparently intended to emphasize and limit the income out of which the dividend may arise rather than to specifically require a "declared" dividend (see 21 Cal. Law Review 548).

There may be some question as to whether the amounts are out of income "included in the measure of the tax." The estimated tax computed on a separate basis by the various subsidiaries and remitted to the parent is applicable only where the subsidiary has income and we should reasonably assume that the payment of the amounts to the parent are out of that income.