Legal Ruling 379

Franchise Tax - Interest Equivalent Offset Computation Under Section 24344(b)

The parenthetical phrase, "except dividends deductible under the provisions of Section 24402," in Revenue and Taxation Code Section 24344(b), refers to dividends of the type allowed as a deduction by § 24402, irrespective of the commercial domicile of the recipient corporation.

Section 24344(b) of the Revenue and Taxation Code provides:

(b) If income of the taxpayer is determined by the allocation formula contained in Section 25101, the interest deductible shall be an amount equal to interest income subject to allocation by formula, plus the amount, if any, by which the balance of interest expense exceeds interest and dividend income (except dividends deductible under the provisions of Section 24402) not subject to allocation by formula. Interest expense not included in the preceding sentence shall be directly offset against interest and dividend income (except dividends deductible under the provisions of Section 24402) not subject to allocation by formula.

In determining the interest allowable under the second step, the section provides that interest paid shall be reduced by dividend and interest income received. It is further provided by way of the parenthetical phrase that dividend income shall first be reduced by the § 24402 deduction.

The question at issue is whether the parenthetical phrase refers to dividends received by a foreign domiciliary corporation. In December of 1958 the department published Legal Ruling No. 128. The legal ruling provides in part:

. . . Since dividends with a situs outside the State were not included in income in the first instance, no part of such dividends are deductible under Section 24121j, therefore, the entire amount must be used to measure the amount of interest expense to be disallowed under alternative computation No. 1. The regulation specifically sets forth that the exception as to Section 24121j dividends was not applicable to dividends with a situs outside the State.

This ruling was based in part on Cal. Admin. Code, tit. 18, Reg. 24121(b). Regulation 24121(b) has since been repealed. Regulation 24344(a)(2) issued in April of 1972 does not contain the situs requirement of Regulation 24121(b).

The most recent case considering the § 24344(b) interest offset was Pacific Telephone and Telegraph v. Franchise Tax Board, 7 Cal. 3d 544 (1972). At page 555 of that decision, the court, in referring to a foreign domiciliary corporation, stated:

. . . At the outset it must be pointed out that the fact that the corporation declaring the dividend does no business in the state points in the direction of tax consequences in California rather than away from such consequences. Under Section 24402, dividends declared from income due to California activities are deductible, and subsection (b) in the parenthetical phrase expressly excludes those dividends from the subsection computation. Thus, the dividends which have tax consequences under the franchise tax are those which are not declared from income due to California activities. . . . (Emphasis added.)

By virtue of this statement, the court indicates that dividends declared out of California taxed income will be allowed as a deduction to foreign domiciliary corporations in computing the interest offset. This interpretation follows the original explanation of the parenthetical phrase given at the time of its enactment in 1937. The allowance of a § 24402 deduction on foreign situs dividends in the interest offset computation is also consistent with the purpose of § 24402.

The Revenue and Taxation Code § 24344(b) parenthetical phrase shall include dividends of the type allowed as a deduction by § 24402, regardless of the commercial domicile of the recipient corporation, and to the extent of any inconsistency with Legal Ruling No. 128, this ruling shall prevail.