Legal ruling 413

Allocation and Apportionment Treatment of Installment Sales

Facts

A taxpayer doing business in States A, B, and C sells a substantial portion of its business assets located in State B. An election is made to report the gain on the sale on the installment basis.

Questions

1. In what year is the sale included in the receipt's factor?
   
   
2. What year's factors are utilized to apportion the gain as it is reported?

Decisions

1. The sale should be included in the year of sale regardless of the date of receipt subject to Regulation § 25137(c) (1) (A).
   
   
2. The factors of the year of sale should be utilized in apportioning the gain or loss regardless of the installment sale election.

Discussion

1. In the Appeal of Donald M. Drake Company, March 2, 1977, the State Board of Equalization stated:

   "The general rule of the Uniform Act, is that a taxpayer's apportionment factors for any income year will reflect the items of property, payroll, and sales which relate to its business activity in that particular year."

   "A taxpayer's use of completed-contract accounting does not require an exception to the general rule for determining its apportionment factors. Completed-contract accounting is no more than a device for determining in what year profit or loss will be recognized, and items of receipt and expense are generally not ignored in pre-completion years simply because the profit or loss they produce is deferred."

This reasoning applies with equal force to installment reporting. It is the taxpayer's business activities within and without California, not the taxpayer's accounting method, which should determine the taxpayer's apportionment percentage for each income year. All the activities which give rise to the gain realized on the installment sale occur or are concluded in the year of sale. Therefore, the sale should be included in full in the year of the sale.

Proceeds from the sale of assets which would not otherwise be included in the receipts factor under Regulation § 25137(c) (1) (A) are not to be included even though installment reporting is elected.

2. Income from installment sales is reported at least in substantial part in a year other than the year in which the sale took place. Apportionment of installment sale income on the basis of the factors in the year the income is reported or received would result in such income being apportioned by activities which had no connection with the earning of the income. The Board of Equalization held in Drake, supra, that the use of an apportionment factor which does not fully reflect the activities which give rise to the income was a distortion and that therefore a variance from the standard formula under § 25137 is authorized.

The Board of Equalization in Drake, supra, approved the use of a method which  reflected all the activities which give rise to the income. Based upon the Board of Equalization's reasoning in Drake, supra, the gain or loss from an installment sale should be apportioned on the basis of the factors of the year of sale regardless of the year in which such gain or loss is actually reported.

A taxpayer which in the regular course of business makes installment sales as a dealer in tangible personal property may normally apportion the gain on the basis of the factors of the year the gain is received since its apportionment factors will not normally vary significantly on a year-to-year basis.

The application of this memorandum is illustrated by the following example:

X is doing business in States A, B, and C. During Year 1, X has sales of $2,000,000 (including $1,000,000 from the sale of a plant at year end excluded from the sales factor under Regulation § 25137(c)(1)(A)) in State A, $3,000,000 in State B, and $5,000,000 in State C. X realized a gain of $500,000 on the sale of the plant. X elects to report the $500,000 gain on the installment basis with equal payments received in Years 2 and 3. X has sales of $100,000 in State A; $4,900,000 in State B; and $5,000,000 in State C in Year 2; and sales of $200,000 in State A; $3,000,000 in State B; and $6,800,000 in State C in Year 3. Assume the property and payroll factors are equivalent to the sales factors for each year X would report income from the installment sale to States A, B, and C, in the following manner:

Year 1 -- Gain from Installment Sales 0

	A	B	C
Sales Factor	1,000,000	3,000,000	5,000,000
	9,000,000	9,000,000	9,000,000
Apportionment Factor	11	33	56
Installment Sale Gain	0	0	0

Year 2 -- Gain from Installment Sale $250,000

	A	B	C
Sales Factor	100,000	4,900,000	5,000,000
	10,000,000	10,000,000	10,000,000
Apportionment Factor	1%	49%	50%
Installment Sale Gain (Year 1 Factor X Gain)	27,500	82,500	140,000

Year 3 -- Gain from Installment Sale $250,000

	A	B	C
Sales Factor	200,000	3,000,000	6,800,000
	10,000,000	10,000,000	10,000,000
Apportionment Factor	2%	30%	68%
Installment Sale Gain (Year 1 Factor X Gain)	27,500	82,500	140,000