Legal Ruling 1993-4

Taxation of a Qualified Settlement Fund

Issue

To what extent is a qualified settlement fund (including a designated settlement fund), as defined in Treas. Reg. § 1.468B, subject to tax under Revenue and Taxation Code (RTC) § 24693?

Facts

Pursuant to the order of a California court, FUND is established to resolve or satisfy one or more claims asserting liability of one or more defendants to a class of plaintiffs who are residents and nonresidents of California. Defendants X, Y, and Z transfer funds and intangible property to FUND.

FUND is a qualified settlement fund (QSF) under Treas. Reg. § 1.468B. Modified gross income of the FUND consists of income from intangible property, including obligations of the United States exempted from state tax by section 3124, Title 31, United States Code. During a prior year, FUND had a net operating loss, i.e., the costs of administration, incidental expenses, and losses related to the sale, exchange, or worthlessness of assets exceeded income received by FUND.

Law and Analysis

In General

Internal Revenue Code (IRC) § 468B provides for the taxation of designated settlement funds and directs the Department of the Treasury to prescribe regulations providing for the taxation of an escrow account, settlement fund, or similar fund, whether as a grantor trust or otherwise.

§ RTC § 24693 n1 incorporates IRC § 468B by reference, with modifications to provide that a tax shall be imposed upon the gross income of the fund at a rate equal to the rate in effect under RTC § 23501. This tax is in lieu of any other tax imposed by part 10 (Personal Income Tax) or part 11 (Bank and Corporation Tax) of the RTC upon or measured by that income.

n1 Section 468B of the IRC was originally incorporated in California law by AB 53 (Stats. 1987, Ch. 1138), which added section 17515 to the RTC. Section 17515 was repealed by AB 802 (Stats. 1989, Ch. 1352), which added section 17570 to the RTC. SB 2252 (Stats. 1990, Ch. 1348) repealed section 17570 of the RTC and added section 24693.)

In accordance with IRC § 468B(g), the Treasury promulgated rules for the taxation of qualified settlement funds, including designated settlement funds as defined in IRC § 468B. (See Treas. Reg. §§ 1.468B-O to 1.468B-5, T.D. 8459, 57 Fed. Reg. 60983, December 23, 1992.) Pursuant to RTC § 23051.5(f), these regulations govern the interpretation of comparable provisions in the RTC.

Taxation of Interest on Obligations of the United States

RTC § 24693 imposes tax on "the gross income" of the fund. This tax is in lieu of any other tax imposed by part 10 or part 11 (which includes the corporate franchise tax) upon or measured by that income.

Section 3124, Title 31, United States Code, exempts interest on obligations of the United States from state taxation, other than a nondiscriminatory franchise tax imposed on a corporation.

Since the tax imposed by RTC § 24693 is an income tax, interest on obligations of the United States Government received by FUND is exempt from the tax imposed by RTC § 24693.

Taxation of Qualified Settlement Fund (QSF) Income

Pursuant to Treas. Reg. § 1.468B-1(c)(1), a qualified settlement fund (QSF) is a fund, account, or trust that is established pursuant to an order of, or is approved by, the United States, any state, territory, possession, or political subdivision thereof, or any agency or instrumentality (including a court of law) of any of the foregoing and is subject to the continuing jurisdiction of that governmental authority.

If a fund, account, or trust that is a qualified settlement fund could be classified as a trust (within the meaning of Treas. Reg. § 301.7701-4), it is classified as a qualified settlement fund for all purposes of the IRC and the RTC. If a fund, account, or trust, organized as a trust under applicable state law, is a qualified settlement fund, and could be classified as either an association (within the meaning of Treas. Reg. § 301.7701-2) or a partnership (within the meaning of Treas. Reg. § 301.7701-3), it is classified as a qualified settlement fund for all purposes of the IRC and the RTC. If a fund, account, or trust established for contested liabilities pursuant to Treas. Reg. § 1.461-2(c)(1) is a qualified settlement fund, it is classified as a qualified settlement fund for all purposes of the IRC and the RTC. See Treas. Reg. § 1.468B-1(b).

RTC § 23040 provides that "income derived from or attributable to sources within this State includes income from tangible or intangible property located or having a situs in this State and income from any activities carried on in this State, regardless of whether carried on in intrastate, interstate, or foreign commerce."

Under RTC § 23040, income received by such a QSF from real or tangible property located in California is derived from sources within California and taxable under RTC § 24693. The situs of intangible property for tax purposes is the commercial domicile of the owner unless the intangible property has acquired a business situs elsewhere. See Southern pacific v. McColgan (1945) 68 Cal.App.2d 48 [156 P.2d 81 and 18 Cal. Code Reg. § 23040].

Generally, the commercial domicile of a corporate taxpayer is the corporation's principal office or place of business or from where the corporation's business is managed or controlled. In the absence of evidence of a commercial domicile elsewhere, the commercial domicile of a QSF (including a designated settlement fund) will be presumed to be at the court or the governmental authority which ordered or approved the establishment of the QSF and which exercises continuing jurisdiction over the QSF.

In general, intangible property has a business situs where it is employed as capital or where it is possessed in connection with a business so that it attaches to and becomes an asset of the business. With regard to intangibles used in a unitary business conducted within and without California, see the Uniform Division of Income for Tax Purposes Act (UDITPA), RTC §§ 25120-25139.

Net Operating Loss Deductions

Pursuant to Treas. Reg. § 1.468B-2, a qualified settlement fund is subject to tax on its modified gross income. Modified gross income is its gross income, as defined in IRC § 61, reduced by several deductions including a deduction for the amount of a net operating loss of the fund to the extent the loss would be deductible in determining the taxable income of a corporation under IRC § 172(a).

The amount and operation of a deduction for a net operating loss under the RTC is substantially different than federal law. This difference is an "obvious difference" for purposes of RTC § 23051.5(f). As a result, a qualified settlement fund is permitted a deduction for the amount of a net operating loss, as determined under Treas. Reg. § 1.468B-2, subject to the limitations for such deductions under the RTC.

Since a net operating loss is deductible to the extent the loss would be deductible in determining the taxable income of a corporation, the deductibility of a net operating loss by a qualified settlement fund is governed by RTC § 24416, as in effect for the year in question, without regard to whether the provision of the RTC imposing tax on a qualified settlement fund was codified in the Personal Income Tax Law or the Bank and Corporation Tax Law.

In general, RTC § 24416 permits the deduction of a net operating loss attributable to years beginning on or after January 1, 1987. Only 50 percent of the entire amount of the net operating loss for any year is eligible for carryover. Net operating loss carrybacks are not allowed.

Holding

FUND income (other than interest on obligations of the United States) from California sources is taxable under RTC § 24693. Income from intangible property (other than interest on obligations of the United States) received by a QSF which was established or approved by, and subject to the continuing jurisdiction of, a court or government agency located in California is attributable to California sources and taxable under RTC § 24693, unless the QSF has established a commercial domicile elsewhere or the intangible property has acquired a business situs elsewhere.

A qualified settlement fund is permitted a deduction for the amount of a net operating loss, as determined under Treas. Reg. § 1.468B-2, subject to the limitations for such deductions under the RTC.

Drafting Information

The principal author of this ruling is Patrick J. Kusiak of the Franchise Tax Board Legal Division. For further information regarding this notice, contact Mr. Kusiak at the Franchise Tax Board Legal Division, P.O. Box 1468, Sacramento, CA 95812-1468.