Legal ruling 1995-2

Crediting Tax Payments in Situations Involving Overpayments and Assessments for Corporations Included in an Election to File a Combined Unitary Group Single Return (Schedule R, Schedule R-7)

Issue

For corporations engaged in a unitary business that have elected to participate as members in a group filing (currently indicated by completion of Schedule R-7 of the Schedule R (Apportionment and Allocation of Income)), what is the proper manner for crediting tax payments if separate assessments or refunds are issued to the individual members? 

Situation 1 Parent corporation, M, elected to file a Schedule R-7 as key corporation on behalf of the unitary taxpayer group M-Y for Income Year 1. M is a management company for a subsidiary savings and loan, Y. M remitted tax with the group return in the amount of $50,000 on behalf of the M-Y group. Had M and Y filed separate returns in lieu of the Schedule R-7 filing, the California tax liability under Legal Ruling 234, October 27, 1959, for M; and Y would have been $5,000 and $45,000, respectively, reflecting intrastate apportionment of the group's business income. M later determined that the group M-Y was due a refund of $20,000 for Income Year 1, resulting from reduction of business income of the group, and filed a refund claim on behalf of the group. However, before the refund claim could be processed, Y entered bankruptcy and a competing separate refund claim was filed by its trustee.

Situation 2 Parent corporation A elected to file a Schedule R-7 as key corporation on behalf of the purported unitary taxpayer group A-B for Income Year 1. In that year, A's separate operations resulted in a profit; B's separate operations produced a loss. In the combined report as filed, A's income and B's loss were offset, and the A-B group return reflected net apportionable income. The data in the combined report indicated that A and B's self-assessed tax liabilities, based upon intrastate apportionment of the purported group's combined business income, were $12,000 and $3,000, respectively. When the return was filed, the combined tax liabilities of $15,000 were paid by A, on the taxpayer group's behalf. An audit examination determined that A and B were not unitary. As a result of the de-combination, A and B's adjusted tax liabilities were $30,000 and $800 (minimum tax), respectively.

Law and Analysis

Under the unitary method of taxation as applied by California, the business income of each entity included in the combined report is combined, and an apportionment formula is applied to the unitary business income to derive the group's income from California sources. In a procedure commonly described as "intrastate apportionment," each taxpayer member of the group determines its apportioned share of the California business income in accordance with FTB Legal Ruling 234, October 27, 1959, as modified by FTB Notice 90-3, June 8, 1990 (see, also, Appeal of Kaiser-Frazer Sales Corporation, Cal. St. Bd. of Equal., Nov. 7, 1958). Each taxpayer then adjusts its apportioned share of the business income by any California nonbusiness income or loss and any adjusted net operating loss carryovers in order to determine its net income subject to California taxation. Unlike the Federal consolidated return which imposes a joint and several liability, each taxpayer member in the combined report has an obligation to file its own return and pay its own tax liability on its income from California sources (Rev. and Tax. Code §18601 (obligation to file a return), §23037 (defining the term "taxpayer"), §23151 (imposition of tax), §25101 (measure of tax on California source income), see, Safeway Stores, Inc. v. Franchise Tax Board (1970) 3 Cal.3d 745, 752, fn. 8).

If each taxpayer member of a group of unitary corporations files its own separate return, the combined reporting data is duplicated in each of the returns which are filed. As a convenience to taxpayers, the Franchise Tax Board has allowed unitary taxpayers (i.e., those with a California tax liability) to elect to file a single "group" return, in the name of a designated key corporation, attaching only a single combined report. This filing is treated as satisfying the individual filing responsibility of each of the taxpayer members.

Prior to 1991, this election was effected by a filing FTB Form 4523A, Election to File a Single Return. Beginning in 1991, the election was incorporated into the Schedule R, Schedule R-7. The contractual terms and conditions of the election are stated on the respective election forms, and the instructions related thereto. Taxpayers manifest their acceptance of the terms and conditions by the key corporation's filing of the form and the failure of the other taxpayer members to file their own separate returns.

The Schedule R-7 and instructions provide that payments are to be made using the key corporation's California corporation identification number, and provide that any subsequent adjustments to the liabilities of the members are to be assessed, billed or paid to that corporation. However, it is a well established principle of tax law that taxpayers cannot, by contract or otherwise, shift tax liabilities amongst themselves. (See Old Colony Trust Co. v. Commissioner, (1929) 279 U.S. 716.) Payments by a parent corporation with respect to a subsidiary's tax liability are not properly deductible by the parent, as the liability is not that of the parent corporation (Interstate Transit Lines v. Commissioner, (1943) 319 U.S. 590; Austin Co. v. Commissioner, (1979) 71 TC 955). Therefore, when the key corporation, pursuant to the agreement to act on behalf of the group, makes a payment or accepts an assessment or refund attributable to another member of the group, it does not act in its own capacity, and can be acting only as an agent and surety on behalf of that member. The surety relationship derives from its agreement to pay taxes owed by its members (Cal. Civ. Code §2787).

The fact the Schedule R-7 and instructions provide that payment of taxes are to be made using the key corporation's California corporation number is merely a handling convenience--it is the department's practice (and the taxpayers' understanding) that amounts deposited to the key corporation's account will be used to satisfy the liabilities of each of the members of the group participating in the election. Thus, the account does not function as the account only of the key corporation, but rather functions as a merged account of all of the members.

Accordingly, the fact that funds are deposited to the key corporation's account does not mean that such funds are properly credited solely to that key corporation in the event that separate assessments or refunds are required to be issued. (Separate refunds or assessments may be appropriate when, for example, the key corporation is unable to fulfill its duties as agent or surety, or where separate refunds are required after later disaffiliation of the former unitary taxpayers.)

Questions have arisen as to the method of apportionment of previously self-assessed and paid tax to the individual members of the original group return when separate assessments or refunds are required. The appropriate methodology for assignment of such payments is to apportion the previously paid self-assessed tax back to the members based on the principles of Legal Ruling 234, as modified by FTB Notice 90-3, using the combined report income and apportionment data in the original group return as filed.

For that purpose, it does not matter whether or not the key corporation received reimbursement from the other taxpayer members of the group for their respective share of the total liabilities of all members. When the key corporation is reimbursed by a member of the group for a member's tax liability it paid, it acts as a simple agent of the member. Payments by an agent on behalf of a principal are treated as payments of the principal. See, for example, Cooledge v. Commissioner, (1939) 40 BTA 1325. On the other hand, whenever a parent corporation pays a liability that is clearly that of its subsidiary, without expectation of repayment, that payment is treated as a contribution to the capital of the subsidiary (South American Gold & Platinum Co. v. Commissioner (1947) 8 TC 1297, aff'd per curiam, 168 F.2d 71 (2d Cir., 1948). A payment by a parent in satisfaction of a subsidiary's liability is treated as if the liability had been paid from the subsidiary's own funds (Revenue Ruling 84-68, 1984-1 C.B. 31). Likewise, whenever a subsidiary pays a liability of its parent, the payment of that liability results in a constructive dividend to the parent corporation (F.G. Lamb v. Commissioner, (1928) 14 BTA 814;Silverstein v. Commissioner, (1961) 36 TC 438; Sachs v. Commissioner, (1959) 32 TC 815, aff'd 277 F.2d 879 (8th Cir., 1960), cert. den., 364 U.S. 833 (1960)).

Thus, payment in satisfaction of a member's self-assessed liability is properly credited to that member, regardless of the source of the funds.

Holding

If the self-assessed tax liability for each member of the Schedule R-7 filing is disclosed, either with the return or in available workpapers used in preparing the return, and reasonably reflects the appropriate tax liability of each member using intrastate apportionment procedures, payments by the group will be credited reflecting the self-assessed tax so shown. If self-assessed tax liabilities of the taxpayer members are not so disclosed, previously paid tax will be credited to the taxpayer members under the intrastate apportionment procedures of Legal Ruling 234 (modified, as applicable, by FTB Notice 90-3), using the member's share of the group's income and apportionment data in the return or amended return. Similar principles apply for payments made pursuant to an audit examination.

In the event that the self-assessed liabilities of the members cannot be derived from the return data itself, the original self-assessed liabilities of the each of the respective members will be reconstructed from data obtained during audit or supplied by the taxpayers, using the best available information. If data necessary cannot otherwise be developed to assign the California business income of the group to each of the taxpayer members by means of intrastate apportionment, the department will, in its discretion, credit taxes paid in a manner which is reasonable under the circumstances.

Based on this holding, the application of these principles to the above-described fact situations follows:

Situation 1.  As a result of the claim, M and Y's revised tax liabilities, reflecting intrastate apportionment, are $3,000 and $27,000, respectively. M will be credited with the amount represented by its apportioned share of the tax payment reflected in the original return (i.e., $5,000), is entitled to a refund of $2000.Y will be credited with $45,000 of the total group self-assessed tax payment, and is entitled to a refund of $18,000. M is not entitled to any of the refund attributable to Y.

Situation 2.  A and B will be credited with the amount of the self-assessed tax represented by their apportioned shares of the total $15,000 tax liability reflected in the original combined report, i.e., $12,000 and $3,000, respectively. Upon decombination, A has a deficiency of $18,000 ($30,000 less $12,000). B has an overpayment of $2,200 ($3,000 less $800).

If it is clear from the circumstances that the key corporation remains the agent of the other members of the original Schedule R-7 filing, the Franchise Tax Board will ordinarily remit refunds directly to the key corporation, but in so doing, it makes payment to the key corporation only in its capacity as agent. If, under the circumstances, the Franchise Tax Board has terminated the agency relationship, or the Franchise Tax Board is on notice that the other members have terminated their agency relationship, or that payment to the principal might place payment to the member at risk, the Franchise Tax Board will remit refunds directly to the taxpayer member entitled to the refund under the principles of this ruling.

Drafting Information

The principal authors of this ruling are Michael Brownell and Craig Swieso of the Franchise Tax Board Legal Division. For further information regarding this ruling, contact Mr. Brownell or Mr. Swieso at the Franchise Tax Board Legal Division, P.O. Box 1468, Sacramento, CA95812-1468.

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