On April 21, 2010, the California Franchise Tax Board (FTB) will hold an interested parties meeting to elicit public input on possible amendments to Regulation 25106.5-1, which covers intercompany transactions between members of a combined reporting group. Among the issues to be discussed is the need to amend deferred intercompany stock account (DISA) provisions in the regulation.
DISAs concern all taxpayers filing on a unitary combined basis. As the rules now stand, many corporate taxpayers making intercompany distributions may be blindsided by the ambiguities in the current DISA rules, leading to the creation or trigger of DISAs. Below are some of the potential problems that corporations may face as well as solutions that would make the DISA rules conform to unitary theory and provide much needed clarity to corporations.
Amending the current DISA rules is necessary for many corporations filing combined reports because the current DISA rules are unclear on important issues. After the FTB issued Notice 2009-1 and Notice 2009-5, which set due dates for California taxpayers to disclose their previously undisclosed DISA balances or face the threat that the FTB would exercise its discretion to require the recognition of such balances, many corporations scrambled to put together disclosures but found the rules unclear. A host of interpretation issues surfaced, making it difficult to comply. It is likely that the FTB has recognized the problem and believes that the rules must be clarified so that corporations trying to properly disclose their DISA balances can do so with some semblance of certainty.
California regulations defer intercompany transactions between members of a combined reporting group until a triggering event occurs, such as when one of the parties to the transaction leaves the unitary combined reporting group. This defers non-dividend distributions in excess of basis (IRC section 301(c)(3) gain). DISAs are the accounting mechanism created by the FTB to track deferred non-dividend distributions in excess of basis.
DISAs were created by the FTB with a similar purpose as the U.S. Department of the Treasury’s rules on intercompany distributions—to clearly reflect taxable income of a combined (or consolidated) group of corporations. The Treasury regulations accomplish this purpose with excess loss accounts (ELAs), which adjust a parent’s basis in its subsidiary’s stock to reflect contributions and distributions, including dividends, between parents and subsidiaries. However, whereas ELAs defer both non-dividend distributions in excess of basis and dividend distributions, the FTB believed that it was without authority to defer the recognition of dividends because Safeway Stores v. FTB, 3 Cal. 3d. 745 (1970) required the immediate taxation of dividends, unless exempted by statute. Thus, despite following the spirit and purpose of the federal ELA rules, the DISA rules could not conform to the ELA rules in their entirety.
The lack of full conformity to the ELA rules left the DISA rules quite brief, with issues not explicitly resolved. Some of these issues could be resolved by interpreting the DISA rules consistent with unitary theory. However, amending the DISA rules is still necessary to provide corporations some needed clarity. In particular, four areas of the DISA rules must be addressed:
Whether multiple distributions up a chain of subsidiaries can result in the multiplication of DISAs
Whether capital contributions can cure DISAs
How to treat liquidations
How to treat reorganizations other than liquidations
Multiplication of DISAs
Regulation 25106.5-1(j)(4) expressly provides that “the timing rules of this regulation apply to the calculation of California earnings and profits.” This provision is written outside the context of the DISA rules but still is in the same regulations as the DISA rules. Thus, this provision has the potential of being interpreted to permit earnings and profits credit for non-dividend distributions in excess of adjusted basis only after DISAs are triggered. This would lead to a harsh result that is wholly inconsistent with unitary theory.
For example, there may exist a chain of corporations, P-S1-S2-S3, with each corporation having no basis in the stock of its subsidiary, and each subsidiary having no earnings and profits. If S3 distributes $100 to S2, it would create a DISA of $100 for S2. However, if the above earnings and profits timing rule is read to apply to DISAs, S2 would not receive immediate earnings credit for this DISA. Thus, if S2 distributes that same $100 to S1, it will be a non-dividend distribution in excess of basis, and yet another DISA of $100 would be created. The same would occur when S1 distributes the $100 to P. Thus, if the earnings and profits timing rule is read to apply to the DISA rules, distributions of the same $100 up a chain of corporations would create three $100 DISAs, rather than one DISA of $100 and two dividends of $100 each. This result is inconsistent with unitary theory and the express purpose of the regulations—to clearly reflect income—as it would effectively convert dividends into non-dividend distributions, thereby improperly altering the tax consequences of the distributee.
To prevent this result—one that is directly contrary to Safeway Stores—Regulation 25106.5-1 should make it clear that the receipt of a DISA gives the recipient immediate earnings and profits credit.
Cure by Capital Contribution
DISAs are described in the regulation as “deferred income.” The DISA rules are silent with regard to whether they can be cured by a capital contribution or whether the amount of deferred income, once deferred, remains fixed regardless of the actual amount by which the distributee is enriched beyond its investment in the distributing company as measured at the time of the DISA triggering event.
By contrast, federal ELAs are described as “negative basis.” For federal purposes, a capital contribution in excess of an ELA eliminates the ELA and provides the parent with a positive basis in the subsidiary.
Pursuant to unitary theory and the purpose of the intercompany transaction regulations, DISAs should operate in a manner similar to federal ELAs for purposes of determining the amount of gain a distributee should properly take into account under IRC section 301(c)(3) upon the occurrence of a triggering event. Transactions between corporations that are part of a unitary group should be treated as between divisions of a single corporation until it is no longer possible to do so. Accordingly, a DISA, once created, should reflect all subsequent capital contributions and non-dividend distributions so that when a triggering event occurs it will be possible to determine the amount that the distributee has actually received in excess of its investment in the distributing company.
However, the current regulations are silent as to the effect of capital contributions, and this silence is troubling. Some members of the FTB staff have expressed the view that DISAs are fixed amounts of deferred gain and cannot be cured by subsequent capital contributions. If so, wholly non-tax-motivated movements of funds or property within an affiliated group could create taxable income when there is no economic increase in wealth.
To prevent this result, Regulation 25106.5-1 should be interpreted to permit DISA balances to be reduced or eliminated by capital contributions from the DISA-holding parent in respect of the stock of its subsidiary.
Currently, Regulation 25106.5-1(f)(1)(B) provides that a parent must take its DISA in respect of its subsidiary’s stock into account when the subsidiary liquidates. This result was thought to be necessary when the intercompany regulations were adopted because the FTB staff believed that the federal rule where ELAs disappear in an IRC section 332 liquidation offered an opportunity for taxpayer manipulation. These fears are unfounded, and the regulation must be fixed.
The purpose of the intercompany transaction rules is to clearly reflect income and to produce the effect of transactions between divisions of a single corporation. There is no clearer time for this purpose to apply than when the two entities actually become divisions of a single corporation.
Reorganizations Other Than Liquidations
The DISA rules are silent with respect to whether a merger between brother/sister corporations trigger a DISA and, if not, how to allocate the DISA among the stock.
The proper way to clearly reflect the income of the brother/sister entities and the parent is to interpret the California rules consistent with the federal rules, which provide that if a subsidiary merges sideways into a target (its sister corporation), the target would be a “successor person” to the merged subsidiary, and the target’s stock held by the parent and related to the merger would be a “successor asset.” See Treas. Reg. § 1.1502-13(j)(1). Accordingly, the federal rules provide that the parent’s ELA in respect of its merged subsidiary’s stock would carry over to the target shares received by the parent in the exchange. If the parent has a positive basis in its target shares, the parent’s basis in each of its target shares would be reduced proportionally by the ELA. This rule must apply in the DISA context for a fair result that is consistent with unitary theory.
The FTB has now recognized that these issues require resolution. Above are the appropriate ways by which the DISA rules can be clarified to ensure they operate to clearly reflect the income of the taxpayer members of a unitary, combined reporting group.