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California OTA allows apportionment factor representation relating to deductible income
August 2023
In brief
UPDATE: The OTA updated the decision from "pending precedential" to "precedential."
In the Appeal of Southern Minnesota Beet Sugar Cooperative (SMBSC), the California Franchise Tax Board (FTB) sought to exclude Appellant’s Minnesota-based cooperative activities from the apportionment factor because those activities generated income deductible under R&TC section 24404, consistent with the FTB’s published position in Legal Ruling 2006-01. The Office of Tax Appeals (OTA) opinion dismissed the FTB’s position and concluded “there is no language in the UDITPA to support FTB’s position that unitary business activities are excluded from the apportionment formula if they relate to deductible income.”
The takeaway: This decision rejects the FTB’s long-standing position that denies apportionment factor representation for activities that generate deductible income. While the OTA decision directly addressed the treatment of factors for a unitary business that includes a cooperative, taxpayers may wish to analyze the need to adjust the sales factor for business activities that generate deductible income based on the guidance in FTB Legal Ruling 2006-01.
The OTA released its opinion on August 2, 2023, noting that it is “Pending Precedential.” Procedurally, this indicates the start of a 30-day public comment period after which the OTA will determine whether the decision will be precedential. The FTB cannot appeal the OTA’s decision.
[In re Southern Minnesota Beet Sugar Cooperative and Subsidiary, California Office of Tax Appeals, No. 19034447 (3/17/23, released as “Pending Precedential” 8/2/23)]
In detail
Facts
SMBSC is an agricultural cooperative based in Minnesota. California R&TC section 24404 allows a cooperative to deduct income “resulting from or arising out of [its] business activities for or with [its] members.” In 2005, SMBSC acquired California-based Spreckels Sugar Company (Spreckels). Spreckels is not a cooperative. For the 2008 to 2011 years under consideration, SMBSC and Spreckels were part of the same unitary business and filed a combined report using the standard apportionment rules as set forth in R&TC sections 25120 through 25141 (UDITPA).
OTA rejects exclusion of factors relating to deductible income
The FTB challenged SMBSC’s apportionment method and sought to exclude factors from the apportionment formula that represented business activities giving rise to production of the deductible cooperative income. In support of its position, the FTB relied on language from the 1977 decision in Chase Brass & Copper Co., Inc. v Franchise Tax Board (1977) 70 Cal.App.3d 457, which required the taxpayer to eliminate sales between members of the same unitary group from its apportionment formula. According to the 1977 decision, “[s]ince no net income is produced by the internal sales, it was not required that they be included in the computation.”
In its decision on SMBSC, the OTA found that Chase Brass did not support the FTB’s position and distinguished that case for a number of reasons. First, the OTA found “[i]ncome or loss generated from intercompany transactions within a combined reporting group is not the same as gross income generated from outside the group and subsequently deducted.” Second, the OTA noted that the question in Chase Brass is now addressed by at least one California statute and regulation, and that no statute or regulation contains any language that requires a taxpayer to exclude from the apportionment factor unitary activities giving rise to deductible income. Third, the OTA noted that Chase Brass construed a pre-UDITPA apportionment statute that allowed the FTB considerable discretion to alter the standard formula without resort to R&TC section 25137 (UDITPA section 18). Last, the OTA cautioned against the FTB’s consideration of SMBSC’s cooperative activities as somehow separate or distinct from the unitary business as an argument in favor of “separate accounting,” which was something that the Chase Brass decision warned against.
OTA does not defer to FTB’s policy
The FTB also asked the OTA to defer to its long-standing FTB Legal Ruling 2006-01, issued on April 28, 2006. The Legal Ruling, titled “Apportionment Factor Treatment of Exempt Income,” addresses factor representation for business activities giving rise to income that is not subject to tax, including exempt and deductible income. The Legal Ruling concludes that the apportionment formula should be modified to reflect only those activities giving rise to net taxable income.
The Legal Ruling justifies its conclusion on the following basis:
[T]he exclusion [from the apportionment formula] is the result of the basic function of the UDITPA formula, which seeks to assign net business income solely on the basis of those activities that gave rise to such income. The activities that gave rise to the excluded income amounts are simply irrelevant in the UDITPA approach. This would be equally true for all activities that do not result in net business income, regardless of whether it is because the activity results in income that is nonbusiness in character or results in income that is excluded by operation of a statute.
The scope of the Legal Ruling is reflected in a footnote stating that “[t]his analysis would apply regardless of whether the statute uses the term ‘exempted,’ ‘excluded,’ ‘deducted,[’] ‘not recognized,’ etc. The conclusion is based upon the fact that these amounts are related to activities excluded from net income subject to apportionment, not the language used in the statute to reach this conclusion.”
The OTA stated that the FTB’s long-standing interpretation may be due some deference, and further that the language of the Legal Ruling “does not squarely address deductible member income under R&TC section 24404.” In addition, the Opinion distinguishes items subject to deduction from “items that are ‘exempted,’ ‘excluded,’ or ‘not recognized’” on the basis that the latter items “generally do not enter into gross income (or gross receipts) to begin with and are not included in net income.”
Even so, the OTA stated that the Legal Ruling “contains broad language that is similar to FTB’s arguments [in this case]” and rejected the application of the Legal Ruling to this case. According to the Opinion, “the FTB’s position does not persuasively explain how the relevant statute or regulations might be interpreted in the manner it proposes, which would result in excluding unitary business activities that contribute to the production of apportionable business income form the apportionment formula without support in the UDITPA and its regulations.” The OTA also noted that the FTB’s position conflicts with premise for the unitary determination which includes all members of the unitary group in the combined report, regardless of whether the entity does or does not generate taxable income.
In support of its conclusion, the Opinion relied on the plain language of the operative statutes and regulations that direct that net income, after any deductions for cooperative member income under R&TC section 24404, is determined “before allocation and apportionment,” and further that “[t]hat there is no language in the UDITPA to support FTB’s position that unitary business activities are excluded from the apportionment formula if they relate to deductible income.”
Observations
While the SMBSC Opinion directly addresses the treatment of factors for a unitary business that includes a cooperative, taxpayers may wish to analyze the need to adjust the sales factor for business activities that generate deductible income based on the guidance in FTB Legal Ruling 2006-01. For example, a similar analysis and rationale might appear to apply to include factors related to the portion of any dividends deductible pursuant to R&TC section 24411, which FTB Legal Ruling 2006-01 also concludes should be removed from the apportionment factor.
Although the Opinion is public, it remains to be seen if the Opinion will be designated as precedential or how the FTB may respond to the analysis in the Opinion in other cases.
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