California BOE: Interest expense on certain debt is nonbusiness

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January 2018

Overview

On November 14, 2017, the California State Board of Equalization (BOE) found that a taxpayer’s interest expense incurred on debt used to fund a distribution to its private equity fund shareholder was nonbusiness and not deductible in California. Interest expense on the portion of the debt used to fund a distribution to employee shareholders was allowed as a deduction against business income. The BOE appeared to reason that the distribution to employee shareholders provided value to the taxpayer’s business operations, consistent with Hoechst Celanese Corp. v. Franchise Tax Board (2001) 25 Cal.4th 508, while the distribution to its private equity fund shareholder did not.

This decision potentially has broad impact, particularly if applied to debt funded stock buy backs of publicly traded corporations and not just debt funded distributions to private equity owners. Accordingly, taxpayers that have borrowed money for these purposes may have refund opportunities or exposure in California depending on where the taxpayer is domiciled.

The takeaway

The decision was one of the last major decisions by the BOE before its adjudicatory authority transferred to the new Office of Tax Appeals on January 1, 2018, and suggests that taxpayers that borrow money to fund distributions to shareholders may have refund opportunities or exposure depending upon their commercial domicile.

Specifically, the BOE ruling may benefit California-based companies that fund distributions, stock buybacks, etc., to shareholders through debt. If California-based companies fund such transactions through debt and have zero or a small percentage of employee shareholders, the BOE’s decision in Leslie’s provides support that the resulting interest expense can be allocated to California as ‘nonbusiness.’

For out of state companies, on the other hand, there is potential exposure for debt-funded distributions as well as similar transactions funded by debt. The FTB may argue that debt-funded transactions are nonbusiness in nature and any related interest expense should be allocated outside of California. Out of state companies may wish to contemporaneously document the business purpose behind debt-funded transactions as evidence that the transaction was intended to benefit the operations of the business.

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Peter Michalowski

Peter Michalowski

State and Local Tax Leader, PwC US

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