California rules intrastate unitary combined reporting election

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September 2018


On August 22, 2018, in an unpublished opinion, the Fourth District California Court of Appeal upheld a lower court decision ruling that a statute allowing taxpayers conducting a wholly intrastate unitary business to choose between filing on a separate or combined basis did not violate the Commerce Clause of the US Constitution despite the election being unavailable to taxpayers conducting unitary business operations on an interstate basis.

The appellate court upheld the lower court’s determination that even if the election were deemed to discriminate against interstate commerce, the state has a “valid interest in preventing the manipulation and hiding of taxable income,” and there was no reasonable nondiscriminatory alternative that would adequately serve the state's interest.

Update: On December 12, 2018, the California Supreme Court denied review.

The takeaway

It is not known at this date whether Harley will seek review of the appellate court’s decision, and there are other taxpayers currently litigating the same issue (see, e.g., Abercrombie & Fitch v. Franchise Tax Board, Fresno Superior Court Case No. 12CEGC03408). While combined reporting may be one means of fairly apportioning interstate business activity to the state and can have the effect of preventing “the manipulation and hiding of taxable income,” the issue remains for further litigation whether the appellate court in Harley correctly concluded that “there does not appear to be a reasonable nondiscriminatory alternative that would adequately serve the state’s interest.”

A number of states view separate reporting to be an adequate means of fairly determining the portion of income derived from interstate business activity attributable to their state. While intercompany transactions can have the potential to shift income between entities and jurisdictions, most states, including California, have statutory or other authority based on, or similar to IRC Section 482, that allows them to adjust such transactions to more clearly reflect income. In this regard, the US Supreme Court, while refusing to reject worldwide combined reporting, has noted that separate reporting coupled with IRC Section 482-based transfer pricing also is a reasonable method of determining income attributable to a taxing jurisdiction.

In addition, where necessary to prevent distortions not captured by the pricing of intercompany transactions alone, combined reporting has been allowed or required on a case-by-case basis in some states that otherwise require separate reporting (e.g., Indiana, North Carolina, and South Carolina). California adopts IRC Section 482 and has separate statutory provisions contained in California Revenue and Taxation Code Sections 25102 and 25104 that provide the Franchise Tax Board with discretionary authority to require combined and consolidated reporting, respectively, to clearly reflect income or prevent the evasion of taxes.

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Peter Michalowski

Peter Michalowski

State and Local Tax Leader, PwC US

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