2014 RECENT
DEVELOPMENTS IN CALIFORNIA TAX LAW
By
© Mark Muntean*
As the title implies, below is a summary of the 2014 significant
California tax law changes through judicial decisions, legislative and
regulatory changes; and administrative pronouncements.
A. Judicial
Decisions.
1. FTB of Cal. v. Hyatt, 130 Nev. Adv. Op.
71 (Nevada Supreme Court September 18, 2014). In the 1991
Gilbert P. Hyatt Hyatt moved from California to Nevada. He filed a “part-year” resident income-tax
return in California for 1991and reported only part of his licensing fees to
California. In 1993, California audited
Hyatt. The audit focused on claim that
he had changed residency to Nevada shortly before receiving substantial
licensing fees for certain patented inventions related to computer
technology.
In auditing Hyatt, the
FTB sent letters to third parties that included Hyatt’s social security number
and home address. The FTB also
interviewed Mr. Hyatt’s ex-wife and estranged brother and daughter. Hyatt sued the FTB in Nevada District
Court. The FTB sought complete immunity
based on the U.S. Constitution’s Full Faith and Credit Clause (Art. IV, § 1)
and comity. The Nevada Supreme Court
ruled for Hyatt. The U.S. Supreme Court
upheld the Nevada Supreme Court’s ruling that the FTB was only entitled to
partial immunity under comity principles. Franchise Tax Bd. of Cal. v. Hyatt,
538 U.S. 488 (2003).
A jury returned a
verdict awarding Hyatt $85 million in damages for emotional distress, $52
million for invasion of privacy, $1 million as special damages for fraud, and
$250 million in punitive damages. The
FTB appealed the verdict to the Nevada Supreme Court. On September 18, 2014, the Nevada Supreme
Court affirmed the special damages award for fraud and the finding of liability
for intentional infliction of emotional distress. FTB of Cal. v. Hyatt, 130 Nev. Adv. Op. 71
(2014). However, the court remanded the
case for a new trial on damages on the emotional distress claim. The court reversed Hyatt’s other causes of
action. The court also ruled that the
FTB, as a government agency, is immune from punitive damages under Nevada
law. The court’s opinion highlights
numerous instances of misconduct on the part of the FTB.
2. Cutler v. Franchise Tax
Board, B248270 C.A. 2nd Dist., September 2, 2014 (Cutler II). Previously, in 2012 the Court of Appeal held
that the QSBS statute (Cal. Rev. & Tax. Code Section 18152.5) discriminated
on its face in violation of interstate commerce under the federal commerce
clause. Cutler v. FTB (2012) 208
Cal.App.4th 1247 (Cutler I). Cutler
sought attorney fees under CCP Section 1021.5.
The trial court denied his application.
The trial court concluded that Cutler did not meet two statutory
prerequisites: (1) he did not confer "a significant benefit, whether
pecuniary or nonpecuniary, . . . on the general public or a large class of
persons," and (2) the "necessity and financial burden of private
enforcement" were not "such as to make the award appropriate. . .
." CCP Section 1021.5.
On the first point, the
trial court found it was "speculative" that the lawsuit conferred any
benefit on the general public or a large class of people. On the second point,
the court found an award was not appropriate because Cutler sought a refund of
"a significant sum of money" ($442,000), so — even though he incurred
attorney fees of more than $685,000 — he had an incentive to bring the
litigation, and any benefit he conferred on the public was incidental. The Court of Appeal reversed holding the
trial court erred on both points. The court remand the case for a determination
of the amount of fees to be awarded.
3. Comcast v. Cal. Franchise Tax Bd. In
ComCon Prod. Servs. I Inc. v. Cal. Franchise Tax Bd., Cal., Super. Ct., No.
BC489779 (3/6/2014) (“Comcast”) two issues were before the court: (1) whether Comcast and its subsidiary QVC
formed a unitary business for California franchise tax law purposes, and (2)
whether the termination fee Comcast received from MediaOne as the result of a
failed merger generated business income apportionable to California, or
nonbusiness income allocable outside California. In Comcast, the judge ruled that (1) Comcast
was not unitary with QVC, which was a victory for Comcast, and (2) Comcast’s
$1.5 billion termination fee is taxable business income to Comcast, a loss for the
taxpayer. The $1.5 billion in income
would be apportionable such that it would only be partially taxed in
California.
There is no written
decision at this time. The judge ordered
the FTB and the California Attorney General to draft a written decision, using
text from Comcast's closing brief as the court's findings on the unity issue
and text from FTB's closing brief for the termination fee issue findings. Since there is real money at stake, it is
likely Comcast will appeal.
4. Property Tax. SHC Half Moon Bay v. County of San Mateo
(A137218), May 22, 2014. A decision
issued by the California Court of Appeal is significant for hotel owners and
operators, and for any commercial real property owners where the the property
includes intangible assets. After many years of litigation, there now appears
to be a definitive ruling on whether the "Rushmore approach" may be
used to value hotel properties in California. SHC Half Moon Bay v. County of
San Mateo (A137218), May 22, 2014. The Rushmore approach is a technique
employed by appraisers to remove the value of intangible assets and rights that
are used in conjunction with hotels such as workforce and hotel management and
franchise agreements. In its decision, the Court of Appeal specifically held
that "the deduction of the management and franchise fee from the hotel's
projected revenue stream pursuant to the income approach did not – as required
by California law – identify and exclude intangible assets" such as
workforce and other intangibles. The court also said that the taxing authority
had not explained how the deduction of the management and franchise fee
captured the value of the intangible property.
B. Legislation.
1. Enterprise Zones. The
California legislature terminated the Enterprise Zone program and replaces it
with a new three-part program. AB 93
also limits the application of hiring and sales and use tax credits to
employees hired, or purchases made prior to January 1, 2014. Taxpayers may
utilize any carryforward hiring or sales and use tax credits generated prior to
2014 through 2024. The bill also limits the net interest deduction for lenders
making loans to businesses in Enterprise Zones to interest received before
January 1, 2014.
(a) New Sales Tax Exemption for
Manufacturing Equipment. Effective
July 1, 2014, AB 93 adds a new, state-level sales tax exemption for
manufacturing equipment. The exemption is also available for purchases of certain
equipment primarily used for manufacturing and in research and development. The
legislation caps the exemption at $200 million in purchases per taxpayer per
year. This cap applies to the cumulative purchases of a single entity or the
aggregated purchases of all members of a combined group. The exemption is set
to expire January 1, 2021 for purchases of equipment to be used within a former
Enterprise Zone or certain designated census tracts, and January 1, 2019 for
purchases of equipment to be used elsewhere in California.
(b) New Hiring Credit. AB 93 also adds a new hiring credit to
replace the old EZ hiring credit. The credit is available on 35 percent of
wages between $12 - $28 per hour for companies that employ “hard to hire”
workers in certain defined geographic areas of the state. Hard to hire workers
include individuals who have been unemployed for six months, previously
unemployed veterans, recipients of the federal Earned Income Tax Credit, and
ex-offenders. To continue to qualify for the credit, an employer must increase
the number of full-time employees employed in the state from one year to the
next. The credit may only be claimed on a timely filed original return.
Temporary help services, retail trade services, food services, and employers in
certain NAICS services are not eligible for the hiring tax credit. The new
hiring tax credit applies to tax years beginning on or after January 1, 2014,
and before January 1, 2021.
(c) New California Competes Credit. The third new incentive is the California
Competes Tax Credit, which is negotiated through and administered by the
Governor’s Office of Business and Economic Development (GO-Biz). The pool of
credits available under the California Competes Credit is limited to a
specified sum each fiscal year ($30 million for fiscal year 2013-2014).
Businesses compete for the credit based on a number of factors, including the
number of jobs to be created, the amount of investment in the state, incentives
available to the taxpayer within and outside of California, and the duration of
the proposed project. Priority is to be given to taxpayers whose project or
business is located or proposed to be located in an area of high unemployment
or poverty. The California Competes Tax
Credit is applicable for tax years beginning on or after January 1, 2014 and
before January 1, 2025.
D. Regulations.
1. Regulation 17942, On May 14, 2014, California adopted
regulation 17942, which provides guidance regarding an LLC’s total income from
all sources derived from or attributable to California. The regulation
provides guidance on: (1) the treatment of flow-through income from
partnerships, (2) special assignment rules for total income from certain
passive holdings and occasional sales, (3) an alternative method for assigning
total income, and (4) disregarding the assignment rules if all business
activities are conducted in California.
2. Section 25106.5-1. Amended California Code of Regulations
(Reg.) section 25106.5-1, regarding the treatment of Deferred Intercompany
Stock Accounts (DISA), was approved by the Office of Administrative Law on
January 8, 2014, and will become effective April 1, 2014.The FTB amended
its regulations under Section 25106.5-1 “Intercompany Transactions” to provide
additional guidance regarding its treatment of Deferred Intercompany Stock
Accounts (“DISAs”). Four notable changes
were made by the amendments to the Regulation (“Amendments”) discussed below.
All California taxpayers with a federal Excess Loss Account should be aware of
these Amendments and consider their implications.
California tax law conforms
to Internal Revenue Code Sections 301 and 311 (distributions) and Section 312
(earnings and profits), which may give rise to non-dividend distributions. When current and accumulated earnings and
profits have been depleted, additional (non-dividend) distributions will reduce
the shareholder’s basis in the stock. Distributions in excess of both earnings
and profits and the shareholder’s basis in the stock are treated as a capital
gain. However, under the federal
consolidated return group rules, a shareholder may have a negative basis in the
stock as a result of such intercompany distributions. Under California law the
portion of an intercompany distribution that exceeds California earnings and
profits and the parent’s basis in the stock creates a DISA which is deferred
income. The deferral continues until a
triggering event results in the distribution is
excluded from
the unitary group by a water’s-edge election) or until the a sale, liquidation,
redemption or any other disposition of shares of the stock. Under the amended law, where the distributor
is merged out of existence, the deferred gain will not be triggered if the
majority of the voting shares of the stock of each are owned by other members
of the combined reporting group. The amount
of DISA attributable to the non-surviving member’s stock will be included
(proportionately) with any DISA attributable to the surviving member’s stock
and will be taken into income when the surviving member’s stock is sold. The
amended law further provides that taxpayers must now annually report any
reductions to DISAs brought about by such capital contributions.
The amended law provides
that if a parent transfers stock with a DISA attributable to it to another
member of the combined reporting group and the transferee already possesses
shares of that stock that do not have a DISA attributable to them, the DISA
will continue to be deferred and the transferee’s basis in its existing stock
can reduce the DISA attributable to the shares of the stock transferred. If an excess distribution that ordinarily
would result in a DISA was allowed to create earnings and profits, the second
distributee would not have a DISA when that distributee distributed the same
amount of money or the same property to another member of the combined
reporting group. However, prior to amendment, the Regulation did not allow
intercompany transactions to create earnings and profits.
In response, the
Amendments eliminate multiple DISAs from arising in this situation. The
Amendments provide that where the same property or the same amount of money is
being distributed through various tiers of members of a combined reporting
group, the DISA that results at the initial level from the initial distribution
is treated as creating earnings and profits.24 The Amendments add an example
illustrating a situation where the same amount of money is distributed and also
provide an example illustrating the effect of an additional amount of money
subsequently being distributed.
E. Administrative.
1. Legal Ruling
2014-01. The FTB issued Legal
Ruling 2014-01 which provides that businesses entities that are members of multiple-member
limited liability companies (LLCs) must file a tax return and pay any
applicable taxes and fees based on the fact that the LLC is doing business in
California. An LLC is doing business in
California if the LLC (i) is organized or commercially domiciled in California,
or (ii) has California property, payroll or sales which exceed the amounts
applicable under Cal. Rev. and Tax. Code Section 23101(b) (2), (3), or (4), of
subdivision (b).
The
FTB has determined that the “business of the partnership is the business of
each partner,” and “the activities of the partnership are attributed to each
partner, with the consequence that in geographic locations where the
partnership is ‘doing business,’ the partners are also ‘doing business.’” The
FTB relies on Internal Revenue Code Section 702 (b). However, this is not the rule in California
for limited partners. The FTB pints out
the exception for limited partners in Appeals of Amman & Schmid FinanzAG, et al., 96-SBE-008,
April 11, 1996. In Amman, the California State Board of
Equalization held that limited partners of limited partnerships were not doing
business in California even if the limited partnerships were doing business in
California. Thus, the take away here is
that if a business entity anticipates investors which are out of state business
entities, a limited partnership may be a better vehicle that a LLC.
2. Chief Counsel Ruling
2014-2. Occasional Sales Rule. Taxpayer's asset sales in implementing its
Plan of Reorganization under Chapter 11 of the Bankruptcy Code are within
Taxpayer's normal course of business and occurred frequently thus are not
"occasional sales" within the meaning of Regulation section
25137(c)(1)(A) and the resulting gross receipts must be included in Taxpayer's
sales factor for apportionment purposes.
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