California requires taxpayers that have income within and outside the state to "apportion" their overall income between the two categories based upon certain factors and rules for determining their California tax liability.
In general, many states follow the U.S. federal income tax rules with respect to Section 382’s application, and the calculations that are part of determining the appropriate limitations arising from a Section 382 limitation in situations where a loss corporation undergoes an "ownership change." Certain states modify the rules with respect to the use of their particular state-generated net operating losses (NOLs), or other tax attributes. This article focuses on certain California-specific modifications of the U.S. federal income tax rules under Section 382 for purposes of determining potential limitations on and the use of state NOLs.
California’s Approach to Section 382 and the Use of State-Generated NOLs
Section 24451 of the California Revenue & Taxation Code (CRTC) incorporates by reference Subchapter C of Chapter 1 of Subtitle A of the Internal Revenue Code (IRC), which includes Sections 382 and 383. In general, Section 382 and the accompanying Treasury Regulations require that a loss corporation calculate increases in the percentage of stock ownership of 5-percent shareholders to determine whether an ownership change occurred on a testing date. A loss corporation is defined in Section 382 as a corporation entitled to use an NOL carryforward (among other tax attributes) or having an NOL for the taxable year in which the ownership change occurs.1 The term "loss corporation" includes a corporation that is entitled to use a capital loss carryover, a capital loss arising in the tax year of the ownership change, a carryover of excess foreign tax credits, a carryforward of a general business tax credit and/or a carryover of a minimum tax credit.2 Section 383 effectively applies the rules of Section 382 to limit the use of certain capital losses and excess credits. These limitations can completely eliminate the ability of a loss corporation to use its tax credits if the relevant limitation is so low that such credits will expire unused.
California requires taxpayers that have income within and outside the state to "apportion" their overall income between the two categories based upon certain factors and rules for determining their California tax liability.3 California also applies specific modifications to Section 172 with respect to the allowable utilization in any particular year of California state NOLs or other tax attributes if the taxpayer is subject to the apportionment rules because it has income from inside and outside the state.4 A complete discussion of the California apportionment rules, the modifications to Section 172, and other provisions that effect timing and ability to use California state NOLs or other California state tax attributes is beyond the scope of this article. However, it is crucial that any taxpayer seeking to use its California NOLs to offset California income carefully consider all of the California rules.
Calculating the Section 382 Limitation
Section 382(a) provides that if a loss corporation undergoes an ownership change, the amount of post-ownership change income that can be offset by pre-ownership change losses cannot exceed the Section 382 limitation. Section 382(b)(1) provides that the Section 382 limitation is the value of the loss corporation (with adjustments provided elsewhere in Section 382) multiplied by the long term tax exempt rate. The California FTB recently issued a technical advice memorandum that clarifies whether the Section 382 limitation is calculated on a pre-apportionment basis or a post-apportionment basis. In addition, the memorandum addresses the pre-apportionment or post-apportionment question with respect to the calculations required by Section 382(h) for net unrealized built in gain (NUBIG), recognized built in gain (RBIG), net unrealized built in loss (NUBIL) and recognized built in loss (RBIL).5
In the California FTB guidance, the state evaluated whether it had authority to require that the Section 382 limitation be calculated on a post-apportionment basis, because to do so would result in a lower Section 382 limitation that would be applied against post-ownership change California income. In its analysis of the issue, the state reviewed relevant authorities with respect to the state of the law in California on the timing of calculating the Section 382 limitation as either pre-apportionment or post-apportionment. While concluding that no statute or case allowed California to require its taxpayers to calculate the Section 382 limitation on a post-apportionment basis, it noted that Alabama, Georgia, Pennsylvania and South Carolina each require that the Section 382 limitation be calculated on a post-apportionment basis, presumably resulting in a lower Section 382 limitation that could be used to offset post-change income from each of those states for the loss corporation that undergoes an ownership change. The state noted that it had sought to change the law in the California legislature but could not find sponsorship from any of the legislators to advance the bill. The implication from this evaluation is that a taxpayer in California that is subject to apportionment of its income and undergoes an ownership change is permitted to calculate its Section 382 limitation on a pre-apportionment basis.
Post-Apportionment Proper for Section 382(h) Calculations
The state also noted that when calculating a NUBIG, RBIG, NUBIL or RBIL, the taxpayer must apply the apportionment factor percentage that existed at the date of the ownership change. The state noted that each of these items "relate to items of income that would be subject to apportionment. Therefore, these relative post-apportionment amounts must be considered for California tax purposes."6
Taxpayers that operate in states with apportionment tax systems must separately calculate their Section 382 limitations for each relevant state to comply with that particular state’s rules. This can result in multiple calculations for each ownership change, and requires a detailed scheduling of the Section 382 limitation, calculations of the NUBIG, NUBIL, RBIG and RBIL amounts for potential increase, or further limitations, with respect to events that occur post ownership change. These calculations will be in addition to determining each state’s expiration periods for their NOLs and other tax attributes, which may differ significantly from the standard 20-year carryforward provided for U.S. federal income tax purposes.