The California Franchise Tax Board (“FTB”) has amended its Section 25106.5-1 “Intercompany Transactions” regulation1 (“Regulation”) 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.
The Amendments were intended to address situations raised by FTB staff, taxpayers and taxpayer representatives involving DISAs, which were not previously addressed in the Regulation. The Amendments were filed with the Office of Administrative Law on January 8, 2014, with an effective date of April 1, 2014.2 They are applicable to transactions occurring on or after January 1, 2001, but a taxpayer may elect to have the amendments apply prospectively only (i.e., effective April 1, 2014).3
As a matter of background, California Revenue and Taxation Code Sections 24451 et seq. generally conform California law to Internal Revenue Code Sections 301 and 311 (distributions) and Section 312 (earnings and profits), which may give rise to non-dividend distributions that present DISA issues.4 Once 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.5 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. Specifically, Treasury Regulations provide for the concept of an Excess Loss Account (“ELA”), the purpose of which is to recapture in consolidated taxable income the shareholder’s negative adjustments with respect to the stock.6 However, California does not follow the federal ELA concept. Instead, the FTB’s Regulation provides that the portion of an intercompany distribution that exceeds California earnings and profits and the parent’s basis in the stock “will create a DISA.”7
The DISA is treated as deferred income. That deferral continues indefinitely until either the distributor or the recipient is no longer included in the combined report (e.g., excluded from the unitary group by a water’s-edge election) or until the occurrence of some other triggering event (e.g., the “sale, liquidation, redemption or any other disposition of shares of the stock”).8 Income restored from a DISA transaction is taken into account ratably over 60 months, unless the taxpayer elects to take the income into account in full in the year of liquidation.9
The Regulation provides that the balance of each DISA account must be disclosed annually on the taxpayer’s return.10 If a taxpayer fails to disclose its DISA balance on its annual tax return, the FTB may, in its discretion, require that the amounts in the undisclosed DISA accounts be taken into account in whole or in part in any year of such failure.11 Penalties also may apply for failure to make the annual DISA disclosure.12
As noted above, the Amendments were intended to address situations that were not previously addressed in the Regulation. Accordingly, the regulation process leading to the Amendments was not a contentious one. The Amendments are as follows:
First, issues arose when a (brother/sister) merger occurred between members of a combined reporting group that were owned by the same members of the combined reporting group. There, the stock of the non-surviving member was essentially eliminated, although the assets of the non-surviving member continued to be held within the combined reporting group. Prior to amendment, any DISA attributable to the non-surviving member’s stock would be recognized under the Regulation. Moreover, because the DISA is a deferred income item, financial accounting rules require its tax impact to be reflected, which reduced financial statement net income. A capital contribution to the DISA would prevent the financial rules from applying. However, prior to amendment, the Regulation did not provide for a mechanism that allowed subsequent capital contributions.13
In response, the Amendments provide that a disposition of stock that triggers a DISA will not occur when members of a combined reporting group merge into one another, if the majority of the voting shares of the stock of each are owned by other members of the combined reporting group.14 The Amendments also provide that the amount of DISA attributable to the non-surviving member’s stock will be included (proportionately) with any DISA attributable tothe surviving member’s stock and will be taken into income when the surviving member’s stock is disposed of.15 The Amendments also add an example illustrating a (brother/ sister) merger of members.16
In addition, because previously there was no mechanism, the Amendments now allow for subsequent capital contributions to reduce existing DISAs.17 The Amendments also add an example involving a subsequent capital contribution.18 The Amendments further provide that taxpayers must now annually report any reductions to DISAs brought about by such capital contributions.19
Issues also arose regarding when one member of the combined reporting group transferred stock in another member of the combined reporting group that had no attributable DISA to a third member of the combined reporting group that already possessed stock in the member whose stock was transferred and there was a DISA attributable to that stock. Prior to amendment, the transferee would be forced to retain two separate classes of stock, one class of stock with a DISA attributable to it and another class of stock without a DISA attributable to it.20
In response, the Amendments provide 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.21 The Amendments also provide an example illustrating the transfer of stock with a DISA balance.22
Finally, issues arose where the same amount of money or the same property was being distributed through various tiers of members of a combined reporting group. Prior to amendment, it was possible that multiple DISAs might result from essentially the same distribution. 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.23
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.25
In conclusion, taxpayers should consider this new opportunity to reduce or eliminate existing DISAs by making capital contributions, the option to elect to apply the Amendments retroactively or prospectively, the potential financial impact of the Amendments and any applicable new annual reporting requirements.