A recent State + Local Tax Insights article discussed “Potential Unity and Business Income in California.”1 That article discussed the relationship between business income and the unitary business concept in the context of the disposition of assets that had only the “potential” to be incorporated into a unitary business. Subsequent to that article, in August 2012, the California Franchise Tax Board (“FTB”) issued Legal Ruling 2012-01 (“Ruling”), the subject of which is the “Business/Nonbusiness Characterization on Sale of Stock.” The Ruling presents the following Issue:
If one corporation purchases stock in a corporation with which it has preexisting operational ties with the intent to integrate the target corporation into its unitary business operations, but the intended integration does not occur, does the later sale of the stock in the target corporation give rise to business or nonbusiness income?
The Ruling then posits three factual situations and provides “Holdings” for each situation. This article addresses the “potential” issue in the context of the Ruling and discusses the reasoning and application of the Ruling.
In California, all business income issues start with the statute. The statutory framework for determining business income is found in California Revenue and Taxation Code2 Section 25120, which provides:
“Business income” means income arising from transactions and activity in the regular course of the taxpayer’s trade or business and includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer’s regular trade or business operations.3
This definition has not been amended by the California Legislature since its adoption in 1965. Administrative and judicial decisional law including, most notably, the California Supreme Court decision in Hoechst Celanese Corp. v. Franchise Tax Board, has made clear this statutory definition contains two separate and independent (i.e., alternative) tests for business income: a “transactional” test and a “functional” test.4 The Ruling, and, more broadly, the “potential” issue addressed in the Ruling, arises in the context of the functional test–that is, when income from the acquisition, management and disposition of property “constitute integral parts of the taxpayer’s regular trade or business operations.”5
Hoechst Celanese provides additional, and more modern, guidance on the statutory meaning of business income.6 There, the California Supreme Court reiterated the statutory standard in Section 25120 that “[u]nder the functional test, corporate income is business income ‘if the acquisition, management and disposition of the [income-producing] property constitute integral parts of the taxpayer’s regular trade or business operations.’”7 The court went on to explain that the “critical inquiry” for purposes of the functional test is “the nature of the relationship between this property and the taxpayer’s ‘business operations.’”8 The court explained that the statutory language of Section 25120 requires a two-part inquiry.9 First, the statutory phrase “acquisition, management and disposition” directs us to examine “the taxpayer’s interest in and power over the income-producing property.”10 If the taxpayer has a sufficient interest in the income-producing property under that standard, one then moves to the second inquiry, which is whether “the taxpayer’s control and use of the property [are] an ‘integral part of the taxpayer’s regular trade or business operations.’”11
However, Hoechst Celanese receives only passing mention in the Ruling. Instead, the Ruling correctly points out the most pertinent authorities on the potentiality issue addressed herein are a series of administrative decisions by the California State Board of Equalization (“SBE”), some of which date to the early 1980s. Those SBE decisions are Appeal of Standard Oil,12 decided in 1983; Appeal of Occidental Petroleum,13 also decided in 1983; Appeal of Mark Controls Corporation,14 decided in 1986; and Appeal of CTS Keene,15 decided in 1993.16 Upon analyzing those decisions, the Ruling concludes the “common thread” running through them “is the Board’s careful analysis of the underlying facts surrounding the relationship between the acquiring or parent corporation and the stock that was the subject of the inquiry in determining whether gain or loss on the disposition” is business income under the functional test.17 That is essentially a correct statement and simply another way of saying the legal issue presented under Section 25120 is whether the acquisition, management and disposition of the property (i.e., the stock) constituted an integral part of the taxpayer’s regular trade or business operations. The Ruling then goes on to conclude that “[i]n those circumstances in which the Board found the gain or loss on disposition to be business income, the taxpayer and the entity represented by the stock at issue had an actual operational business relationship of some significance.”18 Note here how the Ruling departed from the language of Section 25120 by looking for “an actual operational business relationship of some significance” instead of looking to the language in Section 25120 for “an integral part of the taxpayer’s regular trade or business operations.” One can envision scenarios where an “actual operational” business relationship of “some significance” under the benchmark of the Ruling may not be an “integral” part of a taxpayer’s “regular” trade or business operations under the standard adopted by the Legislature in Section 25120 and as interpreted by the court in Hoechst Celanese.
The Ruling goes on to state that the SBE has “consistently not focused on the taxpayer’s frustrated intention to acquire majority ownership in its intended target as determinative” and although that intent “along with other factors, may support a determination that an operational relationship did or did not exist, it is the actual operational ties and the significance of such ties that are most important.”19 While these are essentially correct statements, they are clearly an oversimplification of the proper analysis.
Remember that a unitary business and business income are different concepts and employ different law in their analyses. Recall that the Uniform Division of Income for Tax Purposes Act (“UDITPA”), which is the origin of the Section 25120 definition of business income, is a model apportionment formula that contains no provision addressing the tax base. But Occidental Petroleum and a number of other SBE decisions leap across that gap to connect the two concepts.20 Indeed, Occidental Petroleum boldly states that “if the income-producing intangible [e.g., stock] is integrally related to the unitary business activities, the income is business income subject to formula apportionment. If the intangible is unrelated to those activities, however, the income is nonbusiness income subject to specific allocation.”21 In the case of certain of the stock sales at issue in Occidental Petroleum, the SBE stated that business income was generated by those sales where “the stock had been acquired (or created) and managed in furtherance of the actual operation of appellant’s unitary business.”22 But here, the Ruling takes an alternative route and instead bridges the gap by interpreting the SBE decisions to find that having an asset related simply to “actual operational ties”–not unity–is sufficient to result in business income.
Consider the Holdings in the three situations discussed in the Ruling. In Situation 1, Corporation A has no preexisting or ongoing business relationship or operations with Corporation B, but purchased 20% of Corporation B’s stock “merely as part of its plan to acquire a majority interest” in Corporation B and “integrate” Corporation B into Corporation A’s unitary business.23 The Holding in Situation 1 states the gain or loss from Corporation A’s subsequent sale of Corporation B’s stock is nonbusiness income, because Corporation A’s “intention” was frustrated.24 This appears to be a clear-cut answer based entirely upon an assumption of the nature of the relationship between Corporation B’s stock and Corporation A’s business–that no unitary relationship existed between Corporation A and Corporation B and that there were no “actual operational ties” between Corporation A and Corporation B as provided in the language of the Ruling.
Situation 2 in the Ruling is more paradoxical. Under Situation 2, the only reason the parent purchased a minority stock interest in the target company was to gain information regarding the target’s technology. The two companies had no preexisting relationship and the parent never had the intent to acquire a controlling interest in the target company.25 The Holding in Situation 2 states the parent’s subsequent sale of the target’s stock generated business income; the rationale being that because of the technology information acquired by the stock purchase, which the Ruling identifies as an “operational factor,” the target’s stock was “integrated” into the purchaser’s “unitary business.”26 Initially, note how Situation 2 is not responsive to the Issue identified in the Ruling. The Ruling was designed to address a situation where one corporation purchases stock of another corporation “with the intent to integrate the target corporation into its unitary business operations.” 27 Situation 2 makes clear the purchaser had no such intent.
In any event, is the FTB saying here the target’s stock is “integrated” into the purchaser’s unitary business simply because of the technology gained? Apparently it is. Certainly the income from the technology gained may be business income, but why is the income from the sale of the target’s stock also then business income, especially if the technology transfer agreements with the target continue after the sale? The technology transfer agreements and the target’s stock are separate assets and each should be analyzed differently under Section 25120, unless the FTB believes business income is contagious and the character of one asset somehow contaminates the other asset.
Moreover, what does the FTB mean in its Holding in Situation 2 when it states the target’s stock is “integrated” into the purchaser’s “unitary business?” 28 Clearly, the Holding in Situation 2 assumes away the Issue in the Ruling which speaks of the situation where integration of the stock does not occur. If “unitary business” is used here in a combined reporting sense, then should not activities (i.e., payroll, property and sales) of the “unitary” minority stock ownership somehow be reflected in the parent’s combined report? If the term is not used in the combined reporting sense, how is the term used? To repeat: a business income analysis must remain true to the statute responsible for creating the need for that analysis. The language of Section 25120 does not speak of “unity” or “operational relationship.” That statute speaks of whether the “acquisition, management and disposition” of the asset constitute “integral parts of the taxpayer’s regular trade or business operations.”29 The FTB appears here to gloss over the terms of Section 25120 and use “unity” and “operational relationship” as a proxy for the language of the statute. While there certainly are similarities and commonalities among the terms, one must be careful when applying statutes. When interpreting a statute, “we must discover the intent of the Legislature to give effect to its purpose, being careful to give the statute’s words their plain, commonsense meaning. If the language of the statute is not ambiguous, the plain meaning controls and resort to extrinsic sources to determine the Legislature’s intent is unnecessary.”30
Holding in Situation 3 is the most instructive as to the FTB’s position regarding the stated Issue in the Ruling. Here, the parent and its 20% owned subsidiary had a prior agreement (i.e., before the parent acquired ownership in the subsidiary) under which the parent is a “significant distributor” of the subsidiary’s products.31 After the purchase of the subsidiary’s stock, the parent becomes the “predominant distributor” of those products. The FTB explains in its Holding that the gain on the parent’s subsequent sale of the subsidiary’s stock is business income because the “significant ongoing relationship” between the parent and subsidiary continued despite the parent’s unsuccessful attempt to acquire a majority ownership interest “and integrate it” into the parent’s “unitary business.”32 So, here, the Holding by the FTB is for business income, even absent integration of the stock into the parent’s unitary business because of the “significant ongoing relationship.”
Recall that the Issue in the Ruling involves the business/nonbusiness treatment of gain on the sale of a minority stock interest where: (1) there are preexisting operational ties; (2) there is the intent to integrate the target corporation into the parent; (3) the integration does not occur; and (4) the stock is later sold. Situation 1 instructs that where there are no preexisting operational ties, but an intention to integrate that is subsequently frustrated, the gain on the stock is nonbusiness income. Situation 2 instructs that where there are no preexisting operational ties, and no intention of acquiring control of the subsidiary, the gain on the stock sale is business income where the stock is integrated into the parent’s unitary business. While the reasoning of Situation 2 is interesting, for the reasons discussed above and for what it says about the FTB’s view on the relationship between the business income analysis and the unitary analysis, it is puzzling what place Situation 2 has in this Ruling. The Ruling is intended to address the significance of the intent to integrate and there is expressly no intent to integrate under the facts of Situation 2. Situation 3 is, by far, the most interesting and most relevant of the scenarios because of the FTB’s statement here on how strongly the FTB feels that preexisting operational ties justify business income treatment where there is a goal to integrate that is ultimately unrealized. One might read the Holding in Situation 3 to state that even where there is a frustrated intent to integrate the stock of a target corporation, the mere existence of some level of preexisting operational ties will be sufficient to make the gain on the sale of that stock business income. However, such a reading might do an injustice to the Ruling, because recall the factual scenario also involves the fact that after the purchase of the shares, the parent becomes the “predominant distributor” of the products of the target corporation. If the FTB is assuming here the stock ownership caused the parent to become the predominant distributor, and that but for the stock ownership, the parent would not have become the predominant distributor, then the FTB would seem to have the better side of the argument that the stock was acquired, managed and disposed of as an integral part of the parent’s regular trade or business operations under Section 25120. However, in the absence of that assumption, the mere existence of “preexisting operational ties” that cannot be causally linked to the acquisition of the stock, but nevertheless continue after the acquisition, hardly seem sufficient grounds by themselves under the language of Section 25120 to cause the gain on the ultimate sale of that stock to be classifiable as business income.
In summary, the FTB is to be commended for issuing the Ruling. Any written guidance from the FTB on the business income issue is a positive development and, certainly, in the context of the “potential” issue, there are many unknowns on which guidance is needed. The specific issue addressed in this Ruling, i.e., the relationship between the “potential” issue and “preexisting operational ties,” is a frequently recurring one. However, it is unfortunate that the three factual scenarios presented did not more forcefully address this relationship. In the author’s opinion, the key to properly weighing the importance of preexisting operational ties is examining whether those “pre” existing ties increase or decrease as a result of the purchase of the stock, i.e., the extent of the causal relationship between the stock ownership and increasing or decreasing “operational ties,” to use the FTB’s term. The Ruling falls short of addressing that key consideration.