A Reed Smith Quarterly Update (4th Quarter 2014)

Case Updates

California Supreme Court Accepts Review of Documentary Transfer Tax Case In our last quarterly update, we reported on a controversial opinion recently published by a California Court of Appeal. In 926 North Ardmore Avenue, LLC v. County of Los Angeles,1 the court held that when there is a change in control of a legal entity directly or indirectly owning real property, the sale of the ownership interests in the legal entity constitutes realty sold for purposes of the documentary transfer taxes imposed by Los Angeles County and the City of Los Angeles.

The decision rattled taxpayers and practitioners alike because the court reached its conclusion by basing its interpretation of the documentary transfer tax statute on property tax legislation enacted long after the enactment of the documentary transfer tax. It equated the documentary transfer tax concept of “realty sold” with the property tax concept of “change of ownership,” notwithstanding that the “change of ownership” concept was introduced as part of the legislation implementing Proposition 13, more than 10 years after the enactment of the real estate transfer tax legislation that the Court of Appeal was supposed to be interpreting.

The taxpayer filed a petition for review with the California Supreme Court, and several parties filed requests to depublish the Court of Appeal’s decision. The court granted review January 14, 2015.

Takeaway: The taxpayer and practitioners spoke, and the Supreme Court listened. That the court accepted the taxpayer’s petition for review indicates that the Supreme Court understands the merits of the case and its implications. The opening brief is due to be filed March 25, 2015.

Cutler v. Franchise Tax Board Previously, we reported that the California Court of Appeal held – in a published decision – that Reed Smith secured a significant benefit for the public by bringing a case that resulted in the court striking down portions of an unconstitutional and discriminatory tax incentive in Cutler v. Franchise Tax Board.2

Following the court’s decision, the Franchise Tax Board (FTB) filed a petition for review with the California Supreme Court, along with a request for depublication of the Court of Appeal’s decision. On November 25, 2014, the Supreme Court denied the FTB’s petition but, without comment, ordered the decision depublished. On January 9, 2015, Reed Smith filed its motion for attorney fees on remand. The FTB has until March 3 to file an opposition. The hearing is set for March 16 in Los Angeles Superior Court.

Regulatory Updates

Partnership Regulation questioned, yet approved by the FTB In a prior update, we reported that the FTB had plans to revise Regulations 25137-1 and 17951 4, relating to the apportionment and allocation of partnership income. One of the agenda items at the July 2014 Interested Parties Meeting was the proposed amendment to Regulation 17951-4. Regulation 17951-4 provides guidance for non-residents regarding the sourcing of income from a business, trade or profession conducted within and without California. The proposed amendment to the regulation would address the sourcing of income from a business, trade or profession conducted by a partnership with nonresident partners, and conform the sourcing of such income for purposes of the personal income tax with the with corporation tax allocation and apportionment rules found in Regulation 25137-1. The effect of this change would be to require the apportionment of partnership income at the partnership level, not the partner level. The amendment would effectively trump – at least with respect to income from partnership interests – the general rule, provided in Rev. & Tax. Code section 17952, that the income of nonresidents from intangible property is sourced outside of California, unless the property has acquired a business situs in-state.

At the December 2014 FTB meeting, FTB staff noted that because of taxpayer concerns, the amendments to the partnership regulations – which it believed merely clarified existing law – would be applied on a prospective basis only. FTB member Jerome Horton noted that making a regulation apply prospectively seems to imply that it is more than just a clarification of the law. Still, the FTB approved the amendments, which continue to move through the formal regulatory review process before the Office of Administrative Law.

Takeaway: The FTB’s proposed changes to the partnership regulations effectively supersede the application to partnership interests of the old general rule for sourcing receipts from intangibles. The fact that the FTB will be applying the rule on a prospective basis only appears to be a tacit acknowledgment by the FTB that the proposed amendments are a departure from existing law, rather than a mere clarification.