By default, California employs the worldwide unitary method to tax the income of corporations engaged in a unitary business on an international basis. That method has passed federal constitutional muster in cases where there is either a domestic1 or a foreign2 parent corporation. However, in 1986, and primarily for political reasons, the California Legislature enacted a water’s-edge election (“Election”) beginning in income year 1988, under which certain foreign operations of a taxpayer’s worldwide unitary business were excluded from the tax base.3
Terms of the Election
Subsequent to its legislative creation over 25 years ago, the Election has gone through many legislative amendments. Currently, the most basic of the terms of the Election are:
(1) it must be made on a timely filed original return for the year of the Election by all unitary taxpayers included in the combined report; (2) the taxpayer elects for an initial 84 month period and the Election generally remains in place thereafter until terminated; (3) the taxpayer agrees to the business income treatment of certain dividends; and
(4) the taxpayer agrees to the taking of depositions from key employees or officers and the acceptance of subpoena duces tecum for reasonable document production.4 Six classifications of entities are included in the water’s-edge
group, four of which are wholly-included and two of which
In general, the income and apportionment factors of a unitary CFC that are included in the water’s-edge group are determined by multiplying the income and apportionment factors of the CFC by a fraction, the numerator of which is the CFC’s Subpart F income (as defined in IRC Section 952) for that taxable year and the denominator of which is the CFC’s earnings and profits for that year (as defined in IRC Section
964).9 Thus, in the simplest of examples, if a CFC has Subpart F income of $100 for the year and its earnings and profits for the year are $200, then the so called “inclusion ratio” (i.e., 100/200) is 50%. That ratio does not change depending on the ownership interest held in the CFC.10 Likewise, 50% of the CFC’s apportionment factors – currently sales only11 –
are included in the combined report.12 If there is either no Subpart F income or no current earnings and profits, then none of either the income or the apportionment factors of the CFC will be included in the combined report.13
Other than any adjustments for dividends exclusions/ deductions discussed below, rarely should material issues arise regarding the computation of the current year earnings and profits figure to be used in the inclusion ratio because, in most cases, that figure can be taken directly from Federal Form
Likewise, regarding the income of the CFC against which the inclusion ratio is applied, other than adjustments for dividend exclusions/deductions discussed belo, rarely should material issues arise regarding the computation of the CFCs netincomebecausethatfigurecanbetakenfromtheCFCs booksandrecords,adjustedtoconformtoCaliforniataxla15
Dividend Elimination Under the Election
A significant problem involving CFCs under the Election arises in connection with how dividends are included in the Subpart F income used to compute the inclusion ratio where a CFC owns another CFC and a dividend is paid by a lower- tier CFC to a higher-tier CFC. There are typically two sections of the California Revenue and Taxation Code under which a
are partially-included.5 This article will examine the partial
corporation may eliminate or deduct such dividends.
inclusion of the income and factors of unitary controlled foreign corporations (“CFCs”).
Specifically, the CFCs subject to partial inclusion in the water’s-edge combined report are unitary CFCs, as defined in Internal Revenue Code (“IRC”) Section 957, that have Subpart F income.6 A CFC, generally, is a corporation organized in a foreign country that is more than 50% owned by U.S. shareholders.7 “Subpart F” income takes its name from Subpart F of the IRC and includes certain forms of passive income earned by CFCs, for example, dividends, income from bank accounts and stock investments.8 For federal tax purposes, Subpart F income is treated as a deemed dividend to the U.S. shareholder. However, in the
Election, Subpart F income becomes part of the formula used to determine the portion of the CFC’s income and factors that are included in the combined report.
Section 25106 generally provides that a corporation may
eliminate dividends received from unitary subsidiaries to the extent that the dividends are paid from unitary earnings and profits accumulated while both the payee and payor were members of the combined report.17 Second, Section 24411 generally provides a 75% deduction for qualifying dividends paid to a member of the water’s-edge combined report.18
A significant problem involving CFCs under the Election arises in connection with how
dividends are included in the Subpart F income used to compute the inclusion ratio where a CFC owns another CFC and a dividend is paid by a lower-tier CFC to a higher-tier CFC.
Whether dividends are eliminated under Section 25106 or deducted under Section 24411 is generally important in two contexts. First, the obvious difference is that Section 25106 provides a full exclusion while Section 24411 permits taxation of 25% of the dividends. Second, other provisions may provide a related disallowance or offset of expenses where dividends are deducted under Section 24411.
For example, Section 24425 disallows deductions for expenses that are “allocable”19 to items of income that are not included in the measure of tax, but Section 24425 does not apply to expenses that are allocable to dividends eliminated under Section 25106.20 In addition, Section 24344(c) provides that interest expenses incurred for purposes of foreign investment (as defined in the statute) may be offset against the foreign dividend deduction allowed under Section 24411.21 Thus, taxpayers may deduct expenses related to dividends eliminated under Section 25106, but expenses and interest expenses related to dividends deducted under Section 24411 may be curtailed under Sections 24425 and 24344(c).22
Taxpayers may deduct expenses related to dividends eliminated under Section 25106, but expenses and interest expenses related to dividends deducted under Section 24411 may be curtailed under Sections 24425 and 24344(c).
Fujitsu IT Holdings, Inc. v. Franchise Tax Board 23
In Fujitsu IT Holdings, Inc. v. Franchise Tax Board, the Court of Appeal held that where a CFC receives a dividend that was paid by a lower-tier CFC out of current year earnings consisting of a mix of income previously included in a combined report24 and excluded from a combined report, the dividends are (1) first treated as paid out of earnings eligible for full (100%) elimination under Section 25106; and (2) the excess is treated as paid out of earnings eligible for the partial (75%) deduction under Section 24411.
For example, if the lower-tier CFC has current year income of
$100, $60 of which was included a combined report25 and $40 of which was not included in a combined report, and pays a dividend of $100 to a higher-tier CFC in the combined report, then $60 will be eliminated under Section 2510626 and $40 should be deductible under Section 24411.27
Fujitsu also held that the dividends at issue were excluded not only because of the Section 25106 exclusion, but also because of California’s incorporation of IRC Section 959(b), which excludes from gross income such dividends to the extent they “are, or have been” included in the gross income of a U.S. shareholder under Subpart F.28
Fujitsu stated that in addition to the dividend elimination/ deduction from the income of the CFC, “dividends paid out of unitary income of lower-tier subsidiaries should be excluded from all the factors” used in the computation of the inclusion ratio of the recipient CFC.29 That is, such dividends should be excluded from the numerator (Subpart F income) and the denominator (earnings and profits).30 Thus, the $60 in the above example should be excluded under Fujitsu from both the numerator (Subpart F) and the denominator (earnings & profits) of the inclusion ratio.
The Franchise Tax Board’s (“FTB’s”) immediate reaction to its loss in Fujitsu was less than enthusiastic. In a 2005 Technical Advice Memorandum (“TAM”), the FTB directed audit and legal staff to implement Fujitsu as follows: (1) dividends described in IRC Section 959(b) will be excluded from the numerator of the inclusion ratio; (2) dividends described
in Section 25106 will be eliminated from the numerator of the inclusion ratio; (3) the FTB will not eliminate dividends described in IRC Section 959(b) or Section 25106 from the denominator (earnings and profits) of the inclusion ratio;31 and (4) dividends will be eliminated from the apportionable income base pursuant to Section 25106, but no reduction in the apportionable income base will be made with respect to dividends described in IRC Section 959(b).32 The FTB
stated these positions were taken “pending consideration” of
proposed amendments to the FTB’s regulations.33
Most surprising in the 2005 TAM was the FTB’s bold statement that notwithstanding Fujitsu, it would “continue” to treat dividends as being paid proportionately from the current year earnings and profits and then from the next succeeding prior year. To its credit, the TAM stated that taxpayers “should be advised this position is contrary” to Fujitsu, but that the FTB had prepared proposed regulatory amendments “to provide clarity with respect to this issue.”34 However, apparently upon further reflection and in light of the fact that the FTB never amended its regulations,35 the FTB later changed course and announced in a 2011 TAM that under Fujitsu, dividends paid from current year earnings and profits consisting of a “mix”
of included and excluded income should be treated as paid first out of earnings eligible for elimination under Section 25106, with any excess paid out of earnings eligible for partial deduction under Section 24411 until that year’s earnings
are depleted.36 This ordering rule (as opposed to a pro rata approach) remains the FTB’s current position with respect to Fujitsu under the 2011 TAM.
Apple, Inc. v. Franchise Tax Board 37
Seven years after Fujitsu, the Court of Appeal decided Apple, Inc. v. Franchise Tax Board.38 As in Fujitsu, CFCs partially included under the Election repatriated earnings as dividends to the parent. Apple argued that the dividends were being paid from the CFC’s undistributed earnings and profits accrued over the current and prior tax years and that California already had taxed all the earnings out of which the dividends were being
paid. Accordingly, Apple asserted that all of the dividends were excluded under Section 25106. In sum, Apple’s position was that Section 25106 was applied by first looking to the current year’s included income and next to the most recent year’s included income, and so forth, until all of the previously included (i.e., previously taxed) income was exhausted, and only then does one look to excluded income.
So, returning to the earlier example, Apple would argue that if the lower-tier CFC has current year earnings of $100, $60 of which were included in the current year a combined report and $40 of which in the current year were not included in a combined report, but the CFC has $40 of income from the immediate previous year that was included in the combined
report, and pays a current year dividend of $100 to the higher- tier unitary CFC, then the entire $100 will be eliminated under Section 25106.39
The FTB in Apple had a different view. The FTB argued that dividends were deemed paid first from current year’s earnings, regardless of whether or not all the current year’s
earnings were previously included in a combined report. The FTB argued that, in applying Section 25106, only after the current year’s earnings are fully exhausted does one look at the earnings in prior years.
So, in the above example, the FTB would argue that the $100 dividend is first deemed to be paid from the current year’s earnings of $100 and, because only $60 of those current year earnings was previously included in a combined report, the taxpayer is entitled to a deduction under Section 25106 of only
$60 (not $100).
The FTB prevailed in Apple. Accordingly, the FTB’s current
determining how members of the unitary group are included in the combined report. If an entity (even a CFC) is not unitary,
it is excluded from the water’s-edge combined report just as it would be excluded from a worldwide combined report.42 Also, consider the possibility that a taxpayer may have multiple unitary businesses.43 Second, determine if the income from the member is business income under California’s so-called transactional and functional tests.44 Third, determine the correct amount of income of the CFC for California purposes. Fourth, determine the numerator of the inclusion ratio based upon Subpart F income and ensure that certain dividends have been properly removed. Fifth, determine the denominator
of the inclusion ratio. Sixth, determine the includable apportionment factors (i.e., sales) of the CFC. Seventh, determine the proper amount of dividend deductions and eliminations under Fujitsu and Apple. Eighth, determine the impact of any dividend exclusions and eliminations upon claimed expenses under Sections 24425 and 24344(c).
Application of the Fujitsu and Apple Decisions
Finally, to consider a more abstract and interesting issue, was Apple correctly decided? Unfortunately, the California Supreme Court declined review in both Fujitsu and Apple, and both published Court of Appeal decisions were allowed to stand.
In the author’s opinion, certainly Fujitsu and Apple do not fit seamlessly together, and Apple’s distinguishing characterization of Fujitsu as addressing the application of Section 25106
and the inclusion ratio “in a different context” is a bit of an exaggeration.45 The Apple decision takes the position that because the facts in Fujitsu involved the ordering of dividends within a tax year, Fujitsu has nothing to say on the issue of the ordering of dividends involving prior tax years.46
position with respect to Apple and Fujitsu is as follows:
Ordering of Distributions Within a Year. Under Fujitsu, dividend distributions within a year are treated as first paid from that year’s earnings and profits, which are eligible for elimination under Section 25106, until those earnings are depleted, then from earnings eligible for other deductions, such as Section 24411, until that year’s earnings are depleted.40
Last-In-First-Out Ordering Among Years. Under Apple, the Last-In-First-Out (“LIFO”) ordering rule applies to de- termine the order of the years from which dividend distri- butions are made, starting with the current year, and, only after that year’s earnings are depleted, moving to the most recent prior year.41
To recap, where the Election is made involving CFCs, one should make the following basic inquiries: First, determine whether the dividend payor is a member of the taxpayer’s water’s-edge combined reporting group. Remember that
a water’s-edge election is simply the methodology for
The Apple decision takes the position that because the facts in Fujitsu involved the ordering of dividends within a tax year, Fujitsu has nothing to say on the issue of the ordering of dividends involving prior tax years.
Several questionable points appear to drive the Apple decision. First, the court there gave short shrift to the issue of double taxation, perhaps because both the court and the FTB pointed out that “Apple cannot demonstrate any actual double taxation here” because, under the facts in that case, all of the dividends not eliminated under Section 25106 were fully deducted under Section 24402.47 The FTB’s briefing to the appellate court also stressed this point that none of the dividends were subject to tax in the year in issue because they all had been eliminated
or deducted and, thus, Apple’s claim that the FTB’s ordering
rule led to double taxation lacked merit.48 However, as noted above, if the case had instead involved facts where dividends were deducted under Section 24411, then only 75% of those dividends (instead of 100%) would have been deducted and double taxation most certainly would be an issue.
In addition, if the dividends are deducted under Section 24411, there is still the issue of expenses being disallowed under Sections 24425 and 24344(c), which are related to those dividends. In short, the Apple court’s discussion of the double taxation issue is situational rather than comprehensive.
“expressly incorporated,” Fujitsu did, in fact, hold that California has “adopted” IRC Section 959(b) and the Fujitsu court then proceeded to apply that subsection.55 The problem with the second point is that the Fujitsu court certainly was aware of IRC Section 316 because they cited to it in defining dividend income.56 IRC Section 316, “Dividend Defined,” simply defines what a “dividend” is, but that section says nothing about how to “order” dividends, much less how to order dividends for purposes of applying a California-only dividend exclusion, i.e., Section 25106. The problem with
the third point is that the validity of regulation 24411 was
not even an issue in Fujitsu, and cases are not authority for
The Apple court’s discussion of the double taxation issue is situational rather than comprehensive.
propositions not considered.57 The regulation may indeed be invalid if one were to challenge it. In short, Apple improperly end-runs Fujitsu by proceeding on the premise that the Fujitsu court would have written a different opinion and would have
not have made the “assumption” that California had adopted
IRC Section 959(b) had the Fujitsu court considered the “clear
Second, the Apple court’s adoption of the FTB’s argument that, “unlike the circumstances in Fujitsu,” there is “specific statutory and regulatory authority” involving ordering and prior tax years is unsound.49 Apple found that IRC Section 316, incorporated by reference into the California Revenue and Taxation Code,50 and the FTB’s regulations51 both contain a LIFO, by year, dividend ordering rule.52 The problem with the Apple court’s reliance upon the regulatory authority is that an administrative agency may not promulgate a regulation that is inconsistent with the governing statute or that alters, amends, enlarges or impairs the scope of the statute, which brings us back to the question of the meaning, authority and scope of the underlying statute.53
The problem with the Apple court’s reliance upon the regulatory authority is that an administrative agency may not promulgate a regulation that is inconsistent with the governing statute or that alters, amends, enlarges or impairs the scope of the statute.
The problem with the Apple court’s reliance upon that statutory authority is that, as argued by Apple, IRC Section 959(c) contains “except as otherwise provided” language, which Apple argued to mean that IRC Section 959(c) “trumps” IRC Section 316. The court rejected Apple’s argument here by stating that: (1) IRC Section 959(c), “unlike IRC section 316,” is not “expressly incorporated” into the California Revenue and Taxation Code; (2) Fujitsu did not consider the “clear language” of IRC Section 316; and (3) Fujitsu “did not purport to invalidate Regulation 24411.”54
The problem with the first point is that whether or not
language” of IRC Section 316 and FTB regulation 24411.58
Additionally, Apple essentially ignores the discussion and conclusion in Fujitsu regarding the purpose and function of Section 25106:
The Legislature could hardly have chosen words with a clearer meaning. Simply put, section 25106 ensures that amounts included in the combined income of a unitary group can be moved (in the form of dividends) among members of the unitary group without tax consequence. The reason for this is also clear. In a combined unitary group, the subsidiaries’ apportioned earnings are taxed as income of the unitary business. Because the state has already taxed the earnings out of which the dividends are paid, the dividends themselves are not subject to taxation. This prevents dividends from subsidiaries from being taxed twice – once as earnings of the issuing subsidiary, and once as separate income to the unitary business from receipt of the dividend.59
The Apple court responded simply that Section 25106 says nothing about the ordering of dividends or the tax year in which they should be recognized.60 The court’s approach ignores the language above, that Section 25106 ensures that amounts included in the combined income of a unitary group can be moved (in the form of dividends) among members of the unitary group “without tax consequence.”61
Although the Apple court concedes that Section 25106 “expresses a clear legislative policy against imposition of double taxation on income,” the court goes on to state that it was not convinced that the double taxation “specter” Apple invoked necessarily arose simply by virtue of LIFO ordering of
the dividend distributions.62 Most telling is the Apple court’s next statement that “[c]ertainly it does not appear that it did so with respect to the tax year at issue here.”63 Again, the author reads much of the Apple decision as being driven by the fact that both parties and the court agreed that none of the dividends for the year in issue were being taxed by the FTB because they were all either being eliminated or deducted in
any event. That will not be the case for a taxpayer where only a partial (i.e., 75%) deduction is taken under Section 24411, but Section 24411 was not an issue in Apple.
Fourth, there is perhaps a subtle undercurrent in Apple of a need to rule to prevent tax avoidance. For example, the Apple court comments that to allow preferential ordering of dividends between tax years, as sought by Apple, “would allow potentially indefinite tax avoidance . . . .”64 The FTB added fuel to the fire by arguing in its briefing to the court that Apple’s proposed ordering rule was a “manipulation of the tax laws . . . .”65 Not so. Tax “avoidance” to use the Apple court’s term, or more correctly, the avoidance of double taxation, would continue only until all previously taxed income was exhausted as a source for dividend elimination under Section 25106.
Finally, although referencing it, the Apple decision appears to give little weight to the California Supreme Court’s
longstanding rule that ambiguities in tax statutes are resolved in favor of the taxpayer.66 Still further, while both the Apple and Fujitsu decisions cite to a standard body of case law that such decisions are not legally binding, the court in Apple seems to have given excessive and unwarranted deference
to the lower administrative decision in the matter by the
California State Board of Equalization.67
In conclusion, the inclusion ratio for CFCs under California’s water’s-edge election presents a variety of continuing issues involving the application of Fujitsu and Apple. And, in the author’s opinion, Apple is ripe to be re-litigated.