California Source Net Operating Losses:

• Publication year: 2021
• Author: Karen Notz and Lili Sowlati

CALIFORNIA SOURCE NET OPERATING LOSSES:

A PROPOSAL FOR ELIMINATING INEQUITY IN COMBINED REPORTING BY PROVIDING TAXPAYERS IN A COMBINED REPORTING GROUP WITH AN OPTION TO ASSIGN CALIFORNIA SOURCE NET OPERATING LOSSES TO OTHER MEMBERS IN THE SAME COMBINED REPORTING GROUP¹, ²

AUTHORS

Karen Notz

Lili Sowlati

EXECUTIVE SUMMARY

The issue is straightforward-the existing provisions within California's combined reporting regulations regarding the utilization of California source net operating losses generated by taxpayer members of a combined reporting group results in the incongruent tax treatment of taxpayers required to use combined reporting compared to taxpayers that use separate accounting. In addition, with respect to the application of California source net operating losses, the existing provisions within California's combined reporting regulations are inconsistent with California's rules regarding the utilization of most tax credits generated by taxpayer members of a combined reporting group.

Under the existing provisions, a taxpayer member of a California combined reporting group may only reduce its own post-apportioned California source income with a net operating loss the taxpayer member incurred in a prior year. Consequently, a California source net operating loss, which is calculated by aggregating the profits and losses of all members of the California combined reporting group, may not be shared with another taxpayer member of the same combined reporting group to offset or reduce the other taxpayer member's portion of California source business income attributed to the combined reporting group.

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In 1999, the California Franchise Tax Board adopted the combined reporting regulations in accordance with California's tax laws at the time. Since then, there have been significant changes and developments to the state taxation of combined reporting groups and the calculation of the California apportionment factor, which impacts the effect of California's combined reporting regulations. As a result, certain provisions within California's existing combined reporting regulations have been operating in a manner that results in the disparate treatment of California source net operating losses (compared to other tax attributes generated by members of a combined reporting group), to the detriment of the individual taxpayer that generated the California source net operating loss as well as the other taxpayer members within the same combined reporting group.

This paper proposes that the Franchise Tax Board amend subsections(c)(1)(C) and (e) of California Code of Regulations Section 25106.5 to provide taxpayer members of a combined reporting group with an option to assign California source net operating losses generated while a member of a combined reporting group to other taxpayer members within the same combined reporting group. Enacting this change would parallel how California currently treats most tax credits generated by taxpayer members of a combined reporting group. As such, providing an option to assign California source net operating losses to other taxpayer members of a combined reporting group resolves the incongruent tax treatment between taxpayers required to use combined reporting and those that use separate accounting, while also resolving the disparate treatment between most tax credits and general business net operating losses generated by taxpayer members of a combined reporting group.

DISCUSSION

I. APPLICABLE LAW

A. OVERVIEW OF COMBINED REPORTING

California Revenue and Taxation Code ("R&TC") Section 23151 imposes a corporate franchise tax on the net income of every corporation doing business in California.³

For corporations that derive income from sources both within and without California, R&TC Section 25101 provides that the corporate franchise tax is measured by net income derived from or attributable to California sources.⁴ Generally, corporations conducting business in multiple states, including California, determine the portion of their total net income attributable to California based on an apportionment formula that relies on one or more factors (i.e., sales, property, and payroll).

In the case of two or more corporations that are members of a commonly controlled group and are engaged in a "unitary business" within and without California, are required to use a California combined report to determine their California source income subject to tax under R&TC Section 25101.⁵ The corporate franchise tax is measured in the same manner for unitary business groups as it is for a non-unitary single corporations (i.e., measured by net income derived from or attributable to California sources).⁶ The only distinction arises when determining the portion of a unitary business's total income attributable to California sources because California utilizes the unitary business principle.⁷

The unitary business principle is premised on the notion that a common business activity conducted by a commonly owned or controlled group of corporations is considered to be a single trade or business.⁸ In a nutshell, the unitary business principle recognizes that for tax purposes, a company can be an integral part of a larger unitary system, and thus, the use of "separate accounting is inadequate and unsatisfactory when ascertaining the true result (i.e., business income) of the activities and values attributable to that business."⁹

In general, California considers a group of commonly controlled corporations to be engaged in a single trade or business (a "unitary business") if there is evidence to indicate that the corporations' activities within and without California are integrated with, dependent upon, or contribute to each other and

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the operations of the corporation as a whole.¹⁰ Corporations that are required to be included in the same California combined report are collectively referred to as the "combined reporting group."¹¹

The purpose of the combined report is to provide a fair method for computing California source income for corporations engaged in a unitary business. In other words, the combined report is a means by which the business income of a unitary business is divided ("apportioned") among the various taxing jurisdictions in which the unitary trade or business is conducted.¹² In a combined report, the entire amount of unitary business income of all corporations in the combined reporting group (including unitary members with no property, payroll, or sales within California) is aggregated into the combined report.¹³ Subsequently, the total combined business income is apportioned to California in accordance with California's combined reporting method, and to the unitary members subject to tax in California, by formula apportionment commonly referred to as "intrastate apportionment".¹⁴

It is important to note that only when two or more corporations conduct a unitary business within and without California are they required to file a combined report. In contrast, unitary businesses that are wholly within California, have the option to file a combined report or use separate accounting.

B. MECHANICS OF THE CALIFORNIA COMBINED REPORT

Although the California Legislature ("Legislature") established the general statutory framework for combined reporting in California, it did not provide taxpayers with any guidance regarding the mechanics of California combined reporting. Instead, the Legislature delegated its rulemaking authority to the Franchise Tax Board ("FTB") in R&TC Section 25106.5, by specifically granting the following authority:

The FTB "may adopt regulations necessary to ensure that the tax liability or net income of any taxpayer whose income derived from or attributable to sources within this state which is required to be determined by a combined report pursuant to Section 25101 or 25110 of this chapter, and of each entity included in the combined report, both during and after the period of inclusion in the combined report is properly reported, determined, computed, assessed, collected, or adjusted."¹⁵

In accordance with this authority, the FTB published in 1999, a set of combined reporting regulations under Sections 25106.5 through 25106.5-11 of the California Code of Regulations ("CCR"), which provide definitions, procedures and detailed rules regarding the general mechanics of combined reporting.¹⁶

C. TAXATION OF MEMBERS IN A COMBINED REPORTING GROUP

California recognizes each member of the combined reporting group as a separate legal entity with its own distinct tax liability.¹⁷ In other words, each member of a combined reporting group is subject to tax in California individually, as a separate company.¹⁸ Thus, despite being engaged in a unitary business, a combined reporting group may include two types of members: (i) taxpayer members, which are subject to tax in California, and

non-taxpayer members, which are not subject to tax in California but are members of the combined reporting group because they are unitary with the taxpayer members.¹⁹

As a result, CCR Section 25106.5(c) provides that each member of a combined reporting group is required to compute its California source income in accordance with a seven-step process, in the order indicated below.²⁰ Please note, the paper is only focused on the issue presented in the last step, relating to the utilization and carryforward of

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California source net operating losses generated in a combined reporting group.

First, each member of a combined reporting group must identify its total separate net income as if the member was not part of the combined reporting group, subject to the following three modifications:

• Intercompany Transactions-California conforms to federal consolidated return regulations for intercompany transactions (i.e., Treasury Regulation Section 1.1502-13), and thus provides for the deferral of gains or losses from intercompany transactions in order to produce the effect of transactions between divisions of a single corporation.²¹
• Capital...