Clean Break: Terminating Agency Relationship With Key Corporation

• Publication year: 2016
• Author: By Mike Shaikh & Erin Mariano

Clean Break: Terminating Agency Relationship with Key Corporation1

By Mike Shaikh & Erin Mariano²

EXECUTIVE SUMMARY

California combined group filing is quite simple: Each corporation filing in California must file a separate return. Corporations that are part of a combined unitary group may elect to file a combined report, with a "key corporation" filing on behalf of each member of the group and taking any future actions on behalf of all group members. This election is made for a particular tax year. By default, the election continues in perpetuity, permitting the key corporation to act on behalf of all other members, even after a member is no longer part of the unitary group. The election for any given tax year may be withdrawn by providing notice to the Franchise Tax Board ("FTB").

Though simple, lack of education and guidance to taxpayers has left some taxpayers in the dark regarding actions that other corporations may take on their behalf. Some taxpayers are unaware that the relationship may be severed. Others, relying on language in tax forms, believe that ending the relationship for future years does so for past years as well.

In this paper, we seek to bring clarity to this problem by making taxpayers explicitly aware of their options and giving them a simple manner of communicating that choice with the Franchise Tax Board.

We propose clarifying when and how taxpayers may terminate the key corporation election. Our proposal is to include new language on Schedule R-7 - the Schedule on which the group filing election is made - and on a new short-form schedule. The language would state that - upon severance of a unitary relationship - a taxpayer or key corporation has three options with regard to prior tax periods: (1) completely sever the key corporation relationship; (2) continue permitting the key corporation to act on behalf of the former group member, but provide the former group member notice of dealings with the FTB; or, (3) continue the relationship as-is.

We believe bringing these options to the forefront would bring necessary clarity to California corporate taxpayers.

DISCUSSION

California taxpayers computing income on a unitary basis are required to file separate returns. The Franchise Tax Board permits elections for a "key corporation" to file returns and act as agent for all members of a unitary group. This allows "affiliated taxpayers to avoid the burden of filing duplicative combined reports, while allowing the Franchise Tax Board to coordinate with only one taxpayer as opposed to many."³

The FTB permits corporations to sever the key corporation election with written notice.⁴ Many taxpayers are unaware of such an option. And others believe ending the unitary relationship for one year severs ties for all years. In either event, educating taxpayers about their options and permitting an easy way to exercise their options would go a long way. Our proposed remedy provides both the education and accessible opportunity.

First, we discuss some background for context.

I. THE ELECTION TO FILE A SINGLE REPORT WITH A KEY CORPORATION AS AGENT IS EFFECTIVE, BUT THERE MUST BE CLEAR OPTIONS ON HOW TO TERMINATE THE ELECTION.

Corporations that are part of a unitary business must compute income by reference to the total combined income and apportionment factors of the entire combined reporting group.⁵ Despite computing California-source income on a combined basis, each member is ultimately responsible for reporting and paying its own tax liability based on its own share of the California income.⁶

Requiring each corporation to separately report and pay its own tax liability can, of course, become unnecessarily complex both for the members of the combined reporting group and for the state. In addition to each corporation preparing and filing a separate return and making a separate payment to the state, could potentially result in different audits, notices, amended returns, refund claims, and even different statute of limitations expirations for each entity. Of course, this type of separate administration for each corporation can occur in separate filing states, where corporate taxpayers compute income on an individual basis.⁷ In California and other states where taxpayers compute income by reference to the unitary group, it makes sense for the unitary group to also file one return. Thus, California offers an election for the members of the unitary group to file a return as a group and allow one corporation within that group - the "key corporation" - to act for all other members.⁸

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The key corporation is an agent for all members of the group.⁹ It possesses various rights, obligations, and duties: it can fulfill a member's filing obligation if a member fails to file its own return;¹⁰ it acts as a surety for each member for income and franchise tax payments owed;¹¹ it has the authority to execute tax filing extensions or waivers to extend the statute of limitations for all members of the group;¹² it can receive notices regarding the liabilities for any member and any additional amounts due may be assessed and billed to it, for which it is liable;¹³ and, it can receive any member's refund or credit.¹⁴

The key corporation must either be the parent corporation of the combined reporting group¹⁵ or, if the parent corporation is not a taxpayer member, then the taxpayer member with the largest California property factor numerator.¹⁶ Taxpayer members are corporations that are required to file returns in California,¹⁷ are members of the combined reporting group,¹⁸ have the same taxable year as the key corporation or have a taxable year wholly within the key corporation's taxable year,¹⁹ and have the same statutory filing due date as the key corporation for the taxable year.²⁰

Members of a combined reporting group are permitted to make an annual election to file a group return. As detailed in the FTB's regulations, each year's election is binding on the key corporation and taxpayer members for the taxable year of the election.²¹ The election is made by having the key corporation file Schedule R-7 and listing each member of the unitary group.²²

By default, each tax year's election continues in perpetuity, regardless of anything else that happens between the key corporation and its member in later years. Thus, the split of or sale of a member of the unitary group in a later year does not sever the election for the tax year for which the election was taken.

This rule makes sense. The election was taken for efficient tax administration in a year in which all electing members determined their income and apportionment as a group. It remains administratively convenient for taxpayers who elected to file one return to continue having the key corporation agent to act on their behalf.

Of course, when a corporation leaves a group, any agency relationship between the parent and subsidiary would terminate for certain non-tax purposes. Despite the administrative efficiency, the parties may desire the same termination for tax purposes. And even though the corporations filed a combined return, each member of the group remains ultimately liable for its own share of tax liabilities in any given year.²³ Thus, when interests are adverse, the former member may not want the key corporation to act on its behalf.

The FTB is cognizant of the potential adversity with former group members. And the FTB's regulations provide a solution. Just as with any agency relationship,²⁴ the members of the group can terminate the authority of the key corporation to act on their behalf at any time.²⁵ Once the agency relationship is terminated, the key corporation cannot bind any member who terminates the relationship.

It is the method of terminating the agency relationship that we believe must be changed. By regulation, members of the combined reporting group can terminate the key corporation election by notifying the FTB and the key corporation.²⁶ Of course, this can be achieved by simply sending a letter to the FTB and key corporation notifying a termination of the agency relationship. This is not the whole picture. As we will describe in more detail below, the current Schedule R-7 does not contain an explicit method of terminating the election, yet it contains a section that can lead some to...