California combined report includes unitary insurance subsidiary.

• Author: Sakurai, Edward

In a recent letter decision, the California State Board of Equalization (SBE) ruled that a taxpayer's combined report should include a wholly owned unitary insurance subsidiary (SBE Letter Decision No. 361467, Appeal of Electronic Data Systems Corp. (8/8/08)). In addition, the decision held that the premiums received from the subsidiary's Texas insurance operations should be included in the calculation of the parent company's sales factor.

Background

Electronic Data Systems Corporation (EDS) filed California franchise tax returns for the years ended December 31, 1997, and December 31, 1998. EDS had a unitary insurance subsidiary, National Heritage Insurance Company (NHIC), which conducted an insurance business in Texas and also conducted a noninsurance business in California. NHIC was qualified to do business as an insurance company in Texas and was regulated by the Texas Department of Insurance.

EDS excluded NHIC from its combined reports for the years at issue. On audit, the California Franchise Tax Board (FIB) auditor determined that NHIC should be included in the EDS combined report. In computing the California sales factor, the auditor did not include premiums received by NHIC from its insurance business in the sales factor denominator.

EDS protested the auditor's findings and later filed an appeal asserting that the auditor was correct that NHIC should be included in EDS's combined reports and further asserted that the premiums from NHIC's Texas insurance activities should be reflected in its sales factor.

Inclusion in Combined Report

EDS originally excluded NHIC from its combined reports for the years at issue, relying on FTB Legal Ruling 385, Treatment of Insurance Company Affiliates for Combined Reporting Purposes (3/28/75). In addressing that ruling, the SBE found that the ruling's basic holding was that instate insurance affiliates must be excluded from a combined report. Legal Ruling 385 stated that its holding also applied when an affiliated insurance company operated "entirely outside of California."

Thus, Legal Ruling 385 could be read two ways. First, it could apply whenever the unitary affiliate conducted its insurance business entirely outside California, whether or not it conducted any other business in California. Second, the ruling could be read to apply only when the unitary affiliate conducted all its business outside California.

Given that Legal Ruling 385 could be interpreted in two ways, the question became one of...