Federal consolidated return principles create confusion in California combined reports.

• Author: Salmon, Scott A.
• Position: Appeal of Rapid-American Corp.

California recently opened a new chapter in its ongoing struggle with the use of Federal consolidated return principles in the California combined report. A pair of rulings illustrates the conflict and confusion created by simultaneously rejecting and embracing such principles.

Appeal of Rapid-American Corp.

In Appeal of Rapid-American Corp. (10/10/96), the State Board of Equalization (SBE) declined to apply Federal consolidated return principles to calculate the stock basis for California franchise tax purposes of a subsidiary owned by a member of the same combined group. Under Regs. Sec. 1.1502-32, a parent's basis in a consolidated subsidiary's stock is generally increased by that subsidiary's undistributed taxable income. In contrast, the SBE held that, for California franchise tax purposes, a parent's stock basis in its subsidiary may not be increased to reflect that subsidiary's undistributed earnings.

The taxpayer, which filed a California combined report with its subsidiaries, realized substantial capital gains from the sale of several subsidiaries. The taxpayer reduced the gains to reflect increases in its stock basis attributable to the undistributed earnings of each of the disposed subsidiaries. The taxpayer contended that the increases were necessary to prevent double taxation of the subsidiaries' retained earnings, which already had been reported as income in previous California combined reports. In disallowing the adjustment, the SBE held that the lack of an upward basis adjustment did not result in impermissible double taxation; although the subsidiary's earnings had been taxed as the income was earned, those earnings had not been previously subjected to tax at the shareholder level. Even though an upward basis adjustment is allowed under Regs. Sec. 1.1502-32, there was no California statute, regulation or case allowing a similar adjustment for members of the same California combined report. Accordingly, the SBE declined to allow the taxpayer to exclude the gain that would have been eliminated if the stock basis had been adjusted.

The SBE rejected concerns that denying the upward basis adjustment may open the door to manipulation. The taxpayer noted that the state could be "whipsawed" by this holding. As an example, the taxpayer stated that a parent corporation planning a divestiture could have the subsidiary declare a dividend of all its earnings and profits (E&P) prior to the sale. This intercompany dividend generally would...