Every state has its own way of taxing banks and financial institutions, whether they impose some version of the corporate income tax or create a separate system of taxation. California’s Franchise Tax Board (FTB) alleges that it has apportionment issues when it comes to taxing gold (i.e. financial institutions) in the Golden State, but may have come up with a solution.
California Financial Institutions
For some background, California taxes banks and financial entities at the same rate as general corporations, plus 2 percent. That system worked until entities started acquiring and controlling general corporations like security broker-dealers and filing state taxes as mixed financial and non-financial combined reporting groups.
California defines financial institutions as corporations where more than 50 percent of total gross income is attributable to dealings in money or moneyed capital in substantial competition with the business of national banks under Regulation 23183. These financial institutions typically generate large amounts of business income and small amounts of gross receipts.
Apportionment of Income to California
When banking entities and security broker-dealers file taxes in California in the same combined reporting group, the method in which their income is apportioned to California under the current Regulation 25137-4.2 distorts the apportionment formula in a way that the FTB claims does not accurately reflect the income of the group.
The California apportionment formula is the method the state uses to determine how much income of a multistate taxpayer it can tax. In 1990, the state adopted specific apportionment rules for situations where financial and non-financial corporations combine in unitary business groups under Regulation 25137-10.
“The problem is that RTC 25120 specifically confirms that a broker-dealer uses gross receipts (not net receipts), as does the old Merrill Lynch case from the SBE. The statute requires them to use gross receipts. But when you put those gross receipts into a combined report with a bank or financial institution, that has to include only net receipts under the 25137-4 regulation, and the FTB thinks that is distortive. The problem is magnified because the broker-dealer gross receipts come with a very low income margin,” explained Eric Coffill, Senior Counsel with Eversheds Sutherland’s Sacramento, Calif., office and co-author of California Corporate Income Tax Navigator (subscription required).
The sales factor is part of the apportionment formula and contains, among other items, income in the numerator and gross receipts in the denominator under Regulation 25137-4.2. Security broker-dealers typically generate large amounts of gross receipts and small amounts of business income, the opposite of their financial institution parents, which, the FTB claims, inflates the denominator and reduces tax liability to California.
The FTB’s Small Cap Solution
A few months ago, the California Franchise Tax Board held a second interested parties meeting (IPM) for possible amendments to California Code of Regulations, title 18, sections 25137-10 (Combination of General and Financial Corporations) and 25137-4.2 (Banks and Financial Corporations – Allocation and Apportionment of Income) regarding the proper treatment of mixed financial and non-financial combined reporting groups.
The FTB “believes the most reasonable and legally supportable solution is to include in the sales factor the broker-dealer principal trade transaction receipts at net. However, as an alternative approach, staff is further considering the possibility of including broker-dealer principal transaction receipts at gross in the sales factor, provided that the principal transaction gross receipts are capped at a small percentage of the combined reporting group's total sales factor denominator,” according to the FTB Supplemental Request for Comments.
This “small cap” solution would limit the amount by which subsidiary security broker-dealers could reduce the unitary group’s tax liability in California by restricting the amount of gross receipts taken into account in the denominator of the sales factor. It is one of many of proposed solutions to the apportionment dilemma, and one that the FTB appears to favor. “The FTB wants to keep the broker-dealer from including gross receipts. One current idea from FTB is to only include some small piece of those gross receipts,” said Coffill.
“FTB staff is preparing a report to summarize the comments received from the public during the last IPM and those received in response to the staff’s recent Supplemental Request for Comments,” the FTB told Bloomberg BNA, “The staff is also working on a draft statement explaining the rationale behind the possible ‘small cap’ solution. However, both the comments summary report and the draft explanation are still under FTB internal review.”
Affected taxpayers should not hold their breath for an answer to the apportionment distortion problem. The issue goes back decades and the first IPM was held in 2014.
Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: Is the FTB’s Small Cap Solution the best way to solve the apportionment distortion issue?
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