No Sugarcoating: The California Office of Tax Appeals Limits the California FTB’s Application of Legal Ruling 2006-01 the Appeal of Southern Minnesota Beet Sugar Cooperative (2023-OTA-342P) (Beet Sugar), the California Office of Tax Appeals (OTA) issued a precedential opinion holding the California Franchise Tax Board (FTB) is not entitled to apply its FTB Legal Ruling 2006-01 (Apr. 28, 2006) to prohibit taxpayers from including in their apportionment factors property, payroll, and sales that generated statutorily deductible income. The OTA’s guidance on the FTB’s interpretation and application of Legal Ruling 2006-01 in this opinion also has implications beyond the specific issue in Beet Sugar, as the FTB has been attempting to expand the application of the limited legal ruling to other inapplicable situations. For example, an opinion by the OTA in the Appeal of Microsoft Corporation & Subsidiaries (OTA Case Number 21037336) is also anticipated to be issued soon, which appeal concerns whether the FTB is entitled to apply Legal Ruling 2006-01 to prohibit taxpayers from including in their apportionment sales factors statutorily deductible foreign dividend amounts.

In Beet Sugar, the taxpayer was an agricultural cooperative corporation permitted to deduct certain income by statute related to its agricultural business activities. During the period at issue the taxpayer included all its property, payroll, and sales attributable to its deductible income in its apportionment factors. The FTB sought to exclude the property, payroll, and sales attributable to the taxpayer’s deductible income from the apportionment factors on the basis only activities giving rise to net business income are appropriately included in the apportionment formula, primarily relying on Legal Ruling 2006-01 for this position. The OTA disagreed with the FTB’s position in a thorough analysis.

The OTA first analyzed and in turn determined the plain language of the Uniform Division of Income for Tax Purposes Act (UDITPA), including its accompanying regulations, do not prohibit the taxpayer from including property, payroll and sales attributable to its statutorily deductible income from its apportionment factors. Second, the OTA determined the sole case cited by the FTB in support of its position, Chase Brass & Copper Co., Inc. v. Franchise Tax Bd. (1977) 70 Cal.App.3d 357, was inapplicable because Chase Brass involved the issue of intercompany transactions within a combined reporting group whereas Beet Sugar involved gross income generated from outside the combined reporting group and subsequently deducted. Last, the OTA turned to the FTB’s primary reliance on Legal Ruling 2006-01 for its position in the appeal and determined, over the course of a seven-page analysis, the FTB’s position is not entitled to deference.

As noted by the OTA in Beet Sugar, FTB Legal Ruling 2006-01 addresses the issue of how activities related to income that is partially or completely excluded or exempted from the measure of the income or franchise tax should be reflected for apportionment factor purposes. Specifically, the legal ruling squarely addresses two hypothetical situations the OTA found to be distinguishable from the issue in Beet Sugar: (1) when an organization that is exempt from California’s franchise or income tax engages in activities that generate both exempt and taxable income, only the non-exempt activities reflected in the tax base should be included in the apportionment formula; and (2) when a U.S. corporation receives a dividend from a unitary foreign corporation excluded from the group’s water’s-edge election, and eliminates 75% of the dividend income from its tax base pursuant to California tax law, only 25% of the dividend is includable in the apportionment formula because the remaining 75% was excluded from the U.S. corporation’s tax base.

The OTA expressly stated Legal Ruling 2006-01 “should be viewed with caution when considering its application to different factual situations.” The OTA also highlighted the FTB’s own website statements that its legal rulings represent its conclusion “regarding the application of law to the entire statement of facts specified[,]” and that taxpayers and others are therefore “cautioned against reaching the same conclusion in other cases unless the facts and circumstances are the same.”

As the specific hypotheticals in Legal Ruling 2006-01 were not applicable to the issue in Beet Sugar, the OTA addressed the FTB’s basis for seeking to expand the legal ruling to other situations, which boils down to a short footnote in the legal ruling. As characterized by the OTA, footnote four of Legal Ruling 2006-01 “broadly asserts this same analysis ‘would apply regardless of whether the statute uses the term “exempted,” “excluded,” “deducted,” “not recognized,” etc.’” and then “disclaims any reliance on statutory language.” The OTA did not approve of the FTB’s grouping of all such terms of art together, and specifically distinguished statutorily deductible income from income that has been “exempted,” “excluded,” or “not recognized” because unlike “deducted” income the other three items generally do not enter into gross income (or gross receipts) and are not included in net income.

The OTA also rejected an argument by the FTB that the California Legislature endorsed Legal Ruling 2006-01 in 2016 when it stated “‘[i]t is the intent of the Legislature that [FTB] Legal Ruling 2006-01 . . . regarding the treatment of apportionment factors attributable to income exempt from income tax shall apply to apportionment factors attributable to the income of qualified health care service plans […]’” The OTA determined that “[i]f anything, the Legislature’s statement—‘income exempt from income’—appears to endorse Legal Ruling 2006-01’s conclusion related to organizations exempt from the CTL, but should not be broadly interpreted as applying to the deductible member income at issue here.”

Additionally, the OTA rejected an argument by the FTB that the following quote from Professor William Pierce, the principal drafter of the model act reflected in California’s UDITPA, bolstered its position: “[T]he uniform act assumes that the existing state legislation has defined the base of tax and that the only remaining problem is the amount of the base that should be assigned to the particular taxing jurisdiction. Thus the statute does not deal with the problem of ascertaining the items used in computing income or the allowable items of expense.” The OTA determined this statement does not support the FTB’s position because it does not suggest deductions that reduce the tax base also require alterations to the apportionment formula. In fact, the OTA found that if any inference can be drawn from the statement, it is that the computation of net income, including the application of deductions, is determined “before and separate from the UDITPA.” The OTA also cited to other guidance by Professor Pierce supporting the conclusion that the taxpayer activities at issue should be included in the group’s apportionment formula since they contribute to the overall production of the group’s business income.

In sum, the OTA decidedly denied the FTB’s attempts to expand the deferential scope of Legal Ruling 2006-01 beyond the specific two hypothetical situations squarely addressed by the legal ruling. Accordingly, taxpayers should take a close look at any disputes with the FTB regarding the FTB’s interpretation and application of Legal Ruling 2006-01 in light of this new precedential legal authority. The Pillsbury SALT Team will continue to report on related developments, including the anticipated issuance of the OTA’s opinion in Appeal of Microsoft Corporation.