California NOLs should be carried over and deducted on a combined group basis
California requires affiliated corporations conducting a unitary business to file a combined report, thus treating the group “as an integral unit in an entire business comprising the parent and all of its subsidiary corporations.”1 If the business is conducted in more than one legal entity, the state “look[s] at the total income of the group.”2 Therefore, although the statute imposes tax on “every corporation doing business” in California,3 the tax itself is computed as if a unitary group of corporations were a single entity.
The method of computing income of corporations within a unitary group also applies when computing losses of the members of the group. Thus, consistent with the theory of a unitary business, if a corporation is a member of a unitary group, an NOL is generated if the group’s deductions exceed the group’s gross income. The Franchise Tax Board (FTB) agrees with this proposition. Thus, it follows that if the NOL is defined by reference to the group’s deductions and gross income, the resulting carryover and deduction must be made against the group’s gross income in a succeeding year. Indeed, the business income from all activities of a unitary business is combined into a single combined report, whether activities are conducted by divisions of a single corporation or by members of a commonly controlled group of corporations.4
Despite computing income and losses as a unitary combined group, Regulation 25106.5(e) explicitly computes an NOL at the corporate member level. It does so based on a reading of Revenue and Taxation Code Section 25108 that removes any context from its definition of “net operating loss.” That section defines the NOL deduction for a unitary group engaged in a multistate business. Section 25108 uses the singular term to refer to the taxpayer (“the corporation” or “that corporation”). But that singular term reflects the singular unitary group unit—not the particular legal entity within the unitary group. Thus, under Section 25108, the group’s net loss is deductible against the group’s net income.
Our interpretation of Section 25108 is valid for two reasons.
This method is consistent with the California Legislature’s intent:
There is no indication in the statute that the Legislature intended for NOLs generated by a unitary group as a whole to be deductible only by certain members of the group. To the contrary, when California’s tax agencies have adopted a position contrary to unitary theory, the Legislature has stepped in to correct that position.
This method is consistent with both the unitary business principle and the policy principles behind an NOL deduction:
The unitary business principle “is a principle of taxation in which several elements of a business are treated as one unit in which several elements of a business are treated as one unit for taxation purposes, with the goal of achieving a fair valuation.”5 Moreover the principle behind an NOL is to “permit a taxpayer to set off its lean years against its lush years, and to strike something like an average income computed over a period longer than one year.”6 Our method is consistent with both principles.
The FTB’s mechanism for assigning NOLs to particular members of a combined group still has value. Each member’s NOLs must be computed annually for purposes of tracking NOLs. This method would be similar to the federal rule for divvying up NOLs among members of a consolidated group: it would be used to track the amount of losses that would follow if a particular member were to leave the group.
Thus, we think California NOLs generated by a combined group should be carried over and deducted on a combined group basis.
Taxpayers can extend carryover period for suspended NOLs by up to six years
In California, the standard rule for NOL carryovers is that they carry over for 10 years7 following a loss year for 2000 through 2007 and 20 years for 2008 and forward.8 However, as a part of the state’s 2002-2003 budget, California suspended losses for tax years 2002 and 2003 and extended the carryover periods by one year for losses incurred in 2002 and two years for losses incurred before 2002.9 Then as part of the state’s 2008-2009 budget, from 2008 through 2009, the NOL deduction was suspended.10 A couple of years later, as a part of its 2010-2011 budget, California extended the suspension of the NOL deduction for an additional two years—2010 and 2011.11
Similar to the 2002-2003 NOL suspension, although the Legislature disallowed NOL deductions for the 2008-2011 years, the 2008-2011 NOL suspension was supposed to be just a matter of timing: the carryover period for NOLs suspended in 2008 through 2011 was extended by four years for losses incurred in years prior to 2008, by three years for losses incurred in 2008, by two years for losses incurred in 2009, and by one year for losses incurred in 2010.12
Nevertheless, it is the FTB’s policy that there is no extension unless the NOL deduction would have produced a tax benefit were it not for the suspension.13 Under Legal Ruling 2011-04, the taxpayer must essentially “test” each NOL carried into the suspension period. If the NOL would have produced a tax benefit in the suspension period, were it not for the suspension, the carryover period for that NOL is extended. If not, the NOL carryover period is not extended. In other words, the taxpayer must have sufficient income in the suspension year so that it could have used the NOL, were it not for the suspension. Only then has the deduction been denied under the language of the statute, thereby triggering the extension provisions.
In our view, the FTB’s “tax benefit/income testing” limitation on the statutory NOL extension provisions is invalid because:
The “tax benefit/income testing” limitation is not authorized by, and conflicts with, the plain language of the statute; and
The “tax benefit/income testing” limitation is contrary to the legislative intent of the statute, because the Legislature intended that the suspension be purely a timing shift to address budget shortfalls.
Thus, we think taxpayers should consider ignoring the FTB’s “tax benefit/income testing” limitation and extend the carryover period of California NOLs carried over into the suspension years as follows:
We also think taxpayers should consider using this approach for purposes of valuing their deferred tax assets related to California NOLs.
Office of Tax Appeals update
On February 21, 2019, the Office of Tax Appeals unanimously denied the FTB’s petition to rehear former NFL player Keyshawn Johnson’s California residency tax appeal that was decided by the California Board of Equalization (BOE) prior to the creation of the Office of Tax Appeals.14 The FTB’s main argument was that Johnson failed to follow the evidentiary rules, because it was not until the day of the BOE oral hearing that Johnson presented the “Typical NFL Player Calendar,” which he relied on heavily in the hearing to prove that he was not a California resident during the tax years at issue. The Office of Tax Appeals rejected this argument on the basis that the NFL calendar was a major point of the entire proceeding and has been relevant since the beginning of the proceedings.
The FTB also argued that a new hearing was warranted because there was an irregularity in the proceedings. The alleged irregularity was over the date when Johnson abandoned his California domicile/residency and whether that abandonment actually occurred. Finally, the FTB argued that the original BOE decision was factually and legally insufficient. However, the Office of Tax Appeals rejected the FTB’s arguments and ruled that there was sufficient evidence in the record to support the conclusion reached by the Board of Equalization. Therefore, the Office of Tax Appeals denied the request for rehearing for lack of good cause.
- Edison Cal. Stores v. McColgan, 30 Cal. 2d 472, 475 (1947).
- Container Corp. of Amer. v. FTB, 117 Cal. App. 3d 988, 994 n. 3 (1st App. Dist. 1981) aff’d 463 U.S. 159 (1983).
- Cal. Rev. & Tax Code § 23151(a).
- Cal. Code Regs. tit. 18, § 25106.5(b)(2); California FTB Publication 1061, Guidelines for Corporations Filing a Combined Report (2015).
- See Tenneco West, 234 Cal.App.3d at 1518 (emphasis added).
- See Lisbon Shops, Inc. v. Kohler, 353 U.S. 382, 386 (1957) (“Those [net operating loss carryover and carryback] provisions were enacted to ameliorate the unduly drastic consequences of taxing income strictly on an annual basis. They were designed to permit a taxpayer to set off its lean years against its lush years, and to strike something like an average income computed over a period longer than one year.”).
- Cal. Rev. & Tax. Code § 24416(e)(1)(B). Effective January 1, 2016, Cal. Rev. & Tax. Code, § 24416.20, which replaced formerly repealed Cal. Rev. & Tax. Code § 24416, was renumbered as Cal. Rev. & Tax. Code, § 24416.
- Cal. Rev. & Tax. Code § 24416.22.
- Cal. Rev. & Tax. Code § 24416.3.
- Cal. Rev. & Tax. Code § 24416.9.
- Cal. Rev. & Tax. Code § 24416.21. As a result of S.B. 858, Cal. Rev. & Tax. Code § 24416.9 was repealed and the provisions set forth therein were generally moved to Cal. Rev. & Tax. Code § 24416.21.
- Cal. Rev. & Tax. Code § 24416.21(b).
- California FTB Legal Ruling 2011-04, September 23, 2011.
- OTA Case No. 18010057.
Client Alert 2019-066
