Source: https://www.ftb.ca.gov/law/notices/1999/99_5dis.shtml
Timestamp: 2018-04-24 22:36:31
Document Index: 164680875

Matched Legal Cases: ['§25110', '§25110', '§25110', '§25110', '§25110', '§1502', '§1', '§1', '§1', '§1', '§1', '§1', '§1', '§1', '§1', '§1', '§1', '§1', '§1', '§1', '§1']

Discussion Draft, Section 25106.5-1 Regulations--Intercompany Transactions 4/15/99 | California Franchise Tax Board
Discussion Draft, Section 25106.5-1 Regulations -- Intercompany Transactions 4/15/99
Conformity to Treas. Regulation Section 1.1502-13
Timing rules as a method of accounting
Recomputed corresponding items
Treatment as a separate entity
Divisions of a single corporation
Redetermination of separate entity attributes does not apply to sourcing
Ex. 1 - Intercompany sale of land followed by sale to a nonmember
Ex. 2 - Depreciable property
Ex. 3 - Intercompany sale followed by installment sale
Ex. 4 - Intercompany sale of installment obligation
Ex. 5 - Performance of services
Ex. 6 - Rental of property
Ex. 7 - Source of income subject to Section 863 of the Internal Revenue Code
Acceleration rule
Circumstances not known by end of year
Ex. 1 - Becoming a nonmember
Ex. 2 - Conversion to nonbusiness use
Election to treat intercompany transactions on a separate entity basis
Stock of members
Exception for distributee member
Ex. 1 - Dividend exclusion and property distribution
Ex. 2 - Dividends paid from pre-unitary earnings and profits
Ex. 3 - Deferred intercompany stock accounts
Ex. 4 - Deferred intercompany stock accounts, reverse sequence
Ex. 5 - Partial stock sale
Ex. 6 - Loss, rather than cash distribution
Ex. 7 - Intercompany reorganization
Ex. 1 - Interest on intercompany debt
Substantial change in the combined reporting group
Tested members of the S-B group
More than one change during the income year
Reasonable result not achieved because of acquisitions, dispositions or reorganizations
Ex. 1 - S and B are sold
Ex. 2 - S and B excluded by waters-edge election
Ex. 3 - Other members of group sold
Ex. 4 - More than one change during income year
Ex. 5 - Election to accelerate in same period as for federal consolidated return purposes
Ex. 6 - Election to accelerate not made
Ex. 7 - Election not applicable if S-B group is less than 60% of former combined reporting group
Recognition of income from intercompany transactions occurring prior to entering the state
Ex. 1 - Sale outside of group after member enters the state
Ex. 2 - S leaves the combined reporting group after member enters the state
Partially included waters-edge banks and corporations
Coordination with Section 25110(a)(4)
Coordination with Section 25110(a)(6)
Separate entity election for transactions with partially included entities
Ex. 1 - Intercompany sale of land by an entity included pursuant to §25110(a)(4)
Ex. 2 - Intercompany transaction where buyer is an entity included pursuant to §25110(a)(4)
Ex. 3 - Transaction not related to U.S. activities
Ex. 3(a) - Transaction allocated between U.S. activities and foreign activities
Ex. 4 - Asset ceases to give rise to U.S. source income
Ex. 5 - Both seller and buyer partially included under Section 25110(a)(4)
Ex. 6 - Seller excluded from the waters-edge combined reporting group
Ex. 7 - Seller included under §25110(a)(6)
Ex. 8 - Buyer included under §25110(a)(6)
Ex. 9 - Both Seller and Buyer included under §25110(a)(6)
Ex. 10 - Intercompany transaction between seller included under Section 25110(a)(4) and buyer included under Section 25110(a)(6)
Ex. 11 - Depreciable asset sold to buyer partially included under Section 25110(a)(6)
Ex. 12 - Decreasing partial inclusion ratio
Ex. 13 - Election made under Subsection (j)(3)(B)(5)
Foreign country operations
(Reserved for pass-through entity rules)
Acceleration upon failure to disclose DISA balance
(1) Purpose. This regulation provides rules for taking into account items of income, gain, deduction, and loss of members of a combined reporting group from intercompany transactions. The purpose of this regulation is to provide rules for reporting intercompany transactions in order to clearly reflect the taxable income (and tax liability) of the taxpayer members that is allocated or apportioned to California. The general rule is one of deferring gains or losses from intercompany transactions in order to produce the effect of transactions between divisions of a single corporation.
(2) Conformity to Treas. Regulation Section 1.1502-13. Intercompany transactions. Except as otherwise provided, this regulation incorporates Treas. Regulation Section 1.1502-13 as amended by T.D. 8597, effective July 12, 1995, to the extent possible onsistent with combined reporting principles, to enable ease of administration and compliance. This regulation does not restate all the provisions of the federal regulation in full, but the methodology of the federal regulations shall generally apply. Exceptions will arise due to the differences between the composition of the federal consolidated group and the combined reporting group, the requirements of the allocation and apportionment provisions, jurisdictional limitations and treatment of members of a combined reporting group as separate entities for many purposes under the Revenue and Taxation Code. Further exceptions will arise in those instances when Treas. Regulation Section 1.1502-13 incorporates by reference provisions of the Internal Revenue Code (IRC) to which California law has not conformed. Unless explicitly provided otherwise, conformity to Treas. Regulation Section 1.1502-13 in no way implies conformity to any other regulation under Section IRC §1502 of the Internal Revenue Code.
(3) Timing rules as a method of accounting. Treas. Regulation Section 1.1502-13 (a)(3) is incorporated in full. The rules shall apply to all members of the combined reporting group.
(4) Other Law. Other applicable law (including nonstatutory authorities) shall apply in addition to the rules of this regulation to the extent that this regulation does not exclude such application.
(A) Non-applicability of Section 304 of the Internal Revenue Code. Section 304 of the Internal Revenue Code, to which California conforms pursuant to Section 24451 of the Revenue and Taxation Code, does not apply to any acquisition of stock of a corporation in an intercompany transaction occurring on or after the effective date of this regulation.
(B) Non-applicability of Section 163(e)(5) of the Internal Revenue Code. Section 163(e)(5) of the Internal Revenue Code, to which California conforms pursuant to Section 24344 of the Revenue and Taxation Code, does not apply to any intercompany obligation (within the meaning of subsection (g) of this regulation) issued in an income year beginning on or after the effective date of this regulation.
(C) Non-applicability of Section 1031 of the Internal Revenue Code. Section 1031 of the Internal Revenue Code, to which California conforms pursuant to Section 24941 of the Revenue and Taxation Code, does not apply to any intercompany transaction occurring in income years beginning on or after the effective date of this regulation.
(5) Sourcing. In the income year that intercompany items are taken into account, their source shall be determined as if the selling member(s) (S) and the buying member(s) (B) are divisions of a single corporation. Therefore, such intercompany items are treated as current apportionable business income and apportioned to California in accordance with Sections 25120 - 25141 of the Revenue and Taxation Code. California law does not conform to the Federal sourcing rules provided or referenced in Treas. Regulation Section 1.1502-13.
(A) Sales Factor.
1. Sales attributable to intercompany items are not included in Ss sales factor either in the year of the transaction or in the year(s) in which such intercompany items are taken into account.
2. Gross receipts from Bs corresponding item will be included in the sales factor of B if otherwise included under Section 25134 of the Revenue and Taxation Code.
3. Deemed sales under Treas. Regulation Section 1.1502-13(d)(1)(ii) will be disregarded for purposes of the sales factor.
(B) Property Factor
1. As of the date of the intercompany transaction, the property transferred from S to B will then be included in Bs property factor at the original cost to S.
2. Intercompany rent expense is not included in the property factor.
3. Intercompany obligations otherwise includable under California Code of Regulations Sections 25137-4.2 or 25137-10 shall not be included in the property factor.
4. If Ss intercompany item is accelerated as a result of S or B no longer being members of the same combined reporting group, or as a result of substantial change in the combined reporting group described by subsection (j)(1)(A) of this regulation, the value of Bs property acquired from S in an intercompany transaction will be adjusted immediately after the acceleration event to reflect Bs original cost.
5. Subsections (a)(5)(B)(1) through (4) above shall apply regardless of whether an election is made under subsection (e)(2) of this regulation to treat an intercompany transaction on a separate entity basis.
(6) Overview - The principal rules of this regulation that implement single entity treatment are the matching rule of subsection (c) and the acceleration rule of subsection (d). Under the matching rule, Seller (S) and Buyer (B) are generally treated as divisions of a single corporation for purposes of taking into account their items from intercompany transactions. The acceleration rule provides rules for taking the items into account if the effect of treating S and B as divisions cannot be achieved (for example, if S or B leave the combined reporting group or if the subject of the intercompany transaction is converted to nonbusiness use). Intercompany items will be treated as current apportionable business income for the year(s) in which the item is taken into account. Subsection (b) of this regulation provides definitions used in the application of this regulation. Subsection (e) of this regulation provides simplifying rules for certain transactions. Subsections (f) and (g) of this regulation provide additional rules for stock and obligations of members. Subsections (h) and (j) of this regulation provide anti-avoidance rules and miscellaneous operating rules. Subsection (i) of this regulation is reserved for future use.
(1) Intercompany transactions
(A) Except as provided in subsection (b)(1)(B), the term intercompany transaction means a transaction between corporations which are members of the same combined reporting group immediately after such transaction. "S" is the member transferring property or providing services; "B" is the member receiving the property or services. Intercompany transactions include, but are not limited to-:
1. Ss sale of property (or other transfer, such as an exchange or contribution) to B.
2. Ss performance of services for B, and Bs payment or accrual of its expenditures for Ss performance;
3. Ss licensing of technology, rental of property, or loan of money to B, and Bs payment or accrual of its expenditures; and
4. Ss distribution to B with respect to S stock.
(B) The term intercompany transaction does not include transactions which produce nonbusiness income or loss to the selling member or income attributable to a separate business activity of the selling member. Nor does the term intercompany transaction apply when the subject of the transaction is acquired for the buyers nonbusiness use or for the use of a separate business activity of the buyer. For purposes of this regulation, such transactions shall be considered as if between corporations that are not members of a combined reporting group.
(2) "Combined reporting group" has the same meaning as defined in California Code of Regulations Section 25106.5(b)(3). For purposes of this regulation, the members of the combined reporting group include:
(A) Both S and B, when the income and apportionment factors of those corporations are properly included in the same combined report for the income year of the intercompany transaction, and
(B) any affiliated corporation (or portion thereof) whose income and apportionment factors are properly included in the same combined report in combination with the income and apportionment factors of S and B for that income year.
(3) Intercompany items
(A) In general. Ss income, gain, deduction, and loss from an intercompany transaction are its intercompany items. For example, Ss gain from the sale of property to B is an intercompany gain. An item is an intercompany item whether it arises directly or indirectly from an intercompany transaction.
(B) Related costs or expenses. Ss costs or expenses related to an intercompany transaction are included in determining its intercompany items.
(C) Amounts not yet recognized or incurred. Ss intercompany items include amounts from an intercompany transaction that are not yet taken into account in deriving net income under its separate entity method of accounting.
(4) Corresponding items. Bs income, gain, deduction, and loss from an intercompany transaction, or from property acquired in an intercompany transaction, are its corresponding items. If B buys property from S and sells it to a nonmember, Bs gain or loss from the sale to the nonmember is a corresponding gain or loss. An item is a corresponding item whether it is directly or indirectly from an intercompany transaction (or from property acquired in an intercompany transaction).
(5) Recomputed corresponding items. The recomputed corresponding item is the corresponding item that B would take into account if S and B were divisions of a single corporation and the intercompany transaction were between those divisions. For example, if S sells property with a $70 basis to B for $100, and B later sells the property to a nonmember for $90, Bs corresponding item is its $10 loss, and the recomputed corresponding item is $20 of gain (determined by comparing the $90 sales price with the $70 basis the property would have had if S and B were divisions of a single corporation).
(6) Treatment as a separate entity. Treatment as a separate entity means treatment without application of the rules of this section, but with the application of the other combined reporting regulations.
(7) Divisions of a single corporation. When S and B are treated as divisions of a single corporation for purposes of this regulation, such divisional treatment applies only to the unitary, apportionable trade or business operations included in the combined report. For example, neither nonbusiness income of S or B nor income from activities of S or B that are excluded from a waters-edge combined report would be considered for purposes of treating S and B as divisions of a single corporation.
(8) Deferred Intercompany Stock Account ("DISA"). DISA is an accounting mechanism in which a distributee corporation, which is a member of the combined reporting group, receives and tracks non-dividend distributions in excess of its adjusted basis in the stock from a subsidiary corporation which is a member of the same combined reporting group, until this intercompany item is required to be taken into account pursuant to this regulation. The balances of each DISA account must be disclosed annually on the taxpayers return.
(9) Attributes. The attributes of an intercompany item or corresponding item are all of the items characteristics, except amount, location, and timing, necessary to determine the items effect on taxable income (and tax liability). For purposes of this regulation, "location" does not refer to geographical location. It refers to location within the combined reporting group, i.e., which member of the combined reporting group realizes the item.
(c) Matching rule. The separate entity attributes of Ss intercompany items and Bs corresponding items are redetermined to the extent necessary to produce the same effect on total group combined report business income as if S and B were divisions of a single corporation, and the intercompany transaction was a transaction between divisions. Generally this regulation applies the matching rule provisions of Treas. Regulation Section 1.1502.13(c). Exceptions will arise due to the reasons stated in subsection (a)(2) of this regulation.
(1) Redetermination of separate entity attributes does not apply to the sourcing of the combined report business income. Sourcing of income is described in Subsection (a)(5) of this regulation.
(2) Examples: For purposes of the examples in this regulation section, unless otherwise stated, P, S and B are members of a combined reporting group. P owns all of the stock of S and B. X is a person unrelated to any member of the combined reporting group. The income year of all persons is the calendar year.
Example 1: Intercompany sale of land followed by sale to a nonmember.
(Refer to Treas. Reg. §1.1502-13(c)(7)(ii), example 1.)
Facts. S holds land with a basis of $70 for business purposes. On January 1 of Year 1, S sells the land to B for $100. B also holds the land for business purposes. On July 1 of Year 3, B sells the land to X for $110.
Definitions. S's sale of the land to B is an intercompany transaction. S's $30 gain from the sale to B is its intercompany item, and B's $10 gain from its sale to X is its corresponding item. The total gain of $40 is the recomputed corresponding item.
Timing. Under the matching rule, S takes its intercompany item into account in the income year(s) in which there is a difference between B's corresponding item and the recomputed corresponding item. If S and B were unitary divisions of a single corporation and the intercompany sale were a transfer between the divisions, B would succeed to S's $70 basis in the land and would have a $40 gain from the sale to X in Year 3, instead of a $10 gain. Consequently, S takes no gain into account in Years 1 and 2, and takes the entire $30 gain into account in Year 3, to reflect the $30 difference in that year between the $10 gain B takes into account and the $40 recomputed gain (the recomputed corresponding item). In accordance with Subsection (j)(5) of this regulation, the earnings and profits of S will not reflect S's $30 gain until the gain is taken into account in Year 3.
Apportionment. As would be the case if A and B were unitary divisions of a single corporation and the intercompany sale was a transfer between the divisions, that transfer will not be reflected in the sales factor in Year 1. In Year 3, the $110 gross receipts from B's sale of the land to X will be included in B's sales factor unless the receipts are excluded pursuant to Cal. Code of Regulations Section 25137(c)(1)(A). The land is attributable to B after the intercompany sale, and it will be reflected in B's property factor at Ss $70 original cost basis until it is sold outside the combined reporting group in Year 3. This is the result that would have occurred had the intercompany transaction been a transfer between unitary divisions. Both S's $30 gain and B's $10 gain will be treated as current apportionable business income in Year 3.
Example 2: Depreciable property.
(Refer to Treas. Reg. §1.1502-13(c)(7)(ii), example 4.)
Facts. On January 1 of Year 1, S buys property with a 10-year useful life for $100 and begins to depreciate it under the straightline method. On January 1 of Year 3, S sells the property to B for $130. B determines that the useful life of the property is 10 years from the date of Bs acquisition, and also uses the straightline method. Both S and B use the property in their unitary trade or business.
Depreciation through Year 3; intercompany gain. S claims $10 of depreciation for each of Years 1 and 2 and has an $80 basis at the time of the sale to B. Thus, S has a $50 intercompany gain from its sale to B ($130 sales price - $80 adjusted basis). For Year 3, B has $13 of depreciation with respect to its $130 basis.
Timing. If S and B were divisions of a single entity, that entity would modify its useful life of the property based upon the same change in facts and circumstances that caused B to determine that the useful life would exceed the original 10 year period. Therefore, the recomputed depreciation for Years 3 through 12 would be $8 per year ($80 remaining basis / redetermined 10-year life). S's $50 gain is taken into account to reflect the difference for each income year between B's $13 depreciation (B's corresponding item) and the $8 recomputed depreciation. Thus, S takes $5 of gain into account in each of Years 3 through 12.
Apportionment. As would be the case if the intercompany sale were a transfer between unitary divisions of a single corporation, the transfer will not be reflected in the sales factor. The property will be included in B's property factor at Ss $100 original cost basis regardless of the subsequent depreciation or intercompany gain taken into account. In each year, S's intercompany gain and B's depreciation deduction will be included in the computation of combined report business income and apportioned using the current apportionment percentage for that year.
Example 3: Intercompany sale followed by installment sale.
(Refer to Treas. Reg. §1.1502-13(c)(7)(ii), example 5.)
Facts. S holds land with a basis of $70 for business purposes. On January 1 of Year 1, S sells the land to B for $100. B also holds the land for business purposes. On July 1 of Year 3, B sells the land to X in exchange for X's $110 note. The note provides for 24 monthly interest payments beginning August 1 of Year 3, and for principal payments of $55 in Year 4 and $55 in Year 5. The California apportionment percentage for the combined reporting group was 10% in Year 3, 90% in Year 4, and 93% in Year 5. The amount of the installment note is substantial in relation to the business activities of the combined reporting group. Therefore, because the deferral of gain recognition under the installment sale provisions should not substantially change the ultimate amount of income apportioned to California, application of Section 25137 of the Revenue and Taxation Code requires that the installment income be apportioned using the apportionment percentage from the year in which the installment sale occurred.
Timing and attributes. Under Section 453 of the Internal Revenue Code and Section 24667 of the Revenue and Taxation Code, B's corresponding items are its $5 gain in Year 4, and its $5 gain in Year 5. B's recomputed gain, computed as if the intercompany sale were a transfer between unitary divisions, would be $20 in Year 4 and $20 in Year 5. Thus, S takes $15 of intercompany gain into account in each of Years 4 and 5 to reflect the difference between B's $5 corresponding gain and $20 recomputed gain. Bs interest income on the installment note is not a corresponding item, and is taken into account when accrued in Years 3 through 5.
Apportionment. As would be the case if the intercompany sale were a transfer between divisions, there will be no effect on the sales factor in Year 1, and the $110 gross receipts from the sale to X will be included in B's sales factor in Year 3 (assuming that the receipts were not excluded pursuant to Cal. Code of Regulations Section 25137(c)(1)(A)). Because the installment sale income is being apportioned to California using the apportionment percentage from the year of the sale to X under Section 25137 of the Revenue and Taxation Code, both S's $15 intercompany gain and B's $5 corresponding gain for each of Years 4 and 5 will be apportioned to California using the 10% apportionment percentage from Year 3. The property will be included in B's property factor at Ss $70 cost basis until it is sold to X in Year 3. Bs interest income accrued in Years 3, 4 and 5 is current period income and will be apportioned using the current apportionment percentages for those years (10%, 90% and 93% respectively).
Example 4: Intercompany sale of installment obligation.
(Refer to Treas. Reg. §1.1502-13(c)(7)(ii), example 6.)
Facts. S holds land with a basis of $70. On January 1 of Year 1, S sells the land to X in exchange for X's $100 note, and S reports its gain on the installment method under Section 453 of the Internal Revenue Code. X's note bears interest at a market rate of interest in excess of the applicable federal rate, and provides for principal payments of $50 in Year 5 and $50 in Year 6. On July 1 of Year 3, S sells X's note to B for $100, resulting in a $30 gain from S's prior sale of the land to X. Both Ss and Bs income would be considered business income under Section 25120(a) of the Revenue and Taxation Code. The California apportionment percentage for the combined reporting group was 8% in Year 1, 15% in Year 3, and 90% in Years 5 and 6. The amount of the installment note is substantial in relation to the business activities of the combined reporting group. Therefore, because the deferral of gain recognition under the installment sale provisions should not substantially change the ultimate amount of income apportioned to California, application of Section 25137 of the Revenue and Taxation Code requires that the installment income be apportioned using the apportionment percentage from the year in which the installment sale occurred.
Timing and attributes. S's sale of X's note to B is an intercompany transaction, and S's $30 gain is an intercompany gain. S takes $15 of the gain into account in each of Years 5 and 6 to reflect the difference between B's $0 corresponding gain and B's $15 recomputed gain. S's gain continues to be treated as its gain from the sale to X, and the deferred tax liability of each taxpayer member remains subject to the interest charge under Section 453A(c) of the Internal Revenue Code (as modified by Section 24667 of the Revenue and Taxation Code).
Apportionment. The $100 gross receipts from the sale of the land to X will be included in S's sales factor in Year 1. When S's gain is taken into account in Years 5 and 6, application of Section 25137 of the Revenue and Taxation Code requires that it will be apportioned to California using the 8% apportionment percentage from Year 1. This is the same result that would have occurred had the intercompany sale of the installment note been a transfer between unitary divisions.
Worthlessness. Assume that X's note becomes worthless on December 1 of Year 3 and B has a $100 loss on a separate entity basis (a $100 corresponding loss). S takes its $30 gain into account in Year 3 to reflect the difference between B's $100 corresponding loss and B's $70 recomputed loss. On a separate entity basis, Ss $30 gain would be an installment gain. However, there would be no net installment income if S and B were divisions of a single corporation. Therefore, when the separate entity attributes of Ss intercompany items and Bs corresponding items are redetermined under Treas. Regulation Section 1.1502-13(c)(1)(i) to produce the same effect as if S and B were divisions of a single corporation, both Ss $30 gain and Bs $100 loss will be apportioned to California using the 15% apportionment percentage from Year 3.
Example 5: Performance of services.
(Refer to Treas. Reg. §1.1502-13(c)(7)(ii), example 7.)
Facts. S is a driller of water wells. B operates a ranch and requires water to maintain its cattle. During Year 1, B pays S $100 to drill an artesian well on B's ranch, and S incurs $80 of expenses related to drilling the well. B capitalizes its $100 cost for the well, and takes into account $10 of depreciation deductions in each of Years 2 through 11. If S and B were divisions of a single corporation, the $80 costs incurred in drilling the well would be capitalized and the depreciation deduction would be $8 in each of Years 2 through 11.
Timing. S has intercompany income of $20 ($100 receipts less $80 expenses). In each of Years 2 through 11, S takes $2 of its intercompany income into account to reflect the annual difference between B's $10 corresponding depreciation deduction and the $8 recomputed depreciation deduction.
Apportionment. As would be the case if the services were performed between unitary divisions of a single corporation, the transaction will not be reflected in the sales factor. If Ss expenses related to drilling the well included payroll expenses, those expenses would be included in the payroll factor in Year 1. When the well is placed in service, it will be included in B's property factor at its capitalized cost to S of $80. In each year, S's $2 intercompany income and B's $10 depreciation deduction will be included in current apportionable business income for that year.
Example 6: Rental of property.
(Refer to Treas. Reg. §1.1502-13(c)(7)(ii), example 8.)
B operates a ranch that requires grazing land for cattle. S owns land adjoining B's ranch. On January 1 of Year 1, S leases grazing rights for one year to B for $100. S takes its $100 rental income into account in Year 1 to reflect the $100 difference between B's $100 corresponding rental deduction and the $0 recomputed rental deduction. To achieve the effect of the rental transaction occurring between unitary divisions of a single corporation, the intercompany rental income will not be included in the Ss sales factor. The land will continue to be included in S's property factor at its original cost, and Bs property factor will not reflect Bs rent expense related to the land.
Example 7: Source of income subject to Section 863 of the Internal Revenue Code.
(Refer to Treas. Reg. §1.1502-13(c)(7)(ii), example 14.)
Facts. S manufactures inventory in the United States, and recognizes $75 of income on sales to B in Year 1. B resells the inventory in Country Y and recognizes $25 of income on sales to X, also in Year 1.
Timing. Under the matching rule, S's $75 intercompany income and B's $25 corresponding income are taken into account in Year 1.
Apportionment. California law does not conform to the federal sourcing rules under Section 863 of the Internal Revenue Code except for purposes of determining the extent to which a corporations income and apportionment factors are included in a combined report under Section 25110(a)(4) of the Revenue and Taxation Code. Furthermore, subsection (c)(1) of this regulation provides that the redetermination of attributes described in Treas. Regulation Section 1.1502-13(c)(1)(i) does not apply to the sourcing of California combined report business income. In order to achieve the results that would occur if S and B were divisions of a single corporation, B's receipts from its sales to X will be reflected in B's sales factor in Year 1. Both S's $75 intercompany income and B's $25 corresponding item will be treated as current apportionable business income in Year 1.
(d) Acceleration Rule. Ss intercompany items and Bs corresponding items are taken into account under this subsection to the extent they cannot be taken into account to produce the effect of treating S and B as divisions of a single corporation. For example, except as provided in subsection (d)(1)(B) of this regulation, such effect can not be produced if S and B are no longer in the same combined reporting group. Generally this regulation applies the acceleration rule provisions of Treas. Regulation Section 1.1502.13(d). Exceptions will arise due to the reasons stated in Subsection (a)(2) of this regulation.
(1) Additional circumstances which will cause the acceleration rule to be applied include:
(A) the object of the intercompany transaction is converted to nonbusiness use, or
(B) there occurs a substantial change in the composition of the combined reporting group as described by subsection (j)(1)(A) of this regulation. A change in the composition of the combined reporting group which is described in subsection (j)(1)(A)(i) will not trigger the acceleration rule if subsection (j)(1)(A)(ii) does not apply to such change.
(C) See subsection (j)(3) for additional acceleration rules applicable for banks or corporations partially included in a waters-edge combined reporting group.
(2) Circumstances not known by end of year. In the event that circumstances which would cause the acceleration rule to be triggered during an income year are not known or have not occurred in time for the taxpayer members to file an accurate return, it may be necessary to make an estimate based on available information and amend the return at a later date.
(3) Examples. The acceleration rule of this subsection (d) is illustrated by the following examples.
Example 1: Becoming a nonmember.
(Refer to Treas. Reg. §1.1502-13(d)(3), example 1.)
Facts. S owns land with a basis of $70, which it uses in its unitary business activities. On January 1 of Year 1, S sells the land to B for $100. B also uses the land for unitary business purposes. On July 1 of Year 3, P sells 60% of S's stock to X and, as a result, S becomes a nonmember of the combined reporting group.
Matching rule. Under the matching rule, none of S's $30 intercompany gain is taken into account in Years 1 through 3 because there is no difference between B's $0 gain or loss taken into account and the recomputed gain or loss.
Acceleration of S's intercompany items. Once the stock of S is sold, S is no longer a member of the combined reporting group and the effect of treating the unitary operations of S and B as divisions of a single corporation cannot be produced. Therefore, under the acceleration rule of subsection (d) of this section, Ss $30 gain is taken into account in Year 3 immediately before S becomes a nonmember.
California law does not conform to the stock basis adjustments required for federal purposes by Treas. Regulation Section 1.1502-32. P's basis in S's stock will be P's original cost, increased by any capital contributions and decreased by any returns of capital.
Apportionment. The intercompany sale is not reflected in the sales factor in Year 1. In Year 3, Ps receipts from the sale of S stock may be included in the sales factor if not otherwise excluded under Section 25137 of the Revenue and Taxation Code and the regulations thereunder. The land will be included in B's property factor at Ss $70 original cost until S's intercompany gain is accelerated. Immediately after S's gain is taken into account, the $70 value of the land in B's property factor will be stepped up to reflect Bs $100 cost. S's intercompany gain will be treated as current apportionable business income in Year 3.
Example 2: Conversion to nonbusiness use.
Facts. S owns land with a basis of $70 which it holds for trade or business purposes. On January 1 of Year 1, S sells the land to B for $100. B also uses the land in its trade or business. On July 1 of Year 3, B converts the land to a nonbusiness use.
Acceleration of S's intercompany items. Because the effect of treating the unitary operations of S and B as divisions of a single corporation cannot be achieved once the land is removed from the unitary trade or business, the acceleration rule causes S to take its $30 gain into account immediately before the nonbusiness conversion takes place.
Apportionment. If the land had been transferred between divisions of a single corporation and then converted to nonbusiness use, those transactions would have no effect on the sales factor. Thus, neither the intercompany sale in Year 1 nor the acceleration of S's intercompany gain in Year 3 will be reflected in the sales factor. The land will be included in B's property factor at Ss $70 original cost until it is converted to nonbusiness use, at which time it will be removed from the property factor. S's accelerated intercompany gain will be treated as current apportionable business income in Year 3.
(e) Simplifying Rules
(1) Generally this regulation applies the simplifying rules of Treas. Regulation Section 1.1502-13(e). Differences may occur due to non-conformity with federal treatment, such as the treatment of bad debt reserves. However, to the extent bad debt reserves are allowed under the Revenue and Taxation Code, Treasury Regulation Section 1.1502-13(e)(2) is applicable.
(2) Election to treat intercompany transactions on a separate entity basis.
(A) If members of the combined reporting group make a federal election to treat intercompany transactions on a separate entity basis under Treas. Regulation Section 1.1502-13(e)(3), the taxpayer members will be treated as having made a California election. A separate California election must be made by the taxpayer members to prevent the federal election from applying for California purposes. A taxpayer which is qualified to request federal consent to treat intercompany transactions on a separate entity basis under Treas. Regulation Section 1.1502-13(e)(3) but does not request or is not granted consent, may not elect such treatment for California purposes.
(B) If the members of the combined reporting group properly report transactions on a separate entity basis for federal or foreign national tax purposes and subsection (e)(2)(A) does not apply, the taxpayer members may elect to treat those transactions on a separate entity basis for California purposes. The election may be made for all items, or for items from a class or classes of transactions. For example, intercompany sales of inventory to a controlled foreign corporation included in a waters-edge combined reporting group pursuant to Section 25110(a)(6) of the Revenue and Taxation Code may be considered a class of transactions for which an election may be made.
(C) Elections described by this subsection (e)(2) are made by reporting the intercompany transactions in the manner required by the election on a timely filed original tax return (not an amended return) for the first combined report year to which the election is to apply. An election under this subsection shall be treated as an accounting method, and shall be effective for all intercompany transactions occurring in the combined report year to which the election is first applied, and thereafter.
(D) An election made under this subsection does not apply for purposes of taking into account:
(i) losses and deductions deferred under Section 267(f) of the Internal Revenue Code, or
(ii) items from intercompany transactions with respect to stock or obligations of members.
(f) Stock of Members
(1) Generally this regulation applies the provisions of Treas. Regulation Section 1.1502-13(f) relating to stock of members.
(A) Exception for distributee member. Treas. Regulation Section 1.1502-13(f)(2)(ii) shall not apply to exclude intercompany distributions from the gross income of the distributee member. Intercompany dividend distributions described by Section 301(c)(1) of the Internal Revenue Code are included in the income of the distributee member unless subject to elimination or deduction under other applicable law, including Sections 25106 or 24402 of the Revenue and Taxation Code. The treatment of intercompany distributions described by Section 301(c)(3) of the Internal Revenue Code is provided by subsection (f)(1)(B) of this regulation.
(B) Deferred intercompany stock account (DISA). That portion of an intercompany distribution which exceeds earnings and profits and Bs basis in Ss stock (the portion of a distribution described by Section 301(c)(3) of the Internal Revenue Code) will create a DISA. The DISA will be treated as deferred income. To the extent of a sale, liquidation or other disposition of shares of the stock, the balance of the DISA with respect to such shares will be taken into account as income or gain to B even if S and B remain members of the same combined reporting group. The disposition shall be treated as a sale or exchange for purposes of determining the character of the DISA income or gain.
(i) A disposition of all the shares shall be deemed to have occurred if either S or B becomes a non-member of the combined reporting group, if there is a substantial change in the group to which subsection (j)(1)(A) of this regulation applies, or if the stock of S becomes worthless.
(ii) Because Bs DISA is deferred income and not negative basis, DISA is taken into account upon liquidation including complete liquidation into the parent. The deferred income restored as a result of the liquidation will be taken into account ratably over 60 months unless the taxpayer elects to take the income into account in full in the year of liquidation. For example, if S liquidates and the exchange of Ps stock in S is subject to Section 332 of the Internal Revenue Code (Section 24451 of the Revenue and Taxation Code), Ps DISA income taken into account under this subsection (f)(1)(B) is recognized over 60 months, unless an election is made to recognize the deferred income in the year of liquidation. Nonrecognition or deferral shall not apply to DISA income or gain taken into account as a result of an event described in subsection (f)(1)(B)(i) of this regulation.
(iii) If P sells the stock of S to another member of the combined reporting group, Ps DISA income will be an intercompany item and deferred under the rules of this regulation.
(iv) At the date of enactment of this regulation, if a closing agreement has been executed with the Franchise Tax Board to defer income from distributions described under Section 301(c)(3) of the Internal Revenue Code, then such income shall be included in the DISA of the distributing member to the extent that it has not already been taken into account in the income of the distributee member. Thereafter, the balance of the DISA account shall be taken into account under the rules of this regulation.
(2) Examples. The application of this section to intercompany transactions with respect to stock of members is illustrated by the following examples.
Example 1: Dividend exclusion and property distribution.
(Refer to Treas. Reg. §1.1502-13(f)(7), example 1.)
Facts. S owns land that is a business asset with a $70 basis and $100 value. On January 1 of Year 1, Ps basis in Ss stock is $100, and S has accumulated earnings and profits of $500 from prior year combined reports of S and P. During Year 1, S declares and makes a dividend distribution of the land to P. P also uses the land in the unitary business. Under Section 311(b) of the Internal Revenue Code, S has a $30 gain. Under Section 301(d) of the Internal Revenue Code, Ps basis in the land is $100. (California law generally conforms to Internal Revenue Code Sections 301 - 385 under Section 24451 of the Revenue and Taxation Code.) On July 1 of Year 3, P sells the land to X for $110.
Dividend treatment. Ss distribution of the land is an intercompany distribution to P in the amount of $100. Because the distribution is paid out of earnings and profits of S, which have been included in a combined report of S and P, it will be eliminated from Ps income pursuant to Section 25106 of the Revenue and Taxation Code. The payment of the dividend has no effect on Ps basis in the stock of S.
Matching rule. Under the matching rule (treating P as the buying member and S as the selling member), S takes its $30 intercompany gain into account in Year 3 to reflect the $30 difference between Ps $10 corresponding gain ($110 - $100 basis in the land) and the $40 recomputed gain ($110 - $70 basis that the land would have had if S and P were divisions).
Apportionment. The intercompany distribution is not reflected in the sales factor in Year 1. In Year 3, the $110 gross receipts from Ps sale of the land will be included in Ps sales factor. After the distribution in Year 1, the land will be included in Ps property factor at Ss $70 original cost basis. Both Ss $30 gain and Ps $10 gain relative to the distributed land will be treated as current apportionable business income in Year 3.
Example 2: Dividends paid from pre-unitary earnings and profits.
The facts are the same as in Example 1 except that Ss earnings and profits from prior combined reports of S and P is only $10. S also has $490 of earnings and profits that arose in years before a unitary relationship existed between S and P. Because only $10 of Ss distribution was paid from earnings and profits attributable to business income included in a combined report of S and P, only $10 is eliminated under Section 25106 of the Revenue and Taxation Code. The remaining $90 of the dividend will be taken into account by P in Year 1, subject to any applicable deductions under Sections 24402 or 24411 of the Revenue and Taxation Code.
Ps corresponding item is not its dividend income, but its income, gain, deduction or loss from the property acquired in the intercompany distribution. Therefore, none of Ss intercompany gain will be taken into account in Year 1. As in Example 1, S will take its $30 intercompany gain into account in Year 3 to reflect the $30 difference between Ps $10 corresponding gain and the $40 recomputed gain.
The apportionment results are the same as in Example 1, except that to the extent that the Year 1 dividend is not eliminated under Section 25106 or deducted under Sections 24402 or 24411, Ps dividend income will be treated as current apportionable business income in Year 1. The intercompany distribution is not included in the sales factor in Year 1.
Example 3: Deferred intercompany stock accounts.
(Refer to Treas. Reg. §1.1502-13(f)(7), example 2.)
Facts. S owns all of Ts stock with a $10 basis and $100 value. S has substantial earnings and profits which are attributable to business income included in a combined report of S, T and P. T has $10 of accumulated earnings and profits, all of which are attributable to business income included in a combined report of S, T and P. On January 1 of Year 1, S declares and distributes a dividend of all of the T stock to P. Under Section 311(b) of the Internal Revenue Code, S has a $90 gain. Under Section 301(d) of the Internal Revenue Code, Ps basis in the T stock is $100. During Year 3, T borrows $90 from an unrelated party and declares and makes a $90 distribution to P to which Section 301 of the Internal Revenue Code applies. During Year 6, T has $5 of current earnings which is attributable to business income included in the combined report of S, T and P. On December 1 of Year 9, T issues additional stock to X and, as a result, T becomes a nonmember.
Dividend elimination. Ps $100 of dividend income from Ss distribution of the T stock, and its $10 dividend income from Ts $90 distribution, are eliminated from income under Section 25106 of the Revenue and Taxation Code.
Matching and acceleration rules. P has no deferred intercompany stock account (DISA) with respect to T stock because Ts $90 distribution did not exceed Ts $10 of earnings and profits and $100 stock basis. Therefore, P's corresponding item in Year 9 when T becomes a nonmember is $0. Treating S and P as divisions of a single corporation, the T stock would continue to have a $10 basis after the distribution from S to P. T's $90 distribution in Year 3 would first reduce T's $10 earnings and profits to zero, then reduce the $10 recomputed basis in T stock to zero and create a $70 recomputed DISA. T's $5 of earnings in Year 6 does not effect the amount of the DISA. Because the recomputed DISA would be taken into account upon T becoming a nonmember in Year 9, P will have a $70 recomputed corresponding item. Under the matching rule, S takes $70 of its intercompany gain into account in Year 9 to reflect the difference between P's $0 corresponding gain and the $70 recomputed gain. S's remaining $20 of gain will be taken into account under the matching and acceleration rules based on subsequent events (for example, under the matching rule if P subsequently sells its T stock, or under the acceleration rule if S becomes a nonmember or if the stock of T becomes a nonbusiness asset.)
Apportionment. Neither the distributions in Years 1 and 3, nor T becoming a nonmember in Year 9, have any effect on the sales factor. S's $70 intercompany gain will be treated as current apportionable business income in Year 9.
Example 4: Deferred intercompany stock accounts, reverse sequence.
(Refer to Treas. Reg. §1.1502-13(f)(7), example 2(d).)
Facts. The facts are the same as in Example 3, except that T borrows the $90 and makes its $90 distribution to S before S distributes T's stock to P. To the extent of T's $10 earnings and profits, T's distribution to S is a dividend and is eliminated under Section 25106 of the Revenue and Taxation Code. The remaining distribution reduces S's $10 basis in T stock to $0, and creates a $70 DISA. The fair market value of T's stock after T incurs the $90 debt and distributes the proceeds is $10. Under Section 311(b) of the Internal Revenue Code and the provisions of this regulation, S has an $80 gain from the distribution of T stock to P ($10 value less $0 basis, plus $70 DISA recaptured). Under Section 301(d) of the Internal Revenue Code, P's initial basis in the T stock is the $10 fair market value of the stock. T's $5 of earnings in Year 6 has no effect on P's basis in the T stock.
Matching and acceleration rule. P's corresponding item in Year 9, when T becomes a nonmember, is $0. Treating S and P as divisions of a single corporation, the T stock would continue to have a $0 basis after the distribution from S to P, and a $70 balance would remain in the DISA. When T becomes a nonmember in Year 9, P must include the amount of its DISA in recomputed income, and therefore has a $70 recomputed corresponding item. Under the matching rule, S takes $70 of its intercompany gain into account in Year 9 to reflect the difference between P's $0 corresponding gain and the $70 recomputed gain. S's remaining $10 of gain will be taken into account under the matching and acceleration rules based on subsequent events.
Apportionment. Neither the distributions in Year 1 nor T becoming a nonmember in Year 9 have any effect on the sales factor. S's $70 intercompany gain taken into account in Year 9 is treated as current apportionable business income in Year 9.
Example 5: Partial stock sale.
(Refer to Treas. Reg. §1.1502-13(f)(7), example 2(e).)
Facts. The facts are the same as in Example 3, except that P sells 10% of T's stock to X on December 1 of Year 9 for $1.50 (rather than T's issuing additional stock and becoming a nonmember). T's $90 distribution to P in Year 3 reduced T's $10 of earnings and profits to $0, then reduced P's $100 basis in T stock to $20. Under the matching rule, S takes $9 of its gain into account in Year 9 to reflect the difference between P's $.50 loss taken into account ($1.50 sale proceeds minus $2 basis) and the $8.50 recomputed gain ($1.50 sales proceeds minus $0 basis plus $7 recomputed DISA).
Apportionment. If not excluded pursuant to 18 Cal. Code Regs. Section 25137, the $1.50 gross receipts from P's sale of the T stock to X is included in P's sales factor in Year 9. Both S's $9 gain and P's $.50 loss are treated as current apportionable business income in Year 9.
Example 6: Loss, rather than cash distribution.
(Refer to Treas. Reg. §1.1502-13(f)(7), example 2(f).)
Facts. The facts are the same as in Example 3, except that T retains the loan proceeds and incurs a $90 operating loss in Year 3. The loss results in an earnings and profits deficit of $80 for T, but has no effect on P's basis in T's stock. Therefore, no DISA is created. T's $5 of earnings in Year 6 reduces its earnings and profits deficit to $75, but also has no effect on the stock basis. Because there is no DISA balance to take into account when T becomes a nonmember in Year 9, both P's corresponding item and the recomputed item are both $0. Consequently, S's entire $90 intercompany gain continues to be deferred pending subsequent events.
Example 7: Intercompany reorganization.
(Refer to Treas. Reg. §1.1502-13(f)(7), example 3.)
Facts. P forms S and B by contributing $200 to the capital of each. During Years 1 through 4, S and B each accumulate earnings and profits of $50, which is attributable to business income included in the combined reports of S, B and P. On January 1 of Year 5, the fair market value of S's assets and its stock is $500, and S merges into B in a tax-free reorganization. Pursuant to the plan of reorganization, P receives new B stock with a fair market value of $350 and $150 cash.
Treatment as a distribution under Section 301 of the Internal Revenue Code. Under Treas. Regulation Section 1.1502-13(f)(3), P is treated as receiving additional B stock with a fair market value of $500. Under Section 358 of the Internal Revenue Code, P's basis of the additional B stock is $200 (P's basis in the relinquished S stock). Immediately after the merger, $150 of the stock received is treated as redeemed, and the redemption is treated under Section 302(d) of the Internal Revenue Code as a distribution to which Section 301 applies. Under Section 381(c)(2) of the Internal Revenue Code, B is treated as receiving S's $50 of earnings and profits in addition to its own $50 of earnings and profits. Therefore, $100 of the deemed distribution is treated as a dividend and is eliminated from income under Section 25106 of the Revenue and Taxation Code. The remaining $50 of the distribution reduces P's basis in the B stock from $400 to $350.
Apportionment. The reorganization has no effect on the sales factor. After the reorganization, S's property will be reflected in B's property factor at S's original cost.
(g) Obligations of members
(1) Generally this regulation will follow Treas. Regulation Section 1.1502.13(g) relating to the obligations of members.
(2) Examples. The application of this section to obligations of members is illustrated by the following example.
Example 1: Interest on intercompany debt.
(Refer to Treas. Reg. §1.1502-13(g)(5), Example 1.)
Facts. On January 1 of Year 1, B borrows $100 from S in return for Bs note providing for $10 of interest annually at the end of each year, and repayment of $100 at the end of Year 5. Under their separate entity methods of accounting, B accrues a $10 interest deduction annually, and S accrues $10 of interest income annually.
Matching rule. Under subsection (g)(1) of this regulation, the accrual of interest on Bs note is an intercompany transaction. Under the matching rule, S takes its $10 of income into account in each of Years 1 through 5 to reflect the $10 difference between Bs $10 of interest expense taken into account and the $0 recomputed expense.
Interest offset. Neither Ss intercompany interest income nor Bs corresponding interest expense are taken into account for purposes of determining the interest offset or foreign investment interest offset under Section 24344 of the Revenue and Taxation Code.
Apportionment. Ss interest income is not included in the sales factor in any of Years 1 through 5. If S were a financial corporation or otherwise required to include loan balances in its property factor under Section 25137, the intercompany loan would be excluded from Ss property factor.
(h) Anti-avoidance rules. If a transaction is engaged in or structured with a principal purpose to avoid the purposes of this section (including, for example, by avoiding treatment as an intercompany transaction or by manipulating the sourcing of income), adjustments may be made to carry out the purposes of this section.
(i) (Reserved.)
(j) Miscellaneous operating rules.
(1) Substantial change in the combined reporting group.
(A) When a substantial change in the composition of the combined reporting group occurs, Ss intercompany items are required to be taken into account under the acceleration rule pursuant to Subsection (d) of this regulation. A substantial change in the composition of the combined reporting group occurs when both subsections (j)(1)(A)(i) and (ii) apply.
(i) Immediately after the change, S and B are unitary with each other and the asset which was the object of the intercompany transaction is a unitary business asset of B; and
(ii) the property, payroll and sales of the tested members of the S-B group immediately after the change accounted for an average of less than 60% of the property, payroll and sales of the combined reporting group in which S and B were members immediately prior to the change.
(iii) If subsection (j)(1)(A)(i) applies to a change in the composition of the combined reporting group but subsection (j)(1)(A)(ii) does not apply, and the event causing the change in the group causes Ss intercompany item to be taken into account in a federal consolidated return that includes S and B, then S may make an irrevocable election to take the intercompany item into account in the same period for California purposes. The election is made by reporting the income, gain, deduction or loss on a timely filed original tax return. If this election is not made, then S and B must maintain sufficient records to track the intercompany gain or loss which has been taken into account for federal purposes but which remains deferred for state purposes.
(B) Tested members of the S-B group. Except as provided otherwise in subsections (j)(1)(B)(i) through (iii) For purposes of applying the 60% test in subsection (j)(1)(A)(ii), the tested members of the S-B group for purposes of applying the 60% test in subsection (j)(1)(A)(ii) shall include any affiliated corporations which are unitary with S and B immediately after the change in the composition of the group, and which were members of the same combined reporting group as S and B immediately prior to the change.
(i) S and B are in the waters-edge combined reporting group. If the change in the composition of the group is attributable to a waters-edge election and S and B are members of the waters-edge combined reporting group immediately after such election, then the tested members of the S-B group shall not include those affiliates (or the portions of those affiliates, for partially included entities) which do not remain in the waters-edge combined reporting group with S and B.
(ii) S and B are excluded from the waters-edge combined reporting group. If the change in the composition of the group is attributable to a waters-edge election and S and B remain unitary but are both excluded from the waters-edge combined reporting group as a result of the election, then the tested members of the S-B group shall only include those unitary affiliates (or the portions of those affiliates, for partially included entities) which were also excluded from the waters-edge combined reporting group as a result of the election.
(iii) Only S or B are in the waters-edge combined reporting group. If , as a result of a waters-edge election, either S or B, but not both, remain a member of the waters-edge combined reporting group, then this subsection (j)(1) shall not apply, and Ss intercompany items shall be taken into account under the acceleration rule pursuant to subsection (d) of this regulation.
(C) Testing period. The property, payroll and sales used in the above 60% test shall generally be those amounts which were included in the apportionment factors from the beginning of the income year to the date of the change in the composition of the group. If such period is less than 3 months, then the property, payroll and sales included in the apportionment factors for the immediately preceding income year shall be used.
(D) If, during the income year, there occurs more than one change in the composition of the group to which subsection (j)(1)(A)(i) applies, then such incremental changes shall be aggregated and treated as a single change in the composition of the combined reporting group for purposes of this subsection (j)(1). The aggregate change shall be considered substantial for purposes of subsection (d) of this regulation if the property, payroll and sales of the tested members of the S-B group immediately after the last of the incremental changes accounted for an average of less than 60% of the property, payroll and sales of the combined reporting group immediately prior to the first incremental change.
(E) In cases where the rules of this subsection (j)(1) do not achieve a reasonable result because of acquisitions, dispositions, reorganizations or a series thereof (including a series of such events which occur over one or more income years) that substantially affect the results of the 60% test, the staff of the Franchise Tax Board may, in its sole discretion, permit or require modification of these rules in order to carry out the purpose of this subsection.
Example 1: S and B sold.
P, a calendar year taxpayer, is the principal corporation in a combined reporting group in which S, B, T, U and V are members. On August 31, P sells S, B and T to X, an unrelated entity. The property, payroll and sales factor denominators of each member for the period January 1 through August 31 are:
S, B, T and X are unitary with each other immediately after the sale. Although S, B, T and X are members of the S-B group, only S, B and T were also members of the same combined reporting group as S and B immediately prior to the change in the composition of the group. Therefore, S, B and T are the tested members of the S-B group. Because the period from the beginning of the income year to the date of the change is more than 3 months, that period will be used as the testing period. During the testing period, the average percentage of the property, payroll and sales of the combined reporting group that was attributable to S, B and T was 55%, computed as follows:
Property of S, B and T:
Payroll of S, B and T
Sales of S, B and T
Because the property, payroll and sales of the tested members of the S-B group averaged less than 60% of the property, payroll and sales of the combined reporting group prior to the change, Ss intercompany items will be taken into account under the acceleration rule immediately before the sale of S, B and T to X.
Example 2: S and B excluded by waters-edge election.
Assume the same facts as in example 1, but instead of selling S, B and T to X, the taxpayer members of the combined reporting group make a waters-edge election as of January 1. S, B and T are foreign corporations and are wholly excluded from the waters-edge combined report as a result of the election. S, B and T are the tested members of the S-B group under subsection (j)(1)(B)(ii). If the property, payroll and sales of S, B and T accounted for an average of less than 60% of the property, payroll and sales of the combined reporting group for the previous income year, then Ss intercompany items will be taken into account immediately before the waters-edge election under the acceleration rule.
Example 3: Other members of group sold.
Assume the same facts as in example 1, but instead of selling S, B and T to X, P sells T, U and V to an unrelated entity. Because P, S and B are unitary after the change in the composition of the group, and were all members of the combined reporting group prior to the change, P, S and B are the tested members of the S-B group. During the testing period of January 1 through August 31, the percentage of the property, payroll and sales of the combined reporting group that was attributable to P, S and B averaged 56%, computed as follows:
Property of P, S and B
Payroll of P, S and B
Sales of P, S and B
Because the property, payroll and sales of the tested members of the S-B group accounted for an average of less than 60% of the property, payroll and sales of the combined reporting group before the change, Ss intercompany items will be taken into account under the acceleration rule immediately before the sale of T, U and V.
Example 4. More than one change during income year.
P, a calendar year corporation, is the principal corporation in a combined reporting group with S, B, D, E and F. On April 30, P sells S and B to X. On July 31, P sells D and E to X. The provisions of subsection (j)(1)(A)(i) apply after both the April 30 and July 31 sales (S and B remain unitary with each other and the asset which was the subject of the intercompany transaction is a unitary business asset of B). D and E become unitary with S and B again immediately after the July 31 sale. Under subsection (j)(1)(D), the April 30 and July 31 sales are treated as a single change in the composition of the combined reporting group. The tested members of the S-B group, determined after the July 31 sale, are S, B, D and E. If the property, payroll and sales of S, B, D and E accounted for an average of less than 60% of the property, payroll and sales of the combined reporting group of which S and B were members immediately prior to the April 30 sale, then Ss intercompany items will be taken into account under the acceleration rule. For purposes of the 60% test, the testing period shall be the period from January 1 through April 30.
Example 5: Election to accelerate in same period as for federal consolidated return purposes.
The members of the combined reporting group are the same as the corporations included in the federal consolidated return. S and B are sold to X by P, and the requirements of subsection (j)(1)(A)(i) are met. The property, payroll and sales of S and B accounted for an average of more than 60% of the property, payroll and sales of the combined reporting group prior to the change in the composition of the group. Therefore, intercompany transactions between S and B are not required to be taken into account under the acceleration rule. The federal consolidated return regulations require the intercompany transactions between S and B to be taken into account. The taxpayer also takes the intercompany transactions into account on its timely filed original California return. Under subsection (j)(1)(A)(iii), the taxpayer has elected to take the intercompany transactions into account for state purposes.
Example 6: Election to accelerate not made.
The facts are the same as in Example 5, except the taxpayer makes a state adjustment to exclude the intercompany gain or loss from income. S and B must maintain sufficient records to track the intercompany gain or loss which has been taken into account for federal purposes but which remains deferred for state purposes.
Example 7: Election not applicable if S-B group is less than 60% of former combined reporting group.
The facts are the same as if Example 5, except that the property, payroll and sales of S and B accounted for an average of less than 60% of the property, payroll and sales of the combined reporting group prior to the change in the composition of the group. Ss intercompany items must be taken into account under the acceleration rule regardless of whether the sale of S and B caused the intercompany items to be taken into account for federal consolidated return purposes. The election provided by subsection (j)(1)(A)(iii) does not apply.
(2) Recognition of income from intercompany transactions occurring prior to entering the state.
(A) Intercompany transactions as defined in subsection (b)(1) of this regulation shall include those transactions which occur prior to any member becoming taxable in this state if S and B would have been members of the same combined reporting group had any unitary member been taxable in this state in the year of the transaction.
(B) Examples. The application of this section to transactions occurring prior to entering the state can be illustrated by the following examples.
Example 1: Sale outside of group after member enters the state.
Facts. S and B are members of a unitary group. In Year 1, when no member of the group is a California taxpayer, S sells land with a basis of $100 to B for $110. The land is used in the unitary business. In Year 2, a member of the unitary group becomes taxable in California. Prior to the member becoming taxable in this state, no event occurred which would have caused the intercompany item to be taken into account. In Year 3, B sells the land to X for $130.
Matching rule. Ss sale of the land to B is an intercompany transaction, and Ss $10 gain is its intercompany item. S takes its intercompany gain into account in Year 3 to reflect the $10 difference between Bs corresponding item of $20 from the sale to X, and the recomputed corresponding item of $30 ($130 - $100). This is the same result that would have occurred if S and B were unitary divisions of a single corporation and the transaction had been a transfer between divisions prior to the corporation becoming taxable within this state.
Apportionment. The land is included in Bs property factor at Ss $100 original cost basis. In Year 3, the $130 gross receipts from Bs sale to X will be included in Bs sales factor. Ss gain will be treated as current apportionable business income in Year 3.
Example 2. S leaves the combined reporting group after member enters the state.
Facts. The facts are the same as in Example 1, except that instead of B selling the land, the stock of S is sold in Year 3 and S becomes a nonmember of the combined reporting group.
Acceleration rule. Once the stock of S is sold, the effect of treating the unitary operations of S and B as divisions of a single corporation cannot be achieved. Therefore, under the acceleration rule of subsection (d) of this regulation, Ss $10 gain is taken into account in Year 3 immediately before S becomes a nonmember.
Apportionment. The land will be included in Bs property factor at Ss $100 original cost basis until Ss intercompany gain is accelerated. Immediately after Ss gain is taken into account, the $100 value of the land in Bs property factor will be increased to reflect Bs $110 cost. Ss intercompany gain will be treated as current apportionable business income in Year 3.
(3) Partially included waters-edge banks and corporations.
(A) Coordination with Section 25110(a)(4).
(1) If a bank or corporation partially included in a waters-edge combined reporting group pursuant to Section 25110(a)(4) of the Revenue and Taxation Code is S in a transaction with another member of the waters-edge combined reporting group, the transaction is an intercompany transaction if the resulting income, gain, deduction or loss would, but for the provisions of this regulation, be included as apportionable business income in the waters-edge combined report under Section 25110 of the Revenue and Taxation Code.
(2) Except as provided in (3) below, intercompany transactions include transactions where B is a bank or corporation partially included in the combined reporting group immediately after such transaction pursuant to Section 25110(a)(4) of the Revenue and Taxation Code, but only to the extent that the object of the intercompany transaction gives rise to income, gain, deduction or loss which would be included as apportionable business income in the waters-edge combined report under Section 25110 of the Revenue and Taxation Code.
(3) The sale, exchange or other transfer of stock of an affiliated bank or corporation (as defined by 18 Cal. Code Regs. Section 25110(b)(1)) to a bank or corporation partially included in the combined reporting group pursuant to Section 25110(a)(4) will not be treated as an intercompany transaction unless the stock is considered to be a United States real property interest as defined in Section 897(c) of the Internal Revenue Code.
(4) Where either S or B was partially included in a waters-edge combined reporting group pursuant to Section 25110(a)(4) of the Revenue and Taxation Code, the intercompany item will be taken into account under the acceleration rule immediately before any income year in which either S or B has no includable income pursuant to Section 25110(a)(4) and is therefore excluded from the combined reporting group. If, for any year, the includable income of S or B pursuant to Section 25110(a)(4) is insubstantial, the staff of the Franchise Tax Board may permit or require the intercompany item to be taken into account under the acceleration rule immediately before such year.
(5) Where B is partially included in a waters-edge combined reporting group pursuant to Section 25110(a)(4) of the Revenue and Taxation Code, the acceleration rule will apply to take an intercompany item into account to the extent the object of the intercompany transaction ceases to give rise to income, gain, loss, or deductions which would be included as apportionable business income in the waters-edge combined report under Section 25110. For example, if intangible property gives rise to income includible in the waters-edge combined report under Section 25110 while held by B, but a disposition of such property results in foreign-source gain or loss under Sections 861 through 865 of the Internal Revenue Code which is not included in the waters-edge combined report, then the disposition will trigger application of the acceleration rule to take into account Ss intercompany items with respect to such property.
(6) Where a sale, exchange or other transfer of stock to a bank or corporation included in the combined reporting group pursuant to Section 25110(a)(4) of the Revenue and Taxation Code has been treated as an intercompany transaction under subsection (j)(3)(A)(3) of this regulation, the acceleration rule will apply to take into account intercompany items arising from that intercompany transaction if the stock ceases to be a United States real property interest as defined in Section 897(c) of the Internal Revenue Code.
(B) Coordination with Section 25110(a)(6).
(1) Definition. For purposes of this subsection (j)(3), the term "partial inclusion ratio" shall refer to the ratio described in Section 25110(a)(6) of the Revenue and Taxation Code, and the regulations thereunder, for determining the includable amount of income and apportionment factors for a partially included bank or corporation described in Section 25110(a)(6).
(2) A transaction between a bank or corporation included in a waters-edge combined reporting group pursuant to Section 25110(a)(6) of the Revenue and Taxation Code and another member of the combined reporting group will be an intercompany transaction to the extent of the Section 25110(a)(6) corporations partial inclusion ratio for the income year.
(3) If both S and B are banks or corporations included in a waters-edge combined reporting group pursuant to Section 25110(a)(6) of the Revenue and Taxation Code, the partial inclusion ratios of both S and B must be applied to determine the portion of the transaction that will be treated as an intercompany transaction.
(4) Where either S or B is included in a waters-edge combined reporting group pursuant to Section 25110(a)(6) of the Revenue and Taxation Code, the intercompany item will be taken into account under the acceleration rule immediately before the first income year in which the partial inclusion ratio for either S or B is an amount equal to or lower than 50% of its partial inclusion ratio for the year of the intercompany transaction. Regardless of whether the ratio decreases 50% or more below the intercompany transaction year partial inclusion ratio, the acceleration rule will apply to take the intercompany item into account if the partial inclusion ratio is less than 10%.
(5) If subsection (j)(3)(B)(4) of this regulation applies, then as an alternative to the application of the acceleration rule provided by that subsection, the taxpayer may elect to have the acceleration rule apply to take into account only a proportionate share of the intercompany item relative to amount of decrease in the partial inclusion ratio. If further decreases in the partial inclusion ratio occur in subsequent years, additional portions of the intercompany item must be taken into account under the acceleration rule in proportion to such decreases. If, in any income year, the partial inclusion ratio is below 10%, any remaining intercompany items shall be taken into account. The election must be made by reporting the proportionate share of the intercompany item on a timely filed original tax return for the first year in which the partial inclusion ratio decreases 50% or more below the intercompany transaction year partial inclusion ratio. As a condition of this election, the taxpayer must maintain books and records sufficient to identify the amounts of intercompany items, the annual partial inclusion ratios, and the application of this provision to the intercompany items.
(6) Where both S and B are included in a waters-edge combined reporting group pursuant to Section 25110(a)(6) of the Revenue and Taxation Code, and the partial inclusion ratios of both S and B decrease 50% or more below the intercompany transaction year partial inclusion ratios, the acceleration methodology of subsection (j)(3)(B)(5) of this regulation shall be applied in proportion to the greater of either (1) the amount of decrease attributable to S or (2) the amount of decrease attributable to B.
(C) Separate entity election for transactions with partially included entities. See subsection (e)(2)(B) for application of the election to treat transactions on a separate entity basis with respect to transactions with partially included entities.
(D) Examples. The application of this section to partially included entities in a waters-edge combined report is illustrated by the following examples.
Example 1: Intercompany sale of land by an entity included pursuant to Section 25110(a)(4).
Facts. S is a foreign corporation with U.S. branches that are included in a waters-edge combined reporting group pursuant to Section 25110(a)(4) of the Revenue and Taxation Code. S has a basis of $70 in land which it uses in its U.S. trade or business operations. On January 1 of Year 1, S sells the land to domestic corporation B for $100. On July 1 of Year 3, B sells the land to X for $110.
Matching rule. Except for the provisions of this regulation, Ss $30 gain from the sale to B would be treated as U.S. source income and included in the waters-edge combined report under Section 25110. Therefore, the transaction is an intercompany transaction and Ss $30 gain is an intercompany item. S takes its intercompany item into account under the matching rule in Year 3 to reflect the $30 difference for the year between Bs corresponding item of $10 and the recomputed corresponding item of $40.
Apportionment. To produce the result that would occur if the S and B were unitary divisions of a single corporation, the intercompany sale of land will not be reflected in the sales factor in Year 1. In Year 3, the $110 gross receipts from Bs sale will be included in Bs sales factor. The land is attributable to B after the sale, and it will be reflected in Bs property factor at Ss $70 original cost basis until it is sold outside the waters-edge combined reporting group in Year 3. Both Ss $30 gain and Bs $10 gain will be treated as current apportionable business income in Year 3.
Example 2: Intercompany transaction where buyer is an entity included pursuant to Section 25110(a)(4).
Facts. B is a foreign corporation with a U.S. branch which is included in a waters-edge combined reporting group pursuant to Section 25110(a)(4) of the Revenue and Taxation Code. In Year 1, domestic corporation S incurs expenses of $300 to provide engineering services to B in connection with the renovation of Bs U.S. facility. B capitalizes the $500 fee which it pays to S for the services and computes depreciation on that basis. If S and B were divisions of a single corporation, only the $300 expenses would have been capitalized, which would result in smaller depreciation deductions.
Matching Rule. Because the engineering services are attributable to a facility used in the operation of U.S. business activities which gives rise to income, gain deduction or loss included in the combined report under Section 25110, the performance of those services is treated as an intercompany transaction. S has intercompany income of $200 ($500 receipts less $300 expenses). Ss intercompany income will be taken into account in subsequent years based upon the difference between Bs corresponding depreciation (based on a $500 basis) and the depreciation recomputed as though S and B were divisions of a single corporation (based on a $300 basis).
Apportionment. As would be the case if the services were performed between unitary divisions of a single corporation, the transaction will not be reflected in the sales factor. If Ss expenses related to the engineering services included payroll expenses, those expenses would be included in Ss payroll factor in Year 1. When the renovated facility is placed into service in the unitary business, the $300 capitalized cost of the engineering services will be included in Bs property factor. In each subsequent year, Ss intercompany income taken into account and Bs corresponding depreciation deduction will be treated as current apportionable business income for that year.
Example 3: Transaction not related to U.S. activities.
Assume the same facts as in Example 2, except that the engineering services relate to the construction of a plant in Brazil. Although B is partially included in the waters-edge combined reporting group under Section 25110(a)(4) of the Revenue and Taxation Code, the engineering services do not relate to an asset which will give rise to income, gain, deduction or loss which will be included in the waters-edge combined report under Section 25110. Therefore, the performance of services is not treated as an intercompany transaction. Ss income of $500 and expenses of $300 are taken into account in Year 1. Gross receipts of $500 are included in Ss sales factor.
Example 3(a): Transaction allocated between U.S. activities and foreign activities.
Facts. Assume the same facts as in Example 2, except that the engineering services relate to the construction of two plants, one in the U.S. and one in Brazil. Ss expenses related to the engineering services are allocated 55% to the U.S. activities under the rules in Treas. Reg. Section 1.861. Therefore, 55% of the transaction will be treated as an intercompany transaction.
Matching Rule. S has intercompany income of $110 ($500 receipts less $300 expenses, multiplied by 55%). Ss intercompany income will be taken into account in subsequent years based upon the difference between Bs corresponding depreciation deduction and the depreciation deduction recomputed as though S and B were divisions of a single corporation.
Apportionment. Because 45% of the transaction is not treated as an intercompany transaction, Ss $90 of non-intercompany income ([$500-$300] x 45%) will be treated as current apportionable business income in Year 1. Likewise, receipts from engineering services of $225 ($500 x 45%) will be included in Ss sales factor in Year 1. The capitalized cost of the engineering services allocated to the U.S. plant is $165 ($300 total cost x 55%). When the U.S. plant is placed into service in the unitary business, the $165 capitalized cost will be included in Bs property factor. In each subsequent year, Ss intercompany income taken into account and Bs corresponding depreciation deduction will be treated as current apportionable business income for that year.
Example 4: Asset ceases to give rise to U.S. source income.
Facts. Assume the same facts as in Example 2, except that the engineering services relate to the design of specialized equipment which is placed in service in Bs U.S. facility by the end of Year 1. On December 31 of Year 4, the equipment is shipped to Germany for use in another plant owned and operated by B.
Matching rule. As in Example 2, S has intercompany income of $200, a portion of which is taken into account in Years 2 through 4 to reflect the difference between Bs corresponding depreciation deduction and the depreciation recomputed as though S and B were divisions of a single corporation.
Acceleration rule. In Year 4, the equipment ceases to give rise to income, gain, loss or deductions included in the waters-edge combined report under Section 25110. Under the acceleration rule and subsection (j)(3)(A)(5) of this regulation, Ss remaining intercompany income is taken into account in Year 4.
Apportionment. The apportionment results of the transactions in Years 1 through 4 are the same as in Example 2. Because no gross receipts related to the transaction are generated in Year 4, the accelerated income is not reflected in the sales factor.
Example 5. Both Seller and Buyer partially included under Section 25110(a)(4)
S and B are both foreign corporations with U.S. branches that are included in a waters-edge combined reporting group pursuant to Section 25110(a)(4) of the Revenue and Taxation Code. S sells equipment which it uses in its U.S. trade or business operations to B for a gain. Thereafter, the equipment is used in Bs U.S. trade or business operations. Except for the provisions of this regulation, Ss gain from the sale of equipment would be treated as U.S. source income and included in the waters-edge combined report under Section 25110. Bs use of the equipment gives rise to income, gain, deduction or loss which will be included in the waters-edge combined report under Section 25110. Therefore, because the requirements of subsections (j)(3)(A)(1) and (2) of this regulation are both satisfied, Ss sale of the equipment to B is treated as an intercompany transaction and subject to the rules of this regulation.
Example 6. Seller excluded from the waters-edge combined reporting group.
Facts. S is a foreign corporation which owns 100% of the stock of affiliated domestic corporations B and RP. RP is a United States Real Property Holding Corporation as defined in Section 897(c) of the Internal Revenue Code. In Year 1, S has no income from U.S. activities, and is excluded from the waters-edge combined reporting group of B and RP.
In Year 2, S sells its stock in RP to B for a gain of $1,000. Because Ss sale of RP is treated as a disposition of a United States real property interest as defined by Section 897 of the Internal Revenue Code, Ss income and apportionment factors attributable to that sale would, but for the provisions of this regulation, be included in the waters-edge combined report in Year 2. Therefore, the transaction is treated as an intercompany transaction. Ss intercompany item is its $1,000 gain.
In Year 3, S has no income from U.S. activities, and is again excluded from the waters-edge combined reporting group of B and RP.
Acceleration Rule. The effect of treating the operations of S and B as divisions of a single corporation cannot be achieved once S is excluded from the waters-edge combined reporting group. Therefore, under the acceleration rule, Ss $1,000 intercompany gain is taken into account in Year 2 (immediately before the income year in which S is excluded from the combined reporting group).
Apportionment. Neither the intercompany sale of RP stock nor the acceleration of the intercompany gain is reflected in the sales factor in Year 2. Ss accelerated gain will be treated as current apportionable business income in Year 2.
Example 7: Seller included under Section 25110(a)(6).
Facts. Corporation S is a controlled foreign corporation as defined in Section 957 of the Internal Revenue Code, and is included in the waters-edge combined reporting group under Section 25110(a)(6) of the Revenue and Taxation Code to the extent of its partial inclusion ratio. In Year 1, S sells land with a basis of $500 to domestic corporation B for $600. Ss partial inclusion ratio for Year 1 is 66%. In Year 5, when Ss partial inclusion ratio is 75%, B sells the land to X for $650. At no time in Years 2 through 4 did Ss partial inclusion ratio fall to 33% or lower (50% of the Year 1 ratio; see subsection (j)(3)(B)(4) of this regulation).
Matching rule. $66 of Ss $100 gain is an intercompany item and is deferred ($100 x 66%). The remaining $34 of Ss gain is not included in the waters-edge combined report. In Year 5, B has a corresponding gain of $50 ($650 - $600). For purposes of calculating the recomputed gain, Ss original cost of $500 is increased by the amount of Ss $34 non-intercompany gain. Therefore, the recomputed gain would be $116 ($650 - $534). Ss $66 intercompany gain is taken into account in the waters-edge combined report in Year 5 to reflect the $66 difference between Bs $50 corresponding gain and the $116 recomputed gain.
Apportionment. Gross receipts of $396 from Ss sale to B are included in the waters-edge combined report ($600 x 66%). If S and B were divisions of a single corporation, the transaction would not be reflected in the sales factor. Therefore, the $396 intercompany gross receipts shall be eliminated from Ss sales factor under subsection (a)(5)(A) of these regulations. For purposes of Bs property factor, the land will be reflected at Ss cost basis under subsection (a)(5)(B)(1) of these regulations, adjusted by any gain or loss recognized by S as a result of the non-intercompany portion of the transaction. The net value assigned to the land in Bs property factor will be $534 ($500 cost basis to S + $34 non-intercompany gain).
Example 8: Buyer included under Section 25110(a)(6).
Facts. On December 31 of Year 1, domestic corporation S sells land with a basis of $500 to corporation B for $600. Corporation B is a controlled foreign corporation as defined in Section 957 of the Internal Revenue Code, and is included in the waters-edge combined reporting group under Section 25110(a)(6) of the Revenue and Taxation Code to the extent of its partial inclusion ratio. Bs partial inclusion ratio for Year 1 is 66%. On December 31 of Year 5, when Bs partial inclusion ratio is 75%, B sells the land to X for $650. At no time in Years 2 through 4 did Bs partial inclusion ratio fall to 33% or lower (50% of the Year 1 ratio).
Matching rule. $66 of Ss $100 gain is an intercompany item and is deferred ($100 x 66%). Ss remaining $34 gain is taken into account currently in Year 1. In Year 5, B has a corresponding gain of $50 ($650 - $600). For purposes of calculating the recomputed gain, Ss original cost of $500 is increased by the amount of the $34 non-intercompany gain taken into account by S. Therefore, the recomputed gain would be $116 ($650 - $534). Ss $66 intercompany gain is taken into account in the waters-edge combined report in Year 5 to reflect the $66 difference between Bs $50 corresponding gain and the $116 recomputed gain.
Apportionment. Ss sales factor in Year 1 will reflect gross receipts of $204 from the non-intercompany portion of the sale to B. The remaining $396 ($600 sale price x 66%) will be eliminated from Ss sales factor under subsection (a)(5)(A) of these regulations. The valuation of the land for purposes of Bs property factor is Ss cost basis adjusted by any gain or loss recognized by S as a result of the non-intercompany portion of the transaction. The net value assigned to the land will be $534 ($500 cost basis to S + $34 non-intercompany gain). The $534 valuation will be included in Bs property factor to the extent of Bs partial inclusion ratio for that year. For example, if Bs partial inclusion ratio was 50% in Year 2, the land would be reflected in Bs property factor for Year 2 at $267 ($534 x 50%). In Year 5, $487.50 gross receipts from Bs sale of the land to X will be reflected in Bs sales factor ($650 sales price to X x 75% Year 5 partial inclusion ratio).
Example 9: Both Seller and Buyer included under Section 25110(a)(6).
Facts. Assume the same facts as in Example 8, except that S is also a controlled foreign corporation as defined in Section 957 of the Internal Revenue Code, and is included in the waters-edge combined reporting group under Section 25110(a)(6) of the Revenue and Taxation Code to the extent of its partial inclusion ratio. Ss partial inclusion ratio for Year 1 is 80%. On December 31 of Year 5, when Ss partial inclusion ratio is 60%, B sells the land to X for $650. At no time in Years 2 through 4 did Ss partial inclusion ratio fall to 40% or lower (50% of Ss 80% Year 1 ratio).
Matching rule. $52.80 of Ss $100 gain is an intercompany item and is deferred ($100 x Ss 80% Year 1 ratio x Bs 66% Year 1 ratio). Of Ss remaining $47.20 non-intercompany gain, $27.20 is currently taken into account in Year 1 ($100 total gain X Ss 80% Year 1 ratio = $80 of total gain includable in waters-edge combined report; less $52.80 deferred intercompany portion); $20 of non-intercompany gain is not included in the waters-edge combined report. In Year 5, B has a corresponding gain of $50 ($650 - $600). For purposes of calculating the recomputed gain, Ss original cost of $500 is increased by the amount of Ss $47.20 non-intercompany gain. Therefore, the recomputed gain would be $102.80 ($650 sales price - $547.20 recomputed basis). Ss $52.80 intercompany gain is taken into account in the waters-edge combined report in Year 5 to reflect the $52.80 difference between Bs $50 corresponding gain and the $102.80 recomputed gain.
Apportionment. Gross receipts of $480 from Ss sale to B are included in the waters-edge combined report ($600 x Ss 80% Year 1 ratio). Of that amount, $316.80 ($480 x Bs 66% Year 1 ratio) is attributable to the intercompany transaction and will be eliminated from Ss sales factor under subsection (a)(5)(A) of these regulations. Ss sales factor will continue to reflect the remaining gross receipts of $163.20. In Year 5, $487.50 gross receipts from Bs sale of the land to X will be reflected in Bs sales factor ($650 x Bs 75% Year 5 ratio).
The valuation of the land for purposes of Bs property factor is Ss cost basis of the land adjusted by any gain or loss recognized by S as a result of the non-intercompany portion of the transaction. The net value assigned to the land will be $547.20 ($500 cost basis to S + $47.20 non-intercompany gain). The $547.20 valuation will be included in Bs property factor to the extent of Bs partial inclusion ratio for that year. For example, if Bs partial inclusion ratio was 50% in Year 2, the land would be reflected in Bs property factor for Year 2 at $273.60 ($547.20 x 50%).
Example 10: Intercompany transaction between Seller included under Section 25110(a)(4) and Buyer included under Section 25110(a)(6)
Facts. S is a foreign corporation with a U.S. branch which is included in the waters-edge combined reporting group under Section 25110(a)(4) of the Revenue and Taxation Code. B is a controlled foreign corporation as defined in Section 957 of the Internal Revenue Code, and is included in the waters-edge combined reporting group under Section 25110(a)(6) to the extent of its partial inclusion ratio. In Year 1, S sells land with a basis of $800 which it used in its U.S. trade or business activities to B for $1,000. Bs partial inclusion ratio in Year 1 is 60%. In Year 4, when Bs partial inclusion ratio is 65%, B sells the land to X for $1,100. At no time in Years 2 or 3 did Bs partial inclusion ratio fall to 30% or lower (50% of Bs 60% Year 1 ratio).
Matching rule. Except for the provisions of this regulation, Ss $200 gain from the sale to B would be treated as U.S. source income and included in the waters-edge combined report, therefore the requirements of Subsection (j)(3)(A)(1) are satisfied. $120 of Ss gain is an intercompany item and is deferred ($200 total gain x Bs 60% partial inclusion ratio). Ss remaining $80 non-intercompany gain is taken into account in the waters-edge combined report in Year 1. In Year 4, B has a corresponding gain of $100 ($1,100 - $1,000). For purposes of calculating the recomputed gain, Ss original cost of $800 is increased by the amount of the $80 non-intercompany gain taken into account by S. Therefore, the recomputed gain would be $220 ($1,100 sales price - $880 recomputed basis). Ss $120 intercompany gain is taken into account in the waters-edge combined report in Year 4 to reflect the $120 difference between Bs $100 corresponding gain and the $220 recomputed gain.
Apportionment. Ss sales factor in Year 1 will reflect gross receipts of $400 from the non-intercompany portion of the sale to B. The remaining $600 ($1,000 sale price x 60%) will be eliminated from Ss sales factor under subsection (a)(5)(A) of these regulations. The valuation of the land for purposes of Bs property factor is Ss cost basis adjusted by any gain or loss recognized by S as a result of the non-intercompany portion of the transaction. The net value assigned to the land will be $880 ($800 cost basis to S + $80 non-intercompany gain). The $880 valuation will be included in Bs property factor to the extent of Bs partial inclusion ratio for that year. For example, if Bs partial inclusion ratio was 55% in Year 2, the land would be reflected in Bs property factor for Year 2 at $484 ($880 x 55%). In Year 4, $715 gross receipts from Bs sale of the land to X will be reflected in Bs sales factor ($1,100 sales price to X x Bs 65% Year 4 partial inclusion ratio).
Example 11: Depreciable asset sold to buyer partially included under Section 25110(a)(6)
Facts. On January 1 of Year 1, domestic corporation S buys equipment with a 10-year useful life for $100 and begins to depreciate it under the straightline method. On January 1 of Year 6, S sells the equipment to B for $60. B is a controlled foreign corporation partially included in the combined reporting group under Section 25110(a)(6) of the Revenue and Taxation Code. Bs partial inclusion ratio is 40% in Year 6. B determines that the useful life of the equipment is 5 years from the date it was acquired by B.
Depreciation through Year 5, intercompany gain in Year 6. S claims $10 of depreciation for each of Years 1 through 5, and has a $50 basis at the time of the sale to B. Thus, S has a $10 gain from its $60 sale to B in Year 6. $4 of Ss gain is an intercompany gain and is deferred ($10 gain x Bs 40% partial inclusion ratio). Ss remaining $6 non-intercompany gain is taken into account currently in Year 6.
Matching rule. In each of Years 6 through 10, Bs corresponding item is its $12 depreciation deduction ($60 basis / 5-year life). If S and B were divisions of a single corporation, the recomputed depreciation deduction would be the $10 annual depreciation for Years 6 through 10 based on Ss $100 basis, plus an additional $1.20 of depreciation attributable to the $6 increase in basis resulting from Ss non-intercompany gain ($6 non-intercompany gain / 5-year remaining life). Thus, in each of Years 6 through 10, S will take $.80 of its intercompany gain into account to reflect the difference between Bs $12 corresponding depreciation and the $11.20 recomputed depreciation.
Apportionment. Ss sales factor in Year 6 will reflect gross receipts of $36 from the non-intercompany portion of the sale to B. The remaining $24 ($60 x Bs 40% partial inclusion ratio) will be eliminated from Ss sale factor under subsection (a)(5)(A) of this regulation. The valuation of the equipment for purposes of Bs property factor is Ss cost basis of $100. (Because Ss $10 total gain from the sale to B does not exceed the depreciation already deducted by S with respect to the equipment, the basis is not adjusted by the non-intercompany gain. If the total gain had exceeded the amount of depreciation already deducted by S, then the valuation of the property in Bs property factor would be increased by the 60% non-intercompany portion of the excess gain.) The $100 valuation will be included in Bs property factor in each year to the extent of Bs partial inclusion ratio for that year. For example, the equipment would be reflected in Bs property factor in Year 6 at $60 ($100 x 60%). In each of Years 6 through 10, Ss $.80 intercompany gain will be treated as current apportionable business income. Bs $12 depreciation deduction will be included in combined report business income in each year to the extent of Bs partial inclusion ratio for that year. For example, $7.20 of Bs depreciation deduction would be included in combined report business income in Year 6 ($12 depreciation deduction x 60% partial inclusion ratio).
Example 12: Decreasing partial inclusion ratio
Assume the same facts as in Example 8, except that B does not sell the land to X in Year 5. In Year 6, Bs partial inclusion ratio is 25%, a 62% decrease from Bs Year 1 ratio of 66% (41% difference between 66% Year 1 ratio and 25% Year 6 ratio, divided by 66% Year 1 ratio, equals 62%). Under subsection (j)(3)(B)(4) of this regulation, the acceleration rule will apply to take Ss intercompany gain of $66 into account in Year 5 (immediately before the income year in which Bs partial inclusion ratio falls below the 50% threshold).
Example 13: Election made under Subsection (j)(3)(B)(5).
Assume the same facts as in Example 12, except that the taxpayer elects under Subsection (j)(3)(B)(5) of this regulation to have the acceleration rule apply to take into account only a proportionate share of the intercompany item. Bs partial inclusion ratio is 33% in Year 7, 16% in Year 8, and 8% in Year 9. $40.92 of Ss intercompany gain would be taken into account in Year 6 ($66 intercompany gain multiplied by the 62% proportionate decrease between Bs 66% Year 1 ratio and Bs 25% Year 6 ratio). Bs partial inclusion ratio rose in Year 7; but the Year 8 partial inclusion ratio represented a new low point. At 16%, the Year 8 partial inclusion ratio was 76% below the Year 1 ratio of 66% (50% difference between 66% Year 1 ratio and 16% Year 8 ratio, divided by 66% Year 1 ratio, equals 76%). Accordingly, $9.24 of Ss intercompany gain would be taken into account in Year 8 ($66 intercompany gain x 14% incremental difference between 76% decrease and the 62% decrease that was previously recognized). In Year 9, Bs partial inclusion ratio fell below the 10% floor, so Ss remaining intercompany gain of $15.84 is taken into account.
(4) Earnings and profits. The timing rules of this regulation apply to earnings and profits. Therefore, the earnings and profits of S will not reflect Ss intercompany items until those items are taken into account under this regulation.
(5) Foreign country operations. To the extent that foreign country operations are included in the combined report, and the corporations engaging in those operations are not required to report intercompany transactions under a similar deferral method for federal income tax purposes or any other purposes, then intercompany transactions involving those foreign operations may be reported using the method used for consolidated financial reporting purposes if that method reasonably reflects income and approximates the result that would be obtained from use of the rules in this regulation. However, adjustments may be permitted or required for any transaction or series of transactions for which the financial reporting method does not produce a result which reasonably approximates the results under this regulation.
(6) Reserved for pass-through entity rules.
(7) If the taxpayer fails to disclose its DISA balance on its annual tax return, the staff of the Franchise Tax Board may, in its discretion, require the amounts in the undisclosed DISA accounts to be taken into account in part or in whole in any year of such failure.
(8) Recordkeeping. Intercompany and corresponding items must be reflected on permanent books and records (including work papers). See also 18 Cal. Code Regs. Section 19141.6.
(k) Effective date. This regulation applies to intercompany transactions occurring on or after [effective date of reg].