Opinion ID: 1353007
Heading Depth: 1
Heading Rank: 3

Heading: the general operation of section 24344

Text: The basic provision we are called upon to construe by the parties is the phrase interest and dividend income ... not subject to allocation by formula as used twice in section 24344. Section 24344 at times relevant here [3] provided as follows: (a) Except as limited by subsection (b), there shall be allowed as a deduction all interest paid or accrued during the income year on indebtedness of the taxpayer. [¶] (b) If income of the taxpayer is determined by the allocation formula contained in Section 25101, the interest deductible shall be an amount equal to interest income subject to allocation by formula, plus the amount, if any, by which the balance of interest expense exceeds interest and dividend income (except dividends deductible under the provisions of Section 24402) not subject to allocation by formula. Interest expense not included in the preceding sentence shall be directly offset against interest and dividend income (except dividends deductible under the provisions of Section 24402) not subject to allocation by formula. [4] In view of the complexity of the section, it is helpful to consider at the outset how the subsection operates in a situation not involving intercompany dividends. It must first be observed that subsection (b) only comes into play if the income of the taxpayer is determined by the allocation formula contained in Section 25101, and this makes clear that we are only concerned with corporations which are engaged in multi-state operations, i.e., corporations which do business both within and without California and perhaps a corporation which is part of a unitary business conducted by it and affiliated corporations within and without California. [5] Under subsection (b), it may be said that there are four steps in calculating the allowable interest expense. First, a deduction for interest expense is permitted to the extent that there is interest income subject to allocation by formula. In other words, interest expense is first used to cancel out interest income subject to allocation by formula. [6] This first step is not in issue in the instant case, and will not be considered in the remainder of this opinion. The second step is to ascertain the amount of interest and dividend income ... not subject to allocation by formula. Under the first sentence of subsection (b), an amount of interest expense equal to that amount of income, is disallowed as a deduction. This is because the sentence only allows as a deduction the amount of expense that exceeds the described amount of income. The third step is to allow as a deduction any excess interest expense, i.e., the amount of interest expense, if any, which exceeds the described amount of income. The fourth step is that set forth in the second sentence of subsection (b). This provides that interest expense not allowed by the preceding sentence shall be offset against interest and dividend income ... not subject to allocation by formula. The latter income is exactly the same income referred to in step 2. Accordingly, the amount of interest expense equal to interest and dividend income ... not subject to allocation by formula is allowed as an offset against the described interest and dividend income. Another way of describing the operation of the last three steps is that interest expense must first be used to offset the quoted interest and dividend income and the remaining interest expense, if any, may be used to reduce net operating income. To further explain the operation of subsection (b), it would seem desirable to start with an illustration of the subsection in a context where its operation is not disputed by the parties. Let us assume that a corporation has $10 net operating income from sources both within and without the state prior to the deduction of interest expense. Under the formula approved in Edison California Stores v. McColgan, supra, 30 Cal.2d 472 (dealing with how this income is to be apportioned to California and other states), 30 percent of the income is apportionable to California. In addition, the corporation owned some stock in corporations not engaged in a unitary business, which provided dividends totalling $5. Finally, assume that interest expense incurred by the corporation totalled $2. Given the illustration, the important question then arises as to whether the interest expense is deductible from the operating income or from the dividend income. The importance of this determination may be illustrated by the following calculations of net taxable income as to a domiciliary corporation. TABLE I Interest Expense Deductible From Operating Results Net operating income prior to interest expense ...... $10.00 Interest Expense .................................... 2.00 ______ Net operating income ................................ $ 8.00 30 percent attributable to California ...................... $2.40 Dividend income ............................................ 5.00 _____ Net Taxable Income ......................................... $7.40 ===== TABLE II Interest Expense Deductible From Dividend Income With the Balance of Interest Expense, If Any, Deductible From Operating Income Net operating income prior to interest expense ......... $10.00 30 percent attributable to California .................. $3.00 Dividend income ........................................ 5.00 Interest expense ....................................... 2.00 ______ Net Investment Income .................................. 3.00 _____ Net Taxable Income ..................................... $6.00 ===== It is apparent from Tables I and II that the net income subject to tax will vary greatly (between $7.40 and $6 in the illustration) depending upon whether the interest expense is deducted from operating income or from investment income. This is due to the fact that only part (30 percent in the illustration) of the operating income and expenses is taken into account in determining the net income; whereas all of the income from dividends and interest (the investment income) is taken into account in computing the net income. To put the matter another way, if the interest expense is to be deducted from the operating income rather than from the dividend income, the taxpayer will lose 70 percent of the deduction. None of the parties dispute that Table II reflects the proper result under subsection (b). It is apparent that, when viewed in the light of a domiciliary corporation, subsection (b) does not deprive the taxpayer of any of its interest deduction but is merely an attempt to provide how the interest expense shall be allocated as between income from operations and income from investments. Further, the allocation of interest expense is very favorable to the domiciliary corporation in limiting the loss of the interest expense deduction which might otherwise occur. The foregoing points up the logic upon which the subsection is based. This is rather simple to state in a general fashion. In essence, once we get beyond step one above (the cancellation of interest income appearing in the operations calculation) interest expense shall be deducted from investment income so far as possible rather than income from operations, and only the excess interest expense shall be used to offset income from operations. In treating interest expense as the opposite of investment income (interest and dividend income), the subsection is obviously approaching the problem presented in a reasonable manner. Interest expense is the opposite of interest income, and dividend income is sufficiently analogous to interest income that it is reasonable to provide for the offset of interest expense against dividend income. (This is not to say that another treatment of the interest expense would be unreasonable; the only point is that the approach of the Legislature was not unreasonable.) When we turn to a foreign corporation doing business both within and without the state, receiving dividends from other corporations, and having interest expense, it is apparent that under the principle of mobilia sequuntur personam the dividends received by the foreign corporation are viewed as received at its domicile and such dividend income is not taxed in California. The dividend income is not taxable in California whether or not the dividends are paid by a corporation engaged in the same unitary business as the parent and whether or not the dividend-paying corporation engaged in a different business is a subsidiary. Since the dividends are not taxable in California, the foreign corporation, unlike the domiciliary, will generally favor exclusion of dividends from the statutory phrase interest and dividend income ... not subject to allocation by formula. Using the figures of the prior illustration, the point may be illustrated as follows: TABLE III Dividends Excluded From the Quoted Phrase Net operating income prior to interest expense ....... $10.00 Interest Expense ................. $2.00 Less dividends included in the quoted phrase ............ 0.00 _____ Deductible Interest Expense .......................... 2.00 _____ Net Operating Income ................................. 8.00 30 percent attributable to California ...................... $2.40 This is the position favored by Pacific in general. It is Pacific's position at least as to all of the dividends, other than those paid by Nevada Bell ($2,329,250) to Pacific and those paid by nonmembers of the Bell System ($8,344,594), namely, Pacific's position at least as to $761,448,405 of dividends. TABLE IV Dividends Included in the Quoted Phrase Net operating income prior to interest expense ....... $10.00 Interest Expense ................ $2.00 Less dividends included in the quoted phrase ............ 5.00 _____ Deductible Interest Expense ............................ 0.00 ______ Net Operating Income .................................. $10.00 30 percent attributable to California ......................... $3.00 Table IV represents the board's position except as to the effect to be given to the Nevada Bell dividends. (The effect to be given to the Nevada Bell dividends as it relates to the interest expense deduction will be considered at the end of this opinion.)