On May 14, California Governor Gavin Newsom released proposed trailer bill language for the so-called “apportionment fix” introduced in his “May Revise” to the state budget last week (see our prior Legal Alert here). Incredibly, the bill would retroactively codify a provision that would overturn two important apportionment cases that allowed taxpayers to include receipts in the sales factor even if the related income was not included in the tax base. Making matters worse, the proposed legislation excuses the Franchise Tax Board (FTB) from complying with the state’s Administrative Procedure Act in promulgating regulations that implement this new apportionment statute – which is startling.
Specifically, the Governor’s proposal enshrines FTB Legal Ruling 2006-01 into law. This 18-year-old ruling provides that the sales factor excludes receipts if the related income is not taxed. Legal Ruling 2006-01 was at the heart of two taxpayer wins – the Appeal of Southern Minnesota Beet Sugar Co-op and Appeal of Microsoft Corp. These Office of Tax Appeals (OTA) decisions rejected the substance of Legal Ruling 2006-01 as inconsistent with California law.
The proposed bill resurrects Legal Ruling 2006-01, stating that it “shall apply with respect to apportionment factors attributable to the income” of California corporate taxpayers. Adding new section 25138.9 to the California Revenue and Taxation Code, the bill excludes from apportionment formulas “[a] transaction or activity, to the extent that it generates income or loss not included in ‘net income’[.]” The term “‘not included in “net income” is defined to mean:
“income from transactions and activities that is not included in net income subject to apportionment for any reason, including, but not limited to, exclusion, deduction, exemption, elimination, or nonrecognition.”
Further, the bill authorizes the FTB to adopt regulations to implement the purpose of the new statutory language, namely “to prevent inclusion within the apportionment formula of transactions and activities that give rise to income that is not subject to apportionment.” In a maneuver to avoid the fallout of the recent San Francisco Superior Court decision in American Catalog Mailers Association v. FTB, in which the court struck down informal FTB guidance as an invalid “underground” regulation, the bill states that California’s Administrative Procedure Act (APA)
“shall not apply to any regulation, standard, criterion, procedure, determination, rule, notice, guideline, or any other guidance established or issued by the Franchise Tax Board pursuant to this section.”
Excluding the FTB from complying with the state’s APA means that the public will not be provided with an opportunity to comment on proposed regulations under the proposed apportionment statute – or even receive notice of them. How can that be good tax policy? Additionally, the new statute would have retroactive effect, applying to “taxable years beginning before, on, or after the effective date of the act adding this section.” Finally, as a clarification of existing law, the bill would only require a simple majority in each chamber to pass.
To summarize, just one month after OTA released its decision in Microsoft, sending a shockwave – and a rare ray of hope – through the taxpayer community by awarding a nearly $100 million refund on an issue with wide-reaching impact, the Governor released a bill effectively telling OTA that two separate panels of judges were wrong on the law in two unrelated cases, declaring that 18-year-old informal guidance has the effect of a statute, authorizing the FTB to promulgate a regulation outside of the APA, and, most importantly, that hundreds of millions of dollars of taxpayer refunds will be thwarted via a “clarification.”
The fact that the FTB cannot appeal from an adverse decision at OTA was always thought to be a significant boon to the taxpayer community. That thinking is now called into question as the FTB is “reversing” decisions in the legislature.
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