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State Tax Planning and Litigation

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Like the IRS, the California Franchise Tax Board (“FTB”) is authorized to audit tax returns and assess additional tax liabilities, interest, and penalties. Although a FTB audit seems similar to an IRS audit, an FTB audit is very different in nature, and the outcome of an FTB audit may be dramatically different than an IRS audit.

The Initial Contact Letter

Just about every FTB audit will begin with an initial contact letter. In most cases, the FTB will send to the individual or business being audited an Information Document Request. The reason the FTB sends an Information Document Request to taxpayers is to determine if there was omitted taxable income from a tax return and to determine if a taxpayer can substantiate expenses claimed on a tax return. Nobody ever likes responding to an Information Document Request, but it is extremely important to timely respond to an Information Document Request. What happens if you fail to timely respond to an Information Document Request? Depending upon the facts and circumstances of the particular case, the Franchise FTB may consider an untimely response as evidence of a badge of fraud and a reason to assess a seventy-five percent civil fraud penalty. The case may even be referred to a special investigations unit for criminal prosecution consideration. Consequently, it is extremely important to timely respond to a FTB Information Documentation Request, and carefully respond to a FTB Information Document Request.

Taxpayers that participated in a tax shelter (such as captive insurance or conservation easement) or received income from an undisclosed foreign asset may receive a contact letter that is different from usual Information Document Requests from the FTB. In these cases, it is extremely important to take a closer look at the initial correspondence received from the FTB. If the initial correspondence from the FTB states that the agency received information that the taxpayer may have participated in a tax shelter or received income from a previously undisclosed foreign financial account, it may be possible to avoid an audit and significant penalties by filing amended tax returns. In these cases, the FTB must be contacted quickly.

Administratively Contesting an Audit

After a taxpayer receives notice from the FTB of an audit, the audit will proceed much like an IRS audit. However, there are significant differences that should be taken into consideration. For example, many tax professionals believe they can request a conference with an FTB auditor and attempt to espouse legal theories to settle a case or attend a protest hearing as if it were an IRS appeals conference. A professional doing either of these two examples may be wasting their client’s time and money. This is because neither an auditor nor a hearing officer has the authority to resolve a state tax liability on a theory of the hazards of litigation. With that said, unlike the IRS, the FTB has a special Settlement Bureau. This Settlement Bureau was created for the sole purpose of reaching settlements based on the hazards of litigation. However, the Settlement Bureau cannot consider a settlement until a Notice of Proposed Assessment has been issued.

Federal and State Tax Law Differences

Statute of Limitations Differences

For federal income tax purposes, the IRS generally must assess a tax liability within three years of the filing of a tax return. On the other hand, the FTB must only issue a Notice of Proposed Assessment within four years of the filing of a tax return rather than making an assessment. However, if a transaction was taken to avoid taxes, the statute of limitations on an assessment is eight years from the date of the filing of a tax return. There is a six year statute of limitations that will apply both for state of California and federal purposes if there has been a greater than twenty-five percent omission of income. The statute of limitations is unlimited for federal and state of California purposes if a taxpayer filed a false or fraudulent tax return with the intent to evade tax or a willful attempt to defeat or evade tax.

It may be possible to utilize the statute of limitations as leverage to favorably resolve an examination. However, it must be understood when the statute of limitations can be used as leverage. The IRS and FTB have entered into a Memorandum of Understanding regarding the sharing of information relating to tax audits. This means that if the IRS timely audited a taxpayer and is sharing information with the FTB, an attempt to delay an audit to insure that the state statute of limitations has run will not likely be effective. Therefore, a tax professional must carefully consider both federal and state of California statute of limitations in any audit of a California resident.

California Tax Penalties that are Unique

California has two civil penalties that have no federal counterparts. These penalties are the 1) interest based penalty and the 2) noneconomic substance transaction penalty (“NEST”).

The interest based penalty is imposed by the FTB if a taxpayer was assessed a liability that is the result of an abusive tax shelter. The penalty is equal to 100 percent of the interest assessed against the taxpayer.

The NEST penalty is a 40% penalty which applies to a noneconomic substance understatement. A transaction is treated as lacking economic substance if the taxpayer does not have a valid nontax business purpose for entering into the transaction. Once assessed, the authority to compromise a NEST penalty is delegated solely to the Chief Counsel. The Chief Counsel’s decision may not be reviewed by a state court.

Determining and Contesting California Taxation of Residency

Due to California’s high income tax rates, many individuals and corporations want to avoid having a nexus with California. However, due to complex California laws, this is not always an easy task.

Domicile is an important concept in California state taxation. An individual or business whose domicile is in California is subject to state tax on worldwide income even if income is received outside of California. Domicile is the place where an individual has his or her permanent home or principal establishment and where he or she intends to return after temporary absences. Domicile does not change until the individual moves to a new location which he or she intends to make his or her new home.

Residency is not equal to domicile since a person or business can have many transient residences where he or she may only have one legal domicile. Residency is significant for California tax purposes because residents of California are taxable on all income, including income from sources outside California. On the other hand, non-residents are taxed only on income from California sources.

The determination of residency requires an evaluation of all relevant contacts with the state of California as compared to contacts with other states. No single factor is conclusive. Under this test, even minor contacts with California could trigger residency if an individual is unable to demonstrate that there are more significant contacts with any other state. This means the weight of any given factor may vary. Factors which tend to indicate residency include, but are not limited to, maintenance of a family home in California, retention of business interests in California, and attendance by a taxpayer’s minor children in California schools. However, the most persuasive evidence of an individual being a resident of California is their physical presence within the state. The longer a taxpayer remains in California, the more likely a finding of California residency becomes. Physical presence within California for as little as 45 days may create a presumption of residency by the FTB. The determination can have serious consequences. This is because reclassification can result in the assessment of significant back taxes, interest, and penalties.

Residency Audits

All residency disputes begin with an FTB audit. Once the audit commences, the FTB may visit any out of state locations claimed to be an individual’s principal residence or business location. In addition, any individual being audited by the FTB should expect a review of credit card statements and bank charges to determine physical presence with California as compared to other states. In certain cases, an individual can file California non-resident tax returns to commence the running of the statute of limitations on income tax assessments. By filing non-resident tax returns, it may be possible to commerce the running of the statute of limitations on income tax assessments. This could be an extremely valuable tool in a potential residency audit.

Residency Litigation

If the FTB makes an adverse determination regarding residency against you and you do not agree with the results, it is very important to retain a tax attorney who not only can vigorously advocate on your behalf, but also understands the administrative process. The residency appeals process in California is multilayered with many strict deadlines. If these strict timelines are not satisfied in an appeal of a residency determination, the case will be dismissed and the FTB will collect on its assessment. A determination by the FTB regarding residency is presumed to be correct. This means if the FTB determines that you are a resident for California tax purposes, you will carry the burden of proving that the FTB’s determination is incorrect. With that said, the presumption of residency is rebuttable and is only presumed correct in the absence of sufficient evidence to the contrary.

If the FTB determines an individual is a California resident for tax purposes, the FTB must mail a Notice of Proposed Additional Assessment stating the additional tax liability. If you receive this Notice, it must be responded to within 60 days of the notice date. If a protest is not timely filed, the proposed assessment reflected on the Notice of Proposed Additional Assessment becomes final and the state tax liability reflected on the notice will be collected by the FTB. If a protest has been timely filed, the FTB will reconsider the assessment through a conference with a settlement officer. If the controversy cannot be resolved with a settlement officer, the FTB will mail you a Notice of Action. If you receive a Notice of Action, it must be responded to within 30 days of the date of the notice by filing an appeal with the State Board of Equalization affirms the deficiency assessment, the decision becomes final within 30 days after the date of determination unless a Petition for Rehearing is filed. If a Petition for Rehearing is filed, the determination becomes final 30 days after the date the State Board of Equalization issues an opinion regarding the residency controversy.

In the event of an adverse decision by the State Board of Equalization based on residency, if you wish to litigate the matter without payment of tax liability, you must, within 60 days after the determination becomes final, commence an action for determination of residency against the FTB in the Superior Court of the County of Sacramento, the County of Los Angeles, or the City and County of San Francisco. The complaint contesting the residency must be based on the same grounds stated in the initial protest that you filed with the FTB.

Conclusion

If you are facing a California residency audit, it is extremely important that you retain a tax attorney with significant experience dealing with California residency audits. The tax attorneys at Diosdi and Liu, LLP have significant experience representing clients before the FTB in residency audits and litigation before state courts.

An Overview of the California Water’s Edge Election for State International Tax Purposes

Many California corporations also have foreign subsidiaries. This often leads to complex tax situations, including the issue of determining income for the unitary group of corporations (typically consisting of a U.S. parent corporation and one or more foreign subsidiary corporations). There are two approaches to dealing with unitary group members that are incorporated in a foreign country or conduct most of their business abroad. One approach is a worldwide combination, under which the combined report includes all members of the unitary business group, regardless of the country in which the group member is incorporated or the country in which the group member conducts business. The alternative approach is a water’s-edge combination, under which the combined report excludes group members that are incorporated in a foreign country or conduct most of their business abroad.

Overview of State Corporate Income Taxes

Most states that impose a corporate income tax use either federal taxable income before the net operating loss and special deductions (federal Form 1120, line 28) or federal taxable income (federal Form 1120, line 30) as the starting place for computing state taxable income. The use of the federal tax base as the starting point greatly eases the administrative burden of computing state taxable income. The use of the federal tax base as the starting point greatly eases the administrative burden of computing state taxable income. However, most states require numerous addition and subtraction modifications to arrive at state taxable income. Examples of common additional modifications include interest income received on state and municipal debt obligations, state income taxes, royalties and interest expenses paid to related parties. Examples of common subtraction modifications include interest income received on federal debt obligations, state net operating loss deductions, state dividends-received deductions, and federal global intangible low-taxed income or GILTI, Subpart F, and Internal Revenue Code Section 78 gross-up income.

States employ a wide variety of consolidation rules for a group of commonly controlled corporations. California typically requires members of a unitary business group to compute their taxable income on a combined basis. Roughly speaking, a unitary business group consists of two or more commonly controlled corporations that are engaged in the same trade or business, as exhibited by such factors as function and centralized management. To prevent double taxation on worldwide income, California permits unitary business groups to make a water’s-edge election.

Worldwide Versus Water’s-Edge Combined Reporting

Requiring a multinational corporation to compute its state taxable income on a worldwide combined reporting basis is controversial for a number of reasons, including: 1) the difficulty of converting books and records maintained under foreign accounting principles and in a foreign currency into a form that is acceptable to the state; 2) the inability of the state to audit books and records located in foreign countries; and 3) distortions in the property and payroll factors caused by significantly lower wage rates and property values in developing countries. Despite these practical difficulties, the constitutionality of requiring a multinational corporation to compute its state taxable income on a worldwide combined basis is firmly established. In Container Corp. of America v. Franchise Tax Board, 463 U.S. 159 (1983), the United States Supreme Court ruled that California’s worldwide combined reporting method was constitutional with respect to a U.S.-based parent corporation and its foreign subsidiaries. In Barclays bank plc v. Franchise Tax Board, 512 U.S. 298 (1994), the United States Supreme Court held that California’s worldwide combined reporting method was also constitutional with respect to a foreign-based parent corporation and its U.S. subsidiaries.

In spite of these legal victories, the international business community took a dim view of combined unitary reporting and, in particular, the practice of requiring a worldwide combination. This ultimately resulted in California repealing a mandatory worldwide combined reporting requirement and allowed for a unitary group to make a water-edge election. A water-edge election is made for an initial period of 84 months and remains in effect thereafter, year by year, until terminated by the taxpayer. For California tax purposes, a water’s-edge group includes the following members of the unitary group: 1) corporations whose average property, payroll, and sales factor in the United States is 20 percent or more; 2) corporations organized in the United States that have more than 50 percent of their stock controlled by the same interests; 3) foreign sales corporations and domestic international sales corporations; 4) controlled foreign corporations or “CFCs”, which are included based on the ratio of their current year income to current year E&P; and 5) any other corporations with U.S. located business income, which are included to the extent of their U.S. located income and factors. See Calif. Reg. Section 25110. If a water’s-edge election is not made, the group members that are taxable in California compute their income on a worldwide combined basis.

The effect of a water’s-edge election is to make the determination of state tax more predictable. Whether or not it is beneficial for a taxpayer to make a water’s-edge election typically depends on the facts and circumstances of the case. A major advantage of making a water’s-edge election is that it avoids the compliance burden of a worldwide combination, which can be substantial, particularly if the unitary business group includes numerous foreign members. On the other hand, a water’s edge election could increase the taxpayer’s California tax, particularly if the unitary group’s state operations are more profitable than its foreign operations.

The water’s-edge analysis dramatically changes when a foreign corporation that is a member of a unitary group conducts business (even without physical presence) in California.The economic nexus rules under Cal. Rev. and Tax Code Section 23101 can result in the foreign corporation having a filing requirement in California without any physical presence. For foreign corporations of a unitary group that generates revenue from intangible assets, these nexus rules can be extremely unfavorable. A foreign corporation that has an economic nexus with California will have a state filing requirement and be subject to California income tax. However, if the foreign corporation has established an economic nexus in California without any physical presence in the state, the foreign corporation can make a water’s-edge election to avoid including its income in a combined report. Some or all of the foreign corporation’s income will not be excluded from the combined report, however, if the foreign corporation has effectively connected income (“ECI”) or a 20 percent or higher U.S. apportionment factor will result in an income inclusion. When a foreign corporation engages in a trade or business in the United States, it likely has received income that is ECI.

A foreign corporation is considered to be conducting business in California and engaging in a trade or business if it actively engages in any transaction for the purpose of financial or pecuniary gain or profit. A foreign corporation also conducts business in California if it has a minimum amount of property, payroll, or sales in California. Can a foreign corporation that is engaged in a trade or business in California make a water’s edge election to avoid reporting foreign source income on a California income tax return? The general rule is that if a foreign corporation makes a water’s-edge election it can exclude its income from a water’s edge return; that is, unless it has either ECI or a 20 percent or higher U.S. apportionment factor. Thus, if the foreign corporation has ECI, then it will be included in the combined report to the extent of its ECI. If a foreign corporation does not have any ECI, it may still be included in the water’s-edge combined report if its U.S. apportionment percentage is 20 percent or more. California Revenue and Tax Code Section 25110(a)(1)(B) states that any corporation (other than a bank) will be fully included in the water’s-edge combined report regardless of where it is incorporated if the average of its property, payroll, and sales factors within the United States is 20 percent or more.

California allows corporations to elect to compute income attributable to California sources on a water’s-edge combined report (Form 100W). This election results in the exclusion of affiliated foreign corporations from the combined California report. This results in the U.S. corporation only being required to pay California tax on California sourced income. The election is made on Form 100-WE and must be attached to a timely filed original Form 100W. Given the 84 month election length, it is important to consider the following before making a water’s-edge election:

  1. Do the corporation foreign subsidiaries generate a loss and if so, is this loss expected to continue. If the losses from foreign subsidiaries are expected to continue in the future, these losses could be utilized to reduce state of California income tax liabilities.
  2. Do the corporate foreign subsidiaries generate income? If so, this foreign source income could increase taxable income apportioned to California.
  3. Does the corporation’s foreign subsidiaries generate revenue from intangible assets? In these cases, failing to make a water’s-edge election can result in an unfavorable result.

Conclusion

Multinational Corporations that conduct business in California are subject to unusual tax consequences. One way to mitigate tax consequences of foreign source income is to make a water’s-edge election. There are a number of complexities and nuances to consider before making the California water’s-edge election. For this reason, a California international tax attorney must model the potential implications of making the election. The tax attorneys at Diosdi & Liu, LLP have significant experience advising multi-national corporations to reduce their global tax liabilities.

Anthony Diosdi

Written By Anthony Diosdi

Partner

Anthony Diosdi focuses his practice on international inbound and outbound tax planning for high net worth individuals, multinational companies, and a number of Fortune 500 companies.

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