FTB to Clean Up Deferred Intercompany Stock Account Regulation

by Reed Smith
Contact

On July 25, the FTB held a public hearing on its proposed revisions to its regulation on intercompany transactions.1 The changes attempt to fix issues with the current rules governing Deferred Intercompany Stock Accounts ("DISAs").2

Background

California does not incorporate the consolidated group concept of the Internal Revenue Code, so California does not conform with all of the Treasury Regulations under IRC § 1502. California does, however, generally follow Treasury Regulation § 1.1502-13 with regard to intercompany transactions, with some significant differences.

Both federal and California rules regarding intercompany transactions account for distributions between members of a consolidated or combined reporting group. For example, at the federal level, taxpayers use an Excess Loss Account ("ELA") to account for non-dividend distributions in excess of basis between members of a consolidated group.3 California accounts for such distributions with its DISA rules.4 A federal ELA is treated as negative basis5 while a California DISA is not.6 A DISA is treated instead as deferred income, which can be triggered by transactions that do not trigger income recognition at the federal level.7 In its proposed regulatory changes, the FTB attempts to cure many—but not all—of these differences.

Proposed DISA Changes

Mergers

Under the current DISA rules, it is unclear whether, if members of a combined group merge, the DISA attributable to the non-surviving member must be recognized as income.8 If a merger would trigger recognition, that result would conflict with the spirit of the intercompany transaction rules, "to produce the effect of transactions between divisions of a single corporation."9

To address this, the FTB added new language to the DISA rules that provides that a disposition of stock, requiring a DISA to be taken into income, does not occur when members of a combined reporting group merge into one another.10 Instead of triggering the DISA when the merger occurs, the DISA attributable to the non-surviving member’s stock is added to any DISA attributable to the surviving member’s stock, and is taken into account as income or gain upon disposition of the surviving member’s stock.

Capital Contributions

Under the federal rules concerning intercompany transactions, ELAs are treated as negative basis. So a capital contribution that increases basis has the effect of reducing an ELA. Unlike its federal counterpart, a DISA is treated as deferred gain. As a consequence, it is not clear whether a DISA can be reduced by a capital contribution. To fix this, the FTB has added language explicitly allowing a parent to make a capital contribution to a subsidiary in order to reduce the DISA attributable to the parent’s stock in its subsidiary.11 If a DISA is eliminated as a result of capital contributions, any subsequent capital contributions increase the parent’s basis in its subsidiary’s stock.12

Transfers of Stock within a Combined Group

Under the current DISA rules, if a parent has a DISA attributable to its stock in a subsidiary and then transfers its stock of the subsidiary to another member of the combined group, the transferee continues to have a DISA in the subsidiary’s stock.13 The current regulation is silent as to how the transferee’s DISA in the subsidiary’s stock is computed in instances in which the transferee already owned stock in the subsidiary in which it had basis prior to the transfer. The FTB’s proposed language allows the transferee to reduce its DISA in the subsidiary’s stock by any basis in the stock of the subsidiary that it already owned before the transfer.14

Multiplication of DISAs

Currently, the FTB’s regulations could be interpreted in a manner that causes a non-dividend distribution of one item of property up a chain of subsidiaries to increase the DISA of each corporation in the chain of distribution. Take, for example, a parent with three tiered subsidiaries, none of which has earnings and profits or basis in the others’ stock. The current rules could be interpreted so that a distribution from a subsidiary to a parent corporation does not increase the earnings and profits (E&P) of the parent.15 As a consequence, if a corporation has neither E&P nor basis in the stock of its subsidiary, then each distribution increases the corporation’s DISA with respect to the subsidiary corporation’s stock. Thus, a distribution of $100 up the chain of three tiered subsidiaries described above causes a $100 increase in each distributee’s DISA. As a result, $100 moving through this chain could cause a $300 increase in DISA.

This conflicts with the purpose of the intercompany transaction rules to produce the effect of transactions between divisions of a single corporation.16 The proposed rule attempts to resolve this problem.17 Under the proposed rule, the first distribution creates a DISA—but that distribution (and all subsequent distributions) increase E&P. Since the distributions increase E&P, subsequent distributions are treated as dividends made from E&P and as such, DISA is no longer created at each subsequent distribution.

Liquidations

Under the current DISA rules, a parent corporation must recognize the full amount of any DISA associated with a liquidating subsidiary.18 Again, this defeats the very purpose of the intercompany transaction rules—to treat the members of the group as divisions of one corporation. When a subsidiary corporation liquidates into its parent, the two corporations become a single corporation, and such action should not be a recognition event. Unfortunately, this rule remains unchanged in the FTB’s proposal.

What to Expect Next

The FTB’s notice of the public hearing marked the first steps in California’s formal regulatory process. Although no oral comments were made during the hearing, the FTB indicated it had received two written comments. The FTB must respond to these comments before it presents its final draft of the proposed regulation to the three-member board. Once approved, the FTB will submit the regulation to the Office of Administrative Law, which then has 30 days to review, finalize, and file it with the Secretary of State. Because the FTB has held three interested-parties meetings up to this point,19 we expect the process to proceed in a timely manner.

1. Cal. Code Regs. § 25106.5-1.
2. The FTB’s proposed regulations also bring the California intercompany transaction regulation conformity date to correspond with most recent version of Treasury Regulation §1.1502-13, and "clarify" that an election to trigger otherwise deferred income under the Regulation §25106.5-1(e) simplifying rules does not allow taxpayers to include intercompany transaction receipts in their sales factor in the year of the election.
3. Treas. Reg. §1.1502-32(a)(3)(iii) and -19.
4. Cal. Code Regs. § 25106.5-1(f).
5. Treas. Reg. §1.1502-19(a)(2)(ii) (an ELA "is treated for all Federal income tax purposes as basis that is a negative amount ….").
6. Cal. Code Regs. § 25106.5-1(f)(1)(B)(2) ("DISA is deferred income and not negative basis ….").
7. In addition, the FTB believes that it cannot defer the recognition of dividend income under the DISA rules because of the California Supreme Court’s decision in Safeway Stores v. FTB, 3 Cal. 3d 745 (1970).
8. Cal. Code Regs. § 25106.5-1(f)(1)(B)(1) ("A disposition of all the shares shall be deemed to have occurred if [a member of the combined reporting group] becomes a non-member of the combined reporting group or if the stock [of the member] becomes worthless.") The question is whether a merger is a "disposition" for this purpose.
9. Cal. Code Regs. § 25106.5-1(a)(1).
10. Proposed Cal. Code. Regs. § 25106.5-1(f)(1)(B)(2) ("A disposition of stock will not occur when members of a combined reporting group merge into one another, if the majority of the voting shares of the stock of each is owned by other members of the combined reporting group.")
11. Id. ("If a DISA has been created as a result of an intercompany distribution, prior to P’s disposition of the S stock, the DISA will be reduced by any subsequent capital contributions that P makes to S.")
12. The basis increase will be in accordance with Cal. Rev. & Tax Code § 24916.
13. Cal. Code. Regs. § 25106.5-1(f)(1)(B)(4) ("If P transfers 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.")
14. Proposed Cal. Code. Regs. § 25106.5-1(f)(1)(B)(4) ("If the other transferee member of the combined reporting group to whom P transfers the S stock already possesses S stock with positive basis, any outstanding DISA attributable to the shares transferred by P will be reduced by the basis in the stock already possessed by the other member of the combined reporting group.")
15. Cal. Code Regs. § 25106.5-1(f) ("the California earnings and profits … will not reflect … intercompany items until those items are taken into account under this regulation ….").
16. Cal. Code Regs. § 25106.5-1(a)(1).
17. Proposed Cal. Code Regs. § 25106.5-1(j)(4) ("[w]hen a member distributes an amount of money or property to another member, who in turn thereafter distributes no more than the amount of money or the same property to another member, any DISA arising from the initial distribution will be treated as earnings and profits for purposes of determining the DISA, if any, arising from the second distribution.")
18. Cal. Code Regs. § 25106.5-1(f)(1)(B)(3). ("Because P’s DISA is deferred income and not negative basis, the DISA is taken into account upon liquidation, including complete liquidation into the parent.")
19. The first meeting was held April 21, 2010; the second September 22, 2010; and the third, August 16, 2011.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Reed Smith | Attorney Advertising

Written by:

Reed Smith
Contact
more
less

Reed Smith on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.