Cal. Code Regs. tit. 18 § 25106.5-1
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 use in the trade or business of the combined reporting group. On January 1 of Year 1, S sells the land to B for $100. B also holds the land for use in the trade or business of the combined reporting group. On July 1 of Year 3, B sells the land to Y 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 Y 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 was 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 Y 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)(4) 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 S 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 Y will be included in B's sales factor unless the receipts are excluded pursuant to Title 18, California Code of Regulations, section 25137. 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: Intercompany sale of 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 used 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 was 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 use in the trade or business of the combined reporting group. On January 1 of Year 1, S sells the land to B for $100. B also holds the land for use in the trade or business of the combined reporting group. On July 1 of Year 3, B sells the land to Y in exchange for Y'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 was 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 Y will be included in B's sales factor in Year 3 (assuming that the receipts were not excluded pursuant to Title 18, California Code of Regulations, section 25137). Because the installment sale income is being apportioned to California using the apportionment percentage from the year of the sale to Y 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 Y 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 Y in exchange for Y's $100 note, and S reports its gain on the installment method under section 453 of the Internal Revenue Code. Y'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 Y's note to B for $100, resulting in a $30 gain from S's prior sale of the land to Y. 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 Y'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 Y, and the deferred tax liability of each taxpayer member remains subject to the interest charge under section 453 A(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 Y 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 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 Y'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 Treasury 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 by a member for a member.
(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: Intercompany 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 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 F and recognizes $25 of income on sales to Y, 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)(5) of the Revenue and Taxation Code. Furthermore, subsection (c)(1) of this regulation provides that the redetermination of attributes described in Treasury 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 Y 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.
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 the trade or business of the combined reporting group. 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 Y 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 regulation, S's $30 gain is taken into account in Year 3 immediately before S becomes a nonmember.
California does not conform to the stock basis adjustments required for federal purposes by Treasury 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 use in the trade or business of the combined reporting group. 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 conversion to nonbusiness use 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.
The DISA will be treated as deferred income. To the extent of a sale, liquidation, redemption or any 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 P even if S and P 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. The DISA is held by the distributee.
If a DISA has been created as the 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. Once a DISA has been eliminated as the result of subsequent capital contributions, any further subsequent capital contributions will then increase P's basis in the S stock in accordance with section 24916 of the Revenue and Taxation Code.
Example 1: Dividend exclusion and property distribution.
(Refer to Treas. Reg. § 1.1502-13(f)(7), example 1.)
Facts. S owns land that is used in the trade or business of the combined reporting group 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 years' 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 Y 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, unless otherwise excluded, 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.
Facts. 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.
Dividend treatment. 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.
Matching rule. 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.
Apportionment. 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 of the Revenue and Taxation Code, 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: DISAs.
(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 Y 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 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 affect 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: DISAs, 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 Y on December 1 of Year 9 for $1.50 (rather than T 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 Title 18, California Code of Regulations, section 25137, the $1.50 gross receipts from P's sale of the T stock to Y 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, 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 Treasury 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.
Example 8: Merger of members (Brother/Sister Merger)
Facts: P owns 100% of the stock of B and S, and P, B and S are members of a combined reporting group. There are 100 outstanding shares of B stock, with an accompanying DISA of $500. There are 100 outstanding shares of S stock, with an accompanying DISA of $1,000. S merges into B, with P receiving one share of B stock for each share of S stock surrendered. Accordingly, following the merger, P has 200 shares of B stock.
Amount of DISA Taken Into Account Following the Merger: Prior to the merger, there was a $5 DISA attributable to each share of B stock. (500 / 100 = 5) Therefore, for each share of B's stock that that might have been disposed of prior to the merger, P would have taken into account $5 of income or gain. Similarly, prior to the merger, there was a $10 DISA attributable to each share of S stock. (1,000 /_ 100 = 10) Therefore, for each share of S's stock that might have been disposed of prior to the merger, P would have taken into account $10 of income or gain. Following the merger, there is a $7.50 DISA attributable to each share of B's stock. (1,500 / 200 = 7.50) Thereafter, when P sells or otherwise disposes of B stock, it must take into account $7.50 of income or gain per share.
Example 9: Subsequent capital contribution
Facts: P and S are members of a combined reporting group. P owns 100% of S's stock and has no basis in its shares of S stock. S has no earnings and profits.
Subsequent capital contribution reducing DISA: S borrows $1,000 and distributes it to P. The result is that P has a $1,000 DISA attributable to its shares of S stock. During the year following the creation of the DISA, P makes a $2,000 capital contribution to S. The capital contribution is first applied against P's $1,000 DISA attributable to its shares of S stock, which is eliminated. The remaining $1,000 increases P's basis in its shares of S stock in accordance with section 24916 of the Revenue and Taxation Code
Example 10: Transferring stock with a DISA balance
Facts: P and S and T are members of a combined reporting group. P owns 100% of T's stock. P and T each own 50% of S's stock. Initially, P and T each had a separate basis in S's stock of $500. However, due to an excess distribution, P has a $400 DISA attributable to its stock in S. T does not have a DISA attributable to its stock in S. P transfers its S stock to T.
Reducing DISA to reflect transferee's basis: After P transfers its S stock to T, the $400 DISA attributable to P's stock reduces T's original basis in its stock in S. Thereafter, T has a $100 basis in the 100% of S's stock that it holds.
Example: 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. The intercompany loan is excluded from S's property factor, even if S is required to include loan balances in its property factor under Title 18, California Code of Regulations, section 25137.
Except as otherwise provided, this regulation applies the provisions of Treasury Regulation section 1.1502-13(j) relating to miscellaneous operating rules; in addition, the provisions of subsections (j)(5), (j)(6), and (j)(7) of Treasury Regulation section 1.1502-13 shall not apply.
Example 1: S and B sold.
P is the principal corporation in a combined reporting group in which S and B are members. P sells S and B to Y, an unrelated entity. S and B remain unitary after the sale. The sale of S and B does not cause S's intercompany items to be taken into account under the acceleration rule. Therefore S's intercompany items will remain deferred until subsequent events cause those intercompany items to be taken into account under either the matching rule or the acceleration rule. However, if the sale of S and B caused S's intercompany items to be taken into account in the federal consolidated return, the taxpayer may elect the same treatment under subsection (j)(1)(B) of this regulation by taking the intercompany items into account on its timely filed original California return.
Example 2: S and B excluded by water's-edge election.
Assume the same facts as in example 1, but instead of selling S and B to Y, the taxpayer members of the combined reporting group make a water's-edge election. S and B are foreign corporations and are wholly excluded from the water's-edge combined report as a result of the election. Because S and B left the combined reporting group together as a result of the water's-edge election, the water's-edge election will not cause S's intercompany items to be taken into account under the acceleration rule if S and B are still unitary immediately after the election.
Example 1: Sale outside of group after member enters the state.
Facts. S and B are members of a unitary group which conduct all of their business activity in the U.S. Both are members of a federal consolidated return 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. S's $10 gain is treated as a deferred intercompany item in S and B's consolidated return. 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 Y 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 Y, 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 Y, unless otherwise excluded by California Code of Regulations section 25137, will be included in B's sales factor. S's gain will be treated as current apportionable business income in Year 3.
Example 2. Retroactive election under subsection (e)(2).
Facts. The facts are the same as in Example 1, except that S and B do not file a consolidated federal return. The Year 1 intercompany transaction between S and B is reported as a $10 gain on S's separate return for federal purposes. An election to treat intercompany transactions between S and B on a separate entity basis could have been made if any member of the unitary group was a California taxpayer in the year of the transaction. Therefore, a retroactive election is deemed made under this subsection in Year 3, which is the year that S's intercompany item would otherwise be taken into account.
Example 3. S leaves the combined reporting group after a 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.
Example 1: Intercompany sale of land by an entity included pursuant to section 25110(a)(4) of the Revenue and Taxation Code.
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 Y for $110.
Matching rule. But 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 of the Revenue and Taxation Code. However, 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 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, unless otherwise excluded, 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) of the Revenue and Taxation Code.
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 in expenses would be 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 give rise to income, gain, deduction or loss included in the combined report under section 25110 of the Revenue and Taxation Code, 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 with respect to the engineering services include 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.
Facts. Assume the same facts as in Example 2, except that the engineering services relate to the construction of a plant in Brazil.
Matching rule. 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 of the Revenue and Taxation Code. 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.
Apportionment. Gross receipts of $500 are included in S's sales factor.
Example 3a: 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 with respect to the engineering services are allocated 55% to the U.S. activities under the rules in Treasury Regulation 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. S has intercompany income of $200 (see computations in Example 2), 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 of the Revenue and Taxation Code. 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) of the Revenue and Taxation Code.
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 of the Revenue and Taxation Code. 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 of the Revenue and Taxation Code. 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) of the Revenue and Taxation Code.
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 Y 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 this regulation. For purposes of B's property factor, the land will be reflected at S's cost basis under subsection (a)(5)(B)1. of this regulation, 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) of the Revenue and Taxation Code.
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 Y 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 ($100 x 66%) is an intercompany item and is deferred. 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. Unless otherwise excluded, 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 sales price x 66%) will be eliminated from S's sales factor under subsection (a)(5)(A) of this regulation. 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, unless otherwise excluded, $487.50 gross receipts from B's sale of the land to Y will be reflected in B's sales factor ($650 sales price to Y x 75% Year 5 partial inclusion ratio).
Example 9: Both Seller and Buyer included under section 25110(a)(6) of the Revenue and Taxation Code.
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 Y 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 ($100 x S's 80% Year 1 ratio x B's 66% Year 1 ratio) is an intercompany item and is deferred. 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 ($600 x S's 80% Year 1 ratio) are included in the water's-edge combined report. 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 this regulation. Unless otherwise excluded, S's sales factor will continue to reflect the remaining gross receipts of $163.20. In Year 5, unless otherwise excluded, $487.50 gross receipts from B's sale of the land to Y ($650 x B's 75% Year 5 ratio) will be reflected in B's sales factor.
The valuation of the land for purposes of B's property factor is S's cost basis in 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) of the Revenue and Taxation Code.
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) of the Revenue and Taxation Code 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 Y 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. of this regulation are satisfied. $120 of S's gain ($200 total gain x B's 60% partial inclusion ratio) is an intercompany item and is deferred. 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. Unless otherwise excluded, 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 this regulation. 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, unless otherwise excluded, $715 gross receipts from B's sale of the land to Y ($1,100 sales price to Y x B's 65% Year 4 partial inclusion ratio) will be reflected in B's sales factor.
Example 11: Depreciable asset sold to buyer partially included under section 25110(a)(6) of the Revenue and Taxation Code.
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 using 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 ($10 gain x B's 40% partial inclusion ratio) and is deferred. 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. Unless otherwise excluded, 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 sales 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.
Facts. Assume the same facts as in Example 8, except that B does not sell the land to Y 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%).
Acceleration rule. 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. of this regulation.
Facts. 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.
Acceleration rule. In Year 6, $40.92 of S's intercompany gain would be taken into account ($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.
Example 1: Same Amount of Money Distributed
Facts: P, B and S are members of a combined reporting group. P owns 100% of B's stock, while B in turn owns 100% of S' stock. S has no earnings and profits and B has zero basis in its shares of S' stock. Similarly, B has no earnings and profits and P has zero basis in its shares of B's stock.
Amount of Earnings and Profits Arising from Initial Distribution: S borrows $1,000, which it distributes to B. The result is that B has a $1,000 DISA attributable to its shares of S' stock. After receiving the $1,000 from S, B distributes the same amount to P. However, the $1,000 DISA that is attributable to B's shares of S' stock is treated as if resulted in an increase of $1,000 in B's earnings and profits. Thereafter, when B distributes the $1,000 to P, the distribution is treated as a $1,000 dividend to P. The $1,000 dividend to P similarly results in P increasing its earnings and profits by $1,000. (Pursuant to section 25106 of the Revenue and Taxation Code, the deemed $1,000 dividend to P would be eliminated for California tax purposes if it were actually taken into account.)
Example 2: Additional Amount of Money Subsequently Distributed
Facts: P, B, S 1 and S 2 are members of a combined reporting group. P owns 100% of B's stock, which in turn owns 100% of S 1 's stock, which in turn owns 100% of S 2 's stock. S 2 has no earnings and profits and S 1 has zero basis in its shares of S 2 's stock. S 1 has no earnings and profits and B has zero basis in its shares of S 1 ' stock. B has no earnings and profits and P has no basis in its shares of B's stock.
Amount of Earnings and Profits Arising from Initial Distribution and DISA Resulting From An Additional Amount of Money Subsequently Distributed: S 2 borrows $1,000, which it distributes to S 1. The result is that S 1 has a $1,000 DISA attributable to its shares of S 2 's stock. After receiving the $1,000 from S 2, S 1 distributes the same amount to B. However, the $1,000 DISA that's attributable to S 1 's shares of S 2 's stock is treated as if it increased S 1 's earnings and profits by $1,000. Thereafter, when S 1 distributes the $1,000 to B, the distribution is treated as a $1,000 dividend to B. B borrows an additional $1,000, which it combines with the $1,000 distribution it received from S 1, and then B distributes $2,000 to P. The $1,000 dividend to B similarly results in B increasing its earnings and profits by $1,000. Thereafter, when B distributes $2,000 to P, $1,000 of it is treated as a dividend to P. However, the remaining $1,000 represents an amount in excess of B's earnings and profits and P's basis in B's stock. Therefore, the result is that P has a $1,000 DISA attributable to its shares of B's stock. (Pursuant to section 25106 of the Revenue and Taxation Code, the deemed $1,000 dividend to P would be eliminated for California tax purposes if it were actually taken into account.)
Cal. Code Regs. Tit. 18, § 25106.5-1
2. Amendment of subsection (a)(2), new subsection (a)(5)(A)4., amendment of subsections (b)(6), (e)(2)(A)-(C) and (f)(1)(B), new subsection (f)(1)(B)2., subsection renumbering, amendment of newly designated subsection (f)(1)(B)4. and subsections (f)(2), (j)(4), (j)(7) and (k) and new subsections (k)(1)-(2) filed 1-8-2014; operative 4-1-2014 (Register 2014, No. 2).
Note: Authority cited: Sections 19503 and 25106.5, Revenue and Taxation Code. Reference: Section 25106.5- 1, Revenue and Taxation Code.
2. Amendment of subsection (a)(2), new subsection (a)(5)(A)4., amendment of subsections (b)(6), (e)(2)(A)-(C) and (f)(1)(B), new subsection (f)(1)(B)2., subsection renumbering, amendment of newly designated subsection (f)(1)(B)4. and subsections (f)(2), (j)(4), (j)(7) and (k) and new subsections (k)(1)-(2) filed 1-8-2014; operative 4-1-2014 (Register 2014, No. 2).