The California Franchise Tax Board (FTB) recently issued much anticipated guidance on the California Other State Tax Credit (OSTC) and allowable deductions for taxes paid to other states. In FTB Legal Ruling 2017-01 (issued Feb. 22, 2017, by the Legal Division of the FTB), the FTB explains general OSTC and deduction rules and its process for determining whether the tax paid to another state qualifies for an OSTC or deduction. The Legal Ruling provides guidance on whether the other state tax is characterized on the entire potential tax base and this characterization of the tax applies universally for all taxpayers. The guidance also walks through various examples, including whether a taxpayer may claim an OSTC or deduction for the Texas franchise tax, the Tennessee franchise and excise taxes, and the New York City Metropolitan Commuter Transportation Mobility Tax, among others.

General guidance

As a mechanism to avoid the imposition of double taxation under its personal income tax, like other states, California allows an OSTC. Eligibility for the OSTC varies, depending on the residency and status of the taxpayer. For instance, California residents may claim an OSTC for net income taxes imposed by and paid to another state on income that is also taxed by California, when the income is derived from sources within the other taxing state, and the other state does not allow a California resident a credit against its tax for taxes paid to California. The guidance also explains the OSTC requirements for the following: (1) a California nonresident, (2) a California resident or nonresident S corporation shareholder, (3) a California resident or nonresident partner in a partnership or member in a limited liability company (LLC) taxed as a partnership, (4) a California resident estate or trust, and (5) a California resident beneficiary of an estate or trust.

Under the general deduction rules, the FTB explained, "neither an individual, an entity taxed as partnership, nor a corporation can deduct gross income or net income paid to another state."¹ Rather, "a deduction is available for taxes that are not on, or according to, or measured by income or profits (a measure based on income, which includes gross and net income taxes) imposed by and paid to another state by an individual, entity taxed as a partnership, or corporation in connection with 'carrying on a trade or business' or 'for production of income,' with certain exceptions."²

Simply put, whether the tax paid to another state is eligible for an OSTC or deductible for California purposes depends on the following: (1) whether the tax is properly characterized as a tax on, or according to, or measured by income, and if so, (2) whether the tax is properly characterized as a net income tax. If the tax is not properly characterized as being measured by income, a taxpayer may deduct the tax (provided all other requirements are met) but not claim an OSTC. If the tax is properly characterized as a net income tax, then it must be determined if the tax is imposed by and paid to another state such that the taxpayer may claim the OSTC. In addition, a shareholder in an S corporation that is subject to and pays a tax characterized as on, or measured by, income to another state in which it is doing business, may be eligible to claim the OSTC based on his/her pro rata share in the S corporation (provided all other criteria are met).

If a state's tax is a multifaceted tax comprised of a conglomeration of "separate and independent taxes" (instead of a single, indivisible tax), in the Legal Ruling, the FTB's legal division stated that each tax will be analyzed independently. An indication of a multifaceted tax is one that may be divided into multiple smaller, separate, independent taxes with different tax bases. Under this principle, a portion of the multifaceted tax may be eligible for the OSTC but not deductible, while another part of the tax may be deductible but is not eligible for the OSTC.

Determining the character of a tax

The Legal Ruling states that the general tax laws governing California's income tax principles, and not those of the other state, will be used in determining the proper characterization of another state's tax for California purposes. Thus, California's determination is not dictated by the other state's denomination or judicial characterization of its tax as an "income" or "gross receipts" tax. Moreover, the FTB's characterization of another state tax is "universal for all taxpayers" and is not made on a taxpayer-by-taxpayer basis according to the items actually taxed in a specific instance.

The Legal Ruling also provides extensive guidance for determining whether a tax is on, or according to, or measured by income. That determination, according to the FTB, depends on the activities and potential tax base to which the tax applies. By comparison, the FTB explained, when a state's tax mechanism provides a tax base that includes earnings from manufacturing, merchandising or mining, the characterization of the tax as having a measure based on income (and thus, non-deductible) or another base (e.g., a gross receipts and therefor, possibly deductible) depends on whether, under the other state's tax system, the tax base could include cost of goods sold (COGS) or a return of capital. In contrast, the characterization of the tax as one that is on, or according to, or measured by income, is mandated when the tax base cannot include proceeds from an activity that has COGS associated with it, and the tax only applies to such things as royalties, rents, dividends, etc. The FTB, citing MCA,³ noted that "this is true even if the gross income of a particular taxpayer is equal to that taxpayer's gross receipts." The FTB illustrates this general rule by discussing and comparing various cases.⁴

After determining whether a tax is on, or according to, or measured by income, the next step is to determine whether it is a net income tax eligible for the OSTC. For the tax to be a net income tax, certain deductions must be present, including a deduction for the entire cost of wages. Another factor to consider, is whether the other state allows other deductions from the tax base, in addition to those allowed under IRC Section 1001(a) for the computation of gain or loss.

The final step in determining whether a tax qualifies for the OSTC asks whether the tax in question is imposed by and paid to another state. The position set forth in the Legal Ruling is that the OSTC is not allowed for taxes imposed by and/or collected by cities, counties and other localities that are political subdivisions of another state. The FTB Legal Division distinguished its ruling from that set forth in the US Supreme Court decision in Wynne,⁵ by reasoning that the tax in that case was a "so-called 'county tax' upon its residents, [but] the tax was actually a state tax imposed by and paid to the state of Maryland, '[d]espite the name[] that Maryland had assigned.'"

Specific state tax examples

Texas franchise (margin) tax: This example involves an S corporation doing business in Texas and California as a general construction company (R Corp.) of which 12% of the shares are owned by Q, a California resident. In year one, R Corp. calculates its Texas margin tax using a formula that equals 70% of its total revenue and in year two it calculates its margin by subtracting its COGS from its total revenue. For each year, Q claims an OSTC against her personal income tax for her pro rata share of R Corp.'s income. The FTB Legal Ruling concludes that R Corp. can deduct, on its California franchise tax returns, the amount of Texas franchise tax paid in years one and two. FTB Legal Division based this determination on the initial conclusion that the Texas franchise tax is a single, indivisible tax. FTB Legal Division further noted it was a single tax "even though the taxpayer may compute multiple margins in order to comply with the requirement that the lesser margin be utilized as the base upon which the tax is computed." Further, the FTB Legal Division provided that not all methods for computing the Texas franchise tax removed COGS from the tax base and, as such, the FTB Legal Division concluded that "the potential remains for COGS to be included in the tax base." As a result, since COGS may be included in the tax base, the FTB concluded that the Texas franchise tax is neither a gross or net income tax. Accordingly, Q, the individual California resident shareholder, cannot use the Texas franchise tax to calculate or claim an OSTC. Instead, the taxpayer can take her pro rata share of the tax and claim it as a deduction against her California personal income tax liability. In the example provided in the Legal Ruling, the California resident was permitted to deduct the amount of Texas franchise tax paid in years one and two on her personal income tax returns.

Arizona income tax: In this example, an Arizona resident is a 25% partner in a partnership doing business only in California. Arizona is also a "reverse credit" state in that it allows a credit to California residents for tax paid to California on income sourced to Arizona. The resident claims an OSTC against her California income tax liability based on tax that she paid to Arizona on her pro rata share of partnership income. The FTB concluded that the resident is entitled to claim the OSTC based on the pro rata share she paid to Arizona because Arizona is a "reverse credit" state.

Tennessee franchise and excise taxes: In this example, the FTB Legal Division addressed the consequences for a California resident and sole shareholder of an S Corporation doing business in Tennessee. The S corporation filed a Tennessee tax return, which is measured by the sum of a franchise tax and an excise tax. The franchise tax is computed based upon the greater of net worth or the book value of real and tangible property located in Tennessee. The excise tax is based on its net earnings from business done in Tennessee. The California resident claimed an OSTC based on his pro rata share of the total franchise and excise taxes the S corporation paid to Tennessee. The FTB Legal Division concluded, however, that the two taxes paid to Tennessee were actually separate, independent taxes and the California resident shareholder was not entitled to an OSTC for her share of the S corporation's franchise tax paid to Tennessee, since it was not a tax on, or according to, or measured by income. The FTB Legal Division further concluded that the California resident shareholder was entitled to an OSTC only for her share of the amount of Tennessee excise tax paid to Tennessee, finding that it is a tax measured by income because there is no component of COGS contained within the measure of the excise tax.

New York City Metropolitan Commuter Transportation Mobility Tax (MCTMT): In this example, a trust with a non-contingent California resident beneficiary is a 25% member of an LLC that is taxed as a partnership and subject to the MCTMT because it has an office in New York City (NYC). The LLC's MCTMT is calculated based on the payroll expense of its employees working at its NYC location. The trust does not distribute any of its income to its beneficiary and, on its California fiduciary tax return, it claims an OSTC based on its pro rata share of MCTMT paid by the LLC. The FTB Legal Division concluded that the trust is not entitled to a California OSTC based on its pro rata share of the MCTMT paid by the LLC, because the MCTMT is based on payroll expenses paid by the taxpayer and, therefore, it is not a tax on, or according to, or measured by income. Moreover, although the MCTMT is administered by the state, it is a tax paid to the Metropolitan Transportation Authority and, therefore, is not a tax imposed by or paid to another state.

Kentucky Limited Liability Entity Tax (LLET): In this example, the FTB Legal Division addressed the effect of the LLET taxes paid to Kentucky by a California resident and member of an LLC that does business in that state. The LLET is paid based upon the lesser of $0.095/$100 of Kentucky gross receipts⁶ or $0.75 /$100 of Kentucky gross profits." Kentucky allows an individual member, shareholder or partner of a limited liability pass-through entity a nonrefundable LLET credit equal to the individual's proportionate share of the entity's LLET after it is reduced by the minimum tax due and any other nonrefundable credits. The resident used his share of the LLET credit to fully satisfy his personal income tax liability owed to Kentucky, and then filed a California personal income tax return claiming an OSTC based on the amount of LLET credit used to satisfy his Kentucky income tax liability. The FTB Legal Division concluded that the resident is not entitled to a California OSTC on the LLET credit as the LLET credit is not an amount of tax paid to another state. Rather, it is a nonrefundable tax credit. In addition, the resident cannot use his pro rata share of taxes paid by the LLC to compute the OSTC. Also, the California resident cannot deduct on his California income tax return his proportionate share of LLET credit used to fully satisfy his personal income tax liability owned to Kentucky, as it is not an income tax paid to another state.

New York fiduciary tax return: In this example, a trust is a partner in a partnership holding real property located in New York and has a California resident as its sole, non-contingent beneficiary. Trust sold its interest in the partnership, but did not distribute the gain from the sale to its beneficiary or the partnership. Based on New York and California laws, the trust reported the gain from this sale on its New York and California fiduciary tax returns and paid tax to New York. Trust claimed the OSTC on its California return for the amount of tax paid to New York. The FTB Legal Division concluded that the trust is entitled to a California OSTC for the amount of tax paid to New York on the gain of the sale of its partnership interest. The FTB Legal Division explained that, for purposes of the OSTC for dual resident trusts, the OSTC is allowed regardless of the source of the income.

Effective date

The ruling applies retroactively to tax years beginning on or after January 1, 2016. The effective date is unusual for a legal ruling, which is an interpretation of law. This arguably means that the interpretation of the law set forth in the Legal Ruling may only be applied for tax years beginning on or after January 1, 2016, as to guidance which was newly issued.

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ENDNOTES

¹ Cal. Rev. & Tax Code Section  17201, 17220, 17853 and 24345.

² Cal. Rev. & Tax Code Section  17201 and 24345.

³ MCA, Inc. v. Franchise Tax Bd., 115 Cal. App. 3d 185 (1981) ("MCA").

⁴ See, MCA; Beamer v. Franchise Tax Bd., 19 Cal. 2d 467 (1977); Robinson v. Franchise Tax Bd., 120 Cal. App. 3d 72 (1981); Appeal of Dayton Hudson Corp., 94-SBE-003 (Cal. SBE Feb. 3, 1994); Appeal of Kelly Services, Inc., 97-SBE-010 (Cal. SBE May 9, 1997).

⁵ Comptroller of the Treasury of Maryland v. Wynne, 135 U.S. 1787 (2015).

⁶ Kentucky gross profits is Kentucky gross receipts reduced by returns and allowances attributable to Kentucky gross receipts, less the COGS attributable to Kentucky gross receipts.