On April 6, 2017, the California Franchise Tax Board (FTB) issued Technical Advice Memorandum (TAM) 2017-03, providing guidance on the application of the loss limitation rules under Internal Revenue Code (IRC) Sections 382, 383 and 384 for California tax purposes as it relates to apportioning taxpayers. This ruling provides guidance to California taxpayers that have tax attributes (e.g., net operating losses (NOLs) and tax credits) and have undergone an ownership change such that the attributes are subject to valuation limitations.

IRC Sections 382, 383 and 384 govern the use of tax attributes when there is a substantial change in the stock ownership of an entity with such attributes (a loss corporation). IRC Section 382 provides a limitation on the use of NOLs of the loss corporation and explains the impact of net unrealized built-in gains/losses (NUBIGs/NUBILs) and recognized built-in gains/losses (RBIGs/RBILs) on that limitation. IRC Section 383 provides a limitation on the use of tax credits and capital loss carryovers similar to the limitation in IRC Section 382. IRC Section 384 limits the use of losses in other corporate reorganizations and acquisitions.

Before the publication of the TAM, while California's tax law generally conformed to provisions of Subchapter C of the IRC (i.e., IRC Sections 301-385),¹ neither California tax law nor the FTB provided guidance to taxpayers as to whether IRC Sections 382-384 applied on a pre-apportionment or post-apportionment basis.

Under the TAM, with respect to IRC Section 382, the FTB determined that the limitation provided in IRC Section 382(b)(1) and the analogous limitation on the use of excess credits provided in IRC Section 383(a)(1) are to be applied on a pre-apportioned basis. The FTB reasoned that because IRC Section 382 does not address any items of income/deductions or gains/losses, apportionment could not apply to IRC Section 382 absent express legislative action. Under California tax law and case authority, apportionment is only applied to items of income/deductions or gains/losses. As a result, the FTB concluded that IRC Section 382 must be applied for California purposes on a pre-apportioned basis. Likewise and for the same reasons, the FTB concluded that the valuation limitation for credits under IRC Section 383 must be applied on a pre-apportioned basis. The FTB pointed out that it had suggested a legislative proposal to apply IRC Sections 382 and 383 on a post-apportioned basis but was unable to find a legislator that would agree to sponsor the legislation. The FTB also spent considerable time distinguishing between California's legislative treatment of IRC Section 382 loss limitations rules and those in other states that clearly adopted a post-apportionment modification.

In analyzing the IRC Section 382 provisions for NUBIGs/NUBILs and RBIGs/RBILs, however, the FTB concluded that because these were items of income/deductions or gains/losses, they should be applied on a post-apportioned basis under existing law. The FTB also applied this reasoning to California's treatment of RBIGs set forth in IRC Section 384.

Because California has not promulgated its own regulations addressing IRC Section 383, the IRS regulations should be applied, except to account for obvious differences. The FTB concluded that the federal income tax rate is an obvious difference. Therefore, the TAM provides that when using the examples from Treasury Regulation Section 1.383-1(f), which illustrate the application of IRC Section 383, the California corporate franchise tax rate provided in Cal. Rev. and Tax Code Sections 23151 and 23186 should be substituted for the applicable federal corporate income tax referenced in the regulation.

Implications

The clarification on the valuation limitations for NOLs and tax credits is a long-awaited decision that presents an opportunity for California taxpayers to use a proportionately greater amount of tax attributes limited under IRC Sections 382, 383 and 384 than they might be able to use for federal income tax purposes. Corporate taxpayers that have such limited attributes should evaluate their California tax attribute balances and consider whether the TAM could affect any valuation allowances.

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¹ See Cal. Rev. & Tax. Code Section 24451 (general California conformity to Subchapter C of the IRC (including IRC Sections 382-384)); 24458, 24459, 24472 (each making California modifications to IRC Section 382) and 24481 (making California modifications to IRC Section 383)