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California Double Whammy: Dividends Are Apportionable Income, Not Deductible

The California Board of Equalization (BOE) recently issued a decision holding that dividends received by an out-of-state corporate taxpayer were business income because the dividend payor played an integral and operational role in the taxpayer’s unita

February 25, 2011

The California Board of Equalization (BOE) recently issued a decision holding that dividends received by an out-of-state corporate taxpayer were business income because the dividend payor played an integral and operational role in the taxpayer’s unitary business.  The BOE also denied the taxpayer’s dividends received deduction (DRD) under Cal. Revenue & Tax Code (R&TC) § 24402Appeal of Rio Doce Ltd., No. 402204 (Cal. Bd. of Eq. Nov. 17, 2010) (released Jan. 17, 2011).

To determine whether the dividends were business income, the BOE concentrated its analysis on the functional test, which examines how the income-producing asset relates to the taxpayer’s regular trade or business operations. The taxpayer argued that its interest in the subsidiary was for investment purposes, rather than operational purposes, and thus generated non-apportionable income.

The dividend payor was not part of the taxpayer’s unitary reporting group because the taxpayer held only a 50 percent interest in the dividend payor. However, the BOE found that the taxpayer and dividend payor functioned as part of a unitary business. The BOE noted that the taxpayer and dividend payor were part of a chain of related companies that mined and produced iron ore; sold and exported the ore to related companies worldwide; processed the ore into steel slabs; sold the final product to dividend payor; and shipped the steel slabs to facilities in Los Angeles. As such, the dividend payor provided a means of entry into the U.S. market and the taxpayer’s interest in the dividend payor was an integral part of the worldwide business enterprise and unitary business. Therefore, the dividends constituted business income under the functional test. 

In addition, although the taxpayer’s DRD technically complied with the R&TC § 24402, the BOE denied the deduction, following the California Court of Appeals’ decisions in Abbott Labs. v. Franchise Tax Bd., 175 Cal. App. 4th 1346 (2009) and River Garden Retirement Home v. Franchise Tax Bd., 186 Cal. App. 4th 922 (2010). Like the taxpayers in those cases, Rio Doce had argued that the DRD could be preserved by severing the provision that was held to discriminate against interstate commerce in Farmer Bros. Co. v. Franchise Tax Bd., 108 Cal. App. 4th 976 (2003), a claim the BOE found unavailing.

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