June 2001

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State Taxes 

By Chris Micheli and E. Scott Ewing

Chris Micheli is an attorney and registered lobbyist for the Sacramento governmental affairs firm of Carpenter Snodgrass & Associates. 
E. Scott Ewing is an attorney and senior tax manager for the Los Angeles office of Deloitte & Touche LLP. 

Unless otherwise provided by law, the California Franchise Tax Board (FTB) interprets state tax laws that a tax credit may only be applied against the tax liability of the entity that generated the credit. As a result, a business cannot apply those tax credits against the tax liability of the unitary (combined) group to which that entity belongs. Although this legal interpretation is disputed by taxpayers, the FTB's application of these laws was recently upheld by the California Court of Appeal (Appeal of Guy F. Atkinson, California State Board of Equalization, June 12, 2000).

The major problem with the FTB's interpretation is that entities generating important tax incentives enacted in California in recent years, including the manufacturers' investment credit (MIC) and research and development credits, may not have sufficient California franchise or income tax liability to be able to fully utilize these credits, even in cases when the unused credit is applied throughout the specified carryforward period. Additionally, even if the credits could be carried forward, it would mean a loss in the time value of the credit dollars for the taxpayer.

There are two possible legislative approaches to deal with the problem of businesses not being able to fully utilize their tax credits. One option is to make business tax credits refundable to the taxpayer. In this manner, any unused credits can be refunded to them so that the full benefit of the economic incentive can be realized. Unfortunately, historically no business tax credits are refundable. Under current law, only the child-care credit is refundable. Previously, California's renter's tax credit was refundable.

The other option is to allow credits to be utilized by any affiliated entities. Unused credits should be allowed to be applied against the tax liability of the other unitary or combined group members. There should be consistent tax treatment of the members of a unitary group. Unfortunately, the FTB has been able to have it both ways (i.e., businesses are "unitary" for the purpose of taxation, but separate entities for the purpose of applying tax credits). This unfairness should be eliminated.

Members of a unitary group should be treated consistently as one taxpayer for all income tax purposes, including tax credits. Such treatment of unitary group members would comport with the economic realities of a unitary operation. Again, a business should be unitary for all tax purposes, not just select ones that adversely affect taxpayers.

The very genesis for the unitary method arises from the notion that a single business enterprise should be considered as a whole (unitary is from the word "unit," meaning one). Segmenting a business along the boundaries of corporate entities introduces artificial distortions. While the FTB staff has found support for its position, the State Board of Equalization (SBE) case law regarding an analogous matter has required unitary group members to be treated as one taxpayer (Appeal of Finnigan, California State Board of Equalization, August 25, 1998).

In that case, the SBE ruled that the term "taxpayer," for the purpose of applying the sales throwback rule for franchise and income tax purposes, was deemed to include all members of the unitary group. The term was not narrowly confined to the entity that generated the operation of the throwback sales. This rule should be followed in other cases that come before the SBE.

With this conflict in case decisions, the Legislature should step forward with a statutory resolution to this problem. Although there is a revenue impact to the state by allowing all tax credits to be applied against unitary group liability, such a change in the law would effectuate the purposes of these tax incentives and allow them to be fully recognized by business taxpayers.

By allowing full utilization of these credits in the current tax year, the Legislature would get the desired effect because businesses would be able to take full advantage of the tax credits and increase their investments in areas such as manufacturing and research and development.