DIVIDENDS ARE IN THE NEWS AND NOT JUST BECAUSE OF A REDUCTION IN TAX RATES

DIVIDENDS ARE IN THE NEWS AND NOT JUST BECAUSE OF A REDUCTION IN TAX RATES

HAROLD S. SMALL, J.D., CPA, and AEP

The headlines in the daily newspapers on May 24, 2003 were about dividends and Annika Sorenstam. This column will not provide commentary on Annika’s play at the Colonial or repeat the articles that discussed the new tax law approved by Congress and signed by the President. However, I will address issues relating to dividends (with a brief reference to the change in the tax law).

Although the final law was not available to me at the time of writing this column, it appeared that it would include a reduction in tax rates on capital gains and dividends to 15% for most taxpayers for five years, and then the higher existing income tax rates will be reinstated in 2008. Some members of Congress have indicated that they hope to extend the tax cut before it expires. This is a significant change and can provide very significant planning opportunities. However, another significant change occurred with the announcement of the decision of Farmer Bros. Co. V. Franchise Tax Board (2003), by the Second District, California Court of Appeals 4^th District only a few days before.

The Court in Farmer Bros. stated that it is a “case of first impression” and went on to state “...we hold that [California] Revenue and Taxation Code section 24402 (section 24402), known as the ‘dividends received deduction,’ violates the commerce clause of the United States Constitution (commerce clause) by discriminating against corporations engaged in interstate commerce. [footnote omitted] Section 24402 affords to a corporate taxpayer an income tax deduction for a portion of the dividends it receives from another corporation when the dividends are declared from income which was included in the payer corporation’s measure of California franchise tax, alternative minimum tax, or corporation income tax.”

In this case, the California Franchise Tax Board (“FTB”) appealed from a judgment awarding the taxpayer, Farmer Bros. (“Taxpayer”), state tax refunds totaling $811,000 for the tax years 1992 through 1998, plus interest and costs, as a remedy for overpaying taxes under the provisions of section 24402. The trial court determined the statute to be unconstitutional under the commerce clause and this appellate court agreed and affirmed the judgment.

Taxpayer is a California corporation primarily engaged in the business of manufacturing and selling coffee and related products. Taxpayer timely filed its corporate income/franchise tax returns for the years in controversy. The Court stated that “Each return reported a ‘dividends received deduction’ under section 24402, representing a portion of the dividends Taxpayer had received during the income year. Taxpayer owned less than 20 percent of the stock in each of the payer corporations which had issued dividends to Taxpayer during the years at issue. Thus, for those dividends which qualify for the deduction under the terms of section 24402, subdivision (a), the statute affords Taxpayer a maximum deduction of 70 percent of the amount of the dividend.” It went on to state that “FTB had promulgated a schedule listing the corporations and the percentage of their dividends that were deductible under section 24402. The schedule was based on a formula which allowed for a sliding scale deduction so that the taxpayer was entitled to more of a deduction if more of the income of the payer corporation was subject to specified California corporate taxes.”

Section 24402 states “Taxpayers are permitted a deduction under Section 24402, for dividends received which were declared from income included in the measure of tax of the declaring corporation under this part.” A formula was created, which provided for a percentage of the dividends received to be deductible.

The Farmers Bros. Court quoted from the decision of Hunt-Wesson, Inc. v. Franchise Tax Bd. (2000) 528 U.S. 458, 460--461 [120 S.Ct. 1022, 1024--1025] and stated “California, like many other States, uses what is called a ‘unitary business’ income-calculation system for determining its taxable share of a multistate corporation’s business income. . . . [¶] The income of which California taxes a percentage is constitutionally limited to a corporation’s ‘unitary’ income. Unitary income normally includes all income from a corporation’s business activities, but excludes income that ‘derive[s] from unrelated business activity which constitutes a discrete business enterprise,’ [citation]. As we have said, this latter ‘nonunitary’ income normally is not taxable by any State except the corporation’s State of domicile (and the States in which the ‘discrete enterprise’ carries out its business).” (Hunt-Wesson, Inc. v. Franchise Tax Bd. (2000) 528 U.S. 458, 460--461 [120 S.Ct. 1022, 1024--1025, 145 L.Ed.2d 974].)

Some of the dividends received by Taxpayer from some corporations in certain years were not deductible pursuant to the FTB formula. The facts in Farmers Bros. indicate that the Taxpayer timely filed amended tax returns and claimed a dividends received deduction for all dividends received for the years at issue and requested refunds of taxes totaling over $800,000. Taxpayer’s claim was based upon §24402 violating the commerce clause of the U.S. Constitution. FTB denied the refund claim and appealed to the State Board of Equalization (“Board”). The Board sustained the FTB’s action and stated that it “does not have the authority to deny the application of Revenue and Taxation Code section 24402 on constitutional grounds.” The Taxpayer filed a claim for refund of corporate franchise/income tax. In its amended complaint, “Taxpayer asserted that section 24402 is unconstitutional under the commerce clause of the United States Constitution because it discriminates on its face against interstate commerce by improperly taxing income that is not attributable to business transacted in California and the deduction cannot be justified as a lawful compensatory tax.”

The Court later stated, “We conclude that section 24402 is discriminatory on its face because it affords to taxpayers a deduction for dividends received from corporations subject to tax in California, while no deduction is afforded for dividends received from corporations not subject to tax in California. As a result, the dividends received deduction scheme favors dividend-paying corporations doing business in California and paying California taxes over dividend-paying corporations which do not do business in California and pay no taxes in California. The deduction thus discriminates between transactions on the basis of an interstate element, which is facially discriminatory under the commerce clause.” [Citations omitted.]

Although §24402 was amended, it appears that issues relating to dividends between entities may result in a different income/-franchise tax treatment than previously understood. Entity taxpayers that receive dividends need to review how the decision in Farmers Bros. may affect their planning and their tax compliance, and should consult with attorneys and accountants familiar with this area.

THE FOREGOING CONCEPTS AND IDEAS ARE GENERAL STATEMENTS AND ARE INTENDED TO PROVIDE CONCEPTS FOR CONSIDERATION IN BUSINESS AND TAX PLANNING. CAREFUL CONSIDERATION NEEDS TO BE GIVEN BY THE USER REGARDING THE USE AND APPLICATION OF THE CONCEPTS. YOUR LEGAL AND TAX COUNSEL SHOULD BE CONSULTED BEFORE THE IMPLEMENTATION OF ANY OF THE IDEAS INDICATED HEREIN. SHOULD YOU HAVE QUESTIONS REGARDING THIS MATTER, HAROLD S. SMALL, ESQ., CAN BE REACHED AT 12526 HIGH BLUFF DRIVE, SUITE 200, SAN DIEGO, CALIFORNIA 92130 OR AT 858.350.8888.