Legal ruling 1998-5
STATE OF CALIFORNIA
Franchise Tax Board - Legal Division
PO Box 1720
Rancho Cordova CA 95741-1720
916 845 3309
FAX: 916 845 3648
Kathleen Connell, Chair
Dean Andal, Member
B. Timothy Gage, Member
November 30, 1998
Business or NonBusiness Income Characterization of Income Generated from Liquid Investments in Excess of Current and Identified Future Business Needs
Is income generated from liquid assets in excess of current and identified future business needs properly characterized as business income (Revenue and Taxation Code section 25120(a)) solely because such excess assets are available for business use?
Taxpayer’s trade or business generates large amounts of cash, such that Taxpayer has cash in excess of its current business needs. Taxpayer has no long-term uses for which these funds are earmarked, nor does it have any specific nonbusiness uses for which the funds are earmarked. The cash is invested in liquid assets that produce interest and dividends.
Law and Analysis
California Revenue and Taxation Code section 25120 provides in pertinent part:
(a) "Business income" means income arising from transactions and activity in the regular course of the taxpayer’s trade or business and includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer’s regular trade or business operations.
(d) "Nonbusiness income" means all income other than business income.
Under the case law of California and the majority of states, the above language of section 25120(a), which is identical to that of UDITPA section 1(a), provides for two distinct tests for business income. The first test, known as the "transactional test," is based on the first clause of section 25120(a), which defines business income as "income arising from the transactions and activity in the regular course of the taxpayer’s trade or business." The focus is on the regular transactions of the business. The second test, or "functional test," is derived from the second clause of section 25120(a), which states that business income "includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer’s regular trade or business operations." (E.g., Appeal of CTS Keene, 93-SBE-005, Feb. 10, 1993; Appeal of Borden, Inc., 77-SBE-007, Feb. 3, 1977; cf. Pledger v. Getty Oil Exploration Co. (1992) 309 Ark. 257 [831 S.W.2d 121]; Dover Corp. v. Department of Revenue (1995) 271 Ill.App.3d 700 [648 N.E.2d 1089]; Laurel Pipe Line Co. v. Board of Fin. & Revenue (1994) 537 Pa. 205 [642 A.2d 472].)
The definition of business income is refined in Title 18, California Code of Regulations section 25120. Subdivision (a) provides, in pertinent part:
Section 25120 defines "business income" as income arising from transactions and activity in the regular course of the taxpayer’s trade or business and includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer’s regular trade or business operations. In essence, all income which arises from the conduct of trade or business operations of a taxpayer is business income. For purposes of administration of Sections 25120 to 25139 inclusive, the income of the taxpayer is business income unless clearly classifiable as nonbusiness income.
Nonbusiness income means all income other than business income.
The classification of income by the labels occasionally used, such as manufacturing income, compensation for services, sales income, interest, dividends, rents, royalties, gains, operating income, nonoperating income, etc., is of no aid in determining whether income is business or nonbusiness income. Income of any type or class and from any source is business income if it arises from transactions and activity occurring in the regular course of a trade or business. Accordingly, the critical element in determining whether income is "business income" or "nonbusiness income" is the identification of the transactions and activity which are the elements of a particular trade or business. In general all transactions and activities of the taxpayer which are dependent upon or contribute to the operations of the taxpayer’s economic enterprise as a whole constitute the taxpayer’s trade or business and will be transactions and activity arising in the regular course of, and will constitute integral parts of, a trade or business.
The regulations provide the following examples to illustrate the principle that "[i]nterest income is business income where the intangible with respect to which the interest was received arises out of or was created in the regular course of the taxpayer’s trade or business operations or where the purpose for acquiring and holding the intangible is related to or incidental to such trade or business operations" (Cal. Code Regs., tit. 18, § 25120, subd. (c)(3)):
Example (E): The taxpayer is engaged in a multistate manufacturing and selling business. The taxpayer usually has working capital and extra cash totaling $200,000 which it regularly invests in short-term interest bearing securities. The interest income is business income.
Example (F): In January the taxpayer sold all the stock of a subsidiary for $20,000,000. The funds are placed in an interest-bearing account pending a decision by management as to how the funds are to be utilized. The interest income is nonbusiness income.
Decisions of the State Board of Equalization have been consistent in holding that income realized from liquid funds set aside or utilized as business cycle working funds is properly characterized as business income. (E.g., Appeal of American Medical Buildings, Inc., 86-SBE-105, June 10, 1986 (interest income generated from intangibles held to be business income; purpose for acquiring intangibles was integrally related to taxpayer’s trade or business); Appeal of Inco Express, 87-SBE-016, March 3, 1987 (interest income from liquid assets accumulated by taxpayer from business earnings to avoid borrowing cash needed for ordinary business operations held properly characterized as apportionable business income); Appeal of R.H. Macy Co., 88-SBE-020, July 26, 1988 (working capital invested in short-term securities to maximize income while awaiting its use as needed in taxpayer’s business held properly characterized as apportionable business income).)
The cases cited above support the proposition that accumulation of funds as part of the taxpayer’s working capital needs produces business income. (See id.; see also Cal. Code Regs., tit. 18, § 25120, subd. (c)(3), Example (E).) However, none of the previously cited cases or other authorities suggest that funds, simply by virtue of merely being "available" for business use, should automatically be characterized as business income.
In Appeal of Cullinet Software, Inc., 95-SBE-002, May 4, 1995, the principal issue was whether interest income earned on funds raised in stock offerings is properly characterized as business or nonbusiness income. Appellants, Cullinet and its subsidiaries, were engaged in the unitary business of designing, developing, and marketing "off-the-shelf" computer programs. Cullinet made stock offerings netting $15 and $29 million, respectively, to "provide additional capital for the acquisition of companies and products in the systems and applications software markets or in markets complimentary [sic] to the Company’s business." (Id.) Soon thereafter, Cullinet contributed substantially all the proceeds to two qualified Massachusetts Securities Corporation subsidiaries, CIC and CSC. The funds apparently were invested in accordance with the terms of the offering prospectuses, which provided that "until the proceeds were utilized for their intended purpose, they would be invested in United States Government obligations, certificates of deposit, short-term commercial paper and other liquid investments." (Id.) The Board noted that the record contained no indication as to whether "any purchases of new businesses or products were investigated or completed during the appeal years," but also pointed out that the record "reveal[ed] intercompany transactions involving CSC’s funds, suggesting that these funds were used as working capital during the appeal period." (Id.) Finally, the Board stated that "[a]lthough appellants allege that CIC’s funds were not used as working capital, there is no proof that that was so." (Id.)
Appellants contended, especially with respect to CIC, that the proceeds of the stock offerings were not used in their unitary business, but were segregated in separate subsidiaries that invested those funds "until such time as our management determined a viable business opportunity in which to utilize them." (Id.) As support for its position that funds so held give rise to nonbusiness income, appellant cited Regulation 25120, subdivision (c)(3), Example (F).
In holding for the Franchise Tax Board, the Board found business income:
In essence, appellants appear to argue that, even though these funds were invested in highly liquid financial instruments which were part of the pool of capital which Cullinet kept available at all times for immediate use in the business, the income from these funds must be classified as nonbusiness income because CIC and CSC decided how to invest the funds, and because it was not a certainty that appellants would decide to use the funds in the unitary business. Respondent, on the other hand, contends that investing in liquid assets and holding them ready for use in the unitary business gives rise to business income, especially where, as in this case, the funds are earmarked for the acquisition of companies and products similar or complementary to the taxpayer’s unitary business. It appears that respondent’s view is that such assets do not generate nonbusiness income unless the taxpayer’s management somehow segregated them in a way which clearly establishes that they were not being held for use in the unitary business. We think respondent is correct.
Appellant’s position conflicts with respondent’s regulations and is not supported by the relevant decisions. In substance, appellants’ argument is that these funds generate nonbusiness income unless there was a specific intent to use the funds in appellants’ regular business. If that is so, it would amount almost to a presumption in favor of nonbusiness income, at least in cases where there is some doubt regarding the nature of the asset’s relationship to the unitary business. That, however, would be completely contrary to respondent’s regulations, which clearly establish a presumption in favor of business income (Cal. Code Regs., tit. 18, reg. 25120, subd. (a).)
The United States Supreme Court’s opinion in Allied-Signal clearly indicates that income from stock investments constituting interim uses of idle funds accumulated for the future operation of a nondomiciliary taxpayer’s business is constitutionally apportionable. (Allied-Signal v. Director, Division of Taxation, supra, 504 U.S. at – [119 L.Ed.2d at 552].) The Court also reiterated the heavy burden of proof that must be borne by a taxpayer challenging a state tax, namely, that of showing by "clear and cogent evidence" that the state is seeking to tax extraterritorial values. (Allied-Signal v. Director, Division of Taxation, supra, 504 U.S. at – [119 L.Ed.2d at 549].) In the context of state taxation of income from short-term investments of idle funds, we have great difficulty perceiving how a taxpayer could satisfy this burden of proof when it admits, as appellant does here, that a major reason for having the funds was to meet the future capital needs of its business.
Finally, we believe that appellant’s reliance on example (F) of regulation 25120, subdivision (c)(3), is misplaced. The example provides that the taxpayer sells a subsidiary for $20,000,000 and places the proceeds in an interest-bearing account pending a decision by management on use of the funds. In our opinion, the example describes a situation in which the funds have clearly been set aside in an account distinct from the taxpayer’s normal pool of working capital. It seems to us that one may assume, from the statement that management has not yet decided how to use the money, that the funds have not yet been made available as part of the working capital of the business. In appellant’s case, there is no proof that the funds were set aside from appellants’ working capital, and it is admitted that they were available for use in appellant’s regular business operations, if and when needed.
We conclude that idle funds invested in liquid financial instruments are part of a unitary business’s working capital pool, and thus generate business income (Appeal of R.H. Macy & Co., Inc., 88-SBE-020, July 26, 1988), unless management segregates or earmarks the funds in such a way as to clearly establish that they were not being held readily available for use in the taxpayer’s regular trade or business operations. (Cf. Appeal of Inco Express, Inc., 87-SBE-016, March 3, 1987.) In the present appeal, it is clear not only that there was no such segregation or earmarking but also that the proceeds from appellant’s stock offerings were, in fact, at all times held readily available for any use in its unitary business which might have arisen during the appeal years. The income earned on these investments, therefore, constituted business income.
(Id. (emphasis added).)
When read on its facts, Cullinet is properly considered a burden of proof case. The Board specifically found that the taxpayer had earmarked the funds at issue to acquire companies and products similar or complementary to the taxpayer’s unitary business. The Board found no evidence, however, that the taxpayer acquired any companies or products with those funds, or that the taxpayer even investigated any such new purchases. Instead, the Board pointed out that (1) intercompany transactions "suggested" the funds contributed to CSC were used as working capital, and (2) "no proof" was presented that the funds contributed to CIC were not used as working capital (in fact, the Board noted that "it is admitted that [the funds] were available for use in appellant’s regular business operations, if and when needed"). The Board further stated that it had "great difficulty perceiving how a taxpayer could satisfy this burden of proof when it admits, as appellant does here, that a major reason for having the funds was to meet the future capital needs of its business." (Id.).
Under California law, a presumption stands as proof of the presumed fact unless and until evidence is introduced to support a finding of its nonexistence, in which case the effect of the presumption disappears and the case is determined without regard to the presumption. (Evid. Code § 604; see Appeal of Sierra Production Services, 90-SBE-010, Sept. 12, 1990.) Accordingly, the Board held that the taxpayer failed to meet the burden of proof necessary to overcome the regulatory presumption in favor of business income. (See Cal. Code Regs, tit. 18, § 25120, subd. (a) ("income of the taxpayer is business income unless clearly classifiable as nonbusiness income").) By concluding the funds were used as part of the taxpayer’s working capital, the Board’s decision effectively treated those funds as meeting the conditions of Example (E) regarding the application of working capital.
However, any implication in Cullinet that a liquid asset produces business income merely because it has the potential to be used in the trade or business is not consistent with the language of 18 California Code of Regulations, section 25120, subdivisions (c)(3) and (4), which for business treatment require that the funds must have been generated in the course of the business (e.g., an interest bearing account receivable), or acquired and held for an identified purpose related to the business (e.g., funds set aside for workers’ compensation claims). The facts in Cullinet supported a holding that the funds at issue were held for a business purpose, and it was unnecessary to reach the issue of whether income from funds held for no identified purpose should always be treated as business income. (See, e.g., Brown v. Kelly Broadcasting Co. (1989) 48 Cal.3d 711, 734-735 [771 P.2d 406; 257 Cal.Rptr. 708], quoting River Farms Co. v. Superior Ct. (1933) 131 Cal.App. 365, 369 [21 P.2d 643] ("It is the general rule that the language of an opinion must be construed with reference to the facts presented by the case, and the positive authority of a decision is coextensive only with such facts."); Stockton Theaters Inc. v. Palermo (1956) 47 Cal.2d 469, 474 [304 P.2d 7] ("The discussion or determination of a point not necessary to the disposition of a question that is decisive of the appeal is generally regarded as obiter dictum and not as the law of the case."); Sakamoto v. Duty Free Shoppers, Ltd. (9th Cir. 1985) 764 F.2d 1285, 1288, cert. denied, 475 U.S. 1081 (court’s unstated assumptions on nonlitigated issues are not precedential holdings binding future decisions).)
Cases interpreting Revenue and Taxation Code section 25120 have uniformly held that the mere potential for integration of an asset into the taxpayer’s trade or business does not give rise to business income. (E.g., Appeal of Mark Controls Corp., 86-SBE-204, Dec. 3, 1986; Appeal of Occidental Petroleum Corp., Op. on Pet. for Rehg., 83-SBE-119, June 21, 1983.) Accordingly, the mere holding of liquid assets in excess of current and identified future business needs cannot be considered as producing business income despite the fact that such assets may be potentially used in the taxpayer’s trade or business.
Moreover, the broad proposition of an "available for business use" test in and of itself raises concerns under the "potentiality doctrine" of F.W. Woolworth v. Taxation & Revenue Department (1982) 458 U.S. 354, 362 (for purposes of applying unitary business principle in determining apportionability for state income taxation of interstate enterprise, potential to operate a company as part of a unitary business is not dispositive when, examining underlying economic realities of the unitary business, dividend income from subsidiaries in fact is derived from unrelated business activity constituting discrete business enterprise). Such an interpretation of the facts and holdings of the cases discussed above would leave the proponent of this view with the difficult task of attempting to establish a constitutionally sufficient connection between "available" funds and activities within this state, an approach tantamount to advancing the "acquired, managed or disposed of for purposes relating or contributing to the taxpayer’s business" theory advanced by the state in ASARCO v. Idaho State Tax Commission (1982) 458 U.S. 307. The Court in ASARCO firmly rejected this approach:
This definition of unitary business would destroy the concept. The business of a corporation requires that it earn money to continue operations and to provide a return on its invested capital. Consequently all of its operations, including any investment made, in some sense can be said to be "for purposes related to or contributing to the [corporation’s] business." When pressed to its logical limit, this conception of the "unitary business" limitation becomes no limitation at all. When less ambitious interpretations are employed, the result is simply arbitrary.
(Id., at 326 (emphasis in original)(footnote omitted).)
The Court set forth the constitutional limit for apportionability in Allied-Signal, Inc. v. Director, Division of Taxation (1992) 504 U.S. 768, holding that an investment must serve an operational rather than an investment function in order for the income to be apportionable. Although funds held for an investment function may still be deemed "available" in the sense that they can be liquidated, this fact, by itself, does not satisfy the constitutional requirement that the generated funds must have an operational connection with the taxpayer’s business.
Thus, there is no support in the statute, regulations, or case law for the proposition that funds, in merely being available for business use, should always be characterized as business income: Given the fungibility of money, funds available for business use are likewise available for nonbusiness use. Rather, the facts of a particular case ultimately control resolution of the question of how income should be properly characterized under either the functional or transactional tests for business income. Accordingly, the relevant analysis is whether the funds are needed for the taxpayer’s current business cycle needs or have been identified for future business needs.
To the extent that funds can be identified as in excess of any business need or contingency, the functional and transactional tests of business income have not been satisfied. Thus, the income from such funds clearly is not business income. Because income that is other than business income is not business income (Cal. Code Regs., tit. 18, § 25120, subd. (a)), the failure to satisfy these tests is sufficient to rebut the presumption of business income.
Income generated from liquid assets in excess of current business needs and identified future business needs cannot properly be characterized as business income for purposes of Revenue and Taxation Code section 25120(a) solely because such excess assets are available for business use. The large amount of invested cash accumulated by Taxpayer in excess of its ordinary business needs cannot be characterized as generating business income solely because it is available for business use. Instead, the income must be analyzed under the transactional and functional tests of business income contained in Revenue and Taxation Code section 25120 and its associated regulation. The income does not satisfy either the transactional test, in that it clearly did not arise "from transactions and activity in the regular course of the taxpayer’s trade or business," or the functional test for business income, in that it was not acquired, managed, or disposed of as an integral part of the taxpayer’s regular trade or business operations. Furthermore, the generation of this income is not a transaction or activity of the taxpayer that is dependent upon or contributory to the operations of the taxpayer’s economic enterprise as a whole, thereby constituting the taxpayer’s trade or business, nor is it a transaction or activity arising in the regular course of, and thus an integral part of, the taxpayer’s trade or business. (See Cal. Code Regs., tit. 18, § 25120, subd. (a).) As a result, the regulatory presumption in favor of business income does not apply because Taxpayer’s income is clearly classifiable as nonbusiness income. (Id.)
The principal author of this ruling is Frederick W. Campbell-Craven of the Franchise Tax Board’s Legal Branch, Multistate Tax Bureau. For further information regarding this ruling, contact Mr. Campbell-Craven at the Franchise Tax Board, Legal Branch, P.O. Box 1720, Rancho Cordova, CA 95741-1720.