Gillette Mach 2? – The potential return of three-factor in California | Perspectives

23 September 2021 Reed Smith Client Alerts

Home Perspectives Gillette Mach 2? – The potential return of three-factor in California

On October 11, 2016 when the United States Supreme Court denied taxpayer’s petition for writ of certiorari in The Gillette Company, et. al. v. Franchise Tax Board, most taxpayers thought that was the final nail in the coffin for taxpayers seeking to apply a three-factor apportionment formula in California. However, in a complaint filed earlier this year, One Technologies LLC (One Technologies) is challenging the validity of the ballot initiative that eliminated three-factor apportionment and cost of performance sourcing.¹ This development, plus the ability of California taxpayers to extend suspended net operation losses provides plenty of reasons for taxpayers to file refund claims before the statute of limitations for the 2016 tax year lapses.

Three-Factor apportionment formula with cost of performance

One Technologies, a Texas based technology company, filed a complaint in Los Angeles Superior Court challenging the validity of Proposition 39 (Prop 39) – the 2012 ballot measure that enacted a mandatory single-sales factor and market-based sourcing regime in California. At the heart of the challenge is the way Prop 39 was presented on the ballot. Specifically, One Technologies argues that Prop 39 contained three, distinct elements: (1) single-sales factor apportionment and market-based sourcing; (2) a special reduced sales factor for cable companies; and (3) an earmark of funds for clean energy projects. This, according to One Technologies, violates the single-subject rule of the California Constitution.² That rule provides that any “initiative measure embracing more than one subject may not be submitted to the electors or have any effect.”³ Thus, because Prop 39 had three elements, where possibly one or more of the elements are unrelated, One Technologies argues the proposition is invalid.

If One Technologies ultimately prevails with its lawsuit and Prop 39 is struck down, One Technologies argues that it should be allowed to apportion its income using the pre-2013 statutory apportionment formula. That formula was composed of single-weighted payroll and property factors and a double-weighted sales factor with cost-of-performance sourcing for sales other than sales of tangible personal property.⁴ While any potential resolution on the constitutional issue raised by One Technologies may take several years, it would be prudent for any taxpayers that may be entitled to a refund under a three-factor apportionment formula with cost of performance sourcing to file a protective refund claim with the Franchise Tax Board (“FTB”) before the statute of limitations period for any tax year lapses. This opportunity applies largely to corporate taxpayers with substantial payroll and property located outside of California.

Revive suspended net operating losses by extending the carryover period

In California, net operating loss (NOL) carryovers from loss years from 2000 through 2007 generally are available for carry forward for up to 10 years following the loss year⁵ and NOL carryovers from loss years 2008 and forward are available for carry forward up to 20 years.⁶ However, as a part of the state’s 2002-2003 budget, California suspended the use of NOL carryovers for tax years 2002 and 2003 and extended the carryover periods by one year for losses incurred in 2002 and two years for losses incurred before 2002.⁷ Then, as part of the state’s 2008-2009 budget, the deduction for NOL carryovers was suspended again from 2008 through 2009.⁸ A couple of years later, as a part of its 2010-2011 budget, California extended the suspension of the NOL deduction for an additional two years – 2010 and 2011.⁹ Although the Legislature disallowed NOL deductions for the 2008-2011 years, this NOL suspension was supposed to be just a matter of timing: the carryover period for NOLs suspended in 2008 through 2011 was extended by four years for losses incurred in years prior to 2008, by three years for losses incurred in 2008, by two years for losses incurred in 2009, and by one year for losses incurred in 2010.¹⁰

And most recently, directly in response to the pandemic, the Legislature passed Assembly Bill 85, which similarly suspended the use of NOLs in 2020, 2021 and 2022 by individuals and corporate taxpayers with business income or adjusted gross income in excess of $1 million. Like prior California NOL suspensions, A.B. 85 extends the standard NOL carryforward period due to suspended NOLs.

Nevertheless, the policy of the FTB is that no extension is available unless the NOL deductions would have produced a tax benefit in a suspension year but for the suspension.¹¹ Under Legal Ruling 2011-04, the taxpayer must essentially “test” each NOL carried into the suspension period. If the NOL would have produced a tax benefit in the suspension period, were it not for the suspension, the carryover period for that NOL is extended. If not, the NOL is not extended. In other words, the taxpayer must have sufficient income in the suspension year so that it could have used the NOL, were it not for the suspension. Only then has the deduction been denied under the language of the statute, thereby triggering the extension provisions.

In our view, the FTB’s “tax benefit/income testing” limitation on the statutory NOL extension provisions is invalid because:

The “tax benefit/income testing” limitation is not authorized by, and conflicts with, the plain language of the statute; and
The “tax benefit/income testing” limitation is contrary to the legislative intent of the statute, because the Legislature intended that the suspension be purely a timing shift to address budget shortfalls.

Thus, taxpayers should consider ignoring the FTB’s “tax benefit/income testing” limitation and extend the carryover period of California NOLs carried over into the suspension years as follows:

California NOL Carryover Period Table

Taxpayers should consider filing protective refund claims before the statute of limitations period for any tax year lapses to revive their suspended California NOLs and/or raise this issue as an offset to any proposed assessments issued by the FTB. Taxpayers should also consider using this approach for purposes of valuing their deferred tax assets related to California NOLs.

For more information on the challenge to California’s single-sales factor apportionment regime, the FTB’s policies regarding the carryover of NOLs generated before or during the NOL suspension periods and how taxpayers can protect their rights by filing protective refund claims, contact the authors of this alert or another member of the Reed Smith State Tax Group.

The Reed Smith State Tax team includes several lawyers focused exclusively on California state tax matters. The Reed Smith team handles California tax matters of all types, from audit defense to appeals and litigation.

One Technologies LLC v. Franchise Tax Board, Cal. Super. Ct., 21STCV21844, complaint for refund of taxes 6/11/21.
Cal. Const. Art. II, § 8(d).
Id.
See Cal. Rev. Tax. Code § 25128.5 (eff. 1/1/2011 to 12/31/2012).
Cal. Rev. & Tax. Code § 24416(e)(1)(B). Effective January 1, 2016, Cal. Rev. & Tax. Code, § 24416.20, which replaced formerly repealed Cal. Rev. & Tax. Code § 24416, was renumbered as Cal. Rev. & Tax. Code, § 24416.
Cal. Rev. & Tax. Code § 24416.22.
Cal. Rev. & Tax. Code § 24416.3.
Cal. Rev. & Tax. Code § 24416.9.
Cal. Rev. & Tax. Code § 24416.21. As a result of S.B. 858, Cal. Rev. & Tax. Code § 24416.9 was repealed and the provisions set forth therein were generally moved to Cal. Rev. & Tax. Code § 24416.21.
Cal. Rev. & Tax. Code § 24416.21(b).
California FTB Legal Ruling 2011-04, September 23, 2011.

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Gillette Mach 2? – The potential return of three-factor in California

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