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On Feb. 21, 2019, the California Office of Tax Appeals (OTA) issued an opinion denying a petition by the California Franchise Tax Board (FTB) for rehearing in a matter examining whether dividend income received by a taxpayer constituted business or nonbusiness income.1
In determining that the dividends received from a minority interest in a foreign corporation constituted nonbusiness income, the OTA addressed the interpretation of the “functional test” for business income by California courts.
In 2005, Bank of America Corporation (“BAC”), a North Carolina-based global banking, investment and financial services company, acquired a minority ownership interest in China Construction Bank (“CCB”), a Chinese financial institution. CCB’s majority owner was a state-owned investment company. While a series of banking reforms in China permitted BAC to become a partial owner, foreign investment in Chinese banks was still heavily regulated. BAC’s stock ownership of CCB was limited to 19.9 percent,2
with a single seat on its board of directors. BAC was restricted from selling any of its stock for a three-year period after the initial investment.
During its time as an investor, BAC received dividend income from CCB between 2008 and 2011 and recognized capital gains on the eventual sale of its interest in CCB in 2011. On its originally filed 2008 California income tax return, BAC reported over $586 million of dividend income from CCB as apportionable business income. BAC later filed an amended return, claiming that this dividend income was more appropriately classified as nonbusiness income, allocable to its state of commercial domicile, resulting in a substantial refund for the 2008 tax year.
The FTB performed an audit of the 2008 amended return, following which BAC agreed to all audit adjustments except for the treatment of the CCB dividends. The FTB rejected the taxpayer’s argument that the dividends were nonbusiness income and denied the associated refund claim. BAC filed an appeal with the California State Board of Equalization (SBE).3
SBE’s application of functional test
Income is classified as apportionable business income if it arises “from transactions and activity in the regular course of the taxpayer's trade or business [the transactional test] 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 [the functional test].”4
The transactional test was not applied at the SBE by either side, so only the functional test was addressed. Both parties heavily relied on the California Supreme Court’s decision and analysis in Hoechst Celanese
which set out a multiple part test to determine the business/nonbusiness classification of income under the functional test. In order for income to be classified as business income, the taxpayer must have control and use of the income-producing property, and this control and use must be “an integral part of the taxpayer’s regular trade or business operations.”
BAC argued that it did not exercise sufficient control over CCB to meet the control test. It was a minority investor with extremely limited representation on the Board and no control over the company’s day-to-day operations. BAC emphasized the fact that it was unable to exercise the most basic control over its investment by being unable to sell its shares for an extended period. The FTB countered that the control test is a low threshold and had been met in cases where greater restrictions on ownership existed.
BAC also argued that its investment did not constitute an “integral” part of its business operations. For this test to be met, the investment would have been inseparable from BAC’s other business operations and a two-way flow of value would have existed between the companies. Instead, BAC considered CCB to be a passive investment. The business consulting provided by BAC did not benefit its business operations, but instead was an attempt to enhance the value of its investment.
The FTB quoted BAC’s own annual reports to investors as evidence that it viewed CCB as a strategic partnership to grow its business in China. The FTB pointed to statements that BAC anticipated pursuing joint ventures with CCB to further expand its market presence in the country. BAC’s loan portfolio in China increased over the period it held the investment in CCB, showing that a benefit was received to its business operations. BAC maintained that the aspirational plans described in its investor reports could not be relied upon as evidence of the actual relationship between BAC and CCB. The taxpayer attributed the increase in its Chinese loan portfolio to organic growth created by favorable economic conditions. While the taxpayer had hoped to use its investment in CCB as a springboard to additional, profitable joint ventures in the Chinese financial market, these opportunities did not materialize. BAC argued it was not appropriate for the FTB to characterize its income from CCB as business income based upon mere intent.
After hearing oral arguments, the SBE voted in favor of the taxpayer. The FTB appealed this decision by filing a petition for rehearing.
Petition for rehearing
While the SBE heard BAC’s original appeal of the FTB’s assessment, the FTB’s petition for rehearing was transferred to the newly formed OTA. To obtain the rehearing in front of the OTA, the FTB was required to show good cause for such a hearing, which required showing that the decision being appealed was against law (meaning “unsupported by any substantial evidence”), and the FTB’s rights were materially affected.6
If successful, the FTB would be entitled to a new hearing, and the opportunity to introduce new evidence and arguments.
In its appeal, the FTB argued that BAC had led the SBE to incorrectly apply the law. It argued that the functional test, as interpreted by Hoechst Celanese
, was made up of two parts, rather than three as the taxpayer had stated. The OTA did not find that any confusion or misapplication of law resulted from this distinction.
The OTA ultimately upheld the decision in favor of the taxpayer, finding that substantial evidence supporting the original decision by the SBE existed. The evidence supporting the taxpayer’s nonbusiness income centered around the investment in CCB not being “integral” to the taxpayer’s business operations. The OTA accepted that there was no two-way flow of value between CCB and BAC. Any increase in BAC’s loan portfolio that could be attributed to its relationship with CCB was deemed to be incidental. The OTA also cited BAC’s assertion that no actual joint business ventures resulted from its agreements with CCB to attempt to pursue such partnerships.
Based on the evidence presented, the OTA concluded that the investment in CCB did not “materially contribute to [BAC’s] production of income” and therefore was not “integral” to its business. Without this test being met, the classification of income from the CCB investment as nonbusiness income was held to be appropriate.
Because the OTA has ruled on few business tax matters, the publication of this non-precedential decision provides valuable insight into how the OTA will interpret business/nonbusiness income determinations. Not surprisingly, the OTA referenced and indicated its intent to remain consistent with prior SBE opinions on this issue. As the taxpayer has the sole right to appeal a decision of the OTA to the California courts, no further action may be taken on this matter by the FTB.
It should be noted that BAC also reflected dividends and capital gains from its ownership in CCB as nonbusiness income on refund claims for the 2009-2011 tax years. As the FTB disputed these refund claims on other grounds as well as the business/nonbusiness income classification of dividends and capital gains from CCB, neither the SBE not the OTA addressed these tax years. One would expect that the OTA’s analysis would serve to support BAC’s 2009-2011 refund claims on the nonbusiness income classification with respect to both the dividends and capital gains.
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