California tax ruling clarifies income classification

Mortgage servicing taxpayer not defined as a ‘financial’ corporation


Michael Boykin
Los Angeles
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Dana Lance
San Jose
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Tom Stonkus
Los Angeles
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Jamie Yesnowitz
Washington, DC
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Chuck Jones
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Lori Stolly
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The California Franchise Tax Board (“FTB”) recently issued a Chief Counsel Ruling determining that a taxpayer that predominantly engages in servicing mortgages is not a “financial corporation” because it does not derive more than 50% of its gross income from dealings in money or moneyed capital.1 As a result, the taxpayer is classified as a non-financial or general corporation rather than a financial corporation. Also, the ruling concluded that the taxpayer’s gains from hedging contracts are classified as non-financial income because the hedging contracts are not considered to be money or moneyed capital.

Background The taxpayer is a specialty financial services company that derives its income from two main sources: (1) loan origination or purchasing, securitization and subsequent mandatory sale of the loan with the retention of the loan servicing pursuant to mortgage servicing rights (“MSR”) contracts, and (2) the purchase of MSRs directly from third parties and generating income from the servicing of the related loans. Further, the taxpayer engages in hedging activities for various risk management purposes, which include but are not limited to forward purchase and sales contracts, mortgage-backed securities options, futures, and interest rate futures and swaps.

Financial corporations Under California law, financial corporations are taxed at 10.84%, which is the current general corporate rate of 8.84% plus 2%.2 In addition to the tax rate differential, financial corporations and general corporations use different apportionment methodologies. Taxpayers that derive more than 50% of their gross business receipts from conducting a qualified business activity, which includes banking or financial business activity, apportion income using an equally weighted three-factor formula.3 “Banking or financial business activity” is defined as “activities attributable to dealings in money or moneyed capital in substantial competition with the business of national banks.” 4 A special regulation governs the apportionment of income for banks and financial corporations.5 In contrast, most general corporations use a single sales factor apportionment formula.6

A California regulation provides a detailed definition of “financial corporation.”7 Similar to the apportionment statute, the regulation defines a financial corporation as a corporation that “predominantly deals in money or moneyed capital in substantial competition with the business of national banks.”8 In order to satisfy the definition of “predominantly,” two tests must be met. First, more than 50% of the corporation’s total gross income must be attributable to dealings in money or moneyed capital. Second, the corporation must be engaged in substantial competition with the business of national banks.9

Loan servicing and financial corporation status In Marble Mortgage Co. v. Franchise Tax Board,10 the California Court of Appeal established that the activity of loan servicing does not constitute dealing in moneyed capital. Since the inception of its business, the taxpayer has historically derived more than 50% of its gross income from servicing the mortgages (a service-based activity), rather than from the origination or purchase and resale of the loans. Accordingly, the FTB classified the taxpayer as a non-financial or general corporation under the regulation.

Hedging activities and financial income status The FTB also concluded that the taxpayer’s gains from hedging activities did not constitute dealing in moneyed capital and thus, financial income. As a result, the hedging activities did not support the taxpayer’s classification as a financial corporation. Unlike the loan servicing determination, the FTB found no specific precedent to assist in deciding how to classify the gains from interest rate hedging contracts. To reach its conclusion, the FTB closely analyzed its own financial corporation regulation, which provides that ‘“money or moneyed capital’ includes, but is not limited to, coin, cash, currency, mortgages, deeds of trust, conditional sales contracts, loans, commercial paper, installment notes, credit cards, and accounts receivable.”11

The FTB examined the intent of the regulation, applied statutory construction via the principle of ejusdem generis (“of the same kind or class”), and considered numerous related cases concerning “money” or “moneyed capital” in order to determine if the interest hedging activity met the requirements of financial income.

Following its analysis, the FTB determined that even though the taxpayer engages in hedging activities similar to banks, the activity itself does not meet the definition of “dealing in money or money capital” as required by the financial corporation regulation. The main argument presented was the fact that the hedging activities that the taxpayer engages in are not explicitly listed in the regulation, and they do not share any of the characteristics with a listed example of moneyed capital. As a result, the FTB ruled that hedging gains do not represent financial income, and, rather, should be classified as general income.

Commentary The continuous innovation and evolution of the Internet and other technologies along with the changing financial industry have resulted in the creation of new hybrid companies that blur the lines between finance and technology. Using rules that were adopted well before these hybrid companies were envisioned, it is often difficult to determine whether an entity should be classified as a “financial corporation.” This ruling provides valuable guidance for determining and appropriately classifying the revenue streams necessary to decide whether taxpayers qualify for financial corporation status, and given the analysis provided, potentially may result in fewer taxpayers being classified as financial corporations.

The consequences of such a determination are important because financial corporations are subject to a higher tax rate than general corporations, along with the use of a three-factor apportionment methodology in contrast to the single sales factor typically used by general corporations. In addition, the special apportionment rules for financial corporations may change the method in which sales are sourced within and outside California. Finally, the determination of whether a taxpayer is a financial corporation or general corporation may be beneficial from the perspective of California local taxes, because the corporation franchise tax on financial corporations is imposed in lieu of many local taxes.12

In some cases, a corporation that has little physical presence in California may actually benefit from an overall California income tax perspective if classified as a financial corporation instead of a general corporation. However, the financial corporation classification often serves to significantly increase a corporation’s tax liability.  

1 Chief Counsel Ruling 2018-01, California Franchise Tax Board, Nov. 2, 2018. This ruling is available at
2 CAL. REV. & TAX. CODE §§ 23151; 23186.
3 CAL. REV. & TAX. CODE § 25128(c).
4 CAL. REV. & TAX. CODE § 25128(d)(5).
5 CAL. CODE REGS. tit. 18, § 25137-4.2.
6 CAL. REV. & TAX. CODE § 25128.7.
7 CAL. CODE REGS. tit. 18, § 23183.
8 CAL. CODE REGS. tit. 18, § 23183(a).
9 CAL. CODE REGS. tit. 18, § 23183(b)(1). Because the taxpayer did not satisfy the money or moneyed capital requirement, the FTB did not need to consider the competition with national banks requirement.
10 241 Cal. App. 2d 26 (1966).
11 CAL. CODE REGS. tit. 18, § 23183(b)(3).
12 CAL. REV. & TAX. CODE § 23182. This statute provides that “[t]he tax imposed under this part upon banks and financial corporations is in lieu of all other taxes and licenses, state, county and municipal, upon the said banks and financial corporations except taxes upon their real property, local utility user taxes, sales and use taxes, state energy resources surcharge, state emergency telephone users surcharge, and motor vehicle and other vehicle

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