California Court Leaves in Place Tax Ruling That’s Clear as Mud

Recently, the California Supreme Court declined to review an appellate court’s confusing decision in the 2009 Metropoulos Family Trust v. California Franchise Tax Board, further muddying the waters on how nonresidents should source gains from the sale of intangibles to California.

The heart of the dispute in Metropoulos was whether nonresident taxpayers should apply a statute or a conflicting interpretive regulation to source gains from the sale of goodwill. Pabst Corporate Holdings Inc. was a S corporation which held assets related to the brewing of beer. In 2014, Pabst sold a subsidiary that was treated as an asset sale under the Internal Revenue Code. The sale resulted in capital gain, and almost all the gain was attributable to intangible assets such as goodwill. On the originally filed California return, the gain was apportioned between the jurisdictions and tax was paid to California based on the income attributable to California. However, in 2016, the taxpayers filed amended returns claiming a refund, asserting that none of the gain should be sourced to California since the taxpayers were not residents of California at the time of the sale.

The refund was premised on the application of California Revenue and Taxation Code Section 17952, which provides that a nonresident’s income from intangible property is sourced to the nonresident’s state of residence unless that property acquires a business situs in California. In contrast, the Franchise Tax Board’s argument was premised on the application of California Code of Regulation 17951-4, which provides income from a business, trade, or profession that is within and without California must be apportioned between California and the other relevant jurisdictions and the nonresident must report the California apportioned gain as California sourced income. The taxpayers apportioned the gain from the sale of the subsidiary under Regulation 17951-4 on originally filed returns but subsequently claimed refunds on the basis that none of the gain should be sourced to California under Section 17952.

The claims were denied by the Franchise Tax Board, the Office of Tax Appeals, and California Superior Court, where each tribunal held that Section 17951-1 was the appropriate rule to source gain from the sale of intangible property. The Court of Appeals affirmed the lower court’s decision, and the California Supreme Court declined to review the court’s holding. Notably, the court confusingly stated that even if Section 17952 applied, the intangible personal property in question partially acquired business situs in California and, therefore, the result would likely be the same as the apportionment rule.

The Metropoulos case is a puzzling case because rarely does a case work its way through the courts for the purpose of clarifying the rules but ends up further convoluting the rules. First, the court sets forth a complicated analysis to determine which rule (Section 17952 or Regulation 17951-4) applies to a nonresident taxpayer that sold intangible property for a gain. The nonresident must determine if they are unitary with a trade or business in which the intangible property was used. If unity exists, then the nonresident taxpayer must apportion the gain; if no unity exists, then the nonresident taxpayer must bifurcate between California activities and non-California activities and source the California activities to California. If no trade or business is involved, then the nonresident shareholder would source the gain from the sale of the intangible to their state of residence.

Second, the court took an extraordinary step to hold that the apportionment regulation trumped the personal income tax sourcing statute. In doing so, it argued that the regulation should be “accorded the same dignity as a statute.” In other words, the court viewed the conflict not between a regulation that was subordinate to a statute, but rather between two statutes. This decision directly conflicts with longstanding California precedent and blurs the line between the roles of the legislature and administrative agencies.

Finally, the court’s statement that even if Regulation 17951-4 did apply, the conclusion would not change because part of intangible personal property in question established business situs in California is contrary to established California law. It is well recognized that the business situs rules are rules of allocation—i.e., the situs rule—is an all-or-nothing rule. This is confirmed by Section 17952, which states that once intangible personal property of a nonresident establishes business situs in California, the entire gain from the sale of that property is sourced to California. The court’s analysis and conclusion regarding the business situs rule appears to confuse apportionment versus allocation rules.

The Metropoulos decision is significant not for what it did but rather for what it didn’t do: namely provide clarity to California taxpayers. The complicated analysis to determine which rule applies—once reserved for multistate corporations and sophisticated taxpayers—will now find its way to the average individual taxpayer. Nonresident taxpayers will now have to be cognizant of the analysis performed by every pass-through entity when there is a sale of an intangible. Given the complicated nature of the analysis, if the pass-through entity gets the analysis “wrong,” then the nonresident taxpayer may be on the hook for additional California taxes, interest, and penalties. That proposition itself may lend one to open a can of Pabst Blue Ribbon.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Shail Shah is a shareholder at Greenberg Traurig LLP in San Francisco. His practice focuses on complex California tax planning and representation in front of various boards and offices as well as administrative and judicial adjudicating forums at the state and local levels.

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