Unitary Alert: California Court of Appeal Affirms that Shopping and Sitcoms Don’t Go Together

The California Court of Appeal recently held that a cable service business, Comcast Corporation, and its majority-owned home shopping channel, QVC, should not be included in the same California combined report for California corporate income/franchise tax purposes.

The Case at a Glance

The court also ruled that a termination fee from an aborted merger was business income to Comcast. The appellate decision may temper the Franchise Tax Board’s (FTB’s) expansive view of unity in cases where combination benefits the state of California but also leads to increased audit risk when combination benefits the taxpayer.

California requires a taxpayer to apportion business income. Business income is generally defined as an item of income that is significantly related to a taxpayer’s trade or business. In addition, California requires the combination of entities that meet statutory unitary requirements for purposes of computing California corporate income/franchise tax. Unity generally describes common characteristics between entities that justify combination of the entities’ income and apportionment factors to accurately reflect the business activities in California. Absent the presence of unitary factors, California may not combine entities. 

In Comcon, Comcast held a majority interest in QVC. While QVC paid Comcast to carry its programming, Comcast and QVC maintained separate headquarters, operated separate call centers and warehouses and retained separate departments responsible for the operations of their business. In addition, Comcast received a termination fee for an aborted merger with MediaOne. The trial court and appellate court found that the termination fee was business income due to Comcast’s recurring mergers and acquisition activities. On the issue of unity, both courts held that despite the economic relationship between Comcast and QVC, the FTB was unable to show the presence of requisite unitary factors between Comcast and QVC because of the arm’s-length relationship between the two companies. Due to a lack of unity, both courts barred the combination of Comcast and QVC for California income/franchise tax purposes.

Significance for Corporate Taxpayers

Corporate taxpayers that receive an extraordinary item of income related to mergers and acquisition activities may be required to apportion the income item to California. This requirement may be important for corporate taxpayers headquartered outside of California but conduct significant business activities in California because while a nonbusiness income item may be sourced to the taxpayer’s headquarters, a business income item may be significantly apportioned to California.  

In contrast, the Comcon decision on unity may provide corporate taxpayers (and the FTB) more latitude to analyze diverse business entities for purposes of determining the members of a combined report.  The FTB has generally taken an expansive view of unity whereby any flow of value between commonly controlled corporations may be indicia of unity requiring combination. The appellate court decision dismissed several indicia of unity, including intercompany transactions, interrelated board members and certain common corporate functions, to find a lack of unity. The decision indicates that a unitary relationship requires more than a mere showing of some intercompany connection.

Takeaways for Taxpayers Now and in the Future

The FTB will likely appeal the decision given the tax dollars involved and precedent that the adverse unitary holding may set for the FTB. For now however, the Court of Appeal decision in Comcon may be relied on by taxpayers. While unity determinations are highly factual, taxpayers may reconsider facts similar to Comcon where de-combination may be advantageous. Taxpayers may also consider relative audit risk if de-combination is disadvantageous.