Press Room: Tax Release

February 03, 2011

California’s New Listed Transaction

New California Specific Corporate Listed Transaction Designated – Immediate Action May Be Required

FTB Notice 2011-01

For the first time in eight years, the California Franchise Tax Board (FTB) has expanded its list of “tax shelters.” FTB Notice 2011-01designates as California listed transactions certain partnership arrangements that it deems to be abusive tax avoidance transactions. With this designation comes a number of reporting requirements and potential penalties. The designated transactions encompass certain arrangements with a partnership (or any pass-through entity classified as a partnership for California tax purposes) that increase the denominator of the California sales factor, thereby reducing the income apportionable to California for franchise or income tax purposes. It joins two other California listed transactions, which were both added when the program was started in 2003. This addition to the enumerated listed transactions was issued without prior public warning to taxpayers. The most urgent impact of this provision is the new requirement that companies now disclose these transactions in order to avoid nondisclosure “strict liability” penalties. Disclosure may be required immediately depending on facts and circumstances as more fully described herein. In addition, we anticipate stepped-up audits of any companies with partnerships in their structure.

The “Abuse” California is Seeking to Address

According to California Regulation 25137-1(f)(3), a partnership’s sales which give rise to business income are included in the sales factor of the corporate partner taxpayer if the partnership and corporate partner conduct a unitary business. Intercompany sales between the partnership and a corporate partner taxpayer are eliminated. However, sales made by the partnership to a nonpartner are included by the corporate partner in an amount equal to the partner’s interest in the partnership.

The FTB’s concern lies with certain structures created to apply this regulation in a manner that would inflate the denominator of a corporate group’s sales factor and drive down the income apportioned to California. The Notice provides two generic examples of disfavored structures. For clarity, we provide the following example in a manufacturing context:

Corporation A, B, and C are all members in a unitary business and file in the same combined return. Corporation A and B each operate a manufacturing plant outside of California that make widgets. Corporation C contains the sales force that solicits sales to customers within and without California. Corporations A and B sell the widgets to Corporation C, which then resells the product to customers. In the combined return, sales made by Corporation A and B to Corporation C are eliminated when computing the California sales factor.

Corporation A and B organize a partnership and contribute the manufacturing facilities to partnership. The partnership then sells the widgets to Corporation C, which are delivered at the manufacturing facilities. Corporation C then sells and delivers the widgets to its customers. Under this new structure, the sale between the partnership and Corporation C would be included in the sales factor, doubling the California denominator.

The inclusion of the partnership sales in this example appears to follow the plain language of the regulation. However, without changing the regulation Notice 2011-01 cites eight reasons why elimination is proper between a partnership and any members of its corporate partner’s combined reporting group. Among these reasons, the Notice places the burden on the taxpayer to prove that any of these structures have both economic substance and a business purpose.

Taxpayers must disclose their participation in these transactions during any period of time currently open for assessment even if they believe the transactions have economic substance and business purpose or are otherwise valid under the law. It is important to note that even if the FTB agrees that the transaction or arrangement meets the economic substance and business purposes standards, disclosure may still be warranted to avoid the $30,000 strict liability penalty. Disclosure may be made on Federal Form 8886, Reportable Transaction Disclosure Statement, and should be filed with the FTB’s Tax Shelter Filing Unit within 90 days of January 6, 2011, the date of the notice. The FTB will be issuing guidance in the next few weeks as to how far back disclosure needs to go. Failure to comply with the reporting requirements results in the imposition of reporting penalties. In addition to reporting penalties, taxpayers engaged in such transactions may be subject to accuracy-related, noneconomic substance, interest-based penalties and fraud penalties regardless of whether they disclose the transaction.

A Pervasive Issue?

To date, there is no controversy on this particular issue that is in any public forum – either the State Board of Equalization or Superior Court. Informally the FTB has stated that there are a large number of taxpayers currently in audit on this issue going back as far as 2001. In discussions with the FTB, they have stated that they believe that the volume of these transactions alone warrants their designation as a California listed transaction and that the Notice process is the most appropriate method of addressing this issue at this point in time. We believe a number of issues associated with the Notice and its provisions will be the subject of future challenges.

If you have a partnership within your unitary group, we recommend that a review be made of any intercompany transactions that might be deemed the same as or substantially similar to those addressed in Notice 2011-01. Our professionals can assist you in understanding the intricacies of the Notice and whether disclosure is required. Our team will provide an update of the specific disclosure requirements as noted above upon issuance by the FTB. If you feel you may be affected by the Notice, please contact your WTAS advisor.


Disclosures for the new listed transaction must be made by April 6, 2011 (within 90 days after issuance of the Notice). In addition, ANY California income/franchise tax return filed after the date of the NOTICE must include disclosure with the return AND to the FTB’s Tax Shelter Filing Unit.