United States

California guidance on the Other State Tax Credit and deductions

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The California Franchise Tax Board (FTB) released Legal Ruling 2017-01 on Feb. 22, 2017, providing general guidance on how to determine if a taxpayer is eligible for the Other State Tax Credit (OSTC) or a deduction for taxes paid to another state under the California Revenue and Taxation Code (CRTC). The Legal Ruling also provides examples addressing taxes paid to Arizona and business taxes paid to Kentucky, New York State and City, Tennessee, and Texas.  The Legal Ruling is effective for taxable years beginning on or after Jan. 1, 2016.

For California residents, the state will generally tax all income from all sources. To avoid double taxation, California generally allows an OSTC for individuals, estates, and trusts for net income taxes imposed by and paid to another state on income that is also subject to tax in California. (See Cal. Rev. & Tax Code 18001 – 18011; Cal. Code of Regs., tit. 18 sections 18001-1, 18001-2; FTB Sch. S.) The OSTC is also available for California nonresidents and may vary depending on the residency and status of the taxpayer. If the OSTC is not available, and subject to exceptions, a taxpayer (both individuals and/or entities) may claim a deduction. (Cal. Rev. & Tax. Code sections 17201, 24345).

The Legal Ruling provides that the characterization of the tax as eligible for the OSTC, or is deductible, is by its operation, not its labels. A tax is analyzed by applying general tax law, including applicable federal and California authorities.

In order to determine whether an OSTC or deduction is permitted, the taxpayer should look to the deduction rules first. If it is determined that the tax is not a tax on, or according to, or measured by income, then the analysis ends, and the taxpayer may claim a deduction for the tax, assuming all other requirements are met, but cannot claim the OSTC.

There are generally three types of taxes paid to other states: Gross Receipts Tax, Gross Income Tax, and Net Income Tax.

  • A gross receipts tax is a tax imposed on gross income and a return of capital, which includes cost of goods sold.
  • A gross income tax is a tax imposed on gross income only, with any return of capital (such as cost of goods sold) excluded from the tax base.
  • A net income tax is a tax imposed on the income that remains after gross income is reduced by deductions, credits, or exemptions. (See FTB Notice 2010-2).

When a tax is not a single, indivisible tax, but rather a conglomeration of “separate and independent taxes,” the character of each of the separate taxes is analyzed independently.

If it is determined that:

  1. the tax is properly characterized as a tax on, or according to, or measured by income (which includes both gross and net income taxes), and
  2. the tax is properly characterized as net income tax, then
  3. the taxpayer may claim an OSTC as long as the tax is imposed by and paid to the another state by an individual, an entity taxed as a partnership, or a corporation in connection with “carrying on a trade or business” or “for production of income” with certain exceptions. (See Cal. Rev. & Tax. Code, §§ 17201, 24345; Beamer, supra, at 474.)
  4. However, if the tax is imposed by and/or collected by a county, city, or other locality, the OSTC is not available but can claim the deduction.

The fact that a tax’s measure is based on gross receipts or some other measure might coincidently also equal gross income for a particular taxpayer does not automatically convert that tax into a tax on, or according to, or measured by income, or vice-versa. (See Beamer, supra, at 480. See also MCA, supra, at 198).

For the Revised Texas Franchise Tax (RTFT), the RTFT is not a tax on, or according to, or measured by income, regardless of the manner in which the entity’s taxable margin is determined. The Texas franchise tax is a single, indivisible tax, as a taxpayer can only be subject to paying one tax on one base in any year, regardless of the number of activities in which the business engages. This is true even though the taxpayer may compute multiple margins in order to comply with the requirement that the lesser margin be utilized as the base upon which the tax is computed. Thus, each computation method cannot be analyzed on its own, but rather, the tax as a whole must be analyzed to determine its character.

As a result, each Texas computation method cannot be analyzed on its own, but the tax as a whole must be analyzed to determine its character. The RTFT is a tax on many types of business activities, including manufacturers, merchandisers, miners, and service providers, so there is a potential for cost of goods sold (COGS) to be included in the tax base. Although the RTFT offers several methods for computing the taxpayer's margin, not all of the methods remove COGS from the tax base, and that is the FTB's basis for their determination that the tax is not on, or according to, or measured by income. Although the tax does not qualify for the OSTC, it would be a deductible tax under this analysis.

The following chart summarizes the six scenarios presented in Legal Ruling 2017-01:

Jurisdiction

OSTC

Deduction

Arizona

Allowed - reverse credit state

Not Allowed

Tennessee Excise Tax

Allowed - measured by net earnings and no component of cost of goods sold

Not Allowed

Tennessee Franchise Tax

Not Allowed

Allowed - tax is not on, or according to, or measured by income

Texas Margin Tax

Not Allowed - tax is not on, or according to, or measured by income regardless of manner in which entity's taxable margin is determined

Allowed

NY MCTMT

Not Allowed - based on payroll expenses paid by the taxpayer

Allowed

Kentucky LLET

Not Allowed - LLET (non-refundable) credit is not amount "paid" to the other state

Not Allowed - not an income tax "paid" to the other state

NY tax paid on gain on sale of interest

Allowed - dual resident trusts under section 18004, OSTC is allowed regardless of source of income

Not Allowed

 

The guidance provided in Legal Ruling 2017-01 is applicable to tax years beginning on or after Jan. 1, 2016. California taxpayers subject to tax in multiple jurisdictions should carefully review the Legal Ruling and reach out to their tax advisors with questions. 

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