Rev. Rul. 79-410

ISSUE

When can an accrual method, calendar year taxpayer deduct the California corporation franchise tax?

FACTS

Under the California Revenue and Taxation Code (Cal. Rev. & Tax Code), section 23151 (West Supp. 1976) a franchise tax is imposed on commercial corporations, with some exceptions, for the privilege of doing business as a corporation within California. The tax generally is measured by the net income of the year preceding the year for which the tax is imposed ("income year"--see Cal. Rev. & Tax Code, section 23042, (West 1970)), subject to a minimum tax, with special rules for a corporation's first and final years. As used herein "California tax year" refers to the year for which the franchise tax is imposed ("taxable year"--see Cal. Rev. & Tax Code 23041, (West 1970)). The California law was amended in 1963 (effective for the tax year 1966), 1971, and 1972.

Rev. Rul. 68-305, 1968-1 C.B. 213, provides that for purposes of section 461 of the Internal Revenue Code, a corporation using an accrual method of accounting may not deduct until the "taxable year" amounts paid during the "income year" on its estimated (California) franchise tax as all the events that determine the fact of liability do not occur until the first day of the taxable year. A corporation using the cash receipts and disbursements method of accounting may deduct in the year in which actually paid amounts that it is required to pay on its estimated franchise tax.

Under the California law in effect prior to 1966, the tax for the first year a corporation commenced business (other than a short year) was based on its net income for that year, with a minimum tax paid upon incorporation. The tax for the second year was also measured by the first year's net income. A commencing corporation was required to file a return on or before the fifteenth day of the third month after the close of its first year that constituted its return for both its first year and second year. The tax due for its first and second years was payable during its second year. The tax for its third and subsequent years was based on its net income of the preceding year (the income year), and was payable in two installments, on or before the fifteenth day of the third and ninth months of the California tax year. The tax for the year a corporation dissolved was prorated. It was still based on the net income of the preceding year, but when the final year was a short year, the tax was only a pro rata amount in accordance with the number of months the corporation existed.

For 1966 and years prior to 1972 under the amended California law the tax for the first year a corporation commenced business (other than a short year) was based on its net income of that year, with minimum tax paid upon incorporation. The tax for the second year also was measured by the first year's net income. A commencing corporation was required to pay most of its estimated tax for both the first and second years during its first year, and any remaining balance still owing for both years was paid in the second year when the corporation filed its return for both taxable years. The tax for the third and subsequent years was based on the net income of the preceding year, and most of it was paid during the preceding year, based on estimated income of the preceding year. Any balance of its tax for the third and subsequent years was paid during the tax years when the corporation filed its return. The tax for the year a corporation dissolved before 1973 was prorated. It was still based on the net income of the preceding year, but when the final year was a short year, the tax was only a pro rata amount in accordance with the number of months the corporation existed. Thus, if the portion of the estimated tax for the final year, paid in the preceding year, exceeded this amount, the excess was refunded.

Under the present California law as amended in 1971 and 1972, the tax for the first year a corporation commences business after 1971 is a minimum tax prepaid upon incorporation. The tax for the second year is measured by the first year's net income and is paid during the first year based on estimated income of the first year. Thus, a commencing corporation in its first year pays both the minimum tax for its first year and the estimated tax for its second year based upon an estimation of the corporation's first year income. Any balance of its tax for the second year is paid in the second year when the corporation files its first year return. The tax for the third year is measured by the net income for the second year, and is paid during the second year based on estimated income of that preceding year. The balance, if any, of its tax for the third year is paid in such tax year when the corporation files its return for the preceding year. This procedure is followed for all subsequent years. The tax for the year a corporation dissolves consists of two parts. One part is measured by the net income for the preceding year and is paid during the preceding year based on estimated income of the preceding year. The balance, if any, of this part of the tax is paid with the return due in the final year. The second part is measured by the net income of the final year. A credit is allowed, however, against the final year's tax for: (1) the minimum tax paid for the first year, if the corporation's first year commenced after 1971; or (2) the tax paid for the first year that constituted a full 12-month year of operation, if the corporation's first year commenced before 1972. Thus, a dissolving corporation in its final year pays a tax on any balance due on its preceding year's net income and on its final year's net income, and is credited the tax for its first year.

LAW AND ANALYSIS

The applicable sections of the Code and the Income Tax Regulations are section 164, relating to deduction for taxes, 461, relating to taxable year of deduction, and 1.461-1(d), relating to the limitation on acceleration of accrual of taxes.

Section 164(a) of the Code generally allows a deduction for state taxes paid or accrued within the tax year in carrying on a trade or business and for certain other taxes. The California corporate franchise tax is deductible under this section. See Rev. Rul. 66-185, 1966-2 C.B. 51 (amounts paid for privilege of exercising corporate franchise or other powers or privileges within Pennsylvania are deductible as taxes under section 164(a)).

An accrual method taxpayer, under section 461(a) of the Code, and specifically under section 1.461-1(a)(2) of the regulations, deducts an item in the taxable year "in which all the events have occurred which determine the fact of the liability and the amount thereof can be determined with reasonable accuracy." Under section 1.461-1(a)(1), however, "any expenditure which results in the creation of an asset having a useful life which extends substantially beyond the close of the taxable year may not be deductible, or may be deductible only in part, for the taxable year in which incurred."

Generally, under section 1.461-1(a)(2) of the regulations, all events have occurred that determine the fact of the liability when (1) the event fixing the liability, whether that be the required performance or other event, occurs, or (2) payment therefore is due, whichever happens earliest.

Section 461(d) of the Code provides that in the case of a taxpayer whose taxable income is computed under an accrual method of accounting, to the extent that the time for accruing taxes is earlier than it would be but for any action of any taxing jurisdiction taken after December 31, 1960, such taxes are to be treated as accruing at the time they would have accrued for such action by such taxing jurisdiction.

Section 1.461-1(d)(1) of the regulations provides, in part, that any such action which, but for section 461(d) would accelerate the time for accruing a tax, is to be disregarded in determining the time for accruing such tax for the purposes of the deduction allowed for such tax both with respect to a taxpayer upon which the tax is imposed at the time of the action and a taxpayer upon which the tax is imposed at any time subsequent to such action.

Section 1.461-1(d)(1) of the regulations further provides that whenever the time for accruing taxes is to be disregarded, the taxpayer shall accrue the tax at the time (the original accrual date) the tax would have accrued but for such action.

Section 1.461-1(d)(2)(iii) of the regulations provides, in part, that the term "any action" includes the enactment or reenactment of legislation the result of which is an acceleration of the accrual event of any tax.

In accordance with the above principles, under pre-1966 law the California franchise tax accrued and was deductible in the California tax year, when the event fixing the liability (exercise of the corporate franchise), occurred. Central Investment Corporation v. Commissioner, 9 T.C. 128 (1947), aff'd 167 F.2d 1000 (1948).

Under the 1966 California law, pursuant to general accrual principles, the California franchise tax due and paid in the year preceding the California tax year accrued in the income year since payment therefor was due and made. Nonetheless, the expenditure resulted in the creation of an asset (a prepaid expense) that was useful throughout the California tax year. As such, under the second test of section 1.461-1(a)(2) of the regulations, it would not have been deductible until the California tax year. The portion of the tax not paid in the income year accrued for Federal income tax purposes (and was deductible) in the California tax year, when the event that fixed the liability (exercise of the corporation franchise) occurred. Thus, the 1966 California law constituted "an action" resulting in the acceleration of the accrual event of the portion of the franchise tax paid in the income year. Pursuant to section 461(d) of the Code, even under 1966 law, the franchise tax continued to accrue in its entirety in the California tax year, which is the time it would have accrued but for the enactment of the 1966 law.

Under the current California law, pursuant to general accrual principles, the tax accrues in the income year. Under the all events test, it accrues for federal income tax purposes when due. Furthermore, the event fixing the liability is the earning of net income in the income year rather than exercise of the corporate franchise in the California tax year. And, because the tax is no longer dependent on exercise of the corporate franchise in the California tax year, the payment in the income year does not, to the extent not refundable, result in the creation of an asset. See Rev. Rul. 71-212, 1971-1 C.B. 145.

However, as noted above, the entire tax accrued under 1966 law during the California tax year. Therefore, current law results in the acceleration of the accrual of the franchise tax from the California tax year to the California income year and makes the provisions of section 461(d) of the Code applicable. See Epoch Food Service, Inc. v. Commissioner, 72 T.C. 1051 (No. 86, September 12, 1979).

HOLDING

For federal income tax purposes the California franchise tax continues to accrue in the California tax year. This is true for corporations that were subject to the tax prior to 1972 and corporations commencing the conduct of business in California after 1971. See section 1.461-1(d)(1) of the regulations.

Rev. Rul. 68-305 is superseded for taxable years beginning after December 31, 1971.