Pacific Tel. & Tel. Co. v. Franchise Tax Bd.

• Decision Date: 13 July 1972
• Docket Number: S.F. 22852
• Citation: 102 Cal.Rptr. 782,498 P.2d 1030,7 Cal.3d 544
• Court: California Supreme Court
• Parties: , 498 P.2d 1030 PACIFIC TELEPHONE AND TELEGRAPH COMPANY, Plaintiff and Respondent, v. FRANCHISE TAX BOARD, Defendant and Appellant. in Bank

Page 782

102 Cal.Rptr. 782

7 Cal.3d 544, 498 P.2d 1030

PACIFIC TELEPHONE AND TELEGRAPH COMPANY, Plaintiff and Respondent, v. FRANCHISE TAX BOARD, Defendant and Appellant.

S.F. 22852.

Supreme Court of California,

in Bank.

July 13, 1972.

Rehearing Denied Aug. 9, 1972.

Thomas C. Lynch and Evelle J. Younger, Attys. Gen., James E. Sabine, Asst. Atty. Gen., and John J. Klee, Jr., Deputy Atty. Gen., for defendant and appellant.

Pillsbury, Madison & Sutro, John A. Sutro, Francis N. Marshall, Noble K. Gregory, Frank H. Roberts and Toni Rembe, San Francisco, for plaintiff and respondent.

Loeb & Loeb and Frank M. Keesling, Los Angeles, amici curiae on behalf of plaintiff and respondent.

PETERS, Associate Justice.

Defendant Franchise Tax Board (board) appeals from a judgment in the sum of $1,324,591.96 plus interest in favor of The Pacific Telephone and Telegraph Company (Pacific) in this action for a refund of a portion of the franchise taxes paid to the State of California for the year 1960.

The problem presented relates to the interest expense deduction and more specifically the extent to which the interest paid by Pacific and its affiliated corporations should be reduced, in arriving at the interest expense deduction, by dividends received by one of the affiliated corporations from another affiliated corporation (intercompany dividends).

Pacific, a subsidiary of American Telephone and Telegraph Company, a corporation (American), is a member of a group of affiliated corporations engaged in a unitary communications business. At times pertinent to this case this unitary business (Bell System) consisted of American, Pacific and 53 other corporations. Other than Pacific, all of these corporations had their commercial domiciles and principal business operations outside of California. Pacific and three other corporations engaged in business in California. Pacific represents all four in this litigation.

In the year 1959, the dividends received by the members of the Bell System amounted to the sum of $772,122,249. Of the total dividends received the amount of $763,777,655 (intercompany dividends) was received from other members of the Bell System and $8,344,594 was received from other companies who were not members of the Bell System. Of the total intercompany dividends in the sum of $763,777,655, the sum of $95,373,025 was paid by Pacific. Included in the total amount of intercompany dividends was the sum of $2,329,250 received by Pacific from its wholly owned subsidiary, Bell Telephone Company of Nevada (Nevada Bell).

During the year 1959, the Bell System incurred interest expense in the sum of $226,715,715. The deductibility of this interest in determining the 'net income' of the Bell System is at the heart of the issue in the instant litigation. Except for a small amount, the board determined that this interest expense was not deductible in arriving at such 'net income.' The reason for disallowance of interest expense is based on the fact that the dividends, including intercompany dividends, exceeded the interest expense. Pacific paid the taxes attributable to the disallowed interest deduction under protest and then brought the instant action for a refund. The court below, in finding in favor of Pacific's claim, held that the interest expense was a deductible item in arriving at 'net income.'

INTRODUCTION

Before looking at the statutory provision governing the interest expense deduction it is helpful to consider the general scheme of the franchise tax as it applies to operating income and dividend income of corporations like members of the Bell System, doing business both within and without the State of California.

The measure of the franchise tax due from Pacific, a corporation doing business within the state, is the net income of the preceding year derived from or attributable to sources within this state. (Rev. & Tax.Code, §§ 23151, 25101.) ¹

Since Pacific is a member of a unitary business, doing business both within and without the state, the amount of operating income earned in California by the business is determined by calculating the net operating income of the entire business and then apportioning part to California by applying an apportionment formula pursuant to principles established in Edison California Stores v. McColgan, 30 Cal.2d 472, 183 P.2d 16. (Safeway Stores, Inc. v. Franchise Tax Board, 3 Cal.3d 745, 748, 91 Cal.Rptr. 616, 478 P.2d 48.) The apportionment formula resulted in a percentage of 10,3422 in this case, and the percentage is not disputed. The amount of operating income attributable to California is arrived at by multiplying the net operating income of the entire business of the Bell System by that percentage.

In addition, dividend income may be included in the computation of income. (§ 24271.) As we pointed out in Safeway, 'the franchise tax is to be measured only by that portion of the corporation's income which had its 'source' in California. However, the 'source' of dividend income is the stock upon which the dividend was paid, and the taxable situs of the stock is generally held to be at the domicile of the owner of the stock. (See Miller v. McColgan (1941) 17 Cal.2d 432, 437--440, 110 P.2d 419; Robinson v. McColgan (1941) 17 Cal.2d 423, 110 P.2d 426.)' (3 Cal.3d at p. 749, fn. 3, 91 Cal.Rptr. at p. 618, 478 P.2d at p. 50.) Under the doctrine of mobilia sequuntur personam dividend income from securities is specifically applicable to the domicile of the owner of the stock. ² (Fibreboard Paper Products Corp. v. Franchise Tax Bd., 268 Cal.App.2d 363, 367, 74 Cal.Rptr. 46; Southern Pacific Co. v. McColgan, 68 Cal.App.2d 48, 53--56, 156 P.2d 81.) Thus, dividend income will not be allocated in relation to the operations of the corporation owning the shares but is attributed to the domicile. In other words, there is no apportionment of the dividend income as exists with respect to operating income where part of the income is attributed to one state and part to another, depending upon the extent of operations; dividend income is taxable on the basis of domicile of the shareholder.

THE GENERAL OPERATION OF SECTION 24344

The basic provision we are called upon to construe by the parties is the phrase 'interest and dividend income . . . not subject to allocation by formula' as used twice in section 24344. Section 24344 at times relevant here ³ provided as follows: '(a) Except as limited by subsection (b), there shall be allowed as a deduction all interest paid or accrued during the income year on indebtedness of the taxpayer. ( ) (b) If income of the taxpayer is determined by the allocation formula contained in Section 25101, the interest deductible shall be an amount equal to interest income subject to allocation by formula, plus the amount, if any, by which the balance of interest expense exceeds interest and dividend income (except dividends deductible under the provisions of Section 24402) not subject to allocation by formula. Interest expense not included in the preceding sentence shall be directly offset against interest and dividend income (except dividends deductible under the provisions of Section 24402) not subject to allocation by formula.' ⁴

In view of the complexity of the section, it is helpful to consider at the outset how the subsection operates in a situation not involving intercompany dividends. It must first be observed that subsection (b) only comes into play if the 'income of the taxpayer is determined by the allocation formula contained in Section 25101,' and this makes clear that we are only concerned with corporations which are engaged in multi-state operations, i.e., corporations which do business both within and without California and perhaps a corporation which is part of a unitary business conducted by it and affiliated corporations within and without California. ⁵

Under subsection (b), it may be said that there are four steps in calculating the allowable interest expense. First, a deduction for interest expense is permitted to the extent that there is interest income subject to allocation by formula. In other words, interest expense is first used to cancel out interest income subject to allocation by formula. ⁶ This first step is not in issue in the instant case, and will not be considered in the remainder of this opinion.

The second step is to ascertain the amount of 'interest and dividend income . . . not subject to allocation by formula.' Under the first sentence of subsection (b), an amount of interest expense equal to that amount of income, is disallowed as a deduction. This is because the sentence only allows as a deduction the amount of expense that 'exceeds' the described amount of income.

The third step is to allow as a deduction any excess interest expense, i.e., the amount of interest expense, if any, which 'exceeds' the described amount of income.

The fourth step is that set forth in the second sentence of subsection (b). This provides that interest expense not allowed by the preceding sentence shall be offset against 'interest and dividend income . . . not subject to allocation by formula.' The latter income is exactly the same income referred to in step 2. Accordingly, the amount of interest expense equal to 'interest and dividend income . . . not subject to allocation by formula' is allowed as an offset against the described interest and dividend income.

Another way of describing the operation of the last three steps is that interest expense must first be used to offset the quoted interest and dividend income and the remaining interest expense, if any, may be used to reduce not operating income.

To further explain the operation of subsection (b), it would seem desirable to start with an illustration of the subsection in a context where its operation is not disputed by the parties. Let us assume that a corporation has $10 net operating income form sources both within and without the state prior to the deduction of...