by Joel Kane
Basis adjustments are often an overlooked issue in computing California apportionable income, which in many cases has resulted in a material tax benefit. In discussing basis adjustments, we are looking at asset basis and stock basis. Generally, in both cases the adjustment arises from a disposition in these asset classes. For stock basis adjustments, this could also include a realization of a worthless stock. The asset basis adjustment is calculated on the accumulated difference in depreciation deducted on the Federal 1120 return compared to the amount of the accumulated deduction taken on the California return. The adjustment would apply to both Worldwide California returns as well as Water’s Edge returns. Usually, the adjustment does not apply to combined foreign entities although it could, depending on how foreign income is computed such as using Earnings & Profits, GAAP or reconciling to a California taxable income. The source of foreign income in the year of asset disposition also matters. A misconception relating to the asset basis adjustment is that it could result in a tax benefit or adverse tax effect depending on the location of the assets disposed of. In effect, if a material portion of the state adjustment is from assets located in California, then the tax effect of the issue would be negative. This is incorrect since the asset basis adjustment is purely a state adjustment to income and not affected by the location of the assets. To properly calculate the asset basis adjustment, the taxpayer needs to have records substantiating the amount of accumulated Federal 1120 depreciation deducted for each asset disposed of as well as the accumulated depreciation taken on the California return. In some instances, a reasonable approximation could be presented including a reconstruction of the accumulated Federal and California depreciation. In all cases, it would limit the time and effort to only analyze asset dispositions with the most tax benefit potential. An example of this would include a disposition with large proceeds along with accumulated depreciation of the entire cost basis of the asset for Federal 1120 purposes. Basically, only in rare circumstances, is this issue not a benefit to the taxpayer and therefore one in which a State of California auditor would normally never address.
Stock basis adjustments result from the different treatment of computing the basis of a member of the consolidated Federal return compared to the basis of a domestic member of the combined unitary California return. When a domestic subsidiary included in both the Federal consolidated return and California combined return is disposed of, this usually results in a state adjustment to income based on the different investment basis in the subsidiary and resulting difference in gain or loss. For Federal return purposes, the parent company’s basis in the consolidated subsidiary is its original cost increased by net income of the subsidiary plus tax-exempt income, and decreased by net losses, non-deductible expenditures, and distributions out of accumulated earnings and profits. California does not conform to this formula for calculating the investment basis instead using the parent’s original cost basis. For both Federal and California purposes, basis is increased by additional capital contributions and reduced for distributions classified as a return of capital with no difference between the effect on Federal and California basis. The two methodologies usually result in a different stock basis and resulting gain or loss on disposition. It could be the case that a consolidated subsidiary in the Federal return generates net income during its period of ownership and distributes all the income out as dividends, whereby the stock basis would be the same for Federal and California. Depending on the facts, a disposition of a consolidated subsidiary that is also a member of the California unitary return could result in either a positive or negative tax effect. If the consolidated subsidiary for Federal return purposes is not a member of the California unitary return, then a basis issue would not exist but should require a separate analysis of other potential California state tax issues.
Stock basis differences could also apply to investments in controlled foreign corporations (CFCs). For Federal purposes, deemed dividend income known as subpart F income, increases the stock basis in the CFC to the extent the subpart F income is included in the U.S. shareholders income. The stock basis in the CFC is then reduced by any distributions out of previously taxed subpart F income (PTI). California does not conform to the Federal CFC basis computation using the original unadjusted cost basis. Similar to the investment in domestic subsidiaries, both Federal and California increase basis for additional capital contributions and reduce basis for distributions classified as a return of capital with no difference between the effect on Federal and California basis.