Of the many technical aspects of the California corporation tax return, the computation of income component can prove more problematic compared with the corresponding computation for most other states. For one, it can involve more filing methods—including worldwide unitary combination, separate unitary groupings along worldwide and domestic lines, and water’s edge filings which could consist of domestic combination or some form of worldwide combination. Add to this California’s nonconformity to the IRS in many areas, and taxpayers face yet another element of complexity. In all methods of filing, however, determining the proper net income starting point is important.
Having worked with the California Franchise Tax Board for 20 years as a senior auditor and supervisor of the Major Case Audit Group, I often saw areas of the return that were prepared without much review and analysis, including the calculation of net income. During those 20 years and the 16 years spent with Ashland, I always focused on the calculation of net income because in many cases it resulted in positive tax adjustments. Some of the reasons for this focus arise from the original source of the net income amounts and the adjustments required due to the nonconformity of these sources with California tax law.
Depending on the structure of the corporation and the filing method, taxpayers may look to several varying sources in computing net income. Quite often, the better approach is to view these sources as a starting point and not a final amount. The extent of adjustment to this starting point depends on the complexity of the company covering many items. The following is a discussion of several computation-of-income sources and their corresponding benefits as well as problems.
The Consolidated Federal Form 1120 is a common starting point for computing net income. It is an especially useful tool for taxpayers filing a California return that is limited to U.S. domestic companies, with no existing or includible foreign operations for California return purposes. Form 1120 includes a common parent company and all affiliates directly or indirectly owned at least 80% by that parent. It does not include:
The Federal Consolidated Return requires the inclusion of affiliates based solely on an ownership percentage criterion, while the California return includes affiliates that satisfy both a unitary requirement and an ownership rule that differs from the Federal Consolidated Return. Because Form 1120 does not include foreign corporations, taxpayers with foreign entities that satisfy California’s ownership and unitary rules must look to another source to properly combine their income.
Another such source for computing net income is Form 5471, which U.S. parent companies must file for each foreign subsidiary. Taxpayers filing Form 5471 will include an Income Statement and Balance Sheet—along with additional supporting statements and schedules—that is to be prepared in accordance with GAAP. A schedule included with Form 5471 is supposed to reconcile GAAP Income with Earnings and Profits.
But the use of Form 5471 as a source to compute income presents several problems. Because the form is an information return, the IRS does not typically audit it. And throughout my 36 years of practice, I have found countless errors in their preparation. Taxpayers lack consistency in using GAAP Income or Earnings and Profits, which can result in material differences in their computations. Here are some areas prone to error:
Although filing Form 5471 for foreign subsidiaries presents multiple issues, a California combined return that includes a foreign parent corporation is also a complicated matter. A typical starting point for the income computation of the foreign parent is an SEC Form 20-F, which is similar to Form 10-K filed by U.S. parents. Form 20-F is prepared in accordance with GAAP and, if not, must disclose differences from GAAP in schedules reconciling Income Statement and Balance Sheet items to amounts that would have been present if using GAAP. Form 20-F is a reliable source since it should include all majority-owned affiliates and eliminate all intercompany transactions.
For a taxpayer using a Foreign Parent Consolidated Financial Statement not in accordance with GAAP, the computation of income becomes even more difficult. In combination with Form 20-F or another source of consolidation, it is a good idea to review the supporting Consolidating Financial Statement Workpapers. These workpapers should reconcile to the starting point, such as the Form 20-F, and can be a useful tool since it shows the separate income of all affiliates along with intercompany eliminations and consolidating adjustments to book income.
If using Form 20-F as the starting point for net income, adjustments need to be made to convert to a California tax basis. You might choose to first convert to a federal tax basis, followed by a conversion to a California tax basis. Depending on the complexity of the reconciliation, at a minimum you must convert the domestic U.S. entities to a California tax basis, which always first requires an adjustment to a federal tax basis. Regardless of the source of the foreign parent starting point, it is critical to read the Notes to the Consolidated Financial Statements, which can identify potential adjustments needed in the reconciliation.
The most common method used during my 20 years with the Franchise Tax Board to convert from GAAP to a California tax basis relies on a formula I helped develop. The formula incorporates the Consolidated Financial Statements as the starting point and makes book to federal tax adjustments through adding and subtracting Federal 1120 Schedule M-1 Adjustments. You must conduct a thorough analysis of each Schedule M-1 Adjustment to determine if further modifications are needed to conform to California tax law.
For example, a Schedule M-1 Line 4 Adjustment for Subpart F Income has to be reversed because it is not taxed under California law. In addition, you must again thoroughly review the Notes to the Consolidated Financial Statements for further reconciliation issues and their interaction with Schedule M-1 items. For instance, equity income could be reflected on the Consolidated Financial Statements but not so in California taxable income. Schedule M-1 may report an adjustment, but you have to review and confirm that no equity income ends up in the California tax base. Depending on the circumstances, a comparison should be done between the above formula and the California return net income. Consideration should be given as to whether the comparison is proper. Ask yourself whether both amounts represent net income before state adjustments, net income after state adjustments, or a mixture of the two. Confirm also that both amounts are on the same basis.
Finally, a few additional items to be addressed in the reconciliation are what is described as Off-Book Adjustments and Ghost or Hidden Schedule M-1 Adjustments. Off-Book Adjustments are book adjustments that are made as a consolidating adjustment to Schedule M-1 book income and not directly to the separate books of the individual entity. If the net income starting point uses the book income of all combined entities, it would miss the consolidating adjustments. Ghost or Hidden M-1 Adjustments are book to tax differences that are made directly to Schedule M-1 Line 1 Book Income and not reflected in Schedule M-1 itself where they can be easily identified.
Authored by: Joel Kane, California – 36 years of California Franchise Tax experience, 20 years of which was with the CA Franchise Tax Board as a large case Audit Supervisor.