California Combined Report Includes Unitary Insurance Subsidiary

By Edward Sakurai, CPA, J.D., Singer Lewak LLP, Los Angeles, CA (not affiliated with CPAmerica International) .

Editor: Michael D. Koppel, CPA, PFS

In a recent letter decision, the California State Board of Equalization (SBE) ruled that a taxpayer's combined report should include a wholly owned unitary insurance subsidiary (SBE Letter Decision No. 361467, Appeal of Electronic Data Systems Corp. (8/8/08)). In addition, the decision held that the premiums received from the subsidiary's Texas insurance operations should be included in the calculation of the parent company's sales factor.


Electronic Data Systems Corporation (EDS) filed California franchise tax returns for the years ended December 31, 1997, and December 31, 1998. EDS had a unitary insurance subsidiary, National Heritage Insurance Company (NHIC), which conducted an insurance business in Texas and also conducted a noninsurance business in California. NHIC was qualified to do business as an insurance company in Texas and was regulated by the Texas Department of Insurance.

EDS excluded NHIC from its combined reports for the years at issue. On audit, the California Franchise Tax Board (FTB) auditor determined that NHIC should be included in the EDS combined report. In computing the California sales factor, the auditor did not include premiums received by NHIC from its insurance business in the sales factor denominator.

EDS protested the auditor's findings and later filed an appeal asserting that the auditor was correct that NHIC should be included in EDS's combined reports and further asserted that the premiums from NHIC's Texas insurance activities should be reflected in its sales factor.

Inclusion in Combined Report

EDS originally excluded NHIC from its combined reports for the years at issue, relying on FTB Legal Ruling 385, Treatment of Insurance Company Affiliates for Combined Reporting Purposes (3/28/75). In addressing that ruling, the SBE found that the ruling's basic holding was that instate insurance affiliates must be excluded from a combined report. Legal Ruling 385 stated that its holding also applied when an affiliated insurance company operated "entirely outside of California."

Thus, Legal Ruling 385 could be read two ways. First, it could apply whenever the unitary affiliate conducted its insurance business entirely outside California, whether or not it conducted any other business in California. Second, the ruling could be read to apply only when the unitary affiliate conducted all its business outside California.

Given that Legal Ruling 385 could be interpreted in two ways, the question became one of deference to the legal ruling's holding. The SBE found that "[w]hen the Board is acting in its quasijudicial capacity in hearing an appeal from the FTB, a Legal Ruling is entitled to an appropriate degree of respect and deference, but is not necessarily binding." The SBE went on to say that it has the authority to render its own opinion of the underlying law "using all the tools at its disposal," including relevant statutory and constitutional provisions.

In determining that NHIC should be included in EDS's combined report, the SBE observed that taxpayers engaged in a unitary business must file a combined report (CA Rev. & Tax. Code §25101). The SBE found that there was agreement that NHIC was a taxpayer and that EDS and NHIC were engaged in a unitary business.

Further, Article XIII, Section 28, of the California constitution did not preclude NHIC from being subject to the franchise tax. Section 28 imposes a gross premiums tax on insurance companies. This tax is "in lieu of all other taxes and licenses, state, county, and municipal" except for real estate taxes and motor vehicle taxes and licenses. Thus, insurance companies are exempt from the corporate income and franchise tax. The exemption also covers income from noninsurance activities. However, the California Supreme Court has stated that the "tax is on ‘gross premiums . . . received . . . by such insurer upon its business done in this state.' . . . If the insurer does no insurance business here, there are no gross premiums received and section 28 does not apply" (Mutual Life Ins. Co. of NY v. City of Los Angeles, 50 Cal. 3d 402 (1990)). NHIC did no insurance business in California, so Section 28 did not apply and thus did not preclude NHIC from being subject to the franchise tax.

Inclusion of Insurance Company Premiums in the Sales Factor

On audit, the FTB auditor determined that NHIC should be included in the EDS combined report. The auditor did not include premiums received by NHIC from its insurance business in computing the California sales factor.

After analyzing whether the premiums were gross receipts includible in the sales factor and whether the standard apportionment formula fairly represented EDS's business activity in California, the board concluded that the calculation of the sales factor should include the premiums received by NHIC from its insurance operations in Texas.

Petition for Rehearing

The above decision would have become final 30 days from the board's August 8, 2008, decision date unless EDS or the FTB filed a petition for rehearing. The FTB did file such a petition. Practitioners and similarly situated taxpayers should monitor the outcome of the rehearing closely because it could result in planning opportunities as well as traps for the unwary. 


Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.

The Tax Adviser would like to acknowledge the special contribution to the December Tax Clinic of Singer Lewak LLP; Mark G. Cook, tax partner in the Irvine, CA, office; and Steve Cupingood, the partner in charge of that firm's tax practice.

For additional information about these items, contact Mr. Koppel at (781) 407-0300 or

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