Section 382 Ownership Changes and the California Combined Report

This article was originally published in the California Tax Lawyer Magazine, co-authored by Jenna Mayfield. Click the links below to jump to the various sections:

• Introduction
• Outline of Internal Revenue Code Section 382
• Relevant Federal Consolidated Return Rules
• Outline of the California Combined Report Rules
• Application of Section 382 in a Federal Consolidated Return and in a California Combined Report
• Conclusion
• Endnotes

Introduction

Many tax practitioners equate the filing of a federal consolidated income tax return with the filing of a California combined report. There are certainly similarities between the two filing regimes, but there are often overlooked differences that can produce drastically different tax results. This article will explore the differences in the treatment of net operating losses by a federal consolidated return group and a unitary group that files a California combined report. In particular, we will focus on the differences that arise when there has been an ownership change within the meaning of Internal Revenue Code (IRC)² Section 382.³

This article will outline the federal and California rules with a broad brush and then focus more closely on how the principles of Section 382 will (or should) apply in each context. We will not, however, cover every nuance of the federal and California treatment of net operating losses; our goal is merely to contrast the two tax reporting methods. ⁴

The article will include a numerical table that illustrates the divergent paths followed under these two tax regimes. The authors believe that this analysis is timely because the deductibility of net operating loss carryovers is currently scheduled to be reinstated under California law after a four year suspension period (2008-2011).⁵

Outline of Internal Revenue Code Section 382

Section 382 of the IRC provides that if there has been a more than 50 percentage point increase in certain shareholders' stock ownership of a loss corporation over a three year (or less) testing period, an annual limitation will be imposed on the loss corporation's ability to carry over the pre-change losses to the post-change period. This limitation (the "Section 382 limitation") is calculated in two steps.

First, the basic Section 382 limitation is calculated by multiplying the fair market value of the equity of the loss corporation immediately before the ownership change by a prescribed percentage rate (the "long term tax exempt rate") that is announced monthly by the IRS.⁶ The equity value of the loss corporation may be adjusted under Section 382(1)(1) for certain capital contributions or under Section 382(1)(4) for the loss corporation's ownership of certain non-business assets, but this article will limit the discussion to the unadjusted equity value of the loss corporation.

Under the second step in calculation the annual Section 382 limitation, if the assets of the loss corporation have a fair market value which exceeds their aggregate tax basis (i.e. "net unrealized built-in gain") at the time of the ownership change, the basic Section 382 limitation will be increased by the amount of such unrealized gain which is recognized in the five-year period following the ownership change.⁷ Unrealized built-in gain will only exist if the amount of such gain exceeds a threshold amount which is equal to the lesser of (1) 15 percent of the fair market value of the corporate assets immediately before the ownership change or (2) $10 million. ⁸

If the assets of the loss corporation have a tax basis exceeding their fair market value at the ownership change date, the loss corporation will have a net unrealized built-in loss and to the extent that loss is recognized in the five-year period following the ownership change, it will be limited in a manner similar to the limitation that applies to net operating loss carryovers from pre-ownership change periods.⁹ Unrealized built-in loss will only exist if the amount of such loss exceeds the lesser of (1) 15 percent of the fair market value of the corporate assets immediately before the ownership change or (2) $10 million. If the unrealized built-in gain or the unrealized built-in loss does not exceed the threshold amount, the unrealized built-in gain or loss is zero and the Section 382 limitation will equal the equity value of the loss corporation immediately prior to the ownership change multiplied by the long term tax exempt rate.

Once the Section 382 limitation has been calculated, that amount will be the maximum amount of net operating loss carryover originating in the pre-charge period that the corporation can absorb in any post-change carryover year. If the corporation does not have sufficient taxable income in the carryover year to absorb the full amount of the "freed up" loss, then the excess of the Section 382 limitation over the taxable income in that year carries over to the next year and increases the Section 382 limitation in that succeeding year.¹⁰

Relevant Federal Consolidated Return Rules

Section 1502 of the IRC delegates extensive authority to the Department of the Treasury to prescribe such rules as are necessary to determine the tax liability of an affiliated group of corporations that files a consolidated federal income tax return. Those regulations can be principally found in Treasury Regulation sections 1.1502-1 through -100. Although there are certain exceptions,¹¹ the federal consolidated return regulations generally take a single entity approach and treat the component members of the groups as divisions, rather than separate taxable entities. For example, the consolidated tax liability of the group is calculated by multiplying the consolidated taxable income of the entire group by the statutory tax rates.¹² Once the consolidated tax liability has been determined, each of the members is severally liable for the entire consolidated tax liability, regardless of a particular member's income or loss.¹³

The deductions, credits, etc. of a consolidated return group are also largely calculated as if the group were a single entity. For example, the consolidated charitable contribution deduction is determined by aggregating the charitable contributions made by the various members of the group and then applying the 10 percent limitation of Section 170(b)(2)(A) to the consolidated taxable income of the group.¹⁴ This leads to a situation where a member of a group with a loss for the year could make a currently deductible charitable contribution because the 10 percent limitation would be determined by reference to the consolidated taxable income of the group, rather than the taxable income of that particular member. A similar situation arises where a member of a group incurs a net capital loss that would be unusable in a separate return setting (because there are no capital gains in the carryback or carryover periods), but such capital loss could be used in a consolidated return setting because cross-crediting of capital losses and capital gains between members of the group is permissible.¹⁵

The treatment of net operating losses is likewise done on a consolidated basis (i.e. under the single entity approach) and the net operating loss of any member during a consolidated return year (as calculated on a separate member basis) is freely allowable in determining the consolidated taxable income or consolidated net operating loss for that year.¹⁶ In addition, net operating loss carryovers from prior consolidated return years and, subject to limitations that will be discussed infra, from prior nonconsolidated return years, are fully allowable against the group's consolidated taxable income in the year to which the loss is carried. As long as entities are not joining or leaving a consolidated return group, the consolidated net operating loss is calculated on a single entity basis and the identity of the entity that incurred the loss does not generally have relevance in determining the group's consolidated tax liability.

Another single entity concept in the federal consolidated return rules that bears mentioning is the "loss subgroup" concept. if two or more corporations were previously affiliated through 80 percent stock ownership and join a consolidated return group at the same time, they will generally be treated as a "loss subgroup" and, with certain exceptions, all of the Section 382 concepts (e.g. the calculation of the Section 382 limitation, the determination of the existence of built-in gain or loss, etc.) will generally be applied as if those new members were a single entity joining the consolidated return group. There is no analogue to this under California law. While the loss subgroup concept will contribute further to the disparity in the treatment of losses under the federal and California rules, it will not be discussed further in the interest of simplicity.

Outline of the California Combined Report Rules

In general, the California Revenue and Tax Code (RTC) conforms to the IRC either through language that mirrors the federal language or through incorporation by reference. Where California conforms to the IRC, it generally conforms to the underlying regulations to the extent they are not in conflict with California law.¹⁷ As noted above, California conforms to the statutory rule of Section 382 of the IRC, but other differences between federal and California corporate tax law create a tension that is the subject of this article.

Although there are certain exceptions,¹⁸ California generally does not conform to the consolidated return regulations.¹⁹ However, RTC Section 25106.5 is similar to Section 1502 of the IRC in delegating extensive authority to the Franchise Tax Board to prescribe such rules as are deemed necessary to properly determine the tax liability or net income of a taxpayer that is part of a combined report. Those regulations can be found in the California Code of Regulations, title 18, sections 25106.5 - 25106.5-11. Additionally, the FTB has provided detailed guidance for taxpayers preparing a combined report in FTB Publication 1061.

Like most states, California determines the business income subject to tax under a formulary apportionment system. This requires corporations deriving income from sources both within and outside of California to determine the portion of total income that is attributable to California based on the unitary business principle.²⁰ In California, the business income from all activities of a unitary business is combined into a single report.²¹ The combined business income is apportioned to California through interstate apportionment and then assigned to each member of the unitary group through intrastate apportionment.²² Non-business income is generally allocated to a particular state.²³

Unlike a consolidated return in which the group is treated as a single taxpayer, members of a combined reporting group remain separate taxpayers. A combined report is not a return; it is a method used to determine the apportionable business income of the unitary business and how that income should be apportioned among various jurisdictions where the unitary business operates. Accordingly, even though members of a unitary group may elect to file a single group return,²⁴ each member generally remains liable for its own tax liability.²⁵

For these reasons, each member of the combined reporting group is generally treated as a separate entity. For example, credits are generally applied on a separate entity basis and cannot be shared among members of a combined reporting group.²⁶ If the entity that generated the tax credit does not have tax in a particular year, it will not be able to claim the credit nor will any other member of the combined reporting group. Likewise, capital gains and losses cannot be shared among members of the combined reporting group. Each member of the combined reporting group nets its capital gains and losses after apportionment and allocation, and if the entity has a net capital loss, that loss may only be carried over by that entity.²⁷

The treatment of net operating losses is similarly done on a separate entity basis. Each member must separately compute its loss carryover, and application of the loss carryover is based on that member's apportioned and allocated share of California income or loss.²⁸ Unlike with a federal consolidated group, the loss carryover of one member may not be applied to the apportioned income of another member.

Application of Section 382 in a Federal Consolidated Return and in a California Combined Report

In light of the differences outlined above between the general operation of a federal consolidated return and a California combined report, it is not surprising that Section 382 will operate differently (sometimes dramatically differently) in the federal and California settings. The discussion that follows will focus on the federal Section 382 rule and how the authors believe that situation should be handled under the principles reflected in FTB Publication 1061.

Ownership Changes at the Common Parent Level
In determining whether an ownership change has occurred with respect to a federal consolidated return group, the regulations follow the single entity approach and focus on changes in the stock ownership at the common parent level (the so-called "Parent Change Method").²⁹ Thus, if the "5% shareholders"³⁰ of the common parent company have increased their percentage interest by more than 50 percentage points during the three-year period that precedes the testing date, there will be an ownership change that brings Section 382 into play for the entire consolidated net operating loss. Shifts in the ownership of subsidiary members of the group are disregarded, at least where the subsidiary remains a member of the consolidated return group.³¹

The federal "Parent Change Method" only applies if the affiliated companies file a consolidated return. If the companies do not file a consolidated return, either because they have not elected to file on that basis or because the 80 percent stock ownership requirement is not satisfied (and they cannot elect to file on a consolidated basis), the stock attribution rules of Treasury Regulation section 1.382-2T will apply and each entity will be separately tested based on the increases in the percentage interest that the 5-percent shareholders hold in each entity in the group. For example, if individual A owns 100 percent of the stock of P, and P owns 80 percent of the stock of L, a sale by A of 51 percent of the stock of P to an unrelated party would cause a Section 382 ownership change with respect to P but not with respect to L because there would only be a 40.8 percent shift in the ownership of L (51% times 80%). If P and L filed a consolidated return, a sale of 51 percent of the stock of P would cause an ownership change with respect to the PL consolidated group.

FTB Publication 1061 does not treat the group as a single entity for most purposes, and there is no reason to believe that the Parent Change Method would be applied in a manner similar to the federal rule for consolidated groups. Instead, the authors believe that the normal attribution rules of Section 382 should apply in the same manner that they apply to federal groups that do not file consolidated returns. Under those rules, it is necessary to identify the 5-percent shareholders of both the common parent and each of the subsidiaries to determine if the 5-percent shareholders of each of these entities have had a more than 50 percentage point increase.

For example, assume that P owns 80 percent of the stock of S and 50 percent of the stock of T. The remaining 20 percent of the stock of S is owned by individual A and the remaining 50 percent of the stock of T is owned by unrelated individual B. The group operates a unitary business and files a California combined report. Individual C purchases 70 percent of the stock of P from its existing shareholders. An ownership change occurs with respect to P because C has had a 70 percent increase in its percentage interest in P (from zero to 70%). An ownership change also occurs with respect to S because C now has a 56 percent indirect interest in S (70% of the 80%). An ownership change does not occur with respect to T because C only acquires a 35 percent interest in T (70% of the 50% held by P). Similarly, unlike under the federal Parent Change Method, a Section 382 ownership change could occur at the subsidiary member level without an ownership change occurring with respect to the parent company.³²

The authors believe that in determining whether an ownership change has occurred, California should apply a rule similar to the federal rule that is applicable to non-consolidated groups. This requires that a fundamentally different analysis be done for federal and California Section 382 purposes.

The Basic Consolidated/Combined Section 382 Limitation
Treasury Regulation section 1.1502-93(a)(1) and (b) generally provide that the consolidated Section 382 limitation is determined by multiplying the value of the equity of common parent plus the value of any outstanding minority interests in the subsidiaries not owned by the common parent times long term tax exempt rate.³³ Thus, the Section 382 limitation operates as if the consolidated group were a single entity.

FTB Publication 1061 does not explicitly state how the Section 382 limitation should be calculated. If our conclusion is correct that ownership changes should be determined on a company by company basis (much like the federal rule for affiliated groups that do not file a consolidated return), then California will likely require a company-by-company calculation of the Section 382 limitation. Thus, the parent company's limitation would be calculated by multiplying the value of equity of common parent (exclusive of value of its subsidiaries' stock) times the long term tax exempt rate. The limitation for each of the subsidiaries would likewise be separately calculated by multiplying the value of their respective equity times the long term tax exempt rate. This approach will cause additional disparities because some members of the combined group may not be in a loss position and the value of the equity of the profitable members may not increase the Section 382 limitation of the loss members.

The following example contrasts how the federal and California limitations would be calculated under this approach. The California table follows the format of FTB Publication 1061. However, it is assumed that none of the corporations have any non-business activities.

Year 1:	Corp. X	Corp. Y	Corp. Z	Total
Separate bus. income (loss) subj. to apportionment California apportionment percentages Income (loss) apportioned to California California net loss to be carried forward	$(150,000) 40%	$50,000 30%	$(50,000) 10%	$(150,000) 80%
	$(60,000) $(60,000)	$(45,000) $(45,000)	$(15,000) $(15,000)	$(120,000) $(120,000)

Year 2:	Corp. X	Corp. Y	Corp. Z	Total
X 382 limitation ($1MM equity value x LTTER of 5%) Y 382 limitation ($1MM equity value times 5%) Z 382 limitation ($2MM equity value times 5%) Separate bus. income (loss) subj. to apportionment California apportionment percentages California net income (loss) NOL carryover from Year 1 allowed California net income (loss)	$50,000
		$50,000
			$100,000
	$25,000 30%	$25,000 20%	$150,000 30%	$200,000 80%
	$60,000 $(50,000)	$40,000 $(40,000)	$60,000 $(15,000)	$160,000
	$10,000	-	$45,000
NOL available to be carried forward Unused 382 limitation available to be carried forward	-	$10,000	-	-
	-	$10,000	-	-

Applying the 382 limitation to NOLs in a Consolidated Return

Year 1:	Corp. X	Corp. Y	Corp. Z	Consolidated Total
Net income (loss)	$(150,000)	$50,000	$(50,000)	$(150,000)
NOL available to be carried forward	$(150,000)	$50,000	$(50,000)	$(150,000)

Year 2:	Corp. X	Corp. Y	Corp. Z	Consolidated Total
Consolidated 382 limitation ($4MM times 5%) Current year income (loss) NOL carryover from year 1 allowed Net Income (loss)	$25,000	$25,000	$150,000	$200,000 $200,000 $(150,000)
				$50,000
NOL available to be carried forward Unused 382 limitation available to be carried forward	-	-	-	-
	-	-	-	-

As shown in the table, the separate income of each California corporation is determined by multiplying its share of the California apportionment factor by the groupwide unitary business income. Note that the apportionment percentages in Years 1 and 2 do not total 100 percent because a portion of the group's apportionment factors (20 percent in this case) are outside California. The long term tax exempt rate is assumed to be 5 percent.

For federal purposes, the entire $150,000 loss carryover from Year 1 can be utilized in Year 2 because the consolidated Section 382 limitation is in excess of the Year 1 carryover. Therefore, the income subject to federal taxation in year 2 is $50,000 and there is no carryover to Year 3.

Under what we believe the California rule should be, the Section 382 limitation for each member of the group is computed on a separate entity basis. Corporation X has a $60,000 apportioned loss carryover from Year 1, which is limited to $50,000 due to X's Section 382 limitation. Accordingly, Corporation X has a loss carryover to Year 3 of $10,000. Corporation Y has a $45,000 loss carryover from Year 1, which exceeds its Year 2 apportioned income of $40,000, but none of that excess may be used against X's Year 2 net income. Instead, Y's excess loss will be a carryover to Year 3 and Y's excess Section 382 limitation will increase Y's Year 3 Section 382 limitation under Section 382(b)(2). Thus, even though the loss carryovers are fully allowable in Year 2 for the federal consolidated group, in the California setting, X's Year 1 loss carryover is limited in Year 2 to X's separate company Section 382 limitation and Y's losses are limited because its loss carryover from Year 1 exceeds its apportioned taxable income in Year 2.

An alternative approach that would at least be more consistent with the federal consolidated rule would be to calculate a combined group Section 382 limitation based on the value of the common parent's equity and then apportion that combined amount amongst the members based on the ratio of each member's (or each loss member's) California apportionment factor to the California apportionment factor of the group, as determined in the year of the ownership change. This is somewhat analogous to the method that FTB Publication 1061 uses to apportion business losses among the members in the year that a unitary business loss originates. This approach treats the combined group as a single entity for Section 382 purposes and in that regard, it could be regarded as inconsistent with the FTB Publication 1061 approach. Further, since formulary apportionment would have been applied to determine the business income and loss of each entity, one might argue that formulary apportionment should apply to calculate a reduced Section 382 limitation before it is apportioned among the members of the group and applied to limit the members' separate net operating loss carryovers.³⁴ On balance, we do not believe that calculating a combined group Section 382 limitation under this alternative approach is consistent with the single entity treatment generally required by FTB Publication 1061.

Net Unrealized Built-in Gain or Loss
Consistent with the single entity approach generally taken under the federal consolidated return rules, the existence of net unrealized built-in gain or net unrealized built-in lass is based on the aggregate of the separately computed net unrealized built-in gains or losses of each member that is included in the group.³⁵ Thus, if P and S in the PST group had $1,000 and $500, respectively, of net unrealized built-in gain on a separate entity basis and member T had a net unrealized built-in loss of $300, the PST group would have a consolidated net unrealized built-in gain of $1,200 (assuming the threshold amount was exceeded). If any asset with built-in gain held by P, S, or T at the change date were sold during the five year recognition period, the consolidated Section 382 limitation for that year would be correspondingly increased. Since a loss corporation (or group) can have either net unrealized built-in gain or net unrealized built-in loss (but not both), if any member of the PST group sold an asset which had a tax basis which exceeded its fair market value at the change date, the recognized loss generally will not affect the Section 382 limitation.

FTB Publication 1061 does not address net unrealized built-in gain or loss in the Section 382 context. However, if loss carryovers are to be tracked on a company-by-company basis in a combined report, it seems reasonable to conclude that for California franchise tax purposes, P and S would have $1,000 and $500 of net unrealized built-in gain, respectively, and T would have a net unrealized built-in loss of $300. Thus, P and S could increase their Section 382 limitation by asset sales within the five-year recognition period.

Corporations Joining the Group
The federal consolidated return rules generally follow the principles of Section 172 in determining how net operating loss carryovers and carrybacks are absorbed.³⁶ Under Section 172, losses are generally first carried back to the second preceding year, then to the first preceding year, and are then carried forward to the next succeeding 20 years. An election may be made to waive the carryback period and only carry losses forward. Where a net operating loss originates in more than one taxable year, the net operating loss from the earliest year is absorbed before net operating losses arising in subsequent years.

These same rules are applied in a somewhat modified fashion to a federal consolidated return group. Loss carryovers that are utilized in a consolidated return year are generally absorbed in the order of the taxable years in which they arose, regardless of whether the loss arose in a prior consolidated or nonconsolidated return year (subject, of course, to Section 382 or other limitations). If two members of the consolidated return group have net operating loss carryovers that arise in the same prior year, the losses are utilized in the current year on a pro rata basis. For example, if the group has a consolidated net operating loss in one year and that loss is carried back or carried over to another taxable year of that same group, the single entity concept is applicable and the loss generated by one member in the loss year can be fully utilized against consolidated taxable income in the carryback or carryover year.

The single entity approach is compromised when a new member joins a group and has a net operating loss carryover from the preconsolidation period. There are two sets of limitations that must be overcome before that preconsolidation net operating loss may be included in consolidated group's net operating loss deduction. One limitation is the separate return limitation year restriction (the so-called "SRLY limitation"), which provides that the loss carryover can only be used against consolidated taxable income in the carryover year to the extent of the new member's contribution to consolidated taxable income in that year.³⁷ The second limitation that may apply is the Section 382 limitation that may result if there has been a Section 382 ownership change with respect to the new member. If an ownership change occurs as a result of the transaction in which the new member joins the group or if the ownership change occurs either within the six months preceding or following the date when the new member joins the consolidated group, the Section 382 limitation will apply to the loss carryover of the new member but the SRLY restriction will not apply.

If an ownership change occurs when the new member joins the consolidated return group (or if it occurs within the six month period before or after the new member joins the group), Section 382 applies to the new member's loss carryovers on a separate company basis and the amount of the loss carryovers that can be offset against consolidated taxable income in the post-acquisition period is determined on the basis of the new member's equity value immediately prior to the ownership change multiplied by the long term tax exempt rate for that month.³⁸ In this situation, it is no longer necessary to track the changes in the new member's stock ownership and a subsequent ownership change will only occur if there is an ownership change with respect to the common parent of the consolidated return group.³⁹

If an ownership change does not occur at the time that the new member joins the group (or in the six month period before or after it joins the group), the SRLY limitation will apply and it will be necessary to continue to track changes in the ownership of the new member's stock in much the same manner as if the affiliated group filed separate returns (i.e. not consolidated returns). This separate tracking of the new member must continue for a five year period following the date when it joins the consolidated return group and if there is an ownership change with respect to the new member's stock during that five year period, an ownership change will occur and the Section 382 limitation will arise with respect to that member's losses from the preconsolidation period.⁴⁰

By contrast, the California rule for members joining a combined reporting group is fairly straightforward. If the new member has net operating loss carryovers when it joins the group and a Section 382 ownership change occurs as a result of that transaction, a Section 382 limitation would be calculated for the new member and the new member would be entitled to utilize its loss carryovers to the extent permitted by Section 382. if the new member does not suffer a Section 382 ownership change as a result of joining the group, its loss carryovers could be used without limitation against the income attributed to that member under the principles reflected in FTB Publication 1061. There is no California equivalent of the federal SRLY limitation.

Corporations Leaving the Group
If a member leaves a consolidated return group, any unabsorbed net operating loss carryovers from preconsolidated return years and the apportioned amount of any consolidated net operating loss becomes a loss carryover to the succeeding taxable years of the departing member.⁴¹ Under Treasury Regulation section 1.1502-21(b)(2)(iv), the portion of the consolidated net operating loss attributable to a member is determined by multiplying the consolidated net operating loss for the year times a fraction, the numerator of which is the separate company net operating loss of that member for the year and the denominator of which is the sum of the net operating losses of all members having a net operating loss.

The treatment of the Section 382 attributes of the departing member is not so straightforward. If the consolidated group had an ownership change while the departing member was part of the group, any portion of the consolidated net operating loss attributed to the departing member would remain subject to the Section 382 limitation following its departure. The Section 382 limitation with respect to that apportioned net operating loss will be zero unless the common parent company of the group elects to apportion all or a portion of the consolidated Section 382 limitation to the departing member.⁴² The common parent may also apportion all or a portion of the consolidated unrealized built-in gain to the departing member. The consolidated Section 382 limitation and the consolidated unrealized built-in gain of the group is correspondingly reduced by the amount attributed to the departing member.

If the stock of the departing member is sold to an unrelated party, a Section 382 ownership change will normally occur for both federal and California purposes and the Section 382 limitation arising from that ownership change will likely be the same amount. However, prior ownership changes may have occurred while the departing corporation was a member of the federal consolidated return group and while it was included in the California combined report. In the federal consolidated return setting, the common parent corporation of the group makes an election to determine that a specific percentage (including 0%) of the consolidated Section 382 limitation be apportioned to the departing member. With a California combined report, a member's Section 382 limitation would have been separately calculated with respect to ownership changes that might have occurred during the period of combined filing and that limitation would carry over unmodified into the post-combination period.

Conclusion

The federal consolidated return regulations have a detailed set of rules for applying Section 382 in a consolidated return setting. However, significant differences between the federal consolidated return regulations and the California combined reporting methods require a different application of Section 382 concepts. Because FTB Publication 1061 and the California combined reporting regulations generally treat each member of the group as a separate entity, the authors believe a reasonable approach is to apply the Section 382 limitations on a separate entity basis. This article has attempted to explore this approach and illustrate how it would be applied to members of a California combined reporting group. While this separate entity approach may result in significant differences between the federal consolidated group and the California combined reporting group, the authors believe it is a reasonable approach based on current law and guidance.

Endnotes

1. John Brogan is a shareholder with Burr Pilger & Mayer, Inc., a CPA firm based in Northern California. He currently serves on the Executive Committee of the Taxation Section of the State Bar of California. He may be reached at (650) 855-6888 or jbrogan@bpmcpa.com. Jenna Mayfield is a Tax Counsel with the California Franchise Tax Board and currently serves as the Secretary of the State and Local Tax Committee of the Taxation Section of the State Bar of California. She may be reached at (916) 845-7965 or jenna.mayfield@ftb.ca.gov. The comments contained in this article are solely the individual views of the authors and do not represent the position of either the Franchise Tax Board or the State Bar of California.
2. Hereinafter, any section references are to the Internal Revenue Code unless otherwise specified.
3. For taxable years beginning on or after January 1, 2010, California conforms to Section 382 of the Internal Revenue Code as in effect on January 1, 2009 (Rev. & Tax Code §§17024.5(a)(1), 23051.5, 24451). Where California conforms to the Internal Revenue Code, it generally adheres to Federal income tax regulations to the extent that they are consistent with California law (Rev. & Tax Code §23051.5(d)). However, it should be noted that the California Revenue and Taxation Code (RTC) provides for an exception for differences in federal and state terminology, including the "substitution of 'Franchise Tax Board' for 'secretary' when appropriate, and other obvious differences." (Rev. & Tax Code §23051.5(d)) As will be demonstrated herein, while the statutory rule is essentially identical under the IRC and the RTC, the application of these rules to a consolidated/combined group is quite different.
4. Section 382 applies only to net operating loss carryovers. Section 383 applies similar rules to capital loss carryover, certain tax credits, etc. This article will not deal with the tax attributes covered by Section 383 but many of the same considerations are relevant there.
5. Rev. & Tax. Code §24416.21(a).
6. IRC §382(b)(1).
7. IRC §382(h)(1)(A).
8. IRC §382(h)(3)(B).
9. IRC §382(h)(1)(B).
10. IRC §382(b)(2).
11. Certain computations within the consolidated return setting necessarily must be preliminarily done on a separate entity basis. For example, banks and insurance companies are generally includible within a consolidated return with nonbanks or noninsurance companies, but those entities are subject to tax under statutory rules that are different than the rules applicable to nonbanks or noninsurance corporations. Banks determine their bad debt deductions in a manner different than a regular C corporation. Insurance companies are entitles to claim deductions for additions to reserve accounts and enjoy tax deferral on investment income. In such circumstances, it would not be practical to determine the tax liability of such component members of a group as if they were divisions or branches of a single entity that included nonbanks or noninsurance companies.
12. Treas. Reg. §1.1502-2.
13. Treas. Reg. §1.1502-6. While tax sharing agreements between the members may contractually allocate the tax liability, etc. among the participants, Treasury Regulation section 1.1502-6(c) makes those agreements ineffective against the tax claims of the federal government.
14. Treas. Reg. §1.1502-24.
15. Treas. Reg. §1.1502-22.
16. Treas. Reg. §1.1502-21.
17. Rev. & Tax. Code §23051.5(d).
18. For example, under Regulation section 25106.5-1, California conforms to Treasury Regulation section 1.1502-13, with certain modifications. Therefore, for purposes of intercompany transactions, subsidiaries are generally treated as divisions of the parent corporation rather than as separate entities.
19. See FTB Pub. 1061 (2010).
20. Rev. & Tax. Code §25101; see FTB Pub. 1061 (2010).
21. Rev. & Tax. Code §§25101, 25102; see FTB Pub. 1061 (2010). Note that this rule is not without exceptions. For example, insurance companies are generally exempt from the California franchise tax and are not included in a combined report even if part of a unitary group (See FTB Legal Ruling 385).
22. Rev. & Tax. Code §25128; Cal. Code Regs., tit. 18, §25106.5(c)(7); see FTB Pub. 1061 (2010).
23. Cal. Code Regs., tit. 18, §25101(a).
24. Cal. Code Regs., tit. 18,§25106.5-11.
25. Rev. & Tax. Code §18601; FTB Legal Ruling 95-2.
26. For tax years beginning on or after January 1, 2010, RTC section 23663 allows a one-time assignment of credits in certain situations
27. Cal. Code Regs., tit. 18, §25106.5-2.
28. Rev. & Tax. Code §25108.
29. Treas. Reg. §1.1502-92(b)(1).
30. The term "5% shareholder" has a special meaning in this context. Treasury Regulation section 1.382-2T and -3 contain a series of rules that (1) look through entities to determine the individuals who hold a 5 percent or more interest in the loss corporation and (2) aggregate or segregate individuals or entities that do not hold 5 percent or more of the loss corporations into deemed "5% shareholders." These rules are quite complex and beyond the scope of this article. Moreover, the identification of 5 percent shareholders should be identical under both the Federal and California rules.
31. Treasury Regulation section 1.1502-92(b)(2), Example 2. There is an exception to this disregard of subsidiary company stock shifts that is evidently designed to capture transactions structured to avoid the consequences of an ownership change. (Treas. Reg §1.1502-92(c))
32. The authors acknowledge that this is an oversimplification of the federal rule, and that there are circumstances where separate tracking of the ownership is necessary when a company joins a consolidated return group in a transaction that does not bring Section 382 into play. This article is not intended to be a comprehensive explanation of the consolidated return regulations in this area.
33. As noted above, IRC section 382(1) may require the adjustment of the equity value to reflect the anti-abuse rules of Section 382(1) (the anti-stuffing rule and the ownership of substantial non-business assets).
34. If this approach were applied, other tax attribute reductions should be applied similarly. For example, the reduction in net operating losses due to cancellation of debt income under IRC section 108 (RTC §24307) should be similarly apportioned such that there would be less of a reduction in net operating losses and/or other tax attributes.
35. Treas. Reg. §1.1502-91(g)(1).
36. Treas. Reg. §1.1502-21(b)(1).
37. Treas. Reg. §1.1502-21(c)(1).
38. Treas. Reg. §1.1502-94(b).
39. Treas. Reg. §1.1502-94(a)(4).
40. Treas. Reg. §1.1502-94(b)(4), Examples 1 and 3. Separate tracking of the ownership changes in the new member's stock are not required after the expiration of the five-year period.
41. Treas. Reg. §1.1502-21(b).
42. Treas. Reg. §1.1502-95(c).

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