California Tax Developments - February 2014

Happy 2014! The start of the New Year invites a look back on highlights from the past year. In case you missed it, here's a recap of what happened in the great Golden State during the last quarter of 2013.

1. Cases to Watch

   (a) Comcast decision expected shortly

   After a trial that included 19 days of testimony before the Los Angeles Superior Court, closing briefs were filed in Comcon Prod. Services I, Inc. v. Franchise Tax Board ("Comcast").1 Two issues were before the court: (1) whether Comcast and its subsidiary QVC formed a unitary business, and (2) whether the termination fee Comcast received from MediaOne as the result of a failed merger generated business income apportionable to California, or nonbusiness income allocable outside California.

   In California, a unitary relationship exists if any of three unity tests is satisfied. These include the Mobil2 three-factor test, the three unities test3, and the contribution and dependency test4. Comcast presented evidence and testimony at trial that focused chiefly on the three factors of the Mobil test to show that it was not engaged in a unitary business with QVC. Under that test, unity is established with a showing of centralized management, functional integration, and economies of scale between the entities in question. The Franchise Tax Board, however, focused on the application of the contribution and dependency test, which, as its name implies, focuses on whether the entities contribute to, or depend on, one another, in its attempt to affirmatively show unity between Comcast and QVC. Comcast's discussion of the contribution and dependency test was minimal. It will be interesting to see how the court decides the issue since each party relied on a different test to support its position.

   In addressing the issue of whether the MediaOne merger termination fee constituted business income, Comcast relied on the test articulated by the California Supreme Court in Hoechst Celanese5. In that case, the Supreme Court held that for an item of income to be business income, it must satisfy both a transactional test and a functional test. In order to satisfy the transactional test, the transaction giving rise to the income must be in the regular course of the taxpayer's business. In order to satisfy the functional test, the property generating the income must be an integral part of the taxpayer's regular trade or business. Comcast argued that neither test was met because its receipt of the termination fee was a "once-in-a-corporate lifetime experience" that was not part of its regular trade or business, nor was the contractual right to the termination fee an integral part of its trade or business as a cable company. The FTB rebutted Comcast's position by focusing on the fact that Comcast regularly bought and sold other cable companies as its primary trade or business. Thus, it highlighted the fact that Comcast made seven acquisitions in the same tax year as the failed MediaOne merger, to demonstrate that the termination fee was indeed income received in the regular course of, and integral to, its trade or business as a cable company in the business of buying and acquiring other cable companies.

   The court had until February 18, 2014 to issue its decision. However, shortly before this update, the case was reassigned to a new judge. Such a late reassignment is very rare, and it could require resubmissions of evidence, including witness testimony. This reassignment will likely result in the decision being substantially delayed.

   Takeaway. Unitary business and business/nonbusiness income cases tend to be driven by the facts; the Comcast case is no exception. Given that the parties argued the facts with reference to different unitary business tests, if the outcome of this case is appealed, the decision of an appellate court could...