GREAT WESTERN FINANCIAL CORPORATION, a corporation, Plaintiff and Respondent. v. FRANCHISE TAX BOARD of the State of California, Defendant and Appellant.
For Opinion on Hearing, see 92 Cal.Rptr. 489, 479 P.2d 993
Defendant appeals from an adverse judgment after court trial in this action for refund of franchise taxes paid by plaintiff under protest for the income years 1958, 1959 and 1960. At issue below and here is whether section 24425, Revenue and Taxation Code,1 precludes deduction of any expenses which are properly allocable to deductible dividend income received by the taxpayer from certain California corporations.
The matter was submitted for decision on stipulated facts which, summarized, are as follows: Plaintiff, a Delaware corporation, owns stock in several subsidiary California corporations, the dividends from which constituted a substantial amount of its gross income (some two-thirds) for the fiscal years above stated. Pursuant to section 24402, Revenue and Taxation Code,2 plaintiff properly deducted such amounts as dividends received. During the same years plaintiff incurred certain interest expense, as well as general and administrative expenses, which it reported as “deductions.” A portion of such expenses being allocable to the dividends deducted under section 24402, defendant disallowed the above “deductions” under its interpretation of section 24425. Plaintiff paid the additional tax assessed by reason of such disallowance, exhausted its administrative remedies and thereafter commenced the instant action for a refund.
Following submission of the cause, the court made findings of fact from which the following conclusions of law (in pertinent part) were drawn:
“3. In determining the amount of its franchise tax under the California Bank and Corporation Tax Law, the plaintiff is entitled to deduct all interest expense, all amortization of debenture expense, and all ordinary and business expenses allocable to the production of dividends received by it from its California subsidiary corporations, even though, under Section 24402 of the Revenue and Taxation Code, such dividends are deductible by plaintiff in computing its taxable income.
“4. All interest expense, all amortization of debenture expense, and all ordinary and necessary business expenses allocable to dividends received from plaintiff's California subsidiary corporations are not made non-deductible by the provisions of Section 24425 of the Revenue and Taxation Code, such expenses being allocable to a class of income which has been included in the measure of the tax imposed by the California Bank and Corporation Tax Law, Part 11, Division 2, of the Revenue and Taxation Code.
“5. The effect of the defendant Franchise Tax Board's disallowance of plaintiff's expenses is to subject the income from which the dividends received by plaintiff were declared to a double tax burden at the corporate level, in violation of the purpose for which Section 24402 of the Revenue and Taxation Code was enacted, and to vitiate that section's operation.”
Both sides recognize certain policies inherent in the California Bank and Corporation Tax Law (Rev. & Tax.Code, § 23001 et seq.), namely, that (1) corporate income should not be taxed more than once at the corporation level, and that, (2) on the other hand, a corporate taxpayer should be prohibited from taking a double deduction or double exemption, directly or indirectly. It also seems conceded by each party that the proper resolution of the sole issue at bar lies in the construction to be given the words “measure of the tax” as found in the above legislation, particularly section 24425, supra. While there appear to be no California decisions directly in point, two cases are cited by plaintiff in support of its interpretation of the language above quoted. In Burton E. Green Inv. Co. v. McColgan, 60 Cal.App.2d 224, 140 P.2d 451 recovery of deficiency tax assessments paid under protest was sought by plaintiff corporate taxpayer. Previously it had deducted from its taxable income the amount of dividends received from an oil company which, in turn, had derived most of its income during the income year in question from oil and gas production in California. The defendant Tax Commissioner argued that because the oil depreciation allowance (27 1/212%)taken by the oil company actually exceeded its depletion deduction based upon actual cost, such excess of statutory over cost depletion was not a part of the income which had been “included in the measure of the tax” imposed within the meaning of section 8(h) (now section 24402). It was accordingly contended by defendant that only that part of the dividends attributable to that amount of income of the declaring corporation which generated the tax actually paid by that corporation was deductible by plaintiff under section 8(h). Answering such contention, plaintiff argues that even though the oil company did not actually pay tax on all of its income, all of such income was “gross income” and includible, therefore, in the measure of the tax not withstanding the deduction (27 1/212%) therefrom.
The Green court held that it is gross income that is income “included in the measure of the tax”; the oil company dividends having been declared from income which had been included in gross income and, therefore, “in the measure of the tax,” they were held deductible under section 8(h). Important here is the court's reference to then section 9(d), the predecessor of section 24425, for [f]urther proof of the legislative intention.” (P. 233, 140 P.2d p. 456.)
“The language there used refers to income which is excluded from the computation of the franchise tax. That section was designed to prevent corporations from deducting amounts properly allocable to income but not subject to taxation under the Act. The language of Section 9 subd. (d) leaves no doubt that ‘income’ is used in the sense of gross income not subject to the franchise tax. ‘Net income’ could not have been in the mind of the legislature in the phrase, ‘allocable to * * * income not included in the measure of the tax imposed * * *.’ Deductions are not allocable to net income. A deduction expires the moment it is subtracted from the gross income. Throughout the act we are constantly reminded that some deductions are allocable to certain gross incomes. In view of the use of the word income in Section 9, subd. (d) in the sense of gross income we are convinced that it has the same significance in Section 8 subd. (h). The legislature could not have intended to use a significant word in two different senses in the same statute [citations]. * * * Since the gross income and specified deductions are the factors included in arriving at the net income, the conclusion is unavoidable that it is gross income that is included in the measure of the tax.” (60 Cal.App.2d at p. 233, 140 P.2d at p. 456.) In the second of the two cases relied on by plaintiff here, Rosemary Properties, Inc. v. McColgan, 29 Cal.2d 677, at page 687, 177 P.2d 757, the majority of the court quoted with approval from this last excerpt from Green; approval of the reasoning in Green (albeit without direct quotation) is also found elsewhere in the majority opinion. True, as in Green, the Rosemary case did not directly involve the predecessor of section 24425, being concerned (as was Green) with the predecessor of section 24402; however, the two statutes contain identically the same phraseology, “included in the measure of the tax,” the significance and effect of which are noted in the passage from Green already quoted. Too, we agree with plaintiff's contention that the two phrases must be construed together if the purpose of section 24402 is to be effectuated; as well observed by the trial court in the course of a lengthy memorandum opinion rationalizing its determination, the construction of section 24425 contended for by defendant would mean that “the legislature would be giving with one hand (sec. 24402) while taking back with the other (sec. 24425).”
The facts in Rosemary are similar to those in Green except that the subsidiary corporation (Ventura Land and Water Company) had recovered in full the cost depletion for its oil-bearing lands. Ventura nevertheless deducted the statutory 27 1/212% depletion allowance, thus reducing its net income for franchise tax purposes to considerably less than its actual earnings and profits. Defendant Tax Commissioner accordingly contended that since the dividends were paid out of this larger amount of earnings rather than the smaller figure of net taxable income (after deducting the 27 1/212% depletion allowance), the dividends declared and paid to plaintiff taxpayer were declared in part from earnings or profits which had not been “included in the measure of the tax” and, therefore, were not fully deductible to plaintiff as the dividend-receiving corporation. Plaintiff, on the other hand, argued that “income which has been included in the measure of the tax” did not mean statutory net income, as contended both there and here, but referred to gross income subject to taxation by the state; since that item would include earnings and profits attributable to California sources, dividends paid therefrom would be declared from income which has been “included in the measure of the tax.”
The Supreme Court rejected the argument thus advanced by the Tax Commissioner: “The tax in question is not one on income as such but one which the corporation must pay ‘for the privilege of exercising its corporate franchises within this state’ [citation] and ‘according to or measured by its net income.’ (§ 4(3).) As the nature of the tax is distinguished, so is its basis of calculation. Thus, the act uses the term ‘net income’ to specify the sum which, when multiplied by the prescribed percentage rate, determines the amount of the franchise tax. In this sense ‘net income,’ as defined by the act, is the final measure by which the tax is computed. [Citation.] Since ‘net income’ means ‘gross income less the deductions allowed’ (§ 7), these factors necessarily enter into the computation and are included in the measure of the tax. The income involved is all income, including earnings and profits, attributable to California sources; the deductions, including the prescribed depletion rate of 27 1/212 percent of gross income from oil and gas properties, are additional considerations. Following these principles, any dividend paid from ‘earnings and profits'—an item of gross income entering, like the authorized deductions, into the determination of net income—would be a dividend paid out of income included in the measure of the tax. As such the dividend is exempt from franchise tax in the hands of the recipient corporation. * * * This same conclusion was reached in the case of Burton E. Green Investment Co. v. McColgan, 60 Cal.App.2d 224, 140 P.2d 451, with regard to a practically identical factual situation involving the application of section 8(h) in its 1937 form.” (29 Cal.2d 677, at pp. 681–682, 177 P.2d 757, at p. 760.) As further reasons for this interpretation of the phrase, “included in the measure of the tax,” the court discussed the legislative history of section 8(h). As first enacted in 1929 it provided for deductibility of dividends “received during the taxable year from income arising out of business done in this state.” Since this was construed to mean that it did not require dividends to arise out of business done in this state by the declaring corporation (thus permitting the deduction even where the declaring corporation was a foreign corporation and did no business in California but merely owned stock in corporations operating in California [Corporation of America v. Johnson, 7 Cal.2d 295, 299–300, 60 P.2d 417] ), section 8(h) was amended in 1933 to add the requirement that the declaring corporation must have done business in this state and must also be constitutionally taxable in this state. Then in 1937 section 8(h) was amended by deleting the words “arising out of business done in this state” and substituting language permitting the deduction of dividends when declared from “income which has been included in the measure of the tax imposed by this act upon the bank or corporation declaring the dividends.” With reference to these legislative changes the court stated at page 685 of 29 Cal.2d, at page 762 of 177 P.2d: “With its attention so focused on the eliminated provisions, the Legislature in the 1937 amendment apparently considered them unnecessary in view of the new wording, briefer in form, as expressive of the purpose of the deduction to avoid double taxation. Thus the language ‘income which has been included in the measure of the tax’ appears to have a definite connection with the problem of allocating income within and without the state; and appears to refer to income attributable to California sources. Such view of the 1937 amendment coincides with the original purpose of the dividend deduction and with the natural import of the words. (Cf. Burton E. Green Investment Co. v. McColgan, supra, 60 Cal.App.2d 232–233, 140 P.2d 451.)”
A lengthy dissenting opinion, two justices concurring, in Rosemary was filed by Justice Traynor; according to the parties here, such dissent is said to sustain the position presently taken either by plaintiff or defendant, as the case may be. We are of the opinion that the reasoning of the above dissent is not inconsistent with the interpretation claimed by plaintiff for the statutes under consideration. While concluding that the oil depletion allowance in that case served to exclude that portion of the income from the measure of the tax, such determination was reached because of the dissenters' view that no double taxation occurred when the dividend-received deduction was denied. In that regard, it is emphasized throughout the dissent that section 8(h), now section 24402, was designed solely to prevent double taxation of corporate income, which intention should be given effect as against any interpretation tending to the contrary. Since the hypothetical situation in the passage now to be quoted precisely fits the facts at bar,3 it becomes most persuasive authority for plaintiff's position in the premises: “If all of the net income of a corporation is derived from business in California, and all o its earnings or profits are included in the measure of the tax, all dividends declared out of such earnings or profits will be deductible by the recipient corporations. The same income would be taxed twice if it were included in the measure of the tax on the dividend-declaring corporation and included against in the measure of the tax on the recipient corporations.” (29 Cal.2d at p. 689, 177 P.2d at p. 765.)
A still further argument against defendant's interpretation of the legislation in question, wholly apart from the above decisional law, was advanced by the court below in the course of its written memorandum decision: “The fallacy of defendant's position of requiring allocation is shown by the possibility that the parent corporation might not receive any dividends. The fact that a corporation has money invested in stock in subsidiary corporations affords no guarantee that it will, in the future, receive any dividends at all upon its investment. In such event, should it be denied the right to deduct all or any of its operating and interest expense? Certainly not. This, then, would lead to an absurd result. Total deductibility of such operations and interest expense would then depend upon the corporation not receiving any dividend income whatsoever—the moment it did, the extent of deductibility would be reduced and to the extent of that reduction, the dividend income would be taxed a second time. The effect of this is to deny to the corporate taxpayer the benefit of section 24402 dividends because of the extent of the denial of expense deductions related thereto, the taxpayer stands on no better footing than if the declaring corporation had declared the dividends from out-of-state business. The law should not countenance such emasculation of a statute which so clearly reflects the legislative purpose and the public policy which inheres therein.” The above analysis of the instant problem has our full concurrence.
According to defendant, much (if not all) of the persuasiveness inherent in Green and Rosemary was later set at naught by the unanimous decisions in Security-First Nat. Bk. of Los Angeles v. Franchise Tax Bd., 55 Cal.2d 407, 11 Cal.Rptr. 289, 359 P.2d 625, which assertedly requires the interpretation of the several statutes by it contended for. Involved in Security-First National was the question as to whether under statutes predecessor to sections 24404 and 24405, providing for deduction of income received by cooperative associations from business activities on a non-profit basis with non-members, there should be allocated to such deductible income a reasonable share of the operation's expense thereto attributable instead of allowing all such expenses to be allocated solely against income from profit making activities which concededly should be taxable. The court concluded that it was proper under the predecessor to section 24425 to deny deduction of expenses allocable to the production of the deductible income arising from business done with members and non-members on a non-profit basis. Said the court: “The method of calculation urged by plaintiffs would give cooperatives an unwarranted benefit closely akin to a double deduction because they would be entitled to deduct, in addition to gross income from membership and non-profit business, all operating expenses, which would include those attributable to the production of that income. Thus cooperatives would always have a loss from their cooperative business in the amount that expenses were incurred in carrying on that business, and this loss would substantially, if not entirely, offset income from profit-making activities, which should be taxable. In the present cases the trial court found that under the method of calculation urged by plaintiffs all cooperatives would have net losses for the years in question.” (P. 423, 11 Cal.Rptr. pp. 297–298, 359 P.2d pp. 633–634.)
We think that the above holding should be limited to the case of cooperatives, thus distinguishing the decision from the facts at bar. Unlike plaintiff's situation, where the income out of which the dividends were declared had been included in the measure of the tax imposed upon the declaring corporation, in Security-First National the cooperative's income had not yet been taxed, nor would a tax be imposed until it reached the member. This follows from the fact that the excess of a cooperative's receipts over its operating expenses actually belongs to the members and is not the property of the cooperative. See Bogardus v. Santa Ana W. G. Ass'n, 41 Cal.App.2d 939, 948–949, 108 P.2d 52, to the effect that directors of a cooperative hold the property and property rights of the members thereof as trustees. Although there are still other distinctions, it will suffice to point out that the court in Security-First National took cognizance of the holdings in both Green and Rosemary without any disapproving statement of the results there reached, possibly because they “interpret[ed] one provision of the act not involved here * *.” (55 Cal.2d at p. 424, 11 Cal.Rptr. at p. 298, 359 P.2d at p. 634.)
Further support for plaintiff's interpretation of the instant legislation is found by reference to its counterpart in the federal taxation scheme. Thus, section 265(1) of the Internal Revenue Code of 1954 reads as follows: “No deduction shall be allowed for—
“(1) Expenses.—Any amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued wholly exempt from the taxes imposed by this subtitle, or any amount otherwise allowable under section 212 (relating to expenses for production of income) which is allocable to interest (whether or not any amount of such interest is received or accrued) wholly exempt from the taxes imposed by this subtitle.” (Emphasis added.)
The portions of the statute, above emphasized, makes it clear that the only relevant language difference is that section 265(1) refers to classes of income “wholly exempt from the taxes imposed by this subtitle,” while section 24425 refers to income “not included in the measure of the tax imposed by this part.” Since no federal cases have been called to this court's attention in which the Internal Revenue Service has suggested that section 265(1) prevents the deduction of expenses related to the production of dividend income, the apparent lack of litigable controversy in the area becomes significant when cognizance is taken, as it must, of the many holding companies which have dividends as their principal source of income and pay federal income taxes thereon.
In summary, contrary to defendant's apparent position the language of section 24425 is not clear and unambiguous; absent such lack of clarity, the trial court properly applied the settled rule that tax statutes are construed strictly in favor of the taxpayer and against the taxing power. Hence, “Tax courts will not adopt a strained construction to impose a tax that is not a part of the legislative act. Strict construction is reasonable, because presumptively the legislature has given in plain terms all the power intended to be exercised.” (46 Cal.Jur.2d, Taxation, § 30, p. 519.)
The judgment is affirmed.
1. Necessarily read with section 24421, such statute provides that in computing “net income” of taxpayers, no deduction shall be allowed for “Any amount otherwise allowable as a deduction which is allocable to one or more classes of income not included in the measure of the tax imposed by this part, regardless of whether such income was received or accrued during the income year.”
2. Necessarily read with section 24401, such statute provides that in addition to the deductions provided in Article I, there shall be allowed as deductions in computing taxable income “Dividends received during the income year declared from income which has been included in the measure of the taxes imposed under Chapter 2 or Chapter 3 of this part upon the taxpayer declaring the dividends.”
3. The trial court found that “Plaintiff owns stock in a number of subsidiary California corporations which, in turn, derived all of their income from business done in California.”