rr-03-90.pdf

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Part I

Section 461. – –General Rule for Taxable Year of Deduction

26 CFR 1.461-1: General rule for taxable year of deduction.
(Also § 164; 1.164-1.)

Rev. Rul. 2003-90

ISSUE

For taxable years beginning on or after January 1, 2000, when does a taxpayer
using an accrual method of accounting incur a liability for California franchise tax for
federal income tax purposes?

FACTS

X is a corporation that uses an accrual method of accounting and files its federal
income tax return on a calendar year basis. X has conducted business in California
continuously for several years and is required to pay a franchise tax imposed under §
23151 of the California Revenue & Taxation Code (Cal. Rev. & Tax. Code) (West 1998
& Supp. 2002). In 2002, X has net income attributable to California of $10,000. X
remits payments of estimated California franchise tax of $884 during 2002. Under
California law, X’s franchise tax liability for 2002 is $884, determined on the basis of X’s
2002 net income attributable to California of $10,000.

LAW AND ANALYSIS

Section 164(a) of the Internal Revenue Code allows a deduction for certain taxes
paid or accrued during the taxable year including state franchise taxes imposed on
corporations.

Section 461(a) provides that the amount of any deduction or credit is taken for
the taxable year that is the proper taxable year under the method of accounting used in
computing taxable income.

Section 1.461-1(a)(2)(i) of the Income Tax Regulations provides that under an
accrual method of accounting, a liability is incurred in the taxable year in which all the
events have occurred that establish the fact of the liability, the amount of the liability can
be determined with reasonable accuracy, and economic performance has occurred with
respect to the liability. Section 1.461-4(g)(6)(i) generally provides that if the liability of a
taxpayer is to pay a tax, economic performance occurs as the tax is paid to the
governmental authority that imposed the tax.

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However, § 461(d) provides that, in the case of a taxpayer whose taxable income
is computed under an accrual method of accounting, to the extent the time for accruing
a tax is earlier than it would have been but for any action of any taxing jurisdiction taken
after December 31, 1960, the tax is to be treated as accruing at the time it would have
accrued but for the action by the taxing jurisdiction. Section 1.461-1(d)(1) provides that
any action by a taxing jurisdiction that results in the acceleration of the accrual of any
tax is to be disregarded in determining the time for accruing the tax for purposes of the
deduction allowed for the tax, with respect to both taxpayers upon which the tax is
imposed at the time of the action, and taxpayers upon which the tax is imposed at any
time subsequent to the action.

Section 1.461-1(d)(1) further provides that, whenever an acceleration of the time
for accruing a tax is to be disregarded, the taxpayer shall accrue the tax at the time the
tax would have accrued but for the accelerating action (original accrual date). Section
1.461-1(d)(1) also provides that in the absence of any action of the taxing jurisdiction
placing the time for accruing the tax at a time subsequent to the original accrual date,
the taxpayer shall continue to accrue the tax as of the original accrual date for all future
taxable years.

Section 1.461-1(d)(2)(iii) provides that the term "any action" includes the
enactment or re-enactment of legislation, the adoption of an ordinance, the exercise of
any taxing or administrative authority, or the taking of any other step, the result of which
is an acceleration of the accrual event of any tax.

Cal. Rev. & Tax. Code § 23151 (West 1998 & Supp. 2002) imposes a franchise
tax for the privilege of doing business as a corporation within California. For years
beginning before January 1, 2000, the tax generally was measured by the net income of
the year preceding the year for which the tax was imposed, subject to a minimum tax,
with special rules for corporations commencing or ceasing business in California. Cal.
Rev. & Tax. Code, § 23151.1 (West 1998 & Supp. 2002). The year in which the tax was
imposed and payable was a corporation's “taxable year” (“California taxable year”). Cal.
Rev. & Tax. Code § 23041(a) (West 1998 & Supp. 2002). The income year (“California
income year”) was defined as the "year upon the basis of which the net income is
computed." Cal. Rev. & Tax. Code § 23042(a) (West 1998 & Supp. 2002). Thus, in the
case of an ongoing corporation, the tax due for a California taxable year for the privilege
of exercising the corporate franchise during the California taxable year was calculated
based on the net income earned during the preceding year (the California income year).

Under pre-1961 California law, a corporation’s liability for the franchise tax
became fixed upon the corporation’s exercise of the franchise in the California taxable
year.
Central Investment Corporation v. Commissioner
, 9 T.C. 128 (1947), aff'd 167
F.2d 1000 (9th Cir. 1948). A corporation that ceased to do business in California had
no liability to pay franchise tax measured by income earned in the final year of operation

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if the corporation did not exercise its franchise in the following California taxable year.
Thus, under pre-1961 California law, a continuing corporation did not have a fixed
liability to pay California franchise tax with respect to income earned in Year 1 (the
California income year) until the corporation exercised its corporate franchise in Year 2
(the California taxable year). As a result, for purposes of § 1.461-1(a)(2), the
corporation did not have a fixed liability in Year 1 for the California franchise tax with
respect to income earned in Year 1, but rather the liability for California franchise tax
with respect to income earned in Year 1 became fixed in Year 2, when the corporation
exercised its corporate franchise. See
Hallmark Cards , Inc. v. Commissioner
, 90 T.C.
26 (1988).

Rev. Rul. 79-410, 1979-2 C.B. 213, addresses the timing of the deduction for
California franchise tax liabilities and the application of § 461(d) to California law for
years after 1972. Amendments to California law in 1971 and 1972 required a
corporation ceasing to do business after December 31, 1972, to pay a franchise tax in
its final year of operation based upon both the preceding year's net income and the net
income earned in the corporation’s final year. The ruling concludes that the 1971 and
1972 amendments caused the liability for California franchise tax to become fixed for
purposes of § 1.461-1(a)(2) in the California income year. However, because the fixing
of the liability in the California income year was earlier than when the liability became
fixed under pre-1961 California law, the ruling concludes that, pursuant to § 461(d), the
amendments are disregarded and the liability continues to be incurred for federal
income tax purposes in the California taxable year, the taxable year in which the liability
became fixed under pre-1961 California law. See also
Epoch Food Service, Inc. v.
Commissioner, 72 T.C. 1051, 1054 (1979).

For taxable years beginning on or after January 1, 2000, the Cal. Rev. & Tax
Code was amended to replace references to the term “income year” with the term
“taxable year” (“redefined California taxable year”). Cal. Rev. & Tax. Code § 23042(b)
(West Supp. 2002). As a result, the California franchise tax is measured by the net
income of the year in which the tax is imposed and payable. Cal. Rev. & Tax. Code §
23151.1(c)(2) (West Supp. 2002). The transition year (2000) was the California taxable
year under the former law with respect to income earned in 1999, and also the
redefined California taxable year under the amendment for income earned in the first
taxable year beginning on or after January 1, 2000. The accompanying legislative
history states, however, that there was no intent to change the amount of tax or the
timing of payment. See 2000 Cal. Stat. 862 (Sept. 29, 2000).

Under § 1.461-1(a)(2)(i), the liability for California franchise tax is established and
the amount can be determined with reasonable accuracy in the taxable year that the net
income is earned. However, when compared to pre-1961 California law, the 2000
amendment to the California law, like the 1971 and 1972 amendments, accelerates the
accrual of the franchise tax for a continuing corporation from the taxable year following
the taxable year in which the net income is earned to the taxable year in which the net

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income is earned. Thus, pursuant to § 461(d), the 2000 amendment must be
disregarded and the liability for California franchise tax continues to be incurred for
federal income tax purposes in the California taxable year, the taxable year in which the
liability became fixed under pre-1961 California law.

Therefore, for taxable years beginning on or after January 1, 2000, X incurs a
liability for California franchise tax for federal income tax purposes in the taxable year
that follows the taxable year in which X earns the income on which the tax is measured.
The California franchise tax of $884 that X pays in 2002, based on the $10,000 of net
income that X earns in 2002, is deductible on X’s federal income tax return for taxable
year 2003.

HOLDING

For taxable years beginning on or after January 1, 2000, a taxpayer that uses an
accrual method of accounting incurs a liability for California franchise tax for federal
income tax purposes in the taxable year following the taxable year in which the
California franchise tax is incurred under the Cal. Rev. & Tax. Code, as amended.

EFFECT ON OTHER DOCUMENTS

Rev. Rul. 79-410 is amplified.

DRAFTING INFORMATION

The principal author of this revenue ruling is Sean M. Dwyer of the Office of
Associate Chief Counsel (Income Tax and Accounting). For further information
regarding this revenue ruling, contact Mr. Dwyer at (202) 622-5020 (not a toll-free
number).