Is a merger termination fee business income in California, and does it belong in the sales factor?

The base question: business income under the transactional test

California defines business income as income arising from transactions and activity in the regular course of the taxpayer's trade or business, along with income from property whose acquisition, management, and disposition constitute integral parts of the taxpayer's regular operations (RTC 25120(a)). The two clauses are read as independent tests, transactional and functional, and either one makes the income apportionable.

A merger termination fee looks at first like the opposite of regular course activity: it is a one time payment, triggered by a deal that did not happen, under a liquidated damages provision rather than a sale of anything. The court of appeal confronted that argument in the Comcast litigation and held the fee to be business income under the transactional test, reasoning that the taxpayer regularly engaged in mergers and acquisitions, so a payment arising from the collapse of one such transaction arose from the regular course of its business even though the specific event was singular (ComCon Production Services I, Inc. v. Franchise Tax Board (Cal. Ct. App. Dec. 14, 2016, No. B259619)). The Court of Appeal affirmed on December 14, 2016 in an unpublished opinion, which California Rules of Court, rule 8.1115(a) bars courts and parties from citing or relying on, so the decision is best read as a record of how the Franchise Tax Board approaches the question rather than as authority. The frequency of the payment is not the question; the question is whether the activity that generated it, here the ongoing program of acquiring and combining businesses, is part of how the enterprise operates. For a company whose growth runs through acquisitions, a breakup fee is the income of a deal program, and deal programs are business.

The classification matters because business income is apportioned to every state where the recipient files, while nonbusiness income is allocated, typically to the commercial domicile for an intangible receipt of this kind. A taxpayer domiciled outside California generally prefers nonbusiness treatment for a large fee; the transactional test, as applied to serial acquirers, generally forecloses it.

The factor question: the occasional sale rule

Once the fee is in the apportionable base, the instinct is to put the receipt in the sales factor. For taxable years beginning on or after January 1, 2011, the first question is whether the fee is a gross receipt at all. Section 25120(f)(2) limits gross receipts to the gross amounts realized on the sale or exchange of property, the performance of services, or the use of property or capital (including rents, royalties, interest, and dividends) in a transaction that produces business income, and a termination fee paid as liquidated damages fits none of those categories comfortably; section 25120(f)(2)(D) separately excludes damages and other amounts received as the result of litigation. If the fee is not a gross receipt, it is not a sale under section 25120(f)(1) and stays out of the sales factor without reference to the occasional sale rule, which then serves as an alternative ground. The years at issue in the Comcast litigation predate this statutory definition.

Where the fee is treated as a gross receipt, California's special industries and special circumstances regulation interrupts the instinct to include it. Where substantial amounts of gross receipts arise from an occasional sale of a fixed asset or other property held or used in the regular course of the taxpayer's trade or business, those receipts are excluded from the sales factor (Cal. Code Regs. tit. 18, § 25137(c)(1)(A)). The regulation supplies both operative definitions. A sale is occasional if the transaction is outside the taxpayer's normal course of business and occurs infrequently. A sale is substantial if its exclusion results in a five percent or greater decrease in the sales factor denominator, tested for the combined reporting group where one exists, with receipts from the same purchaser in a single year aggregated.

The arithmetic is mechanical and should be run before anything is concluded. Consider a hypothetical group with a thirteen billion dollar denominator receiving a fee approaching two billion dollars; it is far past the line: the fee would be more than a tenth of the potential denominator, and its exclusion would decrease the denominator well beyond five percent. The occasional element is equally straightforward on such facts, since even a serial acquirer does not regularly collect breakup fees; the deal program is regular, the collapse payments are not. That distinction is why the base answer and the factor answer differ without contradiction: the transactional test asks whether the generating activity is regular, while the occasional sale rule asks whether the receipt is, and a regular activity can throw off an irregular receipt.

One application question deserves honesty. The regulation speaks of an occasional sale of a fixed asset or other property, and a termination fee is not the sale of anything; it arrives under a contract provision, not a transfer of property. The regulation's own examples, though, run from factories to patents to stock of an affiliate, and its purpose is distortion control: a large, unusual gross receipt inflates the denominator and dilutes the California percentage without any corresponding California activity, whatever its doctrinal label. The considered position, consistent with how the exclusion has been applied in practice, is that a substantial, occasional receipt of this character falls within the rule, and it is worth noting that in the Comcast litigation it was the Franchise Tax Board itself that excluded the termination fee from the sales factor denominator. A taxpayer arguing for inclusion of a large fee in its denominator should expect to litigate against both the regulation and the agency's demonstrated position.

The procedural trap the case law adds

The Comcast litigation carries a second lesson that has nothing to do with substantive law. The taxpayer sought to challenge the exclusion of the fee from its sales factor denominator in court, and the court refused to hear the argument because the ground had not been raised in the refund claim. California's refund procedure limits the taxpayer to the grounds stated in the claim, so a computation position not preserved at the claim stage is gone regardless of its merits. For any year in which a large unusual receipt was reported, the refund claim should state every ground the taxpayer may want later: the character of the receipt, its inclusion or exclusion from the base, and its treatment in each factor, even the positions that seem secondary at filing.

Practice notes

The termination fee analysis has three parts. First, the character memo: document the taxpayer's deal history, because the transactional test analysis rises or falls on whether acquisition activity is regular, and the record of transactions pursued, completed, and abandoned over the surrounding years is the evidence. A genuine one-off, a company that attempted a single transformative merger and never another, presents a different transactional test case than a serial acquirer, and the memo should say which one the facts support. Second, the substantiality computation: build the sales factor denominator with and without the fee, at the combined group level, aggregate same-purchaser receipts, and state the percentage against the five percent line, because the occasional sale exclusion is not elective and applies by its terms once its conditions are met. Third, the consistency check: the base treatment, the factor treatment, and the filings in other states should tell one coherent story about the same dollars, and where other states include the receipt in their factors, the multistate picture should be reconciled rather than left to surface on audit. And in any refund posture, plead everything: the claim drafted narrowly is the claim that forecloses the argument that turns out to matter. G&G State Tax Group provides apportionment analysis and refund claim representation before the Franchise Tax Board alongside its state and local tax practice.