Do gains from hedging, treasury activity and foreign currency belong in the sales factor, and if so at gross or net and sourced where?

A partnership holds an interest-rate swap on its borrowings, a currency option that hedges a loan denominated in euros, a gain under Internal Revenue Code section 987 from a foreign branch, and a small trading book. Three questions follow for each item. First, does the receipt enter a state's sales factor? The sales factor is the fraction of a taxpayer's receipts that apportions business income to a state: the receipts assigned to the state (the numerator) divided by the receipts everywhere (the denominator). Second, if the receipt enters the factor, is it counted gross or net? Third, which state receives the numerator? Each state's own definition of receipts decides. For several states, no published source answers one or more of the three questions. A separate article in this library covers gross proceeds against net gains for securities, dividends and interest in an investment partnership's factor. This article goes item by item through hedging, treasury and currency receipts.

What federal law settles before a state rule applies

Three federal labels matter. Foreign currency gain or loss on a debt instrument, a payable or receivable, or a currency forward, future or option is ordinary and computed separately under I.R.C. section 988. A branch's currency gain on remittances under section 987 is ordinary and takes its source from the earnings it relates to. The section 987 regulations were not reviewed. Under I.R.C. section 1221(a)(7) and (b)(2) and Treas. Reg. section 1.1221-2, a hedge entered in the normal course of business to manage interest rate, price or currency risk is not a capital asset if the taxpayer identifies it as a hedge before the close of the day it is entered. The regulation also requires identification of the item or risk hedged.

Two federal mechanics decide whether a receipt exists before any state rule applies. First, a swap settles net, meaning the parties exchange only the difference between what each owes. The net income or net deduction from a notional principal contract for the year is included in or deducted from gross income, and each periodic payment is recognized ratably for the year it relates to (Treas. Reg. section 1.446-3(d) and (e)(2)(i)). A swap whose settlements net to a payment for the year therefore produces a net deduction and no item of gross income. Second, a currency option that hedges a euro loan held as an asset can be identified and integrated with the loan under section 988(d), so that the two are treated as a single transaction and no separate option gain is recognized. An option that is not identified or not integrated produces its own gain at settlement.

These federal results do not decide a state factor. Each state starts from its own definition of receipts.

California: a gross receipt first, then two defined exclusions

For taxable years beginning on or after January 1, 2011, Cal. Rev. and Tax. Code section 25120(f)(2) defines gross receipts as "the gross amounts realized (the sum of money and the fair market value of other property or services received) 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, in which the income, gain, or loss is recognized (or would be recognized if the transaction were in the United States) under the Internal Revenue Code, as applicable for purposes of this part." The statute then lists items that are not gross receipts even if they are business income, among them the repayment, maturity or redemption of the principal of a loan or similar instrument. That exclusion removes the principal repayment of a euro loan from the factor.

The FTB's likely order of analysis, on the statute and the cases, has four steps. First, whether there is a receipt. Second, whether a listed exclusion removes it. Third, whether section 25137 is invoked, by the FTB or the taxpayer, with the clear and convincing burden; that section allows a different formula when the standard one does not fairly represent the taxpayer's activity in the state. Fourth, the numerator, which is the share of the receipts assigned to California. Three consequences follow from the wording.

• On a sale or exchange the amount realized "shall not be reduced by the cost of goods sold or the basis of property sold," so a disposition is measured by its proceeds, not its gain.
• The federal requirement that income be recognized under the Internal Revenue Code comes first. A swap's year-end net deduction is not a recognized item of gross income, and an option integrated under section 988(d) has no separately recognized gain. No source reviewed answers whether a swap's net periodic income, or a section 987 remittance gain, is an amount realized on the use of capital or on an exchange. That is open.
• The statute has no rule for netting hedges, that is, offsetting gains against losses. It removes whole categories, and subparagraph (K) speaks of "gross receipts and overall net gains" from disposing of treasury-function assets.

Exclusion does not change character, meaning whether income is business or nonbusiness. Section 25120(f)(3) provides that "Exclusion of an item from the definition of 'gross receipts' shall not be determinative of its character as business or nonbusiness income."

The treasury function exclusion: what it removes and what it may reach

Subparagraph (K) of section 25120(f)(2) excludes "Amounts received from transactions in intangible assets held in connection with a treasury function of the taxpayer's unitary business and the gross receipts and overall net gains from the maturity, redemption, sale, exchange, or other disposition of those intangible assets." It defines a treasury function as "the pooling, management, and investment of intangible assets for the purpose of satisfying the cash flow needs of the taxpayer's trade or business, such as providing liquidity for a taxpayer's business cycle, providing a reserve for business contingencies, and business acquisitions, and also includes the use of futures contracts and options contracts to hedge foreign currency fluctuations."

The definition has two parts joined by "and also includes." The second part is definitional and states no condition on the first. The FTB's likely reading is that any use of futures or options to hedge foreign currency fluctuations is, to that extent, a treasury function. That reading cuts against a taxpayer that wants a currency hedge gain in its denominator, and the text reviewed does not rule it out. No source reviewed answers whether the second part requires a cash-management pool. No source answers either whether currency forwards and swaps are "futures contracts and options contracts"; the statute names only futures and options, and no source defines either term for this purpose.

The FTB's likely reading of the first part also reaches a swap on the taxpayer's own debt, on the view that managing the cost and timing of borrowings is the management of intangible assets to meet cash flow needs. No pronouncement applying subparagraph (K) to a swap was found.

A lender's small trading book is, on the definition's first example, an investment of intangibles to provide liquidity. On the statute's words, the book falls outside (K) only in one of two situations. One is facts showing a profit-seeking trading account run for gain rather than a liquidity reserve. The other is a taxpayer "principally engaged in the trade or business of purchasing and selling intangible assets of the type typically held in a taxpayer's treasury function, such as a registered broker-dealer," which the last sentence of (K) says is not performing a treasury function as to income so produced. FTB Chief Counsel Ruling 2012-01 (April 30, 2012) applies the last sentence of (K) to a registered broker-dealer and says nothing on hedging, swaps or exclusion (L).

The regulation repeats the structure for interest, dividends and dispositions, for taxable years beginning on or after January 1, 2007 (operative May 29, 2008) (Cal. Code Regs., tit. 18, section 25137(c)(1)(D)). It adds two points. First, a treasury function "does not include a taxpayer's trading function that engages in futures and option transactions" for the purpose of hedging price risk of the taxpayer's own products or commodities. Second, "This subsection shall not apply to entities that apportion their income under the rules of regulation 25137-4.2."

The hedging exclusion is narrower than the word suggests

Subparagraph (L) excludes "Amounts received from hedging transactions involving intangible assets." It defines a hedging transaction as "a transaction related to the taxpayer's trading function involving futures and options transactions for the purpose of hedging price risk of the products or commodities consumed, produced, or sold by the taxpayer."

On those words, an interest-rate swap on the taxpayer's debt is not a futures or options transaction, and its risk is not the price of a product or commodity. A currency hedge on a loan held as an investment hedges currency risk on a financial asset, not the price of a product or commodity. No FTB ruling, regulation or opinion applying (L) to either was found, so whether (L) reaches an interest-rate swap or a currency hedge of a financial asset is open. The words fit the pattern of the General Mills dispute, in which futures hedged a grain purchaser's commodity price. In 2012 the Court of Appeal noted that the "2009 amendment to section 25120 will require hedging gross receipts to be excluded from the UDITPA sales factor". UDITPA is the Uniform Division of Income for Tax Purposes Act, enacted in California as sections 25120 through 25139. The court's note suggests (L) was written for that pattern, which would explain why it is narrow.

How the California rules developed and what General Mills decided

The exclusions arrived in steps, and two appellate decisions on hedging came between them.

In Microsoft Corp. v. Franchise Tax Board (2006) 39 Cal.4th 750, the Supreme Court held three things. The redemption of short-term marketable securities held by a treasury department generated gross receipts for the sales factor. Section 25137 relief was available. An alternative formula including only net receipts from the redemptions was reasonable. FTB Notice 2006-3 (September 28, 2006) then said that a taxpayer that excluded redemption amounts and included only interest income and net gains would not face the accuracy-related penalty, leaving the exclusion itself subject to audit. The decision and the Notice both predate the 2007 regulation and the 2011 statute and are history, not current rules.

General Mills, Inc. v. Franchise Tax Board (2009) 172 Cal.App.4th 1535 ("General Mills I") held that the full sales price of commodity futures contracts used to hedge a grain purchaser's purchases was gross receipts under section 25120, subdivision (e), as it then read. The full sales price was the number of bushels times the price. The court remanded for a decision whether the FTB could impose an alternative formula under section 25137. General Mills, Inc. v. Franchise Tax Board (Cal. Ct. App., 1st Dist., 2012), No. A131477, filed August 29, 2012 ("General Mills II"), affirmed the judgment upholding that alternative for the tax years ending May 1992 through May 1997. The formula, "including only the net gains" from the futures sales, "is reasonable and may be imposed consistent with UDITPA." The futures activity produced about 19 percent of gross receipts and essentially no net income, and "Even an average 8.2 percent distortion of income is not insubstantial."

The cases, not section 25137, supply the burden. General Mills II states that the FTB "has the burden of proving by clear and convincing evidence" that the standard formula does not fairly represent the taxpayer's activity in the state and that its alternative is reasonable, citing Microsoft, 39 Cal.4th at p. 765. General Mills II also cites Microsoft at page 771, with a "Cf." signal, as noting that in some cases counting only net treasury receipts in the sales factor "may go too far in the opposite direction and fail the test of reasonableness." A net gains alternative is therefore a remedy to be proved on the facts, not a default, and it is the only California netting route found for hedge or trading receipts.

The regulation followed in 2008. It carves a trading function's futures and options hedges of the taxpayer's own commodity price risk out of the treasury function. Those receipts therefore stayed in the factor for taxable years 2007 through 2010, subject to section 25137. Subparagraph (L) removes them for years beginning on or after January 1, 2011.

Section 25128.9, effective June 27, 2024, removes from the apportionment formulas a transaction or activity "to the extent that it generates income or loss not included in" net income subject to apportionment, for any reason, "including, but not limited to, exclusion, deduction, exemption, elimination, or nonrecognition." The Legislature declared the section "declaratory of, existing law," and it applies to taxable years beginning before, on or after its effective date. It matters to a hedge only if the hedge income is itself outside net income. On its words, it would remove the separate gross payments in each direction of a swap to the extent only the net amount reaches net income.

In the Appeal of Microsoft Corporation and Subsidiaries (OTA, July 27, 2023, 2024-OTA-130; rehearing opinion February 14, 2024, 2024-OTA-131), the Office of Tax Appeals read section 25120(f)(2) as including gross rather than net amounts and treated dividends as gross receipts with no applicable exclusion. Both copies reviewed are marked nonprecedential, and both predate section 25128.9.

Where California assigns a hedge receipt that stays in the factor

Where a hedge receipt stays in the factor, the next question is where it is assigned. Cal. Code Regs., tit. 18, section 25136-2, in its final text for taxable years beginning on or after January 1, 2026, assigns interest on investments to California if the investment is managed there. It assigns interest on loans secured by real property by the property's location, and interest on unsecured loans by the borrower's location. No rule in the final text names a hedge, derivative, swap, currency or treasury item. A counted hedge receipt that is a gross receipt from intangible property therefore falls to the two fallbacks for intangible property. The first assigns the receipt to the location where the property is used, reasonably approximated ((d)(1)(B)). The next uses the purchaser's billing address ((d)(1)(C)). No rule applies either fallback to a hedge receipt by name. Where the counterparty is outside California, a rule that follows the payor, purchaser or billing address gives a numerator of zero. That result follows from the counterparty's location and is not a rule written for hedges.

Massachusetts and Oregon: the model exclusion and the definition of security

The Multistate Tax Compact, Article IV, section 1(g), as amended July 30, 2014, excludes receipts from hedging transactions and from the maturity, redemption, sale, exchange, loan or other disposition of cash or securities. The Multistate Tax Commission's model regulation, as adopted in 2018, adds a purpose test for hedging. It says that tax or accounting treatment is evidence of that purpose but not determinative. It also excludes receipts from holding or disposing of cash or securities whether or not the purpose is hedging. A model binds only a state that enacts it.

Massachusetts excludes from "sales" interest, dividends and gross receipts from the maturity, redemption, sale, exchange or other disposition of securities (Mass. Gen. Laws ch. 63, section 38). The statute's definition of security, in subsection (h)(6), begins "any interest or instrument commonly treated as a security" and illustrates it with "cash and cash equivalents including foreign currencies and repurchase and futures contracts." The statute does not mention hedging, options, swaps or derivatives. 830 CMR 63.38.1(9)(a) lists the same exclusions without addressing hedging in the parts reviewed. A disposition of currency and a futures hedge are therefore reached through the definition. Whether a swap or option is an instrument "commonly treated as a security" is open. Section 475(c)(2) of the Internal Revenue Code names notional principal contracts and options among securities for the federal dealer rule. That is a lead and no more, because no Massachusetts pronouncement applying the term to a swap or option was found.

Oregon's rule, OAR 150-314-0425, applies to tax years beginning on or after January 1, 2018. It excludes "Sales of a taxpayer from hedging transactions" where the primary purpose of the activity is "to reduce the exposure to risk" caused by other business activities. Separately, it excludes receipts from holding or disposing of cash or securities, whether or not the transaction is a hedge. Its definition of security opens "any interest or instrument commonly treated as a security" and lists "cash and cash equivalents including foreign currencies" and "repurchase and futures contracts." The rule names no options, swaps or forwards. On those words, Oregon's hedging purpose test would reach the example's swap and currency option.

Illinois: the only state reviewed that ties a hedge to the receipt it relates to

Illinois defines a hedging transaction as one that is "entered into by a taxpayer in the normal course of business" and made "primarily to manage interest rate risk or the risk of price or currency fluctuations" (86 Ill. Adm. Code 100.3380(c)(6)(A)). Income, gain or loss from a hedge identified as such under the Internal Revenue Code "shall be excluded from the numerator and denominator of the sales factor" ((c)(6)(B)). Two rules keep a hedge in line with what it hedges. First, a hedge of sales receipts follows those receipts, in the denominator when they are included and in the numerator in the same proportion ((c)(6)(C)). Second, section 988 gain or loss on accrued interest, debt instruments, payables, receivables or forward contracts adjusts the related income and is sourced the way that income is sourced. Currency gain on principal repayment is excluded from both factors because principal repayment is not sales factor income ((c)(7)(A)). Hedges of expense-side risk, and hedges that cannot be linked to a particular transaction or class, are excluded. The books and records must tie the hedge to specific receipts at the time the federal rules require ((c)(6)(D)). A hedge integrated with the hedged item for federal tax purposes is outside the subsection ((c)(6)(E)). Currency gain or loss under section 986(c)(1) on distributions of previously taxed income is excluded from both factors ((c)(7)(B)).

The rule does not name either a hedge of the taxpayer's own borrowing or a currency hedge of a loan held as an asset, but its structure answers each. A swap on the partnership's own debt hedges a cost and is excluded if identified. A currency option integrated with the loan falls outside (c)(6) and is governed by (c)(7)(A). A currency option that is identified and not integrated is excluded by (c)(6)(B). A section 987 item is not named in (c)(7) and is open. A trading book goes to 86 Ill. Adm. Code 100.3370(c)(8)(C). For a dealer that marks its securities to market under section 475, that rule sources interest, net gains (never below zero) and other income from intangible personal property by the customer's location. For other taxpayers it uses the income-producing activity. It also excludes a dealer's mark-to-market gain or loss outside a customer transaction from both factors. Other states differ in kind: Oregon names a hedging exclusion and Texas names hedges and swaps in its sourcing rule, but neither ties the hedge to the receipt it relates to.

Florida and Pennsylvania: securities excluded by statute

Florida defines "sales" as all gross receipts of the taxpayer "except interest, dividends, rents, royalties," "and gross receipts from the sale, exchange, maturity, redemption, or other disposition of securities" (Fla. Stat. 220.15(5)(a)). The statute does not define "securities" and has no hedging, currency or treasury words. Whether futures, options, swaps or currency dispositions are securities in Florida is therefore open. For a financial organization the statute counts "Gross profits from trading in stocks, bonds, or other securities managed within this state" (220.15(5)(c)2). The rule, Fla. Admin. Code r. 12C-1.0155, adds no hedge text in the copy reviewed. No Florida hedging position is stated here.

Pennsylvania excludes from "sales" gross receipts from the sale, redemption, maturity or exchange of securities "except those held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business" (72 P.S. 7401(3)2.(a)(1)(E)). Subparagraph (17)(E) sources the receipts from securities held for sale to customers to Pennsylvania "if the customers are in this State." For taxable years beginning after December 31, 2022, subparagraph (17)(K) provides that gross receipts "received from intangible property, not otherwise described in this paragraph," "shall be excluded from the numerator and the denominator of the sales factor." Subparagraph (17)(H) sources interest on loans made by a corporation that "regularly lends funds to unaffiliated entities or to individuals" by the borrower's location: Pennsylvania receives the numerator if "the borrower is located in this State."

On the words reviewed, a swap settlement, a currency option gain and a section 987 gain are receipts from intangible property that no other subparagraph of (17) describes, so Pennsylvania removes them from both factors. A trading book's proceeds are outside "sales" except where the securities are held for sale to customers.

New York, Texas and New Jersey: sourcing in place of exclusion

New York. Tax Law section 210-A has no hedging or foreign currency text. For the category of other financial instruments, two rules apply. Interest enters the numerator "if the payor is located in the state," as the statute puts it. "Net gains (not less than zero) from sales of other financial instruments" enter by the ratio of gross proceeds from New York purchasers to gross proceeds from all purchasers. These rules are in section 210-A(5)(a)(2)(H) and 20 NYCRR 4-2.12(d)(3)(i). Under 20 NYCRR 4-2.12(d)(2), gains and losses are netted within each type of instrument, "provided the result cannot be less than zero," and "gains from one type of financial instrument cannot offset losses from another type of financial instrument." Example 6 treats foreign currency swaps as one type of other financial instrument and foreign government debt as another. That suggests the residual category of other financial instruments is where a swap falls if no specific clause describes it. The regulation does not mention hedging or interest-rate swaps. A swap that nets to a payment for the year gives zero under subdivision (d)(2) or under subdivision (e), "Other income (not less than zero)." A corporate taxpayer that marks a qualified financial instrument to market under I.R.C. section 475 or 1256 may elect annually, on its original timely return, to include "eight percent of all net income (not less than zero) from qualified financial instruments" in the numerator (section 210-A(5)(a)(1); 20 NYCRR 4-2.11). A swap can be marked to market only under section 475, because section 1256(b)(2) excludes interest rate and currency swaps from section 1256 contracts. A non-dealer partnership without a section 475 election therefore has no marked swap. A separate article in this library covers New York's two methods for an investment partnership's factor.

Texas. 34 Tex. Admin. Code section 3.591(e)(10) provides that "Gross receipts from the settlement of financial derivatives contracts, including hedges, options, swaps, futures, and forward contracts, and other risk management transactions are sourced to the location of the payor." The rule does not say what amount counts as the gross receipt from a settlement. For futures that are securities, a published decision answers that question. CITGO Petroleum Corp. v. Hegar, No. 03-21-00011-CV (Tex. App.-Austin, October 14, 2021), was a franchise tax case for report years 2008 and 2009. The court held that commodity futures contracts "met the definition of 'security' in Texas Tax Code section 171.0001(13-a)," that the taxpayer "did not hold these securities as inventory," and that "the gross proceeds of the sale of those securities could not be considered gross receipts." It rejected the argument that a federal mark-to-market election made the contracts inventory. On the decision, a hedge instrument that is a security and not federal inventory therefore counts at net proceeds in Texas, consistent with Tex. Tax Code sections 171.106(f) and 171.1011(g-2) and with the rule that "Securities and loans held for investment, hedging, or risk management purposes are not inventory" (section 3.591(b)(5)). The decision's review status was not confirmed. Whether a swap is a "security" is open. The statutory definition takes its meaning from section 475(c)(2) of the Internal Revenue Code, which names notional principal contracts, a lead that suggests a swap may be a security, but no decision or Texas Comptroller pronouncement applying it to a swap was found. For other capital assets and investments, the rule provides that "A net loss from the sale of a capital asset or investment is not included in gross receipts," and netting across sales was allowed only for reports originally due before January 1, 2021 (section 3.591(e)(2)).

New Jersey. N.J.A.C. 18:7-8.9 excludes receipts from sales of capital assets from the numerator and denominator. It counts net gains from capital assets only when they come from operational income. It provides that a net loss does not offset a net gain in the numerator. If trading securities and other financial instruments is the taxpayer's business, those assets are not capital assets, and receipts follow the federal accounting method. This text was amended effective June 16, 2025; the 2017 text treated own-account trading proceeds on a net basis. Other intangible income is sourced by the intangible's taxable situs, which generally follows the owner's or creditor's commercial domicile, in general terms where the business is based (N.J.A.C. 18:7-8.12(e)). Neither regulation mentions hedging, and the receipts fraction of N.J.S.A. 54:10A-6 carries no hedging or securities words.

Foreign currency gains and section 987

No source reviewed treats a section 987 remittance gain by name. Illinois addresses section 988 items and section 986(c) distributions. Massachusetts and Oregon treat foreign currencies as securities whose dispositions are excluded. California names futures and options hedging foreign currency inside its treasury function definition. New York treats foreign currency swaps as a separate type for netting. Pennsylvania removes intangible receipts that no other subparagraph describes. Texas, New Jersey and Florida have no foreign currency text in the sales factor provisions reviewed. For a section 987 gain, each state's general intangible and gross receipt rules apply, and the section 987 regulations and state conformity to them were not reviewed.

In California the threshold question is whether anything is received. A possible FTB position has three parts. A remittance moves the taxpayer's own funds from branch to home office. No money or property is received from another person, so there is no gross receipt at all. The gain is in net income and outside the factor, a result section 25128.9 leaves alone. The taxpayer's answer is the Office of Tax Appeals' reading in Microsoft that an amount in a business income transaction is a gross receipt unless a listed exclusion applies. No pronouncement chooses between the two.

Who counts as being in the business

The line between a taxpayer whose receipts stay in and one whose receipts come out is drawn differently in each state.

• California withholds the treasury exclusion from a taxpayer principally engaged in buying and selling treasury-type intangibles, such as a registered broker-dealer.
• Illinois separates a section 475 dealer, whose customer transactions are sourced by customer and whose mark-to-market gain outside a customer transaction is excluded, from a non-dealer.
• New Jersey treats securities trading that is the taxpayer's business as outside the capital asset rule, with receipts following the federal accounting method.
• Pennsylvania keeps securities receipts in for a taxpayer holding them primarily for sale to customers.
• Florida counts gross profits from trading securities managed in Florida for a financial organization.
• Texas counts gross proceeds only where the security is federal inventory, and the CITGO footnote says that taxpayers who buy, sell or hold securities "for investment or speculation" are not dealers.
• Massachusetts, Oregon and the model regulation carry no such carve-out in the text reviewed.

On its face, a dealer line does not describe an investment partnership with a small trading book beside a lending business. The California definition's first example, liquidity, could describe the book. Classification depends on the facts and the text.

The partnership layer

In California the business or nonbusiness character of a partnership item is determined at the partnership level (Cal. Code Regs., tit. 18, section 25137-1(a)). A corporate partner unitary with the partnership (operating with it as one business) includes its share of the partnership's factors, and the partnership's sales that give rise to business income are in the denominator. For a non-unitary partner, the partnership's own factors apportion its business income. For a nonresident individual partner, the partnership's business income is apportioned at the partnership level unless the partnership and the partner's business are unitary. A nonbusiness item is sourced as if the partner had earned it individually (section 17951-4(d)). Intangible income of a nonresident is California source income only if there is a business situs or regular, systematic buying and selling in California, and the second of those reaches the profit or gain from the trading, not all intangible income (Cal. Rev. and Tax. Code section 17952).

No sentence reviewed says whether the treasury function test applies at the partnership or at the partner, and that is open. The FTB's likely reading, on the words, is that it applies at the partnership. Four provisions point that way. Subparagraph (K) speaks of "a treasury function of the taxpayer's unitary business". Regulation 25137-1(a) classifies at the partnership level. Subdivision (f)(3) routes the partnership's sales through the sales factor regulations and section 25137(c), which holds the rule at (c)(1)(D). Regulation 17951-4(d)(1) applies the partnership's own factors to a nonresident partner. Those words support applying the exclusion in computing the partnership's sales before the partner takes its share.

A further threshold question comes before (c)(1)(D). The regulation does not apply to entities that apportion under Regulation 25137-4.2, and that regulation applies to a bank or financial corporation (subdivision (a)(1)). For taxable years beginning on or after January 1, 2025, section 25128(c)(2) no longer lists banking or financial business activity as a qualified business activity. The example states that the partnership is not a bank or a financial corporation, so (c)(1)(D) applies to it.

Exclusion from the factor does not change business character, so a hedge gain can be business income apportioned by a factor that does not contain its receipt. A separate article in this library covers whether a corporate limited partner in a fund apportions or allocates its California income and takes classification as given.

A worked example

Facts (invented). In 2026 an investment partnership, taxed as a partnership, originates and holds loans and keeps a small trading book. It is not a bank or a financial corporation, so Regulation 25137-4.2 does not apply to it and section 25137(c)(1)(D) does. It has no operations in California beyond borrowers there. A corporate partner owns 40 percent and a nonresident individual owns 20 percent. Every swap, option and trading counterparty, and the foreign branch, is outside California, so any payor, purchaser or billing-address rule gives a California numerator of zero for those items. That zero follows from the invented facts; no rule names the hedge items for the numerator, and the example applies no other assignment rule to them.

Loan interest is $20,000,000, of which $4,000,000 is interest on unsecured loans to California borrowers. Net income before expenses is $20,200,000: loan interest $20,000,000, trading gain $200,000, a swap net deduction of $300,000, an option gain of $600,000 offset by a $600,000 section 988 loss on the euro loan's principal, and a section 987 gain of $300,000. Interest expense and other costs of $17,200,000 leave $3,000,000 of business income. The swap's settlements went the partnership's way in some periods ($400,000 received in total) and against it in others ($700,000 paid in total), so the year's net is a $300,000 payment. The currency option is not identified as a section 988 hedging transaction and is not integrated with the euro loan, which the partnership held as an asset and which was repaid in 2026. The trading book is a profit-seeking account run for gain, not a liquidity reserve, and the partnership is not principally engaged in buying and selling intangibles.

The five items (Readings A to D are defined in the next list).

• Loan interest, $20,000,000, numerator $4,000,000. Counted: interest on the use of capital in a business income transaction.
• Swap on the partnership's debt: $400,000 received and $700,000 paid, a net payment of $300,000. Reading A counts the $400,000 as money received. The Internal Revenue Code nets the swap for the year, so whether the periodic receipts are gross receipts at all is open, and (K) may reach the swap.
• Currency option on the euro loan: $600,000 gain at settlement. The loan's principal repayment is excluded by section 25120(f)(2)(A), and the $600,000 section 988 principal loss is not a negative receipt. The gain is a candidate receipt because the option is not integrated, and it is out if (K) reaches an option hedging foreign currency fluctuations. Had the option been identified and integrated under section 988(d), there would be no separate gain.
• Section 987 gain on a foreign branch remittance, $300,000. Whether anything is received is open; if counted, it is in the denominator.
• Trading book: $5,000,000 of proceeds on sales ($4,800,000 basis, $200,000 net gain). Proceeds are counted at gross because amounts realized are not reduced by basis. They would be excluded only if the securities were held in a treasury function, and on these facts they are not. The net gains alternative of General Mills II would apply here (Reading D).

Denominators and factors, each with a numerator of $4,000,000.

• Reading A, every item counted: $20,000,000 + $400,000 + $600,000 + $300,000 + $5,000,000 = $26,300,000, a factor of 15.21 percent.
• Reading A without the swap, because the federal year-level netting leaves no gross item: $25,900,000, 15.44 percent.
• Reading A with the option integrated under section 988(d): $25,700,000, 15.56 percent.
• Reading B, with the swap, option and section 987 items out (each either not a receipt or within (K)): $25,000,000, 16.00 percent.
• Reading C, with the trading book also out, which would require a treasury function: $20,000,000, 20.00 percent.
• Reading D, the net gains alternative for the trading book, with the swap, option and section 987 items out: $20,000,000 + $200,000 = $20,200,000, 19.80 percent. With those three items also counted, $21,500,000 and 18.60 percent.

The spread from Reading A to Reading C is 4.79 points. Readings B, C and D are bounds on what the exclusion text and the General Mills route could remove, not methods. The Reading D figures illustrate that route and are not a prediction that the FTB would propose it. The trading book's gross proceeds are 19.01 percent of Reading A's receipts ($5,000,000 / $26,300,000), close to the proportion the court described in General Mills II. That is a similarity in ratio only, because the court's finding rested on its own facts and on the FTB's burden of clear and convincing evidence.

Two checks follow. First, the swap. $400,000 received less $700,000 paid is a net payment of $300,000. That is a net deduction and no gross income under the Internal Revenue Code. Reading A's inclusion of the $400,000 therefore depends on treating each period's net receipt as a gross amount realized, which is the open question. No California source reviewed says a factor can include a negative receipt, so the example computes no net-based factor. A state that nets by type and counts nothing below zero, as New York does, would carry zero for this swap. Second, the option. The $600,000 gain sits in Reading A's denominator, while the $600,000 currency loss on the loan principal is not a receipt. The denominator therefore rises by an amount with no economic counterpart in the partnership's net result. The mismatch disappears if the option is integrated.

Partner layer.

• The corporate partner (40 percent, unitary) takes a numerator share of $1,600,000 and a denominator share of $10,520,000 under Reading A, $10,000,000 under Reading B, $8,000,000 under Reading C and $8,080,000 under Reading D, each combined with its own factors under Regulation 25137-1(f).
• The nonresident individual (20 percent) has a distributive share of business income of $600,000. Its California-source business income is $91,254.75 under Reading A ($600,000 x $4,000,000 / $26,300,000), $96,000 under Reading B, $118,811.88 under Reading D and $120,000 under Reading C. The $28,745.25 difference between Readings A and C is the whole dollar effect of the open points on that partner.

The example shows that classification of five items moves the California factor by 4.79 points, and that the order of analysis is receipt, then listed exclusion, then section 25137, then numerator. It leaves out the numerator assignment of hedge receipts (the counterparties are outside California), other states and the partners' own factors.

Practice notes

List every hedge, currency and treasury item by instrument type (swap, option, forward, future), by purpose (borrowing, loan asset, branch, trading) and by identification date before filling any factor. Establish under the federal rules whether a swap's settlements net for the year and whether a currency option on a loan was identified and integrated under section 988(d) before reporting any gross leg or gain. For California, test each item first against the gross receipt definition and then against the exact words of subparagraphs (K) and (L). Record why an item is excluded or counted, because no pronouncement applies the text to swaps or forwards. Before relying on the General Mills II net gains alternative, record the facts that show the standard formula distorts, because the party proposing the deviation carries the burden by clear and convincing evidence.

In other states, classify foreign currencies and futures contracts as securities for Massachusetts and Oregon. Apply Oregon's hedging purpose test to swaps and options. Treat a swap or option in Massachusetts as unresolved because the definition does not name it. Check each state's text for a dealer carve-out before relying on an exclusion. Test receipts in Florida and Pennsylvania against the statutory securities exclusion and, in Pennsylvania, against subparagraph (17)(K). Keep Illinois hedge documentation that ties each hedge to specific receipts at the time the federal rules require, and separate section 988 items on interest and receivables from items on principal. Net only as each state's text nets. New York nets by type and counts nothing below zero. Texas nets sale by sale, with net proceeds for a security that is not federal inventory. For a partnership, give each partner an item-level schedule of hedge, currency and treasury receipts rather than a single other-income line, so that the partner can apply a state's exclusion and the partnership-level classification. G&G State Tax Group advises investment partnerships and their partners on sales factor classification and multistate apportionment alongside its state and local tax practice.