(a) No deduction shall be allowed for any interest paid or incurred by a taxpayer during the taxable year with respect to its corporate acquisition indebtedness to the extent that such interest exceeds—

(1) Five million dollars ($5,000,000), reduced by

(2) The amount of interest paid or incurred by such corporation during such year on obligations (A) issued after December 31, 1967, to provide consideration for an acquisition described in paragraph (1) of subdivision (b), but (B) which are not corporate acquisition indebtedness.

(b) For purposes of this section, the term “corporate acquisition indebtedness” means any obligation evidenced by a bond, debenture, note, or certificate or other evidence of indebtedness issued after October 9, 1969, by a corporation (hereinafter in this section referred to as “issuing corporation”) if—

(1) Such obligation is issued to provide consideration for the acquisition of—

(A) Stock in another corporation (hereinafter in this section referred to as “acquired corporation”), or

(B) Assets of another corporation (hereinafter in this section referred to as “acquired corporation”) pursuant to a plan under which at least two-thirds (in value) of all the assets (excluding money) used in trades and businesses carried on by such corporation are acquired,

(2) Such obligation is either—

(A) Subordinated to the claims of trade creditors of the issuing corporation generally, or

(B) Expressly subordinated in right of payment to the payment of any substantial amount of unsecured indebtedness, whether outstanding or subsequently issued, of the issuing corporation,

(3) The bond or other evidence of indebtedness is either—

(A) Convertible directly or indirectly into stock of the issuing corporation, or

(B) Part of an investment unit or other arrangement which includes, in addition to such bond or other evidence of indebtedness, an option to acquire, directly or indirectly, stock in the issuing corporation, and

(4) As of a day determined under paragraph (1) of subdivision (c) either—

(A) The ratio of debt to equity (as defined in paragraph (2) of subdivision (c)) of the issuing corporation exceeds 2 to 1, or

(B) The projected earnings (as defined in paragraph (3) of subdivision (c)), do not exceed three times the annual interest to be paid or incurred (determined under paragraph (4) of subdivision (c)).

(c) For purposes of paragraph (4) of subdivision (b)—

(1) Determinations are to be made as of the last day of any taxable year of the issuing corporation in which it issues any obligation to provide consideration for an acquisition described in paragraph (1) of subdivision (b) of stock in, or assets of, the acquired corporation.

(2) The term “ratio of debt to equity” means the ratio which the total indebtedness of the issuing corporation bears to the sum of its money and all its other assets (in an amount equal to their adjusted basis for determining gain) less such total indebtedness.

(3) (A) The term “projected earnings” means the “average annual earnings” (as defined in subparagraph (B)) of—

(i) The issuing corporation only, if cause (ii) does not apply, or

(ii) Both the issuing corporation and the acquired corporation, in any case where the issuing corporation has acquired control (as defined in Section 24564), or has acquired substantially all of the properties of the acquired corporation.

(B) The average annual earnings referred to in subparagraph (A) is, for any corporation, the amount of its earnings and profits for any three-year period ending with the last day of a taxable year of the issuing corporation described in paragraph (1), computed without reduction for—

(i) Interest paid or incurred,

(ii) Depreciation or amortization allowed under this part,

(iii) Liability for tax under this part, and

(iv) Distributions to which Section 301(c)(1) of the Internal Revenue Code, relating to property distributions, applies (other than such distributions from the acquired to the issuing corporation), and reduced to an annual average for such three-year period pursuant to regulations prescribed by the Franchise Tax Board. Such regulations shall include rules for cases where any corporation was not in existence for all of such three-year period or such period includes only a portion of a taxable year of any corporation.

(4) The term “annual interest to be paid or incurred” means—

(A) If subparagraph (B) does not apply, the annual interest to be paid or incurred by the issuing corporation only, determined by reference to its total indebtedness outstanding, or

(B) If projected earnings are determined under clause (ii) of subparagraph (A) of paragraph (3), the annual interest to be paid or incurred by both the issuing corporation and the acquired corporation, determined by reference to their combined total indebtedness outstanding.

(5) With respect to any corporation which is a bank or is primarily engaged in a lending or finance business—

(A) In determining under paragraph (2) the ratio of debt to equity of such corporation (or of the affiliated group of which such corporation is a member), the total indebtedness of such corporation (and the assets of such corporation) shall be reduced by an amount equal to the total indebtedness owed to such corporation which arises out of the banking business of such corporation, or out of the lending or finance business of such corporation, as the case may be;

(B) In determining under paragraph (4) the annual interest to be paid or incurred by such corporation (or by the issuing and acquired corporations referred to in subparagraph (B) of paragraph (4) or by the affiliated group of which such corporation is a member) the amount of such interest (determined without regard to this paragraph) shall be reduced by an amount which bears the same ratio to the amount of such interest as the amount of the reduction for the taxable year under subparagraph (A) bears to the total indebtedness of such corporation; and

(C) In determining under subparagraph (B) of paragraph (3), the average annual earnings, the amount of the earnings and profits for the three-year period shall be reduced by the sum of the reductions under subparagraph (B) for such period.

For purposes of this paragraph, the term “lending or finance business” means a business of making loans or purchasing or discounting accounts receivable, notes, or installment obligations.

(d) In applying this section—

(1) The deduction of interest on any obligation shall not be disallowed under subdivision (a) before the first taxable year of the issuing corporation as of the last day of which the application of either subparagraph (A) or subparagraph (B) of paragraph (4) of subdivision (b) results in such obligation being corporate acquisition indebtedness.

(2) Except as provided in paragraphs (3), (4), and (5), if an obligation is determined to be corporate acquisition indebtedness as of the last day of any taxable year of the issuing corporation, it shall be corporate acquisition indebtedness for such taxable year and all subsequent taxable years.

(3) If an obligation is determined to be corporate acquisition indebtedness as of the close of a taxable year of the issuing corporation in which clause (i) of subparagraph (A) of paragraph (3) of subdivision (c) applied, but would not be corporate acquisition indebtedness if the determination were made as of the close of the first taxable year of such corporation thereafter in which clause (ii) of subparagraph (A) of paragraph (3) of subdivision (c) could apply, such obligation shall be considered not to be corporate acquisition indebtedness for such later taxable year and all taxable years thereafter.

(4) If an obligation which has been determined to be corporate acquisition indebtedness for any taxable year would not be such indebtedness for each of any three consecutive taxable years thereafter if paragraph (4) of subdivision (b) were applied as of the close of each of such three years, then such obligation shall not be corporate acquisition indebtedness for all taxable years after such three consecutive taxable years.

(5) In the case of obligations issued to provide consideration for the acquisition of stock in another corporation, such obligations shall be corporate acquisition indebtedness for a taxable year only if the issuing corporation owns 5 percent or more of the total combined voting power of all classes of stock entitled to vote of such other corporation.

(e) An acquisition of stock of a corporation of which the issuing corporation is in control (as defined in Section 24564) in a transaction in which gain or loss is not recognized shall be deemed an acquisition described in paragraph (1) of subdivision (b) only if immediately before such transaction (1) the acquired corporation was in existence, and (2) the issuing corporation was not in control (as defined in Section 24564) of such corporation.

(f) For purposes of this section, the term “corporate acquisition indebtedness” does not include any indebtedness issued to any person to provide consideration for the acquisition of stock in, or assets of, any foreign corporation substantially all of the income of which, for the three-year period ending with the date of such acquisition or for such part of such period as the foreign corporation was in existence, is from sources without the United States.

(g) In any case in which the issuing corporation is a member of an affiliated group, the application of this section shall be determined, pursuant to regulations prescribed by the Franchise Tax Board, by treating all of the members of the affiliated group in the aggregate as the issuing corporation, except that the ratio of debt to equity of, projected earnings of, and annual interest to be paid or incurred by any corporation (other than the issuing corporation determined without regard to this subdivision) shall be included in the determinations required under subparagraphs (A) and (B) of paragraph (4) of subdivision (b) as of any day only if such corporation is a member of the affiliated group on such day, and, in determining projected earnings of such corporation under paragraph (3) of subdivision (c), there shall be taken into account only the earnings and profits of such corporation for the period during which it was a member of the affiliated group. For purposes of this section, the term “affiliated group” has the meaning assigned to such term by Section 1504 of the Internal Revenue Code except that all corporations other than the acquired corporation shall be treated as includable corporations and the acquired corporation shall not be treated as an includable corporation.

(h) For purposes of this section—

(1) Any extension, renewal, or refinancing of an obligation evidencing a preexisting indebtedness shall not be deemed to be the issuance of a new obligation.

(2) Any obligation which is corporate acquisition indebtedness of the issuing corporation is also corporate acquisition indebtedness of any corporation which becomes liable for such obligation as guarantor, endorser, or indemnitor or which assumes liability for such obligation in any transaction.

(i) No inference shall be drawn from any provision in this section that any instrument designated as a bond, debenture, note, or certificate or other evidence of indebtedness by its issuer represents an obligation or indebtedness of such issuer in applying any other provision of this part.

(j) This section shall apply to the determination of the allowability of the deduction of interest paid or incurred with respect to indebtedness incurred after December 31, 1970.

(Amended by Stats. 2000, Ch. 862, Sec. 169. Effective January 1, 2001.)