The California Office of Tax Appeals (OTA) recently issued its long-awaited decision awarding Microsoft $94 million in refunds for overpayments of California’s corporate income tax.[1] The OTA ruled that Microsoft was correct in asserting that repatriated foreign dividends received from foreign subsidiaries should be included in the software company’s single-sales apportionment factor, even though they qualified for California’s 75% dividends received deduction (DRD) for “water’s-edge” groups and were not included in taxable income.
Background
During the fiscal year ending June 30, 2018, Microsoft received approximately $108 million in dividends distributed by foreign subsidiaries that qualified for California’s DRD. Microsoft had made a water’s-edge election, and the foreign subsidiaries were not included in Microsoft’s California water’s-edge combined group. Microsoft initially filed a California Corporation Franchise or Income Tax Return for the period and reported a 75% California water’s-edge “qualifying dividends” deduction of $81 million in accordance with California tax laws. The remaining net foreign dividends of $27 million were included in Microsoft’s pre-apportioned net taxable income as well as in the denominator of its single-sales apportionment factor, which was used to calculate the post-apportionment taxable income and, ultimately, Microsoft’s tax due. The $81 million worth of dividends qualifying for the DRD were not included in the denominator of Microsoft’s single-sales factor.
Microsoft subsequently filed a refund claim for $94 million, asserting that the entire amount of the foreign dividends received should have been included in the denominator of the sales factor, resulting in a reduced apportionment factor (Microsoft claimed the dividends should be sourced abroad). The California Franchise Tax Board (FTB) denied the refund request, arguing that the dividends that had been deducted from taxable income should not be included in the denominator of the sales factor.
Microsoft appealed the denied claim for refund to the OTA. On July 27, 2023, the OTA ruled in favor of Microsoft that the entirety of the dividends were included in the denominator of the sales factor. The OTA effectively affirmed its ruling by denying the FTB’s petition for rehearing on February 14, 2024.
FTB’s Arguments Rejected – Deductible Dividends Included in California Sales Factor
The FTB presented three primary arguments to support its denial of Microsoft’s refund claims and petition for rehearing.
First, the FTB argued that the repatriated dividends, which were eligible for the 75% DRD, should have been excluded from the sales factor as was consistent with “the basic principles of apportionment,” a concept also referred to by the FTB as the “matching principle.” The FTB asserted that the basic principles of apportionment provide that once the apportionable tax base has been determined, it can only be apportioned by the activities that gave rise to the income or loss reflected in the apportionable tax base. The FTB contended that activities giving rise to income or loss that are not included in the apportionable tax base by way of exemption, exclusion, deduction, or otherwise may not be included in the sales factor.
The OTA was not persuaded and reasoned that, under the plain language of the statute, the dividends qualified as gross receipts and that “sales” includible in the sales factor meant all gross receipts of the taxpayer that specifically were not excluded or exempt. Because none of the exclusions provided by statute related to deductible dividend income, the OTA determined that the dividends qualified as “sales” includible in the sales factor. The OTA acknowledged the FTB’s argument regarding the “basic principles of apportionment” but found the plain language of the statute to be controlling.
The FTB also argued that the dividends should have been excluded from the sales factor under its regulation excluding receipts from the sales factor constituting substantial gross receipts from occasional sales. The OTA noted that the regulation is limited to occasional sales of fixed assets or other property held or used in the regular course of the taxpayer’s trade or business. The OTA determined that the receipt of the dividends did not qualify as a “sale” of property under the state’s regulations and should not be classified as an occasional sale.
Finally, the FTB argued that the use of an alternative apportionment method was warranted because the apportionment provisions did not fairly represent the extent of the taxpayer’s business activity in California. Under California law, the FTB, which was the party seeking a deviation from the standard apportionment formula, had the burden of establishing, by clear and convincing evidence, that (1) application of the standard apportionment formula did not fairly represent the taxpayer’s activities in California, and (2) its proposed alternative apportionment methodology was reasonable.
The FTB argued that the dividends were the result of a one-time repatriation tax created by the Tax Cuts and Jobs Act of 2017 and were occasional. As such, they did not fairly represent the extent of Microsoft’s ongoing business activity in California. The OTA held that the dividends were not occasional because Microsoft regularly received dividends, including repatriated dividends, from numerous subsidiaries and controlled foreign companies.
The FTB also attempted to introduce California’s legislative history as evidence in its petition for rehearing, but the OTA determined that the proposed evidence should have been brought forth during the initial hearing and denied the petition.
Key Takeaways
This ruling represents a significant development that challenges traditional views on apportionment and will likely have a lasting impact.
California taxpayers receiving dividends from foreign subsidiaries should immediately review their current approach to apportionment and determine if they may have overpayments in the state.
Taxpayers operating in other states may have similar opportunities; however, they should be cognizant of the different laws in those states. The plain language of state statutes is of utmost importance but tends to vary from state to state.
Ultimately, this decision was a major win for Microsoft that will likely prompt further legal challenges and interpretations, not just in California but in other states as well.
If you have any questions or need assistance, please reach out to a professional at FORVIS.
- 1 Opinion on Petition for Rehearing. OTA Case No. 21037336. Aboutblaw.com.