Microsoft Prevails in California Dispute on Inclusion of Gross Foreign Dividends in Apportionment Formula

The BR State + Local Tax Spotlight

By Irwin M. Slomka

In a decision that may have significant repercussions regarding apportionment for California corporate tax purposes, the California Office of Tax Appeals (“OTA”) has denied the Franchise Tax Board’s (“FTB”) petition for a rehearing and in doing so let stand its holding that Microsoft was entitled to include 100 percent of its foreign dividends in its sales factor denominator, including the portion that qualified for a 75 percent deduction from income under California law. Appeal of Microsoft Corporation and Subsidiaries, Opinion on Petition for Rehearing, Case No.: 21037336 (Calif. Office of Tax Appeals, Feb. 14, 2024).

Facts: For the fiscal year ended June 30, 2018, Microsoft filed on the basis of a California water’s-edge unitary combined return. Microsoft received repatriated dividends distributed by certain unitary controlled foreign corporations (“CFCs”) totaling approximately $109 billion. On its original California return, Microsoft excluded 75 percent of those dividends from income pursuant to the California corporation tax law (R&TC § 24411(a)), resulting in only 25 percent of the dividends being included in business income.

Also on its original California return, Microsoft included only the 25 percent of the dividends in its sales factor denominator, commensurate with the net amount included in business income. On its amended return, however, Microsoft included 100 percent of the dividends ($109 billion)—that is, before the 75 percent deduction—in the sales factor denominator and claimed a refund of nearly $94 million. The FTB denied the refund claim and this litigation followed.

Prior Opinion: In July 2023, the OTA ruled that Microsoft properly included 100 percent of the dividends in its sales factor denominator and rejected the FTB’s alternative arguments that the amounts should be excluded as a “substantial and occasional sale” or under alternative apportionment to avoid distortion. The FTB filed a motion for rehearing, principally on the alleged grounds that the Opinion was “contrary to law.”

Opinion on Petition for Rehearing: On February 14, 2024, the OTA issued its Opinion in which it rejected the FTB’s arguments and declined to grant it a rehearing. It declined to apply the FTB’s “matching principle” set out in Legal Ruling 2006-01, under which only income included in the apportionable tax base could be included in the sales factor. The OTA found the plain language of the tax law, which required the inclusion of the taxpayer’s “gross receipts” in the sales factor, to require that the gross amount of dividends be included before the 75 percent qualifying dividends deduction, making the “matching principle” unpersuasive.

The OTA also rejected the FTB’s claim that the qualifying dividends constituted receipts arising from “substantial and occasional sales,” which are excluded from the sales factor, noting that the FTB’s regulations make clear that the exclusion is limited to receipts from the “sale of a fixed asset or other property[.]”

The OTA also held that the FTB failed to prove that use of its discretionary authority to exclude 75 percent of the dividends in order to “fairly represent” Microsoft’s business activity in the state was warranted. Citing to the California Supreme Court decision in Microsoft Corp. v. Franchise Tax Board, 39 Cal. 4th 750 (2006), which set out criteria for deviating from the standard apportionment formula, the OTA held the FTB failed to show that Microsoft’s receipt of dividends was occasional and qualitatively different from its main line of business and that the quantitative effect of their inclusion was as substantial as the inclusion of the gross amount of securities redemptions in the 2006 Microsoft decision.

The FTB cannot appeal the Opinion and it is therefore final, entitling Microsoft to nearly $94 million in tax refunds. As of this writing, the OTA had not yet posted the Opinion on its web site, which it may designate as either “precedential” or “non-precedential.” The Opinion sheds important light on what constitutes gross receipts for California sales factor purposes, as well as on what must be shown for application of discretionary authority to justify deviation from the statutory sales factor.

This update is one in a series of updates written for the March 2024 edition of The BR State + Local Tax Spotlight.

© 2024 Blank Rome LLP. All rights reserved. Please contact Blank Rome for permission to reprint. Notice: The purpose of this update is to identify select developments that may be of interest to readers. The information contained herein is abridged and summarized from various sources, the accuracy and completeness of which cannot be assured. This update should not be construed as legal advice or opinion, and is not a substitute for the advice of counsel.