On July 27, 2023, the OTA, in its decision in Microsoft Corporation & Subsidiaries, agreed with the taxpayer that foreign dividends, including dividends excluded from income under the dividends received deduction (DRD), are taken into account in computing the California sales factor of the apportionment formula. The FTB released the decision on April 2, 2024, as a nonprecedential opinion, meaning that it cannot be relied upon or cited by other taxpayers when filing an original return or a refund claim.
Crowe observation
The Microsoft decision follows a similar 2023 decision in Southern Minnesota Beet Sugar Cooperative and Subsidiary in which the OTA rejected the FTB’s historical position that denied apportionment factor representation for deductible income.
Background
California requires taxpayers that are part of a unitary group of multinational corporations to file a worldwide combined return unless an election is made to file on a water’s-edge basis. A worldwide return includes all global unitary corporations, while a water’s-edge group generally includes only corporations that are organized in the U.S., with some exceptions. With certain exceptions, a unitary combined group determines its California tax liability by apportioning its aggregated modified federal taxable income by a percentage measured by the ratio of its California sales compared to its sales everywhere, or its sales factor.
A water’s-edge taxpayer is allowed a DRD to reduce its California tax base equal to 75% of the qualified dividends received from foreign subsidiaries. At issue in Microsoft is whether a taxpayer includes in its sales factor denominator 100% of its foreign dividends received or only the 25% that remains in its California income tax base following the application of the 75% DRD.
The FTB’s position is that the sales factor reflects activities that give rise to income subject to tax, and therefore income excluded from the tax base also should be excluded from the sales factor. The taxpayer’s position is that dividends qualify as gross receipts and nothing in California law requires a reduction in gross receipts for amounts excluded from income or franchise tax.
The Microsoft case
For the 2018 tax year, Microsoft filed its original California corporate income tax return on a combined water’s-edge basis. The company received dividends from foreign subsidiaries that were not members of the water’s-edge combined group filing in California. As permitted under California tax law, the company deducted 75% of the foreign dividends from its preapportioned business income.
On its original California corporate income tax return, the taxpayer included in its sales factor denominator only the 25% of foreign dividends included in its taxable income. The taxpayer filed a refund claim asserting that 100% of the foreign dividends it received should be included in its sales factor denominator regardless of the fact that the 75% of the foreign dividends it received were properly excluded from its preapportioned business income.
Microsoft appealed its case to the OTA, and, in July 2023, the OTA ruled that the taxpayer may include 100% of its foreign dividends in its sales factor.
At the OTA hearing, the FTB relied on its Legal Ruling 2006-01 for the proposition that basic principles of apportionment provide that a taxpayer’s base income is apportioned only by activities that gave rise to income included in the base and that any income excluded from the tax base also should be excluded from the sales factor.
The OTA disagreed with the FTB and held that dividends qualify as gross receipts for sales factor purposes and that California tax law contains no exclusion from the sales factor for amounts properly excluded from income. Quoting its previous decision in Southern Minnesota Beet Sugar, the OTA stated that “[t]here is no language ... to support FTB’s position that unitary business activities are excluded from the apportionment formula if they relate to deductible income.”
The OTA also found that California's substantial and occasional sales exclusion for the apportionment formula did not operate to exclude the deducted 75% foreign dividend and that alternative apportionment treatment was not warranted.
Looking ahead
While the OTA has decided in two cases that amounts properly excluded from the California income tax base (cooperative member income and foreign dividends eligible for the DRD) are not excluded from the apportionment sales factor formula, the FTB may continue to challenge this position. Given the current environment on this issue, taxpayers filing income tax returns in California should consult with their tax advisers regarding their sales factor and apportionment formula.
