California Office of Tax Appeals allows dividends subject to the dividend received deduction to be included in the denominator of the sales factor

In Summary

On July 27, 2023, the California Office of Tax Appeals (OTA) ruled in favor of the taxpayer, Microsoft, allowing the inclusion of 100% of its qualifying foreign dividend receipts in the California sales factor denominator on its water’s-edge return for fiscal year ending June 30, 2018. The ruling resulted in an approximately $94 million corporate tax refund.

In turn, the California Franchise Tax Board (FTB) timely filed a Petition of Rehearing in August 2023. The OTA recently denied the FTB petition for hearing on February 14, 2024, and upheld its July 2023 ruling allowing 100% of foreign dividend income in the California sales factor denominator.

In Detail

Microsoft filed a water’s-edge combined return for the fiscal year ending June 30, 2018. Microsoft was unitary with controlled foreign corporations (CFCs) that sell Microsoft-branded software and other products outside the United States. These CFCs were responsible for most of Microsoft’s foreign earnings and were excluded from its water’s-edge return. Microsoft repatriated foreign dividends that qualified for the 75% dividend received deduction (DRD) under Revenue and Taxation Code (R&TC) Sec. 24411.

On its original return, Microsoft only included the net dividends after applying the 75% DRD in its total/gross sales and the sales factor denominator. Subsequently, Microsoft filed a claim for refund of approximately $94 million with the FTB, asserting that the foreign dividends should be included in the sales factor denominator without a reduction for the qualifying DRD. The FTB denied Microsoft’s refund claim and as such Microsoft appealed to the OTA.

Three issues evaluated in the case were:

1. Whether qualifying dividends deducted from income are includable in the sales factor;
2. Whether gross receipts from qualifying dividends should be excluded from the sales factor as a substantial and occasional sale;
3. Whether the FTB has shown the use of an alternative apportionment method is warranted.

The following conclusions were reached:

1. OTA concluded 100% of foreign dividends are eligible for sales factor denominator inclusion

Microsoft argued that the foreign dividends should be included in the sales factor denominator without a reduction for the qualifying DRD based on the plain language of the statute, legislative history and legal authority establishing dividends as gross income. Conversely, the FTB argued that 75% of the dividends should be excluded from the sales factor pursuant to FTB legal Ruling 2006-01.

The OTA agreed with Microsoft that gross receipts from dividends should not be reduced to account for the DRD pursuant to R&TC Sec. 24411. As such, the gross qualifying dividends are includable in the sales factor denominator.

2. Foreign dividends are not excluded from the sales factor as a substantial and occasional sale

The FTB argued that the distribution of dividends qualified as a “sale” under the occasional sale regulation and therefore should be excluded from the sales factor. The OTA concluded the FTB provided no support for the position that dividends are a sale of “property” for purposes of the occasional sale regulation. Therefore, Microsoft’s receipt of the dividends did not qualify as a sale of property for purposes of the occasional sale rules.

3. FTB did not demonstrate an alternative apportionment was warranted

California authority provides that if the allocation and apportionment provisions do not fairly represent the taxpayer’s business activity in the state, an alternative method may be petitioned for by a taxpayer or required by the FTB. Here, the FTB sought a deviation from the standard apportionment formula, and as such, had the burden of establishing the inclusion of Microsoft’s gross foreign dividends in the sales factor denominator would be distortive and therefore, an alternative apportionment formula should be used.

The OTA concluded the FTB did not satisfy its burden to show by clear and convincing evidence that the standard apportionment formula did not represent Microsoft’s activity in California.

What’s next?

As detailed above, the OTA denied FTB’s petition for rehearing and as such, the OTA’s July 2023 decision stands. However, the OTA posted both opinions this week without making them precedential. With a nonprecedential designation, the FTB is not obligated to follow the rulings if a taxpayer makes a similar claim.

That said, the ruling could give support to similarly situated taxpayers. Please reach out to your tax advisor to discuss whether the opinion impacts your business and your California corporate income tax returns.

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