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.