California OTA confirms earlier repatriated dividends ruling

The California Office of Tax Appeals (OTA) has confirmed an earlier ruling holding that a water’s-edge group could include the gross amount of repatriated dividends in the denominator of its sales factor without taking the 75% qualifying dividend deduction.¹ The OTA also held that the dividends should not be excluded from the sales factor as a substantial and occasional sale because dividends do not qualify as a “sale” of property. Finally, the OTA rejected the argument that the use of an alternative apportionment method was warranted because the California Franchise Tax Board (FTB) failed to show that the standard apportionment formula did not fairly represent the filing group’s activity in California.

Background

The taxpayer is based in Washington and operates a worldwide unitary business that includes developing, manufacturing, licensing and selling software and other products and services. For the fiscal year ending June 30, 2018, the taxpayer filed a water’s-edge combined report with certain affiliated entities. The taxpayer also was unitary with controlled foreign corporations (CFCs) that were excluded from its water’s-edge group.² The CFCs outside the water’s-edge group paid over $109 billion of repatriated dividends to the taxpayer that qualified for California’s dividends received deduction (qualifying dividend deduction). The taxpayer eliminated intercompany dividends from these gross receipts, but the total foreign dividends remained nearly $109 billion.

After reporting a 75% qualifying dividend deduction of over $81 billion, the taxpayer reported net foreign dividends of approximately $27 billion. In computing the single sales factor apportionment percentage, the taxpayer included the net dividends in the sales factor denominator, resulting in a sales factor of 5.63%. The taxpayer subsequently filed a claim for refund with the FTB for approximately $94 million, asserting that the foreign dividends should be included in the sales factor denominator without a reduction for the qualifying dividend deduction. By including the gross amount of foreign dividends in the sales factor denominator, the sales factor was reduced to 3.37%.³ The FTB denied the claim for refund and the taxpayer subsequently appealed this decision.

Qualifying dividend deduction is not included in sales factor 

The OTA determined that the taxpayer’s gross receipts from dividends should not be reduced to account for the 75% qualifying dividend deduction. Prior to analyzing the issue, the OTA reviewed the applicable law. The OTA noted that a multistate business that is engaged in a unitary business generally determines its California tax liability based on a worldwide combined report,⁴ but qualifying taxpayers in a unitary business may elect to file a water’s-edge report that generally includes the income and apportionment factors of California and U.S. based entities and partially included CFCs.⁵

In 2017, federal legislation, the Tax Cuts and Jobs Act (TCJA),⁶ was enacted that included provisions designed to encourage the repatriation of foreign income. Under Internal Revenue Code (IRC) Sec. 965, previously untaxed foreign earnings of deferred foreign income corporations, such as CFCs, were deemed to be repatriated and subject to a one-time federal transition tax, regardless of whether the income was distributed. For the tax year at issue, the taxpayer was subject to the federal transition tax. California generally adopts the IRC as of Jan. 1, 2015, but selectively conforms to the TCJA.⁷ However, the state does not conform to IRC Sec. 965.

Under California law, members of a water’s-edge combined group compute their total separate net income before allocation and apportionment.⁸ Taxpayer’s making the water’s-edge election are allowed a deduction of 75% of qualifying dividends to the extent not otherwise allowed as a deduction or eliminated from income.⁹ The water’s-edge combined report applies the Uniform Division of Income for Tax Purposes Act (UDITPA) to allocate and apportion income.¹⁰ California generally uses a single sales factor to apportion business income to the state.¹¹ The numerator and denominator of the sales factor use the taxpayer’s sales during the tax year.¹² “Sales” is defined as all gross receipts that are not allocated as nonbusiness income.¹³

The taxpayer argued that its foreign dividends should be included in the sales factor denominator as gross receipts, without a reduction for the qualifying dividend deduction, based on the plain language of the statute, legislative history, and legal authority establishing dividends as gross income without deductions. In agreeing with the taxpayer that dividends should be included in the sales factor on a gross basis, the OTA explained that California law defines gross receipts as including the gross (rather than the net) amounts realized and recognized for corporate income tax purposes.¹⁴

The OTA rejected the FTB’s argument that the qualifying dividend deduction should be treated like eliminated intercompany dividends which are not included in the sales factor.¹⁵ There are differences between the two types of dividend deductions because the intercompany dividends statute expressly provides that the dividends be eliminated from income whereas the qualifying dividend deduction statute does not contain such language. The FTB cited several cases to support its argument that the deducted dividends should be eliminated from the sales factor, but the OTA rejected these cases as concerning issues that were inapposite to the instant case.¹⁶

The FTB unsuccessfully argued that the OTA should give deference to its interpretation in Legal Ruling 2006–01 that the sales factor includes only the net dividends after applying the qualifying dividend deduction.¹⁷ The OTA noted that the ruling was not a formal regulation and it interpreted a statute as opposed to the FTB’s own regulation. Also, the OTA found that the FTB’s interpretation in the ruling is inconsistent with well-established law. Accordingly, the OTA concluded that the FTB’s interpretation in Legal Ruling 2006–01 was unpersuasive.

Qualifying dividends excluded as sale 

The OTA also rejected the FTB’s argument that the gross receipts from the qualifying dividends should be excluded from the sales factor as a substantial and occasional sale. A California regulation provides that, where substantial amounts of gross receipts arise from an occasional sale of a fixed asset or other property held or used in the regular course of the taxpayer’s trade or business, these receipts should be excluded from the sales factor.¹⁸ The OTA determined that the FTB provided no evidence or legal authority establishing that the dividends were a sale of property under the regulation.

FTB Fails to justify apportionment change 

The FTB was unable to persuade the OTA that an alternative apportionment method should be applied. California law provides that if the allocation and apportionment provisions under UDITPA do not fairly represent the extent of the taxpayer’s business activity in the state, the taxpayer may petition for, or the FTB may require, alternative apportionment.¹⁹ Because the FTB was the party seeking alternative apportionment, it had the burden of establishing, by clear and convincing evidence, that (i) application of the standard apportionment formula does not fairly represent the taxpayer’s activities in California; and (ii) its proposed alternative apportionment methodology is reasonable.²⁰ Courts consider the following two factor in determining whether there is distortion: (i) whether the activities generating the receipts were qualitatively different from the taxpayer’s main line of business; and (ii) whether the quantitative distortion that arose from the inclusion of the receipts was substantial.²¹

The FTB argued that the qualitative and quantitative factors show that inclusion of the total qualifying dividends in the sales factor denominator resulted in distortion similar to a substantial and occasional sale. The proposed alternative method was to exclude the dividend gross receipts from the sales factor, similar to the treatment of a substantial and occasional sale. As applied, the sales factor would be approximately 7.3% as opposed to 3.37% if the deducted dividends were included in the sales factor denominator. The FTB noted that the sales factor had increased from 5.29% to 6.68% during the past three years and the current year percentage of 3.37% does not follow the pattern of steady increases. The taxpayer argued that the change in tax law under the TCJA required it to alter its business practices to make actual dividend distributions. According to the taxpayer, the repatriation of dividends is now a frequent event and prior year factors do not show the current year factor is distortive.

The OTA determined that the FTB failed to show distortion. Under the qualitative analysis, distortion may be found when the standard formula is biased by a substantial activity that is not related to the taxpayer’s main line of business. The FTB argued that the repatriated dividends were similar to an occasional sale because they were a one-time event due to the TCJA and were not part of the taxpayer’s normal business. The OTA disagreed with this argument because the dividends were not comparable to an occasional sale. The dividends were not outside the taxpayer’s normal course of business because it regularly received repatriated dividends and non-repatriated dividends each year. Also, the dividends were consistent with the intent of the TCJA to encourage companies to permanently change their business practices to repatriate rather than defer foreign earnings.

The FTB also failed to convince the OTA that there was quantitative distortion. In the Microsoft case from 2006, the court found that there was quantitative distortion because the profit margins differed by a multiplier of 170.²² In the instant case, the FTB’s profit margin calculation only differed by a multiplier of 6.25. Courts also consider the degree by which the inclusion of the contested activity affects the standard apportionment formula. In the instant case, the change in the formula from 5.63% to 3.37%, a 40% decrease, was comparable to a percentage change that was allowed in a prior case.²³ Finally, the FTB unsuccessfully argued that the lower sales factor disrupts the steady pattern of increases. The OTA explained that the taxpayer’s repatriation of earnings was consistent with the intent of the TCJA and the pattern in the sales factor for prior years was not dispositive. Because the OTA found there was no distortion, it was not required to consider the proposed alternative apportionment method.

Petition for rehearing denied

On Feb. 14, 2024, a separate panel of the OTA denied the FTB’s petition for rehearing. After summarizing the underlying opinion challenged by the FTB, the OTA examined each of the three primary holdings and rejected the FTB’s arguments that they were contrary to law. First, the OTA agreed with the holding that the qualifying dividends which were deducted are includible in the sales factor. The OTA explained that the FTB provided the same or similar arguments that previously were considered and rejected, and which the OTA continued to find unpersuasive. Further, the OTA noted that this holding is consistent with the OTA’s precedential opinion in Southern Minnesota Beet Sugar Cooperative which found that Legal Ruling 2006–01 was unpersuasive to the extent it treats the qualifying dividend deduction at issue as excluded from gross receipts.²⁴ The OTA also agreed with the second holding that gross receipts from qualifying dividends should not be excluded from the sales factor as a substantial and occasional sale, in part due to the fact that the regulatory exclusion rule relied upon by the FTB applies to sales of fixed assets or other property, and not to dividends otherwise includible in the statutory definition of “sales.”

In rejecting the FTB’s challenge of the third holding that alternative apportionment was not warranted, the OTA reviewed and confirmed the prior qualitative analysis concerning an occasional transaction and the taxpayer’s main line of business. The FTB also argued that approximately nine weeks following the oral argument in this case, the U.S. Supreme Court granted certiorari in Moore v. U.S.²⁵ According to the FTB, if the U.S. Supreme Court holds that IRC Sec. 965 is unconstitutional in Moore, this decision will demonstrate error in the OTA’s examination of this provision in concluding that the receipt of dividends was not occasional. As explained by the OTA, such a ruling in Moore would not impact the instant decision because California does not conform to IRC Sec. 965. The FTB also offered a new legal theory in its petition for rehearing that the dividends were qualitatively different because the one-time dividends reflected accumulated foreign earnings and profits that were not part of the taxpayer’s main line of business. The OTA declined to address this new theory because it raised material issues that were not previously considered, and the record did not include sufficient evidence for the OTA to perform the necessary analysis. Also, the OTA rejected the FTB’s quantitative distortion arguments.²⁶

Commentary

This is an important and thoughtful opinion that may provide significant refund opportunities to taxpayers along with potential exposure concerns depending on a taxpayer’s facts and circumstances. The recent rejection by a separate panel of the OTA of the FTB’s petition for rehearing strengthens the support of the underlying opinion. Both decisions are expected to be posted by the OTA in April 2024. At this time, the OTA should indicate whether the underlying decision is precedential.

Each of the three main holdings is noteworthy and should be separately considered by taxpayers. The determination that the gross amount of the repatriated dividends should be included in the sales factor denominator without an exclusion or elimination of the 75% dividends deduction may allow taxpayers that are getting dividends from outside the state to include substantially more of their dividends in the sales factor. This holding also is significant because it rejects the FTB’s policy in Legal Ruling 2006-01 which excluded the deducted dividends from the sales factor. Also, this holding provides a more conclusive determination of how dividends repatriated under IRC Sec. 965 should be treated and may be helpful for taxpayers that are currently under audit with respect to this issue.

The holding rejecting the exclusion of substantial and occasional sales from the apportionment factor also is significant because it acts to narrow the application of this rule. In limiting the substantial and occasional sale exclusion rule to sales of property, the OTA decided that this rule may not be used to exclude other types of income such as dividends. As a result, the FTB and taxpayers will be precluded from using this rule in certain circumstances.

Finally, the OTA’s decision may make it more difficult for the FTB and taxpayers to use alternative apportionment in the future. In this case, the FTB was unable to show that there was any distortion. The FTB’s argument that the repatriation of dividends under IRC Sec. 965 was a one-time event was rejected because the taxpayer received dividends on a frequent and regular basis. Furthermore, the FTB failed to show that any of the quantitative tests for distortion had been met. This decision should be carefully considered by taxpayers in deciding whether to pursue alternative apportionment. 

1 In re Microsoft Corp., California Office of Tax Appeals, No. 21037336, July 27, 2023, rehearing denied, Feb. 14, 2024. The OTA has not posted the opinion on its website or indicated whether it is precedential. However, the opinion has been unofficially disseminated to the public. Similar to the underlying opinion, the decision denying the petition for rehearing has not been posted on the OTA’s website. The decisions are expected to be posted by the OTA in April 2024. 
2 A CFC generally is a corporation that is organized in a foreign county and is more than 50% owned by U.S. shareholders. IRC § 957(a).
3 For the three prior fiscal years, the taxpayer had sales factor percentages of 5.29%, 5.68%, and 6.68%. Also, the taxpayer reported total dividend income of $2.9 billion, $4.2 billion, and $4.4 billion for the three prior fiscal years.
4 CAL. REV. & TAX CODE §§ 25101; 25120-25137.
5 CAL. REV. & TAX CODE §§ 25110(a); 25113, see Fujitsu IT Holdings, Inc. v. Franchise Tax Board, 120 Cal.App.4th 459 (2004).
6 P.L. 115-97. 
7 CAL. REV. & TAX CODE § 23051.5(1)(a); A.B. 91, Laws 2019.
8 CAL. CODE REGS. tit. 18, § 25106(b)(18), (c)(1). 
9 CAL. REV. & TAX CODE § 24411(a). “Qualifying dividends” means those received by the water’s-edge group from corporations if both of the following conditions are satisfied: (i) the average of the property, payroll, and sales factors within the U.S. for the corporation is less than 20%; and (ii) more than 50% of the total combined voting power of all classes of stock entitled to vote is owned directly or indirectly by the water’s-edge group.
10 CAL. REV. & TAX CODE §§ 25101; 25110(a)(3); CAL. CODE REGS. tit. 18, § 25106.5(b)(8), (9).
11 CAL. REV. & TAX CODE § 25128.7. 
12 CAL. REV. & TAX CODE § 25134.
13 CAL. REV. & TAX CODE § 25120(f)(1). 
14 CAL. REV. & TAX CODE § 25120(f)(2).
15 CAL. REV. & TAX CODE § 25106 provides for the elimination of intercompany dividends.
16 The FTB cited the following cases to support its argument: (i) Chase Brass and Copper Co. v. Franchise Tax Board, 70 Cal.App.3d 457 (1977); (ii) Great Western Finance v. Franchise Tax Board, 4 Cal.3d 1 (1971); and Microsoft Corp. v. Franchise Tax Board, 39 Cal.4th 750 (2006). 
17 Legal Ruling 2006-01, California Franchise Tax Board, April 28, 2006. Under this ruling, a domestic corporation that received dividends from a unitary CFC excluded from the water’s-edge group must include in the sales factor denominator only the net dividends after applying the qualified dividend deduction. 
18 CAL. CODE REGS. tit. 18, § 25137(c)(1)(A). 
19 CAL. REV. & TAX CODE § 25137. 
20 Microsoft, 39 Cal.4th at p. 765. 
21 Id. at 766. The qualitative and quantitative effects are not separate tests and are examined together.  
22 Microsoft, 39 Cal.4th at 767. 
23 In re Merrill, Lynch, Pierce, Fenner, & Smith, Inc., California State Board of Equalization, 89-SBE-017, June 2, 1989. 
24 California Office of Tax Appeals, No. 19034447, March 17, 2023 (released Aug. 2023). In Southern Minnesota Beet Sugar, the OTA held that: (i) the taxpayer properly included in its combined reporting group’s California apportionment percentage its property, payroll and sales related to business activities that permitted it to deduct certain agricultural cooperative income; (ii) the taxpayer could not deduct interest expense used to acquire a unitary entity against its taxable nonmember income; and (iii) the taxpayer could not deduct depreciation expense incurred from assets to produce deductible income related to agricultural cooperatives against its taxable nonmember income. Similar to Microsoft, the OTA refused to follow Legal Ruling 2006-01. For a discussion of this decision, see GT SALT Summary: “California OTA holds deductible income must be included in sales factor.” 
25 36 F.4th 930 (9th Cir. 2022), cert. granted, 143 S. Ct. 2656 (2023). 
26 The OTA also rejected the FTB’s arguments concerning irregularities in the proceedings or errors in law. Specifically, the OTA disagreed with the FTB’s arguments that its petition should be granted because its request for additional briefing was denied, the hearing experienced interruptions, and the OTA relied on the taxpayer’s incorrect statements concerning the amount of repatriated dividends received in subsequent years. Finally, the OTA rejected the FTB’s argument that a rehearing should be granted based on newly discovered, material evidence.