Better than a box of chocolates: Foreign dividends included in California sales factor denominator

Eversheds Sutherland (US) LLP

On February 14, 2024, the California Office of Tax Appeals (OTA) denied the California Franchise Tax Board’s (FTB) request for rehearing in the Appeal of Microsoft Corporation and Subsidiaries (OTA Case No. 21037336). Microsoft is allowed to include 100 percent of its foreign dividend income in its sales factor denominator. This is a huge opportunity for similarly situated California water’s-edge taxpayers.

In July, an OTA three-judge panel unanimously ruled that Microsoft could include in its sales factor denominator 100 percent of dividends it received from foreign affiliates. Microsoft filed a water’s-edge return and included only 25 percent of the same dividends in its apportionable income. The FTB argued a “matching principle” should apply - that because California law provides for a 75 percent dividends received deduction, then 75 percent of the dividends should be excluded from the sales factor. The FTB issued Legal Ruling 2006-01 almost two decades ago setting forth this “matching principle” and asked the OTA to follow its lead in Microsoft.

However, the OTA refused to defer to the FTB’s longstanding interpretation and analysis, and instead concluded that nothing in California’s statutory or regulatory scheme required Microsoft to exclude otherwise includable “gross receipts” from the sales factor. This ruling echoed the OTA’s earlier precedential ruling in Appeal of Southern Minnesota Beet Sugar Cooperative and Subsidiary, 2023 – OTA – 342P (Mar. 17, 2023), where the OTA held that a taxpayer’s payroll, property and sales giving rise to deductible cooperative income were nonetheless included in the taxpayer’s apportionment factors based on California law.

Including 100 percent of the non-US dividends significantly reduced Microsoft’s California apportionment factor, resulting in a refund of nearly $100 million. The FTB filed a petition for rehearing in response to the ruling, which the OTA has now denied. With this Valentine’s Day ruling, the OTA’s July 2023 decision on the merits is final. Notably, the FTB cannot appeal.

We anticipate that the OTA will publish both the July 2023 opinion and the recent petition for rehearing on the OTA website in the next month or so. It remains to be seen whether either opinion will be designated as precedential.

Eversheds Sutherland observation: Regardless of whether the Microsoft decision is precedential, water’s-edge taxpayers in California that have followed the FTB’s misguided matching principle by including only 25 percent of foreign dividends received in the sales factor denominator may have a significant refund opportunity.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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