California OTA allows dividend inclusion in the sales factor

Update: On April 2, the California Office of Tax Appeals (OTA) published as nonprecedential both 1) its July 27, 2023 opinion that Microsoft Corp. could include its entire gross foreign dividend amount as gross receipts in its California sales factor, and 2) its February 14 opinion denying the Franchise Tax Board's Petition for Rehearing. [Appeal of Microsoft Corp. and Subsidiaries, California Office of Tax Appeals, 2024-OTA-130 and -131] Pursuant to the OTA Rules of Practice, any person may request that the opinion be designated as precedential. 

In brief

What happened?

The California Office of Tax Appeals (OTA) on July 27, 2023 ruled that Microsoft Corp. could include its entire gross foreign dividend amount as gross receipts in its California sales factor (Opinion). The OTA rejected the Franchise Tax Board’s (FTB’s) argument that the portion of dividends deducted from California income pursuant to the state’s water’s-edge dividends received deduction (DRD) at California Revenue and Taxation Code (CRTC) section 24411 should be removed from the sales factor. In reaching that conclusion, the OTA declined to follow the FTB’s longstanding position set forth in FTB Legal Ruling 2006-01. The OTA further ruled that inclusion of the gross dividends in the sales factor did not give rise to distortion under CRTC section 25137.

The FTB challenged the OTA determination by a Petition for Rehearing (Petition) filed on August 28, 2023. The OTA denied the FTB Petition by order issued on February 14, 2024, and the OTA decision will go final on or about March 13, 2024. The OTA has not announced whether the decision will be precedential.

[Appeal of Microsoft Corp. and Subsidiaries, California Office of Tax Appeals, No. 21037336 (7/27/23)]

Why is it relevant?

The OTA decision to allow deductible income to be included in the sales factor follows the rationale in the OTA’s precedential opinion in the Appeal of Southern Minnesota Beet Sugar Company (SMBSC), which allowed activities that generated cooperative income deducted under CRTC section 24404 to be included in the apportionment factor. Please click here for our Insight summarizing the SMBSC decision.

In both the SMBSC and Microsoft decisions, the OTA found that the FTB did not provide sufficient support for the position set forth in FTB Legal Ruling 2006-01 that income that is deducted from the apportionable tax base also must be excluded from the apportionment factor. Both decisions raise questions as to the continued viability of the Legal Ruling as applied to other deductions, exclusions, or eliminations.

In Microsoft the FTB also argued that inclusion in the sales factor of the deductible dividend amount caused distortion in the standard apportionment formula. The OTA ruled against the FTB on the distortion issue on the basis that the FTB did not meet its burden to prove by clear and convincing evidence that inclusion of the dividends at issue resulted in an unfair reflection of Microsoft’s business activities. The OTA’s decision on distortion in this case may limit the FTB’s ability to use distortion to exclude receipts arising from isolated or distinct revenue streams going forward. 

OTA opinion allows deductible foreign dividends in the sales factor

The Opinion concludes that gross receipts from dividends should not be reduced to account for dividends deducted under CRTC section 24411. In reaching that conclusion, the OTA followed the rationale of the SMBSC precedential opinion and concluded that there is nothing in the plain language of California statutory or judicial law or legislative history that bars Microsoft from including receipts that are deductible pursuant to CRTC section 24411 in the sales factor.

As applied to deductions allowed pursuant to CRTC section 24411, the Opinion rejected the reasoning from FTB Legal Ruling 2006-01, which concludes that receipts that are deducted from gross income generally are not included in the California sales factor.  

Alternative apportionment not required

The FTB argued that the inclusion of Microsoft’s gross foreign dividends in the sales factor would not fairly reflect the extent of Microsoft’s business activity in California and should therefore be subject to an alternative apportionment formula. Under California law if the standard apportionment provisions do not fairly reflect the taxpayer’s activity in the state, the taxpayer may petition for, or the FTB may require, if reasonable, the employment of an alternative apportionment method to effectuate an equitable allocation and apportionment of the taxpayer’s income.

The FTB sought to exclude the gross dividend receipts from the sales factor as an occasional sale or based on asserted qualitative and/or quantitative distortion as described in the Microsoft and General Mills decisions by the California courts. 

The Opinion concludes that the FTB did not satisfy its burden to prove by clear and convincing evidence that inclusion of Microsoft’s gross foreign dividends in the sales factor results in an unfair reflection of Microsoft’s business activities..