Microsoft's recent California Office of Tax Appeals win results in the opportunity for significant California corporate tax refunds for taxpayers with dividends from foreign affiliates.
On February 14, 2024, the California Office of Tax Appeals (OTA) denied the California Franchise Tax Board’s petition for rehearing in Appeal of Microsoft Corporation and Subsidiaries, OTA Case No. 21037336 (Feb. 14, 2024). The OTA upheld its July 2023 ruling, which determined that Microsoft could include 100% of foreign dividend income in the denominator of its California sales factor and resulted in a $94 million California corporate tax refund.
The inclusion of the foreign dividend income in the sales factor denominator may result in a major refund opportunity for taxpayers with dividends from foreign affiliates.
For California corporate tax purposes, corporations filing a combined report can make a “water’s-edge” election to exclude certain foreign affiliates from the California combined report, rather than computing the combined California income on a worldwide basis. Pursuant to Cal. Rev. & Tax. Code § 24411(a), taxpayers filing a water’s-edge combined report are entitled to a 75% foreign dividend received deduction (DRD) for qualifying dividends received from foreign affiliates. As such, 75% of the dividend income received from foreign affiliates is not included in California business income subject to tax.
A taxpayer’s business income is apportioned to California by multiplying the business income by a single sales factor apportionment formula. The sales factor is a fraction computed based on total California sales divided by total sales everywhere during the tax year.
On its original return, Microsoft reported foreign dividend income received from foreign affiliates subject to the 75% foreign DRD and, since only 25% of the foreign dividends were included in business income, Microsoft included only 25% of the foreign dividends in the denominator of its California sales factor. Subsequently, Microsoft filed a refund claim with the California Franchise Tax Board (FTB) asserting that 100% of the foreign dividends should be included in the denominator of the sales factor, thus reducing the California apportionment percentage and business income apportioned to California.
The FTB denied Microsoft’s refund claim, and Microsoft filed an appeal with the OTA. The FTB argued, based on its longstanding administrative interpretation, that since the water’s-edge combined group was entitled to a 75% foreign DRD on the dividends received from foreign affiliates, then under a “matching principle,” 75% of the foreign dividends should be excluded from the sales factor. Under this principle, amounts that a company deducts, excludes, or exempts for California purposes are not included in the formula used to calculate what is taxable in California. [1]
On July 27, 2023, the OTA issued an opinion rejecting the FTB’s position and determining that the California tax statutes and regulations do not require the exclusion of any portion of the foreign dividends from the California sales factor on the basis that the foreign dividends are subject to the foreign DRD. Accordingly, the OTA granted Microsoft’s refund claim in the amount of $94 million for the fiscal year ending June 30, 2018. The FTB filed a petition for rehearing, and on February 14, 2024, the OTA issued an opinion denying the FTB’s petition for rehearing.
The OTA’s decision is now final, and the FTB is not permitted to appeal. It has not yet been determined whether the OTA’s decision in Microsoft will be designated as precedential, which is likely to occur in April 2024.
Taxpayers that filed California water’s-edge combined returns and received qualifying dividends from foreign affiliates subject to the 75% foreign DRD may have significant refund opportunities if their returns followed the FTB’s matching principle and included only 25% of foreign dividends in the California sales factor denominator. Whether Microsoft is published as precedential or non-precedential by the OTA, the OTA’s reasoning provides the basis for a California refund claim opportunity to the extent that California taxpayers received foreign dividends and included only 25% of the foreign dividends in the sales factor denominator based on the FTB’s prior interpretation.
California taxpayers that have filed water’s-edge combined returns and received foreign dividend income should carefully consider whether they may be entitled to California corporate tax refunds. Additionally, taxpayers with foreign dividends should consider whether refund opportunities may be available in other states to the extent those states apply a similar matching principle.
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[1] See Cal. Rev. & Tax. Code § 24425(a) stating “[n]o deduction shall be allowed for any amount otherwise allowable as a deduction which is allocable to one or more classes of income not included in the measure of the tax . . . .” See also, Cal. Code Regs. tit. 18, § 25120(d).