Check Your California Receipts: California Supreme Court Should Provide Appropriate Standards For Equitable Apportionment

Transcription

1 Check Your California Receipts: California Supreme Court Should Provide Appropriate Standards For Equitable Apportionment Introduction by Jeffrey A. Friedman, Kendall L. Houghton, and Maryann H. Luongo Jeffrey A. Friedman and Kendall L. Houghton are partners and Maryann H. Luongo is an associate with the law firm of Sutherland Asbill & Brennan LLP, Washington. Their practice is devoted to multistate tax matters, including appellate litigation. They submitted an amicus brief (on behalf of United Technologies Corp.) in support of the petition for review filed by Microsoft Corp. with the California Supreme Court. Pending in the California Supreme Court are two cases dealing with sales factor apportionment issues resulting from ordinary treasury function activities, General Motors v. Franchise Tax Board 1 and Microsoft Corp. v. Franchise Tax Board. 2 In each case, the Franchise Tax Board (FTB) sought to exclude from gross receipts the return of principal from the sale of securities for purposes of determining the sales factor for apportionment purposes. The General Motors decision dealt only with the statutory definition of gross receipts. The Microsoft decision, on the other hand, found that the general definition of gross receipts led to an unfair result and therefore the FTB applied equitable apportionment in excluding the return of principal from the apportionment factor. 1 General Motors v. Franchise Tax Board, 16 Cal. Rptr. 3d 41 (Cal. App. 2d Dist. 2004). (For the California Court of Appeal s decision in General Motors v. Franchise Tax Board, see Doc or 2004 STT ) 2 Microsoft Corp. v. Franchise Tax Board, 2005 WL (Cal. App. 1st Dist. 2005). (For the Court of Appeal s decision in Microsoft Corp. v. Franchise Tax Board, see Doc or 2005 STT 42-4.) This article analyzes whether return of principal should be excluded from gross receipts. First, through discussion of the General Motors case, the article discusses the statutory interpretation of gross receipts. Second, and the focus of this article, we discuss use of equitable apportionment when the calculation of gross receipts makes the standard apportionment formula arguably unfair. Background In General Motors v. FTB, the court of appeal upheld the trial court s calculation of income apportionable to California. 3 General Motors operated its corporate treasury function in New York and bought and sold securities on a regular basis. The court of appeal held that the FTB properly excluded returns of principal resulting from maturities and repurchase agreements from the General Motors sales factor calculation of gross receipts. In analyzing the type of transactions giving rise to those receipts, the court held that repurchase agreements and maturities are not sales, but rather secured monetary transactions similar to loans. The disposition of these securities is, according to the court of appeal, a return of principal, made up of one s own funds, 3 California adopted UDITPA section to apportion income from multistate businesses. All business income is apportioned to California by multiplying the business income by a fraction the numerator of which is the property factor plus the payroll factor plus twice the sales factor. The denominator of the fraction is four. California Revenue and Taxation Code section (2005). If the business derives more than 50 percent of its gross business receipts from conducting one or more qualified business activities, a single-weighted sales factor is used and the denominator is 3. The sales factor, our focus here, has a numerator made up of gross receipts attributable to California. The denominator includes the total gross receipts of the taxpayer from transactions and activities in the regular course of business (California Revenue and Taxation Code section (2005)). State Tax Notes, September 5,

2 and does not constitute a sale. Because the court concluded that the transaction resulting in the return of principal was not a sale, it was not includable in the California sales factor as gross receipts. However, the interest earned on the principal, or net gain, was includable in the California sales factor. 4 The FTB also sought to apply equitable apportionment to the taxpayer, in the event that the court did not agree that the so-called return of principal should be excluded from gross receipts. 5 The court of appeal decided the gross receipts issue, and thus did not reach the equitable apportionment issue. The case is on appeal to the California Supreme Court; its petition was granted October 13, 2004, and the parties await scheduling of oral argument. The court held that the returns of principal from the investment in short-term financial instruments held to maturity did not arise out of a sales transaction and therefore should not be included as gross receipts. In a recent case with facts similar to General Motors (a treasury function disposing of investments at maturity), Limited Stores Inc. v. FTB, the court of appeal also held that the returns of principal from the investment in short-term financial instruments held to maturity did not arise out of a sales transaction and therefore should not be included as gross receipts in the denominator of the California sales factor for apportionment purposes. 6 However, in Limited Stores, the court of appeal also noted that 4 General Motors v. Franchise Tax Board, 16 Cal. Rptr. 3d 41 (Cal. App. 2d Dist. 2004). 5 Many states, including California, have adopted UDITPA and therefore allow for equitable apportionment. Although California statutes and regulations use the term alternate apportionment, it is generally referred to as equitable apportionment and that term will be used throughout this article. Section 18 of UDITPA states: If the allocation and apportionment provisions of this Act do not fairly represent the extent of the taxpayer s business activity in this state, the taxpayer may petition for or the tax administrator may require, in respect to all or any part of the taxpayer s business activity, if reasonable: (a) separate accounting; (b) the exclusion of any one or more of the factors; (c) the inclusion of one or more additional factors which will fairly represent the taxpayer s business activity in this state; or (d) the employment of any other method to effectuate an equitable allocation and apportionment of the taxpayer s income. 6 Limited Stores Inc. v. Franchise Tax Board, 2005 WL (Cal. App. 1 Dist. 2005). (For the court of appeal s decision in Limited Stores Inc., see Doc or 2005 STT ) Sutherland Asbill & Brennan Observation: A refund opportunity may exist for companies that have included net gain rather than gross receipts from the sale of securities in their California sales factor. The FTB has acknowledged that the gross proceeds from the prematurity sale of securities should be included in the sales factor as gross receipts. the FTB agreed that under existing California law, actual sales of short-term financial instruments to third parties prior to maturity are properly included with the sales factor computation. (Emphasis added.) 7 In General Motors and Limited Stores, the FTB and the court of appeal drew artificial lines to determine which receipts were includable in the California sales factor, including return of principal on sales before maturity and excluding sales at maturity (General Motors also excluded return of principal in repurchase agreements). The chart on the next page illustrates the result of basing sales factor inclusion of gross receipts from treasury function investments on maturity. If the investor sells the bond one day before maturity, the gross receipts of the investment, return of principal and gain, will be included in the sales factor. If the investor waits and sells the security the next business day, only the net gain will be included in the sales factor. The Microsoft case also focuses on the inclusion of treasury function receipts from the disposition of securities in the sales factor. Microsoft s treasury function, which is composed of six employees, is located in Redmond, Wash. The treasury function generates income for Microsoft through the purchase and sale of marketable securities such as commercial paper, corporate bonds, U.S. Treasury bills and notes, discount notes, U.S. money market securities, and loan repurchase agreements. In the 1991 tax year, Microsoft owned on average $600 million in marketable securities at any one time. 8 7 Id. Note that General Motors received similarly favorable treatment of its prematurity sales. See General Motors v. Franchise Tax Board, 16 Cal. Rptr. 3d 41 (Cal. App. 2d Dist. 2004). Also, the trial court in Microsoft, addressing the FTB s distinction between securities sold before maturity and securities sold at maturity, said the FTB has rationalized a distinction where no logical [sic] exists; the economic effect of the time of the sales of securities is the same. Microsoft Corp. v. Franchise Tax Board, Case No (San Francisco County Super. Ct. 2003), rev d, 2005 WL (Cal. App. 1st Dist. 2005). 8 Microsoft Corp. v. Franchise Tax Board, Case No (San Francisco County Super. Ct. 2003). 746 State Tax Notes, September 5, 2005

3 Purchase 10-Year Bond on: Maturity Date Sold 10-Year Bond on: The superior court, citing the Uniform Definition of Income for Tax Purposes Act (UDITPA) definition of sales, ruled that the definition of sales did not include a limitation regarding return of principal. 9 Therefore, the superior court upheld inclusion of all of Microsoft s treasury function receipts from the sale of marketable securities in the sales factor at gross value. 10 The FTB asked the court to apply equitable apportionment principles. In response, the superior court held that the FTB had not met its burden of proving that standard apportionment led to an unfair result because the FTB provided no evidence as to the business activities of Microsoft in California that would enable a determination to be made as to the fairness of the application of the standard apportionment formula. 11 The superior court interpreted gross receipts as including the proceeds from matured securities. However, the court of appeal reversed. Rather than overruling the superior court decision on the gross receipts issue, the court of appeal instead decided the case on the alternative ground of equitable apportionment, holding that the inclusion of receipts from transactions in marketable securities at gross value distorted the sales factor and produced an unfair result that must be remedied by an alternative apportionment formula. 12 The California Supreme Court granted review on June 8, 2005, and awaits scheduling for oral argument. The implications of the application of equitable apportionment by the court of appeal in Microsoft are far-reaching and profoundly unsettling to every 9 Gross receipts is defined for business income purposes as sales as defined in subdivision (e) of California Revenue and Taxation Code section and the regulations under section California Revenue and Taxation Code section 25128(d) (2005). Section 25120(e) defines sales as all gross receipts of the taxpayer not allocated under section through section California Revenue and Taxation Code section 25120(e) (2005). Section of the regulations defines sales as all gross receipts derived by the taxpayer from transactions and activity in the regular course of such trade or business. Cal. Code regs. tit. 18, section The definition of gross receipts references the definition of sales and vice versa. 10 Microsoft Corp. v. Franchise Tax Board, Case No (San Francisco County Super. Ct. 2003). 11 Id. 12 Microsoft Corp. v. Franchise Tax Board, 2005 WL (Cal. App. 1 Dist. 2005). Inclusion of Disposition in Sales Factor January 1, 2005 January 1, 2015 January 2, 2005 Gross Receipts January 1, 2005 January 1, 2015 December 30, 2014 Gross Receipts January 1, 2005 January 1, 2015 January 1, 2015 Net Gain California taxpayer conducting investment activities and treasury functions which is nearly every large U.S. business. The court of appeal s ad hoc resort to equitable apportionment, without a corresponding articulation of guidance or standards for use of equitable apportionment in this or any other case, renders nearly all large California taxpayers vulnerable to second-guessing by the FTB. Setting standards for the application of equitable apportionment is of greater importance than the General Motors and Microsoft cases suggest, because questions of equitable apportionment arise in a variety of contexts that implicate each of the three standard apportionment factors (that is, payroll, property, and sales) in reviewing the overall result of the formula. 13 This article sets forth reasons why the 13 Equitable apportionment has historically been applied in a wide range of income tax cases. For example, in Communications Satellite Corp. v. FTB, the California Court of Appeal sustained the Franchise Tax Board s use of equitable apportionment to include in the property factor interests in satellites not located in California. The satellites functioned in and through California through the earth station located in the state and owned in part by the corporation so the Franchise Tax Board included them in the property factor. Communications Satellite Corp. v. Franchise Tax Board, 156 Cal. App. 3d 726 (Ct. App. 1984). In Twentieth Century-Fox Film Corp. v. Department of Revenue, the Oregon Supreme Court approved modification of the property factor to more equitably apportion income of a taxpayer whose only business activity in Oregon was the licensing of motion pictures to independent theaters. Whereas the taxpayer only included in its property factor the cost of the positive prints of its films, the Department of Revenue modified the property factor to include a portion of negatives stored in California, worth significantly more than the positive prints. The court concluded that the standard formula, which did not include the negatives, did not fairly represent the taxpayer s business in Oregon. Twentieth Century-Fox Film Corp. v. Department of Revenue, 700 P.2d 1035 (Or. 1985). The Montana Supreme Court applied equitable apportionment to modify the section 18 special industry sales factor for motor carriers (which is calculated by reference to the mileage method) at the request of a taxpayer in Montana Department of Revenue v. United Parcel Service Inc. The court held that United Parcel Service was not required to use the mileage method generally applicable to motor carriers for determining its Montana sales factor, because it overstated the revenues fairly attributable to the state. Montana Department of Revenue v. United Parcel Service Inc., 830 P.2d 1259 (Mont. 1992). In Lancaster Colony Corp. v. Limbach, the taxpayer made its sales through independent contractors working outside of Ohio. This made the taxpayer s payroll factor higher than if the independent contractors were employees. The court allowed the taxpayer (Footnote continued on next page.) State Tax Notes, September 5,

4 California Supreme Court justifiably decided to review the equitable apportionment issue presented in Microsoft and examines why the supreme court s guidance in this area is so desperately needed by taxpayers. Controversy Over Statutory Construction Of Gross Receipts Presaged the FTB s Corollary Effort To Resort to Equitable Apportionment The court of appeal in General Motors and the trial court in Microsoft focused on the statutory definition of sale, while the court of appeal in Microsoft bypassed the gross receipts question and instead examined the result through an equitable apportionment lens. The issue of whether the gross proceeds from sales of investment instruments are properly included in the sales factor is not new. States have struggled with the definition and have attempted to sidestep statutes by promulgating regulations to narrow the definition. The Multistate Tax Commission Model Regulation prescribes the following approach for dealing with the receipt of income from treasury functions: If a taxpayer holds liquid assets in connection with one or more treasury functions of the taxpayer, and the liquid assets produce business income when sold, exchanged or otherwise disposed, the overall net gain from those transactions for each treasury function for the tax period is included in the sales factor. For purposes of this subsection, each treasury function will be considered separately. 14 (Emphasis added.) Hawaii, Idaho, and Utah have adopted that MTC provision in their own regulations. 15 Illinois adopted a similar provision that, although worded differently from the MTC version, has the same effect of including only net gain (or loss) rather than gross receipts realized on sales of business intangibles in the sales factor. 16 Changing the definition of gross receipts by regulation leads to an unsupportable application of the underlying statute. The statute would include all gross receipts in the sales factor, while the regulation would omit certain gross receipts. to include the payroll of the independent contractors in its payroll factor. Lancaster Colony Corp. v. Limbach, 524 N.E.2d 1389 (Ohio 1989). 14 MTC Model Regulations, reg. IV.18.(c) (November 2004). 15 See Idaho Admin. Code reg (2004); Haw. Code. reg ; Utah Admin. Code R865-6f-8(j) (2005). 16 Cf. Ill. Admin. Code tit. 86, section (c)(5). Indeed, California has a bill pending that amends California s statutory definition of sales by narrowing the definition of gross receipts. 17 Comments to the bill have described it as codifying existing practices at the FTB; however, the bill actually changes existing law. The bill states that gross receipts shall be limited to net gain realized from transactions undertaken as part of the treasury function. The bill has been sponsored by Steve Westly, the state controller and FTB chair, and is currently awaiting a hearing date. 18 The timing of this legislative initiative underscores the relevance of the pending litigation. The implications of the application of equitable apportionment by the court of appeal in Microsoft are far-reaching and profoundly unsettling to every California taxpayer conducting investment activities and treasury functions. In addition to promulgation of regulations, litigation of the statutory construction question associated with the definition of gross receipts has also been undertaken by taxpayers and revenue departments when the applicable law, regulations, and agency audit practices and policies have been inconsistent. 19 While this process is less predictable, the 17 AB 1037, Sess. (California 2005). 18 Laura Mahoney, Unitary Groups Treasury Function, Use of Credits Before State High Court, BNA Daily Tax Report, No. 141 (July 25, 2005). 19 Walgreen Arizona Drug Co. v. Arizona Department of Revenue, 97 P.3d 896 (Ariz. Ct. App. Div. One 2004) (return of principal from the type of short-term investment commercial paper, municipal securities, auction stock, Euro-dollar investments, and money markets is not includable in the sales factor denominator). (Note: The Walgreen court said that the purpose of the sales factor is to tax an entity for the benefits it receives by exploiting a market in that state. Applying this to Microsoft, where the business activity giving rise to the receipts took place not in California but in Redmond, Wash., none of the receipts would be included in the numerator of the California sales factor.) See also American Telephone and Telegraph Co. v. Director, Division of Tax, 476 A.2d 800 (N.J. Super. Ct. App. Div. 1984) (only net gains from the disposition of short-term investments are includable in the sales factor); Sherwin-Williams Co. v. Department of Revenue, 996 P.2d 500 (Oregon 2000) (Oregon definition of sales includes gross receipts not net gain). (For the Arizona appellate court s decision in Walgreen, see Doc or 2004 STT For the Oregon Supreme Court s decision in Sherwin- Williams, see Doc or 2000 STT ) 748 State Tax Notes, September 5, 2005

5 20 While UDITPA provides a three-factor formula with equally weighted formulas, few states equally weight the factors, with many double-weighting the sales factor. Also, some states are moving toward a single-factor formula based on sales or gross receipts. In states where a single sales factor is used, the issue whether treasury receipts distorts the sales factor becomes even more significant. CCH State Tax Review, Issue 25 (June 21, 2005). 21 Container Corp. of Am. v. Franchise Tax Board, 463 U.S. 159 (1983); Exxon Corp. v. Wisconsin Department of Revenue, 447 U.S. 207 (1980); Moorman Manufacturing Co. v. G.D. Bair, Director of Revenue of Iowa, 437 U.S. 267 (1978). Also, the U.S. Supreme Court has applied tests of internal and external consistency to determine fair apportionment under the dormant Commerce Clause. Oklahoma Tax Commission v. Jefferson Lines Inc., 514 U.S. 175 (1995); Armco Inc. v. Hardesty, 467 U.S. 638 (1984); American Trucking Ass ns v. Scheiner, 483 U.S. 266 (1987). 22 John S. Warren, 1150 T.M., Income Taxes: Principles of Formulary Apportionment, section (B). Viewpoint FTB has forced taxpayers to resort to it in an effort to achieve final resolution of this issue. Equitable Apportionment UDITPA provides a model three-factor formula for apportioning corporate interstate income. 20 UDITPA s general (three-factor) apportionment provisions are designed to satisfy the U.S. Constitution s due process and Commerce Clause requirements that taxes on or measured by income arising from interstate activity be fairly apportioned. 21 Nevertheless, the drafters of UDITPA recognized that for certain specific industries, and in certain circumstances, the general apportionment provisions might not yield a fair reflection of a taxpayer s in-state business activity. Therefore, if the apportionment formula does not fairly represent the extent of the taxpayers business activity in [a particular] state, section 18 of UDITPA allows the taxpayer or tax administrator to apply an alternative apportionment scheme. Before the adoption of UDITPA, state statutes generally allowed only tax administrators to stray from the standard apportionment formula. Therefore, the tax administrator was presumed to be correct in its treatment of the taxpayer, and the taxpayer had the burden of proof to show otherwise. 22 With the adoption of a section 18 statutory provision, both taxpayers and tax administrators may resort to equitable apportionment. Although section 18 provides for the deviation from the standard apportionment formula and application of equitable apportionment, it offers little guidance as to (1) when equitable apportionment should be applied in lieu of standard apportionment or (2) which method of alternative apportionment should be applied to a taxpayer s special facts and circumstances. Some states have applied section 18 by promulgating regulations providing distinct alternative apportionment formulas for specific industries. 23 In drafting the model three-factor apportionment formula, UDITPA s framers anticipated that states would look at the activities of certain industries and promulgate specific rules for those industries for apportionment of income. Walter Hellerstein, author of the leading treatise on state taxation, notes, however, that even those states that have enacted such formulas seldom have adopted them for all the special industries for which they are needed. 24, 25 California Law Regarding Equitable Apportionment Standards Is Deficient The Application of Section 18 by the Court of Appeal in Microsoft Lacks Clarity California Revenue and Taxation Code section (the equivalent to UDITPA section 18) authorizes a deviation from the standard apportionment formula if allocation and apportionment provisions do not fairly represent the extent of the taxpayer s business in California. California regulations permit a departure from the standard apportionment and allocation methods only in limited and specific cases. 26 Section 25137, its supporting regulation, and the decisions of California courts each sanction deviation from the standard apportionment formula, based on a demonstration that its application would be inequitable; however, they do not provide specific guidelines or examples to help the taxpayer or tax administrator determine when a result is inequitable. 27 Moreover, the only requirement in section that directly relates to the particular alternative apportionment method selected as a substitute 23 See e.g., Hawaii Admin. Code reg. section (special apportionment for air carriers, construction contractors, ocean carriers, publishing, radio broadcasting and television broadcasting); Idaho Admin. Code reg (2004) (special apportionment for construction contractors, airlines, railroads, trucking companies, television and radio broadcasting, and publishing); Missouri Code of Regs. 12 section (1) (special apportionment formula for airlines and construction contractors). 24 Jerome R. Hellerstein and Walter Hellerstein, 1 State Taxation: Constitutional Limitations and Corporate Income and Franchise Taxes, 9.20[1] (3d ed. 1998). 25 Id. 26 Cal. Code regs. tit. 18, section Note that many tax professionals and some court decisions refer either to a requirement or conclusion that the standard apportionment results in distortion, before deviation under section may be justified. The concept of distortion in this context need not take on constitutional significance (cf. Hans Rees Sons Inc. v. North Carolina, 283 U.S. 123 (1931) (held that when state s standard apportionment formula, as applied to taxpayer, results in 250 percent distortion, the tax is unconstitutional); however, when a tax would result in a constitutionally significant level of distortion, the result would certainly be unfair and would justify resort to an alternative apportionment method under section State Tax Notes, September 5,

6 for standard apportionment is that such alternative method be reasonable. The court of appeal in Microsoft did not help to further clarify equitable apportionment. The court of appeal reasoned in its decision that the returned principal portion of Microsoft s gross receipts swamps the revenues attributable to its normal business activity. 28 While swamps is an evocative verb, it hardly constitutes a legal standard that either the FTB or the California taxpayer community can apply effectively. Burden of Proof for Party Seeking Equitable Apportionment Remains Unclear In California, Despite Examination Of Other States Rules Many courts reviewing equitable apportionment challenges have held that the party invoking section 18 equitable relief, whether the taxpayer or tax administrator, has the burden of proving that the standard apportionment result is not fair. 29 The party seeking the application of an alternative apportionment method must prove unfairness of the standard apportionment formula by clear and cogent evidence. 30 Not all states require the same burden of proof to show entitlement to an alternative apportionment formula. However, not all states require the same burden of proof to show entitlement to an alternative apportionment formula. In the Matter of the Appeal of Fluor Corp., the California State Board of Equalization (BOE) reviewed the burden-of-proof requirements of different states. 31 For example, Utah narrowly construes the relief provisions of section 18 of UDITPA, so that the party seeking to deviate from the standard formula must prove distortion due to the application of that standard formula. Oregon takes a two-step approach; not only must the party seeking to depart from the standard UDITPA formula prove distortion, but it also must show that the alternative method selected is reasonable. Wisconsin treats the special or alternative methods adopted 28 Microsoft Corp. v. Franchise Tax Board, 2005 WL (Cal. App. 1 Dist. 2005). 29 See Butler Brothers v. McColgan, 315 U.S. 501 (1942); Twentieth Century-Fox Film Corp. v. Department of Revenue, 700 P.2d 1035 (Oregon 1985); St. Johnsbury Trucking Co. v. State, 385 A.2d 215 (N.H. 1978); Ruby Construction Co. v. Department of Revenue, 578 S.W.2d 248 (Ky. Ct. App. 1978); Deseret Pharmaceutical Co. v. State Tax Commission 579 P.2d 1322 (Ut. 1978); Bendix Corp. v. Director, Division of Taxation, 592 A.2d 536 (N.J. 1991). 30 Butler Bros. v. McColgan, 315 U.S. 501 (1942). 31 In the Matter of the Appeal of Fluor Corp., 95-SBE-016. by its taxing agency as rules of general application (that is, effectively they serve as standard formulas for such special industries), and the taxpayer must show distortion thereunder to deviate from those rules. The California BOE said: Even the forays made by this board [the BOE] into this murky area have resulted in opinions that have been, at best, difficult to reconcile. 32 California Supreme Court Should Provide Clarity In California, the party seeking to use section must prove by clear and cogent evidence that application of the general apportionment provision would lead to an unfair representation of the extent of the taxpayer s activities in California. 33 While the California standard for meeting the burden is by clear and cogent evidence, the court of appeal in Microsoft did not mention that standard, much less apply it. California courts have addressed equitable apportionment, but their use of general and undefined terms in decisions renders many of those cases unhelpful to taxpayers or tax administrators who seek guidance. California courts have addressed equitable apportionment, but their use of general and undefined terms in decisions renders many of those cases unhelpful to taxpayers or tax administrators who seek guidance on when to resort to equitable apportionment methods. The California BOE has said that to determine if equitable apportionment may be used, the relationship between the structure and function of the standard apportionment formula and the circumstances of the taxpayer must be reviewed. 34 If the analysis reveals some manner in which the formula does not adequately deal with the taxpayer s circumstances, or results in a distortion, equitable apportionment may apply. 35 The word distortion does not give the taxpayer much in the way of reliable standards. For example, what makes apportionment factors distortive? A change in the 32 Id. 33 See Colgate-Palmolive Co. v. Franchise Tax Board, 10 Cal. App. 4th 1768 (3rd Dist. 1992) (aff d sub nom. Barclays Bank PLC v. Franchise Tax Board, 512 U.S. 298 (1994)); Microsoft Corp. v. Franchise Tax Board, Case No (San Francisco County Super. Ct. 2003); Appeal of Dart Container Corp. of California, 92-SBE-021; Appeal of Merrill, Lynch, Pierce, Fenner & Smith Inc., 89-SBE Appeal of Crisa Corp., 02-SBE Id. 750 State Tax Notes, September 5, 2005

7 relevant apportionment factor by a threshold percentage? The generation of more or less tax in a specific situation? The case law provides scant illumination of these concepts and the California Supreme Court should add clarity when it decides Microsoft. The BOE noted that California reg permits equitable apportionment when the standard apportionment formula produce[s] inequitable results when applied to unusual factual situations. 36 What constitutes an unusual situation, for purposes of this test? Applying this standard to Microsoft, we believe that there is nothing unusual about a treasury function nearly all large companies have one. Microsoft s treasury function invests in marketable securities to earn income for working capital for the Microsoft Corp. The treasury organization buys and sells marketable securities nearly every business day of every year. If the court reviews the operations of any large company, it will see that each has a treasury function investing in similar types of securities on a daily basis. 37 The broad statements in the BOE s analysis in Appeal of Crisa Corp. and Microsoft provoke more questions rather than provide the taxpayer an understanding of when it is entitled to seek equitable apportionment. Compounding the lack of guidance on equitable apportionment, there is a lack of consistency in California s application of the burden of proof for applying section A review of the relevant decisions shows that generally taxpayers are found not to have met their burden of proof, 38 while the FTB generally is found to have satisfied the burden of proof Appeal of Merrill, Lynch, Pierce, Fenner & Smith Inc., 89-SBE California would certainly not concede that the treasury receipts produce business income and the presumption that business income receipts are includable in the sales factor. American Home Products Corp. v. Limbach, 49 Ohio St. 3d 158 (Ohio 1990). If Microsoft s treasury function produces significant income, is it fair to exclude these receipts from the sales factor just because the activity happens to be performed outside California? 38 Appeal of Kikkoman International, 82-SBE-098; Appeal of Crisa Corp., 02-SBE-004; Appeal of CTI Holdings, 96-SBE- 003; Appeal of Quick & Reilly Inc., St. Bd. Eq. No (2004); Appeal of Weyerhaeuser Co., St. Bd. Eq. Nos and (2005); Colgate-Palmolive v. Franchise Tax Board, 10 Cal. App. 4th 1768 (3rd Dist. 1992); Appeal of Milhous, St. Bd. Eq. Nos. 99A-0186 and 99A-0187 (2002); Appeal of Guy F. Atkinson Co., No. 96R-0051 (1997); Appeal of The Bank of Tokyo, 95-SBE-006; Appeal of Sanrio Inc., St. Bd. Eq. No. 89A-0413 (1995). 39 Communications Satellite Corp. v. Franchise Tax Board, 156 Cal.App.3d 726 (Cal. App. 1st Dist. 1984); Appeal of John Deere Plow Co., 61-SBE-081; Appeal of Polaroid Corp., St. Bd. Eq. No (2003); Appeal of Montgomery Ward and Co. Viewpoint To Date, California Lacks a Workable Standard for Application of Equitable Apportionment to Treasury Receipts Treasury Functions Are Not Unusual Section applies only when the standard apportionment formula produce[s] inequitable results when applied to unusual factual situations. 40 Also, the California regulation promulgated thereunder states that section may be invoked only in specific cases in which unusual fact situations produce incongruous results under standard apportionment formulas. The regulation clarifies unusual to mean unique and nonrecurring. 41 As discussed above, the facts and circumstances in Microsoft (that is, investing in marketable securities) are neither unique nor nonrecurring, making resort to a nonstandard apportionment treatment inappropriate, as compared with other cases in which the FTB sought to use alternative apportionment methods under section Treasury functions of corporations raise funds to serve generally as working capital. The funds are used to provide financial assistance through, for example, loans, advances, and stock investments. Also, treasury function receipts are used to pay taxes, dividends, and interest, to provide for capital needs, and to meet legal liquidity and credit rating requirements. Generally, pending their use by unitary businesses, the funds are invested in short-term, interestbearing, and discount securities. 43 Some corporations have a general policy of holding treasury investments to maturity, liquidating prematurity securities only when the funds are needed to meet unscheduled cash needs of subsidiaries. 44 Treasury Inc., St. Bd. Eq. No (2002). But see, Appeal of BCE Develop. Inc., St. Bd. Eq. No. 93R-0266 (1996); Appeal of Pneumo Abex Corp., St. Bd. Eq. No. 93R-0024 (1993). 40 Appeal of Merrill, Lynch, Pierce, Fenner & Smith, Inc., 89-SBE-017 (emphasis added). 41 Cal. Code. regs. tit. 18, section See, e.g., Appeal of New York Football Giants Inc., opinion on rehearing 77-SBE-014 (treatment of home game gate receipts); Appeal of Fluor Corp., 95-SBE-016 (receipts from sale of taxpayer s headquarters); Appeal of John Deere Plow Co., 61-SBE-081 (including only 50 percent of war sales in receipts factor); Communications Satellite Corp. v. Franchise Tax Board, 156 Cal.App.3d 726 (Cal. App. 1st Dist. 1984) (property and receipts factors for commercial satellites orbiting in outer space); Appeal of BCE Develop. Inc., St. Bd. Eq. No. 93R-0266 (1996) (installment sale receipts from transactions that closed before a subsidiary became a member of the unitary group); Appeal of Pneumo Abex Corp., St. Bd. Eq. No. 93R-0024 (1993) (receipts from the sale of the stock of three unitary subsidiaries). 43 In the Matter of the Appeals of Pacific Telephone and Telegraph Co., 78-SBE Id. (Footnote continued in next column.) State Tax Notes, September 5,

8 investments also serve a sweeping function; the cash left in subsidiaries bank accounts is swept each day and invested to achieve a higher rate of return. Compounding the lack of guidance regarding equitable apportionment, there is a lack of consistency in California s application of the burden of proof for applying section The court should provide a standard for determining unusual factual situations. While the court cannot anticipate every possible factual scenario it may ultimately face, its articulation of standards to control and render consistent determinations of unusual factual situations will guide both taxpayers and tax administrators in their application of the doctrine of equitable apportionment. The court may look to see if the taxpayer has a new or unique business that has a significant impact on a specific factor for a particular year. One example would be the one-time favorable treatment for repatriation of dividends provided by Internal Revenue Code section 965. Section 965 provides for a temporary elective 85 percent dividends received deduction for extraordinary cash dividends repatriated into the United States. The requirement that the dividends be extraordinary could result in a corporation repatriating a very large dividend that would affect its apportionment factors if the dividends are business income and are not deductible on the state return. 45 Because of the temporary and unprecedented nature of this activity, it may fit within the unusual and nonrecurring description provided by the regulation. Another example of a potentially unusual fact situation relates to a pension reversion. If corporations experience excess funding in their pension plans, they may choose to release the excess funds. This would only occur if the market circumstances were such that the funds were earning enough to allow for a reversion. It would likely be an unusual and possibly nonrecurring event and may justify equitable apportionment Surprisingly, the FTB has stated in Legal Ruling (July 8, 2005) that the business/nonbusiness distinction is premised on how the Internal Revenue Code section 965 dividends will be reinvested. If the IRC section 965 dividends are earmarked for a specific use of the recipient s unitary business, the dividends constitute business income and are apportioned. 46 Hoechst Celanese v. Franchise Tax Board, 25 Cal.4th 508 (2001) (income from a pension reversion is business income). The California Supreme Court Must Reshape the Court of Appeal s Alleged Distortion Standard The court of appeal s decision did not provide a comparative analysis that taxpayers or the state can use to identify distortion. The California Court of Appeal, in using the description swamps, was referring to a comparison of proceeds from Microsoft s other operations, which totaled $659 million in income and $2.1 billion in gross receipts, compared with the $10.7 million of income and $5.7 billion of gross receipts from Microsoft s treasury function. Presumably, other operations as used by the court of appeal is intended to mean the same thing as Microsoft s normal business activity as used in the statute. 47 The court of appeal provides little support for the analysis associated with comparing a taxpayer s normal business activity with the taxpayer s treasury functions. Is this the exclusive comparison to be used in determining whether alternative apportionment should be applied? Or, is the comparison of a taxpayer s treasury function with normal business activity (however defined) one of several alternative comparisons that a party has available to it? If the latter, are the alternatives to be ranked? Averaged? The California Supreme Court should address these important questions in Microsoft. If the court chooses not to, taxpayers and the FTB will be forced to ask the court to address each potentially unusual fact pattern as it arises. The court of appeal did note that Microsoft s sales factor would decrease from percent to percent by including gross proceeds, not net gains, from the investment transactions. Further, Microsoft s total apportionment factor would drop from percent to percent by inclusion of gross proceeds. Are such decreases relevant for determining the application of alternative apportionment? If so, do such decreases support the application of alternative apportionment? The court of appeal s abbreviated analysis leaves taxpayers to ponder such questions while undertaking the already complex task of calculating California franchise tax liability. The court did not indicate how much or little reliance was placed on these differences. California taxpayers are left in a deeper state of confusion as a result of the court of appeal decision, and the supreme court should provide needed clarity. By comparing the income and apportionment factors associated with in-state business activity versus out-of-state business activity, the court of appeal invites significant controversy. California 47 While the FTB conceded that Microsoft s treasury functions were part of its unitary business, the court of appeal has disregarded this critical fact in setting up a comparison of the taxpayer s treasury function with its normal business activity. 752 State Tax Notes, September 5, 2005

9 employs a unitary system of taxation that takes into account the income and apportionment factors of a taxpayer and its unitary affiliates. 48 This unitary method of taxation takes into account in-state and out-of-state activities and functions. The court of appeal s comparison of the profitability and apportionment factors of Microsoft s business activity partly conducted within the state (for example, software sales) with Microsoft s business activity conducted wholly outside the state (for example, investment activity and other treasury functions) leads one to question whether the unitary business principle is the exclusive test to determine the taxation of a taxpayer s in-state and out-of-state businesses. The court of appeal s adoption of the FTB s approach effectively divides an otherwise unitary business into subsegments deserving varying apportionment methods. Lack of Guidance to Determine Method Of Equitable Apportionment Section provides four methods of equitable apportionment, one of which is a catchall provision allowing employment of any other method to effectuate an equitable allocation and apportionment of a taxpayer s income. 49 However, there are no guidelines as to which option is appropriate; only a requirement that the option chosen be reasonable. With no standards as guidance, how is the taxpayer or the FTB to know which formula should or will be used to calculate the tax? Assuming equitable apportionment is appropriate, what if the taxpayer and the FTB advocate different alternative apportionment formulas? What factors will determine which formula prevails? The purpose of equitable apportionment is to make sure the tax imposed on a corporation is fair. However, the California Supreme Court should provide some analysis as to the proper selection of an alternative apportionment formula. In Microsoft, the superior court required proof by clear and cogent evidence by the FTB that the standard apportionment formula was unfair and that the alternative formula fairly reflected Microsoft s business activity in California. The superior court did not view the FTB s redefinition of gross receipts as the provision of an alternative apportionment formula required by the statute, and this, along with a lack of evidence of unfairness, led the court to hold that the FTB did not meet its burden of proof. The court of appeal reached the opposite conclusion, holding that calculation of the sales factor using only net income from the sale of securities is a reasonable and fair alternative apportionment formula, well within the boundaries of section However, there was no discussion as to why the inclusion of only net, versus gross, treasury receipts in the sales factor constituted a reasonable or more fair calculation of tax. The California Supreme Court can set the appropriate standards for when taxpayers and the FTB may apply equitable apportionment and how to choose which alternative method of apportionment is appropriate. The court of appeal s lack of guidance, standards, or elaboration of the required clear and cogent evidence standard prevents taxpayers from understanding how the court of appeal reached its decision that the FTB s proposed adjustment was reasonable. While the court of appeal s adoption of the FTB s approach tidily disposed of the case at hand, it does nothing to inform the future design of alternative apportionment formulas. It is certainly as reasonable, to quote the court of appeal, to suppose that a taxpayer might use a range of alternative apportionment methods when it was clearly established that inclusion of gross receipts did not fairly represent the taxpayer s business activity in California. Such methods might reasonably include any of the following: inclusion of net receipts in the sales factor (that is, the approach in Microsoft); exclusion of certain types of receipts within the class of treasury function receipts from the sales factor; inclusion of a percentage of the gross receipts from a taxpayer s treasury function; design of a new investment receipts factor that would be used in addition to the existing sales factor; or exclusion of all such treasury function receipts from the sales factor (both numerator and denominator). 50 Questions also arise regarding the court s review of the alternative apportionment methods. Is a court required to review all possible alternative apportionment methods raised by the parties to a case? How is a choice to be made if the parties both propose alternative apportionment methods? Should it be based on the court s assessment as to which is most reasonable? Or should the determination hinge 48 See, e.g., California Revenue and Taxation Code section (2005). 49 See California Revenue and Taxation Code section (2005). 50 See California Revenue and Taxation Code section (2005). Laura Mahoney, Unitary Groups Treasury Function, Use of Credits Before State High Court, BNA Daily Tax Report, No. 141 (July 25, 2005). State Tax Notes, September 5,

10 only on whether the party that originally sought to deviate from standard apportionment (in the case of both General Motors and Microsoft, that party is the FTB) has proposed a reasonable (versus most reasonable ) alternative apportionment method? The court needs to set out a standard for determining which type of equitable apportionment is appropriate and what factors will be considered if more than one alternative formula is presented. Conclusion Apportionment of the income of multistate corporations is premised on the constitutional requirement of fairness. Knowing how one s tax is calculated seems to be part of this fairness and state law provides for standard apportionment formulas. Section 18 provides a safety valve for both taxpayers and tax administrators by allowing for alternative apportionment if application of the standard apportionment formula yields an unfair result. However, by providing no guidelines or standards by which taxpayers and tax administrators should apply equitable apportionment, the court of appeal s application of equitable apportionment seems to run afoul of this notion of fairness. The California Supreme Court has an opportunity right now to remedy this situation. Through its decision in Microsoft, the California Supreme Court can set the appropriate standards for when taxpayers and the FTB may apply equitable apportionment and how to choose which alternative method of apportionment is appropriate. 754 State Tax Notes, September 5, 2005