California OTA Won’t Rehear Microsoft, Limits Decision’s Weight

The California Office of Tax Appeals (OTA) decided Appeal of Microsoft Corp. and Subsidiaries, No. 21037336, on July 27, 2023, and on February 14, 2024, rejected the California Franchise Tax Board’s (FTB’s) petition for rehearing.

The facts of Microsoft are fairly straightforward. Microsoft, a water’s-edge return filer, repatriated $108 billion in dividends for the 2017 tax year in connection with the IRC Section 965 inclusion rules enacted by the Tax Cuts and Jobs Act. Microsoft included those dividends, which did not come from entities included in the water’s-edge group, in its income tax base. It deducted 75 percent of the dividends based on the dividends received deduction (DRD) as per section 24411 of California’s Revenue and Taxation Code (RTC).

On its original return, Microsoft included in the sales factor denominator the dividends remaining after applying the 75 percent DRD. It amended its 2017 tax return and included the gross amount of dividends received in its sales factor denominator. 

The FTB denied the refund claim, saying: 

  • FTB Legal Ruling 2006-01 is controlling and requires that only net dividends be included in the denominator of the sales factor;
  • Gross receipts from qualifying dividends should be excluded under Cal. Code Reg. §25137(c)(1)(A) as a substantial and occasional sale; and 
  • RTC section 25137 warrants the use of an alternative apportionment method.

The OTA rejected all three of the FTB’s arguments. 

This case is important for California sales factor purposes because it establishes that some income excluded from the sales factor denominator under FTB Legal Ruling 2006-01 is now includable. 

Legal Ruling 2006-01 addressed the treatment of exempt income included in the apportionment factor, concluding the sales factor denominator excludes dividend receipts deducted under RTC section 24411. The OTA ruled in Microsoft that there was no statutory basis in Legal Ruling 2006-01 to exclude from the denominator the receipts from dividends subject to the DRD. 

The OTA further ruled that Cal. Code Reg. §25137(c)(1)(A), which applies to the occasional sale of a fixed asset or other property, should not apply because the receipt of dividends is not a sale.

Finally, the OTA ruled that the FTB did not prove that the inclusion of 100 percent of the repatriated dividends in the sales factor denominator resulted in distortion under RTC section 25137.

On petition for rehearing, the FTB made a new argument that the one-time dividends received in the year at issue were qualitatively different because they reflected accumulated foreign earnings and profits that were not part of Microsoft’s main line of business. The OTA rejected that argument as raising new material issues not addressed.

Microsoft potentially applies to other gross receipts with a corresponding deduction that results in the reporting of net receipts in the sales factor. (See Appeal of Southern Minnesota Beet Sugar Cooperative, 2023–OTA–342P.)

The OTA recently declined to give precedential value to its decision in Microsoft, so taxpayers can expect the FTB to continue contesting this issue.

BDO Insights

  • Although the OTA has tempered the weight of Microsoft by not giving it precedential value, it effectively overruled Legal Ruling 2006-01, resulting in the full inclusion of dividends received subject to the water’s-edge DRD in the California sales factor denominator. 
  • Microsoft could also affect taxpayers’ net operating losses and credit usage for prior years.