The redemption of equitable apportionment.

• Author: Friedman, Jeffrey A.

Introduction

On August 17, 2006, the California Supreme Court issued decisions in Microsoft Corp v. Franchise Tax Board and General Motors v. Franchise Tax Board. The two cases offered the court the opportunity to clarify the calculation of the California sales factor and application of equitable apportionment principles to multijurisdictional businesses, regardless of whether the taxpayers "won" (i.e., by being permitted to reduce their California tax by including gross receipts generated through treasury function investments in their California sales factor denominators). While the standards today are clearer, they still pose both challenges and opportunities to taxpayers.

The court ruled in General Motors that one specific type of investment--a "repurchase agreement"--constitutes a loan rather than a sale and therefore may be included in the sales factor only to the extent of net proceeds. (1) In Microsoft, it held that the California sales factor must include the gross proceeds from redemptions of marketable securities, but that this statutorily mandated treatment resulted in an unfair reflection of Microsoft's in-state business activity, thus justifying the FTB's use of an alternative apportionment method with respect to those receipts (i.e., inclusion of only net gains on such investments). (2)

To view the decisions as complete wins for the State and defeats for taxpayers, however, is short sighted. Despite the nominal victory for the State in the two cases, taxpayers generally stand to benefit from the creation of relatively clear standards for application of what has been the murky application of equitable or alternative apportionment methods. These standards apply much more broadly than the specific factual context of the two cases (i.e., treasury function receipts), and assist taxpayers in effectively asserting their right to equitable apportionment (or defend against its assertion) in a State that previously had applied a "tails-I-win, heads-you-lose" approach to petitions for apportionment relief under section 18 of the Uniform Division of Income for Tax Purposes Act (codified as Section 25137 of the California Revenue and Taxation Code).

This article discusses the taxpayer benefits produced by the decisions in Microsoft and General Motors.

Sales Factor and the Treasury Function: What's In, What's Out?

A common issue in the General Motors and Microsoft cases was whether to include certain treasury function transactions in the California sales apportionment factor. General Motors asserted that it should be allowed to include the gross proceeds from repurchase transactions (i.e., transactions involving borrowing money in exchange for transferring a security followed by a subsequent repurchase of the security) in its California sales factor. Microsoft asserted that it should be allowed to include the gross proceeds from redemptions (i.e., investments held to maturity at which point principal is redeemed) in its California sales factor. The FTB disallowed the inclusion of the gross proceeds from these transactions and took the position that the sales factor should only include net receipts.

Observation

* Because most large companies have sophisticated treasury functions that engage in large and recurring transactions, the ramifications of how to reflect treasury function activities in the California sales factor can materially affect the amount of income subject to tax. If the treasury function occurs outside of California, the inclusion of the gross receipts can materially reduce (or dilute) the California sales factor because the treasury function activities are included in the California sales factor denominator, but not the numerator. For instance, the inclusion of General Motors' and Microsoft's net proceeds versus gross proceeds from its treasury function resulted in twice as much California taxable income.

The California Supreme Court analyzed the Uniform Division of Income for Tax Purposes Act, which a number of states (including California) have adopted to determine multistate taxpayers' apportioned income. UDITPA's sales factor is calculated by dividing instate gross receipts by all of the taxpayer's gross receipts. The FTB argued, and the California Supreme Court agreed, that...