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August 21, 2006
Sales Factor Apportionment in California
by Jennifer Carr and Cara Griffith

Full Text Published by Tax Analysts®

Article originally published in
State Tax Notes on August 21, 2006.

In April 2006 the California Court of Appeal, Third Appellate District, held that Toys "R" Us Inc. may include only interest earned on financial instruments in the sales factor of the state's apportionment formula. The court concluded that including principal and interest did not fairly represent the corporation's in-state business activity. The decision was appealed to the California Supreme Court. That decision comes on the heels of two other cases, General Motors Corp. v. Franchise Tax Board and Microsoft Corp. v. Franchise Tax Board, in which two California appellate courts upheld the Franchise Tax Board's exclusion of principal from the sale of securities for determining the sales factor in California's apportionment 881E (Cal. Ct. App. 2004); Microsoft, No. A105312, California Court of Appeal, First Appellate District (opinion filed Feb. 28, 2005). Those cases are pending before the California Supreme Court, and an opinion is expected before the end of August. Although the court has also accepted review of Toys "R" Us, it is anticipated that rulings in General Motors and Microsoft will largely determine the outcome of the Toys "R" Us litigation. The decisions in all of those cases will significantly affect sales factor apportionment and the activities of corporate treasury departments.

Toys "R" Us v. Franchise Tax Board

Toys "R" Us Inc. has a treasury department that manages its investments in short-term financial instruments. During the tax years at issue, Toys "R" Us reported income earned from those instruments as business income and apportioned it to California under the statutory apportionment formula. In July 2001 Toys "R" Us filed for income tax refunds, contending that the total gross receipts from the sale of its short-term financial instruments must be included in the sales factor of its apportionment formula under California Revenue and Taxation Code (RTC) sections 25120 and 25134. Finding that the inclusion of the principal and interest from Toys "R" Us's financial instruments significantly reduced the amount of income apportioned to California and did not fairly represent its in-state business activity, the Franchise Tax Board (FTB) denied the refund claims. The superior court affirmed the FTB's denial, and Toys "R" Us appealed to the California Court of Appeal, Third Appellate District.

The appeals court held that Toys "R" Us was not entitled to its requested income tax refunds, because only the interest earned on short-term financial instruments may be included in the apportionment formulas' sales factor. The term "gross receipts," the appellate court determined, is not ambiguous and includes the full amount realized on the redemption or sale of short-term securities. However, the invocation of the equitable apportionment provision under RTC section 25137, the court said, limits gross receipts to interest only. The court concluded that RTC section 25137 permits the FTB to use an alternative allocation method if the allocation and apportionment provisions of section 25120 do not fairly represent a corporation's in-state business activity. Here, the court concluded, the FTB clearly demonstrated that by including in the sales factor the principal from the financial instruments, Toys "R" Us could move 11 percent to 23 percent of its income to another state simply by relocating its treasury department employees.

The appeals court also rejected Toys "R" Us's argument that RTC section 25137 limits relief to "unique and nonrecurring" circumstances. Instead, it held that RTC section 25137 permits deviation from the allocation formula if the formula fails to fairly represent a corporation's business activity. The case has now been appealed to the California Supreme Court, although briefing has been deferred until the court issues an opinion in General Motors and Microsoft.

Microsoft Corp. v. Franchise Tax Board

The facts and issues in Microsoft are similar to those in Toys "R" Us. In 1991 Microsoft had a gain of $10.7 million on its securities transactions, which yielded gross proceeds (including return of principal) of $5.7 billion. Microsoft's other operations yielded $2.1 billion in gross receipts with about $670 million in profit. The trial court concluded that Microsoft could include all its receipts in its apportionment formula and that the FTB had not proved that the standard formula did not represent Microsoft's business activity in California. The FTB appealed to the Court of Appeal, First Appellate District.

The appeals court agreed that the FTB "failed to advance an alternate method of apportionment under section 25137." However, on whether the returned principal from Microsoft's investments should be considered sales, the court reversed the trial court's decision. The court first concluded that decisions from Arizona, Oregon, and New Jersey supported that rationale. The court also said it believed the issue would be resolved by the California Supreme Court in the future. However, the court held "there are persuasive considerations favoring the systematic exclusion of returned principal from 'sales' when securities transactions are utilized for cash management purposes." Finally, the court said that dealing with those issues case by case under section 25137 would be too difficult to implement. The trial court was reversed.

General Motors Corp. v. Franchise Tax Board

In General Motors, there were four major issues before the Court of Appeal, Second Appellate District. The first issue, as in Toys "R" Us and Microsoft, was the exclusion of returned principal from gross receipts. The remaining issues involved a research credit, a foreign tax deduction, and the constitutionality of a dividend deduction under RTC section 24402. Regarding securities sales, the court noted that the repurchase transaction amounts for the tax years in question, 1986-1988, constituted approximately 90 percent of GM's gross receipts. The court also said that "GM rolled over its short-term marketable securities every 3.25 days."

The court began its analysis of the gross receipts issue by evaluating the definitions of gross receipts and sales to the extent they are defined in the Uniform Division of Income for Tax Purposes Act (UDITPA) and the RTC. The court then looked to decisions from other jurisdictions and determined they supported the FTB's position excluding the return of principal. The court then provided an interesting commentary on potential differences in the treatment of short-term and maturing securities. The discussion was sparked by GM's argument that under IRC section 1271, maturing securities are merely "exchanges." The court concluded that both maturing securities and funds from security repurchase transactions are not "sales, but rather secured monetary transactions that are the equivalent of loans." As a result, the return of capital is not includable in the denominator of GM's sales factor. Having determined that the items at issue were not gross receipts, the court declined to address the FTB's proposed application of RTC section 25137.

Meaning of 'Gross Receipts' — Arguments for Exclusion

Although the facts are slightly different, General Motors, Microsoft, and Toys "R" Us involve one main issue: whether the gross proceeds from the sale of investment instruments should be included in the sales factor of California's apportionment formula. The disputes all arise out of what are considered the ordinary treasury functions of a corporation. Treasury functions are typically investments in intangibles that provide temporary returns for liquid assets. In all three cases, the FTB took the position that interest, dividends, and gains from those investments should be included in the sales factor of the apportionment formula, but that the principal amount returned should not be included.

The FTB's position is supported by several arguments. First, including the return of principal as a gross receipt can distort a corporation's allocation of its worldwide business activity and opens the door for abusive tax planning. A corporation's treasury department typically engages in many investment transactions. Those sales of assets tend to be high-volume, low-yield sales, with most sales activity concentrated in the state where the corporation is headquartered. As a result, apportioning on the basis of gross receipts would assign a disproportionate amount of income to that state.

For instance, in GM, the repurchase transactions constituted about 90 percent of GM's gross receipts for the years at issue. In Microsoft, the company showed a gain of $10.7 million on its securities transactions, which yielded a gross return of $5.7 billion. The software company's other operations yielded a mere $2.1 billion in gross receipts with $670 million in profit. Those numbers show that the returned principal portion of both companies' gross receipts "swamps the revenues attributable to its normal business activities." In Toys "R" Us, Prof. Steven Sheffrin testified on how the company could move a significant percentage of its income to another state simply by moving its treasury department to that state. The facts in each of those cases demonstrate that including return of principal in gross receipts can distort a company's worldwide business activities.

Although the potential for distortion and abuse exists, the California statute is ambiguous and does little to provide the support needed to prevent the "absurd results" (a phrase used by the appeals court in Toys "R" Us) seen in cases like GM, Microsoft, and Toys "R" Us. Despite the ambiguity, the Legislature most likely intended RTC section 25210 to exclude return of principal from the definition of gross receipts. RTC section 25210 codifies the basic definition of sales from UDITPA, which defines the term as "all gross receipts of the taxpayer not allocated under [the nonbusiness income provisions of UDITPA]." Unfortunately, neither UDITPA nor the RTC provides a definition of gross receipts. Consequently, courts have struggled to provide their own definition.

The California Legislature has taken a step toward clarification with a new bill, AB 1037, which would "provide that for computation of the sales factor, only the overall net gain, interest and dividends realized from transactions undertaken and assets held as part of the company's treasury function are to be included in computing the company's apportionment percentage." However, the bill, pending before the California Senate Committee on Revenue and Taxation, is not without its faults. In provisions not strictly related to the issue at hand, some industries will be permitted to compute their state tax based on the existing double-weighted sales formula or a new quadruple-weighted sales formula. Preferential treatment for particular industries is, of course, against the principles of good tax policy: Taxes should generally be levied on as broad a base as possible. Also, an analysis of the bill says that it may run afoul of the Commerce Clause of the U.S. Constitution, because courts could view the bill as an attempt to tax income not earned in the state. The outcome of the legislation will likely depend on what happens in GM and Microsoft.

Arguments for Inclusion

Although the corporations seeking inclusion of returned principal failed to convince any of the three appellate courts of the rightness of their position, they convinced at least one trial court they were correct. That is because there are some persuasive counterarguments to those posed by the FTB. Most important is the statutory and regulatory language at issue. As noted by the Toys "R" Us court, RTC section 25134 states that the denominator of the sales fraction is the "total sales of the taxpayer everywhere during the income year." Section 25120 defines sales as the "gross receipts of the taxpayer not allocated under section 25123 through 25127." There is nothing in the statutory language that would prohibit the return of principal, just as there's no limitation prohibiting corporations from excluding manufacturing costs from the equation.

Along those lines, the Toys "R" Us opinion discusses the testimony of Prof. Richard Pomp of the University of Connecticut regarding the exclusion issue. According to the court, Pomp "opined there was no principled reason under tax policy why the gross receipts from the disposition of financial instruments should be treated any differently than the gross receipts from the disposition of inventory." The FTB countered that testimony by noting the vast difference in profit margin between the retail sales and the company's treasury functions. However, as Pomp said in his testimony, just because the toy sales in this particular instance had a large profit margin does not mean that they have to make a profit as a matter of course. He views cash, from whatever source, as cash. At the end of the day, a company can convert that cash into inventory or a financial instrument. But both are investments that are at some point turned over. In short, Pomp did not see the "difference in the gross receipt generated by a financial instrument or by a Cabbage Patch doll."

Ideally . . .

Now that we have examined the best arguments for and against exclusion of return of principal from the sales factor denominator, it seems as though the FTB has the strongest arguments. Although the statute fails to explicitly exclude the receipts at issue, the bottom line is that the return of principal on an investment isn't the same thing as the gross receipt from a sale. Granted, it's difficult to articulate why they're different, but two potential distinguishing factors are the rate of return on investment and the fact that treasury functions are not a unitary business's primary operation.

It's also fairly certain that exclusion of principal is what most state legislatures intended when they enacted the statutes. Hence, the Oregon legislature's reaction when the issue arose in that state in Sherwin-Williams Co. v. Department of Revenue. Before Sherwin-Williams could reach that state's supreme court, the legislature amended the statute to exclude "gross receipts arising from the sale, exchange, redemption or holding of intangible assets, including but not limited to securities, unless those receipts are derived from the taxpayer's primary business activity." Ideally, that is the action legislatures in other states will take to remedy this issue.

Finally, a recurring theme in the California litigation has been the possible application of RTC section 25137 to resolve these cases. That section would allow the FTB to advance an alternative method of apportionment to "effectuate an equitable allocation and apportionment of the taxpayer's income." As pointed out by the Microsoft court, relying on that section to resolve the issue would be too time-consuming and difficult to implement. Also, relying on case-by-case resolution under section 25137 would likely result in unfair and inconsistent application of the law.

Thus, we are left with three conclusions. First, principal should be excluded from sales factor denominators as a matter of policy. Second, that is likely what legislatures would have intended had the statutes addressed the issue. Finally, exclusion should not occur on a case-by-case basis. As a result, the most practical resolution of the issue is an across-the-board clarification of the rule — ideally, from the legislature.

Jennifer Carr and Cara Griffith are State Tax Notes legal editors.

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