California Rules in Favor of Microsoft’s Income Tax Refund Claim

By: Jeff Glickman, SALT Partner

At a glance

• The main takeaway: The State of California upheld Microsoft’s refund claim, concluding that the taxpayer’s sales factor denominator should include dividends received that were deducted from the tax base.
• Assess the impact: This case presents a refund opportunity for businesses who may have excluded amounts from the denominator of the California sales factor.  
• Take the next step: Aprio’s State and Local Tax (SALT) team can assist your business with state income tax apportionment and sourcing rules to ensure you are not over-apportioning your income to a state and to identify potential refund claims.   

Schedule a free consultation today to learn more!

The full story:

On February 14, 2024, the California Office of Tax Appeals (OTA) issued an opinion upholding its prior ruling that Microsoft was entitled to a refund of almost $94 million because it correctly included the full amount of its repatriated dividends in the denominator of the California sales factor, even though 75% of those dividends were deducted from the tax base.^[1]

A closer look at the case

For its fiscal year ending June 31, 2018, Microsoft filed its combined California income tax return under the water’s-edge method. During that tax year, Microsoft received repatriated dividends from controlled foreign corporations that are outside of the combined water’s-edge group of over $108 billion. Those dividends qualified for a 75% deduction on Microsoft’s California return, thus approximately $27 billion in net taxable dividends were reported as pre-apportioned business income.^[2]

In computing its California sales factor, Microsoft originally included the $27 billion net dividend in the denominator, but subsequently filed a claim for refund asserting that the entire amount of the repatriated dividends (i.e., $108 billion) should be included in the denominator of the sales factor.  California denied the refund claim and this appeal ensued.

Unpacking the ruling

Under California law, regarding the computation of its sales factor, “sales” means “all gross receipts of the taxpayer not allocated [under California tax code section dealing with nonbusiness income].”^[3] “Gross receipts” means:

“the gross amounts realized (the sum of money and the fair market value of other property or services received) on the sale or exchange of property, the performance of services, or the use of property or capital (including rents, royalties, interest, and dividends) in a transaction that produces business income, in which the income, gain, or loss is recognized (or would be recognized if the transaction were in the United States) under the Internal Revenue Code . . . .”^[4]

Microsoft’s position is that this language clearly supports its position to include the full amount of the dividends in the sales factor of the denominator as gross receipts. The state made two arguments to support its position that only the net amount of the dividends is includible in the denominator of the sales factor.

The first argument relied on the principle set forth in Legal Ruling 2006-01, which it refers to as the “matching principle.” That principle states that “if an activity generates both income included in the measure of tax and excluded income, only factors related to the production of the income subject to tax should be utilized to apportion that income.” The OTA rejected this reasoning since it is contrary to the plain language of the statute. The opinion also noted that the statute lists certain gross receipts that are excluded from the factor (even when those receipts produce business income), and that list does not include deducted dividends.

The second argument is that the dividends should be excluded from the sales factor as a substantial and occasional sale. Specifically, California’s regulation provides that “[w]here substantial amounts of gross receipts arise from an occasional sale of a fixed asset or other property held or used in the regular course of the taxpayer’s trade or business, such gross receipts shall be excluded from the sales factor.”^[5] The state contends that the dividends qualify as a “sale” under this regulation because they are considered “sales” for purposes of the sales factor generally.^[6]

In rejecting this argument as well, the OTA concluded that the use of the term “sale” in the regulation referred specifically to the “sale of a fixed asset or other property” whereas the definition of “sales” in the sales factor statute was broader, and specifically included amounts “from the use of property or capital” such as dividends. Thus, the regulatory exclusion did not apply in this case.

The bottom line

This case presents a potential refund opportunity for businesses that may have excluded amounts from the denominator of the California sales factor because those amounts were not otherwise included in the business income tax base. Aprio’s SALT team has experience with state income tax apportionment and sourcing rules (which vary among the states). We can assist your business to ensure that you are not over-apportioning your income to a state and identify and pursue refund claims on your behalf.  We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

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[1] In the Matter of the Appeal of: Microsoft Corporation and Subsidiaries, OTA Case No. 20137336, Feb. 14. 2014.  This opinion was issued in response to the state’s petition for rehearing after the OTA granted Microsoft its refund in a prior ruling on July 27, 2023. 

[2] Cal. Rev. & Tax Code § 24411(a).

[3] Cal. Rev. & Tax Code § 25120(f)(1).

[4] Cal. Rev. & Tax Code § 25120(f)(2).

[5] Cal. Code Regs. Tit. 18, § 25137(c)(1)(A).

[6] In other words, the use of the term “sale” in this regulation is the same as the definition of “sales” under Cal. Rev. & Tax Code § 25120(f)(1).