Ruling by California Office of Tax Appeals Presents Major Opportunity for Corporate Tax Refund

The California Office of Tax Appeals (OTA) originally ruled that Microsoft could exclude 100 percent of repatriated income from their California business income subject to tax in July 2023. On Feb. 14, 2024 the California OTA denied the California Franchise Tax Board’s appeal for rehearing, upholding the software giant’s $94 million California corporate tax refund.

The decision is now final and cannot be appealed by the Franchise Tax Board. It is still uncertain if the ruling in the Microsoft case will be designated as precedential, but that decision is expected in April 2024. Even if it is not deemed precedential, applicable taxpayers can use this ruling to understand how the tax board will continue to rule. Furthermore, the situation may have applications in other states depending on their treatment of foreign dividends.

Understanding California’s water’s-edge election

For California corporate tax purposes, multinational companies with combined reporting requirements may make a “water’s-edge” election to exclude certain foreign affiliates from the California report. Those companies are entitled to a 75 percent foreign dividend received deduction (DRD) for qualifying dividends received from foreign affiliates that allows them to exclude 75 percent of the foreign dividend income from California business income tax.

California calculates business income using a formula that multiplies business income by a single sales factor apportionment formula. The sales factor is a fraction computed based on total California sales divided by total sales everywhere during the tax year. Using the DRD, only 25 percent of the foreign dividends would be included in the denominator in that formula.

Microsoft exposes water’s-edge loophole

On its original return, Microsoft followed the California tax code utilizing the DRD by including 25 percent of foreign dividends in the denominator of the California sales factor. Shortly after, Microsoft filed a refund claim with the Franchise Tax Board asserting that 100 percent of the foreign dividends should be included in the denominator, significantly reducing the California apportionment percentage and California business income.

The refund claim was denied and then appealed with the Office of Tax Appeals, who ultimately determined that the California tax statutes and regulations do not require the exclusion of any portion of the foreign dividends from the California sales factor on the basis that the foreign dividends are subject to the foreign DRD.

Refund opportunity for California corporate income tax

Taxpayers that filed following California’s water’s-edge combined returns, and the 75 percent DRD may be subject to significant refunds if they only included 25 percent of foreign dividends in the California sales factor denominator. These companies are strongly encouraged to review their returns and consider whether they may be entitled to California corporate tax refunds. Additionally, taxpayers in other states with foreign dividends should investigate their state and local tax codes to see if there is a similar matching principle in their state.

State and local tax specialists can explore this potentially lucrative refund opportunity

Our State and Local Tax Practice specializes in these exact situations. We have extensive knowledge of the state tax codes in all markets and have professionals dedicated to state and local tax issues. Fill out the form on this page to connect with a member of our State and Local Tax Practice.