The redemption of equitable apportionment.

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 repurchase agreements constitute "loans" and not "sales." Therefore, the court determined that repayment of the loans does not produce "gross receipts" for sales factor apportionment purposes. As a result of this characterization, the court allowed only the interest from the repurchase arrangement to be included in the sales factor.

The court held, however, that the full amount received by Microsoft on the redemption of securities constitutes gross receipts that are properly included in Microsoft's sales factor:

   We agree with Microsoft that the meaning of "gross receipts"
   in the UDITPA more naturally includes the entire redemption
   price of a marketable security. "Gross" implies the whole
   amount received, not just the amount received in excess of
   the purchase price. To only consider the net price difference
   as "gross receipts" is an awkward fit with the statutory language,
   at best. To the extent this language is ambiguous, we
   generally will prefer the interpretation favoring the taxpayer.

Microsoft, Slip Opinion at 7-8 (footnotes and citations omitted).

Observation

* The FTB in Microsoft and General Motors did not contest the inclusion of the gross proceeds of a sale of a marketable security in a taxpayer's sales factor. Following is a summary of the treatment of gross proceeds from treasury function activities for California sales factor purposes:

Sales of Securities [right arrow] Required to Include in Sales Factor

Redemptions of Securities [right arrow] Required to Include in Sales Factor

Repurchase Transactions [right arrow] Required to Exclude from Sales Factor

Application of Equitable Apportionment

The analysis of the inclusion of treasury function activities in the California sales factor did not conclude with the statutory interpretation of what constitutes a "gross receipt." UDITPA [section] 18 contains an "equitable apportionment" provision that allows a taxpayer or the State to apply a different apportionment method when the statutory method leads to a result that does not fairly represent the taxpayer's in-state business activity. California codified this provision in section 25137 of the California Revenue and Taxation Code, but the FTB argued that it should apply to Microsoft so that net proceeds, instead of gross proceeds, from redemptions should be included in Microsoft's sales factor.

A. Inconsistent Application

Section 25137 generally allows the use of an alternative apportionment methodology if the standard formula does not "fairly represent the extent of the taxpayer's business activity in this state." (3) California regulations recognize that the standard apportionment provisions are not appropriate when applied to certain industries and types of transactions, and provide special apportionment procedures for those situations. (4) Absent a fact pattern that is consistent with these special regulations, however, there have been no bright-line tests for determining whether special apportionment is appropriate. Determinations must be based on the unique facts and circumstances of each case, which has led to a great deal of uncertainty and inconsistent application. Thus, despite the concept of "alternative" or "equitable" apportionment in California law, the FTB has never applied section 25137 in a consistent manner on audit. Nor have the State Board of Equalization and courts of California provided consistent oversight of the FTB concerning the standard of proof that must be met in order to move off of the standard apportionment formula and rules.

B. "Unusual Situations" Not Required

Section 25137 only applies when the standard apportionment formula would "produce inequitable results when applied to unusual factual situations." (5) Likewise, the relevant regulations state that section 25137 only applies "in specific situations where unusual fact situations (which ordinarily will be unique and nonrecurring) produce incongruous results under the apportionment and allocation provisions...." (6) The facts and circumstances in Microsoft (i.e., investing in marketable securities) are not particularly unique or worthy of non-standard apportionment treatment, as compared with other cases where the FTB sought to utilize alternative apportionment methods pursuant to section 25137. (7) Nevertheless, the California Supreme Court authorized the use of equitable apportionment: "While Revenue and Taxation Code section 25137 'ordinarily' applies to nonrecurring situations, it does not apply only to such situations; the statutory touchstone remains an inquiry into whether the formula 'fairly represent[s]' a unitary business's activities in a given state, and when it does not, the relief provision may apply." Slip Opinion at 23-24 (citations omitted).

C. Taxpayer Opportunities

The California Supreme Court's analysis in Microsoft of equitable apportionment will provide substantial controversy and opportunities for California taxpayers. The court compared the profit margins of Microsoft's treasury function (less than 0.2%) with Microsoft's software sales and other activities (31%). The Court determined that "[t]his situation, when one mixes apples--the receipts of low-margin sales--with oranges--those of much higher margin sales--presents a problem for UDITPA. The UDITPA's sales factor contains an implicit assumption that a corporation's margins will not vary inordinately from state to state." Id. at p. 20-21. The court concluded that this apples-to-oranges comparison establishes that inclusion of the gross proceeds from redemptions "seriously distorts the standard formula's apportionment of income to each state." Id.

Observation

* The California Supreme Court correctly noted that equitable apportionment found in UDITPA differs from "distortion," which is proscribed by the Due Process and Commerce Clauses of the U.S. Constitution. Equitable apportionment requires that the State or the taxpayer prove by clear and convincing evidence that the standard apportionment formula does not fairly represent the taxpayer's in-state business activity. Unconstitutional distortion requires that the State or the taxpayer prove that the standard apportionment formula leads to a grossly distorted result. In both cases, however, the party seeking to establish that the standard apportionment factor is either inequitable or distortive bears the burden of proof. The standard apportionment formula is presumed to be correct unless and until either the State or the taxpayer proves that the results of the standard formula violate equitable apportionment or the U.S. Constitution through "clear and convincing evidence."

Because the gross margin disparity with respect to Microsoft's business activity and its treasury function is relatively large (i.e., a multiple or factor of 155), the State may not be successful in arguing equitable apportionment as applied to other taxpayers. Taxpayers generally are required to apply the statutory analysis in Microsoft (i.e., that the gross proceeds of both sales and redemptions of marketable securities constitutes gross receipts) and include gross proceeds from treasury function activities in the California sales factor. It will be up to the FTB to assert the application of equitable apportionment and bear the burden of proof in doing so.

General Motors also engaged in redemption transactions. The California Supreme Court remanded that portion of the General Motors case to the California Court of Appeal to determine whether General Motors' redemption transactions justify the application of equitable apportionment. Taxpayers may thus be provided with further beneficial guidance as to the application of the California Supreme Court's gross margins analysis.

Also certified for review by the California Supreme Court and standing in the wings is Toys R Us, Inc. v. Franchise Tax Board, 138 Cal. App. 4th 339, 41 Cal. Rptr. 3d 285 (Cal. Ct. App. 3rd Dist. 2006). In Toys R Us, the Court of Appeal held that the statute requires inclusion of gross receipts, but that the FTB met its burden of proof to shift the taxpayer to a net receipts-based sales factor. (8) The Supreme Court may choose to remand Toys R Us (as it did with General Motors) for further consideration of the FTB's demonstration of distortion under the standard apportionment formula, or it may affirm or reverse the Court's ruling by reference to the standards it provided in Microsoft.

Conclusion

Many taxpayers currently have treasury receipts issues before the California Settlement Bureau, or under audit with the potential for settlement. Depending on their particular facts and circumstances, taxpayers have the following important legal and strategic decisions before them.

* Taxpayers should consider including sales, redemptions and similar transactions in the California sales factor in order to comply with the California Supreme Court's interpretation of "gross receipts." Taxpayers do not have an obligation to apply equitable apportionment pursuant to section 25137.

* Taxpayers that already have treasury function issues on audit with the FTB may find this to be a favorable time to engage in settlement discussions with the FTB attorney who is handling the protest or seek to initiate settlement with the Settlement Bureau on the basis that all treasury receipts cases now constitute factual disputes under section 25137.

* Taxpayers seeking to demonstrate the presence of unfair apportionment in order to support their own applications for alternative apportionment, or the absence of unfair apportionment in cases where they oppose the FTB's proposed alternative apportionment method, now have additional flexibility in structuring their analysis and proof. In the context of treasury receipts, for example, a taxpayer has the following options: (1) analysis on year-by-year, tax period-specific, or long-term basis; (2) averaging of gross margins or other means to reflect varying margins on non-treasury functions (e.g., this may benefit taxpayers that realize gains and losses from year to year with respect to non-treasury functions); or (3) analysis on an investment-specific or treasury-function-generic basis, and likewise, comparison to discrete taxpayer business functions or to all other taxpayer activities that generate receipts.

* Taxpayers likewise have some flexibility--albeit also some uncertainty--as they gauge the decisions' effect on their FAS 109/ FIN 48 financial statement analysis.

* Taxpayers should consider the ramifications in other states associated with treasury function activities. For instance, a Tennessee court recently held that treasury function receipts may be treated as allocable (non-apportionable) income. Siegel-Robert, Inc. v. Johnson, Tenn. Chancery Ct., Dkt. No. 00-3763-III, Aug. 17, 2006. Therefore, while some states have modified their statutes to exclude treasury receipts from the sales factor, taxpayers may likewise be able to exclude income from treasury functions from the state's apportioned tax base.

* The California Supreme Court's analysis vis-a-vis the sales factor is applicable to transactions and activity that affect the property and payroll factors. Taxpayers should consider requesting equitable apportionment relief when transactions materially affect these factors.

In summary, taxpayers have much more leverage in the equitable apportionment arena than before the decisions in General Motors and Microsoft.

(1.) The court also held that California's research credit may only be used by the entity performing the research activity, with any excess credit not being available to other members of the unitary group. The portion of the court's decision on the research tax credit is beyond the scope of this article, except to note that taxpayers will uniformly suffer from the FTB's position of limiting the benefits of certain tax attributes to the member of the unitary group that generated the activity creating the tax attribute.

(2.) Tax Executives Institute filed an amicus brief supporting General Motors, and Sutherland Asbill & Brennan filed an amicus brief on behalf of United Technologies Corporation ("UTC") in support of Microsoft's appeal to the California Supreme Court. The UTC amicus brief urged the California Supreme Court to review Microsoft simultaneously with General Motors (with respect to which certiorari had already been granted) because of the need of multistate taxpayers to obtain guidance on (1) the standards that govern the apportionment treatment of gains on sale or other disposition of various types of taxpayer investments (e.g., investments that vary by reference to length of term; production of income/loss; frequency; in-state or out-of-state character; and holding period by reference to maturity), and (2) when alternative apportionment should be applied in accordance with section 25137 of the California Revenue and Taxation Code (section 18 of UDITPA) (e.g., which party bears the burden of proof, what satisfies the burden of proof, and what constitutes a "reasonable" alternative method).

(3.)Colgate Palmolive Co. v. Franchise Tax Board, 10 Cal. App.4th 1768, 1786-1787 (1992); Appeal of Crisa Corp. 2002 Cal. Tax LEXIS 269.

(4.) Cal. Code Regs., tit. 18, [subsection] 25137-1 - 25137-12.

(5.) Appeal of Merrill, Lynch, Pierce, Fenner & Smith, Inc., 89-SBE-017 (Cal. St. Bd. Eq. June 2, 1989) (emphasis added).

(6.) Cal. Code Regs., tit. 18, [section] 25137(a) (emphasis added).

(7.) E.g., Appeal of New York Football Giants, Inc., 77-SBE-014, (Cal. St. Bd. Eq. opinion on rehearing June 28, 1979) (treatment of home game gate receipts); Appeal of Fluor Corp., 95-SBE-016 (Cal. St. Bd. Eq. Dec. 12, 1995) (receipts from sale of taxpayer's headquarters); Appeal of John Deere Plow Co., 61-SBE-081 (Cal. St. Bd. Eq. Dec. 13, 1961) (including only 50 percent of war sales in receipts factor); Communications Satellite Corp. v. Franchise Tax Board, 203 Cal Rptr. 779 (Cal. App. 1 Dist. 1984) (property and receipts factors for commercial satellites orbiting in outer space); Appeal of BCE Develop., Inc., No. 93R-0266 (Cal. St. Bd. Eq. Jan. 11, 1996) (installment sale receipts from transactions that closed before a subsidiary became a member of the unitary group); Appeal of Pneumo Abex Corp., No. 93R-0024 (Cal. St. Bd. Eq. Jan. 01, 1993) (receipts from the sale of the stock of three unitary subsidiaries).

(8.) In comparison with Microsoft--which the Supreme Court noted had a 170 ratio for its 1991 tax year, based upon a .2 percent margin on treasury investments and a 31 percent margin on all other business activities--Toys R Us had a 220 ratio for its 1991 tax year, based upon a comparison of income to gross receipts (gross margins) for Toys R Us's treasury and retail functions.

Jeffrey A. Friedman and Kendall L. Houghton are partners with the law firm of Sutherland Asbill & Brennan LLP, located in Washington, D.C. Their practice is devoted to multistate tax matters, including appellate litigation. Mr. Friedman received his B.S. and J.D. degrees from the University of Maryland and his LL.M. degree from Georgetown University Law Center. He has worked as an attorney-adviser in the Office of Tax Policy of the U.S. Department of the Treasury and Vice President-Counsel of the Committee on State Taxation. Ms. Houghton received her A.B. degree from Harvard University, her J.D. from New York University, and her LL.M. degree from Emory University School of Law. She has served as General Counsel for the Committee on State Taxation. Mr. Friedman and Ms. Kendall submitted an amicus brief on behalf of United Technologies Corporation in support of the petition for review filed by Microsoft Corporation with the California Supreme Court. They may be reached at jeff.friedman@ sablaw.com and [e-mail].