California Conflict From Undoing Microsoft Tax Refund, Explained

The conflict over California’s rules for the tax treatment of multinational companies’ foreign-affiliate dividends entered its next phase with two lawsuits filed in state trial courts.

The lawsuits, one filed Aug. 14 by the National Taxpayers Union and another from the California Taxpayers Association on Aug. 15, signal the rules won’t be settled for a while.

Companies have argued with the state Franchise Tax Board for decades about the treatment of foreign dividends, because it can make a big difference in their California income tax bills. But the stakes grew exponentially when the 2017 federal tax law offered lower rates on repatriated earnings. The large amounts of repatriated earnings have a ripple effect on how much income tax companies owe in California, and Microsoft Corp. was first to test it.

In February, the California Office of Tax Appeals ruled in Microsoft’s favor, rejecting the tax board’s argument that because Microsoft took a 75% California deduction for those foreign dividends, it could only include 25% of those proceeds in the formula it uses to calculate how much tax it owes to the state. The OTA ruling allowed Microsoft to include 100% of the $108.8 billion it received, finding that the tax board lacks the statutory authority to treat deducted income the same as it does excluded or exempt income.

It’s about the apportionment formula, which divides a taxpayer’s California income by its total income to determine what percentage of total income is taxable in the state. By including the dividend income in the denominator, the percentage assigned to California is smaller, lowering the final tax bill—by $94 million in 2018 alone in Microsoft’s case.

In the wake of Microsoft and a similar ruling six months earlier, California faced $1.3 billion in refunds to other multinationals that have similar disputes involving past years, plus $200 million annually in future years. But Gov. Gavin Newsom (D) and lawmakers stepped in during the state budget process to include a bill (S.B. 167) overturning the Microsoft decision. The bill, which became law June 27, does so by declaring that the FTB’s position on the tax treatment of repatriated income, as argued in the Microsoft case, has been the law since the agency issued a legal notice on the subject in 2006.

Taxpayers immediately cried foul, leading to the newly filed cases.

1. What arguments are NTU and CalTax making?

Retroactivity is at the core of both lawsuits. The groups argue the law violates due process because it applies retroactively to any years that are open under the statute of limitations. It’s retroactive because lawmakers said it is a clarification of existing law, based on the 2006 legal notice. Rather than clarifying existing law, however, the groups argue it is a significant change in the law that can’t be applied retroactively.

The NTU also argues that the law violates US and California due process protections because it is vague, contrary to precedent, and at odds with other state apportionment laws.

CalTax also argues that lawmakers violated separation of powers protections under the state constitution because the law is contrary to court precedent. The complaint also alleges the law violates the state’s single-subject rule for legislation because if it were a mere clarification of law, it would have no impact on the state budget and thus wasn’t reasonably germane to the budget bill. The group also argues the state is violating the nondelegation doctrine—which prohibits one branch of government giving its powers to another—because the new law exempts future tax board regulations implementing it from the Administrative Procedure Act and judicial review.

2. How much litigation could there be?

CalTax and the NTU are asking two different state trial courts to declare the law unconstitutional and block the state from enforcing it. The NTU filed its complaint in Sacramento County Superior Court, and CalTax filed in Fresno County Superior Court.

The taxpayer groups want the courts to strike down the statute as facially unconstitutional on behalf of their members. More litigation could come from individual companies if the FTB denies their refund claims, giving them standing to sue.

3. What happens in the meantime?

As the two lawsuits make their way through the courts, the FTB is likely to keep similar disputes with individual companies on hold. The tax agency has been holding those cases since the Microsoft case was pending before the Office of Tax Appeals. Depending on how quickly the courts act, the rules may still be up in the air when it’s time for multinationals to file their next California income tax returns.