Microsoft’s California Win Signals More Large Refunds to Come

Microsoft Corp.'s $94 million win before the California Office of Tax Appeals regarding the treatment of repatriated income opens the door for a broad range of multinational companies to seek similar income tax refunds, tax practitioners say.

The number of companies and amount of refunds could be large. No similar cases are pending before the tax appeals office, but companies that regularly face similar issues in administrative proceedings with the Franchise Tax Board are likely to rely on the ruling to ask for refunds and change their position prospectively, they said.

“This is the most significant corporate income tax case before the OTA since its inception and it happens to be a taxpayer win,” said Shail P. Shah, attorney with Greenberg Traurig LLP.

Although Microsoft’s case involved repatriated earnings under the 2017 federal tax law, the ruling could benefit companies whether or not they repatriate, Shah said. All companies that file California income tax returns on a water’s edge basis—which means they exclude income from foreign affiliates when calculating how much income is taxable in California—could seek a refund. Nearly 17,000 companies filed on a water’s edge basis in 2020, according to the California Department of Finance’s most recent report on tax expenditures.

That’s because the OTA’s Microsoft ruling undoes what the tax board calls the “matching principle” when it comes to the company’s treatment of foreign dividends, said Timothy A. Gustafson, attorney with Eversheds Sutherland LLP. Under the principle, amounts that companies deduct, exclude, or exempt for California purposes can’t be included in the formula used to calculate what is taxable in California.

More specifically, the OTA rejected the tax board’s argument that because Microsoft took a 75% California deduction for dividends received from its foreign affiliates—as is required for water’s edge filers—it can only include 25% of those proceeds in the denominator of its apportionment formula. The OTA said the tax board lacks the statutory authority to treat deducted income the same as it does excluded or exempt income, and Microsoft can include 100% of the $108.8 billion it received, Gustafson and Shah said.

The apportionment formula divides a taxpayer’s California income by its total income to determine what percentage of total income is taxable in the state. With the total amount of dividends in the denominator, the percentage assigned to California is smaller and the company’s tax bill is lower.

Relying on this holding, companies that have been following the 75% deduction rule for received dividends consistently over the years—regardless of the federal repatriation rules—can now include all of the deducted amounts in the apportionment formula, they said.

Companies with water’s edge elections have been making the same arguments as Microsoft about treatment of the dividend proceeds at the protest stage with FTB for many years, Shah and Gustafson said. Many of those companies have reached settlements to end their disputes. The Microsoft case is the first to reach the OTA on the issue.

Companies have “been told by their tax advisers ‘there’s nothing to be done about this,’ and now potentially there’s something to be done about it,” said Rick Najjar, director in the state and local tax group for Forvis LLP.

Even if the tax board starts to allow taxpayers to include their dividend proceeds to follow the Microsoft ruling, it could continue to push back on a second argument raised in the case: whether inclusion distorts the amount of taxable activity in the state so much that an alternative formula should be applied, Gustafson said. The OTA rejected the argument, but the FTB could continue to make the argument on a case-by-case basis, he said.

The OTA issued two companion rulings in the case obtained by Bloomberg Tax: an opinion in July in favor of Microsoft and a second opinion Feb. 14 denying the board’s petition for a rehearing. The office hasn’t yet decided whether to propose that the opinions be precedential, or if they would only apply to Microsoft. That decision will be known when the office officially posts the opinion in April.

If the ruling isn’t precedential, taxpayers can still look to it to understand how the tax board will continue making the distortion argument, Gustafson said.

The case also could have applications in other states depending on how they treat dividends, said Scott Smith, managing director in the state and local tax group at Forvis.

Until more cases come forward in California or other states, Microsoft is the big winner, the practitioners said.

“Microsoft got to have its cake and eat it too,” Najjar said.

The case is In re Microsoft Corp. and Subsidiaries , Cal. Office of Tax Appeals, 21037336, opinion on petition for rehearing 2/14/24 .

— With assistance from Perry Cooper and Michael Rapoport.