Office of Tax Appeals/OTA Archives

Microsoft Scores Massive Win in California, Opens the Door for Others Nationwide

by Stephen P. Kranz, Diann Smith and David Jasphy | Mar 15, 2024 | Allocation/Apportionment, California, Federal Tax, Income Tax, Nationwide Importance, Tax Base

The Office of Tax Appeals (OTA) handed Microsoft an enormous win in its controversy with the California Franchise Tax Board (FTB) over the inclusion of qualifying dividends in the sales factor denominator for which it also claimed a dividends received deduction (DRD).

Microsoft filed a water’s-edge combined report for the years at issue and deducted 75% of qualifying dividends received from foreign affiliates outside its water’s-edge group. Initially, Microsoft only included the 25% net amount of dividends received in its sales factor denominator. Subsequently, Microsoft filed a refund claim asserting that the gross amount of dividends received should be included in the sales factor denominator, which would have resulted in a nearly $100 million refund.

The FTB argued that its own legal ruling (Ruling 2006-01) limiting the denominator to net dividends was dispositive of the issue. In its opinion, qualifying dividends should be excluded like eliminated intercompany dividends that were previously reported as income. The FTB also argued that a “matching principle” should apply to exclude the dividends like other items expressly excluded for allegedly not contributing to the tax base.

However, the OTA did not defer to FTB’s legal ruling because it was not a formal regulation. It was interpreting a statute, and its interpretation was inconsistent with the law. The OTA also disagreed with the comparison to eliminated intercompany dividends as there is no similar express exclusion in the DRD statute. Furthermore, the OTA found that “the legislative history” did not support the FTB’s “matching principle” because if the legislature intended the list of exclusions to be non-exhaustive, it would have used language like “such as” or “and other similar transactions.”

In its petition for rehearing, the FTB raised new arguments that the legislative history supported its interpretation and that qualifying dividends should be excluded from the denominator because they are qualitatively different from Microsoft’s main line of business. The OTA again rejected “the same or similar arguments that were considered and rejected in the Opinion” and stated that “new theories that could have been raised, but were not, is not one of the causes that permits a new hearing.” Accordingly, the OTA found that Microsoft was entitled to the nearly $100 million refund.

* * *

Corporate taxpayers should consider this decision as the basis for similar claims both in California and nationwide. While the Microsoft case involved dividends resulting from the Section 965 inclusion regime, it should apply to any type of dividend. The position is not conceptually different from including the factors of a unitary business entity that is in a loss while simultaneously using the loss for a net operating loss deduction. Therefore, in states where taxpayers are including only dividends in the denominator to the extent included in the base, there may be a position to instead include all dividends – even those subject to a deduction from the base. Depending on the statutory language in any given state, this could be true even if 100% of the dividends are deducted. [...]

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OTA Finds CDTFA’s Audit Methodology Arbitrary

by Charles Moll, III, Troy M. Van Dongen, Marcy Jo Mandel and Elle Kaiser | Jul 24, 2023 | Audits, California, Sales Tax

In Appeal of Colambaarchchi (OTA Case No. 21017152; 2023-OTA-302), a California-based retailer was audited by the California Department of Tax and Fee Administration (CDTFA) for years 2016 through 2019. Upon audit, CDTFA determined that taxable sales went unreported. In calculating the extent of the underreporting, CDTFA used various indirect methods for different periods in the audit years and applied a method to each period that maximized the amount of tax due. The Office of Tax Appeals (OTA) found that this methodology was utilized simply to create the largest underreporting, was inconsistent and lacked the required minimum rational and reasonable basis.

Colambaarchchi operated two perfume retail stores. During its audit, CDTFA performed various sales tests that suggested unreported sales. To compute the taxable measure, CDTFA used a combination of the federal income tax returns (FITR) method and the bank deposits method. Specifically, CDTFA used the bank deposits method for 2016, switched to the FITR method for 2017, then switched back to the bank method for 2018 and Q1 2019. In the audit work papers, CDTFA noted that the “[a]uditor used the higher of FITR or bank deposit difference to arrive at audited taxable sales.” In other words, CDTFA alternated between the two methodologies simply to maximize the tax liability.

CDTFA subsequently issued a notice of determination, which the company timely appealed. At the prehearing conference, OTA placed the parties on notice that, in deciding the appeal, the OTA may consider “[w]hether respondent was justified in selecting the bank deposit method for 2016, 2018 and the first quarter of 2019 and gross receipts from the [FITR] for 2017.” Accordingly, bearing the initial burden of showing that its decision to switch between two methods was reasonable and rational, CDTFA argued that it “selected the FITR method for 2017 because ‘the bank deposits may not have all cash deposited into the bank’ in 2017, and that it may have selected the bank deposits method for 2016, 2018 and 1Q19 because the income tax returns ‘may not be accurate because obviously there are additional [bank] deposits in addition to what they reported on their income tax returns.’”

OTA rejected this argument because it found “no support in the record for CDTFA’s assumption that the bank deposits method is less accurate in 2017 than in the other periods such that it would be reasonable and rational for CDTFA to switch to the FITR method in 2017.” According to OTA, CDTFA “cannot assume that one indirect audit method is more accurate in one period than another just because it produces a higher result.” OTA further stated that “this arbitrary selection made solely to increase unreported taxable sales is not reasonable and rational. Where CDTFA alternates between indirect audit methods because one method produces a higher result, CDTFA is no longer attempting to estimate the correct measure of tax but instead is arbitrarily increasing the tax measure.” Consequently, OTA held that CDTFA failed to meet its burden of proof, and CDTFA was ordered to utilize the bank deposits [...]

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Buehler Doesn’t Get a Day Off from Double Taxation

by Charles Moll, III and Michael J. Hilkin | May 12, 2023 | California, Constitutional Issues, Income Tax, Massachusetts, State Tax, Unitary Business

The California Office of Tax Appeals (OTA) recently held that a California resident’s income tax paid to Massachusetts from the sale of his membership interest in a limited liability company (LLC) doing business in Massachusetts was not eligible for California’s other state tax credit. The OTA reached this conclusion while acknowledging that it “will result in the income” from the sale of the membership interest “being double taxed.”

The taxpayer in the case, Mr. Buehler, was one of three managing members of an LLC that had an office in Massachusetts and provided portfolio management services for pooled investment vehicles. Buehler “was actively involved in” the LLC’s management and operations. After selling his membership interest in the LLC, Buehler filed a Massachusetts nonresident tax return and reported and paid tax on a share of the net gain from the sale of the membership interest, using the LLC’s Massachusetts apportionment factors.

The OTA’s decision did not question whether Buehler properly determined, under Massachusetts law, the tax owed to Massachusetts from the sale of his LLC membership interest. At that time, the Massachusetts Department of Revenue took the position that such sales of pass-through entity interests were taxable in Massachusetts where the entity conducted business regardless of whether the seller was “unitary” with the entity. (See, e.g., VAS Holdings & Investments LLC v. Comm’r of Revenue, 489 Mass. 669 (2022).) Instead, the OTA focused on the language of California’s other state tax credit, which applies to income taxes paid to another state on “income derived from sources within that state.” As stated by the OTA, “in order for a California taxpayer to be entitled” to a credit, “income taxes paid to the nonresident state (here, Massachusetts) must be based on income sourced to that nonresident state using California’s nonresident sourcing rules.” (Emphasis in original).

The OTA determined that under Cal. Rev. & Tax. Code § 17952, the LLC interest was not sourced to Massachusetts because Buehler’s LLC membership interest had not acquired a “business situs” in Massachusetts. According to the OTA, Buehler’s activities as a managing member of the LLC did not cause the “membership interest itself” to be “integrated into the business activities” of the LLC “in Massachusetts.” (Emphasis in original). In other words, while Buehler’s “services for” the LLC “as one of its three managing partners may connect him with” the LLC’s “Massachusetts business activities, that fact alone does not show that [Buehler’s] membership interest was localized in Massachusetts.”

The OTA also rejected Buehler’s alternative argument that his active involvement in the LLC caused him to “become unitary” with the LLC’s business, allowing for combination and apportionment under California Tax Regulation § 17951-4(d). The OTA explained that Buehler did not establish that he was “operating a sole proprietorship or any kind of business activity” separate and apart from the LLC “that could be considered unitary with” the LLC.

The OTA acknowledged that its decision would lead to double taxation of income from the sale of the LLC membership interest but concluded [...]

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Microsoft Scores Massive Win in California, Opens the Door for Others Nationwide

OTA Finds CDTFA’s Audit Methodology Arbitrary

Buehler Doesn’t Get a Day Off from Double Taxation

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