United States: Gross Receipts and Unitary Credit Issues Ripen After California Supreme Court Acts in "Microsoft" and "General Motors"

On August 17, 2006, after years of litigation and speculation, the California Supreme Court issued its decisions in both Microsoft Corporation v. Franchise Tax Board (Case No. S133343) and General Motors Corporation v. Franchise Tax Board (Case No. S127086). Both cases presented the Revenue and Taxation Code Section ("Section") 25120 "gross receipts" issue and the Section 25137 "distortion" issue. The General Motors case also presented the Section 23609 "unitary credit" issue. The decisions will undoubtedly have varied and widespread effects on many taxpayers doing business in California.

The Court treated Microsoft as the lead opinion on the gross receipts and distortion issues. The Court framed the two issues as follows: (1) whether the redemption of marketable securities at maturity generates "gross receipts" (or, alternatively, the net price difference) includible in the sales factor; and (2) if so, whether the FTB met its burden of showing Section 25137 should be applied. In short, the Court ruled (1) the redemption of marketable securities at maturity does generate gross receipts for sales factor purposes; and (2) the FTB did meet its burden under Section 25137, in that instance, and an alternative formula should be used.

In General Motors, the Court dealt with two issues not present in Microsoft: (1) how repurchase agreements (repos) are to be treated for sales factor purposes; and (2) whether California’s research credit can be claimed only by the company performing the research or by all members of that company’s unitary group. The Court ruled (1) repos have the characteristics of loans and therefore only the interest received is a gross receipt for purposes of Section 25120; and (2) the Section 23609 California Research Tax Credit may be used only by the company that incurred the credit and may not be shared among all members of its unitary group.

Microsoft and General Motors separately argued that the entire gross proceeds from certain treasury function transactions must be included in their respective sales factor as "gross receipts" under Section 25120. Microsoft’s transactions mainly included marketable securities held to maturity, while General Motors’ transactions included both marketable securities held to maturity and repurchase agreements. The Court concluded in both cases that "gross receipts" from marketable securities held to maturity are to be included in the sales factor, for essentially four reasons.

First, the Court stated that the meaning of "gross receipts" in Section 25120 "more naturally includes the entire redemption price of marketable securities." (Microsoft, Slip Op. at p. 7.) The Court stated that inclusion of only the net difference as gross receipts "is an awkward fit with the statutory language, at best." (Id. at pp. 7-8.) Second, the Court stated that the legislative history behind Section 25120 supports inclusion of marketable securities held to maturity as gross receipts. Section 25120 is part of the Uniform Division of Income for Tax Purposes Act (UDITPA), which a number of states, including California, have adopted to determine multistate taxpayers’ apportioned income. The Court noted than an early version of the UDITPA defined "sales" as "all income of the taxpayer" not otherwise allocated, but this provision was amended to define "sales" instead as "all gross receipts of the taxpayer" not otherwise allocated. (Id. at p. 9.) Third, the Court stated that inclusion of the entire gross proceeds is also supported by the State Board of Equalization’s interpretation of gross receipts to include the full amount of any redemptions ("albeit in a more limited fashion"). (Id.) Fourth, the Court looked to the "economic reality" of the taxed transaction and concluded "the full redemption price, like the full sale price, must be treated as gross receipts" under Section 25120. (Id. at p. 11.)

Regarding the repos at issue in General Motors, the Court concluded that although repos are truly "hybrids" that blend characteristics of both a sale of securities and a secured loan, for gross receipts purposes, a repo has the characteristics of a loan, so only the interest received is a gross receipt for purposes of the UDITPA. (General Motors, pp. 12, 16.)

Having concluded in Microsoft that the full redemption price constitutes gross receipts, the Court turned to the application of the alternative apportionment provisions of Section 25137. Regarding which party bears the burden of proof, the Court found that FTB, as the party invoking Section 25137, bears the burden of proving by clear and convincing evidence that (1) the approximation provided by the standard formula is not a fair representation; and (2) its proposed alternative is reasonable. (Microsoft, Slip Op. at p. 16.) The Court concluded that FTB met its burden of proof "in this instance." (Id. at p. 2.)

As part of the Section 25137 distortion analysis, the Court found persuasive the SBE’s interpretation of Section 25137 to allow correction of distortion arising from the operation of a large corporate treasury department in Appeals of Pacific Telephone & Telegraph (May 4, 1978) [1978-1981 Transfer Binder] Cal. Tax. Rptr. (CCH) ¶ 205-858, page 14,907-36. (Microsoft, pp. 17-18.) The Court stated that the problem arising from inclusion of the full sale or redemption price of a marketable security is "one of scale: short-term securities investments involve margins (i.e., differences between cost and sale price) that may be several orders of magnitude different than those for other commodities." (Id. at p. 20.) In short, the Court stated that "the different nature of short-term investments means that mixing short-term gross receipts with gross receipts from other types of business activity involves an apples-to-oranges comparison that may require correction." (Id. at p. 23.)

Applying Section 25137 to the facts in Microsoft, the Court concluded mixing the gross receipts from Microsoft’s short-term investments with the gross receipts from its other business activity "seriously distorts the standard formula’s attribution of income to each state." (Microsoft, Slip. Op. at p. 24.) The Court continued: "These transactions generated minimal income (just under 2 percent of Microsoft’s business income for 1991) but enormous receipts (approximately 73 percent of gross receipts for 1991)." (Id. at pp. 24-25.) The Court concluded that inclusion of these receipts "in the standard formula does not fairly represent the extent of Microsoft’s business in California." (Id. at p. 25.) Finally, the Court found the FTB’s proposed alternative of including only net receipts from the redemptions to be reasonable under Section 25137. (Id. at pp. 25-26.)

In General Motors, the Court ordered the case be remanded to the lower courts to allow the FTB "to make its section 25137 case" in accordance with the principles set out in Microsoft. (General Motors, pp. 18-19.)

The General Motors case also presented the Section 23609 "unitary credit" issue. One of General Motors’ unitary group members, Delco, incurred roughly $2.8 million in research expenses that qualified for a research tax credit under Section 23609. The Franchise Tax Board allowed Delco to apply the credit to its 1988 tax liability and, because the credit exceeded Delco’s 1988 liability, to carry the credit forward to subsequent years. General Motors argued the credit must be shared among all members of its unitary reporting group that incurred 1988 California tax liability.

The Court’s interpretation of Section 23609 focused on IRC Section 41, which is incorporated by reference into the California Revenue and Taxation Code. IRC Section 41 provides that no amount of credit be allocated to those members of the controlled group of corporations who research expenses did not increase in the taxable year. The Court found that nowhere in Section 23609 did the California Legislature, when it adopted Section 23609, "indicate it wished to apply a different rule and issue credits based on apportioned, rather than actual, contributions research." (General Motors, p. 21.) The Court concluded the Section 23609 research credit may be used only by the company that incurred the credit (Delco), and may not be shared among all members of its unitary group.

Neither Microsoft nor General Motors is a clear victory for the parties or the many taxpayers waiting for the decisions. Both cases raise important issues that will likely affect many taxpayers doing business in California. The California Supreme Court has not expressed an across-the-board approach that will determine the answer in every case. Depending on the particular facts and circumstances of the individual taxpayer, the resolution may vary significantly. Further litigation may ensue as a result of the Court’s Section 25137 analysis and its application in particular cases.

A legislative fix could also be on the horizon for the gross receipts and distortion issues. The Court welcomed the California Legislature "to follow [the] leads" of other states that have amended their sales factor statutes to expressly exclude investment returns of capital from the definition of gross receipts. (Microsoft, Slip. Op. at pp. 26-27.) Assembly Bill ("AB") 1037, which would prospectively change the treatment of investment returns of capital under the UDITPA, is currently pending in the California Legislature. (See AB 1037 (2005-2006 Reg. Sess.) as amended Aug. 7, 2006, § 1.) The 2005-2006 legislative session is set to conclude in September and it is far from clear whether AB 1037 will pass, or a new bill will be introduced and passed, before the conclusion of the current session.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved