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

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.

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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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ALJ Rules That a Taxpayer Is a Qualified New York Manufacturer Even Though Qualifying Property Was Operated by a Third Party

The New York State Division of Tax Appeals determined that E. & J. Gallo Winery is a qualified New York manufacturer (QNYM) even though its only property in New York that could allow it to qualify for QNYM classification – a vineyard – was operated by a third-party contractor and Gallo did not have any of its own employees involved in the operation of the vineyard.

Gallo is a multinational manufacturer of table wines that acquired a vineyard in New York and hired a third-party contractor to maintain and farm the vineyard “so as to produce the quantity and quality of grapes” that Gallo’s significant winemaking operations needed. “The service agreement [between Gallo and the third-party contractor] was not a lease,” but instead gave the contractor the responsibility of the “full and complete management, supervision and control of the development and operation of the . . . vineyard.” In this role, the contractor was required to hire employees and subcontractors. The service agreement with Gallo confirmed that the contractor was to be treated “in all respects [as] the sole employer of such persons, employer of such persons, employees, duly licensed contractors, or firms.”

Gallo claimed it was a QNYM during the years at issue (2016 to 2019) under New York Tax Law §§ 210(1)(a)(vi) and 210-B(1)(b)(i)(A), which the administrative law judge (ALJ) summarized as requiring a taxpayer or combined group to have:

  • Been “principally engaged” (derived more than 50% of its gross receipts) in the production of goods by manufacturing, processing, assembling, refining, mining, extracting, farming, agriculture, horticulture, floriculture, viticulture or commercial fishing
  • Owned property in New York that had an adjusted basis of at least $1 million at the close of each taxable year or had all of its real and personal property located in New York
  • [Whereby] such property is principally used by the taxpayer in the production of goods by the same list of activities noted above, including manufacturing and viticulture.

The New York State Department of Taxation and Finance agreed that Gallo satisfied the first two requirements, but claimed, pursuant to TSB-M-15(3)C, that Gallo failed to meet the third requirement because it did not have any employees related to the vineyard and, therefore, it did not actually use the relevant New York-located property in the production of goods.

The ALJ, however, pointed out that “TSB-Ms are informational statements of the Division of Taxation’s policies” and “do not have legal force or effect.” And because the QNYM statute is a rate reduction and not an exemption, “it is to be construed most strongly against the government and in favor of the taxpayer.”

In analyzing the statute, the ALJ found that there was no “employee requirement” like that in the alternative test (i.e., having 2,500 manufacturing employees and $100 million of manufacturing property in New York) to be considered a QNYM. Therefore, the ALJ stated, “there is no basis to import the requirements from one test to the other when the Legislature could have easily done [...]

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New Jersey Governor Flip-Flops on Corporate Business Tax Surtax Expiration

After months of insisting that he would not allow New Jersey’s 2.5% corporate business tax surtax to be extended – and previously having allowed it to lapse for tax years beginning on January 1, 2024 – New Jersey Governor Phil Murphy is now proposing that the surtax be revived for companies earning profits that exceed $10 million a year (up from the prior threshold of $1 million). The proposal appears to apply retroactively to January 1, 2024.

This will cause New Jersey to once again have the highest corporate income tax rate in the nation at 11.5%. According to the New York Times, Governor Murphy is selling the revival of the surtax as a “corporate transit fee” because the extra revenue will be earmarked for New Jersey Transit.

The governor’s proposed flip-flop is expected to receive significant pushback from the business community. The New Jersey Chamber of Commerce, which has already called the governor’s proposal a “nightmare scenario for New Jersey,” has indicated that it will be meeting with the Murphy administration and legislative leaders to voice their opposition.




Remote Retailers Held Responsible for Tax Collection in Washington

If there’s a lesson to be learned from the Washington Court of Appeals’ recent holding in Orthotic Shop Inc. and S&F Corporation v. Department of Revenue, No. 39321-6-III (Jan. 23, 2024), it’s that the use of a marketplace does not eliminate a remote seller’s tax responsibilities, particularly for pre-Wayfair periods.

The dispute in Orthotic Shop involved a retailing business and occupation tax (B&O tax) and a retailing sales tax assessment against two merchants for sales they made on an online retailer’s website. The audit report asserted that the merchants were “retailers” who maintained a nexus to Washington because they maintained a stock of goods in the online retailer’s warehouses located in the state. As such, the audit report concluded that the merchants were liable for retailing B&O tax and sales tax on sales to Washington customers made via the online retailer’s website.

The merchants admitted before the Court of Appeals that they sold their goods to consumers and not to the online retailer. However, the merchants challenged the assessment and argued that the online retailer’s provision of fulfillment services necessarily rendered it a “consignee” responsible for remitting retailing B&O tax and sales tax on transactions facilitated through its website in accordance with WAC 458-20-159. The merchants also asserted that the assessment was unfair because they lacked an understanding that they could incur a tax collection liability in Washington through the storage of their merchandise in an in-state warehouse.

The Court of Appeals determined that the merchants failed to show that the online retailer was a consignee with sole responsibility for tax collection. “A consignee,” the Court of Appeals explained, “makes sales on behalf of the consignor.” By contrast, the merchants’ product pages on the marketplace’s website listed the merchants as the sellers, not the online retailer. Accordingly, the Court of Appeals concluded: “[s]ince the merchants sold to buyers, they are liable for retailing B&O tax on those sales.”

The merchants’ failure to list the online retailer as the “seller” on their respective sales pages was also fatal to their argument that they were not liable for retailing sales tax on sales made via the online retailer’s website. The Department of Revenue’s administrative rules explain that while a consignee is responsible for collecting and remitting sales tax on sales made in its own name, when the consignee is selling in the name of the consignor, the consignor may instead report and remit the retail sales tax. Here, the Court of Appeals noted that while the online retailer’s agreement with the merchants provided that it would remit the sales tax if the merchants asked it to do so, neither merchant made such a request.

The Court of Appeals also was unimpressed by the merchants’ assertions that they did not understand that they could establish physical presence nexus and incur a tax liability based on the storage of their goods at a warehouse in the state. The Court of Appeals explained that ignorance of the law, was not an acceptable defense.

CASE TAKEAWAYS

Although Orthotic Shop [...]

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Vermont Considers Imposing Mandatory Worldwide Combined Reporting

The Vermont House Committee on Ways and Means is actively exploring a proposal to become the first state to enact mandatory worldwide combined reporting for corporate income tax purposes. While legislation has not been formally proposed, the Committee has examined a working draft that could be embedded into a broader tax legislation package.

In Committee testimony supporting the adoption of mandatory worldwide combined reporting, Don Griswold, a senior fellow at the Center on Budget and Policy Priorities, argued that multinational corporations “pay huge fees to sophisticated advisers to develop an endless variety of complex schemes that shift their profits offshore.” According to him, mandatory worldwide combined reporting would be “the complete solution” to stopping what he perceives as a “loophole for massive tax avoidance.” He also intimated that several companies are among those he believes are currently engaging in “tax avoidance,” even though he freely acknowledged that he worked in a “Big 4 accounting firm’s 600-person ‘state tax minimization’ group” for most of his career.

On the other hand, at least one representative from the Vermont Department of Taxes has suggested that worldwide mandatory combined reporting is not the panacea that Griswold claims it would be. In Committee testimony, Will Baker, assistant attorney general and general counsel at the Department of Taxes, pointed out that a corporation’s Vermont taxable income could increase or decrease under worldwide combined reporting depending on the profitability of the corporation’s domestic and overseas subsidiaries and the locations of the corporate unitary group’s sales throughout the world. Baker also suggested that the Department of Taxes would face practical challenges calculating the income of subsidiaries that are not part of a corporate filing at the US federal level. Finally, he added that “small states” should generally “have the same rules that other states have” to make it easier for taxpayers to comply with Vermont law.

The McDermott state & local tax team will be closely monitoring this legislative proposal to see whether the Vermont General Assembly takes heed of the advice of its own officials at the Department of Taxes.




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