Toys "R" Us, Inc. v. Franchise Tax Bd.

• Decision Date: 05 April 2006
• Docket Number: No. C045386.,C045386.
• Court: California Court of Appeals Court of Appeals
• Parties: TOYS "R" US, INC., et al., Plaintiffs and Appellants, v. FRANCHISE TAX BOARD, Defendant and Respondent.

41 Cal.Rptr.3d 285

138 App.4th 339

TOYS "R" US, INC., et al., Plaintiffs and Appellants, v. FRANCHISE TAX BOARD, Defendant and Respondent.

No. C045386.

Court of Appeal, Third District.

April 5, 2006.

Morrison & Foerster, Eric J. Coffill, and Carley A. Roberts, Sacramento, for Plaintiffs and Appellants.

Bill Lockyer, Attorney General, Lawrence K. Keethe, Supervising Deputy Attorney General, and Michael J. Cornez, Deputy Attorney General, for Defendant and Respondent.

RAYE, J.

Toys "R" Us, Inc. (Toys) sells not only toys for tots but also maintains investments in short-term financial instruments, including debt securities and repurchase agreements. As a nationwide purveyor of toys, Toys pays state income tax proportionate to its profits in each state. In California, a retailer's tax obligation is based on an apportionment formula: the average of three fractions to arrive at a percentage that is then multiplied times the corporation's worldwide income to determine the amount of income apportioned to California. The three fractions are California payroll divided by worldwide payroll, California property divided by worldwide property, and California sales divided by worldwide sales. Toys challenges the calculation of the sales fraction of the equation, arguing the worldwide sales figure should include not only the interest earned by its short-term financial investments but also the principal amount of these investments. Since Toys's financial arm operates out of the State of Delaware, the principal and interest income would inure to the worldwide sales figure and, accordingly, significantly reduce the amount of income apportioned to California.

Toys filed a complaint for refund of taxes, requesting a refund of taxes and interest paid to defendant Franchise Tax Board (FTB). The complaint alleged Toys was entitled to a refund on the ground that all gross receipts received by Toys from the sale of short-term financial instruments must be included in the apportionment factor. Following a court trial, the trial court found in favor of the FTB. Toys appeals, contending the trial court erred in interpreting the Revenue and Taxation Code. We shall affirm the judgment.

FACTUAL AND PROCEDURAL BACKGROUND

Toys sells children's toys, games, and furniture through its chain of Toys "R" Us stores.¹ During the years at issue, Toys maintained a treasury department in New Jersey. The treasury department managed Toys's investments in "repurchase agreements and ... debt securities held to maturity," referred to as "short-term financial instruments."

For a portion of the relevant period, the treasury department directly invested funds for Toys according to investment guidelines established by Toys. For the remainder of the period, Toys engaged an outside brokerage firm to assist in the management of its short-term financial instruments. Toys's short-term financial instruments are usual, ordinary, and recurring transactions for Toys.

Not surprisingly, toy sales peak during the Christmas season. Retailers manage cash from Christmas sales to build inventory through the summer and fall to prepare for the next Christmas season. At Toys, its treasury department manages this excess cash.

The treasury department invested Toys's excess cash with the objective of maximizing yield while maintaining liquidity as needed for the business. During the years in question, Toys reported the income earned from its short-term financial instruments as business income. This income was apportioned to California based on the apportionment formula set forth in Revenue and Taxation Code section 25120 et seq.²

In July 2001 Toys filed a complaint for refund of taxes for the income years ending February 2, 1991; February 1, 1992; January 30, 1993; and January 29, 1994, in the amount of $4,812,618 plus interest. The complaint alleged Toys was entitled to a refund on the ground that all gross receipts received by Toys from the sale of short-term financial instruments must be included in Toys's sales factor under sections 25120, subdivision (e) and 25134.

A court trial followed. Toys presented two witnesses. Jon Kimmins, Toys's senior vice president-treasurer, testified he was responsible for Toys's capital structure and cash management during the relevant period. Kimmins explained the operation of Toys's treasury department and the necessity for cash management in the cyclical toy business. Kimmins stated investments were made based upon the rate of return and the duration of the investment.

Richard Pomp, a professor of tax law, testified as an expert witness. Professor Pomp opined there was no principled reason under tax policy why the gross receipts from the disposition of financial instruments should be treated any differently than the gross receipts from the disposition of inventory, which is fully includable as gross in the sales factor.

Under Professor Pomp's analysis, the company has a certain amount of cash at the end of the day. The company can convert the cash into inventory, a doll for example, and sell it the following day. However, if conversion to inventory is not a good use of the money, the company can instead invest the cash in a financial instrument. As Professor Pomp explained: "That these are alternatives, and ... one of the functions of the treasurer is to decide what the best use of that cash might be. And I guess I see a financial asset as a competitor for inventory. And each one, in a sense, is using the funds generated by the business. Each one is an investment, [one] in an inventory and one in a financial asset. Each one gets turned over in some period of time.... [¶] The financial instruments generate a small-profit margin ... that could be true of toys too or in the case of diapers, no profit margin. So I guess I see that the money being fungible, all of this just would generate the income which now the state is taxing.... I don't see any fundamental difference in the gross receipt generated by a financial instrument or by a Cabbage Patch doll."

The FTB presented testimony by Steven Sheffrin, an economics professor. Professor Sheffrin testified regarding whether the inclusion of the total amount received from the financial investment transactions would fairly represent Toys's business activity in California.

Sheffrin, in forming his opinion, made a number of calculations based on the data in the Toys annual reports and the stipulations between the parties. In 1991, for every dollar of sales of toys, clothes, and furniture, Toys generated about 30.62 cents of gross profit. If gross receipts are included in the return of principal, then for every dollar of sales in the treasury function, Toys generated about .043 cents of gross profit. The ratio of these two numbers is approximately 711. This meant the retail sales portion of the business generated 711 times more gross profit than the treasury function.

Sheffrin next compared the ratio of net income before taxes to sales and determined that for every dollar of sales, the profit was 9.47 cents. The ratio here was 220, meaning that the sales in a store are 220 times more powerful in terms of generating income than the treasury function.

Sheffrin then testified as to the potential effect of including the return of principal from short-term investments in the sales factor. For 1991, if the principal is included in total receipts, they would constitute about 35.34 percent of all receipts. If this number is divided by 3, because of the three-factor apportionment formula, the number is 11.78. If the treasury function were moved from New Jersey to New York, 11.78 percent of Toys's apportionable income would be moved from New Jersey to New York. In Sheffrin's opinion, it was implausible that by simply moving six employees responsible for the treasury function, Toys could move 11.78 percent of its income to another state.

Sheffrin considered the remaining years and found similar results. For 1992, retail sales generated 346 times more net income before taxes than the treasury function. Toys's stores in California constituted about 11.3 percent of its total stores. This percentage is close to the sales factor percentage for California under the FTB's interpretation of the statute. If the return of principal is included in gross receipts, the treasury function constitutes 68.57 percent of total receipts. When divided by 3, as in the apportionment formula, the treasury function equals 22.86 percent. Sheffrin testified this meant that by moving six employees to another state, Toys could move 22.86 percent of its apportionable income to another state.

For 1993, retail sales generated 844 times more gross income per dollar of sales than the treasury function. Retail sales generated 267 times more net income before taxes per dollar of sales than the treasury function. Toys's stores in California constituted about 11.11 percent of total stores, a percentage close to the sales factor percentage under the FTB's analysis. If the return of principal is included in gross receipts, the treasury function would constitute 57 percent of total receipts, or 19 percent when divided by 3. Again, Sheffrin testified that under this analysis, by moving six employees to another state Toys could move 19 percent of its apportionable income to another state. When Sheffrin applied this analysis to 1994, he reached similar results.³

The trial court issued a ruling on submitted matter in favor of the FTB. The court began by considering the meaning of "sale," concluding "the term `sales' must be a function, or derivative, of `gross receipts.' Therefore, if no `sale' has occurred, no gross receipts have been produced. If that is true, then Toys' return of principal from its short-term paper cannot reasonably be deemed to be `gross receipts' from `sales,' since Toys was not selling anything when they invested their spare cash. Interest is not received from the `sale' of money."

The court reviewed the...