Apple, Inc. v. Franchise Tax Bd.

• Decision Date: 04 January 2012
• Docket Number: A129090.,Nos. A128091,s. A128091
• Citation: 132 Cal.Rptr.3d 401,11 Cal. Daily Op. Serv. 11736,199 Cal.App.4th 1,2011 Daily Journal D.A.R. 13865
• Court: California Court of Appeals Court of Appeals
• Parties: APPLE, INC., Plaintiff and Appellant, v. FRANCHISE TAX BOARD, Defendant and Appellant.

199 Cal.App.4th 1

132 Cal.Rptr.3d 401

11 Cal. Daily Op. Serv. 11,736

2011 Daily Journal D.A.R. 13,865

APPLE, INC., Plaintiff and Appellant,

v.FRANCHISE TAX BOARD, Defendant and Appellant.

Nos. A128091, A129090.

Court of Appeal, First District, Division 5, California.

Sept. 12, 2011.

Rehearing Denied Oct. 5, 2011.

Review Denied Jan. 4, 2012.

Pillsbury WinthropShaw Pittman, Jeffrey M. Vesely, Kerne H.O. Matsubara and Annie H. Huang, San Francisco, for Plaintiff and Appellant.

Edmund G. Brown, Jr., and Kamala D. Harris, Attorneys General, Paul D. Gifford, Senior Assistant Attorney General, Joyce E. Hee and Kristian D. Whitten, Deputy Attorneys General, for Defendant and Appellant.

BRUINIERS, J.

Apple, Inc. (Apple) is one of the world's largest multinational corporations.¹ It is incorporated in California and has its principal place of business in this state, but operates worldwide as the parent of a number of wholly owned foreign subsidiary corporations. Apple and its subsidiaries design, manufacture, and market personal computers, portable digital music players, and mobile communication devices and sell a variety of related software, services, peripherals, and networking solutions.

At issue in this tax refund action is the California tax treatment of repatriated dividends paid to Apple from certain of its subsidiaries in its 1989 tax year. More specifically, the issue is the appropriate method to account for the source from which repatriated dividends are paid, and which of two competing methods is more consistent with the provisions of our tax code that seek to ensure that foreign subsidiary income is appropriately taxed—but only once. Also in dispute is an interest deduction taken by Apple in its 1989 tax year, but disallowed by the California Franchise Tax Board (FTB).

Apple argued that FTB improperly subjected it to double taxation when it applied a last-in-first-out (LIFO) proration of its income, treating the dividends as paid first from current year's earnings, and only then from the most recent prior years' earnings on a year-by-year basis. Apple contends that Revenue and Taxation Code section 25106,² as interpreted by this Districtin Fujitsu IT Holdings, Inc. v. Franchise Tax Bd. (2004) 120 Cal.App.4th 459, 15 Cal.Rptr.3d 473( Fujitsu ), requires that such dividends instead be subject to “preferential ordering” and be deemed to be paid first out of income already taxed in prior years, and thus eliminated entirely from the recipient's income subject to California tax. Apple also argued that FTB improperly disallowed an interest expense deduction on its domestic borrowing, which FTB allocated in part to nontaxable dividends repatriated in the 1989 tax year.

Following a nonjury trial, presented largely on stipulated facts, the trial court ruled against Apple on the dividend ordering issue, but in Apple's favor on the disputed interest deduction. As a result, it ordered that a refund be paid to Apple in the amount of $920,482.80 plus interest—the full amount sought by Apple in its complaint. Apple subsequently moved for an award of its attorney fees under section 19717, subdivision (a)³ and Code of Civil Procedure section 1021.5.⁴ The court denied the motion, finding the position taken by FTB was “substantially justified.”

Apple appeals the court's adverse ruling on the application of section 25106. FTB cross-appeals, challenging the determination on the interest deduction and the refund order. We have also consolidated Apple's separate appeal from the court's denial of its motion for attorney fees. We affirm in all respects.

I. Background

As our Supreme Court has observed, “Ours is a global economy. In contrast, government and the taxing authority used to fund it are national and local. This geographic disparity generates difficulties when each jurisdiction seeks its piece of the economic pie, a pie generated by economic activity that knows no borders.” ( Microsoft Corp. v. Franchise Tax Bd. (2006) 39 Cal.4th 750, 754, 47 Cal.Rptr.3d 216, 139 P.3d 1169( Microsoft ).)

At the federal level, a United States corporation is taxed on all of its income whether it is earned inside or outside of the United States. To deter United States taxpayers from using related foreign companies to accumulate earnings offshore, the federal Internal Revenue Code (26 U.S.C. (hereafter IRC)) requires that a United States entity include in current taxable income, as a constructive dividend, a portion of the United States entity's share of the controlled foreign company's current income.⁵ ( IRC §§ 951– 965; Koehring Co. v. United States (7th Cir.1978) 583 F.2d 313, 317.) California instead focuses on dividends “paid,” and takes intercompany dividends into account for tax purposes at the time that they are distributed. ( § 25106.) ⁶

California Taxation of Unitary Business Enterprises

California imposes a franchise tax on corporations doing business within the State on the corporation's net income derived from or attributable to sources within California. (§ 25101.) When a corporation, and its affiliated corporations, conduct business both within and outside the State as part of a larger unitary business enterprise, it becomes necessary to determine how much of the income of the unitary business is attributable to sources within California.

California has adopted the unitary business principle to determine the portion of a corporate taxpayer's total income that is attributable to this state for California franchise and income tax purposes. ( Container Corp. v. Franchise Tax Bd. (1983) 463 U.S. 159, 162–163, 103 S.Ct. 2933, 77 L.Ed.2d 545.) A unitary business is one that receives income “from or attributable to sources within and without the state....” (§ 25101.) “A unitary business is generally defined as two or more business entities that are commonly owned and integrated in a way that transfers value among the affiliated entities.” ( Citicorp North America, Inc. v. Franchise Tax Bd. (2000) 83 Cal.App.4th 1403, 1411, fn. 5, 100 Cal.Rptr.2d 509.) “A unitary business has been judicially defined as one in which the following factors are present: (1) unity of ownership; (2) unity of operations, as evidenced by central accounting, purchasing, advertising, and management divisions; and (3) unity of use in a centralized executive force and general system of operation. [Citations.]” ( Fujitsu, supra, 120 Cal.App.4th at p. 468, 15 Cal.Rptr.3d 473.) Apple agrees that it operated as a unitary business in the relevant tax years.

Under the unitary business principle, an affiliated group of corporations under common control or ownership is viewed as a whole or a single unit. A taxpayer that is engaged in a unitary business generally determines its tax based upon a worldwide combined report, which includes the income of all domestic and foreign members (e.g., corporate affiliates and subsidiaries) of the unitary business. A formula is applied “ ‘apportioning the total income of that “unitary business” between the taxing jurisdiction and the rest of the world[,] ... taking into account objective measures of the corporation's activities within and without the jurisdiction.’ [Citation.]” ( Microsoft, supra, 39 Cal.4th at p. 756, 47 Cal.Rptr.3d 216, 139 P.3d 1169, fn. omitted.) “[T]axes are apportioned based on property, payroll, and sales to allocate to California for taxation ‘its fair share of the taxable values of the taxpayer....’ [Citation.]” ( Fujitsu, supra, 120 Cal.App.4th at p. 469, 15 Cal.Rptr.3d 473.)

Effective January 1, 1988, taxpayers that constituted a unitary business were allowed to choose a “water's-edge election” combined report that includes the income of domestic entities and only a portion of the income of certain controlled foreign subsidiaries (controlled foreign corporations; CFCs).⁷ (§§ 25110; 25111.) A CFC that is partially included in the water's-edge report has two kinds of earnings: (1) “excluded income” (i.e., income not included in the unitary group's combined report) and (2) “included income” (i.e., income included in the unitary group's combined report). An “inclusion ratio” is provided by section 25110 ⁸ to determine the portion of the income and apportionment factors of the CFC that must be included in the water's-edge group's combined report. The “inclusion ratio” is a fraction, the numerator of which is the “Subpart F income” of the CFC and the denominator of which is the entire earnings and profits of the CFC for that taxable year. “Subpart F income” gets its name from Subpart F of the IRC ( IRC §§ 951– 965). ( Fujitsu, supra, 120 Cal.App.4th at p. 469, 15 Cal.Rptr.3d 473.) It expressly includes dividend income. California has chosen to measure Subpart F income by incorporating the federal definition. ( Id. at p. 477, 15 Cal.Rptr.3d 473.) A CFC's net income is multiplied by its inclusion ratio to arrive at the CFC's income that is to be included in the water's-edge group's combined report. ( Id. at p. 476, 15 Cal.Rptr.3d 473.)

Apple's California Tax Filings

Through the taxable year ending September 30, 1988, Apple filed its California franchise tax returns on the basis of a worldwide combined report, which included Apple and all of its domestic and foreign subsidiaries that were engaged in a single unitary business. During 1989 and prior tax years, Apple owned 100 percent of the stock of Apple Computer Inc. Limited, incorporated in Ireland (ACL), which, in turn, owned 100 percent of the stock of two subsidiary corporations, Apple Computer International Limited, a United Kingdom company (ACIL), and AC Limited, incorporated in Ireland (AC Ltd.). During the 1989 tax year in question, ACIL owned 100 percent of the stock of Apple Computer Cayman Finance Limited (AC Cayman), a Cayman Islands company. Apple calculated its inclusion ratios under section 25110 for ACL at 9.6490 percent; for ACIL at 73.7722 percent; and for AC Ltd. at 1.4578 percent. Also included in Apple's worldwide combined report were...