Microsoft Corp. v. Franchise Tax Bd.

• Citation: 39 Cal.4th 750,139 P.3d 1169,47 Cal.Rptr.3d 216
• Decision Date: 17 August 2006
• Docket Number: No. S133343.,S133343.
• Parties: MICROSOFT CORPORATION, Plaintiff and Respondent, v. FRANCHISE TAX BOARD, Defendant and Appellant.
• Court: United States State Supreme Court (California)

47 Cal.Rptr.3d 216

39 Cal.4th 750

139 P.3d 1169

MICROSOFT CORPORATION, Plaintiff and Respondent, v. FRANCHISE TAX BOARD, Defendant and Appellant.

No. S133343.

Supreme Court of California.

August 17, 2006.

Bill Lockyer, Attorney General, Randall P. Borcherding and Julian O. Standen, Deputy Attorneys General, for Defendant and Appellant.

Frank Katz and Shirley Sicilian for Multistate Tax Commission as Amicus Curiae on behalf of Defendant and Appellant.

Michael P. Boyle, Michael J. Bernard, Kurt A. Lamp; Baker & McKenzie, J. Pat Powers; Preston Gates & Ellis, Reed Smith, James P. Kleier, San Francisco, Brian W. Toman, Charles R. Zubryzcki and John R. Messenger, for Plaintiff and Respondent.

Ajalat, Polley & Ayoob, Charles R. Ajalat and Christopher J. Matarese for General Motors Corporation as Amicus Curiae on behalf of Plaintiff and Respondent.

WERDEGAR, J.

[139 P.3d 754]

Ours is a global economy. In contrast, government, and the taxing authority used to fund it, is 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.

[139 P.3d 755]

The Uniform Division of Income for Tax Purposes Act (UDITPA)¹ attempts to address these problems and fairly assess corporate taxes. Adopted by the District of Columbia and 22 states, including California, it seeks to establish uniform rules for the attribution of corporate income, rules that in theory will result in an equitable taxation scheme—equitable to each jurisdiction, seeking its own fair share, and equitable to the taxpayer, who in the absence of uniform rules faces the prospect of having the same income taxed by two, three, or more different states.

The UDITPA's application is not always clear.² This case requires us to resolve how the UDITPA should apply to income arising from the redemption of marketable securities, a critical aspect of the operations of the treasury departments of many large corporations, including plaintiff Microsoft Corporation (Microsoft). We conclude (1) the redemption of marketable securities at maturity generates "gross receipts" that are includible in the formula used to calculate a multistate entity's tax, but (2) the Franchise Tax Board (the Board) has met its burden of establishing that, in this instance, an alternate formula should be used to calculate Microsoft's tax.

THE UDITPA

The United States Constitution bars taxation of extraterritorial income. (Container Corp. v. Franchise Tax Board (1983) 463 U.S. 159, 164, 103 S.Ct. 2933, 77 L.Ed.2d 545 (Container Corp.); ASARCO Inc. v. Idaho State Tax Com. (1982) 458 U.S. 307, 315, 102 S.Ct. 3103, 73 L.Ed.2d 787; Barclay's Bank Internat., Ltd. v. Franchise Tax Bd. (1992) 2 Cal.4th 708, 714, 8 Cal.Rptr.2d 31, 829 P.2d 279 (Barclay's Bank).) However, it permits taxation of "an apportionable share of the multistate business carried on in part in the taxing State" (Allied-Signal, Inc. v. Director, Div. of Taxation (1992) 504 U.S. 768, 778, 112 S.Ct. 2251, 119 L.Ed.2d 533) and grants states some leeway in separating out their respective shares of this multistate income, not mandating they use any particular formula (Container Corp., at p. 164, 103 S.Ct. 2933). One constitutional method of apportionment, the unitary business/formula apportionment method, "calculates the local tax base by first

[139 P.3d 756]

describing the scope of the `unitary business'<sup>3</sup> of which the taxed enterprise's activities in the taxing jurisdiction form one part, and then apportioning the total income of that `unitary business' between the taxing jurisdiction and the rest of the world on the basis of a formula taking into account objective measures of the corporation's activities within and without the jurisdiction." (Container Corp., at p. 165, 103 S.Ct. 2933.) The UDITPA is generally based on this method. (Ibid.)

Under the UDITPA, a unitary enterprise's income is divided into "business income" and "nonbusiness income." (Hoechst Celanese Corp. v. Franchise Tax Bd. (2001) 25 Cal.4th 508, 518, 106 Cal.Rptr.2d 548, 22 P.3d 324 (Hoechst); Rev. & Tax.Code, § 25120, subds. (a), (d).)⁴ With some exceptions, nonbusiness income is generally allocated directly to the taxpayer's domiciliary state. (Hoechst, at p. 518, 106 Cal.Rptr.2d 548, 22 P.3d 324; §§ 25123-25127.) In contrast, business income is apportioned among the states according to a formula. The portion of a taxpayer's business income attributable to economic activity in a given state is determined by combining three factors: payroll, property, and sales. (§ 25128.) Each factor is a fraction in which the numerator measures activity or assets within a given state, while the denominator includes all activities or assets anywhere. (§§ 25129, 25132, 25134.) The combination of these fractions is used to determine the fraction of total global business income attributable to the given state. (See Container Corp., supra, 463 U.S. at p. 170, 103 S.Ct. 2933; Barclay's Bank, supra, 2 Cal.4th at p. 715, 8 Cal.Rptr.2d 31, 829 P.2d 279.)⁵ This method provides a rough but constitutionally sufficient approximation of the income attributable to business activity in each state. (Container Corp., at pp. 170, 183-184, 103 S.Ct. 2933; Barclay's Bank, at pp. 718-721, 8 Cal.Rptr.2d 31, 829 P.2d 279.)

Only the sales factor is at issue here. The sales factor is a ratio comparing sales in a given state to total sales everywhere. (§ 25134.)

[139 P.3d 757]

Sales are measured by counting a business's "gross receipts." (§ 25120, subd. (e).) Increases in in-state gross receipts will lead to a larger fraction, greater apportioned income, and higher tax; conversely, increases in out-of-state gross receipts will lead to a reduction in the fraction attributable to California and a reduction in California tax.

The UDITPA contains a relief provision. If application of the foregoing provisions fails to "fairly represent the extent of the taxpayer's business activity in this state," the taxpayer may seek or the Board may impose an alternate method of calculation to achieve an equitable result. (§ 25137.)

FACTUAL AND PROCEDURAL BACKGROUND

Microsoft is an international software company with principal offices in the State of Washington. Microsoft and its worldwide subsidiaries operate as a unitary business. Microsoft's business generates excess operating cash, which its treasury department invests in various short-term marketable securities.⁶ Some of these securities Microsoft resells to third parties; others it holds and redeems at maturity. These investments are generally short-term; in 1991, the tax year at issue, approximately 80 percent of investment receipts came from securities held for 30 days or less.

In an amended 1991 California tax return, Microsoft reported the income of its treasury department as business income and the entire amount it received from sales and redemptions of marketable securities, $5.7 billion, as gross receipts. In its audit, the Board accepted the treatment of treasury department income as business income and allowed the inclusion of securities sales as gross receipts, but disallowed the return of capital for securities redemptions. That is, for securities held to maturity, it counted as gross receipts only the price differential between the redemption price and the purchase price. Because redemptions of securities were credited to Microsoft's treasury department in Washington State and contributed to Microsoft's sales factor denominator but not its sales factor numerator, inclusion of the full price in the sales factor would have had the effect of diluting that factor (from roughly 11 percent to 3 percent) and cutting Microsoft's California income tax nearly in half, while inclusion of only the net price differential had the effect of increasing Microsoft's sales factor and its state tax. (See § 25134.)

Microsoft exhausted its administrative remedies without success and filed a refund suit. After a bench trial, the trial court ruled for Microsoft, holding that the entire amount received when Microsoft redeemed its securities at maturity

[139 P.3d 758]

counted as gross receipts. The trial court further held that the Board had failed to carry its burden of showing that a section 25137 modification to the formula used to compute Microsoft's tax was necessary to achieve a fair representation of Microsoft's California business.

The Court of Appeal reversed, deciding the case solely on section 25137 grounds. It held that inclusion of Microsoft's securities redemptions in its gross receipts would seriously distort the formula's representation of Microsoft's California business and that the Board's proposed exclusion of the returned capital portion of these redemptions was authorized under section 25137. We granted review.

DISCUSSION

I. Redemptions as Gross Receipts

Microsoft asks us to apply a substantial evidence standard of review to the question whether the full amount or net price difference of its redemptions constitutes gross receipts for purposes of the UDITPA, arguing that both the nature of its investments and the extent of its activity here and out-of-state involve factual issues. We decline. The factual attributes of Microsoft's transactions are undisputed. Similarly, the parties have stipulated to the relevant facts concerning the scope of Microsoft's activities in California and elsewhere. While the parties dispute the proper legal characterization of Microsoft's transactions under the UDITPA, "[t]he application of a taxing statute to uncontradicted facts is a question of law, and this court is accordingly not bound to accept the trial court's findings of fact made from the uncontradicted facts shown in the parties' stipulation and the documentary evidence." (Communications Satellite Corp. v. Franchise Tax Bd. (1984) 156 Cal.App.3d 726, 746, 203 Cal.Rptr. 779.)

As with any issue of statutory interpretation, we begin with...