California Appeal Court Clarifies Tax Treatment of Dividends Received From Controlled Foreign Corporations

California Appeal Court Clarifies Tax Treatment of Dividends Received From Controlled Foreign Corporations

The California Court of Appeal, First Appellate District, held that a parent corporation's dividends income received from controlled foreign corporations that also have an undistributed pool of accumulated earnings from prior tax years and a surplus in the current year is subject to the last-in-first-out ordering rule.

For the Fujitsu IT Holdings Inc. v. Franchise Tax Board decision, see Doc 2004-14091 <a href="//s3.amazonaws.com/pdfs.taxnotes.com/2004/2004-14091-1.pdf" title="PDF: 2004-14091"><img src="//s3.amazonaws.com/binary.taxnotes.com/image/etl/pdficon_small.gif" width="14" height="14" border="0"/></a> or 2004 STT 133-8 <a href="/lr/resolve//4hb7"> <img src="//s3.amazonaws.com/binary.taxnotes.com/image/etl/doclink.gif" border="0" alt="2004 STT 133-8: State Court Opinions"/></a>. This decision was originally listed as Amdahl Corp. v. Franchise Tax Board. However, Amdahl changed its name to Fujitsu IT Holding Inc. during the pendency of the lawsuit.

The California Court of Appeal, First Appellate District, held that a parent corporation's dividends income received from controlled foreign corporations that also have an undistributed pool of accumulated earnings from prior tax years and a surplus in the current year is subject to the last-in-first-out ordering rule. Apple Inc. operates worldwide as the parent of several wholly owned foreign subsidiary corporations. Apple and its subsidiaries design, manufacture, and market personal electronics devices as well as a variety of related software, services, peripherals, and networking solutions. During the 1989 tax year, Apple owned 100 percent of the stock of Apple Computer Inc. Ltd. (ACL), which owned 100 percent of the stock of two subsidiary corporations, Apple Computer International Ltd. (ACIL) and AC Ltd. (AC Ltd). ACIL owned 100 percent of the stock of Apple Computer Cayman Finance Ltd. (AC Cayman). The subsidiaries are controlled foreign corporations (CFC) for purposes of IRC section 951 through 965. Through the taxable year ending September 1988, Apple filed its franchise tax returns on a worldwide combined reporting basis. Beginning with the 1989 tax year, Apple filed its franchise tax return on a water's-edge combined reporting basis, which included all income of its unitary domestic subsidiaries and the partial income of certain CFCs. Apple applied preferential ordering of dividends received from its foreign operations, arguing that the dividends were being paid from the CFC's retained earnings accrued over prior tax years. Apple excluded the dividends from its combined report as nonbusiness income or deductible items. Apple also claimed a deduction for interest expenses incurred in 1989. Following an audit, the Franchise Tax Board determined that the dividends should be treated as paid first from current year's earnings and then from the most recent prior year's earnings on a year-by-year basis. The board disallowed Apple's interest expense deduction on its domestic borrowing and allocated a portion of the dividends to nontaxable dividends repatriated in the 1989 tax year. Apple appealed to the superior court seeking a refund of $920,482.80 plus interest. Apple argued that the appeals court in Fujitsu IT Holdings Inc. v. Franchise Tax Board held that dividends received from CFC income are subject to preferential ordering. The superior court held that the board properly applied a last-in-first-out (LIFO) method to Apple's dividends. However, it found that Apple was entitled to the interest expense deduction. The superior court granted Apple's refund request. Both parties appealed to the California Court of Appeal, First Appellate District. The court rejected the board's argument that Apple was precluded from appealing the superior court's ruling on the dividend ordering issue because it succeeded in obtaining the full refund requested in its complaint. The court found that the superior court's adjudication of the dividend ordering issue was not immaterial to the judgment entered because the issue raised a legal question of how the dividends are subject to preferential or LIFO ordering. Turning to the merits of the case, the court held that the board properly applied LIFO ordering of Apple's dividends received from its foreign operations. The court rejected Apple's argument that Fujitsu is controlling and held that that case did not discuss how earnings accumulated over multiple tax years should be treated. Moreover, it noted that unlike the circumstances in Fujitsu, there is specific statutory and regulatory authority that supports the board's position. The court found that IRS section 316 and former Revenue and Taxation Code section 24495 establish a definitive LIFO ordering rule for dividends paid. The court also found that the FTB regulations incorporate the LIFO dividend ordering rule. The court rejected Apple's argument that IRC section 316 is only a rule of general applicability and that section 959(c) trumps section 316. The court held that section 959(c) unlike section 316 is not expressly incorporated in the Revenue and Taxation Code and that the federal tax scheme treats income of CFCs differently. Finally, the court held that Apple was entitled to claim the interest expense deduction because it presented sufficient evidence to show that the dominant purpose of its borrowing in 1989 was to fund its domestic operations. The superior court's decision was affirmed.

The California Court of Appeal, First Appellate District, held that a parent corporation's dividends income received from controlled foreign corporations that also have an undistributed pool of accumulated earnings from prior tax years and a surplus in the current year is subject to the last-in-first-out ordering rule. Apple Inc. operates worldwide as the parent of several wholly owned foreign subsidiary corporations. Apple and its subsidiaries design, manufacture, and market personal electronics devices as well as a variety of related software, services, peripherals, and networking solutions. During the 1989 tax year, Apple owned 100 percent of the stock of Apple Computer Inc. Ltd. (ACL), which owned 100 percent of the stock of two subsidiary corporations, Apple Computer International Ltd. (ACIL) and AC Ltd. (AC Ltd). ACIL owned 100 percent of the stock of Apple Computer Cayman Finance Ltd. (AC Cayman). The subsidiaries are controlled foreign corporations (CFC) for purposes of IRC section 951 through 965. Through the taxable year ending September 1988, Apple filed its franchise tax returns on a worldwide combined reporting basis. Beginning with the 1989 tax year, Apple filed its franchise tax return on a water's-edge combined reporting basis, which included all income of its unitary domestic subsidiaries and the partial income of certain CFCs. Apple applied preferential ordering of dividends received from its foreign operations, arguing that the dividends were being paid from the CFC's retained earnings accrued over prior tax years. Apple excluded the dividends from its combined report as nonbusiness income or deductible items. Apple also claimed a deduction for interest expenses incurred in 1989. Following an audit, the Franchise Tax Board determined that the dividends should be treated as paid first from current year's earnings and then from the most recent prior year's earnings on a year-by-year basis. The board disallowed Apple's interest expense deduction on its domestic borrowing and allocated a portion of the dividends to nontaxable dividends repatriated in the 1989 tax year. Apple appealed to the superior court seeking a refund of $920,482.80 plus interest. Apple argued that the appeals court in Fujitsu IT Holdings Inc. v. Franchise Tax Board held that dividends received from CFC income are subject to preferential ordering. The superior court held that the board properly applied a last-in-first-out (LIFO) method to Apple's dividends. However, it found that Apple was entitled to the interest expense deduction. The superior court granted Apple's refund request. Both parties appealed to the California Court of Appeal, First Appellate District. The court rejected the board's argument that Apple was precluded from appealing the superior court's ruling on the dividend ordering issue because it succeeded in obtaining the full refund requested in its complaint. The court found that the superior court's adjudication of the dividend ordering issue was not immaterial to the judgment entered because the issue raised a legal question of how the dividends are subject to preferential or LIFO ordering. Turning to the merits of the case, the court held that the board properly applied LIFO ordering of Apple's dividends received from its foreign operations. The court rejected Apple's argument that Fujitsu is controlling and held that that case did not discuss how earnings accumulated over multiple tax years should be treated. Moreover, it noted that unlike the circumstances in Fujitsu, there is specific statutory and regulatory authority that supports the board's position. The court found that IRS section 316 and former Revenue and Taxation Code section 24495 establish a definitive LIFO ordering rule for dividends paid. The court also found that the FTB regulations incorporate the LIFO dividend ordering rule. The court rejected Apple's argument that IRC section 316 is only a rule of general applicability and that section 959(c) trumps section 316. The court held that section 959(c) unlike section 316 is not expressly incorporated in the Revenue and Taxation Code and that the federal tax scheme treats income of CFCs differently. Finally, the court held that Apple was entitled to claim the interest expense deduction because it presented sufficient evidence to show that the dominant purpose of its borrowing in 1989 was to fund its domestic operations. The superior court's decision was affirmed.