Last week, Judge A. James Robertson II of the San Francisco Superior Court yet again ruled against General Mills in the ongoing saga over whether (and how) hedging transactions are included in the sales factor.1 The taxpayer is expected to appeal.

The issue, of course, is whether (and to what extent) General Mills-the maker of Wheaties-may include grain-hedging transactions in its sales factor. In 2007, the trial court held that the notional value2 of General Mills' hedging contracts were not "gross receipts" for purposes of the sales factor. The Court of Appeal reversed. The Court of Appeal held that the notional value of the hedging contracts are "gross receipts" generally includible in the sales factor.3 The court remanded the case back to the trial court, however, to determine whether the Franchise Tax Board had met its burden of proving, under California's version of UDITPA § 18, that the resulting apportionment formula distorts the measure of General Mills' activity in the state.4

With respect to distortion, the trial court had to decide whether General Mills' futures trading activity is qualitatively different from its principal business, and whether inclusion of such trading activity results in quantitative distortion.

On the qualitative issue, most observers felt that the Franchise Tax Board ("FTB") had a difficult burden. The appeals court had written that "hedging allows General Mills to stay in business" and that "it is difficult to imagine a program more closely related to a company's manufacturing enterprise...than hedging...." So it seemed that hedging was-qualitatively-an inextricable part of General Mills' cereal business. The trial court disagreed, finding that the Court of Appeal's lengthy discussion on this topic was mere dicta and, therefore, not binding. Instead of following the Court of Appeal's lead, the trial court pointed to variables such as the time, labor, and costs required to produce food products versus the time, labor, and costs involved in the hedging activities. Because the two activities differed under these criteria, the trial court held that the futures trading activities were qualitatively different from General Mills' food product sales.

On the quantitative distortion issue, the trial court analyzed metrics such as (1) the reasonableness of the amount of General Mills' income assigned to the location where the hedging activity was conducted, (2) a comparison of General Mills' hedging income as a percentage of its total income with General Mills' hedging receipts as a percentage of its total gross receipts, (3) the number of General Mills' employees engaged in hedging compared with the total number of employees in the company, and (4) the profit margin from the hedging activity compared with the profit margin for the overall business. The court held that these metrics for General Mills were comparable to the metrics generated by the treasury function of the taxpayers in Microsoft, Limited, and Pacific Telephone (wherein distortion had been found). Largely on that basis, the trial court concluded that the FTB met its burden that there was quantitative distortion.

In all, the trial court concluded that there was distortion and ordered that General Mills' sales factor include the hedging activities on a net basis.

There may be an interesting byproduct, however, of the FTB strategy to litigate this case. The trial court adopted much of the FTB's qualitative and quantitative analysis. If the trial court's use of that analysis is sustained, taxpayers will have an explicit roadmap for arguing that a variety of activities are "distortive" and that they are entitled to special apportionment under UDITPA § 18 (Cal. Rev. & Tax § 25137). For companies with unitary business activities that are different in character (financing, manufacturing, licensing, services, etc.), the FTB's approach opens up a whole new way to analyze whether special apportionment may be necessary for one or more of the different business activities.