A California Superior Court's decision last month in the Apple litigation should be considered by any water's-edge California franchise taxpayer that has received a foreign dividend.1 The court concluded that Fujitsu IT Holdings, Inc. v. Franchise Tax Bd.2 does "not govern how to order distributions made by a controlled foreign corporation (CFC) to its parent when the distributions are made out of earnings from multiple years."3 Still, the Apple court kept some semblance of the Fujitsu preferential ordering approach. (By "preferential ordering," we mean that previously taxed earnings are counted in some way before untaxed earnings in determining whether a dividend is eliminated. A preferential ordering approach, which has various flavors, contrasts with a pro-rata approach in which any dividend is deemed equally divided between the two types of earnings. Preferential ordering, of course, is better for taxpayers.) Specifically, the court concluded that:
. . . a distribution is deemed paid entirely from included income of a CFC's most recent year's earnings until exhausted. Then the remainder of the distribution is deemed drawn from the excluded income of the most recent year. When that source is exhausted, the remainder is deemed paid from the included income of the previous year and so on until the entire amount of the distribution is accounted for.4
For Apple, and many other taxpayers receiving dividends from foreign subsidiaries, the court's ordering of distributions results in a large portion of any dividend from a foreign subsidiary being deductible, not excludible. Under California law, an exclusion is almost always preferable to a deduction.5
Although the court ruled for the FTB on the dividend exclusion issue, it ruled for Apple on the portion of the case dealing with California's foreign investment interest offset provisions. Under those provisions, a taxpayer may lose interest deductions unless it can prove that the interest was not attributable to its investment in the foreign subsidiaries that paid deductible dividends.6 The court concluded that Apple did not borrow to benefit its foreign dividend payors; instead, it borrowed to benefit its domestic operations.7 As a result, the court held that the debt was not incurred for purposes of foreign investment, and no interest offset was required.
Although Apple didn't get everything it asked for, this decision is likely to be appealed. Therefore, all California water's-edge franchise taxpayers that have received dividends from a foreign subsidiary should review the ordering applied to their foreign dividends to see if they have a refund opportunity under the preferential ordering approach that Apple advocated. Franchise taxpayers that repatriated foreign earnings to take advantage of the American Jobs Creation Act of 2004 and repatriated foreign earnings in 2005 may need to act quickly to take advantage of this refund opportunity. For many of these taxpayers, the four-year statute of limitations for refunds expires this fall.
In addition, the Superior Court's decision in Apple creates a refund opportunity for any corporation with foreign subsidiaries that has lost interest expense deductions under California's foreign interest offset provisions. Such a corporation may now be able to deduct its interest expense from its non-dividend income if it can demonstrate that the underlying debt was not incurred for the purposes of investing in its foreign subsidiaries.