Superior Court of San Francisco City and County, No. CGC 08-471129, Harold E. Kahn, Judge. (San Francisco City & County Super. Ct. No. 471129)
The opinion of the court was delivered by: Bruiniers, J.
CERTIFIED FOR PUBLICATION
Apple, Inc. (Apple) is one of the world's largest multinational corporations.*fn1 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,*fn2 as interpreted by this District in Fujitsu IT Holdings, Inc. v. Franchise Tax Bd. (2004) 120 Cal.App.4th 459 (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 non-jury 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)*fn3 and Code of Civil Procedure section 1021.5.*fn4 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.
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 (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.*fn5 (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.)*fn6
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.) 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.) "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.4that p. 468.) 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, 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.)
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).*fn7 (§§ 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*fn8 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.) It expressly includes dividend income. California has chosen to measure Subpart F income by incorporating the federal definition. (Id. at p. 477.) 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.)
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 Apple Computer Holding BV, Apple Australia, Apple Canada and Apple Computer A.B.
Beginning with the 1989 tax year, Apple made a water's-edge election and filed its California franchise tax return on the basis of a water's edge combined report, which included all the income of its unitary domestic subsidiaries and the partial income of certain CFCs. In 1989, Apple had previously undistributed foreign subsidiary earnings of $698,778,366. It repatriated $86,600,000 in dividends from its foreign operations. AC Cayman distributed a dividend of $11,400,000 to ACIL, ACIL distributed a dividend of $45,100,000 to ACL, AC Ltd. distributed a dividend of $2,000,000 to ACL, and ACL distributed a dividend of $50,000,000 to Apple. In addition, in the 1989 tax year, Apple received the following dividends from its other foreign subsidiaries: $10,440,309 from Apple Computer Holding BV; $8,000,000 from Apple Australia; $18,000,000 from Apple Canada; and $210,035 from Apple Computer A.B.
In its tax filing, Apple applied preferential ordering to the dividends and took the position that the dividends were being paid from the CFC's retained earnings accrued over prior tax years. Since, it argued, California had already taxed the earnings out of which dividends were being paid, section 25106 allowed it to transfer the dividends without tax consequence. As a result, all of these the dividends were either excluded from Apple's water's-edge combined report as nonbusiness income or treated as deductible items.*fn9 FTB agrees that, if preferential ordering is required, nearly all of the dividend distributions would be eliminated from Apple's 1989 California taxable base.*fn10
Apple deducted $10,691,430 in interest expenses for its 1989 tax year. FTB disallowed $1,893,886 of this amount on the basis that, to the extent that the dividends paid by Apple's CFCs were paid out of excluded income, they were deductible as "Qualifying Dividends" under section 24411.*fn11 FTB made an allocation of Apple's domestic borrowing to its foreign subsidiary operations, and applied a formula under section 24344, subdivision (b) to reduce the allowable deduction.*fn12 As we have noted, as a result of the subsequent decision Farmer Bros., supra, 108 Cal.App.4th 976, FTB determined that the dividends should be deductible instead (at least for the 1989 tax year) under section 24402. Section 24402 provides that even in the absence of a unitary business, where the payor corporation was subject to California tax, the recipient corporation may deduct from its gross income dividends that were declared from income already included in the measure of California franchise tax imposed upon the payor corporation.*fn13 The same allocated portion of the interest deduction was then disallowed under section 24425.*fn14
FTB determined that Apple had underpaid its 1989 franchise tax liability and owed an additional $231,038 in tax for that tax year. With interest of $689,444.80, the total amount of FTB's assessment was $920,482.80. Apple paid this amount prior to filing the suit for refund.
On January 16, 2008, Apple filed its complaint against FTB in San Francisco Superior Court seeking a refund in the amount of $920,482.80, plus interest. A non-jury trial was held on February 25-26, 2009 (before Judge Harold E. Kahn), presented largely on stipulated facts with limited live testimony. On January 26, 2010, the trial court issued its final statement of decision, ruling against Apple on the LIFO issue, and in favor of Apple on the section 24425 issue. An amended judgment was entered on February 22, 2010, granting Apple a tax refund in the amount of $920,482.80 plus interest. Apple filed its notice of appeal on March 29, 2010, and FTB filed its notice of cross-appeal on April 19, 2010.
On March 29, 2010, Apple filed its motion seeking an award of attorney fees. A hearing on the motion was held on April 26, 2010, and the trial court issued an order denying Apple's motion for attorney fees on June 22, 2010. Apple filed and served a ...