by Diann L. Smith and Miranda K. Davis
sales factor.’’1 General Mills involved the question
whether commodity futures sales that are made to
hedge against price fluctuations of agricultural commodities (for example, grain) used in the taxpayer’s
business should be included in the sales factor of the
Uniform Division of Income for Tax Purposes Act
apportionment formula.
The FTB concluded that the receipts from the
futures contracts should be excluded from the denominator of the sales factor.
Diann L. Smith
Miranda K. Davis
An often quoted definition of insanity, sometimes
attributed to Albert Einstein, is ‘‘doing the same
thing over and over again and expecting different
results.’’ By that definition, the California Franchise
Tax Board is demonstrating questionable tendencies
regarding its aversion to including receipts from
sales of marketable securities in the California sales
factor. The FTB argued in General Mills v. Franchise
Tax Board, A120492 (Cal. Ct. App. 2009), that —
despite the clear language of the statute (and two
California Supreme Court cases) — ‘‘gross receipts’’
does not mean all receipts. Not surprisingly, the FTB
lost its argument. We propose that rather than
continue down the hard-line position of attempting
to exclude as much out-of-state activity as possible
from the California sales factor denominator, the
FTB should advocate a moderate and reasonable
position.
Background
On April 15, in a unanimous decision, the California Court of Appeal, First Appellate District, held
that ‘‘the full sales price of . . . futures contracts are
gross receipts within the meaning of the UDITPA
State Tax Notes, May 4, 2009
Gross Receipts and UDITPA
During the years at issue, California incorporated
the UDITPA definition of sales for purposes of computing the sales factor as ‘‘all gross receipts of the
taxpayer not allocated’’ as nonbusiness income.2 The
meaning of the phrase ‘‘gross receipts’’ has also been
the subject of two recent California Supreme Court
cases that considered the import of that phrase in
determining a California company’s sales factor.3 In
1
General Mills v. Franchise Tax Bd., A120492 (Cal. Ct.
App. 2009). In addition to vacating the trial court’s denial of
the refund claims, the court awarded General Mills’ costs on
appeal. For the California Court of Appeal, First Appellate
District’s decision in General Mills v. Franchise Tax Board,
see Doc 2009-8727 or 2009 STT 73-3.
2
California passed legislation in February 2009 amending
the definition of gross receipts in California Revenue and
Taxation Code section 25120(f)(2). The amended language
excludes from gross receipts ‘‘amounts received from hedging
transactions involving intangible assets. A ‘hedging transaction’ means a transaction related to the taxpayer’s trading
function involving futures and options transactions for the
purpose of hedging price risk of the products or commodities
consumed, produced, or sold by the taxpayer.’’ Calif. Revenue
and Taxation Code section 25120(f)(2)(L). The court did not
consider that new statutory definition of gross receipts because that statute was not in effect for the tax years at issue
in General Mills.
3
See Microsoft Corp. v. Franchise Tax Bd. (2006) 39 Cal.4th
750; General Motors Corp. v. Franchise Tax Bd. (2006) 39
Cal.4th 773. For the California Supreme Court’s decision in
General Motors Corp. v. Franchise Tax Board, see Doc 200615758 or 2006 STT 162-4; For the state supreme court’s
decision in Microsoft Corp. v. Franchise Tax Board, see Doc
2006-15737 or 2006 STT 162-3.
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(C) Tax Analysts 2009. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
No Hedging on Gross Receipts
Inclusion in Sales Factor
A Pinch of SALT
Rejecting a definition of sales as
‘all income of the taxpayer’ in
favor of ‘all gross receipts of the
taxpayer’ indicates that UDITPA’s
drafters intended ‘sales’ to include
more than gross income.
The transactions in the cases discussed above
differ from General Mills’ futures contracts. In
Microsoft, the court considered short-term marketable securities and found the entire amounts of the
redemptions of the securities at maturity were
‘‘gross receipts’’ under the UDITPA definition of
sales for purposes of computing the sales factor.
General Motors involved a type of repurchase
agreement that is a hybrid of the sale of a security
and a secured loan. The court found that the
repurchase agreement ‘‘should be characterized as a
secured loan for purposes of the UDITPA sales
factor and repayment of the loan should not be
counted as ‘gross receipts.’’’
Futures Contracts Included in Sales Factor
In General Mills, the FTB argued that no receipts
from futures contracts should be included as gross
receipts in the sales factor. Alternatively, the FTB
argued that only the net gains on the futures contracts should be included in the sales factor under
the standard apportionment formula.
The court focused on the substance of General
Mills’ transactions and noted that the hedging activities contributed to its business income for the
years at issue. The FTB argued that General Mills
did not establish that the futures contracts were
legally binding obligations because those contracts
are routinely settled by offsets and are revocable at
will. The court disposed of both those points. The
court reasoned that the use of offsets does not nullify
the transaction. The economic reality of the transaction is that ‘‘when General Mills offsets a futures
sales contract with an equivalent futures purchase
contract, it receives consideration in the amount of
416
the full sales price of the sales contract.’’ It has been
relieved of the obligation to sell the number of
bushels of the commodity identified in the contract
in the delivery month specified in the contract. The
court disagreed with the FTB that the contracts are
revocable at will, because the trading party cannot
unilaterally fail to honor the contract, but must find
a counterparty to enter into the offsetting transaction.
The FTB also argued that the futures contracts
have no value at inception and their value returns to
zero at the end of every business day. The court
rejected that argument on the basis that the FTB
misconstrued the mark-to-market process. Though
the mark-to-market process posts credits or debits to
a trader’s margin account at the end of each day, ‘‘it
is incorrect to say the value of the contract returns to
zero at the end of the business day since the underlying value of the contract (the right to buy or sell
the commodity in the delivery month) remains intact until offset or delivery,’’ the General Mills court
held. The economic reality is that General Mills
receives ‘‘gross receipts’’ on the fulfillment of its
futures contracts.
The court rejected the FTB’s alternative argument that only the net gain should be included in
the sales factor. Relying on the conclusion in
Microsoft that the entire amount of the redemption
is included in gross receipts for purposes of the sales
factor, the court agreed with General Mills that the
entire amount of the sales price of the ‘‘future sales
contracts should be counted as gross receipts in the
UDITPA sales factor.’’
Holding Consistent With Purpose of UDITPA
The FTB argued that receipts from the futures
contracts should be treated as an adjustment to its
costs of goods sold rather than sales because General Mills does not engage in futures contracts for
the primary purpose of generating profit, but rather
as a means to protect itself against the risks associated with price fluctuations of agricultural commodities. The FTB relied on General Mills’ accounting for its trades as adjustments in its costs of goods
on its financial statements and federal tax returns
as indicative that this is the correct treatment. The
court easily dismissed the financial accounting
treatment as not binding for tax purposes because
the two have differing objectives. Further, the court
said that UDITPA requires inclusion of receipts in
the sales factor that are ‘‘not counted as ‘sales’ on
financial statements or federal tax returns and that
do not fit the ordinary understanding of the word
‘sales,’ including royalties and rental income.’’
Remaining Issues
The trial court did not rule on the question
whether the FTB may impose an alternative apportionment formula under California Revenue and
State Tax Notes, May 4, 2009
(C) Tax Analysts 2009. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
General Motors, gross receipts were defined as ‘‘the
total amount of money or other consideration received by a business taxpayer for goods sold or
services performed in a year, before deductions.’’ In
Microsoft, the court explained what is encompassed
by ‘‘gross’’: The term ‘‘implies the whole amount
received, not just the amount in excess of the purchase price.’’ In reaching the conclusion regarding
the scope of ‘‘sales’’ under the UDITPA definition, the
Microsoft court considered the legislative history of
UDITPA. Rejecting a definition of sales as ‘‘all income of the taxpayer’’ in favor of ‘‘all gross receipts of
the taxpayer’’ indicates that UDITPA’s drafters intended ‘‘sales’’ to include more than gross income.
A Pinch of SALT
Stop the Insanity
The FTB still has many cases in which it seeks to
limit the inclusion in the sales factor of receipts from
intangible property transactions. One would have
thought that once California’s highest court told the
FTB that gross means gross, the FTB would have at
least grudgingly accepted that as binding. Not only
has the FTB continued to pursue those cases vigorously, but also — and you can’t make this stuff up —
it has issued a regulation requiring that receipts
from property identical to the property at issue in
Microsoft be excluded entirely from the sales factor.
One would have thought that once
California’s highest court told the
FTB that gross means gross, the
FTB would have at least grudgingly
accepted that as binding.
in the system. Something more than just another
FTB loss should be on the line. A real possibility of
the imposition of attorney’s fees against a state tax
authority that ignores judicial or statutory authority
would be a good start.
Short of a significant threat of sanctions, watching the FTB repeat itself on the gross receipts issue
is a bit like watching the movie Ferris [T.] Bueller’s
Day Off.5 Bueller’s friends described his disregard
for authority or consequences in much the same way
that taxpayers now see the FTB: ‘‘Why should he get
to do whatever he wants, whenever he wants? Why
should everything work out for him? What makes
him so [expletive deleted] special?’’ Ferris Bueller’s
Day Off (1986). The lesson is straightforward —
offer realistic distortion guidelines, drop the cases —
move on to college.
✰
Diann L. Smith is of counsel and Miranda K. Davis is an
associate with Sutherland Asbill & Brennan LLP’s State
and Local Tax Practice.
Sutherland’s SALT Practice is composed of 17 attorneys
who focus on planning and controversy associated with
income, franchise, sales and use, unclaimed property, and
property tax matters. Sutherland’s SALT Practice also
monitors and comments on state tax legislative and policy
efforts.
Sutherland is representing several clients before the
California Franchise Tax Board and in other states on the
inclusion of treasury receipts in the sales factor.
The FTB’s actions impose significant costs — on
the state, the taxpayer involved, and to general faith
4
In Microsoft, the transactions resulted in a nearly 50
percent reduction in California income tax liability.
State Tax Notes, May 4, 2009
5
Actually, it does not appear that the movie character had
a middle name, but if he did, it would surely have started with
a T. See also James T. Kirk.
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(C) Tax Analysts 2009. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
Taxation Code section 25137. To warrant the imposition of an alternative formula, the FTB has the
burden to prove the standard apportionment formula does not ‘‘fairly represent’’ a taxpayer’s business activity within California. Whether ‘‘an alternative formula could be imposed under Revenue and
Taxation Code section 25137 if the challenged activity both qualitatively differs from the taxpayer’s
principal business and quantitatively distorts the
formula by a substantial amount,’’ as the court
permitted in Microsoft, was a question the appeal
court remanded to the trial court.4