Court Gives Apple a Split Decision on Interest and Dividend Deductions
On September 12, 2011, the California Court of Appeal rejected Apple’s argument that it was improperly subjected to double-taxation of repatriated dividends when the Franchise Tax Board (FTB) applied a last-in-first-out (LIFO) approach, but found that Apple was entitled to an interest expense deduction on the full amount of its domestic borrowing. Apple Inc. v. Franchise Tax Bd. (Cal. App. 1 Dist. 2011) 2011 WL 4014357
(1) Repatriated Dividends
In 1989, Apple switched from a worldwide combination apportionment formula to a water’s-edge election. During that year, only the repatriated dividends paid to Apple by its foreign subsidiaries, and thus only a small portion of Apple’s foreign subsidiaries’ earnings were included in Apple’s water’s-edge return and taxed. Apple argued that under the case Fujitsu IT Holdings, Inc. v. Franchise Tax Bd. (2004) 120 Cal.App.4th 459, dividends must be subject to “preferential ordering” and be deemed to be paid first out of income already taxed in prior years. Preferential ordering means that Apple would treat its dividends as first paid from a pool of previously taxed earnings. Thus, under the preferential approach, Apple would eliminate its foreign dividends to the extent the pool of previously taxed earnings were eliminated.
The FTB, however, argued that a LIFO accounting method should be used, and that under such method dividends should be deemed paid first from the current year’s earnings until exhausted, and then from the most recent prior year’s earning until exhausted, and so on. Under this method, Apple would need to account for any untaxed earnings generated in 1989 before it could benefit from the previously taxed earnings from years prior to 1989.
The Court, agreeing with the FTB’s argument, stated that LIFO ordering between tax years “deters abuse by preventing a corporation from declaring what year’s earnings are being distributed.” (Apple Inc., 2011 WL 4014357 at *10.) The Court reasoned that to allow preferential ordering “would allow potentially indefinite tax avoidance by ignoring consideration of earnings attributable to untaxed excluded income until all included income had been exhausted.” (Id.)
(2) Interest Expense Deduction
In 1989, Apple also deducted business expenses. Although evidence with respect to the deduction was largely uncontested, there was a dispute as to the dominant purpose of Apple’s borrowings. The FTB argued that because money is “fungible,” a portion of Apple’s domestic interest expense should be allocated to its foreign source dividend distributions paid from excluded income and thus disallowed Apple’s interest deduction. Apple, however, showed substantial evidence to support that the dominant purpose of its borrowing in 1989 was to fund its domestic operations. The FTB, nevertheless, insisted on its fungibility argument, claiming that even when money is borrowed for a specific purpose, the borrowing will generally free other funds for discretionary purposes and that the expense thereby contributes to all aspects of corporate operations.
The Court, rejecting the FTB's argument and found that Apple met its burden to establish that its dominant purpose for borrowing, and its actual use of the funds, was to support domestic income-producing activities. The Court stated that the “FTB’s approach would…implement an effectively conclusive presumption that if a domestic corporation borrows at all, it has done so at least in part to support its other unitary operations, regardless of any contrary showing by the taxpayer.” (Id. at *13.) Because of this, the Court declined to adopt the FTB’s position, stating that it “would push the concept of fungibility of money ‘past reasonable bounds’.” (Id.)
The decision in Apple Inc. may influence an international business’s decision regarding whether to conduct business, borrow, and/or spend borrowed funds in California. Businesses should seek advice of counsel to determine what affects the Apple, Inc. decision may have on their tax liability.
If you have any questions regarding the contents of this newsletter, please contact the following attorneys in the firm’s State and Local Tax Practice Group.
| Chicago (312) 558-5600 | San Francisco (415) 591-1000 |
| Robert F. Denvir | Charles J. Moll III |
| Alan Lindquist | Troy M. Van Dongen |
| Bradley R. Marsh | |
| Jocelyn M. Wang | |
| Dina M. Bronshtein | |
| Jasmine I. Tollette |