Repatriation of Dividends from a Wholly Owned Foreign Sub Taxable under CA Law

By Mark Muntean

Excerpt: 2011 Emerging Issues 5996

Repatriation of Dividends from a Wholly Owned Foreign Subsidiary Taxable under California State Law

SUMMARY: This Emerging Issues Analysis discusses the repatriation of earnings from controlled foreign corporation and the application of the earnings to current and prior year earnings. A secondary issue is also addressed concerning the allocation of interest expense between taxable and nontaxable expenditures.

ARTICLE: The California Court of Appeal recently held that the repatriation of earnings from a controlled foreign corporation, in this case a wholly owned foreign subsidiary, were applied to current year earning first before applying the dividends to prior year earnings on a LIFO basis. Apple, Inc. v. Franchise Tax Board, Nos. A128091 and A129090 Court of Appeals, 1st Dist., Div. 5 (9/12/11), Apple, Inc. v. Franchise Tax Bd., 199 Cal. App. 4th 1 (Cal. App. 1st Dist. 2011). In the same case, the court decided a second issue that, with respect to an interest expense deduction, in allocating the interest expense between taxable and nontaxable expenditures, the taxpayer must demonstrate its dominant purpose in borrowing the funds generating the interest expense deduction and allocate the interest expense to that purpose. Id.

A. Background. Apple, Inc. (Apple) is incorporated and has its principal place of business in California. Apple operates its global operations through a number of wholly owned foreign subsidiary corporations. Apple paid the tax and sued the California Franchise Tax Board (FTB) seeking a refund of taxes. The issue before the court related to the California tax treatment of repatriated dividends paid to Apple from its subsidiaries. The court focused on the appropriate method used to account for the source from which repatriated dividends are paid.

B. Worldwide and Water's Edge. Apple filed its California tax returns on a worldwide basis prior to 1989. According, Apple's foreign subsidiaries earning were added into its worldwide tax calculation, and were taxed. Normally, dividends paid from previously taxed earnings are eliminated from the tax calculation in the year of the dividend.

Apple made a water's-edge election in 1989. Also, in 1989 it recognized only a small part of its worldwide foreign subsidiary earnings in its water's-edge tax return subject to tax. Apple received a dividend (dividending its repatriated foreign earnings) from its wholly owned foreign subsidiaries in 1989. In claiming its foreign earnings were previously taxed, Apple applied preferential ordering approach as provided in Fujitsu IT Holdings, Inc. v. Franchise Tax Board., 120 Cal. App. 4th 459 (Cal. Ct. App. 2004).

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ABOUT THE AUTHOR(S):
Mark Muntean, J.D., LL.M. Taxation (Georgetown), is a business and tax lawyer in the San Francisco/Bay Area of California with over 25 years of experience in federal, state, and international tax matters. He represents clients in connection with corporate, real estate, mergers and acquisitions, private equity, business law and criminal tax issues.