United States: Gross v. Net….The Debate Continues in California And Arizona; California — GM Revisited

On October 13, 2004, the California Supreme Court granted review of General Motors Corp. v. Franchise Tax Bd., 120 Cal.App.4th 881E, as modified (Jul 06, 2004). Under the Cal.Rules of Court, Rule 976, Rule 977, and Rule 979, the Court of Appeals’ decision is automatically depublished and cannot be cited.

The two issues on appeal are: (1) In calculating the proportion of a unitary business group’s income that is subject to California income tax under the Uniform Division of Income for Tax Purposes Act (Rev. & Tax. Code, s 251310 et seq.), are the "gross receipts" of sales of securities measured by the total sales price (including return of principal) or the net proceeds (not including return of principal)? (2) Is the credit allowed a taxpayer for research expenses available to offset the tax liability of any member of a unitary business group or only the tax liability of the particular corporate member of the group that incurred the expense?

Relying in part on the California Court of Appeal’s decision in General Motors, the Arizona Court of Appeals held that the term "total sales" in the sales factor includes only the net proceeds from short-term investments, not the return of principal. Walgreen Arizona Drug Co. v. Arizona Dept. of Revenue, 97 P.3d 896, 435 (Ariz.App. Div. 1 Sep 23, 2004).

Walgreen Arizona Drug Company and Walgreen Company (hereinafter "the companies") file their Arizona income taxes on a combined basis. Walgreen Company, headquartered in Deerfield, Illinois, earns interest on short-term investments and typically reinvests the proceeds in similar interest-bearing instruments. The companies amended their returns for the fiscal year ending August 31, 1988 through August 31, 1995 to include the return of principal in the denominator of the corporate income tax formula and requested refunds totaling more than $1,300,000. The Arizona Department of Revenue ("ADOR") denied the refund requests and, on appeal, the tax court ruled in favor of the ADOR. The companies then appealed to the Arizona Court of Appeals.

On appeal, the companies argued that under the plain language of the statutes, the reference to "total sales" in the sales factor (A.R.S. § 43- 1145) must be construed to mean "gross receipts" under A.R.S. § 43-1131(5). In response, however, the ADOR argued that such a interpretation would require the court to ignore the caveat "unless the context otherwise requires" preceding the definition of "sales" in A.R.S. § 43-1131. In this instance, only the net gain from short-term investments should be treated as a sale; otherwise, "the denominator of the sales factor is distorted by (at a minimum) double-counting the same receipts: first, as revenue generated from retail sales, and, second, as additional revenue from the corporations’ investment of its excess cash."

The companies also argued that the investment of funds in short-term investments is analogous to the reinvestment of funds in inventory. However, according to the court, "[i]ncluding gross receipts from the reinvestment of funds in inventory in the sales factor reflects ongoing business activity and does not artificially distort the sales factor as does inclusion of unadjusted gross receipts from investment and reinvestment of intangibles."

The court then proceeded to cite decisions in other jurisdictions that reached the same conclusion, including the decision in General Motors, as well as a report issued by the Multistate Tax Commission in 1997 finding that "the inclusion in the sales factor of gross receipts from the generally short term investment and reinvestment of certain intangibles (generally idle cash) held for future operation of the taxpayer’s business, inherently produces incongruous results." According to the report, the definition of "sales" is not etched in stone. Instead, the drafters of UDITPA and Multistate Tax Compact:

The court also found "unpersuasive" the companies’ citations to appellate decisions from other UDITPA jurisdictions determining that the gross receipts of certain intangibles or the return of principal from certain types of short-term investments constitutes a "sale." Finally, the court concluded that "the ‘strict’ interpretation approach urged by Taxpayer would create a tax loophole for non-domiciliary businesses neither intended by the Arizona legislature nor required by the plain meaning of A.R.S. § 43-1131(5) and the related statutory scheme."

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