Microsoft wins section 965 repatriation challenge in Oregon

Oregon Tax Court rules in favor of Microsoft

On Aug. 29, 2024, the Oregon Tax Court ruled in favor of Microsoft Corp., concluding that 20% of deemed dividends repatriated under section 965 is includable in the sales factor for the water’s edge group resulting in a partial refund of Oregon income taxes paid on these repatriated earnings. 

The challenge

Recall that section 965 was a one-time tax imposed on the accumulated foreign earnings of certain foreign corporations to implement transition to a new participation exemption system of taxation. Oregon, a rolling conformity state, adopted the federal law but allowed 80% of the federal repatriated income to be excluded from the tax base under the state’s dividend received deduction. The state further clarified in Revenue Bulletin 2018-01 that the federal repatriated amount is excluded from the sales factor for tax years beginning on or after Jan. 1, 2018.

In May of 2019, Microsoft filed their original Oregon tax return in which 20% of the federal repatriated income was included in the Oregon tax base and did not include any federal repatriated income in the numerator or denominator of the sales factor which resulted in about $17 million of Oregon income tax. Shortly after, Microsoft amended their Oregon tax return based on the use of alternative apportionment, in which Microsoft argued that 100% of the federal repatriation amount should be included in the sales factor denominator resulting in a refund claim of about $11 million. As part of the amendment, Microsoft proposed three alternative apportionment methods: 1) Inclusion of 20% of CFC earnings in the sales factor denominator, 2) inclusion of 100% of federal repatriated amount in the sales factor denominator and 3) separate accounting.

The court rejected all three proposed alternative apportionment methods under the grounds that the methods were distortive and ignored the unitary nature of the overall business enterprise. However, the court conceded that 20% of Microsoft’s federal repatriated income could be ‘reincluded’ in the denominator after relying on the court’s analysis from its 2021 Oracle Corp. V. Dept. of Rev. (Oracle II) decision. Oracle II held, among other things, that deemed dividends under subpart F were eligible to be treated as "derived from the taxpayer's primary business activity" if the taxpayer is a water's edge group that is engaged in a single unitary business with its CFCs and thus be included in the sales denominator. However, the court stated that Microsoft failed to show that there should be a ‘reinclusion’ greater than 20% of the federal repatriated amount and thus denied any further relief under a factor representation theory.

Takeaways

Taxpayers who did not include repatriation income in their Oregon apportionment formula may be entitled to refunds. Whether a taxpayer is eligible for refunds will depend on several factors including whether the income is derived from the taxpayer’s primary business activity and whether the limitations period is still open.  

Taxpayers should be aware that this issue has arisen in other jurisdictions. For example, in February, Microsoft won a similar case out of the California Office of Tax Appeals. In that decision, Microsoft successfully argued that 100% of the federal repatriated income should be included in the sales factor denominator, even though only 25% of the income was included in the tax base after factoring in California’s dividend received deduction. However, the state subsequently clarified the law by codifying a 2006 ruling and establishing the FTB’s position on the tax treatment of repatriated income as argued in the Microsoft case. The bill explicitly stated that this provision was not a change in law or practice of the FTB but simply a declaration of existing law. The retroactive nature of that clarification effectively overturns the decision for similarly situated taxpayers that would have filed similar refund claims. Currently, the constitutionality of the law is being challenged by at least two petitioners.

Taxpayers with repatriated income should consult with their state tax advisers for more information.