Case: The Limited Stores, Inc. v. Franchise Tax Board, No. A102915 (Cal. Ct. App. 6/8/07)

The One Sentence Summary: Because national retailer’s inclusion of short-term securities’ full redemption price as “gross receipts” unfairly represented the extent of its business activity in California, Franchise Tax Board prevailed on challenge to retailer’s calculation of California taxes.


What They Were Fighting About:

The Limited, a national retailer based in Columbus, Ohio, filed an action seeking refund of $5.6 million in corporate taxes for the years 1993 and 1994 after California’s Franchise Tax Board (FTB) disputed the retailer’s methodology for calculating taxes on its California source income. California’s Uniform Division of Income for Tax Purposes Act (UDITPA) utilizes apportionment formula to determine the taxes that may be levied on a business that retails within and without California. The “sales factor” of the formula is calculated using a fraction, the numerator of which is taxpayer’s total sales (defined only as all “gross receipts”) in California and denominator of which is total sales everywhere.

The Limited’s treasury department in Ohio invested excess cash flow in short-term financial instruments like commercial paper, certificates of deposit, treasury bills, and money market mutual funds. In calculating the sales factor under UDITPA, The Limited included in the denominator all money received when those investments matured, including return of principal. FTB argued that only income received when the investments matured should be included in the denominator.

Court Holdings:

  • Under California Supreme Court authority, taxpayer may treat the full redemption price (including return of principal) from short-term financial instruments held to maturity as “gross receipts” under UDITPA.

  • However, UDITPA also contains a provision that enables FTB to require a different apportionment in order to fairly represent the taxpayer’s business activity in California.

  • FTB has burden to prove by clear and convincing evidence that apportionment provided by standard formula is not a fair representation and that FTB alternative is reasonable. Courts apply two-part test: (1) whether taxpayer’s treasury functions are “qualitatively different from its principal business” and (2) whether the quantitative distortion is substantial by including taxpayer’s investment receipts in the formula.

  • Applying this test, the court held that The Limited’s including in “gross receipts” the full redemption price of short-term securities did not fairly represent the extent of its business activity in California.

  • First, The Limited’s treasury department functions are qualitatively different from its main business, the retail sale of apparel and other merchandise. Second, The Limited’s calculation would lead to substantial quantitative distortion of its business activities in California. In the two years at issue, The Limited’s short-term investments produced less than 1 percent of its annual income but more than 50 percent of its gross receipts. This distortion was seen in huge disparity between margins for its principal business (46 percent) and treasury functions (less than 1 percent).

  • Court concluded that FTB’s proposal to included in sales factor denominator only the net income from The Limited’s redemptions of short-term securities was reasonable.