Foreign Dividends In California: Apple Loses On Dividend Ordering. Now What?

The California Court of Appeal in Apple Inc. v. Franchise Tax Board rejected Apple's claim for preferential ordering for dividends paid by foreign subsidiaries. The court did, however, conclude that Apple was entitled to deduct interest that the FTB had disallowed under the Foreign Investment Interest Offset rules. This alert summarizes the dividend ordering issue and discusses steps that taxpayers can take to mitigate its impact.

What happened?

Before 1989, Apple filed its California returns on a worldwide basis, so all earnings of its foreign subsidiaries were factored into the calculation of tax. Under California law,1 a dividend paid out of those pre-1989 earnings is "previously taxed" and is eliminated. Beginning in 1989, Apple made a water's-edge election. During that year, only a small portion of the earnings of the foreign subsidiaries (i.e., the portion that was subpart F income) was included in the water's-edge return. So only a small portion of the foreign earnings generated in 1989 was taxed; the rest was untaxed.

During 1989, Apple repatriated foreign earnings by way of dividends. To determine whether the dividends were eliminated, Apple applied Fujitsu's preferential ordering approach.2 Preferential ordering means that Apple treated the dividends as paid first from a pool of previously taxed earnings. The pool of previously taxed earnings was the subpart F income in 1989 and all of the world-wide earnings from years before 1989. Because, under the preferential ordering approach, Apple eliminated the dividends to the extent of the pool of previously taxed earnings, a substantial portion (if not all) of Apple's dividends were eliminated.

The FTB argued for a LIFO approach. Under LIFO, dividends are deemed paid first from current year's earnings until exhausted and then, from the most recent prior years' earnings on a year-by-year basis until each year's earnings are exhausted. Under the LIFO method, therefore, Apple had to take into account the untaxed earnings generated in 1989 before it got the benefit of the previously taxed earnings generated in years before 1989.

The court sided with the FTB. The Court of Appeal determined that Fujitsu only requires preferential ordering with respect to current year earnings. That is, under Fujitsu, Apple's dividend is deemed first paid out of the previously taxed earnings generated in 1989. After these previously taxed 1989 earnings were mathematically exhausted, the Court of Appeal then...