California tax battle affects billions Newsom is counting on

During Jerry Brown’s first stint as governor of California, he became enmeshed in a very complicated dispute over how the state should tax the incomes of multinational corporations.

More than four decades later, the issue has resurfaced in a corporate tax case involving Microsoft, one of the nation’s largest corporations, a legislative bill that was semi-secretly attached to the state budget in June, and two subsequent lawsuits.

The outcome could reopen tax returns from past years and potentially force companies to pay billions of dollars in retroactive taxes, or alternatively could eliminate a windfall of corporate taxes that Gov. Gavin Newsom is counting on to help close the state’s budget deficit.

The issue that Brown faced in the 1970s was whether corporations should report their global incomes to California and have a calculated percentage subjected to state taxes, or could confine their taxable income reports to actual activities within the state.

At the time, the first methodology, called “unitary taxation,” was used by the Franchise Tax Board, which is California’s version of the Internal Revenue Service. However, foreign corporations, particularly those based in Japan and Great Britain, were adamantly opposed and sought the alternative, dubbed “water’s edge.”

Brown initially supported the tax board but after visiting Japan did a 180-degree flip, while accusing the board’s executive officer, Martin Huff, of giving him “flaky data.” Huff responded by essentially accusing Brown of lying, which led to Brown and legislative leaders quickly changing a unique state law that had protected the tax board’s executive from political interference.

Huff had also alienated legislators by publicly suggesting that their “per diem” expense payments be subject to income taxes. After the law was changed to make it easier for Huff to be fired, he resigned.

The infighting over corporate taxation continued. At one point it even became an issue in a tax treaty that the U.S. government was negotiating with the British government. Eventually, in the 1980s, corporations were given the option of using either the unitary or water’s edge method. Microsoft adopted the latter for its 2017-18 tax return, but found itself in a dispute with the tax board over how dividends from foreign subsidiaries should be treated.

The dispute jelled when Microsoft sought a $90.9 million refund, the tax board rejected the claim and the company appealed to the Office of Tax Appeals, which is essentially a tax court. Last year, after extensive trial-like hearings, a three-member appellate panel unanimously ruled in favor of Microsoft.

It could have forced the state to refund $1.3 billion immediately and perhaps more as the decision trickled through the state’s corporate tax process. But the tax board did not concede defeat and instead turned to Newsom and the Legislature for a rescue.