California Legislature Overturns OTA Decision, Negates APA Requirements, Raising Broader Deference Questions

by Niki Ford 

As previously reported in Checkpoint State Tax Update,¹ California Governor Gavin Newsom on June 27, 2024, signed into law² a repeal of the California Office of Tax Appeals’ (OTA’s) 2023 decision in Appeal of Microsoft Corporation and Subsidiaries.³ The Microsoft decision, which was designated non-precedential, held that the gross dividends received from a taxpayer’s foreign affiliates should be included in the taxpayer’s sales factor denominator, even though the dividends were deductible from the taxpayer’s net income. As discussed in a prior article by this author,⁴  this decision overruled a Franchise Tax Board ruling that activities generating income not included in the income base—such as deductible dividends—should be excluded from a taxpayer’s apportionment formula.⁵ The OTA held that Legal Ruling 2006-01 was not entitled to deference, and applied its own independent judgment to conclude that, under California law, deductible dividends should be included in the taxpayer’s sales factor.

Legislative intent and APA negation.

Reversing the course set by the OTA, the June 2024 legislation establishes “the intent of the Legislature that the Legal Ruling [2006-01] shall apply with respect to apportionment factors attributable to the income of taxpayers subject to tax under the Corporation Tax Law.”⁶ The law also expressly declares that “[a] transaction or activity, to the extent that it generates income or loss not included in ‘net income’… shall be excluded from the apportionment formulas” provided in the California Revenue and Taxation Code. Notwithstanding the OTA’s contrary decision in Microsoft, the legislation states that the apportionment provision does not constitute a change in law, but is instead “declaratory” of existing law. Finally, in a novel approach, the legislation provides that “[t]he Administrative Procedure Act… shall not apply to any regulation, standard, criterion, procedure, determination, rule, notice, guideline, or any other guidance established or issued by the Franchise Tax Board pursuant to this section.”

Significance following Loper Bright.

While there are a number of controversial aspects to the legislation (including the statement that the apportionment provision is a clarification of existing law), the legislature’s statement concerning the California APA is particularly noteworthy in light of the U.S. Supreme Court’s recent companion decisions in Loper Bright Enterprises v. Raimondo, No. 22-451 and Relentless, Inc. v. Dept. of Commerce, No. 22-1219.⁷ As this author reported, these cases collectively overturned the Chevron doctrine and held that courts may not defer to an agency interpretation of the law simply because a statute is ambiguous.⁸ In Loper Bright, the Court explained that Chevron, which had mandated deference to reasonable agency interpretations of ambiguous statutes within that agency’s purview, could not be “reconciled with the [federal Administrative Procedure Act (“APA”)]” because “[t]he APA… incorporates the traditional understanding of the judicial function, under which courts must exercise independent judgment in determining the meaning of statutory provisions.” Because of the federal APA’s mandates, Loper Bright held that courts are required to exercise “independent judgment” when reviewing ambiguous statutes. The Loper Bright decision also points out that lawmaking power is vested in the legislature, and that unambiguous statutes leave no room for administrative interpretation (a legal principle that was also recognized by the Chevron Court). Although Loper Bright only expressly applies to federal administrative interpretations, California has often looked to federal cases, including Chevron, when employing its own variable deference approach,⁹ and it may look to the Loper Bright approach in future cases where agency interpretations are challenged by taxpayers.

In fact, the OTA in Microsoft had taken an approach that aligned with the Supreme Court’s subsequent opinion in Loper Bright, when it decided to exercise its independent judgment to interpret the state’s apportionment statute and determined that deference to an agency interpretation was not appropriate. The subsequent California legislation, however, mixes somewhat uneasily with the viewpoint of the Supreme Court in Loper Bright.

Divergence from Loper Bright approach.

On the one hand, the legislation clears up any ambiguity as to whether deductible dividends are included in the sales factor, and thus a court using a Loper Bright analysis would likely find that the legislature appropriately exercised its authority to say what the law is. On the other hand, the legislation markedly diverges from Loper Bright, which relied heavily on the federal APA, by negating applicability of the APA to the FTB’s interpretation of the new apportionment provision. Again, while California is not bound by either the federal APA or Loper Bright, the state does have a counterpart state-level APA, which the OTA relied upon in a different 2024 decision that invalidated certain “underground regulations” issued by the FTB.¹⁰ It is unclear how the legislature’s novel approach of eliminating the APA with respect to specific statutory provisions will be viewed by the OTA or the courts if these provisions are challenged in litigation.

New questions raised.

The legislation also raises the question of whether other states will choose to take a similar route when enacting new tax legislation. As discussed in earlier articles, states that expressly follow Chevron or use a Chevron-like deference standard may soon see litigation where parties argue for a Loper Bright approach or may experience pressure to legislatively reject Chevron deference.¹¹ However, as the California legislation shows, there may be certain cases where the legislature and the taxing authority are aligned, and the legislature would like to remove the possibility that a reviewing court will not defer to the agency’s guidance or overturn that guidance on APA grounds—outcomes which have proven more frequent in recent months. Indeed, aside from California, tribunals in two other significant states have recently invalidated tax department interpretations; as previously discussed by this author, in New York, an Administrative Law Judge refused to defer to guidance issued by the New York Department of Taxation in Finance,¹² and in Texas, a district court invalidated certain amendments to the state’s sales tax sourcing regulations, ruling that the Comptroller failed to substantially comply with the procedural requirements of the Texas APA in their adoption.¹³ Whichever course states take, it appears likely that they will in some manner respond to the new “lack of deference” landscape that exists after Loper Bright. Notably, Congress is already reacting to the Supreme Court decision, with competing bills filed that would either codify the Chevron doctrine¹⁴ or impose more stringent requirements on administrative rulemaking.¹⁵ In instances where the state legislature and the taxing authority have similar viewpoints, state legislatures may choose to follow California’s lead and either codify the agency’s approach, remove APA requirements for certain statutes, or both.

Checkpoint Resources.  For previous reporting on deference in the state tax environment by this author, see:

• Ford, US Supreme Court Overturns Chevron; Future of Federal and State Tax Guidance in Question, Checkpoint State Tax Update, 06/28/2024;
• Ford, Another Deference Blow: In Rebuke, California Court Voids Non-Compliant Tax Regulations, Checkpoint State Tax Update, 02/21/2024; and
• Ford, The Shifting Deference Landscape: California and New York Decisions Reject Tax Agency Guidance, Checkpoint State Tax Update, 03/13/2024.

For a deep dive into California’s approach to the sales factor and combined reporting, see:

• Catalyst Topic # 1007CA:1000, Sales Factor in California;
• Catalyst Topic # 1013CA:1000, Combined/Consolidated Reporting in California;
• Catalyst Topic # 1017CA:1000, Subtractions in California; and
• State Charts offering a quick multistate overview of related issues, including: Sales Factor—Dividend Income; Dividends Subject to Dividends Received Deduction; Conformity to Post-TCJA IRC § 965 Deemed Repatriation Rules; and Water’s-Edge Combined Reporting.