Toys

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Toys

State: California

Court: 1st District Court of Appeal 1st District Court of Appeal

Docket No: C045386

Case Date: 07/26/2006

Preview:Filed 4/5/06

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IN THE COURT OF APPEAL OF THE STATE OF CALIFORNIA THIRD APPELLATE DISTRICT (Sacramento) ---TOYS "R" US, INC., et al., Plaintiffs and Appellants, v. FRANCHISE TAX BOARD, Defendant and Respondent. C045386 (Super. Ct. No. 01AS04316)

APPEAL from a judgment of the Superior Court of Sacramento County, Brian R. Van Camp, J. Affirmed. Morrison & Foerster, Eric J. Coffill, and Carley A. Roberts for Plaintiffs and Appellants. Bill Lockyer, Attorney General, Lawrence K. Keethe, Supervising Deputy Attorney General, and Michael J. Cornez, Deputy Attorney General, for Defendant and Respondent. Toys "R" Us, Inc. (Toys) sells not only toys for tots but also maintains investments in short-term financial instruments, including debt securities and repurchase agreements. As a

nationwide purveyor of toys, Toys pays state income tax proportionate to its profits in each state. In California, a

retailer's tax obligation is based on an apportionment formula: the average of three fractions to arrive at a percentage that is then multiplied times the corporation's worldwide income to 1

determine the amount of income apportioned to California.

The

three fractions are California payroll divided by worldwide payroll, California property divided by worldwide property, and California sales divided by worldwide sales. Toys challenges

the calculation of the sales fraction of the equation, arguing the worldwide sales figure should include not only the interest earned by its short-term financial investments but also the principal amount of these investments. Since Toys's financial

arm operates out of the State of Delaware, the principal and interest income would inure to the worldwide sales figure and, accordingly, significantly reduce the amount of income apportioned to California. Toys filed a complaint for refund of taxes, requesting a refund of taxes and interest paid to defendant Franchise Tax Board (FTB). The complaint alleged Toys was entitled to a

refund on the ground that all gross receipts received by Toys from the sale of short-term financial instruments must be included in the apportionment factor. Following a court trial, Toys appeals,

the trial court found in favor of the FTB.

contending the trial court erred in interpreting the Revenue and Taxation Code. We shall affirm the judgment. FACTUAL AND PROCEDURAL BACKGROUND Toys sells children's toys, games, and furniture through its chain of Toys "R" Us stores.1 During the years at issue,

1

The parties stipulated to most of the relevant facts. 2

Toys maintained a treasury department in New Jersey.

The

treasury department managed Toys's investments in "repurchase agreements and . . . debt securities held to maturity," referred to as "short-term financial instruments." For a portion of the relevant period, the treasury department directly invested funds for Toys according to investment guidelines established by Toys. For the remainder of

the period, Toys engaged an outside brokerage firm to assist in the management of its short-term financial instruments. Toys's

short-term financial instruments are usual, ordinary, and recurring transactions for Toys. Not surprisingly, toy sales peak during the Christmas season. Retailers manage cash from Christmas sales to build

inventory through the summer and fall to prepare for the next Christmas season. excess cash. The treasury department invested Toys's excess cash with the objective of maximizing yield while maintaining liquidity as needed for the business. During the years in question, Toys At Toys, its treasury department manages this

reported the income earned from its short-term financial instruments as business income. This income was apportioned to

California based on the apportionment formula set forth in Revenue and Taxation Code section 25120 et seq.2

2

All further statutory references are to the Revenue and Taxation Code unless otherwise indicated. 3

In July 2001 Toys filed a complaint for refund of taxes for the income years ending February 2, 1991; February 1, 1992; January 30, 1993; and January 29, 1994, in the amount of $4,812,618 plus interest. The complaint alleged Toys was

entitled to a refund on the ground that all gross receipts received by Toys from the sale of short-term financial instruments must be included in Toys's sales factor under sections 25120, subdivision (e) and 25134. A court trial followed. Toys presented two witnesses. Jon

Kimmins, Toys's senior vice president-treasurer, testified he was responsible for Toys's capital structure and cash management during the relevant period. Kimmins explained the operation of

Toys's treasury department and the necessity for cash management in the cyclical toy business. Kimmins stated investments were

made based upon the rate of return and the duration of the investment. Richard Pomp, a professor of tax law, testified as an expert witness. Professor Pomp opined there was no principled

reason under tax policy why the gross receipts from the disposition of financial instruments should be treated any differently than the gross receipts from the disposition of inventory, which is fully includable as gross in the sales factor. Under Professor Pomp's analysis, the company has a certain amount of cash at the end of the day. The company can convert

the cash into inventory, a doll for example, and sell it the following day. However, if conversion to inventory is not a 4

good use of the money, the company can instead invest the cash in a financial instrument. As Professor Pomp explained: "That

these are alternatives, and . . . one of the functions of the treasurer is to decide what the best use of that cash might be. And I guess I see a financial asset as a competitor for inventory. And each one, in a sense, is using the funds Each one is an investment, [one] in Each one gets turned

generated by the business.

an inventory and one in a financial asset. over in some period of time. . . . [

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