Case Updates

BREAKING NEWS: Gillette Oral Arguments Scheduled

The California Supreme Court has scheduled oral arguments in the Gillette Multistate Tax Compact case. This comes three years after the California Court of Appeal issued its decision allowing taxpayers to elect to use the three-factor, equally weighted method to apportion income.

Oral arguments will be held October 6, at 9 a.m. in San Francisco. We anticipate the court to issue its written decision by January.

Reed Smith State Tax Attorneys Awarded Attorney's Fees

The California Court of Appeal held in its September 2014 decision, Frank Cutler v. Franchise Tax Board,1 that Reed Smith secured a significant benefit for the public by bringing a case that resulted in the court striking down portions of an unconstitutional and discriminatory tax incentive. Thus, the taxpayer, Frank Cutler, was entitled to attorney fees incurred in the action. The basis for the fee award was California's Private Attorney General Statute.2 The court remanded the case to the trial court solely to determine the amount of fees to be awarded to Cutler.

On remand, because the Franchise Tax Board (the "FTB") did not challenge the hourly rates, the court focused on whether the number of hours claimed was reasonable. In the fee motion, Reed Smith State Tax attorney Marty Dakessian argued that Cutler was entitled to a lodestar of $920,264, and that a significant multiplier was warranted in this case based on the exceptional result achieved, the difficulty of the case, the skill displayed by counsel, and the delay in payment of attorney fees. The FTB contended that Cutler was only entitled to a lodestar of $216,096.

Ultimately, the trial court awarded nearly $600,000 in attorney fees to Cutler, which included a 1.1 multiplier on fees incurred for the underlying issue based on the constitutional issues involved, the successful results, the benefit to the public, the skill involved by counsel, and the delay in payment of the attorney fees.

The case involved the 1998 tax year. The taxpayer also has two other years (1999 and 2000) that are currently pending before the Board of Equalization. In November 2014, Cutler filed a petition for rehearing for these years. On April 28, 2015, the Board voted unanimously to grant Cutler's petition. At the May 2015 hearing, the board voted 5-0 to publish its summary decision granting Cutler's petition.

Takeaway: The trial court's award aligns with the spirit of the Court of Appeal's decision. The plaintiff secured a victory under the state's Private Attorney General Act, and the trial court awarded fees that reflected the public benefit conferred.

G&C Equipment Unanimously Wins Board of Equalization Appeal Applying Board's Audit Manual Method for Lost Data

G&C Equipment Corporation ("G&C") won a recent sales tax appeal before the California State Board of Equalization (the "BOE"). G&C leases equipment and provides personnel to construction contractors. The nature of this business results in wide variance in the amount of taxable and tax exempt sales from one period to the next. Prior to its sales tax audit, G&C lost all of its electronic tax data in a massive database malfunction. On audit, the auditors took an aggressive position, arguing that all G&C's sales during the period covered by the audit should be treated as taxable unless proven otherwise. In contrast, G&C took a position consistent with the BOE's own audit manual—that the error rate in that quarter should be determined by reference to the error rate in the other quarters in the audit period. After a lengthy audit and several lower-level administrative appeals blessing the audit method, G&C brought its case to the BOE. On appeal, all five members of the BOE agreed with G&C's position. This resulted in a reduction of tax of nearly 98% from the auditors' starting point.

Takeaway: G&C's victory was clear. Reed Smith State Tax attorneys Marty Dakessian and Mike Shaikh successfully demonstrated to the BOE that G&C had acted reasonably, and that BOE staff was required to follow their own audit procedures.

Harley-Davidson Case Holds Unconstitutional Lack of Apportionment Election for Multistate Taxpayers

Under California statute, unitary taxpayers that do business entirely in California can choose to compute and report tax on either a separate company basis or a combined basis. In contrast, California statutory law requires unitary taxpayers that engage in interstate commerce to file on a combined basis. Harley-Davidson challenged this discriminatory statutory regime on constitutional grounds, asserting that the regime provided that a unitary business operating entirely in California enjoys benefits not available to multistate businesses.

The Court of Appeal agreed with Harley-Davidson. In Harley-Davidson v. Franchise Tax Board,3 the court determined that California's statutory scheme discriminates against interstate commerce, because it resulted in "differential treatment of in-state and out-of-state economic interests that benefits the former and burdens the latter." The court further held that a restriction on commerce that is discriminatory is per se invalid under the Commerce Clause, unless the state can show that the restriction advanced a legitimate local purpose that could not be adequately served by "reasonable nondiscriminatory alternatives."

The FTB conceded that under the statutory scheme, in-state and multistate businesses enjoyed different treatment. But the FTB still argued that this different treatment didn't rise to the level of constitutional discrimination. The court didn't agree with the FTB. It held that the statutory regime discriminated on its face on the basis of an interstate element in violation of the commerce clause," because the method of computing California tax "is determined solely by where the unitary business engages in commerce."

The case will now be remanded back to trial court to determine whether there was a legitimate reason for the discriminatory treatment of unitary businesses engaged in interstate commerce, and whether that reason could have been adequately served by nondiscriminatory alternatives.

The Court of Appeal separately held that a bankruptcy-remote securitization entity with no employees or property in California was nonetheless taxable in California, based on its relationship with a finance company with California nexus.

Takeaway: Although the Harley-Davidson case is not finally resolved, the Court of Appeal's decision sets the stage for equalization between in-state and multistate taxpayers that has been a long time coming. Taxpayers who have been harmed by this discriminatory treatment should review their California returns to determine if this recent development benefits them.

LLC Cases Await Oral Argument

In our previous Quarterly Alert, we reported on the status of the two consolidated LLC tax refund cases – Bakersfield Mall, LLC v. Franchise Tax Board4 and CA-Centerside II, LLC v. Franchise Tax Board.5 The substantive issue in both cases is whether the LLC fee imposed by former Revenue and Taxation Code section 17942 was facially unconstitutional. Procedurally, the plaintiffs are appealing the trial court's denial of their motion for class certification.

The consolidated case is now fully briefed, and in March 2015, both parties filed requests for oral argument. The case is now awaiting oral argument.

Regulatory Updates

FTB to Hold Regulation Hearing for Market-Based Sourcing Rules for Sales Other than Tangible Personal Property

On September 22, the FTB will hold a hearing for its proposed amendments to Regulation 25136-2. Regulation 25136-2 provides rules for sales other than tangible personal property. The last interested parties meeting was held in July 2014. Since then, the FTB has added language to the regulation that clarifies how the statute applies. Most notably the added language:

(1) Supplies a definition of marketable securities. Section 25136 states that "[s]ales from intangible property are in this state to the extent the property is used in this state. In the case of marketable securities, sales are in this state if the customer is in this state." The proposed change to the regulation defines marketable securities in detail as "any security that is actively traded in an established stock or securities market and is regularly quoted by brokers or dealers in making a market."6

(2) Provides guidance on how to assign sales of marketable securities to California. As noted above, sales of marketable securities are assigned to this state if the customer is located in California.7 The proposed regulation makes clear that when the customer is an individual, the sale is assignable to California if the individual's billing address is in California; and, when the customer is a business entity, the sale is assignable to California if its commercial domicile is in California.8 There would be a safe harbor allowing the taxpayer to determine its customer's commercial domicile based on the taxpayer's books and records kept in the normal course of business. A taxpayer can overcome this presumption by showing that, based on a preponderance of the evidence, its commercial domicile is in another state.9

(3) Provides guidance on to the sourcing of asset management fees for taxpayers not subject to the mutual fund service provider and asset management service provider rules under Regulation 25137-14. Section 25136 provides that sales from services are in this state to the extent the purchaser of the service received the benefit of the services in California.10 The proposed regulation assigns sales to California for asset managers that provide services for pension plans, retirement accounts, or other investment accounts by contracting with third parties to provide the services when the shareholders, beneficial owners, or investors are in California.11 And, when an asset manager cannot determine the location of shareholders, beneficial owners or investors based on its books and records, then the sales are assigned by reasonably approximating the domicile of the shareholder, beneficial owner, or investor based on zip code or other statistical data. And when a reasonable approximation is not possible, such receipts are excluded from the sales factor.12

(4) Provides that gross interest receipts from intangible property are assigned to California if the investment is managed in California. Interest receipts from loans secured by real property are sourced to California if the real estate is located in this state. Interest receipts from loans not secured by real property are assigned to California if the borrower is located in California.13

Takeaway: Even with the addition of the clarifying language, the proposed market-based sourcing rules contain many ambiguous provisions. For instance, the proposed regulations, as modified, provide that where a customer's commercial domicile cannot be determined using the taxpayer's books and records, or where the shareholders, beneficial owners, or investors of retirement accounts cannot be determined, then their location "shall be reasonably approximated."14 Although this leaves some flexibility in the interpretation of the regulation, it also opens the door for future arguments between taxpayers and the FTB about what constitutes a "reasonable approximation." The proposed changes are planned to be presented to the three-member Franchise Tax Board at its December meeting.

Sales and Use Tax Regulation Amended to Include Specific Medical Device

On April 28, the BOE unanimously voted to adopt the proposed amendments to Regulation 1591.

Regulation 1591 addresses the exception to the applicability of sales tax to medicines and medical devices. In California, sales tax is imposed on retailers for the privilege of selling tangible personal property at retail.15 However, the Revenue & Taxation Code provides an exemption for the sale or use of medicines that are dispensed, furnished, or sold under certain circumstances, as enumerated in the statute.16 It exempts medicines, which it defines as "any substance or preparation intended for use by external or internal application to the human body in the diagnosis, cure, mitigation, treatment, or prevention of disease and commonly recognized as a substance or preparation intended for that use."17 The statute further excludes as medicine "[a]rticles that are in the nature of splints, bandages, pads, compresses, supports, dressings, instruments, apparatus, contrivances, appliances, devices, or other mechanical, electronic, optical or physical equipment or article or other component parts and accessories thereof,"18 but includes "[b]one screws, bone pins, pacemakers, and other articles, other than dentures, permanently implanted in the human body to assist the functioning of any natural organ, artery, vein, or limb and which remain or dissolve in the body."19

Regulation 1591 clarifies the statutory definition of "medicine" for purposes of the sales and use tax exemption. Generally, there is a permanency element that makes an item a "medicine" for purposes of the exemption. But, Regulation 1591 did not address medical devices permanently implanted to mark the location of a medical condition, nor what type of Federal Drug Administration approval is required for a medical device to qualify as a medicine.

In response to a February 2014 case addressing whether breast tissue markers, which are fully implanted to diagnose breast cancer, the BOE directed staff to clarify whether such markers qualify for the sales tax exemption for "medicines." Thus, the Regulation has been amended to clarify that permanently implanted articles to mark the location of a medical condition qualify as medicines under the statute,20 and that all FDA-approved products that receive premarket notification qualify as medicines.21

Takeaway: Sales and use tax laws vary widely from state to state and are driven largely by each state's policy. Given the broad and slightly unclear definition of "medicine" for purposes of sales and use tax exemption, the changes bring clarity for taxpayers that these types of items are indeed exempt from California's sales and use tax.

Administrative Updates

Franchise Tax Board Offers Taxpayers Guidance Following Federal Determinations Involving the Research Credit

IRC section 41 provides a credit against federal income tax for taxpayers that increase research activities. California allows a similar credit against franchise tax if the taxpayer's research activities satisfy a four-part test: (1) the research expenses associated with the activity must have qualified as deductible as a business expense under IRC section 174; (2) the research must have been undertaken to "discover information which is technological in nature;" (3) the taxpayer must intend to use the information to develop a new or improved business component; and (4) the taxpayer must pursue a "process of experimentation" during substantially all of the research.22 In addition, although California generally allows the credit for increasing research activities, it does so with modifications, including modifications to what qualifies as "qualified research" and "basic research" for purposes of computing the credit. Thus, for research activities to constitute "qualified research" or "basic research" for purposes of computing the California credit under the statute, such research must be conducted in California.23

In informal guidance released to the public in May, the FTB attempted to clarify how it treats federal determinations in research credit cases.24 The FTB advised that in instances where the IRS issues a no change, it generally follows the federal determination if the federal examination included a review of the corporation's qualification for the federal research credit. However, the FTB provided a series of examples to demonstrate the appropriate level of review of the federal research determination, depending on the level of review of the research credit claimed at the federal level.

In cases where the IRS audits the federal return but does not inquire about the federal research credit, and in cases where the IRS uses a standard information request for the research credit but does not analyze the information, the FTB's position is that it "is not appropriate to" follow the federal determination because there was no "on-point" exam of the research credit.25

Where the IRS issues the standard information request for the research credit and the audit file indicates it evaluated the response and withdrew the issue because of the lack of audit risk based on materiality, time, and resources, the FTB's position is that it "would be appropriate" to follow the federal determination "because there was an on-point examination" of the federal credit.26 Likewise, when the IRS makes an examination and subsequent determination of years X1, X2, and X3, and California examines years X3 and X4, the FTB finds it "appropriate to" follow the federal determination if the activities and expenses from the federal audit "are the same, or substantially similar to, the activities and expenses claimed in the year under audit."27 Where the activities and expenses that are the basis of the California credit are different, the FTB reserves its right to examine the "California research project activities even in the same year."28

Takeaway: Although the FTB has made an effort to clarify when it will follow federal determinations with respect to computing the research credit, the wording of the examples does little to make clear when the FTB shall or must follow the federal determination, and when it won't. However, in the same notice the FTB did articulate that for some taxpayers, entering into a closing agreement with the FTB may be mutually beneficial and can provide quicker resolution to research credit examination issues with more certainty. Thus, the closing agreement process may be preferable for many taxpayers to relying on the FTB's rather uncertain informal guidance.

Footnotes

1. California Court of Appeals, Case No. B248270.

2. CA Code of Civil Procedure § 1021.5.

3. California Court of Appeal, Case No. D064241.

4. California Court of Appeal, Case No. A140518.

5. Fresno Sup. Ct., Case No. 10CECG00434.

6. Proposed Regulation 25136-2(b)(5).

7. Section 25136(a)(2).

8. Proposed Regulation 25136-2(e)(2).

9. Id.

10. Section 25136(a)(1).

11. Proposed Regulation 25136-2(c)(2)(6).

12. Proposed Regulation 25136-2(c)(2)(7).

13. Proposed Regulation 25136-2(d)(1)(A)(2)

14. Proposed Regulation 25136-2(c)(2)(7); (e)(3).

15. CA Rev. & Tax. Code § 6051.

16. CA Rev. & Tax. Code § 6369(a)(1)-(6).

17. CA Rev. & Tax. Code § 6369(b).

18. CA Rev. & Tax. Code § 6369(b)(2).

19. CA Rev. & Tax. Code § 6369(c).

20. 18 Cal. Code Regs. 1591(b)(2).

21. 18 Cal. Code Regs. 1591(a)(9).

22. CA Rev. & Tax. Code §§ 17052.12, 23609.

23. Id.

24. FTB Tax News, May 2015 edition, "Following a Federal Determination for Research Credit Cases."

25. Id., Examples 1 and 2.

26. Id., Example 3.

27. Id., Example 4.

28. Id.

This article is presented for informational purposes only and is not intended to constitute legal advice.