Source: https://www.reedsmith.com/en/perspectives/2015/09/california-tax-developments
Timestamp: 2019-04-22 02:58:59+00:00

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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.
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 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.
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 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.
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.
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.
On April 28, the BOE unanimously voted to adopt the proposed amendments to Regulation 1591.
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.
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.
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.
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.
California Court of Appeals, Case No. B248270.
CA Code of Civil Procedure § 1021.5.
California Court of Appeal, Case No. D064241.
California Court of Appeal, Case No. A140518.
Fresno Sup. Ct., Case No. 10CECG00434.
CA Rev. & Tax. Code § 6051.
CA Rev. & Tax. Code § 6369(a)(1)-(6).
CA Rev. & Tax. Code § 6369(b).
CA Rev. & Tax. Code § 6369(b)(2).
CA Rev. & Tax. Code § 6369(c).
18 Cal. Code Regs. 1591(b)(2).
18 Cal. Code Regs. 1591(a)(9).
CA Rev. & Tax. Code §§ 17052.12, 23609.
Id., Examples 1 and 2.

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