1 BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 2 450 N STREET 3 SACRAMENTO, California 4 5 6 7 8 REPORTER'S TRANSCRIPT 9 MARCH 23, 2010 10 CORPORATE FRANCHISE AND PERSONAL INCOME TAX HEARING 11 APPEAL OF 12 WALTER B. ELCOCK AND LAURA K. ELCOCK 13 NO. 474172 14 AGAINST PROPOSED ASSESSMENT OF 15 ADDITIONAL INCOME TAX 16 17 18 19 20 21 22 23 24 Reported by: Juli Price Jackson 25 CSR No. 5214 26 27 28 1 1 P R E S E N T 2 For the Board Betty T. Yee of Equalization: Chair 3 Jerome E. Horton 4 Vice-Chair 5 Barbara Alby Acting Member 6 Michelle Steel 7 Member 8 Marcy Jo Mandel Appearing for John 9 Chiang, State Controller (per Government Code 10 Section 7.9) 11 Diane G. Olson Chief 12 Board Proceedings Division 13 14 For Board of Charles Potter Equalization Staff: Staff Counsel 15 16 Amy Kelly Tax Counsel 17 18 For Franchise Tax Terry Collins Board: Tax Counsel 19 Natasha Page 20 Tax Counsel 21 For Appellant: William E. Taggart, Jr. 22 Attorney 23 ---oOo--- 24 25 26 27 28 2 1 450 N STREET 2 SACRAMENTO, California 3 MARCH 23, 2010 4 ---oOo--- 5 MS. YEE: Our next matter, please? 6 MS. OLSON: Our next item is B2, Walter B. 7 Elcock and Laura K. Elcock. 8 Please come forward. 9 MR. POTTER: Good afternoon, Madam Chairwoman. 10 MS. YEE: Good afternoon. 11 Great, we are on item B2, Members, Walter B. 12 Elcock and Laura K. Elcock. 13 Let me have Appeals introduce the matter. 14 MR. POTTER: Good afternoon, Madam Chairwoman, 15 Members of the Board. My name is Charles Potter and I'm 16 an attorney with the Appeals Division. 17 The issue in this appeal is whether 18 Respondent's allocation methodology to source California 19 income from the exercise of nonqualified stock options 20 received from Appellant husband's employer was proper. 21 Second issue is whether Respondent's allocation 22 methodology to source California income from the vesting 23 of restricted stock grants received from Appellant's 24 husband's employer was proper. 25 The third issue is whether Appellants have 26 shown reasonable cause to support the abatement of late 27 filing penalties for 2003 or 2004. 28 MS. YEE: Thank you very much. 3 1 Good afternoon. 2 MR. TAGGART: Good afternoon, Madam Chairperson 3 and Members of the Board. 4 I'm William Taggart, I'm representing Walter 5 and Laura Elcock in this appeal. 6 MS. YEE: Okay. You have ten minutes. 7 Thank you, please proceed. 8 MR. TAGGART: Thank you. 9 And in view of the constraints on your time, I 10 am going to skip most of the things that I was planning 11 on saying and try to take this back to the very simple 12 matter that is before the Board. 13 I won't discuss the restricted stock. I won't 14 discuss the penalties and simply want to address three 15 points. 16 The first one being that there is an unstated 17 assumption in the analysis of this problem by the 18 Franchise Tax Board and by the staff of the Board that 19 there is a sufficient justification for not treating the 20 income realized -- the compensation income realized from 21 the exercise of nonqualified stock options as 22 attributable to a period of time other than the year in 23 which that income is realized, that there is a basis for 24 allocating that income over a multi-year period that 25 flows simply from the nature of the income being 26 generated. 27 And this Board is aware of all of the examples 28 that are analyzed in the summary of this case that was 4 1 presented for all instances in which the specific item 2 of income that is being allocated to a multi-year period 3 was clearly attributable to services performed over a 4 period -- multi-year period and there was a specific 5 link between the item of income and the allocation of 6 that item of income. And then various formulas were 7 worked out. 8 And then the second point that I want to make 9 is that I -- I won't claim that it is necessarily 10 exhaustive, but I think that it is probably accurate 11 that there are really four reasonable formulas that can 12 be used for the allocation of -- in compensation income 13 from the real -- from the exercise of nonqualified stock 14 options over a period of time that are spelled out in 15 the briefing. And various forms are called different 16 things, but, basically, it's the year of grant, the 17 period of vesting, the year of exercise or the grant to 18 exercise rule, which is the one that was applied in this 19 case. 20 In these specific facts the three rules, other 21 than the grant to exercise rule, as a practical matter, 22 would have resulted in all of the income being treated 23 as earned and outside of California by a nonresident at 24 the time. The concern is only under the grant exercise 25 rule that some portion of the income is attributable to 26 the taxpayer as California source income. 27 And I will submit that where three of the four 28 reasonable rules of allocation produce a result that 5 1 is -- there is no income treated as California sourced 2 income, that on its face selecting the one rule and the 3 rule which is probably least justifiable, because it 4 produces an allocation of some income to the State of 5 California, appears to be arbitrary and capricious. 6 Going on, however, to the rule itself, the -- I 7 think that there is a justification for the rule. And 8 if you look carefully at Section 17951-5, which clearly 9 addresses employees within a single year period in a lot 10 of different concepts, but in the part B of that, down 11 towards the end, it clearly establishes that when 12 nothing fits, the Franchise Tax Board has the authority 13 to look at the facts and develop a rule based on the 14 facts that attributes to California the income that is 15 attributable to the services performed in California and 16 to other states the income that is attributable to the 17 services performed in those states. 18 I think that that is the justification in the 19 appropriate case on a case by case basis applying any 20 rule because it fits the facts and the circumstances and 21 that's what the examples in this cover. 22 The problem with this case is that publication 23 1004 establishes a rule and then, to the best of my 24 knowledge, that rule is applied by the Franchise Tax 25 Board to all instances where the -- there's a 26 recognition of income and it's simply allocated over 27 this grant to exercise, period, without regard to 28 whether this rule, which in many instances may be the 6 1 reasonable rule, is appropriate to the specific 2 instance. 3 This case is really one where it doesn't make 4 any difference whether the application of the rule is 5 improper or the rule itself is improper. In either 6 event, the proper result is that no portion of the 7 income that was realized from the exercise of 8 nonqualified stock options should be attributed as 9 California sourced income, whether you throw out the 10 rule or you simply don't apply the rule. And I think 11 either is possible under the existing regulation. 12 But to adopt a general rule pursuant to a 13 publication and then apply it to all instances that fall 14 within a class, without regard to the propriety of it, 15 either throws the rule into question or its universal 16 application into question. 17 I have nothing further. 18 MS. YEE: Okay, thank you, Mr. Taggart. We'll 19 give you time on rebuttal. 20 Franchise Tax Board? 21 MR. COLLINS: Good afternoon, Members of the 22 Board. 23 My name's Terry Collins. To my right is 24 Natasha Page and we represent the Franchise Tax Board in 25 this matter. 26 First of all, there are no factual disputes in 27 this case. We are simply disagreeing about legal 28 standards and legal applications. 7 1 And I want to talk a little bit about 2 compensation. Because this is compensation we're 3 dealing with. And I want you to picture, if you could, 4 if you had a house that sat on the state line of two 5 states and you paid me to paint your house. And I 6 painted every day and I did part of it in California and 7 part of it in the second state. Let's say it took me 8 forty days and you paid me $5,000. 9 It's fair to look at the compensation you paid 10 me for that entire forty days work. That's what they 11 pay my salary for, et cetera. You look at the period of 12 time. 13 And to go and say, "Well, that was for the last 14 four days or the first six days," or whatever is not the 15 way to look at compensation for sourcing purposes, okay. 16 Now, Section 83, the controlling federal 17 statute that we conform, says that, basically, this is 18 between grant and exercise, et cetera, is these items 19 that we are talking about are compensation income, okay. 20 And how do we handle the sourcing of 21 compensation income? The Appellant here worked in and 22 outside of California for several years and these are -- 23 there are multiple grants and exercises, et cetera. But 24 he was in the California working for some periods of 25 time and outside of California. 26 So, when the Code says we've got this 27 compensation, we go, well, some is sourced here, some is 28 not sourced here. Let's look at where the personal 8 1 effort was done and ratio it accordingly. 2 So, we said, "Well, we looked at the California 3 days for the various ones and we made a ratio over the 4 total calendar days and we took that times the income." 5 Okay, now, is that a reasonable -- is that a reasonable 6 method to use? 7 Well, Appellant argues no, he says it's 8 arbitrary and capricious, but this -- the method we used 9 here is very close to the duty day concept. And if you 10 think about it, the duty day concept and the method we 11 use here takes into account every day of that effort in 12 sourcing and in ratioing (verbatim). 13 He raises a couple of arguments. And he first 14 says, . 15 "Well, this is an arbitrary and capricious 16 method and there are three other methods -- the 17 grant date, the vesting period, the exercise, 18 et cetera, that would more accurately reflect 19 what's going on." 20 Well, first of all, go back to my house 21 painting example. We got to look at the whole period. 22 The methods that he suggested aren't going to lead to a 23 reasonable result in all circumstances. I'll give you 24 an example in just a minute. It can be manipulated a 25 little bit. But they are, per se, defective because of 26 the fact that they don't take into account this entire 27 period. 28 For instance, let's assume you use the exercise 9 1 date -- and remember, we are tax administrators, we 2 apply this to the cases as they come in. We're here for 3 more than the Appellant's case, we do this all of the 4 time. 5 Let's assume that I am granted some stock 6 options as a California resident and two days later I 7 leave the state, never to return and ten years later I 8 exercise them. Is it really rational to say that 9 California should tax all of that compensation income 10 merely because I was here for two days and spent the 11 other ten years of that effort that produced that income 12 outside of California? 13 I suggest no. I suggest that there are -- 14 these methods are, per se, invalid because they don't 15 look at the entire period of compensation. 16 And where do we come up with this? Okay, we 17 have Section 17951 that says we only tax nonresidents on 18 source income. 19 We have our regulations that have a slough of 20 examples of various kind -- they don't cover everything, 21 kinds of situations where we would do some sort of 22 weighing of inside and outside, taking into account the 23 full -- the full -- the full time of this compensation. 24 We have any number of Board decisions, Sam 25 Spiegel, et cetera, et cetera, I have a whole list of 26 them. 27 We have California appellate -- published 28 Appellate Court decisions. We have Paul Newman, which 10 1 sanctioned the duty day formula. We have Mark Wilson, 2 which sanctioned the duty day formula. So, we believe 3 our method is not only fair and rational as opposed to 4 arbitrary and capricious, but it has been completely -- 5 it has been validated by the California courts, by your 6 Board. And any number of states do this with athletes, 7 where they look at games played, et cetera, et cetera, 8 to do these kinds of ratios. 9 Let's see, Appellant mentions -- somehow 10 mentions this form that we have, I am sorry, Publication 11 10004 -- Publication 10004 is called Stock Option 12 Guidelines. It is no more meant to be a regulation. We 13 never called it a regulation. It's never been through 14 the regulatory process. It's not a regulation. 15 First of all, we don't need the form. But, 16 secondly, remember the Internal Revenue Service and the 17 Franchise Tax Board puts out a lot of information to 18 help taxpayers. And if you think about the tax 19 environment without those forms, those guidelines to 20 help people, it would be a very different environment 21 that we play in. 22 But this particular form is not a regulation, 23 okay. And, now, Appellant argues that not only do we 24 use it as a regulation, but we apply it to everybody. 25 We look at the publication and apply it. 26 Well, as a matter of fact, I can personally 27 testify that we don't do that. But, secondly, in this 28 case we didn't apply it to him because we didn't use 11 1 duty days, we used calendar days, okay. So, we did some 2 flexibility here. 3 And when we have cases where taxpayers have 4 argued that they did more work in one state or another 5 or they worked more hours, et cetera, we have taken that 6 into consideration. 7 So, I don't believe that this issue of whether 8 our publication is a regulation -- has nothing to do 9 with this. Because again we have so many cases, so many 10 opinions, so many court decisions that have upheld this 11 method. 12 The other thing is he somehow suggests that 13 whatever method is used it should only consider one tax 14 year. Well, we appreciate the facts that tax years are 15 arbitrary, et cetera. 16 But if you look at my house example again, 17 let's assume we had -- that took a period of two years, 18 it's rational to look at the entire period. Does 19 anybody else do this? Yes, all of the sports teams -- 20 we do it with the sports teams. We did it in the Mark 21 Wilson case and you did it in the Sam Spiegel case, 22 where you looked at the whole activity for purpose of 23 the sourcing. Because again it's rational. It measures 24 the whole period. 25 So, even though we are on a tax year concept, 26 there is no -- there is no rule that says for purposes 27 of sourcing compensation we shouldn't look to the entire 28 period and act accordingly. And that's what we do. 12 1 The Internal Revenue Service does the same 2 thing when nonresident aliens come in here and work. 3 So, we believe that the method that we have 4 used here is rational. It's fair and it's been 5 supported over and over again over the decades. 6 The other thing -- the other point that I need 7 to make is he made the statement that under his three 8 methods he either said there is no tax or there is 9 little tax. 10 Well, first of all, I need to point out to this 11 Board, this is a claim for refund. The taxpayer has the 12 burden of showing that they have made an overpayment of 13 tax. 14 This claim for refund comes in and it basically 15 said, "Your method's wrong. We win." There are no 16 numbers that he has submitted to support his contention 17 that under these alternative methods his net tax 18 increase would be zero. And the numbers that we have 19 run, just going through the files, suggests that out 20 of -- in two of his three methods, one of which we'd end 21 up with more tax and the other significant tax. 22 So, the point is they have the burden of 23 showing that. That information is not in the file as 24 we -- as we speak. 25 So, that that's basically the Franchise Tax 26 Board's position. I would be glad to answer any 27 questions that you have. 28 MS. YEE: Okay, thank you very much. 13 1 You have five minutes on rebuttal, Mr. Taggart. 2 MR. TAGGART: I would like to make just a 3 couple of points. 4 First of all, the difference between a duty day 5 analysis and a calendar day analysis is meaningless in 6 this case. That's simply a way of applying a formula. 7 The second point that I would like to make is 8 that the painting example is precisely the point that I 9 was trying to make in referring to the examples because 10 in that case you have a payment for painting a house 11 that is specifically attributable to the forty days that 12 it took to paint the house, whether it's in a single 13 year or over two years, the item of income is 14 specifically attributable to the work that is being 15 done. 16 And the application of the Newman case, the 17 Wilson case, the Spiegel case are all instances where 18 the item of income that is being allocated is an item of 19 income that is allocated to specific work that was being 20 done over a multi-year period and then you get into the 21 formula of how then you allocate that between California 22 sourced income and other states where the services were 23 performed. 24 And the last point that I want to make is that 25 the Franchise Tax Board's assumption -- presentation 26 starts from the assumption that there is a justification 27 for taking this, in many instances, totally fortuitous 28 big chunk of income that is realized in a particular 14 1 year because that's when the employee realizes that the 2 value of the stock has gone up and they can get a lot of 3 compensation income in that year and it's a decision 4 that the employee makes. That income comes into that 5 year. And the Franchise Tax Board's presentation starts 6 from the assumption that because it is income from a 7 nonqualified stock option, it has all of these strings 8 before you got up to that point in time, that somehow 9 the fact that it is income from the exercise of 10 nonqualified stock options justifies allocating that to 11 a year other than the year in which the income is 12 actually realized. 13 And that is a premise that everything flows 14 from. And the alternative rules, and this particular 15 rule, start from saying, 16 "We have this chunk of income. For federal tax 17 purposes it is realized in a particular year as 18 compensation income and is compensation income 19 under California's rules because of 20 conformity." 21 But the issue here is is some part of that 22 income properly attributable to a different year? And 23 there's nothing in federal law that has anything to do 24 with that. It is -- that item of income that you're now 25 saying, 26 "We will allocate that to years other than the 27 year in which it's realized, because it somehow 28 is tied to the performance of services," but 15 1 you're assuming the answer to the question. 2 I have nothing further. 3 MS. YEE: Thank you, Mr. Taggart. 4 Questions, Members? 5 Ms. Mandel, please? 6 MS. MANDEL: I guess, Mr. Taggart, what you're 7 calling allocating it to other years, Franchise Tax 8 Board would call sourcing the income. 9 They are not trying to tax the income in some 10 other year than the year that the -- the same year that 11 the federal law has you -- has the recognition event for 12 the income. 13 MR. TAGGART: That is correct. 14 And my language may have been sloppy in saying 15 that. But, in fact, you are taking this income that is 16 clearly realized in a single year and allocating it, by 17 virtue of the sourcing rules, to other years for 18 purposes of determining how much of it is California 19 income and that is an assumption that is made in 20 deciding that you are going to tax that income -- 21 MS. MANDEL: Well -- 22 MR. TAGGART: -- in this year as if it was 23 earned over this -- 24 MS. MANDEL: -- I don't -- personally, that's 25 not kid of how I see it. 26 MR. TAGGART: Okay? 27 MS. MANDEL: The taxpayer gets the stock option 28 in some year in the past. It vests at some point. 16 1 And at some appointment after it vests, the 2 taxpayer decides, "You know, I think I'm going to 3 exercise those options today." 4 MR. TAGGART: Right. 5 MS. MANDEL: The taxpayer, at that point, 6 unless he goes out and sells the stock, he doesn't 7 really have any cash in hand, but he's got a bunch of 8 stock because he exercised his options to buy the stock 9 at his -- at his strike price. 10 And, so, he has a recognition event, really not 11 -- I don't think it's a realization, I think it's a 12 recognition event for tax purposes. 13 MR. TAGGART: It's a realization event that is 14 also a recognition event. 15 MS. MANDEL: Okay. It's been a long time since 16 we were both in class. 17 And for federal purposes, and then also state 18 purposes, that's characterized as compensation. And I 19 always kind of viewed that as, well, you know, for 20 federal purposes it makes a big difference what kind of 21 income you have, if it's -- you know, if it's going to 22 be capital or not, that there's a lot of things that 23 flow from that -- less things that flow from that 24 distinction for California State purposes because we 25 don't have differences in tax rates and things like 26 that. 27 But, still, for the states -- you are not just 28 talking California, you're talking sort of anywhere -- 17 1 states, if you take your argument, which is it would -- 2 which is, that the state -- that for sourcing of income, 3 the states should never look back at what is the 4 compensation for? 5 He didn't get it when he -- you know, there was 6 no compensation recognized or realized when the grants 7 were made or over the time or it's not a realization 8 recognition event for the nonqualified stock on the date 9 that it vests, it's not until under the tax law he 10 actually exercises it. 11 So, all of the states are just looking at how 12 does that compensation -- he performed services during 13 all this period, in your client's case he was performing 14 services -- and leave aside, for the moment, that it 15 doesn't make a difference what he did once he vested in 16 these particular options. He's performed services over 17 all these periods and now he's -- now he's finally 18 getting, you know, in the form of stock, he's getting 19 the money in hand that the tax law says is compensation. 20 How do we source that? Your argument that you 21 should never look back and look only at the year of, you 22 know, where is he when he -- when he exercises the 23 option, that's your sort of, I guess, ultimate first 24 argument -- that California shouldn't be able to tax it 25 all because he's in Texas -- or wherever he was, I think 26 he was in Texas. He Moved around a lot. 27 But if you accept that it's sort of -- it's 28 compensation -- it's compensation for what? 18 1 And they've got a method, and I guess he was a 2 manager a lot of the time, so, duty days in executive 3 capacity is kind of a, you know, to me it's a misnomer 4 because executives are working eight days a week anyway, 5 but I was kind of interested for a little bit about the 6 vesting period, although that's probably less favorable 7 to your client on a mathematical basis would be my 8 guess, on my sort of overall understanding of the 9 facts. 10 But it almost sounds like you're arguing that 11 once somebody's no longer in California for nonqualified 12 stock -- and maybe you're making this argument too on 13 the restricted -- restricted stock if at the time this 14 restricted stock vests -- that if they were not in 15 California that entire year or had moved from 16 California, were no longer a California resident at the 17 time, that they vested or exercised, that there's no 18 California sourcing issue at all. That's kind of what I 19 am hearing this morning. 20 So, tell me why I am mixed up, I suppose. 21 MR. TAGGART: I don't think you're mixed up at 22 all, I actually think you're focusing on the question. 23 Because if you take your example, it's granted 24 and it vests over a period of time and it -- but the 25 value of the stock doesn't change throughout that time 26 and it is only in the year of exercise that, for reasons 27 that have nothing to do with the employee or anything, 28 it becomes Google or whatever and, all of a sudden, 19 1 there is a big chunk of income that is realized that has 2 nothing to do with any of those periods of time, it's 3 just a fortuitous event that produces this chunk of 4 income. 5 And the assumption is -- and you focused right 6 on it -- that we have to look back at the period of time 7 that is covered by this and this rule, which I concede 8 in lots of factual situations, produces a result that 9 may very well be reasonable and applicable. 10 In this particular case, the grant date, 11 nonresident, the vesting period for most of the options 12 in issue was fully vested before he came to California. 13 And then he left California with respect to most of the 14 things -- most of the options that are involved in this 15 case at the time of exercise. 16 And to apply a general rule to all instances on 17 a grant to exercise, without looking at the specific 18 facts as a rule, may be itself unreasonable. 19 But the specific point of looking at the year 20 that, also becomes a fortuitous event because the 21 election to exercise, you elect on January 3rd and you 22 leave on January 4th, if you do it on a per diem basis, 23 just in that year, it's four days. But if you leave on 24 the last day of the year, even though you exercise on 25 January 3rd, 99 percent of it on the year of exercise. 26 And you're correct that to some extent that the 27 employee may be able to control it by moving 28 out of state and becoming a nonresident But it is the 20 1 application of a rule to a specific set of facts that I 2 think is the problem. Either you don't apply the rule 3 here or you simply say you can't have a rule that is one 4 size fits all is, I think, an issue. 5 MS. MANDEL: So, you're saying that for most of 6 the nonqualified -- you are saying that most of the 7 stuff he was vested in before he ever came to 8 California? 9 MR. TAGGART: I think that that is correct, 10 yes. 11 MS. MANDEL: And I thought I also heard you say 12 that -- I mean, when you say, "Well, what if in the year 13 of exercise it miraculously becomes Google," sort of 14 intimating that whatever this guy might have done in his 15 job had nothing to do with it, it was just like magic in 16 the stock market, I mean that -- I mean, that suggests 17 then the Franchise Tax Board -- you are asking Franchise 18 Tax Board to look at -- at the particular facts inside 19 of a company and whether anything that any individual 20 did in their job resulted in increases in the stock 21 price or not. 22 MR. TAGGART: No, I think -- what I was 23 referring to was the specific regulation part v of, I 24 think it's 17951, that says if none of these rules fit, 25 the Franchise Tax Board has not to look at the company, 26 but to look at the facts of the particular taxpayer and 27 come up with a rule that applies to the specific facts 28 and I think that's exactly what was done in the Newman 21 1 case and in the Wilson case and in the Spiegel case, is 2 the facts of the case were taken and applied to come up 3 with a formula that allocated to California the portion 4 of the income that is reasonably attributable to 5 services performed in California and -- 6 MS. MANDEL: And, so, why -- why does this -- 7 why the does formula that Franchise Tax Board has -- oh, 8 I'm not speaking English. 9 Why -- why -- the formula Franchise Tax Board 10 has used, why is that not reflective of the services 11 performed to get this compensation? 12 MR. TAGGART: Because the -- 13 MS. MANDEL: And why is yours then -- pick one, 14 any one from the three -- more reasonable, if that's the 15 way it breaks out? 16 MR. TAGGART: -- because the income from the 17 exercise of nonqualified stock options when you have 18 this, you know, 14 year period of time over which 19 that -- from the initial grant to the initial exercise 20 would be longer than that, but in this instance I think 21 some of them do actually run out at 14 years -- there is 22 no tie between that chunk of income and any services. 23 So, you have to come up with -- 24 MS. MANDEL: But I guess why? 25 MR. TAGGART: Because that's the nature of the 26 beast, that the income that is realized and amount and 27 timing has no clear relationship to the performance of 28 services. 22 1 So, you need to develop rules for determining 2 how that income is going to be taxed for sourcing 3 purposes. 4 And there are lots of different ways that you 5 can rationally do it, but you're creating an artificial 6 structure and saying, 7 "We've got this chunk of income, it's realized 8 in a specific year. And we think that it -- 9 for sourcing purposes it should be allocated to 10 some other period of time, not for the taxation 11 of it at the federal level, but this amount of 12 income, which is compensation income, realized 13 in this year." 14 We are going to look for sourcing purposes to 15 the creation of an artificial rule for saying, "This 16 portion should be attributable to California." 17 And the grant to exercise is one such formula, 18 but the dated grant is a rule, the period of vesting, 19 which I think is the most logical one, because that -- 20 there is actually a tie because you get the grant and it 21 vests over a three year period, so, that is the period 22 of time it's tied to the performance of services for 23 that value. 24 MS. MANDEL: And could you lose -- could you 25 lose the options, even -- I mean, this is probably just 26 contrary language -- could you lose -- this guy happened 27 to still be working for company? 28 MR. TAGGART: Right. 23 1 MS. MANDEL: And there was some reference in 2 the materials about, you know, well, he could have -- 3 what if he was gone? You know, why would you apply this 4 same sort of ruling if he's no longer gone? 5 I mean, do people -- I mean understand vesting 6 means -- 7 MR. TAGGART: Vesting means it's fully vested, 8 but the answer is, yes, you can still lose them because 9 if you are terminated for cause, then you would lose the 10 benefit of that vesting and, in most instances with 11 nonqualified stock options, if your employment is 12 terminated for reasons other than cause, you get to 13 continue them, even though you don't have to continue 14 being an employee. 15 MS. MANDEL: So, you could leave? 16 MR. TAGGART: You could, in -- 17 MS. MANDEL: So, I guess then the question for 18 the Franchise Tax Board is why -- why -- why your method 19 rather than the vesting period? 20 It just was intriguing, why -- why? 21 MR. COLLINS: I am sorry, could you repeat the 22 question? 23 MS. MANDEL: Why -- why -- why your method, 24 which is days in California, over total days from grant 25 to exercise? 26 Why that rather than vesting period for the 27 nonqualified? 28 Because I understand it is vesting -- 24 1 MR. COLLINS: Because the Code, the law says 2 that that is a chunk of compensation. 3 MS. MANDEL: Well, the dollar figure, the 4 amount that he's required to put on his tax return is 5 compensation -- 6 MR. COLLINS: Yes. 7 MS. MANDEL: -- is measured to the date of 8 exercise because you don't -- you don't know -- well, I 9 guess on the restricted stock you know post to vesting, 10 but -- that's your answers -- 11 MR. COLLINS: Yes. 12 MS. MANDEL: -- because you just -- you won't 13 -- you're trying to -- you are looking at how the amount 14 of compensation is measured and saying that must be the 15 relevant period -- 16 MR. COLLINS: That's correct. 17 MS. MANDEL: -- under the Tax Code? 18 MR. COLLINS: Correct, yes. 19 MS. MANDEL: Well, then I'm -- okay. 20 MS. YEE: Mr. Taggart, the reasoning behind 21 your client's use of the calendar method, I think in his 22 initial return, was it back in 2005 -- one of the tax 23 years? 24 MR. TAGGART: The calendar as opposed to work 25 day method in this instance doesn't really make any 26 difference because all you're doing is adding in the 27 weekend days and it's really period of time in 28 California, period of time outside of California. 25 1 And whether it's -- if you assume that all of 2 the work was done in California when he was in 3 California and was done elsewhere when he was outside, 4 they produce the same result. 5 And that's -- and it was more work to try to 6 figure that out, it just didn't make any difference. 7 But it is really the application of the 8 principles of the rule that that goes to and that's why 9 I just didn't brother addressing it. 10 And if I could I say one more thing because it 11 was brought up? 12 The fact that this is here in a refund claim 13 has really nothing to do with it. 14 The additional taxes that were paid was the 15 amount attributable to these -- the exercise of the 16 nonqualified stock options, at least for the years that 17 it was done after we knew the issue was coming forward 18 and simply filed a return, paid the full amount of tax 19 filed, amended the return and claimed a refund for that 20 portion of it. 21 But that was simply a way of presenting the 22 issue rather than doing it on a -- in response to a 23 Notice of Proposed Assessment and going through the 24 process as a repayment proceeding. 25 MS. YEE: Okay. Then with respect to the 26 alternatives that you proffered here, have you 27 produced -- I don't think I saw it -- what the 28 associated liabilities would be -- 26 1 MR. TAGGART: No. 2 MS. YEE: -- for each alternative? 3 MR. TAGGART: I thought that the purpose of 4 this proceeding was to focus on the principles and not 5 on the details of how it is going to work because it's 6 really an issue that relates to the principles that will 7 apply. And we can always work out the details when we 8 have the decision on what the principles are. 9 MS. YEE: Okay, very well. 10 Mr. Horton? 11 MR. HORTON: Yeah, well -- there are -- the 12 constitution doesn't allow the State of California to 13 tax income derived from another state in this particular 14 case. 15 So, I mean, is there a -- is there a dispute 16 over when the stocks were provided -- date, time, where 17 he was located, when he received it? 18 Is there a dispute over why he received it? 19 MR. TAGGART: I don't think there is a dispute 20 over either -- any factual dispute over these issues. 21 MR. HORTON: Why did he receive it? 22 MR. TAGGART: He received them as part of his 23 compensation he was granted every year, I think, from 24 1998 forward -- 25 MR. HORTON: So, when -- 26 MR. TAGGART: -- nonqualified stock options. 27 MR. HORTON: -- so, when he received the 28 stock -- 27 1 MR. TAGGART: No, he received a grant of non -- 2 MR. HORTON: A grant -- 3 MR. TAGGART: -- qualified stock options. 4 MR. HORTON: -- nonqualified stock. 5 It was -- the intent was to compensate him for 6 his services at that time? 7 The debate -- or at some point later it would 8 be determined the value there at some point down the 9 road? 10 Am I correct? We all seem to agree to that? 11 MR. TAGGART: I think that that is correct if 12 you look at the entire series of steps. 13 You're granted a nonqualified stock option. In 14 general there's a period of time it vests as to 100 15 shares in the first year and another 100 shares in the 16 second year and another 100 shares in the third year, 17 if you're granted 300 a year. 18 So, each year you get a vested -- 19 MR. HORTON: No, I understand how it works. 20 At any point, once it was granted, is there 21 anything that the taxpayer needed to do in order to be 22 vested? 23 MR. TAGGART: The passage of time as an 24 employee. 25 MR. HORTON: I mean aside from just time 26 passing? 27 MR. TAGGART: No. 28 MR. HORTON: Well, what if he quit the second 28 1 year? 2 MR. TAGGART: Doesn't vest. You lose it. 3 MR. HORTON: And how long is the period of time 4 in which he had to remain an employee in order for it to 5 vest? 6 MR. TAGGART: I think all of the stock 7 options -- nonqualified stock options in issue -- vested 8 over a three-year period. 9 MR. HORTON: Three-year period? 10 So, during that three-year period, where was 11 the taxpayer? 12 Was he in California or -- 13 MR. TAGGART: No, I think as to all of that -- 14 and it's hard because there are different ones, but I 15 think he was in North Carolina all of those years. 16 MR. HORTON: So, in all three years that it 17 took in order for this to be -- 18 MR. TAGGART: For it to be vested he was in 19 North Carolina. 20 MR. HORTON: North Carolina? 21 MR. TAGGART: But between vesting and exercise, 22 I think all of these nonqualified stock options -- 23 MR. HORTON: But he -- 24 MR. TAGGART: -- you could exercise them any 25 time in a ten-year period. 26 MR. HORTON: He was working in North Carolina 27 the company? 28 MR. TAGGART: (Whereupon he nods head.) 29 1 MR. HORTON: Okay. 2 MR. TAGGART: Actually for a predecessor 3 company of the company that he was employed by in 4 California and then was employed by -- 5 MR. HORTON: Is the answer no? 6 MR. TAGGART: -- in Texas. 7 No, the answer is -- 8 MR. HORTON: Is it yes, he was working for the 9 company? 10 MR. TAGGART: It's a -- I mean, it's a 11 different company, but it's a -- it is succeeded to in a 12 merger that -- 13 MS. MANDEL: I think the answer's -- the simple 14 answer is yes, he's still working, basically -- 15 MR. TAGGART: He's still working for the same 16 company. 17 MS. MANDEL: -- the same place. 18 MR. HORTON: Same company -- kind of 19 interesting. 20 To the Department, can you speak to the issue 21 of income earned? There's -- the contention seems to be 22 that stock option really has no value at the time that 23 it was given and value has accumulated over a period of 24 time. 25 And, so -- and attributed to employment and 26 attributed to an activity that had to continue to occur. 27 So, in first year that it was granted, clearly 28 there was -- there was a compensation, a measurement of 30 1 compensation here in California. 2 But the taxpayer seems to be arguing that 3 compensation was adjusted or did not -- did not -- was 4 not vested for a period of three years and that there 5 was a direct tie to compensation services rendered 6 during that three year period. 7 So, he had to continue to work and continue to 8 provide service in order for the stock option to have 9 value, otherwise it didn't have any value at all. 10 What's your understanding of that? 11 MR. COLLINS: Well, I question the fact that if 12 I am granted some stock options today that I don't have 13 some value. 14 But I think his analysis of -- 15 MR. HORTON: No, I think there is -- there is 16 value there. 17 MR. COLLINS: But what happens is a grant and 18 then -- 19 MR. HORTON: If you quit the following year, 20 what value is there? 21 MR. COLLINS: You have none. 22 MR. HORTON: No value whatsoever? 23 MR. COLLINS: And the vesting creates a 24 precondition, but it doesn't create the realization 25 event because you don't want that to happen because they 26 have no money to pay the tax on the stocks. 27 MR. HORTON: Right. 28 MR. COLLINS: And then what happens is 31 1 Section 83 at the federal level, creates this compromise 2 between a whole number of competing interests between 3 the deducting corporation and the taxpayer as to say 4 that in this case the income -- there is a realization 5 and recognition event when it is exercised because at 6 that point you've got some value. 7 Same way as you get cash income or somebody 8 gives you a house or something and that's where the code 9 puts the incidence of taxation. 10 And it says -- 11 MR. HORTON: That occurred where? 12 MR. COLLINS: -- when the options are 13 exercised. 14 MR. HORTON: Where did it occur in this case? 15 MR. COLLINS: Out of state, right, 16 out of state, not in California. 17 MR. HORTON: All right. 18 MR. COLLINS: Okay. And, so, then the section 19 says, 20 "But that is attributable to the efforts 21 between the grant and the exercise date. It's 22 compensation." 23 MR. HORTON: Right. 24 MR. COLLINS: And the rule says, "personal 25 services are sourced where they are performed." 26 And that's our job, to find out where they are 27 performed and come up with some rational relationship 28 between the amount we tax and the effort performed in 32 1 California. 2 MR. HORTON: So, you don't disagree that part 3 of the income is non California income? 4 MR. COLLINS: Of course not, no. We certainly 5 agree with that and we haven't taxed it all, by any 6 means. 7 MR. HORTON: Okay. 8 And to the taxpayer, you believe -- 9 MR. COLLINS: Excuse me, we've taxed roughly, 10 overall, about 30 percent of this income. 11 MR. HORTON: So, you believe that 30 percent 12 should not be attributed to California because the -- it 13 was exercised at the time it was exercised, he was out 14 of California? 15 Is that -- 16 MR. TAGGART: That is one theory. 17 As I tried to indicate, I think there are four 18 reasonable rules, one, being -- 19 MR. HORTON: Let's deal with that one. 20 MR. TAGGART: Deal with -- but your question is 21 if -- yes, if he -- because under three of those four, 22 because he was out of state, he was a nonresident and he 23 received his compensation, there is no real 24 justification for allocating part of that compensation 25 to California. 26 MR. HORTON: Based on your argument of vesting, 27 at some point the vesting activity occurred in 28 California? 33 1 MR. TAGGART: No, the vesting occurred before 2 he came to California. And, so, he used the grant to 3 vesting rule. 4 MR. HORTON: So, he -- he had -- he was 5 completely -- he received the stock outside of 6 California? 7 MR. TAGGART: Received the stock options. 8 MR. HORTON: Outside of California? 9 He was fully vested. He stayed outside of 10 California for three years and fully vested and that 11 point that established the value relative to the -- to 12 the service rendered? 13 MR. TAGGART: Yes. 14 MR. HORTON: And then, for some reason, he 15 came to California, had nothing to do with -- at that 16 point there's a separation and the fact that he served 17 here in California -- was serviced in California has no 18 correlation to the value of the stock? 19 Is that -- 20 MR. TAGGART: That is -- that is correct. 21 And that's what I said, I think. 22 MR. HORTON: Well, it seemed to be conflicting 23 information here. 24 So, let me go back to the Department. The 25 Department seems to believe that he served a period of 26 his time in California and that service was rendered in 27 California, therefore, the compensation, they're 28 allocating a percentage of that to California. 34 1 So, there is -- you started out on the premise 2 that you agreed on the facts -- seems to me that you 3 don't agree on the facts and that there is a different 4 set of facts here. 5 So, maybe we can have a discussion about those? 6 MR. COLLINS: Perhaps I can interject something 7 we don't agree on since he just brought it up. 8 We just did a quick computation, based upon a 9 schedule we have in the file, and it looks like roughly 10 2 million of this vested before he became a California 11 resident and about $3 million vested after the time he 12 became a California resident. 13 So, we don't agree on that. 14 MR. HORTON: That works against you, sir. 15 MR. COLLINS: It was not of direct relevance 16 because the vesting for the nonqualified stock options 17 is not the incidence of taxation, but these numbers that 18 he's come up with haven't been developed. 19 And we just did ours quickly off a schedule. 20 MR. TAGGART: I -- that may very well be 21 correct. 22 As I said, this is -- I think should be focused 23 on the principles for making that determination. And 24 how it works out in application is -- I don't think the 25 issue that is before the Board, the issue is the 26 selection of the rule for -- 27 MR. HORTON: Well, there is -- then it's one in 28 and of itself. I mean, you can't have the rule 35 1 without -- 2 MS. MANDEL: We -- 3 MR. HORTON: -- without the principle, seems 4 like. So -- 5 MS. MANDEL: -- we don't have a sort of 6 Rule 155 practice kind of thing. 7 MR. TAGGART: I understand that. I understand 8 that. 9 But, how it applies -- the tax is fully paid. 10 It's a refund claim. 11 And how that will shake out is dependent upon 12 what happens, to some extent, in the application of the 13 rule. 14 But we were -- we were requested to do 15 supplemental briefing on the application of this rule 16 and, so, that's why I thought that you wanted to look at 17 it. 18 And the supplemental briefing was on the 19 question of the Publication 10004 being an underground 20 regulation. 21 And that's what I thought we were having this 22 hearing about today. 23 MR. HORTON: So, you want us to decide whether 24 or not the longstanding historical usage of allocating 25 the funding based on where the services were rendered, 26 whether that that's an underground legislation or not? 27 Is that all you're asking? 28 MR. TAGGART: No. The -- it is a rule that is 36 1 adopted and applied generally for the determination 2 of -- for sourcing purposes of the income realized from 3 the exercise of nonqualified stock options. 4 And there are, I think, three more reasonable 5 rules and I think the grant vesting rule is probably the 6 one that most closely ties the -- 7 MR. HORTON: You know, your client loses under 8 the grant vesting rule? 9 They are asserting 30 percent. 10 MR. TAGGART: I understand. 11 MR. HORTON: Do you want -- 12 MR. TAGGART: Not under the grant vesting rule, 13 under the grant exercise rule. 14 MR. HORTON: Also you -- this is another 15 argument, but this argument is that when they exercise 16 the option where they are, when they exercise it, 17 determines whether or not -- has nothing to do with 18 services rendered compensation for service, but it's 19 just the physical location where they are when they 20 decide to exercise the option? 21 MR. TAGGART: Under the concept that the 22 appropriate allocation is the -- where the services are 23 performed in the year in which the income is realized, 24 which would be the year of exercise, you would look at 25 how many days, work days in California, and how many 26 work days were out of California and that would become 27 the determination for how California would source that 28 income. 37 1 That is one rule. And that would be based on 2 the year of exercise. 3 The rule that most closely ties the concept of 4 receiving nonqualified stock options as compensation to 5 the services being performed is a rule that is based on 6 the period of vesting, which would be from the grant to 7 this, I assume it was a three-year period in all of 8 them, where the services were performed within and 9 without California for that purpose. That would be one. 10 You could use the date of grant, the year of 11 grant as the rule for determining how and then grant. 12 MR. HORTON: Which one are you recommending? 13 MR. TAGGART: I think that the best rule is -- 14 MR. HORTON: You know -- 15 MR. TAGGART: -- the year of exercise because 16 it is justifiable in terms of the -- it being 17 compensation for services for an employee and is mostly 18 administered because there's a W-2 issued for this 19 compensation income. And it's current information. 20 So, I think that is, in terms of practicality, 21 far and away the best rule because it is most clear, 22 clean and efficient logically in the -- based on the 23 principles for the taxation of income for nonqualified 24 stock options. 25 It would be the grant vesting rule but, like -- 26 as in the case here, that's information that is fourteen 27 years old. 28 MR. HORTON: Thank you, sir. 38 1 MR. TAGGART: Thank you. 2 MS. YEE: Let me just clarify. Seems to me 3 we're veering off here quite a bit. 4 Let me take a shot at this. 5 The supplemental briefing that you were asked 6 to provide I would hope would have been to focus on why 7 the Franchise Tax Board's formula was not appropriate 8 for allocating income and I think that's what drove you 9 to really look at the publication as constituting an 10 underground regulation. 11 And -- but once that formula has been used, you 12 bear the burden of proof -- 13 MR. TAGGART: I understand. 14 MS. YEE: -- to demonstrate that it's 15 intrinsically arbitrary and I don't believe you've done 16 that. 17 And, instead, you know, you've kind of 18 proffered, you know, some other alternatives, which 19 seems to me don't really speak to a relationship to the 20 actual time period of the options. 21 And, so, I want to just kind of clarify with 22 Appeals that we, in fact, did ask for a supplemental 23 briefing to focus on that question? 24 MS. KELLY: We did and we offered a couple of 25 additional issues for the Appellant to address, if they 26 wished. 27 We were concerned that Appellant might not be 28 aware of other arguments and wanted to give them a 39 1 chance to brief those, if they wished to do so. 2 The responses came back that they didn't find 3 the issues particularly relevant. 4 So, we're back to focusing on the formulas. 5 MS. YEE: All right. 6 Other questions, Members? 7 MR. HORTON: Move to take it under submission. 8 MS. YEE: Okay, we have a motion by Mr. Horton 9 to take this matter under submission. 10 Is there a second? 11 MS. MANDEL: Second. 12 MS. YEE: Second by Ms. Mandel. 13 Without objection, that motion carries. 14 Thank you, Mr. Taggart -- 15 MR. TAGGART: Thank you very much. 16 MS. YEE: -- and Franchise Tax Board. 17 We will discuss your matter later today. 18 ---o0o--- 19 20 21 22 23 24 25 26 27 28 40 1 REPORTER'S CERTIFICATE 2 3 State of California ) 4 ) ss 5 County of Sacramento ) 6 7 I, JULI PRICE JACKSON, Hearing Reporter for the 8 California State Board of Equalization certify that on 9 MARCH 23, 2010 I recorded verbatim, in shorthand, to the 10 best of my ability, the proceedings in the 11 above-entitled hearing; that I transcribed the shorthand 12 writing into typewriting; and that the preceding pages 1 13 through 39 constitute a complete and accurate 14 transcription of the shorthand writing. 15 16 Dated: May 12, 2010 17 18 19 ____________________________ 20 JULI PRICE JACKSON 21 Hearing Reporter 22 23 24 25 26 27 28 41