BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 450 N Street, Room 121 Sacramento, California REPORTER'S TRANSCRIPT APRIL 13, 2010 ITEM B1 FRANCHISE AND PERSONAL INCOME TAX HEARING APPEAL OF THOMAS A. LEONARDINI AND KAREN M. LEONARDINI (No. 449478) AGAINST PROPOSED ASSESSMENT OF ADDITIONAL TAX Reported by: Beverly D. Toms CSR No. 1662 1 1 2 P R E S E N T 3 For the Board Betty T. Yee of Equalization: Chair 4 Jerome E. Horton 5 Vice-Chair 6 Barbara Alby Acting Member 7 Michelle Steel 8 Member 9 Marcy Jo Mandel Appearing for John Chiang 10 State Controller (per Government Code 11 Section 7.9) 12 Diane Olson Chief, Board 13 Proceedings Division 14 For Board of Lou Ambrose 15 Equalization Staff: Tax Counsel 16 For Franchise Tax Jason Riley 17 Board: Tax Counsel 18 Bill Hilson Tax Counsel 19 For Appellant: Michael A. Thompson 20 Attorney at Law 21 Thomas Leonardini Taxpayer 22 23 ---oOo--- 24 25 26 27 28 2 1 Sacramento, California 2 April 13, 2010 3 ---oOo--- 4 MS. OLSON: Our first item on today's Board 5 meeting agenda is B1, Thomas A. Leonardini and Karen M. 6 Leonardini. Please come forward. 7 Board Proceedings has received contribution 8 disclosure forms for this morning's hearings from the 9 parties, agents and participants. All forms were 10 properly completed and signed. All parties, agents and 11 participants are on the Alpha listing provided to your 12 office. 13 Each person sitting at the table will be asked 14 to introduce themselves and if necessary their 15 affiliation with the taxpayer. 16 Ten minutes is allocated for the taxpayer's 17 opening presentation followed by ten minutes for the 18 Department's presentation, and five minutes is allocated 19 to the taxpayer for rebuttal. 20 Ms. Yee. 21 MS. YEE: Thank you very much, Ms. Olson. Good 22 morning. Our first item, Members, is item B1, Thomas 23 and Karen Leonardini. And let me have Appeals introduce 24 the matter. 25 Good morning. 26 MR. AMBROSE: Good morning, Madam Chairwoman 27 and Members of the Board. This is the matter of the 28 appeal of Thomas A. Leonardini and Karen M. Leonardini. 3 1 And the issues before the Board are, first, whether 2 Appellants have presented evidence sufficient to 3 demonstrate that their activities constituted qualified 4 research as defined in Internal Revenue Code Section 41. 5 Secondly, whether the Appellants have met their 6 burden of proving qualified expenses for purpose of the 7 research and development credit under Rev. and Tax Code 8 Section 23609 for the tax years at issue. 9 And then third, whether Appellant husband's 10 wages were, quote, unreasonable under the circumstances, 11 unquote, so as to disqualify them as expenses under 12 Internal Revenue Code Section 174. 13 MS. YEE: Great. Thank you very much, 14 Mr. Ambrose. Good morning, gentlemen. 15 MR. THOMPSON: Good morning. 16 Good morning. 17 MS. YEE: If you'll introduce yourselves for 18 the record you have ten minutes for your presentation. 19 MR. THOMPSON: Thank you, Madam Chairwoman, 20 Members. My name is Michael Thompson. I represent 21 Mr. Thomas Leonardini. 22 MR. LEONARDINI: My name is Thomas Leonardini. 23 MS. YEE: Okay. Mr. Leonardini, I'm going to 24 ask you to speak right into the microphone when you do 25 speak. 26 MR. LEONARDINI: My name is Tom Leonardini. 27 Thank you. 28 MS. YEE: Very well, thank you. 4 1 MR. THOMPSON: Mr. Leonardini is the proprietor 2 of Whitehall Lane Winery in St. Helena, California, in 3 the heart of Napa Valley. This case involves claims for 4 research credits generated by Whitehall Lane during the 5 2001 to 2004 tax years and that it flowed through to Mr. 6 Leonardini as a shareholder. 7 I want to start by giving a brief outline of 8 the examination that occurred in this case. And I think 9 it -- it has a little bit of bearing on -- on what we're 10 here for today so I -- I ask that you bear with me while 11 I give you dates because they will be important. The 12 amended returns were filed in -- or the calc -- the 13 credits were calculated before April 2005. The tax 14 return for the '01 tax year, the statute was about to 15 run, the credits were calculated at that time. 16 The exam notice in this case did not come until 17 about ten and a half months later in February of '06. 18 There was a site visit conducted by the agent in this 19 case in July of '06. And then in February of 2008 Mr. 20 Leonardini finally received his notice of disallowance, 21 which was a one-page disallowance with no explanation 22 of -- of why he was being denied his credits. 23 We filed a protest requesting that we be 24 provided some guidance as to why the credit was 25 disallowed. 26 In October we received 200 pages of an 27 explanation from the Tax Counsel for the Franchise Tax 28 Board. This becomes important because throughout 5 1 this -- this document the Franchise Tax Board makes 2 reference to audit technique guides issued by the 3 Internal Revenue Service that basically provide guidance 4 as to what the Internal Revenue Service wants to see 5 with regard to substantiation. 6 The first audit technique guide didn't come out 7 until June of 2005, three months after the Leonardinis 8 filed their first tax return regarding research credits. 9 In that audit technique guide they make some reference 10 to substantiation and what they want to see. 11 Also included in this is the second audit technique 12 guide, which talks about things like nexus, which you 13 guys have seen if you've read the briefs in this case, 14 additional substantiation requirements that came out 15 in -- in May of 2008. 16 So what the Franchise Tax Board is essentially 17 doing here is holding my client to a standard of having 18 to see into the future to determine what substantiation 19 is necessary to support the credit. 20 We contend -- and again I don't point this out 21 to point out that we don't have it and we're looking for 22 an excuse. They have the documentation. But at the 23 time the site visit occurred and the questions that were 24 asked produced all information that might substantiate 25 your credit in this case. 26 I've given the Board, which is actually in the 27 record already, there's a packet of information here 28 which includes some various documents that were actually 6 1 attached to the Franchise Tax Board's brief. Standing 2 alone these documents mean absolutely nothing. I'll 3 admit that to you today. Without a technical 4 background, without knowledge of what these documents 5 show, they just look like batch records. They just look 6 like testing data. 7 When -- when the Franchise Tax Board sent four 8 individuals out to the site visit at Whitehall Lane 9 Winery they met with Mr. Leonardini for less than an 10 hour. They did not meet with the winemaker. They did 11 not meet with any of the individuals that were involved 12 in the vineyard projects. Mr. Leonardini had some 13 involvement with that, mostly with the bottle closure 14 project. 15 For instance, the very first page that I've 16 handed you guys on this documentation, if you don't mind 17 looking at it, has to do with -- it's the first and 18 second page -- has to do with -- if you look below 19 Rutherford, under the vineyard, you'll see the a.m. side 20 and the p.m. side. What Whitehall had done, Whitehall 21 has segregated a portion of their vineyard to account 22 for specific experimental research projects. 23 In this case they had planted a quadrilateral 24 vineyard line along a certain trellis and they were 25 looking at the sun comes up in the east and sets in the 26 west, as we all know. It goes over -- the grapes would 27 receive the same duration of sunlight but it's much 28 hotter in the afternoon. 7 1 So, what they were determining is that if they 2 would pick these grapes on the p.m. side earlier in the 3 mix you get more of a brix, more sugar content, than you 4 do on the a.m. side. They would let those rest and 5 linger a little bit longer. 6 They ran two different bottles, two 7 different -- I guess actually casks of wine using these 8 grapes to determine whether or not this was the process 9 they wanted to use when -- when you have sunlight effect 10 on grapes like this. 11 You cannot take overripe grapes and under-ripe 12 grapes, put them together and -- and come out in the 13 middle. It just doesn't work that way. 14 This -- just this documentation. And if you 15 see this along you would never know. That this 16 documentation exists. This is one year's worth of 17 documentation for the -- for the -- I just brought with 18 me today. 19 So there is documentation that exists. Along 20 with the bottle closure project the substantiation -- 21 this was the bottle that came to Whitehall Lane from 22 Alcoa. Alcoa -- this would have been ready to go the 23 minute that -- that it came to Whitehall if they wanted 24 to use it that way. 25 The winemakers at -- at Whitehall Lane, along 26 with Mr. Leonardini, if you'll notice the difference in 27 the bottle necks on these, they're both the same size 28 bottles. With a process like this or a bottle like this 8 1 you get what they call ullage, which is too much air 2 and -- and oxygen, and that's not good for the wine. 3 So the bottle had to be redesigned. The cap, itself, 4 had to be redesigned. And as the Franchise Tax Board 5 points out, Mr. Leonardini did do some market research 6 on this -- this is ugly, to be honest with you. No one 7 is going buy a $100 bottle of wine with this cap on it. 8 To account for that, Mr. Leonardini's time -- 9 no one at Whitehall Lane has more than 40 percent 10 allocation on research. That includes their master 11 winemakers, all of his support. That's two days out of 12 five in a week. Mr. Leonardini is at 20 percent. That's 13 one day. 14 This was not a money grab by Whitehall Lane to 15 say we're going to include everything we do as research. 16 So we accounted for their market research side of 17 this -- this project. 18 In developing a bottle that they could use with 19 this cap they had to work with a bottling company to 20 come up with a different bottle. They had to work with 21 a capsule make -- or they developed a capsule, actually, 22 to keep the -- the closure on top of the bottle. They 23 had to retrofit their machinery to get it to work. They 24 had to do several things that -- to get this to be 25 something that they could use. 26 Case in point is a -- is a hold harmless 27 agreement that they signed with Alcoa before they could 28 use this. If Alcoa had made this product and was going 9 1 to stand behind it and it was their business component, 2 they wouldn't have required a hold harmless agreement 3 saying, hey, you're on your own with this. You've -- 4 you've made so many changes to this bottle and you've 5 made so many changes to this closure that you're on your 6 own. 7 With regard to what qualifies -- and pardon me 8 speaking so quickly but I'm trying get a lot of 9 information in here -- there's a -- there's actually a 10 case that was out of the California Federal Circuit 11 called Lockheed, and it had to do with this funding 12 issue. 13 In short, funding is a discussion between risk 14 and rights. Who has the risk in the research that -- 15 it's conducted, and then who ultimately has the rights. 16 In determining whether or not Lockheed maintained 17 substantial rights under the Code for the research that 18 it conducted -- this is -- this is what Lockheed gave 19 in -- in this case. The government in that case with a 20 contract had the unlimited right to use Lockheed's 21 technical data in disclosure to third parties. 22 Lockheed had to seek prior approval from the 23 State Department before entering any licensing 24 agreement. The Government had complete veto power over 25 whether Lockheed could file a patent application. 26 And also Lockheed had to pay the Government for 27 use of the research. And the Court found that the right 28 to use the research results even without the exclusive 10 1 right is a substantial right under the Revenue Code. 2 We're not here today to tell you that -- that 3 we have the right to sell this piece, to go and market 4 this piece to someone else. But the research that went 5 into working this existing technology into the Whitehall 6 Lane product is absolutely qualified research and its 7 not funded. 8 If it were funded we would not have a hold 9 harmless agreement with Alcoa stating that you're on 10 your own with this. 11 With regard to the other products -- or, excuse 12 me, the other research projects that we have here, the 13 wine-making and the vineyard projects, you know, I just 14 want to recite some of the statements made in the FTB's 15 brief that the method of making Cabernet Sauvignon was 16 laid down more than a century ago in Bordeaux, that wine 17 production by Whitehall Lane is merely tinkering, 18 nothing more than -- the vineyard projects are nothing 19 more than routine commercial farming. And that 20 Whitehall Lane did not create a -- they didn't qualify 21 for the research credit because they did not create a 22 new wine grape or a new method of growing grapes. 23 First of all, the method for growing these 24 grapes, there were new methods developed by Whitehall 25 Lane. But this -- this idea that you have to invent 26 something or it has to be new to the world, this has 27 been litigated over and over again and it's simply not 28 the case. It has to be new to the taxpayer, not new to 11 1 the world. The research does not have to meet, exceed 2 or expand the relevant science that we're dealing with 3 here. You're allowed to rely on existing principles. 4 You're allowed to rely on existing research. 5 That's how research is done in this country. 6 It's not done in these huge steps. You know, research 7 consortiums, universities are the ones that are creating 8 new sciences doing these things. This is a general 9 business credit. It is for businesses -- it's the -- 10 the credit for increasing research activity. That's the 11 actual title of this credit. It's not the credit from 12 new to the world products. It's -- 13 MS. OLSON: Time has expired. 14 MR. THOMPSON: Thank you. 15 MS. YEE: Mr. Thompson, let us give you time on 16 rebuttal. And we are going to want to hear more about 17 some of the other -- 18 MR. THOMPSON: Absolutely. 19 MS. YEE: -- issues in this matter. Let's hear 20 from the Franchise Tax Board. 21 MR. RILEY: Madam Chair, Members of the Board, 22 good morning. I'm Jason Riley for the Franchise Tax 23 Board. And here with me is Bill Hilson. 24 Briefly, the facts here, Appellants grow wine 25 grapes. They make and sell wine in the Napa Valley. 26 In 2005, Appellants amended -- filed amended 27 California returns claiming the R & D credit. 28 Respondent completed a thorough audit of these claims 12 1 and determined Appellants were not entitled to the 2 claimed R & D credit. 3 Respondent denied Appellants' claimed credit 4 far a total of $142,945 in R & D credit and this timely 5 appeal followed. 6 Under -- under Internal Revenue Code Section 7 41(d), which is applicable to California under Revenue 8 and Tax Code Section 23609, qualified research is a term 9 of art. The statute has a four-part requirement. One, 10 it must meet an Internal Revenue Code Section 174 11 expense. The activity must be technological in nature. 12 It must involve a new -- a new use for a business 13 component of the taxpayer. And substantially all of the 14 activities must involve a process of experimentation for 15 a qualified purpose. 16 To claim the -- to claim the credit a taxpayer 17 must first prove that they have engaged in qualified 18 research. Appellants have not met this -- the statutory 19 requirements and Respondent properly denied the credit 20 in full. 21 Appellants have claimed three projects in -- 22 with their amended -- with their amended returns. One, 23 they claim the bottle closure project. Two, they 24 claimed wine-making. And, three, they claimed a 25 vineyard project. 26 Each of these projects failed to meet the 27 requirements of Internal Revenue Code Section 41(d)(1). 28 With respect to the closure, this is not a 13 1 business component of the taxpayer. And these closures 2 are -- as the evidence provided with Respondent's brief 3 and indeed with -- with the -- the new exhibit provided 4 today, it's clearly -- these are clearly Alcoa's 5 products. These are not -- these are not Respondent's 6 products. 7 And, you know, there are many patents 8 throughout the world indicating that these are Alcoa's 9 and that they're invented by a German inventor, Dr. 10 Mateus. 11 The -- you know, the -- with respect to what 12 Mr. Thompson said regarding variation of the closure, 13 you know, quite frankly he -- he admitted that the -- 14 that documentation exists but that it was not provided 15 at audit. You know, if -- if Respondent does not have 16 access to these documents during the audit cycle -- you 17 know, this audit went on for -- for over a year. There 18 was -- there were site visits. There were multiple IDRs 19 issued requesting documentation. These -- these 20 documents were never provided. 21 With respect to the -- the bottle closure, the 22 research that appears to have occurred is not qualified 23 research as -- as, you know, term of art-wise as defined 24 in the statute. But it appears to have been market 25 research, which is specifically excluded as -- as not 26 being a qualified purpose. 27 With respect to the wine-making, you know, this 28 is a routine manufacturer of -- of wine, you know. 14 1 It's -- it's subjective blending. It's a -- it's an art 2 form rather than research. You know, again the -- the 3 requirement here is that there must be a process of 4 experimentation for a qualified purpose. And where 5 something is related to consumer preference or -- that 6 does not constitute a qualified purpose. 7 You know, this is art form that Appellants 8 became famous for prior to filing these claims. The 9 wines before you in 1997, one of the -- I believe it was 10 their cabernet, was rated as the number 3 wine in the 11 world. In 1998 it was rated as the number 5 wine in the 12 world. In 1999 it was rated as the number 5 wine in the 13 world. 14 Nothing changed with respect to these. And 15 that is -- that also falls under a specific exception to 16 qual -- to the qualified research. It's an adaptation 17 of an existing business component or it's a duplication 18 of an existing business component, both of which are 19 excluded specifically under the statute. 20 You know, with -- with respect to tinkering, 21 you know, just blending the wine for somebody's 22 subjective pallet is what the Courts have referred to as 23 tinkering. It's -- it's adding salt to a clam chowder. 24 It's -- you know, it's -- it's turning the dial on a 25 machine. You know, it's -- it's not qualified research 26 under the requirements of the statute. 27 With respect to the vineyard there's nothing to 28 indicate that this is anything apart from commercial 15 1 farming. You know. Again, it must involve a process of 2 experimentation. 80 percent of the activity must 3 involve a process of experimentation for a qualified 4 purpose. 5 Appellants have not demonstrated exactly what 6 the business component is in this case, exactly what 7 they did with respect to the vineyards. You know, 8 exactly why they did it. 9 Now, had -- had Appellants provided 10 documentation to -- to show that qualified research 11 indeed occurred, things may be different. However, they 12 have not proven that qualified research occurred and 13 therefore Respondent properly denied credit in full. 14 The -- the Treasury regulations that are 15 relevant to the -- to Section 41 include a recordkeeping 16 mandate which requires someone claiming the credit -- 17 taxpayer claiming the credit to provide documentation in 18 a sufficiently usable form and detail to substantiate 19 that the expenditures claimed are eligible for the 20 credit. 21 Now, the requirement is flexible with respect 22 to the type of documentation that's required -- that -- 23 the type of documentation provided, but the goal of that 24 documentation must be to demonstrate that -- that it met 25 the requirements of IRC Section 41(d). And the 26 documentation that -- that Respondent -- that Appellants 27 have provided in this case does not -- does not show a 28 process of experimentation. What it does show is that 16 1 Appellants make and sell wine, that they grow grapes and 2 that they're engaged in commercial farming. But these 3 are not -- these are not activities absent a process of 4 experimentation that can qualify for the research credit 5 under IRC 41(d). 6 With respect to the reasonableness of 7 Mr. Leonardini's salary or his compensation, the -- the 8 statute -- the -- the statute and Treasury regulations 9 state that it's reasonable if someone would be paid a 10 like amount for like activities by like under -- 11 enterprises under like -- like situations. 12 Is it reasonable that someone would make -- 13 that a winemaker would make $145,000 while the 14 winemaker's assistant is making $4 million? And if -- 15 if one were to look at a like enterprise and a like 16 situation as the winery across the street, are they 17 paying -- are they paying, you know, a chemist or 18 somebody, you know, $150,000 and paying the chemist 19 assistant $4 million? 20 Respondent found this highly unlikely and -- 21 and therefore found it unreasonable under the 22 circumstances, and so it did not meet the requirements 23 of the statute. 24 And so, with respect to, you know, a nexus 25 between the activities claimed -- that the activities 26 that Appellants claimed and the qualified research 27 expenses the -- which in this case is almost entirely 28 wages, there must -- you know, there's got to be a 17 1 connection. 2 First of all, they must prove that there is 3 qualified research occurring. And Appellants have not 4 done that. But in the case where someone has proven 5 that qualified research occurred, the taxpayer must then 6 demonstrate that the -- the -- the expenditures have 7 some connection to those activities. 8 MS. OLSON: Time has expired. 9 MR. RILEY: And -- and just in closing, 10 Appellants have not done that in this case. 11 MS. YEE: Okay. 12 MR. RILEY: Thank you. 13 MS. YEE: Thank you very much, Mr. Riley. Why 14 don't you take five minutes on rebuttal, and I'm sure 15 we've got lots of questions. 16 MR. THOMPSON: You bet. 17 MS. YEE: Okay. 18 MR. THOMPSON: Thank you. Thank you, Mr. 19 Riley. 20 Okay, first of all just to rebut some of the 21 statements that were made, the FTB did a thorough 22 examination -- let's talk about that. 23 Michael Hancock was the Associate Tax Auditor 24 and in the supplemental reply to our brief in this case 25 he attached an affidavit telling us at this time that 26 he -- I called Mr. Hancock back in -- on September 4th 27 of '07 and he said that he was denying the credit based 28 on the lack of substantiation and documentation. 18 1 That says nothing about funding. That says nothing 2 about qualified research, whether there was qualified 3 research or not. This is all drafted after the fact. 4 This is Tax Counsel's draft of what he thinks went on in 5 that case, not what was actually uncovered in the 6 examination. 7 As far as the business component, business 8 component is a specifically defined term in Section 41 9 of the Internal Revenue Code. First of all, you can -- 10 you can have research related to a new or improved 11 business component. The improved part is extremely 12 important. 13 What is a business component? A business 14 component is either a product, a process, a technique, a 15 formula, an invention or computer software. It is not 16 just the product, itself. The technique for 17 implementing this. The formulas for developing the 18 wines that they're developing. The processes to get 19 this to work with this bottle can be a business 20 component. It's not limited just to the widget that 21 comes off the end of the -- the development line. 22 The documents -- you know, Counsel stated the 23 documents were not provided. These are documents that 24 are attached to his brief. I just explained them to 25 you. I didn't provide them and drop them on you today. 26 These are things that were in his -- that are attached 27 to his brief. 28 There are spider graphs for -- excuse me. 19 1 There are spider graphs for chemical testing done on 2 the -- the bottles of wine that they were producing. 3 These are all attached. 4 This is a yeast experiment that they were doing 5 to determine whether or not they wanted to continue to 6 use indigenous yeast or they wanted to use lab-created 7 yeast. Those have some extremely important qualities 8 when you make that determination. 9 These are pressing records because you're 10 always trying -- in the -- in the making of this wine to 11 get as much out of the grapes as you possibly can. The 12 skin float to the top of the vat, so you have to come up 13 with different pressing techniques and develop these 14 pressing techniques to get the actual maximum out of the 15 wine that you can. 16 These records were all produced. They were not 17 hidden. They were not -- this isn't coming in after the 18 fact. Whether or not the Franchise Tax Board understood 19 what they were when they were presented to them, you 20 know, I can stick my head in the sand and say I didn't 21 see anything and I'm not lying, right? I mean, you have 22 to know what you're dealing with. 23 We provided the opportunity for them to meet 24 with Mr. Leonardini, Mr. Sylvester, Mr. McLoughlin, 25 all these individuals that could have explained these 26 documents to them. 27 As far as the market research that was brought 28 up, I explained, you're absolutely right there was 20 1 market research done here. No business does anything 2 without determining whether the market's going to bear 3 it, right? That's why the folks have no more than a 40 4 percent allocation. That gives you 60 percent, 5 Mr. Leonardini a 20 percent. He's probably the most 6 interested in the market research. 80 percent of his 7 time he spends doing other things. That was accounted 8 for. 9 Wine-making is an art form. I'm sure the folks 10 at U. C. Davis right now in the viticulture and enology 11 program would love to know that they're dealing with 12 art. It's not in the Art Department at U.C. Davis, it's 13 in the Science Department. Plant biology. Cellular 14 biology. Soil testing. Soil science. All these things 15 that they have to go through that are now a part of 16 wine-making, it -- it's not an art form. They would 17 love for it to be such. 18 As far as adaptation and duplication, you know, 19 Mr. Riley stated one year it was the third best wine; 20 the next year it was the fifth best wine; and then back 21 to the third best wine. If this was just adaptation and 22 duplication it would be the third best every year. It 23 would be the fifth best every year. It would just be a 24 static product. It wouldn't increase, it wouldn't go 25 up, it wouldn't go down. 26 Lastly, with the reasonableness of Mr. 27 Leonardini's salary, Mr. Riley points to Section 174 of 28 the Internal Revenue Code, which has a specific 21 1 reasonableness requirement in it. 174 is the deduction 2 for research. Section 41 is the credit research. 3 In the 1990s the IRS made an argument on 4 someone taking a 174 deduction saying that it had to be 5 reasonable. 6 The Court in United States versus Driggs said, 7 no, no, no, we're going to read the statute as it's 8 written. There is no reasonableness requirement in 174 9 so you cannot raise that. 10 Congress went back and amended 174 to include a 11 reasonableness requirement. The same year they made 12 amendments to Section 41. If they wanted a 13 reasonableness requirement to be in Section 41 it would 14 have been put in there. 15 Section 41 refers you to -- when you're 16 determining what wages are, refers you to Section 3401. 17 Wages are specifically defined as any amounts that you 18 receive -- bonuses are included -- any amount of money 19 that you received that would be on a -- on a W-2 can 20 qualify as wages for Section 41. There specifically is 21 no reasonableness requirement in Section 41. 22 MS. OLSON: Time has expired. 23 MS. YEE: Mr. Thompson, let me have you stop 24 there and entertain questions. Okay? 25 MR. THOMPSON: Absolutely. 26 MS. YEE: Very well. Comments or questions, 27 Members? 28 MS. STEEL: I have a question. 22 1 MS. YEE: Ms. Steel. 2 MS. STEEL: For FTB, that R & D according to 3 IRS code, that's mostly that big companies have to meet, 4 but this is the wine -- winery, that it's not really as 5 big that, you know, they are doing their own R & D that 6 how you approach this kind of audit? 7 MR. RILEY: Well, with respect to that, that's 8 why the -- the documentation requirements are flexible. 9 Because the IRS realized that a large company is not 10 going to have the same recordkeeping as -- as a smaller 11 company. However, that does not mean that -- that there 12 is no recordkeeping done. You know. 13 Appellants have admitted that they have 14 documentation that they haven't shown to Respondent. 15 MS. STEEL: But auditor went out for three or 16 four days, that how you find out that their research was 17 qualified or not? Because -- let me ask you one thing, 18 do you drink wine? 19 MR. RILEY: I do drink wine. 20 MS. STEEL: So you know about wine? 21 MR. RILEY: Yes. 22 MS. STEEL: So 2006 is more expensive than 23 2005. It depends on that how much rain that they had 24 and how much -- you know, sunlights that they had and 25 how the weather was. 26 MR. RILEY: Certainly these are -- you know, 27 these are things that go into -- to wine-making, yes. 28 MS. STEEL: It is -- I think wine-making -- I'm 23 1 not expert on wine, but I enjoy it, so I know a little 2 bit about it. It's a science. I mean, you know, you 3 really have to study it that every moment of it and, you 4 know, I really don't understand that, you know, how you 5 going to put those R & D -- to IRS code that winery is 6 different than those new technology companies, and R & D 7 is totally different winery versus other companies. 8 So, I -- I really don't understand that when 9 auditor goes out for three or four days and they said, 10 you know, no, this research is not qualified. 11 I mean, I -- I don't buy that. So, you know, 12 it -- I think every industry has to have different way 13 to weigh in that when they audit. That's what I think. 14 And second thing is, do we have any mandate to 15 salary requirement for all small companies? 16 MR. RILEY: No. 17 MS. STEEL: I think -- so, so much -- you know, 18 my husband is an attorney. Some law firm that they own, 19 somebody gets $20,000 a year. Somebody get half million 20 a year. So IRS can -- IRS and Franchise Tax Board can 21 go out there that other next door law firm is getting 22 only 20,000 so you cannot get paid a half million 23 dollars, because that's not right. 24 I think that's exactly what you are saying to 25 this winery. 26 MR. RILEY: If I -- if I might clarify, what 27 we're saying is that when the winemaker is only making 28 $150,000 -- 24 1 MS. STEEL: But who -- 2 MR. RILEY: -- a year -- 3 MS. STEEL: -- who cares? 4 MR. RILEY: -- the assistant -- it's -- it 5 seems unreasonable that somebody who's only the 6 assistant or is just assisting in that wine-making is 7 making 17 times that. 8 MS. STEEL: Well, you know, I -- I really don't 9 understand that. It's only happens in Communist 10 countries that if somebody gets paid -- that this 11 technician gets paid $10 an hour, next door gets paid 12 50, no, he cannot get paid because average is $10. 13 I -- I just really don't understand that why 14 Franchise Tax Board is going after that his salary 15 that -- he gets to get paid whatever he wants, it's his 16 company. 17 MR. RILEY: Well -- 18 MS. STEEL: And, you know, he puts four hours 19 in it every day, and he wants to get paid $10 million, 20 let's be it, you know. Because he is paying income 21 taxes on whatever he gets from that amount. 22 So, I -- I just really don't understand that 23 why we have to go through this with this company that, 24 you know, from the cap to R & D to salary just doesn't 25 make any sense. Especially those caps, the same thing, 26 too. 27 I was raised in Japan. That you go to the sake 28 makery -- you know, those Japanese alcohol, that they do 25 1 their own caps. They do their own bottle. They make 2 their own different sake there. So when you go out 3 there there's hundreds of different kind of things. 4 They do their own R & D to make the most possible way to 5 cap it for that -- their own bottle. 6 So, you know, even it was invented by Germany 7 with one of the doctor, but they are making their own 8 wine and they are doing their own research. From there 9 they can improve better. That's still R & D for me. 10 So, I -- I just really don't understand that 11 why they are here, that they have to prove themselves 12 that this R and D to start with, and the cap is same -- 13 same thing, too. They're -- they have a lot of 14 different technologies to screw top to -- so many 15 different things. You have to looking at those -- not 16 just wine, but other drinks, too. 17 Those caps are fascinating because when you 18 open up the -- one of the Sake they have actually 19 rubber-banded kind of that they are using it. You pop 20 it. I mean, it's just amazing industry that you can 21 really see that when you really study it. 22 So, I really don't understand that this part 23 that, you know, why they have to prove that this is 24 R & D because they been doing it. And when they say 25 that they are doing it then we have to believe they are 26 doing it. 27 So, that's -- 28 MR. RILEY: Well -- I apologize for 26 1 interrupting, but in this case they are not doing 2 qualified research as it's defined under the statute. 3 You mentioned earlier -- 4 MS. STEEL: How you going to define it? How 5 do -- how you going to define it that statute is so many 6 different kind of industries have so many different R & 7 Ds, how you going to define each industries? How you 8 going to define it? You have to be flexible, it's 9 depends on the industries. That's what I'm saying. 10 MS. YEE: Let me have Mr. Riley answer and then 11 I want to hear from Mr. Thompson on that same question. 12 MR. RILEY: We are -- I mean, we are very 13 flexible. I mean, you mentioned earlier U.C. Davis, 14 that the people at U.C. Davis are doing research. The 15 people at U.C. Davis are also publishing -- publishing 16 their papers that detail their hypotheses and their 17 theories and the tests that they did and the analysis of 18 those tests to -- 19 MS. STEEL: So, great, that's R & D -- 20 MR. RILEY: -- and that is R & D. 21 MS. STEEL: -- and this is R & D. 22 MR. RILEY: That -- that -- you know, and in -- 23 in this case I would say that the most likely situation 24 for a winery in general would be that they would fund U. 25 C. Davis to do something called basic research, where 26 U.C. Davis, they have the labs, they have the equipment, 27 they have the Ph.D.s to go and -- and do the R & D. 28 MS. STEEL: May I ask just one more question? 27 1 So when they provide money to U.C. Davis that's R & D 2 and R & D expenses then? 3 MR. RILEY: It -- it can be. It can qualify as 4 something called basic research. 5 MS. STEEL: You know, it doesn't really make 6 any sense. 7 MR. RILEY: And then -- and then the taxpayer 8 could get something for it at 65 percent. 9 MS. STEEL: I want to hear from the taxpayer. 10 MR. THOMPSON: Okay. So -- well, first of all, 11 what qualifies as research? Again, we talked about it; 12 new or improved business component, and the research 13 related to that. Also, whether or not the research 14 you're doing is technological in nature. 15 So, you're talking about is it a hard science. 16 Not management, not velocity, things like biology, 17 chemistry, things of that nature. 18 Is there uncertainty at the outset? And that 19 uncertainty can be one of three types of uncertainty. 20 It could be the obvious, which is can we do it, 21 capability. There's also uncertainty in, okay, I think 22 we can do it but how do we do it. And there can be 23 uncertainty in the ultimate design. What's the ultimate 24 design going to be? 25 And finally you have to go through a process of 26 experimentation to overcome that uncertainty. That 27 doesn't have to be done at a university. This is a 28 general business credit. I mean, you have to be making 28 1 money to even take this credit. If you're at a net 2 operating loss it's no good to you. 3 So, I mean, this idea that now that -- we're 4 going to read into Section 23609 or Section 41 that you 5 have to be -- you know, you can only do research 6 through -- you know, through colleges -- my point in 7 pointing out U. C. Davis was not to point out they're 8 doing research there, but to point out they're -- 9 they're educating kids to come and be in this industry. 10 They're not teaching -- I mean, they're not teaching 11 them, hey, whenever you get out there in the world, make 12 sure you come back here so we can do your research for 13 you. 14 They're educating these kids so they can go out 15 and work for people like Whitehall Lane Winery and -- 16 and make -- and make wine. 17 MR. LEONARDINI: May I speak to the bottle? 18 MR. THOMPSON: Absolutely. 19 MS. YEE: Mr. Leonardini, please. 20 MR. LEONARDINI: May I speak to the bottle 21 issue, please? When -- when this glass closure was 22 first used it was used only in Germany and it was only 23 used for Rieslings. We were the first in the United 24 States to be approached by Alcoa. They were referred to 25 us by the bottle company. 26 May I have the first bottle. When we saw it 27 looked -- this looked like one of the devices that 28 supermarkets put on the top of a bottle to keep it from 29 1 being stolen, and as you go to check out the clerk takes 2 this thing off of the top. 3 Also, this top, you just touch the side -- I'm 4 trying to go slow -- it pops off. And we said it won't 5 work this way. We -- we're going to modify it. We're 6 going to work on it. And we signed a hold harmless to 7 that effect. 8 The ullage is the space between the bottom of 9 the cork and the wine, and it shouldn't be more than 10 maybe a third of an inch. If you go to any auction, go 11 to any bottle shop and look at wine and you see a large 12 ullage it probably has a defective cork. There's been 13 evaporation. That's why you keep a bottle on its side 14 with the cork, to keep the cork moist to try and 15 eliminate evaporation. 16 We took a bottle and -- and this doesn't fit on 17 any bottle. You just don't buy a top and say, "I think 18 I'll put this on a fancy Italian bottle." It won't 19 work. The bottle is a receptacle for this top. 20 We -- we went to a wider bottle for a little 21 more appeal. The bottom of this bottle, if you see an 22 indentation it's called a punt. We put an artificially 23 large punt on this bottle to raise the level of the 24 wine. So, when you see the ullage between the closure 25 and the wine it's the normal size. 26 Bear in mind when this goes into a bottle this 27 is only one -- third the size of a cork. So, we amended 28 the bottle. It was a two-year process. When we finally 30 1 got down to using the top we had Alcoa make a top 2 smaller to fit the modern bottle. We then had problems 3 with it was coming off too easy. 4 We developed this capsule. We bought a special 5 machine that the manufacturer designed just to work on 6 this lid, and then did internal modifications to make it 7 work. We still had a problem, though. Restaurants 8 would cut around this lid here and the top would just 9 fall off as they're cutting it. 10 We then went to a different O-ring and it had a 11 little bit of glue put in it. We then -- and that 12 didn't work. Another year we tried to heat these to put 13 them in so that it would seal tighter. Then we had a 14 problem pulling them out. 15 It -- this is really an ongoing deal and it's 16 unfortunate that when the auditors came into our office 17 they didn't even ask to see a bottle. It wasn't even 18 part of the equation. It was like they -- they came 19 from a nice lunch in the Napa Valley and let's beat 20 traffic on the way back to Sacramento. 21 MR. THOMPSON: With regard -- also with regard 22 to documentation, I specifically brought stuff that's 23 attached to their brief. I -- I didn't bring anything 24 in here today. There is no new documentation. 25 I could have driven a truckload of this stuff 26 up to the FTB. They don't -- and I don't fault them for 27 not understanding what this is. I didn't know what this 28 was when I first got it. But I sat down with the 31 1 winemaker and he explained it to me. And that's 2 what's -- you know, that's what we're talking about with 3 documentation is not this idea that we're coming in 4 after the fact and, oh, here it is, here's all this 5 documentation. It was provided. An opportunity to 6 review it was provided. But it either wasn't taken or 7 it wasn't understood. 8 MS. YEE: Okay, let me stop you there. I have 9 a couple questions for the Franchise Tax Board. 10 I am a little concerned about the process that 11 ensued here because it seems to me there may not have 12 been clarification about what specific documentation may 13 have been required. But after -- 14 MR. THOMPSON: There's actually -- I'm sorry. 15 MS. YEE: Let me get through this line of 16 question first. 17 MR. THOMPSON: I apologize. 18 MS. YEE: With respect to the documentation 19 that was requested prior to the field audit, how 20 specific was that request for documentation? Do you 21 recall? 22 MR. RILEY: Well, those -- those requests are 23 attached to Respondent's brief and -- and I -- you know, 24 I believe they -- they requested, you know, if Mr. 25 Thompson has them there. I mean, you know, I -- I don't 26 recall exactly what the -- what the -- the request said. 27 However, I -- you know, they -- they requested documents 28 to -- to demonstrate that -- to substantiate that the -- 32 1 that Appellants were in fact engaged in a process of 2 experimentation with respect to the wine. 3 MS. YEE: Okay. 4 MR. RILEY: And just -- you know, I myself, I'm 5 a chemist and -- a bio-chemist, so I understand the 6 documentation that's been provided. And so, it's -- you 7 know, it doesn't -- the fact that, you know, Appellants' 8 counsel has said that Franchise Tax Board didn't 9 understand the -- the chemistry or -- or the enology, 10 that's not the case here. 11 MS. YEE: Okay. Okay, let's -- I appreciate 12 that. And then when the field audit actually took place 13 in July of '06, subsequent to that there were additional 14 documents that were requested by the Franchise Tax 15 Board. And I guess my question here is there wasn't a 16 detailed position letter that was issued after the field 17 audit, and so what were we looking for I guess relative 18 to the additional documentation after the field audit 19 took place that would have been clear for -- for the 20 Appellant in terms of what to provide? 21 MR. RILEY: I mean Respondent requested, among 22 other things, you know, the -- the -- any contracts or 23 agreements with -- with Alcoa with any the vendors and 24 those things were not provided. 25 MS. YEE: Okay. 26 MR. THOMPSON: I'm going to have to be shown 27 that, because I don't -- I don't believe that to be 28 true. I don't think there was a request for -- I could 33 1 be wrong but I don't -- I don't immediately recall 2 that. 3 MS. YEE: Okay. And then I want to get back to 4 Mr. Leonardini's description of the bottle closure 5 project. It seems to me of the three projects that were 6 part of this study that this one is I think the most 7 compelling to me with respect to the degree of 8 experimentation, certainly. 9 I think the fact that there was a no-fault 10 contract that existed with Alcoa at least suggested to 11 me that -- that there was -- there definitely was quite 12 a bit of experimentation that went into this. 13 With respect to the other two projects, I -- I 14 think the heft of that type of documentation, at least 15 in my mind, is not as substantial. I guess given that, 16 the question I have for the Franchise Tax Board is you 17 mentioned I guess the -- the existence of a patent. Is 18 there a provision within the IRC Codes that require 19 existence of a patent and is there any difference in 20 terms of who holds the patent? 21 MR. RILEY: Well, there is definitely a 22 difference when someone else holds the patent and 23 someone's not, you know, on -- if someone's name is not 24 on the patent. 25 They mentioned that there was a second stopper, 26 and I believe that there was -- there was -- Alcoa also 27 received a second patent related to the -- the second 28 closure. And nowhere on that document does it list, you 34 1 know, any contribution with -- with respect to 2 Appellants. 3 It's not a business component of the taxpayer. 4 It's -- it's they're purchasing a commercially available 5 product from someone else and using it in their product 6 for the intended purpose. You know, this is not -- you 7 know, you don't get the research credit for -- for doing 8 that. You know, there's -- there's no -- there was not 9 any experimentation shown during the audit with respect 10 to that. 11 Now, Mr. Leonardini has, you know, stated that 12 they did certain things. Whether or not that rises to 13 the level of qualified research, you know, I can't say 14 because, you know, there's nothing -- there's no other 15 documentation to indicate that there was a process of 16 experimentation. There's no -- I don't know if Mr. 17 Leonardini did that; if some outside contractor did 18 that; if -- if Alcoa did it. You know, there's no -- 19 there's no documentation to show who in fact did any of 20 those things. 21 MS. YEE: Okay. And then I guess -- 22 MR. RILEY: Sorry. The only thing that -- that 23 we have are United States and European patents 24 indicating that this is Alcoa's business product and 25 in -- in such a case -- and that Appellants did not have 26 any -- any right. 27 I mean, the document here that they -- this -- 28 this contract, you know, it states right on here that 35 1 it's for a market trial and that Whitehall Lane gets to 2 use the product in its retail wine business. You know, 3 that's -- that's the extent and it appears without -- 4 you know, without -- you know, on first blush here that 5 this would be excluded under 41(d)(4) as research that 6 occurred after commercial production. 7 MS. YEE: Okay. Mr. Thompson. 8 MR. THOMPSON: The patent is on this. We've 9 admitted the patent is on this. This is -- 10 MS. YEE: The patent is on that -- 11 MR. THOMPSON: -- is on this -- 12 MS. YEE: -- and the patent is held by Alcoa? 13 MR. THOMPSON: Alcoa. This does not get you to 14 a bottle of wine. They had to buy machinery, retrofit 15 that machinery and develop the capsulation process for 16 this. There's a winery next door, right next door to 17 Whitehall Lane, who purchased these same things from 18 Alcoa. They can't use them. They came to Mr. 19 Leonardini and said, "Hey, can we use your machines to 20 put this on?" 21 He said, "Heck, no, I compete with you guys. 22 There's no way I'm going to let you do that." 23 This by itself does nothing. This is a 24 paperweight without the know-how or the technology to 25 put it on this bottle and make it stay on there. 26 As far as whether there's documentation 27 involved, I've been showing you documentation. Again, 28 if you come and you look at two pieces of paper and you 36 1 don't understand them, again I don't want to beat a dead 2 horse here, but there is documentation available. 3 They could have gone and looked at the 4 machinery that they -- that they designed. You know, as 5 far as these -- this brings me to another point, one of 6 the cases they cited -- the Franchise Tax Board cited in 7 their brief was the United States versus McFarren. That 8 was a District Court case out of Houston. That went up 9 to the Fifth Circuit and was vacated. 10 The Government in that case made the exact same 11 substantiation argument that the Franchise Tax Board is 12 making here today and made in this document. They've 13 never supplemented this to inform the Board that this 14 case has been vacated. It's cited ten times in this 15 document. 16 In that case they -- the Franchise Tax Board 17 makes the specific statement it's not enough to just be 18 doing research. You have to have documentation. 19 That -- that was specifically addressed by the Fifth 20 Circuit. And they said, no, if research was conducted 21 the Courts should estimate the expenses associated with 22 those activities. To do this the Court should look to 23 testimony and other evidence, including institutional 24 knowledge of the employees in determining a fair 25 estimate." 26 This is not an either/or one document. In -- 27 in Treasury decision 8930, Treasury tried to write into 28 the -- the Treasury regulations a specific documentation 37 1 requirement that you track hypotheses, things that you 2 overcome, things of these nature. 3 One month after that was put out Congress said 4 no way. They went back and they pulled TD 8930 off the 5 shelf and issued proposed regulations doing away with 6 that specific document requirement. 7 This has been tried. It's exactly what -- what 8 Mrs. Steel was talking about. Every business, you have 9 to take them in the position they stand. You cannot 10 require Whitehall Lane to have the same type of 11 documentation Union Carbide has. It's just not going to 12 happen. 13 Again, this is -- the Whitehall Lane is not in 14 the business of taking the research credit. They're in 15 the business of making wine. The research credit is an 16 incentive for them to continue to do that and continue 17 to hire people. That's exactly what this credit's for. 18 It was passed in 1981 to -- to offset Japanese 19 influence -- when we were competing with Japan on the 20 technological scene. 21 We're very similar now in our economic 22 situation. Chile, Portugal, a lot of Spain, they're 23 sending wines over here that are very good and they're 24 $8 bottles of wine. I mean, if you're going to sell 25 somebody a $100 bottle of wine to put down with a 26 prototype top that they may not open for ten years, you 27 better be darn sure it works. 28 MS. YEE: Okay. Let me have you stop there. I 38 1 guess what I would say to you with respect to the 2 vacating of the McFarren case is that we then still have 3 regulations that would be controlling here. 4 I guess -- and let me conclude my questions to 5 the Franchise Tax Board. What would be compelling 6 documentation that would prove experimentation? 7 MR. RILEY: In this case here? 8 MS. YEE: Yes. 9 MR. RILEY: The experiments that show that -- 10 that Appellant was the one that -- that did something 11 with -- with the -- that engaged in the process of 12 experimentation with -- with the stopper, for one. 13 But, you know, a lab -- a lab notebook to that 14 effect. You know, correspondence between Leonardini -- 15 Whitehall Lane and Alcoa regarding their findings. 16 Correspondence between Whitehall Lane and Encore Glass, 17 which apparently is the -- the bottle manufacturer. 18 Documents such as those that -- that when -- when 19 brought together would prove that qualified research had 20 occurred. 21 MS. YEE: Okay. And to Mr. Leonardini and 22 Mr. Thompson, do those documents exist, those specific 23 types of documents? 24 MR. THOMPSON: There's -- there's no lab 25 notebooks for development of a bottle. There's going to 26 be -- I imagine there's going to be -- 27 MS. YEE: Any -- 28 MR. THOMPSON: -- e-mail correspondence between 39 1 Alcoa and the companies. There were -- again, there 2 were face-to-face meetings. They could test the 3 credibility of these individuals through side visits if 4 they wanted to. The machinery is there. That -- I 5 mean, it's not just a piece of paper. If you go out 6 there and look at the machine and you see how it was -- 7 how it had to be modified to fix this -- to affix the -- 8 I mean, it's a corking machine. It runs cork and glass. 9 MS. YEE: Sure. No. 10 MR. THOMPSON: So I mean as far as there being 11 a specific documentation requirement, I just -- you 12 know, again you have -- you have to take taxpayers as 13 they sit. If we go into Court on this he's going to be 14 up on the stand using his institutional knowledge and 15 his testimony along with the documentation. I mean, 16 it's not a -- here's a piece of paper, we win. I agree 17 with him on that. 18 You know, this -- if this doesn't show or 19 doesn't give you any inkling of what was going on there 20 then it's -- it's worthless. But if you sit down and go 21 through this with somebody with knowledge they can 22 explain to you what -- you know, where the research was. 23 There's not going to be a -- a document in this case 24 that says, "Well, under Section 41(d)(2)(b) we tried 25 this." Under Section 41(d) -- 26 MS. YEE: Mr. Thompson, we're not looking for 27 that. What I'm really after is, is there any other 28 supporting documentation such as correspondence with 40 1 Alcoa or -- I mean, I'm -- I don't have any doubt that 2 Whitehall Winery went through all these processes. The 3 question is under whose direction? To what end are the 4 processes documented. Was there back and forth 5 correspondence with Alcoa? 6 I think what Mr. Leonardini laid out makes 7 perfect sense to me in terms of how you got to the final 8 product. And that I do think that in order to really 9 provide those substantiation that experimentation did 10 take place we need a little bit more than just kind of 11 what's been provided or at least some elaboration of 12 what's -- you know, took place. 13 MR. THOMPSON: Okay. Well, again, we have a 14 hold harmless agreement is the best evidence that 15 Alcoa -- if they had developed -- you know, again -- I 16 don't know -- 17 MS. YEE: Are there any -- 18 MR. THOMPSON: I don't know if an e-mail is 19 going to show you, okay, remember, this is our product, 20 not yours. 21 MS. YEE: No, or just some -- some sort of 22 progress, you know -- 23 MR. THOMPSON: Sure. 24 MS. YEE: -- correspondence as you were 25 developing -- 26 MR. THOMPSON: Alcoa didn't have anything to do 27 with building the machine. I mean -- 28 MS. YEE: No, no, no. 41 1 MR. THOMPSON: -- Alcoa is not in the business 2 of -- 3 MS. YEE: I'm going to stop you there. That's 4 not what I'm asking. 5 MR. THOMPSON: What -- okay, what I'm trying to 6 show you is that -- that you have to look at everything. 7 MS. YEE: No. 8 MR. THOMPSON: I mean -- 9 MS. YEE: And I -- I understand that. 10 MS. MANDEL: Madam Chair. 11 MS. YEE: Yes, Ms. Mandel. 12 MS. MANDEL: Maybe -- can I try -- 13 MS. YEE: Please. 14 MS. MANDEL: -- a little bit? What Mr. 15 Leonardini described and it's his company so I -- you've 16 probably been through the records but maybe he also 17 knows what they have or don't have. 18 He described on this item getting the glass 19 piece from Alcoa with a bottle that came from the bottle 20 company that because of his wine-making experience when 21 he looked at it he's like that bottle -- it's not going 22 to work for the reasons he described. 23 It sounds like his description is that the -- 24 what you would say is the process of experimentation was 25 making -- was sort of two things, making a bottle that 26 would work with the type of closure he was being 27 presented with, because the closure was short and the -- 28 and shorter than a cork for the reasons he explained. 42 1 He doesn't want that much room between the closure and 2 the actual product in the bottle. 3 So, it's not his company that made the bottles. 4 He may have had some correspondence, maybe he just 5 picked up the phone, I don't know, he hasn't said, with 6 the guys who make the bottles, but the guys who make the 7 bottles may have something that says, hey, Leonardini 8 called us and we got a problem because he wants to use 9 this new fancy thing from Alcoa and it doesn't work with 10 with existing bottles. He wants us -- you know, we need 11 to do a bottle that has whatever you called it, to push 12 the wine up and all of the other things. 13 Same thing, he didn't make the machine that 14 puts the closure in. He had to adjust the machine. I 15 don't know if that's the machine-maker who had to make a 16 machine that worked or whether his guys worked with the 17 machine. I don't know of that working with the machine, 18 FTB might say, oh, that was just tinkering with the 19 machine, I don't know. 20 But I don't know if at the company, at 21 Whitehall they do everything by, you know, going into 22 the back room and saying, hey, Joe, you know, can you -- 23 can we -- can we put something there because this is 24 what's happening. This is what we're finding in the 25 field. 26 When I read that it was market research, you 27 know, I -- I thought of it more in terms of -- with 28 respect to the bottle in terms of whether people 43 1 would -- would like a bottle with that just as, you 2 know, we went through this whole thing that you can read 3 about of whether people were going to accept high end 4 wines with the screw tops after the screw tops started 5 coming in from Australia or wherever they were coming in 6 from, or more common on a better wine than what -- you 7 know, Thunderbird or something that people were more 8 used to associating screw caps with. 9 But it sort of -- not just his -- you know, his 10 testimony is good but what records might there be or 11 what third party records might there be, or third party 12 information that would support the story that he's 13 telling of how they worked with the top and the bottle 14 and the product to get something that worked as a 15 practical matter for their business. 16 And then, you know, whether or not FTB or this 17 Board thinks that that whole thing is a process of 18 experimentation and qualified research, then you still 19 have to sort of figure out how do you allocate expenses 20 and how do you demonstrate the expenses. 21 I think that's the kind of stuff that the 22 Chairwoman, if I can guess what she's talking about, is, 23 you know, looking for more of a handle on what really 24 went on to substantiate -- you know, he's telling a good 25 story and we didn't hear that story before on the 26 bottles. I think it would be the same kind of thing 27 on -- on the -- the other two that you have, the 28 wine-making project and the vineyard, it's a little 44 1 hard, you know, to know and -- and kind of exactly 2 everything that went on, and sometimes it's -- you know, 3 taxpayers come in and we -- we say, well, you know, we 4 made the people available and FTB didn't even talk to 5 them. 6 Well, you know, that's an issue at the audit 7 and an issue with the auditor or whatever, but it's also 8 the taxpayer's burden to tell the story and show how it 9 works. You know, it may be -- you know, I hear it's 10 just commercial farming. But I don't know that it's the 11 case because I haven't really heard it argued and I 12 don't remember from the briefs, that even a farmer, 13 granted they're growing grapes -- that even a farmer who 14 wants to make better -- I don't know, corn or anything 15 or cattle or whatever they're doing, can they not set up 16 a test garden in one place and a test garden in another 17 place to see the effects to decide how they want to 18 improve their production? 19 I don't -- you know, is that -- is that in the 20 context of farming something that's excluded from R & D 21 credit because it's farming or because it's -- I guess 22 you would say -- FTB might say adaptation or duplication 23 of existing product or something -- but I don't know how 24 that fits in but again then that's an issue of you have 25 these charts that you're saying are -- you know, I know 26 guess like two test plots. But if they haven't been 27 adequately explained and otherwise substantiated of 28 why -- you know, why -- how it was being done and why it 45 1 was being done and then what use it was put to, its a 2 little hard for FTB or the Board to, you know, get to 3 it. 4 And -- and I guess that's the vineyard project, 5 and the wine-making project, you know, it's -- again, 6 I -- I just thought it was kind of the same thing. It 7 wasn't clear to me whether these were the types of tests 8 and reports that are done in the matter of course in any 9 sort of winery, brewery, distillery where they're 10 testing the batches to making sure they're not going off 11 or does this one need more time or whether these were 12 somehow -- you know, the guys in the back room trying to 13 figure out for -- you know, for next year's vintage what 14 if we -- what if we, you know, did something more, added 15 something or -- or did something -- I don't know enough 16 about it to make something up -- that somehow improves 17 the product in the bottle that's beyond the tinkering. 18 It's not -- I just don't feel like it's 19 specific enough to know what's really going on and 20 whether that's a failure of FTB to interview people 21 and -- and look at the different things that go on. I 22 don't know at what years all these different activities 23 relate to. Even the bottle closure, I don't know really 24 exactly the period of time that all these things were 25 talked about were happening, and then how they fit into 26 the law. 27 But it's -- it's kind of hard to approach it 28 with just sort of a generalized, you know, report. It's 46 1 always very helpful -- and I say I don't know if it's a 2 failure of FTB, I don't know if it's a failure of 3 taxpayer, it is the taxpayer's job to really tell your 4 story and explain it. 5 So I don't -- that's a very long sort of on all 6 the three projects, but what types of documents and 7 materials that we would have expected to see to 8 support -- that you could qualify these things and -- as 9 process of experimentation. And maybe they're just out. 10 MR. THOMPSON: The last thing I will say about 11 the product, and it kind of goes back to -- hit your -- 12 I mean about the documentation it goes back to your -- 13 your statement is that there was no guidance at the time 14 this thing was calculated as to what docu -- what types 15 of documentation you should keep, things of that nature. 16 That's what these audit technique guides try to do. 17 They come out and they say, "Look, when you go out and 18 audit someone you should be looking for X, Y and Z." 19 These things weren't in existence. I mean, 20 even if they had wanted to try to comply with -- with 21 any specific -- specificity, whatsoever, it -- they 22 wouldn't have known what to do. 23 With regard to third party documentation, I 24 don't know if I have the right to go to Encore and say, 25 "Give me your internal correspondence that you guys had 26 with each other and bring that forward. 27 You know, it is the burden of the taxpayer but 28 it's the burden of the taxpayer to provide the 47 1 information that they have, not create information that 2 doesn't exist. 3 And so in this case we contend that -- that 4 there's documentation. There's substantiation outside 5 of documentation, be it both physical and also 6 testimonial and there's also adequate documentation to 7 explain the -- the wine-making and the vineyard project. 8 So, short of belaboring this documentation over 9 and over again, which we'll be glad to do, but to answer 10 your question, I'm sure there is correspondence between 11 Mr. Leonardini and Alcoa but, you know, as far as -- 12 during the examination, you know, what was specifically 13 asked for, it was -- it was -- it's very broad. Give us 14 all the documents that show your process of 15 experimentation. 16 Well, okay, that could be everything. I mean, 17 that could be -- without context it -- it's nothing. 18 MS. YEE: Yeah. 19 MR. THOMPSON: So it's very difficult to -- in 20 your regard, to face an audit, an examination where you 21 think they're searching for something else and then have 22 a 200 page essentially recitation of the Section 41 all 23 the reasons why you don't qualify for it. I mean, 24 it's -- 25 MS. YEE: Let -- yeah, Mr. Thompson, and I 26 would say -- and if I were in your shoes and 27 Mr. Leonardini's shoes that's a very unsatisfactory 28 response. But -- but I do want to -- want you to take 48 1 to heart what Ms. Mandel has -- has so aptly elaborated 2 upon in terms of, you know, just kind of the flavor of 3 the kinds of -- of, you know, backup that we need, 4 frankly. 5 And if you believe it's there, and may be hard 6 to get to, I think this Board would be inclined to give 7 you additional time to do that. If you don't believe 8 it's there I think just in terms of certainly what I've 9 seen the more generalized, you know, types of documents 10 that really don't kind of help me get to where I think, 11 well, we need to go. 12 I have no reason to not believe that Whitehall 13 Lane Wineries and Mr. Leonardini was engaged in all 14 these different projects, and to some great extent 15 which, but we do need to -- to see more. 16 And -- and I don't want to relive -- I think 17 there's been probably adequate deficiencies with respect 18 to the documents that have been requested previously, so 19 I don't want to relive that. We got the issue before 20 us. I want to hone in on what specifically more we 21 would need to look at to substantiate your case. 22 I want to get to Ms. Steel, then Ms. Alby, and 23 then Mr. Horton. 24 MR. THOMPSON: Okay. 25 MS. STEEL: This is just yes and no answer, 26 that did IRS allow your R & D credit for, you know, year 27 2001 to 2004? 28 MR. THOMPSON: Yes. Yes, ma'am. 49 1 MS. STEEL: Okay. Thank you. 2 MS. ALBY: Thank you, Madam Chair. I have to 3 say I am incredulous that the Department was not 4 interested in talking to you regarding the documents 5 that you submitted to them. Despite the fact of being a 6 chemist, I have a relative who's a chemist, and I would 7 guess that he would have a very difficult time looking 8 at this and understanding what it all means to your 9 industry. 10 He understands rocket fuel but he doesn't 11 understand grapes. 12 So, I guess as we're looking for more 13 documentation for this, I have a hunch that if there had 14 been that dialogue, if there had been that interchange 15 between the Department and the taxpayer that this sounds 16 like there might be circumstances in experimentation 17 that are unique to the industry and that could have come 18 forward, and that investigation should have happened 19 before you got here, in my estimation, before you 20 arrived here. 21 So I don't know how we rectify that, that we 22 insist that you meet them and you see their product and 23 you see their preparation and you go through those -- 24 understand their processes that they've been through. 25 I don't think you can look at this and 26 determine that without asking questions. 27 MS. YEE: Thank you, Ms. Alby. Mr. Horton. 28 MR. HORTON: Question of the Department, let me 50 1 make a general statement, though. I mean, generally 2 speaking there's a cost associated with R & D. And 3 typically in the R & D process there's -- there's a 4 risk, can be very risky, but you're anticipating 5 somewhat of return on your expenditures. 6 And so therein is part of my dilemma in 7 addition to the lack of evidence, but let me ask a 8 couple of questions of the Department in that regard. 9 Madam Chair asked a question relative to the 10 patent. I don't remember hearing the answer to that 11 question. I don't want to mis-phrase it but is a pat -- 12 is it necessary to have a patent in order to conduct R & 13 D? 14 MR. RILEY: No, it is not. However, a patent 15 is -- 16 MR. HORTON: It's an indication? It's -- 17 MR. RILEY: It's an indication of -- that 18 the -- that the business component meets the 19 requirement -- the technological in nature requirement. 20 In fact, the Franchise Tax Board would accept a patent 21 as, you know, further evidence of -- 22 MR. HORTON: That makes sense. That makes 23 sense. Is it necessary to own -- to have ownership of 24 any sort? Contractual ownership? Rights to the 25 product? To any degree whatsoever. 26 MR. RILEY: Well, the statute says that it 27 needs to be a business component of the taxpayer. So, 28 there needs to be -- you know, it needs to be -- they 51 1 need to have some substantial rights in the business 2 component. 3 I mean, there's -- there is a funded research 4 exception wherein if -- if the taxpayer doesn't show 5 that they've got substantial right and -- they're not 6 entitled to the credit. If -- if somebody else is 7 paying for it or if somebody else owns it and says, hey, 8 could you -- could you modify this a little bit and, you 9 know -- in -- in that case, you know, I mean that's why 10 we ask for such things as the research contracts between 11 say Alcoa and Whitehall Lane, because in those it should 12 clearly delineate who has what rights in the product. 13 MR. HORTON: Question of the taxpayer, you 14 indicated that part of your scenario that you described 15 that you had developed this technique which resulted in 16 the manufacturer creating a -- equipment or some tool or 17 manufacturing equipment that allowed the stopper to be 18 placed on and to have some lasting benefit. But then 19 indicated that a winery from next doer had asked to use 20 that equipment and you said no. 21 Is that equipment on the market? Can anyone go 22 out and buy it? 23 MR. LEONARDINI: We bought a -- 24 MR. HORTON: Is it unique to -- is that 25 equipment somehow -- do you own any rights to that 26 equipment than the method -- technique? 27 MR. LEONARDINI: No. 28 MR. HORTON: No. 52 1 MR. LEONARDINI: It's a -- it's called a 2 spinner -- 3 MR. HORTON: So -- 4 MR. LEONARDINI: -- that puts a capsule -- it 5 takes a capsule that's much wider than you see here and 6 under high speed revolutions spins it and it makes it 7 tight. 8 MR. HORTON: So it's -- it's not unique to -- 9 to -- 10 MR. LEONARDINI: Ours is unique now to this 11 bottle with that top rather than a cork. We had to buy 12 a special piece of equipment -- 13 MR. HORTON: Do you -- do you have any rights 14 to that equipment? Any -- 15 MR. LEONARDINI: No. 16 MR. HORTON: No rights, no -- 17 MR. THOMPSON: Can I step in? The rights -- 18 it's not the rights to the business component, it's the 19 rights to the research. You can use existing 20 principles. You can use -- I mean, you don't have to 21 have rights to the machine. 22 MR. HORTON: Well, do you have any rights to 23 the research? 24 MR. THOMPSON: Absolutely, yes. They -- 25 there's -- 26 MR. LEONARDINI: But we -- we've shared that 27 with competition. Other -- other competitors, other 28 wineries have come in and they would say -- and we -- we 53 1 try to share as much as we can. They would say, "How do 2 you find the glass closure?" And we -- we say now so 3 far we think it's good. We haven't tested any on a 4 ten-year basis because our first bottling -- 5 MR. HORTON: So -- 6 MR. LEONARDINI: -- was the '03 vintage and it 7 was bottled in '05. So, it's only -- wine has only been 8 in that bottle for five years. We don't know what the 9 long-term effect is going to be. 10 MR. HORTON: So how do you document -- how did 11 you document your rights to the research? You have some 12 rights to the research? 13 MR. THOMPSON: Right. 14 MR. HORTON: Was it -- is it documented 15 somehow? If someone else wanted to use that research 16 could you sue them? Could you -- 17 MR. THOMPSON: It's a trade secret. 18 MR. HORTON: -- market those rights? 19 MR. THOMPSON: I mean it's a trade secret. Why 20 would you -- why would you give that up to someone? You 21 don't have to -- that's what a patent is essentially and 22 that's why a lot of people choose not to patent things, 23 because once you patent it it's out in the -- 24 MR. HORTON: Well, I'm not really asking what 25 it is. 26 MR. THOMPSON: Right. 27 MR. HORTON: I think I understand what it is. 28 MR. LEONARDINI: We have shared that. 54 1 MR. HORTON: I'm asking if do -- do you have -- 2 MR. LEONARDINI: There's -- there's a close 3 fraternity of wine-makers in the Napa Valley. 4 MR. HORTON: Right. 5 MR. LEONARDINI: And if a wine-maker came to 6 our wine-maker, if the wine-maker from Franciscan, 7 across the street, came and said, "What's the deal on 8 those closures? How do you seal it?" And we say, "We 9 buy -- we bought a special piece of equipment and then 10 we had it -- either had it modified or did it 11 ourselves," I don't know. We might have gotten the 12 machinery company in or whatever, had a part 13 manufactured to make it work. 14 MR. HORTON: So you had the -- it modified? 15 MR. LEONARDINI: And we -- we would say to 16 them -- we went to A -- we bought this spinner from ABC 17 company and XYZ made a modification to it and it seems 18 to be working fine. 19 If they wanted to do that, they would go to ABC 20 company and say, "I want the same thing that Whitehall 21 has," and they would take it to XYZ company and say, 22 "Will you modify it like you did at Whitehall Lane 23 Winery?" And we share that with our neighbors. 24 I wouldn't let them come into my winery, bring 25 in their own wine and their own trucks and everything, 26 no. But I would never hide something from them like, 27 yeah. 28 MR. THOMPSON: Again, I go back to the Lockheed 55 1 case who addressed this exact issue. I mean, 2 Lockheed -- Lockheed -- the Government had complete veto 3 power over whether Lockheed had a right to follow 4 patent. I mean, they controlled every single aspect of 5 what Lockheed -- the actual part that Lockheed made. 6 But what the Court has said, their right to use the 7 research results, even without exclusive right, is a 8 substantial right under the Treasury regulations. 9 This case is -- is directly on point. You -- 10 this goes back again to the documentation requirement of 11 not requiring companies to stop down every -- every -- 12 every change they get or not making it a requirement of 13 them to specifically create documentation, be it a 14 license, be it some sort of patent, or something of that 15 nature to -- to solidify that they're doing research. 16 It -- it would be nice if that were the case, 17 I'll agree with you. But it's not a requirement. And, 18 again, this company is not in the business of -- of 19 doing that. They're not in the business of selling this 20 machine, they're in the business of making the 21 modifications to it so that it will work and give them 22 an edge in their -- in their process. 23 MR. HORTON: Yeah. 24 I mean, your argument sort of cuts both ways 25 and I'm actually asking leading questions trying to 26 assist your client, and possibly identifying a situation 27 where your efforts, your R & D, is a step in the process 28 of developing this ultimate product or manufacturing 56 1 equipment. And somehow there's a cost associated with 2 it. As opposed to simply being your expertise as -- as 3 a talented person making wine, and suggesting to others 4 that they ought to modify the bottle, they ought to 5 modify the cap, and here's the research or here's the 6 reasoning why you should make that modification. Part 7 of that logic is tied into marketing, the other part is 8 tied into evidently the quality of the product. 9 Ultimately the goal is to get the best wine that you can 10 possibly develop by modifying the bottle or modifying 11 the stopper. 12 I'm trying to determine to what extent your 13 expenses related to this advice or these concept or this 14 research is tied to the actual end result, the actual 15 bottle or manufacturing equipment or thus the 16 modification of the equipment. I'm not necessarily 17 hearing any of that. 18 MR. THOMPSON: Well, I would say at the point 19 he's sharing the knowledge they're no longer taking 20 credit for that. He's not taking credit in his 21 allocation for sharing that information. It was all the 22 prior -- the development of that knowledge is where 23 the -- the credit's coming from. 24 I mean, I would agree with you 100 percent, 25 going out and telling somebody what -- what -- a certain 26 technology you've developed is not research. You don't 27 meet the four elements at that point. 28 But it's -- it's the -- it's -- you know, you 57 1 asked a question about what rights he has and -- 2 MR. HORTON: Theoretically, if I may interrupt 3 you -- theoretically Alcoa and the -- the bottle top 4 manufacturers, they're going to make money off of your 5 advice. 6 MR. LEONARDINI: Yes. 7 MR. HORTON: Now that you've shared it with 8 everyone else, everyone is going to go to them and order 9 and they're going to make money. They're going to make 10 money off any investment that they've made into 11 developing the end product based on your expertise or 12 your experiments relative to developing this wine. 13 And -- and therein is where the logic relative 14 to books and records sort of comes in whenever there's 15 an exchange of -- or potential revenue generally you 16 sort of anticipate a contractual relationship of some 17 sort, or documentation that ties directly into the 18 ultimate goal. 19 MR. LEONARDINI: But with Encore Glass, as an 20 example, we -- we didn't invent a punt. We didn't 21 invent that process of -- of putting that indentation on 22 the bottom of the bottle. We would have -- or the 23 General Manager buys 750,000 bottles a year. He would 24 have -- and the Encore rep. is in our winery once a 25 week. He would have said to the Encore rep. -- I'll 26 tell you just exactly how would it go, "We can't get 27 this top to work properly on this bottle. What can we 28 do to come up with something? Give us some ideas. Give 58 1 us some sample bottles. Let us fool around with them." 2 MR. HORTON: Who -- who is "us" in that 3 statement? 4 MR. LEONARDINI: Meaning Whitehall Lane Winery. 5 MR. HORTON: Okay. 6 MR. LEONARDINI: Our wine-maker. The General 7 Manager. I remember looking at -- 8 MR. HORTON: So what's the process of giving -- 9 sharing your ideas with -- 10 MR. LEONARDINI: Well, once it's done and -- 11 and we have settled on what we perceived to be a nice 12 looking bottle -- this is a forest green color. It's an 13 Italian design. It has what they call a broad shoulder, 14 it's tapered. And you have to taper the label so it 15 looks uniform to the bottle and so forth. 16 Once we came up with that bottle and started 17 using it, I'll guarantee you Alcoa -- or Encore Glass 18 said to every winery in the Napa Valley, "If you want to 19 use a glass closure we have a bottle that works with 20 it." 21 MR. HORTON: Okay. Thank you. 22 MR. LEONARDINI: Now, I -- 23 MS. YEE: Thank -- thank you, Mr. Horton. Are 24 there other questions, Members? 25 Let -- let me try to put some closure to this. 26 You've heard some of the concerns with respect to 27 additional documentation required and I guess even to 28 Mr. Leonardini's example just now to the extent that 59 1 Encore Glass may have anything in its records to 2 indicate what had to be developed would be helpful in 3 terms of even third party documentation. 4 If this Board -- we're going to take your case 5 under submission. If we should decide to still be 6 desirous of looking at additional documentation, is that 7 something that you could pursue if we gave you 8 additional time? 9 MR. THOMPSON: Absolutely. 10 MS. YEE: Okay. And it would be with respect 11 to all three of the projects. We've spent a lot of time 12 on the bottle closure project but I think it is lacking 13 in all three with respect to what we're looking for. 14 And -- and I appreciate that it was a tough 15 road to get here. I'm not thrilled about the lack of 16 communication, to Ms. Alby's point, about what exactly 17 was being sought with respect to records. Maybe there 18 were conversations that were had, maybe there weren't, 19 but we are where we're at today and I'd like to see how 20 we could advance this forward to certainly give this 21 Board comfort about how to look at the issues before us. 22 MR. THOMPSON: If I could make one request -- 23 MS. YEE: Mr. Thompson. 24 MR. THOMPSON: -- if the taxpayer is going to 25 have to explain, you know, in detail each of these 26 documents, I mean the breadth of these documents, I 27 would ask that you -- we just be given ample time to do 28 that. 60 1 MS. YEE: Sure. 2 MR. THOMPSON: Because, I mean, I don't want to 3 prolong this any longer but if I've got to take, you 4 know, several hundred pages of documents and explain 5 what each line means or -- or do something of that 6 nature, it's going to take -- 7 MS. YEE: Okay, I think that's part of it, but 8 it's also looking at other documentation. 9 MR. THOMPSON: Sure. 10 MS. YEE: Looking into the -- the 11 consideration, as well. 12 MR. LEONARDINI: This -- this -- what you're 13 asking for could be a tremendous project. I mean, it's 14 just not a piece of paper or a memo on -- the 15 wine-making end can be five -- six, seven hundred pages. 16 And to do an explanation of those -- I don't -- we don't 17 have the staff. I mean, we -- we all -- we're busy. 18 We're really busy. 19 MS. YEE: No -- 20 MR. LEONARDINI: And -- and to say -- come up 21 and photograph, make two copies of six or seven hundred 22 pages and write an explanation of them, and that's just 23 for the wine-making part of it, the cost to do that is 24 going to exceed what -- what we're asking for on the 25 wine-making part. It's just -- it just doesn't make 26 sense. 27 MS. YEE: And that's not the kind of burden we 28 want to place on you, Mr. Leonardini. But we do need a 61 1 little bit more than just kind of the generalized, you 2 know, flavor of what we've got now. 3 MR. LEONARDINI: If Mr. Riley is a chemist, why 4 don't we just send them to him and have him do an 5 analysis of them -- of our reports as he said he could, 6 and explain it to the Board. Would that be okay? 7 MS. YEE: No, it would not. 8 Let me -- let me just say this, we're going to 9 take the case under submission. We are sensitive to -- 10 we don't want to add any more expense or burden with 11 respect to producing the documentation, but we do need 12 the documentation. 13 So, let us confer with respect to how that will 14 be articulated to you with respect to what specifically 15 we need to look at. 16 MS. MANDEL: Can I -- oh. 17 MS. YEE: Ms. Mandel. Then Mr. Horton. 18 MS. MANDEL: Can I ask a question of the 19 Franchise Tax Board because they've been listening very 20 patiently to this lengthy exchange and I didn't have a 21 sense -- and maybe, you know, I read them too fast -- 22 from the materials that came in that there was a -- as 23 to what the understanding was of the facts relative to 24 the three projects. 25 And, you know, if the case goes out on a -- on 26 a -- you know, opportunity for more information you 27 would certainly have the opportunity to respond to that 28 information. 62 1 But my question is whether based on the sort of 2 generalized statements that you've heard about what -- 3 what these projects entailed whether you have a gut 4 sense at this point whether you think it meets process 5 of experimentation and then I suppose you -- even if it 6 did that there would be the second question, am I 7 correct about whether the expenses are -- the expenses 8 themselves are substantiated. 9 MR. RILEY: I mean, certainly if -- if 10 Respondent -- I am sorry, sorry, if the taxpayer has -- 11 has documentation that would -- would prove a process of 12 experimentation -- 13 MS. MANDEL: Okay. 14 MR. RILEY: -- we -- we're willing to -- 15 MS. MANDEL: I know you're willing to look at 16 it. You heard him describe what happened with bottle 17 closure. You heard something about maybe these were 18 test plots in the vineyard as -- and I forget the other 19 thing. Oh, maybe we didn't hear so much about what 20 really the wine-making testing was about. 21 I just want a sense of whether you think that 22 there's a possibility that that fits under the process 23 of experimentation or -- or if -- are we -- do you un -- 24 do you sort of follow me, Mr. Hilson if Mr. Riley 25 doesn't? 26 MR. RILEY: I understand. I think I 27 understand. 28 MS. MANDEL: Okay. 63 1 MR. RILEY: I think in this case what we'd -- 2 what would have to occur would -- it would probably need 3 to be shrunk back. There's a rule in here about exactly 4 getting the business component down to exactly the -- 5 the -- you know, the point of -- of experimentation. 6 And if -- 7 MS. MANDEL: Because the business component 8 might be the -- might be the bottle and the thing put 9 together on -- on a bottle. 10 MR. RILEY: It might be -- it might be just the 11 opening at the top of the bottle. 12 MS. MANDEL: Okay. So -- 13 MR. RILEY: It might -- 14 MS. MANDEL: So you're saying maybe? 15 MR. RILEY: I'm saying -- 16 MS. MANDEL: As of today based on what you 17 heard, maybe. 18 MR. RILEY: Yes. Maybe. 19 MS. MANDEL: Okay. And -- and what about if 20 they had separate vineyard test plots, though, went to 21 something. Is that a maybe or is that just, you know, 22 hey, farming? 23 MR. RILEY: Again, with -- with the vineyard 24 project, you know, they're claiming a sprinkler system, 25 they're claiming -- they're claiming -- 26 MS. MANDEL: Well, that's the -- okay, that's 27 maybe particular components of -- 28 MR. RILEY: It would -- they would have to -- 64 1 they would have to identify specifically which -- what 2 is -- identify what is the business component that 3 they're claiming it for. 4 MS. MANDEL: Okay. 5 MR. RILEY: And -- 6 MS. MANDEL: So I'm hearing maybes, generally? 7 Am I hearing maybes generally? Mr. Hilson. 8 MR. HILSON: Yes. 9 MS. MANDEL: Okay. Thank you. 10 MS. ALBY: And may I ask a question, as well? 11 MS. YEE: Ms. Alby, please. 12 MS. ALBY: So that I'm understanding what 13 you're saying here because I'm getting the feeling that 14 if we're looking for more paper that could be a problem. 15 But if -- if you hear on these various claims that are 16 made by the taxpayer that they can totally describe to 17 you the hypothesis, the conclusion, what the control 18 group was and those sort of things that are inherent in 19 experimentation for this, is that -- and you are 20 persuaded that that occurred, and it met the standard, 21 is that good enough? 22 MR. RILEY: If -- you know, if -- if they're 23 providing us with -- with something in addition to -- to 24 their -- to their, yeah, we do research claims, then -- 25 then perhaps. 26 MS. ALBY: But if you're seeing the machinery, 27 if you're seeing the process, or they're explaining it 28 to you, if they're -- 65 1 MR. RILEY: I mean, with respect -- 2 MS. ALBY: -- at some point you have to make a 3 judgment on the veracity of the claim. 4 MR. RILEY: You know, just purchasing the -- 5 the capping machine, everyone's got a capping machine. 6 You know, I -- I can't say that -- that just because 7 it's, you know, down to that -- 8 MS. YEE: Okay. 9 MR. RILEY: You know, it -- it's a -- it's a 10 looking at the totality of the evidence provided in 11 addition to a taxpayer's -- taxpayer's words. I mean, 12 we've asked for -- for these things. If you look 13 specifically at Exhibit V, you know, earlier you talked 14 about how we weren't communicating, but we're asking for 15 specifically the project descrip -- the project 16 description and complete copies, the research contracts, 17 the joint venture agreements, or funding arrangements 18 engaged in by the company for R & D projects during the 19 tax years indicated above. 20 And that was sent to the -- the taxpayers on 21 February 26, 2006. You know, the initial project report 22 or business plan explaining the objective -- objectives 23 of the research and reports generated thereafter which 24 evaluate the -- the progress of the research projects. 25 These things were asked for during the audit 26 and -- and so -- you know, the fact that they -- they 27 allegedly exist and weren't provided, you know, it's -- 28 it's -- 66 1 MS. YEE: Okay, let's stop there. Mr. Horton 2 and then I want to wind this up. 3 MR. HORTON: Yeah. I don't really want to get 4 into debate on the type of records that you should be 5 providing. I certainly do want to encourage that the 6 taxpayer and the Department get together, spend a little 7 time and delineate what type -- types of records that 8 you're looking for. And just making a general 9 statement, if I will, just to provide some additional 10 direction from my perspective, the -- the business 11 component that the taxpayer is in relative to their 12 experimentation is selling the bottle. So at the end of 13 the day they want a bottle that will enhance the value 14 of their product. 15 And so, there seems to be some element of 16 research. How do you quantify it? Is it a step in the 17 process of the R & D conducted by the manufacturer of 18 the equipment or the manufacturer of the bottle 19 stopper? 20 It -- it sounds as if, though, there's case law 21 that says that it doesn't have to be -- it's not 22 necessary that there's a return, that there's a direct 23 association with the profit. And so it is difficult at 24 this juncture to kind of -- kind of make that call and 25 quite frankly I don't know if it exists. But I would 26 certainly encourage Madam Chair that the two spend a 27 little time together and figure out what documentation 28 so that the taxpayer doesn't go off and come back with 67 1 600 pages or spends all this time, because I don't think 2 that's necessary. 3 MS. YEE: Uh-huh. 4 MR. HORTON: I think from the testimony that I 5 have heard today that the information that might be able 6 to support that you meet the criteria of the statute 7 shouldn't be that complicated. 8 MS. YEE: Thank you, Mr. Horton. Let me pose 9 this suggestion. And I want to look to Appeals for 10 this. You've heard our questions and our concerns. And 11 I know there had been multiple document requests that 12 have been made. I think also there are some unique 13 practices specific certainly to the winery business to 14 where -- and certainly what Mr. Leonardini and 15 Mr. Thompson have alluded to that some of this 16 documentation just may not even be in existence. 17 Can you help us just kind of bridge the two 18 parties with respect to what we're specifically seeking, 19 and maybe starting with the initial documentation 20 requests and just kind of getting a sense of what's 21 available and what's not, but to really kind of then get 22 to the concerns all of us have expressed about more 23 specific information. 24 MS. KELLY: Certainly. And I think what you're 25 asking is that we start the further briefing with a 26 letter focusing the parties on what -- 27 MS. YEE: Yes. 28 MS. KELLY: -- the Members are interested in 68 1 seeing, and we can do that. 2 MS. YEE: And maybe using Mr. Riley's reference 3 to the initial documentation request so that we can have 4 a sense of why certain things are missing; why certain 5 things were not provided; why maybe they're not even in 6 existence; what may serve as a proxy for what was 7 requested, those types of things. 8 MS. KELLY: Certainly. 9 MS. YEE: Okay. Very well. Other comments, 10 Members? 11 Hearing none, is there a motion? 12 MR. HORTON: Move to take it under submission. 13 MS. ALBY: Second. 14 MS. YEE: A motion by Mr. Horton to take the 15 matter under submission, second by Ms. Alby. 16 Without objection, that motion carries. 17 Thank you, Franchise Tax Board, Mr. Leonardini 18 and Mr. Thompson very much. I think we have a pretty 19 good feel for how we want to proceed and we'll discuss 20 your matter later today. 21 MR. THOMPSON: Thank you. May we be excused? 22 MS. YEE: Thank you. 23 MR. LEONARDINI: Thank you. 24 ---oOo--- 25 26 27 28 69 1 REPORTER'S CERTIFICATE. 2 3 State of California ) 4 ) ss 5 County of Sacramento ) 6 7 I, BEVERLY D. TOMS, Hearing Reporter for the 8 California State Board of Equalization certify that on 9 April 13, 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 69 13 pages constitute a complete and accurate transcription 14 of the shorthand writing. 15 16 Dated: May 17, 2010. 17 18 19 20 ____________________________ 21 BEVERLY D. TOMS 22 Hearing Reporter 23 24 25 26 27 28 70