BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 450 N Street, Room 121 Sacramento, California REPORTER'S TRANSCRIPT MAY 25, 2010 ITEM C2 SALES AND USE TAX APPEALS HEARINGS PETITION FOR REDETERMINATION filed by LUCENT TECHNOLOGIES, INC. (Case Nos. 317049, 317677, 890024, 16490 OH) Reported by: Beverly D. Toms CSR No. 1662 1 1 2 P R E S E N T 3 4 For the Board Betty T. Yee of Equalization: Chair 5 Jerome E. Horton 6 Vice-Chair 7 Barbara Alby Acting Member 8 Michelle Steel 9 Member 10 Marcy Jo Mandel Appearing for John Chiang 11 State Controller (per Government Code 12 Section 7.9) 13 Diane Olson Chief, Board Proceedings 14 Division 15 For Board of David Levine 16 Equalization Staff: Tax Counsel IV 17 Bradley Heller 18 Tax Counsel 19 Robert Tucker Legal Department 20 Kevin Hanks 21 Sales and Use Tax Department 22 For Petitioner: Jeffrey G. Varga Attorney at Law 23 24 Michael James Guerriero Attorney at Law 25 26 ---OOO--- 27 28 2 1 Sacramento, California 2 May 25, 2010 3 ---oOo--- 4 MS. YEE: Next matter please. 5 MS. OLSON: Our next matter is C2, Lucent 6 Technologies, Inc. Please come forward. 7 MS. YEE: Let me have Mr. Heller get situated, 8 please. 9 Okay. We are on item C2, Lucent Technologies, 10 Incorporated. Mr. Levine. 11 MR. LEVINE: The issues in this petition and 12 claims for refund of Lucent Technologies is whether 13 further adjustments are warranted primarily for sales of 14 software claimed to be custom software or technology 15 transfer agreements. 16 MS. YEE: Thank you very much. Good afternoon, 17 gentlemen. 18 MR. GUERRIERO: Good afternoon. 19 MS. YEE: Speak right into that microphone so 20 we can hear you. Thank you. 21 If you'll introduce yourselves formally for the 22 record you have ten minutes. 23 Good afternoon, Madam Chairwoman and Members of 24 the Board. My name is Mickey Guerriero, Day Pitney, on 25 behalf of Lucent Technologies. 26 MR. VARGA: Good afternoon, Madam Chair, 27 Members of the Board. My name is Jeffrey Varga from 28 Paul, Hastings, Janofsky and Walker. I also represent 3 1 the taxpayer, Lucent Technologies, Inc. 2 MS. YEE: Great. Thank you. Please proceed. 3 MR. VARGA: I'll go first, you know, give part 4 of my time to Mr. Guerriero. I want to discuss only the 5 RTU or the TTA issue and Mr. Guerriero will discuss the 6 other issues. 7 Our brief demonstrated that the amounts that 8 Lucent Technologies, Inc. charged for licensing the 9 right to use the software programs at issue are not 10 subject to tax under Revenue and Taxation Code Section 11 6011(c)(10) and 6012(c)(10). 12 We also submitted exhibits in support of our 13 position. These are copies of relevant contracts, 14 patents. 15 I'm sure every Member of the Board has read our 16 briefs. I'm not going to bother or bore the Board with 17 restating our briefs. I'm simply going to respond to 18 some of the points raised in the Department's reply 19 brief. 20 Naturally, we disagree with the entire brief 21 but, again, time does not permit me to go through and 22 analyze each and every incorrect assertions. I'm just 23 going to highlight a few points. 24 For example, the Board's -- excuse me, the 25 Department's brief at page 2, line 20, says, and I 26 quote, "The Department knew that AT&T had sold the same 27 software during prior audit periods." 28 First to my knowledge, neither AT&T -- Amer -- 4 1 the predecessor to Lucent nor AT&T has ever, quote, 2 sold, end quotes, through -- software. To my knowledge 3 it's always been licensing the right to use software. 4 But in any event it would never have been the 5 same software with respect to the switch-specific 6 software programs because as our brief demonstrated each 7 and every switch-specific software program was created 8 uniquely for the corresponding switch. So, you couldn't 9 possibly have sold or licensed the same switch. 10 At page 2, line 21, the Department again says, 11 "The Petitioner alleged that its 5ESS-2000 software was 12 always custom made. That is not our -- that misstates 13 our position. Again, our position is set forth in our 14 brief. Our brief provided a general broad overview of 15 how each switch-specific software program was created 16 for the corresponding switch for which that software 17 program was uniquely created. 18 Again, I respectfully refer the Members of the 19 Board to our brief where we set forth how that happened. 20 My -- my next comment is on page 3, line 1 of 21 the Department's brief, where the Department contends 22 the taxpayer did not demonstrate that the 23 switch-specific software programs, and I quote, "did not 24 contain any programs that were held or existing for 25 repeated sale or lease." 26 First of all, this statement misstates the 27 proper standard. That's not the standard as to whether 28 something is or is not pre-written. But, more 5 1 importantly, we -- our brief established that the 2 switch-specific software programs, the available basic 3 codes, the basic codes, the office-dependent 4 instructions and indeed the office data administrative 5 systems, none of these were held for repeated sale or 6 lease. None of these existed for repeated sale or 7 lease. 8 So, we respectfully disagree on that point as 9 well with learned counsel for the Board. At page -- at 10 page 6 the -- the Department talks about example 3 in 11 Regulation 1507(a)(1) and also about the Quanta Computer 12 versus LG electronic case. We respectfully disagree 13 that the -- that either the example cited by the 14 Department or the Quanta case has any bearing to the 15 facts of this case that relate -- to the extent they 16 relate to the licensing of the right to use 17 switch-specific software programs. 18 At page 6, lines 13 and 15, the Department 19 purports to -- to again restate our position, the 20 taxpayer position. The position is stated incorrectly. 21 Again, I would respectfully refer the Members of the 22 Board to our brief where we correctly state our 23 position. 24 Lastly, the Department incorporates by 25 reference the D & R, and again we respectfully disagree 26 with the D & R to the extent it contends that the 27 amounts charged for the right to use software programs 28 is subject to tax. However, I want to just point out 6 1 one thing in the D & R, I want to focus in on one 2 comment. The D & R states, and I quote, "In relevant 3 part the Court in Nortel -- in the Nortel decision found 4 that the software at issue was custom programming." 5 That is not what the trial court in Nortel found. 6 If the Members of the Board would find it 7 useful I brought copies of the trial Court statement of 8 decision. I'm sure each and every one of you has it 9 already, but if you would find it useful I brought an 10 extra copy; you can read for yourself what the -- what 11 the Court said. 12 If I may give the rest of my time to Mr. 13 Guerriero. 14 MS. YEE: Please. 15 MR. VARGA: The rest of our time, excuse me; 16 it's not my time 17 MR. GUERRIERO: Thank you. The three points 18 that I wanted to discuss have to do with transactions 19 that are either a sale for resale, transactions in which 20 an XYZ letter has been presented, or a transaction in 21 which the first use of the tangible property occurred 22 outside the State of California. 23 In the exhibits that we sent to the Board I'd 24 like to just briefly refer to those right how because 25 they cover these points. 26 On the sale for resale issue, Exhibit A1 is a 27 copy of an invoice that was issued to the Pacific Bell 28 Company, and that refers to the -- that ties into the 7 1 audit schedule 12B, reference number 5. I don't have 2 the invoice for reference number 7, but these two 3 transactions occurred on October 2nd. They're invoiced 4 on October 2nd, and the resale certificate that is 5 attached as Exhibit A2 issued to Pacific Bell Leasing 6 Company, I would point out that the D & R incorrectly 7 said that it was issued to Southwestern Bell Leasing 8 Affiliates, but it -- if you read the certificate which 9 you have there you'll see that it's to Pacific Bell 10 Leasing Company, and that the certificate is signed as 11 of September 1, 2000, which is very close to the time of 12 these two transactions. 13 In that regard the regulation provides that the 14 form of a certificate, which in this case was issued by 15 Pacific Bell Leasing Company, has to indicate that it is 16 for resale and has to indicate their number -- their 17 seller permit number, and we provided that as well in 18 Exhibit A3. And that it has to be either signed by the 19 purchaser or an authorized representative of the 20 purchaser. 21 In this particular case Pacific Bell Leasing 22 Company was established effective September 1, 2000 to 23 make multiple purchases on behalf of many companies, one 24 of which was Pacific Bell. 25 The second point that I would like to address 26 is the use of an XYZ letter and that's found on page 22 27 and 23 of our brief. In this particular situation we 28 have seven invoices, and I've included those in the 8 1 exhibits that were provided last week to the Board. 2 I would like to point out for the Board's 3 information that three of those actually would be from a 4 time period outside of when the XYZ letter occurred. 5 And that would be Exhibits B3, B5 and B6. However, 6 those transactions are for right to use license fees and 7 therefore still would be part of the taxpayer's 8 contentions in this case even though they would not be 9 part of the GTE XYZ letter. 10 And on that I would like to just point out two 11 things. Exhibit B1 is the e-mail that we received from 12 Verizon, which as you probably know is the company that 13 acquired GTE. And they indicate in there that the 14 transactions that are at issue in the Lucent audit are 15 transactions that were included in the scope of the 16 audit of GTE from -- that audit was 1-7-97 to 6-2000. 17 And also attached to that was a schedule of 18 those particular transactions. And then you have as 19 Exhibit B2 a copy of the XYZ letter itself that refers 20 to the period of 1-1-1997 through 6-30-2000. 21 Regulation 1668(f) does provide and -- and in 22 this regard the XYZ letter satisfies those 23 requirements -- that the letter indicate the name, the 24 permit number and provide the copies of invoices, which 25 is what was done here. And (f)(2)(F)(3) says and that 26 the tax was either paid to the Board pursuant to an 27 assessment against or an audit of the purchaser 28 developed either on a -- 9 1 MS. YEE: Please proceed. 2 MR. GUERRIERO: -- actual basis or a test 3 basis. And -- 4 MS. OLSON: Time has expired. 5 MS. YEE: Go ahead and finish your thought. 6 We'll give you time on rebuttal. Complete your thought. 7 MR. GUERRIERO: Thank you. And in this 8 particular case this was clear this was done on a test 9 basis, which would satisfy that portion of the 10 regulation. And that I did have one more point but if 11 my time is up I won't -- it's on the transactions with 12 Western Wireless. This was the third part for the first 13 use outside the State of California. 14 MS. YEE: Why don't you briefly describe that 15 so -- 16 MR. GUERRIERO: Okay. Well, that is in our 17 brief, again, on page 23. We rely on the -- the 18 Stockton Kenworth case. It's cited in our brief, that 19 where the sole exercise and right and power over 20 tangible property is simply to have it used for the 21 first time outside the State of California, which is the 22 case in this situation. That's why I provided a copy of 23 the contract, so you could see in a copy of the e-mail 24 that in fact this type of equipment would not be used in 25 California by Western Wireless because Nortel was their 26 equipment provider for California, and they did not use 27 this type of equipment in California. 28 So, thank you very much. 10 1 MS. YEE: Thank you very much. We'll give you 2 time on rebuttal. 3 MR. GUERRIERO: Thank you. 4 MS. YEE: Department, please. 5 MR. HELLER: Good afternoon, Madam Chair, 6 Members of the Board. My name is Bradley Heller. I'm 7 an attorney with the Board's Legal Department and I'm 8 here representing the Sales and Use Tax Department. To 9 my right is Bob Tucker, also from the Board's Legal 10 Department. And to his right is Kevin Hanks from the 11 Sales and Use Tax Department. 12 The Department agrees with the Appeals 13 Division's Decision and Recommendation regarding this 14 matter which address all the issues that the -- the 15 Petitioner addressed this morning, including the 16 transactions with Pacific Bell and GTE/Verizon. And 17 based on all of the reasons set forth in the Decision 18 and Recommendation the Department requests that the 19 petition and claim for refund be denied. 20 This afternoon I'm just going to briefly 21 summarize the reasons why the Department believes that 22 tax applies to the Petitioner's charges for switch 23 software, including charges for the right to use 24 software and would be happy to answer any specific 25 questions you may have after I'm finished. 26 During the audit period at issue today, 27 February 1, 1997 through September 30, 2000, the 28 Petitioner sold switch -- digital switches to California 11 1 customers for use in their California networks. Each 2 digital switch was comprised of a computer, which we all 3 refer to as a switch, and a number of computer programs 4 as defined in Regulation 1502 that operate the switch 5 and give it the capability to support multiple network 6 applications, including wire line, wireless voice, 7 local/long distance, et cetera. 8 For the most part the Petitioner sold the 9 5EES-2000 digital switch, including the accompanying 10 software during the audit period. And in some cases 11 separately stated charges to its customers for the use 12 of the software. Those would be the RTU fees in this 13 case. 14 The switch was originally manufactured and sold 15 by AT&T. In 1992 it began setting industry benchmarks 16 for fewest service interruptions in 1993, and eventually 17 became the most widely -- most widely used switch in 18 North American networks mainly because it comes in a 19 number of sizes, it's fully modular and configurable. 20 And -- and this was all done before the 21 Petitioner became a separate entity from AT&T and began 22 selling the same switch and we believe the same software 23 in its own right. 24 During the Petitioner's audit the Department 25 determined that the Petitioner's switch software was 26 pre-written because it was previously sold by AT&T and 27 the Department still stands by the assertions in its 28 brief. 12 1 The Petitioner held the software for repeated 2 sale or lease to numerous customers throughout the audit 3 period since we saw the same switches being sold and the 4 same functionalities being provided. And the Petitioner 5 did not provide any evidence to establish that any of 6 the software charged at issue were for custom computer 7 programs prepared to the special order of the customer, 8 which is the legal standard for custom computer 9 programs, or that the -- any of the charges that the 10 staff was including in the measure of tax were 11 separately stated charges for actual custom 12 modifications to an existing pre-written program. 13 Therefore, the Department concluded that the 14 charges for the pre-written switch software were taxable 15 under Revenue and Taxation Code Section 6010.9 and 16 Regulation 1502 and this conclusion is consistent with 17 the Board's 2008 decision regarding AT&T's sales of the 18 same digital switches and switch software in a prior 19 audit that ended -- I believe the end of that period was 20 January 31st of 1996. 21 In addition, furthermore the Petitioner's 22 switch contracts merely transferred the right to use 23 copyrighted pre-written computer programs which perform 24 imbedded processes. They do not transfer the right to 25 reproduce and sell copyrighted material, the right to 26 produce, reproduce or manufacturer and sell patented 27 products or the right to use a patented process that is 28 not imbedded in tangible personal property. Therefore, 13 1 the Department does not believe that the agreements can 2 constitute technology transfer agreements within the 3 meaning of Revenue and Taxation Code Section 6011 and 4 6012 as interpreted by the California Supreme Court in 5 Preston versus State Board of Equalization. 6 And the agreements do not fall within the 7 meaning of technology transfer agreements as defined by 8 Regulation 1507. 9 Finally, the Department does not believe that 10 the Petitioner -- the Petitioner is entitled to relief 11 under Revenue and Taxation Code 6596 due to its alleged 12 reliance on prior -- prior audit of AT&T and briefly I 13 just want to explain that it was essentially two AT&T 14 audits ago -- ago to -- I guess it had been fully 15 resolved and in that AT&T in its most recent audit to 16 reach the Board argued that it had not collected tax on 17 sales of the same switch software at issue today because 18 the Board had not -- had conclude -- or I should say the 19 Department had concluded that similar software was 20 custom during a prior audit of AT&T. 21 However, at that time the Department was not 22 able to determine that it had actually reviewed the 23 exact same switch software in the prior audit. As far 24 as we could tell the switch software at issue today was 25 cus -- even if it was custom when it was originally 26 manufactured and sold by AT&T in that prior audit two 27 audits ago, the same software would be pre-written for 28 purposes of its receded -- repeated sale to customers 14 1 during the audit period at issue today, and that was the 2 same thing that the Board concluded in AT&T's subsequent 3 second audit. 4 And the Board previously concluded that AT&T 5 could not use the prior audit -- audit as a basis for 6 Section 6596 relief from taxes on pre-written switch 7 software in that subsequent audit. 8 So, essentially the Department -- the Board has 9 already rejected that contention with regard to AT&T 10 who -- who was the recipient of the audit advice. 11 Thank you. 12 MS. YEE: Thank you, Mr. Heller. You have five 13 minutes on rebuttal, gentlemen. 14 MR. VARGA: Very quickly, naturally we disagree 15 with everything Mr. Heller said. Let me focus on just 16 two or three things. You went pretty quickly. I try to 17 catch the highlights. 18 I think I heard Mr. Heller say that a computer 19 is referred to as a switch. Perhaps he misspoke. That 20 is an incorrect statement. A switch is comprised of all 21 the pieces of equipment that are described in our brief 22 that's -- that identifies what a switch is. A switch 23 can be as big as this room or maybe even bigger, 24 consisting of computers, of cables, of cabinets, of 25 drawers. 26 So, I -- I think he misspoke but for the record 27 a -- a switch is not a computer. It's much, much more 28 than that. 15 1 I also thought I heard MR. Heller again say 2 that Lucent or AT&T sold software. Again, to my 3 knowledge software has never been sold; it was always 4 licensed. 5 Mr. Heller argued that the Department found 6 that the same switches were sold. They may have the 7 same functuality. Again, it's a complete mis -- 8 misunderstanding of the facts. As our brief indicated, 9 no two switches are alike. They're not. And therefore 10 you couldn't possibly have two identical switch-specific 11 software programs. 12 And the contracts that Mr. Heller was referring 13 to do in fact license the right to use software 14 programs. And as we explained in our brief, these 15 contracts qualify as technology transfer agreements 16 within the meaning of RTC Section 6011(c)(10)(D) and RTC 17 Section 6012(c)(10)(D). 18 MS. YEE: Mr. Guerriero? 19 MR. GUERRIERO: I think I finished everything I 20 wanted to say. I was sort of hurrying along there. 21 Unless anybody has any questions at the end I'd be happy 22 to address those. But I don't need to repeat it. Thank 23 you. 24 MS. YEE: Great. Thank you 25 MR. GUERRIERO: Thank you. 26 MS. YEE: Questions, Members? 27 MS. MANDEL: I have a question. 28 MS. YEE: Ms. Mandel then Ms. Steel. 16 1 MS. MANDEL: I have a question on the GTE -- 2 GTE/Verizon and the resale certificate. 3 MR. GUERRIERO: Yes. 4 MS. MANDEL: There was -- there were two 5 reasons given to disallow the resale certificate. One 6 was that GTE was the customer and -- or maybe I'm mixing 7 them up -- GTE was the customer and Verizon sent the -- 8 the XYZ -- 9 MR. GUERRIERO: That was the XYZ letter. 10 MS. MANDEL: -- Z response. 11 MR. GUERRIERO: Correct. 12 MS. MANDEL: And what do we -- GTE is now 13 Verizon, or at that time was the -- the same -- 14 MR. GUERRIERO: Verizon has acquired GTE, 15 yes -- 16 MS. MANDEL: -- company, right? 17 MR. GUERRIERO: -- that's correct. 18 MS. MANDEL: So, what -- what's the sort of -- 19 we've got the Department saying, oh, well it's not the 20 same person. What do we normally do -- do -- 21 MR. HELLER: Ms. Mandel, at this point we 22 have -- the Department has verified that there was a 23 merger of GTE that -- into Verizon I believe in -- I 24 forget the exact date, but it was a -- prior to the date 25 of the XYZ letter which was essentially an e-mail. 26 MS. MANDEL: Okay. 27 MR. HELLER: And that that -- for our purposes 28 legally that would be the same taxpayer. 17 1 MS. MANDEL: That would be the same taxpayer 2 and the -- 3 MR. HELLER: By all -- all the requirements. 4 MS. MANDEL: And the -- and the Department 5 staff going down they -- you know, they understand 6 that -- that it -- if there's a name change or a merger, 7 I mean that's standard practice that it's still the same 8 and they don't have to have a new -- 9 MR. HELLER: I would say -- 10 MS. MANDEL: -- resale certificate. 11 MR. HELLER: That's correct. And as far as -- 12 as long as it's essentially the same legal entity, 13 that's treated as continuing under -- you know, under -- 14 like corporate or civil law. 15 MS. MANDEL: Okay. 16 MR. HELLER: And in -- in that regard I would 17 point out that that wasn't the case with regard to the 18 Pacific Bell transactions we were talking about before. 19 MS. MANDEL: Okay, and I'm just -- 20 MR. HELLER: So Pacific Bell still continues 21 to exist and Pacific Bell Leasing Affiliates is a 22 separate entity. 23 MS. MANDEL: Well, okay. I know there was 24 something with Pacific Bell and SBC and who became who 25 and who wound up I don't remember, but I'm focusing on 26 GTE/Verizon. So -- so that was the first part of it. 27 And then the second part was this issue of 28 whether the transactions that were picked up in the 18 1 current audit were picked up in the audit of 2 GTE/Verizon. 3 MR. GUERRIERO: Correct. 4 MS. MANDEL: And all that I saw in the 5 materials that I can remember was that in the 6 GTE/Verizon audit there was a test, and I think 7 Petitioner's counsel referred to a test. And that there 8 was a -- there -- what the Petitioner is saying is 9 that -- that the types of -- that the transactions that 10 were the subject of the XYZ letter were included -- 11 maybe they weren't the ones that were picked up for 12 purposes of the sample for the test, but my -- what I'm 13 hearing him say is that they were in the population for 14 the test. Am I -- am I getting this right? 15 MR. GUERRIERO: That's correct. 16 MS. MANDEL: That they were in the population 17 for the test of the GTE/Verizon audit and so when you 18 then develop the error percentage off that tested 19 population that under the regulations that it's 20 necessary -- that the transactions are necessarily 21 included because that's kind of the purpose of the test. 22 So, can you explain why staff says that these 23 transactions were not part of what was done in the -- 24 MR. HELLER: Right. 25 MS. MANDEL: -- GTE/Verizon audit? I mean, 26 this might be about 20 cents of the thing that's at 27 issue but I just want to get clear. 28 MR. HELLER: Well, I can say that the 19 1 Department did review the prior GTE and Verizon audit 2 and basically they could not see anything that looked 3 like an examination of -- of software and they didn't 4 see anything included in there or anything that would 5 have been picked up in the sample that -- that would 6 relate to software or fees or licenses to use software. 7 And then at the same time the Appeals Division did 8 actually review the Department's determination 9 specifically during the appeals process and in the D & R 10 makes its own affirmative statements that they verified 11 the Department's findings. 12 MS. MANDEL: Okay. Then maybe I'm just 13 confused. What -- what -- what was the -- was the 14 GTE/Verizon -- 15 MR. HELLER: Here's where -- 16 MS. MANDEL: -- invoice, was that software, as 17 well or was it some other type of equipment? 18 MR. GUERRIERO: Some were software, yes, that's 19 right. That's correct. And they -- the exhibit that we 20 provided to the Board in this particular issue is 21 Exhibit B1, is a copy of an e-mail that was sent from 22 the Tax Director at Verizon to the tax person at 23 Lucent -- 24 MS. MANDEL: Right. 25 MR. GUERRIERO: -- advising that this contains 26 the transactions that were part of the auditor's sample 27 and that these were of the type that are included in the 28 Lucent audit, as well. And that was forwarded on then 20 1 to the Board's office in New York City. 2 MS. MANDEL: Right. And there is -- it look -- 3 it looks like there was some Excel spreadsheets and 4 other information that was forwarded. 5 MR. GUERRIERO: Yes. 6 MS. MANDEL: -- with that e-mail. 7 MR. GUERRIERO: That's correct. 8 MS. MANDEL: And -- 9 MR. GUERRIERO: -- and this statement also on 10 the XYZ letter, itself, which is Exhibit C -- B2, excuse 11 me, that points out that this -- it says, "Tax was paid 12 directly to the Board as a result of an audit 13 determination based and dated January 25, 2004 and 14 report of field audit dated August 16, 2004 covering the 15 period 1-1-1997 through 6-30-2000," which is inside the 16 audit period we're dealing with by a few months. 17 This audit period starts 2-1-1996 and ends in 18 9-30-2000. But this is inside. 19 But as I pointed out the invoices that were 20 scheduled are within that period except for three, and I 21 gave you those exhibits that are not. But those would 22 still be covered under the RTU argument we've made in 23 the case. So they wouldn't come out of the audit but 24 they would come out of the XYZ portion. 25 MS. MANDEL: Yeah, see -- I mean, here -- 26 here's -- and I know because you can't put the 27 GTE/Verizon material in front of these people unless, 28 you know, GTE waives everything. 21 1 The -- the -- what I'm having a hard time with 2 is the taxpayer in the other audit said -- gets the 3 invoice and gets the information to be able to answer 4 the XYZ letter, and they say, you know, it's in there. 5 You know, Prego spaghetti sauce audit, it's in there. 6 And -- I borrowed that phrase from a Supreme 7 Court Justice -- and the -- yeah, I'll tell you later -- 8 and the -- but then we have the Department saying, well, 9 we looked at it and it's not in there. 10 And I -- I don't have -- you know, I don't have 11 the road map of how it's in and how it's not in there. 12 Do you see what my con -- 13 MR. GUERRIERO: Well, the regulation -- 14 MS. MANDEL: -- issue is? 15 MR. GUERRIERO: If I could just -- 16 MS. MANDEL: Well, let -- let me -- 17 MR. GUERRIERO: Oh, I'm sorry. 18 MS. MANDEL: -- let me -- I'm just -- asking 19 Mr. Levine, I guess. You see what my issue is? 20 MR. LEVINE: Yes. 21 MS. MANDEL: I'm not -- I -- I can't -- I have 22 conflicting things and I -- I can't -- I am not -- 23 MS. YEE: Mr. Levine. 24 MS. MANDEL: -- tracking. 25 MR. LEVINE: The underlying theory is the 26 Department does an audit. They pick up all the tax 27 that's due. That's the underlying theory to this. So, 28 if the customer was audited any tax that was due was 22 1 picked up. 2 A taxpayer would assume that they paid the tax, 3 an audit was done and they did a test and they paid 4 everything. So, it's quite understandable that a 5 taxpayer, even a sophisticated taxpayer, could issue an 6 XYZ letter of the type we're talking about. But when 7 push comes to shove and the taxpayer who owes tax on the 8 sale is -- takes the position that the tax was paid 9 by -- by the purchaser, or even if they don't because 10 it -- the Department's responsibility is to check, the 11 Department goes in to see if it's at least theoretically 12 possible that it was picked up. And if it was in the 13 population, if there was a test where these items were 14 in the population, then it doesn't matter if any of them 15 were specifically picked up because unless there was 16 zero errors -- we sometimes encounter zero errors -- but 17 as long as the tax assessed is enough on a projected 18 basis to cover these amounts then we would say at least 19 in theory the purchaser paid the tax. 20 MS. MANDEL: Okay. So, is the -- is the -- is 21 the problem here that what was tested for is not the 22 type of property that was purchased? 23 MR. LEVINE: That's it. Now, I didn't 24 personally review this and there's non-description, but 25 a -- the conference-holder is very experienced and if he 26 said he reviewed it and concluded that -- confidently 27 concluded that it wasn't included, then I have to say I 28 confidently conclude that this was not in the test and 23 1 he didn't explain more because it's confidential 2 information how the audit was done of the other 3 taxpayer. 4 MR. GUERRIERO: May I respond to that? 5 MS. YEE: Mr. Guerriero. 6 MR. GUERRIERO: The regulation I think is quite 7 clear on this point. It says the tax was paid to the 8 Board by the purchaser pursuant to an assessment against 9 or audits of the purchaser developed either on an actual 10 basis or a test basis. And that's what the regulation 11 says. 12 It doesn't qualify any of those and it doesn't 13 say that a test basis but only if it includes the 14 transactions that might have been missed in the other 15 audit. It doesn't say that. And it doesn't qualify it. 16 And I think without that kind of a qualification what -- 17 what's being done here is the regulation is basically 18 being ignored. 19 MR. LEVINE: It does say exactly that, the tax 20 has to be paid. 21 MS. MANDEL: Well, and -- and what I -- 22 MR. GUERRIERO: It's either on an actual or a 23 test basis. 24 MR. LEVINE: That's right, it has to be 25 included in the test. 26 MR. GUERRIERO: Oh, yeah. 27 MS. MANDEL: Well, and -- and then as I 28 understand -- 24 1 MR. GUERRIERO: It doesn't -- 2 MS. MANDEL: -- what -- maybe you've looked at 3 the material. My -- and -- because I think I asked this 4 question before and I don't recall if it's in the -- 5 that the -- that the test, if it's -- if it's a test of 6 -- oh, I don't know. You know, you have consumable 7 supplies. You have, you know, these different 8 categories that the auditors have to look at when they 9 go out. And I guess what you're saying, Mr. Levine, is 10 if the auditors go out and they look at a category of 11 sales for resale and they test the sales for resale but 12 there's -- well, this is sales for resale. I'm going to 13 make a bad analogy. Just saying that it's a -- it -- 14 okay, I'm not making sense now. 15 MR. HORTON: Oh, you do it well. Keep it up. 16 MR. LEVINE: If the transactions were in the 17 population that is tested, then the only remaining 18 question is whether the tax picked up is at least enough 19 to cover all the errors that are found and all these. 20 If -- if we had a thousand dollars worth of tax due from 21 the seller and the purchaser was assessed $50 of tax on 22 the population, none of -- then we'd say you didn't pay 23 tax on at least $950 of it. 24 But as long as -- as the number is big enough, 25 and I assume here the numbers are big enough. I don't 26 know anything about the specific audits. 27 I -- I assume that's not the problem. As long 28 as the number's big enough, if the type -- if the 25 1 auditor tested transactions of the type of software that 2 are in question, the fact that none of them were picked 3 up in the sample is irrelevant. 4 MS. MANDEL: Right. 5 MR. LEVINE: Because the theory of the audit 6 and the projection -- 7 MS. MANDEL: It was a test basis. 8 MR. LEVINE: -- is that -- that you find three 9 errors and they stand in for everything else. So, my 10 understanding, I don't have personal knowledge, is that 11 these particular type of transactions were not in the 12 test. 13 MS. MANDEL: It's not in the population being 14 tested. 15 MR. LEVINE: I'm sorry, right, not in the 16 population. 17 MS. MANDEL: Okay. That's where I was getting 18 disconnected. 19 MS. YEE: Department, your -- is that -- 20 MR. TUCKER: I was just agreeing with Mr. 21 Levine, is that's what the assertion from -- not the 22 Department but from the appeals conference-holder is 23 that in essence these could not have been in the test 24 that was conducted. Accordingly, tax could not have 25 been paid. 26 MS. MANDEL: In the population of the test. 27 MR. TUCKER: Correct. In the pop -- 28 MS. MANDEL: Yeah, because when -- when you 26 1 say in the test I think of the six things that were 2 pulled to look at to see if they were okay as opposed to 3 I'm sampling some population. 4 MR. TUCKER: The -- the category of the type 5 that was tested, yes. 6 MR. LEVINE: And it could be -- not likely but 7 could be the dollar amounts. For some reason they only 8 tested under 100,000 and over a million and these were 9 in between because on first look they said it doesn't 10 look like you have any problems with the medium area, 11 only the big and the little. 12 If so, these wouldn't have been tested and so 13 they wouldn't have been in the population that was 14 tested. 15 MS. MANDEL: Thank you for explaining that. 16 MS. YEE: Okay. Thank you, Ms. Mandel. 17 Ms. Steel, please. 18 MS. STEEL: To the taxpayer, that you just 19 said there's no two software programs are identical. 20 MR. VARGA: That's correct, no two 21 switch-specific software programs. 22 MS. STEEL: Switch -- okay. 23 Can this switches can create it for customer 24 to be reused and resold to another customer? 25 MR. VARGA: I don't know the answer to your 26 question. Each switch-specific software program was 27 created for a particular switch -- 28 MS. STEEL: Right. 27 1 MR. VARGA: -- in a particular location. 2 Whether -- if somebody sells the switch to someone else 3 and takes it to a different location, whether the 4 software could work in different location, I strongly 5 doubt it, but I -- I don't know. I don't want to make 6 any statements that I don't know one way or another. 7 MS. STEEL: Then let's go to the Department 8 that, you know, digital switch software is so unique for 9 each customer. So let's forget about that we used or 10 resold. How can we interpret this as a pre-written 11 software? 12 MR. HELLER: That's a very good question, Ms. 13 Steel. And essentially I think in this case nobody -- 14 the Department doesn't dispute that an actual finished 15 switch may not actually have every single functionality 16 of every other single finished switch. But essentially 17 they all perform similar functions like -- such as 18 providing a voice service, so that if you make a phone 19 call it can connect that phone call to the end recipient 20 and that recipient's voice sound comes back to you. 21 That's really what the switch does. 22 And we -- from what we can tell there seems to 23 be no evidence at all to indicate that the Petitioner 24 invents that entire wireless program or the -- the -- 25 excuse me, the software program that transfers the 26 wire -- or that voice communications -- they invent that 27 from scratch essentially every single time a customer 28 says, "I want a -- this particular switch and I want it 28 1 to be able to carry a phone call. 2 So, we look at the Petitioner and we say, can 3 you explain to us what specifically is different about 4 this, you know, program that carries voice -- voice 5 transmissions back and forth between the one that's on 6 this switch. And they don't want to tell us 7 specifically what's different about them. What they 8 want to do is just tell us that the end switch itself is 9 like essentially unique like a snowflake 10 MS. STEEL: So if the taxpayer can explain 11 that then you can determine better that it's a pre -- 12 you know, written switch or it's been custom-made 13 switch? 14 MR. HELLER: Correct. And then in addition if 15 you were theoretically to, you know, invent these types 16 of programs from scratch each time and not rely on 17 anything that was pre-written or pre-existing or that 18 had been used in a sale to a -- or sale or license to 19 another customer, then in that particular case it -- it 20 must be pre-written. There must be something out there 21 existing that they're building on or that they're just 22 tinkering with. 23 And we also understand at least to this point 24 that a lot of the functionalities are actually built 25 into the overall programs and for instance in some of 26 the contracts we've seen they basically indicate that 27 the Petitioner loads a -- basically a spy program inside 28 these switches so that they can tell if their customers 29 1 activate functionalities that they haven't paid license 2 fees for. 3 So that indicates to us that these programs 4 are actually in there and if you just pay a certain fee 5 they activate it for you. And if they don't -- if you 6 don't pay it they don't activate it. So it -- 7 MS. STEEL: But they are getting different 8 programs, though, for each switch. 9 MR. HELLER: The -- 10 MS. STEEL: It's -- it's not identical. 11 That's what you agree and they agree that it's -- 12 MR. HELLER: Not at all -- 13 MS. STEEL: -- you know, none of the switch 14 are -- 15 MR. HELLER: Not really. What we're saying 16 is, is we don't know -- we're not necessarily here to 17 compare every switch they every sold -- 18 MS. STEEL: Uh-huh. 19 MR. HELLER: -- which single one of them and 20 be able to say that in fact there's two that are totally 21 identical. We just don't have that information. 22 My guess is there's been so many sold that 23 it's probably the case and you -- as they indicated, 24 it's very likely that these switches could be -- you 25 know, essentially could sell a plant with a switch in it 26 to another company. They could operate it on their 27 network. And it doesn't make me think that they're so 28 unique that they can't be interchanged, that if another 30 1 telecommunications company moved into California and 2 wanted to purchase a -- you know, a group of switches, 3 they'd simply take over these contracts and they'd be 4 functional within their network. 5 So I don't -- I don't think that's the case. 6 And then essentially what we really look to here is for 7 the Petitioner to tell us what -- actually, what 8 engineering specifically is done with these programs. 9 And the Department's never had a problem with making 10 sure that we don't include charges for actual programing 11 services in the measure of tax. 12 And any time that the petitioner has been able 13 to show us that this is a charge for -- for custom 14 computer programming or custom changes to a preexisting 15 program, then we're happy to eliminate those from the 16 measure of tax. 17 MS. STEEL: So, taxpayer, why -- why you're 18 not showing that because that makes everything so simple 19 here, that we don't -- they don't have to guess and we 20 don't have to guess. 21 MR. VARGA: Mr. -- Mr. Heller, I think, 22 identified the fundamental difference between the 23 Board's position and our position. Mr. Heller and the 24 Board -- 25 MS. YEE: Mr. Varga, I'm going to ask you to 26 speak right into the microphone, please. 27 MR. VARGA: Oh, I'm -- I'm sorry. Thank you, 28 Madam Chairman. The fundamental difference is the Board 31 1 refuses to follow its own regulation. Regulation 2 1502(b)(9) defines pre-written software. Pre-written 3 software is software that is held for sale or -- for 4 repeated sale or lease or exists for repeated sale or 5 lease. Not a single one of the switch-specific software 6 programs is held for repeated sale or lease. Not a 7 single switch-specific software program exists for 8 repeated sale or lease. 9 Each is created uniquely for the target 10 switch. They don't exist. 11 The Board's position is that's not good enough 12 for us, the only way you can prevail, Lucent and Nortel, 13 is if you show us that you created each switch-specific 14 software program from scratch, just as you heard Mr. 15 Heller say just now. And that is the fundamental 16 difference in this lawsuit. 17 Section 6011(c)(10) and 60 -- I said 18 "lawsuit", excuse me -- in the Nortel lawsuit but -- but 19 the the fundamental issues aren't different. Section 20 6011 and 6012(c)(10) -- and 6012(c)(10) allow a taxpayer 21 that licenses the right to use software programs 22 transfer with tangible property pursuant to technical 23 transfer agreements to exclude those amounts from tax. 24 Section 6011(c)(10)(D) and 6012(c)(10)(D) in 25 turn define what a -- what a technology transfer -- a 26 technology transfer agreement is. 27 The Board -- and as the Honorable Members 28 know, we challenged this. But the Board enacted 32 1 Regulation 1507(a)(1) which purports to say that 2 pre-written software programs are -- cannot ever be the 3 subject of a technology transfer agreement. That is one 4 of the issues in the Nortel case. 5 The trial Judge agreed with the Board that 6 that regulation was valid on -- on the Nortel appeal, as 7 you all know. Our position is that the Board acted 8 beyond its authority in enacting that regulation. 9 However, because the regulation's in the books 10 we are addressing why the switch-specific software 11 programs were not pre-written. And we go back not to 12 whether it's custom, because this is not a 6010.9 13 case -- we go back to the definition -- your -- your own 14 definition of what's pre-written. 15 And, unfortunately, I don't have it in front 16 of me, I'm going from memory, but I'm pretty sure it 17 says a pre-written software program is a program that's 18 held or existing for repeated sale or lease or -- I hope 19 I don't get this wrong, please correct me if I get it 20 wrong, you guys have the reg. there -- or used for 21 in-house purposes and then sold for product. 22 The switch-specific software programs do not 23 meet this definition and I don't believe the gentlemen 24 contend that they meet this definition. They want to 25 ignore this definition. They want to go back to 6010.9 26 and argue that we have to establish that the software 27 programs were written from scratch. 28 MS. STEEL: Thank you. 33 1 MS. YEE: Let me follow up because now I'm -- 2 you've questioned what our focus ought to be. Ought it 3 be on the switch or on the program? 4 MR. VARGA: Do we need to wait until -- 5 MS. YEE: No, proceed. 6 MR. VARGA: The issue here and the issue in 7 the litigation is whether the amounts -- 8 MS. YEE: I don't want to talk about the 9 litigation issue here. 10 MR. VARGA: The issue here is whether the 11 amounts charged for the right to use switch-specific 12 programs is or is not subject to sales tax. We've 13 demonstrated in our papers that no switch-specific 14 software program was pre-written. That's the focus. 15 MS. YEE: So are you saying a program -- a new 16 program gets developed for every single new switch 17 application? 18 MR. VARGA: Our papers describe in detail -- 19 well, I don't want to say that that would -- I misstated 20 myself. Our papers provide a general overview, broad 21 stroke overview, of the hundreds of hours needed to 22 create each individual switch-specific software program. 23 Our papers do say, Madam Chairwoman, that we start with 24 a library of available basic codes. 25 MS. YEE: Preexisting. 26 MR. VARGA: Those available basic codes exist. 27 MS. YEE: Okay. 28 MR. VARGA: There's no question. When -- 34 1 when -- actually, when you get down to it there's so 2 little dispute between us it's really -- really the 3 legal implication of the undisputed facts. There's no 4 dispute, there is something called the available -- 5 well, we call it the available basic code. It exists. 6 It's there. 7 MS. YEE: Uh-huh. 8 MR. VARGA: From the available basic code 9 the -- the basic code that relate to a particular 10 geographic area, for example Sacramento for -- for a 11 local telephone service, are extracted from the library 12 of available basic codes. This is all in our papers. 13 And with that basic code is merged office-dependent 14 instructions. These instructions do not exist. They -- 15 they don't exist until you start building the 16 switch-specific software program to operate a switch. 17 For example, if we're going to have a new 18 switch in Sacramento, you purchase the switch and the 19 switch has certain requirements. In order to meet the 20 requirements, for example -- well, I better not give any 21 example because there's so many I don't want to misstate 22 myself -- but each switch for the Sacramento area has a 23 number of unique requirements. 24 How do you route the call to 911? Where is 25 your PSAP? How do you route the call from here to Los 26 Angeles? What area codes do I recognize? Is this a 27 long distance call? Is this a -- there -- it just goes 28 on and on that are unique to each specific switch. 35 1 Moreover, the switch is located in something 2 called the central office. As far as I know, there are 3 no two central offices that are identical. Sometimes 4 you have two stores -- sometimes there are two floors. 5 You have to have part of the switch up here, part of the 6 equipment comprising a switch down here. Sometimes 7 you're in a room with a conference room in between. 8 The imagination can only suggest how many 9 different ways there are, but it is my understanding 10 there are no two switches alike. 11 So for that reason also you can't have the 12 same switch-specific software program. 13 And each is unique. For example, if you were 14 to put a switch-specific software program designed for 15 the Sacramento switch into a Los Angeles switch, I am 16 told that would bring down the whole system. 17 MS. YEE: Okay. I think you've answered my 18 question in a roundabout way. What I was getting to was 19 whether you develop brand new programming for every 20 switch that is developed, and the answer appears to me 21 to be no. 22 MR. VARGA: You start -- 23 MS. YEE: That each switch is unique because 24 of the capability and the features that you want to have 25 associated with that switch. The source codes are 26 preexisting. And so then the programs can then be 27 developed to meet the particular need of the individual 28 switch. 36 1 MR. VARGA: I don't know if the source codes 2 are preexisting. I'd be going outside my own expertise 3 here. But in our brief we -- there's no -- no question, 4 the available basic codes that are the building block to 5 each unique switch-specific software program is in 6 existence. But then there's six or seven hundred 7 hours -- excuse me, again I shouldn't quantify -- there 8 are hundreds of hours to then take that program, which 9 the program, Madam Chairwoman, cannot operate a -- a 10 call. Stick that available basic code in a switch, it's 11 not even going to turn the switch on. But once you add 12 all the unique requirements that are program -- these 13 are instructions. The Board likes to say they're data. 14 They're not. There might be some data but there's 15 instructions, instructions that didn't exist until an 16 order has been received for a switch-specific software 17 program for a program. 18 I hope I answered your question. We're not 19 trying to hide anything. The facts are not in dispute. 20 The available basic codes exist but they don't do 21 anything until much more is added in order to create a 22 switch-specific software program. 23 MS. YEE: Okay. I'd -- 24 MR. VARGA: Thank you so much for indulging 25 me. 26 MS. YEE: Thank you. Other questions, 27 Members? 28 Anything you have? Okay. 37 1 All right, hearing none, is there a motion, 2 Members? 3 MR. HORTON: Move to take it under submission. 4 MS. YEE: Motion by Mr. Horton to take the 5 matter under submission. 6 MS. MANDEL: Second. 7 MS. YEE: Seconded by Ms. Alby. 8 MS. YEE: Without objection that motion 9 carries. 10 Thank you, gentlemen. We will discuss your 11 matter later today and send you -- 12 MR. GUERRIERO: Thank -- thank you -- 13 MS. YEE: -- notice of our decision. Thank 14 you. 15 MR. GUERRIERO: -- Members of the Board. 16 ---oOo--- 17 18 19 20 21 22 23 24 25 26 27 28 38 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 May 25, 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 38 , 13 pages constitute a complete and accurate transcription 14 of the shorthand writing. 15 16 Dated: December 6, 2010. 17 18 19 ____________________________ 20 BEVERLY D. TOMS 21 Hearing Reporter 22 23 24 25 26 27 28 39