1 BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 2 450 N STREET 3 SACRAMENTO, CALIFORNIA 4 5 6 7 8 REPORTER'S TRANSCRIPT 9 MAY 25, 2010 10 11 12 13 14 15 FINAL ACTIONS 16 17 18 19 20 21 22 23 REPORTED BY: JULI PRICE JACKSON 24 CSR NO. 5214 25 26 27 28 1 1 P R E S E N T 2 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 G. Olson Chief, Board 13 Proceedings Division 14 15 ---OOO--- 16 17 18 19 20 21 22 23 24 25 26 27 28 2 1 450 N STREET 2 SACRAMENTO, CALIFORNIA 3 MAY 25, 2010 4 ---o0o--- 5 MS. YEE: Next item? 6 MS. OLSON: The next items are those items that 7 have been taken under submission. 8 ---o0o--- 9 B1 EUGENE MIDLOCK AND PENELOPE MIDLOCK 10 NO. 484989 11 ---o0o--- 12 MS. YEE: Okay. Members, let's return back to 13 B1. This is our right first income tax appeal, Eugene 14 Midlock and Penelope Midlock. 15 May I have a motion, please? 16 MS. MANDEL: Move to sustain the Franchise Tax 17 Board. 18 MS. YEE: Okay, a motion by Ms. Mandel to 19 sustain the Franchise Tax Board. 20 Is there a second? 21 MS. ALBY: Second. 22 MS. YEE: Second by Ms. Alby. 23 discussion? 24 Hearing none, without objection, that motion 25 carries. 26 Thank you. 27 ---o0o--- 28 3 1 MS. YEE: Next item. 2 MS. OLSON: B2, Rheem Manufacturing Company. 3 ---o0o--- 4 B2 RHEEM MANUFACTURING COMPANY 5 NO. 485872 6 ---o0o--- 7 MS. YEE: Okay, item B2, Rheem Manufacturing 8 Company. 9 May I have a motion? 10 MS. STEEL: Move to grant the petition. 11 MS. YEE: Okay, we have a motion by Ms. Steel 12 to grant the appeal. 13 Is there a second? 14 MS. ALBY: Second. 15 MS. YEE: Second by Ms. Alby. 16 MS. KELLY: Madam Chair? 17 MS. YEE: Yes, Ms. Kelly? 18 MS. KELLY: I'm sorry to interrupt, can I just 19 clarify that the -- I am sorry, wrong appeal. I am back 20 on Midlock, I'm sorry. 21 MS. YEE: All right. 22 MS. KELLY: I apologize. 23 MS. MANDEL: Was there something -- 24 MS. YEE: Was there any adjustment on this? 25 MS. KELLY: No, on Midlock they had not argued 26 the third issue. 27 MS. YEE: Correct. 28 MS. KELLY: And that would only come up if 4 1 there was a grant of the appeal. 2 MS. YEE: Right, okay. 3 MS. KELLY: I apologize. 4 MS. YEE: Okay, that's all right. 5 So, on B2, Rheem Manufacturing Company, we have 6 a motion by Ms. Steel to grant the appeal, second by 7 Ms. Alby. 8 Discussion? 9 MS. YEE: I'll go first. 10 I see nothing here that suggests that this was 11 a passive investment. If anything, it kind of suggests 12 the opposite, where there's still a very intertwined 13 relationship between Watsco and Rheem and particularly 14 as it relates to the restrictions in the distribution 15 agreements. 16 Other thoughts? 17 Ms. Alby? 18 MS. ALBY: I'm trying to get -- there it is, 19 you helped me. 20 Thank you, Madam Chair. 21 I was actually persuaded the taxpayer is in the 22 the business of manufacturing, not in the, you know, the 23 buying and selling of stock. 24 So, I just -- he may have been -- Watsco could 25 have been their largest single distributor, but it was 26 only one of many. They had an important relationship, I 27 know, but so do a lot of people with vendors and 28 whatnot. 5 1 I do not believe that the taxpayer controlled 2 Watsco's business. And, so, I -- I just believe we 3 should rule in favor of the taxpayer. 4 MS. YEE: Okay. And I think the question was 5 really controlling management of the asset rather 6 than -- 7 MS. ALBY: I know. 8 MS. MANDEL: Right, of the asset as an integral 9 part -- 10 MS. YEE: Part of -- 11 MS. MANDEL: -- of their business. 12 MS. YEE: Right. 13 MS. MANDEL: And I think what they tried to 14 stress -- what they tried to stress was that there 15 was -- which was the last -- when I was, you know, 16 channeling Ms. Steel, what the taxpayer was trying to 17 stress was that they thought that there was no change in 18 the business relationship throughout the period they 19 held the stock. 20 MS. YEE: Right. 21 MS. MANDEL: And -- but -- and FTB did say it's 22 a long term investment, so, but for the relationship to 23 the business, FTB would say it was non-business. 24 But FTB is looking at the business 25 relationships and saying that holding this particular 26 stock was, in their view, because of where it came from 27 and the continued holding of it, FTB's view was that it 28 was integral to the taxpayer's business -- if I haven't 6 1 completely misstated those two positions. 2 MR. AMBROSE: Yeah, and I think part of the 3 FTB's argument was there's a flow of value as a result 4 of the holding of the stock. 5 I guess initially getting into the joint 6 venture partnership and then the long term relationship 7 between the two companies and they were arguing there 8 was a flow of value. But then -- and I think 9 Ms. Steel's question went to this, if there is a flow of 10 value, then how is that demonstrated if they really 11 haven't increased their volume of sales to Watsco -- 12 MS. MANDEL: Or -- 13 MR. AMBROSE: -- over this period? 14 MS. MANDEL: -- or lost -- 15 MR. AMBROSE: Or lost, right. 16 MS. MANDEL: -- lost when they sold I think was 17 what the arguments were. 18 It's difficult because of all of the, you know, 19 the nature of that business makes it difficult. 20 MR. AMBROSE: So, there was no distinction 21 between their relationship and the relationship of the 22 other manufacturers. 23 MS. YEE: Other comments? 24 Mr. Horton? 25 MR. HORTON: Yes. Madam Chair, I don't really 26 isolate this -- these individual transactions to look at 27 one transaction within itself. 28 I would speculate that if we looked at all of 7 1 the transactions related to this strategy as a whole of 2 increasing method in which to control the market, to 3 gain greater market share, that the intent was to do it 4 through the acquisition of these various different 5 smaller companies. 6 So, there was an economic benefit or a 7 perceived economic benefit in acquiring the stock in 8 this particular asset and being able to continue to 9 control that asset, as reflected by decisions made by 10 the taxpayer. 11 One, initially the taxpayer recorded this, the 12 dividends, as business income. There is a conscious 13 decision that takes place over that three or four year 14 period. And then subsequently a new representative 15 comes in and at a point of sale and makes decisions 16 that -- that this is no longer a business income because 17 at that point the value of the consideration is 18 different than dividends. Now you're talking about a 19 much larger consideration and much larger tax 20 implications, depending on how it was treated. 21 And, so, there are so many other ways to -- 22 other motivations that weren't in play here for an 23 investment. I mean, when the average person makes a 24 stock investment for stock income, there is a different 25 consciousness, I think. And you don't necessarily -- I 26 don't necessarily take the inverted argument is I don't 27 necessarily participate in the tax discussions or the 28 tax decisions. When I start participating in tax 8 1 discussions and decisions, ultimate decisions, I'm 2 actually influencing this operation as the owner of the 3 stock -- which occurred in this particular case. I 4 mean, they had direct influence over this operation. In 5 fact, arguably, it was part of the strategy. 6 And it's indicative of a strategy that has been 7 in play for a long time. I mean, this -- this is how 8 you expand your operation. You go in, you control the 9 smaller companies to some extent, have some influence 10 over it, gain a greater market share, has an economic 11 value, increases your stock. 12 You really don't care if the distribution goes 13 down or up. Your ultimate goal is not to sell to your 14 affiliates, necessarily, your ultimate goal is to 15 control market share and drive up the value of the 16 whole. And in doing so, you drive up the value of your 17 stock as well as the stock that you ultimately sell. 18 And, so, I mean, I -- I concur with the Chair. 19 I can clearly see that there's an economic benefit in 20 controlling the stock. 21 If it were not it just wouldn't have all of the 22 participation in the decision making process and they 23 would have treated it consistently throughout the audit 24 period. 25 MS. YEE: Thank you, Mr. Horton. 26 Ms. Steel? 27 MS. STEEL: I think we should make it very 28 clear here it's business income or non-business income. 9 1 When -- if we interpret this case that way, 2 then I guess I'm managing so many companies out there 3 that, you know, whatever stocks that you own and then 4 you get any -- when you sell your own stock and then you 5 get some income out of it, then I am managing that 6 company. It can not be like that. 7 For this they put in because -- they put the 8 money in because that company, Watsco, was selling 9 70 percent of Rheem's company's merchandise there. So, 10 they were helping, but they tried to get out and they 11 didn't have enough cash for it, so, they give stock. 12 So, they stored that stock, how we going to 13 interpret that as a business income? I just don't 14 understand that. 15 And then another part is then when this company 16 pays taxes for other areas too, right, other states? 17 MS. YEE: Uh-huh. 18 MS. STEEL: And then, you know, coming back and 19 Franchise Tax Board saying yes, you -- you know, you 20 have to pay 9.2 percent of whatever you made. 21 I mean -- well, that's -- that has nothing to 22 do with non-business and business, but, you know, I -- I 23 totally looking at this as, you know, non-business 24 income. 25 MS. YEE: Thank you Ms. Steel. 26 Other comments, Members? 27 Okay, we have a motion by Ms. Steel, second by 28 Ms. Alby to grant the appeal. 10 1 Please call the roll. 2 MS. OLSON: Madam Chair? 3 MS. YEE: No. 4 MS. OLSON: Ms. Alby? 5 MS. ALBY: Aye. 6 MS. OLSON: Ms. Steel? 7 MS. STEEL: Aye. 8 MR. HORTON: Mr. Horton? 9 MR. HORTON: No. 10 MS. OLSON: Ms. Mandel? 11 MS. MANDEL: No. 12 MS. OLSON: Motion fails. 13 MS. YEE: Okay. May I have another motion, 14 please? 15 MR. HORTON: Move to sustain. 16 MS. YEE: Motion by Mr. Horton to sustain the 17 Franchise Tax Board. I will second that motion. 18 Please call the roll. 19 MS. OLSON: Madam Chair? 20 MS. YEE: Aye. 21 MS. OLSON: Ms. Alby? 22 MS. ALBY: No. 23 MS. OLSON: Ms. Steel? 24 MS. STEEL: No. 25 MS. OLSON: Mr. Horton? 26 MR. HORTON: Aye. 27 MS. OLSON: Ms. Mandel? 28 MS. MANDEL: Aye. 11 1 MS. OLSON: Motion carries. 2 ---o0o--- 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 12 1 MS. YEE: Next item. . 2 MS. OLSON: Next item is B3, Todd Lutwak. 3 ---o0o--- 4 B3 TODD LUTWAK 5 NO. 482917 6 ---o0o--- 7 MS. YEE: Okay, item B3, Todd Lutwak. 8 Is there a motion? 9 I'll move to sustain the Franchise Tax Board. 10 Is there a second? 11 MS. MANDEL: Second. 12 MS. YEE: Second by Ms. Mandel. 13 Discussion? 14 Without objection, that motion carries. 15 ---o0o--- 16 17 18 19 20 21 22 23 24 25 26 27 28 13 1 MS. YEE: Next item?. 2 MS. OLSON: Our next item is C1, J's Tires, 3 Inc. 4 Ms. Alby has a disqualifying contribution. 5 ---o0o--- 6 C1 J'S TIRES, INC. 7 NO. 301642 (GH) 8 ---o0o--- 9 MS. YEE: Right, correct. 10 Item C1, J's Tires, Incorporated, Ms. Alby not 11 participating in this matter. 12 Is there a motion? 13 MR. HORTON: Move to adopt staff's 14 recommendation. 15 MS. YEE: Okay, motion by Mr. Horton to adopt 16 the staff recommendation. 17 Is there a second? 18 MS. MANDEL: Second. 19 MS. YEE: Second by Ms. Mandel. 20 Without objection, that motion carries. 21 ---o0o--- 22 23 24 25 26 27 28 14 1 MS. OLSON: Our next item is C2, Lucent 2 Technologies, Inc. 3 ---o0o--- 4 C2 LUCENT TECHNOLOGIES, INC. 5 NO. 317049, 317677, 8900216490 (OH) 6 ---o0o--- 7 MS. YEE: Okay, item C2, Lucent Technologies, 8 Incorporated. 9 May I have a motion, please? 10 MR. HORTON: Move to adopt staff 11 recommendation. 12 MS. YEE: Okay, motion by Mr. Horton -- 13 MS. ALBY: Second. 14 MS. YEE: -- to adopt the staff recommendation, 15 second by Ms. Alby. 16 Discussion? 17 MS. STEEL: Objection. 18 MS. YEE: Okay. 19 MS. STEEL: I think this case came up -- almost 20 same case came up few years ago. And if none of those 21 software programs are identical and then I -- you know, 22 I believe that that's the custom made, to me. 23 You know, I am putting much simple way than, 24 you know, what I'm thinking, but, so, if it's a custom 25 made, then I think that we should grant the petition 26 here. 27 MS. YEE: Okay. Other comments, Members? 28 MR. HORTON: Madam Chair? 15 1 MS. YEE: Yes, Mr. Horton? 2 MR. HORTON: Clearly there is some custom 3 software activity going on. The challenge here is is 4 that they're taking non custom software, combining them 5 in such a way to fit the needs of their customer and the 6 act of combining that has some element of being -- 7 customizing, but does not make the entire transaction 8 a custom software. 9 To some extent one might argue that they're 10 simply assembling non custom, canned software. So, it's 11 hard to distinguish where the customizing takes place 12 and the assembling takes place. 13 And the taxpayer seems not to want to argue 14 that. They seem to want it, you know, all or none -- 15 not wanting to provide any information that would 16 support the fact that there is some customizing labor 17 that takes place here in customizing the software. 18 I don't think that the act of -- an act of 19 customizing or -- in assembling or making or assembling 20 canned software components in order to meet the needs of 21 the customer, in and of itself, makes now what was 22 previously taxable nontaxable. 23 So, therein is, you know, the challenge for me. 24 I would have liked for him to have said, "If I can't get 25 a full loaf, I take a half a loaf." But it didn't go 26 there. 27 MS. STEEL: But, you know, we've been having 28 cases not just for softwares, but we had those 16 1 windows -- or, you know, the custom made windows and 2 doors. You remember that case? 3 And if they using same woods and glass, they 4 making just a little different, what's the difference 5 here between, you know, those window making -- custom 6 made windows and, you know, versus software for me that 7 when customers asking their own program there, then I 8 think that's custom made. That's -- you know, we don't 9 have to going into software -- software comes to little 10 more complicated than, you know, those stores or the 11 furnitures. 12 But I think they are using same thing, try to 13 make little different, to me, that's custom made. 14 MS. YEE: Okay. Any other comments, Members? 15 Okay, hearing none, we have a motion by 16 Mr. Horton to adopt the staff recommendation, second by 17 Ms. Alby. 18 Please call the roll. 19 MS. OLSON: Madam Chair? 20 MS. YEE: Aye. 21 MS. OLSON: Ms. Alby? 22 MS. ALBY: Aye. 23 MS. OLSON: Ms. Steel? 24 MS. STEEL: No. 25 MS. OLSON: Mr. Horton? 26 MR. HORTON: Aye. 27 MS. OLSON: Ms. Mandel? 28 MS. MANDEL: Aye. 17 1 MS. OLSON: Motion carries. 2 MS. YEE: Okay. 3 ---o0o--- 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 18 1 REPORTER'S CERTIFICATE. 2 3 State of California ) 4 ) ss 5 County of Sacramento ) 6 7 I, JULI PRICE JACKSON, Hearing Reporter for the 8 California State Board of Equalization certify that on 9 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 pages 1 13 through 18 constitute a complete and accurate 14 transcription of the shorthand writing. 15 16 Dated: JUNE 4, 2010 17 18 19 ____________________________ 20 JULI PRICE JACKSON 21 Hearing Reporter 22 23 24 25 26 27 28 19