1 2 BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 3 450 N STREET 4 SACRAMENTO, CALIFORNIA 5 6 7 8 9 REPORTER'S TRANSCRIPT 10 JULY 13, 2010 11 12 CORPORATE FRANCHISE AND PERSONAL INCOME TAX HEARING 13 APPEAL OF 14 HANK FEENSTRA and CATHERINE FEENSTRA 15 NO. 464316 16 AGAINST PROPOSED ASSESSMENT OF 17 ADDITIONAL TAX 18 19 20 21 22 23 24 25 26 Reported by: Juli Price Jackson 27 CSR No. 5214 28 1 1 P R E S E N T 2 For the Board Betty T. Yee of Equalization: Chair 3 Jerome E. Horton 4 Vice-Chair 5 Barbara Alby Acting Member 6 Michelle Steel 7 Member 8 Marcy Jo Mandel Appearing for John 9 Chiang, State Controller (per Government Code 10 Section 7.9) 11 Diane G. Olson Chief, Board 12 Proceedings Division 13 For Board of Lou Ambrose 14 Equalization Staff: Staff Counsel 15 16 17 For Franchise Tax Board: Jason Riley Tax Counsel 18 19 Bill Hilson Tax Counsel 20 21 For Appellants: Michael A. Thompson Attorney 22 Hank Feenstra 23 Taxpayer 24 Gary Galbraith Witness 25 26 27 28 ---oOo--- 2 1 450 N STREET 2 SACRAMENTO, CALIFORNIA 3 JULY 13, 2010 4 ---oOo--- 5 MS. YEE: Okay, I'll call the meeting back to 6 order. 7 Our next item, Ms. Olson? 8 MS. OLSON: Next is B1, Hank and Catherine 9 Feenstra. Board Proceedings Division has received 10 contribution disclosure forms for this morning's 11 hearings from the parties, agents and participants. 12 All forms were properly completed and signed. 13 All parties, agents and participants are on the 14 alpha listing provided to your office. 15 Each person at the table will be asked to 16 introduce themselves and, if necessary, their 17 affiliation with the taxpayer. 18 For this first hearing 15 minutes is allocated 19 for the taxpayer's opening presentation, followed by 15 20 minutes for the Franchise Tax Board's presentation and 21 five minutes is allocated to the taxpayer for rebuttal. 22 Ms. Yee? 23 MS. YEE: Thank you very much, Ms. Olson. 24 Members, our first item is item B1, Hank 25 Feenstra and Catherine Feenstra. 26 The Chair has granted 15 minutes for the 27 presentation by both parties. Let me have Appeals 28 introduce the issues. 3 1 MR. AMBROSE: Good morning, Madam Chair, 2 Members of the Board. 3 The issues before the Board in this matter are 4 whether the Board has jurisdiction to hear and decide 5 the appeal of Respondent's disallowance of the research 6 and development tax credits for tax year 2004; secondly, 7 whether Appellants have met their burden of proof to 8 substantiate their fixed base percentage calculation for 9 purposes of determining the allowable amount of research 10 and development credit; and then the third issue is 11 whether Appellants have presented evidence sufficient to 12 demonstrate that the claimed activities constituted 13 qualified research, and to prove the amount of qualified 14 research expenditures in accordance with Internal 15 Revenue Code Section 41. 16 MS. YEE: Thank you very much. 17 Good morning, gentlemen. 18 MR. THOMPSON: Good morning. 19 MS. YEE: If you'll each introduce yourselves 20 for the record, you have 15 minutes. 21 MR. THOMPSON: Thank you, Madam Chairwoman, 22 Members of the Board. 23 My name is Michael Thompson. I am a 24 representative of Mr. Hank Feenstra. 25 MR. GALBRAITH: Hi, my name's Gary Galbraith. 26 I'm manager of Plant Operations for California Cascade. 27 MR. FEENSTRA: I'm Hank Feenstra. 28 MS. YEE: Thank you. Please proceed. 4 1 MR. THOMPSON: Thank you. 2 Basically what we're here to do -- talk about 3 today, as the Appeals issues were presented to you, we 4 feel the crux of this case is whether or not California 5 Cascade Woodland was performing qualified research 6 activities as that's defined in Section 41, to present 7 the Board with our reasons why and what we believe. We 8 have a presentation that we'd like to go through very 9 quickly so that we can show you guys exactly what types 10 of activities they were conducting. 11 Mr. Galbraith here is going to walk you through 12 those activities. I also have a presentation and you 13 can follow along, if you -- if you care to. 14 Go ahead. 15 MR. GALBRAITH: Okay. During 1978 to 2000 we 16 used a copper chromium arsenic solution that had been 17 used in the industry for over 60 years. We used it for 18 about 20 years without any problems whatsoever. 19 There were rumblings in the industry that the 20 EPA was going to come forward with new requirements for 21 a different type of chemicals to be used in place of 22 this. So, we started in 2001 and adopted ACQ, which is 23 ammonical copper quaternary product. And we're using 24 that to present. 25 The known things in the CCA, where, like I 26 said, it was used for 60 years, it was very common. It 27 was easy to use. It was just kind of a drop-in thing. 28 When we adopted it, it wasn't any problem at all to use. 5 1 In the AC -- we used a Redwood stain also, 2 which was called Sunwood at that point, that was used in 3 the process to turn the wood a red color, like Redwood, 4 that the people in the state, they like to use. 5 On the heels of the EPA wanting us to switch to 6 ACQ, we checked into different types of chemicals. We 7 tried borates, we looked at copper azoles. 8 And at the time the thing that was -- seemed to 9 have success was ACQ. It was used back East, about 85 10 percent of all of the business was using it. And they 11 were using a Southern Yellow Pine product. 12 This is our treating area here (indicating), 13 where we have a tank farm, basically, and treating 14 retorts. And the chemicals are stored in that area. 15 We had, like I said, the Sunwood product was 16 also used in the process. And it was just a chemical 17 that was mixed and treated wood at the time. 18 Those are the cylinders that were used in the 19 process itself (indicating). 20 This is a cylinder where we load the wood and 21 then pressurize it and treat it (indicating). 22 This is also just another portion of the tanks 23 here showing what we do (indicating). 24 This is the actual lab, the treating lab, where 25 the guys work and watch all these operations 26 (indicating). 27 And the development of an ACQ product was done 28 by our provider, our chemical provider. And it was 6 1 supposed to do the same job that, you know, that we had 2 in our current product, which was CCA. 3 Upon adopting that, you know, we found out 4 there were several problems. We had problems with the 5 treatment process. It wouldn't penetrate the wood 6 because of the type of incisions that we were using. 7 And the current process had been used for 25 8 years where a -- they were plenty fine under CCA, but 9 under ACQ they weren't dense enough. So, we spent quite 10 a few years trying to come up with an incision process 11 that wouldn't damage the wood, but to make it denser so 12 that it would treat better. 13 We -- in addition to that, we found that we had 14 problems with the absorption, just a blackening of the 15 stain that we used to stain the product that we had 16 always used for 20 years would not work with ACQ. 17 We wound up having to abandon that and go to a 18 prestained product. We had to do a lot of research on 19 that and get that to go. 20 We -- up until 2009 we were still working on 21 those problems. 22 And, in addition to that, we had molds and mold 23 was embedded in a product. And we had to -- we treated 24 about 2 million board feet of product that actually the 25 mold embedded itself and we had to use pressure washers 26 to, basically, clean all this wood up. 27 And then, at that point, we had to adjust our 28 mixes and solutions and so forth to try and overcome 7 1 this different type of mold inhibitors that were out 2 there. The ones we were currently using were a 3 different solution. They were an acidic solution and 4 now we were going to an alkaline solution. So, there's 5 a lot of hurdles with that to get over. 6 So, the main problem we're having was a species 7 at the time and the density of the lumber. So, we 8 developed this (indicating), as you see on the table 9 there (indicating), we have all these different style of 10 teeth. And we had to develop different styles of teeth 11 to penetrate this lumber and actually cut it, not crush 12 it and to keep from tearing the wood and making a viable 13 product. 14 This is an actual incisor (indicating) where 15 the wood goes through the machine and is perforated to 16 allow the chemical to reach a depth of 4/10ths of an 17 inch for copper. 18 MR. THOMPSON: Madam Chairwoman, may I approach 19 and provide these (indicating) for the Board to review? 20 MS. YEE: Sure. 21 MR. THOMPSON: These are essentially -- these 22 are the -- what the wood that was treated and incised 23 with CCA, you can see the pattern of the incisions on 24 that versus what they have to do now with ACQ and the 25 development to achieve the retention that's in the 26 absorption that he's talking about. 27 Go ahead, Gary. 28 MR. GALBRAITH: You know, this is -- this is 8 1 really important to me. 2 Without this (indicating), basically you have 3 American Wood Preservers Association Book of Standards 4 and the National Evaluation Reports Standards that you 5 have to follow. 6 Osmose would provide us with a chemical, but 7 we're the ones that have to make it meet the standards 8 and find a way to make this happen. 9 So, this is what we're spending a ton of time 10 on, along with the stain compromised -- or comprised 11 about 50 percent of all of our business. 12 We had come up with a totally different type of 13 stain process. I mean, we're under the gun. We're 14 under contract with, you know, other companies to get 15 this going. 16 And it wasn't just a drop-in process. This is 17 something we had to work on. We basically came up with 18 different -- we would treat the lumber, take core 19 borings on it, see how it treated. And we'd come up 20 with different processes based on the species of lumber, 21 the -- where the mill -- the mill that it came from, 22 where the lumber was grown, how much moisture content it 23 had in it. There was many factors. 24 We wound up developing hundreds of menus to try 25 and treat these different products because every one is 26 different. You know, we have all different dimensional 27 lumber. We have plywoods, peeler cores. We just have 28 all different kinds of products and it's just like a big 9 1 tree, it just -- it just branches out and you have to -- 2 you have to, you know, determine how this works. 3 And then we would make menus for our employees 4 to follow. We basically had to double our staff when 5 all this happened. We -- you know, we had to create 6 jobs just cleaning lumber, finding out how these things 7 did, having people write down how these processes worked 8 and so forth. 9 Let's see here -- so, we have -- we have a 10 process that's in our quality control lab where the 11 gentleman takes these core borings and lays them out and 12 sees how well they're treated. 13 And then we have certain standards that we have 14 to follow on that. If we don't meet that, the product, 15 you know, it's not buyable. There's an allowance for 16 the way you treat things. Under the standards, you are 17 allowed to treat them three times and after that it's 18 not a viable product any more. You know, you have 19 basically lost your product. 20 And we don't own any of this product. We 21 basically are a treating service only. All we do is 22 provide the service. We don't own the lumber or sell 23 the lumber. So, we would have to buy the lumber if -- 24 you know, if we ruined it weren't successful in it. 25 As far as documentation, I know we offered some 26 that you guys can see forward here and now in this and 27 in the top area here (indicating) is the menuing process 28 that basically shows different temperatures, different 10 1 pressures, different vacuum periods. And all of 2 these -- we have to define those for each amount of 3 lumber. 4 You know, each type of lumber -- rather each 5 species, each -- where it comes from, like I said, if it 6 has different moisture contents and all that. 7 So, even though they give us -- our provider 8 gave us tables to show how to mix something, it doesn't 9 have anything to do with how do you treat it. 10 You still have to follow the standards 11 provided, you know, by American Wood Preservers 12 Association and the National Evaluation Reports, which 13 are used by the building code inspectors and so forth to 14 do this. It's not -- you know, they give you a solution 15 to do it, but you have to make it work. 16 And then, basically we have a -- we have a 17 retention that we're supposed to meet, like in this 18 particular one it would be a .40 retention and we're not 19 meeting that. 20 We pull an assay, the one that was I talking 21 about, the gentleman puts it on an x-ray spectometer and 22 when he reads it, it tells him how many pounds per cubic 23 foot of chemical is left behind. 24 We were having really bad problems with getting 25 this to meet that because all of the -- when they 26 initially developed this, this is all Southern Yellow 27 Pine, which is a really porous product. It's just like 28 a sponge, it just sucks it right up. 11 1 We have a refractory species of lumber on the 2 West Coast and it's very dense and hard to treat. 3 That's why the incisions are so important on this. 4 Again, like I said, we had to develop, you 5 know, many different types of menus to do this. And 6 this is for us to be able to do the work and have our 7 employees, you know, able to carry out these practices. 8 I would spend just tons of time on this trying to 9 develop all of these procedures so that they could do 10 this. 11 Excuse me -- we had lots of problems with our 12 equipment. As you can see, we had some real bad 13 corrosion problems (indicating). When we initially had 14 CCA, it was a real easy product. We never had any 15 problems with equipment. 16 When we first started using this it messed up 17 our pumps. We had heaters in there and just basically 18 shorted them out. There were a lot of problems with 19 equipment. 20 We had to develop a stain line, basically, out 21 of nothing. We -- when we originally treated this, we 22 treated it in the retort with chemicals. That wouldn't 23 work. The CCA that we had always used, the type of 24 chemical was incompatible with the stain. So, we wound 25 up having to develop a stain process, which was separate 26 from the process we had. 27 Before we would just treat the lumber and send 28 it to -- I am sorry, we would incise the lumber, package 12 1 it and send it for treatment. 2 Now we wind up having to put a stain line in 3 there. And we went through three different types of 4 machines developing it to try and get it on. It would 5 just -- originally we just poured it on like a waterfall 6 and then the stuff would fall off and it was just -- it 7 was a mess when you treated it. It didn't look right, 8 you know, for the marketplace. You would send it out 9 and it just looks like a mess. 10 Okay, on the pretreatment for the CCA, 11 basically, what we do -- you are talking about the stain 12 line? 13 Before we didn't use this process. All we did 14 would bring the lumber into the machine, run it through 15 the incision process, package it and send it for 16 treatment. 17 After this, during the stain part, we wound up 18 having to install a system with a stain box. And I 19 don't know if you have a picture of that on there? 20 Okay. And in any case, we wound up -- here we 21 go -- we wound up with a process where the wood comes 22 out of the incisor -- 23 MR. THOMPSON: Your video's not playing. 24 MR. GALBRAITH: -- and, like I said, we went 25 through three different generations of this machine 26 trying to get to it work (indicating). 27 We finally, in 2009, were able to really get it 28 down. I mean, in the meantime we had -- we just had to 13 1 make it work. There's no getting around it. We're 2 under contract to provide, you know, 50 percent of our 3 customers with this product. And you can see it's -- 4 the board's coming out and it's a red stain color 5 (indicating). 6 And, so, we had many problems. We had to tear 7 out machinery that we had had a great investment in. We 8 wound up pulling it all out, having to re-do it, start 9 over again. 10 If he's able to show you here, we have some 11 pictures. 12 MR. THOMPSON: Let me back up a little bit. 13 The video's not working, but let me -- it should go back 14 to where we were. 15 This is the beginning of the process 16 (indicating). And you saw the video that did work, the 17 wood comes down, it goes through the incisor. And it 18 doesn't run through a -- it will not run through a stain 19 box here because this is just treated wood. 20 This is -- when they were using CCA, this is 21 all they had to do and they would treat and stain it all 22 in those retorts, those cylinders that we showed you 23 earlier. 24 So, with the introduction of the ACQ and not 25 being able to treat and stain, California Cascade was 26 forced to, essentially -- this would be looking at 27 that -- that what we just looked at from the other side. 28 If you see that to the right (indicating), that 14 1 big box, that's the stain box that they had to build and 2 it's got the capability of being pushed over in place of 3 that track that they have designed there for just their 4 treated wood. 5 So, this video was going show you coming out of 6 the incisor and going into the stain box. And again 7 this video is not working, but this is the other side 8 coming out of the stain box (indicating). And you can 9 see where it's the same track -- they had to build 10 that -- that machine to where they could push it over. 11 This was something they didn't have to do when they were 12 using CCA. I mean, this was a process they did not have 13 to have this in place. They didn't have to have the 14 outlay of the cost and design time for this. 15 If you look at this when it comes through 16 the -- through the stain machine (indicating), it goes 17 to a restacker (indicating). And this is a picture from 18 about the 2002 to 2004 time period. 19 Gary, go ahead, you can finish. 20 MR. GALBRAITH: And that's -- this is the 21 problems we were having. 22 If you can see underneath there (indicating), 23 it's just an absolute mess. The stain was, basically, 24 falling off of the lumber and it created a large mess 25 underneath there. We wound up paying like 20,000 bucks 26 to chisel that all out, had to take all of the equipment 27 out and dispose of it and build a whole new system. 28 MS. OLSON: Time has expired. 15 1 MR. GALBRAITH: This is -- go ahead. 2 MR. THOMPSON: Madam Chairwoman, may we request 3 five minutes? We can have this finished in five 4 minutes. 5 MS. YEE: Let me see if you can -- let me give 6 you a minute or two, but I want hear from the Franchise 7 Tax Board, but see if you can summarize -- 8 MR. THOMPSON: Okay. 9 MS. YEE: -- this in a minute. 10 MR. THOMPSON: This, essentially, is the type 11 of buildup we were talking about along the stain line 12 (indicating). This is in the stain box. This is what 13 they dealing with when they couldn't get the process 14 down for treating and staining -- excuse me, for 15 staining the wood. 16 This is the inside of the stain box as it's 17 being developed (indicating). More pictures from the 18 time period. 19 This is the end of the stain process 20 (indicating). And we showed you those pictures of what 21 it looked like before and this was taken on July 9th 22 (indicating). So, you can see that they've gotten their 23 stain process into about as good a position as you can. 24 They don't have that buildup, that overkill any more. 25 That's the development. And it took them the 26 time, the effort that they had to put into this. 27 That's basically the presentation. We -- I can 28 rest until my time to reply. 16 1 But, essentially in summary, EPA changes the 2 rules. They can no longer use the process they've been 3 using. They had to redesign and redevelop their entire 4 treating and staining process around this new chemical 5 that was supplied to them by a third party. 6 That is where the research credit was taken in 7 this case. That's what Gary was involved with 8 Mr. Molatore and Mr. Feenstra, to some extent, and the 9 other individuals. 10 So, we'll rest. Thank you, ma'am. 11 MS. YEE: Thank you very much, Mr. Thompson, 12 Mr. Galbraith. We'll give you time on rebuttal. 13 Franchise Tax Board? 14 MR. RILEY: Madam Chair, Members of the Board, 15 good morning. 16 My name's Jason Riley and this is Bill Hilson 17 and we represent Respondent, California Franchise Tax 18 Board. 19 Federal statute -- federal and California 20 statute allow for a research and development credit, but 21 the credit has very specific and narrow requirements. 22 By law, the taxpayer claiming the R & D credit 23 must be engaged in qualified research. And, 24 specifically, taxpayers must engage in a process of 25 experimentation, but they must avoid specific 26 exclusions, such as simply following a set of provided 27 instructions. 28 Here the Appellants did not engage in a process 17 1 of experimentation. Appellants simply followed a 2 recipe. It's a recipe that somebody else created. And 3 you don't get the R & D credit for following someone 4 else's recipe. 5 In fact, the -- following the recipe is a 6 specific exclusion of the R & D credit. It's 7 duplication of an existing process. 8 Appellants are manufacturers of treated lumber 9 that purchased pesticide chemicals from a chemical 10 company, Osmose, and used those chemicals -- those 11 pesticide chemicals -- to treat lumber according to the 12 instructions that Osmose provided and required. 13 Appellants aren't doing research. Appellants' 14 activities are clearly outside the bounds of the R & D 15 credit and Respondent properly denied the claim of R & D 16 credit in full. 17 A taxpayer can get the credit for experimenting 18 on a product or a process. But Appellants don't get the 19 R & D credit for a product because it's clearly Osmose's 20 patented and trademark product. 21 Appellants claimed a substantial chemical 22 reformulation in their credit study of February 2007, in 23 their opening brief filed October 15th, 2008, and again 24 in the supplemental brief on December 21st, 2009. 25 Yet once Respondent proved that Appellant could 26 not have made substantial chemical reformulations to 27 this pesticide without running afoul of US EPA and other 28 governmental regulations, Appellants admitted, for the 18 1 first time, in their most recent brief, the reply to 2 supplemental briefing, that they made no substantial 3 chemical reformulation. 4 They stated, 5 "Appellant would like to clarify that neither 6 Appellant nor Osmose made any chemical changes 7 to any product purchased from Osmose." 8 But note that Appellants have not revealed how 9 much of the dollar value of their R & D credit claim has 10 been removed from the dispute, based on the retraction 11 of their original allegation of a substantial chemical 12 reformulation. 13 So, if Appellant wasn't experimenting on a 14 pesticide product, that leaves only the process. But, 15 again, Appellant doesn't get the R & D credit for the 16 process because Respondent has shown, through the 17 documents provided and, again, today with the 18 documentation with the packet that Osmose provided the 19 process and Appellant was required to use it. 20 Thus, it falls under that specific exclusion I 21 mentioned earlier, the duplication of an existing 22 business component, existing business process. 23 Reproduction of an existing process from plans or 24 detailed specifications is not qualified research. 25 If it's not qualified research, they can't 26 claim the R & D credit for the activity. 27 Appellants claimed a substantial engineering 28 redesign or an overhauling of Osmose's pesticide or 19 1 process, where these pesticides are acutely hazardous 2 and any alteration in sale to the public would require 3 evidence with the EPA, CAL EPA, the requirements of 4 FIFRA, submission of material safety data sheets and 5 other public record documents to demonstrate the 6 differences between Appellants' alleged process and 7 those provided by Osmose. 8 Osmose's product and process have been 9 thoroughly vetted and approved by the EPA and the 10 National Evaluation Service, as Respondent has shown in 11 its supplemental brief and again with the documents 12 provided today, 13 This is Osmose's research. This is not 14 Respondent's -- not Appellants' research. If Appellants 15 had actually done what they claim to have done, they 16 would have similar public records on file detailing 17 their own process. 18 But such records don't exist, apparently. So, 19 either Appellants aren't experimenting and are following 20 Osmose's procedures and recipes, or they've got some 21 explaining to do to the EPA and other governmental 22 bodies involved. 23 Moreover, Osmose offers a warranty to end 24 users. If it's not Osmose's process, it violates 25 Osmose's warranty and strict quality standards. And 26 Osmose wouldn't grant a warranty on the product to end 27 users if it allowed treatment facilities to tinker with 28 the process. 20 1 Modifications also infringe on Osmose's 2 trademark. As a licensee, Appellants can't pass off as 3 Osmose's trademark products when or if it's been 4 modified. It's no longer a trusted or known source if 5 the Appellants modify the -- either the pesticide or the 6 process. 7 What Appellants appear to have done is engage 8 in quality control. In the quality control required by 9 Osmose's Quality Control Manual, which was shown in 10 document NER 628, and provided in Respondent's 11 supplemental brief and again in the exhibits today, 12 Appellants are required to treat wood in accordance with 13 Osmose's quality control standards and procedures, 14 including submitting samples for inspection to third 15 party for quality assurance. 16 Such activities are no more than quality 17 control. And like the duplication of an existing 18 business component, quality control is a specific 19 exclusion from the credit. 20 Respondent has shown that Osmose provided the 21 specifications, the plans, the blueprints and the 22 National Evaluation reports, which details that Osmose 23 provides a quality control manual and plant operations 24 manuals to their licensees. 25 So, either Appellants are following Osmose's 26 directions and are not entitled to the credit because 27 they're just following the instructions or they modified 28 Osmose's product or process and may run afoul of EPA, 21 1 CAL EPA, FIFRA, or other government regulations and 2 Osmose's warranty and Osmose's trademarks. 3 Appellants aren't doing research. They're 4 simply following a recipe and it's a recipe that 5 somebody else created. And you don't get to claim the 6 R & D credit for following someone else's recipe. 7 Appellants produced a prepackaged credit study 8 as their evidence in this appeal. It's an after the 9 fact attempt to recreate alleged qualified research 10 activities from the past. It's a report that contains 11 buzz words and little else. It assumes that research 12 occurred and then estimates expenses based on that 13 faulty assumption. 14 Courts have said that Respondent or your Board 15 doesn't have to accept reconstructions from years after 16 the past. They've called reconstruction's unreliable, 17 inaccurate, incomplete and wholly insufficient to 18 establish either what various workers did and whether 19 such expenses qualify for the research credit. 20 In that -- in that prepackaged credit study 21 Appellants listed an unsupported base amount. An 22 accurate base period calculation is required. And 23 Respondent showed you why in its supplemental briefing. 24 But Congress named this the credit for 25 increasing research activities. So, there must be a 26 comparison between the base year, showing what -- what a 27 taxpayer did in the base years and they must show that 28 the research increased over time. Otherwise -- and a 22 1 taxpayer must be able to prove this base amount. 2 Otherwise, what the taxpayer should do is they 3 should claim the Alternative Incremental Research 4 Credit. Congress knew it was difficult for some 5 taxpayers to document activities that occurred in the 6 vast past, so, they allowed for an Alternative 7 Incremental Research Credit, which doesn't have the 8 burden of calculating a fixed base percentage. 9 But when it comes to the calculation, again, 10 you must show that there is an increase of research 11 expenses compared with the gross receipts. It's the 12 product of the fixed base percentage and the average 13 annual gross receipts and no more than 50 percent of 14 qualified research expenditures can be eligible for the 15 credit. It's a ceiling and it's not a floor. 16 And the Tax Courts have said if it's -- if the 17 base period's not properly calculated, then the taxpayer 18 is not entitled to the credit. 19 As a matter of policy, Congress intended 20 that -- well, a reconstruction would circumvent 21 Congress's intent. Congress intended to give incentive 22 to research in the present and not to attempt to cobble 23 the square peg of past manufacturing activities into the 24 round hole of the R & D credit. 25 While Appellants are certainly manufacturers, 26 their activity does not fit into the -- into the 27 research credit. 28 And while Respondent is sympathetic because 23 1 California no longer has a manufacturing credit, this 2 is -- the R & D credit is not the proper venue for -- 3 it's not the proper vehicle for Appellants' activities. 4 And -- thank you. 5 MS. YEE: Thank you very much, Mr. Riley. 6 You have five minutes on rebuttal, gentlemen. 7 MR. THOMPSON: All right, thank you, Madam 8 Chairwoman. 9 First of all, to address this idea that Osmose 10 gave them the recipe and everything was set and go. 11 I think that the evidence that we have 12 presented here today shows that's not the case. They 13 presented -- this is a document they provided me this 14 morning (indicating). 15 I'd like Mr. -- I'd ask the Franchise Tax Board 16 to show me in here where it talks about incising wood 17 and prestaining wood and having to do all these things. 18 As far as chemical reformulations, he's right, 19 they do not have the ability to go in and change that 20 ACQ chemical. But to get that ACQ chemical to mix with 21 the amount of water and the amount of quat that is 22 needed to treat this wood is absolutely within their 23 realm of possibility and what they're allowed to do 24 without having to go get EPA guidance to do that. 25 Every species of wood is different. Every 26 single charge of wood is different. Every single -- the 27 weather has an effect on it. So, these amounts and 28 these -- these standard operating procedures that they 24 1 have to develop in-house were not provided by Osmose. 2 The chemical was provided by Osmose based on 3 information they had obtained using it for Southern 4 Yellow Pine. Southern Yellow Pine is like a sponge. 5 You can, essentially, put Southern Yellow Pine into a 6 vat and let it just drink up whatever you're trying to 7 get it to drink up. 8 Again, this idea of changing this incisor to -- 9 it seems like it might be a very simple thing to do, but 10 the Treasury regulations have a very, very specific 11 example where a cheese grater was making a certain size 12 cube of cheese and wanted to design a smaller, thinner 13 shred product. They entertained exactly the same type 14 of research that California Cascade went through to 15 develop that smaller, finer shred cheese. 16 I mean, I can't think of a better example than 17 that to show what type of qualified research we're 18 talking about here. 19 I ask, again, the Franchise Tax Board to show 20 me in here where it says, 21 "You must prestain the wood now that you're 22 going to do, although you've been staining and 23 treating it with CCA for 25 plus years." 24 I mean, this idea that Osmose came to them and 25 gave them this full plant process and all these 26 drawings. I have seen no drawings of their plant or 27 process. 28 Osmose worked their tail off to get a chemical 25 1 that could be used, based on their experience with 2 Southern Yellow Pine and where they could work with -- 3 with California Cascade, they did. 4 There were three generations of the AQC 5 chemical that they provided. The first had the issues 6 we talked about with the mold and other -- and other 7 things. There was a second and third generation. So, 8 Osmose was actively involved in working with them from 9 the chemical side. 10 But as far as coming in and telling them, "Hey, 11 this is how you build a stain box. This is where it 12 needs to go," or even saying, "Hey, you need to prestain 13 this wood beforehand," that just did not happen. And I 14 think the evidence shows that. 15 So, this idea that it was a substantial 16 chemical reformulation, again, that -- if that was a 17 misunderstanding from the study, that might have been 18 the case. But they were involved in determining these 19 standard operating procedures, which included these 20 mixing amounts and things of that nature. 21 As far as the Manufacturers' Investment Credit, 22 the Manufacturers' Investment Credit was around in 2001 23 to 2004. So, this idea that it's no longer there, 24 that's kind of a red herring. They could have taken 25 that and I don't know whether they did or did not. 26 Essentially, you know, what we're talking about 27 here with the -- with the research credit is you have 28 to -- as the Board knows, you have to meet four 26 1 elements. 2 You have to be researching and development of a 3 new or improved product, process, technique, formula, 4 computer software or invention. 5 The Treasury regulations distinctly also 6 provide examples of where your product is very much 7 different than your process. You can have a product 8 that is ready to go, but your process is not in a 9 position yet to -- to really make that an economical 10 venture for you. 11 So, there are -- there are examples in the 12 Treasury regulations of product being very separate from 13 the process development itself. 14 Again, it was a very quick presentation, but 15 just to kind of go over what we've provided in this case 16 beyond his statement that it was just a prepackaged 17 credit study. There is pictures provided to you of the 18 time periods in question showing the mold buildup, these 19 blackening issues. 20 Again, if Osmose's processes worked so 21 fantastically, why did those issues present themselves? 22 If you were to follow the Franchise Tax Board's idea of 23 what happened here, you would have to believe that 24 Mr. Galbraith, with his experience, and Mr. Molatore -- 25 with their 25, 50 plus years of experience couldn't 26 follow directions. I mean, that's just simply not the 27 case. 28 This presented real issues. They were under 27 1 strict pressure from the EPA to get this thing up and 2 running. They didn't have the time or the luxury to 3 stop down and do bench level testing and laboratory 4 testing. This had to be on-the-fly testing. 5 In addition to that, we have the treating 6 testing records that we're showing you that they were 7 not -- during the time period that they were not meeting 8 their retired retentions that they had to meet. 9 The process menus that were developed by 10 Mr. Galbraith are available. 11 The stain box itself is out there. I mean, you 12 can take a look at it. I showed it to you. 13 The invoices from having to have these 14 individuals come out there and chip out this material, 15 all this -- you know, the first stain line stacker that 16 they had was so messed up they had to get rid of it. We 17 have invoices for them hauling that off. 18 We have the testimony of Mr. Galbraith, 19 Mr. Molatore, Mr. Feenstra -- all these individuals that 20 were involved in this that can substantiate the 21 research. 22 When we get to that point, if you determine 23 there's qualified research, then the courts have 24 specifically told you you may not deny someone's credit 25 because they used estimates. 26 MS. OLSON: Time has expired. 27 MR. THOMPSON: Thank you. 28 MS. YEE: Complete your thought, Mr. Thompson. 28 1 MR. THOMPSON: Okay. The courts have told you 2 in McFerrin, United States versus McFerrin, which is a 3 case -- the District Court case was cited by FTB on 12 4 of 24 pages in their brief. It was a very -- it was a 5 very taxpayer unfriendly case. That case went up to the 6 Fifth Circuit and was completely vacated. 7 And in that, the Fifth Circuit came out and 8 said, 9 "If there is research, you must estimate." 10 If you -- now, you don't have to go with the 11 taxpayer's recollection, you can find some other 12 recollection, but you may not disallow a credit claim 13 where there is research based on substantiation. 14 So, how many times was that cited in the reply 15 brief after that? Four times, in the end of a string 16 side and then in a footnote. 17 You just -- you don't get that. That's -- 18 there's no mention of that case. That is a seminal case 19 in this area. And it is very clear that the courts had 20 that in mind. 21 So, again, if you have research, you may not 22 disallow based on substantiation. You may use 23 estimates. 24 MS. YEE: Thank you very much. 25 MR. THOMPSON: Thank you. 26 MS. YEE: Questions, Members? 27 Yes, Ms. Steel? 28 MS. STEEL: To the taxpayer, that you didn't 29 1 explain anything about the base amount for the years 2 that -- how did you come out with it? 3 MR. THOMPSON: The fixed base amount was 4 determined in the same way that we determined the credit 5 calculations, we looked at all of the information 6 available. 7 MS. STEEL: So, you had all of the documents? 8 MR. THOMPSON: No, we don't have documents from 9 that time period. We had to rely on the testimony of 10 these individuals that have been out there for that 11 long. 12 But that's a good point, Ms. Steel, because if 13 you go with the FTB's suggestion that there was no 14 research ongoing at all, then the first year we're 15 claiming research was in 2001. 16 There's a statutory 3 percent. There's another 17 calculation, not just the Alternative Incremental 18 Credit. There's also what they call the startup 19 calculation, which is a 3 percent fixed base. 20 And, if you apply 3 percent fixed base 21 percentage to this case, it makes absolutely no change 22 to their credit calculations. 23 So, we believe we have done what we can to 24 substantiate te fixed base, but if you want to adopt the 25 FTB's position and say, "There is no proof there was 26 research ongoing at that time," then 2001 is the first 27 year and it's statutorily set at 3 percent for the first 28 five years. 30 1 MS. STEEL: Okay. To the Franchise Tax Board, 2 that, you know, you were talking about research and 3 experimenting. 4 So, what's the difference there? 5 MR. RILEY: There may not be any difference. 6 MS. STEEL: Okay. 7 MR. RILEY: You know, I stated that they're 8 not -- you know, that you can either experiment on -- 9 MS. STEEL: Or you can research? 10 MR. RILEY: No, I said -- sorry. 11 I said you can either experiment on a process 12 or a product in order to -- to be engaged in qualified 13 research. 14 So, in this -- in that -- and that's when I 15 stated that I was using research and experimentation as 16 synonyms. 17 MS. STEEL: Just one question for -- for the 18 R & D credit for years of 2001 to 2004 that -- did the 19 IRS allowed? 20 MR. RILEY: The IRS -- the documentation that 21 we have, that we've seen and that we provided today in 22 those exhibits, those transcripts don't show any refund 23 from the IRS for 2001 to 2003 for the taxpayer. 24 MS. STEEL: They allowed -- taxpayer, could you 25 verify that? 26 MR. RILEY: And it shows -- 27 MR. THOMPSON: I disagree with -- 28 MS. STEEL: -- that the IRS allowed -- 31 1 MR. THOMPSON: -- that. I think this 2 transcript shows that there's -- first of all, yes, as 3 an officer of this -- this proceeding, they -- 4 MR. FEENSTRA: It was audited and it was 5 passed. I mean, they agreed with the research and 6 development credit, the Internal Revenue -- the IRS. 7 MS. STEEL: So, you got it? 8 MR. FEENSTRA: Yes. 9 MS. STEEL: That's -- that's the way I read the 10 cases. 11 MR. RILEY: The -- I don't believe all of the 12 years were audited. 13 If any year was audited -- 14 MS. STEEL: I am talking about just 2001 to -- 15 MR. RILEY: -- I think only the 2004 year was 16 audited and it resulted in a no change audit. 17 MS. YEE: Mr. Feenstra, do you have you a 18 recollection? 19 MR. FEENSTRA: No, I don't know exactly what 20 year, but, you know, our accountant would. 21 But I know that they came in and did audit it 22 and did, you know, say it was okay. 23 MS. YEE: Okay, I think the years -- 24 MR. FEENSTRA: We would have loved to have 25 bought a dropped-in process, but that's not what we got. 26 You know, the process was designed for the 27 Southern Yellow Pine and it works fine with that. 28 But it doesn't work for the West Coast species. 32 1 We don't have Southern Yellow Pine here. We have Hem 2 Fir and Doug Fir and the process did not work for those 3 species. 4 MS. YEE: Okay, Ms. Steel? 5 MS. STEEL: Only thing is, was interesting to 6 hear from FTB that R & D is not really allowed because 7 they were copying from other study that it's been 8 already done in public. 9 But you went through -- they -- taxpayer went 10 through all these process that, you know, what they have 11 to do for each wood, isn't that for research? 12 Because it depends what kinds of woods they have to 13 use and what kind of things that they supposed to do? 14 MR. RILEY: Well, we've asked for documentation 15 from the very beginning from the taxpayers and they 16 haven't provided it. 17 So -- 18 MS. STEEL: Did you change your mind after you 19 watched what their presentation was? 20 MR. RILEY: Well, what I watched on the 21 presentation shows me that, yes, they are doing 22 manufacturing, but that doesn't show me what process of 23 experimentation they went into. 24 MS. STEEL: But they were doing the different 25 woods have different chemicals and different woods have 26 to have certain pressure there and then -- 27 MR. RILEY: All of that is anticipated by the 28 documentation that Osmose provided to them. 33 1 And it's -- it's indicated in this -- this 2 report we provided today and also with the supplemental 3 briefing. It's Exhibit DDD. It details such things -- 4 it anticipates things like fungal decay. It's -- it 5 talks about using western heartwood species, such as 6 Douglas Fir, Hem Fir and Western Hemlock, that the 7 Appellants claim that they -- that that's the wood they 8 used instead of the West -- the Eastern Yellow Pine. 9 It talks about the use of incising, which is 10 poking the holes in the top to increase the penetration. 11 All of these things were anticipated and, in fact, the 12 Appellants need to follow the instruction of Osmose in 13 order -- in order to comply with -- with the licensor's 14 requirements. 15 The licensor provides them with a quality 16 control manual. The licensor also -- Osmose also 17 provides them with a plant operations manual. 18 So, these are the things that tell them, "Look, 19 you've got to do this." 20 As far as the quality control, you know, it 21 even -- it states in here, oh, well, you know heartwood 22 species or, you know, it lists the penetration that the 23 wood needs to -- the penetration that the chemical needs 24 to go to in the wood. 25 So, all of these things -- while it's 26 manufacturing, it's not -- it's not qualified research 27 under the statute. 28 MS. STEEL: You were talking about Congress 34 1 intent. You know, I hear a lot of times that when you 2 are doing presentation about comparing that about how 3 federal R & D and, you know, with State R & D, seems 4 like, you know, we are going along together. 5 If they got on 2004 it really doesn't matter 6 2001 to 2004 or just one year, 2004, if they got R & D 7 credit, why FTB -- you were using their law and then you 8 were actually combining with federal R & D credit 9 plus -- I mean, using that, then why you are not giving 10 them credit for that? 11 MR. RILEY: Well -- 12 MS. STEEL: Why -- 13 MR. RILEY: -- it wasn't -- 14 MS. STEEL: -- why federal government is 15 allowing and FTB's not allowing -- 16 MR. RILEY: In the case -- 17 MS. STEEL: -- in the same case? 18 MR. RILEY: -- in the case where the IRS audits 19 a taxpayer, they will give us a revenue agent report 20 that details their audit. 21 In this case we completed our own complete and 22 independent audit of -- 23 MS. STEEL: Using federal government 24 regulations? 25 MR. RILEY: -- using the federal government 26 regulations, yes. 27 But we came -- you know, we did our own 28 independent audit, independent of whatever the federal 35 1 government did after the fact. 2 So -- and Respondent and your Board were not -- 3 we don't need to follow an IRS determination if we 4 believe it's erroneous. 5 And in this case -- 6 MS. STEEL: You were using IRS, either 7 regulation or code -- 8 MR. RILEY: Sure. 9 MS. STEEL: -- and, you know, what their 10 regulations and what you supposed met. 11 Can you tell me exactly that, you know, what -- 12 is it IRS audit first or FTB audit first? 13 MR. THOMPSON: I believe -- 14 MS. STEEL: What year exactly? 15 MR. THOMPSON: -- it was the IRS first. 16 MR. FEENSTRA: Yeah. 17 MR. THOMPSON: I am not sure. I don't know the 18 exact date the notices of that came in on this case. 19 I know the timeline for this case, but I'm 20 sorry, I don't know the timeline for that. 21 MS. STEEL: So, 2004 you got total credit for 22 hiring the -- 23 MR. THOMPSON: For 2001 through 2004. 24 MS. STEEL: -- it's all -- 25 MR. THOMPSON: To the extent they were audited, 26 they were reviewed and approved. 27 Now I am not telling you they came out there 28 and did a full-blown audit like the FTB did, I'm just -- 36 1 MS. STEEL: No, I'm just asking that what IRS 2 found -- 3 MR. THOMPSON: Right. 4 MS. STEEL: -- that, you know -- 5 MR. THOMPSON: And if I may respond briefly to 6 this idea that the retention levels are set in Osmose. 7 The retention levels are set by a third party. 8 The .40, we know that, it's how do we get there? 9 That's where the process improvements come. 10 They give us the ACQ and they say, "We'll -- it'll treat 11 this wood." 12 How? You know, I mean, it's -- he says that 13 there's all these -- or all these steps and all these 14 things that they have to follow and the evidence just 15 doesn't support that. 16 I mean, again, these folks -- you know, 17 they're -- they're an ongoing customer of Osmose to this 18 day. If they were doing something, some sort of 19 chemical reformulation, some sort of thing that was off 20 the -- you know, that was going to put Osmose in a bind, 21 they wouldn't be doing businesses with these guys. 22 MS. STEEL: Let me ask the Franchise Tax Board 23 that. 24 Okay, so, you were not agreeing with base of 25 their base year? 26 Then he said about 3 percent from 2001. 27 MR. RILEY: Well, that's -- you know, that's a 28 decision that a taxpayer -- you know, this is -- a tax 37 1 credit is an important tax incentive. 2 And a taxpayer needs to do their research 3 beforehand, not research in the qualified research, but, 4 you know, they need to assess whether or not they can 5 prove that base period at the outset. 6 MS. STEEL: What -- 7 MR. RILEY: So, it's not -- 8 MS. STEEL: -- base period that they couldn't 9 figure it out that you don't agree the way they figure 10 it out base year, then it's 3 percent on 2001. 11 So, if you use that 2001 numbers, it's going to 12 be much higher. 13 MR. RILEY: Well, the taxpayer in this case, 14 you know, they don't sound like they're a startup, they 15 sounded like they -- well, they're -- you know, they 16 have existed. 17 And they don't have the -- excuse me, it's not 18 a decision that you -- you know, you can't just make 19 someone a startup company, okay. 20 MS. STEEL: But it's 1984 to 1989. So, how 21 many years ago it was about 26 years? 22 MR. RILEY: Understandably, but that's why 23 Congress enacted the Alternative Incremental Research 24 Credit to allow for taxpayers who, well, maybe they 25 don't have the records, they can't prove it up, but, you 26 know, they're allowed to have something. 27 MS. STEEL: My question is -- 28 MR. RILEY: It would give them something under 38 1 the Alternative Incremental -- 2 MS. STEEL: -- that's 3 percent? 3 MR. THOMPSON: No. 4 MR. RILEY: No. 5 MS. STEEL: Okay, which -- 6 MR. THOMPSON: If you were to follow the FTB's 7 logic here, we did absolutely no research from 2001 to 8 2004 -- 9 MS. STEEL: Then you should get -- 10 MR. THOMPSON: -- we did. We understated the 11 amount of research we were doing in the '80s. 12 To be an '80s company you have to have 13 qualified research for one year prior to 1983 and for 14 three of five years within the period of 1984 to 1988. 15 We contend that we did that, that we did -- 16 with the evidence available, we proved that, to the best 17 of our knowledge, to the best of our ability, what that 18 base percentage was. 19 Irrespective of that, if you want to take the 20 FTB's position that we'd never done research at all, 21 then 2001 is the start date that we're actually here 22 about today talking about research credit. And that's 23 3 percent statutorily for five years. 24 You would have to defy logic and say, 25 "Okay, you were doing -- you understated the 26 amount of qualified research you were doing in 27 the '80s, but now you are doing none." 28 I mean, that's what you would have to adopt. 39 1 Not to mention this idea that the credit is current. 2 And there is no need to look back, the definition for 3 was qualified research in 1980 -- in the 1980s has 4 changed. 5 There is no more discovery rule. There is no 6 more -- I mean, it has changed statutorily. The 7 regulations have changed as to what's qualified 8 research. 9 So, if you were tracking research costs back in 10 the 1980s using form a 6765 IRS -- or excuse me, yes, 11 IRS form 6765, you couldn't rely on that today. 12 You have to go back and do this review. You 13 absolutely have to. They will throw you out of an IRS 14 audit and out of court if you bring in 6765 from 1987. 15 Because what was research then is no longer what is 16 research now. 17 And you are required by the Treasury 18 regulations to treat your costs consistently. So, if 19 I'm taking a cost now, I have to go back and determine 20 what that same type of cost was back in the '80s. 21 So, this is -- this, you know, this idea that 22 there's only the Alternate Incremental Credit there -- I 23 feel like we -- that's -- first of all, you can only 24 take that on an amended return. You can't take -- I 25 mean, excuse me, on an original return. You can't take 26 that on an amended return. 27 I'm telling you that we did the best that we 28 could to determine what that fixed base percentage is. 40 1 But even if we adopt the FTB's position that no research 2 has ever been ongoing out here, it's 3 percent. That's 3 the statutorily set amount. 4 And it makes no difference to the credit 5 change. 6 MS. YEE: Okay. 7 MS. STEEL: Thank you very much. 8 MS. YEE: Thank you, Ms. Steel. 9 Other questions, Members? 10 MS. ALBY: Question. 11 MS. YEE: Yes, Ms. Alby and Mr. Horton. 12 MS. ALBY: Question for the taxpayer, if I 13 might? 14 When you discovered that you had this -- that 15 the woods you were using, the process that you were 16 applying wasn't working, were you able -- was there any 17 competitors that you could call out here in the West and 18 find out what happened to you? What did you do? 19 Was there any anybody you could turn to in that 20 regard? 21 MR. FEENSTRA: No. First of all, I don't think 22 our competitors would tell us anyway, but -- no, there 23 wasn't. 24 We were the first one on the West Coast to 25 really use this chemical with the West Coast species. 26 And, so, you know, we -- we gave Osmose a lot of data 27 that they used to help other plants be able to use it 28 successfully. 41 1 We had a -- at the time we had a plant in 2 Southern California, in Fontana. And we did all of 3 the -- all of the R & D in Woodland. And then when it 4 was ready to go, we -- we sent it down to Fontana and, 5 you know, we didn't have much of a problem. 6 But, believe me, we -- we spent a lot of time 7 and money trying to make this chemical work. 8 MS. ALBY: Thank you. 9 MS. YEE: Thank you, Ms. Alby. 10 Mr. Horton? 11 MR. HORTON: Question of the Franchise Tax 12 Board, what -- how does the McFarland (verbatim) case 13 apply in this situation? 14 MR. RILEY: McFerrin? 15 MR. HORTON: McFerrin, yes, I'm sorry. 16 MR. RILEY: Well, the key thing to remember 17 about McFerrin is that the court said that you must 18 first prove that you're engaged in qualified research. 19 That's -- that's No. 1. 20 MR. HORTON: Let's presume that that's the 21 case. 22 MR. RILEY: If you presume that that's the 23 case, then the court goes on to say we don't need to re 24 -- we don't need to accept reconstructions from years 25 after the fact. 26 And then the court says that the court -- if 27 there's qualified research that occurred, the court 28 may -- may accept testimony and other evidence, 42 1 including institutional knowledge and other 2 documentation. 3 But when -- but when it talks -- but when the 4 McFerrin court talks about other evidence, you know, 5 when it says, "testimony and other evidence," it cites 6 to the Fudum (verbatim) case and Fudum says that other 7 evidence -- in the Fudum case other evidence was 8 contemporaneous letters, contemporaneous US patents, 9 contemporaneous journal articles. 10 So, the key there, with those documents, they 11 are all contemporaneous. So, in order to accept -- you 12 know, in order to accept testimony, it appears that the 13 court wants some form of contemporaneous documentation 14 to corroborate that testimony. 15 MR. HORTON: Does that exist in this case? 16 MR. THOMPSON: I believe we've showed it you, 17 yes, sir. 18 We have the testing documents. 19 MR. HORTON: What evidence have you presented? 20 MR. THOMPSON: Yes, that was just a sample of 21 what we provided. 22 There are these menus, these standard operating 23 procedures that were developed. There is pictures from 24 the time period. 25 I disagree with counsel's representation -- 26 MR. HORTON: Is that -- 27 MR. THOMPSON: -- of the McFerrin opinion, but 28 that's neither here nor there. 43 1 I mean -- 2 MR. HORTON: Has that been available to the 3 Franchise Tax Board? 4 MR. THOMPSON: It was attached to their brief. 5 Now, the pictures and things of that nature, 6 were -- no, that's -- that was brought, but I will state 7 that the -- they did a site visit. 8 And at the site visit the FTB determined that 9 he was provided test result data from Scott Mace for the 10 tests he conducted on pellets he drilled out of some 11 test charge wood, and test result data from the test 12 charges conducted by the treatment staff and it goes and 13 lists all these people that were in involved and other 14 things. 15 He went out there. He found that there was 16 some research ongoing. He disagreed with the amount, 17 MR. HORTON: Who is "he"? 18 MR. THOMPSON: The auditor, the FTB auditor. 19 And it's on appeal now that we get this, you 20 know, there is no research at all going on. 21 MR. HORTON: It's your testimony that I want to 22 know whether or not the Franchise Tax Board concurs with 23 this, that the auditor did conclude that there is some 24 element of research and development that existed at the 25 site? 26 MR. RILEY: The auditor allowed a credit for 27 one employee. 28 But when it came time for the -- for the claim 44 1 denial letters, the claim was denied in full. 2 But that doesn't -- you know, that doesn't take 3 into account the documents that Respondent requested and 4 then we found, you know, documents showing that these 5 procedures existed, such as the, you know, NER 628, 6 which is provided today. 7 We asked for the licensing agreements and all 8 these things. They weren't provided. And it's only, 9 you know, in Respondent's supplemental brief that we -- 10 you know, we discovered and have provided for your Board 11 documents showing that, in fact, Osmose provided the 12 taxpayer with the detailed specifications, putting them 13 in exclusion of the credit. 14 MR. HORTON: So, in Osmose specifications 15 they -- sounds as if, though, they outlined the 16 challenges that you would face in using this chemical. 17 Did they, in fact, give direction to the 18 manufacturer of how to meet those challenges? 19 MR. RILEY: Well, Osmose offers a -- in 20 addition to plant operations manuals and the quality 21 control manual, Osmose offers, you know, classes on 22 plant operation. 23 And Appellants stated in their most recent 24 brief that Osmose helped out wherever they could, I 25 believe, is something -- 26 MR. HORTON: Were there -- let me just -- 27 there seems to be -- Osmose has created this chemical 28 under the pressure of time and so forth and they met 45 1 that objective. 2 The evaluation of how to use the chemical, to 3 the best of their ability, they established effective 4 specifications. But It was never really tested. 5 It seems that the taxpayer, based on their 6 testimony, was the first one to actually test the usage 7 of this chemical. And then, subsequent to this testing 8 process that they went through, they found that they 9 needed to modify their process in order to maximize the 10 utility of the chemical. 11 That modification, was that recommended by 12 Osmose? Or was that preestablished? It's prior to? 13 Or is that something that the taxpayer had to create? 14 MR. RILEY: Well, in these -- in this National 15 Evaluation Report there are numerous field tests and 16 simulation and laboratory tests, corrosivity tests, 17 treatment testing. 18 It appears that Osmose, you know, thoroughly -- 19 MR. HORTON: Let's presume that the tests had 20 to take place, but the results of the tests dictated 21 that you had to now develop methods, a process different 22 than what you are currently -- I mean, you had to -- you 23 had to -- you had to create additional knowledge 24 somehow. Someone had to figure out how can we maximize 25 this process? How can we maximize the use of this 26 chemical and what the process would be and then create a 27 manufacturing process that helped facilitate that. 28 I mean, when there is thought, when there is 46 1 creativity, when there is all of those elements, they 2 have a tendency to imply research of some sort. 3 And, so, I'm having -- I want to understand 4 where the Franchise Tax Board draws the line or where 5 Osmose's participation was already preestablished in 6 establishing this new process, if it existed. 7 And I would like to have some additional 8 clarification as to what the auditor's position was when 9 the auditor said that they believed research and 10 development did exist. 11 So, there's two questions. 12 MR. RILEY: Okay. As to the first, you know, 13 it appears that in Appellants' most recent brief they 14 said, 15 "Osmose assisted Appellants in its efforts to 16 reengineer the plant process where it could be 17 of service." 18 Okay, that's -- that's about all that Appellant 19 has provided as far as Osmose's participation. 20 I mean, it wasn't until their most recent -- 21 MR. HORTON: How would you classify that 22 reengineering? 23 MR. RILEY: I have no idea how to classify it 24 because they haven't provided any -- any correspondence 25 or documentation to indicate what that would -- 26 MR. HORTON: It's just hypothetically, I don't 27 want to really get into the amounts and so forth, but 28 hypothetically speaking, it appears that there was some 47 1 reengineering that took place, a reengineering of their 2 plant, reengineering of the process. 3 Let's say, hypothetically speaking, how would 4 you classify that? Would that be part of the 5 manufacturing process? Would that be research? 6 MR. RILEY: It looks to be part of the 7 manufacturing process. And it also looks to have 8 occurred -- we don't know exactly when all that -- he 9 showed you a photo from 2010, I mean, the tax years 10 we're dealing with here are 2001 to 2003. 11 That may be well after the fact. 12 MR. HORTON: And you don't know whether or not 13 that -- 14 MR. RILEY: I mean, honestly, I don't know 15 because they just haven't -president provided us with 16 the documentation that shows the licensing agreement, 17 what interest the taxpayer has in the product. 18 You know, Osmose might have come in and helped 19 them out with, you know, to reengineer things. 20 But, at this point, it's clearly Osmose's and 21 we're -- there's no indication of any interest on the 22 taxpayer's part -- apart from being a licensee. 23 MR. HORTON: Statutorily set is 3 percent. 24 What's your position on that argument? 25 MR. RILEY: Well, my argument is that your -- 26 you know, the taxpayer didn't claim they were a startup. 27 You can either claim that you're, you know, you are 28 going to take the regular credit or you're going to be a 48 1 startup. 2 So -- 3 MR. HORTON: So, is this one of those 4 irrevocable claims, once they've claimed it -- 5 MR. RILEY: Yes. 6 MR. HORTON: -- during the audit process -- 7 MR. RILEY: What they can do -- 8 MR. HORTON: -- process, they can't -- 9 MR. RILEY: -- what they can do is they can 10 then claim the AIRC, but they cannot -- the Alternative 11 Incremental Credit, but you can't say, "Oh, I made a 12 mistake, really we're a startup." 13 You know, that can be handled in a settlement 14 situation, but -- 15 MR. HORTON: What's a startup? Is a startup a 16 way -- when you say a "startup company," you're not 17 really saying that they had the -- when they first 18 started business, are you? 19 MR. RILEY: It's when you first have both gross 20 receipts and qualified research expenses. 21 MR. HORTON: Okay. It's when they concurrently 22 occur? 23 And basically when research occurs if you're 24 already in business? 25 MR. RILEY: Yes. 26 MR. HORTON: So, startup meaning when they 27 first started the research and development activity? 28 MR. RILEY: Correct. 49 1 MR. HORTON: And if that exists, the statutory 2 3 percent requirement does apply? 3 MR. RILEY: It should -- it should apply, 4 but -- 5 MR. HORTON: Given all the circumstances. 6 Question of the taxpayer, subsequent to all of 7 this activity, you developed this process, Osmose worked 8 with you, to some extent, and, arguably, would have been 9 benefited from your reengineering of the plant and 10 testing of the chemical and so forth. 11 That -- has there -- is Osmose currently using 12 that? I mean, it's -- the results of your -- 13 MR. FEENSTRA: I just want to clarify -- 14 MR. HORTON: -- I'm trying not to use the word 15 "research," but -- 16 MR. THOMPSON: I'll let him talk, but I just 17 want to clarify one thing. 18 They were not testing the chemical formulation 19 to see, where they -- 20 MR. HORTON: No, I got -- 21 MR. THOMPSON: -- they hadn't developed the 22 chemical. 23 MR. HORTON: I got that. 24 MR. THOMPSON: But how that worked in a 25 process -- 26 MR. HORTON: How to apply it. 27 MR. THOMPSON: Okay, I just want to make sure 28 we're not going to get into that because that's not what 50 1 we're -- 2 MR. HORTON: He didn't get into it either. 3 MR. THOMPSON: Okay. Then go ahead, you guys 4 can talk. 5 MR. FEENSTRA: I'm sure it has, you know, they 6 were -- as we had problems, they, you know, tried to 7 help us solve them, so -- and, you know, data goes back 8 and forth all the time. So, I'm sure that they have 9 used that, you know, for other plants. 10 But I'd like give you one -- one other example. 11 You know, the red stain product that we do, which 12 represents half of our business, and with the CCA, we 13 did that, you know, all in one process. 14 And, by the way, that's not a pesticide. So, 15 there is no, you know, no regulation that a pesticide 16 had. 17 They sent that out. We used it, it didn't 18 work. We had a yard full of lumber with mold and 19 everything on it. They came out and looked at it and 20 they said, 21 "Well, we're going to change this and this and 22 we think this will work." 23 They sent out another -- 24 MR. HORTON: Who made those changes? 25 MR. FEENSTRA: Osmose. 26 MR. HORTON: Okay. 27 MR. RILEY: To the chemical. 28 MR. FEENSTRA: They sent out another 15,000 51 1 gallons. It didn't work. 2 They, over time said, 3 "We've got a third process. We're pretty 4 confident this will work." 5 We said, 6 "We can't -- you know, we don't want to take 7 another chance and do this." 8 They had a plant in Idaho, I believe, it was, 9 that was using it. We flew out there to look at it. 10 And it looked like it was going to work. They 11 were treating a pine product, but it wasn't a Southern 12 Yellow Pine. 13 We got another 15,000 gallons of that and that 14 didn't work. And that's why we had to put in the whole 15 new stain line process to, you know, be able to provide 16 a treated product with the red stain on. 17 MR. HORTON: So, your -- your visit to this 18 other facility, you learn anything from that? 19 MR. FEENSTRA: Well, we learned that it didn't 20 work. 21 We thought it was going to work. It was 22 working on their product. It wasn't Southern Yellow 23 Pine, it was -- I can't think of the species they had 24 there, I don't believe it's Ponderosa, but it's like a 25 Jack Pine or something back there and it was working 26 there. 27 But it would not work on Hem Fir and the Dough 28 Fir. 52 1 MR. HORTON: And why wouldn't it work? 2 Was it the process -- 3 MR. FEENSTRA: Same problem. It developed mold 4 and it turned black in color. 5 MR. HORTON: I mean, was it the chemical? Was 6 that the reason it didn't work or was it -- 7 MR. GALBRAITH: I could answer that, probably. 8 The problems were the incompatibilities with 9 the chemicals. 10 You know, Osmose sent us chemicals that were 11 based on an acidic formulation, we were using an 12 alkaline formulation. They just basically didn't work. 13 MR. HORTON: And so the chemical needed to be 14 modified in order for it to work? 15 MR. GALBRAITH: Well, what we did, we abandoned 16 that process. 17 We wound up building a stain line. We built a 18 whole new process to just overcome this because it 19 wouldn't work. 20 It's like, you know, when you say Osmose gave 21 us a product, yeah, they gave a product, but it's up to 22 us to make it work, a third party puts out the -- 23 MR. HORTON: Here's what is I need to 24 understand -- 25 MR. GALBRAITH: Sure, go ahead. 26 MR. HORTON: -- you've indicated that it's up 27 to you to make it work? 28 MR. GALBRAITH: That's correct. 53 1 MR. HORTON: I need to understand what that 2 means, what's "make it work"? 3 MR. GALBRAITH: American Wood Preservers 4 Association -- 5 MR. HORTON: Let me -- 6 MS. YEE: Let him -- 7 MR. GALBRAITH: I'm sorry. 8 MR. HORTON: Let me help out a little bit. 9 MR. GALBRAITH: Sure. 10 MR. HORTON: You have a chemical. 11 MR. GALBRAITH: Uh-huh. 12 MR. HORTON: The chemical has certain chemical 13 components, elements that doesn't necessarily work 14 properly with this particular type of wood. 15 And, so, it's -- are you saying that a change 16 in process will make the chemical work? 17 MR. GALBRAITH: That's correct. One of the 18 main ones was the incisions. 19 As he showed you, the incision marks on the 20 equipment that was provided. 21 MR. HORTON: There's testimony that the 22 incision marks was part of Osmose. 23 MR. GALBRAITH: Sir, what that is they had an 24 incision -- an incisor that had worked for like 25 years 25 as a very wide incision marks, but with this lumber, 26 that wouldn't work. 27 We had to develop our own incising techniques 28 that would make it denser without tearing up the wood. 54 1 MR. HORTON: What did you go through to develop 2 that? 3 MR. GALBRAITH: Excuse me? 4 MR. HORTON: What process did you go through to 5 develop -- 6 MR. GALBRAITH: We developed different style 7 teeth and put them on the machine and run the wood 8 through there. And then we'd take tests on it to see if 9 it would, you know, made the wood not as structurally -- 10 you know, it wasn't as good structurally, it'd tear the 11 wood up and so forth. 12 So, we had to come up with something that would 13 incise the wood, it would be smooth, you could handle 14 it, and it didn't tear the wood up, but it got -- 15 MR. HORTON: So, you actually developed brand 16 new molds and -- 17 MR. GALBRAITH: -- no, we just -- 18 MR. THOMPSON: We have pictures of the 19 development area where they took teeth and they made 20 prototype -- and the teeth you can pull on and pull off. 21 MS. YEE: Speak into the microphone, 22 Mr. Thompson. 23 MR. THOMPSON: Oh, I'm sorry. 24 MS. YEE: And I don't want to go through the 25 presentation again. 26 MR. THOMPSON: No, no, but we -- we showed 27 pictures of that development area. 28 MR. HORTON: I saw that. 55 1 MR. THOMPSON: Okay. That's where -- that's 2 where they were doing their -- their prototype testing. 3 I mean, it was on the fly-type stuff, it wasn't 4 in a lab. 5 MR. HORTON: Well, I'm am getting at testing 6 the chemical and the process, what did you develop is 7 what I'm trying to figure out. 8 MR. THOMPSON: Well, let me -- let me clarify 9 one thing. 10 There's two things, there's the ACQ, getting it 11 into the wood and there's the ACQ and the stain 12 together. 13 So, I think you guys were talking kind of 14 across each other. 15 He's talking about ACQ together with the stain. 16 MR. GALBRAITH: So, it's incompatible. 17 MR. THOMPSON: Right, because of the alkaline 18 and, I guess you believe, the acidic-type bases? 19 MR. GALBRAITH: Right. 20 MR. THOMPSON: And there's also the idea of 21 even getting the -- finding out the process, the 22 pressures, the volumes, the fill rates, things of that 23 nature to get the actual treatment into the wood without 24 the stain. 25 So, it was one -- one, I guess, impetus, that 26 caused all these problems that they needed to overcome. 27 So, I don't know if that clarifies it a little? 28 He can go back to telling you what he was saying, but -- 56 1 MR. GALBRAITH: Just basically 2 incompatibilities with the chemicals. 3 You know, Osmose provided it and it was going 4 to work. It didn't work. 5 We went through three generations trying to 6 make it work because doing the prestain line that we had 7 to put in was very -- it was a lot of problems. Like I 8 said, we had to double our staff. We went through, 9 just -- you know, just mounds of work. 10 I mean, you know, nobody wants to add double 11 your cost just to do the same thing you've been doing 12 for 20 years. So, we were making this product work for 13 our customers. We're under contract to supply them with 14 a product. We don't have a choice. You know, we have 15 to get this done. 16 We had a red product that had to be developed. 17 So, we developed the stain line up through 2009 and we 18 finally have pretty much got it down now where it's 19 working very well. 20 So, we had to abandon the chemical that Osmose 21 gave us and the stain product, which -- and go to a 22 prestain product, that was one of the incompatibility 23 factors and then, along with that, treating lumber, 24 getting molds and those types of problems and just, you 25 know -- 26 MR. HORTON: Let me be sure I understand what 27 you just said. 28 You had to abandon the process provided by 57 1 Osmosis (verbatim) and go to a prestaining -- 2 MR. GALBRAITH: That's correct. 3 MR. HORTON: -- process? 4 MR. GALBRAITH: That's correct. 5 MR. HORTON: And where did this concept of 6 prestaining come from? 7 MR. GALBRAITH: We -- 8 MR. HORTON: Ever do that before? 9 MR. GALBRAITH: -- we hadn't done it before, 10 but we asked around, what are we going to be able to do 11 here, just trying to figure it out. 12 These things were going on, there's a lot of 13 problems with the different colors and so forth. We had 14 a specific color we had to put out there. So, we 15 contacted different manufacturers and we finally settled 16 with Eco Chemical Company and then it was a process 17 of -- 18 MR. HORTON: How are other manufacturers that 19 were prestaining the wood and -- 20 MR. GALBRAITH: Different manufacturers of the 21 prestain product. 22 Because it had to work with ACQ, it couldn't 23 just -- you know, it might work for one chemical, but 24 not work with another chemical. 25 So, we were looking for something specific that 26 would work with ACQ and then just getting it on the 27 product and, you know, making it look right and making 28 it work right and not inhibit the chemical process. 58 1 MR. HORTON: All right. Madam Chair, just one 2 last question, if I may? 3 MS. YEE: Yes, please? 4 MR. HORTON: The Franchise Tax Board, you've 5 heard the same testimony that we've heard. There seems 6 to be an element of research and development here. 7 Where it is and how you quantify it, I don't 8 know. 9 There also seems to be a lot of manufacturing 10 activity going on and trying to determine how best to -- 11 to accomplish a particular goal. And the end results is 12 two different products, two different processes than 13 existed prior to beginning whatever research and 14 development existed. 15 How do we come up with a number on all of this? 16 And how do we put a number on it seems to be the real 17 challenge and then establishing the base, when it first 18 began, and, so, that we can identify the differential 19 relative to the increase in research and development 20 costs. 21 Any thoughts on all that? 22 MR. RILEY: Ideally a taxpayer, when they world 23 submit their claim for R & D credit would break out 24 employees and projects, you know, individual -- and, so, 25 you would add them up to create a percentage rather 26 than, "Jim does all research." 27 You know, that -- it's up to the taxpayer to 28 break these -- to break the numbers down into -- into 59 1 specific employees and specific activities. 2 I mean, that's where the nexus comes in, you 3 know. 4 MR. HORTON: I know the taxpayers's argument 5 is that in light of the startup research and development 6 that the statutory 3 percent won't apply. 7 If we sort of get beyond that, because the 8 debate is on the startup and when the research actually 9 started and even then you have got to go back and 10 determine what the base year is in order to be able to 11 apply it to a differential. 12 So, you're still going to have a challenge. 13 You're still going to have the same challenge face -- 14 you're still going to face the same challenge, so -- 15 given additional time, can you come up with the 16 information that the FTB is asking for? 17 MR. THOMPSON: Okay, well -- I guess I would 18 need to know what that information is, but let me -- let 19 me speak briefly to this idea about, you know, the 20 employees and projects. 21 At the time this was calculated -- 22 MR. HORTON: I didn't ask that question. 23 MR. THOMPSON: Well, I want to -- this has to 24 do with your -- how you calculate the costs. 25 And I'll tell you right now, the Treasury 26 regulations do not mention the word "project," do not 27 say you must break things out by project. 28 They tell you, look at the individual, the 60 1 amount of time they spent performing qualified research 2 activities over the amount of time that they spent doing 3 all other activities. There's no mention about tying it 4 to a project. 5 So, could we go back and recreate a 6 project-based accounting system for this company? I 7 don't know. I don't know the answer to that. 8 But it wasn't done at the time. It wasn't 9 required. 10 What he's citing to is an audit technique guide 11 that the IRS put out in '08 that they want to see this. 12 This is what they want to see. 13 This was far before -- 14 MR. HORTON: Qualified techniques would refer 15 back to a qualifying project and how you go about 16 determining the amounts relative to that. 17 So, I mean, I could see the audit correlation, 18 I mean, even though it seems like semantics to me for 19 the most part. 20 I mean, the auditor has to make some 21 determination based on some qualifying data, so -- 22 MR. THOMPSON: I agree. But I think you look 23 at the individual and not -- not the project. 24 I think you look at -- the regulations tell you 25 you look at the individual and his activities and 26 whether or not his estimates are reasonable. 27 That's what I believe the law is. And you look 28 at everything that the -- everything in the universe 61 1 that you have to determine whether those are reasonable 2 or not. 3 MS. YEE: Mr. Thompson, hold on. 4 I want to let Mr. Horton finish his questions. 5 I think -- 6 MR. THOMPSON: I'm sorry. 7 MS. YEE: -- he's trying to be helpful in terms 8 of identifying what might be some level of documentation 9 substantiation that we can could rely on. 10 So, let me him finish his -- 11 MR. THOMPSON: Okay, I apologize. 12 MS. YEE: -- train of thought. 13 MR. HORTON: So -- I almost lost it, though. 14 MR. THOMPSON: I am sorry. 15 MR. HORTON: Correlating it to the person, to 16 the project, ultimately you've got to have some direct 17 association, cost to the research and development 18 activity which is tied into the project. 19 And, so, if you've got an individual -- to 20 arbitrarily say, "This individual does absolutely 21 nothing but research and development, it's going to be 22 challenging because you really don't have a research and 23 development department, not one individual is assigned 24 to that. 25 You actually have individuals who will perform 26 dual activities. And, in fact, it seems to me that the 27 activities itself, you're developing -- you're 28 developing a strategy for manufacturing in one case, 62 1 where you're changing -- you ultimately end up with two 2 different manufacturing processes that preexisted prior 3 to and then you are doing -- seems to me you are doing 4 some research and development in order to be able to -- 5 to develop the mechanism and the tools necessary to 6 accomplish your goal to properly utilize the chemicals. 7 And, so, one individual -- you can't isolate 8 one individual, so, you -- and you have to tie it to the 9 project. 10 But this is -- I mean, this is -- this is 11 accounting and this is auditing. And that's not 12 something that the Board does or -- and, so, it seems to 13 me that maybe the Franchise Tax Board and yourselves 14 might want to get together and kind of figure out how to 15 identify that, however significant that may be. 16 And this comment is to the Franchise Tax Board, 17 if R & D did exist, we can't simply say that it didn't 18 exist because of its magnitude or significance to the 19 entire project. 20 And I understand that the law puts the burden 21 on the taxpayer to measure that, but it also -- there is 22 an, I would say, an innate presumption on our part that 23 the Franchise Tax Board would participate in that 24 process and not just arbitrarily say, "Give us 25 something," but give them some idea as to what should be 26 provided. 27 And particularly what really concerns me is 28 that the auditor made an initial assessment based on his 63 1 visual observation, review of the records, that some 2 element of research and development exists. 3 And it's my observation that some element of 4 research and development exists. How much, I don't 5 know. I mean -- and maybe we ought to try to figure it 6 out. 7 But in the absence of that, to the taxpayer, in 8 the absence of that, the McFerrin case and the statute, 9 the federal statute, actually kind of works a little bit 10 against you because establishing the base year is up to 11 you. 12 And being able to support that based amount is 13 a criteria that you have to meet. 14 So, those are my comments. 15 Thank you, Madam Chair. 16 MS. YEE: Thank you, Mr. Horton. 17 Ms. Mandel? 18 MS. MANDEL: I think I'd like to step back a 19 minute from substantiation of the cost to the activity. 20 Because when I was first going through the case and 21 hearing about it and hearing about Franchise Tax Board's 22 view, it seemed very focused on the ACQ chemical from 23 Osmose and was anything being done to the chemical, 24 which I think now everybody agrees, no, no, that's 25 not -- it's not about anything being done to the 26 chemical itself, but what this company's job is, as I 27 understand, it is that they take wood -- I'm a guy who 28 has a bunch of wood that I want to use in construction, 64 1 it needs to be treated so I am allowed to use it. 2 They're a company, this taxpayer is a company, 3 that will take my wood and treat it so that it meets 4 certain building standards. 5 Did I get that right? The gentlemen are 6 nodding yes. 7 That the Osmose ACQ product is a product that 8 when used in treating wood, will produce a certain 9 treated wood. 10 If all they were doing was treating the wood 11 with the Osmose product to meet the building standards 12 for that -- and there was some technical name on it, 13 NatureWood or something -- that Exhibit DDD that you 14 have here does say in it that, 15 "The use of incising may be required to meet 16 the minimum penetration requirements in certain 17 species or sizes of materials." 18 So, if all you had was, we're going to treat -- 19 they're going to treat my wood with ACQ and I have 20 Redwood instead of Southern Pine, they any have to, at 21 their business, figure out that they need to make lots 22 and lots of little marks, as opposed to the number of 23 marks they used to make on the same kind of wood when 24 they used that CCA product for treating wood. 25 And what I think I hear FTB saying is if that's 26 what -- if that's what the company's doing, you would 27 view that as quality control work because they have to 28 figure out how much incising and type of incising to do 65 1 to get the Osmose to penetrate the wood to meet the 2 standard? 3 Is that why you're saying it's quality control? 4 MR. RILEY: No, I'm -- I'm saying this -- the 5 document, it refers to the quality control manuals and 6 the plant operations manuals, but this document itself 7 is not -- I mean -- 8 MS. MANDEL: No, okay. 9 MR. RILEY: -- so, what -- what is actually 10 contained in the quality control manual at the extent it 11 says, you know, "Incise at quarter-inch intervals," or 12 something like that, we don't -- we don't actually know 13 because -- 14 MS. MANDEL: So, you don't -- you don't have 15 those manuals? 16 So, you don't know if it's a manual from Osmose 17 that says incise at 27,000 times as opposed to what you 18 used to do? 19 MR. RILEY: Correct. 20 MS. MANDEL: That's what you're saying. 21 Okay, but -- all right, taking just their 22 testimony where they said, 23 "We had to figure out how much incising to do 24 because we had -- because that was what we had 25 do." 26 If -- if this company, as part of trying to 27 make the piece of wood a treated piece of wood, had to 28 figure out how much incising they had to do, either 66 1 because there was no -- no -- nothing that specified, 2 "Oh, hey, if you have Redwood, you better make 27,000 3 incises," or whatever came in the manuals, I mean, is 4 this manufacturing or is it research if they're figuring 5 out how many incises they have to make? 6 MR. RILEY: It looks to be manufacturing. 7 MS. MANDEL: So -- 8 MR. RILEY: It looks to be -- it looks to be 9 just tinkering. 10 MS. MANDEL: So, when a -- 11 MR. HORTON: That's what Thomas Edison did. 12 MS. MANDEL: -- yeah. 13 Okay, because I thought you were -- I thought 14 that was kind of where your -- tinkering quality of 15 control -- I thought that's kind of where you were going 16 on the things about incising. 17 And then what they were pointing out was 18 something that sounded separate also, which was about 19 trying to produce a product that had a stain, which was 20 separate -- is really separate and apart from the Osmose 21 piece, all of the focus on the Osmose piece is, to me is 22 kind of separate from the company's trying to produce a 23 product that has a stain and that much -- yeah, they say 24 they had to do all the incising, but that much of the 25 other problems that they talked about in their 26 manufacturing line to get me a treated, stained piece of 27 Redwood at the end, they had to deal with the fact of 28 the stain and how the stain wasn't working. 67 1 Because it -- it had some combustible 2 relationship with this Osmose product and they had to 3 figure out some whole new way of doing it. 4 So, they're building -- if they're trying to 5 figure out and build a new manufacturing line to make 6 their manufacturing line work with these two pieces of 7 the product to make the good piece of wood, I mean, it 8 almost sounds like you're saying there's no such thing 9 as research and development when you're -- that research 10 and development is not what you're doing when you're 11 trying to make your manufacturing line work to produce 12 the product or perform the service. 13 You know, if they were a company that was a 14 lumber company and they brought in the lumber, but they 15 do it to other people's lumber, so -- 16 MR. RILEY: That's -- that's not what I'm -- 17 what we're trying to say. 18 We're saying that the -- that the requirements, 19 you know, are that you've got to do 80 percent -- 20 substantially all of your activities need to be a 21 process of experimentation for a qualified purpose, 22 okay. 23 So, what we believe -- it's very confusing as 24 to what exactly Appellants are claiming because, you 25 know, from the -- from the very beginning they've 26 claimed a substantial chemical reformulation of this 27 product, okay? 28 And it's only just now that they're saying, 68 1 "Oh, wait, that's not a part of it." 2 But their entire claim is based on, you know, 3 making this -- this substantial chemical reformulation. 4 While I agree that there is -- some of it is 5 their -- they're basing their claim on a process, which 6 we believe Osmose also provided, but what percent of 7 their original claim? 8 MS. MANDEL: Okay, but now you're talking about 9 substantiation -- 10 MR. RILEY: Well -- 11 MS. MANDEL: -- and how much credit there 12 should be. 13 MR. RILEY: -- I'm talking about the actual 14 activity. 15 They're saying they're doing something, but 16 then in the -- when it comes to time to go before your 17 Board, they say, "Oh, wait, actually we're not doing 18 that." 19 MS. MANDEL: Well, I guess in trying to produce 20 an ultimate product, can somebody be changing -- see, 21 now I don't want to use the word "tinkering" -- you 22 didn't want to use "research" and I don't want to use 23 "tinkering" -- can someone -- 24 MR. RILEY: Tinkering's okay. 25 MS. MANDEL: -- you know, swap pieces in and 26 out and try something new? 27 You know, can they -- can they play around with 28 their assembly line, manufacturing line at their plant, 69 1 because what's coming out the back end is a piece of 2 junk that someone doesn't want to buy because some -- 3 some element of what goes into their ultimate product 4 that they sell has changed and now they need to figure 5 out how to adjust their manufacturing line, which they 6 would say their process. 7 And they do a variety of things over time to 8 say, 9 "Hey, Eureka, today we now have a manufacturing 10 line that gives us the product at the end that 11 our customer will buy with this new, you know, 12 component that we had to add. We now have 13 figured out how to make it work for our 14 manufacturing line." 15 Is that -- is that research and development? 16 Or are you saying, well, that's just the business of 17 being a manufacturer? 18 MR. RILEY: It may involve -- it may involve 19 research, but -- you know, I know you don't want to talk 20 about substantiation, but that's what it comes down to. 21 If it's so important of a research, you know, 22 they should have a way of reproducing it in the 23 future. 24 You know, it's -- 25 MS. MANDEL: Well, once they get it to work, 26 they don't have to make it again. 27 I think that's their -- I mean, once they 28 get -- once they get an assembly line that works, 70 1 once -- once they've got, you know, in my example, once 2 you've got an assembly line that works and you put, you 3 know, the butter in before the milk or whatever and you 4 get the cake at the end and it's not flat, you don't 5 have to build that assembly line again. 6 So -- 7 MR. RILEY: Well, it's just -- you know, it's 8 got to involve a scientific method-type process of 9 experimentation. 10 They just haven't shown it. 11 MS. MANDEL: Okay. So, if -- if this -- so, 12 the gentleman would have to -- somebody would have to 13 make notes every day of, 14 "Oh, I tried this, that didn't work too good." 15 That kind of stuff? 16 MR. RILEY: Ideally, trial and error is 17 typically how the scientific method works. 18 You know, different companies have different 19 operations and there is no set document requirement that 20 says, "Hey, you must have form ABC." 21 But something -- you know, they have got to 22 provide something and in this case it appears that 23 Osmose is the one who's providing it. 24 They haven't been able to rebut that, you know, 25 what -- the documents that we provided that say, 26 "Look, Osmose provided the quality control 27 manual. Osmose gave you the plant operations 28 manual. Osmose offers classes in how to 71 1 operate these plants. And Osmose tells you 2 about incising and that this product works on 3 Hemlock Fir and Western Heartwood species." 4 MS. MANDEL: I understand that. 5 And I -- and maybe this gets back to your point 6 of, well, in the beginning they said it was all this 7 Osmose stuff and now they're saying it's something else. 8 Because what I hear them talking about is not 9 really -- except for the -- lots of little holes or 10 whatever those things are, indents from the incisor, I 11 don't hear them talking so much about the Osmose product 12 and getting it into the wood. 13 A lot of what they showed -- a lot of what they 14 talked about and showed in the pictures had to do with 15 getting the stain to work, which I -- my understanding, 16 unless I'm not remembering, that's not part of the 17 Osmose -- 18 MR. THOMPSON: May I clarify, Madam Chair? 19 MS. MANDEL: -- product. 20 MS. YEE: Mr. Thompson, briefly. 21 MR. THOMPSON: What we essentially have here is 22 the introduction of ACQ created two issues. One was how 23 do we get the ACQ into the wood we have been treating 24 with CCA for years? 25 MS. MANDEL: Right. 26 MR. THOMPSON: And then how do we get the stain 27 to work? 28 MS. MANDEL: Right. 72 1 MR. THOMPSON: Those branched off into two 2 different things. 3 MS. MANDEL: Right. 4 MR. THOMPSON: They had to do the -- they were 5 incising before ACQ -- 6 MS. MANDEL: Right. 7 MR. THOMPSON: -- ever came around. 8 MS. MANDEL: I understand that. 9 MR. THOMPSON: The incision is to get the 10 actual treating chemical into the wood. 11 MS. MANDEL: Right, the ACQ. 12 MR. THOMPSON: Right. 13 MS. MANDEL: I understand that. 14 MR. THOMPSON: Okay, I thought you were saying 15 to get the stain in there. 16 MS. MANDEL: No. 17 MR. THOMPSON: So, they were -- they were under 18 an intense development process of trying to determine, 19 based on the ACQ provided to them, how to develop their 20 treating process to get this into Redwood, to get the 21 ACQ into that white wood that I provided you earlier. 22 MS. MANDEL: Yeah, I understand that. 23 MR. THOMPSON: And then, in addition to that, 24 they had to go figure out a way for the other half of 25 their product -- to figure out how to get the stain 26 right and the -- 27 MS. MANDEL: Right. And what FTB is talking a 28 lot about is the quality control information that comes 73 1 with respect to the ACQ. 2 MR. THOMPSON: Correct. 3 MS. MANDEL: And, so, if there is two pieces, 4 what I'm trying to figure out -- what I heard a lot of 5 talk about and the gunk that was everywhere in the 6 pictures was the gunk because of the -- 7 MR. THOMPSON: Stain line. 8 MS. MANDEL: -- staining. 9 And, so, what I was trying to separate in 10 asking FTB was the ACQ piece off to the side, the 11 staining piece? 12 And again it would get back to, ultimately, if 13 that was research activity, to figure out how you could 14 get the stain piece to work now that this new ACQ 15 element came in so that things aren't working the way 16 they used to work at the plant. 17 I think FTB still have the substantiation 18 question, but I was trying to get to the, sort of, 19 research question of whether -- trying to figure out how 20 get my end product -- there was so much focus on the 21 ACQ. 22 Do you understand what I'm -- 23 MR. RILEY: If I might? I don't think it's 24 been said yet, but Sunwood, which is the stain, is also 25 an Osmose product. 26 MS. MANDEL: Okay. 27 MR. THOMPSON: And would not work. That's the 28 one they had to get rid of to go to the prestain. 74 1 MS. YEE: All right. Thank you, Ms. Mandel. 2 Mr. Horton? 3 MR. HORTON: Can the FTB just elaborate on the 4 80 percent rule? 5 MR. RILEY: The requirement of the statute is 6 that substantially all of the -- of the activities must 7 be a process of experimentation for a qualified purpose. 8 Now the statute -- the regs say that 80 -- 9 substantially all in this percent -- in this case is 10 80 percent. 11 So, when you break down the process, you've got 12 to go to -- you have got to say, "Well, 80 percent of 13 what we're doing here involves a process of 14 experimentation." 15 And if it doesn't, you keep shrinking it down 16 until you find the part that does. So, if -- you know, 17 if Osmose provided them with a process and there's -- 18 well, you know what, there's a little -- there is a 19 device we're going to add onto the end of this, the 20 entire process doesn't qualify, but maybe we can shrink 21 it back to this little end thing. And maybe that will 22 qualify. 23 So, if substantially all of the stuff that went 24 into this little end part involved a process of 25 experimentation for a qualified purpose and a qualified 26 purpose means, you know, it's not seasonal design 27 factors or things like that, then maybe -- then maybe 28 you can take a credit for that -- that little end piece. 75 1 But you don't get it for the entire -- you don't get it 2 for the entire process because the entire process 3 doesn't qualify. 4 MR. HORTON: So, let's say they developed a 5 tool or a widget as a result of this that is different 6 than anything that has ever been used, it's totally 7 different, this little widget. 8 Would that be -- would that end product imply 9 that the end product is new, something different, never 10 been used before, the widget and tool that is now used 11 to penetrate the wood and accomplish this particular 12 manufacturing quality control goal, would that 13 development be considered research and development? 14 And, if so, would you isolate the 80 percent to 15 only apply to the activity related to that? 16 MR. RILEY: Yes. They would both -- in your 17 example, the widget would qualify as a business 18 component of the taxpayer, as a product of the taxpayer. 19 And the people that worked on that widget. 20 MR. HORTON: Another question, last question, 21 Madam Chair, is that the -- with the -- if you have two 22 preexisting processes, in this case, staining and I 23 forget the term for the other -- 24 MR. THOMPSON: Treating. 25 MR. HORTON: -- treating, they preexisted. 26 However, no one really knew that you had to -- 27 you had to combine these two in order to reach a 28 particular end results. And you were never told that 76 1 that was the case. 2 You actually concluded that that was the case 3 as a result of trial and error. And, so, you actually 4 came up with a new process, even though it is the 5 culmination or combination of several different other 6 processes, you know, like -- and this is an obscured 7 example -- but there is a cereal where they came up and 8 they just dumped all of the cereals that they 9 manufacture into a box and shook it up a little bit and 10 came up with a new product -- would that be considered 11 R & D? 12 MR. RILEY: In your hypothetical, it actually, 13 you know, that actually could if you've taken two 14 processes that exist and may -- you know, nobody -- 15 nobody knew we could combine these two processes and, 16 so, we're going to do a process of experimentation to 17 try and do that, that type of a hypothetical, yes, 18 that -- that could qualify. 19 MR. HORTON: I know you don't have the 20 documentation and the evidence has not been provided to 21 specifically identify these various different components 22 of this activity, but given the most recent testimony, 23 is -- and this is a question of both the taxpayer and 24 the Franchise Tax Board -- is that what appears -- could 25 that have been going on in this case? 26 MR. RILEY: Well, it could. However, I would 27 like to see documentation from Osmose itself saying 28 that, well, you know that this wasn't anticipated or 77 1 that they have somehow, you know, done something new. 2 Because, you know, both Sunwood and the ACQ, 3 the NatureWood, are Osmose products, so -- 4 MR. HORTON: Okay. 5 MR. RILEY: You just need to -- 6 MR. THOMPSON: Can I answer my side? 7 MS. YEE: Yes. 8 MR. THOMPSON: It was -- the answer is shortly. 9 And counsel for the FTB contacted Osmose during the 10 course of this audit. It could have requested that 11 information from them at that time. 12 We were never -- we're not holding back these 13 manuals or quality control manuals. I mean, I will 14 produce them. 15 MR. HORTON: Be mindful that the burden of 16 proof is up to you. 17 MR. THOMPSON: I understand. 18 MR. HORTON: It's not really incumbent upon the 19 Franchise Tax Board to figure out how to prove your case 20 or that they should have done this or that prior to now. 21 So, I wouldn't necessarily advance that 22 argument. 23 MR. THOMPSON: Sure. Well, I mean, they're 24 making assumptions that are contrary to the evidence I 25 presented today. 26 Prior to 2000 there was no stain box. Today 27 there's a stain box. 28 You know, if he's going to come in and say, 78 1 "Well, we don't know if Osmose told them that or not," 2 well, so, now I've got -- I built a stain box. I've 3 shown you the stain box. I've shown you what happened 4 during the this time period with it. 5 MR. HORTON: I would -- 6 MR. THOMPSON: So now I have to prove somebody 7 else didn't -- didn't direct me to do it? 8 MR. HORTON: I mean, I would venture to say 9 that if that evidence was available at the onset of the 10 audit, you probably would have had -- the same 11 discussions, probably, would have taken place. 12 MR. THOMPSON: Okay. 13 MR. HORTON: The fact that the evidence -- 14 MR. THOMPSON: Fair enough. 15 MR. HORTON: -- is available now, I 16 understand. It makes sense to me. 17 Thank you, Madam Chair. 18 MS. YEE: Thank you, Mr. Horton. 19 Other questions, Members? 20 Okay, hearing none, may I have a motion, 21 please? 22 MR. HORTON: Let's take it under 23 consideration. 24 MS. MANDEL: Second. 25 MS. YEE: Okay. Motion by Mr. Horton to take 26 this matter under submission and second by Ms. Mandel. 27 Without objection, that motion carries. 28 Thank you, gentlemen. We will discuss your 79 1 matter later today. 2 MR. THOMPSON: Thank you very much. 3 MS. YEE: We'll send you written notice of our 4 decision. 5 MR. FEENSTRA: Thank you. 6 MS. YEE: Thank you very much. 7 ---o0o--- 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 80 1 . 2 REPORTER'S CERTIFICATE 3 4 State of California ) 5 ) ss 6 County of Sacramento ) 7 8 I, JULI PRICE JACKSON, Hearing Reporter for the 9 California State Board of Equalization certify that on 10 JULY 13, 2010 I recorded verbatim, in shorthand, to the 11 best of my ability, the proceedings in the 12 above-entitled hearing; that I transcribed the shorthand 13 writing into typewriting; and that the preceding pages 1 14 through 80 constitute a complete and accurate 15 transcription of the shorthand writing. 16 17 Dated: September 12, 2010 18 19 20 ____________________________ 21 JULI PRICE JACKSON 22 Hearing Reporter 23 24 25 26 27 28 81