BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 450 N Street, Room 121 Sacramento, California REPORTER'S TRANSCRIPT DECEMBER 14, 2010 ITEM B1 FRANCHISE AND PERSONAL INCOME TAX HEARING APPEAL OF KINGSTON TECHNOLOGY CORPORATION (No. 480846) DAVID SUN AND DIANA SUN (No. 4808981) AND JOHN TU AND MARY TU (No. 480894) AGAINST PROPOSED ASSESSMENT OF ADDITIONAL TAX Reported by: Beverly D. Toms CSR No. 1662. 1 1 2 P R E S E N T 3 For the Board Betty T. Yee of Equalization: Chairwoman 4 Jerome E. Horton 5 Vice-Chair 6 Barbara Alby Acting Member 7 Michelle Steel 8 Member 9 Marcy Jo Mandel Appearing for John Chiang 10 State Controller (per Government Code 11 Section 7.9) 12 Diane Olson Chief, Board 13 Proceedings Division 14 For Board of Anthony Epolite 15 Equalization Staff: Appeals Division 16 Amy Kelly Appeals Division 17 18 For Franchise Tax Daniel Biedler Board: Tax Counsel 19 Bill Hilson 20 Tax Counsel 21 For Appellant: Christopher A. Whitney 22 Representative 23 Jung H. Kim Attorney at Law 24 25 ---oOo--- 26 27 28 2 1 Sacramento, California 2 December 14, 2010 3 ---oOo--- 4 MS. YEE: Our next item, please. 5 MS. OLSON: Our next item is B1a, Kingston 6 Technology Corporation; B1b, David Sun and Diana Sun; 7 and B1c, John Tu and Mary Tu. Please come forward. 8 Board Proceedings has received contribution 9 disclosure forms for this hearings from the parties, 10 agents and participants. All forms were properly 11 completed and signed. All parties, agents and 12 participants are on the Alpha listing provided to your 13 office. 14 Each person sitting at the table will be asked 15 to introduce themselves and if necessary their 16 affiliation with the taxpayer for the record. 17 Ten minutes is allocated for the taxpayer's 18 opening presentation followed by ten minutes for the 19 Department's presentation, and five minutes is allocated 20 to the taxpayer for rebuttal. 21 Ms. Yee. 22 MS. YEE: Thank you very much, Ms. Olson. 23 Okay, Members, we are on the first income tax appeal. 24 That's item B1a, Kingston Technology Corporation; B1b, 25 David Sun and Diana Sun; and B1c, John Tu and Mary Tu. 26 Let me have the Appeals Division introduce the 27 matter. Good morning. 28 MR. EPOLITE: Good morning, Madam Chairwoman 3 1 and Members of the Board. Anthony Epolite with the 2 Appeals Division. 3 The issue before the Board in this matter is 4 whether Appellants must recognize gain on the 5 disposition of a contingent note arising from an 6 installment sale under Revenue and Taxation Code Section 7 24667, which conforms to the Internal Revenue Code 8 Section 453B. 9 MS. YEE: All right. Thank you very much, Mr. 10 Epolite. Good morning. 11 MR. WHITNEY: Good morning. Madam Chairwoman, 12 Members of the Board, my name is Chris Whitney and Peter 13 Kim and I represent the Appellants in this appeal, which 14 is from the action of the FTB in denying the Appellant's 15 protest for the tax year 1999. 16 The sole issue as stated in this appeal is 17 whether the cancellation of a highly contingent 18 installment note, hereinafter the note, resulted in gain 19 recognition to Appellant under 453B. 20 It should be noted at the outset that the FTB 21 and Appellant agree on several points. First, FTB and 22 Appellant agree that the cancellation of the note was 23 part of Appellant's repurchase on July 14, 1999 of the 24 business that Appellant had earlier sold to Softbank in 25 1996. 26 Second, FTB does not dispute that Softbank was 27 a Japanese public company and as such was a party 28 unrelated to Kingston. 4 1 Third, FTB and Appellant agree that none of the 2 conditions required for payment under the terms of the 3 note were ever met, and that no payments were received. 4 And, finally, FTB and Appellant agree that 5 Appellant's basis in the note was just under six 6 million. 7 The disagreement then between the Appellant and 8 the FTB and the reason for this appeal centers around 9 the value of the the note on July 14, 1999. The FTB 10 contends that the best available estimate of this value 11 is the note's appraised value at December 31, 1998. We 12 will demonstrate that the best measure of the note's 13 value on July 14, 1999 is the -- the arm's length 14 transaction with Softbank on that date, itself, and that 15 in this transaction neither party attributed any value 16 to the note. 17 In any event, even if an appraisal of the note 18 were relevant, such appraisal would need to be updated 19 to reflect the value of the underlying business on July 20 14, 1999. 21 Using the same methodology he used with his 22 1998 appraisal as we'll discuss, Appellant's expert, Jim 23 Wilson, has computed and updated valuation of the note 24 at July 14, 1999 of 7.6 million. 25 Now, the facts are not in dispute. In 26 September '96 Kingston sold an 80 percent interest in 27 its DRAM memory chip business to Softbank for nearly 28 $1.5 billion, 875 million of which was paid in cash and 5 1 the balance of 633 million was payable under a note of 2 which 333 million remained outstanding at the end of the 3 year. 4 The Suns and Tus in '96 paid nearly 170 million 5 and 50 million each in Federal and California taxes 6 on -- on the transaction. Subsequent to the sale the 7 market for DRAM memory chips softened and in October 8 1997 Kingston agreed to cancel the $333 million note and 9 accept a highly contingent note in its place, which was 10 payable only in the event that either the average annual 11 EBIT over a seven-year period rose to $300 million or 12 there was an IPO or sale of the business with a $1.8 13 billion valuation. 14 These conditions were intentionally set very 15 high and particularly given that the highest EBIT ever 16 achieved by the company in its history was half -- less 17 than half of that amount, neither party thought that 18 these contingencies would ever be met. 19 The DRAM market in fact continued to decline 20 and in 1999 Softbank and Kingston agreed to undo the 21 deal with Appellant buying the stake in the business 22 back for only $450 million. In this connection the note 23 at issue was cancelled. 24 Although FTB recognizes that the note was never 25 collected, FTB assessed tax under 453A -- B based upon 26 the $22.4 million estimate of the fair market value as 27 of December 31, 1998, which had been determined in a 28 study that Appellant commissioned at FTB's request in 6 1 connection with an earlier assessment for 1997 and 1998 2 under 453A on the same transaction. 3 On rehearing on February 28, 2008 your Board 4 held that the best measure of the deferred gain and 5 related tax for purposes of 453A was the amount 6 ultimately received in exchange for the note on July 14, 7 '99 and not the -- the fair market value appraised 8 value. 9 Since the parties at the time agreed that 10 nothing was received at that date with respect to the 11 note, your Board ordered that FTB's '97 assessment be 12 reversed. Subsequent to your Board's holding the FTB 13 withdrew a similar assessment for 1998. 14 Under the installment sale rules, a taxpayer 15 defers gain recognition when one or more payments 16 related to the sale of property is to be received 17 over -- over time. 18 Simply put, the purpose here is to match the 19 payment of tax with the receipt of the proceeds. 20 IRC 453B revisits the basic premise for 21 deferral by requiring gain recognition in situations 22 where the taxpayer has monetized their position in the 23 note and un -- and until 1997 IRC 453B did not require 24 gain recognition under certain tax planning transactions 25 involving note cancellations. 26 As revised and currently covering cancellations 27 to cover -- to cover such, these 453B provisions do not 28 specifically address installment sales involving highly 7 1 contingent notes, as the case here, which neither party 2 expected would ever be paid from the beginning. 3 FTB's arguments basically boil down to two 4 things. First, the FTB asserts that the cancellation 5 was part of an overall repurchase agreement on July 14, 6 '99, and as such the note had value. 7 Second, the FTB asserts that the best available 8 evidence of that value is the praised -- the appraised 9 value at December 31, 1998. 10 With that, Peter and I would like to address 11 each of the FTB's arguments. 12 First, again the key question in this appeal is 13 the value of the note on July 14, 1999, the date that 14 Kingston repurchased the business from Softbank and 15 cancelled the note, not December 31, 1998. 16 In this regard it's helpful to recall the 17 definition of fair market value, which is essentially 18 the amount at which property would change hands between 19 a willing buyer and a willing seller. 20 Since payment under the terms of the note was 21 based upon the performance of the company, the value of 22 the note is correlated with the underlying value of the 23 business. And in this regard it's important to note 24 that Softbank was an unrelated publicly traded company 25 in Japan with a duty to its shareholders to get the 26 highest possible price it could for the business that it 27 resold to Appellant. 28 Similarly, Appellant from the very beginning 8 1 was committed to treating Softbank fairly with respect 2 to this transaction as evidenced by its willingness to 3 cancel the $333 million note and accept a highly 4 contingent note in 1997. 5 As a result when the purchase agreement states, 6 as it does, in Section 1.1 that the total purchase price 7 for the business was $450 million, there's no reason to 8 doubt that this reflected the fair market value of the 9 business negotiated between the parties at that point in 10 time. 11 Also the subsequent behavior of the parties 12 further confirms this point. Softbank reported the 13 total of $450 million in proceeds to its public 14 shareholders and Kingston took a $450 million basis in 15 the property purchased. 16 It is well established in tax law from such 17 landmark cases as the U. S. Supreme Court's decision in 18 U. S. versus Davis and the often cited Philadelphia Park 19 Amusement Company case before it that the value of the 20 property that you give in a transaction is presumed to 21 be equal to the value of the property that you receive. 22 As already noted, strong evidence exists that 23 the value of the business on July 14, 1999 was $450 24 million. As such it can be presumed to be equal in 25 value to what was given, which again according to 26 Section 1.1 was $200 million of cash and a promissory 27 note of -- of $200 million. 28 While Article VII does provide that the 9 1 purchase agreement supersedes and cancels existing 2 agreements between the parties, such as existing 3 partnership agreements, the note at issue and other 4 agreements related to the original sale. The purpose of 5 this was to put the parties back in the position that 6 they were before the original sale in 1996. And there 7 is no evidence that the cancellation of these 8 agreements, including the note, had any overall value in 9 the transaction to the parties. 10 The logical conclusion supported by this 11 evidence is that the note had zero value on July 14, 12 1999, which is consistent with your Board's prior 13 holding with respect to 453A, which again was based on 14 the premise that there was ultimately no gain which had 15 been deferred for which 453A interest could be 16 charged. 17 So with that Peter Kim will add some further 18 remarks concerning the value of the -- the note. 19 MR. KIM: Thank you, Chris. And thank you, 20 Members of the Board. 21 As Chris noted above, values negotiated between 22 third parties are strongly presumed to be the fair 23 market value, and Courts have consistently placed a 24 heavy burden on the party asserting a value different 25 from what was actually negotiated between the parties. 26 For example in Moore-McCormick Lines the 27 taxpayer had purchased certain commercial vessels in 28 exchange for cash and diminutive traded common stock. 10 1 In that case the Tax Court accepted the value that the 2 parties had assigned to the stocks in determining the 3 basis of the ships. In doing so the Court expressly 4 rejected the IRS's use of the resale stock price data 5 that was publicly available at the time. 6 Similarly, it is inappropriate for the FTB to 7 use the '98 valuation in an attempt to rebut the arm's 8 length value that the parties had negotiated for the 9 note at July 14, 1999. 10 The FTB has provided no evidence of any sort in 11 this appeal to support its presumed valuation of $22.4 12 million as of July 14, 1999. 13 Now, despite the Appellant's -- Appellant's 14 position that the note had no value at the time of its 15 cancellation, for the sake of illustration only we have 16 asked the same appraiser of the '98 report to update the 17 computation using the same methodology but based on the 18 actual information and data that were available on July 19 14, 1999. 20 We have -- we have included a copy of this 21 updated report in our exhibits. It should be noted that 22 for the purpose of the '98 report the appraiser had 23 relied on a computed business enterprise value of $760 24 million and had ignored the fact that the business was 25 ultimately sold only for $450 million in '99. 26 Therefore, for the purpose of the valuation as 27 of July 14, 1999 the appraiser used the actual business 28 enterprise value of $450 million as a new starting point 11 1 and also made certain adjustments for the updated 2 revenues and the shorter period remaining under the 3 terms of the note. 4 Under this approach appraiser has estimated the 5 value of the notes as of July 14, 1999 to be $7.6 6 million. All of the foregoing strongly demonstrates the 7 error in the FTB's assessment. 8 And with that we'll close our opening remarks 9 and use the balance of our time to address any questions 10 or concerns that you have. 11 Thank you very much. 12 MS. YEE: Thank you. Thank you, Mr. Whitney, 13 Mr. Kim. 14 Let's hear from the Franchise Tax Board. 15 You'll have time on rebuttal. Thank you. 16 Franchise Tax Board, good morning. 17 MR. BIEDLER: Good morning, Madam Chair, 18 Members of the Board. My name is Daniel Biedler, 19 representing Franchise Tax Board, Respondent. 20 To my right is my colleague, Mr. Bill Hilson, 21 also representing Franchise Tax Board. 22 As Appellants have pointed out, this case deals 23 solely with the cancellation of a -- of a note, which by 24 its -- the explicit terms of the statute that applies, 25 453B, means that gain or loss needs to be assessed as of 26 this. 27 This case is highly distinguishable from the 28 prior proceedings that dealt with gain as yet unrealized 12 1 and an estimate had to be made in measuring it under 2 453A, a separate question with a separate methodology. 3 Appellants recognize that 453B without 4 contention requires a calculation of gain or loss, and 5 their sole position is that because they received 6 nothing on this contingent note that it should -- the 7 value should be zero. They contradict themselves in 8 this statement by providing valuations both six months 9 prior to the sale and then as of the date of sale, 10 although having just received it yesterday Respondent 11 really hasn't had a time to -- to check it out and -- 12 and understand if there's anything to be questioned. 13 Nonetheless, both of them come up with a 14 substantial value, in the millions. So why would it be 15 just because nothing was received on the contingent note 16 that it has no value when their own expert says that it 17 does. 18 This value is reflected if not explicitly in 19 the terms of the repurchase agreement on the schedule or 20 even on the way that Softbank reported things on their 21 financials, there had to have been negotiation 22 considering the purchase price of what all would go into 23 this exchange of cash for the company. Well, the 24 cancellation of this note was clearly a part of it. And 25 if it hadn't been cancelled it would have been an 26 outstanding obligation on the part of Softbank to pay 27 money to Appellants if the contingencies were met. And 28 there were still a number of years remaining on this 13 1 note. 2 The fact that it was cancelled shows that there 3 was a value, and it was done concurrent with the other 4 events in the repurchase. 5 The question of the exact value, whether it be 6 the 22 million from the December 1998 valuation or the 7 now apparent contemporaneous with the cancellation 8 valuation, shows that there's value. And -- pardon me, 9 I know I've repeated myself -- and I'd like to offer 10 some more opportunity to Mr. Hilson here to make some 11 comments to whole up. 12 MR. HILSON: Well, as Mr. Biedler has pointed 13 out, this is not a transaction that just happened. 14 The -- these parties had been joined together for many 15 years with an original sale, a change -- a change of the 16 deal and then finally yet another change of the deal. 17 We don't dispute the DRAM chip marketplace was 18 declining. However, the taxpayers are astute 19 businessmen. This was their business. They were 20 following that marketplace. They knew there was an 21 opportunity to go back in. When they went back in they 22 negotiated a sale. They could -- coming up with $450 23 million to regain the business. 24 You don't do that if the business is worthless. 25 A note given up by the business has to have some value 26 if it -- if they're going to be sitting there saying, 27 we're $450 million upside down, we can't pay this note, 28 we can't meet the contingencies. 14 1 Well, the taxpayers didn't believe that that 2 was the case. They thought there was an opportunity 3 there. 4 That note had to be dealt with as part of this 5 transaction because if not it's there, it's a potential 6 exposure for Softbank to have to be paying these people 7 back some of the $450 million that they are giving them 8 to require the business in the first place. 9 The fact that the business had value is 10 underscored by the fact that even as of last night the 11 taxpayer's appraisers, their experts, are saying that 12 there's $7 million worth of value there. 13 As Mr. Biedler points out, we don't know if 14 that's accurate. We haven't really had a chance to 15 study it. But the fact of the matter is that we know 16 that as of December 31 the taxpayer's experts appraise 17 that note as having a value of $22 million plus. Six 18 months later, again being asked to come up with 19 something for their tax purposes, the number goes down 20 but it goes down to $7 million. 21 To simply say that there's no value in this 22 note is not supported by the opinions of their own 23 tax -- their own experts for the realities of the 24 business world. Thank you. 25 MS. YEE: Thank you very much, Mr. Hilson. 26 Anything else, Mr. Biedler? 27 MR. BIEDLER: Not at this time. I'll be happy 28 to take any questions. 15 1 MS. YEE: Okay, thank you very much. 2 Gentlemen, you have five minutes on rebuttal. 3 MR. WHITNEY: Okay. Thank you, Madam 4 Chairwoman. Listening to FTB's arguments what we're 5 dealing with here is an arm's length transaction where 6 the parties bargained for a $450 million purchase price 7 of the -- the business. That was stated as the total 8 consideration. That was the amount that was reported by 9 Softbank in public annual reports to its shareholders. 10 If there was any additional consideration or any 11 additional value to the business they would have 12 reported it. 13 In fact, in their 2000 annual report, which 14 we've provided in the exhibit, they computed their loss, 15 which they again reported in their 2000 annual report 16 based on the 450 million proceeds received minus 17 their -- their basis in -- in the -- in the property. 18 Similarly, Kingston took a basis of $450 19 million in the property that it purchased. 20 So we're dealing with an arm's length 21 transaction. And the case law is very clear that a 22 party wishing to dispute a valuation determined in an 23 arm's length transaction carries a very substantial 24 burden to demonstrate that the value determined by the 25 parties is not -- not accurate. 26 So what -- what value are they using or what 27 evidence are they using? They're using a valuation 28 computed by an appraiser who specifically ignored any 16 1 transaction or any event after December 31, 1988 in 2 computing -- in computing the value. So he did not take 3 into account that the business was actually worth on 4 July 14, 1999 $450 million when he computed his estimate 5 of the appraised value at December 31, '98 for purposes 6 of a 1988 interest charge. 7 Instead he backed into a value of the business 8 at that time based on the future projections of -- of 9 the company, and -- and based on volatility and price 10 earnings multiple data he backed into a value of $760 11 million. 12 Now, clearly, a business that's worth $760 13 million has a greater likelihood of achieving a $1.8 14 billion fair market value contingency than a company 15 that's only worth 450 million. 16 So, the -- the data that they're using is the 17 wrong date. It's not relevant to the actual transaction 18 of July 14th, which was an arm's length negotiation 19 between -- between the parties. 20 No one is asserting that the business was 21 worthless. We know that the business was purchased for 22 $450 million. We do also know that the consideration 23 was stated and that the purpose of this transaction was 24 effectively to put the parties -- the same two parties 25 that were party to the original transaction in 1996, so 26 there's a period of roughly three years, or less than 27 three years that they were -- you know, had a contract 28 with one another -- back into the position that they 17 1 were prior to 1996. 2 You would not leave loose ends, such as 3 partnership agreements, other agreements incident to the 4 original purchase un -- untied. And so the purpose of 5 that article, Article VII, was to reverse all of the -- 6 the agreements between the parties as created in 1996 7 and the note in '97, and put them back in the position 8 that they were before. 9 There isn't any evidence that either party 10 ascribed any value to this from what they reported to 11 the public from -- from how Kingston reported the basis 12 on -- on the purchase of the assets or any other -- any 13 other evidence. 14 MS. YEE: Okay. Mr. Kim, anything further? 15 Okay. 16 MR. KIM: Thank you. 17 MS. YEE: Very well, thank you very much. 18 Questions, Members? Discussion? 19 Ms. Alby, please. 20 MS. ALBY: Thank you, Madam Chair. I have a 21 question for the Department, and that is I'm confused 22 because it seems to me your position is at odds with the 23 2008 BOE decision relating to the assessment under IRS 24 435A. So if the note was -- had zero value then it 25 seems to me it has zero value under B. Can you help me 26 with that? 27 MR. BIEDLER: Absolutely. Thank you for the 28 question. The 453A case asked a question of how much 18 1 gain do we ascribe to this note as of the end of that 2 year, because the way 453A works is December 31st or 3 whatever the tax year end says, okay, how much gain has 4 yet to be paid tax on, and so we'll charge interest on 5 that. 6 We're calculating interest and we're estimating 7 a value. Your Board decided in that case to wait and 8 see what would actually happen. So for that case, for 9 the 1998 year -- or for the year in that case, pardon 10 me, looking forward you decided to wait and see. There 11 was something to see. 12 In this case 453B, the termination of the note 13 ends the deal, ends the note and so there's gain or loss 14 based on whether they have sufficient basis to cover the 15 value of the note. Everything is known. There's 16 nothing to wait and see. 17 So in that case the "wait and see" result was 18 they got nothing. It was determinative. In this case 19 the note still had value. It didn't matter that they 20 eventually got nothing, there were still years left on 21 the term. So there was value in the note still. Not -- 22 and it didn't matter whether they actually got anything 23 paid on it directly. The value for the note came in the 24 combination with the repurchase agreement. 25 MS. ALBY: Could I ask the taxpayer -- 26 MS. YEE: Sure. 27 MS. ALBY: -- to respond to that? 28 MR. WHITNEY: Yes, please. Thank you, Ms. 19 1 Alby. Yeah, what I think I heard FTB say is that 453A 2 deals with an issue completely separate from 453B. But 3 I also heard that 453A, according to FTB, deals with the 4 ultimate gain on the transaction and the gain on the 5 note, which is exactly what we're talking about here. 6 Is there a gain under 453B on the note? 7 Again, when you have an arm's length 8 transaction the case law, going back to U. S. versus 9 Davis, it's very clear, the value of the property you 10 get is equal to the value of what you receive. 11 So in -- in that transaction if we gave a 12 contingent note plus $450 million of cash and that note 13 had value, that implies that the business that we 14 received was worth more than $450 million. And so we 15 would have received something on the note and there 16 would have been a 453A interest charge. 17 But in -- in fact your Board has already 18 determined and I thought that FTB and Appellant had 19 agreed previously that there wasn't anything received. 20 And I think we just heard that again, that there was not 21 anything of value received for the note. Therefore, 22 there wasn't any deferred gain on which 453A could be 23 based, and there wasn't any fair market value of the 24 note for which a 453B charge could be based, either. 25 Otherwise there would have been something of value 26 received for that note. 27 MS. YEE: Anything else? Okay. Thank you, Ms. 28 Alby. 20 1 Other questions, Members? 2 Mr. Horton. 3 MR. HORTON: Thank you, Madam Chair. Question 4 of the taxpayer. 5 It appears that there was a value to the note 6 from my perspective and -- but that value seems to be 7 declining rather rapidly. 8 MR. WHITNEY: Yes. 9 MR. HORTON: Can you speak to the decline and 10 why it existed and then again to the difference between 11 the method of valuation from December to July, the two 12 different appraisals. 13 MR. WHITNEY: Okay. Thank you, Mr. Horton, 14 yeah, those are good questions. 15 The contingent note was payable in the event 16 that one of two contingencies was met. The first was, 17 was that the average annual EBIT, or earnings before 18 interest and tax, grew to $300 million over a -- a 19 seven-year period. The company had never achieved even 20 half of that EBIT, so it was a very tall order. 21 Because it was a cumulative test, for every 22 year that went by the -- what you missed in -- in the 23 target in the previous year was added to the body 24 effectively that you'd have to meet for the subsequent 25 years. 26 So effectively, you know, every year that you 27 didn't meet the goal, whatever your shortfall was got 28 added to the result that you would have to meet in 21 1 subsequent years. 2 So that's why the -- the so-called EBIT 3 contingency value, which is actually the lower of the 4 two values that the appraiser computed is -- is really 5 quite low. Because every year that went by, you had 6 '97, '98, '99, you have the actual EBIT was coming in at 7 76 million. At that time the projections were -- were 8 very low. In fact, the EBIT for 2000 through 2001, on 9 average those two years were only 50 million of EBIT. 10 So in -- in terms of meeting the EBIT 11 contingency it was extremely remote and getting harder 12 and harder each year, because every year of shortfall 13 adds to basically the hurdle that you'd have to -- to 14 leap in the subsequent years. 15 The reason why the so-called IPO or sale 16 contingency value dropped so much from '98 through July 17 14, 1999 was that when we did the appraisal as of 18 12-31-98 Jim Wilson only took into account events and 19 facts that would have been known at December 31, '98. 20 At that date you wouldn't know that you were going to 21 sell the company six and a half months later for $450 22 million. 23 So he appropriately ignored that point and said 24 for -- for purposes of my starting point what value is 25 the business right now, to try to project the 26 probability of could it grow to be more than a billion 27 eight in the -- the time frame. He had to back into a 28 value of the company using the earnings of the company 22 1 that were projected at that time. And so the value he 2 came up with at that time was 760 million. 3 Now at July 14, '99, you know, what Jim Wilson, 4 using the same methodology, the same Black-Sholes option 5 pricing model formula that was used in the original 6 calculation, basically just plugged in the now known 7 value of $450 million for the business. And a 8 hypothetical, you know, effectively what we asked the 9 appraiser to do is ignore the fact that the note was 10 cancelled in the transaction; imagine that, you know, 11 somehow there was -- you know, the business was sold for 12 450 but that loose end was left hanging out there; what 13 would somebody pay for a note like that. And he plugged 14 in the $450 million beginning value, obviously much less 15 than 760 in just six months, and based on that lower 16 value and that lower starting point the ability to 17 exceed 1.8 billion, you know, after that point just 18 diminished significantly. 19 So that the value dropped based on his 20 Black-Sholes option pricing model down to 7.6 million at 21 July 14th. 22 MR. HORTON: Question of the Department, what's 23 your view of the subsequent appraisal? 24 MR. HILSON: Mr. Horton, it's -- we just got it 25 and really -- really haven't had an opportunity to -- to 26 lay it side by side with the -- the prior appraisals 27 to -- to say, you know, really what the comparison is or 28 is not. 23 1 It's -- there's a logic to the representation 2 that if you start an appraisal with a going concern 3 value of $750 million or -- or a higher number than a 4 lower number, that the im -- excuse me, implementing the 5 entire -- the exact same methodology is going to result 6 in a lower number simply because you're following the 7 same mathematic equation. 8 So, you know, I -- I'm not surprised that it 9 goes down, but I think the point of the matter is, is 10 that the taxpayer's expert still is of the opinion that 11 as of July this note had value. And it's -- it's not 12 just, you know, that they didn't get any money for it, 13 that is the -- the be all and the end all of the 14 analysis. We don't dispute the facts that there's -- 15 there's nothing here that demonstrates that the 16 taxpayers received cash or cash equivalence for giving 17 up on the -- on the pre-existing note. We don't dispute 18 that the annual statement doesn't say that the deal was 19 $450 million plus cancellation of the note. But we know 20 those are the facts. 21 And so to the extent that the deal is $450 22 million plus cancellation of a note, the annual 23 statement is incomplete. And to the extent that they 24 didn't carry the $450 million note on their books 25 doesn't mean that the contingent obligation didn't 26 exist. It means that their books are incomplete. 27 So -- so the note is -- the note is -- is 28 there. Obviously it -- it still had some value. It was 24 1 dealt with. It was eliminated as a contingent concern 2 and I think the fact that it has value is underscored by 3 the fact that the taxpayer's expert gives us three 4 different valuation dates and gives is three different 5 values. 6 I -- I -- I conclude from all of this that the 7 note had value and I think there's a basis for you to do 8 so, as well. 9 MR. HORTON: In the -- 10 MS. YEE: Mr. Horton, can we hear from Whitney 11 on that and then I'll have you continue. 12 MR. WHITNEY: Yeah. Ultimately arm's length 13 transactions between unrelated parties establish value. 14 You perform an appraisal when you don't have an arm's 15 length transaction as of a specific date. So with a 16 453A assessment before it what we were asked to do is to 17 provide an appraisal at the end of years where we didn't 18 have an arm's length transaction at that point. 19 So it -- it does -- it is a bit confusing when 20 we have an arm's length transaction that establishes a 21 value of the business at $450 million with no value 22 being bargained for by the parties with respect to the 23 note that you would use a valuation to -- to instead 24 double -- second-guess, I guess, you know the parties to 25 the transaction to -- to contrive, I guess, a value of a 26 note where the parties have said that the note has got 27 zero value. 28 What we did was, we took the original 25 1 calculation using Black-Sholes as of 12-31-98. And 2 Black-Sholes is something that I dimly remember from my 3 corporate finance classes in, you know, college. And 4 it's something I actually was able to do, you know, back 5 then, but that was, you know, 20 years ago but, you 6 know, you would plug in the starting value, the target 7 value, volatility figures, run it through the 8 Black-Sholes calculation which, you know -- you know, is 9 a well-known calculation, and then you would come up 10 with a calculated value. 11 That would be an alternative. If you had 12 grounds to second-guess, you know, that the transaction, 13 you know, was arm's length, FTB might have taken the 14 model that it was provided with, a 1998 valuation, and 15 simply plugged in the $450 million starting point 16 calculation and then as our appraiser did, you know, 17 calculate what, you know, the estimated value of the 18 note would be. 19 FTB then would have to say that this is the 20 true value that the pargins -- the parties bargained for 21 and that the actual transaction and the price of 450 22 million that they reported to their public shareholders, 23 the basis that they took, what the agreement said was 24 the total consideration was somehow not arm's length and 25 that instead this is the actual value that the 26 parties -- so you would have to have some evidence, I 27 guess, to attack the arm's length nature of the 28 transaction for that to be -- to be valid. 26 1 MR. HORTON: Okay. The note was cancelled July 2 1999. 3 MR. WHITNEY: Yes. 4 MR. HORTON: It seems that all parties seem to 5 agree that there was a downward turn in the valuation of 6 the business. So I believe that there was a value but 7 it's difficult to establish a value with these two 8 different appraisals here. And it's difficult for me 9 to -- to preempt the Department without them having an 10 opportunity to look at the subsequent calculations and 11 the appraisal and determine and be able to speak on 12 whether or not that's comparable. Those are my 13 thoughts. 14 MS. YEE: Okay. Thank you, Mr. Horton. 15 Ms. Mandel. 16 MS. MANDEL: I think that you stated it but the 17 appraisals as of the year end, those were done during 18 the administrative process for the other case, which was 19 a 453A case, or 453A, and the issue there was whether to 20 take a "wait and see" approach to calculating interest 21 so that you would wait until there was some amount 22 realized on the note to recognize a 453A interest 23 amount, or whether to use a fair market value as of the 24 year end under 453A, and that those two valuations, 25 which include the December '98 one that FTB wants to 26 rely on here were done in that -- for that proceeding 27 that weren't done for this proceeding, correct? 28 MR. WHITNEY: That's correct. 27 1 MS. MANDEL: Okay. And there wasn't an 2 appraisal requested by Franchise Tax Board as of the 3 date of the July '99 transaction with Softbank, but for 4 purposes of this hearing you had the December '98 5 figure -- or December '98 appraisal updated to July '99 6 by the same person who performed the -- the December '98 7 appraisal? 8 MR. WHITNEY: That is correct. 9 MR. KIM: That is correct. 10 MS. MANDEL: Okay. And my understanding of the 11 453B is that we're all talking about value as of July 12 '99 and -- and of course even before the December '98 13 there had been the December '97 appraisal, which was 14 considerably higher than December '98 and then the 15 original face value of the non-contingent note, which 16 was swapped out for the contingent note which was even 17 considerably, considerably higher than that. So it's 18 been crash -- crashing over the coup -- couple of years. 19 My understanding of what we're -- both sides 20 are talking about fair market value as of July '99 21 from -- being the measure is because it's a -- a 22 cancellation but I -- I also kind of hear the fair 23 market value as being zero because that's what the 24 parties agreed to in the arm's length transaction with 25 Softbank. And that sounds a little bit to me like the 26 other -- the general rule in 453B is if the note is 27 satisfied for less than face value you use the amount 28 realized. 28 1 Now, it -- are we not in that because we don't 2 have a face value because it's a contingent note or are 3 we not in that because in the deal with Softbank and 4 word "cancellation" was used and so we're in the part 5 about an agreement -- an installment obligation that's 6 cancelled or becomes unenforceable, is treated as other 7 than a sale or exchange and so -- excuse me, then you go 8 to fair market value? I just got a little confused when 9 I heard the -- the zero because of the agreement and 10 whether that was really a zero amount realized on -- on 11 a -- I don't know who wants to answer this. I see 12 everybody, so -- can you -- 13 MR. WHITNEY: Well, 453B, these provisions that 14 we're -- we're dealing with was added in 1987, 15 coincidentally the same year that 453A was added to -- 16 to the code as a partial exception to the idea that, you 17 know, we do an installment sale, you get deferral and 18 you just deal with the tax when you -- when you receive 19 a payment. 20 The reason why they put this in here was for -- 21 for some of the cases that -- that FTB has cited, like 22 Frane and Miller versus Usry and -- and other cases 23 where, you know, you had, yeah, typically a father 24 and -- and children. The father would sell a business 25 under a non-contingent installment note to -- to the 26 children, who would then take a basis, a fair market 27 value basis in that property, depreciate it. They would 28 have less gain if they sold the property. And then as 29 1 part of the note it would cancel upon the death of 2 the -- the parent. 3 So that was really what they were targeting. 4 What they devised is a pretty blunt instrument that 5 requires gain recognition based on the fair market value 6 of any note that -- that you cancel. 7 Now, ordinarily, you know, you would have a 8 cancellation as a separate event. You know, here what 9 we have is a cancellation is part of a repurchase of a 10 business between two unrelated parties, Kingston and 11 Softbank. 12 I think that FTB has -- has agreed as much that 13 this is part of its Article VII of the repurchase 14 agreement. So I think you have to evaluate the -- the 15 fair market value at that time based upon the arm's 16 length overall transaction at that -- that date. 17 MS. MANDEL: So we are in the part of -- we're 18 not in the part of 453B that says look to the amount 19 realized on a -- we're in an -- other than a sale or 20 exchange as to the note? Okay. 21 MR. WHITNEY: I would say -- I would say that 22 this is part of a sale or exchange of a business where 23 FTB is alleging that part of the consideration that was 24 paid for the business was this value of the contingent 25 note, you know, whatever that was at July 14th. 26 MS. MANDEL: No, I -- yeah, I understand. I 27 just -- when I was looking at 453B I just saw that the 28 general rule was the amount realized in the satisfaction 30 1 of -- of a note at other than face value. And when I 2 hear you say this was the -- that there was zero, you 3 know, for the note in this transaction, it just kind of 4 sounded more like that. But if everybody is on the same 5 page that we're in the -- the other than a sale or 6 exchange as to the note and we have to find fair market 7 value, then, you know, I'll just drop it. But -- 8 MR. HILSON: It's -- 9 MR. WHITNEY: I would say it's part of an 10 overall sale or exchange, a repurchase of the business 11 where FTB is arguing that this particular element of 12 Article VII of the agreement, where they cancel the -- 13 MS. MANDEL: No, I understand that -- 14 MR. WHITNEY: -- agreement. 15 MS. MANDEL: -- but I guess you're not arguing 16 that it's an amount realized in satisfaction of the note 17 at other than face value. Because we don't have a face 18 value I guess is what you -- 19 MR. WHITNEY: Right, it's a contingent note. 20 MS. MANDEL: Okay. Right. 21 MR. WHITNEY: That's fair. So -- 22 MS. MANDEL: All right, thank you. 23 MS. YEE: Thank you, Ms. Mandel. 24 Let me, Members, propose something. I 25 appreciate certainly receiving the updated valuation 26 report but as the Franchise Tax Board has indicated, 27 they have not had the the opportunity to really review 28 and examine it in detail and I don't know that I 31 1 personally have the competence to decide this matter 2 without some more input from the Franchise Tax Board. 3 I'm going to pose a question which is going to 4 appear simplistic, but I just would like to hear what 5 the answer might be from both sides, and that is to the 6 extent that there was a decrease in the value with 7 respect to the contingency related to the sale of the 8 entire partnership, I think it was like a 42 percent 9 decrease, why would it not follow that a 42 percent 10 decrease in the value of the note would be appropriate? 11 MR. HILSON: It -- if I may answer it. 12 MS. YEE: Mr. Hilson. 13 MR. HILSON: It may. But it's -- I think the 14 way I would answer is consistent with what I responded 15 to Mr. Horton's question. There's a logic -- 16 MS. YEE: Uh-huh. 17 MR. HILSON: -- if your starting point changes 18 and it's a decrease -- 19 MS. YEE: Sure. 20 MR. HILSON: -- that there would be a 21 concomitant decrease at the bottom line. I just don't 22 know that that takes everything into consideration. I 23 don't know if in fact it's the same methodology. I 24 don't know if the appraiser, for example, looked at 25 what's going on with the DRAM chip marketplace. Has it 26 bottomed up -- bottomed out and started up again? Is 27 that why the taxpayers went back in? If it is, then, 28 you know, does that -- is 7 million a fair appraisal 32 1 under those circumstances? Is a 40 percent decrease 2 appropriate when the indications are that it's going 3 back up? I don't know. 4 MS. YEE: Uh-huh. Mr. Whitney. 5 MR. WHITNEY: Yeah. Again, the value of the 6 note was determined under the established Black-Sholes 7 option pricing model. Under that model a decrease in 8 the starting point valuation would lead to a non-linear 9 decrease in the underlying value of -- of the option. 10 If -- if you can imagine a stock trading, for example, 11 for $100 and an option to purchase that stock at, say, 12 $105 or $95, you would look at the volatility of the 13 stock around that $100 value and you would assess, you 14 know, what is the chance that it might, you know, blip 15 above the 105 or drop down below the 95. That would 16 give you one value. 17 If you then said, okay, the value of that has 18 dropped down to $50 so the stock price isn't $100, it's 19 you know 50, now tell me what the chance is that you're 20 going to hit 105 or 95. You would again look at the 21 historical volatility which is in the report that they 22 did for -- for 1998 and you would say this thing does 23 not have a snowball's chance in -- yeah, the netherworld 24 of -- of hitting that -- that target. 25 So -- yeah, it would not be a linear -- I would 26 not expect a linear decrease and that's exactly what we 27 were given. Using -- using the Black-Sholes option 28 pricing model we have a non-linear drop in -- in the 33 1 value, which is consistent with what I would expect. 2 MS. YEE: Uh-huh. All right. 3 I guess what I'm suggesting is to the extent 4 that we're going to be -- well, I'd like to see the 5 Franchise Tax Board go back and examine the updated 6 valuation report and maybe add to that. I'd be curious 7 to get input from both sides with respect to the 8 relationship between the decrease in the contingency to 9 the decrease in the value of the note, understanding 10 that it's not going to be a, you know, linear 11 progression in terms of the conclusion that we may 12 reach. But it just seems to me there ought to be some 13 relationship or some rationale for looking at that 14 relationship. 15 Other questions, Members? 16 Ms. Mandel. 17 MS. MANDEL: Well, it -- I appreciate getting 18 the updated appraisal because a value as of -- knowing 19 all the circumstances that went into this transaction 20 from the beginning and with the other case and the drop 21 in values over time, the December valuation as an expert 22 valuation, certainly it was -- since the Franchise Tax 23 Board didn't do a valuation it was the only one that the 24 Franchise Tax Board had -- if the Franchise Tax Board 25 was not going to go with the taxpayer's view of the 26 transaction as -- as nothing having been received on the 27 note and that that was a negotiated arm's length 28 unrelated parties, not a -- you know, father and son 34 1 routine. 2 So I appreciate getting the updated appraisal 3 and I -- I hear what the taxpayer is saying, that -- 4 that the appraiser has performed the appraisal using the 5 same methodology as the prior appraisal, which the 6 Franchise Tax Board would adopt, and that taking into 7 account facts known as of the valuation date in July, 8 which is what you would want to do, is know what -- what 9 facts were known or knowable on the valuation date in 10 July. 11 So I do appreciate getting the appraisal and if 12 the Franchise Tax Board was working with the December 13 appraisal and this is simply an update by the same 14 appraiser using updated information available as of 15 July, you know, presumably there's not going to be an 16 issue with the -- with the appraisal, although Franchise 17 Tax Board probably just got it last -- last night. 18 MR. HILSON: That may be exactly the case, as 19 you've -- as you've recited it. But, you know, we just 20 really haven't had a chance to sit down and comprehend 21 what's in there. 22 MS. YEE: Other questions? 23 Okay. Hearing none, is there a motion? 24 MS. MANDEL: Take the matter under submission. 25 MS. YEE: Okay, I have a motion by Ms. Mandel 26 to take this matter under submission. 27 Is there a second? 28 MR. HORTON: Second. 35 1 MS. YEE: Second by Mr. Horton. 2 Without objection -- 3 MS. MANDEL: And, Madam Chair. 4 MS. YEE: Yes, Ms. Mandel. 5 MS. MANDEL: You know, if they didn't get up 6 early enough this morning to read the appraisal, the 7 updated appraisal, can they go read it? 8 MS. YEE: Yeah. 9 MS. MANDEL: Go read it. 10 MS. YEE: Okay, we'll take the matter under 11 submission for discussion later this afternoon and we 12 may be back to you -- 13 MR. HILSON: Okay. 14 MS. YEE: -- for comment. Thank you so much. 15 MR. WHITNEY: Thank you. 16 MS. YEE: Thank you very much. Next item, 17 please. 18 ---oOo--- 19 20 21 22 23 24 25 26 27 28 36 1 REPORTER'S CERTIFICATE. 2 3 State of California ) 4 ) ss 5 County of Sacramento ) 6 7 I, BEVERLY D. TOMS, Hearing Reporter for the 8 California State Board of Equalization certify that on 9 December 14, 2010 I recorded verbatim, in shorthand, to 10 the best of my ability, the proceedings in the 11 above-entitled hearing; that I transcribed the shorthand 12 writing into typewriting; and that the preceding 36 13 pages constitute a complete and accurate transcription 14 of the shorthand writing. 15 16 Dated: January 20, 2010. 17 18 19 20 ____________________________ 21 BEVERLY D. TOMS 22 Hearing Reporter 23 24 25 26 27 28 37