BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 450 N Street, Room 121 Sacramento, California REPORTER'S TRANSCRIPT DECEMBER 15, 2010 ITEM C4 SALES AND USE TAX APPEALS HEARINGS CLAIM FOR REFUND filed by LOCKHEED MARTIN GOVERNMENT SERVICES, INC. (Case No. 300158 OH ) Reported by: Beverly D. Toms CSR No. 1662 1 1 2 P R E S E N T 3 4 For the Board Betty T. Yee of Equalization: Chair 5 Jerome E. Horton 6 Vice-Chair 7 Barbara Alby Acting Member 8 Michelle Steel 9 Member 10 Marcy Jo Mandel Appearing for John Chiang 11 State Controller (per Government Code 12 Section 7.9) 13 Diane Olson Chief, Board Proceedings 14 Division 15 For Board of David Levine 16 Equalization Staff: Tax Counsel IV 17 Chris Schutz 18 Tax Counsel 19 Robert Tucker Legal Department 20 Kevin Hanks 21 Sales and Use Tax Department 22 For Claimant: Rex Halverson 23 Attorney at Law 24 Ilya Gurfinkel Witness 25 26 ---OOO--- 27 28 2 1 Sacramento, California 2 December 15, 2010 3 ---oOo--- 4 MS. YEE: Let's reconvene the Board of 5 Equalization meeting. I apologize for the delay. 6 What's our next matter, Ms. Olson? 7 MS. OLSON: Our next matter is C4, Lockheed 8 Martin Government Services, Incorporated. Please come 9 forward. Ms. Yee. 10 MS. YEE: Okay. I like the bag. Taking a nap? 11 Okay, Members, we are on item C4, Lockheed 12 Martin Government Services, Incorporated. Let me have 13 Mr. Levine introduce the issues in this matter. 14 MR. LEVINE: Good afternoon, Madam Chair, 15 Members. David Levine for the Appeals Division. 16 The issue in this -- primary issue in this 17 claim is whether the group of equipment that claimant 18 leased for use by a user, which it calls a seat, was 19 leased in substantially the same form as acquired or 20 not. If the property was leased in substantially the 21 same form as acquired then the tax claimant paid on 22 purchase price was an irrevocable election to pay tax on 23 its consumption of the equipment and the claim must be 24 dela -- denied. 25 If the property was not leased in substantially 26 the same form as acquired then claimant's leases were 27 continuing sales and purchases which were exempt from 28 tax because the lessee was the U. S. Government. 3 1 And if you decide that then the subsidiary 2 issue is whether about half of the tax in question was 3 Use Tax or Sales Tax reimbursement. 4 I note, just to put this in context, that 5 claimant's argument cuts both ways. It benefits 6 claimant here because its customer was the United 7 States. But claimant is effectively arguing that it had 8 no election to pay tax on cost. If its customer were 9 not the United States or if another lessor leasing the 10 same type of material to a non-United States customer 11 were to pay tax on cost finding that it's not leased in 12 substantially the same form as acquired means that we 13 reject the election to pay tax on cost and collect tax 14 on rentals, which we do when -- when we encounter that. 15 MS. YEE: Okay. Thank you, Mr. Levine. 16 Good afternoon, gentlemen. Thank you for your 17 patience. 18 If you'll introduce yourselves for the record, 19 I believe we granted 15 minutes for your presentation. 20 MR. HALVERSON: Thank you. Good morning Madam 21 Chair and Board members. My name is Rex Halverson and 22 I'm with the firm Rex Halverson and Associates. And I'm 23 representing Lockheed Martin Government Services, which 24 was formerly known as ACS Government Solutions Group. 25 To my immediate left is Ilya Gurfinkel, who's with ACS, 26 who can help answer questions. 27 MS. YEE: Okay. 28 MR. HALVERSON: Before you today is a case of 4 1 first impression as far as I can tell. And I'm an avid 2 leasing expert, having been President of Leasing 3 Association of California years back, and also hailing 4 the Sales and Use Tax function of B of A for over ten or 5 twelve years, managing the -- the 12 leasing companies 6 in their reporting in every state. 7 ACS and later Lockheed, as its successor, 8 entered into a contract with NASA to provide the 9 latter's IT function from start to finish. In assuming 10 that function Lockheed leased computer seats to NASA. 11 And these would be rocket scientists. Okay, there's not 12 mom and pop. 13 These computer seats included all -- all of the 14 following: Personal computers. Canned and custom 15 software. Drives. Memory. RAM. PC cards. Modems. 16 Batteries. Backup drives. Zip drives. Flash drives. 17 Wireless boosters. Decking stations -- docking 18 stations. Scanners. Printers. Print cartridges. 19 Monitors. Power strips. Keyboards. Mice pads. 20 Adapters. USB cables. And label writers. Plus PC help 21 desk services. Maintenance of the network. Updates. 22 Replacement units. Installation. Fabrication and 23 repair, as well as telecom equipment. Phones. PDAs. 24 Fax Machines and radio, as well as cameras, T. V.s, VCRs 25 and projectors. 26 Now, I mention all of those individually 27 because that's how we were billed on our invoices. We 28 get a list of all those things; that's what we paid. 5 1 When taxpayer acquired this equipment it 2 erroneously paid Use Tax to at least one out-of-state 3 supplier, namely Government Micro Resources; I'll call 4 them GMR. And it accrued Use Tax on other purchases, 5 and it's about 50-50. Half was with GMR paid Use Tax 6 and half of it is self-accrued. 7 Because taxpayer leased these seats to NASA, an 8 agency of the Federal Government that is exempt from 9 Sales and Use Tax, it should have tendered its resale 10 exemption certificate to GMR and not self-accrued Use 11 Tax on its purchases. 12 When taxpayer discovered its error and 13 discovered the error for the entire country, because 14 they had NASA offices across the country, it requested 15 that GMR file a refund claim with BOE on its behalf. 16 GMR refused to do so. And that necessitated us filing a 17 refund claim on behalf -- on behalf of our own Use Tax 18 that we paid to GMR and as well at the same time as the 19 self-accrued Use Tax. 20 Now, in the other states in which taxpayer 21 actually made the same error we've gotten refund claims 22 back in every state except one where we have an issue, a 23 Statute of Limitations problem involving the retailer, 24 not us. 25 So, every other state's given the money back, 26 recognize that this is a -- a lease to a Federal exempt 27 entity. 28 Taxpayer's position is the equipment was not 6 1 leased in substantially the same form as acquired. 2 Accordingly, the taxpayer/lessor did not have the 3 election to pay Sales and Use Tax on the front end based 4 on purchase price but was required to collect Use Tax on 5 rentals unless the lessee was an exempt entity, such as 6 NASA, when tax would not be due. 7 Board staff's position is that the lease 8 involved equipment that was leased in substantially the 9 same form as acquired. As such the lessor may elect to 10 pay tax on the front end based on lessor's purchase 11 price or collect tax on rentals. And this is the only 12 State in the union that has this -- this election. 13 But the election is irrevocable and in the case 14 at hand staff determined lessor, or Lockheed, elected to 15 pay the tax on the front end and they denied our refund 16 claim. 17 Now, the law governing true leases in 18 California is rather unique and confusing because I've 19 just told you that election only exists in California 20 law. But I'm going to summarize it in laymen's terms 21 because there's no disagreement between us regarding the 22 statutes and the -- and regs. It's the same. 23 If tangible personal property is leased in 24 substantially the same form as acquired, as Board staff 25 suggests, the lessor may elect to pay tax on the front 26 end or collect tax on rentals. And they'll tell you 27 that this election by the lessor was irrevocable and 28 must be made timely, and it was. 7 1 On the other hand, if tangible personal 2 property is not leased in substantially the same form as 3 acquired, which is our position, the lessor must collect 4 Use Tax on rentals and since the tax is imposed on the 5 lessee, NASA, no tax was due. 6 Now, if this Board determines that the computer 7 seats were not leased in substantially the same form 8 acquired and Use Tax was payable on rentals, the legal 9 incidence of the tax fell on NASA, as I said, and we'd 10 be entitled to our refund based on taxes paid 11 erroneously on the front end. 12 So what constitutes substantially the same form 13 as acquired? That's the key issue. And I found at 14 least 18 annotations that discuss it. I'm only going to 15 use five and we pass the test with all five. 16 Although there are few legal opinions in the 17 Business Tax Law Guide annotation on what is meant by 18 substantially the same form as acquired in the context 19 of leases of personal computers, at least one is 20 illuminating and very helpful to taxpayer's case. That 21 annotation is 330.2103 dated in 1981, and involving 22 leasing of data processing equipment and software, where 23 Mr. Gary Jugum, the former Assistant Chief Counsel, 24 states in a backup letter that was attached to our 25 brief -- he states, "Since the software was proprietary 26 software the client would probably not be leasing the 27 software media," that is the tapes, drums, disks, the 28 manuals, "in the form in which they had been acquired. 8 1 That is ordinarily the client would have required -- 2 acquired blank tapes and would have recorded the 3 proprietary programs onto media. Thus the system would 4 not be leased in substantially the same form in which it 5 was acquired and tax would apply to all lease charges." 6 And he says all. And then, quote, "Importantly, a tax 7 paid purchase resold deduction could be taken with 8 respect to any tax that might have been paid with 9 respect to the acquisition of the hardware." 10 He used the word "hardware." Didn't use the 11 word "software"; he said "hardware." And he included 12 the entire system, the computer and the floppy disk. 13 Now, in this day we didn't download floppy 14 disks or software onto a hard drive. In the earliest 15 day '81 I was around at B of A so I remember the machine 16 called Lexicon. We actually had the machine separate 17 and you had a five-inch disk that went into it. And 18 that's how it operated. And it was used mostly by the 19 two secretaries in the office that were fastest to do 20 memos or whatever for everybody in the office. 21 And this is before any accountant got one at 22 B of A. 23 The sales tax ruling has been in the Business 24 Tax Law Guide since '81, but it's of critical importance 25 because it involved a leased computer system and it was 26 composed of a mere computer and one proprietary software 27 package that was defined as a computerized 28 dictation/transcription system. And the software was 9 1 determined not to be leased in substantially the same 2 form as acquired because the software's form was changed 3 from a blank tape to one which contained proprietary 4 programs on it. 5 More importantly, the entire system, the PC and 6 software, was determined to be not leased in 7 substantially the same form as acquired, as the ruling 8 clearly states that tax would apply to all lease 9 charges. The letter by Mr. Jugum clearly stated, and I 10 quote again, "tax paid purchases resold deduction could 11 be taken with respect to any tax that might have been 12 paid with respect to the acquisition of the hardware." 13 By using the term "hardware" Mr. Jugum was 14 talking about the personal computer as he would not have 15 stated -- it would have stated "software" if he meant to 16 limit this ruling. 17 Now, I'll grant you in the Business Taxes Law 18 Guide summary, in your little green book, they don't 19 talk about hardware. You have to read the backup 20 document, and that's what's important here. Everyone is 21 failing to read the backup document, and that's critical 22 because that's what we follow. 23 Thus where a floppy diskette was changed by the 24 lessor so as to include proprietary programs on it and 25 these programs were released for the computer, the 26 entire computer system was no longer leased in 27 substantially the same form as acquired. 28 Board staff would now have you believe this 10 1 annotation is an assumption and would like to sweep it 2 under the rug as no finding at all, and recommended that 3 it be removed from the Business Tax Law Guide as 4 obsolete because of the march of technology. That's an 5 outrageous position since it's been on the books for 29 6 years and how little software has changed. 7 But one important thing is worth noting since 8 '81, and that is proprietary software is now downloaded 9 onto a PC's hard drive rather than just inserted into 10 the PC as a floppy disk. But we count ourselves lucky 11 the Board legal staff has not yet depublished it prior 12 to our hearing. 13 The Sales Tax counsel ruling discusses the 14 application of tax to a leased computer system that was 15 comprised of hardware and software and the latter 16 changed when the software was downloaded onto a blank 17 floppy disk that was later used in conjunction with the 18 computer. 19 Software on a floppy disk that was used with a 20 computer in '81 is a little different from software 21 downloaded onto the hard drive from a computer diskette, 22 CD, flash drive or electronically today. Once the 23 software program has been added to the computer the 24 system is no longer leased in substantially the same 25 form as acquired. 26 In another relevant annotation involving a 27 leased camera, and again you have to dig -- you have to 28 read the actual backup document to know it was a camera, 11 1 BOE legal staff opined that it is substantially changed 2 when it has been added to, revised or modified. 3 Now let's pause and think about that for a 4 minute. How can a camera be added to, revised or 5 modified? You can add a telephoto lens, micro or macro 6 lenses, filters, flash, tripod, shutter release, a case 7 and a lens cap. I couldn't come up with anything else. 8 That's all I could come up with. 9 But ask yourself, how much skill and time does 10 it take to add any of those? A few seconds? That's 11 right. The answer, of course, is not much has changed. 12 And how are those facts different and even 13 tougher than our PC that is actually opened up at times 14 and we add additional memory or we had a zip drive for 15 the -- for the client? 16 On the other hand BOE legal staff does have an 17 annotation that says -- not that they brought it up, 18 minor repairs and adjustments to recently purchased 19 property are not substantial changes of form. And yet 20 another annotation -- and by the way, that minor repairs 21 is in the same camera -- one. 22 In yet another annotation the staff concluded 23 that furnishing of replacement parts is not regarded as 24 a substantial change in form. 25 These annotations set forth a pattern of what 26 constitutes a substantial change in form. Clearly the 27 computer seats that the taxpayer leases are not leased 28 in substantially the same form as acquired since the 12 1 personal computers are substantially added to, revised 2 and modified. Adding software or memory or a zip drive 3 or a printer or scanner driver or a DVD player are 4 simply not minor repairs and adjustments. Each one of 5 those additions takes time and effort by trained IT 6 personnel when they open up the computer, add the 7 desired memory, zip drive or DVD player, then download 8 software and printer drivers, all of which adds to the 9 value. 10 Furthermore, these additions take two to four 11 years -- two -- pardon me, two to four hours. In 12 addition the BOE legal staff has long adopted the stance 13 that if equipment is shipped to the lessee and assembled 14 by the lessee that's a telltale sign that the equipment 15 is leased in substantially the same form as acquired. 16 But if employees of the lessor, like in our case, 17 assemble the item it is not leased in substantially the 18 same form as acquired. 19 Again, under the test our computer seat is not 20 leased in substantially the same form as acquired since 21 it's Lockheed's employees or their subcontractor 22 employees who assemble all of the components comprising 23 a computer seat. 24 Finally, another important test used by the BOE 25 in determining whether equipment is leased in 26 substantially the same form as acquired can be found in 27 330.3900, which by the way gives you the general rule. 28 In that annotation the BOE legal staff says if the value 13 1 of an item leased is substantially in excess of the 2 purchase price of the property leased, the item is not 3 leased in substantially the same form as acquired. 4 And to quote -- in substance and entirety the 5 summary it says, "If equipment is not leased in 6 substantially the same form as acquired, a lease of that 7 equipment is a continuing sale and Use Tax measured by 8 the rentals payable must be collected and remitted. It 9 is irrelevant that tax is paid on the purchase price, 10 cost or value. If tax has been paid on the purchase 11 price of the equipment, which prior to any use is leased 12 in California but not leased in substantially the same 13 form as acquired, a tax paid purchase resold deduction 14 may be taken for those taxes." 15 "In situations where there has been a 16 substantial increase in value of the leased property the 17 general rule is that the substantial increase in value 18 alone is enough to show that the property is not leased 19 in the same form as acquired." 20 "However, other situations exist where there is 21 a change in form but little increase in value. In such 22 instances the fact that there's no substantial increase 23 in value is irrelevant if there's a change in form 24 between the lessor -- between what the lessor acquired 25 and what the lessor leased such that the property is not 26 leased in substantially the same form as acquired." 27 Unquote. 28 And what constitutes the substantial increase 14 1 in value? Well, that's easy enough. You have a bright 2 line test of 20 percent, and it's in annotation 330.4060 3 and involved a tree with a base put on it. The 4 annotation states, "An appropriate test is whether the 5 value of the tree with the base exceeds by more than 20 6 percent the value of the tree without the base." 7 Okay. I've given you five tests. Every one 8 of them we pass big time because every software package 9 loaded on that computer costs an average of $357 and 10 every one of you in this Board knows that a computer can 11 be bought at any store for 499 to 2,000 bucks, 12 approximately. And 357 is 18 percent. So I'm like 13 within two and almost ten packages of software programs 14 are added to every computer that we actually turn over 15 to NASA. 16 Again, the computer seats leased by taxpayer 17 easily meet this test since each seat must go through a 18 full install. And, remember, that's all components are 19 connected, RAM or zip drives added as required, 20 additional site software packages added, which I told 21 you at least -- no fewer than ten are added. Sometimes 22 I heard 20. The applicable printer and scanner drivers 23 downloaded. Data copied over from the old machine to 24 the new one. PC connected to the network. And the new 25 machine cleaned up. 26 This full install, as I said, takes two to four 27 hours. And before that -- and that is all before the 28 NASA employee, the rocket scientist, takes over that 15 1 computer and uses it for the first time. 2 The seat price, by the way, component of what 3 we charge is made up of -- of a monthly fee that goes 4 out per seat, and we charge -- in the total fee 20 -- 25 5 percent represents the hardware, 15 percent represents 6 the software, 5 to 10 represents network maintenance, 7 help desk represents 5 to 10, local labor 35 to 45, and 8 five percent for miscellaneous. 9 Clearly, the value of the seat leased is 10 substantially in excess of the purchase price of the 11 basic PC and it is a fact that ten application programs 12 are added to each computer seat and the computer seat 13 exceeds by more than 20 percent the value of the PC 14 alone. 15 So to sum up, these are rocket scientists we're 16 dealing with here. This is a very unusual case. This 17 is not your father's Dell computer. And you know when 18 you order a computer from Dell you get it with, what, 19 the operating system. You may get it with an anti-virus 20 program and you may get it with a trial offer of Office 21 Suite. Nothing else. 22 These computers have substantially more because 23 you got to remember who's using them. 24 Now, the final issue to be decided by this 25 Board is a very binding one in my opinion. It's whether 26 GMR, the one -- the one supplier billed and collected 27 California sales tax reimbursement or Use Tax when it 28 sold equipment to the taxpayer. 16 1 A review of GMR's invoices indicate only the 2 word "tax" on them, and none of them state whether its' 3 Sales or Use Tax. In addition, these invoices reflect a 4 Manassas, Virginia address for the seller and a sold to 5 address of ACS in Maryland -- ACS is the same as 6 Lockheed -- with a ship to address of Moffett Field Air 7 Force -- Moffett Field or Edwards Air Force Base or 8 Sunnyvale, California, three sites in California. 9 The original BOE auditor who looked at ACS's 10 invoices concluded that GMR transactions involve Use Tax 11 when she originally audited ACS. 12 Furthermore, she came to this conclusion 13 despite the fact that a little more than half of the 14 invoices reflect a "shipped via" notation of FOB 15 destination. The rest of the invoices are left blank. 16 Mr. Donald Hermann of the BOE, who reviewed 17 GMR's filed returns concluded, and I quote, "While 18 Micro, GMR, does not appear to have been audited by the 19 Department we note that its allocation of local tax upon 20 its returns is consistent with sales occurring outside 21 this state. Specifically, all local tax amounts have 22 been allocated to the countywide pool of the county to 23 which the property was delivered, whereas Sales Tax 24 should be allocated to area code assigned to the 25 retailer's place of business." 26 MS. OLSON: Time has expired. 27 MS. YEE: Finish that thought, Mr. Halverson, 28 then you'll, 17 1 MR. HALVERSON: I can do it in two sentences. 2 MS. YEE: -- have time on rebuttal. 3 MR. HALVERSON: This allocation is clear 4 evidence that GMR collected, reported and remitted Use 5 Tax rather than Sales Tax reimbursement to the BOE. To 6 conclude otherwise flies in the face of GMR's timely 7 filed returns. Accordingly, if you determine it was Use 8 Tax rather than Sales Tax paid that could be refunded to 9 the taxpayer. 10 For all the reasons stated we respectfully 11 request the Board find in favor of the taxpayer, grant 12 its refund claim of 479,117 but we'll allow a 13 subtraction of 5.6 percent of the amount or 26,830, 14 which represents equipment, T. V.s, radios, VCRs, 15 cameras, et cetera, that are leased in substantially the 16 same form as acquired. Thus our total refund claim now 17 amounts to 452,287. 18 Now there's a minor Sales Tax part of 6,193.38 19 that keeps being brought up. We dropped that two years 20 ago easily. So there is no Sales Tax reimbursement 21 involved in this case. 22 Thank you. 23 MS. YEE: Thank you very much, Mr. Halverson. 24 Let's hear from the Department. We'll give you time on 25 rebuttal. 26 Department, please. 27 MR. SCHUTZ: Madam Chair, Members, I'm Chris 28 Schutz from the Legal Department. To my right is Robert 18 1 Tucker, also from the Legal Department, and Kevin Hanks 2 representing the Sales and Use Tax Department. 3 Here claimant's claim for reshun should be -- 4 claim for resun -- refund should be redetermined in 5 accordance with the Appeals Division's recommendation 6 because the property claimant leased to the U. S. 7 Government was leased in substantially the same form as 8 acquired and claimant has failed to establish otherwise. 9 To briefly recap, claimant entered into 10 contract with the U. S. Government to provide the U. S. 11 Government NASA, with seats consisting of computer 12 terminals, attendant peripherals and software and 13 provided IT support services for these seats. 14 Claimant originally treated this as a service 15 contract and generally paid tax, either Sales Tax or Use 16 Tax, when it purchased the tangible personal property 17 used to fulfill this contract. 18 Claimant later determined and the Appeals 19 Division agreed that the contract at issue provided for 20 the lease of the computer equipment and software that 21 made up these seats. As such claimant's receipts from 22 the lease of the equipment to the U. S. Government could 23 potentially be excluded from tax, however because 24 claimant paid tax or tax reimbursement when it purchased 25 the equipment and software it made an irrevoc -- 26 irrevocable election and cannot change that election to 27 shift and pay tax measured by the rental receipts which 28 can be possibly excluded or would be excluded unless it 19 1 is determined that it did not lease the computer 2 equipment and software at issue in substantially the 3 same form as acquired. 4 So, I think Mr. Halverson said, and we're 5 certainly in agreement here on -- on what the issue is; 6 to -- to prove petitioner -- claimant has attempted to 7 segregate out computer equipment and software that it 8 contends is substantially changed in form prior to the 9 leasing to the U. S. Government. Specifically, claimant 10 reviewed invoices received from one of its vendors, GMR, 11 and based on that review contends that computer 12 software, drives, memory, PC cards, scanners, printers, 13 monitors, backup PDAs, label writers, flash drives and 14 wireless boosters were not leased in substantially the 15 same form as acquired while conceding that cables, power 16 strips, mice, keyboards, T.V., VCRs, projectors and 17 other items were leased in substantially the same form 18 as acquired. 19 Based on this segregation claimant has 20 concluded that a little over 94 percent of all its 21 purchases from that one vendor it reviewed were leased 22 not in substantially the same form as acquired, and thus 23 it claimed that it is entitled to a refund of the tax or 24 tax reimbursement it paid on these purchases as is it is 25 contending they were sales for resale. 26 It appears that claimant is contending that the 27 ration or percentage it determined based on its review 28 of these invoices should be applied to purchases it made 20 1 from other vendors where it has not provided the 2 purchase invoices, only amounts purchased. 3 With regard to the issue of whether the 4 computer equipment and software here was leased in 5 substantially the same form as acquired, claimant 6 contends its setting the computer up and connecting 7 attendant peripherals creates a substantial change in 8 form of the computer and its peripherals. Claimant is 9 also claiming that installing various off-the-shelf 10 commercial software and updating of other pre-installed 11 software to the computers creates a substantial change 12 in form in the computer as well as a substantial change 13 in form of the software. 14 Finally, claimant contends that in some 15 limited circumstances it's upgraded memory or capacity 16 of the computer programs -- the computers or added other 17 internal devices to the computer. Addressing these 18 contentions we first note that a determination of 19 whether property is leased in substantially the same 20 form as acquired is made on a case-by-case basis. 21 Property is leased in substantially the same form as 22 acquired if the property is acquired by a lessor and 23 then leased to the lessee without there being any 24 substantial change to the property. 25 In order for a change to be substantial the 26 change must either significantly increase the value of 27 leased property or change the form of the leased 28 property. The amount of the fabrication labor that goes 21 1 into making the change is a factor but it's not itself 2 determinative and there is no substantial change in form 3 when a lessor makes minor repairs or adjustments to 4 recently purchased property that did not change the 5 property's general functional abilities or significantly 6 increase its value. 7 When a lease -- lessor purchases a number of 8 items and rents them as a single rental unit so long as 9 no significant fabrication labor is required to produce 10 the single unit and the single unit is not leased in a 11 substantially different form from its component parts. 12 Then the lease -- the lessee is leasing these items in 13 substantially the same form as acquired, even though it 14 is leasing them as a unit. 15 However, if -- if a new product is created 16 from the component parts, then there has been a 17 substantial change in form. For example, a construction 18 equipment rental company may rent electrical generators 19 and light towers as a single unit or an air compressor 20 along with air hoses, air tools as a single unit and may 21 even plug the light tower to the generator or the 22 compressor, hoses and tools could be connected together 23 prior to rental, however these items would still be 24 considered rented in substantially the same form as 25 acquired despite being rented as a unit and connected 26 together by the lessee prior to rental. 27 Additionally, the following annotations 28 provide similar examples where multiple components are 22 1 rented as a single item and they are considered to be 2 rented in substantially the same form as acquired. 3 Annotation 330.3940, a motor is attached to a 4 boat without significant amount of fabrication labor 5 because it's only necessary to bolt/clamp the motor in 6 place is -- is the boat and the vessel -- the boat and 7 the motor together are still in substantially the same 8 form as acquired. 9 Annotation 330.4090, individual restaurant 10 equipment items assembled into a working unit as a 11 restaurant prior to its leasing, still substantially the 12 same form as acquired. 13 Annotation 330.4140, bindings affixed to snow 14 skis. In short, creating a unit of distinct products is 15 different than creating a new product all together. 16 Here the unit or seat that is leased is a computer 17 system along with the typical peripherals and software 18 you would might expect to accompany such system and 19 which are generally designed by the respective different 20 manufacturers to accompany such a personal computer 21 system, and to easily connect to it. 22 In short, creating a unit of distinct products 23 or components is distinguished from creating a new 24 product all together where the lessor has actually 25 created a -- created or produced a piece of equipment 26 from component parts which bear no resemblance to the 27 finished product which take its form and function 28 through the lessor's efforts. 23 1 Here the unit or seats that are leased are 2 personal computers with attendant software and 3 peripherals that again you might accom -- expect to 4 accompany such a system and which are generally designed 5 by the manufacturers to accompany a personal computer 6 and are easily connected to it. 7 The personal computer and the peripherals all 8 maintain their characteristics as such when combined 9 together. The printer is still a printer. The monitor 10 is still a monitor. The personal computer is still 11 distinguishable as a personal computer. They do not 12 combine together to become a new product. 13 Oddly, I note that here claimant does not 14 claim that the keyboard, mouse or cables become a 15 component part of the new product. But if the seat was 16 a new product then certainly these items would -- would 17 be part of that product because the cables, themselves, 18 are what connect everything together. 19 Finally, claimant does not need to 20 significantly fabricate the personal CPU or component 21 parts because they're already designed to be just 22 connected together. Simply connect together, disconnect 23 it together, depending on how you want to set up that 24 computer system. 25 With regard to whether the software transfer 26 to the computer systems is -- substantially modifies the 27 computer system, simply installing software applications 28 onto a personal computer does not substantially change 24 1 the form of that computer. 2 For example, with personal computers provided 3 to us here at the Board of Equalization, the IT staff is 4 continually adding software applications or updating 5 them through the software downloads which we -- we may, 6 you know, notice or not notice throughout the day. 7 There may be an additional icon but our personal 8 computer, even though it's been constantly updated, you 9 know, throughout the months, throughout the weeks that 10 we're here, is still our personal computer and there's 11 no substantial change in form in that personal computer. 12 Maybe we notice, again, an icon's been added or that, 13 you know, our -- our Adobe version has changed from 9.1 14 to 9.25 but it's still our personal computer and there 15 hasn't been a substantial change in form. 16 Also, if adding a software application program 17 to a computer substantially changes a form of the 18 computer, this could -- this is in direct conflict with 19 our long-standing view that transfers of software by 20 load and leave or electronic transfer is a transfer of 21 an intangible and is not fabrication labor that changes 22 the form of a computer under Regulation 1502. 23 Additionally, I finally note that under the 24 contract at issue Section A.1.36 addresses accusations 25 of -- of commercial computer software under the 26 contract. Subdivision (d)(2) of the section provides 27 that the U. S. Government may use or copy for use any 28 commercial computer program on any computer owned or 25 1 leased by the government as long as it -- it is not used 2 on multiple C -- CPUs, computers, simultaneously unless 3 the license provide it may do so. 4 Additionally, the government has the right to 5 reproduce such computer programs for backups or 6 archiving. 7 Taxpayer has created a leasing unit by loading 8 the software onto the computer, but it has not created a 9 new product since the U. S. Government could easily have 10 added the software, could remove the software and put it 11 to another computer and has additional copies or rights 12 to copies of that same exact software. Thus, both the 13 computer and the software as a unit aren't -- are not 14 leased -- are leased in substantially the same form as 15 acquired. 16 Next, with regard to the software at issue, 17 itself, there are numerous annotations that explain that 18 software is not transferred to the lessee in 19 substantially the same form as acquired when the 20 software is transferred on storage media, disk or tape 21 that was acquired by the lessor as blank or without the 22 software being transferred and the lessor transferred 23 that software to storage media and then leases the 24 storage -- that particular -- that new storage media, 25 because the storage media was previously blank and now 26 the software on it, the storage media with the software 27 now stored on it, cannot be said to be leased in the 28 same form as acquired. 26 1 This proposition is found in annotation 2 330.3428 and annotation 330.2318. However, this does 3 not mean that the software can never be transferred in 4 the same form as acquired. Annotation 330.288.250 make 5 it clear that when canned software is transferred to the 6 lessee on the same storage media the lessor obtained 7 from the vendor the software is transferred in the same 8 form as acquired. 9 Additionally, as a corollary to this, for 10 canned or off-the-shelf software that lessor purchased 11 from a third party, if the lessor does not transfer that 12 original storage media to the lessee but only provides 13 copies of the software or electronic downloads, the 14 lessee's purchase of the software would not be a sale 15 for resale since it does not transfer the original 16 storage media which was a tangible personal property 17 originally subject to tax on its purchases. 18 Here I believe with regard to the GMR 19 contracts there was five percent that -- around five 20 percent that petitioner has claimed as software that has 21 been substantially modified -- its form has been 22 substantially modified. 23 However, that really can't be the case here 24 because, one, either it transferred the original disks 25 to -- to the U. S. Government, in which case they 26 weren't -- they're -- they're -- in which case you don't 27 have a change in form or they transferred new disks or a 28 non-electronic download, in which case the software 27 1 isn't the thing that's being transferred, it's the 2 new -- the backup disks or the copies that were made. 3 Finally, with regard to -- we do note that -- 4 that taxpayer did purchase memory and a -- and hard 5 drives and petitioner claims that in -- in some cases it 6 added memory to computers although it appears that in 7 most cases if -- if a computer was purchased as a 8 computer and it had some -- some defect or lacked 9 specific memory needed to do the job, it would send the 10 computer back, but in some cases it may -- it may have 11 added memory but, again, this is a case-by-case basis 12 and petitioner hasn't proven up any specific computers 13 where they've added a significant amount of memory, hard 14 drive, other things that kind of put together we 15 might -- if they really significantly modified the 16 internal components of a -- of the computer, we might 17 consider it to be substantially modified, but here we 18 don't have any evidence of -- of that. 19 And just merely putting the component parts 20 together of the software does not substantially modify 21 the computer. 22 With that, if you have any questions I'll be 23 happy to answer them. 24 Thank you very much, Mr. Schutz. 25 Mr. Halverson, you want to take five minutes 26 on rebuttal? 27 MR. HALVERSON: Thank you. First of all, the 28 Board staff is trying to zero in on software alone and 28 1 that's not the case. You've got to remember that we 2 actually take the whole function. We do the whole 3 function. 4 So, printer drivers, everything is downloaded 5 onto that computer before we turn it over. So -- beside 6 connecting it up. 7 Now, the staff also wants to make a big deal 8 of the fact that I dropped out as not leased in 9 substantially the same form or leased in substantially 10 the same form as acquired one USB cable invoice and one 11 cable for -- one invoice for the power cord. 12 We did that with Appeals Unit, trying to get 13 them to give us back the majority of our refund and we 14 would have conceded these small items. That's the only 15 reason we did that. We've never conceded cabling. All 16 right. You have to cable quite a bit of computer 17 equipment but you also do a lot of things wirelessly. 18 But you got to remember the whole package has 19 to work for this rocket science -- rocket scientist and 20 other NASA employees before they get to first 21 functionally use it. So, if I tweak your computer for 22 four hours it's not the same computer you buy from Dell. 23 Dell computer you know is leased for what? 20 -- 40 24 bucks a month. The computers we're leasing lease for 25 150 to 350 to 400 a month. All right. 26 Why? Because there's a lot more on that 27 computer. We wouldn't get that kind of money if it was 28 leased in substantially the same form or if it was just 29 1 leased in substantially the same form as acquired. 2 Staff here makes -- makes a huge argument on 3 the fact that you have to keep the components separate 4 in your mind because in fact they're each being leased 5 separately. Well, there's no authority for that. 6 There's not one annotation that says that. In fact, the 7 annotations he mentioned, the boat motor -- the boat 8 motor, restaurant equipment and bindings to skis weren't 9 even a close enough anomaly or close enough analogous 10 situation to make my list of 18. 11 We've given you computer equipment and 12 software. We've given you an annotation on the fact 13 that we -- there's a substantial change in cost. We've 14 said that there's -- our labor does the -- actually 15 assembles these items. We've given you the fact that 16 the 20 percent test is met for the tree and its base 17 which evidently Board -- Board staff came up with as 18 being dispositive, and every one of those tests -- and 19 we also went -- computer equipment is substantially 20 modified, et cetera, when we set it up. 21 They can't point to any of those five tests 22 that they meet. They care -- they're just dancing. 23 They've been dancing from the get-go. There's no 24 authority for saying we're leasing computer to him, that 25 we're leasing the printer to him, that we're leasing the 26 software -- Package One to him and Two to him and Three 27 to him. That's not what's going on here. 28 You get a computer based on your grade. If 30 1 you're a certain grade, if you're the rocket scientist, 2 you're probably the top of the grade. You can pick 3 certain equipment that comes with it and then you can 4 upgrade it any way you want. 5 If you're -- if you're a lower grade person 6 you're going to get less software. You're going to be 7 approved for less things. Probably not the top secret 8 stuff. 9 But it goes by grade. None of those computers 10 are stuff that you buy from Dell or could order from -- 11 from Apple with all the programs on it. And it still 12 takes four hours -- two to four hours of work to get all 13 that stuff on it before it's even ready to go. And 14 you're cleaning up stuff. You're relicensing programs. 15 All of that takes time and can't be forgotten. And it 16 can't be shoved under the -- under the rug. 17 Now, again, I went through the -- I'm the one 18 that did that leasing to -- or did that equipment 19 leasing substantial in the same form as acquired and -- 20 and equipment not leased. We did that, came up with a 21 percentage in order to help Appeals, and say, look, 22 we'll give up the four percent or five percent, whatever 23 it was on this minor bit of equipment. It just is too 24 trivial to us. But by God we should and we will not 25 give up on the rest of it. The computers are not leased 26 in substantially the same form as acquired. Mr. Jugum 27 knew that when he talked about the first computers that 28 came out in '81, and it has not changed. 31 1 MS. YEE: Anything further? 2 MR. HALVERSON: I'd like to hear the authority 3 for the piecemeal. I'm still waiting to hear it. If 4 there's any legal authority I'd like to hear that. 5 MS. YEE: Okay. Thank you, Mr. Halverson. Let 6 me entertain questions and I'm sure that will be a 7 focus. 8 Mr. Horton. 9 MR. HORTON: Just a quick question. What is 10 the piecemeal? 11 MR. HALVERSON: The suggestion by -- by the -- 12 in the -- in the supplemental brief by the Board stated 13 that taxpayer's actually leasing the PCs, then they're 14 leasing the printers, then they're -- you have to regard 15 them all separate. They're not one control -- they're 16 not one big unit. But that it flies in the face of the 17 fact that we lease per seat, in one bill each seat is 18 counted. So if we're leasing 60 Mac computers, top of 19 the line with all the -- 20 MR. HORTON: That's a term to summarize what 21 they were referring to. 22 MR. HALVERSON: They're saying that -- that 23 they don't view it as one -- as one seat, they view it 24 as separate items being -- 25 MR. HORTON: No, no, you indicated you'd like 26 to hear from the piecemeal. 27 MR. HALVERSON: Well, I'd like to hear the 28 Board come to that -- where they found this piecemeal 32 1 idea that you're leasing each piece of equipment 2 separately. That is not happening. 3 MR. HORTON: Okay. Thank you. 4 MS. YEE: Okay. 5 MR. HALVERSON: Not factually, not in law. 6 MS. YEE: Okay. 7 MR. HALVERSON: I mean, I may have overlooked 8 it, Mr. Horton. 9 MR. HORTON: No. No, no, I'm curious, the 10 curious term was -- I wasn't familiar with the term. In 11 reference to a body of folks, I didn't quite get that. 12 MS. YEE: Okay. Well, let's start there. 13 MR. SCHUTZ: I think that's a bit of a 14 mischaracterization. What I'm saying is that you can 15 lease multiple pieces of equipment as one particular 16 unit, wherein none of those individual pieces of 17 equipment have been made a substantial change in form. 18 However, if you add component parts together 19 and you create a new product, that would be a 20 substantial change in form of all those computer -- 21 that -- those component products. That's what I'm 22 saying. Not that -- that might consider it some sort of 23 piecemeal, it's just that you can -- release multiple 24 units and we have annotation 330.4090 about, you know, 25 where a restaurant is sort of built out as a restaurant. 26 It has all the pieces of a restaurant to -- ready to go. 27 It has all the equipment. And that's leased in 28 substantially in the same form as acquired because none 33 1 of that -- that equipment has substantially changed 2 form. And that's very similar to exactly what -- what 3 happened here where the individual equipment really 4 hasn't -- the printer is still a printer. The scanner 5 is still a scanner. The keyboard is still a keyboard, 6 and the personal computer is still the personal 7 computer. It's still the same TPP, it's just rented as 8 one unit together. 9 MR. HALVERSON: If I might add one comment here. 10 One of the annotations we dug up was 330.4165. It 11 involves ex -- large spools of insulated copper cable. 12 Just cut into various lengths with certain adapters and 13 connectors added to them so that they could be plugged 14 in, they were not leased in substantially the same form 15 as acquired. 16 Just the cutting of them and adding adapter. 17 Pretty simple stuff. 18 MS. YEE: Okay. Let's hear from other 19 members. Other questions, Members? Ms. Steel, please. 20 MS. STEEL: To the taxpayer, the -- on an 21 average what was the cost of the leased items at issue 22 as compared to the value of the completed property? 23 MR. HALVERSON: Tough question. The -- off the 24 top of my head I'm not going to recall that, Ms. Steel, 25 but -- but I know -- let's talk about today. We know a 26 Mac computer top of the line probably is 2000 bucks. 27 MS. STEEL: I want to hear what you -- I mean 28 the taxpayer has been talking about these equipments, 34 1 not -- not the computers outside, just average what we 2 really put it in that after you -- you know, paying at 3 the cost and then what you added to those equipment. 4 MR. HALVERSON: Well, -- 5 MS. STEEL: Price. 6 MR. HALVERSON: I think if -- you could 7 summarize it this way, if we add ten packages of 8 software, they average 2 -- $357 each based on my math 9 and going through all the invoices. That's 3,570. And 10 then four hours to -- two to four hours of an IT's time, 11 let's say 75 to 90 an hour. 90 an hour is what I get 12 charged for my office. It probably was less then. But 13 let's say it was 75 -- 75 to be -- that's 150 to 300 14 more. 300 plus 3,500 with a computer top of the line 15 Mac is 2,000. It's over a hundred percent more in many 16 cases. Today. 17 MS. STEEL: Then to the Department, that all 18 these annotation -- annotations that we've been putting 19 that I've been hearing Mr. Schutz that talking about 20 significant or substantial changes, but you said put 21 memory chip in it. That, you know, the first part of 22 your explanation the memory chip is not really 23 substantial change here, but you -- later on you said 24 those memory in it. What substantial change on memory 25 chips we talking about? Those kind of components we 26 talking here. 27 MR. SCHUTZ: You're asking for the computer, 28 itself, if -- if you added memory, you upgraded the CPU, 35 1 itself, you up -- you put in additional PC cards to that 2 and you had to screw -- unscrew and bolt to all this, I 3 think -- and it's on a case-by-case basis. We would 4 have to look at that -- that -- the individual personal 5 computer and say, well, was there a substantial change 6 in form because you've now added additional memory 7 and -- and these are component parts that all go into 8 the personal computer and they then lose their 9 characterization as component parts. 10 You really can't see the memory any more. 11 You can't really see the hard drive. The CPU unit is 12 basically the personal computer, itself. 13 So, we would -- we would -- but petitioner 14 hasn't shown any of that here. He just says, well, you 15 know, sometimes we do add memory, and we do add other 16 additional things, but we don't -- we don't have our -- 17 our hands wrapped around -- petitioner hasn't proved 18 what exactly or how often he's done that. And sometimes 19 he could have changed memory. We just have the vendor 20 invoices and that we notice that memory is purchased, 21 but the memory could have been purchased to repair other 22 computers that, you know, the memory burned out or 23 something. 24 So, we don't know -- 25 MS. STEEL: So during audit whenever we 26 checked it? 27 MR. SCHUTZ: Well, this was a claim -- this 28 was -- this was as a claim for refund. So -- 36 1 MS. STEEL: Right. 2 MR. SCHUTZ: So, we did -- I mean, petitioner 3 provided -- 4 MS. STEEL: But you are not sure? 5 MR. SCHUTZ: -- vendor invoices but we 6 don't -- we don't have anything from him to -- to show 7 exactly, you know, on a computer-by-computer basis, you 8 know, what -- what additional memory and how 9 significant -- how significant they change any 10 individual computer with memory, hard drive, CPU unit, 11 additional cards. 12 MS. STEEL: Didn't I just heard that you said 13 that it's been changed a hundred percent? You know 14 what, this is the afternoon after lunch. I don't know 15 what I'm hearing. I guess just part of it. But didn't 16 you just said that modifying all these computers it 17 change like completely? 18 MR. HALVERSON: Ms. Steel, the contract with 19 NASA was for nine years. So, every three years a -- any 20 person at NASA got a new computer. So, it was totally 21 completely got a brand new computer. And so, every one 22 of them had this happen every three years. 23 MS. STEEL: So it's been still doing it? I 24 mean, this company is -- 25 MR. HALVERSON: Yes, now -- now -- 26 MS. STEEL: -- still doing it? Some of the 27 work, some -- he's right, some of the time you order 28 from a supplier with the memory and it comes in perfect. 37 1 MS. STEEL: Right. 2 MR. HALVERSON: But if it doesn't come in 3 perfect that there's something -- some of the time it's 4 sent back for -- for fixing. Some of the time ACS or 5 Lockheed people changed out memory, added the DV drive, 6 added the Zip drive, et cetera. 7 Now, most of us don't even use Zip any more. 8 But when they came out, they were hot. And I mean, I 9 remember all of us had to have a Zip drive. And so we 10 all asked for one and by God we got them. 11 And that -- that wasn't something I could 12 tackle myself. 13 MS. STEEL: Yeah, I couldn't even open it. 14 But -- so, what you are saying is some of the equipments 15 it's been changed because some came in perfect condition 16 then there's no changes? 17 MR. HALVERSON: Well, no, that's not true. 18 Not all -- there's been no changes. 19 MS. STEEL: That's -- 20 MR. HALVERSON: Because, remember, we still 21 have to dial that computer in. We have to test it -- 22 MS. STEEL: Right 23 MR. HALVERSON: -- make sure it works. We 24 have to then put on all the programs the person wants. 25 MS. STEEL: These annotations -- 26 MR. HALVERSON: We have to look at all his old 27 programs, renew all the licenses of the old programs. 28 Ask him how many he wants. Typically they want every 38 1 program put over on this computer. Then we clean up all 2 the data, what's been working, what's not working. Fix 3 all the -- fix all the bugs of the computer. Make sure 4 that it works exactly correct as we've stated it. 5 And then add the printer drivers, scanner 6 drivers, depending upon the printers they have, et 7 cetera. 8 So that computer only after all that's done is 9 turned over to NASA, and the employee is allowed to 10 touch it which becomes first functionally used. 11 MS. STEEL: So isn't that substantial change? 12 I mean substantial is so not clear here. So, it's 13 depends on how you look at it. 14 MR. SCHUTZ: Our position from the Legal 15 Department is that just merely adding peripherals like a 16 printer, like a keyboard, a mouse, a monitor -- 17 MS. STEEL: That's not what -- shouldn't have 18 said that. 19 MR. SCHUTZ: Excuse me? 20 MS. STEEL: They changed everything every 21 three years they coming in and -- 22 MR. SCHUTZ: Right, but -- but -- and this 23 might be the confusion, I apologize for this, it's -- 24 it's when the vendor -- sorry, taxpayer purchases from a 25 vendor a completed printer, a completed -- already 26 assembled printer, already assembled personal computer, 27 and they then lease it to NASA in substantially the same 28 form as acquired because they're just leasing to them 39 1 the same computer, the same printer, the same scanner 2 that they've acquired from their own vendor. They 3 haven't made a substantial change in form. Merely 4 connecting those different items together, those 5 peripherals and the computer just together and adding 6 software that's application software does not create a 7 substantial change in form. 8 What I was talking but petitioner hasn't shown 9 is if with an individual computer that they got they -- 10 they -- let's say they -- the vendor sent them a 11 computer and they said, okay, we're going to really soup 12 up this computer, we're going to add, you know, a lot of 13 additional memory to it, to the internal workings of the 14 computer, we're going to add a new CPU unit to upgrade 15 the -- the CPU processing speed, we're going to add a 16 whole new hard drive, if -- if they've significantly 17 changed the internal workings of that computer then we 18 would concede that that -- that individual computer has 19 been a substantial change in form because that -- all 20 the component parts that go into that computer lose 21 their -- lose their identity as component parts 22 because -- and there's been a substantial change to that 23 computer. 24 However, here, claimant has not shown any 25 particular computers that -- where they did that and it 26 would be on a case-by-cases basis that we would have to 27 cite. Simply adding a little memory or just swapping 28 out -- possibly just swapping out or adding one 40 1 additional hard drive is not going to be enough to be a 2 substantial change in form for that one individual 3 computer. 4 MS. STEEL: That's not what taxpayer says. 5 Can you explain just one more time that how it's been 6 done substantially changes, you know, from the computer 7 that you bought it to assemble it? 8 MR. HALVERSON: Well -- 9 MS. STEEL: It seems like, you know, the 10 substantial is the -- you know, makes so much difference 11 here. 12 MR. HALVERSON: You may have -- attached to my 13 brief was an affidavit of Jerry -- what was his last 14 name? 15 MR. GURFINKEL: Stanley. 16 MR. HALVERSON: -- Stanley, which laid out -- 17 he was the expert that did this sort of work and laid 18 out what he did, but I'll try to paraphrase. 19 Three months before an employee's anniversary 20 date they will call him and say, you know, you get a new 21 computer, three months from now. What would you like? 22 And they start laying out what they want. I 23 want the Mac 10 with OS 12 and I'm going to need the 24 following software packages. And I want 560,000 25 gigabyte and 470,000 megabyte hard drive and I want ear 26 phones so I can listen to whatever, and I want games on 27 it and, you know, they just start -- they get carried 28 away. But they do fill out a sheet that tells us 41 1 exactly how they build the computer. The computer is 2 then built by our supplier and then shipped to us. 3 Now, we receive it, that is ACS or Lockheed, and 4 we start working on it. First of all we make sure that 5 it came with all the parts that it's supposed to -- it's 6 supposed to come with. We test all of that. And it's 7 tested to make sure it runs, it works right. Anything 8 that is not in the computer as he wanted, for instance 9 it didn't have the 550 gigs that he wanted and it only 10 had 250, we either switch that out or send it back to be 11 fixed. That's the first step. 12 Now, once it complies with his initial list, we 13 call him back and say, okay, we're ready to make -- 14 we're ready to see you, when -- when do you have time? 15 He says, okay, I've got -- I got time Friday, come on in 16 Friday morning. 17 Friday morning we -- we show up with the 18 computer in hand and we start customizing it for him. 19 Okay. What have you got in your old computer? How many 20 programs? What are they? Do you want them all on the 21 new computer? They typically say yes, almost a hundred 22 percent, according to Jerry Stanley. 23 So, he's got ten to twenty programs. Now, on 24 an average I told -- I was told they had four 25 application usually and 20 different other packages, 26 so -- that are applicable to NASA employees. 27 So, they take those programs, they transfer 28 them over. Then they say, okay, what else? And they 42 1 say, well, I want all the data, I got to have all my 2 e-mails and so they say, okay, let's transfer that over. 3 Now, we got it all over. Now, we -- we start 4 testing each package making sure it works. All of that 5 has to go on at the same time. And then we do cleanup. 6 We have to take off anything that -- all right, let's 7 say he's got e-mails enough for ten years ago that's 8 slowing down your computer, let's get rid of that. All 9 that has to be done, all before he turns on the 10 computer, all before he gets his hands on it. 11 So, as I mentioned at least ten programs are 12 added to the computer. The average value of $357, 13 3,570, which is almost double the cost of an Apple, so 14 you can see that we meet the 20 percent test easy, and 15 that's the test put forth by the Board, and there's a 16 substantial increase in value, just that alone. That's 17 the key general rule in this area. And we follow it and 18 we adhere to it, and we should win on that basis alone. 19 But, no, there's a ton of this going on, 20 besides all the cabling. And you remember that any -- 21 you know, you're going to have a printer back in 22 Central, you're going to have a printer on your desk. 23 Both of them have to be dialed in with printer drivers 24 so that the new computer can actually print on either 25 one of those. All of that goes on. 26 MS. STEEL: Okay, thank you. 27 MS. YEE: Thank you, Ms. Steel. Other 28 questions, Members? Mr. Horton. 43 1 MR. HORTON: Madam Chair. 2 You indicated that the supplier will assemble 3 the computer to a certain point based on the 4 specifications of the customer. 5 MR. HALVERSON: Correct. 6 MR. HORTON: And so I'm presuming that the 7 computer comes preloaded with some information and then 8 at some point once you receive it from the -- from your 9 supplier then there is a testing and quality testing to 10 assure that what was requested is on the computer. 11 MR. HALVERSON: That's correct. And they come 12 with only four packages, the ones I mentioned; the 13 operating system, the anti-virus, the -- probably a test 14 package of Office, and I think that's it. I may be 15 missing one, but -- 16 MR. GURFINKEL: Yeah, and the rest of the 17 applications are all loaded -- 18 MR. HALVERSON: Afterward. 19 MR. GURFINKEL: -- by the supplier. 20 MR. HALVERSON: No, no, no -- 21 MR. GURFINKEL: You see -- 22 MR. HALVERSON: -- they're added by Lockheed. 23 MR. HORTON: Oh they're added by -- 24 MR. GURFINKEL: By Lockheed, I'm sorry. By 25 the taxpayer. 26 MR. HALVERSON: Only the -- only the OS 27 system -- 28 MR. GURFINKEL: Yeah. 44 1 MR. HALVERSON: -- which is normal, you know, 2 Windows or -- or Leopard or whatever it's called -- 3 only the -- the anti-virus program and -- and typically, 4 and I -- 5 MR. HORTON: So at that -- 6 MR. HALVERSON: And you also get -- you get 7 internet. You get Internet Explorer. Plus -- that's 8 the one I left off. 9 MR. HORTON: So at the point that the -- the 10 computer is assembled to the initial specifications and 11 you meet with the customer, what changes the 12 characteristics of that product? 13 MR. HALVERSON: Well -- 14 MR. HORTON: At that point it's a computer. 15 It has the -- the preloaded software plus an additional 16 four that comes with it, and so at that point the 17 customer says, well, I'd like to see my original data 18 downloaded to the -- to the machine. That doesn't 19 change the characteristics of it, it's still a computer. 20 Ship -- you just -- it's a service. I'm trying to 21 understand what changes the characteristics of the 22 machine -- 23 MR. HALVERSON: Well -- 24 MR. HORTON: -- subsequent to -- 25 MR. HALVERSON: Understood. 26 MR. HORTON: -- that visit out at the -- 27 MR. HALVERSON: Mr. Horton, you know that if 28 you went on ebay and you bid on a computer like I told 45 1 you that had just the OS system, the anti-virus, 2 Internet Explorer and a trial three-month version of 3 Windows Office that you would probably pay anywhere from 4 599 to 2000. By the time we finish loading that 5 computer it's worth 2, 3, 5 -- 6,000 bucks. 6 If you saw a computer on -- on line at ebay 7 that came with all of the packages we had and you were a 8 rocket scientist, and you're from Russia, you'd be 9 excited as heck because, my God, that computer is 10 priceless to you. 11 But for the most part, if I -- just kidding 12 aside, if you're looking at a computer with ten or 13 twenty more packages of software on it, you're going to 14 pay for it. 15 Ebay, you're not going to be buying that 16 computer for the same price you'd pay for Dell with the 17 basics. It's just not the same computer. It costs a 18 heck of a lot more. 19 MR. HORTON: I understand the analogy. I'm 20 trying to get to the specifics. Let's take one of your 21 transactions and you've got the hardware, you've 22 uploaded four different programs on the hardware or the 23 supplier has to meet four or five or six, whatever the 24 initial specification was from the customer. You've 25 prepared the -- the -- the computer to meet those 26 specifications. And now you've decided to go out and 27 have a discussion with the -- with the customer to see 28 if it -- if they want anything else or if it actually 46 1 meets all of the spes -- the original specification. 2 So at that point what additional hardware, 3 software, service is being performed to change the 4 characteristics of that -- of that modified machine? 5 MR. HALVERSON: Okay. We -- again, we might 6 have -- we might have loaded additional software before 7 you even showed it to the customer because he listed 8 those on his -- oh his sheet what he wanted. 9 So we may have the -- let's say we got a 10 license the day -- 11 MR. HORTON: Now, when you say "we" -- 12 MR. HALVERSON: ACS or Lockheed. 13 MR. HORTON: At -- at some point you indicated 14 that you send it out to your supplier and your supplier 15 actually did all the -- 16 MR. HALVERSON: No, no, no, no, no, supplier 17 only if there's a -- would -- a supplier sends us a 18 computer with those four packages on it; OS, Internet 19 Explorer, anti-virus and a trial package of Office. 20 MR. HORTON: I said supplier -- 21 MR. HALVERSON: That's it. That's it 22 MR. HORTON: Every machine is like that? 23 MR. HALVERSON: That's it. 24 MR. HORTON: Okay. Then what happens? 25 MR. HALVERSON: Now, we get it and we got a 26 sheet from the -- from the client, the person that's 27 going to get the thing, and he goes, I don't want 28 Internet Explorer, I want FireFox. So, all right, we 47 1 download FireFox on the computer beforehand. Much of 2 this can be done on that day beforehand. 3 MR. HORTON: It's still a computer, though, 4 right? 5 MR. HALVERSON: Correct. 6 MR. HORTON: And they have -- 7 MR. HALVERSON: Now we're doing the work. 8 MR. HORTON: The characteristics are the same. 9 MR. HALVERSON: The lessor is doing this work. 10 MR. HORTON: Okay. 11 MR. HALVERSON: He wants FireFox. He wants 12 Mozilla. He wants -- instead of that he wants -- 13 he wants Adobe Acrobat. All of that package may get 14 started being done ahead of time. 15 Now, we notice it didn't have enough -- it 16 didn't have the memory he asked for. We might send it 17 back to get the additional memory or we might do our 18 work ourselves. With a contract this size, I'll bet a 19 lot of it's done. But -- but Stanley -- or Jerry 20 Stanley's affidavit says we may have done it either way. 21 Okay, I can't tell you. 22 MR. HORTON: I -- I can tell you the 23 Department is going to want to know how much of that 24 work is done by you versus your supplier delivering you 25 an end product -- 26 MR. HALVERSON: But that piece -- 27 MR. HORTON: -- that meets your 28 specifications. 48 1 MR. HALVERSON: That -- that -- I meet the 2 five tests without telling them. Okay. But you're 3 right, they would like to know that, Mr. Horton, you're 4 correct. Because that's why -- 5 MR. HORTON: I mean, I would, too, but -- 6 MR. HALVERSON: -- they blocked this thing for 7 six and a half years. That's why it's been dancing 8 around and no -- no one even making the least effort to 9 make a decision. 10 After we're done with the computer, and I mean 11 adding the ten packages you know that computer is more 12 valuable. You know if you went on ebay and you saw one 13 loaded like your son wanted, and he was a rocket 14 scientist, you'd pay a lot more money for it. You're 15 not going to pay the basic what you paid Dell for their 16 computer. 17 So keep in mind that's the way we lease the 18 computer. You're paying us a premium because that's 19 what you get. You're not paying the $40 you paid Dell 20 for their basic computer. You're paying us 200, 300, 21 whatever. 22 MR. HORTON: I'm -- I'm trying to bifurcate 23 the -- the -- the purchase, the sale and the subsequent 24 service. The purchase is the transaction between 25 Lockheed and their manufacturer, or their supplier. And 26 what I'm hearing is, is the supplier will make 27 modifications to this end product and then that product 28 is complete. And then it's sold to Lockheed and then 49 1 Lockheed will look at the specifications and they will 2 make mod -- further modifications to that end product 3 and -- and some potential assembly and so forth. 4 And so I'm trying to get to a point where I 5 can say at this point they've actually changed the 6 characteristics and the form of that tangible personal 7 property; it's no longer the computer that they 8 originally purchased. 9 MR. HALVERSON: Well, you're -- you're right 10 in everything you said. When we buy the computer we get 11 a basic computer, and then we load it up and we modify 12 it. We clean it up. And that takes four hours of time, 13 et cetera. 14 So, the key here is if it is not leased in 15 substantially the same form as acquired we are required 16 to collect Use Tax on rents. 17 MR. HORTON: No, I know what the law -- 18 MR. HALVERSON: Couldn't have paid -- 19 MR. HORTON: -- says. 20 MR. HALVERSON: -- on the front end. 21 So you have to say to yourself, all right, 22 were they leasing the basic computer or not, and we 23 weren't. We leased that computer -- 24 MR. HORTON: No, no, no, it's not -- 25 MR. HALVERSON: -- jazzed up -- 26 MR. HORTON: -- a basic computer, it's the 27 same form that was acquired, it's the characteristics 28 that has to change. 50 1 MR. HALVERSON: In -- 2 MR. HORTON: The form -- I mean, if you look 3 at the definition of form, the form really never 4 changes. 5 MR. HALVERSON: Form doesn't have to change 6 under the annotation. 7 MR. HORTON: And so -- 8 MR. HALVERSON: Remember -- 9 MR. HORTON: -- it doesn't really have to but 10 then if you look at the characteristics of it and you 11 say, well, is it leased in substantially the same form 12 as it was acquired, has the characteristics of a change. 13 Is it now a -- you know, a Model T that's been converted 14 into some special -- and I'm -- 15 MR. HALVERSON: Yeah, but there -- 16 MR. HORTON: -- and I need your assistance to 17 kind of -- 18 MR. HALVERSON: Well, remember that annotation 19 I told you was the general rule? It said form is not 20 important if changed in value. And it changed in value. 21 You don't even look at form. You only look at form in 22 some other cases. Don't look at it here. It's hugely 23 changed in value. I don't even have to go to form. 24 MR. HORTON: So -- 25 MR. HALVERSON: The general rule is if it 26 changes in value it's not in substantial -- it's not 27 leased in substantially the same form as acquired. 28 And we changed the value. 51 1 MR. HORTON: So, question of the Department, 2 the contention is that a -- the sole change in value 3 changes the -- the tax implication on this transaction. 4 I don't -- can you help me understand why that's not 5 true -- 6 MR. SCHUTZ: A couple -- 7 MR. HORTON: -- or why that is true? 8 MR. SCHUTZ: A couple things. First, with 9 regard to just simply adding software applications to a 10 personal computer -- 11 MR. HORTON: No, no, no, no, I -- I'm good 12 there. 13 MR. SCHUTZ: Okay. 14 MR. HORTON: Change -- change in value. I 15 don't mean to interrupt -- 16 MR. SCHUTZ: Simply a change in value, well 17 they're getting the -- they're also getting the 18 computer -- they have rights to the computer software 19 on -- on disks and so you don't have a change in value 20 because they're -- they're receiving that value of the 21 computer software separate -- as a separate unit. 22 So you -- I think the way he's calculating 23 that -- that, oh, a -- a computer loaded with all the 24 software is worth "x" amount of money and the computer 25 not loaded with all the software is worth less than 26 that. 27 And I would say that, well, they're getting -- 28 they have the rights -- the license rights to that 52 1 software so you can't -- it's -- it's a separate unit, 2 the software can be a separate unit in and of itself and 3 you -- the only thing that's being -- adding value is, 4 as he said, maybe the -- the $90 that it took to -- for 5 them to perform that service of loading on all that 6 software. But the software in itself has a value and 7 it's a separate -- they receive it separately, as well. 8 MR. HORTON: So the -- 9 MR. TUCKER: And just to put -- pardon me. To 10 put it another way, Mr. Horton, there's already a lease 11 of the -- or there's -- the software packages are being 12 purchased or leased by -- in this case by their 13 customer. And so he's ignoring that component. It's as 14 if they're not paying anything for the software 15 packages. 16 And here if they're adding ten software 17 packages that cost $300 some odd dollars, the -- their 18 client, their customer, is paying for that in one way or 19 another. And as Mr. Schutz pointed out, all they're 20 doing is taking the software that they're leasing and 21 the computer that they're leasing and installing the 22 software on that computer. And that is not -- for our 23 purposes that's not a substantial change that would 24 warrant the -- the treatment they're asking for. 25 MR. HALVERSON: We wouldn't get -- 26 MR. HANKS: Also, just as a different example, 27 I -- I think, and this might put it into context, let's 28 say that -- that you're renting a couple of different 53 1 types of -- of Apple computers, let's say, from a 2 lessor. And in the one instance you've got a -- a 3 relatively small laptop that -- that you're -- you're 4 renting. The lease value for that is going to be 5 substantially less than it would be for, let's say, a -- 6 an iMac that might have a 27-inch monitor that's going 7 to have more RAM, that's going to have more storage 8 capacity than what you do in -- in the small laptop 9 computer. But we wouldn't say that one is substantially 10 changed in format such that -- that we're not going to 11 regard the lease of the larger computers as subject 12 to -- to tax on rental receipts because it's -- it's not 13 leased in substantially the same form as acquired. We 14 just say that the capacity is for those -- those two 15 different products are -- are different, which I think 16 is -- is happening here. 17 I think what's happening is Lockheed is 18 specifying to the petitioner -- or rather NASA is 19 specifying to Lockheed we need certain computers of -- 20 of this size to meet these applications and -- and 21 these needs. We've got researchers that need to track 22 telemetry at -- at the one location for some space 23 flight that we've got going into orbit. We've got 24 different locations where they're designing what the 25 next space vehicle might look like if we send men back 26 to the moon. So they need to have more CAD type 27 operations to do that type of engineering. 28 And I think that's the difference that you're 54 1 seeing in the different types of computers that -- that 2 are being rented. 3 MR. HORTON: Yeah, I get the -- you know, I 4 get the complexity of the machine. I wanted some 5 clarification on the taxpayer's position that a 6 substantial change in -- or increase in value actually 7 will determine whether or not there's been a substantial 8 change in character of -- 9 MS. MANDEL: As a general rule, right? 10 MR. HORTON: As a general rule as opposed 11 to -- well -- 12 MR. HANKS: If -- if you carried -- 13 MR. HORTON: I think -- I think it was 14 intended to be just an indication that there could be a 15 change which would cause for further investigation. 16 MR. TUCKER: Mr. Horton, I would say -- 17 MR. HORTON: Or is there -- or is there -- or 18 is there a position that the Board has taken that says 19 if you have a 20 percent increase in value you have a 20 substantial change in -- in form and substance? 21 MR. TUCKER: I -- Mr. Horton, I would say our 22 general rule is there any fabrication involved, and we 23 look to see whether or not something has been fabricated 24 from these components. That would be our general rule. 25 There may be certain circumstances and I 26 believe the increase in value was primarily targeted 27 against plants and trees because -- 28 MR. SCHUTZ: They grow on their own. 55 1 MR. TUCKER: Right. 2 MS. YEE: Okay. 3 MR. TUCKER: And that they're not the same 4 as -- I mean, there's a change in value because they 5 grow. 6 MS. YEE: You'll get time, Mr. Halverson. 7 Please. 8 MR. HALVERSON: Okay. 9 MR. TUCKER: And -- and so that's where the 10 change in value rule primarily comes into play, whereas 11 in general our general is was there any fabrication. 12 MR. HORTON: Right. Mr. -- 13 MS. YEE: Go ahead, Mr. -- 14 MR. HORTON: -- Halverson -- Halverson, 15 are all your sales to the U. S. Government? 16 MR. HALVERSON: Just this particular lease 17 transaction. So -- 18 MR. HORTON: What about the others, how are -- 19 MR. HALVERSON: Oh, they're everyone else. 20 That's why this one got screwed up. I don't -- I 21 don't -- 22 MR. HORTON: How -- how are the others 23 treated? The other sales. 24 MR. HALVERSON: Well, it varies state to 25 state, because -- but California was the only one was an 26 election rule. Every other state, as I said, we've 27 gotten our money back. Typically, leases are taxed on a 28 rental stream, everywhere. California is the only state 56 1 that I -- that allows this election on the front end, 2 the pre-tax on the front end, in my experience. 3 MR. HORTON: Here's what I'm asking. Let's 4 say you're right, without making a predetermined 5 judgment. Your other transactions, as was indicated 6 earlier by someone, become leases and so if you treated 7 them differently and you're not collecting tax on the 8 lease receipts to sales to non-U. S. Government, you've 9 incurred a liability. 10 MR. HALVERSON: Oh, sure. That's not 11 happening. You can tell by the screw-up here that ACS 12 when they did this lease treated it like they do 13 everyone else. They paid tax on the front end on the 14 equipment. 15 In states that require it to be paid on 16 rentals, they pay on rentals. They're not -- they 17 haven't avoided tax. They haven't missed -- they just 18 didn't -- they didn't take into account that this was a 19 Federal instrumentality. That happens in big companies. 20 MR. HORTON: I'm just going to share this, 21 not -- it may not even be relevant to -- to this case 22 but it sounds to me dealing with the significance and 23 sophistication of the equipment involved that your lease 24 receipts are going to be much higher than your purchase 25 price. 26 MR. HALVERSON: That's true. 27 MR. HORTON: So if they paid tax on the 28 purchase price and all the other transactions and you 57 1 have somewhere -- let's say based on the numbers that 2 you gave earlier, the $90 an hour and so forth, that 3 sounds like a 600 percent markup. 4 I mean, so even if you got a refund on the 5 purchase you're to end up with a heavy tax liability on 6 the lease receipts. 7 MR. HALVERSON: No, Mr. Horton, I said there's 8 not one state that has this front end election except 9 California. 10 MR. HORTON: Well, California -- 11 MR. HALVERSON: Everyone else collects tax on 12 rent. 13 MS. YEE: Mr. Halverson. 14 MR. HALVERSON: So, if you pay on rents 15 there's no liability. We've been paying correctly in 16 the other states. 17 MR. HORTON: Just -- 18 MR. HALVERSON: One transaction got screwed 19 up. 20 MR. HORTON: I'm trying to be helpful, 21 actually. 22 MS. YEE: Mr. Horton is -- listen to his 23 question. You're -- you're missing his question. 24 MR. HORTON: Yeah -- 25 MR. HALVERSON: I apologize. 26 MR. HORTON: Yeah, I'm trying to be -- 27 MS. YEE: Okay. 28 MR. HORTON: First I'm -- I'm referencing 58 1 non-government contracts. Let's say Board of 2 Equalization, you're leasing this equipment to the Board 3 of Equalization. You purchase it for $50 and you're 4 charging us $500, because of all the service involved. 5 And so now you're leasing it to us for $500 a month 6 at -- and you owe tax on lease receipts. 7 MR. GURFINKEL: Can I say -- 8 MR. HALVERSON: No, we would -- we would owe 9 tax on whichever one -- the way we wanted to pay it, up 10 front on the 50 or on rents. In California you have the 11 election. It's the lessor's election and it's made at 12 the front end and it's irrevocable. Now -- 13 MS. YEE: Okay, I'm going to stop -- 14 MR. HALVERSON: -- what am I missing? 15 MS. YEE: Stop there. Let me -- let me see if 16 I can get -- Mr. Levine, did you get the question? 17 MR. LEVINE: Yes. 18 MS. YEE: Okay. 19 MR. LEVINE: Mr. Halverson is missing the 20 point, and I'm not sure why, but if we had this -- Mr. 21 Halverson said that in this particular contract it made 22 a mistake because of the U. S. government -- 23 MS. YEE: Right. 24 MR. LEVINE: -- which says to me when it has 25 these types of contracts, this very type where they're 26 leasing computer seats -- when the Board can afford the 27 money to get me whatever I want, so you hire Lockheed 28 and I think that the rocket scientists are getting the 59 1 top end things, which are more than -- you know, there's 2 a premium for that extra -- but if they're doing it 3 identically there is no election because what the 4 argument is is that these leases were not in 5 substantially the same form as acquired. And when a 6 lease is not in substantially the same form as acquired 7 there is no election. And so that's what claimant is 8 arguing about against the election which helps him here, 9 might help him in some other cases, for example, where 10 the lease cuts out early, but on a long-term lease -- 11 MR. HORTON: Out of state. 12 MR. LEVINE: -- many lessors like to pay tax 13 up front which they cannot do if it's not leased in 14 substantially the same form as acquired. So your point 15 is if their lease -- if these contracts were with the 16 Board and not with NASA, then they would be defending 17 their election on cost. 18 MR. HALVERSON: No, we'd be paying it -- we'd 19 be paying it the same -- on lease rentals because he's 20 correct, it would still -- 21 MR. LEVINE: Okay. 22 MR. HALVERSON: -- not be leased in 23 substantially the same form as acquired. 24 MR. LEVINE: Okay. There was just a 25 miscommunication on the -- 26 MR. HALVERSON: Yeah, I apologize. 27 MR. LEVINE: -- only reason for the mistake 28 was because of the Feds. 60 1 MS. YEE: That's right. 2 MR. HORTON: So now that there's a better 3 understanding of this -- thank you for indicating I was 4 right; that's helpful, and you've -- your testimony is 5 that all your sales aren't to the U. S. government, this 6 is unique -- 7 MR. HALVERSON: Right. 8 MR. HORTON: -- you may be exposing your 9 client to a liability, larger liability. 10 MS. MANDEL: For California transactions. 11 MR. HORTON: For California transactions 12 MR. HALVERSON: Yeah. 13 MR. GURFINKEL: Well, this is -- I'm a 14 representative with ACS. So this is a unique contract 15 with NASA, with Lockheed Martin, that is a -- a 16 corporation of ours currently. So, I'm not -- I'm not 17 aware of how they -- 18 MR. HORTON: So all the others -- all the 19 others that are just like this -- 20 MR. GURFINKEL: Uh-huh. 21 MR. HORTON: -- were not leased in 22 substantially the same form? 23 MR. GURFINKEL: I can't attest to that. I'm 24 not a -- I don't know how Lockheed Martin handles 25 their -- 26 MR. LEVINE: May I rephrase -- 27 MR. HALVERSON: They're audited every three 28 years. 61 1 MR. GURFINKEL: Right. 2 MR. LEVINE: May I rephrase and -- 3 MS. YEE: Yes. 4 MR. LEVINE: -- and on this issue, and I'd 5 like to just digress a bit on this component part 6 because it's really important. I think it's so obvious, 7 there's no legal authority necessary if you get a 8 turnkey into a -- in an office and you lease all the 9 non-electronic equipment in an office -- desk, chairs, 10 we look at each individual item. Even if it's a lump 11 sum price for how many -- how many seats will there be. 12 How many people sitting in the office? A hundred? 13 Okay, this is what you'll need, we'll charge you "x" per 14 person. 15 So, the lessee pays a lump sum price based on 16 per person; we're still going to go in and if they pay 17 tax up front we're going to accept that with respect to 18 anything that was not -- that was leased in 19 substantially the same form as acquired. But if there's 20 one desk that was put together from a kit we'll say, 21 well, you owe tax on rentals for that and I'll have to 22 prorate it. 23 We do look at each individual item. So, the 24 printers here, they're printers. The scanners are 25 scanners. The computer's the hard question because 26 that's the one with the software and that really is the 27 big ticket here, is the software. The -- the minor 28 changes to hardware are insignificant in my view, but 62 1 the software is the big ticket item for you to decide, 2 and because it cuts both ways I think perhaps you'll 3 want to consider a memo decision just on that issue on 4 is installation of software onto a computer -- I would 5 view it as basically another component. 6 The software -- off-the-shelf software is like 7 a separate component. They're leasing it separately 8 even if they install it on behalf of the customer. But 9 if you don't see it that way and you think a computer 10 with software installed -- with enough software 11 installed that was not installed by the vendor is a 12 substantial change in form, you might want to consider a 13 memo decision. It affects -- or if you don't, you may 14 want to consider a memo decision so we can pin this down 15 and everyone will be treated the same. 16 MR. HORTON: Yeah. So -- 17 MR. HALVERSON: There is no charge for 18 installation, though. There's -- there's no separate 19 charging. 20 MR. HORTON: So, -- now that that's -- now 21 that we dealt with that one, back to the situation at 22 hand. At -- at what point -- what actions, what -- what 23 assembly, what fabrication takes place to this initial 24 product, the computer, that changes its characteristics? 25 And give me one example, any example. Give me the -- 26 the -- where you're dealing with -- where you're 27 changing it significantly. Not just a minor change 28 because you're not dealing with the -- the -- you're not 63 1 dealing with the -- with the employee who is at the top 2 of the rank -- I mean at the bottom of the rank, but 3 you're dealing with the employee at the top of the rank 4 that can order whatever they want. Can you give me an 5 example and -- and kind of walk me through where the 6 characteristics is changed significantly, that is no 7 longer the -- a computer, no longer -- 8 MR. HALVERSON: An example of that would be a 9 person that has a hard drive and wants a -- both a hard 10 drive master and a hard drive slave. So he buys -- he 11 wants a second hard drive in -- inserted into the 12 computer. 13 MR. HORTON: Separate component? 14 MR. HALVERSON: Totally component. So you'd 15 have to -- let's say -- and let's tell us -- 16 MR. HORTON: That's just a separate component? 17 MR. HALVERSON: Desktop. Correct, but you're 18 opening up the computer entirely. You're -- you're -- 19 you're having to get this item. You're going to insert 20 it. You're then having to program it so that the one 21 knows it's the master, one's the slave. That takes a 22 lot of programming, believe me, and then you have to 23 wire it because they don't come pre-wired -- these have 24 to be wired into your computer and have to be wired -- 25 again, the master has to know it's the master and the 26 other has to know it's slave because you have to keep 27 data a certain way. And then once it's done you test 28 it, then you close up the computer, et cetera. 64 1 But it's not -- you know, you have et cetera 2 again. 3 MR. HORTON: Now, the preloaded software has to 4 come with that capacity or you have to send it back to 5 the manufacturer or -- and change the configuration of 6 the computer originally? At least the computers 7 that -- that I've seen, they -- you can add drives all 8 day. 9 MR. HALVERSON: Yeah, but in the case I told 10 you you have to do a lot of DOS programming at the 11 beginning -- 12 MR. HORTON: Okay. 13 MR. HALVERSON: -- to make sure it know -- 14 MR. HORTON: That's a little different. 15 MR. HALVERSON: -- which one is the master, 16 which one is the slave. You can't just open the thing 17 up and shove it in and then -- 18 MR. HORTON: So you have to write a whole new 19 program? 20 MR. HALVERSON: Correct. 21 MR. LEVINE: No. For the record, having done 22 it, the old hard -- modern hard drives -- I don't think 23 that you need to do this any more, but the hard drives 24 back -- even in the early 2000s there's a pin. I can't 25 remember the term for it. There's a pin and there's 26 four slots. And one is for single, one is for slave, 27 one is for master, and one is a dead. 28 And you just pull that out and you put it in 65 1 and you attach your power, you attach your IDE cable now 2 and SATA cable. That's it. 3 In the old days, maybe back in 2001, you 4 screwed in two to four screws and a modern computer you 5 slide, you're done. 6 MR. SCHUTZ: Many of these things, yes, are -- 7 are now plug and play, basically, is the terminology 8 that's -- that's used. But also in this case petitioner 9 hasn't shown where he's done any of this individual -- 10 to an individual computer where they've -- they've 11 significantly modified the internal components of an 12 individual computer. It's sort of just in theory 13 that -- that maybe it was done, but we haven't seen any 14 individual transactions or individual computer where 15 that occurred. 16 MR. HALVERSON: I followed all of the tests 17 that this Board staff, legal staff, has put together on 18 what is a substantial change. We've met every one of 19 them. 20 What I find just mind boggling is that Legal 21 Department won't follow the general rule which I told 22 you was, and it's stated, 330.3900, general rule, 23 substantial change in form, and it says any change in 24 value if it's significant -- and then I told you what 25 significant is, it's 20 percent. They refuse to follow 26 their own rules. They make up this stuff. Why is that 27 fair to the taxpayer? 28 MS. YEE: Well -- 66 1 MR. HORTON: Well, I -- I mean, just -- just to 2 answer that, not -- and I'm going to answer it in -- in 3 general and not specifically to this case, the 4 annotations -- the law, is what actually sort of governs 5 the transaction. And so, the -- the law states 6 substantially the same form. Then you get into 7 interpretation of the law which is what the annotation 8 sort of give you -- gives you some guidance to. 9 But the prevailing presumption or the 10 prevailing thought is, is that there has to be a change 11 in form, there has to be a change in characteristics and 12 that the value in and of itself only is an indication. 13 And in this case it sounds as if, though, the 14 Department is arguing that a lot of value is placed on 15 the intangible. And which is the lease of the -- of use 16 of the software, which is not the actual tangible item 17 that you're either leasing or selling. It's a separate 18 transaction. 19 If that helps you in any way. 20 MR. HALVERSON: Well, I'd only point out, Mr. 21 Horton, that the rule set forth by the Board is that in 22 situations where there's been a substantial increase in 23 value the general rule is the substantial increase in 24 value alone is enough to show property is not leased in 25 the same form as acquired. 26 However, other situations exist where there's a 27 change in form, but little increase in value. In such 28 instances the fact that there's no substantial increase 67 1 is irrelevant if there's a change in form. 2 So they fall back to form only secondarily, in 3 my opinion. That's the way I read that. 4 MR. HORTON: Okay. What about -- what are the 5 other four? You said there were five. 6 MR. HALVERSON: Oh, I've pointed out the -- the 7 20 percent test. Substantial increase in value. 8 MR. HORTON: Got that. 9 MR. HALVERSON: I've pointed out that the -- 10 the camera where you do any adding to it, modifying it, 11 or replacement. And employees of Lockheed do all of the 12 additions of the computer, et cetera. When they receive 13 it they do all the additions of the programs, et cetera. 14 Burn it in, test it, get it ready before they turn it 15 over. It's not done by -- you know, it's not by -- not 16 done by NASA. 17 And it's assembled by ACS. It's assembled by 18 the lessor. 19 MR. HORTON: I'm sure working with the U. S. 20 government that -- I'm not sure. Let me strike that. 21 Is there a point in time when -- when the 22 taxpayer may find themself or -- modifying the -- you -- 23 you mentioned at some point that -- that they would 24 actually go in and change the -- the -- the program, 25 itself, for whatever reason. Does that occur at all 26 where they -- they -- you've got the original preloaded 27 software and -- and you go and you write a whole new -- 28 whole new program for -- so you're doing actual 68 1 programming and you're changing the whole configuration 2 of the -- you know, of the -- of the computer? 3 MR. HALVERSON: Mr. Horton, I didn't get an 4 affidavit from anyone that stated that. I -- you know, 5 my personal experience at KPMG, they came in with five 6 disks of their own proprietary software and whipped it 7 on there so that I couldn't do certain things, couldn't 8 look at certain things. They could advise me whatever 9 they wanted to do things a different way. 10 I -- my guess was, and it's been a little 11 long, but my guess is that there's something that's done 12 that they're -- it's against the law for them to tell 13 me. 14 So the only thing in the -- in the affidavit 15 is a discussion of the fact that almost all the programs 16 are canned software packages. I can't -- you know, I 17 can't believe that in my heart, but I can't tell you 18 anything different. I don't have an affidavit. 19 MR. HORTON: Okay, I'm going to ask the 20 Department then I'm finished, Madam Chair. 21 I'm going to ask the Department to just -- 22 MS. YEE: That's okay. 23 MR. HORTON: -- reiterate the point in which 24 they would make certain concessions and I would ask 25 that -- that you listen to their comments as to when 26 they would make certain concessions on particular 27 transactions and -- and then maybe you can testify if 28 you know that those transactions exist and you have the 69 1 document to support that. Of the Department. 2 MR. SCHUTZ: Right. Where components are 3 added to the particular personal computer, the 4 individual hard drives -- replacement of hard drives, 5 the CPU unit, memory, and there's a -- we'd have to look 6 at a significant amount of -- of changes have been added 7 to the personal computer itself, we will look at a 8 case-by-case basis to see, hey, do we have a -- 9 basically a substantial change in form of that 10 particular computer unit. 11 To -- to talk really quickly to -- to Mr. 12 Halverson's point, in the contract there's a -- a triage 13 level 3, which does look like there's proprietary NASA 14 software but they say, hey, when it -- when it gets 15 really that proprietary and it's a triage level 3 we're 16 going to deal with it ourselves and we're going to add 17 it to the computer and you guys don't touch that. 18 MR. HORTON: Oh, I didn't know that. You 19 understand -- 20 MR. HALVERSON: Well, the -- more importantly, 21 Mr. -- Mr. Horton, is that we have no record of all of 22 the changes made to every computer. It's not done. 23 MR. HORTON: But -- 24 MR. HALVERSON: No record's kept, so I can't 25 provide it. 26 MS. YEE: Can I just ask you a question? I 27 mean, your -- your primary premise is -- hangs on 28 substantial increases in value. There must be a basis 70 1 for that. 2 MR. HALVERSON: There is. 3 MS. YEE: Yes. 4 MR. HALVERSON: The general test. 5 MS. YEE: And -- and one of -- well, and then 6 you've enumerated some other -- 7 MR. HALVERSON: The more minor ones, yes. 8 MS. YEE: Okay. So, working backwards, you 9 can't kind of give us some of where there have been 10 substantial modifications? I mean, the value is based 11 on something. 12 MR. HALVERSON: Well, it is. Remember I told 13 you when -- when we produced -- and we produced a -- an 14 invoice for Wayne -- got it, maybe you can -- 15 MR. GURFINKEL: Hopkins. 16 MR. HALVERSON: Mr. Hopkins. We produced an 17 invoice for him to show us -- you know, and I looked at 18 it very quickly, it -- it sort of goes down the 19 following list. It says, "68 Mac OG3," which would be a 20 Mac computer for a grade OG3 person. And they get a 21 separate list of what they're entitled to get on their 22 computer when they pick. And so it shows a per value 23 and I -- and as I said you came back with a number, I 24 told you. The lowest one I saw was 170 a month and the 25 highest was about 399. I only did a few. I did about, 26 you know, 20 lines on the invoice. 27 The point is they go by -- by your grade, by 28 whether you're the rocket scientist or you're the 71 1 secretary, or whether you're the -- whether you're the 2 HR person or whether you're what. You just don't get 3 all the packages you want in the world. You get ones 4 that you -- you'll use. 5 And so the invoice that we invoice NASA with 6 says 68 OG3 Macs, and then the next one says "Windows 43 7 of OG3," and then it starts going down through each pay 8 grade. So, there's about -- or each -- you know, 9 whatever their salary level is. 10 And it -- and it -- and it -- you know, it 11 will have 20 -- 20 different -- 20 different variations 12 of the computer built to that person's specs., based on 13 his grade. It won't differentiate, you know, if one did 14 not take one package and the other has -- one did. But 15 it will say that he was entitled to all those and this 16 is what he took. I mean, by title this is what he was 17 entitled, it won't tell you what he took. 18 MS. YEE: Okay. I mean, you see where we're 19 kind of stuck here? I mean, we -- we've got to get to a 20 point of really identifying that there's been a 21 substan -- a substantial change in form and, you know, 22 and value is, you know, one indication of that but it 23 doesn't give us the full contextual story of what's 24 going on. And it just seems to me if you're focused on 25 value there's got to be a way to work backwards from 26 that and really figure that out. 27 And if it's based on grade or -- you know, 28 class of employees and particular types of work that 72 1 they do, I mean -- 2 MR. HALVERSON: Well, clear -- you know, I got 3 to -- I got to ask you to look at what you buy from Dell 4 for 20 or 40 bucks a month. 5 MS. YEE: Yeah, but we're not talking about 6 that. 7 MR. HALVERSON: That's the point. It's the 8 same computer basic, though. And it's 20 or 40 a month. 9 But after we load it it's 399 a month. Now why? The 10 value has increased substantially -- 11 MS. YEE: Okay. I want -- I want -- 12 MR. HALVERSON: You wouldn't pay for it. 13 MS. YEE: I want to keep a focus here and I 14 think Mr. Horton is trying to help you kind of figure 15 out what may be produced that helps us get to a 16 determination that there have been substantial changes 17 in form. And because it's -- it's a leap of faith when 18 we just focus on value. I mean, I -- I don't have any 19 sense of what that means but, Mr. Levine, you're 20 champing at the bit here. 21 MR. LEVINE: My understanding of the facts 22 based on what I've read and what I've heard is, for one 23 thing, at least some of these computers are high level. 24 So if you've ever wanted to get the premium computer for 25 that little bit extra speed you get a good one, real 26 good one, for a couple thousand but that little bit 27 extra may be four or five thousand. 28 So, the values, if it matters, I think some of 73 1 these computers are going to be significantly more. 2 They order them and most of them, our understanding is 3 they're put together by the vendor. If they're not put 4 together right they're sent back. There may be 5 occasional things that they tweak it a little bit, but 6 in the big picture we're talking a small amount. It's 7 the software. 8 MS. YEE: Yes, it changes. 9 MR. LEVINE: It's not clear exactly how much 10 they install but clearly they're installing a series of 11 software and software adds up, and if you have an 12 expensive computer and you put several software packages 13 on, it's still going to be -- I believe the technical 14 term is a chunk of change for increasing the -- if you 15 just look at the total value of the computer with 16 software, and in my view that's -- the bottom line is if 17 you look solely at value, adding software onto a 18 computer, that certainly -- many of these -- most, maybe 19 all, are going to be increased by at least the 20 20 percent that Mr. Halverson has mentioned. Some I'm 21 certain a hundred percent, for the software. And that 22 really is in my view the crux of the issue here. 23 It's not the hardware because for all intents 24 and purposes the hardware comes ready made from the 25 vendor with some software. The affidavit doesn't seem 26 to rule out a little bit -- it says includes the several 27 things that Mr. Halverson mentioned, but there's still 28 a -- a bunch of other software packages that seem to be 74 1 installed by claimant. So -- 2 MS. YEE: All right. 3 MR. LEVINE: -- that's my view. We're talking 4 installation of software and is that sufficient to make 5 a substantial change. 6 MS. YEE: Okay. I'm sorry I interrupted you, 7 Mr. Horton. You were conferring with Mr. Schutz about 8 what would be helpful. 9 MR. HORTON: I'm -- no further questions at 10 this point. 11 MS. YEE: Okay. Ms. Mandel. 12 MS. STEEL: So -- 13 MS. YEE: Oh, I'm sorry, Ms. Steel then Ms. 14 Mandel. 15 MS. STEEL: So, Mr. Levine, there's a new 16 software programs were added and average $357 per 17 program -- program makes complete computer system that 18 they put in. And that computer system becomes 19 substantially more valuable because they put those 20 softwares in. That's what they proved it, that it's 21 more than 20 -- over 20 percent plus that what you just 22 said it might be changing to completely the value -- 23 value is going to be changed to hundred percent, then 24 that's substantially increased in value in change. 25 MR. LEVINE: I would generally agree, but the 26 value rule is a general rule and it's a substitute for 27 substantial change in form. Generally when you see 28 something that's increased in value substantially, 75 1 there's been a substantial change in form. You don't 2 need to discuss the particulars, it's a lot more 3 valuable. 4 This is a technology that I don't think the 5 general rule is necessarily applied to. That doesn't 6 mean you -- you can't -- you can. If the Board decides 7 that there's a substantial change in form then it is a 8 substantial change in form. 9 MS. STEEL: But isn't that what annotation is 10 saying, though? 11 MR. LEVINE: It's talking about the general 12 rule. It does say the general rule and -- 13 MS. STEEL: That is the general rule. 14 MR. LEVINE: That's the general rule. 15 MS. STEEL: And that's exactly what this 16 taxpayer meant. 17 MR. LEVINE: But the -- again, the purpose of 18 the general rule is a substitute -- a rule of thumb for 19 change -- substantial change in form and the way we view 20 this, and reasonable minds can differ, Mr. Halverson is 21 reasonable and we differ on this -- is that you have a 22 computer. You install a new program so now can do 23 spreadsheets; you couldn't before. It's still a 24 computer. It's still ready, waiting and willing to do 25 anything that it has instructions by way of computer 26 code to do. And it's still a computer. 27 MS. STEEL: But this annotation is not saying 28 that it's an actual computer has to be changed, but just 76 1 a software program that put it in suddenly it becomes 2 substantially more valuable -- 3 MR. LEVINE: You're looking at -- 4 MS. STEEL: -- than -- 5 MR. LEVINE: -- 330.3900. 6 MS. STEEL: There's about so many 330.2965, 7 4000, 3920. I mean especially 3900. 8 MR. LEVINE: Okay. Again, general rule and 9 if -- if the Board interprets that to apply to anything, 10 then yes. 11 MS. STEEL: Okay. 12 MR. LEVINE: We haven't -- at least the 13 Appeals Division hasn't. 14 MS. STEEL: Thank you. 15 MS. YEE: Ms. Mandel, did you have a question? 16 MS. MANDEL: Yeah, I heard -- I thought I 17 heard staff say that they didn't think there was a 18 substantial increase in value to the computer because 19 the software was somewhere else. 20 MR. SCHUTZ: Right. In -- in this particular 21 contract under the Section A1.136 with regard to any 22 commercial software the U. S. Government is entitled to 23 make copies of the software, change -- move the software 24 from one computer to the -- to another computer as it -- 25 as it will. 26 So, it does seem like that the value stays 27 with the license of that software because it can be 28 moved around and it can be copied and -- and -- and 77 1 changed from one computer to the next based on the 2 contract -- the U. S. Government contract. 3 So, I mean, it's -- it's a bit that -- that 4 the value of the software remains with the software, 5 itself, and -- and if, for example, you wanted to sell 6 that software -- the computer with all that software on 7 ebay, you may not be able to do so because there might 8 be licensing restrictions of you further transferring 9 that software to another party just on that particular 10 computer. 11 So in these cases it does seem like the -- the 12 value of the software remains with the license of that 13 software separate from -- from just adding it to a 14 computer where it can be easily removed or moved to a 15 disk for storage. 16 MS. MANDEL: So you don't -- you don't view it 17 as adding a component part to the computer? 18 MR. TUCKER: I would say probably yes -- I'm 19 sorry. In -- in that there's a license for the software 20 and there's a lease of the computer, there -- so 21 there -- there's payment for each of those components in 22 essence. And all that petitioner is doing is simply 23 loading that software on to the computer. And we don't 24 regard that as a substantial change in form. 25 MS. MANDEL: And if the -- well, then I 26 guess -- I guess the question of what -- what's the 27 story on the -- I forget the annotation number, but the 28 Jugum letter where he's talking about software being 78 1 added to the tangible media and making an assertion that 2 that's somehow a change in form of the tangible media. 3 That's -- I don't know, what's the number, 3 -- 4 MR. HALVERSON: 103. 5 MR. HANKS: Right. 6 MS. MANDEL: Yeah. 7 MR. HANKS: I think the difficulty with -- 8 with that annotation deals with in part just the -- the 9 date of that annotation, it's going back so many years 10 back into the early 1980s when possibly software 11 computers were -- were really at their infancy, anyway. 12 And so I think anything that was designed then was -- 13 was more or less prefabricated to -- to certain 14 specifications. 15 MS. MANDEL: Well, it -- yeah. Well -- and as 16 I remember the -- the backup letter it was talking 17 about -- it talked about different stuff but it talked 18 about putting proprietary software on disks and drums. 19 You know, the old way that you -- that would be the 20 floppy disk. 21 MR. SCHUTZ: Right. And we do have several -- 22 MR. HANKS: Right. 23 MS. MANDEL: -- where so that he's kind of 24 talking about the floppy disk and I guess here they're 25 saying by loading it directly on the computer that 26 that's the media -- so -- 27 MR. SCHUTZ: The storage media, I mean we do 28 have annotations that say loading -- like taking blank 79 1 storage media -- 2 MS. MANDEL: Uh-huh. 3 MR. SCHUTZ: -- and loading software onto that 4 storage media does create a substantial change in form 5 of that storage media, itself. But a storage media disk 6 is -- is completely different than a personal computer. 7 MS. MANDEL: Well, I guess that's -- that gets 8 to be a question because what the taxpayer here is 9 talking about is instead of loading -- I mean there may 10 be an issue that they get the software some other way 11 and they have a bunch of it in the drawer and, you know, 12 that that's a thing, but if he's just -- if you're just 13 focused on the -- the computer -- the computer, itself, 14 and they get the computer from a vendor, Lockheed gets 15 the computer from the vendor, and then Lockheed takes 16 software that it gets from somewhere else because it's 17 canned software, I guess is what we've been told -- they 18 take the software from somewhere else and they load it 19 on the computer and then they sell this loaded computer 20 to NASA, the -- the analogy he's making comparison to 21 the -- to the Jugum thing and then also, you know, to 22 all the sort of loading onto storage media, is that -- 23 that this computer is the equivalent of the storage 24 media. Because it's the media on which -- you see, 25 that's really what he's saying. 26 I mean, you're focused on that it's a computer 27 and I can type on it and make a -- you know, I can make 28 it do things. But in -- in lieu of handing me -- in 80 1 lieu -- he buys a -- Lockheed buys a bunch of blank 2 disks and loads the software on the blank disks and 3 hands me the disks, he's saying, no, Lockheed buys a 4 bunch of computers, loads the software on the computers 5 and sells me the computers, and how is that different 6 from selling the blank disks? Why isn't the substantial 7 change in form applied when I load it on the computer 8 and he -- and -- and I guess maybe where you were going 9 was, well, but a blank disk is worth like ten cents, 10 which is why he then is trying to make his argument 11 about the software -- the software is such incredible 12 super duper software, that's got a huge -- huge amount 13 of value. You know, the software to the computers 14 value-wise is like the software to the diskette. 15 And that's the connection that he's making and 16 that's kind of why he's going to the Jugum letter and -- 17 and so, can you maybe -- 18 MR. SCHUTZ: And I would say in this case the 19 contract, itself, says, hey, we have the -- the right 20 to -- 21 MS. MANDEL: Who's "we"? 22 MR. SCHUTZ: That's right, the government -- 23 U. S. Government has the right to move this software 24 anywhere it wants to -- the licensed software, it has 25 the right to make backup copies of that software, as 26 well. And so that removes sort of the value of that 27 software from just putting -- merely putting it on the 28 computer. It has the -- the -- the license of that 81 1 right, the right to make copies of it, to do all that, 2 is where the value is. 3 MR. TUCKER: My understanding is also that 4 they have -- their license is for those disks, 5 themselves. 6 MS. MANDEL: Who's "they"? I'm sorry. 7 MR. TUCKER: Okay, the government has the 8 license for the disks, themselves. And so in essence 9 they have the license for the disks and they have the 10 lease of the computer. And it is -- I mean, in that 11 regard they are treated very similarly to component 12 parts. 13 MS. MANDEL: You know what, I'm going to 14 ask -- 15 MR. TUCKER: It's an old -- 16 MR. HALVERSON: That's not in the facts -- 17 pardon me, that's not in the facts, though. We've given 18 them nothing like that. 19 ACS leases the computer with our software -- 20 MS. YEE: Mr. Halverson, speak into the -- the 21 microphone, please. 22 MS. MANDEL: Yeah, the instant -- 23 MR. HALVERSON: We're leasing -- ACS is the 24 one -- or Lockheed, is leasing that equipment to NASA. 25 So the software package is being bought by Lockheed and 26 ACS. Now, I grant you, under this contract which is 27 huge and thick Lockheed and ACS can be fired by the 28 Federal government like that. They can name someone 82 1 new, come in, take over the position that Lockheed/ACS 2 is in and then force ACS/Lockheed to sell all their 3 equipment to someone else and they're going to stand in 4 their shoes. 5 The Federal government has the upper hand in 6 this contract, no argument there. But you're correct, 7 in the Jugum annotation he said the whole system was 8 substantially changed in form. The computer and the 9 diskette. Just as a result of the diskette being 10 changed. And that's very important. And it had not 11 changed a bit here. The -- the only thing that's 12 changed is if we downloaded it on a hardware -- we 13 downloaded it onto a hard drive now as opposed to just 14 inserting it every time we use it. 15 MR. LEVINE: You want my comments on the 16 annotation? 17 MS. MANDEL: I know you have some. 18 MR. LEVINE: This is a classic type of 19 annotation that whenever the Appeals Division encounters 20 it we recommend deletion. Whether Mr. Jugum had been 21 the Assistant Chief Counsel at the time or not, he 22 wasn't, he signed as Tax Counsel -- there's no analysis. 23 There's no discussion. And it's -- it's confusing, it 24 doesn't make sense. 25 He's focused on storage media and then he 26 flips over to the computer. The annotation, which is 27 what's officially our Sales Tax counsel rulings exempt 28 from the regulatory requirements is in the green book. 83 1 2 MS. MANDEL: Huh-uh. 3 MR. LEVINE: The backups are to help us 4 understand. So we do go to the backups but it doesn't 5 create a rule at the level of an annotation that's not 6 in the annotation. And it doesn't have that word 7 "hard" -- "hardware system." I don't know why it was 8 left out of the annotation, whether it was intentionally 9 left out because it makes no sense or because it was 10 just left out. But the whole point is Mr. Halverson is 11 relying on one word in the letter that's missing from 12 the annotation. And once you get that one word it 13 doesn't make sense. 14 MS. MANDEL: Okay, but I -- I mean, I -- I 15 don't have it in front of me so I don't remember it 16 exactly and how it's phrased in the annotation in the 17 actual book. But I -- and when I see "system" I think 18 of his argument -- the taxpayer's argument that it's 19 the -- the whole thing is one big thing and so all of my 20 pieces. 21 But when I looked at the letter I focused on 22 the storage Media, which as Mr. Schutz says is just like 23 when the blank tapes -- what we do with blank C.D.s or 24 whatever that gets software put on it. And I thought 25 that was the real comparison to -- if you're just 26 looking at the computers, themselves. 27 MR. LEVINE: Okay. For -- for one thing, on 28 the computers we're talking about here, particularly 84 1 ones that only had one hard drive, we're talking about a 2 hard drive that's not blank, that's getting the 3 software. But in this one we were talking an off the -- 4 I understand an off-the-shelf computer back in 1981 5 where they were not such components. And it was being 6 sold, I believe -- again, not enough information in the 7 backup -- it was sold as a proprietary dictation and 8 transcription system. 9 So as far as the customer was concerned, and I 10 don't know about you but in 1981 I didn't understand 11 computers. So if I was buying this I would have 12 regarded this as a proprietary transcription system 13 supported by computer magic and would not have thought 14 of it as an off-the-shelf system. 15 But here we are talking about off-the-shelf 16 systems with software. 17 MS. MANDEL: Okay, I understand the soft -- 18 let me -- let me -- forget about the Jugum letter then. 19 There's apparently all these annotations that talk about 20 a diskette, a blank diskette that you load software on. 21 The diskette now is substantially changed in form. 22 Right? Is that what you said, Mr. Schutz? 23 MR. SCHUTZ: Right. If you had a blank C.D. 24 and you -- 25 MS. MANDEL: Okay. 26 MR. SCHUTZ: -- loaded a piece of software. 27 MS. MANDEL: Okay. So I have a blank C.D., 28 uploaded them -- boom, boom, boom a substantial change 85 1 in form. I have a C.D. with one program on it, then I 2 load 16 others on it and then I sell that. That's what 3 he's talking And now is that second one just because it 4 wasn't blank and it had one thing on it and now it has 5 16 things on it, is there a substantial change in form? 6 If the answer to that's yes -- I mean that's what he's 7 saying. He's saying he has a computer but I thought 8 there was some other explanation about why loading 9 software onto the computer, no matter, you know, how 10 much software you put on it, wasn't -- 11 MR. SCHUTZ: It doesn't change its 12 characteristics as a personal computer no matter how 13 much software -- I mean of software applications you add 14 onto the personal computer. 15 MS. MANDEL: Well, that's -- 16 MR. HALVERSON: No annotation says that. 17 MR. SCHUTZ: But if we look at -- like our 18 Regulation 1502, if -- if it was a case where you added 19 a bunch of software onto a computer and that 20 substantially changed that -- that computer, then we 21 would consider like load and leave or just intangible 22 downloads as being fabrication labor and -- 23 MS. MANDEL: Okay, that's the answer. 24 MR. GURFINKEL: Absolutely. Absolutely. 25 MS. MANDEL: Okay. That would turn -- that 26 would turn all those things that are -- you're saying 27 that would turn all those things that -- that have long 28 been considered exempt -- 86 1 MR. SCHUTZ: That's correct. 2 MS. MANDEL: -- as not being fabrication labor 3 that would turn all those things into being taxable? 4 MR. SCHUTZ: Right. When a -- for a personal 5 computer, yes. 6 MS. YEE: Okay. 7 MR. HORTON: Question, Madam Chair. 8 MS. YEE: Mr. Horton, yes. 9 MR. HORTON: Question of the taxpayer. 10 This question sort of relate to the contract between you 11 and the government. Are there any -- I'm presuming this 12 is a government purchase order, government contract. 13 Are there any provisions in the contract that deals with 14 title? 15 MR. HALVERSON: Which deals with time? 16 MR. HORTON: Title. 17 MR. HALVERSON: Title. The -- 18 MR. HORTON: When does title pass to the U. S. 19 Government? 20 MR. HALVERSON: Yeah, that's very confusing. 21 There's a specific sentence in here that says that title 22 will not pass to the government. And yet when the -- 23 and then that's why we get involved in calling this a 24 conditional sales agreement with Appeals and finally 25 dropped it as too confusing to explain. 26 The title -- they specifically have one line 27 that says that. But as I told you, they could replace 28 us at any moment they want. If they don't feel we're 87 1 doing satisfying they can flip us out, have the new 2 contractor pay us for their equipment and we go away. 3 But at the end of every three-year period, 4 interestingly, we're forced to give the -- all the 5 equipment to charity, the charity the government picks. 6 So who actually own any of the equipment? 7 Under the rules at this time it was written, 8 okay, it -- Mr. Horton, you know that CSA rule, if it's 9 a mandatory put or purchase option of less than a 10 hundred bucks it's a -- it's -- it's a CSA and can't be 11 a true lease. 12 All right? This one doesn't have anything 13 that it -- that simple. Instead this one's got a ton of 14 stuff in it that says, well, it could be this and it 15 could be that. And it says in effect that at the end of 16 the lease you're going to donate this to charity and I, 17 the government, NASA, is going to tell you who to donate 18 to. 19 So we never actually -- we actually don't ever 20 get it back. Because in essence government tells us to 21 get rid of it. In essence if they want to replace us, 22 they replace us and they force the new buyer -- the new 23 contractor to buy us out. So we're out. 24 The -- the equipment doesn't move. We don't 25 ever get the equipment, we can't walk off with the 26 equipment, can't take it any way, shape or form. 27 So, it -- in a lot of ways it smells like a 28 CSA. Now, depreciation; at the time this contract was 88 1 written the depreciation was taken by ACS. A couple 2 years later, in 2004, as I recall, and don't quote me 3 because I'm not positive -- but 2005, the GAAP rules 4 changed and all of a sudden the government said, "You're 5 no longer able to depreciate it. It's our equipment, we 6 depreciate it." The contract still provided you own the 7 equipment. 8 MR. HORTON: No, I appreciate that. I'm -- 9 MR. HALVERSON: So it -- 10 MR. HORTON: I'm specifically trying to -- I 11 mean without the Federal Acquisition Regulations and the 12 Defense Acquisition within the contract, the DAR and FAR 13 clauses, any of that here that the government says we 14 take title to this? 15 MR. HALVERSON: No, all of it's there but it 16 says that, no, you, lessor, have to keep it; it's not 17 ours. In a one-liner, it says -- it says ACS or 18 Lockheed, you are the owner of the equipment. Even 19 though in every other way NASA now treats it as their 20 own. 21 MS. MANDEL: Well -- 22 MR. HORTON: So they're not taking possession 23 of the equipment upon acquisition by you? 24 MS. MANDEL: He's asking -- 25 MR. HALVERSON: No, not -- they don't step 26 in -- in front. That's correct. 27 MS. MANDEL: From a title -- 28 MR. HALVERSON: That's correct. 89 1 MS. MANDEL: -- perspective for all those -- 2 MR. HALVERSON: That's correct. 3 MS. MANDEL: -- government contracting title 4 rules. 5 MR. HALVERSON: That's correct. 6 MR. HORTON: All right. I tried. 7 MS. YEE: Okay. Thank you, Mr. Horton. 8 Other questions, Members? 9 All right, hearing none may I have a motion, 10 please? 11 MS. MANDEL: Take the matter under submission. 12 MS. YEE: Motion by Ms. Mandel to take the 13 matter under submission. 14 Is there a second? 15 MR. HORTON: Second. 16 MS. YEE: Second by Mr. Horton. Without 17 objection such will be the order. 18 Thank you very much, gentlemen. We will 19 discuss your matter later today and send you written 20 notice of our decision. 21 Thank you. 22 ---oOo--- 23 24 25 26 27 28 90 1 REPORTER'SCERTIFICATE 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 15, 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 90 13 pages constitute a complete and accurate transcription 14 of the shorthand writing. 15 16 Dated: February 2, 2011. 17 18 19 ____________________________ 20 BEVERLY D. TOMS 21 Hearing Reporter 22 23 24 25 26 27 28 91