1 BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 2 450 N STREET 3 SACRAMENTO, CALIFORNIA 4 5 6 7 8 REPORTER'S TRANSCRIPT 9 JANUARY 26, 2011 10 11 SALES AND USE TAX APPEAL HEARING 12 APPEAL OF 13 C3a SMOKE RINGS, INC. 14 NO. 391126 (AR) 15 C3b RAMI MICHELL DARGHALLI 16 NO. 402639 (AR) 17 C3c RAMI MICHELL DARGHALLI AND 18 FAIZ MOHAMED MUNASSAR 19 NO. 404172 (AR) 20 AGAINST PROPOSED ASSESSMENT OF 21 SALES AND USE TAX 22 23 24 25 26 27 Reported by: Juli Price Jackson 28 CSR No. 5214 1 1 P R E S E N T 2 For the Board Jerome E. Horton of Equalization: Chairman 3 4 Michelle Steel Vice-Chairwoman 5 6 Betty T. Yee Member 7 8 George Runner Member 9 10 Marcy Jo Mandel Appearing for John 11 Chiang, State Controller (per Government Code 12 Section 7.9) 13 14 Diane G. Olson, Chief 15 Board Proceedings Division 16 17 For Board of David Levine Equalization Staff: Staff Counsel 18 19 For Department: Scott Lambert Hearing Representative 20 Robert Tucker 21 Tax Counsel Legal Department 22 23 Kevin Hanks Chief, Headquarters 24 Operations Division 25 For Petitioner: Patrick Finnegan 26 Representative 27 Rami Michell Darghalli Taxpayer 28 ---oOo--- 2 1 450 N STREET 2 SACRAMENTO, CALIFORNIA 3 JANUARY 26, 2011 4 ---oOo--- 5 MR. HORTON: Ms. Olson, what's the next 6 scheduled matter? 7 MS. OLSON: Our next matter is C3a, Smoke 8 Rings, Incorporated, C3b, Rami Michell Darghalli, C3c, 9 Rami Michell Darghalli and Faiz Mohamed Munassar. 10 MR. HORTON: Thank you very much. 11 Mr. Levine, please introduce the matter. 12 MR. LEVINE: The issue in these petitions are 13 whether adjustments are warranted to the measure of tax 14 due under each petition. 15 MR. HORTON: Thank you very much. 16 To the taxpayer, you have ten minutes to make 17 your presentation. Before then, please introduce 18 yourself for the record. 19 MR. FINNEGAN: Patrick Finnegan, CPA. 20 MR. DARGHALLI: My name is Rami Darghalli, 21 represented by Patrick Finnegan. 22 MR. HORTON: Thank you very much. Please 23 present. 24 MR. FINNEGAN: It's nice to be back here at the 25 Board of Equalization. I've presented documentation 26 where I want to show the Board of Equalization Members 27 some of the real concerns that we have with this audit 28 conducted on Mr. Darghalli's businesses. 3 1 I've laid it out in specific exhibits and I'd 2 like to go through those with you. First exhibit, 3 Exhibit A, identifies the fact that Mr. Darghalli is a 4 very successful businessperson located in the Lancaster 5 area. He currently has 15 businesses selling cigarettes 6 and tobacco. Mr. Darghalli -- the issues facing here is 7 in the 2002-2003 period, Philip Morris was presenting to 8 businesses what was known as a cigarette buy back 9 program, where he was given up to six, almost $7, at 10 times, for each carton of cigarettes that he sold. 11 The Board of Equalization conducted an audit on 12 his business. What they did is they took the amounts of 13 cigarette cartons that were identified by Philip Morris 14 as distributed to Mr. Darghalli and based the tax based 15 on the cost. And I will go through the documents and we 16 can follow together. 17 As I mentioned, the Board of Equalization staff 18 had serious discussions concerning this audit. So much 19 so, that on June 23rd, 2009, which is shown in 20 Schedule B, we have the supervisor of the Petition 21 Section, Mr. Phil Spielman, on pages 1 and pages 2, 22 having the discussion, 23 "Please explain why purchases were not obtained 24 from or verified with Coremark 25 Industries." 26 Coremark supplied Mr. Darghalli approximately 27 95 percent of his cigarettes is where he purchased the 28 products from. On page 2 of Schedule B, again, 4 1 "Please explain why purchases were not obtained 2 from or verified with Coremark. Were 2004 3 Coremark purchases requested?" 4 And then again, 5 "Was Coremark contacted to verify recorded 6 purchases?" 7 In each of these three audits, Mr. Spielman of 8 the Petition Section was asking the simple question, did 9 the auditor go through the major vendor of 10 Mr. Darghalli, schedule the purchases and identify what 11 he was distributing? 12 The auditor responds in schedule -- or 13 Exhibit C. Let me read to you what he states on the 14 working papers. 15 "Given the weekly purchasing cycles, auditor 16 accepted the recorded Coremark purchases and 17 was of the opinion that vendor verification was 18 not warranted." 19 Again he states that Coremark purchases were 20 accepted as recorded. Yet the next paragraph, he goes 21 on to state, 22 "The projection of cigarette purchases was 23 based on the percentage of purchases from 24 Philip Morris brand to other brands of 25 cigarettes." 26 Therefore, he takes a percentage of error on 27 Philip Morris and applies it to Winston, to Camel and to 28 all other Philip Morris products. Yet in the paragraph 5 1 before he states that he accepted the recorded Coremark 2 purchases -- a complete contradiction of that comment. 3 Then the final statement is, 4 "The difference between the audited cost of 5 Philip Morris's audit was judged to be 6 purchases from other retailers of cigarettes, 7 such as Costco, Sam's Club and others." 8 When I went through the audit working papers, 9 nowhere did the auditor contact Sam's Club, Costco, or 10 any of the numerous distributors located within his area 11 of that Lancaster -- or, for that matter, anywhere in 12 the greater Los Angeles area. 13 I have Schedule D, Exhibit D, is the real 14 problem that I'm noticing, where we believe we have real 15 ethical problems on the audit conducted on 16 Mr. Darghalli's businesses. And I will go through that 17 for you. 18 On Schedule D, page 1, I've identified $391,000 19 as the '04 liability of additional taxable sales 20 computed by the auditor. The auditor comes upon this by 21 making an estimation of cigarette purchases as shown in 22 Schedule D, where he's carrying forward 611,000 of cost 23 to the forward schedules where he applies the markup. 24 Schedule D3 is very critical. I have in front 25 of me -- and shown to you -- the audited costs of sales 26 for Philip Morris. The auditor computed 308,000 and 27 $350,000. The line below he says, 28 "Percentage of Philip Morris sales to total 6 1 tobacco." 2 The auditor got this percentage by looking at 3 Coremark invoices. He does the segregation based on a 4 review of Coremark invoices, yet the auditor never 5 scheduled the total Coremark purchases. He had them in 6 front of him the whole time, yet the most basic of audit 7 approaches, taught in TL 1, you schedule the lead vendor 8 of all these businesses. He failed to do so. 9 Let me carry it down even further, in that, 10 when I take a look at audited cost of cigarettes, 11 subtract it by the Philip Morris, we come to computed 12 cost of non Philip Morris cigarettes. The auditor is 13 showing $243,000 of non Philip Morris in 2002, 276,000 14 in 2003, a total of almost $520,000 of non Philip Morris 15 purchases. 16 Where did he get this? I'd have no idea on how 17 he was able to do that other than a simple projection 18 when, in fact, he had the Coremark invoices in front of 19 him. He could have used recorded sales. 20 In fact, he even states that he accepted 21 recorded sales. So, obviously, that's incorrect. 22 D3, he's showing 133 percent of error on the 23 overall 2002 and 2003. It's an average of the error 24 ratio for those periods. 25 Let me carry that forward. And I'll show you 26 D5. The 2004 period is when these buy back ended from 27 Philip Morris. The gravy train ended. The $6 per 28 carton ended. 7 1 And what you will see in Schedule D7 is that 2 for 2002 we have over 10,000 cartons, 10,944; 2003, 3 12,147. Look at 2004, it drops off the shelf, you've 4 got 2155 cartons that the -- that Mr. Darghalli 5 purchased of Philip Morris products. I carry that 6 forward to 2000 -- to D5 and show that 2155. 7 D6, I do the number of -- that 2155, I do the 8 calculation the same way the auditor did it on the 9 previous schedules. And what I come up with is $172,000 10 of credit, of sales. Mr. Darghalli purchased 11 substantial amounts of cigarettes for distribution to 12 his 15 businesses in the 2003 period. 13 But what does the auditor do? He has the 2155 14 cartons of cigarettes. He take that into account 15 nowhere on the audit working papers. Instead, he takes 16 an average, comes up with $611,000 and says that that's 17 what Mr. Darghalli owes for that beginning period of 18 2004. 19 I have included Exhibit E -- and this is really 20 telling. When the same auditor looked at the last half 21 of '04, the percentage -- and this is a subsequent 22 business -- same location, everything's the same -- he 23 comes up with the 6 percent error ratio. What changed 24 from '04, first half to the second half? 25 Why doesn't the auditor use the same 26 methodology throughout the entire audit, other than the 27 fact that it's to the disadvantage of Mr. Darghalli? 28 Completely crazy audit methodology, not consistent from 8 1 one period to the next. 2 If he's going to do an extension of cost of 3 sales, you've got to take the amounts, you can't pick 4 and choose what you are going to use. 5 The second area that we really have a concern 6 about is in the audit the Department picked up 7 additional O. T. P. purchases from a company called 8 House of Oxford based out of New York. The 9 distributions to one of Mr. Darghalli's business 10 partners occurred in 2002, 3 and 4. The Board of 11 Equalization comes up with $863,000 of sales of other 12 tobacco products from House of Oxford. And I show that 13 in Exhibit I. 14 MS. OLSON: Time has expired. 15 MR. HORTON: Thank you very much. 16 Is there a way you can just wrap it up? 17 MR. FINNEGAN: Absolutely -- 18 MR. HORTON: Okay. 19 MR. FINNEGAN: -- Mr. Chairman. 20 They come up with 868,000. The Board auditors 21 never even contacted the House of Oxford. I wrote a 22 letter and one week later I received an entire 23 documentation from House of Oxford identifying what the 24 actual purchases are. 25 What this audit shows is the taxpayer -- or the 26 auditors aren't doing just a simple job of verifying 27 through letters to the major vendors and, as such, they 28 blue sky these billings that have no basis for fact. 9 1 MR. HORTON: Thank you. 2 Will the Department introduce themselves and 3 present, please? 4 MR. LAMBERT: Good afternoon, Chairman Horton. 5 My name is Scott Lambert and I'll be representing the 6 Department today. 7 To my right is Robert Tucker, with the Legal 8 Department, and to his right is Kevin Hanks, with the 9 Sales and Use Tax Department. 10 In this particular three audits, in the first 11 two audits, which were the corporate -- excuse me, the 12 partnership and the sole proprietor, the rebates from 13 Philip Morris were used to establish the audit 14 determination. 15 In other words, we were able to get the number 16 of cartons that Philip Morris gave buy backs for. And, 17 based on that, we were able to establish what the Philip 18 Morris purchases were. 19 And one of the reasons why we did this is 20 because in the records -- the taxpayer's records 21 indicated that there was a negative markup, which means 22 that the cost of the product is higher than the sales 23 that they reported. That typically doesn't happen. 24 So, anyway, in terms of the information that 25 was presented by the Petitioner, it was an argument of 26 the taxpayers during the audit that they purchased for 27 one account, they were delivering it to numerous other 28 locations that Mr. Darghalli owned. 10 1 We went out and took a look at two of those 2 locations and found, in fact, that the markup for those 3 locations were either understated or negative or very 4 low. There was no indication that any of the purchases 5 had been allocated from Mr. Darghalli's business to the 6 other location. 7 So, in other words, when you take a look at the 8 buy backs that were given by Philip Morris, the 9 purchases of Philip Morris products would have been 10 included in those records. So, there's no question that 11 they were not recorded in the books and records. 12 And one of the reasons that we feel that there 13 were other purchases is that there had been a number of 14 inspections that have been performed on Mr. Darghalli's 15 businesses, I believe 15, during that time, somewhere in 16 the neighborhood of 10 -- there were 10 either purchases 17 of counterfeit stamped cigarettes or -- or a seizure of 18 those cigarettes. 19 Also during that time period there were ten 20 citations -- ten or eleven citations that were given for 21 failure to maintain adequate records. 22 So, in other words, they were instructed early 23 on that they were required to maintain purchase invoices 24 and, in fact, they didn't. 25 The information that we have is that when you 26 purchase counterfeit stamped cigarettes, you're 27 generally doing it with cash. And you're generally 28 doing it from people that don't issue you purchase 11 1 invoices. 2 So, if you were purchasing from an established 3 business, like Coremark, Sam's Club, McClain, Costco -- 4 any of those, they're not going to sell you counterfeit 5 stamped cigarettes. 6 And also they had purchases of other tobacco 7 products, which they could not provide invoices for, 8 which, although we can't tell on the O. T. P. where it 9 came from, because there is no stamp on the product 10 itself, when you don't have an invoice, we can tell that 11 you did not purchase it from a licensed distributor. 12 In this particular case, House of Oxford is not 13 a licensed distributor tore in the State of California. 14 So, anyway, just to go through some of the 15 examples. Some -- on the Petitioner's Exhibit B, it is 16 written, 17 "Please explain why purchases were not obtained 18 from or verified with Coremark." 19 And the comment that is provided, Exhibit C, 20 the statement made by the auditor in this case is 21 inaccurate. I have a contract history from the auditor. 22 And a comment was made February 6th, 2006, which the 23 information has been provided to Petitioner, it says, 24 "Called Coremark to request purchase 25 information. I was informed that they did not 26 have records for 2002 and 2003." 27 So, in that particular case, the statements 28 that are written down here are accurate for the 12 1 corporation. They're not accurate for the partnership 2 or the sole proprietorship. 3 And that -- and that -- and that's one of the 4 reasons when the Petitioner does mention that in the 5 corporation, why didn't they use -- why didn't the 6 auditor use the same method? The reason he didn't use 7 the same method is because he did not have the buy back 8 information from Philip Morris. 9 Does it make sense that the purchases would 10 drop that much from one period, when you are a 11 partnership to become a corporation? It doesn't seem 12 like a change in ownership would make any difference. 13 In regards to the O. T. P. purchases, we -- the 14 Investigations Division did obtain information from the 15 House of Oxford, not directly from them, they filed 16 returns from -- to the State of New York. And the State 17 of New York is the one that provided us with the 18 information, the House of Oxford information. 19 We obtained the common carrier deliveries 20 through a subpoena. And the two didn't match up. We 21 had more -- we had more deliveries than we had 22 purchases, which didn't make sense and, so, therefore, 23 the Department estimated those particular deliveries. 24 Just to go back to the citations that were 25 issued, the taxpayer was found with counterfeit stamps, 26 counterfeit cigarettes themselves, which are cigarettes 27 not even manufactured by the particular brand name, 28 M. S. -- M. S. A. violations, which is a Master 13 1 Settlement Agreement, they're not allowed to have 2 certain cigarettes in the State of California if they 3 haven't agreed to the Master Settlement Agreement, which 4 means that you're not purchasing those cigarettes from a 5 licensed distributor. 6 He was also found with export only cigarettes, 7 which means cigarettes that had been shipped outside the 8 country and they've been brought back in. 9 There were complaints by competitors, 10 manufacturers, former employees, customers, confidential 11 informants and anonymous individuals. So, this was an 12 ongoing situation that we have documented from 2001 all 13 the way up to when this last Board hearing was scheduled 14 in 2009. 15 The Petitioner was cited in July of 2009 for 16 not possessing the proper documentation. 17 And with that, I will be available for 18 questions. 19 MR. HORTON: Thank you very much. 20 You have five minutes on rebuttal. 21 MR. FINNEGAN: Yeah, thank you. 22 Let me explain how you'd receive a negative 23 markup on business that has buy backs. The way buy 24 backs work is your cost is going to be around $30 a 25 carton. 26 Maybe Rami can pitch in here? 27 MR. DARGHALLI: It's about $30 dollars per 28 carton. 14 1 MR. FINNEGAN: All right. What the Depart -- 2 what Philip Morris was doing is then -- you buy the $30 3 and then, at a later time, they'd come in with the $6 4 buy back. 5 So, let's say you moved a thousand cartons 6 during the month, they'd give you a $6,000 check. Your 7 -- the requirement, though, on that buy back is that you 8 lower your sale price. In fact, I believe it's in 9 Publication 31 of the Board of Equalization for Grocers 10 that says that if there is a requirement to lower the 11 price of it, then that portion of the buy backs become a 12 taxable charge. 13 In fact, in the audit you will see the taxable 14 charge being picked up for these buy backs. We don't 15 dispute that issue. 16 But what you're going to see is the sales 17 coming in at $24. And the cost is going to be 30. 18 In fact, Mr. Darghalli can state this -- what 19 he was selling the carton of Marlboros for. 20 MR. DARGHALLI: We were selling 24.99. I mean 21 we were looking at an unbelievable low margin. 22 MR. FINNEGAN: So, he's selling them -- he's 23 purchasing them for 30, he's selling them for 24.99. 24 You're going to see a fairly substantial negative markup 25 that the Board will look at and say, "Hey, we got 26 problems here," when, in fact, that's just the nature of 27 the buy back. 28 We also see during the audit working papers 15 1 that the auditor used a 2006 cost of sales information 2 to determine what the markup factor. Well, when you're 3 a $6 buy back, what you needed to do was go into 4 2002-2003 and do the -- do the markup factor. 5 The other thing that's kind of funny, not 6 funny, ha-ha, but kind of concerning, the auditor writes 7 in June of '06 that Coremark doesn't invoices available 8 or documentation for 2002-2003. 9 This is Coremark. They're a major corporation. 10 You're telling me they don't have records going back 11 three years? That is very disturbing. 12 And then the auditor makes his comment -- the 13 audit working papers are in September '09 where he 14 states that he accepted Coremark purchases and felt that 15 there was no -- verification was not warranted. 16 You know, that's kind of a real change of tune 17 from the three year period. What we're going to ask the 18 Board to do is to -- we'd like -- we are presenting 19 enough evidence that what we feel is there should be 20 great concern, skepticism would be a better word, that 21 the auditor felt that he was going down a path and got 22 down that path and stayed down that path for too long 23 instead of just doing is audit techniques, checking with 24 the vendors, writing letters out to see if there is any 25 other purchases. I mean simple things. 26 That wasn't done. They looked at this real 27 obscure methodology and they stopped with it. 28 Now as far as Mr. Darghalli receiving 16 1 counterfeit stamps and so forth, we're not hearing a 2 quantity. You know, they say that it's happened. 3 Mr. Darghalli owns 15 businesses. There is 4 people all the time coming through selling. He looks at 5 his stamp. He does his best to confirm that they're 6 accurate. 7 I mean, he's been in business since what, 1996? 8 MR. DARGHALLI: 1995. 9 MR. FINNEGAN: Go ahead respond to some of 10 those allegations, sir. 11 MR. DARGHALLI: As far as the issue of the 12 California tax stamp, about 2003 the State Board, I 13 think they made up some machines to verify that stamps 14 are counterfeit or they're not counterfeit. 15 Most of our cigarette was coming from Coremark, 16 from Costco or from Sam's Club. And there is no way for 17 us to determine if the cigarettes really counterfeit or 18 not counterfeit. 19 All the cigarette had tax stamps on it. 20 MR. FINNEGAN: Again -- and as far as the House 21 of Oxford documentation, the Board has the ability to 22 contact the vendor or, at the minimum, they go to the -- 23 to Mr. Darghalli and say, "Please supply us with 24 records." 25 The methodology the Board used is crazy is they 26 took the distributions, the UPS shipments and they come 27 up with a projected cost on each of those shipments. 28 They might have eight shipments on one day. 17 1 Nobody is there to sign for it or there might be 2 multiple boxes. And they called those eight separate 3 shipments. Each box, remember, has a separate UPS 4 number. 5 I went line by line from those UPS and I can 6 account for 98 percent of those shipments. And what I 7 didn't account for, I included as a C. O. D. But, all 8 the Board had to do was add a couple of those accounts 9 together and they would come up with the number shown on 10 the C. O. D. 11 I had $161,00 from this House of Oxford 12 documentation. After I added just $10,000 of C O. D. 13 deliveries, I came up with 171. I am very confident 14 that number will stand. 15 MS. OLSON: Time has expired. 16 MR. FINNEGAN: It's certainly is nowhere close 17 to the 868,000 in sales that the Board is estimating. 18 MR. HORTON: Thank you very much. 19 Questions or discussion, Members? 20 MS. STEEL: Yes? 21 MR. HORTON: Member Yee -- Member Steel, then 22 Member Yee. 23 My apologies. 24 MS. YEE: I will go after Ms. Steel. 25 MS. STEEL: For the taxpayers that you said 26 most of cigarettes that you buy from Costco or Sam's 27 Club and them -- 28 MR. FINNEGAN: Coremark. 18 1 MS. STEEL: -- okay. So, when you get caught, 2 seems like I am going to ask about 11 citations -- when 3 you get the citations, you must have invoices? 4 MR. DARGHALLI: Yes. 5 MS. STEEL: So, you -- 6 MR. DARGHALLI: We do have invoices. 7 MS. STEEL: -- fought that? 8 Fought for those citations, for 11 of them? 9 MR. DARGHALLI: I'd like to know what 11 10 citations because I'm, you know -- I'm -- 11 MS. STEEL: You don't know? 12 Mr. Lambert, give me a little more information 13 about those citations. I thought when they get caught 14 for two times -- so, is it all different stores you 15 talking about, adding all together -- 16 MR. LAMBERT: That's -- 17 MS. STEEL: -- 11? 18 MR. LAMBERT: Yes. 19 MS. STEEL: Okay. So, when -- out of those 11 20 citations, this taxpayer said that he bought most of 21 merchandise from the well-recognized distributors, that 22 anything's been dropped because he provided all the 23 invoices and other stuffs. 24 Because they cannot really sell non stamped 25 cigarettes, right? 26 MR. LAMBERT: They're not permitized. 27 MS. STEEL: Right. 28 MR. LAMBERT: That's correct. 19 1 MS. STEEL: So, 11 citations, give me little 2 more information about 11 citations out of how many 3 stores? 4 He says he owns 15. 5 MR. LAMBERT: Okay. I have the dates and 6 they -- they were a combination of buys and seizures and 7 citations. 8 So, before 2005 there weren't any citations. 9 MS. STEEL: Why? 10 MR. LAMBERT: And that's because AB 71 had not 11 passed yet. 12 So, at that particular time, there wasn't much 13 you could do against the retailer. In other words, you 14 could confiscate it from them, but, really, what the 15 Excise Department and Investigations were trying to do 16 would be to track down the person that was putting the 17 stamps on there. Those were the people that we were 18 after to get the 87 cents for each one of them. 19 MS. STEEL: So, it was mostly before 2005 you 20 are talking about? 21 MR. LAMBERT: No, that's not correct. 22 It -- well, I can read you the dates for 23 location No. 1, Smoke 4 Less, they were -- had seizures 24 on April 15, '05, June 19th of '06, April 21 of '09. 25 When they did have the second seizure, they 26 were -- their license was suspended. 27 MS. STEEL: So, they can not sell any more? 28 MR. LAMBERT: They were not supposed to. 20 1 MS. STEEL: But they did? 2 MR. LAMBERT: They did, yeah. 3 But -- they did. And, so, when you say that 4 you purchased from Costco, Coremark and Sam's Club -- 5 and although I'm not representing the Investigations 6 Division, it's my understanding that they have never 7 found any of those to sell counterfeit stamped 8 cigarettes except in one occasion they found a Costco 9 that had counterfeit stamped cigarettes. And the 10 problem was they were selling cigarettes to people and 11 they were returning them. And they would return the 12 counterfeit stamped. 13 So, now Costco does not allow people to return 14 the cigarettes back just for that reason. 15 MS. STEEL: But can we match with the 16 merchandise with invoices? 17 MR. LAMBERT: Yeah. 18 MS. STEEL: Especially -- 19 MR. LAMBERT: Well, when you take a look -- you 20 can't quite do that. You -- although you can match up 21 the item to an invoice, when it's a counterfeit stamped 22 cigarette, you can match it up to an invoice, but that 23 wasn't the invoice that they purchased it with. 24 That -- 25 MS. STEEL: That was Sam's Club and the Costco 26 are same? 27 MR. LAMBERT: That has been -- well, that's 28 what they're saying. And that's what's been proven by 21 1 us going out and doing inspections at those type of 2 establishments. 3 And we have never found -- like -- again, I am 4 not from Investigations, I'm not member representing 5 them, but I am aware of some information. And mine is 6 we've never found counterfeit stamped cigarettes other 7 than the time that I'm -- 8 MR. FINNEGAN: Well, first off, the dates he's 9 talking about are outside of our statute. So, he -- 10 he's coming up with the discussion that we were 11 suspecting that the taxpayer was dealing with all these 12 counterfeits and doing this. He's talking about 2009. 13 The audit was taking place in 2006. Where is the -- 14 where is the nexus? Where is the -- where is the 15 connection? 16 The other thing that I have to -- I worked for 17 the Board of Equalization for 20 years as an Excise Tax 18 Auditor. What -- a big portion of the -- when we were 19 doing a cigarette audits, what we would find is there 20 was often cases where we do these major, major cigarette 21 companies, let's say, Costco, for anything, they're 22 stamping cigarettes. 23 And then we do a reconciliation of their stamps 24 to their cigarettes. And if we have more cigarettes 25 than they purchased stamps for, we'd issue 26 determinationIs. Generally the reasons for doing that 27 were there were stamping errors. 28 I mean, we'd have some fairly large 22 1 liabilities. Cigarettes go out without stamps. That 2 occurs. Whether on Costco, it was -- I don't believe it 3 was actually their intent, but it does happen. It 4 happens for them, it happens for Coremark. 5 Down the line we show liabilities on these 6 major cigarette distributors. But what I will contest 7 is -- yes? 8 MR. HORTON: I'm just going to interrupt you 9 just for one minute. 10 Deviating just a little bit from the 11 question -- 12 MR. FINNEGAN: Yeah. 13 MR. HORTON: -- but this is entirely up to 14 Ms. Steel, if she wants to have the additional response? 15 Ms. Steel? 16 MS. STEEL: I'm done, thank you. 17 Actually, I heard enough from both sides, so -- 18 MR. HORTON: All right, thank you very much for 19 your presentation. 20 Any other questions or concerns? 21 Member Yee? 22 MS. YEE: Just a question for the Department, 23 if you could maybe just walk through for us? 24 There were -- there was a re-audit done in 25 which there were subsequent adjustments. And, like I 26 said, I was curious as to how those adjustments were 27 made absent any, I guess, substantiation or -- 28 MR. LAMBERT: The last time this was scheduled 23 1 for a Board hearing, their -- the Department went 2 through the audits and discovered that there were 3 O. T. P. purchases from the House of Oxford that the 4 auditor was unaware of. And, therefore they were 5 directed to enter that information into the audit and -- 6 which they did that. 7 There were also some other errors that were 8 noted. 9 MS. STEEL: What's O. T. P.? 10 MR. LAMBERT: Oh, I'm sorry, it's called -- 11 it's a slang. 12 MS. STEEL: I still don't know those. 13 MR. LAMBERT: It's other tobacco products. 14 MS. STEEL: Oh, okay, thank you. 15 MR. LAMBERT: And, so, it's like your cigars -- 16 MS. STEEL: Right. 17 MR. LAMBERT: -- chew. 18 MS. STEEL: Got it. 19 MR. LAMBERT: Yeah. 20 MS. STEEL: Okay. 21 MR. LAMBERT: Things of that -- and I apologize 22 for that. 23 MS. STEEL: Still learning. 24 MR. LAMBERT: Oh, yeah. 25 The Department also noticed that there were 26 other errors in there. There was some self consumption 27 that needed to be made that wasn't made that the 28 Department hadn't been directed to do and took off $100 24 1 a month instead of $100 a month a location. That was 2 adjusted. 3 The -- an adjustment was made for inflation for 4 cigarettes. And, again, this was to the taxpayer's 5 favor, to lower the price. 6 And then also, one of the audits used an 7 estimate for a markup on other tobacco products and they 8 were directed to lower that particular markup. 9 So, when you take a look at one of the audits, 10 even though the purchase from House of Oxford were 11 found, the liability actually went down because of some 12 of the adjustments that we made -- the Department made. 13 MS. YEE: Can you speak to the theft allowance and on 14 what basis that was?. 15 MR. LAMBERT: Yes. The theft was -- I believe 16 there were two thefts that were allowed in the -- 17 MS. YEE: Smoke Ring. 18 MR. LAMBERT: -- partnership. And based -- and 19 the taxpayer had -- they had police reports that 20 supported that. 21 And, so, therefore, even though -- I believe 22 they had two in one and then one -- one in the -- in the 23 sole proprietor. 24 The location of the first partnership, they 25 wanted a deduction for $85,000 for cigarettes that were 26 stolen from there. 27 Based on an inspection that we had performed 28 in -- when we went in, there was about 2500 cartons of 25 1 cigarettes that were in there. They were claiming that 2 they wanted 2800 and that was allowed. 3 So, that -- the next one in the sole 4 proprietor, there was -- they stole -- there was a 5 burglary for 140 something thousand dollars and that 6 that was forty something hundred cartons of cigarettes, 7 which is a substantial amount and the Department allowed 8 that one. 9 MS. MANDEL: I think the one that -- 10 MR. LAMBERT: I am getting to that. 11 MS. MANDEL: Oh, are you getting to the one 12 that -- 13 MR. LAMBERT: I'm going to get to it. I was -- 14 MS. MANDEL: All right. 15 MR. LAMBERT: So, the next one was the -- the 16 corporation. And there was a -- they provided a police 17 report that showed, I am going to say $78,000, I am not 18 sure if that's the correct figure, but somewhere in that 19 particular -- they provided that. And I think it was 20 2400 cartons of cigarettes. 21 We had performed an inspection there a year 22 earlier and there was only 450 cartons of cigarettes and 23 700 packs, which works out to 520 cartons of cigarettes, 24 which seems to be quite a bit less than the 2400 that 25 the -- that taxpayer is requesting. 26 Their argument was is that they were purchasing 27 these cigarettes and had them in their, I assume, back 28 room, which was 2400 and then they were going to 26 1 distribute them to their other locations. 2 We had several problems with accepting that. 3 One, it didn't look right. The location was sold the 4 next day. The burglary happened on February 27th of 5 '06. They sold the business February 28th of '06. To 6 get the cigarettes into that business, you would have to 7 hand carry them. The back door was just a separate 8 door, it wasn't a roll-up door. So, you'd have to carry 9 it in. 10 And I think the thing that kind of tipped the 11 balance for us the most is that when you took a look at 12 their purchases that you would have to have three months 13 of purchases for all six locations in order to equal 14 what they claim was stolen from that one delivery. 15 So, when they say, "I made a large purchase," 16 there's no indication in their records that, in fact, 17 they had any large purchases of that amount. 18 And I'm sorry for how long that took. 19 MS. YEE: No, no, and that's the kind of 20 inconsistency I am trying to see if Mr. Finnegan can 21 comment to. 22 MR. FINNEGAN: I'd actually like 23 Mr. Darghalli, he's more aware of his businesses than I 24 am. 25 MS. YEE: Okay. 26 MR. DARGHALLI: For a period of time, smoke 27 shops, for some reason, we were targeted a lot by people 28 breaking into them, cutting power lines, disconnecting 27 1 alarms and stealing -- emptying the stores. 2 As far as the third one, he's -- where -- the 3 one was disallowed, he's saying that a year ago we had 4 450 cartons of cigarettes. That's when we bought the 5 business. So, inventory did get added up during the 6 year. So, it's not uncommon for that store to have 7 2000, which all other stores they average 25 to 2800 8 cartons per store. 9 I just want to talk about that. 10 MS. YEE: Okay. 11 MR. FINNEGAN: I think we can readily show that 12 cigarette businesses were targeted in that area. 13 There's sufficient public record. I can provide the 14 Board with probably numerous examples of this happening. 15 MR. DARGHALLI: Break-ins. 16 MR. FINNEGAN: Of these break-ins. 17 MS. YEE: These stores were varied in size in 18 terms of square footage, yes? 19 MR. DARGHALLI: They're about 1200 square feet, 20 average store. 21 MS. YEE: Each store? 22 MR. DARGHALLI: Yeah. 23 MR. LAMBERT: That store was not. 24 MS. YEE: Yeah. 25 MR. LAMBERT: That was their smaller store. 26 MS. YEE: Smaller store? 27 MR. LAMBERT: That store was less than 1000 28 square feet. 28 1 MR. DARGHALLI: Just estimated 1200. 2 MR. HANKS: We should probably also add that we 3 did allow -- that there was a theft that occurred at 4 that store and, so, an adjustment was made for $7500, 5 which represented approximately one month's worth of 6 recorded purchases. 7 MS. YEE: Okay, thank you. 8 MR. HORTON: Thank you very much, Ms. Steel 9 (verbatim). 10 Mr. Runner? 11 MR. RUNNER: Just a couple of -- again, just 12 trying to see how this process works. 13 So, right before this hearing, as you -- as we 14 started this, I get handed a folder all this information 15 in it. 16 MR. FINNEGAN: I apologize. 17 MR. RUNNER: Let me just ask, to the -- to the 18 staff here, is there anything in this material that A, 19 is new, that was not -- you would not have been aware of 20 or -- and as a result of that, would it at least require 21 or maybe helped to have additional time to review? 22 Because I don't know. I mean, I just -- I 23 don't know at this point. I just get a packet of 24 information. 25 MR. LAMBERT: There is -- most of that 26 information has been information that we've seen before. 27 The theories behind some of it are new. From 28 briefly taking a look at, I had the time before the 29 1 hearings, there it is nothing in there that would change 2 my mind in terms of having a different -- 3 MR. RUNNER: Did you get this the same time we 4 did? 5 MR. LAMBERT: I did. 6 MR. RUNNER: Okay. 7 Let me just ask you in regards to the issue of 8 -- one of the issues -- 9 MR. LAMBERT: Oh, I'm sorry, I did not. I 10 received, I guess, you just -- you just obtained it? 11 MR. RUNNER: Yes. 12 MR. LAMBERT: I obtained it before the hearing 13 started today. 14 MR. RUNNER: Okay, relatively new then, okay. 15 Let me just ask you in regards to this issue, 16 the negative markup issue, your comments were that you 17 thought that that was an unusual event. 18 And the taxpayer represents that that is the 19 normal process to which Philip Morris was participating 20 in at that time. 21 Let me go back to you, is that -- had you seen 22 that previously in other audits that were conducted in 23 regards to the negative markup with that particular 24 manufacturer? 25 MR. LAMBERT: Right. When you subtract out the 26 cash -- the buy backs, when you subtract that out of 27 purchases, there should be a positive markup on that. 28 And, at least in some of the periods, that was 30 1 not the case. 2 And when you take a look at the Philip Morris 3 buy backs that they gave, based on the number of 4 cartons, those -- all those cartons could not have been 5 recorded in the records based on the information that we 6 obtained from Philip Morris. 7 MR. RUNNER: Thank you. 8 MR. HORTON: Question of the Department, how 9 were the rebates treated in the markup test? 10 MR. LAMBERT: They were subtracted out before 11 they were -- 12 MR. HORTON: So, you took them out? 13 MR. LAMBERT: That's right. 14 MR. HORTON: Okay. 15 MR. FINNEGAN: Mr. Chairman? 16 MR. HORTON: Yes? 17 MR. FINNEGAN: They didn't -- they couldn't 18 have done that. 19 In 2006 is when the markup factors was computed 20 and there was no buy backs at that point. 21 We can show that the Department did the 22 analysis -- in fact, although audit working papers are 23 dated in 2006 for the markup and they came in at 112 24 percent. 25 MR. HORTON: Department, you want to speak to 26 that? 27 MR. LAMBERT: It wasn't 2006. 28 My understanding was it was 2004 that they 31 1 provided us the -- the price -- the price list sheet 2 that the taxpayer themselves provided to us. 3 MS. YEE: Okay. Question of the taxpayer. 4 You indicated that as a result of the -- 5 because of the buy back program and the benefit of that, 6 that you had a low markup. 7 What did you expect your markup to be? 8 MR. DARGHALLI: Our markup was from 10 to 15 9 percent. That's how much our markup on cigarettes was. 10 MR. HORTON: All right, thank you. 11 Any further discussion, Members? 12 Do we have a motion? 13 MS. MANDEL: Take the matter under submission. 14 MS. YEE: Second. 15 MR. HORTON: It's been moved by Ms. Mandel, 16 second by Ms. Yee to take the matter under your 17 submission. 18 Objection, Members? 19 Without objection, hearing none, such will be 20 the order. 21 Ms. Olson -- 22 MR. FINNEGAN: One quick question on -- 23 MR. HORTON: Sir, we -- 24 MR. FINNEGAN: -- I'm just showing where the 25 markup was computed in 2006 on this document, Exhibit D, 26 page 5, auditor goes, 27 "2006 selling price for a carton of cigarettes 28 was 33.33." 32 1 MR. HORTON: Let's do this, if you -- 2 MR. FINNEGAN: All right. 3 MR. HORTON: -- no, no, no, I think that could 4 be important. 5 As the Members take that under submission, 6 please provide us with a copy of that, provide the 7 Department with a copy of that as well and not during 8 the process, but prior to the process, anything you want 9 to give to us, let's see if we can look at it. 10 Okay, as you know, we'll take the matter up at 11 later date and inform you of the results of our 12 decision. Thank you. 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 33 1 REPORTER'S CERTIFICATE 2 3 State of California ) 4 ) ss 5 County of Sacramento ) 6 7 I, JULI PRICE JACKSON, Hearing Reporter for the 8 California State Board of Equalization certify that on 9 JANUARY 26, 2011 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 pages 1 13 through 33 constitute a complete and accurate 14 transcription of the shorthand writing. 15 16 Dated: MARCH 11, 2011 17 18 19 ____________________________ 20 JULI PRICE JACKSON 21 Hearing Reporter 22 23 24 25 26 27 28 34