BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 5901 Green Valley Circle, Room 207 Culver City, California REPORTER'S TRANSCRIPT MARCH 22, 2011 ITEM B1 FRANCHISE AND PERSONAL INCOME TAX HEARING APPEAL OF PACIFIC SOUTHWEST CONTAINER, INC. (No. 473487) DONALD J. MAYOL (No. 474114) JOHN MAYOL AND TAMI MAYOL (No. 474120) JAMES MAYOL AND BIRGITT MAYOL (No. 474107) AND LOIS M. MAYOL (No. 474108) AGAINST PROPOSED ASSESSMENT OF ADDITIONAL TAX Reported by: Beverly D. Toms CSR No. 1662 1 1 2 P R E S E N T 3 For the Board Jerome E. Horton of Equalization: Chairman 4 Michelle Steel 5 Vice-Chairwoman 6 Betty T. Yee Member 7 George Runner 8 Member 9 Marcy Jo Mandel 10 Appearing for John Chiang State Controller 11 (per Government Code Section 7.9) 12 13 Diane Olson, Chief Board Proceedings Division 14 15 For Board of Lou Ambrose Equalization Staff: Tax Counsel 16 For Franchise Tax Jason Riley 17 Board: Tax Counsel 18 Ann Hodges Tax Counsel 19 Mike Halahan 20 Tax Counsel 21 Bill Hilson Tax Counsel 22 23 For Appellant: Reed Schreiter Attorney at Law 24 Jon A. Sperring 25 Attorney at Law 26 Kendall B. Fox Attorney at Law 27 28 ---oOo--- 2 1 Culver City, California 2 March 22, 2011 3 ---oOo--- 4 MS. OLSON: Our first item on today's agenda is 5 B1a, Southwest -- Pacific Southwest Containers, 6 Incorporated. 7 MS. YEE: I -- I don't think your mike -- can 8 you pull your microphone down further? I can't hear 9 you. 10 MS. OLSON: Okay. Our -- is it on now? 11 MR. HORTON: No. No. 12 MS. YEE: No. Or pull it up close to you. 13 MR. RUNNER: Just pull it closer to you. 14 MS. YEE: Yes. 15 MS. OLSON: Okay. 16 MS. YEE: That's better. 17 MS. OLSON: Okay. Thank you. Our first item 18 is B1a, Pacific Southwest Container, Incorporated; B1b, 19 Donald J. Mayol; B1c, John Mayol and Tami Mayol; B1d, 20 James Mayol and Birgitt Mayol; and B1e, Lois M. Mayol. 21 Board Proceedings has received contribution 22 disclosure forms from this morning's hearings from the 23 parties, agents and participants. All forms were 24 properly completed and signed. All parties, agents and 25 participants are on the Alpha listing provided to your 26 office. 27 Each person sitting at the table will be asked 28 to introduce themselves and if necessary their 3 1 affiliation with the taxpayer for the record. 2 Ten minutes is allocated for the taxpayer's 3 opening presentation followed by ten minutes for the 4 Franchise Tax Board's and five minutes is allocated to 5 the taxpayer for rebuttal. 6 Mr. Horton. 7 MR. HORTON: Thank you. Mr. Ambrose, would you 8 please introduce the case. 9 MR. AMBROSE: Good morning, Mr. Chair and 10 Members of the Board. The matter before you -- the 11 first matter before you this morning is the appeal of 12 Pacific Southwest Container, et al. And the questions 13 before the Board are, first, whether Appellants have 14 presented evidence sufficient to establish that 15 Appellant Southwest -- Pacific Southwest Container 16 conducted activities that constituted qualified research 17 as defined in Internal Revenue Code Section 41, sub d. 18 And then, two, if Appellants have established 19 that Appellant Pacific Southwest Container engaged in 20 qualified research; whether Appellants have met their 21 burden of proving qualified research expenses and the 22 claimed research and development tax credit under 23 Internal Revenue Code Section 41. 24 MR. HORTON: Thank you. The taxpayers will 25 have ten minutes to make their presentation. Please 26 begin with introducing yourselves. 27 MR. SCHREITER: Good morning, Mr. Chairman of 28 the Board. Thank you for the opportunity to appear 4 1 before you today on this matter. 2 My name is Reed Schreiter. I'm from 3 Pricewaterhouse Coopers and I'm appearing on behalf of 4 the Appellants Pacific Southwest Container and its 5 shareholders. 6 Also appearing with me today is Mr. Jon 7 Sperring and Mr. Kendall Fox, both from Pricewaterhouse 8 Coopers. 9 Also here today are some representatives from 10 Pacific Southwest Container. They're seated behind me. 11 Mr. John Mayol, who's the President and CEO of PSC. And 12 next to him is Mr. Darrin Jones. He's the Executive 13 Vice-President in charge of Operations. And to his 14 right is Mr. Jim Mayol, who is General Counsel for PSC. 15 These consolidated appeals arise from claims 16 for refund filed by the Appellants for the tax years 17 1999 through 2001. In the amended returns Appellants 18 claimed a credit for research and development activities 19 conducted during the claim years. 20 Despite conceding that PSC conducted R&D 21 activities the FTB disallowed 80 percent of the claimed 22 credit. PSC appealed the FTB's determination resulting 23 in the hearing today. 24 The sole issue for your decision today is 25 whether the R&D study prepared by Pricewaterhouse 26 Coopers for PSC substantiated PSC's qualified research 27 expenses. 28 A bit of background on PSC is an order for 5 1 today's hearing. PSC is an independent box manufacturer 2 in Modesto, California. It was founded in 1973 by 3 Donald Mayol as a traditional brown box manufacturer and 4 operated this way for the next 20 years. 5 In the early 1990s PSC recognized that it could 6 no longer compete against the multi-national brown box 7 manufacturers such as International Paper. 8 The brown box industry is a low margin industry 9 and the multi-national companies have a clear cost 10 advantage over PSC because of their integrated 11 operations. 12 For example, the larger companies own the trees 13 that serve the operations. 14 PSC identified an opportunity to refocus its 15 business operations to provide engineered packaging 16 solutions. This is a fancy way of saying that PSC does 17 a lot of research and development and this sets them 18 apart from the big guys. 19 PSC continues to thrive because of its 20 intellectual property they bring to the product. And as 21 you can see from the chart that's over here on the 22 easel, over the last 16 years PSC created manufacturing 23 jobs while as a whole California was losing 24 manufacturing jobs. 25 The R&D credit is authorized by Internal 26 Revenue Code Section 41 at the Federal level and 27 California Revenue and Taxation Code Section 23609 at 28 the State level. California essentially incorporates 6 1 the Federal rules into California tax law with a few 2 minor variations that are not relevant for this appeal. 3 The Treasury Department began promulgating new 4 regulations for the R&D credit in 2001. The -- the 5 regulations were finalized in 2003. During this process 6 Treasury specifically rejected rigid recordkeeping 7 requirements for the R&D credit, recognizing that 8 most -- most taxpayers maintain their business records 9 on a cost center basis rather than a project accounting 10 basis. 11 Therefore the Treasury decided that taxpayers 12 merely needed to keep and maintain the books and records 13 they normally generate in their business operations and 14 did not need to generate an additional set of records 15 for tax purposes. 16 In 2002 the IRS prepared an Audit Technique 17 Guide for the R&D credit. In the ATG the IRS clearly 18 contemplates that taxpayers will compute the R&D credit 19 on a cost center basis. The ATG states, if the taxpayer 20 computed the research credit using a cost center or 21 departmental approach the work paper should identify 22 each cost center or department by its appropriate cost 23 center or department name and/or number. 24 Now, because the -- the study is central to 25 this case, let's take a look at the methodology used in 26 preparing the study. 27 MR. HORTON: Excuse me, sir. 28 MR. SCHREITER: Sure. 7 1 MR. HORTON: Your testimony may not be on the 2 record. That's your decision to -- 3 MR. SCHREITER: Yeah, I'll try and speak as 4 loudly as I can. 5 MR. HORTON: Go ahead. It's your call. 6 MR. SCHREITER: Okay, thank you. 7 As you can see the study methodology is 8 essentially a four-step process. The first step being 9 to identify qualified -- 10 MR. HORTON: Let's -- let's see if we can -- 11 MS. STEEL: Without that -- 12 MS. MANDEL: You -- you need to project your 13 voice -- 14 MR. HORTON: Keep -- keep -- 15 MS. MANDEL: -- you know, from drama class, 16 Reed. 17 MR. SCHREITER: Okay. 18 MS. MANDEL: Just really let it out. 19 MR. SCHREITER: Okay. 20 MR. HORTON: Okay. Is that as close as we can 21 get? 22 MR. AMBROSE: Here we go. 23 MR. SPERRING: So, try it again. Why don't you 24 go ahead and do that, also. Back down again. 25 MR. HORTON: Yeah. I knew you guys had a team 26 for some reason. 27 MR. SCHREITER: Yeah, that's right. 28 MR. RUNNER: You need a Vanna White. 8 1 MR. SCHREITER: Okay. So it's a four-step 2 process. The first step -- first step is to identify 3 qualified research projects. 4 The second step is to review the documentation 5 that are contemporaneous records provided by PSC. 6 The third step then is to identify the 7 qualified research activities that are performed on the 8 qualified projects. 9 And then fourth you apply the appropriate 10 Treasury regulation. 11 Now since that's where we're headed, let's go 12 ahead and see what that regulation says. And I was 13 going to read it off the -- okay. 14 Treasury regulation Section 1.41-2(d)(1); In 15 the absence of another methodology of -- or excuse me, 16 other method of allocation that the taxpayer can 17 demonstrate to be more appropriate the amount of 18 in-house research expense shall be determined by 19 multiplying the total amount of wages paid to or 20 incurred for the employee during the taxable year by the 21 ratio of the total time actually spent by the employee 22 in the performance of qualified services for the 23 taxpayer to the total time spent by the employee in the 24 performance of all services for the taxpayer during the 25 taxable year. 26 Now -- now that we know what the regulation 27 says, let's look and see how it was applied in this 28 case. 9 1 As I said, the first step in preparing the 2 study was to identify qualified research projects. To 3 do this the study team initiated an information 4 gathering and sharing process with PSC. Mr. Fox and his 5 team requested and reviewed documentation regarding the 6 activities and expenses of PSC. 7 The team then interviewed PSC personnel 8 familiar with PSC's activities and expenses. This 9 two-step process accomplished two important goals. One, 10 it provided Mr. Fox's team with an understanding of 11 PSC's overall operations and activities. And, two, it 12 provided the team an opportunity to educate PSC personal 13 regarding the R&D rules. 14 Now, using the rules learned from Mr. Fox's 15 team, PSC personnel then identified the projects that 16 they believed were qualified R&D projects. 17 The next step was to request and review all PSC 18 documentation related to the projects to ensure that the 19 projects were in fact qualified R&D projects. 20 The documentation requested and reviewed 21 include contemporaneous records such as design 22 iterations and test data and results. 23 Once the study team confirmed that the projects 24 were qualified R&D projects the team then asked PSC what 25 activities it engaged in to invent or design the new box 26 or process that was identified. 27 The study team then next utilized the list of 28 activities they compiled with PSC to create the wage 10 1 surveys for each Department. 2 And you can see from the exhibit we've 3 brought -- we've compiled a two-page wage survey and a 4 one-page here for your review. There are a couple -- a 5 couple of important things to take from this. 6 You can see at the bottom there's a box with 7 qualifying activities. That is on the first page of the 8 wage survey. And those activities were put on this wage 9 survey based on these -- interaction between PSC and the 10 study team in identifying the qualified and 11 non-qualified activities. 12 Also on the first page was a space for the 13 employee to identify the qualified research -- research 14 and development projects they engaged in. And now you 15 can see that's the list to the left there. 16 The -- those were previously identified 17 qualified R&D projects with -- the PSC and the study 18 team identified. Now, it's important to note that a 19 qualifying -- an activity was not a qualifying activity 20 unless it met two criteria. First it had to be in that 21 list of qualifying activities and it had to be then 22 performed on a qualified research project. If it did 23 not meet those two criteria it was identified as a 24 non-qualifying activity. 25 The second important thing to take from that 26 wage survey is that all of the time and activities of an 27 employee were accounted for in that list of qualifying 28 and non-qualifying activity. So one hundred percent of 11 1 their activities were accounted for. 2 Now at the same time they were working on the 3 wage survey the study team also was working on qualified 4 research narratives. Oops. In a qual -- in a qualified 5 research narrative the study team -- and we've used the 6 example of Hilmar Cheese here, which was one of the 7 projects -- the study team gathered from PSC all of 8 their contemporaneous records of testing and design 9 documentation. They then prepared a written narrative 10 describing the project, the problem that needed to be 11 solved, some of the uncertainties that were being -- 12 sought to be overcome. Test data, test -- the test runs 13 that were going to be done and the results of those 14 runs. 15 They also then identified qualified activities 16 through the wage surveys, which we just described, and 17 then applied the regulation to determine the qualified 18 research expenses. 19 Now the -- the next step in the overall process 20 was, just as we noted there -- was once the qualified 21 research activities were identified the team followed 22 the rules in the Treasury reg. and the ATG to determine 23 qualified research expenses. 24 For example, with wages the team obtained W-2 25 information for the employees and multiplied those -- 26 that wage information by the qualified percentage of 27 activities from the wage surveys. A similar process was 28 also followed to determine supply expenses and contract 12 1 research expenses. 2 The final step in the study was to compile 3 PSC's contemporaneous business records into the 4 17-page -- excuse me, 17-binder study which is here and 5 was submitted to FTB. 6 As you can see the -- the study is thorough. 7 It complies with the rules and guidelines issued by the 8 IRS and the FTB. And, finally, it provides significant 9 contemporaneous documentation to support the R&D credit 10 claim. All of this information was provided in a timely 11 fashion to FTB. 12 We respectfully request therefore that the R&D 13 credit claimed by Appellants be allowed in full. Thank 14 you for your time and consideration. 15 MR. HORTON: Thank you very much. You will 16 have five minutes on rebuttal after the FTB presents 17 their case. 18 FTB, you have ten minutes. 19 MR. RILEY: Good morning, Mr. Chairman -- 20 MR. HORTON: Good morning. 21 MR. RILEY: -- Members of the Board. I'm Jason 22 Riley. And here with me is Ann Hodges, Bill Hilson and 23 Michael Halahan, subject matter specialist for the R&D 24 credit. 25 As complicated as this case may appear, it can 26 be summarized in three words; some, not all. Federal 27 and California statute allow for R&D credit but the 28 credit has very narrow and specific requirements. By 13 1 law a taxpayer claiming the R&D credit must be engaged 2 in qualified research. Specifically, the activity -- 3 the statute requires the activity must qualify as an IRC 4 174 expense. It must be technological in nature. 5 Taxpayers must identify the discrete business component, 6 those products or processes for which they claim the 7 credit, and they must engage in a process of 8 experimentation for a qualified purpose. The 9 Treasury regulations contain a mandate requiring 10 Appellants' documentation, whatever docu -- whatever 11 form that documentation takes, that it must be retained 12 in sufficiently usable form and detail to substantiate 13 that the expenditures claimed are eligible for the 14 credit. 15 So to be eligible for the R&D credit the 16 taxpayer must comply with the qualified research 17 requirement and the taxpayers' records must demonstrate 18 that the taxpayer engaged in qualified research, 19 including a process of experimentation. 20 So, what's wrong with Appellants' activities; 21 We must look to their operations and we must be able to 22 separate what is simply technological in nature from 23 that involving a process of experimentation. We must 24 separate just their manufacturing from actual 41(d) 25 qualified research. 26 Here there's no demonstrable process of 27 experimentation. The statute and the Union Carbide 28 Court demand that an actual scientific style method -- 14 1 scientific method style process of experimentation is 2 necessary. And they require the documentary proof that 3 the process of experimentation required. Appellants 4 haven't complied with the statute. 5 But what about Appellants' sample projects that 6 they've submitted and their documentation? They 7 submitted no contemporaneous analysis. Okay. They do 8 not identify the discrete business components for which 9 they claim the credit. Is it the box? Is it the 10 procedure? Is it the inks? Appellants chose to call 11 their business components a product yet a product ends 12 once the prototype is validated. Related manufacturing 13 is irrelevant to that question. 14 The statute requires that the test shall be 15 applied separately with respect to each business 16 component of the taxpayer. 17 So let's talk about the Hilmar Cheese project. 18 This is the third time we've seen it. It was submitted 19 in 2006. It was submitted again in 2007. And again it 20 was submitted last week. It is nothing new. It 21 claimed -- it's claimed at times as a product and at 22 other times as a process. It is routine quality 23 control, routine data collection. There is no 24 contemporaneous analysis. There is no process of 25 experimentation. And it -- there is insufficient 26 identification of the discrete business component. 27 Under the Union Carbide Court this fails the 28 process of experimentation. There was no 15 1 experimentation and it lacked analysis and evaluation. 2 Union Carbide stated that data collection alone, no 3 matter how detailed, does not constitute a process of 4 experimentation if it is not followed by a meaningful 5 analysis. 6 Appellants simply -- Appellant appears to 7 simply be -- it appears to be simply a change to their 8 process followed by a verification that that change 9 would work. These are tooling changes, ink blending 10 changes, cutting die changes, roller setting changes. 11 These are their normal operating parameters. This is 12 what their machines are designed to. Eustace called 13 this tinkering. You can call it day-to-day box 14 manufacturing, but we cannot call it a process of 15 experimentation. 16 This leads us to the McFerrin Court. If a 17 taxpayer proves qualified research occurs then the Court 18 may allow with -- may follow up with a reasonable 19 estimate of expenses under Cohan versus Commissioner. 20 But McFerrin also states that Respondent or your Board 21 does not have to accept reconstructions from years after 22 the fact. And here's why. Courts have called 23 reconstructions unreliable, inaccurate, incomplete and 24 wholly insufficient to establish either what various 25 workers did or whether such expenses qualify for the 26 research credit. This is a Tier One issue for the IRS 27 because of faulty credit studies like the one in this 28 case. 16 1 So, what are the deficiencies with Appellants' 2 study and estimate? Let's start with these wage 3 questionnaires that they've put up on the boards. These 4 are the cornerstones of their -- of their activities. 5 But they engage -- it's a flawed methodology. 6 Appellants' method assumes qualified research occurs and 7 makes an estimate of alleged qualifying wages based on 8 that faulty assumption. It's flawed in execution. It 9 failed to include all the non-qualified activities 10 described in the various employees' interviews and these 11 wage questionnaires again they form the basis of 12 Appellants' claim. 13 We notice they included a number of normally 14 excluded executives like Mr. Jones and Mr. Mayol, so we 15 took a closer look at those interviews and the 16 declarations submitted. 17 For Mr. Jones, for whom they put up one of 18 the -- the wage questionnaire, he's the Executive 19 Vice-President. We have a wage questionnaire, we have 20 an interview and we have a signed declaration for him. 21 But the dates on these are a problem. Mr. Jones signed 22 the wage questionnaire on July 9, 2003. This was the 23 day before the interview occurred, on July 10, 2003, and 24 it is apparent from the interview that the wage 25 questionnaire is inaccurate. Because his own interview 26 contradicts the wage questionnaire prepared by 27 Appellant's representatives. 28 We know it to be inaccurate because it claims 17 1 to account for one hundred percent of Mr. Jones' time 2 even though his activity is basic strategic management 3 according to his interview. 4 Moreover, the study does not allow for all the 5 routine non-qualified research activities such as 6 leveraging one hundred percent of what they know on a 7 new project, that is on activities that are not 8 qualified research. The so-called "me, too" projects 9 according to their opening brief. 10 Yet new -- just calling something new does not 11 mean that there's any experimentation. In the interview 12 there are no parameters given for the terms that Mr. 13 Jones uses, such as innovation or engineering or 14 blending, and there is no attempt at clarity in this 15 interview. There are no followup questions. 16 In essence, there is no nexus between what is 17 talked about in the interview and any documentation. 18 And all we have for him is the interview because they 19 don't keep experimental records. So, how can a wage 20 quali -- how can a wage questionnaire be accurate when 21 it doesn't take into account all of the non-qualified 22 activities described in the interview? 23 The declarations also contradict the credit 24 study. Mr. Jones talks in his declaration about all of 25 his supervisory activities. Yet the credit study claims 26 Mr. Jones as direct support. Under the regulations 27 direct support does not include supervision. 28 As for President and CEO John Mayol, he is 18 1 claimed as direct support in the study for his 2 purchasing decisions. But these purchasing decisions 3 are specifically excluded by the regulations. Officers 4 engaged in supervising financial matters do not qualify 5 as direct support. So, which is it? Is it direct 6 support? Is it direct supervision? They cannot have it 7 both ways. They are at -- these men are at a level too 8 high for direct supervision and either way they're 9 excluded and not qualified. 10 We cannot confuse their business decisions with 11 qualified research or experimentation decisions. Are 12 these men important to their business? Absolutely, yes. 13 Are they personally engaged in qualified research or 14 direct support or supervision? No. The point here, 15 this credit study is deficient, inaccurate, incomplete 16 and wholly insufficient to substantiate Appellants' 17 claimed credit. 18 Let's talk about your Board's precedence 19 regarding Cohan versus -- versus Commissioner. 20 Respondent allowed a reasonable estimate under Cohan, 20 21 percent of the claimed credit, which amounted to $4.8 22 million in wages and supplied over the three years. 23 Where a qualified research activity is proven, Cohan 24 merely permits a reasonable portion of unsubstantiated 25 expenses to be estimated. Your Board has long 26 indicated, however, its reluctance to disturb 27 Respondent's determinations involving unsubstantiated 28 amounts without independent facts upon which to base a 19 1 different finding. 2 Cohan bears heavily upon the taxpayer whose 3 inexactitude is of their own making. If a taxpayer 4 fails to keep detailed records, then he must bear the 5 consequences and settle for an approximation of his 6 expenses. 7 If your Board were to find independent facts 8 upon which to base a different finding, then your Board 9 is entitled to do so under Cohan. Yet as Respondent has 10 shown, any estimate cannot be one hundred percent of 11 what Appellants claim because of the unreliability, 12 inaccuracy and inexactitudes of Appellants' own making 13 complained in the credit study. 14 Appellants' primary activity is box 15 manufacturing and there is a tremendous amount of box 16 manufacturing. And this is within their normal process. 17 This is not experimentation. Union Carbide says this is 18 not enough. 19 In spite of the absence of records proving what 20 exactly the business components were or what process of 21 experimentation occurred with respect to those business 22 components, the auditor toured the plant, observed 23 Appellants' operations, interviewed key employees, 24 reviewed the documentation provided in an attempt to 25 understand this undocumented claim of R&D credit. 26 On the plant tour the auditor saw evidence of 27 some possibly qualified activity. But it was not 28 properly claimed in the study. It was never documented 20 1 and so Appellants have not satisfied the statutory 2 requirements. 3 Yet based on the totality of the circumstances 4 the auditor concluded that the taxpayer was engaged in 5 some as yet unquantifiable amount of research. 6 MS. OLSON: Time has expired. 7 MR. RILEY: If I can just sum up here. 8 MR. HORTON: Sure, go ahead. 9 MR. RILEY: Respondent was reasonable. Our 10 reasonableness should not be held against us because 11 Respondent's estimate is only as good as Appellants' 12 documentation. 13 If there is a flaw it is because Appellants 14 provided with -- Respondent with the documentation 15 insufficient to make a proper estimate. The 16 inexactitude is of Appellants' own making. Under Cohan 17 they bear the consequences. The auditor allowed some, 18 but not all. 19 Thank you. 20 MR. HORTON: Thank you very much. We will add 21 the additional time on your rebuttal, as well, to be 22 able to respond. Please begin. 23 MR. SPERRING: Sure. At first I'd like to 24 point out that -- 25 MR. HORTON: Bring the mike a little closer, 26 sir. 27 MR. SPERRING: Certainly. First I'd like to 28 point out, you've heard FTB critique the taxpayer's 21 1 study. And what I thought I would have us do is bring 2 us to tab 6 here in the handout where the IRS warns 3 their agents in the field about the exact type of 4 arguments that you've heard here today. And what does 5 the IRS inform its examiners? That audit adjustments 6 based solely upon critiques of the taxpayer's 7 methodology and prepackaged submission in many cases 8 stand little chance of being sustained in appeals or in 9 the Court. 10 So you -- you've heard critiques, the date 11 doesn't match up, something like that, okay, but one 12 thing you didn't hear any discussions was about what's 13 in those 17 binders and the research and the testing 14 that was -- is going on at Pacific Southwest Container 15 on a daily basis. 16 And so what I thought I would do is ask Mr. 17 Kendall Fox to walk you through what's in those 18 bindings -- binders, the testing that he saw going on 19 every day and the process of experimentation that was 20 going on during his time auditing and researching their 21 eligibility for the credit. 22 So, Mr. Fox, if you could walk us through what 23 is exactly in those binders as well as the process of 24 experimentation you saw in the Hilmar Cheese project. 25 MR. FOX: Okay. Yeah, I think the comments 26 made were that, for example, with Hilmar Cheese there 27 was uncertainty as to what the business component was. 28 Was it a process? Was it ink changes? Was it a box? 22 1 Actually, the documentation is crystal clear on what it 2 is. There is a narrative that describes the project. 3 It is a container. 4 Continued within the study are 11 months' worth 5 of development work which includes all of the design 6 drawings showing each different iteration, all of the 7 tasting -- testing data that was collected to validate 8 the design and its analysis as they went through the 9 subsequent revisions. 10 Also included are different notes and emails 11 going back and forth talking about the failures that 12 occurred and the different testing that took place both 13 within PSC and at the customer's location in order to 14 validate the design. 15 So to say that the company does not have 16 records of its experimentation is not true. Actually, 17 the company has retained complete records of all of its 18 projects. It has in its system 416 megabytes of data 19 from this time period, which record all of the design 20 changes to each and every business component as well as 21 all of the testing data that was collected and analyzed. 22 So the fact that they engaged in systematic 23 trial and error is easily documented by the company. 24 I think the confusion comes in because the 25 company has never stated that they don't have this 26 documentation for its projects. The only thing they've 27 stated is they didn't maintain a project accounting 28 system to assign cost to these projects. But the 23 1 ability to prove that they engage in experimentation can 2 be done for each and every project. 3 So within the binders we show that not only do 4 they have this documentation for the Hilmar Cheese 5 project, but for the other ones that you'll see listed 6 on the survey, Sun Microsystems, Selectron, Autodesk, US 7 Print, again we were able to go into the system and 8 validate that these were qualified projects by reviewing 9 the documents, the design changes, the experiments and 10 everything that took place over time and these are all 11 date stamped and have the people that were involved in 12 the project listed on the documentation. 13 PSC recognizes it's primarily a manufacturer. 14 That's why less than ten percent of the costs were 15 claimed. The majority of the costs relate to 16 manufacturing and none of the routine manufacturing was 17 claimed as a qualified activity. I think there's 18 confusion on that point. 19 Now, in order to validate the design because 20 they don't have a separate stand-alone pilot facility 21 they borrow manufacturing capacity to conduct tests and 22 experiments. But when that incurs they're using 23 experimental design and they're collecting extra data 24 that they normally wouldn't collect and testing more -- 25 more boxes than they normally would as part of 26 manufacturing in order to validate the design. 27 But that's not manufacturing. None of those 28 products are commercial yet. None of the designs have 24 1 been validated. And none are sold. 2 So there is a clear distinction between what 3 was claimed as research and what was claimed as a -- and 4 what was not claimed. 5 And it's very clear to the people as we 6 conducted this that only the time spent on these 7 activities with this robust documentation qualified. 8 There are also comments -- a couple comments made about 9 just making purchasing decisions for equipment. 10 During this period the company engaged in a 11 very large scale project to use a brand new technology 12 that's given them a huge competitive advantage and 13 actually allowed them to be successful. And this was 14 their UV printing system. 15 And so, there was hands-on development during 16 this period. It wasn't a routine purchasing decision of 17 a piece of equipment. There was a lot of analysis of 18 different types of ways to accomplish their goal so that 19 they could create state of the art technology that 20 allows them to compete and to do things that their 21 competitors can't. 22 So, again, I think that there's also kind of a 23 mischaracterization of some of these activities. But, 24 again, the only thing I can say is the documentation is 25 clear on all of the products, experiments and whether 26 something was a component or a process, the project 27 specific and it describes exactly what it was. 28 MR. SPERRING: The next thing I'd like to talk 25 1 about is you heard reference to Union Carbide. But one 2 of the things we ought to keep in mind about Union 3 Carbide was in that case the taxpayer did not have cost 4 center accounting. Okay. They actually had to 5 reconstruct their records. They didn't have the -- 6 qualified wages and so they actually brought in experts 7 to estimate wages. Okay. Nonetheless, even though they 8 didn't have one of the two cited accounting methods in 9 the IRS Audit Techniques Guide, the Court still allowed 10 them the credit, okay. 11 So here you have a situation where in this 12 270-page opinion you have the FTB quoting excerpts out 13 of there about the taxpayer's burden when the taxpayer 14 didn't have -- in a situation where the taxpayer didn't 15 have the records. We have the records. 16 So -- and nonetheless, okay, the Court told the 17 IRS that they should be entitled to some of the credit. 18 But it's an entirely situ -- a different situation than 19 why we're here today, which raises the next question, 20 why we're here. One thing you didn't hear FTB talk 21 about was their requirement of project accounting. 22 Which when you look at their Audit Issue Presentation 23 Sheet you see the words "Project Accounting" five times 24 in here. Five times they basically say your failure to 25 have project accounting. 26 MS. OLSON: Time has expired. 27 MR. HORTON: We'll allow a few more minutes. 28 Two. 26 1 MR. SPERRING: Thank you, your Honor. And -- 2 and basically what they say is PwC -- although PSC has 3 stated it does not have complete project accounting of 4 R&D projects, PSC also has not provided acceptable 5 alternative documentation from the time of the credit. 6 So if you turn to tab 10 you'll see what 7 documentation we have. And the documentation we have is 8 everything that's listed in the IRS Audit Techniques 9 Guide. And in fact, okay, when you look at the FTB's 10 FAQs on the R&D, okay, what you notice is, one, there's 11 no requirement of project accounting as is in the AIPS 12 but, two, the listing here is mostly the same as this 13 list. The only real deviation is the fact that they 14 make it California specific, it has -- the activities 15 have to occur in California. 16 So, you know, we're here today because we 17 didn't have project accounting. And yet FTB doesn't 18 require that in their Frequently Asked Questions. 19 MR. HORTON: Thank you. Thank you very much 20 for your rebuttal. Member Yee. 21 MS. YEE: Thank you, Mr. Chairman. I have 22 several questions, but let me just first try to get some 23 clarification about what actually was examined during 24 this appeal. 25 The 17 binders, can the Franchise Tax Board 26 speak to its examination of materials provided? 27 MR. RILEY: Yeah, these were -- these are -- 28 this is their credit study. This -- it's contained in 27 1 17 binders here. I don't know, I think it was nine 2 binders when we got it. I believe it to be the same 3 amount of binders, whether it's 9 or 17. 4 It is -- it is mostly -- if you were to go and 5 flip through that stuff, it is mostly these wage 6 questionnaires. It is -- there are, I believe, probably 7 three projects within there that they claim as research, 8 yet what they claimed as their -- as their research 9 during -- you know, during the -- the audit was 1100 10 projects per month, which they later said that they 11 mischaracterized and really it's only 400 projects per 12 month. Yet they don't -- I mean, there's no process of 13 experimentation with these -- 14 MS. YEE: Okay. 15 MR. RILEY: -- with these things. Okay, 16 there's -- there's a lot of high level estimates of 17 expenses. It is very, very, very short on anything 18 involving any actual experimentation. 19 MS. YEE: Okay. Let me get back to that 20 question. I'm troubled by -- here's what I'm troubled 21 by. We've heard previously Research and Development 22 appeals -- credit appeals that really were quite lacking 23 in documentation and I just want to be sure that what 24 was provided here was adequately examined and we have an 25 understanding about what these documents actually 26 represent. 27 And I know there were several information 28 document requests that were issued during the course of 28 1 corresponding with the Appellants, and I just want to be 2 sure that what we're hearing today from the Appellants 3 is supported by what they believe is contained in those 4 binders. 5 MR. RILEY: I mean, if -- if these are the 6 binders that they submitted as their credit study then 7 we know exactly what these are. And I mean, this -- 8 that's why we're here. This is what our estimate is 9 based on. 10 MS. YEE: Okay. And how would you characterize 11 the documents? I mean -- 12 MR. SPERRING: Well, I -- 13 MS. YEE: I guess I -- 14 MR. SPERRING: I find it very interesting. 15 MS. YEE: Well, let -- 16 MR. HORTON: One second, sir. 17 MS. YEE: -- let -- let me -- I want to know if 18 there are source documents contained in those binders. 19 MR. SPERRING: There is, Madam Yee. There 20 seems to be complete confusion as to what's in the 21 binders by the FTB, okay. But the bind -- the wage 22 surveys, okay, are two pages. Okay. If you look at the 23 Hilmar Cheese, okay, example, right, what you're going 24 to see is -- and I'm -- I'm lifting it up right here. 25 This is -- is testing, okay. It's mostly testing and 26 CAD drawings. Okay. The wage summary is the shortest 27 piece in the file. And in fact what's in those 17 28 binders are not wage summaries. They are the 35 29 1 projects. 2 So, here we have a -- a mischaracterization of 3 the number of projects as well as a mischaracterization 4 of the wage surveys. Wage surveys are two pages. 5 If we were going to have 17 binders these 6 people have more employees than Bank of America. Okay. 7 What's in here is the drawings -- CAD drawings and the 8 various testing that was going on for the 35 projects. 9 And if you go back behind the 35 projects you get 416 10 megabytes of these drawings and test -- testing 11 documents. 12 MS. YEE: Okay, let me stop you there, Mr. 13 Sperring. We have in front of us I think this response 14 to Board Member inquiry that has a number of drawings I 15 think related to the Hilmar Cheese project. Is this 16 similar to what's in the binders for other projects 17 then? 18 MR. SPERRING: Exactly. 19 MS. YEE: Okay. All right. Okay, let me shift 20 gears for a sec. Question to the Franchise Tax Board. 21 You -- you didn't mention, and I'm surprised, but if you 22 could comment on the use of the project accounting as 23 opposed to the cost center approach. Is there a dispute 24 there with respect to which approach is appropriate? 25 MR. RILEY: I think the dispute here is more 26 about the actual activity that they say they engaged in, 27 okay. The -- you know, I've brought Michael Halahan 28 here who can speak to project accounting versus cost 30 1 center accounting if -- 2 MS. YEE: Uh-huh. 3 MR. RILEY: -- if you'd like. Mike, I don't 4 know if you want to talk. 5 MR. HALAHAN: Generally, the -- the difference 6 between project accounting and cost center accounting is 7 for a lot of manufacturers who do customized product you 8 can employ project accounting, i.e. obviously you have 9 to justify to your buyer where their costs are 10 associated. 11 Cost center accounting is -- is more of an 12 accounting vehicle to organize it around particular 13 frames or cost focuses. Those would be the two 14 differences. 15 As far as -- the point being here in project 16 accounting that may be more of a misnomer. What we're 17 looking for is more operational, not accounting base. 18 MS. YEE: Uh-huh. 19 MF. HALAHAN: We're looking for the operations 20 of the business to see how they track and document their 21 projects from inception through completion, not 22 necessarily how they cost it -- cost those items. 23 MS. YEE: Okay. 24 MR. RILEY: But again, you know, whatever those 25 documents are that they have -- the first step here is 26 that they must prove that they're engaged in qualified 27 research. Okay. The auditor went out and said, yeah, 28 you know, I think there's some -- 31 1 MR. HORTON: Par -- 2 MR. RILEY: -- some part of it. 3 MR. HORTON: Pardon me, sir. 4 MR. RILEY: But -- 5 MR. HORTON: I'm just going to caution everyone 6 that try to the best of your ability to respond to the 7 Member's question and then allow the Member an 8 opportunity to continue the thought process in the 9 series of questions. That might be most helpful in us 10 being able to deliberate the case. 11 MR. RILEY: Apologies. 12 MR. HORTON: No problem. 13 MS. YEE: Thank you -- 14 MR. HORTON: It's understandable, though. It's 15 understandable. 16 MS. YEE: Thank you, Mr. Chairman. 17 Well, let me follow up with a question to the 18 Franchise Tax Board. In light of what's been described 19 as what's contained in the binders that were provided 20 and in light of the concern about R&D studies oftentimes 21 lacking nexus between the business component and the 22 qualified research expenses, knowing now what was 23 described as being contained in the binders, does that 24 change your -- your thought with respect to how you 25 would examine -- 26 MR. RILEY: I mean it's very dramatic to 27 present the binders right now. But I -- you know, 28 there's nothing new -- 32 1 MS. YEE: But they were provided before. Yes? 2 MR. RILEY: Yeah, I mean there's nothing new 3 within the binders. This was all examined at audit. 4 MS. YEE: Okay. 5 MR. RILEY: So it would not -- you know, the 6 fact that they, you know, have given you a description 7 of what they think is in there, that doesn't change 8 Franchise Tax Board's opinion. 9 MS. YEE: Okay. And then let me just ask one 10 final question and I'll return to -- some other 11 thoughts. 12 Executive salary and executive time. I guess 13 to both parties, are there ever instances where an 14 executive is directly involved in an activity that is 15 eligible for consideration for the credit? 16 MR. RILEY: Sure. 17 MS. YEE: Okay. 18 MR. RILEY: If -- if that executive is -- is 19 directly involved in the -- in the research and there 20 are documents showing that they are. For example, if -- 21 if an executive's name was on a U. S. patent, and so it 22 shows that he's -- he's the one doing the research. I 23 mean many corporations start out as, say, St. Jude's 24 Medical, that's -- that was a doctor who invented 25 something and started a corporation based on that. 26 MS. YEE: Uh-huh. 27 MR. RILEY: Okay. So in that case likely his 28 name is on the patent, he's the one who's, you know, 33 1 then engaged in the -- the qualified research. 2 Here we've got -- I mean we've got this 3 extensive interview. I believe it's about 56 pages of 4 Mr. Jones describing what he does and talking about how 5 much stuff they leverage off of what they know already. 6 So they're not doing -- you know, much of what they're 7 talking about is not qualified research. I mean, 8 more -- and moreover they don't -- you know, the -- the 9 interview, you know, it's -- I would -- it does not rise 10 to the level of testimony. Although I've spoken to Mr. 11 Jones and I believe him to be a -- you know, a stand-up 12 guy. 13 I don't believe that the interview allowed him 14 to elaborate on -- on many of the things that are talked 15 about in that -- in the interview. It doesn't allow him 16 to identify exactly -- you know, he -- he talks in 17 general terms of -- you know, in lay person's terms of 18 engineering or ink blending, but this is -- you know, 19 for the credit it is qualified research. It is a 20 very -- like I said, it's very narrow and specific 21 requirements. The requirements for general IRC Section 22 174 research are different than for 41. 23 All 41 research has to qualify for 174, but all 24 174 does not necessarily qualify as 41. 25 MS. YEE: Okay. 26 MR. RILEY: I mean it's like one of those big. 27 Ven diagrams, you know. 28 MS. YEE: Right. Right. 34 1 And then, Mr. Riley, can you speak to Mr. 2 Mayol's involvement? 3 MR. RILEY: I mean, Mr. Mayol, they said that 4 he engaged in purchasing decisions -- 5 MS. YEE: Oh, I'm -- 6 MS. MANDEL: Which Mr. Mayol? I'm sorry, 7 there's more than one. 8 MS. YEE: Yes, there is. 9 MR. RILEY: I believe you're talking of John 10 Mayol, the -- 11 MS. YEE: John Mayol. 12 MR. RILEY: -- President and CEO. 13 MS. YEE: Yes. 14 MR. RILEY: I -- I believe that Jim Mayol, who 15 is -- you're the attorney? 16 JIM MAYOL: Yes. 17 MR. RILEY: I believe he's one of the few 18 people that was not claimed in -- in the credit. So -- 19 but for John Mayol they're claiming -- they're claiming 20 his as an executive for making purchasing decisions. 21 There is no process of experimentation, no scientific 22 method style process of experimentation in that. 23 Moreover, the -- the Treasury regulations say that 24 direct supervision does not occur above first level 25 management, and in the credit study they claimed 26 Mr. Mayol as direct support. 27 So, again, under the regs. he's -- he's not 28 qualified. 35 1 MS. YEE: Okay. I'm going to ask Appellants 2 the same question and I -- I just want to understand 3 this because I know Mr. Mayol does bring specific 4 experience and expertise to this, but what -- maybe you 5 can explain Mr. Mayol's involvement and what you believe 6 substantiates his involvement that would qualify for the 7 credit. 8 MR. SPERRING: Sure. Mr. Fox. 9 MR. FOX: I mean Mr. -- Mr. Mayol's activity, 10 as I mentioned, during this time period -- and by the 11 way, in all the years over the study he did not 12 necessarily engage in qualified research. There's other 13 years that he didn't. But in the time period that he 14 was claimed he was heavily involved directly, not just 15 supervising or supporting, but directly involved in the 16 UV process, which was a major project for the company, a 17 major investment and very difficult, and it took them 18 years to complete. 19 And again, around that project there is robust 20 documentation, there's a lot of lab analysis of the way 21 that the ink spread, why they weren't performing and 22 significant cost to the company. 23 So the experimentation again is -- are in the 24 binders and are well laid out. And Mr. Mayol was 25 directly involved with that. 26 MS. MANDEL: During the -- 27 MR. FOX: And so that was the project for which 28 he was claimed. It wasn't routine purchasing decisions, 36 1 it was strategy or other admin. 2 MS. YEE: And what -- what were the nature of 3 his activities -- Mr. Mayol's activities? 4 MR. FOX: The na -- 5 MS. MANDEL: For that project that you -- 6 MS. YEE: For the -- 7 MR. FOX: For that project? Again, he was 8 using his experience from the -- all of his years of 9 experience and his technical background in manufacturing 10 to help bring this new technology on board, including 11 all the customization. 12 So, he's actually here if you could -- like him 13 to further elaborate. 14 MS. YEE: Yeah, maybe just to get a flavor. 15 JOHN MAYOL: Sure, be happy to. I appreciate 16 the opportunity. 17 During those years we made -- there was a -- a 18 critical path forward or no path. And so my involvement 19 was to make sure that we made the appropriate decisions 20 on a go forward basis. Specifically in the UV process 21 it had never been done before. 22 So Mr. Jones and I collaborated -- I wouldn't 23 even hazard a guess as to how much time and energy we 24 put forth to make the right decisions. And then once we 25 made the decisions to make sure that we -- made sure 26 that the decision worked. Because out of the chute 27 guaranties were made by the manufacturer, the equipment 28 weren't lived up to, we had to reevaluate, re-eningeer 37 1 processes. I'm not an engineer, I'm a business person. 2 But the years of experience I've had in process 3 and decision-making were I would say pretty valuable 4 to -- to making sure that the end result was what you 5 saw here, which was successful job creation moving 6 forward. So -- 7 MS. YEE: Okay. And then -- I'm sorry, Mr. 8 Chairman, let me ask one last question -- 9 MR. HORTON: Sure. 10 MS. YEE: -- of the Franchise Tax Board. 11 Is the Federal allowance of the credit, ought 12 that be instructive to the Board in any way during the 13 years in question? 14 MR. RILEY: For this particular taxpayer? 15 MS. YEE: Yes. 16 MR. RILEY: If the -- if the IRS didn't audit 17 their -- their credit study, then no. I mean, this 18 is -- if it wasn't audited then it wasn't audited. I 19 mean there's -- they can't audit every taxpayer, so -- 20 MS. YEE: Okay. Thank you, Mr. Chairman. 21 MR. HORTON: Thank you, Madam Yee. 22 Mr. Runner, please. 23 MR. RUNNER: Thank you. Thank you. Just a 24 couple of followup questions. It -- from at least part 25 of the discussion so far it seems to me that the core of 26 this discussion in regards to the accepting of what's in 27 the binders, the accepting of what takes place in 28 regards to the amount of time that -- whether it's an 38 1 executive or whoever is engaged in this R&D it seems to 2 me comes down to the issue of -- of a cost centered 3 accounting versus a project accounting. 4 And -- and let me just ask the Appellant at 5 that point that question, and that is, is some of the 6 issues that -- that at least you're hearing disallowed 7 from the State Franchise Tax Board based upon what you 8 would believe is a -- a biased lens, if you will, 9 because of a desire to see and look at valuations based 10 upon the issue of a project accounting? 11 MR. SPERRING: I do, Senator Runner. What's 12 our frustration that we've had during this entire 13 process is FTB's refusal to understand what's in the 14 binders. You see it here today. It was -- we uncovered 15 it during the audit. The whole time we were bludgeoned 16 with project accounting, we need to see the cost to 17 develop this project and you have to add up all the 18 number of projects and show us the amount of costs with 19 each product to get the amount of credit. 20 And the whole time we were like why don't you 21 go and look at the study? Why don't you review the 22 documentation? You interview the people in the studies. 23 I mean, you hear again just the total confusion the FTB 24 has about it, is you heard the comment, oh, well, Jim 25 Mayol, the lawyer, was one of the few people, okay, that 26 we didn't claim credit on. But actually if you look at 27 the survey that was up there what you see in Darrin 28 Jones' survey is the only one in the survey where there 39 1 was credit claimed. Okay. All the other names there's 2 a zero, okay. 3 So, again you have a lot of great inflammatory 4 rhetoric that sounds wonderful. I mean five percent for 5 the CEO, okay, his time. You know, like we're just 6 going hog wild on that. And you hear lots of critiques 7 of the study, okay, dates, you know, whatever. Number 8 of binders they critique, you know, is it prepackaged, 9 is it not? 10 You know, you hear that. But you don't hear 11 any discussion about we went, we interviewed the 12 employees that Mr. Kendall Fox interviewed and we 13 disagree. You won't hear that because they refused to 14 do that. 15 MR. RUNNER: So again, is that based -- do you 16 believe on a bias toward looking at a project orient, an 17 accounting versus a cost center? 18 MR. SPERRING: Exactly. Yes, I believe the 19 whole reason why we're here is because we didn't have 20 project accounting, and because our books and records 21 are set up on a cost center basis and that's why we're 22 here, because they refuse to look at the study and -- 23 and verify the results of the study. 24 MR. RUNNER: Okay. Let me just go back to FTB 25 real quick, and that is that -- if that indeed is at 26 least part of the -- part of the conflict in regards to 27 judging the material and whether, you know, in the 28 binder or what the auditors found or whatever, from 40 1 FTB's perspective is there -- do you -- do you believe 2 you evenly hand -- hand -- handled the issue between the 3 methods of accounting when it comes to the issue of -- 4 of R&D? Do you somehow feel like you've got a -- a - 5 you know, a better handle on the idea of project 6 accounting versus cost center because, you know, at 7 least it's all -- you know, it's a little more tangible? 8 You know, you can -- you kind of see the center -- the 9 project a little more clearly when it's a project versus 10 a cost center? 11 MR. HALAHAN: Senator Runner, I guess I would 12 have to say in general again I think the term "project 13 accounting" is a misnomer in this case. I've been 14 heavily involved in the training of audit staff 12 15 years. 16 What these studies and the problems we find 17 with the studies is they focus on the costing, the 18 estimating of costs. And our focus has always been you 19 have to establish a qualified activity before you can 20 estimate a cost. 21 I have no problem and I've instructed audit 22 staff that we have no problem with the concept of 23 estimating, but it has to be estimating based on an 24 established qualified activity. That's where we have 25 the problem usually with the study. They generally rely 26 on interview. 27 MR. RUNNER: You're talking about their method 28 now? 41 1 MR. HALAHAN: Their method. 2 MR. RUNNER: Their method is based on 3 interview? 4 MR. HALAHAN: Right. As a matter of fact, this 5 is the first time I've had an opportunity to see a 6 transcribed interview of a senior person within an 7 organization or client that they've done. And -- and I 8 was -- I have to admit I was surprised that there was 9 such a lack of followup with things that -- where I 10 wouldn't necessarily say isn't qualified but requires 11 substantial more detail and development to determine if 12 it was qualified. 13 But these were not followed up. So you're left 14 with an ambiguity where statements can be taken one or 15 another way. They don't really address it. 16 MR. RUNNER: And isn't that the nature -- and 17 you don't believe that's the nature of the conflict 18 between the two accounting methods? 19 MR. HALAHAN: That has nothing to do with 20 costing. 21 MR. RUNNER: Okay. 22 MR. HALAHAN: It doesn't really matter. I -- 23 I've -- there's no problem doing project, there's no 24 problem doing cost center, departmental, straight GNA -- 25 MR. RUNNER: So what you don't like is the idea 26 that it was done on this interview basis, it was done 27 then with the assignment of percentages of activities 28 then that these individuals participated in as a route 42 1 to get to the -- the -- the -- the claiming the R&D? 2 You don't believe that's a valid method? 3 MR. HALAHAN: In and of itself without 4 additional documentation to support statements and 5 estimates, yes, I would say that based on just interview 6 solely that both the IRS, the Courts and us have all 7 agreed you need more than just somebody's interview to 8 establish a qualified nature. 9 MR. RUNNER: Okay, let me ask the Appellant 10 then in regards to the interviews, I guess it -- the -- 11 it would seem to me the bottom line of that is what 12 did -- what did the in -- what -- what did the 13 interviews produce then that became the documentation? 14 MR. SPERRING: Exactly. And the reason why you 15 don't hear FTB come right out when you asked them point 16 blank is -- is the interview process permissible is 17 because the regulation says it is. Okay. So that's in 18 the IRS Treasury regulation, it says you do interviews. 19 Okay. 20 Now, then the next question is, well, okay, are 21 there documents to back up what they're saying? And 22 that goes to the 416 megabytes in the CAD system, and in 23 the SAS system, and it goes to the 17 binders that we 24 pulled when they started talking about projects. And 25 then once we got to the individual product, like for 26 example Hilmor -- Hilmar Cheese, we -- what do we see? 27 But we see testing, okay? 28 So here according to FTB a few minutes ago this 43 1 is supposedly all questionnaires and high level analysis 2 by PwC. But actually what this all is is testing 3 documents that was created contemporaneously while -- 4 during the 11 months it took them to develop this cheese 5 box that could hold -- that could stack a liquid, okay, 6 four feet high. 7 MR. RUNNER: Okay. So just to see if I get -- 8 understand here, what you're saying is the issues that 9 were done and the percentages of time were done upon 10 a -- based upon interviews and then the interviews and 11 the percentages then were backed up then by the material 12 that showed the activities that -- of which they 13 participated in. 14 MR. SPERRING: Exactly. 15 MR. RUNNER: Okay. Let me you ask you this in 16 terms of my understanding -- just in terms of the -- 17 the -- the Appellants' involvement with what was going 18 on in this R&D. Did this R&D -- were there -- when 19 these issues -- when these activities were taking place 20 and R&D was being ascribed to -- to their activities, 21 was there a contract in place by the individuals -- by 22 the -- for the work that they were doing? 23 For instance, whether it be Hilmar Trees (sic) 24 or whoever, was there -- were they working in -- in 25 the -- in the essence of fulfilling a contract or was 26 this done without any contract and therefore it was 27 based upon an effort to do R&D in order to get a 28 contract? 44 1 MR. SPERRING: Exactly, yeah. It's the latter. 2 The way PSC has been able to grow its business, okay, is 3 by inventing a better mousetrap. So, they go to 4 prospective clients and they say, we see what your 5 packaging is, it's simple, it's plain. Here's what we 6 can do to save you money. We can make a prettier 7 package that is more cost effective. 8 And they do that through their intellectual 9 mind power, and by doing testing. And that's how -- 10 that's their market niche. 11 MR. RUNNER: Okay. And let me just go back 12 then to -- to -- to FTB. Does -- does that make a 13 difference in the sense that you have no contract in 14 place, that you are indeed -- in essence do an R&D in 15 order to be competitive with a -- the project that you 16 may or may not be getting, therefore you may not even 17 have, quote, you know, revenue coming in for that 18 particular activity? Does that make any difference in 19 the review of -- 20 MR. RILEY: With respect to Hilmar Cheese, 21 Hilmar Cheese went to PSC and asked them to remake a 22 cheese box that they had from some other manufacturer. 23 MR. RUNNER: Okay. 24 MR. RILEY: They then -- 25 MR. RUNNER: Let me just ask -- let ne just 26 follow up real quick on that since you bring that up. 27 Okay, when -- when -- does that mean -- does that mean 28 when Hilmar Cheese -- that -- that the company had a 45 1 contract and therefore if they -- 2 MR. SPERRING: Absolutely not. There was no -- 3 we had to build a better mousetrap to win the work. 4 MR. RUNNER: To get the work? 5 MR. SPERRING: Exactly. 6 MR. RUNNER: Is there a difference -- I mean, 7 there's -- isn't a difference -- I mean, I can -- I -- I 8 know lots of R&D the government goes to some -- you 9 know, some -- some manufacturer and says this is what we 10 want -- 11 MR. SPERRING: Right. 12 MR. RUNNER: -- and then they go and do an R&D 13 and they get these. 14 So it seems to me just the fact that you had 15 some -- some previous customer go to you and ask you if 16 you can do this doesn't necessarily mean you have a 17 contract in place. 18 Mr. RILEY: What -- well -- go ahead, please. 19 MR. HALAHAN: I think the issue of what you're 20 describing here, there is a term for it, it's called 21 independent R&E cost expense which you can incur in the 22 bidding process. And if that yields to a contract of a 23 product specifically identified with that R&D it should 24 be allocated to that contract. 25 So there are provisions in place for even this 26 kind of up front type of thing that you do on an 27 independent basis to try and win a contract, would still 28 have to be factored in. 46 1 MR. RUNNER: And so if they do that then -- 2 help me understand what you just said there. So if they 3 do that then they -- then that is -- then -- then that 4 is a qualified activity for R&D if indeed it was done 5 prior to the -- 6 MR. HALAHAN: Well, now you're getting to a 7 more detailed analysis where you have to get in and say, 8 okay, again this is where I think the interview falls 9 down. We didn't get in and start talking about funded 10 research which I think is your -- the point of some of 11 your questioning. Well, that D&R -- 12 MR. RUNNER: Well, there was no funded 13 research, as I can understand. There was none. So 14 there was no funded research. 15 MR. HALAHAN: Well, alls I can say is at audits 16 we've -- we've had that stated and found otherwise. 17 MR. RUNNER: Did you find otherwise? Do you 18 believe that some of these audits were funded -- were 19 funded? Or some of these R&D projects were funded? 20 MR. HALAHAN: Quite possibly. Based on my 21 review -- 22 MR. RUNNER: That's not -- 23 MR. HALAHAN: -- that I found -- 24 MR. RUNNER: Okay. Quite possibly you think 25 they were? 26 MR. HALAHAN: I'm saying quite possibly they 27 have the opportunity -- you know, without the actual -- 28 MR. RILEY: Without the contracts we don't -- 47 1 MR. HALAHAN: -- without it actually in 2 contract -- 3 MR. RILEY: -- you know, we don't know who -- 4 who -- 5 MR. HALAHAN: -- we can't tell. 6 MR. RILEY: But remember with this Hilmar 7 Cheese project -- 8 MR. RUNNER: But you don't -- okay, without the 9 contracts you don't know one way or the other? 10 MR. RILEY: Right, we don't -- 11 MR. RUNNER: Okay. 12 MR. RILEY: -- we don't know one way or the 13 other. 14 MR. RUNNER: Okay. 15 MR. RILEY: But with Hilmar Cheese, I mean what 16 he's showing you here, this -- this 150 pages of stuff 17 or however many it is, that is a lot of data collection. 18 But as Union Carbide stated, data collection 19 alone without a meaningful analysis does not equal -- it 20 does not constitute a process of experimentation. Okay. 21 So, just because they're taking all this data, 22 if there's no then contemporaneous analysis that does 23 not mean that there's -- I mean there's no -- 24 MR. RUNNER: So by your definition the 25 contemporary analysis does not equate to the interviews 26 and the backup documentation? 27 MR. RILEY: No, no, it does not. I mean, those 28 are -- those are years after the fact, for one. And 48 1 they are relating to their operations in general. Okay. 2 There's -- there is a -- a narrative created 3 for the study, I believe it was in 2003 for Hilmar 4 Cheese, which as Mr. Fox stated earlier it says it's for 5 a product, but in response to IDR 9 the -- the taxpayer 6 included a Treasury regulation; they said this is 7 exactly what we did in Hilmar Cheese, and that Treasury 8 regulation is relating to a proc -- a process. 9 So, they -- I mean, they're not identifying -- 10 there not only is there no documentation for detailing 11 the process of experimentation but they're not -- 12 they're also not identifying exactly what it is that 13 they are claiming. 14 MR. RUNNER: Okay. 15 MR. RILEY: Is it the change in the box from, 16 you know, by a quarter inch to make it -- make the 17 cheese inside no longer break? We -- you know, 18 that's -- that's the kind of thing that they're not -- 19 that they're not identifying. 20 Is it the process to fold the box? That's what 21 they're not identifying. 22 MR. RUNNER: Okay, let me -- let me go back 23 then to the issue of the -- the issue of contemporaneous 24 records. How -- obviously one of the -- part of this 25 issue lies on the issue of the -- at least in FTB's view 26 the lack of. How do you respond to that particular 27 issue in regards to contemporaneous records? 28 MR. SPERRING: Sure. I'll let Mr. Fox answer 49 1 the question. 2 MR. FOX: Yeah, the -- the reason that we 3 included the cites of the regulation is not because it 4 was a process. It's because it defines an example of 5 what is a qualified research activity, and -- and in 6 this case it was a food product, but what's key is that 7 they said that the design, testing, retesting and 8 evaluation of materials as part of a systematic trial 9 and error is qualified research. 10 That was the context of why that's provided and 11 that's exactly what they did with the Hilmar Cheese. 12 To say that we just collected data but there's no 13 meaningful analysis is not consistent with all the 14 different tests that were conducted. And every time 15 there were tests and they discovered failures they did 16 redesigns. Exactly what's in the reg. Design. Test. 17 Redesign. Retest. 18 So there is copious contemporaneous 19 documentation of the designs, what came out of the 20 design, the evaluation of the test results resulting in 21 why did it fail, how do we redesign. And so there may 22 not have been complete notes taken on -- 23 MR. RUNNER: So your definition of 24 contemporaneous would be the interviews that were done 25 in terms of how it is that -- how a person's time 26 allo -- is allocated and the documentation then that is 27 in the binders that then backs up the -- the information 28 that's -- that was done in the interview? 50 1 MR. FOX: And that -- 2 MR. SPERRING: Well, let me jump in. 3 The interview by definition is not going to be 4 contemporaneous, right? 5 MS. YEE: Right. 6 MR. SPERRING: I mean, the IRS, okay, in their 7 regulation acknowledges that you need to do an interview 8 if you have cost center accounting to determine the time 9 spent on R&D. Okay. 10 So, if you had a time sheet that would be 11 contemporaneous and then you wouldn't need interview, 12 and they wouldn't have this in the regulation. 13 So the only thing that's not contemporaneous in 14 the record is the survey, the employee survey 15 questionnaire. That's the only thing. Which the IRS 16 acknowledges that's what you have to do. So I don't -- 17 MR. RUNNER: But the survey goes back then 18 to -- and it is -- it is backed up then by the record -- 19 MR. SPERRING: Which is contemp -- 20 MR. RUNNER: -- which is contemporaneous. 21 MR. SPERRING: Exactly. 22 MR. RUNNER: Okay. Thank you. I'm -- I'm 23 done. 24 MS. MANDEL: Question. 25 MR. HORTON: Sure. Madam Mandel. 26 MS. MANDEL: So is -- is FTB saying that if a 27 company has documents that -- that relate to the 28 particular project and the documents, if you're 51 1 technical enough to know what they are, say -- show that 2 someone has designed something to meet a certain -- try 3 to meet a certain customer need, that they did some 4 testing on it and maybe sometimes it didn't have to go 5 back for redesign but sometimes it did -- is your -- 6 what I hear you saying is that you have a problem 7 because the people who were doing that sort of design, 8 testing, redesign and, Mr. Mayol, if you went down to 9 the floor and said, no, gee, Joe, you know, try doing it 10 this way, that they didn't write it up, that they 11 didn't -- that they don't have a little memo that's -- 12 that -- that -- you know, from the associate to the 13 partner saying here's what I did and here's how it 14 worked, that -- that's -- when you say analysis, that's 15 what it sounds like to me, that you're looking for a 16 writeup of here's my conclusions based on the testing 17 and maybe one time it worked and I didn't have to write 18 anything up. But that's what it sounds like you're 19 looking for. Is that -- 20 MR. RILEY: Well, if we can -- if we look to, 21 say, the Union Carbide decision, which is -- 22 MS. MANDEL: Which is a giant manufacturing -- 23 MR. RILEY: Which is -- 24 MS. MANDEL: -- concern, or a -- 25 MR. RILEY: Well -- 26 MS. MANDEL: -- pharmaceutical company which, 27 you know, it would be kind of traditional in your 28 mind -- 52 1 MR. RILEY: But these projects are isolated at 2 smaller plants, okay. So, their -- their process -- 3 their -- their plant employs, I -- I don't know, 350 to 4 500 people. 5 MS. MANDEL: Which -- who's -- who's they? 6 MR. RILEY: The -- the taxpayers. 7 MS. MANDEL: Taxpayer here? 8 MR. RILEY: Yes. 9 MS. MANDEL: Okay. 10 MR. RILEY: But in Union Carbide, for -- 11 they -- they analyzed five projects and they talked 12 about the documentation that was -- that was available 13 and that they looked at in the -- in their -- okay, that 14 Union Carbide provided. They provided a report to 15 detail whether tests were feasible, potential hazards, 16 necessary technical information. They specified the 17 equipment they had available. How much of the chemical 18 to purchase. The rate at which this chemical was to be 19 added. The benefits and drawbacks of dilution of that 20 chemical. A diagram of how it was to be injected. It 21 set out all the steps. 22 The report was approved by their environmental 23 pollution department and their R&D department. They 24 referred to it as a test run. They -- the supplier of 25 the chemical recommended amounts and the Union Carbide 26 followed it. The employees monitored and took 27 measurements of the chemical reaction. They -- they 28 didn't develop or refine the process and there was no 53 1 evidence of any analysis. 2 And the Court said that this is data collection 3 alone. And data collection alone, no matter how 4 detailed, does not constitute a process of 5 experimentation if it is not followed by a meaningful 6 analysis. 7 Now, if we take a project that did qualify, 8 which was -- this was a project that was mentioned in 9 the prehearing conference, the UCATJ -- 10 MS. MANDEL: I'm sorry, the -- the -- you said 11 that very fast, the what? 12 MR. RILEY: It was mentioned in the prehearing 13 conference. 14 MS. MANDEL: What was the name of it? You said 15 the name. 16 MR. RILEY: UCATJ. 17 MS. MANDEL: Okay, thank you. 18 MR. RILEY: -- which their -- the expert's 19 identified, you know, as a -- a textbook example of a 20 process of experimentation. They prepared run 21 documentation that identified objectives of each run, 22 and these were not produced for routine commercial runs 23 and they did not address minor problems to be solved by 24 troubleshooting. 25 They monitored the performance of the reaction. 26 They monitored the problems. They conducted experiments 27 during each run, adjusting compound ratios, adjusting 28 the environment, modifying the catalyst. UCATJ is a -- 54 1 is a catalyst. Introducing new technologies. They 2 collected samples. They reported the performance during 3 and following the job. They analyzed the results and 4 they developed ways to improve. 5 That was what the Court said this is a textbook 6 example of a process of experimentation. And all of 7 that was documented. Okay. 8 Here we have data collection. 9 MS. MANDEL: So -- so I guess your answer is if 10 there's not a memo at the end of it then your -- then 11 your view is it's just data collection. But if there 12 were a memo with conclusions at the end of it instead of 13 perhaps Mr. Jones reaching a judgment that then -- is -- 14 MR. HALAHAN: May I address that, your -- 15 MS. MANDEL: I mean -- 16 MR. HALAHAN: -- your general question? 17 MS. MANDEL: Because that's what I'm hearing 18 and I'm getting -- 19 MR. HALAHAN: It's -- 20 MS. MANDEL: And let me say that it was my 21 impression coming in today that there -- there were -- 22 well, there might have been and -- you know, somebody 23 tell me I'm just -- got this wrong, well, there might 24 have been a lot of projects that the company did and 25 projects maybe includes, you know, orders, things 26 they're building for people that -- that while there 27 might have have been some lesser amount of things that 28 they felt were really innovative in their work, my -- my 55 1 general understanding, and I don't -- you know, we 2 haven't seen the 17 binders. I don't know that we have 3 them. But my understanding of how the study has been 4 portrayed was that there were not hundreds and hundreds 5 of projects covered by the study but a select amount of 6 projects from which like maybe 33 -- 35, something like 7 that, and that -- that the auditor reviewed five that -- 8 that you can take a sample to try to figure out life in 9 general on these things, was my understanding, and that 10 of the five that -- that -- that certainly three were 11 accepted by the Franchise Tax Board as involving 12 research and development. That was my understanding. 13 And that two maybe there's a dispute a little bit about 14 whether they did or not, but my understanding was that 15 they did but the FTB thought they were outside -- they 16 weren't started until outside the time period so they 17 were kicked out. 18 And so, I'm -- I kind of thought that the major 19 focus of the case was really were the expenses that were 20 claimed adequately tied to the projects, not whether 21 there was actually something happening in R&D, but now 22 you've kind of got me confused about whether they have 23 to have a memo at the end of each sort of test run. 24 So, yeah, that -- that -- that maybe informs 25 you about why I had the question, because I -- we're not 26 talking about what I thought we were going to be talking 27 about. 28 MR. HALAHAN: Yes, Madam, I think I understood 56 1 your -- your point clearly as far as -- if I can 2 paraphrase it, the general proposition of what is FTB's 3 position at audit regarding what is sufficiency of 4 documentation and its nature and what does it mean. 5 I'd like to say we pull from a wide variety of 6 sources. They point out Publication 1082. Well 7 familiar with it. As a matter of fact, I'm a principal 8 author of it. We do pull from a lot of indirect, fly by 9 the seat of your pants, what -- what the taxpayer has 10 available. Because as -- as I'm sure you can 11 appreciate, taxpayers of varying sizes have various 12 levels of complexity, various levels of -- of detail and 13 documentation and you got to have that ability to kind 14 of sift through what you -- what they can provide you. 15 It's not uncommon for us to go down to emails 16 to try and get a sense of what they're doing. 17 Again, what we found problematic here was the 18 (inaudible) of qualified activity. Not necessarily just 19 the costing of it, the estimates. 20 Again, FTB is not having a problem with 21 estimating. I mean, but here the auditor couldn't 22 establish the qualified activity so there's really not a 23 point in looking too deeply into how to cost it. 24 MR. RILEY: If I can talk about one of those 25 five projects, one of the five sample projects, Juice 26 joint, which I believe is one that's attached to 27 Respondent's brief. To support that claim this is what 28 they submitted. They submitted an unrelated patent of 57 1 another company. It's a -- it's a basket carrier patent 2 from 1994. Why they submitted it to prove that they're 3 doing qualified research, I don't know. 4 They submitted evidence of a carrier design 5 copied from the Paperboard Packaging Council. That's 6 duplication of an existing business component and is 7 excluded from the credit by law. 8 The SAS, the Sales Automation System, entries 9 that they included show nothing more than cosmetic 10 changes to the items manufactured, such as changing the 11 graphic on the box from orange tangerine to lemonade to 12 tropical. These -- this activity, it's not a qualified 13 purpose under the statute. It relates to style, taste, 14 cosmetic or seasonal design factors. That's esthetics 15 and graphics. It's artistry and it's not a qualified 16 research. 17 So that project was also outside of the credit 18 years but for those -- there were a couple of entries in 19 the SAS system that were dated in December of 2001 and 20 those are the ones that relate to this style, taste or 21 cosmetic changes, the orange tangerine to lemonade to 22 tropical. 23 MS. MANDEL: So when -- 24 MR. RILEY: It's just changing -- 25 MS. MANDEL: -- when you say that you're 26 talking about -- 27 MR. RILEY: The printing on the box. 28 MS. MANDEL: -- the printing on the box. 58 1 MR. RILEY: So -- 2 MS. MANDEL: But I -- 3 MR. RILEY: -- instead of that that says from 4 diet to -- 5 MS. MANDEL: -- whatever it says was not -- 6 MR. RILEY: -- what's -- what's -- 7 MS. MANDEL: Let's not -- let's not criticize 8 my drink but -- but -- okay -- 9 MR. RILEY: Change it from cranberry 10 cocktail -- 11 MS. MANDEL: Yeah, just a different -- 12 MR. RILEY: -- to cranapple juice. 13 MR. HALAHAN: What color. 14 MS. MANDEL: And -- and -- and I think they 15 have a different answer on why they thought that -- 16 there was something about the materials they were 17 working with, that it -- that it wasn't just that they 18 hired some guy who made a flashy new design that was -- 19 but it's -- okay. 20 MR. HALAHAN: Ms. Mandel, I think you're 21 referring to the hybrid UV inks and coatings. I think 22 that's a project that's been -- been raised here for 23 2001. 24 Again, this gets back to the ambiguity of the 25 interview. Because when I look at that, one, hybrid UV 26 inks have been around since '96. They were well 27 established by 2001. Major manufacturers were producing 28 them at will. 59 1 Really from what I can tell from the high level 2 interview that was conducted, it appears the taxpayer is 3 referring to the blending of inks and that's no 4 different than a painter with a pallette. You -- it's 5 to please the esthetic eye, what are you looking for? 6 What hue? What might be the right hue of blue for you 7 may not be the right blue of hue for me. 8 Coatings, whether it's gloss or high gloss. 9 You may consider it gloss; I consider it high gloss. I 10 mean, frequently my wife and I get into this, you know, 11 a satin finish versus an eggshell finish and going back 12 and forth about what each think it looks like. 13 Again, that is what Jason is referring to as a 14 non-qualified purpose. If you're looking at the 15 esthetics of it it's not there. 16 MR. RILEY: And remember, with these 33 17 projects, you know, Franchise Tax Board just asked for 18 whatever projects they -- they thought qualified for the 19 credit. We asked them -- they could have produced for 20 us any -- anything that they had. Okay. And they chose 21 these 33 as the projects that they wanted to put forth. 22 The fact that two of them were outside the 23 credit years and -- and with this one that -- that it 24 just deals with the esthetics and the graphics. 25 MR. HORTON: Member Yee. 26 MS. YEE: Thank you, Mr. Chairman. I guess 27 before I ask my question can we just close the loop on 28 Joint Juice and the projects outside the -- the period, 60 1 because I think we -- I want to understand why 2 Appellants don't believe that to be true and I want to 3 go back to the Franchise Tax Board to see if there's any 4 concession there. 5 MR. SPERRING: Sure. Sure. Yeah, one -- one 6 of our -- our frustrations again is it doesn't appear 7 like they really looked at the study, what's been 8 provided to them. 9 MS. YEE: Actually, just speak specifically to 10 Joint Juice, since it -- 11 MR. SPERRING: Sure. With respect to -- with 12 respect to Joint Juice, the patent was provided to show 13 that -- the complexity was we had to design around an 14 existing patent. So the patent that was shown was for a 15 patent in -- earlier that a competitor had received on 16 a -- a similar product. And so now PSC was faced with a 17 situation where they had to design a package, a 18 six-cart, okay, that could hold six containers, and they 19 had to design it around an existing patent. 20 Nothing to do with the color. So that was the 21 complexity and it required a process of experimentation 22 to see if they could do it, get around these existing 23 patents, and still have a product that worked. 24 And so, what you have is we attached the 25 existing patent to the exhibit. FTB looked at that 26 patent date and said it's outside the audit. But the 27 whole point was that we had to design around an existing 28 patent. 61 1 MS. YEE: Okay. Stop there. And Franchise Tax 2 Board, you didn't think the -- what was provided was 3 clear enough with respect to what the patent 4 represented? 5 MR. RILEY: If that's the case it's probably 6 outside of the credit years. I mean, this Joint Juice 7 project, according to this SAS -- these SAS entries are 8 going, you know, from 2002 to 2006. Our latest tax year 9 here is 2001. Okay. 10 And within the 2001 year the entries that we've 11 got are the ones that I described. They're changing 12 from orange tangerine to lemonade to tropical. 13 MS. YEE: Okay. 14 MR. RILEY: This is -- this is Exhibit BB to 15 Respondent's opening brief at page 3 of 51. 16 MS. YEE: Okay. 17 I'm sorry, Mr. Chairman, let me -- 18 MR. HORTON: Oh, please continue. 19 MS. YEE: -- let me continue. I'm really 20 struggling here and I'll tell you why. This issue of 21 documentation is -- has me troubled. And the elusive 22 analysis that we're all looking for, or that the 23 Franchise Tax Board is looking for. 24 It seems to me that for each of the projects 25 there's been consistency with respect to what's been 26 provided and it's -- I think records documenting 27 repeated testing, revised drawings to the extent and the 28 tests haven't met the goal of the project. Project 62 1 narratives that describe the goal, and I would hope the 2 goal suggests that there had to be some experimentation 3 to reach that goal. The uncertainties of problems 4 encountered. The repeated development efforts and the 5 like. 6 Maybe that's not a sufficient analysis that's 7 all wrapped up with a bow on it. But in many ways it 8 exceeds what I think even Union Carbide required, and -- 9 and furthermore with respect to the allocation of the 10 employees' time on these projects I think the Appellant 11 has taken a more strict -- well, actually, they -- 12 they've I think really been diligent about strict 13 allocation of employees' time as opposed to what 14 happened in the Union Carbide for the years at issue. 15 Why isn't that sufficient? I mean, it just 16 seems like such a high hurdle. And -- and if we're 17 talking about the inability of the State to really 18 decipher these documents and records, I think we have a 19 bigger problem with respect to how to look at these 20 claims. 21 But why isn't all that sufficient to constitute 22 an analysis? 23 MR. RILEY: Because of the -- because of things 24 like the interview where Mr. Jones describes how -- 25 MS. YEE: Forget the interview. 26 MR. RILEY: Okay. 27 MS. YEE: Forget the interview. I mean, I'm -- 28 I'm troubled by the interview because they're very high 63 1 level, they don't speak to me about specific activities 2 that relate to the -- the claim. I really just want to 3 know did we examine the documents that were provided? 4 Did we understand what they were? 5 MR. RILEY: Yes, I understand exactly -- 6 MS. YEE: Okay. 7 MR. RILEY: -- what they are. 8 MS. YEE: Okay. 9 MR. RILEY: I mean, I -- I worked in an 10 orthopedic laboratory. 11 MS. YEE: Okay. 12 MR. RILEY: I did crush tests day after day. I 13 know exactly what those crush tests are. 14 So I know what's data collection and what 15 involves a process of experimentation. When I look at 16 the Hilmar Cheese project that's a bunch of data 17 collection. There's not -- there's -- you know, there's 18 no analysis at the end. And that's what -- that's what 19 the statute requires. I didn't write the statute but 20 Franchise Tax Board, we need to implement it. 21 MS. YEE: I'm going to -- I'm going to -- I'm 22 going to stop you there and just if you could then fill 23 in the gaps for us as far as what would have made for a 24 complete analysis of the Hilmar Cheese project. If in 25 fact it were a project that involved experimentation, 26 what's missing? 27 MR. RILEY: What's missing are the objectives 28 from the get go. The -- 64 1 MS. YEE: So there was no objective stated up 2 front? 3 MR. RILEY: No. 4 MS. YEE: Okay. All right, keep going. 5 MR. RILEY: There's no contemporaneous 6 analysis. 7 MS. YEE: Okay -- 8 MR. RILEY: I mean -- 9 MS. YEE: -- we're back to that word. 10 MR. RILEY: Well, I -- I -- I mean, I'm -- I'm 11 sorry for using it, but -- 12 MS. YEE: No, but what is it? What is it? 13 MR. RILEY: What is it? 14 MS. YEE: Yes. 15 MR. RILEY: It's -- you know, it's taking your 16 hypothesis. It is -- Mike -- hang on a second. Where 17 is my -- 18 MR. HALAHAN: Madam Yee, contemporaneous simply 19 means that it was done at the time the experimentation 20 took place. 21 MS. YEE: Okay. Okay. But we keep raising 22 this word "analysis" as if there's something more 23 involved going on and -- and I just have to say this is 24 what, the third -- fourth R&D case that's come before 25 this Board and with all of this documentation I just 26 want to know that we've given it -- 27 MR. SPERRING: Right. 28 MS. YEE: -- due consideration, and if there's 65 1 something lacking, given that the prior cases that we've 2 seen we've had very, very lacking situations -- 3 MR. HALAHAN: Well -- 4 MS. YEE: -- of documentation. 5 MR. HALAHAN: -- the test results that you see 6 with -- with data collection was just run numbers as far 7 as provided -- you have to see how that testing data 8 compares to normal quality assurance manufacturing 9 process testing. It's done on the system all the time. 10 Taxpayer -- or Mr. Jones indicates in his 11 interview that they do it on a regular basis. 12 So you have to distinguish that from what does 13 this documation -- documentation provide. Is this 14 specifically for working out those prototypes and -- and 15 functional models, or are we doing a manufacturing test 16 run collecting that data anyway, which we would anyhow? 17 MR. RILEY: If -- if I can jump in here, I 18 found my note. I mean, to satisfy the process of 19 experimentation the taxpayer should develop a hypothesis 20 as to how a new alternative might be used to develop a 21 business component, test that hypothesis in a scientific 22 manner, analyze the results of the test and either 23 refine the hypothesis or discard it and develop a new 24 hypothesis and repeat the previous steps. 25 But it is not sufficient that the taxpayer use 26 a method of simple trial and error to validate that a 27 process or product change meets the taxpayer's needs. 28 While the -- it requires a systematic trial and 66 1 error methodology. And while that can -- you know, 2 while that can be a process of experimentation, the term 3 "systematic" suggests that the process must involve a 4 methodical plan involving a series of trials to test the 5 hypothesis, analyze the data, re -- refine the 6 hypothesis and retest the hypothesis so that it 7 constitutes experimentation in the scientific sense. 8 Testing and refining hypotheses may involve 9 determining strengths and weaknesses of the alternatives 10 tested, whether and how the process could be further 11 refined and improved, and whether alternatives might be 12 better suited for achieving the taxpayer's goal. 13 We've got a lot of data -- 14 MR. HORTON: Excuse me. 15 MR. RILEY: We've got a lot of data. 16 MR. HORTON: Pardon me, where are you reading 17 from? 18 MR. RILEY: This is from Union Carbide versus 19 Commissioner at 223 to 224. 20 MR. HORTON: Okay. 21 MS. YEE: And -- okay. And -- and I believe 22 the Appellants have done that and I think what I'm 23 trying to tease out is do we have -- do we have to 24 discern this differently depending on the type of 25 product that's being developed, I guess? And we're not 26 talking about a biopharmaceutical company, we're not 27 talking about a medical company or a medical equipment 28 company, we're talking about containers and boxes. 67 1 And I think the degrees of sophistication are 2 going to differ depending on the product. And I do 3 think there were systematic processes that were in place 4 with respect to this Appellant. And so I'm -- I'm just 5 really having a tough time here about trying to figure 6 out whether -- you know, just really what's lacking 7 and -- and -- but I also want to know that, Franchise 8 Tax Board, you have confidence in terms of having 9 examined what was provided to come to your conclusion. 10 MR. RILEY: Yes, I'm -- I'm very confident 11 in -- in our conclusion. I mean, you know, Hilmar 12 Cheese is one of their projects. We've got -- you know, 13 I don't want to open that circle again that you've 14 closed, but those other projects there's not a whole lot 15 there, either. 16 MS. YEE: Okay. I'm going to conclude with one 17 final question, Mr. Chairman. I -- excuse me. 18 So the number of projects that we're focused 19 on, there were many more, you narrowed the number down. 20 Speak to us about the criteria for why you chose these. 21 MR. SPERRING: I'll let Kendall speak to that. 22 MR. FOX: Yeah, I mean one of the questions 23 on -- focusing on the interview was there were things 24 that should have been followed up on. Well, remember, 25 the interview was at the -- before we gathered the data. 26 We did do followup. That's to -- to basically further 27 identify and qualify the projects. 28 And so we chose a representative sample out of 68 1 the system so they would describe the number of projects 2 and they -- and we would say great, now we need to see 3 all of the underlying data. 4 So we tested and we kept collecting data until 5 we got them for 35. And we didn't find any exceptions, 6 any projects didn't qualify. We found that to be 7 sufficient. 8 The company does have all the records for the 9 rest of the projects. 10 So, again, in their system they have all the 11 projects, they have them identified. So, basically we 12 were testing their assertion that when they did these 13 design tests, analyzed projects, that they did have all 14 the -- they did have all of the underlying 15 documentation. 16 And, again, we were focused only on the new 17 products. We didn't include any of the "me, too" or the 18 existing commercial products. 19 MS. YEE: Okay. And can you kind of describe 20 what universe that is of the overall number? 21 MR. FOX: Umm -- 22 MS. YEE: So excluding the "me, toos" and 23 anything that wasn't exclusively new. 24 MR. FOX: Yeah, there's probably about -- 25 again, about 400 projects that would have been 26 qualified. 27 MS. YEE: Uh-huh. 28 MR. FOX: And we didn't -- and then the overall 69 1 there's about 1100 projects. So 700 were -- they're 2 volume production, most of the manufacturing, none of 3 those were included in the analysis. 4 MS. YEE: Okay. 5 MR. FOX: And we -- again, we confirmed that 6 they didn't include any of those by actually making them 7 pull documentation from the list of projects -- from the 8 system that they provided. 9 MS. YEE: Okay. So that was the discrepancy 10 between the 1100 and the 400 that you -- 11 MR. FOX: Yes. 12 MS. YEE: -- mostly came to? Okay. 13 Franchise Tax Board, is that -- 14 MR. RILEY: They -- I mean they initially 15 started out, they said that they engaged in 1100 16 projects per month as their research. And when we 17 pressed them then they changed it, they said they 18 mischaracterized the 1100 projects and they dropped that 19 estimate to 400 projects that involve R&D without 20 reducing the dollar amount of the claim. Okay. 21 MS. YEE: I don't think you're saying anything 22 different. 23 MR. RILEY: Well, but they then con -- 24 contradicted that claim by saying 800 to 1000 orders per 25 month are routine or repeat orders that do not involve 26 R&D activities. 27 Again, this drops it to what, 300 to 100? 28 Their web's -- 70 1 MS. YEE: But then we're talking about orders 2 versus projects. 3 MR. RILEY: Well, they never make a 4 distinction. 5 MS. YEE: Okay. 6 MR. RILEY: They call it orders, projects, 7 jobs, whatever they -- I mean, there's really never a 8 distinction, okay, in the interviews or anywhere else. 9 Their web site drops that to 100 to 200 brand 10 new designs of nearly 100 -- or of nearly 1,000 jobs per 11 month. In Mr. Jones' interview he talks about 15 to 25 12 new projects per day, or in Mr. Mitten's interview he 13 talks about 125 to 200 new items per month. 14 But, remember, new doesn't necessarily mean 15 that there's research, you know. 16 MS. YEE: Right. 17 MR. RILEY: If he calls it a new item, a design 18 or a project, a new -- that doesn't mean that there's 19 any research involved. As far as we know, these are 20 just customer orders. Okay. 21 But the -- when the auditor went for an 22 estimate she said, all right, I'm going to look at this 23 in the most objective fashion possible. We'll look at 24 your volume of work. You -- you say it's as low as 100 25 projects per month and as high as 1100. Well, we'll -- 26 we'll take the average of all these people, of Mr. 27 Mitten, of Mr. Jones, and we'll say there's like 300 28 projects per month. 71 1 So -- and then 350 divided by 1100, that's 32 2 percent. Okay. 3 So, we're saying like 32 percent of what 4 your -- of -- is in -- is these new projects. 5 Then, you know, the taxpayer and the -- and 6 Respondent had agreed to a sampling, you know, of five 7 of their largest projects. Two of them were outside so 8 she took the remaining 60 percent, multiplied that times 9 32, that equals 19.2 percent, which she rounded to 20 10 percent, and that's what Respondent's estimate's based 11 on, it's a mathematical calculation of what they gave to 12 us, you know. 13 And that -- I mean, 20 percent may sound a 14 little low, but that is $4.8 million in wages and 15 supplies that we allowed. 16 MS. YEE: Yeah. okay. Thank you, Mr. 17 Chairman. 18 MR. HORTON: Thank you, Member Yee. 19 Quite a bit of stuff here. Let me start out 20 with whether or not the FTB believes that there is some 21 qualifying activity here. It sounds as if though you do 22 based it on some sort of testing. I think I heard 23 earlier your testimony that you have concluded that 24 there is some qualified activity, is that correct, or am 25 I wrong in my hearing? 26 MR. RILEY: There's some possibly qualified 27 activity but it's -- you know, it hasn't been proven 28 by -- you know, with -- with documents. 72 1 MR. HORTON: Did you allow any? 2 MR. RUNNER: (inaudible) it. 3 MR. RILEY: We -- yeah, the -- the auditor did 4 allow. 5 MR. HORTON: And why did the auditor allow any 6 qualified activity? 7 MR. RILEY: Out of a basic sense of fairness. 8 I mean, she went on a plant tour. She -- she looked at 9 the -- all their stuff and said, you know, I think some 10 of these processes that you're doing here, these could 11 qualify. 12 MR. HORTON: So the auditor concluded based on 13 whatever methodology she may have used that there was 14 qualifying activity here? 15 MR. RILEY: She toured the plant. She looked 16 at their operations. She interviewed key employees. 17 And she reviewed the documentation that -- that they 18 provided. And -- 19 MR. HORTON: So -- 20 MR. RILEY: -- said that there's some. 21 MR. HORTON: So I'll take that as a yes. 22 MR. RILEY: I'd prefer if you would take it as 23 a -- that there is some but not a -- an unqualified yes. 24 MR. HORTON: Some means that it exists. So it 25 exists, yes or no? 26 MR. RILEY: Some exists. 27 MR. HORTON: Okay. So now that we've 28 established that there is qualified activity then we go 73 1 to how do we measure this qualified activity. And we 2 start out with the premise of whether or not it's 3 appropriate for the taxpayer to use call center 4 accounting or project accounting. Does the FTB concur 5 that either could be used? 6 MR. HALAHAN: Yes, Chairman Horton, we'd agree 7 either could be used. 8 MR. HORTON: Okay. And under cost center 9 accounting, is that method -- what's the primary 10 difference between cost center accounting and project 11 accounting? 12 MR. HALAHAN: The primary difference would be 13 that project accounting would be say, for instance, 14 the -- the cheese manfacturer product, that container, 15 they would track that specifically, all costs associated 16 with that container, in its development, in its 17 manufacture. 18 MR. HORTON: So it would go right back to a 19 specific project? 20 MR. HALAHAN: Correct. 21 MR. HORTON: And that's why they'd use the term 22 "project" -- 23 MR. HALAHAN: Project -- 24 MR. HORTON: -- "cost accounting" -- project 25 accounting versus cost center. Cost center other -- is 26 a larger -- looking at the larger center, maybe the 27 center of labor or some other center within the 28 operation. 74 1 Now, under the ATG are they allowed to use cost 2 center accounting? 3 MR. HALAHAN: Absolutely. 4 MR. HORTON: Are they allowed to use estimates 5 in order to determine what percentage might be 6 qualifying material, which seems to be where we are? 7 We've said that it does exist. We're trying to 8 determine what the percentage is. 9 MR. HALAHAN: Correct. 10 MR. HORTON: Are they allowed to use 11 interviews? 12 MR. RILEY: They're allowed to use interviews 13 in junction with contemporaneous documentation. 14 MR. HORTON: Okay. 15 MR. RILEY: Interviews alone -- 16 MR. HORTON: So let me go -- let me go back to 17 the taxpayer. Within these documents that you have here 18 the law requires that there is nexus to the business 19 component. And so, this is what they're referring to -- 20 in my mind this is what I want to see relative to 21 contemporaneous information. 22 Is there -- the -- the testing that you -- the 23 interviews that you conducted, can you tie that back to 24 a specific business component? Mr. Fox, I believe you 25 would be the appropriate person. 26 MR. FOX: Yes, we can tie it back to the 27 business components that were worked on by each cost 28 center. 75 1 MR. HORTON: And was that done in the test -- 2 tests? 3 MR. FOX: Yes. Again, we -- 4 MR. HORTON: Back to the FTB. What did we do 5 to impeach that? I mean, what did we do to say that's 6 wrong, that they -- did we trace -- did we take the 7 documents and trace it back to the business component, 8 analyze the business component and say yes or no, this 9 is qualified or is not, or is a hundred percent 10 qualified or 30 percent qualified? 11 MR. RILEY: We can -- 12 MR. HORTON: What did we do? 13 MR. RILEY: We can look at their response to 14 IDR 9, in which they state PSC works on 1100 projects 15 per month -- 16 MR. HORTON: No, no, no, no, no. 17 MR. RILEY: -- thus it would be impossible -- 18 MR. HORTON: Sir -- 19 MR. RILEY: -- to provide -- 20 MR. HORTON: -- sir -- 21 MR. RILEY: -- descriptions -- 22 MR. HORTON: -- sir, help -- I'm going to help 23 you out a little bit. When I ask the question if I 24 don't feel that I'm getting the answer, because the goal 25 here is for me to understand, and -- and I really 26 appreciate your testimony, don't -- don't get me wrong, 27 but I'm really asking so I can get the information that 28 I need to understand what happened. 76 1 Did the auditor trace from the document here 2 back to the business component and verify whether or not 3 that was a valid business component that had some 4 qualifying activity? 5 MR. RILEY: She was -- I think she was unable 6 to do that because of -- because of the -- the high 7 level nature of the -- of the wage questionnaires as 8 compared with the -- you know, as -- as Respondent -- as 9 Appellant stated with respect to things like the Hil -- 10 the Joint Juice project that these projects are so tiny 11 that they only account for less than one percent of any 12 employee's time. 13 MR. HORTON: So the auditor did not impeach or 14 determine that the business component reflected in the 15 interview, in the test, was valid or not? 16 MR. RILEY: To the extent possible she -- she 17 attempted that. 18 MR. HORTON: Okay. What prohibited her from 19 doing it? 20 MR. HALAHAN: Chairman Horton -- 21 MR. HORTON: Or -- let's not use -- what 22 prohibited the auditor from doing it? 23 MR. HALAHAN: Chairman Horton, let me -- part 24 of the problem you've identified, it's right on point. 25 The cost accounting method only has bearing in 26 estimation of expense. It really doesn't have a 27 bearing, per se, on how you develop -- 28 MR. HORTON: Yeah, that's -- that's kind of -- 77 1 MR. HALAHAN: -- qualified activity. 2 MR. HORTON: That's kind of where I'm going and 3 so the arguments against this test is more of a project 4 accounting arguments in where you would be looking for 5 project accounting and therefore you would be looking 6 for certain documentation. 7 But if you -- if you take the cost center 8 approach and you say, okay, this is a cost center, is it 9 allowed, apparently it is, and what document is 10 necessary. The interview's allowed but it's required 11 that you have contemporaneous information, required that 12 you back up that interview to support that there is 13 nexus that connects it to a business component. 14 And so it's inherent upon the auditor to -- to 15 verify the test, to say that this test is inadequate. I 16 don't really hear that we've necessarily done that. 17 What we've -- what we've said is, is that we're starting 18 from the premise that certain project cost account -- 19 project accounting methodologies were not employed. 20 Well, they weren't because that's not what they're 21 doing -- that's not what they're utilizing. They're 22 utilizing cost center. 23 And so when you have that distinction you have 24 to audit based on cost center strategies, which are 25 clearly delineated in the ATG. 26 MR. HALAHAN: Well -- 27 MR. HORTON: It says -- I mean, I don't want to 28 repeat what it says but -- 78 1 MR. HALAHAN: Right. 2 MR. HORTON: -- help me -- help me understand 3 how you test what they did and then concluded that it 4 was inadequate and that it wasn't tied to a particular 5 qualifying project. Not the overall general assessment, 6 we'll get there later on, but I'm just trying to walk 7 through this if you help me. 8 MR. HALAHAN: I'm really trying to help you 9 here, Mr. Chairman. Again, what you're -- what you're 10 trying to establish, this -- this tie between accounting 11 data and a qualified activity isn't possible. It's -- 12 they're used for two different purposes. 13 When we're talking about a qualified activity 14 we're talking about their business operations, not their 15 accounting structure. 16 MR. HORTON: So -- 17 MR. HALAHAN: We're not even looking at the 18 same kind of -- 19 MS. STEEL: So the tests that they -- the tests 20 that they -- they -- they conducted is inappropriate? 21 MR. HALAHAN: It's not designed to capture 22 qualified activity. It's designed to cost it. It 23 presupposes -- 24 MR. HORTON: That's cost center accounting in 25 and of itself. 26 MR. HALAHAN: And project accounting. 27 MR. HORTON: And -- 28 MR. HALAHAN: It's all accounting methods. 79 1 MR. HORTON: But if they tie it back to a 2 particular business component wouldn't we want to go 3 back and say trace it back to that business component? 4 Here's -- here's where -- here's where -- I want to 5 understand what the FTB did to impeach these records. 6 And -- 7 MR. HALAHAN: Basically what -- what happens 8 is -- 9 MR. HORTON: If we -- if we presume that cost 10 accounting is acceptable, interviews is acceptable and 11 contemporaneous information is tying it back to the cost 12 center and all the data that's there to do that, 13 starting with the premise that some type of qualified 14 activity exists, be it ten percent as -- as claimed by 15 the taxpayer, or 20 percent of the ten percent, that's 16 where we are, is trying to -- 17 MR. HALAHAN: But -- but -- but, again, that's 18 focusing on the cost, not the activity. So let me kind 19 of back you up and -- and fill you in on how we would do 20 it at audit. 21 MR. HORTON: Okay. 22 MR. HALAHAN: You have to establish the 23 qualified activity. Once the auditor is satisfied with 24 that then you can look to these accounting methods as 25 estimates of that cost. 26 MR. HORTON: Did -- did the auditor establish 27 qualified activity? 28 MR. RILEY: Well, let's back up. Just -- just 80 1 because the auditor allowed a -- 2 MR. HORTON: No, I -- 3 MR. RILEY: -- a toe in the door of qualified 4 research does not mean that suddenly they get whatever 5 it is they claim. Just because she said I think that 6 there's some of it, I don't know what -- how much it 7 is -- 8 MR. HORTON: No, I agree with that. 9 MR. RILEY: -- but there's -- 10 MR. HORTON: I agree with that. 11 MR. RILEY: -- it doesn't mean that, hey, the 12 floodgates are open and whatever we claim that's what we 13 get. That's -- 14 MR. HORTON: I agree with that. I agree with 15 that. You're throwing me off my train of thought here, 16 which is not a good idea, believe me. I mean, I don't 17 take that as an effort to really explain yourself. I 18 take that more as a defense. 19 MR. RILEY: Well -- 20 MR. HORTON: And so what I'm -- I'm not asking 21 for another explanation. So let's go back to -- 22 MR. HALAHAN: Did the auditor properly 23 establish the qualified activity in this case. 24 MR. HORTON: Yes. And -- and if not, how do 25 they do it. And if so, what do they do to establish 26 that a qualified activity existed? 27 MR. RILEY: We look at the documents. 28 MS. MANDEL: I think he's asking (inaudible). 81 1 MR. HALAHAN: In my opinion, a more thorough 2 review would -- should have been done to establish 3 qualification. In my opinion, based on what I've seen 4 of this record I would have left it unsubstantiated. 5 MR. HORTON: Okay. And that puts us at a real 6 disadvantage. 7 MR. HALAHAN: I understand that. 8 MR. HORTON: Yeah. Okay. 9 The test that was done, the test of, I believe, 10 five items -- before I get started, which one of you are 11 going to speak to this question? 12 Okay. The test of the five -- five items, tell 13 me what happened there. And what was concluded. 14 MR. RILEY: You know, the auditor attempted 15 to -- you know, she said after the plant tour -- I 16 believe before the plant tour the auditor was going to 17 deny the credit in full. Went on the plant tour. She 18 saw -- she saw something at the plant tour -- 19 MR. HORTON: Let -- let me -- let me -- before 20 the plant tour the auditor was going to deny it in full 21 based on what? 22 MR. RILEY: Based on a lack of substantiation 23 in the documents provided. 24 MR. HORTON: Okay. So the taxpayer had not 25 provided the -- the auditor the documentation in order 26 to make that determination, so the auditor decided to do 27 an alternative test -- 28 MR. RILEY: Right. 82 1 MR. HORTON: -- which is a physical 2 observation? 3 MR. RILEY: She went out and she -- 4 MR. HORTON: Which is okay. That's -- 5 MR. RILEY: Yeah. 6 MR. HORTON: That's the appropriate thing to 7 do. So -- 8 MR. RILEY: I -- I would think so, yeah. 9 MR. HORTON: Okay. 10 MR. RILEY: She went out. She -- 11 MR. HORTON: Now, another way to have done it 12 is to just ask for the documents that you want to see. 13 MR. RILEY: The -- 14 MR. HORTON: But, you know, as -- as we sort of 15 established we probably should have did more work but, 16 please. 17 MR. RILEY: I mean, when we did ask for those 18 documents, they were not provided. So, I mean when we 19 asked for further documentation of an actual -- a 20 process of experimentation they weren't provided. So 21 the auditor said, all right -- 22 MR. HORTON: Okay, I'll -- 23 MR. RILEY: -- we'll do a -- 24 MR. HORTON: -- I'll get to the process of 25 experimentation. 26 MR. RILEY: Okay. 27 MR. HORTON: The -- 28 MR. RILEY: We're talk -- 83 1 MR. HORTON: You can't segregate your comments. 2 Try to stay focused on the question and the matter 3 before us. 4 You just shifted to experimentation, which is 5 another qualification, another subject matter that we do 6 have to determine -- 7 MR. RILEY: Yeah. 8 MR. HORTON: -- whether or not it existed, but 9 we're starting from the premise that some 10 experimentation did exist and I'm trying to have a 11 better understanding of how we establish that or how we 12 concluded that it didn't exist. 13 I'm -- I'm -- either way I'm good. 14 MR. RILEY: So she -- she went on the plant 15 tour. She interviewed some people at the plant tour. 16 Sorry. And she -- she just -- she observing 17 their operations, you know. There were a number of -- 18 of process lines that she thought, you know, I think 19 based on this, based on my observation of this process 20 line, based on the interviews, you know, Mr. Jones 21 talking about these, I think that possibly these things 22 could qualify. 23 But she -- 24 MR. HORTON: When you say the interviews, what 25 interviews are you referring to? 26 MR. RILEY: I'm -- I'm -- she -- she talked 27 with Mr. Jones at the plant tour. We -- 28 MR. HORTON: These are -- these are not the 84 1 interviews conducted by the taxpayer, these are the 2 interviews conducted by the auditor? 3 MR. RILEY: Correct. 4 MR. HORTON: Okay. 5 MR. RILEY: Later we have, you know -- I think 6 in -- in 2006 probably the -- the interview conducted by 7 Appellant's representatives with Mr. Jones was 8 submitted. 9 MR. HORTON: Okay. 10 MR. RILEY: So -- but based on these things she 11 thought, I don't know, I -- I think maybe some research 12 is going on. I can't -- you know, you -- you -- 13 MR. HORTON: She didn't -- she didn't think -- 14 you can't characterize an auditor's examination. The 15 auditor concluded that it was some activity, qualified 16 activity, going on based on her physical observation. 17 MR. RILEY: Correct. 18 MR. HORTON: I mean, I -- I don't want to 19 minimize the -- the work of the auditor. 20 MR. RILEY: No, we shouldn't. It was a -- it 21 was a very difficult audit. It went on for a very long 22 time. 23 MR. HORTON: Yeah. 24 MR. RILEY: And, you know, just trying to get 25 at is there qualified research here. 26 MR. HORTON: So -- so once the auditor has 27 concluded that qualified research does exist -- 28 MR. RILEY: She said let's take -- let's -- 85 1 okay, they submitted the Hilmar Cheese project, the -- 2 and the X-Box project and the auditor and 3 representatives disagreed as -- the auditor said this 4 doesn't qualify. So, let's -- 5 MR. HORTON: Are we speaking of the five items 6 that were submitted? 7 MR. RILEY: This -- just prior to the five 8 items they submitted -- 9 MR. HORTON: Are they -- 10 MR. RILEY: -- Hilmar Cheese. 11 MR. HORTON: And they said it didn't qualify? 12 MR. RILEY: And the auditor said this doesn't qualify. 13 MR. HORTON: Okay. 14 MR. RILEY: So she said, look, give us your 15 biggest projects. We're going to take a sample of them. 16 The taxpayer gave us a list of 33. The taxpayer -- the 17 auditor selected five of those. 18 MR. HORTON: Okay. 19 MR. RILEY: And of those five the Guardian 20 project was outside the credit period. The Joint Juice 21 project that we spent a lot of time on was outside the 22 credit period and -- 23 MR. HORTON: So let me -- 24 MR. RILEY: -- it didn't qualify. 25 MR. HORTON: -- let me stop you there. 26 By virtue that it was outside the audit period 27 and that it was a substanance test that you were 28 performing, not necessarily a quantity sort of test, 86 1 you're trying to make a determination. So it was a test 2 to determine whether or not qualified activity -- I'm 3 having a little bit of a challenge from a testing 4 perspective when you're making a determination test as 5 to why it really matters whether it was in the audit 6 period, and particularly when the premise is, is that 7 this is consistent with the activity of the company. 8 Can you help me there? 9 MR. RILEY: Well, because the company does an 10 incredible amount of just manufacturing these so-called 11 "me, too" projects that they -- that they talk about, 12 this -- this stuff where they're leveraging one hundred 13 percent of what they know, that's not research. 14 So we need to be able -- 15 MR. HORTON: Well -- 16 MR. RILEY: -- to separate -- 17 MR. HORTON: -- that's been established. Even 18 by the taxpayer's own admission, 90 percent of what they 19 do is what you just described. 20 MR. RILEY: But even those projects that they 21 said here's our ones that qualify -- 22 MR. HORTON: Uh-huh. 23 MR. RILEY: -- like Hilmar Cheese, the -- the 24 auditor determined and we've -- you know, we concur that 25 that's not a qualified project. 26 MR. HORTON: So of the -- 27 MR. RILEY: Of the five. 28 MR. HORTON: -- three that was -- of the five, 87 1 none of them were qualified projects? 2 MR. RILEY: Of the five two were outside and so 3 were excluded because they're not -- you know, you can't 4 claim a credit for 2002 in (inaudible). 5 MR. HORTON: So let's go with that. The three 6 that were included, did the auditor accept those three? 7 MR. RILEY: She accepted those three. 8 MR. HORTON: Wow. 9 MS. MANDEL: But -- and that's where you got -- 10 you took 60 percent of -- everything that's claimed? 11 MR. RILEY: Three of the five, yeah. 12 MS. MANDEL: No, no, no, no, no, let me do the 13 math and then tell me I'm wrong. Don't tell me I'm 14 wrong in the middle of the math because you don't know 15 the rest of the math. All of the dollars claimed in the 16 study, if you took 60 percent of all of the dollars 17 claimed in the study as a starting point and then 18 applied the percentage that you said before to the 60 19 percent to get to the dollars? 20 MR. RILEY: Yeah, either -- either way, if 21 you -- 22 MS. MANDEL: Right, but the -- 23 MR. RILEY: -- if you -- 24 MS. MANDEL: -- but the -- but the measure -- 25 the measure -- the starting measure before she applied 26 percentages, whichever percentage she applied first, 27 the -- the measure was all the dollars that they were 28 claiming in the study. 88 1 MR. RILEY: Yes. 2 MS. MANDEL: Okay. And the 60 percent was 3 because she said 60 -- said three out of the five 4 projects involved qualifying activity? 5 MR. RILEY: Or at least were within the credit 6 period. 7 MR. HORTON: Well, wait. 8 MS. MANDEL: Okay. Okay. So -- okay, so if -- 9 if all five of the projects involved qualifying activity 10 and were inside the credit period she would have applied 11 a hundred percent to the dollars claimed in the study, 12 as the first math? Or the -- 13 MR. RILEY: As the first math, yes. 14 MS. MANDEL: Okay. And then -- but then she 15 seemed to have been of the view that there was some 16 difficulty with all of the dollars claimed in the study, 17 which I think is where Ms. Yee started in the very 18 beginning. Executive wages; there were some departments 19 that she thought were post-production and then she had 20 this somewhat amorphous -- this is my recollection, so 21 somewhat amorphous view of how many projects there 22 really were that should qualify and so she came up with 23 a number of -- which you put at 32 percent, I think was 24 the number. 25 MR. RILEY: Correct. 26 MS. MANDEL: But when I heard you talk about it 27 I heard 32 percent in terms of sort of the -- just a 28 rough cut on the number of projects rather than these 89 1 other elements. So, -- 2 MR. RILEY: I mean mathematically it's the same 3 if you multiply it by 60 percent first or by 32. 4 MS. MANDEL: No, I understand, but I -- I mean, 5 if the Board were to find that the other two projects 6 actually started inside the period so -- and if the 7 Board were to find that the other two projects had 8 qualifying activities, if the Board were to do nothing 9 else in terms of estimating expenses or deciding that -- 10 that for, you know, a variety of reasons they are -- the 11 Board is willing to accept the entire study as it is, 12 dollars as it is -- if the Board were just to pull those 13 two projects in then using your auditor's method the 14 percentage goes from 20 to 32 or -- 15 MR. RILEY: Correct. 16 MS. MANDEL: Okay. And then if the Board were 17 to conclude that -- that there was a misunderstanding 18 or, as the taxpayer's preferred word is, confusion about 19 what the executives were really doing, whether they 20 were, you know, down in the dirt with Mr. Jones on the 21 testing or whether they were saying, oh, okay, when he 22 brings it to them -- if the Board were to conclude that, 23 you know, Mr. Mayol -- I forget the other people's names 24 that you have as the executives, were really that first 25 line for the percentage, which was what, like five 26 percent of their time or -- that the executive wages -- 27 that the -- that the auditor should not have excluded 28 executive wages, that conceivably bumps up her 32 90 1 percent a little bit. 2 I'm just trying to figure out where -- 3 MR. RILEY: Yeah, if -- yeah, it -- it could 4 conceivably bump up the 32. 5 MS. MANDEL: And the -- and the four 6 departments that were excluded as post-production, I'm 7 trying to remember them all, but I think there was -- 8 MR. RILEY: Transportation and quality control. 9 MS. MANDEL: -- transportation and quality 10 control -- and my understanding was it wasn't a hundred 11 percent of those departments that were claimed but some 12 percentage based on the surveys, is that correct? 13 So if the Board were to conclude that what 14 was -- that those departments, because again it's this 15 cost center accounting -- I think this is where we get 16 into the thing about cost center accounting and project 17 accounting -- that the auditor thought that -- that 18 transportation only meant moving the stuff around in the 19 final production phase of actually making boxes or 20 whatever they're -- you know, whatever; and that quality 21 control only had to do with making sure everything was 22 copasetic when they're running the production line as 23 opposed to some other time during their activities that 24 they do at the company -- that if the Board were to 25 conclude that -- that -- and we haven't had -- that was 26 kind of written up in the briefs but you guys haven't 27 talked about those four departments, that also -- the 28 exclusion of those kind of went into part of her, you 91 1 know, 32 percent. 2 I mean, I hear what you say about the Board -- 3 you know, that there have been cases where the Board has 4 not disturbed a Cohan adjustment made by Franchise Tax 5 Board, but we have -- it seems like you have to 6 understand what went into that judgment that it's 32 7 percent, and then if the Board has -- takes issue with 8 the things that went into the judgment as to the 32 9 percent that that could impact what percentage the Board 10 might think was appropriate or the whole thing. 11 I mean, from an analytical standpoint. Does 12 that make -- 13 MR. RILEY: Yeah, I mean the cases are -- I 14 mean, the -- the -- I believe your Board has published 15 29 decisions involving Cohan, and they are split 16 basically 50-50 between cases where your Board did not 17 disturb the Franchise Tax Board's determination and 50 18 percent where the -- there were independent facts upon 19 which you could base a different finding. 20 MS. MANDEL: Okay. 21 MS. STEEL: Chairman Horton -- 22 MR. HORTON: Okay. 23 MS. STEEL: -- I know -- I don't want to throw 24 you out from your thought -- 25 MR. HORTON: Go ahead -- go ahead, though. 26 MS. STEEL: -- but just -- just one question 27 here -- 28 MR. HORTON: I could -- 92 1 MS. STEEL: -- that I've been listening from 2 Franchise Tax Board that a lot of if possible, not fair, 3 some. I just really need definite language there 4 because, you know, from the audit. 5 But I heard that there's two projects out of 6 five that it's been audited were outside of that audit 7 period. 8 I want to hear from the taxpayer about those 9 two. 10 MR. SPERRING: Sure. Sure. Yeah, the first -- 11 MR. HORTON: Please come closer to the -- 12 MR. SPERRING: Yeah, the first one involved 13 Joint Juice. 14 MS. STEEL: Yeah. 15 MR. SPERRING: And as we spoke about the 16 difficult -- technological difficult was designing 17 around a patent. Okay. There were several patents our 18 competitors had that we designed around. 19 And so to show that this in fact was the truth 20 we did two things. We attached two patents to our -- 21 our response to the IDR and audit. One was a patent 22 that a competitor held of a similar product that we had 23 to design around. And the other one was a -- a patent 24 that we had on a similar -- a similar box. 25 And so, that was -- it was those patents that 26 the auditor looked at and then wrote that because these 27 patents were prior to the audit cycle, okay, the project 28 fell outside the audit cycle, when in fact there was 93 1 no -- there was never a patent on this product. 2 MS. STEEL: So, you don't put patent on some of 3 the products because -- 4 MR. SPERRING: Exactly -- yeah, because clients 5 generally -- customers don't want to have -- be using a 6 patented project. 7 MS. STEEL: Because they have to stock with one 8 of the company -- 9 MR. SPERRING: Exactly. 10 MS. STEEL: -- and they would be very 11 competitive. 12 MR. SPERRING: Exactly. 13 MS. STEEL: Okay, thank you. 14 MR. HORTON: I don't -- I don't -- I'm -- I'm 15 not clear that question was answered, for me, at least. 16 But let me start off by saying it sounds as if, though, 17 this was a test to make a certain determination relative 18 to qualified versus non-qualified. And I'm not 19 really -- I'm not really focused on whether it's in the 20 audit period or not in the audit period. 21 I would be more concerned about whether or not 22 the data was representative of the -- of the 23 transactions that existed, and apparently it was by 24 virtue it was selected out of a larger universe. 25 So I'm going to make that conclusion to start 26 now but just for my own clarification, if you will, were 27 those two items in your opinion within the test period 28 or were they not? 94 1 MR. SPERRING: They were. Absolutely. 2 MR. HORTON: And why is there a difference of 3 opinion between you and the Franchise Tax Board? 4 MR. SPERRING: Well, on the Joint Juice project 5 we feel they didn't read the description of the project. 6 And as a result they didn't understand that we were -- 7 the technological feat was we had to design around 8 patent -- a patented product. 9 MR. HORTON: So the activity occurred -- 10 occurred subsequent to the patent? 11 MR. SPERRING: Exactly. 12 MR. HORTON: The patent date was outside, the 13 activity was within the audit period. 14 MR. SPERRING: Exactly. 15 MR. HORTON: Is that what you're saying? 16 MR. SPERRING: Yeah. 17 MR. HORTON: Okay. 18 MR. SPERRING: So that's Joint Juice. Then we 19 can talk about the other product if you'd like. There's 20 two, right? So -- so that was Joint Juice. 21 MR. HORTON: Sure. 22 MR. SPERRING: Guardian, the product there -- 23 or -- or the -- the reason we're in this situation was 24 in our response we did -- PwC did a typo and wrote 2002 25 on the project when all the attached documentation on 26 the project was earlier. So that was a typo on our 27 part, which we corrected in a subsequent response. So 28 as soon as we saw that we had made that typo we 95 1 corrected it. 2 MR. HORTON: Well, how -- how would the auditor 3 know that? 4 MR. SPERRING: Well, two things. One, we 5 corrected it, but first when you look at the 6 documentation behind the description all the 7 documentation -- the contemporaneous documentation had 8 the correct date on it. 9 MR. HORTON: Of the Franchise Tax Board, this 10 particular statement -- 11 MR. RILEY: Guardian project, yeah. 12 MR. HORTON: Were we -- were -- was the 13 Franchise Tax Board ever made aware that the documents, 14 there was a typo or -- 15 MR. RILEY: They've never said it was a typo 16 before this moment, but -- 17 MR. HORTON: Okay. Well -- 18 MR. SPERRING: That's not true. We have a 19 letter. 20 MR. HORTON: I'm -- 21 MR. SPERRING: I'm sorry. 22 MR. HORTON: Okay. Did they -- they -- their 23 testimony is that there was documentation behind it that 24 indicated that some of the activity, if not all or a 25 percentage, occurred subsequent to the -- to the cutoff 26 period for the audit period. Was that examined or do 27 you have access to -- did you have that information? 28 MR. RILEY: I don't have the Guardian project 96 1 with me today. 2 MR. HORTON: Did the auditor have -- 3 MR. RILEY: But I recall -- 4 MR. HORTON: -- all of that? 5 MR. RILEY: The auditor had all -- yeah, of 6 course. 7 MR. HORTON: Okay. 8 MR. RILEY: I do recall the documents that were 9 provided along with it, and there were a number of order 10 forms and things which were -- that they claimed were 11 for the project. Those were in 2002. 12 MR. HORTON: Okay. That's -- you know, as soon 13 as I go back to the taxpayer they're going to say that 14 they sent you a document or they sent you subsequent 15 information, so let me just ask. 16 Did you receive any subsequent information that 17 would clarify the date and times of this particular 18 transaction? 19 MR. RILEY: Not to my knowledge regarding the 20 Guardian project. 21 MR. HORTON: Okay. Do you -- you -- you 22 believe that you submitted it? 23 MR. SPERRING: Yes, we did. 24 MR. RILEY: Do you have a date? I mean, I've 25 got a lot of the documents in here. 26 MR. HORTON: Okay. I don't really want to 27 conduct an audit, you guys. The Cohan adjustment, you 28 know, in the absence of evidence the taxpayer's done a 97 1 test and it seems to me before we can go to the Cohan 2 adjustment we've got to impeach the test. We've got to 3 trace it back. We've got to say here's the fallacy in 4 this, it doesn't conform. 5 Help me understand how we -- what was the 6 conclusion, how did we come to this conclusion that we 7 were going to use these hypotheticals to determine what 8 the percentage of qualified activity was? 9 MR. RILEY: This will be going back and 10 repeating a lot of my presentation but I'm happy to do 11 it. 12 The wage questionnaire that they submitted is 13 the cornerstone of the -- of the credit study that is 14 based on their interviews. It was signed by Mr. 15 Jones on July 9, 2003, the day before they conducted the 16 interview on July 10, 2003. And it's apparent from the 17 interview that they are not taking into account much of 18 what Mr. Jones says in the interview in this wage 19 questionnaire. They're not taking into account all the 20 non-qualified time that he says he does in the 21 interview, yet the wage questionnaire claims one hundred 22 percent of his time as qualified research. 23 Now, there are a few little things -- a few 24 administrative categories for which they claim Mr. 25 Jones. I think it's actually one of the exhibits that 26 they -- that they gave us today. So let's refer to 27 that. 28 MR. HORTON: Well, just -- just for clarity 98 1 let -- let me -- let me stop you for a second. I don't 2 know that they claimed a hundred percent. I think they 3 may have used IRS rules that says that if it's in excess 4 of a certain percentage that they can round up to a 5 hundred percent. So just -- 6 MR. RILEY: Right. They claim -- 7 MR. HORTON: What -- 8 MR. RILEY: -- they claimed 83 percent of his 9 time as qualified research. 10 MR. HORTON: Okay. 11 MR. RILEY: They claimed -- so 17 percent as 12 budgeting, scheduling, hiring and non-technical 13 meetings. 14 MR. HORTON: Okay. 15 MR. RILEY: Okay. So this does not take into 16 account the -- the vast amount of time that he describes 17 in this interview about where they're leveraging one 18 hundred percent of what they know on past activities. 19 Okay. 20 When you're doing that that doesn't -- that's 21 not qualified research, you know. 22 MR. HORTON: Okay. 23 MR. RILEY: They also -- they claimed, you 24 know, in wages Mr. -- Mr. Jones made over a million 25 dollars over the three years. So they are claiming over 26 a million dollars just in his wages. And they're also 27 claiming it for a bunch of these "me, too" projects that 28 are -- you know, these -- these things that they already 99 1 know how to do and so there is no qualified research. 2 MR. HORTON: So -- so the auditor concluded 3 that a percentage of Mr. Jones, other -- of the 80 4 percent that they -- 83 percent that they had claimed, 5 that a percentage of that was not qualified? 6 MR. RILEY: Yes. And in fact because Mr. Jones 7 is a -- 8 MR. HORTON: Based on -- based on the 9 interview. Based on the -- 10 MR. RILEY: Based on the interview, yeah. 11 MR. HORTON: -- the actual interview. And can 12 you give me some examples of what the auditor said 13 wasn't qualified? 14 MR. RILEY: Sure. Where is our interview? 15 Well, for example, the -- 16 MR. HORTON: And -- 17 MR. RILEY: -- the -- I mean -- 18 MR. HORTON: -- while he's doing that -- 19 MR. RILEY: -- first -- first of all -- 20 MR. HORTON: -- let me just get the taxpayer 21 going on the followup question. What percentage of Mr. 22 Jones is reflected in the entire test? You don't have 23 to answer now but you may have to during a -- 24 MR. RILEY: Oh, I'm sorry. 25 MR. HORTON: Mr. Riley, please. 26 MR. RILEY: I'm -- I'm ready. So he's talking 27 about buying equipment and bringing in engineers from 28 the equipment manufacturer to get that started. That's 100 1 on page 17 of their -- of the interview. 2 MR. HORTON: To get the acquisition started of 3 the equipment? 4 MR. RILEY: To get the -- to get the equipment 5 started. If you're just buying a piece of equipment 6 that's not qualified research. And if you're using 7 somebody else to get it started that's not qualified 8 research, either. 9 MR. HORTON: Okay. 10 MR. RILEY: They're talking about bringing in 11 engineer -- bringing in engineers from the ink vendors 12 to do blending on UV hybrid inks. He's talking a whole 13 lot about managing relationships with his customers. 14 You know, he talks a lot about engineering and 15 innovation and blending but there's really -- there is 16 no clarity as to what exactly Mr. Jones believes these 17 terms mean. Because -- 18 MR. HORTON: Okay, I got it. 19 So -- so what percentage of Mr. Jones' activity 20 did the auditor conclude was qualified? 21 MR. RILEY: Well, the auditor lumped him into 22 everything else and he was allowed at 20 percent. 23 MR. HORTON: So the auditor -- the auditor 24 tested Mr. Jones, who is clearly serving in an 25 administrative capacity and didn't look at the others? 26 I mean, the -- the weight is going -- 27 MR. RILEY: The other administrators. 28 MR. HORTON: I mean, the weight is going to 101 1 clearly vary. I mean, if you take an administrator 2 versus a designer that percentage is going to vary. I 3 mean it's just inherent in the activity that they do. 4 So if we're disallowing -- it doesn't seem like 5 we should have done that. 6 MR. RILEY: We probably shouldn't have. I 7 mean, the -- the taxpayer's very fortunate, I believe, 8 to have been allowed 20 percent in this case. 9 MR. HORTON: No, it doesn't seem like -- 10 doesn't seem like we should have used the -- we should 11 have used the -- the most supervision, administration in 12 and of itself is inherently not part of R&D. I mean, 13 it's just inherent within the law. 14 And so you take a person that is in that 15 category and you make a conclusion without looking at 16 the rest of them, that seems a little unfair. That's 17 what I'm saying. 18 And without drilling down and saying, okay, 19 let's take a look at this one particular item and 20 instead of 83 percent it should have been 60 percent, 21 and then make the adjustment here and then extrapolate 22 as opposed to saying, okay, we're going to go back to -- 23 now we're going to use the Cohan adjustment -- okay, 24 I'm -- I'm good. 25 MR. RILEY: I think you -- if I -- if I may. 26 MR. HORTON: Please. 27 MR. RILEY: I don't think you're going to like 28 this answer, but it comes down to the documentation. 102 1 MR. HORTON: No, but -- but -- 2 MR. RILEY: There's no nexus between what Mr. 3 Jones does and any documentation. 4 MR. HORTON: Okay. 5 MR. RILEY: Okay. So -- 6 MR. HORTON: Well, let me -- let me -- 7 MR. RILEY: -- that -- that type of analysis -- 8 MR. HORTON: -- let me just clarify something. 9 I really don't like or dislike anything. You know, I 10 just try to look at the facts and try to extract them. 11 So I'm not -- I'm not sitting in any one of those chairs 12 right now. 13 To the taxpayer, Mr. Jones' activity. The 14 auditor concluded that a percentage of that was not 15 qualified. It seems to make a little bit of sense. 16 Did -- at any point did you go back and take a 17 look at what the auditor said and -- and -- and present 18 any additional evidence or challenge that or -- was 19 there any discussion at all? 20 MR. FOX: As part of the process we made Mr. 21 Jones available for interview to explain exactly what 22 was on his questionnaire. 23 MR. HORTON: Okay. 24 MR. FOX: He does go into quite a bit of 25 specificity about all the different activities that he 26 was involved in, including listing out his projects. 27 And in -- keeping in mind that the purpose of the 28 interview was it done near the front end of the study 103 1 about not only gaining information about his activities 2 but the company as a whole. 3 So if he's making comments about we do "me, 4 toos" he's talking about the company and not necessarily 5 only his activities. 6 But we did follow up specifically on -- 7 MR. HORTON: Can -- can we keep it specifically 8 to his activities -- 9 MR. FOX: Yeah, I am. 10 MR. HORTON: -- that the -- FTB has -- has 11 delineated or described some activities that sound as 12 if, though, they should not be qualifying activities. 13 What are your thoughts about that? 14 MR. FOX: Yes, he was referring to the "me, 15 toos" which is their main -- which is the routine 16 manufacturer. And none of those activities were 17 included in qualifying projects or allocated time to. 18 And so, when Mr. Jones was describing we leverage that 19 to do those, he was talking about the company, not 20 necessarily his specific activities. His specific 21 activities are recorded on his survey. And we followed 22 up again by talking to him in more depth about the 23 projects as we gathered and reviewed the documentation. 24 So there were many more discussions that took 25 place with Mr. Jones throughout the conduct of the study 26 to verify the project qualification. We just didn't 27 have a transcript made of each and every discussion. 28 So you have to take it in con -- you know, in 104 1 conjunction with all the other document -- 2 contemporaneous documentation put in place. It also 3 describes Mr. Jones -- 4 MR. HORTON: Yeah, that's the challenge that 5 I'm having. It doesn't sound like we're comparing 6 apples with apples. It seems that the interview 7 conducted by the taxpayer was pursuant to a qualified 8 component, which the response is going to be totally 9 different. 10 Okay. I'm going to ask each of you to respond 11 to this question just to give us some more insight. 12 Based on the testimonies here and the evidence that's 13 being presented it is clear to me that all parties are 14 in -- in agreement that qualified activity exists. So 15 now we're down to trying to measure that qualified 16 activity. 17 It is also clear that the FTB should have done 18 some additional testing and should have focused on the 19 test that was conducted by the taxpayer or at least 20 followed through in some particular areas, and I won't 21 necessarily go into that, and possibly because of the 22 lack of information in a timely fashion. I don't really 23 know what it is, but we are where we are. And so, 24 somewhere in between the number that we have and the 25 number that has been assessed -- allowed is where we 26 will end up. Maybe. At least from my perspective. 27 But in the absence of that we have not 28 impeached what the taxpayer has claimed and that's 105 1 pretty clear to me. 2 So, FTB, maybe you want to provide some -- 3 MR. RILEY: Impeachment? 4 MR. HORTON: -- clarification or -- yeah, 5 something. Help me out here. 6 MR. RILEY: I think what you said is generally 7 correct. But I -- I also think that we -- you know, 8 that in our presentation, in our briefs, that we have 9 impeached and created -- not created, we've -- we've 10 pointed out the -- the flaws in the credit study. Okay. 11 I mean, these are very high level wage qualifica -- wage 12 questionnaires and it's -- there's -- it comes -- this 13 is a -- a research credit, okay. It comes down to 14 something called qualified research and that's what they 15 need to prove. 16 Becau -- just because the auditor, you know, 17 allowed, you know, some -- it doesn't mean that the rest 18 of it is -- is -- is proven. So I think, you know, 19 pointing out in their interviews the inconsistencies, 20 the fact that they're claiming executives at -- at -- 21 you know, at high levels for -- for making purchasing 22 decision of machines, you know, for -- for items that 23 are not qualified research, for those -- for those 24 projects like Joint Juice where we've shown that they're 25 just changing an esthetic quality of -- which is not a 26 qualified purpose under the statute. 27 So, from our perspective I believe we've 28 impeached. 106 1 MR. HORTON: Okay. Sir. 2 MR. HALAHAN: I'd say -- Chairman Horton, I'd 3 put it to you this way, as far as impeaching the credit 4 study I would say what you have is -- is such a 5 ambiguous document other than in costing detail. It's 6 based on -- the costing is based on huge amounts of 7 presumption and trying to -- one of the points that -- 8 that Jason tried to point out to you is -- is the 9 business component difference between what are we 10 talking about the product. Are we talking about the 11 process? 12 Because it -- what you use to measure and 13 determine what -- how that would affect expenses and 14 what's allowable are very different. Okay. 15 So if I say I'm going for a product research 16 there's a point of stop and a point of start. Certain 17 activities are fine to be included and associated costs 18 are -- are fine to be included. I'm talking about a 19 process, it's a different -- completely different ball 20 game. Now we're looking at certain costs that you 21 wouldn't even see on a product research activity. 22 Here in looking at this they've kind of blended it all 23 together and you're trying -- you're left asking, well, 24 what's regular manufacturing? What's specialized? 25 What's this? What's that? 26 And you throw on top the complexities of some 27 of the things that I've heard cited as far as, well, 28 this is testing. Well, is it typical manufacturing 107 1 testing, which is incidental? Because that may be 2 qualified for 174 but it wouldn't qualify for 41. It's 3 a big problem that we have at audit when we're 4 addressing taxpayers is -- is the idea of there's bus -- 5 there's research for business, for the lay businessman. 6 And there's research for deduction purposes. And 7 there's research for financial purposes. And there's 8 research for credit purposes. And none of them are the 9 same. 10 And the specificity that you lock in with the 11 credit has to be that tight. If you're saying it's the 12 product it has to be able to be correlated back to that 13 product. Readily identifiable. Different than when 14 you're trying to produce it as a finished good, just a 15 pilot or model. 16 In -- in citing the Union Carbide side, the one 17 thing that they did say that was very clear, these raw 18 materials and supplies, these -- these rough estimations 19 were right on point with what most of these studies do, 20 assign an allocated percentage. 21 The Court came back and said, no, you can't. 22 You have to identify it. Beyond that your product ended 23 up in finished goods, anyway, demonstrating that 24 manufacture ability rather than a model or a process. 25 MR. HORTON: Okay. 26 MR. HALAHAN: So, again, within that -- 27 within -- when you open up a study you expect to see 28 evidence of that, that the consultant went forth and 108 1 showed you the distinguishment between what is 2 manufacturing, what is R&D. 3 If you're going to sit here and say here's 4 tests results how are these different than your normal 5 manufacturing? 6 MR. HORTON: All right. To the taxpayer. 7 MR. SPERRING: Sure. The first thing we want 8 to make clear is the method in the study is the method 9 that is cited in the FTB regulations and in their Audit 10 Techniques Guide. 11 So -- and this method Kendall Fox uses 12 routinely in his studies. He handles all R&D studies 13 for the firm on the West Coast. And this method has 14 been audited by the IRS repeatedly and it's been 15 repeatedly accepted because it's in the regulations and 16 their Audit Techniques Guide. 17 So that's about the methodology. Now let's 18 talk about the underlying activities, okay. And you've 19 heard today they're running away from their Audit Issue 20 Presentation Sheet which says that there is R&D going 21 on, and that we just haven't quantified the amount. 22 Okay. 23 And so, but let's talk about the activities. 24 Because quantification was done through the methodology 25 in the regs. and the Audit Techniques Guide, okay. So 26 we know how we quantified it, fully consistent with how 27 IRS mandates. 28 So then the next issue is do we have qualifying 109 1 activities. And the qualifying activities, okay, are in 2 the 416 megabytes, okay, of -- of data that is in their 3 CAD CAM system and in their SAS system. And -- and -- 4 and so with that data we have tested, pulled out 35 -- 5 not 33, which is in the AIPS, but 35 which is listed and 6 given to them -- and we pulled out 35 and we have 7 reviewed the materials in front of us for each 35, 8 drafted an analysis and explained why this is R&D. And 9 in every one of those cases that were cited by the 10 various employees we found qualifying activity. 11 And in fact FTB -- you know, you hear comments 12 again about Hilmar Cheese not qualifying, yet nowhere in 13 the AIPS does it say that. Okay. So, you know, there 14 is a -- a disconnect between what's being said here 15 today and what's going on on the AIPS. 16 And then just the -- the last point is Mr. 17 Jones. Okay. This company transformed itself, okay, 18 from a brown paper box into customized packaging. And 19 Mr. Jones was critical in that innovation. 20 If he was doing "me, toos" he would not have 21 made, as FTB pointed out, a million dollars during these 22 three years, okay, to be running a line doing "me, too" 23 projects. His substantial salary was based on the fact 24 that he was integral to this company realigning its 25 business and going from a commodity business to a 26 technology business. And that's why they were able to 27 demand -- turn a low profit business into a profitable 28 business and pay high wages. 110 1 These wages would not have been paid. And in 2 fact, as a result of Mr. Jones' intellectual capital he 3 brought to this business he is now a shareholder. So 4 this business started as a family business; he is now a 5 part owner. 6 And the reason why he's an owner is not because 7 he can run a machine quickly, okay. Not because he can 8 do "me, toos", but because he has intellectual capital 9 that he brings to the table. 10 MR. HORTON: Okay. Thank you very much. 11 Further question, Members? 12 Hearing none is there a motion? 13 MS. YEE: Move to take the matter under 14 submission. 15 MR. HORTON: It's been moved by Ms. Yee to take 16 this matter under submission. 17 MS. MANDEL: Second. 18 MR. HORTON: Second by Ms. Mandel. 19 Such will be the order. 20 Without objections? 21 Hearing none such will be be order. 22 Gentlemen, thank you so very much for coming 23 before us today. The Board will take this matter under 24 consideration later on and we will send you a written 25 notice of our decision. 26 MR. SPERRING: Thank you. 27 MR. FOX: Thank you. 28 ---oOo--- 111 1 REPORTER'S CERTIFICATE 2 3 State of California ) 4 ) ss 5 County of Sacramento ) 6 7 I, BEVERLY D. TOMS, Hearing Reporter for the 8 California State Board of Equalization certify that on 9 March 22, 2011 I recorded verbatim, in shorthand, to the 10 best of my ability, the proceedings in the 11 above-entitled hearing; that I transcribed the shorthand 12 writing into typewriting; and that the preceding 111 13 pages constitute a complete and accurate transcription 14 of the shorthand writing. 15 16 Dated: April 14, 2011. 17 18 19 ____________________________ 20 BEVERLY D. TOMS 21 Hearing Reporter 22 23 24 25 26 27 28 112