1 BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 2 450 N STREET 3 SACRAMENTO, CALIFORNIA 4 5 6 7 8 REPORTER'S TRANSCRIPT 9 SEPTEMBER 20, 2011 10 CORPORATE FRANCHISE AND PERSONAL INCOME TAX HEARING 11 APPEAL OF 12 PACIFIC BELL TELEPHONE COMPANY AND AFFILIATES 13 NO. 521312 14 AGAINST PROPOSED ASSESSMENT OF 15 ADDITIONAL INCOME TAX 16 17 18 19 20 21 22 Reported by: Juli Price Jackson 23 CSR No. 5214 24 Kathleen Skidgel 25 CSR No. 9039 26 27 28 1 1 P R E S E N T 2 For the Board Jerome E. Horton of Equalization: Chair 3 Michelle Steel 4 Vice-Chairwoman 5 Betty T. Yee Member 6 George Runner 7 Member 8 Marcy Jo Mandel Appearing for John 9 Chiang, State Controller (per Government Code 10 Section 7.9) 11 Diane G. Olson Chief 12 Board Proceedings Division 13 14 For Board of Grant Thompson Equalization Staff: Staff Counsel 15 16 For Franchise Tax Kathleen Andleman 17 Board: Tax Counsel 18 Carl Joseph Bureau Director 19 Multistate Tax 20 For Appellant: Derick Brannan Attorney 21 Jon Sperring 22 Attorney 23 John Stephens Witness 24 Ligia Machada 25 Representative 26 ---oOo--- 27 28 2 1 450 N STREET 2 SACRAMENTO, CALIFORNIA 3 SEPTEMBER 20, 2011 4 ---oOo--- 5 MR. HORTON: Thank you. 6 Ms. Olson, what's our next scheduled matter is 7 B1, Pac Bell Telephone Company and affiliates. 8 MR. HORTON: Before they come forward, I 9 understand that a couple of requests have been made. 10 One is to have displays of some sort, which I 11 have not yet necessarily seen, and then a continuation 12 or an extension of time, which is acceptable to the 13 body, I believe, without objection. 14 And let's take a five minute recess, Members. 15 It looks like we're going to have quite a few 16 displays. 17 VOICE: They're going to decorate. 18 MS. OLSON: Thank you. 19 MR. HORTON: We are recessing. 20 (Whereupon a brief recess was had.) 21 MR. HORTON: Just before we commence, 22 Ms. Olson, a couple of questions. 23 Has the Franchise Tax Board had an opportunity 24 to review these? And do you deem it necessary? 25 MR. JOSEPH: Oh, their submittals this morning? 26 MR. HORTON: Yes. 27 MR. JOSEPH: No, I'm fine. 28 MR. HORTON: Okay. 3 1 MR. JOSEPH: There was one document in the 2 package that they gave us that Mr. Brannan told me we 3 hadn't seen before. 4 I quickly reviewed it and that's fine. 5 MR. HORTON: Okay. We're all on the same page. 6 Some of these I can't read anyway. 7 MR. JOSEPH: We have handouts. 8 MR. HORTON: So, what I'm going to do is assume 9 that you're going to refer to them and reference the 10 copies that you provided us. 11 So, I would ask that someone move them to the 12 right a little bit. 13 MS. YEE: Yeah, I think the audience needs to 14 see us. 15 So, can we maybe put them along to the side a 16 little bit? 17 MR. BRANNAN: Absolutely. 18 MS. YEE: And if we have -- 19 MR. HORTON: That one's good. 20 MS. YEE: -- yeah, that's good. 21 MR. HORTON: And you could probably leave that 22 one in the center, if you like, okay. 23 MS. YEE: That's great, thank you. 24 MR. HORTON: All right. Bring it forward just 25 a little bit just in case the fire marshal comes. 26 MR. SPERRING: Is that all right? 27 MR. HORTON: Okay, it's okay. 28 MR. BRANNAN: It's perfect. 4 1 MR. HORTON: Can you move that one backwards so 2 I can make sure I can't see it? That's good. 3 Just kidding. 4 MR. SPERRING: That one needs to move right up 5 here. 6 MR. HORTON: Okay, okay. Ms. Olson. 7 MS. OLSON: This item is B1, Pac Bell Telephone 8 Company and Affiliates. 9 Board Proceedings has received contribution 10 disclosure forms for this morning's hearings from the 11 parties, agents and participants. All forms were 12 properly completed and signed. 13 All parties, agents and participants are on the 14 alpha listing provided to your office. 15 Additional time has been granted by the Chair 16 for this appeal. Each person sitting at the table will 17 be asked to introduce themselves and, if necessary, 18 their affiliation with the taxpayer for the record -- 19 for the record. 20 Fifteen minutes is allocated for the taxpayer's 21 opening presentation, followed by 15 minutes for the 22 Franchise Tax Board's presentation and five minutes is 23 allocated to the taxpayer for rebuttal. 24 Mr. Horton? 25 MR. HORTON: Thank you very much. 26 Mr. Thompson, if you'd please introduce the 27 issues in this case? 28 MR. THOMPSON: Good morning, Mr. Horton and 5 1 Members of the Board. 2 MR. HORTON: Good morning. 3 MR. THOMPSON: There are two basic issues in 4 this case. 5 The first, as you know, is whether income 6 received from Appellant's foreign investments 7 constitutes business income. 8 And the second is whether amounts received in 9 connection with certain transactions performed by 10 Appellant's Treasury office should be excluded from 11 gross receipts in the sales factor. 12 With regard to the second issue, as the Board 13 knows, the parties agreed to some concessions in those 14 issues in letters dated September 1st and September 6, 15 which I would just like to note for the record. 16 And those have been previously distributed to 17 the Board and the parties. 18 MR. HORTON: Okay, thank you very much. 19 The Appellant will have 15 minutes to make your 20 presentation. Would you please commence with your 21 introduction? 22 And at that time after your presentation, we 23 will go to the FTB and then return, allow you five 24 minutes on rebuttal. 25 At will. 26 MR. BRANNAN: Thank you, Mr. Horton. I 27 appreciate the time this morning. And we'll move 28 briskly through the issues because there's a lot of 6 1 material to cover. 2 MS. YEE: Derick, could you move the microphone 3 closer to you? 4 MR. BRANNAN: First, at counsel table with me, 5 Mr. -- to my immediate right is Mr. John Stephens, the 6 Chief Financial Officer for AT & T; to Mr. Stephens' 7 right is Jon Sperring; and my left, Ligia Machado, both 8 with PricewaterhouseCoopers here in Sacramento. 9 As Mr. Thompson indicated there are two issues 10 for discussion today. 11 I'm going lead the discussion of the business, 12 non-business issue and, more specifically, whether there 13 was a sufficient relationship between, at that time, 14 SBC, Southwestern Bell Corporation's, domestic phone 15 business, and the foreign investments. 16 If there is sufficient relationship, then 17 receipts or income from those foreign investments would 18 be treated as business income. But clearly, based on 19 the facts and the law, there is not a sufficient 20 integral relationship. 21 And we're going to start with the law because 22 the law squarely favors the taxpayer in this case. 23 Under Rev & Tax Code Section 25128, income is business 24 income under the functional test if the acquisition, 25 management and distribution of the property constitutes 26 integral parts -- integral parts -- of the taxpayer's 27 trade or business. 28 And the first case we're leading off with 7 1 Hoechst Celanese, it's also Tab 1 in the materials in 2 the white binder that we handed out. 3 And the language of Hoechst Celanese is the 4 most recent California Supreme Court pronouncement on 5 this statute and the statutory test. 6 The property must be, in order to generate 7 business income, interwoven into the fabric of the 8 taxpayer's business operations. It must also be 9 indivisible or inseparable from the taxpayer's trade or 10 business. And, significantly, both activities must give 11 value to each other. 12 So, in essence, you have an upstream value and 13 a downstream value. 14 And then lastly, although not highlighted, the 15 property must contribute materially. What that does is 16 protect against any sort of amorphous exchange of value 17 or something that is the subject of conjecture. 18 The State Board of Equalization has also issued 19 a number of decisions on this case. And I think most 20 important for this particular case, the Appeals of 21 Occidental Petroleum and also the appeal of the Mark 22 Controls, which is the Board immediately behind me. 23 And the language from the Occidental Petroleum 24 is at Tab 2. Very significantly, the mere potential for 25 control is not sufficient to constitute an integrated 26 business. 27 And the result of that means there's going to 28 be a lot of discussion here about what may have 8 1 happened, what could have happened. But if nothing 2 happened at the end of the day -- and SBC could have 3 done something -- if nothing happened, then it's not 4 enough for a determination that the businesses were 5 integrated. 6 Also we have relied to some extent on the 7 Supreme Court case in the ASARCO matter. What's 8 important about ASARCO is it was ruling on a statute 9 that is identical to the one that's in California. And 10 their determination was, even though there was a 11 majority ownership in one case, Board of Directors' 12 seats, a transfer of personnel for fees, at the end -- 13 and the same line of business, the ASARCO court 14 determined that that was not sufficient integration to 15 justify determination of business income. 16 Finally, Allied Signal teaches us there must me 17 more than just a monetary return from an investment in 18 order for that income to be treated as something other 19 than non-business income. 20 This case is really one of common sense at the 21 end of the day. But we need to restate the issue based 22 on the authorities. 23 And the issue can be stated thus, whether 24 various investments were integral, or more specifically, 25 based on the rule set forth by the California Supreme 26 Court, whether the investments were indivisible and 27 inseparable from SBC, material to SBC, and provided 28 value to SBC beyond a monetary return of its investment. 9 1 Set the stage. Southwestern Bell Corporation, 2 SBC, is a regional Bell operating company. They are 3 limited in what they can do following the breakup of 4 AT & T. They acquire -- due to regulatory constraints, 5 they acquire foreign investments. The foreign 6 investments did not change SBC's domestic business. 7 Later they sold those foreign investments. SBC had the 8 same domestic phone company at the end of the day. It 9 was only in 2005, when they acquired AT & T, that they 10 became a global provider. 11 Moving to the regulatory environment at that 12 time, there's a modification of final judgment that 13 limited SBC's ability to engage in the long distance 14 business. The FCC, through its international 15 settlements policy, basically made everybody operate 16 under the same terms, vis-a-vis, domestic and foreign 17 companies. So, there was no business advantages. 18 The World Trade Organization, the European 19 Union had similar constraints on the foreign side. 20 There was significant restraints on foreign ownership 21 with respect, for example, Telmex could not be -- have 22 majority ownership from the US. 23 So, we're going to jump into the facts and I'm 24 going to ask Mr. Stephens to walk through SBC's 25 perspective on these transactions. 26 MR. STEPHENS: Thank you. 27 And thank you for the opportunity to speak to 28 the Board on behalf of AT & T. 10 1 Under Tab 3 of a listing of the investments 2 that were at issue in the case, let me briefly talk 3 about each one of those and hand it back to Derick. 4 The first investment there is Amdocs. It's a 5 software provider, clearly not a line of business that 6 SBC participated in. Amdocs did provide us some billing 7 software, much like we do today with many other 8 providers, including names that you might be familiar 9 with like Oracle or Convergence or Accenture. 10 They were never integrated into our business. 11 We never shared employees. We never shared space. They 12 were not in any way woven into the fabric of our a 13 company. 14 We did make an investment them because we were 15 -- thought their products were attractive and that they 16 could be a successful business. We took that 17 opportunity to make an investment with them and it 18 proved to be successful. 19 The next item on your list is Telmex, that's 20 the Mexican telephone company. It's an investment we 21 made in 1990. It was an opportunity for us to take our 22 excess capital and take our expertise and go to these 23 privatizing telephone companies outside the United 24 States and make an investment and maximize our return on 25 that investment. 26 That was not ever integrated or interwoven into 27 SBC's operations. We not only did not accomplish that, 28 but in many ways were prohibited from doing that by 11 1 federal law both on the US and the Mexican side. 2 For example, we were not allowed to enter into 3 long distance at the time we made this investment. And 4 this investment was approved by the US District Court 5 prior our making it based on the fact it was going to be 6 a separate operation. 7 Our ownership interest varied in this 8 investment, but it always remained a little bit less 9 than 10 percent. It was placed in a voting trust, which 10 we were not the controlling shareholders. So that even 11 if we wanted to integrate it, we were not able to do 12 that because we did not have control. 13 TransAsia and diAx are the next two items. 14 I'll talk to them consistently. These were wireless 15 operations where exported our technical expertise and 16 our capital to help build wireless operations in Taiwan 17 and in Switzerland. 18 In both cases we were minority owners. We were 19 not the controlling partners. We were paid for our 20 services, and our expense provided. But, as you can 21 see, we had a very minimal number of employees there. I 22 think in the Taiwan situation we had two employees that 23 were sent over there. 24 We never integrated these into our wireless 25 business. In fact, for the most part, they used 26 separate and different technologies. For example, we 27 never jointly bought hand sets because we were not using 28 the same handsets they were. 12 1 They were separate investments. And, as you 2 can see by the period of time we held these investments, 3 we held them for a very short period of time, cashed 4 them out and accepted our returns from our investment 5 activities. 6 The next three properties, including Belgacom, 7 Tele Danmark and Bell Canada, were properties that we 8 acquired in our acquisition of Ameritech. Ameritech was 9 our acquisition of five Midwestern state telephone 10 companies. 11 And our goal there was to allow us to expand in 12 scale and scope our domestic telephone business and to 13 use that as a growth platform to become a national local 14 provider and protect our domestic revenues. 15 These three properties, as you can see, were 16 sold within a short period of time after our acquisition 17 of Ameritech. And the proceeds were used to finance 18 further investments in our wireless business. 19 In all cases here there was not integration or 20 interwoving of our operations. And to my knowledge, I'm 21 not aware of any situations where there was any flow 22 back of knowledge or value to the company. 23 My own situation is such that I was the 24 controller for the ten year period listed here. And 25 prior to that, I was part of the finance team that was 26 involved in all merger and acquisition activities. So, 27 I would have known or should have known of any flow back 28 of value that would have come from any of these 13 1 investments to our company. 2 Thank you. 3 MR. BRANNAN: Mr. Stephens, the FTB has 4 suggested that you were involved in global business. 5 And I'd like you to respond directly to that point. 6 MR. STEPHENS: Our intention with the Ameritech 7 merger was to form a national local company to become a 8 primary provider of domestic telephone services because 9 our customers, for example, Anheuser Busch, 10 headquartered in St. Louis, Missouri, had breweries 11 across the country. So, we wanted to not only utilize 12 our presence in Missouri as the local telephone company, 13 but put a foothold in Florida, where they might have a 14 brewery so we could provide that service. 15 Once that was done, we had aspirations to 16 become an international and then take those services 17 internationally. We were never successful in that. 18 As you can see in our statements in the SEC 19 filings preceding the AT & T merger in 2005, we made it 20 clear that not only were we not successful in becoming a 21 global business, but, quite frankly, we had not been 22 successful in becoming a national local provider and 23 that basically at that time we were a 13-state telephone 24 company. 25 MR. BRANNAN: I think one last point, as a 26 member of the Board for some of these companies, you've 27 indicated to me that if a situation arose where there 28 was a divergent interest as between SBC and the foreign 14 1 investments, there were certain levels of conduct there 2 required on your part? 3 MR. STEPHENS: Yeah, I sat on the Board 4 representing our company's interest in Telmex and some 5 of its related entities. 6 And in a couple of cases we had situations 7 where the interests were in conflict, specifically in 8 the Spectrum auction situation, where I literally -- 9 along with my fellow Board members, got up and left the 10 room and excused myself from any participation in those 11 and were given Board minutes and Board notes that 12 excluded any discussions of those matters. 13 So, there was a separation on those issues that 14 was pretty strict, not only from my side, but also from 15 the Mexico side where they required me to leave the room 16 as well as my willingness to leave. 17 MR. BRANNAN: So, what we have based on the 18 factual presentation is not as -- we have impediments to 19 integration, specifically, ownership limitations. You 20 saw those impact our participation in the Board of 21 Directors' meetings; regulatory limitations, which 22 motivated a decision to invest overseas because they 23 couldn't invest or expand the business at the time 24 domestically; logistical limitations we have overseas. 25 I mean, in order to complete a long distance call, 26 you've got to own each of the pieces in the wire line to 27 complete the call. Wireless technology, different for 28 some, obviously, not all of the -- all of the entities. 15 1 But you have a whole plethora of impediments 2 that kept them from integrating these businesses. 3 And we talked for a long time about the 4 integration, whether it happened or not, but, 5 potential -- even if we were there, even if we were in 6 the room, potential for integration is not enough for 7 income or receipts from these businesses to be treated 8 as business income. 9 So, with that, I'll let Jon address the gross 10 receipts question. 11 MR. SPERRING: Yeah, during the years under 12 appeals, the SBC's internal Treasury Department was 13 located in San Antonio, Texas. The Treasury Department 14 on behalf of SBC sold marketable securities, including 15 shares of money market mutual funds. 16 The FTB has disallowed inclusion of the 17 proceeds associated with the redemption of money market 18 mutual funds from the SBC sales factor on the grounds 19 that the proceeds are not gross receipts. 20 A money market fund is an open-ended mutual 21 fund that invests in short term debt securities. The 22 investors buy and sell shares in the fund. 23 The money market fund is a conduit for the 24 underlying securities. The predominant type of 25 securities in the funds that SBC invested was commercial 26 paper. The FTB does not dispute that gross proceeds 27 from the sale of commercial paper is includable in the 28 sales factor as a gross receipt. 16 1 It is wholly inconsistent that FTB would not 2 afford SBC the same treatment because it invested in 3 commercial paper through money market funds. 4 Under California law, gross receipts from the 5 sale of marketable securities should be included in the 6 sales factor. 7 Regulation 25134 defines sale as, 8 "All gross receipts from transactions and 9 activity in the regular course of such trade or 10 business." 11 The California Supreme Court, in Microsoft, 12 held that, 13 "Gross receipts include the entire redemption 14 price of marketable securities." 15 In General Motors, the Court further told us 16 that, 17 "If the sale price of the shares fluctuates 18 with the market and is not a function of the 19 price paid to acquire the shares, the gross 20 proceeds are gross receipts for sales factor 21 purposes." 22 Gross proceeds from the following securities 23 have been found to be includable in the sales 24 factor, regardless of whether the securities 25 are sold or held until maturity. 26 For many of these securities, the prices paid 27 at maturity is closely related to the price paid and the 28 investments are extremely stable -- US Treasuries, 17 1 including Treasury bills, Treasury notes, Treasury bonds 2 and Treasury inflation protected securities, US savings 3 bonds, municipal bonds, corporate bonds, commercial 4 paper, futures contract and auction rate securities. 5 So, the question that FTB has failed to answer 6 is why should the above instruments be includable in the 7 sales factor and not money market mutual -- and not 8 money market mutual funds, which simply holds the before 9 mentioned securities and which is, in and of itself, a 10 registered security under the SEC? 11 Based on California law, including Microsoft, 12 General Motors and General Mills, the gross proceeds 13 from the money market funds should be included in the 14 sales factor. 15 The sales price of the shares and the money 16 market funds fluctuate with the market and are not a 17 function of the price paid to acquire the shares. 18 The FTB position is plainly contrary to the 19 applicable authorities. 20 Thank you. 21 MS. OLSON: Time has expired. 22 MR. HORTON: Thank you very much. We'll now go 23 to the FTB. You have 15 minutes to make your 24 presentation. 25 MR. JOSEPH: May we ask Mr. -- it -- was 26 Mr. Stephens a witness? Can we ask him a few questions? 27 Or would like us to just go ahead and move on with our 28 presentation? 18 1 I wasn't quite clear whether he was testifying 2 as a witness or -- 3 MR. HORTON: He was not sworn in as a witness. 4 MR. BRANNAN: We're happy to do that, 5 Mr. Chairman or Mr. Joseph. 6 MR. JOSEPH: It's at your pleasure, either 7 way. 8 MR. HORTON: Why don't we do this, why don't we 9 swear him in as a witness and then we will -- 10 MS. OLSON: Please raise your right hand. 11 And state your name for the record. 12 Do you swear or affirm to tell the truth in 13 these proceedings? 14 MR. STEPHENS: I do. My is John Stephens. 15 MS. OLSON: Thank you. 16 MR. HORTON: Okay. 17 MR. JOSEPH: Thank you. Will this count as 18 part of our 15? 19 MR. HORTON: Yes. 20 MR. JOSEPH: Oh? Then I'll be very quick. 21 I just wanted to ask Mr. Stephens -- 22 Mr. Stephens, do you -- 23 MR. HORTON: One second. Please introduce 24 yourself for the record. 25 MR. JOSEPH: I'm sorry, my name is Carl Joseph. 26 I'm the Bureau Director for Multistate Tax at the 27 Franchise Tax Board. 28 I am appearing today with Kathleen Andleman, 19 1 who is the attorney who was the assigned to this case 2 and briefed this case to your Board. 3 MR. HORTON: Okay, fabulous. 4 MR. JOSEPH: Mr. Stephens, you sat on the Board 5 of Directors of Directors of Telmex, correct? 6 MR. STEPHENS: Yes, I did. 7 MR. JOSEPH: Okay. Can you explain a little 8 about the background of the interaction of SBC with 9 Telmex? 10 Our -- as how you interacted with them, how 11 many employees were down there, they were doing? 12 MR. STEPHENS: Yeah, at the time I was involved 13 with them I interacted with them as a Board Member would 14 act with any other Board position. 15 I have been a Board Member on other companies 16 and I acted much the way I did with them -- 17 MR. JOSEPH: What's -- 18 MR. STEPHENS: -- as an advisor or as a 19 consult, as a reviewer, but not as a management decision 20 maker. 21 Our employees that were there, for example, my 22 CFO, who was located in Mexico City, reported to me as I 23 was the CFO over -- of our international operations of 24 that group, acted to review financial statements, review 25 financial results, keep me updated on the status of the 26 investment. 27 He was not involved with keeping their books, 28 their records, filing their SEC documents and handling 20 1 their audit. 2 MR. JOSEPH: Okay. 3 MR. STEPHENS: Those were -- those were 4 activities he did not perform. 5 MR. JOSEPH: Okay. One of the pieces of 6 information we had was that there were 30 managers in 7 Mexico by your company overseeing the operations and 8 that the idea was to provide active roles in the 9 companies through those 30 managers. 10 Is that incorrect? 11 MR. STEPHENS: I don't know that the 30 is 12 correct. There may have been -- we have a list of the 13 16, and I believe that is correct. 14 There may have been people coming and going in 15 same, a person assigned -- staying there through June 16 and then a new person coming down that causes that 17 number to be enlarged. 18 But, yes, we did have people down there as 19 advisors or consultants. They were not running the 20 business, but rather providing our expertise and helping 21 grow our investment. 22 MR. JOSEPH: Okay, thank you. Thank you, 23 please go ahead. 24 MS. ANDLEMAN: The SBC is -- was really much 25 more than a 13-state domestic telephone business. It 26 was a global telecommunications company. It had five 27 operating segments. And to use the taxpayer's own 28 words, the segments were strategic business units. 21 1 One of these strategic business units was this 2 international segment. And this international segment 3 included the seven companies that were -- that are 4 before you today. 5 So, the issue before your Board is whether the 6 seven foreign companies were integrally related to SBC's 7 global telecommunications business such that the 8 resulting dividends and capital gains constituted 9 business income. 10 Appellant cannot overcome Respondent's 11 determination of business income. It cannot meet its 12 burden of proving that these seven companies did not 13 give rise to business income. 14 SBC did hold itself out as a global 15 telecommunications business in its press releases, in 16 its own corporate history and in its statements to the 17 Securities and Exchange Commission in its annual 18 reports. 19 It filed a worldwide combined report that 20 included a number of different companies, including SBC 21 International and Ameritech International, which the 22 held -- the holding companies that held the foreign 23 companies that are before us today. 24 It had 25 companies in its international 25 segment. There's been no challenge on appeal with 26 respect to any of the other companies, whether they were 27 included by SBC or whether they were added -- made part 28 of the unitary group at audit. 22 1 And here on appeal there is no challenge as to 2 the business income determination with respect to these 3 other companies. These other companies were, for the 4 most part, majority owned. 5 The companies we're talking about today were, 6 in fact, minority owned. But as Carl Joseph will be 7 elaborating on in a minute, you do not need to have a 8 unitary relationship or majority ownership in order to 9 have this business income. 10 Now, SBC would also like you to believe that it 11 was a passive investor, but its activities were anything 12 but that of a passive investor. A passive investor is 13 not involved in the day-to-day operations company. 14 James Flynn was an SBC employee. And he was 15 the Chief Operating Officer for diAx, the Swiss company. 16 He was -- the Chief Operating Officer is a critical 17 position for a corporation. And Mr. Flynn was involved 18 in the day-to-day operations and decisions of that Swiss 19 company. 20 Mr. Klute (verbatim) was also an SBC employee. 21 And he served as Chief Financial Officer for Bell 22 Canada. He was involved in daily financial operations 23 and decisions of Bell Canada. This is not the activity 24 of a passive investor. 25 SBC also had regular hands-on involvement. 26 Information was provided by the taxpayer that they had a 27 group that would go into the foreign operations. It was 28 comprised of senior level personnel, including a senior 23 1 level Executive Officer, a senior level Finance 2 Executive, an HR Administrator and others. 3 They also devoted expatriates to their foreign 4 businesses. During -- over the time there were 262 5 expatriates devoted to the 25 different companies. Yet 6 during -- yet almost half of these were devoted just to 7 the seven companies that you have before you today. 8 Also the expatriates were involved in myriad of 9 different activities, whether it is financial, 10 engineering, different aspects of these businesses -- 11 clearly much more than just a passive investment. 12 Now although majority ownership is not required 13 for finding a business income, what is significant is a 14 flow of value. And SBC admits in its opening brief that 15 there was a flow of value. 16 Not -- although not essential, there actually 17 was a flow of value in both directions. The SBC and the 18 seven holdings shared information. They shared product 19 development. SBC was provided with access to new 20 markets and the parties shared best practices in the 21 industry, which was critical. 22 Rick Morre, in his affidavit which SBC 23 submitted in its reply brief, stated that the foreign 24 holding companies provided an opportunity for SBC to use 25 its excess human capital. 26 SBC had strategic partnerships with the 27 majority of these -- of these seven companies. Tele 28 Danmark, Telmex, Bell Canada, Belgacom -- these involved 24 1 for the sharing of information all of the things that we 2 have discussed. 3 It had a joint venture with Telmex which 4 provided for -- for investment in other companies, 5 including a Brazilian wireless company. 6 Telmex, Bell Canada and SBC formed a joint 7 venture to create a vehicle for expansion into Latin 8 America. 9 SBC was the single largest shareholder for Tele 10 Danmark, Belgacom -- Tele Danmark, TransAsia, and after 11 the Belgium government, Belgacom. 12 It built at least two companies from the ground 13 up, diAx and TransAsia. 14 And with respect to Amdocs, SBC was one of 15 Amdocs' largest customers. It provided office 16 facilities and support services for Amdocs. It was -- 17 as a software company, it wasn't the only software -- 18 software company SBC had. SBC also had Sterling, which 19 was -- which had foreign operations and was a member of 20 the unitary group. 21 SBC has made a number of arguments with respect 22 to technological and legal roadblocks. First of all, 23 there's nothing to prevent them from engaging in foreign 24 operations. In fact, this is the only -- these are the 25 only foreign operations that they're -- that they're 26 challenging. They had a number of operations which, by 27 their own choice or through or subsequent actions, have 28 been included in the unitary group. 25 1 They also have talked about incompatible 2 technology, TDMA versus GSM. This is wireless 3 technology. But only 16 to 17 percent of SBC's business 4 was wireless. And although SBC used TDMA, as did 5 Telmex, GSM -- it had made the decision -- and this is 6 stated in its opening brief -- that it was converting to 7 GSM. Well, it had this great relationship with these 8 other companies who used GSM. What a wonderful 9 opportunity. 10 Finally, they state that there is -- they 11 challenged the fact that there were arm's length 12 agreements. Well, there is no requirement of 13 preferential treatment in order to have a finding of 14 business income. 15 Before turning this over to Carl, I'd also like 16 to touch upon the Treasury receipts. The taxpayer is 17 seeking to add the returned principal to the sales 18 factor denominator. 19 Only the money market funds are in dispute now. 20 But the money market funds constitute 80 percent of the 21 receipts for 2001 and 88 percent of the funds for 2002. 22 And if you look at the economic reality, these money 23 market funds were akin to a savings account. They were 24 low risk investments. They had a steady rate of return. 25 They weren't -- they're not sold to third parties, 26 they're redeemed by the issuer. 27 People treat them as savings accounts. I have 28 one. I treat it as a savings account. I recently 26 1 wanted to withdraw money. It was just a matter of going 2 online, placing instructions. At the end of the day, I 3 was able to write a check for the funds -- like others, 4 savings accounts. 5 And SBC has asked that you look beyond just the 6 instrument itself to the underlying investments. Well, 7 that's not appropriate because those underlying 8 investments are not the activity of this taxpayer. 9 If the money market funds are included, the 10 sales factor will not accurately reflect the taxpayer's 11 business activity in California. 12 We must look to both the quantitative and the 13 qualitative effect. Quantitatively, this case is 14 similar to other cases in which your Board and courts 15 have found distortion. Qualitatively, if that return 16 principal is included, the amount of receipts assigned 17 would be 30 times more than what was earned -- than the 18 income from these receipts. And for -- that was for 19 2001. For 2002, the Treasury Department provided more 20 gross receipts than SBC's entire California sales. 21 With that, I am going to turn this over to 22 Carl. 23 MR. JOSEPH: Thank you. 24 Good morning, my task here today is to try to 25 simplify the analysis for the business, non-business 26 issue a little bit and explain why a couple of the 27 Appellant's arguments are simply irrelevant. 28 The first one that Appellant brings up is that 27 1 they must control the business in order for it to give 2 rise to business income. 3 That's simply not true. It's black letter law. 4 The Supreme Court, in the Allied Signal case in 1992, 5 held that and your Board has applied that in many cases. 6 Just in the past few years we've had, I think, three 7 case that your Board's decided where there was not a 8 controlling interest in the company, yet business income 9 was found by the Board. So, that issue is simply not -- 10 not an issue that your Board should be concerned with. 11 Second, even though Appellant admits it 12 provided flows of value to its foreign affiliates, it 13 says that this is of no consequence because all of the 14 flows were one way. 15 Now, this also clearly wrong. First, we 16 strongly disagree with the factual allegation that the 17 flow of value was one way. Appellant gained access to 18 markets it could have never gotten directly. The only 19 way to get into these countries was to buy these 20 interests in these foreign activities. And there were 21 flows of value and the better use of their people and 22 the other items that are up on the exhibit here 23 (indicating). 24 But beyond that, the case law clearly 25 demonstrates that a flow of value, even if it's one way, 26 will not keep businesses from being found to integrated. 27 The best example is the Supreme Court case of 28 Container that we have up to the board. In the 28 1 Container case, the taxpayer provided many flows of 2 value to its foreign affiliates. The foreign affiliates 3 and the taxpayer were in the same line of business. 4 There were personnel supplied to the foreign entities, 5 just like this case; technical assistance to the foreign 6 entity, just like this case; funding assistance to the 7 foreign entity, in this case they provided a lot of 8 capital to these companies; and management guidance to 9 the foreign entities, also something that happened here. 10 Was there any flow of value back? No. Did it 11 keep the Supreme Court from finding that it was an 12 integrated business? No. 13 The issue that's raised by the Appellant is 14 simply not necessary. Your Board has found this in 15 other cases as well. This is not a new argument. 16 Most of the unitary law's been around quite a 17 while and there have been other cases that your Board 18 has decided were taxpayers and made similar flows of -- 19 one-way flow of value argument and they've always been 20 rejected by the Board. 21 Now what is required? Well, these are very 22 factual inquiries. And there has to be a showing that 23 there's a relationship between the property at issue, in 24 this case, the stock, and the operations of Appellant's 25 business. This comes down to facts. These cases are 26 always about the facts. 27 A good way that I like to think about analyzing 28 these cases is to think of sort of a set of scales in my 29 1 mind. And on one side I put the items that evidence a 2 business relationship and on the other the non-business 3 relationship. 4 In doing that, I'm guided by two presumptions. 5 The first one is that all income is business income 6 unless clearly classifiable as non-business. The second 7 one is that when companies are in the same line of 8 business, it is probably a pretty good bet that one 9 functioning investment is to make better use, either 10 through economies of scale, operational integration or 11 sharing of expertise of the parent's business-related 12 assets. 13 So, you start out with a little bit of an edge 14 to the business side. The facts of this case clearly 15 evidence more on the business side of the equation than 16 the non-business side of the equation. 17 What does Appellant put on the non-business 18 side of the scale? Aside from its argument about lack 19 of control and a self-professed investment motive, not a 20 lot. 21 Most of Appellant's arguments are either legal 22 or go to the weight that should be afforded the 23 evidence. For instance, yes, we had employees in these 24 entities, but not very many. We had agreements to share 25 expertise, but they never really came to anything. We 26 had officers, but they didn't really do much. We had 27 directors, but we didn't have control. 28 Now, typically what you find in a case where 30 1 there's strong evidence of non-business is there's no 2 common officers, no employee transfers, no same line of 3 business, no sharing of expertise at all -- no changes 4 in the business of the entity due to the activities of 5 the Appellant. All of this is lacking in this case. 6 The scales in my mind, therefore, are tipped 7 heavily toward this is business income. And I think 8 that your Board should decide similarly. 9 Regarding the Treasury issue, this is no 10 different than any of the other Treasury cases that have 11 come down here in the past. The only wrinkle is the 12 question about the money market funds. In substance, 13 these accounts are like checking accounts and should 14 be treated -- 15 MS. OLSON: Time has expired. 16 MR. JOSEPH: -- as such. 17 Thank you. 18 MR. HORTON: Sounds like you were concluding? 19 MR. JOSEPH: Yes, sir. 20 MR. HORTON: Okay. On rebuttal? 21 MR. BRANNAN: Thank you, Mr. Horton. 22 A couple of points, I think there are so many 23 things to talk about here I'm just going to try and get 24 to the most material elements. 25 First of all, I guess, the one thing I didn't 26 hear in Mr. Joseph's articulate discussion on the law, 27 he didn't talk about Hoechst Celanese, the California 28 Supreme court case that talks about the statute that 31 1 governs the outcome of this case. 2 The holding of the case says that, 3 "An integral relationship requires that the 4 underlying activities be interwoven into the 5 fabric, indivisible and inseparable." 6 And it says, "With both giving value to each 7 other." 8 Now I appreciate the holding in Container and I 9 think there's a simple explanation there which is the 10 court found there was a sufficient degree of integration 11 between the domestic and the foreign businesses, so that 12 they could be treated as part of the same unitary group. 13 But that's the test from the California Supreme Court. 14 That case came out after Container. 15 Additionally, I looked to ASARCO for this 16 Supreme Court case authority. ASARCO was also talking 17 about the same statute. Container was not. Container 18 was talking about a unitary business question with 19 majority ownership, that's why we keep going back to 20 that. 21 We have never said there's an absolute 22 requirement of majority ownership. What we have said is 23 that majority ownership puts the taxpayer in a better 24 position to manage and control. 25 And what we have heard here, with a minority 26 ownership, we couldn't. And that's directly from the 27 Chief Financial Officer. 28 So, let's talk about a couple of further 32 1 statements -- statements about the annual report 2 governing or being evidence of business income. Let's 3 go real quickly to Tab 4. What we have is a couple of 4 highlighted remarks there. This is the FTB's brief. 5 What they say is in the pink portion. 6 "We rank," referring to SBC, "among the largest 7 providers of telecommunication services in the United 8 States and the world." 9 Well, yes, as a stand alone domestic company, 10 they are one of the largest providers in the world. So, 11 that doesn't imply anything about actually providing 12 services in an international segment. 13 "Also through our subsidiaries," that's the 14 green portion, "we provide communication services and 15 products in the United States and have investments" -- 16 it's a word the FTB conveniently ignores throughout the 17 10K -- in more than 25 countries." Yes, we have 18 investments. That's the crux of the issue here. 19 Continuing down on this same page, 20 international subsidiaries hold investments in primarily 21 foreign entities outside of the United States. 22 Two pages later, under the operating 23 segments -- and this is a critical point -- the FTB has 24 latched on to the language highlighted in pink, 25 "Our segments are strategic business units." 26 Stop, that's fine. That's straight from the annual 27 report, but it doesn't tell the whole story, much like 28 the rest of the FTB's argument. 33 1 "They're offered different products and 2 services and are managed accordingly." 3 Further down in the green, we have five 4 reportable segments. That's important. Under the SEC 5 the way they're managed as separate investments, they 6 must be presented separately. Additionally, as an 7 equity investment -- that means we didn't control -- 8 they must be presented separately on the books and 9 records. 10 If it was part of the operations, they would be 11 presented as either wire line or wireless or other, 12 which is kind of a catchall category. 13 These are separately stated because the law 14 requires that they be separately stated and they were, 15 in fact, managed in that manner. 16 The FTB has relied almost exclusively on what 17 we call aspirational statements. We know what roads are 18 paved with good intentions. All of the things we wanted 19 to do, all of the things -- sharing of expertise, you 20 know, all purchasing discounts, things of that nature -- 21 there are any number of those statements about what we 22 hope to accomplish. 23 The bottom line is, based on the declarations 24 submitted as part of the record under penalty of 25 perjury, based on Mr. Stephens' testimony today -- and 26 he can certainly expand on any questions that you may 27 have -- it didn't happen. 28 Regardless of the standard of the law, 34 1 Mr. Joseph's standard of the law is, you know, if we 2 contributed to them, then that's enough. 3 Well, we don't think it is. But the level of 4 contribution was minimal, at best. And there was 5 nothing -- there was no purchasing advantages, there was 6 no technological advantages that ever flowed back to SBC 7 as an investor. 8 There's also reference about these entities 9 that were considered international entities. And 10 there's a very lengthy discussion in the briefs and 11 there's an exhibit in our rely brief, I think it's 12 Exhibit 22, that walks through these 48 so-called 13 international entities. 14 Well, the level of analysis there was if it 15 said "global" or "international," in the title, it must 16 be international. 17 Well, the bottom line is, all of those 48 18 entities are domestic entities. One owned the 19 investments in the seven foreign companies that we're 20 talking about today. Two, one inherited from Ameritech, 21 one of SBC's own, managed the expatriate employees. The 22 rest were rather inconsequential to the outcome of this 23 case or to the tax determination. 24 You mentioned Sterling Commerce. Sterling 25 Commerce is a separate software company. Sterling, by 26 the way, the rest of the story yet again, had nothing to 27 do. There is no interaction between Sterling and any of 28 the other foreign investments. It had nothing to do 35 1 with those companies. The idea that they did software 2 is again -- it's a suggestion with no factual backing. 3 Amdocs did software which was the directory 4 publishing company. And Sterling was more, I believe, 5 into the switching end of things -- totally different 6 software development -- had nothing to do with each 7 other. 8 MS. OLSON: Time has expired. 9 MR. BRANNAN: Thank you. 10 ---o0o--- 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 36 1 MR. BRANNAN: And, Ms. Yee, if I may. One of 2 the, uh -- in response to the FTB submission late last 3 week, uh, what we've done is pulled, uh, excerpts from 4 the submission to the FCC -- again, so comparable 5 documents -- in connection with the acquisition of AT & T 6 in 2005. And that's at tab five of your materials. . 7 And just -- these are excerpts. The entire 8 document is 700 pages long. Uh, but it really goes to 9 kind of evidence that that strategy simply didn't work. 10 Because what's contained in here is we weren't 11 successful in the domestic strategy, and we didn't have 12 an international presence; and that's why we needed to 13 acquire AT & T. And that's all in the documents. 14 It's interesting, because the same gentleman 15 that provided a supporting declaration, Mr. James -- I 16 think it's Jim. 17 MR. STEPHENS: Jim Conn. 18 MR. BRANNAN: Jim Conn provided a supporting 19 declaration in 2005. 20 MS. YEE: Mm-hmm. 21 MR. BRANNAN: He has a little bit of egg on his 22 face unfortunately. I get in trouble for saying that 23 with my client. But, I mean, he had to back off the 24 aspirational statements that were in the initial 25 submission. And so what you have is the same thing: 26 Going in, great plans. Coming out, nothing happened. 27 MS. YEE: Mm-hmm. Uh, no, and I appreciate, 28 uh -- uh, your pointing us to, uh, that report. 37 1 I guess, here's more what I'm troubled by. I 2 mean, I see certainly the 10-Ks and what was reported 3 and the various, uh, business segments. That all makes 4 sense to me. Uh, I also think that what makes sense was 5 during, um, the years that we are looking at and 6 certainly the motivation for some of these investments 7 had to do with the restricted regulatory environment in 8 which, uh, the Appellant was operating under, uh, here 9 domestically. So I -- so I get all that. 10 Uh, but it is -- even as aspirational as many 11 of the plans were, um, there was engagement, to a 12 degree, that, um, you know, was pretty active; 13 Mr. Stephens, who served on several boards, we had 14 expertise that was sent to these various countries. Uh, 15 and I think what I'm left with -- and I really have been 16 around this case, um, several times, and I'm sure my 17 colleagues have been as well. 18 What I'm left with is really to look at the -- 19 you know, um, you know, what -- what legal authorities 20 were -- were -- were -- was the Appellant operating 21 under at the time? And, uh, I'm just going to say this 22 because I don't feel equipped to really opine, uh, 23 anything at this point. But given all of the case 24 citations that we saw, the briefing materials, I don't 25 feel any more prepared with respect to understanding, 26 uh, what that whole, you know, wall of authority, uh, is 27 or could be, uh, under which you were operating and 28 making your decisions. 38 1 I think, um, certainly from the Appellant's 2 standpoint, reliance on Hoescht Celanese makes sense. 3 Uh, but there have been other cases that speak to 4 certainly the integral nature of, uh, what we were 5 dealing with here. It doesn't have to be in whole. It 6 could be in part or in phases. 7 We've had this whole, um, test of whether we're 8 looking at an asset that, um, is, uh -- the whole 9 operational versus, uh, you know, investment dichotomy 10 that I don't think has been fully fleshed out. So, I 11 mean, there's just been a lot that's been cited, but I'm 12 not sure that any one thing has been on point. 13 I find, uh -- so then I went back to look at 14 the specific investments to see if there was some degree 15 of discernment that could be made relative to what 16 actually took place in each of these countries. And 17 some of these countries the Appellant went in and 18 actually built systems from the ground up. In others, 19 uh, there had been a prior relationship with respect to 20 software development. So I think there was some trust 21 in terms of what, um -- and a comfort about having a 22 relationship, certainly an investment relationship here 23 going forward in the case of Amdocs. 24 And so there's just kind of a whole myriad of 25 things that are going on that I'm uncomfortable saying 26 that there wasn't some value with some of these. I 27 think the Amdocs thing, to me, just seems really ripe in 28 its face. You know, there had been a prior relationship 39 1 on product development, um, certainly a comfort with 2 working with one another. And I think, uh, there was 3 probably something more -- more intricate going on, and 4 integral going on there. 5 But I think, Mr. Chairman, what I'm driving at 6 is, um, I really would like to see a little bit more 7 work done relative to the case law and certainly to the 8 prior Board decisions, uh, with respect to, uh, how we 9 ought to look at this. 10 I -- I -- I'm really at a loss about kind of 11 which aspect of these investments I ought to be focusing 12 on; whether it's the operational, uh, investment 13 dichotomy; whether it's looking at the integral nature, 14 you know, in whole or in phase; uh, whether it's the, 15 uh -- uh -- I mean, and just the whole, you know, how we 16 look at business income generally. 17 Um, I think we've had cases that really don't, 18 uh -- that have been embedded in one another that have 19 been refined such that -- and I think the Franchise Tax 20 Board's come up with this position, but I haven't seen 21 kind of the building blocks to really, kind of, get us 22 there. 23 MR. HORTON: Okay. 24 Further discussion, Members? 25 MR. RUNNER: Quick question. 26 MR. HORTON: Mr. Runner. 27 MR. RUNNER: You know, again, I'm not sure -- 28 if indeed, if the Board has the direction here to -- 40 1 to -- to spend some -- ask to have another look at or 2 have FTB and Pac Bell come back and help define some of 3 these areas, that certainly can be appropriate. 4 But let me just say that in that -- in that 5 setting then, um, the issue that I'm trying to struggle 6 through are some of the, uh, some of the court cases and 7 decisions, uh, that are there to help give direction to 8 taxpayers. 9 And so I guess if indeed we do that, I guess 10 what I would like to see then done is that FTB take a 11 hard look then at the court cases that are there. The 12 Container case that was -- that was -- that was 13 mentioned there, um, you know, was a -- you know, 14 obviously was a U.S. Supreme Court decision made in 15 1983, I think, 1983, um, in regards to a specific case; 16 and, therefore, direction was given a specific case. 17 The State Supreme Court hasn't made a decision 18 then since then, as early as, what, the early 2000s, I 19 think, uh, in regards -- in regards to it. And -- and 20 actually then gave a test to which then taxpayers could 21 make their decision on. 22 And so my question, I guess, that I would like 23 to see reflected on -- and I don't know if we -- you can 24 do it now, if we're going to have to continue this 25 discussion, or we can do it in -- in -- in between if 26 we're going to go ahead and delay this. But the 27 decision -- or discussion if we're going -- if we're 28 going to continue with this discussion today and have 41 1 this decision today, I just as soon would like it 2 answered now. 3 If not, it's one thing that I'd like worked in 4 between; and that is, given that, given the Container 5 case, did the Container case, in our opinion, in FTB's 6 opinion, give direction to taxpayers in regards to 7 helping to make these decisions? Or was that actually 8 more under the latest State Supreme Court, which 9 actually gave direction? Because, to me, the direction 10 that I'm understanding in regards to the -- to the -- to 11 the latest U.S. Supreme -- or State Supreme Court 12 decision, talks more specifically about other tests and 13 what it is that -- that function. 14 And so it kind of cuts through for me this idea 15 of, gee, Do you have Board members? Don't have Board 16 members? Do you have international -- to me, it cuts 17 through that because there's more specific tests then, 18 just rather than what we would think of as anecdotal 19 information. 20 Um, so anyhow, again, that's -- if -- if -- 21 if the -- if the desire of the Board is to put this off 22 and have more discussion, that's the issue that I would 23 like to address. If we're going to continue with this 24 discussion, I guess I'd like to have that answered now. 25 MR. HORTON: Um -- 26 MR. RUNNER: I'll leave that up to the Chair in 27 regards to where he thinks the direction of this is 28 going. 42 1 MR. HORTON: Uh, Members, certainly if our -- 2 our colleagues are interested in having additional 3 information, uh, we have always taken the position to 4 oblige. 5 Uh, but, at this point what I would encourage 6 us to do is to -- is to go through this -- go through 7 the process and address the concerns; and hopefully that 8 may or may not get us there. 9 I too have concerns about, uh, trying to 10 resolve some of the information and some of the 11 conflicting statements. In some cases I actually 12 believe it to be semantics, um, and want to sort of 13 focus in on the law and the facts that govern, uh, the 14 fact pattern that sort of governs that. And we will 15 have that discussion today. 16 So, uh, with that said, uh, Mr. Runner. 17 MR. RUNNER: Okay. Yeah, based on that, I 18 guess I'd like some -- that input in regards to that 19 observation. 20 Um, I guess I'll start with FTB for their 21 response and then we'll ask the taxpayer to make a 22 response at that point. 23 MR. JOSEPH: Thank you. 24 Uh, first of all, I think, uh, a little bit of 25 context is necessary in, uh, understanding what the 26 issue was before the California Supreme Court in the 27 Hoescht Celanese case. 28 In the Hoescht Celanese case the issue before 43 1 the court was whether or not California had a functional 2 test for business income at all. The taxpayer in that 3 case, uh, had money from a pension reversion, I think it 4 was. Is that correct? 5 And -- and the question was whether or not that 6 pension activity, the holding of those assets in that 7 pension when it was sold, would give rise to business 8 income or not. 9 So the point before the court, factually, was 10 pretty straightforward as far as what the pension did 11 for the business. Obviously it helps to keep your 12 employees and things of that nature. Uh, the legal 13 point before the court was really, Do we have a 14 functional test? 15 Uh, so from the standpoint of what the Hoescht 16 Celanese case was trying to provide to taxpayers, it 17 clearly provided that we have two tests in California, 18 and that's good. Uh, but it provided some information 19 about how to do it based upon prior precedent. 20 Uh, this language that -- that the Appellant 21 puts on the Board is really not anything remarkable. 22 The idea of their being flows of value has been along a 23 very long time. It's a Constitutional requirement that 24 there be flows of value, uh, that's why we cite the 25 Container case. Because in Container, the question was 26 essentially the same question, Was there an integral 27 relationship between the parties? 28 I don't know that Celanese in and of itself 44 1 changed the law in that -- in that manner. I don't 2 believe it was the intent of the court to flush out a 3 new type of functional test. Uh, I think the intent was 4 to apply the existing precedent and affirm that there 5 was in fact a functional test in California. 6 The unfortunate thing about doing 7 business/non-business cases is -- and the Supreme Court 8 has said this as well -- they're exceedingly factual 9 cases. They require getting into the detail, and 10 there's usually not a whole lot of agreement about what 11 the significance is of -- of any one item or any two 12 items. 13 Uh, I think that the Supreme Court, the U.S. 14 Supreme Court put it pretty well when they said: 15 "The burden is never met merely by showing 16 a fair difference of opinion, which as an 17 original matter might be decided differently. 18 In Constitutional cases they have the power to 19 examine the whole record and supply their" -- 20 "their institutional judgment, but that does 21 not mean they'll re-examine, as a court of 22 first instance, the finding of facts supported 23 by the evidence." 24 And in this case, that's exactly what's going 25 on here. There's a difference of opinion about the 26 weight of these things. I don't know that we disagree a 27 whole lot on what happened. 28 If you'd like more information or more analysis 45 1 on how the law functions, we'd certainly be happy to 2 provide that. But this idea of flows of value to each 3 other, well, you have to look at the facts here if that 4 is the case that you're going to apply and see how that 5 works for this taxpayer. 6 There was two ways taxpayers could get into 7 foreign invest -- markets during this time period. One 8 was the way MCI did it, which was to start from the 9 ground up and make global companies. The other one was 10 to invest with existing phone systems that were in those 11 countries that used to be owned by the government but 12 now were being privatized. 13 That's what Pac Bell did. They have immense 14 knowledge about how to set up a wireline system. 15 They've done this successfully in the United States. 16 They go to these foreign company -- countries and they 17 form a partnership with them to develop their wireline 18 and wireless in those countries and bring their -- what 19 they do is bring their expertise to the table. 20 One of Appellant's employees, I think, put it 21 about as well as I could say. He said, "Anybody can 22 send money. We're not an investment bank. We provide 23 value." And that's what is going on here. 24 This, to me, is not a whole lot different than 25 the old cases we had in the oil business. As you may 26 remember, a lot of state-owned oil companies in the 27 Middle East and things of that nature, and U.S. entities 28 wanted to get involved in getting access to those assets 46 1 and to that oil. And so they entered into partnerships 2 with the government and with other oil companies, 3 partnering with the government in order to actually get 4 the ability to get to that -- to that flow. 5 And those cases came before your Board. 6 Standard Oil, I think, is the one we cite in our brief. 7 And the Board found, of course, business income, even 8 though the activities there were in relation to what you 9 would call investments. They did not run the things in 10 the sense of having control over the operations and 11 things of that nature. But they were a part of the oil 12 business in the same manner that providing all of these 13 wireline expertise and all of this wireline, uh, 14 knowledge to these other entities in foreign countries 15 serves for this Appellant. 16 It's not oil that's the asset here. It's 17 customers. And the customers in those markets were 18 accessible to Pac Tel by the use of these partnerships 19 with these entities in the foreign countries. It's as 20 simple as that. 21 MR. RUNNER: Let me just follow up in -- you 22 know, in regards to the, uh -- the Hoescht Celanese, um, 23 decision. 24 Um, and again, you know, you've referred to the 25 issue of the portion of that decision, which is the 26 issue of giving value to each other. Let me go back to 27 the other issue there that seems to be a part of that 28 functional test, which is becoming indivisible and 47 1 inseparable. 2 MR. JOSEPH: Yes. 3 MR. RUNNER: Um, you know that you said that 4 giving value portion of it was a -- you know, was 5 clear. 6 MR. JOSEPH: Mm-hmm. 7 MR. RUNNER: Did -- did that provide any 8 different direction, do you believe, for taxpayers in 9 terms of the issue of being inseparable and indivisible? 10 MR. JOSEPH: No. I -- I think that from a sort 11 of case law analysis and black letter law analysis, part 12 of the reason that the unitary business principle, uh, 13 was affirmed by the Supreme Court is that these flows of 14 value are not easily separated out. That's the reason 15 we use an apportionment system. 16 In this case, you know, you have federal 17 property and sales and you determine the footprint in 18 the state, and that's how much you tax because nobody 19 really can separate out what values were earned in each 20 place. 21 Take, for instance, the knowledge, uh, that the 22 gentleman over there has in his head. He has a lot of 23 knowledge about how to run a phone business. He has a 24 lot of experience in doing that. He sat on the Board 25 for the Mexico company in question here. Other people 26 from Pac Tel were involved in that. 27 What's the value of that knowledge that they 28 gained in their heads working for Pacific Telephone and 48 1 SBC for 15 or 20 years? I can't really separate out 2 that value that they provide to SBC from that value that 3 they take in their head when they go down and talk to 4 Mexico. It's the same value. It's inseparable. It's 5 the knowledge that they've had from their experience 6 working in the unitary business. 7 MR. RUNNER: So -- so it would be the opinion 8 of FTB that simply by sitting on the Board -- 9 MR. JOSEPH: No, no. 10 MR. RUNNER: Oh. Okay. 11 MR. JOSEPH: Just sitting on the Board alone is 12 probably -- is fine in most cases. If that was all that 13 went on here, we probably wouldn't be down here today. 14 It was far deeper than that. 15 MR. RUNNER: Okay. I was just confused by when 16 you talked about the issue of the knowledge that was 17 learned as you're sitting on the Board, if that was 18 creating then that -- 19 MR. JOSEPH: Oh, I'm sorry. Uh, what I was 20 trying to point out is just the idea of having your 21 employees who have experience running wireline and 22 wireless businesses, going down and imparting that 23 knowledge to these companies in the foreign countries, 24 and that that knowledge is really knowledge that was 25 earned in the unitary business of the taxpayer and can't 26 be separated out when it's handed through conversations 27 or analysis. 28 MR. RUNNER: So, again, let me see if I'm 49 1 hearing correctly. If you had a Board member that was 2 not knowledgeable about the phone business that you put 3 into that Board, then that would not create business 4 income. 5 MR. JOSEPH: Yeah. 6 MR. RUNNER: If you have a person who has phone 7 knowledge sitting on the Board, then that's a -- then 8 that creates business income. 9 MR. JOSEPH: It could. 10 MR. RUNNER: Okay. 11 MR. JOSEPH: I -- I -- I think that -- 12 MR. RUNNER: Just trying to get through what -- 13 you know. 14 MR. JOSEPH: Yes. I -- I think that the -- the 15 distinction there is, in a lot of nonbusiness cases, the 16 person who's sitting on the Board is there to do just a 17 few things; monitor how much money's being spent, 18 monitor what the -- what the company is in fact doing 19 that year, whether they were successful or not. 20 MR. RUNNER: I would submit that one of their 21 jobs is to protect their -- to protect the investment. 22 MR. JOSEPH: Absolutely. 23 MR. RUNNER: And I would say that if you're 24 protecting your investment, you probably ought to have 25 somebody on the Board who knows the phone business. 26 MR. JOSEPH: I would agree with that. 27 MR. RUNNER: Okay. Let me ask for a response 28 then. 50 1 MR. SPERRING: Sure. Uh, why don't I turn it 2 over to Mr. Stephens for us, to address those specific 3 questions. Then we'd like just to clarify the law if we 4 could. 5 So Mr. Stephens. 6 MR. STEPHENS: Let me try to take us back a 7 little step. 8 Um, we did have expats, you know, provide a 9 service to these companies. And as can you see in the 10 case of Bell Canada, there were seven and there was 11 75,000 Bell Canada employees. And in the case of 12 Telmex, there were 16 and there were 63,000 Telmex 13 employees, just to give you a scope. These were 14 advisers and we were paid for those services, and those 15 have been included in these unitary returns. 16 The rest of the returns we got were just like 17 any other investors. You look in these investments, 18 there's a lot of other investors in these companies, 19 whether it be the public companies, whether they be 20 Carlos Slim in Mexico, whether they be public 21 shareholders in Amdocs, they got the same dividends in 22 capital or gains for their investment that we did, so 23 that we were in -- treated just exactly like any other 24 investor. So just to give you that perspective. 25 Secondly, I don't know of and don't recall any 26 expatriates or, if you will, foreign nationals coming to 27 the United States to assist us with our business. I'm 28 not aware of any, and I'm not aware of ever paying for 51 1 any of those services. 2 Once again, to make sure I'm clear on our 3 rev -- our value from this was for those expatriate 4 services and then, over and above that, from our 5 investment. We weren't like the oil company examples 6 where they may have shared in royalties or some kind of 7 revenue production. We shared like every other 8 shareholder made an investment. That's -- I think 9 that's the first thing. 10 Um, we did not have the same ability to invest 11 in foreign networks like MCI and some of the other 12 nonlegacy Bell companies because of legal restrictions 13 on our operations. So I just think that is an 14 important, uh -- uh, part to point out. 15 MR. BRANNAN: One further factual question. 16 Mr. Joseph suggested that the foreign 17 investments gave you access to the customers overseas. 18 MR. STEPHENS: They -- they did not. Um -- 19 um -- and quite frankly, for example, um, in the case of 20 Telmex, um, they didn't even give us access to Telmex's 21 business. Because at this time we weren't able to 22 provide long distance in all our states, Telmex actually 23 used Sprint, one of our competitors, in providing their 24 long distance business. Um, so that -- that assumption 25 is -- is just inaccurate. 26 There's also a whole collection of world trade 27 organization rules with regard to, you know, getting an 28 advantage with regard to pricing that we're just not 52 1 capable or any -- you know, any one telephone company 2 over another. We were all treated fairly. But we 3 didn't have the capability at the time frame; we didn't 4 get it throughout our 13-state region until 2003. 5 That's -- that's a matter of record. 6 MR. SPERRING: Yeah. And on the law, I 7 understand there's a little bit of, uh, confusion on 8 that. You've heard FTB tell you that, uh, this was 9 not -- we were not a passive investor. This was not a 10 passive investment, okay. 11 And the thing to keep in mind is that this case 12 is a business/nonbusiness case. It is not a -- whether 13 we fall into the passive activity rules, okay. Yet you 14 have FTB talking about passive investors. 15 You also have FTB talking, their case is 16 Container, a unitary case, okay. Again, we're here in a 17 bus./nonbusiness case and we look to ASARCO, we look to 18 the statute, and we look to the California Supreme 19 Court's pronouncement on business/nonbusiness. 20 And -- and of all the cases that you were cited 21 where the court found you had nonbusiness, in all those 22 cases, you had board of directors, you had expats, okay, 23 or -- or employees going to, uh -- uh, the investee, 24 okay. 25 And so, again, FTB doesn't want to talk about 26 those cases. They want to talk about unitary. They 27 want to talk about passive activity. But they don't 28 want to talk about the business/nonbusiness cases. 53 1 And let me just sort of go back to what the 2 court said in ARSACO because it declared it no less than 3 six times. And it said, uh, that, uh, if there's proof 4 of a discrete business enterprise, then it is not 5 appropriate to, um, treat those dividends from that 6 discrete business enterprise as, uh, business income. 7 They said it six times. 8 Clearly you have a situation where, uh, Bell 9 Canada, Telmex, okay, and these others -- Amdocs -- are 10 discrete business enterprises. There's no doubt about 11 it. Okay. And thus, FTB doesn't want to talk, okay, 12 about, uh -- uh, the case law or even the statute, okay. 13 Instead, what they want to talk about is a unitary 14 case. 15 ---oOo--- 16 17 18 19 20 21 22 23 24 25 26 27 28 54 1 MR. BRANNAN: I think one further comment, if I 2 may? 3 The Standard Oil case is -- is the classic 4 example of an investment leading to business income. 5 Standard Oil, through those investments, got roughly 6 50 percent of the oil supply that they needed to conduct 7 their business through those investments, their bread 8 and butter. 9 There is no such flow of value in this case. A 10 comparison to Standard Oil is -- is illusory, at best. 11 There simply was not that sort of, you know, flow of 12 product or flow of value moving upstream from the 13 investment in this case. It didn't happen. 14 MR. HORTON: Member Yee. 15 MS. YEE: Thank you, Mr. Chairman. 16 I'm going to make a statement. I just want to 17 see if there's agreement on both sides about it. And I 18 would -- I want to thank Mr. Sperring for bringing us 19 back to focus about what the nature of this case is. 20 But I think this might be the starting point 21 for looking at how we -- and examine the case law and 22 prior Board decisions. 23 But the statement I want to make is that if -- 24 if there is -- if the interest in the asset, in this 25 case investment, is integrally related to the unitary 26 business activities of the taxpayer, then the dividend 27 received from these integrally related interests is 28 business income. 55 1 Just kind of put your hat aside in terms of the 2 Appellant in this case, but is that -- is that a true 3 statement -- 4 MR. SPERRING: Yes. 5 MS. YEE: -- in your view? 6 MR. SPERRING: Yes. 7 MR. JOSEPH: I think so. 8 MS. YEE: Okay. So then, it seems to me then 9 what is specific to this matter before us has to do with 10 the ownership interest of the asset, so, whether it's 11 minority or majority owned; the integral nature of the 12 activity, whether integral in whole or in part, are 13 questions that are before us. 14 And, you know, I also went back to kind of take 15 a look, as I had mentioned earlier, about the specific 16 nature of these seven investments. And they do have 17 significant differences among them, where four are, 18 essentially, former nationalized phone companies, three 19 are not. And of the three, we have two that are in a 20 completely different type of consumer service. 21 And, so, I'm not even sure how the law even 22 reflects upon, you know, that -- if there is any 23 relevance to how -- whether we need to differentiate 24 between that. 25 But what I want to do was to see if I could -- 26 here's where I'm kind of headed, Mr. Chairman, that is, 27 I really do want to understand the case law better. If 28 that's -- if -- if what I have just stated with respect 56 1 to what gives rise to business income is true and agreed 2 upon by everyone, then it seems to me relevant to this 3 particular case what I would like to have is further 4 examination of the case on the prior BOE decisions as it 5 relates to this whole operational versus investment 6 dichotomy and, you know, what are the kind of 7 constitutional limits associated with that? 8 And, secondly, this whole issue about the 9 integral nature of the business, and, again, you know, 10 whether it has to be wholly integrated, phases 11 integrated, what is the case law? How does that -- how 12 does the case law in other relevant decisions instruct 13 us about that? 14 And it could be -- I think what I've heard is 15 that a phase could -- of a taxpayer's business could 16 establish this type of relationship. But I wanted to 17 just kind of see where that authority comes from. 18 MS. MANDEL: You spoke very fast, I didn't hear 19 the last tiny bit. 20 MS. YEE: Oh, to what extent a phase of the 21 taxpayer's -- 22 MS. MANDEL: Oh, phase? 23 MS. YEE: -- business may establish such a 24 relationship and -- and to what phase of the taxpayer's 25 unitary business does the income producing property 26 materially contribute to the establishment of the 27 relationship. 28 So, I mean, there's like all these nuances that 57 1 are kind of embedded in this case law. And I just -- I 2 really need this teased out because it's easy to just 3 kind of point to a provision of a particular case and 4 overlay it on the facts of this case. 5 And I could -- I could make the case as well. 6 But I think there's a lot more going on here, 7 particularly if you go back to what the main issue is in 8 this case. 9 Then this whole issue about flow of value. We 10 have had cases that talk about the flow of value. Do 11 any of the cases even instruct us about how we determine 12 value? And to -- and to the extent that the fact 13 patterns may differ in some of these cases, how do we, 14 you know, really look at this whole concept of value? 15 Then, finally the notion of control, that if -- 16 I think in the Hoechst Celanese case there was a quite a 17 bit of discussion with respect to the taxpayer not 18 owning or holding legal title to some of the income 19 producing property. 20 And, so, I think these issues about control -- 21 and not just in this case, but how do we evaluate 22 control and material contribution and in matters like 23 minority ownership, in matters about -- relative to 24 legal restrictions on a taxpayer's ability to utilize 25 the assets and then other considerations as well. 26 But these are all things that I think are so 27 embedded in this case and yet I don't believe any one 28 case kind of fully responds to it. That's my discomfort 58 1 with this. 2 I'm happy to lay this out. And, Mr. Chairman, 3 what I'd like to suggest -- because I really don't want 4 to delay this any more, it's been -- it's an older 5 appeal -- but I think the cases have been cited. They 6 have been relied upon. The former -- prior Board 7 decisions have been cited. And what I'd like to suggest 8 is that the Appeals Division -- I know they're going to 9 hit me over the head -- take a stab at really examining 10 each of these decisions along these lines of concepts 11 that I have just articulated. 12 And I'll try to fine tune it even more and 13 articulate specific direction. But I think those are 14 kind of all of the issues that are embedded in this case 15 that I really would like to see teased out by 16 examination of these prior decisions. 17 MR. THOMPSON: Are you thinking about a memo, a 18 confidential memo to the Board from the Appeals 19 Division? 20 Or what are you -- I want to make sure I 21 understand. 22 MS. YEE: Well, I'm not ready to decide the 23 case today, Mr. Chairman, and I don't know what your 24 preference is, but to defer the case until we -- 25 MR. THOMPSON: Get our minds -- 26 MS. YEE: -- yeah -- 27 MR. THOMPSON: -- around the case law a little 28 better? 59 1 MS. YEE: -- right, right. I think that's my 2 thinking. 3 But Mr. Thompson, is that a realistic request 4 or should we -- 5 MR. THOMPSON: Well, we'd certainly be happy to 6 do that. 7 MS. YEE: Okay. 8 MR. THOMPSON: And I can definitely sympathize 9 with you on the case law. 10 I think anybody that's not doing apportionment 11 every day picks up ASARCO and then picks up Container 12 Corp. and they come away scratching their head a little 13 bit -- and then some commentators did. 14 On the other hand, I think -- I know that 15 you've heard the expression, you know, given enough 16 lawyers and enough time, nothing is clear. 17 I think there is a risk of that. I do think 18 both parties have ably presented their case here. And I 19 think that case law does dovetail together in the sense 20 that you've got to find an integral relationship. 21 Now, sometimes you find that through control 22 and centralized economies, sometimes cases find that 23 where there is a use of the asset in the business 24 enterprise. The classic example of that would be corn 25 futures, where the corn futures were used to hedge the 26 taxpayer's business risk. 27 And, so, while the test may seem a little 28 disparate and there's a lot facts and a lot of factors, 60 1 it all hinges on that issue of is it integral to the 2 business enterprise as a whole? 3 MS. YEE: Okay. Mr. Chairman, what I'd like to 4 do -- and I'd like to hear from my colleagues as to 5 whether this approach makes sense, but I'm happy to try 6 to put in writing my request to the Appeals Division. 7 I am not looking for additional briefing. I 8 would agree with Mr. Thompson, I think both parties have 9 adequately argued the case. But I still -- I mean, the 10 way that I like to look at this case is to just really 11 kind of understand and build in my own mind all of the 12 relevant authorities and then begin to apply the facts 13 of the case against them. 14 And I just don't -- that wall of authority 15 isn't filled in for me yet, so, I need some wallpapering 16 to be done. 17 MR. BRANNAN: Ms. Yee, I'm -- I want to be 18 respectful and that's certainly your prerogative. 19 MS. YEE: Uh-huh. 20 MR. BRANNAN: The idea of a -- you know, kind 21 of a very substantial legal discussion and I know that 22 hasn't been the order of the Board yet, but I really 23 would appreciate the opportunity for both parties to 24 address it in some -- some form. 25 MS. YEE: Well -- 26 MR. BRANNAN: If, in fact, that's the direction 27 that the Board goes. 28 MS. YEE: -- well, here's my thought, the cases 61 1 have been cited. The decisions have been cited. I've 2 just articulated or suggested a direction for the 3 Appeals Division. 4 And, Mr. Chairman, I don't know what your 5 preference is. We could bring this back. I was 6 thinking that we would defer the matter so that it's not 7 taken under submission, but that once the memo has been 8 completed, that the matter would still be before the 9 Board. 10 And, so, that -- I am -- I'm open to -- from a 11 process standpoint -- 12 MR. HORTON: Okay. 13 MS. YEE: -- in terms of what you want to do. 14 MR. HORTON: Okay. Of course, I'm supportive, 15 as I mentioned before, of my colleagues collectively 16 being able to assure that we have a full debate of the 17 issue and that it's very informative. 18 So, I would be supportive of deferring it if 19 the Members so felt that that was not the case and they 20 needed additional time and additional information to be 21 able to absorb the complexities of these cases. 22 But I want to walk through this, if you will, 23 and give us an opportunity to try to flesh it out and, 24 hopefully, if that is the direction that we go, it will 25 give the Appeals a little more perspective from -- from 26 the issues that are here, if you -- if -- so, why don't 27 I do that? 28 I want -- I want to start out with just trying 62 1 to delineate and distinguish, if you will, some of the 2 legal terms and some of the issues that have been 3 brought to bear. 4 Let's start out taking a look at global versus 5 domestic. The argument is is that we're dealing with 6 semantics and that the terms that were cited in a 7 particular document reference "global." But the 8 definition of global on the side of the taxpayer and the 9 definition of global on the side of the Department seems 10 to be quite different. 11 And without restating that, I'm going to ask 12 the taxpayer to give us their definition of global as 13 it's reflected in your minutes and Board statements and 14 any other statements that may be out there. 15 MR. STEPHENS: Let me -- I'll take that, 16 Mr. Chairman. 17 I think the view of the company was an 18 aspirational goal to become a provider of global 19 communication services. So, that would mean that we 20 would be able to serve a customer based on our territory 21 wherever they are provide -- wherever they needed 22 telecommunication services. That was our aspiration. 23 We were not able to do that. 24 MR. HORTON: So, in this aspiration, certainly 25 there was a -- well, let me not -- let me not say. 26 Was there a benefit to the company by having 27 these relationships with these affiliates? 28 MR. STEPHENS: Essentially, no. And 63 1 specifically because at this time the World Trade 2 Organization required equalization of trade between 3 foreign telephone companies across -- across foreign 4 borders and equalization of rates, same rates for all 5 providers. 6 So, in that light, there was not a specific 7 advantage to that. 8 MR. HORTON: Let me segregate these. The 9 customer -- is there an expansion of customer base? 10 MR. STEPHENS: There was -- if you will, I'll 11 will say from this -- 12 MR. HORTON: And -- and I'd like to hear, let 13 me just qualify that, I'd like to hear because, in my 14 mind, if there could have been an expansion, there would 15 have been. 16 And, so, what would have prohibited you from 17 expanding? 18 MR. STEPHENS: Yeah. 19 MR. HORTON: If that does exist, then that's a 20 fact. I mean, that's a fact that we can -- we can 21 establish. 22 And, so, I'd like to kind of go through these, 23 if you could? 24 MR. STEPHENS: Yes, sir. We -- I would say at 25 this point, from our pers -- 26 MR. HORTON: Let me ask the Franchise Tax 27 Board, can you do me a favor? 28 Just kind of -- I don't want to encourage you 64 1 to take notes, but be conscious that I'm going to come 2 back and give you an opportunity to respond to the same 3 questions without restating the questions. 4 MR. JOSEPH: Thank you. 5 MR. HORTON: If that's okay with you? 6 MS. ANDLEMAN: Thank you. 7 MR. HORTON: Okay. 8 MR. STEPHENS: From -- from SBC's perspective, 9 I don't believe we, if you will, gained access to any of 10 Telmex's or Belgacom's customers in any way from our 11 relationship with Telmex or Belgacom. 12 And, quite frankly, I think we did not allow 13 Telmex or Belgacom access to our customers here 14 domestically. 15 These were our customers and those were theirs. 16 We did not have any benefits with regard to cross border 17 transactions because of the rules that were in place at 18 that time. 19 MR. HORTON: In the Standard Oil case there was 20 vertical integration. Did that exist in this case? 21 MR. STEPHENS: No. If you will -- when you 22 talk about economies of scale or centralization, you 23 talk about joint procurement. You talk about joint 24 accounting systems, joint payroll systems, joint HR 25 systems, joint billing, bundling, product offerings, 26 advertising. None of that took place. 27 If you would go down the laundry list of kind 28 of divisions within a company, there was no sharing of 65 1 budgets or sharing of dollars. There were no common 2 contracts. I think we pointed out our materials in the 3 Belgium situation, we were specifically forbidden from 4 doing it because of some Belgian law, but we didn't -- 5 besides that, we just didn't do it anyway. 6 There were -- there wasn't that many cases it 7 could have even been done because, for example, we were 8 offering TDMA phones and our handsets would only work on 9 TDMA systems, when so many of the networks were using 10 GSM. 11 But even in -- even in, I think Telmex, at the 12 time, was using TDMA phones and even in that case we did 13 not do it. There was no joint purchasing. 14 So, all of the -- all of the -- and, 15 respectfully, sir, you know, from the company that -- we 16 merged with Pac Bell, we merged with Southern Bell 17 Telephone, we merged with Ameritech. We knew those 18 economy steps. That was our bread and butter for SBC on 19 how we grew from being the small company to a larger 20 one, in the sense of being able to get those economies 21 of scale and centralize. 22 There was none of that activity. And the best 23 evidence I can give you that is when I sold all these 24 investments, it was just a transaction on the stock 25 exchange. I cashed out. I took my money. There wasn't 26 anything to separate. 27 There is -- there weren't any systems to 28 separate. There weren't any people to separate. There 66 1 wasn't any customers to separate. I mean, that's just 2 the economics of what happened. 3 MR. HORTON: The individuals that served on the 4 Board and that were there in various different 5 capacities, did they ever return to the State? 6 And was there -- and participate in any form or 7 fashion -- 8 MR. STEPHENS: I think -- 9 MR. HORTON: -- here in the States? 10 MR. STEPHENS: -- excuse me, sir, didn't mean 11 to interrupt. 12 I think most -- a high percentage, I don't want 13 to say "most" in the sense of 51, but a very high 14 percentage did return to our company. They came back in 15 kind of normal jobs or other positions in our company. 16 That was common. 17 We -- we did not -- as a company, we 18 repatriated our people. We did not leave them on their 19 own in foreign countries. That wasn't our approach. It 20 wasn't our style, if you will, sir. 21 MR. HORTON: And, so, when they returned to -- 22 to -- to work at the domestic environment, the domestic 23 company, the knowledge that they gained by being engaged 24 in activities in these seven affiliates, let's call 25 them, any benefit there? 26 MR. STEPHENS: I think -- I'll say it this way, 27 I don't believe there was anything -- any benefit coming 28 back to the company from a specific knowledge base from 67 1 those companies that we didn't already have. 2 And what I mean by that is we were down there 3 as the experts. We were accepted by these foreign 4 countries as a good bidding partner because we had the 5 ability to, A, bring capital and, B, bring technical 6 expertise. So, we were, so to speak, already in that 7 position. 8 And this isn't a case of, you know, all -- in 9 many aspects of it. So, now, you'd have to ask the 10 individuals were they good experiences? Those 11 individuals, I certainly hope so. I never -- were they 12 developmental? Were they helpful to those individuals? 13 I hope so. I was never a full-time expat. I 14 only served on the Board relationship situation. 15 MR. HORTON: Speak to the law. Are you 16 familiar with the Holly Sugar case? 17 MR. STEPHENS: I can't say that I am. 18 MR. BRANNAN: I can speak to that, 19 Mr. Horton. 20 MR. HORTON: Okay. In the Holly Sugar case, 21 they -- they sort of spoke to -- as well as in the 22 Hoechst Celanese -- they spoke a little bit about value 23 and what the measurement of that value -- whether it was 24 incidental, infinitesimal. 25 Can you -- can you give us your perspective as 26 it relates to what the courts have interpreted value to 27 mean -- 28 MR. BRANNAN: Well, it goes to -- 68 1 MR. HORTON: -- in determining business versus 2 non-business. 3 MR. BRANNAN: -- in that case, it was the 4 purpose behind the acquisition or the management of the 5 California subsidiary. 6 Holly Sugar was not a California-based company, 7 but the investment that was at issue was a 8 California-based company. 9 And the materiality threshold that the court 10 looked at had to do with, you know, public statements by 11 the parent indicating they were going to manage that to 12 our advantage. 13 And, in fact, Holly Sugar ended up on the 14 manufacturing side, a meaningful portion of the sugar, 15 and it was the identical, you know, basically, business 16 structure. 17 And, so, publicly they said what they were 18 going to do with the subsidiary and then they did it. 19 MR. HORTON: Okay. So, the distinction is that 20 that they actually incurred some benefit in addition to 21 the -- I don't want to -- I don't know if I'm catching 22 the Department off guard, but I do want to hear from 23 them on that same question instead of waiting, if I 24 could? 25 MR. JOSEPH: Go ahead. 26 MS. ANDLEMAN: Go ahead. 27 MR. JOSEPH: Well, I would say that the -- that 28 it's certainly easier when you're talking about 69 1 something where you're -- you're dealing with a source 2 of supply or something like that -- 3 MR. HORTON: Right. 4 MR. JOSEPH: -- involving these relationships. 5 MR. HORTON: Yeah. 6 MR. JOSEPH: But in relation to the actual 7 benefit that is received, I don't think that it's 8 inconsistent to say that that benefit can be received in 9 other ways -- sharing of expertise being the one in this 10 case. 11 I don't know that the analysis is any 12 different. The substance of what's being provided is 13 less tangible, obviously. But -- but from a standpoint 14 of applying the analysis, this idea of what happened, 15 you know, versus what could have happened, is 16 certainly -- that's something we can talk about more in 17 this case. 18 I think the facts in that case -- 19 MR. HORTON: I'll get there. 20 MR. JOSEPH: -- integrate -- that it did, in 21 fact, happen in the Holly Sugar case. So, that was 22 relatively straightforward. 23 As far as whether it was minimal or something 24 like that, that just goes to the weight of the evidence. 25 And we certainly continue with here as well. 26 MR. HORTON: See, in the Holly Sugar case and 27 the Standard Oil case, it's really clear. 28 MR. JOSEPH: Yes. 70 1 MR. HORTON: I mean, it's really clear because 2 you have oil. You have sugar. 3 Here we're dealing with intangibles. And, so, 4 is there anything that says that that intangible -- that 5 there has to be connected to income and that it's when 6 that intangible -- let's hypothetically say that it did 7 exist. 8 MR. JOSEPH: Uh-huh. 9 MR. HORTON: That an intangible exists, at what 10 point is it considered income? 11 Wouldn't you have to generate some income? Or 12 could you have the intangible and just by virtue that 13 you have it, you can allege that your company benefited 14 and, therefore, it made more money? 15 But the company could have lost by having that 16 same knowledge. 17 MR. JOSEPH: Absolutely. 18 MR. HORTON: And in this case, the measurement 19 would not be the dividends, necessarily, which is the 20 income before us, it would actually be some other form 21 of income that would have been derived from the -- from 22 the company. Is -- 23 MR. JOSEPH: Yes, you're absolutely right, that 24 could happen, absolutely. 25 We have had taxpayers in the past that have 26 tried to make arguments that they're not unitary because 27 they didn't make any money. It's rather irrelevant what 28 they -- 71 1 MR. HORTON: Not unitary, I wanted to -- 2 MR. JOSEPH: -- made money or not. 3 MR. HORTON: -- I want to differentiate -- 4 MR. JOSEPH: Okay, sure. 5 MR. HORTON: -- unitary concept, I get that, to 6 the business income concept and go back to the Hoechst 7 Celanese and see where the value is. 8 MR. JOSEPH: Yes. 9 MR. HORTON: I want help -- 10 MR. JOSEPH: Okay. 11 MR. HORTON: -- understanding the economy of 12 scale and if that existed and where the value is, that 13 these intangible things that we're discussing, do we 14 score that somehow? 15 Is that -- is the value -- when is it incurred 16 and at what point do we recognize that value? 17 Or are we saying that that value is the 18 dividends that were -- were received? And, if so, then 19 I'm going to ask that both sides try to distinguish the 20 dividends from any other investor because the taxpayers 21 argue that their position as investors and that it was 22 an arm's length transaction and they received services 23 rendered for -- they got paid for those services as 24 advisors -- 25 MR. JOSEPH: Uh-huh. 26 MR. HORTON: -- and there's no difference in 27 the marketplace. 28 And I can't recall the case, I don't know if 72 1 Allied Signal or so forth, that sort of speaks to the 2 marketplace and that there has to be some distinction in 3 that income, above and beyond what's -- what any other 4 individual could receive in the marketplace. 5 MS. ANDLEMAN: I think one of the things to 6 focus on here, while it wasn't required that there be a 7 mutual flow of value, the best practices are very 8 critical in corporations. 9 Corporations talk about that frequently. And 10 what you have here is you have an exchange of best 11 practices with respect to developing the -- the 12 developing industries, the -- the GSM, the -- just in 13 general, wire line and wireless. 14 SBC also was the beneficiary of having greater 15 access to this -- to the markets. And although I may be 16 drifting a little bit, but we talk about -- 17 MR. HORTON: You are not, you're doing a good 18 job. 19 MS. ANDLEMAN: -- thank you. 20 We talk about Mexico. And, yes that was 21 government owned. But one of the critical things no 22 one's brought up today is that at that time that SBC 23 made its investment, the Mexican telephone company was 24 not operating very well. There were a lot of people who 25 did not have telephones. There were long waiting lines. 26 And what SBC did was to come in and to provide 27 some technical assistance, even though it may have had 28 limited or minority ownership, and opened up that market 73 1 and developed -- made it possible for more people to 2 have telephones. 3 And what's the great value to SBC -- SBC? It's 4 doing -- it has corporate customers all over the world. 5 And now those corporate customers are in a country which 6 has a better telecommunication system. 7 And I -- that's very critical, despite the 8 government ownership. So, there was a -- there was a 9 flow of value in this case in both directions, but I 10 think as far as looking at SBC, you have to look at the 11 fact that they were opening those markets and the best 12 practices. 13 MR. HORTON: Okay. So, let's -- let's presume 14 that there is a flow of value. 15 Be nice if we -- if the taxpayer -- the burden 16 of proof is on the taxpayer. 17 MS. MANDEL: I have a question, Mr. Horton. 18 MR. HORTON: Give me second -- 19 MS. MANDEL: Okay, thank you. 20 MR. HORTON: -- Ms. Mandel. 21 So, -- well, strike that. On this on issue, 22 Ms. Mandel? 23 MS. MANDEL: Yeah, but I don't want you to lose 24 your train of thought. 25 MR. HORTON: Okay, I'm good. 26 But I want to make sure that -- because it's on 27 this that we can get your thoughts on the table as well, 28 so -- 74 1 MS. MANDEL: Okay. 2 MR. HORTON: -- please? 3 MS. MANDEL: It's -- you know, these are very 4 factual cases And Hoechst Celanese does lay out this 5 test for its description of how you apply the functional 6 test. 7 And with respect to the comment earlier about 8 what was the case law at the time, you know, case law 9 goes forward and back in time. So, it doesn't really 10 matter, but I do note that Hoechst Celanese is 2001 and 11 these are the 2001-2002 tax years. 12 So, the taxpayer would have had the benefit of 13 Hoechst Celanese. That said, I feel what I'm hearing 14 out of Franchise Tax Board is -- is -- is sort of a 15 further factual conclusion, what the taxpayer would 16 characterize as speculation, from the facts that are 17 known in the record. 18 Like there were some expats and, gee, in Europe 19 they used a different technology than was currently in 20 use here. 21 But we also have the testimony of the 22 individuals from the company and the gentleman here 23 today who gave testimony about the facts of -- with 24 respect to that technology issue that they already -- 25 you know, they knew about it. 26 It's not -- so, I -- I feel like -- and I'm not 27 saying it's only happening on the FTB side, but I feel a 28 little bit like there's an assertion of a factual 75 1 conclusion that there must have been value that the 2 company operations -- business operations in the United 3 States, or particularly in California, must have gotten 4 from what was happening in the foreign countries because 5 they, you know -- it sounds more like trying to draw 6 some sort of inference off a fact that we know, we can 7 draw, you know, good factual inferences off facts we 8 know, but then I don't hear any -- we have the testimony 9 of the people saying no, that's a wrong inference 'cause 10 it didn't happen. 11 We have to ultimately weigh all that factual 12 evidence, including the -- the testimony. And, so, I'm 13 getting -- 14 MR. HORTON: Yeah. 15 MS. MANDEL: -- I mean, I guess I didn't have 16 a question in there, but -- 17 MR. HORTON: No, I think that's very helpful. 18 And, so, maybe the FTB and the taxpayer can speak to 19 this notion of value and when it incurs. 20 Certainly I don't know what value there could 21 have been, but I would presume that there is some value 22 in having an employee work overseas. 23 And if, in fact, the SBC at some point was to 24 benefit from that customer base, then that value would 25 have a corresponding benefit. You could -- instead of 26 inferring, you could actually measure the benefit. 27 And that's the challenge that -- that I think 28 we're facing. Because when you look at Hoechst Celanese 76 1 and you look at the Holly Sugar case, it asks for -- or 2 it says the court has said there has to be a measurable 3 value to the investor. 4 And, so, the -- the best practices that they 5 brought back to the State, how is that measure of a 6 measurable value? 7 The access to monetary -- to markets overseas, 8 I believe that that's a value, but I just don't know 9 when it occurred because of the restrictions that were 10 placed. 11 And, so, maybe you can bring some clarification 12 to both? 13 MR. JOSEPH: Absolutely. 14 One of the documents that we provided to your 15 Board from the FCC filings last week was an affidavit by 16 one of the folks from Ameritech to talk about these 17 investments. 18 And on page 7 of that affidavit he states, 19 "No other US-based company serves as many 20 customers via affiliates internationally, nor 21 has as a broad a reach of customers within the 22 countries in which it operates. No other 23 US-based company holds as many 24 telecommunication assets internationally and 25 none has made as large or as broad an 26 investment in developing countries." 27 They had access to those markets. They had 28 access to those customers. It goes on to talk about -- 77 1 in this document -- about the examples of what could be 2 done. 3 "The merger provides enhanced domestic 4 operating and marketing practices. They can be 5 explored to the United States and shared that 6 among international affiliates. 7 Ameritech's affiliates in Denmark, for example, 8 have sold billing system software to our 9 affiliates in Hungary and Belgium to the mutual 10 benefit of the companies and has exposed them 11 to new product offerings which they might sell 12 in the future. 13 The merger provides additional purchasing 14 economies across suppliers, which should allow 15 international affiliates to expand their 16 investments and services in their home markets. 17 The merger will allow the benefits of 18 purchasing scale and knowledge to improve the 19 affiliates' operations and expand the areas 20 where new offerings and technology will be 21 employed. This will ..." 22 And then later on it says, 23 "The scope of the combined company will enable 24 US companies to conduct international 25 business more efficiently." 26 I -- I don't know what else we need to say on 27 that. 28 MR. HORTON: Well, the challenge is those terms 78 1 that you have in there that said -- says "will" -- 2 MR. JOSEPH: Well, this was 1998. 3 MR. HORTON: -- "should." How do we measure 4 it? 5 I need your -- it seems to me that the 6 amount -- the dollar value that's before us that's being 7 categorized as income and non-income is -- is the 8 dividends received. 9 And, so, I don't know how to distinguish those 10 dividends from any other dividends that an investor 11 would have made. 12 And I'm presuming that -- and I'm going to ask 13 the taxpayer this -- I'm presuming that there were 14 several investors that invested in the same companies? 15 MR. BRANNAN: Yes, there were. 16 MR. HORTON: Is that right? 17 And those investors, did they receive any 18 additional -- I mean, did you receive anything different 19 from any of the other investors? 20 MR. STEPHENS: We all received common returns 21 based on common investment interests. 22 MR. HORTON: Was there a -- was there an 23 augmentation to your investment as a result of your 24 involvement in any form or fashion? 25 MR. STEPHENS: No, the -- no, sir. 26 And to the point of, for example, in our 27 relationship in Mexico, we were billing them for those 28 expats' services because we were transferring value, as 79 1 the FTB describes, in a very underdeveloped network. 2 Our partner in Mexico is, you know, very good 3 business people. They were not billing us for transfer 4 of knowledge up to us. As I said, if there was a 5 transfer, it just seems logical that there would have 6 been a bill to us for that. There wasn't and that, in 7 my mind, is evidence of that -- 8 MR. HORTON: Well, possibly -- 9 MR. STEPHENS: -- transfer not occurring. 10 MR. HORTON: -- not occurring, yeah. 11 The challenge before us is there was a 12 potential for benefit. 13 And, so, what I'm trying to ask FTB is how do 14 we measure that potential? I mean, what factual 15 evidence other -- income, other than the dividends, 16 which seems to be the same as any other dividends that 17 were received by investors? 18 And, so, let's presume that that income is off 19 the table because they clearly made an investment and 20 they clearly received dividend income as any other 21 investor had made. But that necessarily doesn't say 22 that there wasn't a business income. 23 And I'm just trying to get some assistance in 24 measuring that. 25 MR. JOSEPH: Let me see if I can clarify a 26 little about what you're asking. 27 What you're asking is what, beyond the flow of 28 funds which came back from these companies to the 80 1 Appellant, what beyond that? 2 MR. HORTON: Well, I understand -- I understand 3 that you share -- that there is best practices -- 4 MR. JOSEPH: Uh-huh. 5 MR. HORTON: -- and that there may be an 6 economy of scale -- 7 MR. JOSEPH: Uh-huh. 8 MR. HORTON: -- and that there may be access to 9 this market. 10 MR. JOSEPH: Uh-huh. 11 MR. HORTON: But the mere having access to the 12 market does not generate income or the potential of 13 having access to the market does not generate income. 14 MR. JOSEPH: That's true. 15 MR. HORTON: And there's case law -- the case 16 law that sort -- that sort of states that. 17 And, so, having that access has to generate 18 some sort of income. Because if it was going the other 19 way, the mere fact that you have access and that 20 access -- and there was a loss over there, we certainly 21 wouldn't be arguing that that mere access gives them a 22 right to take a loss on their tax return. 23 MR. JOSEPH: Yeah, there is a difference 24 between combined reporting, where they would have access 25 to that loss -- 26 MR. HORTON: Okay. 27 MR. JOSEPH: -- due to their ownership 28 interest. 81 1 MR. HORTON: Okay. 2 MR. JOSEPH: And business, non-business, where 3 because they have minority interest, they don't have 4 access to that loss. 5 That is solely based upon control. If they 6 would have over 50 percent ownership in the entity, 7 then, of course -- 8 MR. HORTON: We might not be here. 9 MR. JOSEPH: -- well, that would be nice. But 10 I'm not sure -- actually, that's a very good point. 11 I'm not sure if we would be here or not because 12 if control is really the be all, end all of this issue, 13 well, that's easy, the case law clearly says you don't 14 need control. 15 That's an easy question. 16 MR. HORTON: Uh-huh. 17 MR. JOSEPH: If everything were the same, but 18 they owned 51 percent and that would be unitary, then 19 this is business income. That's pretty simple. 20 If you think that the flow of value here needs 21 to be a flow of value back to the taxpayer in excess of 22 what it received in the dividends, then we have to deal 23 with issues about how you quantify that. 24 I don't believe the law would require that, 25 however. I think it's enough that there is an integral 26 relationship between the Appellant's business and the 27 operation of these foreign investments to find it 28 business income. I don't think you need to require 82 1 anything more than that. 2 Now that being said, when you talk -- 3 MR. HORTON: Let me -- 4 MR. JOSEPH: -- oh, go ahead. 5 MR. HORTON: -- let me get some 6 clarification -- 7 MR. JOSEPH: Uh-huh. 8 MR. HORTON: -- from the Department. 9 Therein could be a huge difference in how we 10 view this case and it certainly -- and speaks to the 11 necessity, I believe, for us to -- for us to allow the 12 Department to kind of flesh this stuff out for us and 13 possibly defer the case. 14 But the Hoechst Celanese case and the Holly 15 Sugar case, all of them seem to imply, as I read them, 16 that there has to be a flow in both directions. 17 Can you bring some clarity to that for me? 18 MR. THOMPSON: Yes, that's how I read Hoechst 19 Celanese as well. And, you know, I've actually been 20 sitting here with it in front of me because I think that 21 it addresses this right on. 22 In Hoechst Celanese it was struggling with how 23 do you determine if it's integral. And if one side's 24 saying, "You know what, it's got to be essential, they 25 couldn't live without it," and the court said, "That's 26 too much, that's too much." 27 And then the other side, "Well, as long as it 28 just helps you out, if it's -- then you -- it's helping 83 1 you out. So, that's enough." 2 And, of course, you know, that's too low. 3 MR. HORTON: Yeah. 4 MR. THOMPSON: So, they took -- excuse me, they 5 took a middle course. And it set forth this test that's 6 been quoted to you today that they've got to constitute 7 one part of a whole. 8 And that with regard to the value, the concept, 9 as I read this decision, is that the taxpayer needs to 10 use and control the property to, quote, 11 "Contribute materially to the taxpayer's 12 production of business income." 13 So, my read of that is you need to find that it 14 helps -- or it helped, rather, the taxpayer produce 15 business income. 16 Now, you know, FTB would say, and I think it 17 did, it opened up markets, it benefited their customers. 18 They used surplus employees and made some other 19 arguments. 20 And Appellants here are saying, no, no, those 21 are too minimal and too indirect. What really happened 22 here was an investment that we supported. And 23 everything else we did was incidental to the investment 24 instead of vice versa. 25 MR. HORTON: So, the business income that the 26 cases refer to, in this case, the income that is clear 27 is the dividend income. 28 Are they -- 84 1 MR. THOMPSON: Just to step back. 2 MR. HORTON: Please, go ahead. 3 MR. THOMPSON: Sorry, just to step back. 4 But the issue here is does California get a 5 piece of that dividend income? 6 That's really what it boils down to. 7 MS. MANDEL: I think there was a disconnect 8 between the two of you. Because when you were talking 9 about the court case and saying there has to be 10 material, something on the business income, that 11 business income is not the business income in dispute in 12 the case as business or non-business, which in this 13 instance would be the dividends and capital gains, but 14 the business income of the regular business operations 15 of the -- 16 MR. HORTON: Of the -- 17 MS. MANDEL: -- corporation itself, which in 18 this case, as we've been talking about it, I understand 19 to be the the domestic phone -- particularly the 20 California phone operations of the SBC operation; is 21 that correct? 22 MR. THOMPSON: Yes, that's a good 23 distinction. 24 MR. HORTON: Okay. 25 MR. THOMPSON: So, yeah. 26 MS. MANDEL: That's where I thought the 27 disconnect was because he started talking about -- 28 MR. THOMPSON: I think you're right. 85 1 MS. MANDEL: Yeah. 2 MR. HORTON: So, let me go back to the FTB. 3 SBC, a domestic company, what additional income 4 was derived from those activities that their engagement 5 in the seven affiliates or seven -- however you 6 categorize them? 7 MR. JOSEPH: Well, I think what we learned from 8 the briefing was that they had excess capital, human 9 capital, in their organization. And they had expertise. 10 And those two items -- 11 MR. HORTON: They testified that -- that they 12 were paid for that capital. 13 MR. JOSEPH: That doesn't matter. 14 MR. HORTON: Okay. 15 MR. JOSEPH: The case law's clear, arm's length 16 does not override the fact that there was a flow of 17 value. 18 The case is -- that's been put to bed for 30 19 years. The fact that they were paid arm's length just 20 doesn't matter. 21 The fact that they were involved in the 22 transactions does. So, here we have a company with 23 excess human capital and a lot of expertise trying to 24 make money for the business where they gained that human 25 capital and that expertise and they employed those 26 assets in foreign countries. 27 That, to me, is flows of value. Now, when you 28 say, "What did they get beyond the dividends?" 86 1 Well, the first thing they got was access to 2 the investments in the first place. These investments 3 were not out on the open market, these were partnerships 4 with governments and other telecommunication companies, 5 not just purchases of stock. 6 So, they gained access, which was to their 7 value, and also they gained access to the customers, 8 which we've talked about. 9 I cannot tell you that they have sold more in 10 their 13-state wire line business due to these 11 operations. We do have statements in the record that 12 say that they should because big customers like to have 13 access to having all of their facilities all over the 14 world treated through one entity. And they talk about 15 that in the documents that we provided last week. 16 But I don't know off the top of my head of any 17 other flow of money to the taxpayer other than the 18 capital gains and the dividends that are in question 19 here. 20 And I don't believe -- 21 MR. HORTON: No, that's -- 22 MR. JOSEPH: -- that the law requires that. 23 MR. HORTON: -- the benefit -- I mean, the case 24 law says benefit is sufficient. 25 MR. JOSEPH: Yes. 26 MR. HORTON: It says that we've got -- and I'm 27 going to go to the taxpayer to kind of speak to this -- 28 but I'm trying to understand the benefit in that the 87 1 customers in these foreign countries they could not 2 access. 3 MR. JOSEPH: Not directly. 4 MR. HORTON: So, indirectly they could? 5 MR. JOSEPH: For these investments, yes. 6 MR. BRANNAN: Well -- 7 MR. HORTON: And, so, they invested -- they 8 accessed these customers -- 9 MR. BRANNAN: -- I think -- 10 MR. HORTON: -- one second, please -- 11 indirectly and those customers increased the income for 12 these affiliates. 13 And instead of them getting a K1, or whatever, 14 a share in the profit, they got dividends. But they 15 also invested cash, like another investor, and got 16 dividends. 17 MR. JOSEPH: Yes. 18 MR. HORTON: so, that cash in itself, that 19 investment, that cash, has a value. 20 So, if I was an investor and I invested the 21 same amount of cash that the taxpayer invested in these 22 affiliates, I would have gotten X. 23 And despite the fact that they provided all 24 this additional advice, they still only got X? 25 MR. JOSEPH: Uh-huh. 26 MR. HORTON: So, the benefit has to be a 27 marginal increase, wouldn't you think, just in measuring 28 it? 88 1 I mean there has to be. If I -- if I'm going 2 to receive additional income over and above what the 3 market provides, that income, in the dividend sense, 4 would be measurable somehow or you -- you would be able 5 to differentiate that from any other investor. 6 MR. JOSEPH: Yes. And you can here because 7 they weren't any other investor. They went in to 8 develop these phone companies and to provide the 9 expertise necessary for them to expand. 10 The companies that they partnered with were 11 there to do the same thing. When you're a company -- 12 let's take Hungary, for instance, when you're in Hungary 13 and you've got a 15-year wait for somebody to get a 14 telephone and you decide this State run telephone 15 business is just not working, we need to get privatized, 16 we need to get somebody in here that can make this run. 17 And they bring in these guys -- and I think 18 they might have had another partner too, they can 19 correct me if I'm wrong on that -- and they provide the 20 expertise and knowledge necessary to go from a 15-year 21 wait for a phone to everybody has a phone and the 22 company's successful enough to be listed on the European 23 stock exchange. 24 I think they've added value there. And I think 25 that the value was reflected in the money that they 26 received back. 27 I think you raise an excellent point. If 28 they'd have done it in a partnership, as opposed to 89 1 buying stock in a corporate entity, I don't think we'd 2 be here either. 3 But you have to realize these were State-owned 4 entities, they could not get control, that was the 5 point, it's the telecommunication infrastructure. 6 So, they got stock. 7 MR. HORTON: Okay, let me -- 8 MS. MANDEL: Mr. -- 9 MR. HORTON: -- let me to go taxpayer then -- 10 MR. STEPHENS: Mr. Chairman -- 11 MS. MANDEL: -- no, that's fine. They're 12 probably going to say what I just thought of -- 13 MR. HORTON: Yeah, I'm going to -- 14 MS. MANDEL: -- is my guess. 15 MR. STEPHENS: Just factually, at the time 16 before us, none of these companies were publicly-traded 17 companies. 18 So, I mean just so we're aware there was 19 publicly trading shares in Telmex and Amdocs and -- 20 MR. HORTON: 2001 and -- 21 MR. STEPHENS: -- Enterprises. 22 MR. JOSEPH: Not when they bought them, though. 23 MR. STEPHENS: Depending upon the situation, 24 they could have been -- 25 MR. HORTON: What's audit period? 26 MR. STEPHENS: We're auditing the period here 27 MR. BRANNAN: '01 and '02. 28 MR. HORTON: They're not looking at what we 90 1 can -- 2 MR. STEPHENS: And -- 3 MR. HORTON: -- I mean, unless there's a 4 statute. 5 Okay. 6 MR. STEPHENS: In the -- 7 MR. HORTON: Thank you very much for now, 8 appreciate it. 9 You want to conclude? 10 MR. STEPHENS: No, sir. 11 MR. BRANNAN: Mr. Horton, on that -- on the 12 access to customers, there are -- there is no way for us 13 to access the foreign customer base. It's one of the 14 logistical impediments and technological impediments 15 that we faced that prevented us from accruing this -- 16 this additional value or synergies from the 17 relationship. 18 MR. HORTON: Okay. 19 MR. STEPHENS: And it's proven out. Not only 20 do we have it, but the economics are such that you have 21 to own a switch to be efficient, you cant' do it through 22 partnerships. 23 It's why so many of the -- so many companies in 24 the -- in that decade went through bankruptcy -- 25 MR. HORTON: Okay. 26 MR. STEPHENS: -- over investments. 27 I mean, it's just pragmatic economics and it's 28 why we acquired AT & T. It's the best independent 91 1 evidence. Nobody can dispute that we spent almost 20 2 billion dollars because it didn't work. None of this 3 happened. 4 MR. HORTON: Okay. Mr. Runner, then 5 Ms. Mandel. 6 MR. RUNNER: Yeah, just to follow up on this, 7 on the issue and the discussion in regards to the -- the 8 exchange of best practices. 9 It seemed to me that as FTB was looking at this 10 and in the -- some exchange we had a little bit ago, 11 that the -- that there was an assumption that I would 12 say -- I would observe of exchange of best practices. 13 Can you -- can you help me be more 14 specifically -- specific in regards to the, you know, a 15 documented exchange of best practices that flowed from 16 these investments back to -- 17 MS. ANDLEMAN: Yes, let me take, for example, 18 Tele Danmark. There were -- there were strategic 19 partnership agreements with Tele Danmark that provided 20 for -- and also there with Belgacom, that provided for 21 an exchange of information and exchange of, actually, 22 technical information. 23 They had, basically, product information, 24 developing products with Bell Canada. They decided they 25 didn't want to duplicate efforts and, so, they were 26 going to share information that way. 27 So, they did have a series of different 28 partnership agreements. They even had Belgacom, an 92 1 Ameritech-led consortium, which provided for sharing of 2 information on not only technical, but managerial 3 expertise, how to run a telecommunications company. 4 And those were -- those documents are 5 voluminous. Some of them are attached to the briefs. 6 They were -- they have been -- we have reviewed them. 7 MR. RUNNER: Can we go -- and in terms of 8 the -- in terms of the -- I'll -- I'll come back. 9 But let -- but let me go the other direction. 10 The assumption that was made that because they were 11 apart then and -- and on these boards and the expansion, 12 I think specifically the issue was Hungary and, 13 therefore, there was a whole bunch more telephones in 14 Hungary, can you -- was that -- would -- in your 15 opinion, was that unique because -- only because of this 16 relationship? And that business relationship is what 17 made that possible? 18 MR. JOSEPH: Yes, absolutely. 19 MR. RUNNER: So, you don't believe that there 20 was any other way that -- that the technology or the 21 decisions could be made outside of this -- outside of 22 the relationship that they had with -- with Pac Bell? 23 MR. JOSEPH: Well, I -- 24 MS. ANDLEMAN: Go ahead. 25 MR. JOSEPH: -- I think they could have 26 partnered with another telecommunication company that 27 would have -- that could have happened, that's true. 28 But that's not what happened. In 1993, when 93 1 they invested in Maytag, which Ameritech did, 15-year 2 backlog. 3 And then it says in here -- they talk about how 4 that is increased to the point that there is one and a 5 half million new customer lines in '93 and 2.4 million 6 lines in 1994. 7 And then it says they had the ability to work 8 with these affiliates to have dramatic improvements in 9 service levels and productivity. 10 Yes, it was because they worked with these 11 companies. 12 MS. ANDLEMAN: And you had the same example 13 with Mexico. 14 MR. JOSEPH: Yeah, Mexico's just as large. 15 There was over $12 billion invested in Mexico laying 16 countless miles of fiber and connecting -- 17 MR. RUNNER: And all those investments were 18 unique because of the investment that was made by Pac 19 Bell? 20 No other options? No other ways that those 21 investments could have been done or -- outside of that? 22 MR. JOSEPH: I'm not an expert in the 23 telecommunication industry. You can ask -- 24 MR. RUNNER: Well, they're going to answer in 25 just a moment. 26 MR. JOSEPH: -- but, but -- please go ahead. 27 MS. ANDLEMAN: The Mexican government very 28 concerned about the fact that -- I can't remember the 94 1 number, I want to say like one in six, one in 12 homes 2 had a telephone line. 3 MR. RUNNER: Right. 4 MS. ANDLEMAN: And, so, they were looking to 5 this partner, if you will, to come in and to give them 6 the knowledge and the knowhow in order to be able to 7 expand it. 8 Could someone else have provided it? Maybe. 9 But given who had ownership of the company, who was 10 involved with Mexico, they looked to SBC. 11 MR. RUNNER: Okay. Let me ask for the response 12 in regards to -- 13 MR. SPERRING: Sure. 14 MR. RUNNER: -- the issue of flow both ways. 15 MR. SPERRING: Exactly. FTB is pointing to two 16 items as evidence of flow of value. One is the expats 17 and two is our ability to increase the efficiency of 18 these investments, right, and, therefore, presumably, we 19 would benefit. 20 Well, let me just go back again to the case 21 law, right? And let's look at Mark Controls -- what you 22 had going on there. 23 And in Mark Contr -- it says -- the Board said 24 Mark Controls provided two additional executives to 25 where -- in an attempt to improve where its operation 26 and profitability. 27 Mark Controls loaned two key employees in an 28 attempt to make Weir more efficient and more profitable 95 1 and to smooth away for Weir's eventual integration into 2 Mark Controls' business. 3 And guess what? Even though that was going on, 4 and you had a Board of Directors, what did your Board 5 rule? Non-business income, okay? 6 Again, every single case that we've cited, 7 okay, where the Board or the Supreme Court found 8 non-business income, you had secondment of employees, 9 okay? 10 So, you're hearing that as their big tie, yet 11 every single case that was there and there was a finding 12 of non-business income. 13 So then let's move now to this amorphous 14 idea that, well, okay, we benefited Telmex. And as a 15 result you went from a nine-month wait down to a 60-day 16 wait or a five-day wait, okay. 17 And because they're more efficient, now our -- 18 customers can -- will receive more calls and can make 19 more calls down into Mexico, okay. 20 If this is the flow of value that's enough, 21 then I think it's safe to say that every time Bank of 22 America or Wells Fargo makes a loan to one of its 23 customers, they're unitary, okay, that that would 24 establish flow of value. 25 Because if their customers do better, okay, 26 then they're going to need more banking services. I 27 mean, clearly this flow of value concept is not that 28 amorphous, but that's all they got at the end of the 96 1 day. 2 MR. JOSEPH: Can I add question -- a little bit 3 about about the Mexico partnership? 4 MR. RUNNER: Uh-huh. 5 MR. JOSEPH: Mr. Cliff Eason, who they can 6 vouch was involved in Telmex, talked about what was 7 going on down there. 8 And basically they said, 9 "Our local partners, which was Groupo Carso, 10 added a lot of value to the deal. Groupo 11 Carso's just been a textbook example of 12 a perfect partnership. 13 They've been a bit more cautious and a little 14 bit more deliberate than ...". 15 I'm sorry, I skipped a line, 16 "Analysis said that SBC has been exceptionally 17 savvy in choosing partners for its overseas 18 deals. And Groupo Carso brought valuable 19 insight about the way Mexico business and 20 government sectors work." 21 So, you know, when they got into these things 22 they were providing value, working with partners to come 23 up with ways to make phone systems run in these 24 countries and increased dramatically the access to phone 25 services in these countries. 26 And, you know, in their own mind, they said 27 anybody can send money, we're not an investment bank. 28 MR. RUNNER: Just -- can you just give me the 97 1 context of that? I'm just -- 2 MR. JOSEPH: Yeah, oh, sure. 3 MR. RUNNER: -- not familiar with the 4 individual nor the context. 5 MR. JOSEPH: I'm sorry, this was a New York 6 Times article that quoted Mr. Eason in the San Antonio 7 Express talking about the merger with Ameritech and 8 SBC. 9 MR. RUNNER: Okay. 10 MR. JOSEPH: And Mr. Eason, I believe, was 11 pretty high up in the company. He was the President of 12 SBC's International Operations. 13 MR. RUNNER: Yeah, you know, I -- sometimes -- 14 I always want to try to get the context of those 15 statements and where they come from because -- 16 MR. JOSEPH: Absolutely. 17 MR. RUNNER: -- sometimes -- I struggle 18 sometimes with what I -- what I one time phrased 19 corporate hyperbole in order to establish yourself 20 versus your true operational activity. 21 And, so, that's why I want to kind of get the 22 context of what that was. 23 Okay, thank you. 24 MR. BRANNAN: If we may respond? I -- 25 MR. HORTON: Mr. Runner? 26 MR. RUNNER: Just quickly, please. 27 MR. BRANNAN: Go ahead. 28 MR. HORTON: Go ahead. 98 1 MR. BRANNAN: You want to? 2 MR. STEPHENS: Yeah, just -- just real quickly. 3 You know, we did send people and bring best practices 4 and improve -- and assist in improving those telephone 5 companies' performance. 6 The fact that they needed it goes counter to 7 the argument that they would have provided us value. 8 You -- I mean, it's -- we're arguing both -- someone's 9 arguing both ways here if they were in such dire shape, 10 is it that difficult to believe that there wasn't a 11 value transfer coming up? I mean, there wasn't. 12 And if we're dealing with such a savvy 13 businessman as the man who controlled Groupo Carso, 14 would he give away value without charging me for it? 15 Those -- those practical statements that 16 they're referring to add to our case that there wasn't 17 any value coming back upstream. It just wasn't there. 18 MR. HORTON: Okay. Ms. Mandel. 19 MS. MANDEL: Well, the disconnect that I'm 20 hearing is Franchise Tax Board doesn't think it has to 21 be a two-way street. 22 MR. JOSEPH: That's correct. 23 MS. MANDEL: Taxpayer says under the California 24 Supreme Court test, which uses the exact words of "both 25 giving value," it is -- needs to be a two-way street. 26 MR. BRANNAN: That's correct, Ms. Mandel. 27 MS. MANDEL: What I hear the taxpayer saying is 28 anything that was done on the international front, the 99 1 taxpayer believes they have consistently characterized 2 it as an investment in their financial reporting, in 3 their press statements and in their -- everything that 4 it's characterized as a holding, as a deal, as an 5 investment. 6 MR. STEPHENS: That's an accurate statement. 7 MS. MANDEL: And that whatever people were 8 doing at the -- the taxpayer stresses few people in 9 terms of the overall amount of people that any of these 10 foreign phone companies may have had and dollars going 11 in. 12 We've had testimony, I think, that the 13 technology agreements that were originally with 14 Ameritech, there was testimony that nothing ever 15 happened coming toward the United States. 16 MR. STEPHENS: The statements referred to by 17 the FTB were prior to the Ameritech merger with SBC. 18 And I -- and it's a matter of record, 19 Ameritech's management, effectively CEO, CFO and other 20 key leaders, left shortly after the merger. 21 MS. MANDEL: Right, they didn't -- they were 22 not -- they didn't stay on. 23 MR. STEPHENS: They did not. 24 MS. MANDEL: And that any -- anything that -- 25 the expats' testimony, I think, has been that anything 26 that the expats were doing, they were doing in those -- 27 some of them, like you testified, that the CFO Mexico 28 was -- it sounded like a oversight function, not 100 1 actively involved. 2 I think you would normally think of a CFO as 3 doing the financial work of that company. But it 4 sounded more like oversight and then reporting back on 5 the financial status of the entity in which the parent, 6 the US company had made a substantial -- 7 MR. STEPHENS: He was overseeing a billion 8 dollar investment. 9 MS. MANDEL: -- the substantial investment. 10 And that -- what I thought the testimony was 11 was to the extent that there were people other than that 12 sort of CFO, the people that might have been placed and 13 that the foreign entity was paying full reimbursement 14 for, that the stuff that they might be doing -- that the 15 company -- that you don't dispute that -- that they 16 might have brought some talent to bear at those foreign 17 places. 18 But my understanding of the fundamentals of the 19 dispute is -- is that the taxpayer characterizes that 20 as, "I put a billion dollars," or however much the 21 different investments were, they were quite substantial 22 to take such a substantial a stock ownership position. 23 MR. STEPHENS: That was so we -- 24 MS. MANDEL: That that -- 25 MR. STEPHENS: I'm sorry. 26 MS. MANDEL: -- that my understanding is that 27 your characterization of that is those -- those people 28 were overseeing the investment of dollars and helping 101 1 make the investment better, the taxpayer's a better 2 performer and that the taxpayer's overall sense really 3 hinges on whether something has to come back to the 4 United States besides a greater dividend income -- to 5 the United States business -- to the United States 6 business operation as a whole, or California business 7 operation as a whole, which is why you focused on the 8 inability to do long distance, the inability to do 9 international connection, that -- that my sense is that 10 what you said is, "We invested in something we knew and 11 we have people." 12 So, that's why it just seems to really come 13 down to does -- does something have to come back? 14 Which FTB says nothing has to come back. And 15 then is that -- that's how I understand the case. 16 Am I mixed up? 17 Or that's how I understand the case. I mean, I 18 I don't think that the taxpayer disputes that -- that 19 the -- that the business operation of, for example, the 20 Mexican phone company got better over time while they 21 had some kind of involvement in it. 22 It's just a question of how you characterize 23 that involvement and what had to come back or not come 24 back to the United States in terms of the United States 25 phone operations themselves. 26 Do I have a -- 27 MR. JOSEPH: Well, I think that that's, for the 28 most part, correct. 102 1 But I still think that we would say that there 2 were flows that came back. And the flows that came back 3 were the very reason that they got into the investment. 4 They wanted it -- an opportunity to get involved in 5 foreign markets that they could not do through earning a 6 majority ownership. They just couldn't. 7 Now -- 8 MS. MANDEL: Okay. So, let me ask you, though, 9 after that -- well, he's going to say no, that's not why 10 we were doing it. 11 But -- 12 MR. HORTON: He might say yes. 13 MS. MANDEL: He might say yes, I don't know, in 14 which case, you know, we go down another road. 15 But he's shaking his head no, so, I'm thinking 16 he's going to say no. 17 But the -- but the -- I'm sorry, I'm starting 18 to fade -- but the -- but the -- this -- this is a big 19 company that had, I don't know, maybe they had a lot of 20 money or something laying around. 21 I mean maybe that's what he's going to talk 22 about. 23 MR. JOSEPH: Yeah. 24 MS. MANDEL: But -- 25 MR. JOSEPH: Well, it certainly -- 26 MS. MANDEL: -- the companies make investments. 27 Usually we see, oh, they're making investments because 28 they're trying to, you know, work -- their working 103 1 capital or they're holding the money over here and then 2 we get into that dispute about were they using it for 3 some other purpose later? Did they have it clearly 4 demarked that they were going to use it to buy something 5 that's really part of their business operations? 6 But it seems a little bit like what you have to 7 get through to is the -- the fundamental thing of are 8 they really simply investing in something that they know 9 or is it -- is it a big operation -- single sort of 10 operating business, if you will, which they say no, it 11 can't possibly be and, actually, in fact, couldn't 12 possibly be regulatorily, and, in fact, couldn't be, as 13 a matter of fact, because we didn't have, you know, the 14 equipment. 15 And it's that dispute between what you show on 16 your flow of value chart, Container, where you say it 17 doesn't have to and Hoechst Celanese -- and maybe I 18 don't speak enough German to pronounce it right, that -- 19 MR. JOSEPH: Well -- 20 MS. MANDEL: -- says that it has to be back and 21 forth. 22 So, maybe I'm just rambling -- 23 MR. JOSEPH: No, no. 24 MS. MANDEL: -- because I'm totally fading and 25 maybe I need -- I mean, some kind of -- 26 MR. JOSEPH: No, I think you're right. I think 27 everything you said is fair. 28 I would say that the facts in Celanese did not 104 1 raise the issue that you're questioning today. 2 They did have control over the pension fund. 3 And the pension fund was not a minority interest in 4 another entity that did the same thing Hoechst Celanese 5 does in the United States. 6 It was an activity that in itself was part of 7 the business. It was easy to show whether or not that 8 pension was beneficial to their employees. 9 I think these facts are quite a bit different 10 than that because we are talking about minority interest 11 ownerships in stock, which was not the case in Celanese, 12 it was a pension fund, which had an operational purpose, 13 just like a treasury function, I suppose, would have an 14 operational purpose. 15 So, I'm not sure that I would say that when the 16 court in Celanese wrote each other that I would say that 17 when they were writing that they were thinking about a 18 fact pattern such as this one. 19 MS. MANDEL: Well, yeah, I mean every fact -- 20 every case is only as good as its facts at some level 21 and yet they stated a test. 22 So, what are we supposed to do now that they 23 have stated a test? 24 So, anyway -- 25 MR. BRANNAN: And I think -- I mean, really at 26 the core of what Mr. Joseph is suggesting is that 27 there's two different tests and yet there is no case 28 authority that supports that. 105 1 I mean, a functional test, a functional test, a 2 functional test and that's what's been applied to these 3 situations from time immemorial. 4 And what we have from Hoechst Celanese is a 5 very clear statement of what integral relationship is 6 required in order to pass the functional test. 7 And there is two components of it. One is, 8 yes, there must be a flow of value upstream to the 9 investor and, further, that that flow of value 10 contributes to the material relationship. It can't be 11 the sort of amorphous supposition or speculation that's 12 been offered here today. 13 Unfortunately, what the FTB, at the end of the 14 day, has asked us to do is to prove a negative. That 15 nothing happened. 16 And the best we have is declarations under 17 penalty of perjury from highly placed individuals with 18 knowledge of the transactions and the Chief Financial 19 Officer from AT & T is here testifying under oath that 20 nothing happened. 21 MS. MANDEL: Maybe, Mr. Stephens, since I tried 22 to characterize the -- or not characterize, but restate 23 the facts and what the taxpayer's characterization of 24 them, I sense that you had facts you might want to talk 25 about. 26 MR. STEPHENS: No, I think your -- your 27 characterization of them was very reasonable and very 28 accurate, as I recall. 106 1 We had approximately $10 billion dollars worth 2 -- $10 billion invested in various properties after we 3 merged with Ameritech. And we had people assigned to 4 shepherd those. 5 We had, you know, 200,000 people, or about 6 that, on our payroll. There was a small -- very small 7 fraction of our people were shepherding these -- much 8 like these companies had very large employee bases that 9 were operating. 10 I think your description of the situation was 11 very accurate. 12 MS. MANDEL: Did I get -- did I get it from an 13 Appeals perspective? 14 MR. THOMPSON: Yeah, I think so. 15 I would point out that in Hoechst the Supreme 16 Court, I thought, as I read it, took great pains to 17 state a clear test. 18 And then it applied that test. 19 MS. MANDEL: So, in this case you would say 20 that we have to find something coming back? 21 MR. THOMPSON: I think you're on safe ground 22 when you're looking at Hoechst Celanese, notwithstanding 23 that it didn't involve stock. 24 And on Container Corp., I would note that in 25 the California Court of Appeals decision, my read is the 26 court did look at flow of value going both directions. 27 And it pointed to some of the same things the 28 FTB pointed to here. So, that cuts both ways for FTB. 107 1 But it looked at both. 2 And, so, it just goes back to that test. I 3 worry a little bit we'll get sidetracked by this flow of 4 value issue when it's a piece of the larger picture of 5 is it integral to the business? 6 MS. MANDEL: And when you say, "Is it integral 7 to the business?" What business are we talking about? 8 MR. THOMPSON: Did it contribute materially to 9 the other unitary business income? 10 And that's what I think Hoechst Celanese says. 11 And I'd also add with regard to Container Corp., I 12 wouldn't regard the Supreme Court decision as a ringing 13 endorsement. 14 I know one place in it it says that the 15 California Court's decision was, quote -- I believe it 16 says, "within the realm of the permissible." 17 So, it relied very heavily on the very fact 18 specific determinations that the court made there. 19 And I think, you know, that's appropriate 20 because that's what we are here and that's what the 21 courts are here to do. 22 And, you know, admittedly, the facts and 23 factors are going to vary, and the -- but -- but that's 24 the test. 25 MR. BRANNAN: And I think that -- I mean, 26 you're asking about what trade or business. We have a 27 domestic trade or business that they started with, the 28 RBOCs. 108 1 Foreign investments -- dispose of foreign 2 investments and they still have the domestic trade or 3 business. 4 And that very clearly -- 5 MS. MANDEL: And the RBOCs are the regional 6 Bell companies for those of us -- 7 MR. BRANNAN: The regional Bell companies, 8 excuse me, thank you. 9 MR. JOSEPH: One of the things that's in the 10 record that maybe -- 11 MR. HORTON: When -- sir -- Ms. Mandel. 12 MS. MANDEL: I did not have another question, I 13 don't think. 14 ---o0o--- 15 16 17 18 19 20 21 22 23 24 25 26 27 28 109 1 MR. HORTON: Okay. 2 MR. JOSEPH: Just a very quick point. 3 One of the things that's in the record that 4 hasn't been talked about much was that when they had 5 foreign activities that were over 50 percent owned, they 6 included those activities as part of their unitary 7 business, including entities that held the very 8 employees that we're talking about here. So the 9 compensation paid to those employees was deducted 10 against the business income of the business that was 11 partially in California. 12 MS. MANDEL: Okay, now I have a question. 13 MR. HORTON: That's going to take us back to 14 controls. 15 MS. MANDEL: Well, I mean my -- 16 MR. HORTON: Going from one case to another. 17 Okay. 18 MS. MANDEL: Because my -- I mean, what I heard 19 before -- and, again, it's -- you know, that -- those 20 are facts. The variety of companies with corporate 21 names were listed in the California Schedule R. Um, the 22 companies that were the payroll companies -- and the 23 taxpayer said that during their presentation -- were in 24 the Schedule R. 25 Um, there were, uh -- there were dollars going 26 out to those employees and dollars coming in to pay 27 exactly for those employees. So it's a complete wash, 28 as best I can, uh, understand, on the return. Um, and I 110 1 think one of the comments in the briefs was that a lot 2 of those companies with -- and said today probably, 3 although it's been so long I probably -- it probably 4 was, like, much earlier -- was that a lot of those 5 companies, as I understand it, were inactive or, you 6 know, sort of had -- didn't really have anything in 7 them. That the two payroll, um -- expat payroll 8 companies is what I'm calling them. I don't know what 9 they're technically called -- were in there, but my 10 sense is that's just a wash in terms of numbers. 11 And I -- I understand the assertion of, Well, 12 they put those in, then why didn't they put this in? 13 But, um, presumably there's -- there's an explanation. 14 An easy explanation is, well, it was a wash, but -- 15 MR. STEPHENS: Ms. Mandel, it was -- it was a 16 wash. Um, and the other, you know, companies that were 17 listed in there included bidding companies. Because, as 18 was discussed earlier, when we bid on a property, our 19 competitors, other companies were bidding on them, too. 20 So we'd commonly set up BIDCOs to do that. 21 MS. MANDEL: That's like a company on the shelf 22 ready to roll? 23 MR. STEPHENS: Right. So we bid on a property 24 in Ecuador, and so we've set up a legal entity to do the 25 bidding. And actually that was the entity that did the 26 bidding, and we were prepared to fund it if we won the 27 bid. And then we lost the bid, we didn't get it, so we 28 had that entity there. Or we had holding companies that 111 1 owned the interests in Telmex or may have owned the 2 interest in Bell Canada, a U.S. company that held that 3 interest. It was -- it was a legal structure to have 4 ownership. 5 So those entities were included as were, uh, 6 the entities that employed the expats and provided the 7 expats' salaries and collected the management fees for 8 the expats. And, generally speaking -- I don't mean to 9 speak in exact numbers. But, generally speaking, in a 10 company with $45 million in revenue, those -- those were 11 very insignificant numbers. They effectively offset 12 each other. 13 MS. MANDEL: And -- and when you're stressing 14 that they're U.S. companies, so because they're U.S. 15 companies they wouldn't necessarily be on the federal 16 return which is a different kind of return, is that -- 17 MR. STEPHENS: Um, they could have been on the 18 U.S. return. I don't -- I can't vouch to that. 19 MS. MANDEL: Oh, okay. But I was just focusing 20 on the stress that they were U.S. companies. Okay. 21 MR. STEPHENS: No, it just was that they were 22 just legal entities set up to protect -- you know, quite 23 frankly, they were set up in that manner to protect our 24 expatriates and to provide them benefits and to make 25 sure that they were secure because the company's 26 perspective was if you're going to assign an employee 27 overseas, you need to make sure that they have 28 appropriate, um, benefits and -- and opportunities. 112 1 MR. HORTON: Ms. Mandel? 2 Member Steel. 3 MS. STEEL: As Member Yee wants to put over 4 this case for the next month, that's fine with me. But, 5 um, when we request Appeals to write details to clarify 6 why the case -- uh, court cases related to this case, I 7 want Appellants to do the same thing. So I want to see 8 from both sides. 9 I want to ask Franchise Tax Board that I heard 10 something about the money market. You know, we didn't 11 bring this one up, the money market account. And both 12 of you said that was savings account that you can pull 13 money out. 14 MS. ANDLEMAN: Yes. 15 MS. STEEL: Actually, I heard from both of you 16 about that. So can you explain to me a little bit about 17 that? 18 MS. ANDLEMAN: How does it work? 19 MS. STEEL: Yeah. 20 MS. ANDLEMAN: Um, it's an account. Um, 21 basically it's like any other money market account. 22 It's a littler higher return. And, basically, when I 23 want to pull money out, I go in and I put an instruction 24 in online. And at the end of the day, the funds are 25 basically made available to me and I can write a check 26 on it. 27 MS. STEEL: So you are talking about a savings 28 account for the bank. 113 1 MS. ANDLEMAN: It's -- it's -- it's very much 2 akin to a savings account. 3 MS. STEEL: So you are not really looking at 4 the broad range of security that there is other money 5 markets out there that I just heard from Mr. Sperring 6 today that I guess you didn't hear when Appellant was 7 explaining about the money market here that breach money 8 market. Because I know the savings account money market 9 from the bank is different than security, that from 10 other money markets. So Mr. -- 11 MS. ANDLEMAN: Well -- 12 MS. STEEL: You know what, Mr. Sperring, can 13 you -- 14 MR. SPERRING: Yeah. 15 MS. STEEL: You explained that. 16 MR. SPERRING: Exactly. I think there may be 17 confusion on part of the Franchise Tax Board; originally 18 that's what I thought. I'm not sure there is now. 19 But there is a money market savings account. 20 Okay. And remember back in the 70s, those were 21 unregulated. So in the days where you had regulated, 22 uh, deposits and the, um, federal government controlled 23 how much could be paid on a savings account. Remember 24 the days of 5.5 percent guaranteed interest? Money 25 markets could actually flow with the market. Okay. Uh, 26 but that is clearly, uh, an account at the bank that's 27 FDIC insured. And that is not what's going on here. 28 What these investments are, are in a security 114 1 in which you own shares, and the only thing that's 2 backing up the security is the underlying investment. 3 So unlike a money market savings account where you have 4 the entire assets of the bank to back up what's in the 5 account, as well as the FDIC, which is basically the 6 federal government, in a money market mutual fund, all 7 that you have to back up the value of the share is the 8 pool of assets that are invested by the money market 9 fund complex. Okay. 10 And so, um, there is a clear distinction. And 11 I think FTB's attempt to say this is like a, um, a 12 savings account, uh, is very misguided because people 13 can put their savings in a variety of different, um, 14 vehicles. 15 For example, uh, my children, uh, they put 16 their money in savings bonds, in U.S. savings bonds. 17 Okay. That's where their money is. Those bonds, okay, 18 if redeemed by AT & T would clearly go into, uh -- uh, 19 their sales factor as gross receipts. 20 So it's a little odd to me that, um, this, 21 uh -- uh, share -- these proceeds from these shares in 22 money market mutual funds, which is mostly commercial 23 paper which has real risk, uh, somehow has to go in at 24 net. But yet proceeds from U.S. treasuries and savings 25 bonds, they get to go in at gross. That just doesn't 26 make sense to us. 27 MS. ANDLEMAN: May I clarify? 28 MS. STEEL: Yes. 115 1 MS. ANDLEMAN: I was referring to the same kind 2 of account. My account is with a brokerage house. And 3 I have the regular savings account to which Mr. -- uh, 4 he's referring. 5 But I also have what he's also described, and I 6 treat that as a savings account as other people. The 7 rate of return is consistent. Um, it's not a -- I'm not 8 going to lose money. But if -- and he's right, it is 9 held in shares. But when I want to, uh, use that money, 10 it's just a matter of putting it in order and the money 11 is available. There's not a long process of reconciling 12 and all of that. 13 And so it's a slightly higher yield which is 14 why I use it, but it's still something where I can 15 immediately have those funds, relatively immediately, 16 have those funds available to me and write a check on 17 it. 18 And if you take this argument to its logical 19 conclusion, when you have a regular savings account at a 20 regular bank, those funds are also invested. And 21 they're invested in these safe vehicles like 22 Mr. Sperring's, uh, suggested. 23 So, you know, for all intents and purposes, 24 these money market funds are treated very much the same 25 as a savings account. 26 MS. STEEL: Well, you know what, give me those 27 lists that you mentioned during the hearing that, you 28 know, there is not just one money market from the bank 116 1 or money market, but there's a -- 2 MR. SPERRING: Sure. Yeah. Yeah. I'm more 3 than happy to do that, Madam Board Member. Then I'll 4 ask Mr. Stephens to talk about these, uh, mutual funds 5 that they held because I think they're a little 6 different, uh, than what Ms. Andleman has for her 7 account. 8 But, um, yeah. So treasury bills, treasury 9 notes, treasury bonds. Interestingly enough, treasury 10 inflation-protected securities, which, again, are 11 designed for maximum stability in price because they're 12 moving, the interest rate moves. Um, U.S. savings 13 bonds, municipal -- 14 MS. MANDEL: I'm sorry. This list is a list of 15 things held by a money market mutual fund? I'm 16 confused. 17 MR. SPERRING: Um. No, no. These are -- 18 MS. MANDEL: These are the ones -- 19 MR. SPERRING: Yeah, a list of other securities 20 where FTB concedes they go in at gross. 21 MS. MANDEL: -- everything should be. 22 MR. SPERRING: Exactly. 23 MS. MANDEL: Okay. Thank you. 24 MR. SPERRING: Sure. 25 So municipal bonds, corporate bonds, commercial 26 papers, futures contracts, auction rate securities. 27 Okay. So all these, FTB concedes, go in at gross. 28 And then maybe we ought to discuss, um -- uh -- 117 1 you know, Ms. Andleman pointed out that she can just -- 2 she treats her money market fund like a checking account 3 and she writes checks on it. 4 So why don't I ask Mr. Stephens to talk about 5 these funds where AT & T invested billions of dollars 6 in. And he can talk about how they go about getting -- 7 MS. MANDEL: For the record, I have some money 8 market mutual funds. 9 MR. STEPHENS: I guess, respectfully for the 10 Board, I mean, my point would be is, while we invest in 11 these funds, they are backed up by these same 12 instruments that you're talking about. And to think 13 that there is not risk in the environment that we've 14 just gone through with the collapse of the financial 15 industries, the bankruptcies, whether it's the -- quite 16 frankly, the recent downgrade of the federal government 17 and the change in U.S. treasury values because of that. 18 Going back to this time frame where we were just coming 19 out of some of the resolution trust corporation and some 20 of the really significant, uh -- uh, banking issues that 21 we faced, I just suggest to you, these are -- these 22 don't equate to an FDIC insured personal savings 23 account. 24 MS. STEEL: Thank you. 25 MS. YEE: Mr. Chairman. 26 MR. HORTON: Okay. 27 MS. YEE: On that point, may I ask a question? 28 MR. HORTON: Sure. Member Yee. 118 1 MS. YEE: Um, the question here really is a 2 reflection of the Appellant's business activity in the 3 state, right? So I'm -- and whether it's appropriate 4 that we have an alternative apportionment method. 5 MR. JOSEPH: Yeah, that's right. Even if you 6 were to decide that these were all to be treated at 7 gross every time they withdrew money out of these 8 accounts, whatever, how many times a day they do it, the 9 in -- the inclusion of all of those proceeds would be, 10 uh, distorted. 11 MS. YEE: Distorted. 12 MR. JOSEPH: Just as the other cases that have 13 gone through the system have held. 14 MR. SPERRING: May I address that? 15 MS. YEE: Yeah. 16 MR. SPERRING: Because, you know, you did hear, 17 in FTB's case in chief, them talk about the numbers, 18 about the size of the slice of the sales factor that's 19 gross receipts. We don't -- we don't agree with those 20 numbers. 21 But -- but let's talk about some numbers that I 22 think are beyond dispute. Okay. And that is, um, SBC's 23 sales factor, okay. Um, with these in at net versus 24 gross, okay, because ultimately it is, as you said, 25 Madam Board Member, it's, uh -- does the formula fairly 26 reflect the activities in this state, right? That is 27 the true measurement that we want to look at here. And 28 I'll go through with you our percentage, our 119 1 apportionment percentage before and after. 2 But before I do the overall factor, let's just 3 look at the sales factor, right. So in '01, the sales 4 factor, uh -- uh, with these at net would be 26.4 5 percent. With them in at gross, they would be 25.1 6 percent. Okay. Um, and, uh for '02 it goes from 26.1 7 to 23.6. 8 The absolute factor changes even less, right. 9 Because the sales factor's half of the formula. So if 10 you look at what is -- how far does the absolute factor 11 move, um, the absolute factor goes from 25.4 to 22.2. 12 So for a relative change of 9.9 percent; that's for '01. 13 '02 it's more; it goes from 24.4 to 19.5. So a relative 14 change of 20 percent. 15 But yet when we look at the case law, right, 16 about -- let's talk about Microsoft. How far did 17 Microsoft move? Okay. And in Microsoft, the relative 18 change was, uh, for the overall factor, the relative 19 change was 56.9. And for the sales factor it was 79.5. 20 So we're a far cry from Microsoft at 9.9 and 20 21 versus, uh, basically 80 percent. Okay. And that's, 22 uh -- that's just for the sales factor. Um, and, again, 23 overall factor, we're only going from a 4.8 and 9.4 24 versus 57 percent. Okay. 25 So our change is far less, uh, than what, uh -- 26 uh, than the movement in Microsoft. Uh, it's far less 27 than in Limited. In Limited, the overall change was 21 28 to 26 percent. Merrill Lynch, what your Board found 120 1 wasn't enough movement was 36 percent, right. And we 2 know, obviously, from the Supreme Court in Hans Rees 3 that 250 percent is enough. 4 So we're down at the far spectrum here, uh, 5 with less than 10 percent in one year and 20 percent in 6 the second year. So we don't think that we rise to the 7 level of distortion. 8 However, I will freely recognize that we 9 applied, okay -- we received a letter from the Franchise 10 Tax Board, okay, which is -- uh -- uh, it's tab eight 11 here. Okay. We received a letter, uh, on June 15th, uh, 12 2010 basically inviting us into their resolution program 13 and putting our treasury receipts in at the specified 14 percentages on page two. In which case you'll notice 15 that we fall into, for '01, a situation where FTB 16 concedes 60 percent. In other words, they let us put in 17 60 percent gross. Okay. Uh, and then for the second 18 year at issue, uh, FTB only allows us to put in 30 19 percent, okay, at gross. Okay. 20 We would have taken that program. We applied 21 to get into that program and they said, sorry, this 22 isn't a gross receipt; you're not entitled to get into 23 the program on these, uh, money market mutual funds. 24 So that's really what we're asking for here 25 today. But we don't think FTB has met their burden of 26 proof of showing distortion. 27 MR. HORTON: Member Yee. 28 MS. YEE: On that point, that letter was the 121 1 letter that I think we issued to invite resolution 2 through the closing agreement process. 3 MR. JOSEPH: That's correct. 4 MS. YEE: Is there any inconsistency? 5 MR. JOSEPH: Well, no. I mean, we basically, 6 in order to do the determination as to how much the 7 gross receipts are from the treasury function, you have 8 to figure out what is a receipt. 9 MS. YEE: Right. 10 MR. JOSEPH: And in that letter we set forth 11 our position on what is and what is not a receipt. 12 Uh, one of the things that we put in there was 13 money market accounts; whether they're in a bank or a 14 mutual fund, don't put them in. The taxpayer disagreed 15 with that and turned down the settlement -- the 16 resolution idea and came to your Board, which is why 17 we're here today. 18 Uh, so the question before the Board is, are 19 they in fact gross receipts? And if they are gross 20 receipts, is the inclusion of this activity distorted? 21 Uh, to say that they can go through that process here 22 and then go back and resolve with us, well, the whole 23 point was to not come down here and have to go through 24 all of this and have the Board make all these 25 determinations. 26 And so that seems a bit problematic to me. 27 From a standpoint of the level of distortion here, uh, 28 you know, we're talking about more gross receipts than 122 1 their California activities produced in one of these 2 years. It's not incidental. It -- it's a lot of gross 3 receipts and it moves a lot of income. It's the same as 4 the other cases that have been before the Board and 5 before the courts. It's really no different. 6 MS. MANDEL: Can I -- 7 MR. HORTON: Ms. Mandel. 8 MS. MANDEL: Just on -- on this gross receipts 9 issue, with the numbers -- and, again, it's -- you know, 10 tell me if I read this stuff wrong that came in as the 11 response, additional information, on this issue. 12 The way I understand the numbers that the 13 taxpayer presented was that, assuming distortion and 14 putting these gross receipts in as net, that what the 15 taxpayer does in its numbers is it just puts the money 16 market funds in at net and then everything else, as 17 generally was agreed beforehand of what should be in at 18 gross and what should be in at net, goes in either at 19 gross or at net; is that correct? 20 MR. SPERRING: Correct. 21 MS. MANDEL: Okay. And then the way I read 22 what the FTB said was, if you go to distortion -- if you 23 find that these money market mutual funds are in at 24 gross, um, then -- and then it's distortive, that the 25 FT -- what the FTB's, um -- and I understand the 26 taxpayer's using those numbers to say, look, there's no 27 distortion because it doesn't really do anything, and 28 that the taxpayer's position is if it's distortive -- if 123 1 you find it's distortive, you ought to give us the 60 2 percent. That's what I understand. 3 But what I understand the FTB is saying is that 4 if it's distortive, then all the treasury receipt stuff, 5 to fix the distortion, everything goes in at net. Is 6 that -- 7 MR. JOSEPH: Yes. 8 MS. MANDEL: Okay. 9 MR. JOSEPH: The same remedy that we provided 10 to everybody else who went to court or appeal with us. 11 MS. MANDEL: Okay. I just wanted to make sure 12 I was clear on that. 13 MR. HORTON: Okay. Further discussion, 14 Members? 15 Hearing none, is there a motion? 16 MS. YEE: I'm going to move to take the matter 17 under submission, Mr. Chair. 18 MR. HORTON: It's been moved by Ms. Yee to take 19 the matter under submission. 20 Is there a second? 21 Second by Ms. Steel. 22 Objection? 23 Hearing none, such will be the order. 24 Let me -- let me thank both sides for doing a 25 yeoman's job in articulating these issues, even though 26 you fundamentally disagree on several Supreme Court 27 decisions, uh, that -- uh, and the fact pattern, but you 28 both did a yeoman's job. 124 1 We will take your matter under submission later 2 on this evening and send you a written report of our 3 decision. 4 MS. ANDLEMAN: Thank you. 5 MR. STEPHENS: Thank you, Mr. Chairman. Thank 6 you, Members of the Board. 7 ---oOo--- 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 125 1 REPORTER'S CERTIFICATE 2 3 State of California ) 4 ) ss 5 County of Sacramento ) 6 7 I, JULI PRICE JACKSON, Hearing Reporter for the 8 California State Board of Equalization certify that on 9 September 20, 2011 I recorded verbatim, in shorthand, to 10 the best of my ability, the proceedings in the 11 above-entitled hearing; that I transcribed the shorthand 12 writing into typewriting; and that the preceding pages 1 13 through 36 and 55 through 109 constitute a complete and 14 accurate transcription of the shorthand writing. 15 16 Dated: October 17, 2011 17 18 19 ____________________________ 20 JULI PRICE JACKSON 21 Hearing Reporter 22 23 24 25 26 27 28 126 1 REPORTER'S CERTIFICATE 2 3 State of California ) 4 ) ss 5 County of Sacramento ) 6 7 I, KATHLEEN SKIDGEL, Hearing Reporter for the 8 California State Board of Equalization certify that on 9 September 20, 2011 I recorded verbatim, in shorthand, to 10 the best of my ability, the proceedings in the 11 above-entitled hearing; that I transcribed the shorthand 12 writing into typewriting; and that the preceding pages 13 37 through 54 and 110 through 125 constitute a complete 14 and accurate transcription of the shorthand writing. 15 16 Dated: October 17, 2011 17 18 19 ____________________________ 20 KATHLEEN SKIDGEL, CSR #9039 21 Hearing Reporter 22 23 24 25 26 27 28 127