1 BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 2 450 N STREET 3 SACRAMENTO, CALIFORNIA 4 5 REPORTER'S TRANSCRIPT 6 SEPTEMBER 12, 2012 7 CORPORATE FRANCHISE AND PERSONAL INCOME TAX HEARING 8 APPEAL OF 9 B1a PACIFIC COAST BUILDING PRODUCTS, INC. 10 NO. 514183 11 B1b ERIN SULLIVAN NO. 573889 12 B1c PATRICIA D. ANDERSON (DECEASED) 13 NO. 573893 14 B1d CAROL ANDERSON WARD NO. 573891 15 B1e JOHN E. ANDERSON 16 NO. 573901 17 B1f DAVID LUCCHETTI AND CHRISTINE LUCCHETTI NO. 573905 18 B1g KEITH HARRIS AND MARY HARRIS 19 NO. 573908 20 B1h JAMES ANDERSON AND JACQUELYN ANDERSON NO. 573911 21 22 AGAINST PROPOSED ASSESSMENT OF 23 ADDITIONAL INCOME TAX 24 25 Reported by: Kathleen Skidgel 26 CSR No. 9039 27 Juli Price Jackson CSR No. 5214 28 1 1 P R E S E N T 2 For the Board Jerome E. Horton of Equalization: Chairman 3 Michelle Steel 4 Vice-Chair 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 Joann Richmond Chief 12 Board Proceedings Division 13 For Board of Anthony Epolite Equalization Staff: Tax Counsel IV 14 Lou Ambrose 15 Tax Counsel IV Supervising Tax Counsel 16 For Franchise Tax Jason Riley Board: Tax Counsel 17 Ann Hodges 18 Tax Counsel 19 Bill Hilson Tax Counsel 20 For Appellants: Reed Schreiter 21 Representative 22 Kendall Fox Representative 23 Jon Sperring 24 Representative 25 Dale Puskas Witness 26 William Fraser 27 Witness 28 Bill Padavona Witness 2 1 450 N STREET 2 SACRAMENTO, CALIFORNIA 3 SEPTEMBER 12, 2012 4 ---oOo--- 5 MR. HORTON: Ms. Richmond, our next item. 6 MS. RICHMOND: Our next item is B, Corporate 7 Franchise and Personal Income Tax Appeals Hearings. 8 B1a, Pacific Coast Building Products; B1b, Erin 9 Sullivan; B1c, Patricia D. Anderson (deceased); B1d, 10 Carol Anderson Ward; B1e, John E. Anderson; B1f, David 11 Lucchetti and Christine Lucchetti; B1g, Keith Harris and 12 Mary Harris; and B1h, James Anderson and Jacquelyn 13 Anderson. 14 Please come forward. 15 Board Proceedings has received contribution 16 disclosure forms for today's hearings from parties, 17 agents and participants. All forms were properly 18 completed and signed. All parties, agents and 19 participants are on the alpha listings provided to your 20 office. 21 Each person sitting at the table will be asked 22 to introduce themselves and, if necessary, their 23 affiliation with the taxpayer for the record. 24 Twenty minutes is allocated for the taxpayers' 25 opening presentation, followed by twenty minutes for the 26 Franchise Tax Board's presentation. And five minutes is 27 allocated to the taxpayer for rebuttal. 28 And I understand that the taxpayers do have 3 1 several witnesses that they would like to have sworn in. 2 Mr. Horton. 3 MR. HORTON: Um, thank you. 4 As you -- as described by the, uh, clerk, you 5 have twenty minutes to make your presentation. 6 Uh, we will swear in your witnesses. We would 7 ask that you begin with their introduction, uh, for the 8 record initially. And then that counsel identify, uh, 9 the individuals that they would have -- like to be sworn 10 in. We'll take them one at a time. 11 MR. SCHREITER: Okay. Uh -- uh, so you want to 12 do the swearing in first? 13 MR. HORTON: No. 14 MR. SCHREITER: Is that what -- 15 MR. HORTON: I want to do the introductions 16 first. 17 MR. SCHREITER: Okay. 18 MR. HORTON: So identify who's sitting -- 19 MR. SCHREITER: Okay. 20 Well, first of all, my name is Reed Schreiter; 21 I'm with PricewaterhouseCoopers. And I'm here 22 representing the appellants Pac Coast -- uh, Pacific 23 Coast Building Products, Incorporated and the named 24 shareholders. 25 Seated with me here at the table, uh, 26 immediately to my left, is Mr. Bill Padavona. 27 MR. HORTON: Welcome. 28 MR. SCHREITER: Uh, to his left is Mr. Bill 4 1 Fraser. 2 And then in the audience, currently we have, 3 uh, Dale Puskas. 4 MR. HORTON: Sir. 5 MR. SCHREITER: Uh, and those are the three 6 that I'd like to have sworn in. 7 MR. HORTON: Okay. Um, Mr. Puskas? 8 MR. SCHREITER: Puskas. 9 MR. HORTON: Uh, could you come forward, uh, 10 please, just for the, uh, swearing-in aspect -- 11 MR. PUSKAS: Sure. 12 MR. HORTON: -- so we can go ahead and swear in 13 all of the individuals. 14 Um, and who would -- why don't we do it 15 collectively; is that okay with the -- the parties? 16 Okay. 17 Ms. Richmond. 18 MS. RICHMOND: Please raise your right hand. 19 Do you swear to tell the truth in these 20 proceedings? 21 MR. PADAVONA: I do. 22 MR. PUSKAS: I do. 23 MR. FRASER: I do. 24 MS. RICHMOND: Please state your name for the 25 record. 26 MR. PADAVONA: Bill Padavona. 27 MR. HORTON: Uh, it has to be on the record, so 28 please state your name in the mic, please. 5 1 MR. PADAVONA: Bill Padavona. 2 MR. HORTON: Thank you. 3 MR. FRASER: Bill Fraser. 4 MR. HORTON: Thank you. 5 MR. PUSKAS: Dale Puskas. 6 MR. HORTON: Dale, had you not been introduced, 7 I thought that you would come up and say "Bill Puskas." 8 Uh, welcome. And, uh, thank you, Ms. Richmond. 9 We certainly appreciate that. 10 You have twenty minutes to, uh, make your 11 presentation. 12 MR. SCHREITER: Okay. 13 MR. HORTON: Uh, but, first, we'll start with, 14 uh, Mr. -- 15 I skipped a part here. 16 MS. YEE: Mr. Epolite. 17 MR. HORTON: Yeah. Mr. Epolite, would you, 18 please introduce the issues in this case. 19 MR. EPOLITE: Good morning, Chairman Horton, 20 Members of the Board. Anthony Epolite of the Appeals 21 Division. 22 There are three issues before the Board in this 23 matter: 24 First, whether appellants have presented 25 evidence sufficient to establish that appellant Pacific 26 Coast Building Products conducted activities that 27 constituted qualified research as defined by Internal 28 Revenue Code Section 41. 6 1 Second, if appellants established that Pacific 2 Coast Building Products engaged in qualified research, 3 have appellants established that Pacific Coast Building 4 Products met its burden of proving qualified research 5 expenses for the years at issue. 6 And finally, whether appellants have 7 substantiated Pacific Coast Building Products' 8 fixed-base percentage. 9 MR. HORTON: We'll now go to the taxpayer. The 10 taxpayer will have twenty minutes to make their 11 presentation. Be mindful that we will return and allow 12 you five minutes on rebuttal. Uh, depending on the, uh, 13 discussion, we may extend that rebuttal time. And then 14 we'll go to the Department and allow them twenty minutes 15 as well. 16 MR. SCHREITER: Thank you. Good morning, 17 Mr. Chairman and honorable Members of the Board. Thank 18 you for the opportunity to appear before you today on 19 this matter. 20 As I previously stated, my name is Reed 21 Schreiter; I'm with PricewaterhouseCoopers, and I'm 22 appearing on behalf of the appellants Pacific Coast 23 Building Products, Incorporated and the named 24 shareholders, which I will refer to collectively as 25 "appellant" or "Pac Coast." 26 Uh, appearing with me today are a number of 27 individuals. Uh, Mr. Jon Sperring and Mr. Kendall Fox, 28 who are with PwC, are seated in the audience due to our 7 1 space limitations up here, and they will be, uh, talking 2 with you on the rebuttal portion. 3 Uh, and also, I've introduced Mr. Bill Padavona 4 who was -- now retired, but was the, uh, former general 5 manager for the Gladding, McBean plant in Lincoln. 6 Next to him is Bill Fraser who, uh, is the 7 plant manager for the PABCO Paper plant in Vernon. 8 Uh, Mr. Dale Puskas who was introduced, is the, 9 uh -- who, during years at issue, was the vice president 10 of manufacturing at Basalite in Dixon. 11 Also with us today is Mr. Dave Lucchetti, who 12 is the President and CEO of Pacific Coast Building 13 Products, and Mr. Ken Irwin, who is the former in-house 14 tax director for Pac Coast. And they're available for 15 questions, as well, if you have any. 16 Um, I will talk about the two essential issues 17 in this matter. And that, first, is whether appellant 18 engaged in qualified research activities; and, two, 19 whether appellant incurred qualified research 20 expenditures, or QREs. 21 To qualify for the R&D credit, the taxpayer 22 must conduct qualified research activities as determined 23 under the four-part test in Internal Revenue Code 24 Section 41(d). The four-part test requires the research 25 activity to qualify for the deduction for the IRC 26 Section 174 be undertaken to discover information that 27 is technological in nature; be undertaken to discover 28 information intended to be useful in developing a new or 8 1 improved business component; and finally, involve a 2 process of experimentation. 3 In its regulations, the Treasury Department 4 recognized that many taxpayers maintain their records on 5 a cost center basis rather than a project accounting 6 basis. Therefore, Treasury decided that taxpayers need 7 only to comply with the general record-keeping 8 requirements of Treasury Regulation Section 1.6001-1. 9 The IRS issued an Audit Techniques Guide, or 10 ATG, for the R&D credit. Tab one of the materials we 11 provided to you today includes excerpts from the IRS 12 ATG. 13 On page 10 of the ATG, or the second page, 14 under tab one, the IRS suggests meeting with the 15 taxpayer before commencing the audit to discuss steps to 16 take in the audit and the types of documentation to 17 review. We highlighted some of these suggestions in the 18 red boxes on your copies of the materials. 19 The IRS suggests discussing with the taxpayer 20 the methodology of capturing the QREs and whether the 21 taxpayer sent surveys or questionnaires to employees. 22 The ATG also suggests the use of interviews of current 23 or former employees and a tour of the facilities. 24 On the next three pages under tab one, which 25 are page 32 through 34 of the ATG, the IRS lists the 26 types of documentation and information that may be 27 helpful during the audit. The study at issue in this 28 appeal includes much of the documentation identified on 9 1 the IRS list. 2 On page 34 of the ATG, the IRS states that, 3 quote: 4 "Credible oral testimony may be helpful in 5 evaluating or supplementing a taxpayer's 6 contemporaneous documentation." 7 End quote. 8 Under tab two, you will see that the FTB's Form 9 1082 incorp -- incorporates much of the IR list -- IRS 10 list of documentation. 11 The first FTB auditor in this matter followed 12 the IRS's advice and reviewed the study submitted by 13 appellant, interviewed employees at appellants' 14 facilities, knowledgeable with the R&D conducted, and 15 toured the facilities. 16 The FTB auditor's initial findings set forth in 17 the letter dated January 31st, 2006 allowed an 80 18 percent of appellants' claimed credit. And that letter 19 is under tab three in your materials. 20 Appellants engaged in follow-up discussions 21 with the auditor who seemed to be accepting the 22 explanations provided for the remaining 20 percent of 23 the claimed credit. 24 Unfortunately for the appellant, the auditor 25 went on maternity leave and a new auditor took over the 26 audit. Unlike the first auditor, neither the new 27 auditory, nor the FTB attorney, toured the facilities or 28 interviewed Pac Coast employees with institutional 10 1 knowledge regarding appellants' R&D activities. Thus, 2 they ignored valuable input and information. 3 The FTB eventually denied 100 percent of the 4 credit. The FTB's denial letter is under tab four in 5 your materials. 6 If you compare the two FTB letters, you will 7 see that the first letter provides a detailed review and 8 discussion of the specific audit findings, as compared 9 to the later denial letter which essentially concludes 10 that appellant did not meet its burden of proof and 11 accuses PwC of creating research projects. 12 The IRS also reviewed the study in their audit 13 of appellants' 2005 and 2006 tax returns. The IRS 14 conclude -- the IRS audit concluded in a "no change" to 15 appellants' returns. 16 You can see the IRS "no change" audit letter 17 under tab five, as well as the IRS IDRs number five and 18 number 17, requesting the entire study. 19 Keep in mind that during the years at issue 20 the R&D credit was a Tier I issue for the IRS. This 21 means that the IRS was required to review the R&D credit 22 using the processes set out in the ATG and discussed 23 above. 24 Further, if asked, Mr. Ken Irwin, who is here 25 today, will testify to the fact that the IRS examiner 26 conferred with an IRS technical advisor in Arizona 27 regarding the study. So we know that the IRS reviewed 28 the study before accepting it. The IRS allowed 100 11 1 percent of the claimed R&D credit. 2 Although the years in the IRS audit immediately 3 follow the years at issue here in the FTB audit, both 4 audits rely on the same study for support. 5 Further, a number of the projects relevant to 6 2005 began in earlier years, years under the, uh, audit 7 by the FTB. This means that the IRS reviewed and 8 accepted projects specifically disallowed by the FTB. 9 Because the study is central to this appeal, 10 let's briefly discuss the methodology used in preparing 11 the study. It is important to remember that the study 12 utilizes documents maintained by appellant in the 13 regular course of their business. 14 Appellant is in the business of manufacturing 15 building products such as roof tiles and Gypsum 16 wallboard. It is not in the business of claiming the 17 R&D credit. As a result, not all of the R&D activities 18 set forth in the study are supported by all of the 19 different categories of documents, such as test runs and 20 results, engineering drawings, purchase orders, 21 authorization for fund expenditures or AFEs, executive 22 summaries or qualified activity narratives. 23 The type of documentation available in the 24 study depends, to some extent, on the size of the 25 project, the facility where the R&D occurred, and the 26 kind of project. 27 The first step in preparing the study was to 28 identify qualified research projects. To do this, the 12 1 study team initiated an information gathering and 2 sharing process with appellant. 3 Mr. Fox and his team requested and reviewed 4 documentation regarding potentially qualifying 5 activities and expenses. Mr. Fox's team then 6 interviewed Pac Coast personnel familiar with the nature 7 and purpose of Pac Coast activities and expenses. 8 This two-step process accomplished two 9 important goals: One, it provided Mr. Fox's team with 10 an understanding of Pac Coast's overall operations and 11 activities; and two, it provided the team an opportunity 12 to educate Pac Coast personnel regarding the R&D rules. 13 Using the rules learned from Mr. Fox's team, 14 Pac Coast personnel then identified projects they 15 believed were R&D. 16 After completing this initial information 17 exchange and identification of potential R&D by Pac 18 Coast personnel, the next step was to review 19 documentation to ensure the offered activities were in 20 fact qualified R&D. This allowed the study team, in a 21 sense, to audit Pac Coast's knowledge of the R&D rules. 22 The next step was to identify qualified 23 research activities. Once the study team determined 24 what projects were qualified R&D, the study team then 25 asked Pac Coast what activities it engaged in to create 26 or design the new product or process. A study team 27 utilized the list of activities developed by Pac Coast 28 to create the wage surveys for each plant. 13 1 Tab six is an example of a wage survey from Pac 2 Coast -- or, excuse me, PABCO Paper in Vernon. You can 3 see that it includes both qualified activities and 4 nonqualified activities that total 100 percent of the 5 employees' time. 6 Once the qualified research activities were 7 identified, the team followed the rules in Treasury 8 Regulation Section 1.41-2(d)(1) and the ATG and 9 identified the QREs. 10 For example, for wages, the team obtained W-2 11 information and multiplied each employee's W-2 wage 12 information by the employee's qualified percentage from 13 the wage survey. 14 Once the qualified research activities and the 15 QREs were identified and determined, the team calculated 16 the R&D tax credit, applying Internal Revenue Code 17 Section 41, the regulations, and the ATG. 18 The final step in the study was to document the 19 qualified research activities and the QREs in the 20 study's cost accumulation binders for each year. 21 The study is thorough. It complies with the 22 rules and guidelines issued by the IRS, provides 23 contemporaneous documentation to support the R&D credit 24 claimed and, maybe most importantly, provides an audit 25 road map for identifying and requesting additional 26 documentation. All of this information was provided in 27 a timely fashion to the FTB. 28 Now, with an understanding of the rules and the 14 1 study in mind, let's now walk through three example 2 projects, the documentation provided and supplement the 3 documentation with testimony from the plant managers 4 knowledgeable about the R&D. 5 We'll start with the Roof Tile Modernization 6 Project at Gladding, McBean in Lincoln which occurred 7 during 1999 and 2000. I will first walk through some of 8 the documentation provided in the study and then ask 9 Mr. Padavona to provide additional information regarding 10 the activities. 11 You will find the materials related to this 12 project under tab seven. And I encourage you to ask 13 Mr. Padavona additional questions to satisfy yourselves 14 as to the qualified nature of the activities performed. 15 The first document you see is an executive 16 summary prepared by Mr. Padavona. The executive summary 17 provides a written summary of the R&D performed by or 18 under his direction. 19 Next, we have some examples of meeting minutes 20 from the Roof Tile Modernization Committee, of which 21 Mr. Padavona was a member. The minutes included in the 22 study cover a period of more than one year. 23 In the examples provided, we've superimposed 24 the FTB's briefing information on the minutes so you can 25 compare what FTB says about the minutes with the 26 information actually conveyed by the minutes. 27 We've, uh, also reproduced the July 13th, 1999 28 minutes on the large board behind me over here. 15 1 Excuse me. 2 When you read the -- the FTB's briefs, you get 3 the impression that the meetings dealt only with cost 4 matters. You can see, however, from the green 5 highlighting, that the technical issues of the Roof Tile 6 Project were discussed and, in fact, made up most of the 7 meeting discussions. 8 Moving on from the minutes, we've also provided 9 examples of some of the engineering drawings prepared 10 for the project. Again, the totality of the drawings 11 cover a period of at least seven to eight months. 12 The drawings are followed by the clay roof tile 13 proposal, a contemp -- contemp -- ah, I'll get it out -- 14 a contemporaneous report regarding the project. 15 Let's turn to Mr. Padavona for some additional 16 information. 17 Bill, can you please provide a brief summary of 18 your education and experience? 19 MR. PADAVONA: Yes, uh, thank you. 20 Madam, uh, Board Members and Mr. Chairman and 21 Mr. Board Member, uh, name is Bill Padavona. I'm a 22 graduate of Alfred University with a degree in -- a BS 23 degree in, uh, Ceramic Engineering in 1968. Uh, been in 24 the, uh, business of manufacturing, uh -- in quality 25 control manufacturing in management of ceramic 26 manufacturing companies for about 42 years, and retired 27 from Pacific Coast in, uh, December of last year. 28 Um -- 16 1 MR. SCHREITER: That's fine. Thank you. 2 The business component in this particular study 3 was the, uh, Modernization of the Roof Tile 4 Manufacturing Project; is that correct? 5 MR. PADAVONA: Yes, that's correct. 6 MR. SCHREITER: Okay. And can you briefly 7 describe why this project was undertaken? 8 MR. PADAVONA: Well, Gladding, McBean's an old 9 company, uh, started in 1875. And it's a very unique 10 company in that it manufactures several types of, um, 11 clay building materials, and roof tile being one of 12 them. 13 And, uh, at the time we, uh, felt that our 14 product, uh, quality and appearance was, uh, sufficient 15 to stay in the marketplace and we wanted to expand on 16 the volume that we were producing as well as producing 17 some new products to introduce. 18 And, uh, so this was a major project for the 19 company. Probably the biggest project the company had 20 ever undertaken, uh, in -- in its years of existence. 21 So, um -- uh, we researched, uh, two 22 approaches. One was to, uh, go out and -- and get a 23 premanufactured roof tile factory to put -- put in 24 place. And it just didn't pan out to -- to work within 25 the system that we had. We wanted something where we 26 could use some of the existing assets like the kiln and, 27 uh, some of the extruders, but modify the rest of the 28 system to reduce the labor compliment, get the cost down 17 1 so that we would be more competitive and also enable us 2 to manufacture some different types of roof tile. 3 MR. SCHREITER: Okay. And can you describe an 4 uncertainty that you faced in the project? And I think 5 there are probably more than one. 6 MR. PADAVONA: Yeah. 7 MR. SCHREITER: But due to the lack of time -- 8 MR. PADAVONA: Well, there's several 9 uncertainties. One, we, uh, felt that we wanted to 10 continue to manufacture -- we had to manufacture the 11 tile in a -- in a duplex form or two pieces together, 12 uh, mainly because we wanted to maintain our -- the kiln 13 system that we had and it required pieces to be 14 manufactured, extruded in that form so that they could 15 be set on the kiln through the -- through the furnace. 16 Number two, um, because we were going to 17 increase the, uh, output four times, that meant we had 18 to manufacture some new drying, uh, facilities and 19 the -- and where we were drying tile in four and a half 20 days, we had to reduce that to 16 hours to meet our 21 production and, uh, marketing needs. 22 So, uh, we had to design some, uh, new drying 23 systems, uh, and, you know, and we -- you know, the 24 uncertainty being can the material withstand drying, uh, 25 in a shorter period of time from four and a half days 26 to -- to 16 hours? 27 The other uncertainty was how do we -- how do 28 we manufacture -- or extrude these tiles and support 18 1 them, uh, because they're relatively soft, like modeling 2 clay in the initial stages, support them in this pod 3 arrangement, uh, to get them to the dryer without them 4 collapsing. And so we had to, uh, create some, uh, 5 specially designed, uh, cradles and conveying systems 6 that enabled us to do that. 7 MR. SCHREITER: Okay. Thank you. 8 Uh, next -- next, let's look at the Stock Ratio 9 Control Project at the PABCO Paper plant in Vernon. And 10 you'll find the materials for this project under tab 11 eight, uh, where you'll find there is a stock ratio 12 control AFE. And an AFE is a document used at, uh, 13 Pacific Coast to present a project for approval. And 14 here we've highlighted in orange a statement by the FTB 15 regarding this documentation. 16 Um, but -- uh, however, you'll see that -- uh, 17 again, you'll see that the AFE conveys much more 18 information regarding a project than just cost. 19 Also, looking at page two of the AFE you can 20 see it lists component parts to be purchased and used to 21 develop a piece of equipment, rather than listing a 22 turnkey piece of equipment to purchase. 23 Now, let's turn to Mr. Fraser for some 24 additional information. 25 And, Bill, can you provide a brief summary of 26 your education and background? 27 MR. FRASER: I can. 28 Uh, good morning, Mr. Chairman, uh, Madam Board 19 1 Members, Mr. Board Member. 2 Um, I have a Bachelor of Science, uh, in 3 Chemical Engineering from California State University of 4 Long Beach. 5 I've been in the building products 6 manufacturing sector for almost 29 years; um, and 24 of 7 those specifically in paper manufacture. And during 8 that time, I've held positions from technical manager, 9 uh, engineering and maintenance manager, production 10 manager and, for the last, almost 19, as a plant 11 manager. 12 MR. SCHREITER: Okay. And in this project, the 13 business component was the system feeding the paper 14 stock to the paper machine; is that correct? 15 MR. FRASER: Uh, that's correct. 16 Um, just as a brief history, um, our paper mill 17 was built in 1912. It's an older facility in the 18 beautiful city of Vernon, California, small industrial 19 city just southwest -- or south/southeast of Los 20 Angeles. 21 We are a hundred percent recycled fiber. So, 22 basically, we're taking, uh, trash or waste from other 23 facilities and we're converting it to a final product. 24 One of the challenges we face is that, uh, that 25 material changes on a daily basis. And so we were 26 looking to improve our ability to control the actual 27 fiber qualities that we feed to our paper machine 28 because that ultimately affects not only our product 20 1 quality but our ability to expand our business to other 2 paper grades. 3 And so that's what this project basically was 4 about, trying to make our -- our finished project better 5 and more usable at our, um, customer plants, as well as 6 expand our business into other grades of paper. 7 MR. SCHREITER: Okay. And can you describe an 8 uncertainty that you faced in this project? 9 MR. FRASER: Yes. Since we were designing this 10 from the ground floor internally, which is the way we do 11 most of our projects -- we're a single paper mill. We 12 don't have other paper mills to, uh, rely on for 13 knowledge, so we do a lot of the own -- our own 14 research. Um, we had a lot of uncertainty, not only 15 into how we were actually going to separate these fibers 16 and get them controlled, but also where we were going to 17 locate the -- the system and what components we would 18 use and how we would effectively, um, get the desired 19 results that we were looking for. 20 MR. SCHREITER: And can you describe some 21 experimentation and evaluation you performed? 22 MR. FRASER: Yes. So what we, uh -- we started 23 with was by initially looking at our raw material, uh, 24 feed source. And so we did some experiments where we 25 actually changed feed sources and we modified existing 26 equipment to see if we couldn't separate streams into 27 longer and short fiber, um, into a way where we could 28 actually effectively combine them later. 21 1 Um, and we also ran a bunch of tests around 2 the -- the system itself to see what the effects on the 3 peripheral equipment would be as we modified, especially 4 flow -- flows through the process, because that 5 ultimately could impact, um, how our other equipment 6 works, too. 7 MR. SCHREITER: Thank you, Bill. 8 Finally, let's look at the Development and Test 9 of Mix Designs Project, Basalite plant in Dixon. These 10 tests tend to occur on an ongoing basis, however, the 11 samples in the materials we provided to you are from 12 2001 and 2002. 13 You'll -- uh, you'll find these materials under 14 tab nine. And, again, first up is an executive summary 15 which provides a summary of -- of the project that was 16 undertaken. 17 Next, we've provided several example test -- 18 technical project test sheets. And, uh, if you read the 19 FTB's briefs, these documents are nothing more than 20 quality control. 21 However, we've highlighted the project seat -- 22 sheets so that you can see how, on their face, the 23 sheets satisfy the requirements of Section 41(d). And 24 as you can see, there was a scientific method, a 25 business component, and test trials and analysis. 26 And despite, uh, the evidence on the face of 27 the sheet of experimentation taking place, the FTB 28 concludes, uh, without support or explanation, that 22 1 there's no hypothesis, no alternatives, no actual 2 testing, no analysis or refinement. 3 And yet, again, as you look at the, uh -- as 4 you look at the sheets, you can see that -- that testing 5 did take place. We have control runs with, uh, 6 follow-up tests. There's a -- an objective stated, 7 which includes the hypothesis. And so there's certainly 8 scientific, uh, method taking place, just as you look at 9 the face of these sheets. 10 And now let's look to -- 11 MS. RICHMOND: Time has expired. 12 MR. SCHREITER: Did you say -- oh, I'm sorry. 13 MS. RICHMOND: Time has expired. 14 MR. HORTON: Please continue. 15 MR. SCHREITER: Okay. Thank you. 16 We'll look now to, uh, Dale just for a couple 17 of follow-up questions. 18 And could you provide me a brief summary of 19 your, uh, experience? 20 MR. PUSKAS: Yes. 21 Good morning, Mr. Chairman, Madam Board 22 Members, Mr. Board Member. 23 Uh, my name's Dale Puskas. Uh, I am currently 24 the vice president and general manager of Basalite in 25 Nevada and California. At the time, uh, I was 26 overseeing manufacturing for Basalite. 27 Uh, my background is a BA in, uh -- in 28 Accounting and Political Science, uh, 1977, from 23 1 Baldwin-Wallace College. And since that time I've held 2 various positions in the building materials industry, 3 starting in 1981, uh, specifically in manufacturing 4 management, general management of concrete products 5 since 1986. 6 I've been with Basalite since, uh, 1997. 7 MR. SCHREITER: And the business component in 8 this test, was the concrete chemistry of Basalite 9 products? 10 MR. PUSKAS: It was. 11 MR. SCHREITER: Okay. And can you briefly 12 describe why this project was undertaken? 13 MR. PUSKAS: The project was undertaken for a 14 couple of reasons. Uh, since I've been involved at 15 Basalite, we've been optimizing our mixed designs to 16 reduce cost and increase performance. And the coal fly 17 ash was undertaken primarily to reduce cost, but we also 18 had the side benefit of a positive environmental 19 impact. 20 MR. SCHREITER: Okay. And the last question 21 for you is, can you describe an uncertainty that you 22 faced? 23 MR. PUSKAS: Uh, with the introduction of fly 24 ash not being -- and replacing Portland cement, um, 25 we -- there are a number of -- of physical factors that 26 it can affect in the -- in the particular products. Uh, 27 mainly the increase in cure time, therefore, increase 28 scrap rates potentially. Also, it can change the color 24 1 and appearance and texture of the product. 2 MR. SCHREITER: Thank you, Bill. 3 Our brief demonstration illustrates how the IRS 4 ATG and FTB's own FAQs anticipate that the study and 5 oral testimony can interact and provide a full picture 6 of the R&D activities undertaken by appellant. 7 Unfortunately, in this matter the full process 8 was not undertaken by the second FTB auditor or the FTB 9 attorney. 10 In conclusion, we ask the Board to grant 11 appellants' appeal. And we'll gladly answer any further 12 questions you have, and thank you for your 13 consideration. 14 MR. HORTON: Thank you. 15 We'll now go to the, uh, Department for their 16 presentation. We'll allow them the appropriate amount 17 of time, same amount of corresponding time. 18 Please commence with your introductions for the 19 record. 20 Um, let me ask the taxpayer if they could move 21 the charts just a little bit to the left or the right. 22 Uh, to my left, your right. There you go. 23 Members? 24 Okay. Thank you very much. 25 MR. RILEY: Good morning, Mr. Chair -- 26 MR. HORTON: Good morning. 27 MR. RILEY: -- Members of the Board. 28 I'm Jason Riley. This is Ann Hodges and Bill 25 1 Hilson. And we represent Franchise Tax Board in this 2 matter. 3 Examination of the R&D credit is unique in that 4 it requires evaluation of technological activities to 5 determine whether such activities are eligible for the 6 credit. To simplify explanation, respondent will 7 discuss the steps required for the evaluation. 8 Step one, under 41(d), IRC 41(d) the taxpayer 9 must prove it engaged in activities that constitute 10 qualified research. 11 Under step two, if the 41(d) activities are 12 proven, the taxpayer must prove the expenses claimed 13 relate directly to those qualified activities, and so 14 are qualified research expenses under IRC 41(b). 15 And step three, once activities and expenses 16 are proven, the taxpayers must demonstrate that it 17 increased their research expenses over the base 18 according to the calculation method set out in IRC 19 41(c). 20 Logic, statute, and a long line of case law 21 require such an order. Without proving activities -- 22 without first proving activities, the analysis cannot 23 move from step one. This requires documentation. 24 The record, uh -- the record-keeping mandate 25 states that a taxpayer must maintain -- must retain 26 records in sufficient form and detail to substantiate 27 the expenditures are eligible for the credit. 28 Appellants bear the burden of proof in a claim 26 1 for tax credit as the California Supreme Court recently 2 reminded us with its decision in Dicon. 3 The burden of proof is on the taxpayer to prove 4 respondent's denial is incorrect. The taxpayer must 5 produce evidence to establish the proper amount of tax. 6 The taxpayer must show that they are entitled to the 7 claim, and the taxpayer cannot assert error and thus 8 shift to respondent this burden. 9 Until the burden of proving step one, IRC 41(d) 10 qualified research activities is satisfied, it's a 11 requirement clearly set out in the statute, quantifying 12 the amount of step two, IRC 41(b) expenses, is 13 premature. Yet it's this premature and overstated 14 estimation of expenses that appellants have put forth in 15 the absence of proving qualified research activities and 16 in addition to their improper step three base 17 calculations. 18 In sum, they skipped step one, jumped straight 19 to step two, and made up a method of calculating step 20 three. Appellants have flunked all three steps and 21 they're not entitled to the credit. 22 And here's what they did. Appellant's produced 23 a credit study. When the study was not based on 24 contemporaneous research documentation, put on the 25 after-the-fact recollections of company executives. 26 This study assumed step one, qualified research 27 activities, but it failed to prove that those activities 28 occurred. 27 1 The study addresses expenses based on estimates 2 made up to five years after these expenses were 3 allegedly incurred. It claimed -- it -- it includes 4 claims by the executives of having spent 60 to 100 5 percent of every day over the course of six years on 6 alleged qualified research activities, yet provided no 7 proof to substantiate such unreasonable claims. 8 It provided base calculations that appellants 9 admitted were decided on, rather than calculated, based 10 on discussions with managers and historians. And 11 appellants then made up their own calculation. 12 Whatever methods the credit study used, it did 13 not address the requirements clearly laid out in the 14 statute. When audited, appellants failed to provide 15 documents proving qualified research activities. When 16 asked for proof, appellants replied they did not 17 maintain such documentation. 18 Appellants then provided, for the first time at 19 appeal, as an exhibit to their opening brief, 1500 pages 20 of documentation, 65 of which related to a single 21 potentially eligible project at one of their six plants. 22 When asked for like documentation for the, 23 uh -- for the other five plants, appellants replied that 24 they were unable to locate any additional information. 25 The remaining documentation in that 1500-page 26 submission failed to prove qualified research activity 27 occurred, and simply rehashed the credit study. 28 Appellants continue to ignore the elephant in 28 1 the room, their lack of proof of the touchstone issue 2 underlying the R&D credit, the actual conduct of 3 qualified research. 4 And here's why appellants' approach is wrong. 5 Appellants start with an estimate of expenses and they 6 never prove the activities. While accounting 7 documentation could be relevant to qualified research 8 expenses, it does not and cannot prove that activities 9 occurred. It provides no way of knowing what was done 10 while those -- while incurring those, uh, expenses. 11 And despite respondent's criticis -- uh, 12 appellants' criticism of respondent's review of the 13 study, respondent reviewed and evaluated the study in 14 its entirety and fully understood the contents. 15 The study does not meet the statutory 16 requirements of 41(d); does not follow the long line of 17 case law relating to the 41(d) requirement; does not 18 meet the record-keeping requirement; and it does not 19 meet appellants' burden of proof. 20 Even when repeatedly confronted with the facts 21 that appellants have failed to prove step one, 41(d), 22 qualified research activity, appellants continued to 23 ignore the law and attempt to divert attention from this 24 fact by criticizing the audit. 25 Dicon says that the taxpayer cannot assert 26 error and then shift that burden -- their burden to 27 respondent. 28 As your Board is no doubt aware, respondent has 29 1 examined appellants' documentation and analyzed 2 page-by-page exactly why the claimed projects do not 3 qualify as research activities under the statute. 4 In respondent's review, appellants had one 5 potentially eligible project involving one researcher 6 and five -- six support staff working sporadically over 7 the course of a year and a half at the Lincoln plant. 8 And this was the pop-out project at the Lincoln plant. 9 Appellants claimed wages for 270 employees and 10 claimed these identical -- identical percentages of 11 these wages for all six years at issue. Yet the pop-out 12 documentation only tells of seven employees and lasted a 13 year and a half. 14 This in no way translates to allowing the 15 unproven activities or the unverifiable wages for the 16 other 263 employees over the six years at issue, 17 employees for whom there is no documentation and no 18 evidence that they engaged in qualified research. 19 Based on the pop-out projects, appellants are 20 capable of providing the kind of documents required to 21 substantiate step one activities. Yet, especially when 22 it comes to the executives for whom they claimed 60 to 23 100 percent of the wages for every day for the six years 24 at issue, appellants provided no documentary proof. 25 Appellants have -- have called the estimates 26 for these executives "written testimony." Yet these 27 questionnaires are not testimony. They're flawed and 28 riddled with inaccuracies and overstatements. 30 1 Even when coupled with the -- with the 2 statements of Mr. Padavona and Mr. Puskas and Mr. Fraser 3 given today, they do not prove that qualified research 4 activities occurred. 5 Mr. Padavona did not explain how he could spend 6 more than six hours of every single day over the course 7 of the six-year period that this -- that this, uh -- 8 that this -- at issue in this appeal, allegedly engaged 9 in qualified activities, and yet have no documentation 10 to justify such an incredible volume of activity. 11 Standing alone, there's no justification for granting 12 the credit. 13 Under the Treasury regulations, there is a 14 presumption that executives do not qualify. Okay. This 15 presumption can be overcome, but providing -- but a 16 complete lack of documentation will not do it; nor will 17 an unreasonable claim of time spent engaged in 18 activities. 19 Consider this: Mr. Padavona has claimed to be 20 not only the top executive at Lincoln, but also their 21 top researcher. While Jim Keating, the researcher, uh, 22 involved in the pop-out project, he spent, according to 23 their documents, six percent of his time on qualified 24 research. And for that, there is documentation. 25 For Mr. Padavona, who allegedly spent an 26 incredible 76 percent of his time on qualified 27 activities, there's nothing to -- to prove that he 28 engaged in those activities. 31 1 The reports memorialized who was assigned tasks 2 in the -- in the pop-out project and Padavona was not 3 one of them among them. He was not involved in the 4 day-to-day research activities. And even if he is in 5 the ultimate supervisorial position, his wages are 6 presumed not to qualify under the law. 7 The numbers are completely unreasonable and do 8 not make sense in light of the fact those documents that 9 were provided. Moreover, Mr. Padavona allegedly spent 10 about an hour a day working on research related to 11 corrugated products. 12 The hearing exhibit that respondent provided 13 suggests that this is a -- that this reference is a 14 relic from another pre-packaged credit study involving a 15 corrugated box manufacturer. This serves to highlight 16 that the pre-packaged and inaccurate nature of 17 apparently -- it just serves -- it goes to serve the -- 18 and highlight the pre-packaged and inaccurate nature of 19 appellants' credit study. 20 Or if we look at another executive, like 21 Mr. Anthez, he claimed to have spent 100 percent of his 22 time engaged in qualified research activities. That's 23 every hour, every minute, of every day for six years 24 spent on activities comprising a process of 25 experimentation. And, again, appellants have not a 26 shred of evidence to prove this. 27 Or take Mr. Gunning's survey. He did not claim 28 a single employee engaged in qualified research 32 1 activities. He claimed his employees engaged only in 2 direct support. Logically, there must be someone 3 engaged in the research in order for the supporting 4 employees to directly support. 5 Again, these executives are presumptively 6 excluded. But these serve as examples of just how 7 unreliable, inaccurate, incomplete and wholly 8 insufficient the credit study was. 9 The executive wage estimates are completely 10 unreasonable and do not overcome the presumption that 11 they're not qualified. 12 You've heard Mr. Fraser talk about the Vernon 13 plant, yet the contemporaneous documentations -- uh, 14 documents provided relating to the Vernon plant relate 15 to the purchase of machinery and nothing more. 16 This con -- the contemporaneous documents that 17 appellants do have, the authorization for fund 18 expenditures, include such statements as: 19 "The unit we build will be identical to the 20 existing unit and physically located next to 21 it. This is proven technology we know works in 22 our system." 23 This is acquisition. Okay. This is buying a 24 duplicate machine. This is not research and 25 development. 26 Or the Reject Separator Project; it was a 27 project to install new equipment. 28 We talked about the Stock Ratio Control. Okay. 33 1 That's a change of process followed by a verification 2 that the change would work. This is not qualified 3 research as indicated by the Union Carbide court. 4 The Roof Tile Modernization Product -- uh, 5 project, and the repairs, the building at -- you know, a 6 build -- the repairs to the buildings that appellants 7 discussed, they discussed treating these as 263(a) 8 capitalization or a 160 -- or a 162 deduction. Such 9 capital improvements do not qualify for the R&D credit. 10 Or, with respect to the Basalite Dixon plant, 11 they claim the -- the color variation in Carson City 12 Project. The State of California does not grant tax 13 credits for non-qualifying activities occurring in the 14 state of Nevada. Nothing about these is qualified 15 research. In fact, it's an admission that there is no 16 process of experimentation. And yet, these are the 17 documents that they've put forth to prove their research 18 activities. 19 These documents assume a step one. They don't 20 prove a step one. And then they jump right in to 21 saying, "These are expenses and we get -- we get to 22 claim the credit for them." 23 Compare these documentation -- these documents 24 to those provided for the pop-out project. There's no 25 hypotheses, no methodical plan to test, no evidence of 26 alternatives tested, no scientific testing, no systemic 27 trial and error, no analysis. 28 Appellants claim these documents were never 34 1 intended to be the sole -- as the sole documentation. 2 Yet appellants have provided no other contemporaneous 3 documentation to prove the activities, as they admit 4 with the hearing chart which illustrates that what they 5 did provide was the authorization for fund 6 expenditures -- those don't prove research -- they've 7 provided executive summaries -- those are the 8 after-the-fact summaries -- and -- 9 Statute and a long line of case law requires 10 proof. If a taxpayer can prove activities that were 11 qualified research, then the analysis can move on to 12 expenses. That's 41(d). That's the McFerrin case, the 13 Bayer case, Shamie case, Trinity, Union Carbite and 14 Fudim, all require proof of activities. 15 These documents do not meet the -- the burden 16 of proof or the statutory requirements. 17 Appellants provided a large quantity of 18 documents, 2800 pages in the credit study, according to 19 the audit, plus 1500 pages provided in their opening 20 brief. 21 Quantity does not equal quality. For example, 22 the recently published Bayer case involved a credit 23 study held that was contained in 60 three-ring binders; 24 yet that credit study failed to meet section 41(d), just 25 as the present study. 26 Section 41 does -- is -- is not the purchase 27 and install credit. It's the research and development 28 credit. 35 1 The faults with the credit study do not end 2 here however. The R&D credit is an incremental credit. 3 To claim the credit under step three, IRC 41(c), a 4 taxpayer must demonstrate it increased research expenses 5 over a base amount. Yet appellants couldn't calculate a 6 base amount and -- or the fixed-base percentage as 7 required by statute, so they made up their own method. 8 As the Research, Inc. case stated, this alone 9 is grounds for denying the credit in full. A proper 10 fixed-base percentage requires reference to QREs and 11 gross receipts from the base years of 1984 to 1988. 12 Appellants didn't maintain the required 13 documentation, so they made up a method, taking a 14 one-third estimate of current QREs and gross receipts. 15 Step three, IRC 41(c) ensures that no credit is 16 allowed unless a taxpayer proves an increase over the 17 base. 18 Appellants' method is incomplete guesswork and 19 contrary to law, and respondent properly denied the 20 credit in full. 21 With respect to the IRS 2005/2006 tax audit, 22 the IRS did not audit the tax years at issue. The tax 23 years at issue are 1999, 2000, 2001, 2002, 2003 and 24 2004. 25 It's a different audit for a different cycle. 26 As a result, such a federal audit is irrelevant for the 27 tax years at issue. 28 We don't know what the IRS looked at. All we 36 1 know is that the IRS did not audit the tax years at 2 issue in this appeal; 1999, 2000, 2001, 2002, 2003 and 3 2004. 4 With respect to the expansion of the audit, 5 appellants are the ones that -- that said, "Look again." 6 They rejected respondent's initial offer for 1999. They 7 disputed the executive wages that respondent had 8 disallowed and expanded their claim at a time when 9 taxing agencies like the IRS changed their focus to deal 10 with the influx of pre-packaged credit studies. 11 Uh, they mentioned the IRS Audit Technique 12 Guide from June of 2005. The IRS also put out another 13 one in May of 2008, and -- and R&D cases, such as 14 McFerrin, there's a strong suggestion from the IRS and 15 from the case law not to rely on such pre-packaged 16 credit studies. 17 When the first auditor went out on maternity 18 leave, she was headed in this direction. The second 19 auditor continued the audit consistent with this modern 20 line of guidance. 21 Respondent began expanding the audit to look at 22 activities, executive wages, and respondent sent 23 requests for proof of the activities. 24 Contrary to the implications, respondent was 25 staying up-to-date with IRS guidelines and case law and 26 enforcing the statutory guidelines. Just because the 27 auditor discovered that appellants were not engaged in 28 qualified research activities doesn't mean there was 37 1 some kind of an inconsistency. 2 And even if appellants assert inconsistency at 3 audit, it does not necessarily give them the right to 4 the credit, exactly as stated by the California Supreme 5 Court in Dicon, asserting error does not shift the 6 burden to respondent. 7 In conclusion, appellants started with an 8 estimate of expenses and never proved qualified 9 activities. 10 Appellants have not carried the burden of proof 11 which is expressly on the taxpayer. 12 Appellants' estimates are riddled with 13 inaccuracies and overstatements which cannot prove a 14 nexus to the underlying activities. 15 A taxpayer is only allowed credit for the 16 amount of increased research over the base. And, 17 instead, appellants made up their own method when they 18 couldn't provide the proper calculation. 19 There are rules that all taxpayers must follow 20 to get the credit, and those rules apply equally to 21 these taxpayers. 22 Appellants failed to follow the rules, they 23 flunked the required steps, and they are not entitled to 24 the credit. 25 Thank you. 26 MR. HORTON: Thank you very much. 27 On rebuttal, please. 28 ---oOo--- 38 1 ---o0o--- 2 MR. SPERRING: Great. Mr. Chairman and Madam 3 Board Members, you heard that -- the Franchise Tax Board 4 say, "We don't know what is IRS looked at." 5 So, what we thought we would do is walk you 6 through what we do know, right. And what we do know is 7 in that 2007 the IRS issued an industry directive 8 placing the R & E -- the R & D tax credit on Tier 1 9 status, okay. 10 And what does Tier -- Tier 1 status mean? 11 Well, okay, it means that the service has identified 12 this issue as -- as an area where there is a level of 13 high strategic importance, okay, to large, medium and 14 small business unit at the IRS. 15 And, in fact, what this notice that's on the 16 IRS website directs their auditors -- it says that the 17 auditor must review and follow the guidelines in the 18 ATG, okay. So, why don't we look at what the ATG says? 19 And we included that, the 2008 version, by the way, 20 we've included is that in your packet, okay, as Tab 1. 21 And when you look at the -- at the ATG, on 22 page 10 here, it says they want to know what method -- 23 what methodology was employed for capturing QREs 24 reflected in the research credits, i. e., estimates, 25 interviews, sampling, surveys, reviews of 26 contemporaneous documents. Notice it doesn't just stop 27 at contemporaneous documents, there is more to it than 28 that. 39 1 And then it also says that advised the taxpayer 2 that interviews, okay, that the IRS examiner should 3 interview employees, okay. 4 And then when you go on, okay, to page 32, it 5 lists out the type of documentation, substantiation and 6 -- and recordkeeping. 7 And what does it want? It wants accounts, 8 accounting and finance manuals, organization charts, 9 department descriptions, job descriptions, product 10 lists, okay, documentation of experiments, okay. 11 Other -- on page 33 it talks about submission 12 to management, project authorizations and budgets, okay, 13 are included in there, notes, okay. 14 Then on page 34 it says, 15 "Credible oral testimony may be helpful in 16 evaluating and supporting a taxpayer's 17 contemporaneous documentation." 18 So, in other words, it says you look at the 19 whole file, what's submitted, what's there, okay. 20 And when you look at what the first auditor 21 did, you see that the first auditor went out to the 22 plant, okay, went out and spoke to Pacific Coast, okay. 23 The second auditor did not, okay. 24 And, in fact, when you look at the IRS or, 25 excuse me, the FTB final IDR that was mentioned, okay, 26 and, you know, I used the word loosely when I called it 27 IDR, but that is what they determined -- that is what 28 they termed it. 40 1 But if you look this supposed IDR, what you see 2 is it is nothing more than a request the taxpayer 3 circle -- okay, they don't ask to provide any 4 information, it actually says "questionnaire." And what 5 it provides is that the taxpayer circle, okay. Do they 6 have timesheets? Yes or no? Do they have project logs? 7 Yes or no? 8 In other words, they're going down the route of 9 project accounting, okay, and they're not following the 10 ATG, okay. 11 And, so, it was only after -- you know, we 12 weren't able to circle the "yes" for time sheets and 13 "yes" for project logs that the audit made a turn and we 14 went from saying -- having an audit determination letter 15 saying that we are doing R & D, okay, based on 16 interviews, based on contemporaneous records, to now, 17 all of a sudden, there is no contemporaneous records 18 because you don't have timesheets. This is a 19 prepackaged study. We have a hard policy. We will not 20 look at it, okay. 21 And the taxpayer -- excuse me, Franchise Tax 22 Board mentions Bayer, okay. Well, in Bayer, okay, the 23 taxpayer sought a motion to compel that the IRS to 24 accept, okay, a sampling of the business components. 25 Here our study, we've identified all of the 26 business components, okay. So, that was one. The case 27 was -- is not on point because, unlike Bayer, we have 28 identified our business components. 41 1 But, more importantly -- what -- the case 2 actually supports us, okay, because it says once R & D, 3 okay, activities are established -- which we have, even 4 the FTB concedes that there was R & D to the extent they 5 had the pop-out project. Then it says the court shall, 6 okay, determine the expenses, okay. 7 So, the very notion that somehow Bayer is 8 against us and then, you know, it's just totally, we 9 don't think, accurate. 10 Another important case we ought to bring up is 11 Shamie. To the extent the taxpayer talks about Shamie, 12 let's talk about that briefly. 13 In Shamie you had the two shareholders, the CEO 14 and the VP of Marketing, claiming 100 percent of their 15 time doing R & D, okay. And Mr. Shamie made over -- for 16 the two years -- between 8 and $9 million. 17 Our CEO, Mr. Lucchetti, we claim -- no credit 18 for his wages, which were all under a million dollars 19 during our time period. 20 The executive that the Franchise Tax Board 21 refers about, Al Mueller, okay, there is two points 22 there. Mr. Mueller is -- although called PABCO 23 president -- he was located at Newark plant. And if you 24 look at the memo that was on the board there, okay, 25 for -- the Gladding McBean memo, you see Alfred -- Al 26 Mueller cc'd on the memo. And that's because he was 27 involved in these R & D projects, okay. 28 And, you know, last I take on, before turning 42 1 it over to Kendall, to talk about base year. I just 2 take on the elephant in the room, this very notion that 3 we do not have documentation. As you've seen in our 4 case in chief, okay, the -- we have a variety of 5 different documentation's which would show testing, 6 okay. Not all plants kept memos, okay, like 7 Mr. Padavona at Gladding McBean, okay. But, 8 nonetheless, what you see is documents -- testing 9 documents that meet the requirements of IRC 41. 10 So, with that, I'll turn it over to Mr. Fox to 11 talk about the base year. 12 MR. FOX: Mr. Chairman, Madam, Board Members -- 13 MR. HORTON: Pardon me, Mr. Fox, can I ask that 14 you pull the mike just direct -- there you go. 15 MR. FOX: Okay, excuse me. I also have a 16 little bit of a cold. So, hopefully, I can speak up. 17 But in looking at the base period, the first 18 thing that that's important is to understand exactly 19 what the requirement is. So, the statute, basically, 20 codified a holding in Research, Inc. that if a taxpayer 21 is claiming a new area of research in a current year, it 22 must go back and establish what those expenditures would 23 have been in the base period. And it's referred to as 24 the consistency requirement. 25 And it's exactly what we've done here. And 26 Research, Inc. is -- was, I think, a little bit 27 misquoted because Research, Inc. basically said, 28 "We don't have the records. We can't tell 43 1 you what our base is. So, we're not going to 2 establish the base." 3 And this is under a year when it really 4 mattered what the base was because of the way that it 5 was calculated. 6 So, just a couple comments regarding the base. 7 First, we can prove that we have an increment because 8 the base calculation itself contains a failsafe measure, 9 which is that you -- that the base can never be less 10 than 50 percent of the current year expenditures. 11 What we believe we're able to prove is that our 12 base calculation from the '84 to '88 period always 13 results in a calculation that is less than this minimum 14 base amount. So, we can always prove that we're 15 entitled to a 50 percent increment. 16 And we didn't use current year activities to 17 extrapolate back to the '84-'88 period. Once we'd 18 identified all of our research projects that took place 19 in the current year period, we then, meeting with Mr. Al 20 Mueller and other knowledgeable individuals at each of 21 the plant locations, we then went back and discussed not 22 only current year activities, but which of these 23 activities would have been incurring in the base for the 24 purpose of coming up then with -- with how much of the 25 expenditures associated with those activities would have 26 been. 27 So, for example, at Basalite, which, by the 28 way, with Basalite, Dixon actually has the lab for all 44 1 of Basalite. So, sometimes when you see references to 2 non California plants, they might be running a trial for 3 a non California plant, but it's always done at the 4 plant, in the lab at Dixon. So, it is taking place in 5 California. 6 But, for example, the mix designs are 7 activities that would have taken place in all periods. 8 But a lot of the plant process-based development, if 9 there weren't a lot of improvement activities going on 10 at each of the different plants back in the base period. 11 So, Mr. Padavona can testify as to the types 12 of things that might have been taking place at Lincoln, 13 but they were de minimus in comparison to the roof tile 14 modernization plant. 15 At Vernon, Vernon was a plant that was 16 purchased in '85 and was a mothballed plant. So, the 17 first six to seven years of activity at that plant were 18 merely trying to make the plant operational with the 19 ability to produce product again. There wasn't any 20 research in connection with the process. It was 21 basically turning it back on and getting it up and 22 running. 23 Then once they were able to establish that -- 24 and under Mr. Fraser's direction, they then began doing 25 research in terms of product development and how to 26 improve the process of the facility. 27 So, we went by an actual plant by plant 28 location, determining and documenting what was taking 45 1 place in the plants. We went back and we do have 2 examples of certain test reports that were taking place. 3 We also got product lists. We could compare the product 4 mix back then versus today. 5 And I also, finally, want to point out that 6 while the comments been made regarding the IRS 7 examination of the credit, the fixed base percentage 8 calculation is a required element of the federal 9 research credit. And the IRS, in the reports, 10 specifically acknowledged that they asked for and 11 reviewed the fixed base finder and agreed that we could 12 prove an increment and that we were subject to the 50 13 percent limitation. 14 Can I see how much time we have left? 15 MS. RICHMOND: None. 16 MR. SPERRING: Okay. 17 MR. HORTON: I believe the additional testimony 18 would probably come out in the Q and A process. I 19 certainly would encourage both sides to delineate the 20 various different projects. 21 There seem to be some unique activity and 22 similarity in that regard as well as the various 23 different steps relative to the actual code itself. 24 With that, further discussion, Members? 25 Member Steel. 26 MS. STEEL: I didn't ask for it, but -- from 27 Franchise Tax Board that I've been hearing from you that 28 it's disqualified, nothing and no documents. And, you 46 1 know, that's all I heard for about 15, 20 minutes. 2 And you said obvious -- you know, R & D credit 3 is -- quantity is not equal to quality. It's always not 4 equal because, you know, they tried to bring out the 5 best quality. That's why they are, you know, working on 6 it. 7 Let me ask you this, under the letter that 8 Franchise Tax Board went out on right after the first 9 auditor, that, 10 "Therefore, Pacific Coast Building 11 Products, Inc. activities that were intended to 12 develop or improve a business component 13 functionality, performance reliability or 14 qualified through a process of experimentation 15 undertaken to discover technology, information 16 to eliminate uncertainty were qualified." 17 But you told us that that auditor then after -- 18 that to -- another auditor came in and she -- this lady 19 tried to go forward. What you were talking about there? 20 Because on the letters that they are qualified 21 on R & D project here. So, I want to hear that part. 22 MR. RILEY: Well, with respect to the 1999 23 audit, you know, initially it was a qualified research 24 expense audit only. That's all the -- that's all that 25 Respondent looked at. 26 When Respondent put forth the position that, 27 okay, we'll let you have 80 percent of these claims, the 28 taxpayers came back and said, "We -- we disagree. We 47 1 think that these executives are qualified. Look again." 2 At that point when the -- you know, they 3 invited an expansion of the audit. They -- they invited 4 Respondent to look deeper at the -- at the credit. 5 And at that point, that's -- that's when, you 6 know, this is also when the audit technique guides for 7 the IRS came out. The first one came out in June of 8 2005. I believe the letter was initially sent around 9 the beginning of January -- sorry, January 31st, 2006. 10 And, so, when -- when Appellants rejected that 11 offer and invited further audit of their activities, 12 that's exactly what Respondent did. 13 MS. STEEL: Okay. Then let me -- but that's 14 really interesting because, you know, Franchise Tax 15 Board already said that all these R & D was qualified. 16 MR. RILEY: Well, if I may -- it was only for 17 the two -- 18 MS. STEEL: I got that. 19 MR. RILEY: -- 1999 year. 20 MS. STEEL: Well -- 21 MR. RILEY: I mean, that's -- 22 MS. STEEL: Let me go there then. 23 MR. RILEY: -- that was the -- 24 MS. STEEL: Let me go there then. 25 It's the same study and same practice. And I 26 hear from you that regarding the IRS -- 27 MR. HORTON: Ms. Steel, if I may -- 28 MS. STEEL: -- I think I am just so much hid 48 1 here that -- 2 MR. HORTON: Let me ask of the entire audience, 3 I believe, to cut off their cell phones. It seems to be 4 interfering with our system. 5 And, so, we'll take a pause for about thirty 6 seconds to accomplish that objective. And if we all 7 move at the same time, no one will appear to be 8 guilty. 9 I'll even participate a little bit here. 10 MS. STEEL: Let me go back to IRS matters here. 11 The same study, same practice that 1999 that some part 12 of the audit was done, according to you, but, you know, 13 the finalized letter went out and then the taxpayer 14 protested. 15 I hear some contradictory statement from you 16 that -- regarding that. IRS really doesn't matter, but 17 you, Franchise Tax Board, gave this credit on 2005. But 18 they been doing same practice from 1990 -- 1984, 19 -- 19 the base year, is it 1984? 20 Can you give me that, the year? 21 MR. SPERRING: Yeah, '84. 22 MS. STEEL: 1984. So, they been doing same 23 practice. And IRS gave them -- you said IRS -- the 24 decision was not really matter, but IRS gave them the 25 credit for 2005 after audit. 26 So, why don't we just give them credit the way 27 -- exactly same practices, same studies been done from 28 1984, why we are not doing it? 49 1 Even IRS didn't audit for those period of 2 years, but it was the same study and same practice. 3 MR. RILEY: Well, first of all, we really don't 4 know what happened in the IRS audit. I mean, you see 5 that they have provided IDRs 5 and 17. 6 MS. STEEL: Then let me ask you one thing. So, 7 you didn't know IRS was looking at and still gave this 8 taxpayer credit for 2005 then? 9 MR. RILEY: We didn't give the taxpayer credit 10 for 2005. 11 2005 is not at issue. I mean -- 12 MS. STEEL: Not here. 13 MR. RILEY: -- we disallowed the credit. 14 MS. STEEL: But you gave credit in 2005, didn't 15 you? 16 MR. SPERRING: Correct. 17 MS. STEEL: The Franchise Tax Board? 18 MR. SPERRING: Correct, Board Member Steel. 19 That return was never audited. And it's never been 20 challenged and the statute's expired on it. 21 MS. STEEL: So, got the credit from Franchise 22 Tax Board? 23 MR. SPERRING: Yeah, the credit was -- 24 MS. STEEL: Yeah. 25 MR. SPERRING: -- claimed on that one. 26 MS. STEEL: So, that's -- that's my question. 27 MR. RILEY: Well -- 28 MS. STEEL: It's not this tax period, but I'm 50 1 asking you that why that if -- even you didn't know IRS 2 was looking at, then why you are not giving them -- you 3 give -- you gave them credit for 2005. 4 And now, when we go back to 1999 to 2004, why 5 not? It's the same practice and same study here. 6 MR. RILEY: If the 2005 -- for 2005 they were 7 granted credit from the State Board -- 8 MS. STEEL: Not if, it was. 9 MR. RILEY: -- well, if it was, then that is an 10 administrative mistake, okay, because -- 11 MS. STEEL: So, Franchise Tax Board -- 12 MR. RILEY: -- it is clear that -- 13 MS. STEEL: -- mistake that you're admitting 14 here? 15 MR. RILEY: -- for the years that are at issue 16 at this appeal, 1999 through 2004, Respondent -- we 17 completed a complete audit of their activities. And 18 their activities do not qualify for the R & D credit. 19 If -- look -- 20 MS. STEEL: Okay. 21 MR. RILEY: -- this -- you know, I'm handling 22 this -- this particular audit. 23 MS. STEEL: Well, if you're handling this -- 24 MR. RILEY: -- this -- 25 MS. STEEL: -- case, you supposed to know that 26 what went on between or before or after. 27 And you don't even know that Franchise Tax 28 Board gave this taxpayer credit on 2005. So, what's not 51 1 qualified and what is qualified? 2 And you didn't even study what IRS gave them. 3 That's what I'm asking. 4 MR. HILSON: Ms. Steel, if I may interject? 5 MS. STEEL: You know what, before I hear that, 6 I want to hear from Mr. Sperring about the history of 7 that, what audit was audited, what got credited, why not 8 it's not credited and base year was 1987. 9 MR. SPERRING: Sure, sure and thank you, Board 10 Member Steel. 11 The study was conducted from '95, or excuse me, 12 '99 to '05, okay. '05 was filed on an original return, 13 okay. And every year subsequent to '05, they've been 14 updating the study, okay. 15 And none of those years from '05 on has been 16 audited by the Franchise Tax Board. They've all been 17 accepted, credit claimed. 18 Okay. Now we talk about what did Franchise Tax 19 Board do for '99? And the refund years only is what the 20 FTB's had a problem with. They had a problem with the 21 refund years, okay. And that's why we're here, '99 to 22 '04. 23 To answer your question about the IRS, okay, 24 the IRS audited '05 and '06, okay. The IDRs showed they 25 requested the study. The IDRs show they requested all 26 the binders, including the base period binder. And the 27 IRS gave a no change audit, okay. 28 And then the only other thing I would point 52 1 out, Board Member Steel, is you're hearing lots of 2 representations today by the Franchise Tax Board. One 3 of them is that the first auditor did not audit the 4 underlying research activities, but merely argued -- or 5 merely audited the accounting. 6 And we have folks here -- Ken Irwin can testify 7 that that was not true. And what we think that it -- 8 the very sentence that you read in the audit 9 determination conflicts with what's being represented 10 here today. 11 If you look at -- on page 1 of their audit 12 determination letter, the very sentence you said, states 13 this, 14 "The Pacific -- therefore, Pacific Coast 15 Building Products' activities were intended to 16 develop -- the activities that were intended to 17 develop or improve business components ..." 18 And then it goes through IRC 41, right, 19 "qualify" -- you see, it says it right here 20 (indicating). 21 So, you just heard the Franchise Tax Board, 90 22 seconds ago, tell you that they did not audit the 23 activities, okay. 24 We can bring someone under oath and he'll swear 25 under oath that they -- that they discussed the 26 activities, but you don't need that because the very 27 document, okay, states that they found the activities do 28 qualify. 53 1 Just like you heard earlier, the elephant in 2 the room, we don't have any contemporaneous testing 3 documents, although there's no requirement that we 4 have -- that they be contemporaneous, nonetheless, 5 you've seen documents in our brief that show testing. 6 So, you're hearing a lot of comments, okay, 7 but it's belied by the written record. And the only 8 thing I can say is, you know, I feel bad that there is 9 2800 plus 1500 pages that the Franchise Tax Board has to 10 go through, okay, but, nonetheless, the documents that 11 are in front of this Board support the taxpayer's 12 position. 13 MS. STEEL: Just one more question to Franchise 14 Tax Board. 15 That Franchise Tax Board gave credit for 16 pop-out part -- portion of it? 17 MR. RILEY: We have -- we have -- we are 18 willing to concede that that is a potentially eligible 19 project. 20 MS. STEEL: Isn't -- 21 MR. RILEY: However -- well, if all things -- 22 if -- if they had the proper -- 23 MS. STEEL: -- so, you concede it -- 24 MR. RILEY: -- qualified research expenses. 25 MS. STEEL: -- for that part already? 26 MR. RILEY: Well, yeah, that particular 27 project. If you want to -- 28 MS. STEEL: That's yes and no? 54 1 MR. RILEY: Yes. 2 MS. STEEL: Yes or no? 3 MR. RILEY: Yes. 4 MS. STEEL: Okay, thank you. 5 MR. RILEY: If you would -- if I may explain a 6 bit? 7 MS. MANDEL: I'm confused. 8 MS. STEEL: Okay. 9 MS. MANDEL: I'm not sure he answered the 10 questions that you were asking. 11 MS. YEE: Yeah. 12 MS. STEEL: Go ahead. 13 MR. RILEY: The que -- you asked if we conceded 14 the credit for the pop-out project. 15 No, we did not concede the credit for the 16 pop-out project. We'll concede the activity for the 17 pop-out project, but not the -- but not the credit 18 because they have not proven the -- the expenses. And 19 they have not proven the base amount for the pop-out 20 project. 21 MS. STEEL: So, out of 2700 pages that you 22 didn't really look at and you didn't see any proof 23 there, that's what you are saying -- that pop-out 24 project itself, that it's been provided, the documents 25 been provided, then you going to be considered for that 26 part? 27 Is that what you are saying? 28 MR. RILEY: The pop-out project was not 55 1 provided until appeal. 2 MS. STEEL: Can I hear you? 3 MR. SPERRING: Sure, sure. 4 First thing, that's not true. The pop-out 5 project was mentioned in the study, okay. But, again, 6 another mischaracterization of the record. 7 But, second, let's read an excerpt from Bayer, 8 which the taxpayer -- or which the Franchise Tax Board 9 sent us a few days ago, right. 10 Because we just heard the Franchise Tax Board 11 concede that the pop-out project is a qualified research 12 activity. And, so, what does the Bayer court say? It 13 says -- and quoting the McFerrin, they say, 14 "If McFerrin can show that activities were 15 qualified research, then the court," or FTB, 16 right, "should estimate the expenses associated 17 with those activities." 18 So, what -- what does the law tell us? The law 19 says if there's -- if it's determined there is qualified 20 research activities, okay, and in this case we'll say, 21 "by the government," government's just determined that 22 now, okay, then -- okay, the courts are saying you 23 should quantify it. 24 MS. STEEL: Thank you. 25 MR. HORTON: Thank you. 26 Member Runner. 27 MR. RUNNER: I'm a little -- just let's 28 start -- we've a number of audit issues or issues 56 1 other -- looks -- in regards to the processes and the -- 2 and the R & D issue here before us. 3 Let me start with the first issue a little bit 4 that went on in regards to Member Steel's questions. In 5 regards to the first audit, that individual -- again 6 it's pretty clear to me that -- by the letter -- that 7 they said that the activities were qualified, right? 8 Is there any disagreement with that? 9 MR. RILEY: In the initial position letter? 10 MR. RUNNER: Yeah. 11 MR. RILEY: That was -- that was the 12 conclusion. 13 MR. RUNNER: Okay. The -- that's the only 14 letter we got, right, from her? So -- and it says they 15 were qualified? 16 MR. RILEY: Yes. 17 MR. RUNNER: Okay. 18 MR. RILEY: Says "qualified." 19 MR. RUNNER: Okay. So -- and I -- the question 20 I have is that the comment was that, well, then they 21 decided to expand the audit. 22 It seems to me that at least the intention of 23 the -- of their issue was two-fold -- maybe I'm missing 24 something -- is their concern was that they felt that 25 there was some items that were disallowed, I think it 26 was executive salaries? Is that what was one of the 27 issues? Is that -- in the first audit? 28 MR. SPERRING: Yeah, it was -- it was including 57 1 janitorial -- 2 MR. RUNNER: Okay. 3 MR. SPERRING: -- it was a wide range of items. 4 MR. RUNNER: Okay and involved some salaries, 5 so -- 6 MR. SPERRING: Yeah. 7 MR. RUNNER: -- but it -- was it about 80 8 percent was allowed? 9 MR. SPERRING: Yes, it was. 10 MR. RUNNER: Okay. About 80 percent was 11 allowed. 12 And, so, they get this letter from the FTB 13 saying, "You are engaged in qualified research," right? 14 That's what the letter said, right? 15 MR. RILEY: That's what it says. 16 MR. RUNNER: Okay. And, so -- but they have a 17 dispute in a portion of it. 18 And then they say, "You know, we're 80 percent 19 there, let's go ahead and take a look at these other 20 years." 21 Is that kind of what -- how -- what took place? 22 MR. SPERRING: Correct, yeah. We had full 23 faith in our auditor, who was communicating with us and 24 wanting to do plant tours. And, so, we felt that it was 25 in our interest -- 26 MR. RUNNER: Okay. 27 MR. SPERRING: -- to expedite it. 28 MR. RUNNER: That's good. 58 1 So, the taxpayer gets a letter -- gets a letter 2 that says, "You know, we've looked at your stuff. 3 You've got qualified research going on. We dispute 20 4 percent of it." 5 And, so, the taxpayer says, "Well, you know, 6 we're 80 percent of the way there. Let's go ahead 7 and -- go ahead and take a look at the subsequent years 8 there." So, that was done. 9 So, I'm -- the language that you used was that 10 they opened up their books for a relook. It doesn't 11 seem to me that's exactly what they did. 12 Do you -- I mean, is that -- 13 MR. RILEY: Well, they -- we -- we gave them an 14 offer of 80 percent. They rejected it. 15 MR. RUNNER: Right. 16 MR. RILEY: And then said, "Oh, well, by the 17 way, we want to talk about 2000, 2001, 2002 and 2003." 18 MR. RUNNER: Right, right. 19 MR. RILEY: And at that point, like I said, 20 this is -- this is at a time when the IRS says, "Hey, 21 watch out, because there are these things called 22 prepackaged credit studies," that when the auditor read 23 the audit technique guide probably said, "Hey, this -- 24 this credit study that I just received looks a lot like 25 this thing that the IRS says, 'Hey, look out for because 26 they're overclaiming and they're unable to tie ...'" 27 MR. RUNNER: Okay. 28 MR. RILEY: -- "expenses to activities." 59 1 MR. RUNNER: Okay. 2 MR. RILEY: So -- 3 MR. RUNNER: Let's -- let's go back to that 4 issue then. 'Cause, again, the interesting to me -- 5 issue to me is you've got the FTB basically signing off 6 on the qualified research in 2000 or 19 -- that was done 7 in 1999. 8 No dispute there. The letter says so. 9 And then -- you know, so, then they want to go 10 ahead and throw in these other years now that they think 11 they've got guidance, right? 12 I mean, that's basically what you're getting, 13 you're getting guidance from the FTB. You got, you 14 know, a determination letter, right? 15 So, you're getting guidance from the FTB. And, 16 so, you're saying, "Since we got some guidance, let's go 17 ahead and do these other years and we'll continue to 18 talk about the last 20 percent." 19 So then, all of a sudden, things go upside down 20 and not only do we then, you know, change, obviously, 21 the -- in terms of the interpretation that took place, 22 but we go all of the way back then to the 1999 and say, 23 "Time out. Now we believe no R & D took place." 24 I guess there's a little dispute in regards to 25 maybe this one project, but, at least in general, no -- 26 no R & D. 27 And they do it based upon -- what I'm 28 hearing -- is some new IRS guidelines, which I find 60 1 interesting in light of the fact that there's an IRS 2 audit in 2005, right? 3 MR. RILEY: Correct. 4 MR. RUNNER: Okay. Now did IRS use their own 5 guidelines? 6 MR. RILEY: Well, as -- as I was attempting 7 to -- to answer that question, the IRS issued at least 8 17 IDRs in that audit. 9 Okay, because we have from -- from the 10 documents that they provided, we have IDR No. 5 and 11 No. 17. So, what was the IDR focused on in the other 15 12 IDRs? 13 Was it focused on, you know, their -- their 14 apportionment -- well, it's federal, so -- so, I mean, 15 we don't exactly what the IRS was focused on in the rest 16 of this audit. 17 MR. RUNNER: So, we don't know if the IRS 18 followed their own rules? 19 MR. RILEY: Right. We do not know that. 20 I mean, the -- the two -- the two IDRs that 21 they have, they talk about, okay, "Well, we want to see 22 your credit study, the things related to QREs. And we 23 want to see some of the --" 24 MR. RUNNER: Do we know that they didn't -- 25 MR. RILEY: "-- related database." 26 MR. RUNNER: -- do we know that they didn't 27 follow their own rules? 28 MR. RILEY: I mean, we -- I work for the 61 1 Franchise Tax Board. I don't know what happened at the 2 IRS. 3 MR. RUNNER: Okay. 4 MR. RILEY: What I do know -- 5 MR. RUNNER: Okay. 6 MR. RILEY: -- is that we -- 7 MR. RUNNER: Okay. 8 MR. RILEY: -- we conducted our own independent 9 audit and that we concluded that the activities that 10 they're saying that constitute qualified research, do 11 not. 12 MR. RUNNER: Hold -- right, I mean, you 13 really -- you tend -- you have a problem of being too 14 emphatic about that since you also did another audit in 15 1999 and you found that it did. 16 MR. RILEY: Well, the audit was never 17 finalized. The -- the subsequent -- 18 MR. RUNNER: Was there a letter of 19 determination done? 20 MR. RILEY: Yes. 21 MR. RUNNER: Okay. Is that the end of an 22 audit? 23 MR. RILEY: I'm sorry? 24 MR. RUNNER: Is that the end of an audit? 25 MR. RILEY: Well, the -- this is not a final 26 determination, this is a -- this is an -- 27 MR. RUNNER: Was there a letter of 28 determination? 62 1 MR. RILEY: -- initial position. 2 MR. RUNNER: Was there -- was there a 3 conclusion to the audit to which the -- to which you, 4 the FTB, was done and saying, "This is end of our 5 audit."? 6 And then -- and then it's time for the taxpayer 7 to respond if they'd like? 8 MR. RILEY: The ultimate conclusion of the 9 audit happened in, you know, when the final 10 determination letter went out saying, "You have not 11 substantiated that you're engaged in qualified 12 research." 13 MR. RUNNER: And listen, I'm talking about the 14 first letter. 15 Was the first letter a letter of final determin 16 -- a letter of determination? 17 MR. RILEY: It is a position letter, it is not 18 a final determination. 19 MR. RUNNER: It -- 20 MR. HILSON: Mr. Runner -- 21 MR. RUNNER: -- was there additional -- was 22 there an additional audit going to take place if, 23 indeed, the taxpayer would have said, "Okay, we're fine 24 with this. We'll go ahead."? 25 Was the audit -- 26 MR. RILEY: Probably not. 27 MR. RUNNER: Probably not? 28 MR. RILEY: I mean, for the 19 -- 63 1 MR. RUNNER: You mean if the auditor -- if the 2 -- if the company would have said, "Okay, we'll go ahead 3 and take the 80 percent," that that letter that they 4 received from the FTB was not conclusive enough to say, 5 "Okay, well, we're going to take that letter back and 6 now we're going to go ahead and look at 1999 again."? 7 MR. RILEY: Well, they rejected the offer. 8 MR. RUNNER: That's not what I asked. 9 MR. RILEY: Well -- 10 MR. HILSON: Mr. Runner. 11 MR. RUNNER: Yes. 12 MR. HILSON: In -- the situation you're asking, 13 it's my understanding, is if the taxpayer had simply 14 said, "We'll accept the FTB position --" 15 MR. RUNNER: Right. 16 MR. HILSON: "-- as phrased on January 1." 17 MR. RUNNER: Yes. 18 MR. HILSON: "January 31st of 2006." 19 MR. RUNNER: Yes. 20 MR. HILSON: In all probability that would have 21 been the end of the inquiry into 1999. 22 MR. RUNNER: Thank you. That's the -- thank 23 you. 24 And I guess that's my -- my -- my point is that 25 the -- is that the -- there was conclusion done by the 26 FTB at that -- at that point. 27 And it's only because they were concerned about 28 this last 20 that opened up the door. 64 1 And, quite frankly, again I'd think as the 2 taxpayer, 3 "Gee, I've gotten some guidance now from 4 FTB. Let's go ahead and go forward now and 5 look at the rest of the years." 6 So, you know, part of my feeling is we changed 7 the rules in the process. 8 And, again, you can say, "Well, the F -- the 9 IRS changed the rules," but I -- I have trouble with 10 that argument in light of the fact that then there's a 11 concluding IRS audit at the end of our audit, which I'm 12 going to -- you know, I'm going to go the opposite, I'm 13 going to assume that the IRS followed their own rules, 14 since they were getting guidance at that point. 15 Let me ask it -- just a follow-up, I guess, 16 it's perplexing to me in terms of method and process and 17 then I want to go to some specific questions or issues 18 regards to some of the -- some of the -- the products 19 themselves. 20 If, indeed, the FTB was going to come to such a 21 big conclusion that they're going to change the 22 direction of the audit, why in the world wouldn't the 23 auditor at least go out to the taxpayer to review what 24 the first auditor saw? 25 I just -- you know, it seems to be such a 26 dramatic change that it would just be good practice to 27 be able to do that. 28 Any thoughts? 65 1 MR. RILEY: Well, during the course of the 2 audit there were more than 100 calls exchanged between 3 FTB and the taxpayer's counsel. The -- the taxpayers 4 knew exactly what we were asking for. I mean, in fact, 5 Mr. Sperring referred to a final IDR in which the tax -- 6 we, the -- the Franchise Tax Board just said, "Look, do 7 these documents exist or don't they?" 8 Because at that -- 9 MR. RUNNER: I only asked why it is that nobody 10 went out there? 11 MR. HORTON: Mr. Runner, if I may? 12 MR. RUNNER: Yeah. 13 MR. HORTON: I just want to advise, if you 14 will, to -- to the Department that we -- to the extent 15 possible that we respond to the direct question in order 16 to avoid a colloquy. 17 MR. RUNNER: Yeah. So, my conclusion -- my 18 question, as you recall, was wouldn't it be appropriate 19 with such a dramatic change to at least go out and see 20 what the first auditor saw that bring -- that brought 21 them to the conclusion that there was qualified research 22 going on? 23 MR. RILEY: I don't know that the first auditor 24 went to the -- on the plant tours until after this first 25 determination was issued. 26 I think the plant tours occurred in -- later in 27 2006. 28 MR. RUNNER: So, the auditor made the 66 1 determination prior to the -- to writing the letter? 2 MR. RILEY: The initial, yes. 3 MR. RUNNER: Is that -- I don't know. 4 MR. SPERRING: Well, there is more than one 5 plant here. 6 MR. RUNNER: Right. 7 MR. SPERRING: Okay. So, originally the 8 auditor was coming out to the Lincoln plant, which is 9 right outside of Sacramento. 10 MR. RUNNER: Right. 11 MR. SHERRING: Seeing what was going on with 12 Lincoln, sharing documents -- 13 MR. RUNNER: Was that during the audit? 14 MR. SPERRING: That was during the audit, 15 before the letter. 16 MR. RUNNER: Okay. 17 MR. SPERRING: Now, once -- okay, the 18 auditor -- you saw -- 19 MR. RUNNER: That's not all I needed to know. 20 MR. SPERRING: Okay. 21 MR. RUNNER: So, the auditor did go out during 22 the audit? 23 MR. RILEY: And -- 24 MR. RUNNER: I think I'm seeing some yeses and 25 some confusion. 26 MR. RILEY: -- well, the -- the -- the auditor 27 went on at least three plant tours, okay. 28 MS. HODGES: It was after the -- 67 1 MR. RUNNER: During the audit? 2 MS. HODGES: During the audit. 3 MR. RUNNER: Thank you. Again, that's all -- 4 again, that's all I'm asking. 5 If the -- if the -- let me ask -- 6 MR. RILEY: But after this initial letter -- 7 the plant tours occurred after this initial letter. 8 MR. RUNNER: After the letter? 9 MR. RILEY: After the letter of January 31st, 10 2006. 11 MR. RUNNER: Okay, I'm a little confused. Is 12 that -- 13 MR. SPERRING: Yeah, let me explain. 14 MR. RUNNER: Help me -- help me see -- 15 MR. SPERRING: What -- what did the auditor 16 disallow? 17 The auditor disallowed -- at that point 18 disallowed the utilities and some -- wages for basically 19 employees that didn't sound like they were doing 20 traditional R & D. 21 So, at that point, we asked the auditor to go 22 and visit Vernon, take a tour of the Vernon plant, 23 because that -- 24 MR. RUNNER: When did they go to Lincoln? 25 MR. SPERRING: -- they went out to Lincoln 26 before at audit determination letter. 27 The other plants came after. 28 MR. RUNNER: Okay. 68 1 MR. SPERRING: Okay. 2 MR. RUNNER: Apparently, we -- that's good. 3 Apparently we just have a disagreement 'cause we have 4 different opinions going on. 5 I'm going to move on 'cause there's lots of 6 other issues. 7 And again, part of my issue is -- it's again 8 the IRS guidelines that we're relying on in regards to 9 why it is that the FTB changed its opinion. One of the 10 suggestions that it makes is do a site visit. 11 So, it seems to me again I'm hearing the FTB 12 kind of pick and choose a little bit about what 13 guidelines want to be followed when it comes to the IRS. 14 Let me -- again, what are -- the core issue, it 15 seems to me, that we're talking about here, though, is 16 about this issue in regards to whether or not qualified 17 research went on. 18 And, again, the issue is we have it went on at 19 the first audit that says yes; we basically having an 20 ending audit by the IRS that says yes; and then we've 21 got this in between time, which the FTB, you know, come 22 back, changed the first audit and has an opinion not. 23 And -- and it -- it seems me that is really the 24 core of the discussion because when you talk about the 25 accounting issues and whatnot, but if you can't meet -- 26 at least my understanding is if can't meet the first 27 issue -- and that is whether or not qualified research 28 is being done -- none of the other stuff counts, right? 69 1 MR. RILEY: Correct. 2 MR. RUNNER: Okay. So, I guess I'd like to 3 hear a little more about that, 'cause I think that is 4 the core of the issue. 5 So -- and let's -- I think I'd like to talk a 6 little bit about Vernon. So, I think that's Mr. Fraser; 7 is that right? 8 And again part of our problem with this process 9 and this issue is -- is it's -- there's numerous 10 projects here. 11 And, so, I guess I'm hesitant -- and I don't 12 think any of us want to go through and talk about every 13 project that took place. So, I guess I would like to go 14 and have Mr. Fraser go through some -- a couple of them 15 were touched on during the -- during the test -- during 16 the opening testimony. 17 But I'd like to hear of a few more in the -- in 18 the Vernon plant, again where -- what was, you know, the 19 business purpose that was a part of that, the 20 uncertainty that was trying to be eliminated and the 21 process of experimentation that was going on -- the 22 things that are required in order to be -- take that 23 first step in a couple of more projects. 24 Because I don't think we have time to go 25 through all of them. But it seems to me if we can 26 establish, at least to our opinion, that enough of those 27 indicate that R & D went in, that might -- that should 28 be illustrative of the balance. 70 1 MR. FRASER: Okay. Let's start with the -- 2 MR. RUNNER: Well, let me -- actually, I'm 3 going to ask you one for specific -- 4 MR. FRASER: All right. 5 MR. RUNNER: -- I'm going to ask you 6 specifically to talk about the reject separator because, 7 actually, that's one that was specifically talked about 8 at -- from the FTB that said was not qualified. 9 MR. FRASER: Yeah, that was actually the one I 10 was going to go with too. 11 MR. RUNNER: Okay. 12 MR. FRASER: As I mentioned earlier, we're 100 13 percent recycle mill. 14 So, we bring in waste paper. And, 15 unfortunately, some of the components in waste paper are 16 not paper fiber. And, so, we have to separate those out 17 from our process. 18 At the time we had some issues with too much 19 contaminants that were actually coming into the process. 20 And we weren't able to separate out significant amounts 21 of fiber at times from it. So, we were actually 22 landfilling a lot of useful fiber. 23 So, we were looking for a way to improve our 24 ability to separate those fibers, short term, also long 25 term we were looking for a way to feed lower grade 26 quality waste paper, because it's less expensive. 27 And in our process our fiber costs are -- are 28 significantly our highest cost. And the reason they are 71 1 is because we're located in Los Angeles, next to two 2 large ports that export tens of thousands of waste paper 3 to Asia every month. And that's really what affects our 4 ability to keep our product costs low. 5 So, we looked at our existing system initially. 6 We ran some tests with some existing equipment we had. 7 And we were unable to effectively separate out the paper 8 waste the way we were hoping to. 9 And we also knew at that time that it would 10 limit our ability to feed these lower quality papers 11 because we just couldn't separate out enough of the 12 fiber in the waste treatment. 13 So, after experimenting a little bit with our 14 own process and, you know, it involved installing the 15 flushing showers and doing some other things and feeding 16 different types of paper, we just determined we needed 17 to do something different. 18 So, we went and we looked at options there. 19 And, keeping in mind, when we looked at options, we're 20 looking at different technologies that are available to 21 do that. Again our process, though, our plant, is 22 unique. You will not see another paper mill like PABCO 23 Paper in the world. 24 When these paper mills are built, they're built 25 to -- and, again, ours was built originally in 1912 -- 26 they're built for the need at that time. So, that need 27 determines the type of paper you are making, as well as 28 the width of it, how fast it's going to be run, what 72 1 kind of feedstock stream and, of course, at that time 2 they were using all virgin fiber from trees. 3 So, anyway, we were looking at these different 4 technologies and trying to figure out how we could 5 integrate it into our system. 6 And after experimenting with our own and trying 7 some things, we just didn't have a lot of success. So, 8 we found technology we thought would work. And, so, 9 initially we actually brought in a small unit, a trial 10 unit. 11 And we needed to figure out -- there were a lot 12 of uncertainties, especially in the design aspects of 13 it. So, that's one reason we needed to run more tests 14 with the smaller unit, to make sure it would actually 15 what we wanted. And after running some tests with it, 16 we determined that it looked like it would work well in 17 our system. 18 And then it came down to determining how we 19 would fit it in, how we would integrate it into our 20 process. And we ended up purchasing that unit. 21 During that time then we had to design -- and, 22 again, this is all in-house design that we do. I 23 brought some drawings for some of these projects that 24 you can see are done in-house. So, all of the 25 engineering, the mechanical, the structural, that's all 26 done in-house. 27 Working in a small company, we have a small 28 staff. And it's -- you know, I'm intimately involved 73 1 with all this stuff. You know, I don't come to work 2 like this (indicating). I normally show up in jeans and 3 work boots and that's the way we do it. 4 So, after we ended up integrating this 5 equipment into our process, again we -- there was a 6 significant amount of work done after that fact. And 7 what we actually determined was that we had purchased 8 the wrong size holes in the basket. And we weren't 9 getting the throughput. 10 So, we actually ended up having to go back out 11 and modify the system as well as the feed system that we 12 designed for it because that was all designed in-house. 13 We had to design a head box that would bring in the 14 waste stream. And we had to, you know, size all of the 15 valving and all of the components that went with that. 16 And, so, ultimately, again, our hope was to 17 reduce our waste costs -- which it did, our landfill 18 costs dropped significantly after that -- and to allow 19 us to feed these lower grade -- 20 MR. RUNNER: All those adjustments that you are 21 making were all -- pre-use of the equipment in 22 production? 23 MR. FRASER: Correct. The initial ones were, 24 absolutely. 25 And then once we installed the equipment, 26 before we technically put it online, yes, we do run a 27 significant amount of testing with it. 28 MR. RUNNER: Okay. Maybe I -- just another one 74 1 that you felt that -- again, there is the -- the 2 volume -- there is many volumes of programs -- but again 3 since -- since the core of this issue is whether or not 4 R & D takes place -- because at least FTB uses the 5 phrase "You guys flunked." 6 Help me understand where it is that you believe 7 the FTB is wrong. 8 MR. FRASER: Okay. We'll just pick -- how 9 about the centrifuge? We'll go with that. 10 MR. RUNNER: Okay. 11 MR. FRASER: Again when we make a wallboard 12 paper, we make, basically, for the sheet of paper that's 13 on the outside of the wallboard that's facing your -- 14 the inside of your home, it's got two different 15 materials. It's got a base fiber, that is brown fiber, 16 and then it's got a face sheet that is actually a 17 lighter color, which is the side you would paint in your 18 house. 19 Unfortunately, over the years -- like I said 20 before, I've been in waste paper, recycled paper, 21 manufacturer for 24 years -- the quality of the fiber 22 has disintegrated significantly, mainly due to the 23 amount of recycled content in it. And, unfortunately, 24 like I mentioned earlier, a lot of that material that's 25 in those fibers that we receive are not actually paper 26 fiber. 27 In a lot of cases when we bring in like old 28 magazine sections or, you know, materials out of 75 1 newspapers, they contain a lot of materials like 2 titanium dioxide and calcium carbonate, which are 3 detrimental value to my process -- mainly because when 4 we make gypsum paper, we put a material in there that 5 makes the paper semi water resistant for a short period. 6 And, unfortunately, these contaminants, which is what I 7 will call them, actually have high surface area and they 8 require me to use more chemicals. So, it increases my 9 costs significantly. 10 And it also -- because they offer no strength 11 to the fiber -- they also increase the amount of delay 12 on the machine because they cause paper breaks. 13 So, the other thing they do is they get in my 14 water system when I recycle water and they make it 15 difficult for me to get clean enough water to use in my 16 shower and in other things on the machine. 17 So, in the centrifuge what we were looking to 18 do was we were looking to take this liner stock and 19 remove some of those contaminants. And, again, a lot of 20 different technologies were available. 21 We were looking at something that would be cost 22 effective and highly efficient. And, so, we had done 23 some testing, screening samples in the lab, to see what 24 the particle size distribution was, to see what would 25 actually work. And we came across this technology for a 26 centrifuge through, actually, a glass operating plant 27 that we went and visited. And we decided we would go 28 ahead and give this a shot. 76 1 So, we had to, first of all, design in our 2 process where this piece of equipment would fit and give 3 us the -- kind of the biggest bang for our buck, so to 4 speak, in removing these contaminants, based on the lab 5 work we had done with the screening and knowing what the 6 particle size was. 7 And then we also had to, of course, determine 8 the throughput capabilities and, you know, how that 9 would work with the rest of the equipment in our 10 process. 11 So, we ended up designing the installation, 12 installing it and then, after the fact, ran different 13 tests because what we were doing is we were changing 14 a lot of different parameters around the centrifuge -- 15 feed pressures, flow amounts, consistencies of the 16 material -- just to see how we could optimize the unit. 17 And, so, we ran tests for probably two or three 18 months. And what we ultimately determined was that the 19 unit was not going to handle the amount of material that 20 we needed it to. It just was not capable of separating 21 out enough stock to be of value, based on the horsepower 22 requirements of it. So, we actually ended up not using 23 that unit. 24 MR. RUNNER: That's a program that you 25 basically went through the process of R & D and at the 26 end of the process your hypothesis, if you will, wasn't 27 solved? 28 You could not -- 77 1 MR. FRASER: Correct. 2 MR. RUNNER: -- accomplish what it is that you 3 sought to -- 4 MR. FRASER: Yes, correct. 5 MR. RUNNER: -- accomplish? 6 That centrifuge, was it -- it was not an office 7 was an office -- was that an office -- was that a -- was 8 the use of that centrifuge, what it is that a centrifuge 9 like that would normally be used for? 10 MR. FRASER: As far as I know, there were no 11 other paper mills at that time using a centrifuge at 12 all. 13 ---o0o--- 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 78 1 ---oOo--- 2 MR. RUNNER: Okay. Okay. 3 Again, let me go back to FTB because the core 4 issue was they flunked. 5 With the examples that they just went through, 6 could you delineate for us why it is you believe that 7 those were not righteous R&D, um -- or should -- should 8 indeed be ri -- seen as R&D projects? 9 MR. RILEY: Certainly. 10 The reject separator, they provided these three 11 pages of documentation (indicating). That's the 12 authorization for fund expenditures. Okay. 13 That's -- that's -- well, I'm telling -- this 14 is what -- 15 MR. RUNNER: I don't know what those three 16 pages say. 17 MR. RILEY: Well, they're included as -- 18 MR. RUNNER: So I guess what I need is to talk 19 to the issue. 20 MR. RILEY: I will -- I will talk to the issue. 21 But part of the issue is that they didn't prove the 22 activity. Okay. 23 This is what they provided. They provided 24 three pages of an -- uh, of a document requesting funds. 25 That document, uh, relates to the -- the reject 26 separator, which is a grade three separplast. It's a -- 27 a -- a machine bought from Torino, Italy. Okay. And, 28 as you heard, it separates the stock from like 79 1 contaminants such as plastics, polystyrene, hot melts. 2 This was just a project to install new 3 equipment to handle, uh, the rejects in the pulping 4 process. Okay. This is -- this is all of the 5 documentation that they have, all the contemporaneous 6 documentation that they've provided, with respect to 7 this project. Okay. There's no information, uh -- 8 MR. RUNNER: So your opinion is that this was 9 basically something that was like an off-the-shelf 10 technology that they put in line in order to accomplish 11 their production. 12 MR. RILEY: I'm sure they had someone from 13 Torino come -- come over and -- and help them out with 14 it. I mean, if you're going to spend a thousand 15 dollars -- uh, what did they spend? They spent -- 16 sorry, $101,800 on a machine, probably somebody with 17 a -- with a -- an instruction manual will come along 18 with it. 19 Um, you know, the cost -- 20 MR. RUNNER: Again, your assumption is -- and 21 your -- and your -- what you're telling me is, again, 22 their documentation says that they just basically got 23 the machine, put it in their -- put it in their -- their 24 process line, installed it, and it started working. And 25 then they started it through the process -- you know, 26 into production. 27 MR. RILEY: That's all that we've got. That's 28 all that they've provided to us. 80 1 MR. RUNNER: So based upon what they provided, 2 that's all that you really know that took place. 3 MR. RILEY: All we know is that -- 4 MR. RUNNER: The explanation -- the issue that 5 just went through right now, that's new information, in 6 regards to what was just shared in regards to the -- the 7 justification of the R&D? 8 MR. RILEY: Well, they certainly did not 9 provide any contemporaneous documentation to show that 10 any of what they were talking about involved a process 11 of experimentation for a qualified purpose, which is 12 what the statute requires. 13 MR. RUNNER: It -- does -- does the statute 14 require contemporaneous? 15 MR. RILEY: Well, the case -- 16 MR. RUNNER: Or does it just refer to that? 17 MR. RILEY: Well, the case laws, as -- as 18 the -- as, uh, Mr. Sperring referred to the McFerrin 19 case, the McFerrin case says if a taxpayer's engaged in 20 qualified research activities, then we'll look at -- 21 then we can look at expenses. 22 MR. RUNNER: Uh-huh. 23 MR. RILEY: Okay. And the -- the line right 24 after that says, hey, you can -- you can look to 25 testimony -- 26 MR. RUNNER: Uh-huh. 27 MR. RILEY: -- and other evidence, comma, 28 institutional knowledge, comma, and then the case cites 81 1 to Fudim. 2 When you look at Fudim, to what does "other 3 evidence" mean? It means contemporaneous scientific 4 documents. 5 MR. RUNNER: But it's not exclusive. 6 MR. RILEY: Contemporaneous -- 7 MR. RUNNER: Is it -- is it exclusive 8 contemporaneous? 9 MR. RILEY: Well, with respect to the research 10 documentation, uh, it would make sense that it would be 11 contemporaneous. 12 When you're talking about things -- 13 MR. RUNNER: That's not my question. My 14 question is, is it required? Is it required? 15 MR. RILEY: The Fudim case required 16 contemporaneous documentation. Contemporaneous journal 17 articles, contemporaneous scientific, uh, letters and 18 contemporaneous U.S. patents. That's what that taxpayer 19 used. 20 MR. RUNNER: So all -- so every R&D has always 21 had to be -- is based upon, in order to get it, based 22 upon contemporaneous record? 23 MR. RILEY: The activities, yeah. It should 24 be. And -- and that's what the -- that's what the Fudim 25 case and the -- and the McFerrin case that cites it and 26 all the cases that cite to the McFerrin case, this is 27 what they're referring to. 28 MR. RUNNER: Okay. Let me go back to the 82 1 taxpayer, couple other things. 2 Number one, FTB is saying, hey this wasn't 3 included in -- in -- in the original study, all this 4 explanation that we just went through. So answer that 5 one for me. 6 And then the second issue is in regards to 7 contemporaneous. Uh, what, I guess, is your view in 8 regards to contemporaneous? Is it -- is it a 9 requirement or is it -- is it -- is it just a list of 10 kinds of things that you can have, one of which is 11 contemporaneous? 12 MR. SPERRING: Right, yeah. 13 MR. RUNNER: Either one of those issues, or 14 both of them in either order. 15 MR. SPERRING: Right. Your -- your last 16 question first. 17 Um, it is -- it's other information. Right? I 18 mean, the, uh, Audit Techniques Guide make clear, they 19 have a laundry list of -- of, uh -- of information. 20 I -- I won't bore this Board with reading it to you 21 again, um, but it -- it's in the tab there. And it 22 lists all the things, and there is no requirement that 23 it only be documented with contemporaneous evidence. 24 Okay. 25 Um, and so, uh -- you know, he's just -- that's 26 not an accurate reading of the law. It's not an 27 accurate reading of the ATG. It's not an accurate 28 reading of the IRS policy. 83 1 Uh, but, with that said, we do have 2 contemporaneous -- uh, contemporaneous evidence here, 3 okay, and it was the budgetary approval. Okay. 4 Now, what's interesting is FTB doesn't want -- 5 the more robust description is in the noncontemporaneous 6 project description. Okay. FTB doesn't want to look at 7 that. They don't want to credit that with any weight. 8 They just want to look at the contemporaneous document. 9 Well, the contemporaneous document, that 10 doesn't prove the whole thing. Agreed. But what it 11 does prove is that this expenditure was made. Okay. 12 And I just asked Bill. No, no one from Italy 13 came with the, uh -- a centrifuge. Okay. But we can 14 prove that the expenditure was made, and we've explained 15 it in the, uh, study. 16 Certainly, uh, FTB was free, as the first 17 auditor did, to talk about these projects, okay, uh, and 18 learn more about them and ask for, um, supplemental 19 information. 20 But, again, going back to the -- what the new 21 auditor issued us, there was no -- you know, it would 22 have been wonderful if we got an IDR saying, "Please 23 list all the business components of all your projects 24 listed." Right? Uh, but you didn't get that. Okay. 25 We -- we've never received that. 26 Instead, we, uh, received this: 27 "Do you have time sheets? Yes or no?" 28 "Do you have project logs? Yes or no?" 84 1 Again, two things that are not mentioned in the ATG as 2 even being something an auditor should ask for. 3 MR. RUNNER: So, again, let me go back to the 4 second part of that question. 5 In the -- in the -- in the study that was done, 6 was there some clear explanation, whether 7 contemporaneous or not, of the intentional use and what 8 the plan was or what the use was of the centrifuge? 9 MR. SPERRING: Um -- uh -- uh, there was a 10 brief description of the project. 11 MR. RUNNER: Mm-hmm. 12 MR. SPERRING: Okay. I don't want to say it's 13 going to be as robust as the testimony before you 14 today. 15 MR. RUNNER: Okay. 16 Okay. I'm done. 17 MR. HORTON: Member Yee. 18 MS. YEE: Thank you very much, Mr. Chairman. 19 Uh, I think what I'd like to do is to pose a 20 question to Appeals, if I could. And it does center 21 around this question about contemporaneous documentation 22 as compared to non-contemporaneous documentation. 23 Um, it seems to me that the, uh, case law, uh, 24 does guide us that the burden does require appellants to 25 present contemporaneous business records to confirm that 26 qualified research was conducted. 27 And I -- I see the value in non-contemporaneous 28 documentation, certainly. But, uh, I don't see anywhere 85 1 that that can be the only evidence that, um, helps us 2 determine that qualified research was document -- 3 documented or was conducted. But it can be used to 4 support, uh, or bolster -- 5 MR. AMBROSE: To corroborate -- 6 MS. YEE: -- contemporaneous. Right. 7 MR. AMBROSE: -- I think, right. 8 MS. YEE: Is that a correct reading? 9 MR. AMBROSE: That's how Appeals reads -- reads 10 the case law, yes. 11 MS. YEE: Okay. Um, having said that then, it 12 seems to me what's missing here -- well, let's just see 13 what was presented here -- and I appreciate the 14 voluminous, uh, information that's been provided, uh -- 15 and, uh, I can assure you that my staff has been through 16 every single document that's been provided. 17 Uh, but we have, um -- in terms of 18 contemporaneous documentation we had, uh, authorization 19 for funds expenditures; we had capital expenditure 20 requests; we had cost justification memos; um, project 21 description for raw material handling; and then with 22 respect to the Roof Tile Modernization Project, the 23 committee notes. 24 For non-contemporaneous documentation we had 25 the R&D credit study; the qualified activity narratives; 26 the executive surveys; and the wage allocation 27 questionnaires. 28 That's kind of how we're dividing that. Is 86 1 that -- 2 MR. SPERRING: I guess the only thing I would 3 add is the study has both contemporaneous and -- 4 MS. YEE: No. Okay. 5 MR. SPERRING: Yeah. 6 MS. YEE: All right. I'll, um, submit to that. 7 Seems to me, though, as we're trying to 8 determine the activities that constitute qualified 9 research, that there has to be some explanation of the 10 activity in contemporaneous documentation. And that the 11 expenditures and the cost justifications alone don't 12 really quite get us there. 13 And, um -- and I know we're -- we're looking 14 to -- and I've tried to really look at how we, uh, pair 15 up the non-contemporaneous documentation to, um, you 16 know, corroborate, uh, what's been stated in the 17 contemporaneous -- contemporaneous documentation. 18 And what's still missing for me is really, uh, 19 some specific delineation that there was a process of 20 experimentation that took place with each of these 21 projects. 22 Um, I think there's been -- and then I really 23 appreciate the, uh, verbal explanation that we got 24 today. If that had been specified in any of the 25 contemporaneous documentation, I'd be there with you. 26 But that's what's missing. 27 And, in fact, there were some memos that 28 suggested that it wasn't as robust in terms of qualified 87 1 research, and I'll give you an example. 2 Um, I think the, um -- was it the centrifuge, 3 uh, there was some, um -- I guess it was speculation as 4 to whether it was even going to resolve the problem or 5 not. Um -- and, uh, I don't know that it necessarily, 6 uh, constituted what I would consider the uncertainty 7 that -- that we, uh, traditionally define in terms of 8 the -- of a business process. 9 But -- but even the -- the trials that were 10 done, um, I don't think really had, um, enough 11 substantiation with respect to what was being tested and 12 what the outcomes were, and that there was an evaluative 13 component to it. 14 And so, uh, I wanted to just kind of see if you 15 can comment on that. I think some -- some did or tried 16 to get there a little bit better. But with each of the 17 projects I think that was really what was missing for 18 me, is how -- 19 MR. SPERRING: Sure. 20 MS. YEE: -- how well-defined the process of 21 experimentation was. 22 MR. SPERRING: Sure. And, I guess, one thing 23 that, um, might be helpful, if you wouldn't -- if you 24 would indulge me, Board Member Yee -- 25 MS. YEE: Mm-hmm. 26 MR. SPERRING: -- um, is that we look at, uh, 27 the IRS, uh, regs on this issue because, you know, uh, 28 there becomes a question of what's uncertainty? How 88 1 much uncertainty do you need? Okay. And, you know, 2 uh -- uh -- you know, the example in the IRS reg, um, 3 talks about, uh, a, um, facts -- example three: 4 "X is engaged in the business of 5 manufacturing food products and currently 6 manufactures large shred version of a product. 7 X seeks to modify the current production line 8 to permit it manufactures both a large shred 9 version and a fine shred version of one of its 10 food products. A smaller, thinner shredding 11 blade capable of producing a fine shred version 12 of the food product, however, is not 13 commercially available." 14 So, um -- and the -- the reg goes on to say 15 that that qualifies, uh -- for, uh, you know, as a 16 qualified research activity. Okay. 17 And so, um, here, okay -- uh, there's -- you 18 know, there's no uncertainty, okay, in that example that 19 you can create a thinner blade. Right? I mean, we -- 20 we know that, uh, you know -- you know, America has that 21 technology to create the blade. The question is, how 22 are they going to be doing -- how are they going to do 23 it, that factory, with their resources, okay, uh, and 24 get it working in their plant? Okay. 25 And that's exactly what you have here in the 26 centrifuge project where they had to, um -- uh, 27 basically they had a problem. Okay. They had water 28 contaminates. They tried to figure out a way to resolve 89 1 it. They knew that you could purify water. Right? I 2 mean, everyone knows that -- that, you know, we can get 3 very, very pure water. And so they purchased this 4 product, uh, that they believed would solve it and it 5 did not. 6 And so, um, you know, to, uh -- to us, it's 7 documented because we know they purchased it. Okay. 8 And we know it did not work. 9 MS. YEE: So -- okay. Follow through. Where's 10 the documentation then about the re-design? 11 MR. SPERRING: Uh, well, okay. I mean, the 12 document -- you know, the documentation in the 13 re-design -- again, the study is a, you know, summary, 14 okay, of the projects. It's not meant to be 15 all-inclusive. Okay. 16 And so, you know, Bill Fraser has, you know, 17 right here, okay, the design drawings, okay, that were 18 required to, um, integrate the centrifuge. Okay. 19 Uh, and so, you know -- uh, I mean, we can 20 lament, okay, that that was not in the study. But the 21 study could not, um, include all the records because 22 just for amount of volumes. 23 It was -- it was -- it was basically designed 24 to allow FTB to audit. Okay. So you list the project, 25 now FTB can go down and ask for this information. Okay. 26 And the problem was we were cut short at audit. We had 27 an auditor that was doing that. Things were going well. 28 And then what happened was we had a new auditor 90 1 assigned, a change in policy, I guess, and they no 2 longer wanted this type of information. They wanted 3 time sheets. 4 MS. YEE: Well, hang -- hang on a sec. 5 MR. SPERRING: Sure. 6 MS. YEE: I mean, was -- I -- I can't imagine 7 the Franchise Tax Board reverse course in terms of 8 wanting that information. That just goes right to the 9 crux of what qualifies as research. 10 So, um -- and maybe that's a question of the 11 Franchise Tax Board. When we, uh, shifted to the second 12 auditor, the additional requests were to -- in addition 13 to, yes? What was -- 14 MR. RILEY: Yeah. In addition to what had 15 already been, you know -- 16 MS. YEE: You don't limit -- 17 MR. RILEY: They were looking at expenses. Now 18 we're -- now we're -- you know, now you've expanded the 19 audit to several more years and we're going to expand it 20 to the, uh -- the activities. Because that's what's 21 required under the statute. That's what the IRS 22 guidance says is now required. 23 MS. YEE: And had you made any determination to 24 the appellants that, uh -- with regard to the first 25 issue as to what, um, activities, uh, were qualified as, 26 uh, research? 27 MR. RILEY: Well -- 28 MS. YEE: At that point in time. 91 1 MR. RILEY: Respondent asked for -- for proof 2 of, you know, of these activities and they didn't -- and 3 they replied that they didn't maintain this type of 4 documentation. And so all that we received was the 5 study. 6 And then with respect to that final IDR where 7 there -- you know, it's a -- a list of, "Did you provide 8 time sheets" or, you know, the -- the other things 9 listed on there, that was -- that was an attempt to, 10 look, whatever you've got, we'd like to try and look at 11 it. So check on this box and -- and -- and let's 12 try and -- let's try and find out what you do have so 13 that we can examine the activities and get to the bottom 14 of this. 15 And, you know, they didn't -- they didn't 16 provide the things on activities except for the -- you 17 know, until their -- until their opening brief in those 18 1500 pages, which -- with respect to that pop-out 19 project. 20 MS. YEE: Okay. 21 MR. RILEY: I mean, that's -- that's really the 22 only activities documentation that they've provided. 23 Everything else that they've provided, that's all going 24 toward qualified research expenses. 25 MS. YEE: Expense, right. 26 Mr. Sperring. 27 MR. SPERRING: I just object to that 28 categorically. I mean, we saw in, uh, Reed's opening 92 1 presentation, okay, testing documents that's labelled 2 "R&D," okay, uh, for trial runs at Basalite. 3 That has nothing to do with accounting. 4 Most -- nine -- I would say ninety percent of our 5 documentations have nothing to do with accounting. 6 Okay. What they are is, uh, contemporaneous, um -- uh, 7 documents of the different projects. 8 The problem we have here is FTB, uh, has either 9 failed to read them or has mischaracterized them. 10 Uh, and so, to argue that there is -- could 11 there be more contemporaneous documentation? Yes, there 12 could. Okay. But is, uh -- uh -- is there a lack of 13 contemporaneous documentation in the record? We submit 14 there's not. Okay. 15 There's contempor -- uh, there's contemp -- you 16 know, the -- the -- the file's full of contemporaneous 17 documents, and the problem is that they're being 18 mischaracterized. Okay. 19 We know for a fact, right, that that centrifuge 20 was purchased. We have proven that, you know, in the 21 record. So then the question becomes, okay, was there, 22 uh, a process of experimentation? Okay. 23 Bill has sworn under oath that there was. 24 Okay. So we've clearly met. But, you know, the auditor 25 did -- the second auditor -- or, excuse me, the first 26 auditor did speak to Bill, okay, and got this 27 information. Had the auditors done -- had the second 28 auditor done that, done the tours, did the speaking, 93 1 okay, then you would have had the complete package all 2 there and done. 3 And I just want to object to one other point. 4 You heard a representation that -- that -- that the 5 first auditor was on the verge of changing her mind. I 6 mean, no, the record belies that. 7 The first auditor was on the verge of allowing 8 all the utilities, okay, and the titles, okay. Because, 9 again, since -- as Bill has testified under oath, since 10 we had to do test runs, you needed people like the 11 janitor. Part of their time is appropriate to include 12 because they have to dispose of, uh, product that can't 13 be sold. 14 MS. YEE: Yeah. I -- I -- I understand where 15 you're coming from, Mr. Sperring. It just seems to me 16 that, um, if we're going to focus on expenses, we really 17 have to have the, um, activities, you know, fairly 18 clearly delineated. 19 And, um, I didn't see -- and -- and this Board 20 has seen prior cases where we've had documentation 21 that's been sorely lacking. We've seen a case where the 22 documentation, I thought, was quite robust and met the 23 test. Um, and in this case, um, there's voluminous 24 documentation but not getting at what we need. 25 Now, um, I think with respect to this -- let's 26 use the centrifuge example, uh, if I could. Um, had 27 there been information there about, um, more 28 specifically with respect to the testing that was done 94 1 using the smaller unit, the fact that it then had to be 2 redesigned, uh, in-house as a result of it and the 3 analyses attended to that, um, I think that would take 4 us, you know, more of the way there. But that was not 5 included in the documentation. 6 And I know FTB asked for specific documents, 7 but we can't even focus on expenses until we get to the 8 question of whether the activities, uh, constitute 9 qualified research. So, I mean, I would think that much 10 of the priority would be focused on being sure that, um, 11 the activities were clearly delineated before we get to 12 the expense question. So, I'm -- I'm a little puzzled 13 by that. 14 Um, I want to just outline three projects that 15 I think, um, tried to get us there that, um -- uh, I did 16 take a tour. Uh, I used the information from the tour 17 to really try to look at, uh, the documents that were 18 provided to us. Um -- and even though I think, um, with 19 respect to the Roof Tile Modernization Project, the 20 documentation, um, still was lacking with respect to the 21 process of experimentation and what needed to be 22 documented. Um, certainly taking the tour, uh, I 23 understood, um -- the, um, uncertainty that was 24 identified and what, uh, the, uh, appellants were trying 25 to do to resolve that. 26 And so, I mean, in my mind there -- the body -- 27 the body pop-out project, um, I would agree with the 28 Franchise Tax Board, um, constitutes qualified research. 95 1 But, um, again, not, uh, really being able to tie the 2 expenses to the particular activity. 3 And then the, uh, last one that I thought had 4 some semblance of, uh -- of, uh, getting us to look at 5 the activities as qualified research is this one, I 6 believe it's the last one in your chart, the Development 7 and Testing of the Mix Designs, although I had some 8 issue with the time period. 9 But, um, those, to me, were a little bit 10 further developed with respect to what exactly you were, 11 uh, pursuing with your activity. Uh, albeit that the 12 documentation wasn't as robust as I had hoped. 13 MR. HORTON: Further discussion, Members? 14 Ms. Mandel. 15 MS. MANDEL: I just want to make sure that I 16 understand the mechanics, um, and perhaps the mechanics 17 of something in the study, just with respect to the 18 pop-out project where I hear, um, the briefing was that 19 it was potentially eligible in terms of the activity. 20 And I'm hearing more of a concession on the activity 21 aspect of the pop-out. 22 Now's your chance to not know. 23 MR. RILEY: No, that's -- 24 MS. MANDEL: Okay. 25 MR. RILEY: With -- with respect to that, 26 that's what we're -- 27 MS. MANDEL: Okay. Okay. Excuse me. Hang on 28 a second. I -- I didn't talk all morning and I can't 96 1 talk now. 2 So the mechanics on the credit -- again, 3 just -- I want to talk about the base period. I know 4 that's the back end before the front. But the base 5 period, it looks like the statute has a minimum 50 6 percent of expenses as your base. And then whatever 7 your -- it's, again, assuming the expenses for the 8 current period are shown. 9 (Coughing.) 10 I thought I got rid of my cold. 11 And, um -- for '99, and then 2000 there's 12 different allowable percentages of the increment above 13 whatever your base period is. Is that -- am I correct 14 that that's basically how the mechanics would work? 15 MR. RILEY: Well, I mean the -- 16 (Coughing) 17 MS. MANDEL: Sorry. 18 MR. RILEY: A taxpayer is supposed to take 19 reference to the '88 -- I'm sorry, the '84 to '88 base 20 years and be able to calculate a fixed-base percentage 21 and a -- a base amount. 22 And then using -- for the current years, they 23 then have to exceed that base amount. Um -- 24 MS. MANDEL: That's the incremental portion. 25 MR. RILEY: That's the incremental portion. 26 That's the hurdle that the taxpayer has to get over. 27 MS. MANDEL: Right. Right. 28 What I also heard, and, uh -- is that there is 97 1 a minimum base amount provided in the statute. 2 MR. RILEY: Yes. What the minimum base amount 3 is, is that's -- that's the -- that's the IRS' way of 4 saying, look, you have -- say the credit is 100 percent, 5 we're only going to let you take, as a maximum, 50 6 percent of that. That's what they are saying. At a 7 minimum, we are going to subtract 50 percent of your 8 expenses from the calculation. 9 So you don't get to claim the credit based on a 10 calculation of 100 percent of your QREs. You only get 11 it based on 50 percent of your QREs. 12 MS. MANDEL: Okay. Let me go back because my 13 understanding was that the -- that you -- you're only 14 going to get credit for an increment over some base 15 amount. 16 MR. RILEY: Correct. 17 MS. MANDEL: And -- and there's -- and -- and 18 if you -- if your base amount is 50 and you spent a 19 hundred, you're only going to get credit as to the 50, 20 the extra 50. 21 MR. RILEY: Correct. 22 MS. MANDEL: That's the incremental 50. And 23 that the -- there's a rate to the credit which would be, 24 in the later years, I think, 15 percent of 50 would be 25 the credit amount. 26 MR. RILEY: Correct. 27 MS. MANDEL: Okay. 28 MR. RILEY: That would be the maximum 98 1 allowable. 2 MS. MANDEL: That's the maximum allowable. 3 Um, my understanding is that the base amount, 4 which is what I need to know so that I can figure out 5 how much of what I spent in the current year is 6 potentially -- is subject to the credit. Um, that the 7 base amount is your fixed-base percentage times the 8 gross of the four years. And that's the '84 to '88 that 9 you're talking about. 10 But that in no event -- because, you know, 11 everything else -- leaving everything else aside, in no 12 event the base -- can the base amount be less than 50 13 percent of the qualified expenses for the credit year. 14 So that in the, um -- so -- so that where -- where, 15 um -- what -- what I thought was going on, and you can 16 tell me if that's not how it goes on, but what I thought 17 was going on was if I -- because you're saying they 18 don't know their base amount. That's your underlying is 19 that they can't really compute it based on the '84 to 20 '88; you don't think they've really computed it. 21 MR. RILEY: Correct. 22 MS. MANDEL: They, of course, think they've 23 really computed it. But you don't think they've really 24 computed it. 25 MR. RILEY: Correct. 26 MS. MANDEL: And if they -- if -- if -- if 27 there's -- if in no event it's supposed to be less than 28 50 -- let's say they computed their base amount, in my 99 1 example, and they say the base amount is 25, so they 2 should get credit with respect to the incremental 75. 3 And you're saying, well, they didn't really, 4 um, prove a base -- they didn't really prove a 5 fixed-base percentage because they don't really know 6 what they did in '84 to '88. 7 So are you saying that the "no event" language 8 means that -- that therefore, they can't even -- again, 9 assuming they've proved the expenses are tied to 10 qualified activities, because I'm starting from the back 11 end. Are you saying that they can't get credit with 12 respect to 50, in my example, because that's half of 13 their expenses for the year? 14 MR. RILEY: Yeah, they -- well, they -- the way 15 that -- 50 isn't just a default like, oh, well, we can't 16 figure it out so we're going to take 50 percent. That's 17 not how the credit works. 18 You have to -- in your example you said, oh, 19 well, they have a -- they have 25 percent. 20 MS. MANDEL: That's what they -- you know -- 21 MR. RILEY: Right. 22 MS. MANDEL: Making it up -- and I'm pointing 23 at you because you're sitting there. But, that -- that 24 if a taxpayer said, "I did my fixed-base calculation and 25 I say it's 25," and FTB says, "You haven't -- your -- 26 your numbers -- you don't -- you don't have stuff to 27 substantiate, to show the 25" -- 28 MR. RILEY: So -- 100 1 MS. MANDEL: -- "as your fixed-base 2 percentage," what does the "in no event" -- 3 MR. RILEY: So that means -- 4 MS. MANDEL: I mean "no event," the minimum 5 base is 50 of my current expenses. How do they not -- 6 MR. RILEY: Well, so, in that case -- so, if we 7 use 100,000 -- will be very easy -- if you use $100,000 8 as Q -- as QREs -- 9 MS. MANDEL: Right. 10 MR. RILEY: -- and you said, well, they have -- 11 they have -- for this year they've got 25,000. Okay. 12 MS. MANDEL: Well, that -- that's what they're 13 saying first basis. 14 MR. RILEY: Half of that -- half of that would 15 be 50,000, okay. In no event can it be less than 16 50,000. So even though they're -- you know, they're 17 saying, "Oh, well, we're way down here at 25" -- 18 MS. MANDEL: Right. 19 MR. RILEY: -- they're going to get bumped 20 up. 21 MS. MANDEL: Bumped up in -- in terms of the 22 base and they're only getting -- they only get credit -- 23 MR. RILEY: So -- 24 MS. MANDEL: -- for increment over their 25 base. 26 MR. RILEY: Right. So -- so we would calculate 27 that with respect to $75,000. 28 MS. MANDEL: You would calculate what? I'm 101 1 sorry. Just be specific on the reference. 2 MR. RILEY: You would make the credit 3 calculation with $75,000 rather than -- 4 MS. MANDEL: A hundred. 5 MR. RILEY: -- rather than 50. Because they're 6 way down -- they're way down at $25,000. 7 MS. MANDEL: Okay. I think you mixed up our 8 example. Because my understanding of -- of -- of it, 9 was 25 is what they're asserting is the fixed-base, 10 okay, in -- in the example we're playing with. 11 Twenty-five is what they say is the fixed-base. 12 They had a hundred of expenses that are QRE; 13 you're not fighting about QRE. You're fighting about 14 the base. Because they want to claim credit with 15 respect to the increment over a base of 25. So they 16 want to claim credit with respect to 75. Okay. 17 And you -- and you guys are saying, in my 18 example, "We don't think you have substantiated the 25." 19 So the question is then, the statute says in no 20 event can the minimum base -- they're saying the base is 21 25. And you're saying, "Nuh-huh, no, you haven't shown 22 it." In no event can the minimum, uh, base amount be 23 less than 50 percent of the QRE for the current year. 24 And in the example, the QRE for the current year, the 25 total QRE was a hundred. 26 So, with that as a sort of in no event can the 27 minimum base be less than 50 of your QRE, then it 28 sounded to me like the answer would be my increment that 102 1 I'd be allowed a credit for is 50, not 75. And that's 2 because my -- in my example, they were asserting a 25 3 base. 4 Now, it becomes a little more problematic if 5 they were asserting a 75 percent base. But then, 6 perhaps it wouldn't have been challenged, I don't know, 7 because you can't have a -- a taxpayer, I don't think, 8 could walk in and say, "I'm asserting a 75 percent 9 fixed-base," and then if -- if they say -- if the 10 government says, "Well, you haven't proved a 75 11 fixed-base," I think that taxpayer would be hard-pressed 12 to say, "Then I get the minimum, and I get to claim more 13 credit than I was trying to claim in the first place." 14 But, I don't know, maybe that goes to the issue or 15 not. 16 But do you understand where -- and that -- and 17 that's why I'm just wondering all this fight over a 18 fixed-base. Because one of the things that I heard come 19 out in a -- you know, a half sentence over here from 20 Mr. Fox was that -- and I don't -- I don't -- I don't 21 know -- I don't remember where the fixed-base percentage 22 is in the study. Maybe it was at 15 percent. I don't 23 remember what it was in the study. You can tell me. 24 But I -- what I thought I heard come out in a 25 half sentence was that IRS just -- with respect to the 26 other years that aren't at issue here, that IRS just 27 went to using 50 percent minimum as the fixed-base. 28 That's what I heard. 103 1 So, was that what you said, Mr. Fox? That 2 they -- they allowed 50 percent of the expenses -- 3 MR. FOX: Yeah, the calculation -- 4 MS. MANDEL: Which is -- which is what made me 5 think that they used the 50 percent base because I 6 thought the base you were asserting was less than 50 7 percent. 8 MR. FOX: That's correct. The base that we're 9 asserting is far less than 50 percent. So we're using 10 the 50 percent minimum base amount. 11 MS. MANDEL: So -- okay. So let me go back. 12 So you asserted less than a 50 percent base. 13 But for your calculations and the credit that you 14 claimed, you used 50 percent as the minimum? 15 MR. FOX: Yes. 16 MS. MANDEL: Okay. I guess I went -- now, I 17 guess I got distracted then by the "didn't prove the 18 fixed base," unless you guys think there's something 19 that I'm missing in my example. 20 MR. RILEY: Yeah. I mean, there's -- there's 21 two calculations that they've got to make. They've got 22 to make a fixed-base calculation, which is the 1984 23 through '88 -- 24 MS. MANDEL: Correct. And that's the number 25 that they say -- 26 MR. RILEY: Well, that's the number between -- 27 there's also a -- there's -- that's a number between 28 zero and 16 percent. That's a -- that's a percentage 104 1 that is then multiplied by the average annual gross 2 receipts for the preceding -- 3 MS. MANDEL: Right. And then that's what -- 4 MR. RILEY: And then that's what got to -- 5 MS. MANDEL: Okay. But that makes the 6 fixed-base number. 7 MR. RILEY: Mm-hmm. 8 MS. MANDEL: And what I'm hearing Mr. Fox say 9 is, yeah, we calculated and the way we calculated we 10 came up to whatever the 16 percent, um, that you're 11 saying. But, he's saying I didn't use that in claiming 12 the credit. I went to the minimum base. I went to 13 50. 14 MR. RILEY: Well, I mean, part of the problem 15 is their -- their -- they decided on a -- a -- the 16 numbers that they then -- you know, they didn't have 17 proof for these numbers that they used to calculate 18 it. 19 MS. MANDEL: I hear -- I hear what you're 20 saying, but what I'm wondering is, is did he have to do 21 all the work for the 16 -- 22 Wait a second. Let me finish. 23 Did he have to do all the work to get to 16 24 percent and then go, "I'm not going to use the 16 25 percent. Uh, I'm just going to use the minimum base." 26 Or could he just say, "You know what, the statute 27 provides for a minimum base amount of 50 percent of my 28 QREs and so, we're just going to claim" -- 105 1 MR. HORTON: 50 percent. 2 MS. MANDEL: -- again, assuming QREs are all 3 proved up, which they would have to do, right? I'm just 4 going to use the 50 percent, because the statute says, 5 in no event that's -- I mean, that's -- that's really my 6 question. 7 MR. RILEY: Right. 8 MS. MANDEL: And I -- and maybe Mr. Hilson can 9 help. I don't know. But that's -- 10 MR. RILEY: If I might just quickly jump in. 11 The problem is that these fixed-base percentage, this 12 thing that they -- that they first have to calculate can 13 range up to 16 percent. 14 MS. MANDEL: Can -- okay, listen -- 15 MR. RILEY: That's the statutory maximum. 16 MS. MANDEL: Okay. 17 MR. RILEY: But if you get up to that statutory 18 maximum, in all -- in -- in most circumstances that will 19 serve to eliminate the credit. So a -- a taxpayer -- it 20 benefits a taxpayer to have a smaller fixed-base 21 percentage. 22 So, in this case the taxpayer has claimed a .5 23 percent, half a percent as their fixed-base 24 percentage. 25 MS. MANDEL: Okay. 26 MR. RILEY: Which then, when you do -- when 27 you -- 28 MS. MANDEL: Okay. So this -- 106 1 MR. RILEY: When you do the calculation, that 2 serves to give them the -- the maximum amount of credit, 3 that 50 percent. 4 MS. MANDEL: Okay. So -- 5 MR. RILEY: The 50 percent base amount. 6 MS. MANDEL: All right. Then maybe I don't -- 7 maybe I'm just now completely confused about how you do 8 the mechanics. 9 Because I, um -- I thought, you know, obviously 10 simplistically, that -- that, um -- that you get 11 credit which is not -- you know, it's not a 12 dollar-for-dollar credit. 13 MR. RILEY: No. 14 MS. MANDEL: Right? It's in these later years, 15 15 percent of every dollar that I -- every incremental 16 dollar that I spend; is that correct? 17 MR. RILEY: Fifteen percent of 50 percent. So 18 7.5 percent. 19 MS. MANDEL: Oh, I see what you're saying. So 20 you're saying the -- why are you saying 15 percent? I 21 hope I'm not boring everybody. 22 MR. RILEY: Fifteen percent is the credit rate 23 that California allows. 24 MS. MANDEL: Fifteen percent. 25 MR. RILEY: That's the -- that's -- that's -- 26 MS. MANDEL: Not of every -- not 15 percent of 27 every incremental dollar? You're saying 15 percent of 28 half of every incremental dollar? 107 1 MR. RILEY: Correct. So the -- the end 2 percentage that the -- the most that a taxpayer can get 3 is seven percent of QREs. Okay. So it will -- a 4 taxpayer's -- 5 MS. MANDEL: Oh. Oh. But -- right, right. 6 Because the -- because the -- the -- 7 No. Keep going. I'm sorry. I -- I -- but I 8 thought that it's 15 percent of every dollar over my 9 base amount. Is it not 15 percent of every dollar over 10 my base amount? 11 MR. RILEY: It's 15 percent of -- well, I mean, 12 the very most that a taxpayer -- I mean, it -- in the 13 end, the most that a taxpayer can claim is 15 percent 14 of -- which is the credit rate. 15 MS. MANDEL: Correct. 16 MR. RILEY: Of 50 percent of their QREs. 17 Because under the -- under the base limitation, the most 18 that they're allowed to claim, if they -- if they -- if 19 they vastly exceed their calculated base amount, if they 20 vastly exceed their calculated base amount, then they 21 will be allowed to claim this 50 percent. Okay. But in 22 no event will that be over 50 percent. Okay. 23 So they can't claim it based on, you know, 55 24 or a hundred percent of the credit. So, essentially, 25 the most that a taxpayer can -- can claim under the 26 credit is 50 percent of the QREs times 15 percent as the 27 credit rate for an end percentage of 7.5. 28 But that will range between zero and 7.5 based 108 1 on such things as the fixed-base percentage calculation. 2 And that's why this -- that's why it's essential, uh, 3 that the taxpayers have an accurately calculated 4 fixed-base percentage calculation and an accurately 5 calculated base amount. Because, as Research, Inc. 6 stated, if they can't make these showings, then they are 7 not entitled to the credit. 8 MS. MANDEL: So the base amount that can't -- 9 so you're -- you're saying that I kind of mixed up 10 fixed-base percentage with base amount, I think is what 11 you're saying. 12 MR. RILEY: If I'm allowed -- 13 MS. MANDEL: In my -- 14 MR. RILEY: If I'm allowed to say that you -- 15 that you -- 16 MS. MANDEL: I was confused. I mean -- 17 MR. RILEY: Slight, yes. You know, apologies, 18 but, yes, you were confused. 19 MS. MANDEL: No, I -- you know, if I was 20 confused, I was -- I mean, that -- that -- those were 21 the two things that I was -- okay. 22 So, I'm sorry everybody. Then I was confused. 23 Was I confused? 24 MR. FOX: No. The fixed-base percentage is a 25 component of how you calculate the fixed-base amount. 26 So whatever you calculate is the fixed-base amount, your 27 increment can never be more than 50 percent of that 28 amount. 109 1 And what we're saying in our case, we have 2 calculated it. And if you look at the amount of 3 research in the base, we can prove that we're always 4 going to be subject to the 50 percent limitation. And 5 mathematically and by statute, that's always going to be 6 our increment. 7 MS. MANDEL: Fifty percent of your current -- 8 MR. FOX: -- spending. Yes. 9 MS. MANDEL: So then on the -- I guess I'll 10 have to go read it again. But then based on -- but then 11 the -- then the -- I -- do you fundamentally disagree 12 with the way he just explained it? 13 MR. RILEY: Yes. I mean, the problem -- the 14 problem here is that they -- they have came -- they've 15 come up with -- they decided on a calculation that gave 16 them a very, very low fixed-base percentage. If it was 17 actually calculated -- 18 MS. MANDEL: Okay. So if -- so if -- okay. 19 Let me ask you it this way. If it was actually 20 calculated and it was 25, and you said, "Yes, it was 21 25," you would -- they would -- then you'd say they 22 would be limited to the 50. 23 MR. RILEY: Then -- well, if their fixed-base 24 percentage was 25 percent, then they would have to use 25 the statutory maximum of 16 percent to use -- to do 26 their calculation. And in doing so, having a -- a very 27 large fixed-base percentage such as that would likely 28 serve to disallow the credit in its entirety. 110 1 MS. MANDEL: A fixed-base percentage. Okay. 2 The -- the -- now we're mixing them up again. Base 3 amount. You're saying the base amount overall was under 4 50 percent. 5 MR. FOX: Yes, the base amount. The calculated 6 base amount. 7 MS. MANDEL: And -- and the -- and the 8 limitation is that the base amount can't be under 50 9 percent, which is -- 10 MR. RILEY: Yeah. 11 MS. MANDEL: Okay. So, I guess my -- now 12 I'm -- now I'm circling back around to my question. Let 13 me stop using the phrase "fixed-base percentage" because 14 I got all confused. 15 If -- if a taxpayer did not calculate a base 16 amount, didn't go through the exercise of figuring out a 17 fixed-base percentage, going back to '84 to '88, could a 18 taxpayer under this provision that says you -- you're -- 19 no event are you going to have a base amount under 50 20 percent of your current expenses, could a taxpayer just 21 walk in and say, "I get 50 percent of my QRE"? 22 MR. RILEY: No. 23 MS. MANDEL: Because? 24 MR. RILEY: Well, um, this is one of the things 25 that's, uh, highlighted in the 2008 IRS Audit Technique 26 Guide. But the, um -- it's not an option. It's not, 27 "Well, I think I'm just going to take the 50 percent." 28 The -- the IRS has -- has allowed for 111 1 alternative calculations for -- for taxpayers who, for 2 whatever reason, either they can't calculate a base -- a 3 base amount because they don't have the documentation -- 4 MS. MANDEL: Uh-huh. 5 MR. RILEY: -- or because the -- you know, 6 their fixed-base percentage has creeped up so high that 7 it serves to -- it serves to eliminate the credit. So 8 the tax -- the IRS has allowed for alternative 9 incremental credit calculation for California. 10 And -- and -- so, in a case where a taxpayer 11 cannot substantiate the -- the fixed-base percentage or 12 the base amount, their only option is to claim, on an 13 original return, the alternative incremental credit; as 14 is consistent with the Research, Inc. case which states 15 that if you can't make these calculations, then you're 16 not entitled to the credit. 17 MS. MANDEL: Okay. I'm going to stop unless 18 you have a technical comment in response to that. 19 MR. FOX: Well, the only fact is we did 20 calculate a base. So we believe we can go back and 21 calculate and prove that it's less than the 50. 22 So, unlike Research, Inc., we didn't just say 23 we can't calculate it, we're just going to use 50 24 percent. We did go through the mechanics and -- 25 MS. MANDEL: Okay. 26 MR. FOX: -- documentation of what did 27 happen. 28 MS. MANDEL: But it -- but -- okay. So -- so 112 1 you're saying -- you're sort of saying, but if we 2 didn't, we'd be stuck under this Research, Inc. thing. 3 MR. FOX: Right. 4 MS. MANDEL: Okay. I'm sorry. That's it. 5 ---oOo--- 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 113 1 ---oOo--- 2 MR. HORTON: Okay. The confusion that has 3 arised (verbatim) as a result of the hearing seems to 4 have permeated the entire process to some degree, which 5 ultimately resulted in the documentation necessary to 6 support Step 1, which didn't exist, relative to the 7 fixed base zero to 16 percent. It is apparent that that 8 information was not necessarily reviewed by the FTB. 9 The other concern that I have is -- is a policy 10 concern, Members, whereas, it just doesn't seem to be 11 appropriate policy for us not to follow a position 12 letter and then to have a complete turnaround subsequent 13 to a position letter without a subsequent detailed 14 examination and explanation as to why that position 15 letter no longer stands -- even though the law and 16 previous court cases seem to imply that the position 17 letter is not final. And I understand that. 18 But once you articulate to a taxpayer and there 19 is a certain level of reliance on that, even -- even 20 that position to the point that that position has been 21 established, the activity or any other subsequent 22 evaluation should be post that decision. 23 And I'm referring to the 1999 position that was 24 taken allowing 80 percent of the qualified activity in 25 that particular year. That concerns me. 26 The -- the other thing as it relates to 27 documentation, the conclusion, if you will, that all of 28 the documentation has to be contemporaneous seems to 114 1 have some fallacy as you look at the decisions made by 2 the courts. 3 And, in fact, I personally believe that we 4 should not make decisions based on form over substance 5 when, in fact, there is an end product. 6 I mean, in the case of the -- I believe it was 7 the -- the development of the bricks or tile and so 8 forth, I had the benefit of touring the site and 9 actually saw an end product that resulted in something 10 totally new being created. So, inherent in the creation 11 of a new product has to be research -- research and 12 experimentation in order to accomplish that, if you 13 presume that it wasn't an accident. 14 And, so, as we look at the paper mill, the 15 testimony provided to us today implies some research, 16 but they're still -- that implication should be able to 17 be documented and supported by the taxpayer. Because 18 the testimony seemed to imply as well as the -- that 19 there is the modification of the head box, the feed 20 system and the purchase of the unit and a pre-existing 21 unit. 22 The unit existed and the determination was 23 whether or not that unit would fit into the -- you could 24 integrate it into the manufacturing process. One would 25 think that inherent to that process and that the unit 26 was never used in that industry before is some type of 27 an experimentation. 28 And, but -- in the -- and the lack of 115 1 documentation, until we can get past the first step of 2 justifying the activity, quantifying it after that 3 becomes, you know, pulling a rabbit out of the hat, if 4 we have to at the end of the day, based on the 5 quantitative empirical data that we have. 6 So -- and the challenge that I think we have as 7 a Board, we can't conduct these audits, even though -- I 8 mean, I commend the Members for going out, doing the -- 9 the interviews and touring the plants and so forth. And 10 I think that's just fabulous. And I decided to take it 11 upon myself as well to do that, just to insure that it 12 was necessary. And -- and once observing the plant, it 13 became apparent that it was necessary and that the 14 Department should have conducted those tours and took a 15 look at the process and the potential for science and 16 experimentation and evaluation and so forth. 17 So, with all that said is that I don't see 18 enough information necessarily here to be conclusive 19 about all of these transactions and possibly would ask 20 that -- that we turn to Appeals and ask -- or somehow 21 provide some direction to the FTB, as well to the 22 taxpayer, as to what documentation would be necessary in 23 order to establish the qualified activity, mindful of 24 what has been shared by Member Yee, Member Mandel and 25 the rest of the crew. 26 MR. AMBROSE: Do you want -- 27 MR. HORTON: And I would say this from my own 28 personal perspective, is that the two -- the pop-up 116 1 (verbatim) and the development of the bricks and even, 2 to some degree, the paper mill, there is an element 3 of the -- of research. There's an element of R & D. 4 There's an element of scientific experimental activity, 5 even if you just -- that's inherent. 6 But that being inherent, in and of itself, is 7 not enough to quantify because ultimately when we look 8 at trying to determine the base year and so forth on all 9 those equations, if we isolate it to just that 10 particular activity and say that all the other activity 11 was actually the purchase of equipment, but when you got 12 to the scientific analysis as to whether or not the 13 paper, the new paper, could be broken down in a timely 14 fashion and accelerate that and so forth or the 15 integration of the subsequent equipment that required a 16 shifting in the size and so forth, was actually research 17 and development, but the initial acquisition of the 18 larger piece of equipment was not, I mean, this -- it 19 becomes rather complicated without some documentation or 20 some examinations. 21 And my apologies for just making a statement 22 without providing a question. So, I'm going to open up 23 and just pretend that I did ask a question and go to the 24 Department and see if they have any response. And then 25 go to the taxpayer and allow them to respond as well. 26 MR. RILEY: What -- what sort of document would 27 we like to prove the activities? 28 I mean -- well, we would like documentation 117 1 such as -- 2 MR. HORTON: First -- first -- first, I think 3 you ought to tour the facility. I think you ought to 4 interview the taxpayer and the witnesses. 5 I think you ought to have a thorough 6 understanding of what the process was. And to the 7 extent that you have that understanding, then I think 8 you can -- and I think it ought to be separated by 9 project and not summarily dismissed in totality. And 10 then we can begin to look at contemporaneous 11 documentation. 12 But at the same time, I think the courts have 13 also ruled that once you get past Step 1, you know, the 14 contemporaneous documentation can just be an inherent 15 process, that it's inherent that this occurred, and, 16 therefore, it is necessary that you come up with a 17 number. 18 And, so, I think there is a process that we 19 didn't go through that we kind of have to go through. 20 MR. HILSON: Mr. Horton, if I may? 21 MR. HORTON: Sure. 22 MR. HILSON: On behalf of the Department, 23 clearly, we welcome your observations. We welcome the 24 observations and the comments that have been made by the 25 other Board Members during this -- it's no longer this 26 morning -- but this morning's proceedings. 27 And, clearly, we'll take them to heart, not 28 only in this case, but on a go forward basis as well. 118 1 Because, obviously, this is a significant 2 credit. It's -- it's obviously got business incentive 3 ramifications. The taxpayers are highly interested in 4 it and we do want to see that it gets done right. 5 And, so, that being the case, yeah. I mean, 6 we're -- we're more than willing to do the plant tours 7 if -- if, you know, if appropriate. We're willing to 8 conduct further interviews and follow whatever guidance 9 the Board or Board staff may -- may direct our way. 10 MR. HORTON: The taxpayer? 11 MR. SPERRING: We welcome the opportunity to 12 get to the right answer here. That's what we tried to 13 do during the audit process. That's why we've spent one 14 year with Franchise Tax Board attorney, providing him 15 information that he requested. And we have always been 16 willing to do whatever necessary to get to the right 17 answer. 18 One of the things I object to is the notion 19 that that first audit determination letter was an offer. 20 We're not making deals here. We're trying to get to the 21 right answer. And that's what Pacific Coast Builders is 22 committed to doing. This is a family business in 23 California. 24 And I guess the only thing I would ask -- and 25 I'm very happy to hear that -- Mr. Hilson's comments, 26 the only thing I would ask is that there be some, you 27 know, keeping in perspective here, this company has been 28 fighting this now for, you know, five years. And, you 119 1 know, this is a very legitimate California business here 2 that wants to stay here, wants to invest in these 3 communities. And they feel like the State is 4 persecuting them, okay. The IRS allowed all of the 5 credit, okay. FTB is only objecting to the refund 6 claims and there is a sense, I can, you know, speak for 7 the company, that they're feeling like they have been 8 mistreated. 9 And, so, the only thing I would ask is we don't 10 go through this -- you know, we'll give it our best, but 11 I don't want to come back two years from now and we're 12 in the same situation. That's the -- you know, the only 13 thing is that there be some respect to this company, to 14 the efforts that they have put forth to try to get their 15 taxes right. 16 MR. HORTON: Yeah, I think that's part of the 17 -- part of the concern here. I mean, as I mentioned in 18 the beginning, the issue of form over substance, I think 19 we need to clarify that. 20 I think we all need to play by the same rules 21 and understand what that is, it's just totally unfair to 22 have a set of rules and then those rules change in the 23 course of the activity. 24 When, in fact, we've got -- we've got clear 25 guidance from the courts as whether contemporary -- 26 contemporaneous evidence is totally necessary or you can 27 actually bifurcate the two and say, "Well, if we're 28 trying to determine qualified -- whether it qualifies or 120 1 not," well, you know, maybe form over substance really 2 doesn't apply. 3 I mean, at the end of the day, you're -- you 4 know, you're in a car accident and the -- the -- the 5 dent on side of your door indicates something happened 6 to cause that dent, so -- anyway, Member -- Member 7 Yee. 8 MS. YEE: Thank you, Mr. Chairman. 9 I'm just going to speak a little bit about the 10 frustrations that I've felt about this morning about the 11 testimony on both sides. 12 And, hopefully, we can kind of put some 13 parameters around how we look at the matter going 14 forward. 15 I really would like to focus on the tax years 16 at issue here. I really don't care about what the IRS 17 did for subsequent years. 18 It's maybe instructive, but, frankly, it gets 19 us away from the core issue about focusing on the 20 activities that took place during the tax years. And I 21 really would like that focus if we're going to decide to 22 put this matter over. 23 I thought Mr. Fraser's testimony was 24 compelling. I just want to see it documented. That's 25 what I'm looking for -- and contemporaneously 26 especially. 27 I -- it is -- I think with each of these 28 projects I don't doubt that there was some, you know, 121 1 scientific aspect or some technical aspect that was, you 2 know, being developed, tested. 3 But there is a fairly prescriptive requirement 4 with respect to the process of experimentation that has 5 to be documented. And however form that takes, whether 6 it's more -- if you've got AFEs that are more detailed, 7 if you've got e-mails that speak to test results, 8 whatever it is at the time, that's what we need to see. 9 And, again, you know, having seen cases where 10 the documentation has been robust, this really feels 11 lacking to me. I feel like I'm pulling at straws. I'm 12 trying to be helpful here because I think we all want to 13 arrive at the same conclusion, that the amount of tax is 14 the correct amount of tax. 15 So, I want to just kind of cabin off the issues 16 to the tax years at issue. I think we don't even kind 17 of look at the expense question until we get clear about 18 what the specific activities were that constitute 19 qualified research for each of these projects and what 20 documentation exists to, essentially, support that. 21 And contemporaneous is what I'm looking for 22 because, frankly, all this other stuff -- the tour, I 23 really did -- it really did corroborate at least the 24 committee memo with respect to the roofing modification. 25 But had I not taken the tour, I'm not so sure that I 26 would, you know, be there -- or if the committee memo 27 wasn't there about the roofing modifications, I wouldn't 28 be there. 122 1 So, it's -- non-contemporaneous documentation 2 alone doesn't do it for me. So, it's going to really 3 have to be going back to the basics of what -- what -- 4 what was actually substantiated at the time that the 5 activity was undertaken. 6 MR. HORTON: Further, discussion Members? 7 Member Mandel. 8 MS. MANDEL: It's -- it's interesting, but in 9 light of Mr. Hilson's comments, I guess, perhaps, 10 they'll be looking at some things. 11 The FTB does walk in with the presumption of 12 correctness and the taxpayer has the burden of proof, 13 but I appreciate Mr. Hilson's comments. 14 With respect to the -- I think this is the 15 mixing, the Basalite technical service, where you said, 16 Mr. Sperring, that these were contemporaneous documents 17 and that FTB, you know, didn't know what they said. 18 These documents appear to have been put into 19 the study. They have 6-3-05 date at the top. They 20 don't look like the actual document itself. Maybe this 21 was a printout out of a computer system or something, 22 but when you put something into your study that's not 23 the actual -- actual document, but then has a current 24 date at the top, even though it then has dates like 25 3-5-02 underneath, it -- it -- it tends to have a flavor 26 of reconstruction rather than this is a document that I 27 printed exactly from my computer system, but it's 28 because of the way you put it into the study. 123 1 And then when you have, you know, objective 2 resolution, I mean, these are doc -- as printed out of 3 the computer, which you're nodding yes, so, I'm taking 4 that's where it came from -- these are documents with 5 wording that means something to, I think -- I don't know 6 if this was Mr. Fraser -- but to -- to your -- to the 7 company personnel that someone else looking at, you say 8 this shows testing, it shows testing, it shows testing. 9 It shows an objective and a resolution. 10 They may not be able to get from this, because 11 they're not the guy inside the company who can say, no, 12 no, all -- and I'm making this up because I don't know 13 if 1 through 8 on here is the eight things I did until I 14 got to No. 8 and it worked. I don't know that. Maybe 15 that's not even what it means. 16 But if you're just going to put a document like 17 this into the record here, without a -- an attendant 18 explanation of why and how this document shows testing, 19 then you're counting on our staff and the Members, just 20 like Franchise Tax Board, to be able to understand it. 21 And, you know, it's -- it may not be the kind of 22 document that speaks for itself. 23 So, that's kind of some of the issue that I had 24 with these things on the mixing, was trying to 25 understand, you know, what the -- what the doc -- how 26 the document really showed the testing. 27 And then the -- the date thing makes you kind 28 of wonder where it did come from? And why is it printed 124 1 this way? Because it doesn't say that in -- or I didn't 2 get that from the materials. So, just a FYI for, I 3 don't know, this time or the next time. 4 MR. SPERRING: Thank you for your advice, 5 Ms. Mandel. 6 MR. HORTON: Mr. Runner. 7 MR. RUNNER: Yeah, I -- I mean, I think what 8 the -- the challenge that we have is that I think 9 everybody feels, especially in terms of some of the 10 explanation that was given, some of the things that were 11 observed, that there was qualified R & D that was taking 12 place. 13 The question is -- that seems to be before us 14 is whether or not the -- that was articulated clear 15 enough in -- in the documents that were done and 16 provided then through the audit. 17 Now I think that the thing that confuses that a 18 bit is that the taxpayer went through an audit, got a 19 letter saying it is -- it is righteous. And then ended 20 up saying, "Fine, let's go ahead and expand this now." 21 And, all of a sudden, there were some new rules 22 applied. I think that's very frustrating to taxpayers. 23 I don't think it's appropriate. 24 At the same time, I think what we need to do is 25 try to figure out how to clarify then the activities 26 that were taking place in order to get through that -- 27 that first step. Because I think -- again, I think 28 there's a general belief in the descriptions that were 125 1 done that it did. Again -- and to me that's -- to me, 2 that's how we treat taxpayers. I mean, the fact is 3 that, I think the goal of the -- of the policy is to 4 give benefit to taxpayers when it is that they are 5 choosing to do something in R & D that is supposed to 6 then somehow, you know, encourage and develop new 7 product, new investment, new sales. That's the public 8 policy that we like. And that's why we have an R & D 9 tax credit. 10 So, I think what we've got to do is figure out 11 now if that did take place. And that needs to be 12 articulated a little more clearly then, then -- then we 13 need to then make sure that the taxpayers then are 14 benefited by the tax policy that's in place, that is 15 there for the economic benefit of, not only, at that 16 point, a particular taxpayer, but we -- what we would 17 believe would be the right and benefit for us in our 18 society and why it is we want that investment done. 19 It's pretty clear to me that if you're going to 20 buy a piece of equipment and you're not sure it's going 21 to work and you're going to go ahead and mess around 22 with it and see if it works. Change it around, play 23 around with it and it doesn't work, that you did some 24 R & D. 25 You didn't just replace a piece of equipment 26 and knew it was going to be and plug it in your line 27 and, therefore, you have it in production. 28 You were trying something. It didn't work. 126 1 That's R & D. Sometimes it works, sometimes it doesn't. 2 So, I think we need to figure that out. Now, 3 my question, I guess, is where do we go from here? 4 Because I don't know -- it doesn't seem to me this is 5 what I would think of a a typical 30-30-30 where we're 6 going other get this resolved in the next thirty days 7 back and forth. 8 I'm looking for some thought and some guidance 9 as far as where we think -- now, the other thing is I'm 10 not sure I'm anxious about sending this away for two 11 years and then coming back and visiting it two years 12 from now. 13 MR. HORTON: Yeah. 14 MR. RUNNER: I'm open to some discussion about 15 where we think we should go from here. 16 MR. HORTON: Mr. Runner, with your -- with your 17 permission and indulgence, I think we can resolve 18 this -- I mean, there's quite a bit of evidence out 19 there -- within a relatively short period of time. 20 And I think the Members have provided some 21 direction. And I will certainly rely on Appeals to 22 codify that, the understanding of that. 23 And if I had to somewhat summarize it, the type 24 of evidence that does qualify, depending on what you're 25 looking at, Step 1, Step 2 or Step 3, the method of 26 accounting, just draw that distinction -- whether 27 project accounting, cost accounting, I don't think it 28 really matters to this body. And I don't think there is 127 1 legal support one way -- that justifies it one way or 2 the other. 3 In fact, the courts have ruled that you can 4 come up with other alternative methods other than those 5 two and the audit process and procedures and so forth. 6 And then -- this may be unique to me, but 7 certainly this whole notion of the -- policy notion 8 going forward as it relates to following the position 9 that -- I'm going to go to Appeals to see if they -- 10 they can embellish on that to some degree so that we can 11 assure ourselves that we are all on the same page, at 12 least, agreeing to ultimately get together and see if we 13 can figure this out. 14 MR. AMBROSE: Okay. What I understand the 15 general idea is is that the taxpayer and FTB are going 16 to get together. 17 FTB's going to tour the plant, talk to the 18 appropriate people on a project by project basis. 19 I thought that's what I heard you say, 20 Mr. Chairman, that you -- 21 MR. HORTON: I did. But I think the first step 22 is for them to get together and agree, to the extent 23 they can, on an audit process. Here's what we're going 24 to do, here's what the audit process will entail. 25 MR. AMBROSE: And in -- 26 MR. HORTON: Of course, I'd have to defer to 27 FTB's autonomy as a separate agency to make that 28 determination from their perspective. 128 1 MR. AMBROSE: -- right. I -- I think you 2 started out a while back kind of looking at us to ask 3 us -- to ask Appeals what we thought -- 4 MR. HORTON: Yes. 5 MR. AMBROSE: -- the taxpayer needed to 6 provide. 7 MR. HORTON: Yes. 8 MR. AMBROSE: Which I'm glad you didn't ask 9 that question, but -- 'cause I don't know. I mean, 10 it's -- you know, as you say, it's really, you know, 11 FTB's call. 12 So, I guess getting -- collecting my thought 13 again -- so -- so, the process will be, though, that the 14 parties will meet and figure out, as you just said, how 15 they want to proceed, kind of generally, like a 16 methodology -- 17 MR. HORTON: A methodology. 18 MR. AMBROSE: -- for evaluating each project. 19 MR. HORTON: Yes. 20 MR. AMBROSE: But maybe with an emphasis on 21 identifying each project. And -- I mean, breaking it 22 down that way. 23 MR. HORTON: Yes. 24 MR. AMBROSE: Okay. 25 MR. EPOLITE: Chairman Horton, if I could, I 26 would ask that going forward, the schedule that 27 Appellants provided last week of the 34 projects for the 28 six California facilities be used as the guideline of 129 1 the 34 projects that are at issue. 2 MR. HORTON: Yes. 3 MR. RUNNER: Uh-huh. 4 MR. EPOLITE: And based on that that the 5 contemporaneous documentation that the Board would be 6 looking for would be related to the process of 7 experimentation tests -- 8 MR. HORTON: Yes. 9 MR. EPOLITE: -- that Franchise Tax Board would 10 want to see from the taxpayer -- 11 MR. RUNNER: Uh-huh. 12 MR. EPOLITE: -- first of all. 13 Second of all, with these 34 projects 14 identified, once -- of those 34, the taxpayer comes up 15 with the contemporaneous documentation for specific 16 projects, also the taxpayer needs to tell us what dates, 17 periods of time each of these projects took place. 18 Because then you get to Step 2, the qualified 19 research expenses, when you're going to allocate 20 expenses to individual projects, you need to know the 21 time period for the wages in which those wages are 22 attributable to a particular project. 23 MR. HORTON: True. But let me digress, if you 24 will, and go back to just a qualified activity. 25 Contemporaneous information is a good starting 26 point but there is non-contemporaneous information, such 27 as the interviews, the testimonies, the observation, the 28 tour of the plant, the end results that occurred at the 130 1 end of day. 2 If I may use the tile plant, for example, a 3 total different product was developed. And inherent in 4 developing a totally different product that never 5 existed before is research, unless you presume that it 6 accidentally happened -- and I don't think that's the 7 case. 8 The plant -- the paper mill -- the testimony 9 was was that there was scientific research that had to 10 take place just in trying to determine how to break down 11 the chemicals in the particular paper product that was 12 now being recycled. In and of itself, it's indicative 13 of research and development. The degree of it is -- 14 someone's got to measure it besides us because there is 15 the audit process, that's not the adjudication 16 process. 17 MR. AMBROSE: And I -- I don't -- I dis -- I 18 agree with what you're saying. It's just that in the 19 process -- I mean, I see what you're saying about, you 20 know, you come out with an unresolved and it's a new 21 product and, you know, you can identify the business 22 component. And you know that there was some process of 23 experimentation involved, but there are also other 24 activities mixed in there that -- 25 MR. HORTON: May not be. 26 MR. AMBROSE: -- like quality control, that 27 sort of thing. 28 MR. HORTON: Right, yes. 131 1 MR. AMBROSE: So -- and I think that's why the 2 courts have typically, you know, not -- you know, held 3 fast to it, but have emphasized the contemporaneous 4 documentation is required. 5 I mean that's the problem. 6 MR. HORTON: I agree. I mean, I believe the 7 basis, but in and of itself. I mean, the 8 contemporaneous information has to get us to the point 9 of experimentation, has to get us to the point of 10 research. 11 MR. AMBROSE: Right. 12 MR. HORTON: Has to get us to the point that 13 this is technology -- related to technology. The 14 various basis within the law has to get us there. 15 But, in and of itself, the -- the end results 16 would imply that that contemporaneous information should 17 be there and the facts should be there. 18 And that, in my mind, shifts the burden to -- 19 or shares the burden in trying to discover it. So, I 20 don't think we are saying anything different, I think 21 we're all saying the same thing. 22 So -- and it appears that you have a fairly 23 good handle on it and that some discussions need to take 24 place. 25 Members, and, so, I would entertain a -- unless 26 there's further discussion? 27 MS. YEE: I -- 28 MS. STEEL: Quick comment. 132 1 MR. HORTON: Member Yee, then Member Steel. 2 MS. YEE: I still think the balance and the 3 weight of what we've seen to date has been short on the 4 contemporaneous documentation, but heavy on the 5 non-contemporaneous documentation. 6 MR. HORTON: I agree. 7 MS. YEE: And I appreciate the focus being 8 brought to the process of experimentation being more 9 specifically delineated. 10 I think to Ms. Mandel's point, perhaps the 11 study can also be a road map as well to essentially 12 break down the study so you can look at the supporting 13 documentation, hopefully, source documents that led you 14 to some of the components of the study, project by 15 project, as the Appeals Division has suggested. 16 But -- I mean that's -- I am really looking for 17 that piece of -- short of that being articulated, it 18 does -- I mean, I think one can assume that this is all 19 part of the normal, you know, business process of 20 quality control or just updating assets. And, I mean, 21 it's just -- there is just not enough there to really 22 suggest that there was, you know, some -- some, you 23 know, research. 24 I mean research is there, granted, because 25 we're dealing with a very, very scientific, technical 26 field. But when we're looking at what qualifies as 27 research -- what activity constitutes qualified research 28 in this context, again, the process of experimentation 133 1 is really highly prescriptive in the -- in the law. 2 MR. HORTON: Okay. Is there a motion, Members? 3 MS. STEEL: No, I just want to make one comment 4 here. 5 MR. HORTON: My apologies, Member Steel. 6 MS. STEEL: Thank you. 7 For the Franchise Tax Board, that first letter 8 went out from the first auditor for 80 percent is 9 allowed. 10 And then it seems like it was just when 11 taxpayer didn't agree, it's like little kids that, you 12 know, I'm going to take that 80 percent away from you. 13 And now that it's been for so many years and we are 14 sending this taxpayer back and spending time -- 15 Franchise Tax Board and taxpayer's time out there -- and 16 we searching again and trying to find out that's what 17 wrong and what's right and how much we are giving -- 18 this is really wasting taxpayer's money. 19 And they brought how many attorneys here that, 20 you know, how much this taxpayer's paying and wasting 21 time? 22 So, I really want to have the first letter or 23 any final letter goes out, I want to keep that as a word 24 from Franchise Tax Board begin with. 25 And second, before it comes to the Board 26 hearing, I want everythings to done and then come to us. 27 Because, you know, this is wasting our time too. It's 28 1 o'clock and we've spent more than three hours now and 134 1 we are sending back and we are asking them to come back. 2 So, we really have to do a little better job and try to 3 help taxpayers here. 4 Thank you. 5 MR. HORTON: Further discussion, Members? 6 Hearing none, is there a motion? 7 MS. YEE: Yeah. 8 MR. RUNNER: A motion -- 9 MR. HORTON: Let me -- let me ask Mr. Epolite a 10 question to respond to Mr. Runner's inquiry. 11 Having the matter -- in order to accomplish the 12 objectives set forth by the Members and, at the same 13 time, have the opportunity to hear the testimonies 14 again, what would be your recommendation in order for us 15 to accomplish those objectives? 16 MR. EPOLITE: As far as the time period is 17 concerned, substantially less than two years. I would 18 think 60 to 90 days, perhaps, for -- once the additional 19 briefing letter is issued by Appeals -- for FTB to make 20 a tour of the facilities and for Appellant to then get 21 its documents together. 22 And then once that 90 days is up, then a period 23 for Franchise Tax Board to -- to review the 24 documentation, submit it. 25 MR. AMBROSE: Well -- and then, I -- then 26 they're going to need a period to file a brief and, 27 then, of course, Appellants are going to have an 28 opportunity to respond. 135 1 So, I -- I would think six months. I -- that 2 would be my recommendation. 3 MR. HORTON: So, you are recommending we put 4 this over for six months? 5 MR. AMBROSE: Yeah, bring it back in six 6 months. 7 MR. HORTON: Mr. Runner -- 8 MR. RUNNER: That answers my question. And I 9 think it's a reasonable time frame. 10 Let me just ask, did I understand that this 11 process will begin with Appeals then -- 12 MR. EPOLITE: Yes. 13 MR. RUNNER: -- stating back to FTB and the 14 taxpayer what the road map will be? 15 MR. EPOLITE: Yes. 16 MR. RUNNER: Okay. 17 MR. HORTON: Ms. Mandel. 18 MS. MANDEL: Thank you. And -- and if there's 19 the -- the briefing, it's not really legal argument, but 20 why the material proves the facts that I need to prove? 21 MR. AMBROSE: Right, yeah. I don't think we're 22 arguing law here, I think we're arguing -- I mean, we -- 23 MS. MANDEL: They're going to walk through why 24 this works or why it doesn't work? 25 MR. AMBROSE: Right. I mean, that's my 26 understanding. 27 MS. MANDEL: Okay. 28 MR. AMBROSE: You too? 136 1 MR. EPOLITE: Yeah. 2 MR. HORTON: Okay. Just a general question, 3 any other comments from the Department or the taxpayer 4 relative to what just took place? 5 Hearing none, Members, is there a motion? 6 Mr. -- 7 MR. RUNNER: Motion to have it come back to us 8 in six months for -- 9 MR. HORTON: Mr. Runner -- Mr. Runner proposes 10 that the Board put this matter over for a period of six 11 months to have six months divided evenly to allow the 12 process to take its course, as articulated by the 13 Appeals unit. 14 There is a comment over here? 15 MR. AMBROSE: I have a question. 16 Do you want to -- do you want it to be brought 17 back as an oral hearing? 18 MR. HORTON: Yes. 19 MR. AMBROSE: You do? Okay. 20 MS. YEE: Yes. 21 MR. HORTON: Yes. 22 MR. AMBROSE: Thanks. 23 MR. HORTON: So, that's -- that's the reason 24 I'm just putting it over -- 25 MR. AMBROSE: Okay. 26 MR. HORTON: -- to allow this process to take 27 place. 28 Okay? 137 1 MR. RUNNER: Right. 2 MR. AMBROSE: Okay. 3 MS. YEE: I'll second the motion. 4 MR. HORTON: It's been -- second by Member 5 Steel -- Member Yee. 6 Without objection, Members, such will be the 7 order. 8 Thank you very much. 9 MR. SPERRING: Thank you. 10 ---oOo--- 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 138 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 12, 2012 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 38 and 79 through 113 constitute a complete and 14 accurate transcription of the shorthand writing. 15 16 Dated: October 10, 2012 17 18 19 ____________________________ 20 KATHLEEN SKIDGEL, CSR #9039 21 Hearing Reporter 22 23 24 25 26 27 28 139 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 12, 2012 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 39 through 78 and 114 through 138 constitute a complete 14 and accurate transcription of the shorthand writing. 15 16 Dated: October 10, 2012 17 18 19 ________________________________ 20 JULI PRICE JACKSON 21 Hearing Reporter 22 23 24 25 26 27 28 140