1 BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 2 450 N STREET 3 SACRAMENTO, CALIFORNIA 4 5 6 7 8 REPORTER'S TRANSCRIPT 9 NOVEMBER 14, 2012 10 11 SALES AND USE TAX APPEAL HEARING 12 APPEAL OF 13 EAST BAY SUPPLY, INC. 14 NO. 457738 (BH) 15 AGAINST PROPOSED ASSESSMENT OF 16 SALES AND USE TAX 17 18 19 20 21 22 23 24 Reported by: Juli Price Jackson 25 CSR No. 5214 26 Kathleen Skidgel 27 CSR No. 9039 28 ---o0o--- 1 1 2 P R E S E N T 3 For the Board Jerome E. Horton of Equalization: Chairman 4 5 Michelle Steel Vice-Chairwoman 6 7 Betty T. Yee Member 8 9 George Runner Member 10 11 Marcy Jo Mandel Appearing for John 12 Chiang, State Controller (per Government Code 13 Section 7.9) 14 Joann Richmond Chief 15 Board Proceedings Division 16 17 For Board of David Levine Equalization Staff: Staff Counsel 18 19 For Department: Scott Lambert Hearing Representative 20 21 Kevin Hanks Chief, Headquarters 22 Operations Division 23 Bradley H. Heller Legal Department 24 25 For Petitioner: Jesse W. McClellan 26 Representative 27 28 ---oOo--- 2 1 450 N STREET 2 SACRAMENTO, CALIFORNIA 3 NOVEMBER 14, 2012 4 ---oOo--- 5 MR. HORTON: Ms. Richmond, what is our next 6 item? 7 MS. RICHMOND: Good afternoon, Members. Our 8 next item is C8, East Bay Supply, Inc. 9 Please come forward. 10 MR. HORTON: As the taxpayer comes forward, we 11 would ask that Mr. Levine introduce the issues in this 12 case. 13 MR. LEVINE: Good afternoon, Chairman Horton, 14 Members. David Levine for the Appeals Division. 15 The issue in this petition of East Bay Supply, 16 Inc. is whether additional adjustments are warranted to 17 the amount of understated taxable sales. 18 MR. HORTON: All right. 19 MR. MC CLELLAN: Thank you, Chairman and 20 Members of the Board. 21 That just -- Jesse McClellan, appearing on 22 behalf of the Petitioner, East Bay Roofing Supply, Inc. 23 What I'd like to do is briefly outline some 24 background and relevant facts related to the business 25 operations, outline the -- some facts and relevant 26 information to the audit and then set forth the reasons 27 why we believe the audit should not stand. 28 The business is a retailer of roofing material 3 1 supplies and also provides services, primarily to load 2 those roofing materials to the rooftops of new homes and 3 to spread those materials. Much of what it sells is 4 composite tiles, which is -- essentially is concrete. 5 It's very heavy. And it's a labor intensive process. 6 The -- the taxpayer's revenue is primarily 7 generated through sales to large home builders. 99 8 percent of its revenue is generated through sales to 9 builders of new home construction projects for 10 subdivisions and things of that nature. Approximately 1 11 percent of its revenue is generated from low volume 12 sales to individual homeowners or to speciality 13 contractors. 14 If you look at Exhibit 1 that we provided, 15 there's an invoice which is typical of the methodology 16 used by the taxpayer throughout the audit period. It 17 separately states an amount for the materials sold, for 18 delivery of those materials to the job site and for the 19 separate service. 20 The prices that were established and charged on 21 those invoices were freely and openly negotiated prices 22 with the taxpayer's customers. And there's two primary 23 influencing factors on those prices that we think are 24 relevant to this case. The first is that the 25 manufacturer of these tiles will actually job quote the 26 price of the tiles to the builders. 27 So, when my client goes to a builder to bid a 28 job, the builder knows what my client has paid for those 4 1 tiles and what he can purchase them for. That creates a 2 situation where there cannot be a high markup. And the 3 other factor is that the competitors to my client are 4 under the same circumstances and also sell the same 5 tiles, the exact same tiles, at a very low markup. 6 And I think the second factor is really what 7 controls in that the builder is going to purchase the 8 goods at the lowest price available. 9 With respect to the audit background, this case 10 is approximately eight years old. It initially came to 11 us out of the Oakland District office. And at that time 12 the Department alleged that the taxpayer made sales of 13 its goods and services for a delivered price and, 14 therefore, the full measure of the sale was taxable. 15 We presented the taxpayer's invoices and 16 contracts, ultimately established that that claim was 17 not correct. 18 The Department then went on to allege that the 19 services were taxable because the goods -- the title to 20 the goods didn't transfer prior to the service being 21 provided. 22 We again demonstrated that was not the case. 23 And at this point it's undisputed that the services are 24 not taxable. 25 So, the issue today is focused on the materials 26 that are sold by this taxpayer. 27 The -- the Department had conducted an audit 28 whereby they disallowed a portion of the exempt sales. 5 1 We went to an Appeals conference on that audit and the 2 current audit was recommended by the Appeals Division, 3 which ultimately brings us here. 4 We have not formally disputed the audit. So, 5 the issues that are presented today are really the first 6 time that these issues are being formally addressed. 7 And -- and the method that was used by the 8 Department in the audit we believe is unsupported by 9 well-established Board of Equalization policy and 10 underlying federal and State law. And we believe that 11 the taxpayer is free to negotiate a selling price with 12 its customers. 13 In order to establish what the Department 14 believed this taxpayer should have sold his goods for, 15 they looked at the 1 percent segment of revenue that I 16 referenced earlier. Again 99 percent of this taxpayer's 17 sales are made to home builders. There is a large 18 volume of tiles that are being sold under those 19 transactions. Oftentimes they're for subdivisions, 20 where there's going to be dozens of homes being built, 21 versus what you and I potentially could go in and buy 22 some of these tiles for. And many of those occasional 23 small volume tile sales actually consisted of scrap 24 materials, leftover materials from the larger jobs. 25 Those were the transactions that were used to establish 26 a markup that is being applied to the cost of this 27 taxpayer's large volume sales. And -- and we believe it 28 runs afoul of well-established audit principles. 6 1 It would be tantamount to suggesting that you 2 could go into a convenience store and buy a candy bar 3 and expect to pay the exact same price if you were to go 4 to Costco. Except for in this case the volume 5 differences are actually much larger. 6 There's several annotations that we believe are 7 applicable to the issues in this case. And there's also 8 several court cases that we believe are applicable. 9 Most applicable, from our perspective, is 10 Annotation 295.0646. That's an annotation that dates 11 back to 1973. And it addresses a scenario where a gas 12 station operator started to provide a car wash service 13 in conjunction with its sales. In order to promote that 14 service, the -- the gas station lowered its selling 15 price of the fuel. So, in other words, if someone came 16 in and purchased fuel, they'd be charged one price; if 17 they purchased fuel and also purchased the car wash, 18 which was established to be an exempt service, then the 19 fuel selling price was reduced. 20 Ultimately the question was whether or not 21 a portion of the exempt service should be attributed to 22 the fuel sales. And it was established by the Legal 23 Department that it should not be. And in doing so, they 24 cited Halley v. Johnson, (verbatim), a 1943 case. The 25 facts are not obviously analogous strictly to this 26 scenario, but the principle remains the same. 27 The Department suggests that this -- or that 28 the competitors to this taxpayer and the markup that 7 1 they charge for their goods is irrelevant to what this 2 taxpayer charges for his goods. And to me that runs 3 afoul of, I believe, well-established business 4 principles. If you can buy a good for a lower price, 5 then you're generally going to elect lower price. And 6 in this case where you have a high level of competition 7 and a period of time where there was a very high level 8 of building in the market -- and in his particular 9 area -- the builder is going to select, generally, the 10 lower price. So, the competitor prices are absolutely 11 relevant. 12 And one of the things we were able to do was to 13 get statements signed by two of the taxpayer's 14 competitors. And those are presented in Exhibit 2 and 15 3. And the information and the facts set forth in there 16 state that in this industry they don't sell for markups 17 higher than a single digit markup. 18 There is also a suggestion in the audit that 19 there is actually a negative markup on this taxpayer's 20 sales of materials. That was the purpose of providing 21 Exhibit 1. The recorded cost of goods sold on the 22 federal income tax return that was used for that purpose 23 appears to include non cost of goods sold items. And 24 ultimately what was disclosed through a review of these 25 high volume sales is that the markup that is used by the 26 taxpayer averages 5 percent. 27 This is not a situation where it's a cash based 28 business and the Department is using a markup to 8 1 establish gross receipts. Ultimately what's being done 2 is there's been an increase in the selling price to this 3 taxpayer's goods. And we believe that the taxpayer has 4 the right to negotiate a price with its purchasers -- 5 and it did so in this case in good faith -- and that, 6 ultimately, its reported gross receipts and taxable 7 sales should be accepted. 8 Thank you. 9 MR. HORTON: Thank you. Thank you as well. 10 We'll now go to the Department. The Department 11 has ten minutes to make their presentation. 12 We'd ask that you commence with your 13 introductions for the record. 14 MR. LAMBERT: Good afternoon, Chairman 15 Horton -- 16 MR. HORTON: Good afternoon. 17 MR. LAMBERT: -- and Members. 18 My name is Scott Lambert and I'll be 19 representing the Sales and Use Tax Department today. To 20 my right is Kevin Hanks, also with the Sales and Use Tax 21 Department and to Mr. Hanks' right is Bradley Heller 22 with the Legal Department. 23 In this particular case the taxpayer is a 24 supplier of roofing material. In -- the audit period 25 starts with 2001. In 2001 the taxpayer merely provided 26 or sold building materials to home builders and 27 delivered those materials to the job site. 28 Starting in the second quarter of 2002 the 9 1 taxpayer started a new line of business, which was 2 spreading roofing materials on the roof of the new homes 3 for roofing contractors to install that material. So, 4 there is no installation that's involved in this 5 particular case. The taxpayer -- in regards to East Bay 6 Supply, Inc. -- is not a construction contractor. They 7 are merely a retailer of material, tangible personal 8 property. 9 In 2001, when they had only the sales of 10 materials, the markup in the books was 28 and a half 11 percent. When they went to the spreading services, the 12 markup on the materials in 2002 dropped to a negative 15 13 percent and in 2003 to a negative 21 percent. 14 So, the question has to be asked, why exactly 15 could they get up a markup of 28 and a half percent in 16 the year before and, in effect, your material would 17 decrease by 40 percent during that -- when that service 18 was provided. 19 The markup that was used in the audit was from 20 2001. It was not from a shelf test of over-the-counter 21 sales. There was a test that was done for 22 over-the-counter sales. The markup came out to about 27 23 percent. It was limited in scope and limited in numbers 24 in regards to the invoice items. The Department could 25 not assert that it was a representative sample. But, 26 nonetheless, there was a material markup of 27 percent 27 for over-the-counter. 28 The taxpayer -- I'm sorry -- the customer will 10 1 receive a verbal quote from East Bay Supply. This -- 2 there is no signed contract that the Department is aware 3 of. We were also informed that it's a lump sum figure 4 that's provided to the customer. And if you look at the 5 sales invoices that were provided, for the most part, 6 they're round numbers. They -- they come to an exact 7 dollar amount within a penny. 8 So -- so, the Department does not argue that 9 there were some contracts that had a markup, such as the 10 invoices that have been provided in this particular 11 case, our argument is that when you take a look at the 12 overall markup of all the sales that took place in 2001, 13 which we believe these invoices would be representative 14 of that year, that you're going to come to a 28 and a 15 half percent markup for 2001. So, you're going to have 16 these types of invoices in that group. And -- but, 17 overall, it's going to be 28 and a half percent. 18 In terms of the breakdown, what was included in 19 the cost of goods sold, in 2000 -- in 2001, 2002, 2003, 20 the Department is unaware of any changes in the 21 taxpayer's method of recording purchases. Therefore, 22 when the cost of goods sold for -- used for 2001 and it 23 came to 28 and a half percent, it is similar to the cost 24 of goods sold that are in 2002 and 2003. 25 Therefore, unless it is shown that there is a 26 difference in the cost of goods sold makeup, the 27 Department wouldn't recommend any adjustment. 28 On that note, the -- the Department does 11 1 recognize there was an oversight with the application of 2 taxable percentage for the year 2002. A percentage was 3 applied to the entire year when it should have only been 4 applied to the last three quarters of the year. 5 The tax, although it would go up $130 just 6 because of the anomaly with the District taxes, that the 7 interest drops -- interest drops $711 and the amnesty 8 interest penalty would drop $390, for a net decrease of 9 $970. 10 The Department would be willing to -- to 11 stipulate that we would recommend -- or we would 12 recommend to make that adjustment -- not a stipulation. 13 Accordingly, the Department concurs with the Appeals 14 Division decision and recommendation. 15 MR. HORTON: On rebuttal. 16 MR. MC CLELLAN: Thank you. 17 Some of the facts that he set forth, I 18 disagree. 19 MR. HORTON: Do you want to start on the 20 stipulation? 21 MR. MC CLELLAN: Uhmm -- 22 MR. HORTON: So stipulated? Maybe? Not? 23 MR. MC CLELLAN: I would -- I would stipulate 24 to any reduction in the measure he's suggesting -- 25 MR. HORTON: All right. 26 MR. MC CLELLAN: -- or interest. 27 As far as some of the facts that he set forth, 28 I'm flipping through these now. And there is a number 12 1 of prices that don't end in an even number. So, I'm not 2 sure what he's relying on with respect to that 3 conclusion. 4 There were contracts presented to the District 5 office. And those contracts include an attachment which 6 lists these prices, itemized by lot number. And if you 7 look at the invoices, that's what's presented here. 8 With respect to the 2001 markup being applied 9 in order to establish the audit liability, I understood 10 that that small segment of sales is what was used and 11 what was recommended in the Decision and Recommendation, 12 but, ultimately, the analysis doesn't change. 13 The 2001 book markup, No. 1, like the 2002 and 14 2003 book markup, hasn't been verified. The way to do 15 that is to take a look at the actual sale invoices, the 16 actual purchase invoices during that period and to 17 establish what they actually purchased the goods for and 18 what they sold it for and what the difference was. Out 19 comes the markup. 20 Now with respect to the period prior to them 21 offering this service, it's clearly a different business 22 dynamic. It's not the same as what is in place during 23 the audit period. So, the facts that they're relying 24 upon to justify what they're doing contradicts the 25 principles of auditing. You don't take an 26 unrepresentative period of the business to establish a 27 markup and apply it forward. How long does that markup 28 apply for -- two years, three years, two days, two 13 1 weeks? It's not the way that works. 2 We have records for every sale that occurred 3 during the audit period. If they want to establish what 4 the markup is on these sales, it certainly can be done. 5 If the suggestion is that the taxpayer cannot 6 alter its selling price or the markup on its sale of 7 goods, then I would ask for some sort of authority to be 8 provided in order to have that sort of mandate and price 9 setting. 10 Ultimately, the dynamics of this taxpayer's 11 business changed. We have third party affidavits from 12 competitors saying that they don't sell at anything 13 higher than a 1 percent -- or, I'm sorry, a single digit 14 markup. 15 If this taxpayer sold his goods at what the 16 Department suggests he should have, then we wouldn't be 17 sitting here because he wouldn't have a business. The 18 competitors would still be in business, but he would 19 not. 20 He has every right to sell his goods at a low 21 markup. And he did so through a negotiated price and 22 through market forces which establish what he could sell 23 his goods for. He, like any other business, sold his 24 goods and services for the highest possible price he 25 could in order to continue business, to generate 26 revenue, to pay his employees and so forth. 27 There was no design, there was no effort to 28 lower the tax obligation on his sales. In fact, this 14 1 taxpayer overpaid tax. He paid tax on, I want to say, 2 $1.6 million worth of purchases of tiles during the 3 audit period and then he turned around and charged tax 4 on the sale of those same tiles. So, there's -- there's 5 been no implication of that. 6 But, ultimately, the only thing that I can find 7 that would support the Department reestablishing a 8 selling price under the law and under the Board's 9 established policy is that it was found that this 10 taxpayer went out and intentionally altered its selling 11 price in an effort to minimize its tax. That simply is 12 not the case here. 13 And with respect to using a period outside of 14 the relevant audit period to establish a markup, it's 15 not representative because it's a different dynamic in 16 the business. 17 For those reasons, we ask that the petition be 18 granted. 19 MR. HORTON: Thank you. 20 Discussion, Members? Member Steel. 21 MS. STEEL: So, when this business start 22 selling the materials to builders? 23 MR. MC CLELLAN: Uh-huh. 24 MS. STEEL: Because 2001 it seems like it was 25 over the counter and to the homeowners or some single 26 sales. 27 MR. MC CLELLAN: Uh-huh. 28 MS. STEEL: So, it's been changed from 2001 to 15 1 2004? 2 MR. MC CLELLAN: That's correct. It's -- 3 MS. STEEL: When it really started? 4 Because I heard that 2002 it started, that 5 delivering and put it on the top of the roof and so 6 tried to do some services. 7 But when it start -- the businesses started 8 selling materials to the builders? 9 MR. MC CLELLAN: I don't know the exact date of 10 when they started providing the service versus only 11 selling materials. But I believe it occurred at some 12 point in 2001. 13 And my understanding is that the -- the markup 14 on the tile sales, even leading up to that period, prior 15 to them providing the service, started to decrease 16 dramatically because of market forces, because 17 competitors would sell for less. 18 MS. STEEL: Right. So, you agree that 2001, 19 first part of 2001, the markup was about 28 percent? 20 MR. MC CLELLAN: Well, no, because I haven't 21 been able to verify that. 22 There is an achieved markup, meaning they -- 23 what's reported for federal income tax return purposes 24 against the revenue generated from the sale of materials 25 appears to -- well, that said, there is a 28 percent 26 markup. 27 MS. STEEL: Right. 28 MR. MC CLELLAN: But if you look at the 16 1 subsequent periods, there's a negative markup by that 2 same calculation. 3 But when you go in and you look at the actual 4 transactions and you see that they purchased tile for 5 $44 per square, they sold it for $54 per square -- or 6 whatever the selling amount was. 7 MS. STEEL: So, average was not 28 percent? 8 That's what you're saying? 9 MR. MC CLELLAN: I don't know that it is. 10 MS. STEEL: So, you don't know. 11 But all the invoices been provided? 12 MR. MC CLELLAN: All the invoices have not been 13 requested. They haven't been provided. 14 MS. STEEL: So, you -- 15 MR. MC CLELLAN: They all -- 16 MS. STEEL: -- just gave them sample -- gave 17 the Department only samples of invoices? 18 MR. MC CLELLAN: -- upon request we provided 19 what they wanted to sample. 20 And what they wanted to sample was these small, 21 low volume jobs. They had no interest in reviewing the 22 actual builders' sales. 23 MS. STEEL: So, you have all of those invoices 24 then? 25 MR. MC CLELLAN: Absolutely. The taxpayer 26 still has them. 27 MS. STEEL: So, why we didn't even request all 28 the invoices? And we were using just a sample to come 17 1 up with 27 percent with the samples and why we are 2 applying 28 percent for these taxes? 3 MR. LAMBERT: The 28 percent was the markup of 4 record from 2001. 5 MS. STEEL: Right. 6 MR. LAMBERT: That was for an entire year. We 7 felt that -- 8 MS. STEEL: But do we agree that business 9 practice was changed from 2001 to 2004? 10 MR. LAMBERT: Well, I have a little different 11 understanding of what happened. 12 The -- the customer -- the customers did not 13 change. In other words, they're not selling to -- to 14 the builders. They had already been selling to the 15 builders. This was just a matter of them providing 16 rooftop service -- 17 MS. STEEL: But then -- 18 MR. LAMBERT: -- to them. 19 MS. STEEL: -- that 28 percent of markup is it 20 way too high if they were selling the builders, not 21 the -- what they call, private customers? 22 MR. LAMBERT: The contractors? 23 MS. STEEL: No, not contractors, but home 24 owners -- 25 MR. LAMBERT: Home owners? 26 MS. STEEL: -- single home owners -- 27 MR. LAMBERT: Uh-huh. 28 MS. STEEL: -- that should be 28 percent, 18 1 understandable. 2 But when you are selling to the contractor, 3 it's totally different matter here. 4 MR. LAMBERT: Well, all I can tell you is 5 what's in their records. It shows a 28 and a half 6 percent markup for 2001. 7 That isn't something that we developed. That's 8 their actual records. 9 MS. STEEL: But why didn't we ask them the full 10 invoices then what they have? 11 They have all the documents there but we are 12 not even asking, but we are using only sample, means 13 that we are kind of -- 14 MR. LAMBERT: Right. 15 MS. STEEL: -- assuming that they must be 16 owing -- owing us that 28 percent of the markup. 17 So, it's just -- I just don't understand that. 18 What's our practice to go out there because a lot of 19 cases that we see that taxpayers don't have invoices or 20 Z-tapes or that's the way they get caught. 21 But for this case, that this taxpayer have all 22 the invoices, all the documents, why we are just 23 selecting few samples and coming out with the numbers? 24 MR. LAMBERT: Well, this -- this is the entire 25 case, which is in 2001 our evidence shows that they were 26 selling without any spreading. There was no deduction 27 on the sales and use tax returns without a labor -- or 28 there was no labor charge that was claimed. 19 1 MS. STEEL: So, we didn't even look at any 2 documents from 2002 to 2004? 3 We are just -- 4 MR. LAMBERT: No, no, we took a look at those. 5 I mean, we -- we wanted to make sure that the sales were 6 properly reported in 2001. We were satisfied with that 7 and the 28 -- 8 MS. STEEL: That was only a sample? 9 MR. LAMBERT: -- and a half percent markup. 10 There's no -- just to be clear, there's no 11 question or we're not questioning the total sales that 12 were reported by this taxpayer. 13 MS. STEEL: Right. 14 MR. LAMBERT: That we're say -- 15 MS. STEEL: But its markup -- 16 MR. LAMBERT: -- it's -- well -- 17 MS. STEEL: -- and then who they sold to? 18 MR. LAMBERT: -- it's the markup on the 19 materials. And our concern -- why we didn't want to 20 look at the invoices that they have, where they've made 21 the allocation between the spreading charges and the 22 materials, is that the way that they're quoting them is 23 for a lump sum price and an even dollar. 24 And our opinion is is that they were making an 25 allocation on their own. So, in other words -- 26 MS. STEEL: But that's kind of an assumption? 27 It's your opinion -- 28 MR. LAMBERT: Assumption? 20 1 MS. STEEL: -- means because it's not really 2 clear and exact numbers here. That's what I'm asking. 3 MR. LAMBERT: Well, the reason why we felt that 4 is because when you take a look at the overall markup on 5 the materials, it's a negative amount for 2002 and 6 2003. 7 MS. STEEL: Okay. So, hold there. 8 So, how this business can be survived when you 9 have negative markup that this taxpayer reported? 10 MR. MC CLELLAN: And that was the purpose of 11 providing Exhibit 1 is Exhibit 1 consists of actual 12 sales from 2002, a period in which there is an achieved 13 negative markup. 14 And it's somewhat consistent. It doesn't 15 happen on a high percentage of cases that we come 16 across, but we do see scenarios where the cost of goods 17 sold that are reported on the federal income tax returns 18 include accounting figures in there that don't represent 19 actual purchases of the goods that are sold. 20 And that appears to be the case here. With -- 21 with roofing material suppliers, they have discounts. 22 They have the pallet fees. And they have incentives and 23 various other things that -- 24 MS. STEEL: So, you're getting -- this taxpayer 25 was getting income from other sources but from the 26 materials is that what you are saying? 27 'Cause -- 28 MR. MC CLELLAN: Well, the -- 21 1 MS. STEEL: -- it seems to me that you told us 2 that if you don't compete with other this kind of 3 businesses, then he's going to be out of business. 4 But you do markup, minus markups, then he's 5 going to be out of business either way. 6 So, that's why I'm asking you. 7 MR. MC CLELLAN: Right. Well, he doesn't 8 actually sell his goods for less than what he buys them 9 for is what it comes down to. 10 And we went in -- I asked the taxpayer to pull 11 invoices from 2002. His office manager provided nine 12 invoices with the actual purchases. 13 MS. STEEL: Why didn't provide all the 14 invoices, even the Department wants to look at it or not 15 because business practice changed from 2001 to 2004, 16 so -- 17 MR. MC CLELLAN: We wanted to. 18 MS. STEEL: -- but Department was refusing to 19 get it? 20 MR. MC CLELLAN: They didn't -- if you read the 21 Decision and Recommendation -- and I did so again 22 today -- they didn't want to look at those invoices. 23 What it comes down to is the Department says 24 that this taxpayer sold at a 28 percent markup that 25 they've established through this -- achieved markup 26 through the federal income tax return cost of goods sold 27 and determined, through, apparently, their expertise in 28 the market arena, that that was the appropriate markup 22 1 to sell at and that what this taxpayer did sell at, I 2 guess, wasn't high enough. 3 But it wasn't a negative markup. He did apply 4 a markup to his material sales. 5 MS. STEEL: That -- I still don't understand 6 why we didn't get all of the invoices. You didn't check 7 everything. You just did the markup, 28.5 percent and 8 then just you went through -- it really doesn't matter 9 that, you know, business practice was changed or not. 10 And what -- what's our practice here? 11 MR. LAMBERT: Well, our argument's going to be 12 is they didn't make a proper allocation. When -- they 13 provided the nine invoices and it -- from what it looks 14 like, it -- based on the information they provided, 15 there is a minor markup on these. It's our opinion that 16 these are not representative of the totals for 2002 and 17 2003. 18 MS. STEEL: But they're ready to provide all 19 invoices. 20 MR. LAMBERT: Well, we -- we can -- we can take 21 a look at them. The problem is when you're looking at 22 the invoices where they have the spreading charges, it's 23 our opinion that they're arbitrarily putting the selling 24 prices down there. 25 On these you have the load -- the spreading 26 charge -- I'll call it a load, it's called roof -- 27 rooftop delivery, but we'll -- it's also known as 28 spreading. 23 1 You take a look at these and the spreading 2 charge is about equal to the sale of the materials. But 3 there's quite a few other -- other contracts that we've 4 looked at where it's double or triple -- the labor to 5 spread the material on the roof is greater than the 6 material itself. 7 MS. STEEL: Could you explain that? 8 MR. MC CLELLAN: Absolutely. The -- the prices 9 that are presented on these invoices are the prices that 10 are agreed to between the taxpayer and its customer. 11 If its customer said that, "I'm not buying 12 these goods or services at this price," then it wouldn't 13 pay for them. If it said that the service was too high, 14 that the price charged for the service was too high, 15 then they wouldn't agree to the -- they wouldn't agree 16 to the bargain. This is a contractual negotiation 17 between two parties. 18 The Department is making an allegation that 19 really has been implied up to this point, it's never 20 come out and said to me -- and I've been involved with 21 this case for, I think, seven years now -- that, "Look, 22 we think there was an arbitrary allegation -- or an 23 arbitrary allocation in an effort to minimize the tax." 24 And, ultimately, in doing so what they're saying is that 25 these transactions are not bona fide. 26 Well, there is -- there's a presumption of good 27 faith and fair dealing in all transactions. And an 28 allegation isn't sufficient to support what they're 24 1 suggesting. 2 And if you look at the evidence, Miss Steel, it 3 shows that competitors are selling these same goods for 4 what this taxpayer sold them for. 5 MS. STEEL: Okay. Thank you. 6 MR. HORTON: Member Yee. 7 MS. YEE: Thank you, Mr. Chairman. 8 There have been a couple of re-audits in this 9 matter. And I just wanted to walk through, if I could, 10 some of the adjustments and ask some question about 11 that. 12 With respect to the first re-audit, so, you 13 established the 2002-2003 audited taxable sales by 14 adding the recorded book markup for 2001 and the cost of 15 material sales for the subsequent years? 16 MR. LAMBERT: In this -- we're -- that's 17 correct. 18 MS. MANDEL: Okay. And then in preparing the 19 re-audit you reduced the measure by over a million 20 dollars. 21 And can you talk about that? What that was 22 attributable to? 23 MR. LAMBERT: Yes. The audit approach at the 24 beginning was to approach it from the labor standpoint. 25 And, so, what we tried to do was come up with a -- a 26 reasonable amount of spreading labor. 27 The problem here is is that we -- there's -- 28 during the period of time where they started the 25 1 spreading, we don't have any examples of where they just 2 spread somebody's materials, but -- by themselves or 3 where they sold to the builders without the spreading. 4 And, so, then it -- it became difficult to try 5 and determine what's a reasonable charge for the 6 spreading. And we attempted to do it from that 7 standpoint. 8 But when you ultimately looked at how that 9 original audit markup was on the tangible personal 10 property, I believe it was 41 percent, and the 41 11 percent was substantially higher than the 28 and a half 12 percent from 2001. 13 And, so, consequently, the Appeals Department 14 felt that -- and rightfully so -- that we didn't -- it 15 wasn't reasonable what we came up with. And, so, we 16 switched the approach from trying to verify the labor to 17 taking a look at the sale of tangible personal property. 18 MS. YEE: Okay. And the nine invoices that you 19 looked at that were representative, can you talk about 20 how they were selected? 21 MR. LAMBERT: Well, the nine invoices that 22 we're talking about here were provided for this 23 Appeals -- 24 MS. YEE: Okay. 25 MR. LAMBERT: -- or, I'm sorry, Board hearing. 26 MS. YEE: I'm sorry, okay. 27 MR. LAMBERT: But we did have -- 28 MS. YEE: But you looked at other -- 26 1 MR. LAMBERT: -- yes. 2 MS. YEE: -- you looked at others? 3 MR. LAMBERT: Yes, we -- 4 MS. YEE: Sorry. 5 MR. LAMBERT: -- they provided -- the Decision 6 and Recommendation asked the taxpayer to provide us with 7 sales that did not have spreading charges. 8 MS. YEE: Right. 9 MR. LAMBERT: And they provided us with a -- 10 five invoices. And based on the costs associated with 11 those sales, it came to a 27 percent markup based on -- 12 on the invoices that were provided by the -- by the 13 taxpayer. 14 MS. YEE: Okay. So, the issue here is that 15 there is, I guess, no consistency or just kind of a wide 16 range of variability in terms of the labor charges and 17 the tangible personal property? 18 MR. LAMBERT: Well, right. They go from 2001, 19 where they're -- have a 28 and a half percent markup 20 that they're billing to the same people that they're 21 turning around with a negative markup. And within a one 22 quarter period, the material -- the selling price of the 23 materials drops significantly. And that's really what's 24 at issue here. 25 MS. YEE: Okay. And, Mr. McClellan, your 26 statement about how the Petitioner never sold materials 27 below cost. 28 MR. MC CLELLAN: That's correct. 27 1 MS. YEE: So, how does that reconcile with then 2 the negative markup and then how you allocated to the 3 nontaxable labor? 4 MR. MC CLELLAN: Well, it doesn't reconcile. 5 And therein lies the problem -- that the -- the achieved 6 markup, when you take the total reported figure that was 7 established by a CPA firm, who no longer works for the 8 taxpayer -- and we can't seem to get anything from -- 9 and you look at the actual transactions on a detailed 10 basis, which we think is the best source of information, 11 at the end of the day when you look at the selling price 12 of the individual materials and what they bought it for, 13 there is a markup on there. 14 So, what that tells us is that there is 15 something in the cost of goods sold figure or 16 potentially the figure that the Department's using as 17 the sales figure which is causing a variation or 18 deviation there. 19 We haven't explained it or we haven't done any 20 forensic accounting to determine why it's giving that 21 result. But what's undisputed is that if you look at -- 22 look at the actual sales. And if you look at the sales 23 and you look at the purchases, they -- they do have a 24 markup. 25 MS. YEE: Could it be that these transactions 26 were negotiated based on a total price and then they 27 were -- and then backing up and allocating -- 28 MR. MC CLELLAN: Well -- 28 1 MS. YEE: -- where the dollars went? 2 MR. MC CLELLAN: -- I've never been privy to a 3 negotiation between the taxpayer and his customer. 4 What I have seen is contracts. And what the 5 contracts show is segregated pricing on an exhibit sheet 6 And that -- from that perspective, those prices are 7 established by an agreement. 8 And if you accept what the Department has done 9 here, then you have to accept that you and I can buy 10 these tiles for the same price that Citation Homes can 11 buy them for for a subdivision. And common sense, I 12 think, shows that that simply is not the case. And 13 that's not only true in this industry -- it's especially 14 true in this industry, but it's true in -- for every 15 product that you're going to buy. 16 If you buy 100,000 shirts from a manufacturer, 17 it's going to be a different price than what you buy one 18 for. 19 MS. YEE: I would agree with you if we didn't 20 see such variability between the labor charges and the 21 cost of the materials. But when you do see such 22 variability and not consistency, I do wonder if what was 23 negotiated was a bottom -- you know, a bottom line price 24 and then the charge is allocated between the materials 25 and labor. 26 MR. MC CLELLAN: And -- and I respect that 27 question. 28 MS. YEE: I mean, that would explain the 29 1 variability because the two pieces were negotiated -- 2 MR. MC CLELLAN: The -- 3 MS. YEE: -- separately. 4 MR. MC CLELLAN: -- so, the -- what would 5 explain the variability? 6 MS. YEE: Well, then you're looking at -- for 7 each transaction -- a bottom line price. And of that 8 price, you're allocating a portion to the materials and 9 a portion to the labor. 10 MR. MC CLELLAN: Uh-huh. 11 MS. YEE: Which I then, I think, accounts for 12 some of the variability because you're not -- you don't 13 -- there's not like a consistent -- consistency in terms 14 of the allocation of the two when you look at all of the 15 invoices. 16 MR. MC CLELLAN: You know, that's a good 17 question. And, actually, that leads me to another point 18 that I failed to make is that these builders can get 19 these materials. They can go out and buy them if they 20 so choose. They generally don't buy them themselves 21 because they don't have the labor force and the 22 equipment available to them in order to perform the 23 service. So, it's really the service that makes up the, 24 I suppose, the value in these distributors. 25 As far as -- as far as the -- the materials are 26 concerned, the builder knows what they're buying them 27 for. He knows what other competitors will sell them to 28 him for and so forth. So, there can't really be a 30 1 fluctuation in those products. 2 With respect to the labor component, that's not 3 something that the builder is familiar with and they can 4 fluctuate that price. And I would -- I would think that 5 this taxpayer did so to the fullest extent that he could 6 in order to earn a profit. 7 MS. YEE: Okay. And then one last question for 8 the Department. 9 If you were to be provided with more invoices 10 from 2002-2003, do you think that might be helpful or -- 11 based on what you've seen, does it -- 12 MR. LAMBERT: I don't believe it would. 13 What we've -- what has been asked for, if that 14 was provided, such as just the sale of materials without 15 the spreading charges and they had that, we would -- 16 that would be of interest to us. 17 But just an invoice that has the materials and 18 the spreading charges, it wouldn't -- it wouldn't make a 19 difference. 20 MR. HANKS: I think we're saying that too from 21 the standpoint of -- just looking at the federal income 22 tax returns, if there's a negative markup reflected on 23 the sales of those materials -- 24 MS. YEE: Right. 25 MR. HANKS: -- that's probably what the 26 invoices would reflect as well. 27 MS. YEE: Uh-huh. 28 MR. MC CLELLAN: Well -- as opposed to relying 31 1 on "probably," I would suggest before you assess a six 2 figure sum against the taxpayer, look at the invoices. 3 The invoices that we have looked at show that 4 it's not a negative markup. All of the -- all of the 5 invoices are available. And we certainly can provide 6 them. This has been going on for eight years. And this 7 taxpayer has endured significant hardship because of 8 this. He wanted to be here today. He is attending to 9 some family matters. 10 But, ultimately, what was reported is what was 11 sold. And if -- if there's more inquiry that's 12 necessary in order to resolve this, then certainly we 13 would abide by that and agree to it. 14 But at this point I think the issue -- and I 15 don't think the Department disputes it -- is ultimately 16 that the Department claims that this taxpayer can't 17 alter its markup. 18 And one key point I would add -- and then I'll 19 stop -- is that they're looking for transactions that 20 don't include this loading service. I think the loading 21 service, perhaps, is a distraction. 22 One of the main points that I'm trying to make 23 is that the markup that was conducted, the shelf test 24 that was conducted was of low volume transactions. And 25 it's being applied to these very high volume 26 transactions, which -- which just doesn't make sense. 27 MS. YEE: Is that true? 28 MR. LAMBERT: No, that's not true. 32 1 MR. MC CLELLAN: Well, I'll explain why. 2 MS. YEE: Well, hang on. 3 MR. MC CLELLAN: Okay. 4 MS. YEE: I'm going to have the Department 5 comment. 6 MR. LAMBERT: There's two different things. 7 There is the 28 and a half percent from 2001 is the 8 markup of their records. That's what was used to apply 9 to the purchases or cost of goods sold from 2002 -- 10 MS. YEE: That's their recorded book markup? 11 MR. LAMBERT: -- exactly. That's what was 12 applied. 13 Now, there was the test of those five invoices 14 that came up to 27 percent that were on the 15 over-the-counter sales. That was not used, but it -- 16 what it was was to take a look at it and say, "Oh, well, 17 then if you just had the materials sales, it's still 18 showing a 27 percent markup." 19 And, so, the whole year it just -- it validates 20 the entire year of 2001, which was the 28 and a half 21 percent. 22 And -- and -- and -- and that's what was -- was 23 used in this case. And it wasn't a shelf test that was 24 used, it was their -- it was their reflective markup of 25 record. 26 MS. YEE: Okay. Mr. McClellan. 27 MR. MC CLELLAN: It sounds like there mis -- 28 there may be a misinterpretation of what's gone on here. 33 1 There was a change in the business. There was 2 a change in the industry that drove prices down. They 3 tested the small volume sales from periods in the audit 4 period, did an actual shelf test. And they came up with 5 a markup that was lower than what this achieved markup 6 had shown in the past, which, personally, I don't have a 7 lot of confidence in because the other years show 8 negative. We've already proven that to be false. 9 But what that demonstrates is that if they were 10 selling in 2001 at an achieved markup or at an actual 11 markup of 28 percent to those large builders, they 12 wouldn't -- they wouldn't make that same -- they 13 wouldn't apply the same markup to the small transactions 14 that were tested. These were transactions consisting of 15 a few roofing tiles. 16 MS. YEE: Okay. Yeah, I think that size is not 17 relevant here. 18 Thank you, Mr. Chairman. 19 MR. HORTON: Mr. Runner. 20 MR. RUNNER: Yeah, let's -- talk about the 21 change of the business. 22 MR. MC CLELLAN: Okay. 23 MR. RUNNER: What was the business -- what was 24 the nature of the business and how -- how -- how -- how 25 did these -- how did this business operate during that 26 time in 2001? 27 MR. MC CLELLAN: Senator Runner, that's not 28 something that -- that I've thoroughly investigated. 34 1 All's I can say is that it wasn't providing these 2 additional services. 3 And after the period of change, I know that 4 some of the things I did discuss with my client is that 5 he -- he'd acquired -- 6 MR. RUNNER: Okay. I guess it's hard -- it's 7 hard for -- I'm trying to get to the issue of -- 8 MR. MC CLELLAN: Okay. 9 MR. RUNNER: -- the change of business. 10 MR. MC CLELLAN: Sure. 11 MR. RUNNER: But it's hard for me to get there 12 if you can't explain what the nature of their business 13 was. 14 MR. MC CLELLAN: Well, the nature of their 15 business in the earlier periods was to sell at retail 16 these products -- without any service. 17 MR. RUNNER: To these big retailers -- to these 18 big contractors? 19 MR. MC CLELLAN: I don't know who their 20 customers were, to be honest with you. I don't know if 21 their focus was on individual home owners. I don't know 22 if it was on builders. 23 The Department suggested that they were selling 24 to builders and I don't know how they obtained that 25 information. But I do know that when they made the 26 change they were forced to hire a number of employees. 27 They were forced to buy a number of pieces of equipment 28 and machinery in order to facilitate the service. It's 35 1 a very expensive, time intensive and dangerous process. 2 You're taking, basically, blocks of concrete -- 3 MR. RUNNER: Uh-huh. 4 MR. MC CLELLAN: -- in small lots and you're 5 loading it potentially onto a second roof of a home. 6 And -- and there -- there was a significant change. 7 And aside from that factor, I think in every 8 business you must recognize what your competitors are 9 selling their products for. And if they're going to 10 sell their products for less than you are, then 11 ultimately you're not going to make a sale. 12 MR. RUNNER: Okay. I -- here's what I'm -- you 13 know, I mean, here's, I guess as I'm looking through 14 this, it seems to me that, okay, I can appreciate the 15 fact that business was done a certain way in -- in 16 this -- in this given year, 2001. 17 MR. LAMBERT: Uh-huh. 18 MR. RUNNER: Circumstances changed and, 19 therefore, you had to be competitive and you changed how 20 you did your business. 21 MR. MC CLELLAN: Uh-huh. 22 MR. RUNNER: Okay. I think I can -- and that 23 would make sense to me. 24 MR. MC CLELLAN: Right. 25 MR. RUNNER: In the midst of that -- let me 26 just see if I can reflect on this correctly -- before 27 the way I had to do business, I needed a higher markup 28 on my products that I was selling in order to cover my 36 1 costs. 2 MR. MC CLELLAN: Uh-huh. 3 MR. RUNNER: Because that's what I did. 4 I changed how I do my business because now part 5 of my income for my business is coming from some profit 6 that I make on labor -- 7 MR. MC CLELLAN: Right. 8 MR. RUNNER: -- and, therefore, I can lower the 9 cost -- 10 MR. MC CLELLAN: Uh-huh. 11 MR. RUNNER: -- of my material that I am now 12 selling. 13 MR. MC CLELLAN: Certainly. 14 MR. RUNNER: You know, so -- and -- and I 15 change that because that's the way the market's working 16 out there. 17 MR. MC CLELLAN: Uh-huh. 18 MR. RUNNER: And, so, that's why I'm just kind 19 of getting through. And, so, I'm -- I guess I'm 20 convinced a bit that you could actually change how you 21 do your business and, therefore, lower your costs in 22 regards to what your tax exposure could be on these -- 23 on these products over here. 24 Because now -- because of the nature of 25 business changes, you're making -- you're making more of 26 your profit on an item that is not a tangible good. 27 MR. MC CLELLAN: Right. 28 MR. RUNNER: Right? 37 1 And, so, I can -- I can see how that -- so, I 2 guess, I'm -- I am convinced -- I see the argument as to 3 why the 28 percent may not apply to how I do business 4 any more because it's -- 'cause I do business in a 5 different way. 6 But I'm trying to -- you know, I guess the 7 struggle that I'm having right now is nobody can explain 8 to me how the business was -- how it was operated when 9 it was in 2001. What changed? 10 What was it -- how -- how was that actually 11 changed in order to make it so the that the profit mar- 12 -- so my chief profit was 28 percent there, but now it's 13 -- on -- and it was only goods, there wasn't any 14 labor -- 15 MR. MC CLELLAN: Uh-huh, right. 16 MR. RUNNER: -- and now I have this labor costs 17 and, so, that's not taxable. And, so -- 18 MR. MC CLELLAN: Uh-huh. 19 MR. RUNNER: -- therefore, my profit margin is 20 almost zero or -- I think, it's -- you know, I think 21 we're going to debate whether or not it's negative or 22 zero, or depending upon rebates and all these other 23 things. 24 But, you know, basically, you know, I mean -- I 25 mean, I think -- seems to me I -- I can -- I can -- I 26 can come up with times when businesses that I know -- 27 MR. MC CLELLAN: Uh-huh. 28 MR. RUNNER: -- sell -- if -- if their -- if 38 1 their -- if what they do is both labor and tangible 2 sales, that they can sometimes get their product 3 tangible sales down 'til they're zero because they're 4 going to make all their money over on their labor side. 5 MR. MC CLELLAN: Uh-huh. 6 MR. RUNNER: Huh -- and that's -- and market 7 changes that. 8 In really good times, you might be able to make 9 profit in both places. 10 MR. MC CLELLAN: Well -- 11 MR. RUNNER: But -- so -- so, it's -- you see 12 what I'm -- I'm struggling with -- with somehow there's 13 got to be a change of business plan over here. 14 MR. MC CLELLAN: I -- I think the underlying 15 struggle goes to, obviously, the under -- 16 underlying reason for why there's this discrepancy. 17 And according to the taxpayer, if he could sell 18 his goods for a very high markup and provide the service 19 for free by making money that way, that's the way he 20 would do it. If his -- if the builders would hire him 21 and buy his goods and -- 22 MR. RUNNER: Right. 23 MR. MC CLELLAN: -- have him provide a free 24 service associated with it and it was 100 percent 25 taxable, that's what he what he would do. 26 The -- the -- I think the central point here is 27 that this taxpayer -- 28 MR. RUNNER: But there would be nothing -- 39 1 just -- but there would be nothing wrong if he chose 2 then to lower his price of his goods. 3 MR. MC CLELLAN: -- uh-huh. 4 MR. RUNNER: No, because he doesn't need to 5 make the profit as high on the tangible good -- those 6 tangible goods -- 7 MR. MC CLELLAN: Right. 8 MR. RUNNER: -- in order for him to then charge 9 over here on the labor side? 10 MR. MC CLELLAN: No. And that's why I shared 11 that annotation. And -- and there's other annotations 12 that date back to 1951 -- 13 MR. RUNNER: Uh-huh. 14 MR. MC CLELLAN: -- that -- that share the same 15 principle. 16 MR. RUNNER: Right. 17 MR. MC CLELLAN: But it's okay to do that. 18 MR. RUNNER: Right. 19 MR. MC CLELLAN: And -- 20 MR. RUNNER: So -- 21 MR. MC CLELLAN: -- that's what was done. 22 MR. RUNNER: -- so, let me just ask, in -- in 23 -- in our -- in the audit then, did we -- it doesn't 24 seem that we gave almost any credit for the fact that 25 the -- that the -- that the business model had changed. 26 And there's -- and, therefore, the fact that he 27 needed to make his profit on the -- only on the tangible 28 good changed when all of a sudden he changed his 40 1 business model and started, all of a sudden, loading 2 roofs and, therefore, there was labor and that's where 3 part of his profit center moved to? 4 Did -- we just assumed that his profit center 5 stayed the same, right? 6 MR. LAMBERT: We -- we did not have any 7 information to indicate that there was a change in the 8 profit centers. 9 MR. RUNNER: Oh, hold on, we -- we -- don't we 10 have information that we -- we know that after 2000 -- 11 in those later audits that he started loading the roofs, 12 right? 13 MR. LAMBERT: Yes. 14 MR. RUNNER: Okay. Wasn't that a change -- 15 MR. LAMBERT: Change in -- well. 16 MR. RUNNER: -- why would we not assume that? 17 I mean -- 18 MR. LAMBERT: Well -- 19 MR. RUNNER: -- okay. So, I guess we assume 20 that he started loading roofs, but he still made the 21 same profit on the tiles? 22 MR. LAMBERT: As the -- the Department -- the 23 way the re-audit considers it is that there was a 28 and 24 a half percent markup in 2001. 25 MR. RUNNER: Right. 26 MR. LAMBERT: There was negative markups in the 27 following two years. 28 MR. RUNNER: Right. 41 1 MR. LAMBERT: It was the decision that there 2 was not a proper allocation made of -- to the sale 3 between tangible personal property and spreading 4 charges. 5 So, the only information that was available is 6 that there was a 28 and a half percent markup. 7 MR. RUNNER: So, what information would the 8 taxpayer have to provide to show that he lowered his 9 price of goods and he -- and labor became a profit 10 center for him over here? 11 So that his -- so that -- 12 MR. LAMBERT: Well -- 13 MR. RUNNER: -- so that his margin shrunk? 14 What -- how -- what -- what would he be required to have 15 to show to demonstrate that? 16 MR. LAMBERT: Well, if he had his cost sheets, 17 such as the labor that is used on the spreading and what 18 kind of markup that he got on that. 19 From our indication -- 20 MR. RUNNER: Let me ask about that. It seems 21 to me somebody's got -- I mean, you -- I mean -- isn't 22 -- well, let me ask. 23 Isn't that what the bid is? Doesn't the bid 24 show -- 25 MR. LAMBERT: What -- 26 MR. RUNNER: -- what the cost of spreading the 27 materials is? 28 MR. LAMBERT: -- the invoice does. 42 1 MR. RUNNER: Yeah, I mean the invoice, I'm 2 sorry, the invoice? 3 MR. LAMBERT: I don't believe the bid does. 4 The bid was an oral bid. 5 MR. RUNNER: Okay. But how about -- let's just 6 do the invoice. 7 Doesn't the invoice indicate -- 8 MR. LAMBERT: Right. 9 MR. RUNNER: -- that there was -- that there -- 10 that there was -- there was money -- money -- that there 11 was revenue from the activity of spreading the -- the 12 materials? 13 MR. LAMBERT: It does. 14 MR. RUNNER: And wouldn't we assume that in 15 doing that there must some profit over there? 16 MR. LAMBERT: Oh, absolutely, there's -- there 17 is -- there's a lot of profit based on what the P & Ls 18 show. 19 MR. RUNNER. Okay. 20 MR. LAMBERT: But why -- 21 MR. RUNNER: Okay. If that's the case, why 22 wouldn't we assume that the -- that under this new way 23 of doing business that the -- the -- the margin on the 24 other side could have shrunk on the tangible goods? 25 MR. LAMBERT: Yeah, the -- it could have 26 increased, it could have decreased, based on the market 27 factors. 28 It -- it really -- when you're in the housing 43 1 industry, there are times when the manufacturers -- they 2 charge a lot more. 3 MR. RUNNER: Okay. But just in -- in just kind 4 of -- in the simplest terms then, in reality, though, it 5 seems to me what we've done is we've gone ahead and 6 assumed the same markup factor for the tangible goods 7 that the -- the roofing materials -- that we had before 8 the business started to change their business practices 9 and went to spreading and actually entered a spreading 10 and a labor component to their sales. 11 Is that -- 12 MR. LAMBERT: We treated the markup as -- 13 MR. RUNNER: As the same? 14 MR. LAMBERT: -- as the same. 15 That is correct. 16 ---o0o--- 17 18 19 20 21 22 23 24 25 26 27 28 44 1 MR. RUNNER: Okay. Now let me just ask you 2 this -- because again, it's interesting -- because there 3 is a -- part of our justification for that was, we 4 said -- I think, we went back and you audited some of 5 the sales that took place during the audit period, 6 right? 7 MR. LAMBERT: Over-the-counter sales. 8 MR. RUNNER: Okay. Now, that is a bit relevant 9 to me because -- because I would -- that actually 10 re-enforces, to me, a little bit about the fact that the 11 28 percent was indeed what they charged for the profit 12 when they were just selling over-the-counter, because in 13 reality everything was over-the-counter in -- in some 14 way, in 2001. 15 And so they maintained that same 16 over-the-counter profit on the over-the-counter issues 17 in those later times so it came in close to that -- 18 MR. LAMBERT: 27. 19 MR. RUNNER: -- 27 percent. 20 Um, but it ignores the fact that his business 21 practice may have changed then with these larger 22 contracts when he actually started loading the roofs, 23 right? I mean -- 24 MR. LAMBERT: Mr. Runner -- 25 MR. RUNNER: I mean, aren't you almost having 26 to assume that the over-the-counter sale for the 27 tangible good was the same cost, same cost to sale that 28 he was making when he was selling, you know, tiles to -- 45 1 I don't know how many houses, 15 houses at a time? And 2 that that was the -- then that was the cost that you 3 were -- we were assuming that he was making the same 4 margin on that as he is with selling a small pallet 5 over-the-counter? 6 MR. LAMBERT: Well, what I would say is that 7 there were five invoices that were provided by the 8 taxpayer. 9 MR. RUNNER: Sure. 10 MR. LAMBERT: And there's no way to know 11 whether those are representative of the over-the-counter 12 sales, uh, during that period of time. That's what was 13 provided to us that we had to use. 14 And so, to take a small sample like that, um, I 15 don't know if -- I don't know if you can draw the 16 conclusions that are being -- 17 MR. RUNNER: Okay. 18 MR. LAMBERT: -- being drawn from that. 19 MR. RUNNER: Because you actually didn't use 20 that. But yet -- but yet -- but yet you do in a way 21 because you used it to kind of justify the 28. 22 MR. LAMBERT: Well, that's -- 23 MR. RUNNER: For me to throw it all out the 24 window and say, oh, the sample's too small, we can't use 25 it. 26 MR. LAMBERT: Right. We said it was -- it was 27 consistent with having a markup of materials. 28 MR. RUNNER: Right. But you don't think the 46 1 sample's big enough. 2 MR. LAMBERT: Oh, five invoices -- 3 MR. RUNNER: Okay. 4 MR. LAMBERT: -- um, isn't going to be. 5 MR. RUNNER: Yeah. 6 MR. HANKS: Mr. Runner. 7 MR. RUNNER: Yeah. 8 MR. HANKS: If I could add, too -- 9 MR. RUNNER: Mm-hmm. 10 MR. HANKS: I think what -- what the Department 11 is looking for here is -- is some representation of the 12 fair retail selling price for the -- the materials. And 13 I -- I think that that was represented in -- in the 14 books and records that we examined for 2001. 15 Now, we're in 2002 and 2003 -- 16 MR. RUNNER: Well, let me -- can I stop you 17 right there real quick? 18 The -- the -- the fair selling price of 19 those -- of -- of -- of the -- of the materials, of the 20 tangible good in 2001, would that automatically be the 21 same in the future if indeed the new process was to 22 include, um, you know, a new service? You know, a new 23 service, therefore, the service now ends up changing 24 what is -- I mean, it's kind of like -- is it the same 25 thing as what happened in 2001 if you actually changed 26 the service that you provided? 27 MR. HANKS: See, it could be. We -- we just 28 don't know. 47 1 MR. RUNNER: But it may not be. 2 MR. HANKS: But it may not be. 3 But let's say, given your hypothetical, that 4 what they did is -- is reduce the markup on the sale the 5 materials -- 6 MR. RUNNER: Mm-hmm. 7 MR. HANKS: -- when it incorporated the 8 spreading services. 9 MR. RUNNER: Mm-hmm. 10 MR. HANKS: If we had seen a markup of, let's 11 say, 20 percent, 25 percent, a reduced markup from the 12 earlier years, in these later years after the service 13 spreading became available, we wouldn't have this 14 discussion today, I don't believe. 15 I think the Department would have accepted that 16 their business model had changed, that these 17 considerations were made, um, but that we saw that the 18 product was being sold for a retail selling price. 19 And this actually goes to the annotation that 20 Mr. McClellan was referencing before that concerns the 21 car wash and the gas station. And what that annotation 22 says, that since the reduced price of the gasoline is 23 above cost, the reduced price should be accepted as the 24 selling price of the gas. Here we don't have that. 25 So we've got just the opposite situation here 26 where they're selling the materials for -- 27 MR. RUNNER: Yeah. 28 MR. HANKS: -- 20 percent less. 48 1 MR. RUNNER: Yeah. I -- I am -- I'm troubled 2 by the idea of going from 28 percent to -- to -- to near 3 zero. We'll stay with that number, near zero. That is 4 a bit troubling. I -- I -- this is -- this would be, I 5 would agree, a much more persuasive discussion, for me 6 even, that if all of a sudden you were going from -- 7 from, uh -- you know, from 28 percent to 15 percent and 8 then, you know, and then you changed your business 9 model. 10 So I think that is difficult, you know, at 11 that -- at that point. So that -- all the way down 12 there is -- is a bit troubling in regards to how it is 13 that you do business. So that would be an observation. 14 Do you have a response? 15 MR. McCLELLAN: Um, I would just say that I 16 agree that the sought-after price is the fair retail 17 selling price, and it's provided by regulation, for 18 example, under 1521, the construction contractor 19 regulation, that you go out and you see what similar 20 goods of similar quantities are sold during the 21 period. 22 MR. RUNNER: Mm-hmm. 23 MR. McCLELLAN: It's -- it's a -- it's a 24 standard practice. And -- and we keep going back to 25 these achieved markups from the cost of goods sold. 26 Uh, we've provided actual sales and actual 27 purchases to demonstrate what the -- uh, that there was 28 a markup on these sales. Um, and that has never been 49 1 done for the earlier periods. So we don't know the 28 2 percent is actually a consistent figure that we can even 3 rely upon. 4 We know that those negative markups are not 5 figures that we can rely upon based on what they paid 6 for the goods, what they sold them. 7 Uh, but I'll just close on saying that a fair 8 retail selling price of any good is established, as 9 Mr. Lambert said, by market forces. And -- and the 10 market third-party sources that's presented here as 11 evidence, and not disputed in any way, shape or form, 12 says that they sell these same goods at a single digit 13 markup. Which means that even if it's at nine percent, 14 28 percent would be 19 percent higher than what anybody 15 else is selling it for during that period. 16 MR. RUNNER: Let me just follow up. What -- 17 what have we found, or did we do any kind of industry 18 comparison in regards to that? Because I think, you 19 know, often times we do comparisons and we talk about 20 industry standards and whatnot in regards to that. What 21 did -- what did we find in this case? 22 MR. LAMBERT: To my knowledge, we had looked at 23 one other supplier; and they had, uh, a 26 percent 24 markup, uh, that the -- 25 MR. RUNNER: A supplier that did -- loaded 26 roofs? 27 MR. LAMBERT: I don't believe they loaded 28 roofs. 50 1 MR. RUNNER: Well, they -- hold on. That's the 2 core of the discussion, isn't it? 3 MR. LAMBERT: Uh, well, I think you're looking 4 at the sale of materials. And the question really comes 5 into, um, you know, how do you sell these materials to 6 these contractors at a higher price? 7 MR. RUNNER: So -- okay. Hold on. Let me go 8 back. 9 So the one that you did look at did not 10 offer -- did not do the same business model as what's in 11 dispute with this taxpayer? 12 MR. LAMBERT: I'm unaware of their business 13 model. I, uh, was not aware that they did spreading 14 or -- I couldn't assert one way or the other whether 15 they did or they didn't. 16 MR. RUNNER: Okay. 17 MR. LAMBERT: I was under the impression 18 they -- they did not. But that's, um -- I guess my, 19 um -- 20 MR. RUNNER: Because no one's disputing -- 21 again, I -- I think there's not a lot of dispute going 22 on -- a little bit here, I guess -- in regards to if 23 you're not spreading, that you're in the 27, 28 percent, 24 potentially. I don't know if that's the big part of the 25 dispute. The dispute is over -- is over this issue of 26 the spreading aspect and what that does to lower the 27 cost of the tangible good, right? 28 MR. LAMBERT: I would say -- 51 1 MR. RUNNER: Isn't that the core of this 2 discussion? 3 MR. LAMBERT: I would say generally you're 4 correct, but the housing industry -- 5 MR. RUNNER: I appreciate being generally 6 correct. It's always -- it's always better than being 7 partially or something. 8 MR. LAMBERT: Well, I would say generally, but 9 the -- you know, the -- depending on the housing 10 market -- 11 MR. RUNNER: Uh-huh. 12 MR. LAMBERT: -- it -- it can affect the price 13 of -- 14 MR. RUNNER: Yeah. 15 MR. LAMBERT: -- the product. Sometimes it 16 just -- pardon the expression -- go through the roof. 17 And other times, um, it falls. 18 MR. RUNNER: Mm-hmm. 19 MR. HANKS: But the other part of this -- 20 MR. RUNNER: Yeah. 21 MR. HANKS: -- this discussion, too, is in the 22 sense that the taxpayer's selling his product for less 23 than cost, uh, and charging sales tax reimbursement 24 on -- on that price less than cost, then actually he's 25 at a competitive advantage to others that -- that we 26 know are in the industry also selling roofing 27 materials -- 28 MR. RUNNER: Mm-hmm. 52 1 MR. HANKS: -- who also perform spreading, um, 2 services. 3 MR. RUNNER: Mm-hmm. 4 MR. HANKS: Because that's pretty typical 5 today. 6 Um, so from that standpoint, he's selling his 7 product and advertising that -- that he's having to -- 8 to charge less for those services, collect less tax 9 reimbursement. 10 So in that sense, it's not necessarily a level 11 playing field with -- with the rest of the industry. 12 And I think that's -- that's one -- 13 MR. RUNNER: Well, hold on, hold on. We have 14 not -- I just asked if you compared to the rest of the 15 industry. You said you only did some. 16 You know, it's hard for you to talk about what 17 the rest of the industry is doing, right? 18 MR. HANKS: Well, we haven't seen any other 19 cases where a roofing contractor was selling their -- 20 their roofing materials for below cost, um, and making 21 this -- this -- this allocation, um, the shifting of the 22 allocation between -- 23 MR. RUNNER: I thought we were -- maybe I 24 misunderstood. I thought we said we only looked at one 25 other one. 26 MR. LAMBERT: Well, that was -- 27 MR. RUNNER: What I'm hearing -- what I'm 28 hearing now is that we now have -- we have knowledge of 53 1 other people, how they operate their business. 2 MR. HORTON: I think it was a hypothetical. 3 MR. RUNNER: Well, no, that's not what was just 4 talked about. It was -- 5 MR. HANKS: Well, what I'm saying, Mr. Runner, 6 is that we haven't seen similar situations like this 7 where there's been a -- a treatment, disparate treatment 8 of the allocation of -- of nontaxable services versus a 9 sale of a tangible personal property. And we routinely 10 audit businesses -- 11 MR. RUNNER: Uh-huh. 12 MR. HANKS: -- construction contractors -- 13 MR. RUNNER: Right. 14 MR. HANKS: -- including roofing contractors. 15 MR. RUNNER: Right. 16 MR HANKS: So there are many, many of these 17 roofing contractors that we've examined. None of these 18 cases, that -- that I'm aware of, have -- have come to 19 our attention where we've -- we've got -- 20 MR. RUNNER: Listen, I -- I hear you. Listen, 21 I hear you. I think the issue of that zero to negative 22 is very problematic. So I get you on that. 23 Let you just -- that's my last question. 24 MR. McCLELLAN: And I -- I won't dispute that. 25 But, um, I'll say it for, I think, the third time, we've 26 provided sales invoices and purchase invoices which show 27 that they do not sell below cost, that it's an 28 accounting figure that's relied upon to establish that. 54 1 If the Department has something that they see 2 in this calculation that's specific that they have a 3 problem with, I'd be happy -- 4 MR. RUNNER: Well, let me -- let me just go to 5 that because it is kind of an issue. 6 MR. McCLELLAN: Yes. 7 MR. RUNNER: And that is, you guys are saying 8 we don't sell it below cost. 9 MR. McCLELLAN: Right. 10 MR. RUNNER: You guys are saying we do. 11 MR. McCLELLAN: Yes. 12 MR. RUNNER: You guys are saying you don't sell 13 it below cost because there are certain rebates that 14 take place, there's certain issues that -- that -- that, 15 therefore, make it so that the seller does make profit 16 even when it says that -- the Department says they 17 actually lose money. 18 MR. McCLELLAN: Well, no, that's not what I'm 19 saying. What I'm saying is that they buy, for example, 20 a square of fiber brick TC, Hacienda blend -- 21 MR. RUNNER: Uh-huh. 22 MR. McCLELLAN: -- for $44 a square. 23 MR. RUNNER: Uh-huh. 24 MR. McCLELLAN: They sell it for $56 per 25 square. 26 MR. RUNNER: Okay. 27 MR. McCLELLAN: So the -- the price that they 28 sell it is higher than what they actually purchase it 55 1 at. 2 MR. RUNNER: Okay. 3 MR. McCLELLAN: The Department is taking a 4 figure that's reported on the federal income tax 5 returns, that's reported as costs of goods sold. But 6 it's -- we find situations where labor costs are 7 included in that. There's a variety of costs that 8 accountants may put in there -- 9 MR. RUNNER: Okay. Is your cost of goods sold 10 that you come up with a negative include more than just 11 the materials? 12 MR. LAMBERT: Uh, we don't know the answer to 13 that. The -- what we will say, though, is that there's 14 no evidence that it's any different than what was in 15 2001. 16 So, in other words, 2002 and 2003 appears to be 17 similar, or as far as we're aware, to how they 18 calculated those numbers are similar. And in 2001 it 19 comes up to a 28-and-a-half percent markup. So even if 20 you assume that there's rebates or pallet charges, or 21 whatever else that's in there, it would be the same 22 situation in the -- in the following two years. 23 MR. RUNNER: Okay. Just to then -- just to 24 clarify, the taxpayer never bought a square of roofing 25 material for $50 and sold it for 48? 26 MR. McCLELLAN: Not to my knowledge, no. 27 MR. RUNNER: Thank you. 28 MR. McCLELLAN: And the evidence shows that. 56 1 Can I just address -- 2 MR. RUNNER: No, I -- well -- 3 MR. McCLELLAN: -- two other things? 4 MR. RUNNER: I -- I'm actually done. 5 MR. McCLELLAN: Okay. 6 MR. RUNNER: Maybe if somebody else has a 7 question, that'd be fine. 8 MR. HORTON: Ms. Mandel. 9 MS. MANDEL: Um, I thought I did hear 10 throughout all of this, or at some point in the past 11 several days, something about the volume discounts and 12 rebates, that there might have been. 13 Um, do we know whether there was some kind 14 of -- I mean, I think a lot of times people may report 15 that as "other income" rather than as an adjustment to 16 cost of goods sold on their income tax returns, um, as a 17 possibility. And I thought that was a possibility. 18 But now in this exchange with Mr. Runner, I'm 19 kind of hearing that we don't know what's in cost of 20 goods sold and that the taxpayer hasn't shown what's in 21 the cost of goods sold and it's just intimating that 22 there might be stuff in there that's not actually 23 materials. 24 But do we -- do we know if there was any kind 25 of entry for "other income" or anything that might 26 have -- or we just looked for cost of goods sold and ran 27 the numbers? 28 MR. LAMBERT: My understanding is, from the 57 1 comments and the people that I've talked to, is that 2 they felt the cost of goods sold for 2001, 2002 and 2003 3 were developed in the same manner. Or, to say it 4 another way, we were unaware of any different accounting 5 practices that would cause those numbers to reflect a 6 different makeup. So -- 7 MS. MANDEL: As compared to the 2001 where you 8 did the -- ran the same kind of number to get 28 9 percent? 10 MR. LAMBERT: Exactly. 11 MR. McCLELLAN: Ms. Mandel, may I ask a 12 question of the Department? 13 MS. MANDEL: Um -- uh, not technically. 14 MR. RUNNER: You can ask her. 15 MS. MANDEL: But you can ask me. 16 MR. McCLELLAN: Okay. 17 MS. MANDEL: If I -- you can't really even ask 18 me. But you can, um -- I don't know, rhetorically, um, 19 say something. 20 MR. McCLELLAN: Well, there was -- 21 MS. MANDEL: And maybe I might have a question 22 for someone when I muse upon your rhetorical comments. 23 MR. McCLELLAN: There was in the, uh -- 24 presented by the Department at one point during this 25 long process, a handwritten markup calculation, uh, that 26 was presented as being indicative of a markup in the 27 industry. 28 And -- and I'm curious to know whether or not 58 1 that 26 percent markup that Mr. Lambert was referring to 2 was, in fact, that handwritten document that in no way 3 could be authenticated and eventually was disregarded. 4 MS. MANDEL: I'm so glad you've been going to 5 law school. You're having all these big words now, 6 can't be authenticated. 7 Sorry. I've been sitting here a long time. 8 Uh, my understanding, Mr. Lambert -- correct me 9 if I'm like, uh, sort of off base -- the 26 percent 10 number -- which was from somewhere, written down, not 11 sure exactly the development of it -- my understanding 12 was that that was purported to have been, if my memory 13 is not really off, purported to have been some other, 14 um, business's markup and was just, um -- that the 15 Department kind of used it to say, oh, yeah, you know, 16 28 percent not so bad. 17 Is that -- that's how I understood where the 26 18 percent; is that right? 19 MR. LAMBERT: The -- the two -- right. There 20 was one document. Where it came from was the district 21 principal auditor of the Sacramento district and a -- 22 another supplier of roofing material, they -- he 23 calculated a markup. 24 MS. MANDEL: He who? District principal 25 auditor? 26 MR. LAMBERT: District principal auditor 27 calculated the markup and gave it to the auditor, and it 28 was included in the audit working papers. 59 1 MS. MANDEL: And he -- and the DPA calculated 2 it from someone else. Some -- some other business. 3 MR. LAMBERT: Uh, that's correct. Right. 4 MS. MANDEL: Okay. And you just -- you were 5 using it as a -- 6 MR. LAMBERT: Bench market. 7 MS. MANDEL: -- backstop check on the 28 8 percent that you calculated off the taxpayer's records 9 for that 2001 prior year. 10 MR. LAMBERT: For reasonableness, right. 11 MS. MANDEL: Okay. 12 MR. McCLELLAN: According to my client, the, 13 um -- the information that was presented was actually of 14 a different type of tile, a -- I believe they referred 15 to it as a composite or shake tile. 16 MS. MANDEL: Mm-hmm. 17 MR. McCLELLAN: And I'm not sure if I'm using 18 the correct terminology, but -- 19 MS. MANDEL: That sounds familiar to me. 20 MR. McCLELLAN: But it was a different type of 21 tile than they generally sell. 22 MS. MANDEL: That your client generally 23 sells. 24 MR. McCLELLAN: Precisely. And that it was a 25 local taxpayer of a past audit that was the source of 26 the information. So we have a different, uh -- a 27 different location. 28 MS. MANDEL: And you -- and you -- and you 60 1 believe that, uh -- presumably you're telling me this 2 because you believe that the -- the nature of tile 3 products for roofing, um, some may have greater or 4 lesser markups in the world than others. 5 MR. McCLELLAN: That's correct. Apparently 6 that is definitely the case. 7 MS. MANDEL: Okay. But they thought that 26 8 percent, being lower than what your client showed for 9 2001, um -- 10 MR. McCLELLAN: The -- 11 MS. MANDEL: So I -- I guess I'm not exactly -- 12 MR. McCLELLAN: The evidence -- 13 MS. MANDEL: You could toss out the 26 14 percent -- 15 MR. McCLELLAN: Sure. 16 MS. MANDEL: -- I guess, at some level and you 17 still have the 28 percent from your books that they're 18 relying on. 19 MR. McCLELLAN: From a period that it's not 20 even being applied to. So it's being taken from 2001. 21 What we do have -- number one, what we have available to 22 us is all of the books and records from the actual 23 periods in which it's being applied to. And what we 24 have before us today are signed documents from 25 competitors, uh, who essentially are saying -- well, not 26 essentially, they are saying that they don't sell their 27 goods at a markup higher than a single digit markup, 28 those 2001 periods. 61 1 MS. MANDEL: Okay. Let me -- let me just go 2 somewhere else. 3 MR. McCLELLAN: Okay. 4 MS. MANDEL: Because I thought I also heard the 5 taxpayer's rep say that the taxpayer purchased tax 6 paid -- oh, and this -- in the audit he was allowed the 7 tax paid credit. Okay, never mind. 8 And, um, since nobody else has been called on 9 yet, um, the invoices that the taxpayer's come up with 10 as his Exhibit 1 which are invoices -- again, if I 11 remember correctly -- did not involve any of the service 12 components. Is that -- oh, they do involve service 13 components. 14 Well, I guess I didn't -- 15 MR. McCLELLAN: And they're from, um, looks 16 like periods starting in July of 2002, and I think they 17 go through December of 2003. 18 MS. MANDEL: Okay. But those are ones -- those 19 are ones that have the service component in it, which is 20 part of the current -- 21 MR. McCLELLAN: That's correct. 22 MS. MANDEL: -- issue. 23 MR. McCLELLAN: Yes. That's -- 24 MS. MANDEL: You're using those to try to show 25 that -- that even on those nine invoices, even with the 26 service component, the particular tile was being sold 27 above what that particular tile had been purchased for? 28 MR. McCLELLAN: That's correct. 62 1 MS. MANDEL: And we don't like it just 'cause 2 it's nine invoices. Maybe this is what you went around 3 with Mr. Runner on. 4 MR. LAMBERT: Uh, well that's -- we don't feel 5 it's a representative sample of -- it's been han -- 6 however you want to determine, we don't know how this 7 sample was selected. 8 MS. MANDEL: So you just don't -- okay. And 9 that gets back to Ms. Steel's original stuff of you 10 didn't look at everything for these particular years 11 or -- 12 MR. LAMBERT: Right. Well, what our feeling 13 is, is that if you take a look at all of them, for 2002 14 you're going to come up with a negative 15 percent. 15 MS. MANDEL: Because of what's reflected on the 16 income tax returns? 17 MR. LAMBERT: Exactly. 18 MS. MANDEL: Which you -- we don't know how it 19 was put together, but you're assuming it was put 20 together the same way -- 21 MR. LAMBERT: Right. 22 MS. MANDEL: -- as the prior year. Were the 23 income tax returns for the 2001 and 2002 prepared by the 24 same people? 25 MR. LAMBERT: Right -- oh, I -- I don't know -- 26 I don't know that. But I -- I would say if it was shown 27 that there was a difference between the different 28 periods, uh, obviously we'd be willing to take that into 63 1 account. 2 MS. MANDEL: Okay. Okay. Thank you. 3 Thank you, Mr. Horton. 4 MR. HORTON: Yes. 5 The challenge for me is that it has been sort 6 of consistently ruled that you can't unreasonably 7 allocate between sales and labor for the purpose of 8 avoiding tax. Uh, and then if you couple that with the 9 significant decline, uh, from 2001 to 2002 and three, it 10 just creates a discrepancy that begs for an answer. And 11 if we had an answer, it might make this process a little 12 bit easier. Not to discount the answer that the 13 taxpayer can negotiate an arm's length transaction and 14 sell their product for whatever they decide to sell it 15 for. And they can have loss leaders. 16 But then that in and of itself brings other 17 consistency -- inconsistency, if you will, in that the 18 customer base remain the same. Uh, so all of a sudden 19 we're now selling to the same individuals for 28 percent 20 less. 21 Uh, the other information, uh, where we have 22 the third party indicating that their markup is at 23 single digits, yet, as I heard the testimony, that 24 within the industry there is rebates and discounts and 25 so forth. So not knowing whether or not that markup or 26 that -- that statement reflects the rebates, discounts 27 creates another challenge for the Department as well as 28 for me. 64 1 And so trying to identify where we are at 28 2 percent when we're making retail sales and then when 3 there is a change in the business practice, uh, to 4 include this labor -- which makes sense that you would 5 establish your product as a loss leader in order to get 6 more contracts on the labor side. And I think that's 7 fair and reasonable, but what is the number? 8 Uh, the argument that it's zero or doesn't 9 exist or should be -- that the Department should come up 10 with the number is the challenge, because the burden 11 kind of falls on the taxpayer to at least provide 12 documentation to support that, aside from the allocation 13 which may be reflected on the -- on the, uh, invoice. 14 So, uh -- and then you -- I thought I heard in 15 your testimony that -- I don't know if it was a 16 hypothetical that you provided, that they would purchase 17 a product for $44 and then sell it for 56? 18 MR. McCLELLAN: Mm-hmm. 19 MR. HORTON: Where did that come from? 20 MR. McCLELLAN: That came from a page -- I'm 21 not sure exactly how it was numbered when it was 22 presented to you. But Exhibit 1, it's the first 23 invoice. 24 MR. HORTON: And you do know that -- that 25 amounts to about a 22 percent markup? 26 MR. McCLELLAN: Well, according to the 27 calculation it amounts to an eight percent. 28 MR. HORTON: No. No. 65 1 MR. McCLELLAN: Well, they -- they included -- 2 they -- they did a -- 3 MR. HORTON: That's 12 -- 4 MR. McCLELLAN: I'm sorry. They did a total 5 invoice, uh, markup calculation. 6 But yeah, for that particular item, I don't 7 disagree with that. 8 MR. LAMBERT: There's other items included in 9 the invoice, other than just the tile squares. 10 MR. HORTON: Okay. 11 MR. LAMBERT: So, um -- and I don't know -- I 12 can identify it here, but I don't know what it is. Um, 13 it's about 129 of them. It's -- I don't know. Fire 14 brick TC, Manguard. 15 So that's -- when that is taken into account, 16 uh, it -- it -- 17 MR. HORTON: Breaks it down. 18 MR. LAMBERT: Pardon me? 19 MR HORTON: Go ahead. I'm sorry. 20 MR. LAMBERT: It -- it does come out to that 21 markup when you take the total invoice. 22 MR. HORTON: Okay. 23 MR. LAMBERT: Yeah. 24 MR. HORTON: Um -- 25 MR. McCLELLAN: So -- 26 MR. HORTON: Your -- 27 MR. McCLELLAN: Would -- would you like me to 28 address your express concerns? Or may I? 66 1 MR. HORTON: Yeah. My hesitation is I don't 2 want to be in a position to argue the case, but 3 hopefully to encourage you to -- 4 MR. McCLELLAN: Okay. 5 MR. HORTON: -- to, uh -- 6 MR. McCLELLAN: Well, I'll say this, is what 7 I've heard from all, or at least most of the Members, is 8 that there's some express doubt. 9 Um, what I've heard from the Department is that 10 they haven't verified that this selling price, that 11 really they're forcing on this taxpayer, after the sale, 12 he can't go back to his customers and say, "Look, I've 13 been charged -- forced to charge a higher price, pay 14 up." They haven't validated it in any way. 15 The third party affidavits are the best 16 available evidence that we have here in front of us. 17 MR. HORTON: They're not complete, though. Not 18 to interrupt you, but -- 19 MR. McCLELLAN: I understand what you're saying 20 in that respect, that we can't be certain that 21 they're -- they're potentially referring to a pre-rebate 22 or a pre-incentive markup, I believe, is what you're 23 saying, correct? 24 MR. HORTON: Mm-hmm. 25 MR. McCLELLAN: And I accept that. I -- I -- 26 they do use the word "margin." I think they're 27 referring to their profit margin, which, to me, seems to 28 indicate that they're actually looking at what they're 67 1 making net of it. But rather than dissect those 2 affidavits, if it's going to hinge on an issue like 3 that, um, then I would hate to see this case concluded 4 against my client on information like that. I'd like to 5 find an answer. 6 As far as the same customer base from the 7 period in which the achieved markup is being looked at 8 to the -- to the, uh, actual audit period, the 9 Department indicated that that was the case. I don't 10 know what the source of that information was. I can't 11 recall ever having any communications in that respect. 12 Um, and as far as the proper markup is 13 concerned, um, I think that -- that a proper look to 14 would be what did other people in this industry sell 15 their goods for? And if what that results in is a 16 showing that there's a consistent 28 percent markup when 17 they're making a high volume sale, uh, and they're -- 18 they're providing this additional service -- which at 19 least warrants some adjustment, maybe not down to a very 20 low markup, but I think it warrants some adjustment -- 21 then I think we would be on the -- we would be, um, at 22 least more apt to -- to agree to what's being done here. 23 MR. HORTON: And this case is eight years old? 24 MR. McCLELLAN: Yes. 25 And I certainly don't want to prolong it any 26 further. And I know that my client certainly doesn't 27 want to, and he won't be pleased if it is. But, um, at 28 the -- at the sake of making certain that the right 68 1 decision is made, which I believe should be made in 2 favor of my client, I think that's, uh, certainly a 3 necessary cost that my client would be willing to 4 bear. 5 MR. HORTON: Well, I mean, in the absence of 6 any evidence to the contrary, we have a recorded markup 7 of 28 percent for 2001. 8 MR. McCLELLAN: We have evidence to that 9 contrary though. 10 MR. HORTON: Recorded for 2001. Seems that 11 you -- you agree to that markup? You think that markup 12 for 2001 is wrong? 13 MR. McCLELLAN: Well, we can show that the -- 14 that the same -- they -- the Department has consistently 15 said, um, today that it appears that those markup 16 percentages are that the recorded figures are done in 17 the same manner. 18 We've established that the figures for the 19 latter period, um, are inaccurate. So if inaccurate is 20 the manner for one period, then it must be inaccurate 21 for the other period. 22 MR. HORTON: Give me a date. I mean, 2001, 23 the recorded markup for 2001 -- 24 MR. McCLELLAN: Mm-hmm. 25 MR. HORTON: -- do you believe it's different 26 than what the Department has alleged? 27 MR. McCLELLAN: Based on the evidence, I would 28 say yes. 69 1 MR. HORTON: What evidence? 2 MR. McCLELLAN: The evidence that says that 3 their markup was lower during the following periods, and 4 that the achieved markup for 2002 is negative 14, I 5 believe. And -- and -- and the invoices show that 6 he's -- 7 MR. HORTON: I don't see how that relates to 8 2000 -- 9 MS. YEE: It's 2001. 10 MS. MANDEL: He's just asking you whether you 11 have a disagreement for 2001 that the markup was 12 whatever the number is, 28 percent. That's -- that's 13 where he's saying there's no other evidence as to 2001 14 than the 28 percent. 15 MR. McCLELLAN: Well, I would just -- 16 MR. HORTON: Here, let me -- let me -- let me 17 see if I can help. 18 MR. McCLELLAN: Okay. 19 MR. HORTON: I mean, I would stipulate that the 20 business practices changed from 2001 to 2002, pretty 21 obvious. 22 MR. McCLELLAN: Yes. 23 MR. HORTON: I would also stipulate that, uh, 24 the taxpayer can, at their own discretion, use the sale 25 of material as a loss leader and actually reduce their 26 markup -- 27 MR. McCLELLAN: Mm-hmm. 28 MR. HORTON: -- from the period of time when 70 1 they were not in that business to -- in order to 2 increase, uh, their competitiveness if the profit margin 3 was larger on the sell of product in 2001. I mean, if 4 we had that data to say that there's no motivation, uh, 5 to -- to improperly allocate because the profit margin 6 on the services -- 7 MR. McCLELLAN: Mm-hmm. 8 MR. HORTON: -- is the same as the profit 9 margin on the material, or higher or lower, that would 10 certainly, uh, give us some pause, if you will. 11 But, that's in generalities. You still need 12 documentation or something to support. 13 Let me go to the Department and see if I can 14 help. 15 We looked at the federal income tax returns 16 2001 and 2002 as well? 17 MR. HANKS: Mm-hmm. 18 MR. HORTON: Did we observe a fluctuation in 19 the net profit? 20 MR. LAMBERT: Net profit. Uh, well, we -- we 21 have the gross. 22 MR. HORTON: Was the -- let's start there. Was 23 the gross the same? 24 MR. LAMBERT: Shows gross profit. I have a -- 25 shows 429,000 negative in 2002. 26 MR. HORTON: Negative -- 27 MR. LAMBERT: I don't know -- I don't believe 28 we have the net. 71 1 MR. HORTON: Gross will work. I mean, it 2 should have the same -- 3 MR. LAMBERT: Well, we just have from the -- 4 from the material sales. The material sales calculation 5 from -- 6 MR. HANKS: I think the auditor was primarily 7 concentrating on looking at cost of goods sold. 8 Actually, we've got a really detailed valuation for cost 9 of goods sold. So they've got inventory -- 10 MR. HORTON: Was cost of goods sold consistent? 11 MR. HANKS: The purchases are increasing over 12 time. Cost of goods sold is -- is also increasing over 13 time. 14 But what they've done within the cost of goods 15 sold valuation is actually break down the purchases from 16 the other labor costs. So it's actually quite detailed. 17 They've got inventory, beginning inventory, purchases, 18 cost of labor, other costs, and ending inventory. And 19 then it gives you a cost of goods sold valuation. 20 And so what the auditor was doing was comparing 21 the cost of materials only with what the taxpayer 22 reported as -- as gross sales. And that's how the -- 23 the markup was calculated. 24 So the markup for the first year was 28 25 percent. In the second year what we're finding is that 26 the cost of just materials only were nearly $3 million, 27 but the reported sales were 2.5 million. 28 MR. HORTON: Here's my -- here's my -- what I'm 72 1 trying to understand. Were they consistent, 2001, 2002, 2 just the cost of goods sold? 3 MR. HANKS: Cost of goods sold is increasing. 4 MR. HORTON: It's going up? 5 MR. HANKS: It's going up. So the business 6 activity is really ramping up. 7 MR. HORTON: And -- and gross sales are going 8 up as well, theoretically? 9 MR. LAMBERT: Recorded gross sales, it's going 10 up. 11 MR. HANKS: It's going up, too, but not as high 12 a slope. 13 MR. HORTON: Obviously, with the negative. 14 MR. HANKS: Yeah. Right. 15 MR. HORTON: Okay. Um, there's a ballpark 16 figure out there, but you have to get us in the park. 17 Further discussion, Members? 18 Hearing none, is there a motion? 19 MS. YEE: Move to take the matter under 20 submission. 21 MR. HORTON: Moved by Member Yee to take the 22 matter under submission. Second by Member Mandel. 23 Without objection, Members, such will be the 24 order. 25 Sir, thank you very much for appearing before 26 us. 27 MR. McCLELLAN: Thank you. 28 MR. HORTON: We certainly appreciate it. The 73 1 Board will take your matter under consideration later on 2 this evening and send you a written report of our 3 decision. 4 MR. McCLELLAN: Thank you. 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 74 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 NOVEMBER 14, 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 44 constitute a complete and accurate 14 transcription of the shorthand writing. 15 16 Dated: DECEMBER 4, 2012 17 18 19 ____________________________ 20 JULI PRICE JACKSON 21 Hearing Reporter 22 23 24 25 26 27 28 75 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 November 14, 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 45 through 74 constitute a complete and accurate 14 transcription of the shorthand writing. 15 16 Dated: December 4, 2012 17 18 19 ____________________________ 20 KATHLEEN SKIDGEL, CSR #9039 21 Hearing Reporter 22 23 24 25 26 27 28 76