1 BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 2 5901 GREEN VALLEY CIRCLE 3 CULVER CITY, CALIFORNIA 4 5 6 REPORTER'S TRANSCRIPT 7 OCTOBER 29, 2013 8 CORPORATE FRANCHISE AND PERSONAL INCOME TAX HEARING 9 APPEAL OF 10 B1a PACIFIC COAST BUILDING PRODUCTS, INC. NO. 514183 11 B1b ERIN SULLIVAN 12 NO. 573889 13 B1c PATRICIA D. ANDERSON (DECEASED) NO. 573893 14 B1d CAROL ANDERSON WARD 15 NO. 573891 16 B1e JOHN E. ANDERSON NO. 573901 17 B1f DAVID LUCCHETTI AND CHRISTINE LUCCHETTI 18 NO. 573905 19 B1g KEITH HARRIS AND MARY HARRIS NO. 573908 20 B1h JAMES ANDERSON AND JACQUELYN ANDERSON 21 NO. 573911 22 23 AGAINST PROPOSED ASSESSMENT OF 24 ADDITIONAL INCOME TAX 25 26 Reported by: Kathleen Skidgel CSR No. 9039 27 Juli Price Jackson 28 CSR No. 5214 1 1 P R E S E N T 2 For the Board Jerome E. Horton of Equalization: Chairman 3 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, Board Proceedings 12 Division 13 For Board of Anthony Epolite Equalization Staff: Tax Counsel IV 14 Grant Thompson 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 William Fraser Witness 26 Gerry Gunning 27 Witness 28 Bill Padavona Witness 2 1 5901 GREEN VALLEY CIRCLE 2 CULVER CITY, CALIFORNIA 3 OCTOBER 29, 2013 4 ---oOo--- 5 MS. RICHMOND: Our next item is Item B7a 6 through B7h. B7a Pacific Coast Building, Inc.; B7b 7 Erin Sullivan; B7c Patricia D. Anderson (deceased); 8 B7d Carol Anderson Ward; B7e John E. Anderson; B7f 9 David Lucchetti and Christine Lucchetti; B7g Keith 10 Harris and Mary Harris; and B7h James Anderson and 11 Jacquelyn Anderson. 12 Please come forward. 13 This case was granted an additional 60 14 minutes to make the opening presentation. 15 MR. HORTON: Okay. As the taxpayer settles 16 in, Mr. Ambrose, would you please introduce the 17 issues in this case. 18 MR. EPOLITE: Good afternoon, Mr. Chairman, 19 Members. Anthony Epolite and Grant Thompson of the 20 Appeals Division. 21 MR. HORTON: I did it again. My apologies. 22 MR. EPOLITE: That's okay. We look the 23 same. 24 MR. HORTON: No, you don't. 25 MR. EPOLITE: Welcome to the continuation 26 of the September 12th, 2012 Pacific Coast Building 27 Products hearing first held in Sacramento. 28 Um, the hearing summary that the Board has 3 1 before them today has four exhibits attached to it. 2 The first exhibit is the original hearing summary. 3 The second exhibit is Appellants' spreadsheet of the 4 34 projects that were before the Board on September 5 12th of last year. The third exhibit is the 6 November 9th, 2012 spreadsheet in which Appellant 7 lists the 64 projects. And the fourth exhibit is 8 the spreadsheet of Appellants' qualified research 9 expenses attributable to each of the 64 projects. 10 There are three issues before the Board in 11 this appeal. 12 Issue one: For each project the issue is 13 whether Appellants have provided sufficient evidence 14 to establish that Pacific Coast was engaged in 15 qualified research. More specifically, there is a 16 four-part test under Internal Revenue Code Section 17 41(d) to determine whether a taxpayer is engaged in 18 qualified research. 19 Here the Board's focus has been on the 20 fourth element of that test, the process of 21 experimentation test. Under this test, the question 22 is whether, for each of the projects, substantially 23 all of Pacific Coast's activities constituted a 24 process of experimentation. 25 The second issue: Whether Appellants, for 26 each of the projects, have established a nexus 27 between the claimed research activity and the 28 claimed expenses. 4 1 And the third issue: Whether Appellants 2 have established the base amount and the fixed-base 3 percentage. 4 MR. HORTON: Thank you. 5 The Appellant will have 10 -- oh. 6 What was that, 60 minutes? 7 MS. RICHMOND: 60. 8 MS. YEE: An hour. 9 MR. HORTON: An hour? 10 MR. RUNNER: Wow. 11 MR. HORTON: Let's think about that. 12 Okay. In the interest of adjudication, 13 we'll grant an hour to present, an hour for both the 14 Appellant as well as the Department and see if we 15 can have the rebuttal handled in 20 minutes. Okay. 16 All right. 17 MR. SPERRING: Good afternoon, Mr. Chairman 18 and Honorable Board Members. On behalf of the 19 taxpayer Pacific Coast Building Products, I am -- 20 and its shareholders, I am Jon Sperring with 21 PricewaterhouseCoopers. And with me today is 22 Mr. Kendall Fox and Mr. Reed Schreiter. We also 23 have the California plant managers for Pacific Coast 24 Building Products here as witnesses and they're in 25 the first row. 26 After a brief introduction of the appeal, I 27 will ask Mr. Fox to explain, one, why he determined 28 that Appellants activities -- uh, excuse me -- 5 1 determined why Appellants had engaged in qualified 2 activities, and two, what steps he took to quantify 3 the amount of qualified activities that occurred 4 during the tax years at issue. Then I will ask Mr. 5 Schreiter to question the Appellant plant managers 6 regarding their R&D activities and the wage surveys. 7 Appellants make building products. They 8 dedicated roughly eight percent of their wage and 9 supply expense during these years to research and 10 development, creating new products and improving the 11 manufacturing process to create these products. 12 Appellants have provided evidence of a 13 process of experimentation. Through systematic 14 trial and error, they engaged and developed these 15 new products and processes. 16 Appellants have claimed R&D credits in 17 California and have substantiated the amount claimed 18 with contemporaneous books and records, tours of 19 Appellants plants, interviews with plant personnel, 20 and declarations by plant managers. The key to 21 understanding Appellants claim is the fact that 22 Appellants have allocated these R&D expenses on a 23 cost center basis. 24 Appellants have met their burdens to show 25 qualified research activities occurred and that the 26 research expenses claimed were reasonable. 27 Now I would like to give a brief history of 28 the company, focusing on what occurred in their 6 1 business during '99 to '04 and explain why 2 conducting R&D activities was so crucial to the 3 company's business. 4 Pacific Coast Building Products is 5 family-owned and a California-headquartered business 6 with employees throughout California and the western 7 United States. The company, which during these 8 years employed more than 2500 people, makes building 9 products, including brick, clay, water and sewer 10 pipes, clay roof tiles, concrete pavers and block, 11 and wallboard. 12 The founder, Fred Anderson, started with a 13 single lumber yard and purchased a number of 14 manufacturing facilities in the 70s and 80s, all of 15 which at the time of purchase were either recently 16 closed down or in the process of being shuttered. 17 One of these plants, Gladding McBean, first opened 18 in 1875; and the other, the Vernon paper plant, 19 opened in 1912. 20 Over time, operating badly outdated plants 21 ultimately forced the company to develop a strategy 22 to modernize the plants to remain competitive. This 23 was no small -- this was no small feat given that 24 each plant was one-of-a-kind and badly outdated. 25 Upgrading the -- upgrading the existing facilities 26 required highly skilled individuals to guide the 27 re-engineering of the existing facilities. 28 Ultimately, this is a path the company embarked on 7 1 under Mr. Lucchetti's stewardship. 2 California experienced an unprecedented 3 building boom from '95 -- excuse me, from '99 to 4 '05, and Pacific Coast Building Products was able to 5 meet this surge in demand. For example, the 6 company's sales increased 50 percent -- uh, 56 7 percent from beginning, from '99 to the beginning of 8 '04. Of course this growth at the company's plants 9 not only required innovation and engineering on the 10 production side, but also the introduction of new 11 products to meet ever-changing consumer tastes and, 12 uh -- tastes and demand for improved quality 13 products. 14 With this background we turn to address the 15 issues before us. One, Appellants have provided 16 sufficient evidence to establish that they engaged 17 in qualified research activities; two, Appellants 18 have met their burden of proofing qualified research 19 expenses through a cost center approach; and three, 20 Appellants have substantiated the fixed-based 21 percentage. 22 In order to qualify for R&D credit, 23 taxpayers must engage in qualified research 24 activities. Whether an activity is qualified 25 research depends on meeting a four-part test which 26 is laid out in IRC Section 41, 174 and the 27 regulations thereunder. 28 While we are prepared to discuss how Pac 8 1 Coast research activities meet the requirements of 2 the four-part test, I am focusing my time here to 3 discuss the part that FTP -- FTB appears to have the 4 biggest issue with, the process of experimentation 5 requirement. 6 Before the Board can properly determine 7 whether Appellants have substantiated all 64 8 projects, it is helpful to illuminate the correct 9 legal standards that the projects should be 10 evaluated under. 11 Section 41 states that in order for 12 qualified act -- in order for activities to be 13 qualified research activities, substantially all of 14 the activities must constitute elements of a process 15 of experimentation. 16 The step-by-step process, as stated in the 17 related regulations, provide that activities must 18 involve, one, identifying an uncertainty concerning 19 the development or improvement of a business 20 component which can be related to a product or 21 processes and identifying alternatives to eliminate 22 that uncertainty; two, identifying a process to 23 evaluate the alternatives; and three, conducting an 24 evaluative process which includes systematic trial 25 and error. 26 The 2003 final Treasury Regulations 27 specifically state that systematic trial and error 28 is experimentation. Citing Eustace, the FTB has 9 1 held Appellants to the higher than required standard 2 of trial and error in the scientific sense of 3 forming and testing hypothesis rather than the lay 4 or even engineering sense of trial and error. This 5 is the wrong standard. 6 The Eustace court's reference to trial and 7 error being nonqualified was specifically superceded 8 by the final Treasury Regulations, and the court 9 acknowledged that such final regulations would 10 control. Thus, Respondents' reliance on Eustace 11 definition of experiments and its value and its 12 failure to accept systematic trial and error to 13 satisfy the process of experimentation is misplaced 14 and, I believe, why we're here today. 15 Systematic trial and error, applying 16 principles in mechanical, electrical, chemical and 17 ceramic engineering is the realm in which Appellants 18 process improvements took place. The declaration of 19 plant managers provides some examples. 20 A lot of trial and error really involved 21 more the control on the wet end, trying to figure 22 out the best way to deliver the stock so that we 23 could control it. Where do you place the control 24 valves? What kind of pressures do you run in the 25 inlet side? How do you inject that into the 26 forming, the pumping system that supplies the 27 formers? 28 Part of your design considerations and 10 1 trial and error was, How will it run through the 2 machine best? How can we set up the structure of it 3 to run the proper distances? We are starting from 4 scratch trying to figure out, Okay, how are we going 5 to split these felts, this top felt, and make it 6 work in our process? 7 We had a lot of iterations of design 8 options. But, again, there was a lot of trial and 9 error, with adjustments in dampers and burners, to 10 get the entire system working with the program 11 controls to know exactly what time and temperature 12 relationship we had to build in. Systematic trial 13 and error is a standard required by Section 41, and 14 that is the standard Appellants met. 15 Another key to understanding qualified 16 research at issue is that integration and 17 configuration of equipment into a process can be 18 qualified research. That the components and system 19 need to create paper or the manufacturing line needs 20 to create roof tiles involves systems that interact 21 in complex and varying ways, and that a change in 22 one system might require changes in the other 23 systems. 24 Instead of viewing the R&D conducted by 25 Appellants through this lens, the FTB again 26 misinterprets case law, this time Trinities, Inc. v. 27 United States, and rejects Appellants qualified 28 research projects. 11 1 The IRS argued that Trinity did not conduct 2 R&D because it was merely ordering off a menu by 3 mixing and matching pre-existing and already-in-use 4 design and systems to build its ships. The court 5 disagreed, stating that the determination of how 6 systems fit together could be treated as qualified 7 research activity, and experimentation of the 8 overall scope of the project was needed. 9 The determination of how systems fit 10 together is the type of process improvement R&D 11 conducted by Appellants. Again, the declarations 12 provide examples of this point. 13 With the dryer preheater, the duct side 14 also had to be changed, the fans had to be changed 15 and reworked. We used some old components, matched 16 with new stuff as well. We changed fans around. We 17 purchased new duct work, bigger duct work, to make 18 everything match up better. And then the kilns were 19 reconfigured to be able to handle this new range of 20 temperature. 21 Most of the equipment that we purchased, 22 the bits and pieces, were commercial, things like 23 electric switches, limit switches, relays. All of 24 that is commercially available, but we had to design 25 it. We had to install it ourselves. We had to get 26 it to work ourselves. None of it was guaranteed 27 turnkey from an engineering company. 28 The FTB's reluctance to allow projects 12 1 involving improved manufacturing process is 2 evidenced by its complete disallowance of Appellants 3 credit related to these projects. And yet, we know 4 that according to IRS published statistics, roughly 5 70 percent of the R&D credit claimed in America is 6 by taxpayers categorized as manufacturers. 7 Furthermore, the Treasury Regulations are replete 8 with examples involving manufacturers. 9 A manufacturer undertakes to create a 10 manufacturing process for a valve. So a 11 manufacturer purchased existing equipment for the 12 purposes of modifying it to meet its needs. Example 13 7 from the Section 41 reg. 14 A manufacturer develops a new blade to fit 15 in -- to fit onto its current production line and 16 engages in systematic trial and error to do so. 17 Example 3 in the Section 41 reg. 18 A machine manufacturer is uncertain 19 regarding the appropriate design of a machine for a 20 customer and whether features desired by the 21 customer can be designed in integrating to a 22 functional machine. Example 3 from the proposed 23 Section 174 reg. 24 A wine producer is developing a new wine 25 production process that involves the use of a 26 different method of crushing grapes and has to 27 detect -- has to test the effectiveness of this new 28 process. Example 9 in the proposed Section 174 13 1 regs. 2 With these examples to rely on, it is easy 3 to see how Appellants projects qualify. The R&D 4 activities associated with redesigning its open-air 5 brick kiln to a closed kiln allowed H.C. Muddox to 6 cut the time and energy it required to produce each 7 brick by 50 percent; and those activities qualify as 8 R&D. 9 Only through R&D can a manufacturing 10 company increase its production capability by more 11 than 50 percent in five years without any new or 12 additional facilities. And yet, using the 13 unreasonable standard rejected by the IRS, the FTB 14 disallowed every one of Appellants projects 15 involving an improved manufacturing process and all 16 but one product development project. 17 The FTB allowed qualified research on the 18 Gladding McBean glaze spalling body pop-out project, 19 albeit with dramatically reduced QREs attached. And 20 yet, from the standards above, we also know that R&D 21 was done when Basalite modified the recycle content 22 of its concrete blocks while maintaining their 23 structural integrity. 24 The developing new roof tiles that blend 25 different types of clays is a textbook example of 26 conducting R&D. And the labor associated with 27 redesigning its processes to reduce the number of 28 impurities in its paper, while simultaneously 14 1 increasing the recycle content, qualify as R&D 2 documentation standard. 3 Finally, neither the IRC nor the Rev. and 4 Tax Code contain a specific recordkeeping 5 requirement for the R&D credit. In fact, the IRS 6 considered and rejected the idea of establishing a 7 stringent recordation requirement, determining that 8 it would place an unnecessary and costly 9 recordkeeping burden on taxpayers. 10 So the standard for substantiating R&D 11 credit is the very books and records kept in the 12 normal course of Appellants business. Furthermore, 13 the courts in Union Carbide and McFerrin allowed 14 testimonial evidence to substantiate the qualifying 15 nature of the activities and the associated costs. 16 Appellants have met this documentation 17 standard by providing contemporaneous books and 18 records, tours of Appellants plants, interviews with 19 plant personnel and declarations by plant managers. 20 Now I'm going to ask Mr. Fox to please 21 explain to the Board why and how he determined that 22 the taxpayer had, indeed, engaged in qualified 23 research activities, and second, what steps he took 24 to quantify the amount of activities that occurred 25 during the years of the study. He will also walk 26 you through how he determined the fixed-base 27 percentage. 28 Mr. Fox. 15 1 MR. FOX: Good afternoon, Mr. Chairman and 2 Honorable Members. 3 I've devoted most of my efforts over the 4 last 20 years to consulting with hundreds of 5 companies on the research credit and representing 6 clients upon subsequent examination. I was also 7 engaged by BNA to rewrite the BNA portfolio on the 8 research credit. 9 I have represented PwC in an IRS 10 initiative, which included the other major 11 accounting firms, in ways to improve the efficiency 12 of administration of the credit and written and 13 spoken extensively on the topic. This experience 14 has enabled me to put to practice what we believe 15 are effective means and methods of identifying, 16 documenting and quantifying research credits -- 17 credits in accordance with applicable legal 18 standards. 19 The legal standards include Treasury 20 Regulations, court decisions and IRS administrative 21 guidance, such as published audit techniques guides. 22 These methods also incorporate the experience gained 23 from successfully representing dozens of taxpayers 24 undergoing IRS examination or at IRS appeals, as 25 well as experience with the Franchise Tax Board. 26 The Pacific Coast study was performed 27 taking into account the following factors: 28 First, we gained, through interviews with 16 1 management and plant tours, an understanding of the 2 overall business, plant locations, their products 3 and their processes. 4 Second, we gained, through these plant 5 visits and additional interviews with subject matter 6 experts, an understanding of its manufacturing 7 processes, its design and development of new 8 products, and its design and development of new and 9 improved manufacturing processes. 10 Third, through interviews with Finance, we 11 gained an understanding about Pacific Coast 12 maintained its contemporaneous books and records, 13 understanding that the company uses only cost center 14 records and does not maintain a project-based 15 accounting system. 16 Using this understanding of the company, 17 its development efforts, and its books and records, 18 a methodology was developed specific to Pacific 19 Coast to capture its research activities and related 20 costs. 21 Pacific Coast's procedures were designed to 22 ensure two things: Only qualified activities and 23 costs were included in Pacific Coast's claim, and 24 Pacific Coast's claim could be supported on exam by 25 documentation and testimony, the nature and extent 26 of which would be commensurate with the claim's 27 significance. Also, the procedures were custom and 28 specific to each site, with specific documentation 17 1 and site-specific summary memorandum prepared for 2 each location. 3 Generally, the work performed involved 4 following five steps, each of which will be 5 explained in more detail. 6 First, reviewing activity and cost 7 documentation and conducting interviews. 8 Second, identifying qualifying activities 9 and costs. 10 Third, documenting qualified activities and 11 costs. 12 Fourth, completing the base period review 13 and documentation. 14 And finally, calculating the tax credit. 15 The first step, reviewing activity and cost 16 documentation and conducting interviews. In 17 addition to gathering and reviewing all available 18 documentation regarding potentially qualified 19 activities and expenditures, our investigations were 20 comprised primarily of interviews with Pacific Coast 21 plant managers and other subject matter experts 22 familiar with the nature and purpose of each plant's 23 activities and expenditures. 24 The goal of these interviews was to provide 25 Pacific Coast personnel with an understanding of the 26 legal rules regarding qualified research, qualified 27 services, and qualified research expenditures as 28 they are defined in IRC Section 41, Treasury 18 1 Regulations, legislative history, and relevant case 2 law, so that the determination could be made as to 3 which of the activities and expenditures qualify 4 under these rules. The interviews also allowed us 5 to gain a more thorough understanding of Pacific 6 Coast's organizational structure and business 7 operations in order to better assist an 8 identification of qualified activities and 9 expenditures. 10 The next step was identifying qualified 11 activities and costs. To ensure the Pacific Coast 12 personnel identified only qualified activities and 13 costs, two steps were taken. Activities and costs 14 were qualified only by plant personnel or subject 15 matter experts familiar with the represented facts, 16 and PwC explained the legal criteria to the 17 employees and then reviewed what was qualified to 18 ensure that all relevant law and exclusions were 19 applied. 20 Once Pacific Coast's plant managers and 21 subject matter experts understood the law, each 22 plant manager or subject matter expert identified 23 the activities and expenditures that were determined 24 to be qualified and nonqualified. 25 With regard to identification of qualified 26 activities, activity time surveys were completed for 27 the fiscal years ending March 31st, '99 through 28 March 31st, 2005. 19 1 Treasury Regulation Section 1.41-2(d) 2 requires that where an employee has performed both 3 qualified services and nonqualified services, only 4 the amount of wages allocated to the performance of 5 qualified services constitutes an in-house research 6 expense. 7 The regulation provides that in the absence 8 of another method of allocation that the taxpayer 9 can demonstrate to be more appropriate, the amount 10 of in-house research expenses shall be determined by 11 multiplying the total amount of wages paid to or 12 incurred for the employee during the taxable year by 13 the ratio of the total time spent -- actually spent 14 by the employee in the performance of qualified 15 services for the taxpayer to the total time spent by 16 the employee in the performance of all services for 17 the taxpayer during the taxable year. 18 Note that the regulations do not require 19 that these allocations be made at a project or 20 business component level, only the annual amount of 21 time devoted to research be measured or estimated. 22 The time surveys were used in accordance with the 23 above Treasury Regulation to make such allocation. 24 A percentage of each employee's time was 25 allocated to qualified research activities and the 26 remaining percentage assigned to nonqualified 27 activities. Only Pacific Coast personnel familiar 28 with the nature and purpose identified and verified, 20 1 by signature, all qualified activities and expenses. 2 Pacific Coast is unaware of any source of 3 information that can provide more legally relevant 4 and reliable information regarding the qualification 5 of activities and costs and the individuals who 6 actually performed the activities or incurred the 7 costs. Pacific Coast relied on the most accurate 8 and reliable source of information available to 9 ensure only qualified activities and costs were 10 included in the claim. 11 Finally, documenting qualified activities 12 and costs based upon the first two steps; 13 additionally, Pacific Coast personnel provided 14 information and documentation, including, for 15 example, Authorizations for Funds Expenditures, 16 detailed design drawings, test results and testing, 17 documentation, machine equipment and estimates, 18 miscellaneous correspondence, meeting minutes, and 19 so forth, regarding the nature of the activities 20 performed, such that narratives describing these 21 qualified activities and related contemporaneous 22 evidence were prepared. 23 Um, qualified narratives were not prepared 24 for each and every project, but rather, a sufficient 25 number were documented in order to cover most of the 26 costs incurred and to make sure in tests that 27 Pacific Coast personnel describing the qualified 28 activities properly understood the rules and did not 21 1 allocate any time to unqualified activities. 2 It should also be noted, regarding the 3 records, that different records have different 4 meanings. Some records in and of themselves do not 5 establish that qualified research took place; 6 however, they are direct evidence of approximate 7 time periods and that the activities did take place. 8 For an example, an AFE for Gladding was 9 prepared unless all of the parts and pieces and 10 equipment were purchased to fabricate the newly 11 designed roof tile process. Taken with the detailed 12 design drawings, meeting minutes, and, um, 13 testimonial, um, description of the activities, the 14 documentation corroborates the testimony of the 15 subject matter expert that the research took place 16 and helps establish timelines. 17 It should be noted that the IRS examined 18 and accepted the above described, um, methodology, 19 the related projects and the related costs in its 20 audit of the 2005 and 2006 tax years. 21 Um, step four, base period review. After 22 identifying the plants that performed qualified 23 research activities and expenses, Pacific Coast 24 personnel in all instances, historians, meaning 25 long-term Pacific Coast employees, analyzed the 26 activities and head count for all similar plants in 27 existence during the base period 1984 to 1988. 28 These historians then determined which existing base 22 1 period plants performed qualified research 2 activities and those that did not and provided a 3 measurement from which to calculate the base amount. 4 The base records include financial 5 statements from actual expenditures and receipts and 6 then an estimate of the amount of research performed 7 in the base period as contrasted with the current 8 years. 9 We have also reviewed other available 10 documentation showing the relative number of 11 products developed and sold during the base period 12 as compared to the numerous new products and 13 processes introduced during the 1999 to 2004 period 14 of rapid growth, the rapid growth of new products 15 and plant processing capability, fueled by the high 16 investment in research and development. 17 It should be noted, again, that the base 18 calculation is static, meaning it doesn't change 19 from year to year and that the IRS specifically 20 examined the base period and did not adjust it as 21 part of the its examination of 2005 and 2006. 22 Pacific Coast, by completing the above 23 outlined steps and calculating and documenting the 24 qualified research credit, have met their burden of 25 proof since the record shows that the company 26 maintains a contemporaneous set of books and records 27 that records all expenses incurred by the company by 28 cost center. Those expenditures were allocated to 23 1 research activities in accordance with the 2 regulations. 3 Qualified research activities were 4 identified and documented in accordance with IRS 5 Treasury Regulations, case law, and IRS 6 administrative guidance, and the base period was 7 properly calculated on a consistent basis as 8 required by code and regulations. 9 MR. SPERRING: Now I'm going to ask Mr. 10 Schreiter and the first witness to come up and speak 11 to the Board. 12 MR. SCHREITER: Good afternoon, 13 Mr. Chairman, Honorable Board Members. My name is 14 Reed Schreiter. I'm from PricewaterhouseCoopers, 15 and I'm appearing on behalf of Appellants. 16 And what I'll be doing is questioning three 17 of the plant managers, but all five are here today; 18 so that if you have any questions for them, 19 you're -- you're welcome to ask questions of any of 20 them. 21 Um, Mr. Fraser is going to be testifying, 22 so I don't know if you want to do swearing in. 23 MR. HORTON: Ms. Richmond. 24 MS. RICHMOND: Please raise your 25 right hand. 26 Do you swear to tell the truth in these 27 proceedings? 28 MR. FRASER: I do. 24 1 MS. RICHMOND: Please state your name for 2 the record. 3 MR. FRASER: My name's William Fraser. 4 MR. SCHREITER: Okay. Thank you. 5 What is your current position with Pacific 6 Coast Building Products? 7 MR. FRASER: I'm the general manager for 8 PABCO Paper. 9 MR. SCHREITER: And was this your position 10 during the years that included 1998 through 2004? 11 MR. FRASER: During that time, I was the 12 plant manager. 13 MR. SCHREITER: Okay. Are you familiar 14 with the R&D activities claimed for the years at 15 issue? 16 MR. FRASER: I am. 17 MR. SCHREITER: Okay. And what was your 18 involvement in those activities? 19 MR. FRASER: I was directly involved with 20 both the design, implementation, testing, and 21 start-up of any project at my facility. 22 MR. SCHREITER: Okay. And, Bill, I'd like 23 you to tell me a little bit about your plant; 24 specifically, when was it built? 25 MR. FRASER: Yeah, our plant was built in 26 1912, and it was built primarily at that time to 27 make paper for manufacturing boxes. 28 MR. SCHREITER: Okay. And was it updated 25 1 before your activities in the years at issue, and to 2 what extent? 3 MR. FRASER: There were a couple of major 4 upgrades through the years. In 1918 they put in a 5 second line, which is the line that we currently 6 run. And then in 1940 they upgraded the dryer 7 section to a stack dryer configuration, um, on the 8 current line that we run. 9 MR. SCHREITER: When did Pac Coast buy the 10 facility? 11 MR. FRASER: Pacific Coast purchased the 12 facility in 1984. It began operation in January of 13 1985. 14 MR. SCHREITER: Okay. Was the plant 15 operational when they bought it? 16 MR. FRASER: No, the plant was not running 17 when they bought it. 18 MR. SCHREITER: Okay. And when were you 19 hired as the manager? 20 MR. FRASER: I began work there in December 21 of 1993. 22 MR. SCHREITER: And what goals or 23 directives did the company give you at that time? 24 MR. FRASER: So primarily the plant was 25 purchased to supply a high quality of gypsum paper 26 for our own gypsum operations. So that has always 27 been one of our directives, is to maintain a very 28 high quality paper. 26 1 Um, and as with most facilities, we're 2 tasked with trying to reduce operating costs, 3 especially due to the nature of our process and, um, 4 the age of our equipment. 5 Um, and then during this time period, we 6 had the added task of trying to, um, rapidly 7 increase production so that we could keep up with 8 the demand due to an expansion at our board plant. 9 MR. SCHREITER: Okay. And were you able to 10 make progress on your goals? 11 MR. FRASER: Yeah, absolutely. We were 12 able to increase our speed significantly while 13 maintaining our paper quality and reduce some of our 14 key cost components. 15 MR. SCHREITER: And could you give me a 16 couple specific examples of increases? 17 MR. FRASER: Yes. So in 1998, our paper 18 machine ran 595 feet a minute, producing about 165 19 tons of paper a day. By 2004, we were running 800 20 feet a minute and producing 200 tons per day of 21 paper. And during that time period we cut our 22 natural gas costs per unit by about 20 percent. 23 MR. SCHREITER: Thanks, Bill. 24 Let's look at some of the projects you 25 undertook during the years at issue. Let's start 26 with the wallboard paper development project first. 27 And what was the problem you addressed in 28 that project? 27 1 MR. FRASER: Okay. Wallboard paper 2 development is kind of ongoing with us because, as 3 our processes change, we have to make modifications 4 to our gypsum board paper. 5 During that time period, um, we were 6 addressing a few problems and some opportunities. 7 One of the opportunities was the development of 8 mold-resistant paper that's used currently in our 9 mold-resistant board. 10 Some of the problems we were experience -- 11 experiencing were cockles, which is a surface defect 12 of the gypsum board, um, washboard. And then one of 13 the ones we spent a lot of effort on was board 14 slideability. 15 MR. SCHREITER: Okay. So you mentioned the 16 board slideability problem. How did you try to 17 correct that? 18 MR. FRASER: All right. So board 19 slideability basically impacts not only our 20 manufacturing board plant but also our customer 21 base. 22 Gypsum board is stacked in two-piece 23 bundles that are then stacked on a skid. At the 24 manufacturing plant, that occurs by sliding them 25 across each other. In the field it is when they 26 unstack the board, they slide the board. And so if 27 it doesn't slide very well, it creates major 28 problems. 28 1 So we began a process of trying to 2 determine how we could make our board have a lower 3 friction rate without being so low that it actually 4 slid off the trucks as it was shipped. 5 So we started with looking at our stock 6 systems to see if we could improve the paper ply 7 bonding. By having stronger ply bond, it would 8 prevent the paper from actually peeling as it was 9 slid. We also, um, looked at some different furnace 10 changes, trying to run shorter fibers on that side 11 of the board to, again, prevent them from wanting to 12 roll up. 13 And then lastly, um, because we weren't 14 having a lot of success doing that, we started 15 looking at some different chemical options, and we 16 ran experiments with not only individual chemicals 17 but combinations of chemicals. 18 MR. SCHREITER: Okay. So what was your 19 final solution there? 20 MR. FRASER: So we finally ended up with a 21 combination, um, of two different chemistries that 22 ended up serving our purpose. 23 MR. SCHREITER: Okay. The, uh -- the 24 documentation for the project consists of, among 25 other things, trial trip reports and chemical usage 26 reports. Are these the usual kinds of records you 27 keep in your operations? 28 MR. FRASER: Yeah, that would be consistent 29 1 with what we keep. 2 MR. SCHREITER: Okay. Bill, let's look at 3 the split top felt project next. 4 Um, and Board Members, as we look -- talk 5 about this project, you can look in your materials 6 under Tab 10 and there is a drawing of the paper 7 machine that's located at the Vernon facility. 8 Bill, what was the problem you were 9 addressing in this project? 10 MR. FRASER: Okay. As we discussed 11 earlier, um, we had a need to speed up our paper 12 machine. And, unfortunately, to do that, um, we 13 needed to look at our wet end of our machine, which 14 is on the far left of the drawing, and come up with 15 a way to remove water more effectively, um, while 16 running faster and dropping the weight of the paper. 17 MR. SCHREITER: Okay. And what 18 alternatives were you considering when you began the 19 project? 20 MR. FRASER: So initially when we have an 21 issue that we're trying to address, we'll always 22 look at what we currently have in place and see if 23 there's a simple solution that won't involve a lot 24 of capital investment to -- to fix. 25 So we -- we looked at our existing long top 26 felt. So if you look at that drawing, on the left 27 side you'll see a set of rollers with a -- a line 28 that continuously tracks around. That's the first 30 1 top felt. And then to the right of that, on the top 2 again, would be the second top felt. 3 At that time we had one long continuous 4 felt that ran that entire distance. And so we 5 looked at that first to see if we could modify felt 6 designs, maybe install a separation box in the 7 middle, um, or even install a larger vacuum removal 8 early on to see if it would work. But it became 9 apparent early on that at the higher speeds that 10 wasn't going to work. 11 MR. SCHREITER: So you ended up using the 12 split top felt as opposed to the long top felt? 13 MR. FRASER: Correct. 14 MR. SCHREITER: Okay. 15 MR. FRASER: We decided to go with split 16 top. 17 MR. SCHREITER: Okay. And what was the 18 process of design with that project? 19 MR. FRASER: So in a case like this, 20 because of the age of our machine, we don't really 21 have any good drawings. So we end up having to 22 pretty much go out, um, do all of our own measuring, 23 looking at the potential options. 24 And in this case, you have to be careful 25 because whatever you're doing is going to be 26 integrated with the rest of your machine and you 27 don't want to have negative impacts on other parts 28 of your process. 31 1 So you have to take into account how long 2 each felt's going to be, the position of guiding 3 systems, position of cleaning systems, vacuum boxes. 4 And then ultimately, too, um, the actual felt 5 design, which we have to make a guess on initially 6 because we don't really know what we're going to 7 have once we start it up. 8 MR. SCHREITER: Okay. I'm going to veer 9 off just a little bit here. But can you tell me 10 what does the felt do, and what is it supposed to do 11 in the paper process? 12 MR. FRASER: Okay. So the felt is really 13 one of the key components for making paper. It is 14 the formation fabric; it's what you form the sheet 15 on. And after that its role -- role is to de-water 16 the paper and to impart smoothness to the face side 17 of the paper. 18 MR. SCHREITER: Okay. And so when you're 19 looking at a felt and the process that, um, is used 20 and you've -- one of the considerations is how fast 21 it'll absorb water off the paper? 22 MR. FRASER: Yeah, absolutely. Because as 23 you change speed and you go through your suction 24 knit point, your resonance time in that knit point 25 shrinks, and so you have to adjust for that at the 26 higher speeds. 27 MR. SCHREITER: And what was the, uh -- 28 with the long top felt you had a certain contact 32 1 time at the knit point. And with the split top you 2 had a different time. What were the differences 3 there? 4 MR. FRASER: With the long top felt, since 5 it ran the entire length of the bottom felt, your 6 resonance time was in the probably 40-second range, 7 as opposed to currently we get down into 8 milliseconds. 9 MR. SCHREITER: And in that difference 10 there in the -- down to milliseconds, you're still 11 absorbing as much or more water than before? 12 MR. FRASER: Absolutely. 13 MR. SCHREITER: Okay. The documentation 14 for this process -- for this project consisted 15 primarily of drawings. And, again, are these the 16 type of records you would keep in, uh -- for this 17 type project? 18 MR. FRASER: Yes, they would be. 19 MR. SCHREITER: And what does the drawing 20 specifically show? 21 MR. FRASER: So since our drawings are all 22 hand drawings, they typically show the final 23 iteration of the design. 24 MR. SCHREITER: So your drawings aren't 25 showing iterations along in the design process; you 26 just kept drawings for the final iteration? 27 MR. FRASER: Yeah. As we're doing a 28 drawing and we make corrections, we erase and redraw 33 1 over the top. 2 MR. SCHREITER: Okay. So someone was 3 hand-drawing them, and -- and so you just made the 4 corrections and essentially the first drawing was 5 the last drawing with corrections? 6 MR. FRASER: Yes. 7 MR. SCHREITER: Okay. Great. Thank you. 8 Let's go on now to the last project we're 9 going to talk about, which is the stock pressure 10 loop project. And so what was the challenge you 11 faced with that project? 12 MR. FRASER: So, again, this was another 13 part of our plan to speed up and to be able to 14 lighten our basis weight. Um, and so we -- we 15 needed to come up with a way to not only measure the 16 weight of the paper but control it. Um, so what we 17 did is we got the measurement part of it with our 18 project for our basis weight scanner, and then the 19 control part we got with our stock pressure loop. 20 MR. SCHREITER: Okay. And what alternative 21 did you end up considering? 22 MR. FRASER: Well, again, we looked at the 23 existing headbox design which we were using, which 24 uses a gravity feed system to feed the stock into 25 our forming units. Um, and we looked at potentially 26 modifying it, either changing the way the control 27 gates worked, automating them because they were 28 manual at that time, or changing stock 34 1 consistencies, or even downcomer pipes. But, again, 2 we just didn't feel that it would give us the 3 control we needed for our basis weight scanner. 4 MR. SCHREITER: Okay. So you ended up 5 using the stock pressure loop? 6 MR. FRASER: Yes, we did. 7 MR. SCHREITER: Okay. And what 8 uncertainties did you face in the project? 9 MR. FRASER: Well, in that one, again, 10 because we were doing the design completely 11 in-house, we had a lot of concerns with our 12 engineering calculations and our general layout and 13 design to make sure that it would actually function 14 the way that we hoped it would at the current speeds 15 we were running and at future higher speeds. 16 MR. SCHREITER: Okay. And what was the 17 final result? 18 MR. FRASER: So we ended up just, you know, 19 designing it, putting it in place, and it performed 20 pretty much as we expected. We did have a few flaws 21 in the design, mainly plugging issues, um, at some 22 of the tie-ins between multiple stock systems. 23 MR. SCHREITER: What's -- what's a plugging 24 issue? Plugging? 25 MR. FRASER: Yes, plugging. So the stock 26 actually plugs in the line and then you don't get 27 any flow at all. 28 MR. SCHREITER: Okay. Great, thank you. 35 1 The documentation for this project, among 2 other things, consists of pages of handwritten 3 calculations regarding friction and pipe loss, flow 4 speeds and piping and valve configurations and 5 product specifications and costs. Again, are these 6 the kind of records you would keep for a project of 7 this type? 8 MR. FRASER: Yeah, that would be consistent 9 with, uh, you know, a project we were designing 10 ourselves. 11 MR. SCHREITER: And what specifically does 12 the documentation show? 13 MR. FRASER: Well, in -- in this case, you 14 know, the documentation shows the work that we did 15 in the design side, um, and the different things we 16 looked at as far as types of valves and piping 17 positions, valve positions, things like that. 18 MR. SCHREITER: Okay. Bill, we've talked 19 about three projects. And during the tour you 20 provided to the FTB, to the best of your 21 recollection, did they ask you a lot of questions 22 about the details about the projects or your 23 documentation? 24 MR. FRASER: No, they did not. 25 MR. SCHREITER: Okay. When you undertook a 26 process -- excuse me, when you undertook a project, 27 did it often affect the entire process of the 28 paper-making? 36 1 MR. FRASER: Yeah, absolutely. Any time, 2 like even in this type case of the split top, you'll 3 see it's at the beginning of our process, and so it 4 impacts things that happen downstream. And 5 typically adjustments have to be made, either in 6 further felt designs further on in the press 7 section, maybe press loading, things like that. 8 MR. SCHREITER: Okay. Did you complete the 9 time surveys used for the study? 10 MR. FRASER: I did. 11 MR. SCHREITER: Okay. And do you know all 12 of the employees at the plant and what their jobs 13 are? 14 MR. FRASER: Absolutely, I do. 15 MR. SCHREITER: Okay. So how did you come 16 up with the percentages? 17 MR. FRASER: Again, I looked at who the 18 employees were, what positions they were working at 19 the time and what their impact was to our R&D 20 work. 21 MR. SCHREITER: Okay. Last question. 22 Could you go out and buy a paper mill that works and 23 looks like Vernon? 24 MR. FRASER: No, you could not. 25 MR. SCHREITER: So it's a one-of-a-kind 26 facility? 27 MR. FRASER: It is unique. 28 MR. SCHREITER: Okay. Thank you. 37 1 Gerry. 2 MR. HORTON: Ms. Richmond. 3 MS. RICHMOND: Please raise your 4 right hand. 5 Do you swear to tell the truth in these 6 proceedings? 7 MR. GUNNING: I do. 8 MS. RICHMOND: Please state your name for 9 the record. 10 MR. GUNNING: Gerry Gunning. 11 MR. SCHREITER: Thank you. 12 What is your current position with Pac 13 Coast? 14 MR. GUNNING: I'm the operations manager 15 for H.C. Muddox in Sacramento, California and the 16 Salt Lake plant, Interstate Brick Company. 17 MR. SCHREITER: Okay. And was this your 18 position during the years at issue? 19 MR. GUNNING: During the years 1998 to 20 2004, I was the plant manager of H.C. Muddox in 21 Sacramento. 22 MR. SCHREITER: Are you familiar with the 23 R&D activities claimed during those years? 24 MR. GUNNING: Yes, sir, I was. I was very 25 involved in what turned out to be very successful 26 multi-year and multi-projects. 27 MR. SCHREITER: Okay. And so tell me about 28 the H.C. Muddox facility; when was it built? 38 1 MR. GUNNING: You know, the -- the plant 2 was an older plant that was located at downtown 3 Sacramento. It was moved in the early 60s. The 4 flue kiln was built in 1963. Brick kiln was added 5 in 1968. 6 The plant was built with a very limited 7 budget, using some very old, antiquated equipment. 8 And it was built with a kiln, by a kiln manufacturer 9 that is currently out of business. I think they 10 built two kilns. So it wasn't a -- a high-tech 11 modern kiln. 12 MR. SCHREITER: Okay. And, uh, as -- when 13 you were the plant manager, what goals or directives 14 was -- were you given by the company? 15 MR. GUNNING: Well, it was critical for 16 Muddox to -- to bring the plant to profitability. 17 And it required that, one, we reduce the energy 18 consumption of the kiln. We -- we increased the 19 recovery rates of the plant. 20 You know, the plant was built during times 21 of low energy rates or low energy costs, and during 22 this time energy had gone up to be a significant 23 cost of production. 24 MR. SCHREITER: And did you make progress 25 on your goals? 26 MR. GUNNING: Yes, we did. You know, these 27 R&D projects were very responsible for the improved 28 efficiencies and profitability of H.C. Muddox. 39 1 MR. SCHREITER: Okay. And can you give me 2 some specific examples? 3 MR. GUNNING: Yes, I can. You know, fuel 4 consumption at the plant was reduced from 2000 BTUs 5 per pound to 1200 BTUs per pound; that's a 40 6 percent reduction in fuel. 7 Our push rates, our production capacity was 8 increased from six to nine cars a day; so 50 percent 9 increase in -- in production capacity. And our 10 recovery rates were improved from 90 to 95 percent. 11 MR. SCHREITER: Okay. Gerry, could you 12 give me a description of how a brick kiln works? 13 And before you start, I just want to refer 14 the Board Members to Tab 8 which shows -- is a 15 drawing of the, uh -- how the kiln works at Muddox. 16 So go ahead, Gerry. 17 MR. GUNNING: Basically a tunnel kiln is a 18 bunch of flat railroad-type cars that are on a rail, 19 and they're loaded with brick. The brick enter the 20 kiln in their green fresh molded state. And over a 21 four-day period of time they progress from outside 22 temperature -- the brick are dried and fired -- to a 23 maximum temperature of about 2000 degrees 24 Fahrenheit. And then the brick are cooled down and 25 they exit the tunnel at close to ambient 26 temperature. 27 MR. SCHREITER: Can you tell me a little 28 bit about the science of the kiln; for example, with 40 1 such high heat, how does the air pressure and -- or 2 how does that affect the air pressure and the air 3 flow in the kiln? 4 MR. GUNNING: You know, really there's a 5 critical balance with -- with pressure and 6 temperature. If you look at the chart, you can see 7 a red temperature profile where the brick go from 8 outside temperature up to 2000 degrees and cool back 9 down. 10 Correspondingly, there's a pressure curve; 11 it's the blue line. And -- and there really is a 12 science because the kiln is under different 13 conditions all the time. It's not a static 14 condition. As brick come in, as brick exit, as we 15 change firing temperatures, push rates, it really is 16 a critical balance. 17 MR. SCHREITER: Let's look at some of the 18 projects you did during the years at issue. And 19 H.C. Muddox undertook seven projects during the 20 years. But when we talked with you, you described 21 those seven projects and organized them into three 22 categories. Could you, uh, review that for me? 23 MR. GUNNING: Yeah. Yeah, I can. 24 The flue liner project were Projects 21 and 25 23 on the -- the Board packet. And Projects 22, 24 26 and 25 were the tunnel kiln brick project. And the 27 other projects were Project 26 and 27. 28 MR. SCHREITER: Okay. Now let's take a 41 1 look at the brick kiln project, and what was the 2 problem you addressed there? 3 MR. GUNNING: Well, there were a few 4 problems that we tried to -- to resolve. The fuel 5 consumption, the high fuel consumption was -- was -- 6 was really the driver. 7 Second driver was there was a need to 8 increase our production. And with more production, 9 we pushed more heat down towards the exit end of the 10 kiln. So as a requirement to cool down the bricks 11 so they exited at ambient temperature, it was a 12 safety issue. 13 We had another issue with air quality in 14 the plant. If you back-draft a kiln you get -- 15 allow products of combustion to be into the 16 workplace. So that was something that was a 17 critical factor for us. 18 MR. SCHREITER: Okay. I'm going to, uh -- 19 I want to ask you a question about the, uh -- 20 running them through the kiln. 21 You would have the heat, heat curve here, 22 the red line. And you're saying as you push more 23 heat down the kiln, um, that could affect the 24 process. So what happens if the heat curve moves 25 too far to the one end? 26 MR. GUNNING: Well, what happens, if the 27 red line -- if -- if the air flow doesn't go from 28 right to left and it starts going from left to 42 1 right, there's that ware cool fan, that picks up the 2 products of combustion and sends it to other areas 3 of the plant. You know, it's not a dangerous 4 condition, but it's not very healthful. 5 MR. SCHREITER: So it can impact -- it can 6 impact the product quality? 7 MR. GUNNING: Oh, yes, it can, very much. 8 And it -- you know, it affects the air quality in 9 the plant. 10 MR. SCHREITER: Okay. Um, so going back to 11 the -- oops, excuse me -- going back to the -- the, 12 uh, brick kiln. Uh, there -- one of the projects 13 dealt with the kiln door. And so I want you to tell 14 me about that. 15 And then before you start, Board Members, 16 the, uh -- the kiln door-- there's a picture of the 17 kiln door on Tab 9, or under Tab 9. So you'll get 18 an idea of what he's talking about. 19 MR. GUNNING: Okay. So what we did, we 20 installed a door on the exit end of the kiln, that 21 would be the right side. And what that fan did, it 22 pressurized the exit of the -- the kiln, so we were 23 blowing in cold air against these hot brick. The 24 air became preheated. That was one of the -- one of 25 the benefits. 26 The second thing that did, those fans, it 27 kept the products in combustion in the firing zone 28 where it belonged and didn't let it back-draft into 43 1 the ware cool section of the kiln. 2 And what we ended up doing is having to put 3 variable speed fans on this -- on these fans. So as 4 the kiln conditions changed, these fans could turn 5 on/turn off to keep a perfect balance in the kiln. 6 MR. SCHREITER: Okay. And, Gerry, this may 7 seem like a basic question, but do kilns normally 8 have doors on the end? 9 MR. GUNNING: No, they don't. And -- and 10 kilns of this vintage did not have, uh, doors of 11 this type. 12 MR. SCHREITER: So the kiln door was your 13 idea? 14 MR. GUNNING: Yes, it was. 15 MR. SCHREITER: Okay. What trials did you 16 undertake to test the kiln door alternative? 17 MR. GUNNING: You know, there were 18 numerous, numerous, numerous trials. You know, 19 there was -- first of all, we needed to determine 20 the -- the pressures that were involved in the kiln, 21 and we needed to determine the pressures given push 22 rates, different product types. 23 You know, it was -- it was a very lengthy 24 project where there were a lot of statistics that 25 needed to be analyzed and fan speeds, pressures had 26 to be all accounted for. 27 MR. SCHREITER: Okay. I want to ask you a 28 little bit about the kiln door. Um, you -- how -- 44 1 how was it determined what the door should be like 2 with fans on and all that sort of thing; is that 3 something you did at Muddox? 4 MR. GUNNING: Well, it is. You know, after 5 all these -- these tests that were performed, we 6 knew that we needed so much CFM at high fire, we 7 needed so much CFM at low fire. 8 So what we needed to do, we needed to 9 design the fans to give the appropriate amount of 10 cubic air into the kiln at various kiln rates. And 11 they were -- we put them on a, uh -- a pressure 12 switch. So as the kiln conditions changed, these 13 fans would modulate up and down to interact with 14 the -- the current kiln conditions. 15 MR. SCHREITER: Okay. And so you came up 16 with the specifications, but someone else built it? 17 MR. GUNNING: Oh, yes, sir we did. It was 18 all these R&D efforts that allowed us to go to the 19 marketplace and specify what we wanted on these 20 doors. 21 MR. SCHREITER: Okay. Again, the 22 documentation for this project consists of 23 specifications and estimates from an industrial 24 sheet metal company and a report from a consultant 25 regarding the kiln and dryers. Is that the type of 26 documentation you would keep for this project? 27 MR. GUNNING: Yes, sir, it is. Very much 28 so. 45 1 MR. SCHREITER: Okay. During the tour you 2 provided the FTB, did you -- did they ask you many 3 questions about the projects or documentation? 4 MR. GUNNING: Yes. You know, we tried to 5 be informative as possible to the FTB staff and 6 tried to bring them up to speed and teach them about 7 our operations. There weren't a lot of questions 8 asked of us. 9 MR. SCHREITER: Okay. And I want to -- 10 want to have you think back to preparation of the 11 R&D credit study. And when you completed the time 12 surveys, how did you come up with the percentages? 13 MR. GUNNING: You know, I was -- I was 14 actively involved in these projects and I was 15 acutely aware of all of our people's activities in 16 the plant. You know, we had maintenance personnel, 17 supervisory personnel, kiln personnel that were 18 involved; and records were kept, time cards were 19 kept, you know, for -- for the credits. 20 MR. SCHREITER: Okay. And so just to wrap 21 things up, is it fair to say that the R&D projects 22 during the years at issue helped you meet the goals 23 that you had? 24 MR. GUNNING: Oh, very much so. Very much 25 so. You know, without these projects, you know, 26 there's a good case to be made that maybe H.C. 27 Muddox would not be in operation today. I don't 28 know if -- how competitive we -- we would have been 46 1 without these projects. 2 MR. SCHREITER: Okay. Earlier in the 3 hearing you heard Mr. Sperring describe the Trinity 4 case he referred to, which was the ship builder 5 case. 6 MR. GUNNING: Yes. 7 MR. SCHREITER: And so, um, in that case, 8 the court decided that integration and configuration 9 of pre-existing systems could be R&D. And I'm just 10 wondering if that describes some of the activities 11 you undertook at H.C. Muddox? 12 MR. GUNNING: Yeah. Very much so. You 13 know, the kiln project started out as a single 14 project to -- to -- to add a kiln door to the kiln 15 to solve some problems. 16 After the kiln door was installed, we 17 discovered that we had a lot of extra BTUs available 18 to use in other parts of the factory. We could use 19 these BTUs to preheat other brick and to also dry 20 brick. And so it became -- one project became three 21 and it became significantly more profitable to the 22 plant. 23 MR. SCHREITER: Okay. And could you go out 24 and buy a facility that looks and works like Muddox? 25 MR. GUNNING: No. The H.C. Muddox plant 26 was really an antiquated one-of-a-kind facility. 27 MR. SCHREITER: Thank you. 28 MR. GUNNING: You're welcome. 47 1 MR. HORTON: Ms. Richmond. 2 MS. RICHMOND: Please raise your right 3 hand. 4 Do you swear to tell the truth in these 5 proceedings? 6 MR. PADAVONA: I do. 7 MS. RICHMOND: Please state your name for 8 the record. 9 MR. PADAVONA: Bill Padavona. 10 MR. SCHREITER: Bill, what is your current 11 position with Pac Coast? 12 MR. PADAVONA: I'm currently retired, uh, 13 retired general manager two years ago. And, uh, 14 currently working as a consultant for Pacific 15 Coast. 16 MR. SCHREITER: And what was your position 17 during the years at issue in this case? 18 MR. PADAVONA: Um, I was operations manager 19 and then became general manager and vice president 20 at Gladding McBean. 21 MR. SCHREITER: Are you familiar with the 22 R&D activities claimed for the years at issue? 23 MR. PADAVONA: Yes, I am. 24 MR. SCHREITER: And what was your 25 involvement in the activities? 26 MR. PADAVONA: Well, not only as an active 27 participant and, um, responsible party for the 28 projects but also initiator of the projects that 48 1 were listed. 2 MR. SCHREITER: Okay. And so tell me a 3 little bit about Gladding McBean, which is located 4 in Lincoln and is the plant you worked at; when was 5 it built? 6 MR. PADAVONA: Gladding McBean was built in 7 1875. And, uh, I think it's one of the oldest 8 continuously operating manufacturing plants in the 9 State of California, um, and the manufacturer of 10 clay building materials, is primary products; roof 11 tile, uh, sewer pipe for sanitary sewers, 12 architectural terra cotta and garden pottery. 13 MR. SCHREITER: Okay. Was the facility, 14 um, updated before your activities in the appeal 15 years, and to what extent? 16 MR. PADAVONA: Well, over the years -- I 17 mean, I -- I don't have the complete history of the 18 plant. But, uh, over the years most renovations 19 consisted of replacing broken-down equipment with, 20 uh, more used equipment that was operating. And 21 then also changing the fuel system from originally 22 wood-burning to oil, and then eventually natural 23 gas. 24 So this is a period -- over a period of 25 over a hundred years, you know, this kind of -- same 26 kind of thing went on. 27 MR. SCHREITER: When did Pac Coast buy 28 Gladding McBean? 49 1 MR. PADAVONA: Uh, 1976. 2 MR. SCHREITER: And when were you hired as 3 the Plant Manager? 4 MR. PADAVONA: Um, I was hired in 1991 and, 5 um, took the role as plant manager in 1993. 6 MR. SCHREITER: What goals or directives 7 were you given by the company as you became plant 8 manager? 9 MR. PADAVONA: Well, much like the -- the 10 two other plants under Pacific Coast's control, 11 plants were kind of obsolete and lacked good cost 12 control. Uh, you know, the revenue base was kind of 13 sinking in a growing market and, uh, you know, I was 14 asked to improve quality, reduce costs, and add new 15 products to the -- 16 MR. SCHREITER: Okay, thank you. 17 MR. PADAVONA: -- list of products that 18 were manufactured. 19 MR. SCHREITER: Bill, you had -- have 20 extensive experience in ceramic engineering. And so 21 can you tell me a little bit about that and how you 22 think that influenced being hired at, uh -- by Pac 23 Coast? 24 MR. PADAVONA: Yeah. Um, let's see, I have 25 a degree in ceramic engineering from Alfred 26 University in New York state. And came out to -- to 27 PABCO to kind of assist, um, with the ceramic 28 engineering developments that they needed to -- 50 1 to -- to build the costs, you know, lower costs and 2 improve products. 3 Um, I came to the company with over 25 4 years experience, probably the only person at the 5 company with extensive experience in manufacturing 6 roof tile. 7 So, all of this, uh, was something I could 8 use to create these new products and reduce costs 9 and accomplish what was asked of me. 10 MR. SCHREITER: Okay. Going back to the 11 goals the company had given you. Were you able to 12 make progress on those goals during your time? 13 MR. PADAVONA: Yeah, we made -- we made 14 good progress. I mean, we were able to improve our 15 recovery rate or quality of the plant by about 15 16 percent. We were able to reduce costs in the roof 17 tile manufacturing, labor costs, by over 40 percent. 18 And we developed new products. 19 MR. SCHREITER: Okay. Let's look at the 20 roof tile modernization project. 21 MR. PADAVONA: Okay. 22 MR. SCHREITER: Which was project number 23 28, which actually consisted of the development of a 24 new product, the roof tiles, and the improvement of 25 the manufacturing process. 26 What was the problem you addressed with 27 this project? 28 MR. PADAVONA: Well, um, we tried to 51 1 develop a -- a roof tile process that would somehow 2 fit into the existing other four products or -- or 3 five -- or three products that were manufactured 4 within this plant, uh, without disrupting that 5 operation and still make use of the existing dryers 6 and the tunnel kiln, um, that we had at the plant. 7 So we wanted to use some of the assets that 8 we were -- had in the plant we felt that were 9 viable, um, without disrupting the rest of the 10 operation. 11 MR. SCHREITER: Okay. And what 12 alternatives did you choose to work on? 13 MR. PADAVONA: Well, you know, we looked 14 at, you know, several possibilities, including 15 building a new roof tile facility. And we knew that 16 starting from scratch would be probably somewhere 17 between 15 and $20 million. So we said that really 18 doesn't fit into the, um, the possibilities at 19 Gladding McBean given how old a facility it was. 20 So we decided to see if we could renovate 21 the existing system to -- to cut costs and improve 22 quality and develop some new products. 23 MR. SCHREITER: Okay. And what processes 24 did you undertake to update the facility? 25 MR. PADAVONA: Well, we worked, we brought 26 in a, uh, mechanical engineer who worked with us on 27 designing new equipment and layouts of equipment to 28 accomplish what I said was to get this operation 52 1 working through this maze of other products that 2 were going on at the same time. Because during this 3 period, uh, demand was skyrocketing for -- for sewer 4 pipe, for terra cotta, and for roof tile. And so we 5 didn't want to disrupt those other products, you 6 know, and cost us revenue on that end. 7 Um, so it was a difficult process to -- to 8 find a way to fit this in. And we really couldn't 9 depend on a turnkey system to do that. We had to 10 kind of initiate our own process, discover a way to 11 do it within the confines of Gladding McBean. 12 MR. SCHREITER: Okay. And in doing -- 13 undertaking this project, did you experience 14 failures? 15 MR. PADAVONA: Oh, yeah. Yeah. Several 16 failures. Though you try to guard against those 17 things when you're reinventing the wheel, so to 18 speak, and we were about as old as the wheel. Um, 19 it -- uh, you're going to go through some trial and 20 errors. 21 I mean one that bring to mind right away 22 was the fact that we had to develop a drying system 23 that, uh -- to meet our commitments on -- on, uh -- 24 on increasing production. We had to produce a 25 drying system that would dry tile in 16 hours versus 26 four -- four days. 27 And so in order to do that, we incorporated 28 several moving fans in dryers that we had renovated, 53 1 and the drive system for those fans had to operate 2 at 220-degree temperature; that was the maximum 3 temperature in the dryer. Well, we just found out 4 that, you know, things were failing left and right. 5 And so we had to -- had to redesign the 6 drive system to be external of the dryer so that it 7 wasn't in that high temperature atmosphere and to 8 get that to work. 9 Also, in changing our -- our drying cycle 10 from four days to 16 hours, you know, were we -- was 11 the tile going to withstand that kind of moisture 12 removal in that short -- short of period of time? 13 So we built a little test dryer and we set it at 14 different drying rates to -- to test our existing 15 material to see if it would dry without cracking, 16 you know, come out whole and good quality. 17 And so that took several days of testing 18 and trial and error until we found that we had to 19 actually change the mix. So we had to incorporate 20 some new materials in; and when you do that, that 21 changes a lot of other things in the process, 22 including the firing process. 23 So it was a long period of time between 24 when we ran a test until we finally reached a point 25 where we could successfully put materials through 26 the new dryers. 27 MR. SCHREITER: So it sounds like, with the 28 dryers, the determining what would work, going from 54 1 four days to 16 hours, using fans that moved as 2 opposed to whatever they did before, you were driven 3 by the science of moisture removal from the tile 4 itself? 5 MR. PADAVONA: In part, yes. I mean, um, 6 you know, this is just a physical chemistry problem, 7 determining how many tons of water you're going to 8 remove in X number of hours. But you have that 9 other factor of can the -- the -- the body that 10 you're removing the water from take that kind of 11 fast water removal, that evaporation and water 12 moving through the system without it cracking, 13 creating differential shrinkage and all the other 14 factors. 15 And so, you know, we have to couple both 16 the science, a little bit of black magic in there, 17 to make sure that the product comes out 18 successfully. 19 MR. SCHREITER: Okay. And what impact did 20 the project have on the overall manufacturing 21 process? 22 MR. PADAVONA: Um, well, like I said, it 23 was very successful ultimately. After about a year 24 and -- actually three years of -- from the inception 25 to the end, um, we decreased our labor costs by 40 26 percent. Um, our recovery rate improved by -- by 10 27 percent. And we had a 50 percent increase in 28 output. 55 1 MR. SCHREITER: Now, the improvements you 2 made to the process allowed you to introduce new 3 products. Can you tell me briefly about the new 4 roof tiles? 5 MR. PADAVONA: Yeah. Because of the 6 delivery system or raw materials that we instituted 7 within the new process, we were able to do some 8 things related to mixing different color clays 9 together to form a product that, you know, after 10 being fired, had a variegated look to it which is 11 very desirable in the roof tile business, both 12 concrete and clay. 13 And so we decided that we could mix clays 14 in delivering these clays to the extruder, and then 15 it eliminated having to blend these different colors 16 after the product came through the kiln. 17 So we -- we ran some tests and found that 18 we were successful in creating a nice color scheme 19 that -- that was very attractive and our customers 20 liked. The only problem was, because the clays were 21 so much different, they created a differential 22 shrinkage between certain colors and other colors. 23 So we had tiles that were supposed to be 18 inches 24 long, and some were 18-and-a-quarter and others were 25 17-and-three-quarters. Well, that's just not 26 acceptable in the roofing business. 27 So we had to go back to the lab, find clays 28 that would give us the same shrinkage profile that 56 1 matched with each other. And after a period of 2 several trials, not only in the lab but then plant 3 trials to make sure it works in the plant, uh, we 4 were successful. 5 And the important thing is the product we 6 created, even today, represents about 30 percent of 7 the sales for roof tile. 8 MR. SCHREITER: Okay. And the 9 documentation for this project consists of, among 10 other things, meeting minutes, project analysis 11 reports, a project proposal, drawings and reports. 12 Are these the type of documents you would keep for a 13 project like this? 14 MR. PADAVONA: Yeah. I mean, right -- 15 right from the beginning we -- you know, we made 16 sure that all of our time records -- we had a good 17 cost accounting system that we could rely on. And 18 anything that wasn't a direct cost or an indirect 19 cost that would go into inventory cost was flagged 20 as an R&D. And so in retrospect, you know, coming 21 up with the -- the analysis was an easy thing to go 22 back and pinpoint what hours were associated with 23 what project. 24 MR. SCHREITER: Okay. Bill, I just want to 25 jump ahead here to the -- to the preparation of the 26 R&D credit study and, uh -- and how you completed 27 the percentages for the time surveys. 28 MR. PADAVONA: Well, like I said, we were 57 1 able to pretty much pick that out of the records 2 that already existed that were flagged by the 3 project number. 4 MR. SCHREITER: Okay. 5 MR. PADAVONA: And, um, so, you know, it 6 made my job very simple, you know. Assigning a 7 person to a certain number of hours was already 8 established as we did these tests in the plant. 9 MR. SCHREITER: And so to wrap things up, 10 is it fair to say that the R&D projects that you 11 undertook during the years at issue helped you meet 12 the production goals that the company had given you? 13 MR. PADAVONA: Well, I think it -- it 14 exceeded the goals, you know, I was given. And 15 it -- luckily it did because our roof tile sales 16 went from less than $2 million a year to over $4 17 million. So it doubled. Without this project, for 18 example, we would have never met the commitments 19 that our customers required. 20 MR. SCHREITER: Okay. And could you go out 21 and buy a facility that looks and works like 22 Gladding McBean today? 23 MR. PADAVONA: No, not that looks like 24 Gladding McBean, obviously not. So -- 25 MR. SCHREITER: Thank you. 26 MS. RICHMOND: Time's expired. 27 MR. HORTON: Thank you very much. 28 Is there a concluding statement in all of 58 1 this? 2 MR. SCHREITER: I think we're finished. 3 ---oOo--- 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 59 1 MR. HORTON: Okay, we'll now go to the 2 Department. The Department has -- let me figure out 3 a way to say this -- the Department has one hour to 4 make their presentation. 5 MR. HILSON: Thank you, Mr. Horton. 6 MR. HORTON: You're welcome, sir. 7 MR. HILSON: Mr. Chairman, Members of the 8 Board, I'm William Hilson. 9 To my right is Jason Riley, to his right is 10 Ann Hodges and we are here representing the 11 Franchise Tax Board today in this matter. 12 This case involves Appellants asserting 13 claims of entitlement of more than $35 million of 14 qualified research expenses for their fiscal tax 15 years 1999 through 2004. 16 It now involves an identified 64 projects 17 at seven different business locations involving the 18 manufacturing of brick and clay products, paper, 19 wallboard or Sheetrock and an enterprisewide 20 software system. 21 The projects all have various things in 22 common, including a severe lack of contemporaneous 23 documentation memorializing what is going on or 24 how what is taking place constitutes any kind of a 25 required process of experimentation. 26 There is no question that the taxpayers 27 bear the burden of proof in this matter or that tax 28 credits are a matter of legislative grace and that 60 1 statutes granting tax exemptions must being strictly 2 construed against the taxpayer, resolving any doubt 3 in favor of the Franchise Tax Board. 4 Those principals are not new and were very 5 recently reaffirmed by the California Supreme Court 6 in its unanimous opinion in DiCon. 7 It's also without -- without doubt that the 8 taxpayers are required to retain records necessary 9 to substantiate a claimed credit. Amongst other 10 things that comes out of Trinity. 11 We submit that the records have not been 12 produced, particularly where one considers the 13 substantially all or 80 percent rule applicable to 14 tax research and development credit claims. 15 The Treasury's regulation at Section 16 1.41-4(a)(6), substantially all requirement. In 17 order to -- for activities to constitute qualified 18 research under Section 41(d)(1) substantially all of 19 the activities must constitute elements of a process 20 of experimentation that relates to a qualified 21 purpose. 22 The substantially all requirements of 23 Section 41(d)(1)(C) and paragraph (a)(2)(iii) of 24 this section is satisfied only if 80 percent or more 25 of a taxpayer research activities, measured on a 26 cost or other consistently applied reasonable basis, 27 constitute elements of a process of experimentation 28 for a purpose described in Section 41(d)(3). 61 1 We simply do not have that here. While we 2 have 64 projects identified by name, what we don't 3 have is documentation revealing anything in the way 4 of a process of experimentation, the specific dates 5 that anything was done, the names of the people 6 involved, what they did or why they did it. 7 The same is true with respect to the cost of 8 supplies attributable to these projects and, 9 likewise, the contract expenses claimed. 10 What we have are reconstructions, which, at 11 best, are arbitrary assessments. For example, every 12 person at the paper plant is included in the 13 reconstructed wage claim -- wage claim. We have a 14 minimum of 93 percent of the employees at Muddox, 88 15 percent at Tracy and 96 percent at Lincoln. There 16 is no explanation as to how all of these employees 17 are involved in qualified activities, let alone an 18 explanation as to what it is they did, when they did 19 it or, not to mention, how that activity satisfies 20 the 80 percent rule. 21 The same is true with supplies. All six 22 plants reconstruct what appears to be all of their 23 supply costs for the years at issue, including 24 consulting and legal fees, repair estimate, repair 25 expenses, temporary help, maintenance expenses and 26 utilities. 27 For example, Tracy includes 5 percent of a 28 $617,000 legal bill for the year 2001. And we 62 1 likewise have passed through a facility contract 2 expenses for five of the six plants. 3 This isn't documentation of expenses 4 incurred with discrete processes of elimination. At 5 best it's retrospective guesswork. 6 Time will not permit me to cover all 64 7 projects. I will, however, try to touch upon all 8 seven facilities to illustrate the shortcomings of 9 these claims. 10 Please understand that to the extent I 11 don't discuss a particular project, that it's not 12 because we believe the claim is valid, that simply 13 isn't the case, it's a matter of time constraints. 14 Starting with Newark. The activities in 15 Newark don't appear to be qualified research nor 16 intended to have been research activities. They 17 were -- they were -- they were -- they were the 18 acquisition of equipment designed to compensate for 19 the fact that its sister plant in Las Vegas could -- 20 could no longer provide it with a necessary 21 ingredient it needed to manufacture wallboard or 22 Sheetrock, effectuating long overdue repairs to a 23 section of the wallboard dryer and managing 24 environmental concern. 25 In his May 2013 declaration, Mr. Kopilovich 26 provides an explanation of how gypsum board is made 27 and talks about the importance of adding accelerator 28 to the mix. 63 1 He also tells us that the Newark plant 2 undertook the task of making their own accelerant, 3 which required the acquisition of a ball mill, 4 relocation of various bins and conveyors and 5 supplying materials to the system. Newark's 6 internal documents, scant as they are, provide 7 additional information. 8 In a capital request dated January 28th, 9 1999, it -- we learn, for many years the accelerator 10 used at Newark has been supplied by the Las Vegas 11 plant. But when the new line is in full operation, 12 Las Vegas will not have the capacity to make 13 accelerator for both plants. 14 An attempt was made to purchase accelerator 15 from outside sources, James Hardie Gypsum in Las 16 Vegas turned out to be the only viable supplier. 17 But because of environmental problems at their 18 plant, they cannot continue supplying us with 19 accelerator. The short term solution is to install 20 a ball mill at Newark and make the accelerator here 21 using landplaster purchased from Georgia Pacific in 22 Sigurd, Utah. The long term solution is to install 23 equipment to make landplaster at Newark. 24 It goes to on to tell us the ball mill but 25 be -- where the ball will -- ball mill will be 26 located, on the mezzanine above the mixer. A 27 volumetric feeder will -- will meter landplaster 28 into the ball mill. Accelerator from the mill will 64 1 drop directly into the admix screw, et cetera, 2 et cetera. 3 It goes on to tell us that it will occupy 4 space for such -- previously used for stock storage 5 at handling, so, a stock con -- conveyor system will 6 have to be installed downstairs. 7 It goes on to tell us the project cost is 8 estimated at $38,775. The breakdown components are 9 identified as the ball mill, various feeders, 10 various conveyors and reveal not only that Newark 11 was going to copy what its sister plant was already 12 doing, but that they knew where the equipment that 13 was going to be purchased was and where it was going 14 to go. 15 Although we don't have precise dates of 16 when the equipment was installed, the capital 17 request for the ball mill machinery equipment and 18 equipment purchases, dated May 27th, 1999, tells us 19 that the ball mill hoppers and related conveyors 20 have already been installed and goes on to request 21 56,000 to purchase three bulk bag feeders, including 22 the bags, frame, interface feeder and cranes. The 23 capital request for the bulk bag feeders also tells 24 us that the Newark's maintenance crew is going to 25 install the system and that Newark can eliminate one 26 employee by going to this system. 27 Although these capital requests tell us 28 that the ball mill will cost 39,000 and was 65 1 operating before May 27th, 1999, Appellants claim 2 qualified research expenses for the ball mill for 3 fiscal years '99, 2000, 2001, 2002 and 2003 in the 4 total amount of $1,846,000. 5 We don't know when the bulk bag system went 6 in or what possible experimentation went on with the 7 installation of this pre-manufactured equipment, but 8 Appellants tell us it covered fiscal years '99, 2000 9 and 2001, for which they claim $1.2 million in 10 qualified expenses as compared to $56,000 for the 11 equipment. 12 These are Projects 12 and 13. And they, 13 together with the mixing screw, which the May 29th, 14 1999 capital request tells us has also been 15 installed, are what constitute the raw material 16 handling upgrade project in Project 11, for which 17 Appellants claimed four years at a value of 18 $665,000. 19 There are no documents telling us what 20 process of experimentation was going on with any of 21 these projects. All the documents show is equipment 22 purchases and installations. We don't know who was 23 involved, what they're doing or whether -- or when 24 they did it. 25 However, there's a claim for Mr. Mueller, 26 an Executive Vice President, for his involvement in 27 these -- in these projects for his wages totaling 28 $989,000. 66 1 While his name appears as a recipient on 2 some of the documents, there is no indication that 3 he's done anything. He's a Vice President, 4 presumptively ineligible to have his wages treated 5 as qualified research expenses, though here we are. 6 Project 16 is entitled the Zone 3 Burner 7 System, for which Appellants tell us they are 8 entitled to qualified research expenses for the 9 years 2003 and 2004 in the amount of $648,000. 10 The capital request dated February 5th, 11 2003 for this project is in the amount of $69,800 12 and tells us the zone 3 burner, gas train and flame 13 control system are old and obsolete. It does not 14 operate efficiently. Old age in the upper section 15 and a combination of old age and improper firing in 16 the lower section has resulted in damage to the 17 burner elements, or diamonds, as they are called. 18 Approximately twenty need to be replaced. Because 19 the burner is so old, other diamonds may be damaged 20 if an attempt is made to replace the known bad ones. 21 There's a major safety concern with the burner. 22 If the lower section gas valve is set too low, the 23 flame will go out and raw gas accumulates in the 24 burner chamber. When the fuel-air ratio is high 25 enough, an explosion can occur when the accumulated 26 fuel ignites. This has happened several times, but, 27 luckily, there has been no damage. In order to 28 prevent this from happening, the operators run the 67 1 manual gas higher than it should be. 2 It goes on to tell us the gas train that 3 controls the fuel-air mixture going to the burner is 4 also in bad shape. We believe the diaphragms in the 5 control and regulating valves have become hard and 6 brittle with heat and age and that they are -- no 7 longer function properly. They can't get them 8 anywhere because the company that manufactured them 9 is no longer in business. 10 Same thing with the flame control system, 11 it's old and obsolete. It functions, but it's not 12 compatible with new modern burner systems. 13 They proposed to replace the burning system 14 at a cost of $69,800. And we know from the attached 15 documents to the -- to the capital request is that 16 the repair work is going to be done by a company 17 called Modern Instrument. 18 In a letter dated January 28th, 2003, 19 Modern Instrument confirms the $69,000 price and 20 states they'll complete the job over three three-day 21 weekends, the last of which will include: 22 "Demo old burner system and install 23 new burner and profile plate, plumb in 24 gas and air to valve assemblies, modify 25 and connect gas valve assembly and all 26 assemblies into air and gas supply, 27 finish point to point wiring, start up 28 and adjust burner." 68 1 That quote also confirms that it includes 2 labor. Appellant claims $648,000 in qualified 3 research expenses for this $70,000 repair job. 4 Continuing on, the next projects all deal 5 what what I believe are properly described as 6 environmental compliance projects. 7 We start with the stucco screen and 8 vibrating screen projects at Nos. 14 and 15. 9 What Appellants tell us is that this is 10 about recycling old Sheetrock and figuring out how 11 to keep the old paper out of the recaptured gyption 12 -- gypsum. 13 Newark's internal documents again shed a 14 slightly different light on it. The AFE for 15 Project 14 is entitled stucco screw and tells us it 16 is for the purchase of a vibratory screw on an 17 environmental project, the total expense of which 18 will be $41,000. 19 The document -- the request specifically 20 states, 21 "Dust emissions from -- from the 22 Newark plant are a major bone of 23 contention with the City of Newark and 24 our neighbors, especially those south of 25 the plant. 26 "There is a long term program to 27 eliminate dust emissions. The stucco 28 screen located on a mezzanine under 69 1 No. 2 stucco tank has been identified 2 as a significant dust emission source. 3 "In addition, the paper scrap rejected 4 by the screen is handled by a front-end 5 loader, another dust emission source. 6 There are two options for dealing with the 7 dust from the screen. One, enclose it, or 8 two, replace the screen. The 9 recommendation is to replace the screen." 10 And then they tell us, 11 "This project will purchase a new 12 totally enclosed stucco screen and a screw 13 conveyor to move the rejects to the baler 14 approximately 50 feet away. The 15 installation work will be done by our 16 maintenance department, $37,785." 17 The associated price quotes tell us that 18 the conveyor is coming from Implied Industrial 19 Technologies in California and the screener from an 20 outfit called SMICO or SMICO in Oklahoma City, 21 notwithstanding the itemizations provided in 22 connection with the AFE and admission that the 23 installation will be installed by the maintenance 24 department, we have claims of $191,000 associated 25 with this project for two -- for the year 2003. 26 Of that $191,000, we again have $57,000 in 27 executive wages. There's no documentation 28 pertaining to any experimentation here or what 70 1 Mr. Mueller's involvements are -- is. All they tell 2 is they got to keep the neighbors and the city 3 happy. 4 Projects 17 through 20 all deal with the 5 plant's dust control system in one form or another. 6 Appellants tell us about how they wanted to increase 7 air circulation speed within the plant to help 8 increase production but that's not the entire story. 9 The authorization for the expenditure with 10 respect to 19 -- for No. 17 tells us -- dated 11 November 13th, 2002 tells us, 12 "The imp mill bag house was 13 installed in 1984. The air duct that 14 connects the bag house to the mill 15 cyclones is not insulated, so, the air 16 in the bag house can drop below the dew 17 point on cool days and condense on the 18 walls. Over time this has caused the 19 sidewalls of the clean air plenum and 20 the dust collection hopper to rust 21 through in many areas. The condition is 22 particularly bad in the area where the 23 blaster pipes go through the plenum wall 24 because there is no insulation in this 25 area. The area where the tube sheet meets 26 the outside walls of the plenum has rusted 27 through in several areas. This area has 28 been repaired several times, but it 71 1 continues to be a problem. The bag house 2 has reached the point where it is no longer 3 cost effective to keep repairing the rusted 4 areas." 5 Three options, the last of which is do 6 nothing, continue patching, with a recommendation to 7 buy a state of the art bag house. 8 There's a second AFE dealing with this very 9 same project dated November 29th, 2004, which is 10 fiscal year 2005 and beyond the years in question 11 here. 12 And it states, 13 "The old aerostatic precipitator 14 that was used for imp mill dust control 15 at a time when electric power was less 16 expensive has been out of service for 17 many years. The equipment is unsightly 18 and the space it occupies is needed for a 19 new bag house. The initial examination of 20 the first layer of insulation in the 21 precipitator prior to removal had been 22 tested and didn't contain asbestos. 23 However, a second layer of insulation was 24 discovered and it found -- and it was found 25 to contain asbestos. This requires the use 26 of contractors with a license to remove 27 asbestos. The logical thing to do is 28 remove the precipitator and use the space 72 1 it occupies to install the replacement bag 2 house." 3 The next paragraph in this 1984 4 authorization for funds is identical to the one that 5 I read to you dealing with the 1982 authorization. 6 Nothing happened with this for the two years -- for 7 the two -- the two-year period in between. 8 The latter AFE tells us the total -- that 9 the labor to remove the precipitator is $87,000 and 10 that the entire project is going to cost 370. 11 The documentation for Project 19 contains 12 the same information for the -- for the same 13 information pertaining to the dilapidated bag house 14 and requests an authorization for $42,000 to 15 purchase a new 150 -- 150 horsepower motor because 16 they upped the speed of the existing fans a year 17 earlier, they found that the increased air flow was 18 beneficial. They want to go higher, but to do so 19 they need to buy a new fan. Nevertheless, there's a 20 request for additional -- additional qualified 21 research expenses. 22 The totals for the combined proposals and 23 the combined claims for qualified research expenses 24 for Projects 17 and 19 is $499,000 -- for something 25 that wasn't implemented or put into play until well 26 after the years in question. 27 The final project, No. 20, requests $35,000 28 for something to do with hazardous waste -- waste 73 1 removal. What they could possibly be doing in the 2 way of experimentation in how to remove this 3 asbestos-laden precipitator isn't explained in any 4 detail. 5 Moving on to H. C. Muddox. The first 6 project we encounter with the H. C. Muddox project 7 is the flue liner kiln, Project 21. Through the 8 combined declarations provided by Mr. Gunning and 9 Mr. Morrison, we're told that the kiln had an arched 10 or domed roof, which was inefficient. So, they 11 undertook changing the kiln to a flat roof design, 12 for which Appellants claimed qualified research 13 expenses in the amount of $102,000 for fiscal year 14 1999. 15 Once again when we look at the internal 16 documents, it starts with an explanation from 17 Mr. Pusk -- Mr. Puskas that, 18 "In July (verbatim) 1997, I 19 submitted a capital request for 20 $425,000 to rebuild the flu kiln 21 here at H. C. Muddox." 22 "The situation recently became 23 more critical when the condition of 24 the crown degraded to the point that 25 the kiln was too dangerous to operate 26 and we shut it down." 27 It then goes on to talk about alternatives 28 that he's discussed with Mr. Padavona and they come 74 1 up with No. 4, which is, 2 "Perform major repairs to the 3 existing kiln - this was just a theory 4 until two weeks ago, when we dropped 5 the crown and the inner walls. We were 6 then able to inspect the outer walls 7 and structural steel to determine the 8 feasibility of a repair. This was done 9 in conjunction with J. T. Thorpe & Son. 10 The estimate from Thorpe, which is 11 enclosed, is $237,000." 12 We then come across a separate -- we then 13 come across a letter from Mr. Gunning to Dallas 14 Barrett dated January 22nd, 1998, enclosing the 15 invoice from J. T. Thorpe and stating, 16 "I believe that the flu kiln 17 capital project, H. C. 05, can be 18 closed out as I don't anticipate any 19 further charges." 20 This is fiscal year 1998, prior to the 21 years in question, the project is done. It's -- it 22 predates these years, a situation which Mr. Gunning 23 essentially admits at paragraph 42 of his combined 24 declaration where he states, 25 "So, the kiln work was probably 26 done in late '97, early '98 based upon 27 this documentation." 28 The next project's No. 22, the brick exit 75 1 kiln door, which they tell us was part of a bigger 2 idea to capture heat from the kiln and move it back 3 to the dryer and preheater sections and that the 4 door would help separate the cooldown area from the 5 outside and help retain the warm air being 6 recirculated. 7 We are also told that Mr. -- that Muddux 8 brought in a consulting expert named Henshell to 9 give them an evaluation of the kiln. 10 Among other things, Mr. Henshell recommends 11 a door with variable speed fans be installed. 12 Mr. Henshell's report references a site visit during 13 June or July 1999. And J. T. Thorpe submits bids to 14 manufacture the door with the fans during June 15 of '99. 16 The project culminates with the 17 installation of the door by J. T. Thorpe in a single 18 day on July 16th, 1999 at a quoted price of less 19 than $11,000. 20 There's no demonstration of any kind of 21 experimentation with this door either before or 22 after its fabrication and installation by J. T. 23 Thorpe, yet we have claims QREs in the amount of 24 $304,335 for this door for the years '99, 2000 and 25 2001. 26 Project 23, the flue dryer preheater deals 27 with -- again with the concept of redirecting waste 28 heat back from the kiln to the preheating sections 76 1 of the dryer. In particular it deals with ductwork 2 and air circulation. This idea is not new and was 3 not not new to this kiln. 4 Mr. Henshell's report tells us that when 5 the kiln and dryer were first installed in 1969 it 6 included a dryer with recirculating fans utilizing 7 waste heat, a preheating section and a rapid and 8 slow cool section utilizing waste heat recovery 9 systems. 10 Johnson Sheet Metal again does the work and 11 in its January 5th, 2000 bid says its work will 12 include taking out the old ductwork and replacing it 13 following the same route for the sum of $29,500. 14 And that, 15 "Our price includes all material 16 as stated, installation labor and crane 17 service. This work is figured to be 18 done during the week on a straight time 19 basis. System will have to be down for 20 seven weekdays. $264,00 for QREs for 21 years 1999 and 2000." 22 No. 24, the holding room improvements is 23 more of the same, utilizing some of the waste heat 24 but increasing the capacity of the holding room. 25 An analysis done December 20th, 2000 by 26 Mr. Gunning and a Mr. Kelly say they're going to 27 accomplish a more efficient use of the space by 28 installing four fans per holding room at a cost of 77 1 $12,000 per room, or $36,000 total, and that it will 2 take 12 weeks to complete. 3 In his declaration regarding this project, 4 Mr. Gunning notes checks payable to a company named 5 Danzer, who did the millwork on the project and an 6 invoice from Dan Corbett, who did the electrical 7 work on the project. 8 The purchase order to Danzer is dated 9 9-25-2008 and the invoice for Mr. Corbett is dated 10 March 31st, '09 -- well beyond the years in 11 question. 12 Nevertheless, we have claims of QREs for 13 the $180,000 for 2001 and $89,000 for 2002. 14 Project 25, the ware cool system, the final 15 project associated with the kin-- in a memo -- the 16 kiln, excuse me. 17 In a memo dated January 7, 2002, 18 Mr. Morrison tells Carl Barisich, 19 "The following is an outline 20 defining the objectives for the 21 proposed Kiln Shut Down which would 22 be approximately two weeks in length. 23 "Problem Two: Ware cool duct is 24 showing signs of possible collapse due 25 to age and low grade spiral duct material. 26 Repairs would consist of replacing 16 27 gauge piral -- spiral duct with 10 gauge 28 mild steel, therefore, giving a longer 78 1 life to the ware cool duct system." 2 On January 24th, 2002, Maddux issues a 3 ductwork purchase order to Johnson Sheet Metal in 4 the amount of $17,861, including labor. 5 And on -- on February 11th, 2002, Johnson 6 Sheet Metal sends Muddox an invoice for $8200 to 7 change out the piping over the kiln. 8 Nevertheless, we have qualified research 9 expense claims of $134,000 for '02 and $236,000 for 10 '03. 11 Once again there is no documentation of any 12 experimentation whatsoever, just an unsubstantiated 13 claim of $370,000 in QREs. 14 Project 26, the H-cutter reels, we've been 15 told that what this project was really all about was 16 modifying the mix formula so as to be able to 17 control product -- product shrinkage during drying. 18 The documents -- what the documents tell us in a 19 memo dated November 4th, 2003 is slightly different. 20 "Al, please find attached AFE and 21 Quote for three new H-Cutter Reels. Our 22 two and a quarter, two and a half and 23 three and a half reels are worn out. Zero 24 and near-zero tolerances on size 25 specification has become the norm rather 26 than the exception. We need to replace 27 these reels in order to realize present day 28 customer expectations and requirements." 79 1 Associated with that is a quote from an 2 entity called WCS, Inc. proposing to provide a 3 combined total of six such cutters for a price of 4 approximately $33,000. 5 The projected -- the project produces 6 claims of QREs in the amount $248,000 for fiscal 7 year 2004. 8 The final project with respect to Muddox is 9 Project 27. And I address it only because it's on 10 the list. It's entitled, "The Monorail Brick 11 Packaging System." And the following is from the 12 purchase order issued by H. C. Muddox to an outfit 13 called Basic Machinery in North Carolina on Jan -- 14 on December 21st, 2004. 15 "This purchase order is issued to 16 Basic Machinery Company, Inc. for the 17 design, supply, fabrication, delivery 18 and installation of a new monorail brick 19 packaging system as described in BMC 20 proposal 10463 and the monorail conveyor 21 arrangement dated July 22nd, 2004. 22 "Note: Basic Machinery will be 23 responsible for a complete turnkey 24 installation of all mechanical components 25 and electrical components within the scope 26 of this quotation." 27 Moving on to Dixon. Dixon consists of 14 28 projects. For eight of them we are provided with 80 1 substantially identical documentation. That 2 documentation includes nine two-page weekly 3 construction and equipment delivery updates from the 4 time period of December 1999 to February 28th, 2000 5 pertaining to the Dixon plant expansion. 6 And it also -- and it also includes four 7 copies of a GANTT timeline, indicating that the 8 expansion project at the Dixon site was to commence 9 on November 10th, 1999 and end on February 28th, 10 2000, with equipment startup scheduled to occur on 11 February 14th, 2000. 12 The project for which these common 13 documents have been provided are Project 32, the 14 pallet turnover device; Project 33, the mold 15 insertion device; Project 50, the block blowdown; 16 Project 51, the automation of the sack system; 52, 17 the installation of the conveyor system; 53, the 18 test oven; 55, the portable crusher; 56, the pallet 19 -- excuse me, 62, the pallet thumper; 64, the 20 asphalt conveying system. 21 They cover -- they cover the years '99, 22 2000, 2001 and 2004 and total $772,000. They tell 23 us nothing about any process of experimentation, 24 when it was conducted, who was involved or what the 25 actual costs associated with any of it was. 26 All we have are titles and retroactive 27 assessment -- retroactive estimated cost 28 reconstructions. 81 1 Project 45, the conversion to a 2 semi-automatic five block machine. Appellants claim 3 this involves fiscal years '99 and 2000, for which 4 they claim $163,000. 5 However, in a July 22nd, 1999 memo, 6 authored by Scott Weber and Dale Puskas, describing 7 expansion plans for Northern California and Nevada, 8 the Phase I approach states, 9 "Put in a 5-at-a-time machine in 10 Dixon and transfer the existing V3-12 11 to Goshen. 12 "The capital expense in Dixon will 13 be $3.5 versus 7.0 in Tracy. Dixon needs 14 only the machine batching and handling 15 systems and a few kilns. All 16 infrastructure is in place. 17 "We can turn the in key -- we can 18 turnkey the installation in approximately 19 four weeks." 20 Moreover, the status report dated 21 February 7 -- February 7, 2000 tells us the block 22 machine arrived on January 20 -- on January 31st at 23 2 p.m. 24 There's nothing about experimentation, just 25 a claim. 26 No. 47, the computer research and 27 development program. Project 47 is called the 28 implementation of computer-based system to track 82 1 R & D. 2 Appellants present a claim for 1999 and 3 2000 in a combined amount of $163,000. For this 4 project we were provided no contemporaneous 5 documentation whatsoever. 6 We know little more than the title given to 7 the project and the amounts of the claim other than 8 Mr. Vasquez told us during the plant tour -- plant 9 tour that what they were using was a Lab Con/Tech 10 Con software. Since this is a commercially 11 available product, Appellants simply cannot meet the 12 three prong -- three-part high innovation test. 13 They have provided nothing to demonstrate 14 that what they did was innovative, proposed 15 significant financial risk to them or, as I have 16 already mentioned, that it was not commercially 17 available. 18 No. 49, the tumbling lines, this claim 19 involves substantially similar claims for both Dixon 20 and Tracy. 21 It involves -- the one at Dixon involves 22 machinery through which bricks are tumbled against 23 each other to create a seasoned look. And what the 24 documents tell us is what they did in Dixon is they 25 purchased a complete turnkey system from outfit 26 called Vena Innovative Machinery sometime after 27 May 3rd, 2000 for $45,900 and mostly used temporary 28 labor for the installation. 83 1 Amongst other things the Vena quote reveals 2 that Vena has a patent pending -- patent pending on 3 the system and that they'll provide supervision for 4 installation and startup. 5 There is nothing to show a process of 6 experimentation here or that Dixon did anything at 7 all other than buy the system. 8 When you get to Tracy, you have the same 9 project. And a May 25th, 2000 memo from Mr. Puskas 10 tells us, 11 "Enclosed is the AFE for the Tracy 12 Paver Tumbler System that we have been 13 discussing over the past couple of months. 14 After evaluating the variety of projects 15 that need to be tumbled, it was determined 16 that we will actually need two tumblers, 17 one in Tracy and one in Dixon. The tumbler 18 in -- the tumbler in Tracy will primarily 19 be used for pavers -- pavers fabricated out 20 of mostly used equipment at an estimated 21 cost of $107,000. 22 "We're going to follow the same 23 contiguous process concept employed in the 24 Vena system. Since the paving stone units 25 are not as large, we'll retrofit an old 26 dryer and the retaining wall tumbler that 27 will be five feet in diameter. In 28 addition, we'll utilize the cuber from the 84 1 old Dixon V3-12 and an extra bag house 2 located in Latham. All of the internal 3 labor will be expensed." 4 The breakdown for the Tracy project of the 5 107,000 anticipated cost tells us that Basalite 6 labor to be included in the project is $13,000. 7 Nevertheless, we have total claims for the two 8 projects involved of $788,000. 9 Project 30, the palletizer project, what we 10 know is Tracy ordered a state of the art 11 palletizer/bagging system from Chantland-PVS Company 12 that was shipped to Dixon on March 19th,'99; that a 13 Chantland technician serviced the machine during 14 June 1999 and that a parts order was placed during 15 July of 1999. 16 In his declaration, Mr. Puskas acknowledges 17 that at the time the project was undertaken, 18 Tracy -- Tracy already had an at least one 19 palletizer machine in operation. 20 No documentation of any experimentation 21 whatsoever with this particular palletizer, but a 22 claim of qualified research expenses for 19 -- for 23 1999 and 2000 in the amount of $1.1 million. 24 And these figures may have been enhanced by 25 the assertion that a certain William Stretch spent 26 80 percent of his time on the project in both '99 27 and 2000, the project which they claim ended on 28 July 6th, 2000, which happens to be the exact date a 85 1 letter from Chantland confirming shipment of parts 2 was sent. 3 31, the vapor system. What we know is 4 Tracy purchased a craft vapor cure system to provide 5 a source of steam heat as part of the brick curing 6 process. We don't know when they purchased it, but 7 they had a concern with hard water. They addressed 8 that concern by purchasing a Culligan water softer 9 -- softener system and utilized Culligan's service 10 technicians when necessary. 11 Another thing they did was to monitor the 12 pH balance of the water, which Mr. Puskas tells us 13 was done through an outside technician. 14 No evidence of any experimentation here, 15 yet we have a claim of $454,000 for years 2001 and 16 2002. 17 Project 56, the burner installation 18 project. In connection with this project Appellants 19 submitted a kiln system structural evaluation report 20 dated July of 2003 by Eichleay Engineers. 21 What Eichleay tells us is that the purpose 22 of this study is to evaluate the structural 23 integrity of the curing kiln located at Basalite's 24 Tracy plant. 25 "Several incidents of loaded 26 pallets collapsing have occurred. 27 It seems that the collapse takes place 28 when a pallet board loses its support 86 1 on the angle and drops the pallet load 2 to the pallet just beneath. This then 3 starts a progressive collapse. 4 "An analysis of a typical interior 5 TS column column was performed for 6 vertical static loads. It was 7 determined that the columns are 8 underdesigned to support the loads from 9 the pallets, even without consideration 10 of the combined effect of any seismic 11 loads. They are very slender and 12 flexible for their length." 13 "Proposed repair. For a similar new 14 structure complying with the Uniform 15 Building Code, the columns supporting 16 the racks would have been 10 inches to 17 12 inches deep instead of four and the 18 stiffness of these members would have 19 been 10 to 15 times more than the current 20 stiffness. 21 "Although this retrofit scheme will 22 improve the system by increasing the 23 existing column stiffness four and a half 24 times and increase the seismic resisting 25 system capacity to resist earthquakes, it 26 will not bring the column section into 27 full compliance with the current building 28 code." 87 1 You've got a system that's shot. No 2 documentation about a burner, just a kiln that isn't 3 up to code and can't support the weight loads it's 4 being subjected to. 5 No proof of any experimentation, but a 6 claim of $372,000 in qualified expenses for the 7 years 2000 and 2004. July 4th, of -- July '04 -- 8 excuse me, '04, of course, is outside the years at 9 issue and nothing has been provided to tell us what 10 was going on in 2000. 11 57, pallet repair system for which they 12 claim 26,000 in 2004. Mr. Puskas, I think, sums it 13 up quite nicely at paragraph 136 of his declaration, 14 "This project was pretty 15 straightforward. We did not make any 16 modifications other than providing some 17 protection around it just to protect it 18 from the elements." 19 Finally, the super sack project. The 20 documentation produced for this project includes a 21 January 30th, 2004 memo from Mr. Puskas, which 22 states, 23 "Attached is an AFE for the purchase 24 of two Chantland 4010 dual speed impeller 25 baggers to replace the current impeller 26 cement baggers at the Basalite Tracy 27 Sacking Operation. The stated weights 28 on the sacks versus actual weights have 88 1 been an issue since Weights and Measures 2 began actively monitoring product in 3 stores. The accuracy of the current 4 system does not allow tighter tolerances 5 than what has been achieved." 6 The memo goes on to talk about how 7 they're concerned about the company's exposures to 8 fines from Weights and Measures at -- which are 9 currently $2500 dollars per sack and how that -- 10 buying these new systems will reduce it. 11 "The cost to replace the existing 12 beam scale weighing system with a 13 Chantland 4010 Rapid Flow dual speed 14 impeller packer is $57,000. The 15 system's state the art with load cells 16 and adjustable features." 17 $56,000 for the machine, claims for 18 qualified research expenses, $625,000 in '01; 79,000 19 in '02; 100,000 in '03 -- for a total of $806,000. 20 Tracy's got two other small projects, 21 the transfer sale communication laser and the mix 22 station laser. 23 No documentation whatsoever with respect to 24 either one of them. In fact, they get less than a 25 -- they share a sentence worth of attention in the 26 executive summary, 52,000 for three -- on the -- on 27 the -- on the transfer call system and 102,000 on 28 the mix station laser. 89 1 Lastly, with Tracy, the split hopper, 2 another project for which there's virtually no 3 documentation. What we have is an undated, 4 pre-installation check list provided by a 5 manufacturer that and three pages entitled, "Color 6 System Scope of Work Block Plan," which are dated 7 April 27th, 2005. 8 We don't when they're doing things or what 9 they're doing, yet we have a claim of $76,000 for 10 fiscal year 2003. 11 Moving on to Vernon. Start with the split 12 top felts. We know from Mr. Deck -- Fraser's 13 declaration and his testimony here today that 14 splitting the top felt was a necessary step for the 15 paper plant in its goal of increasing the volumetric 16 speed of its paper production. 17 Mr. Fraser tells us it's a project that 18 started -- they started thinking about in the late 19 '90s and that they -- that they knew the project was 20 going to be a combination of things they bought and 21 things they built. 22 The documents provided include multiple 23 drawings done by Mr. Robbins during 1996, which 24 indicate they had a pretty good idea of what they 25 were going to do. However, as Mr. Fraser explains, 26 "But then we never had either the 27 time to shut it down to do it or 28 whatever until we finally pulled the 90 1 trigger on doing the project." 2 Mr. Fraser goes on to tell us that when 3 they finally did it, it took several days. We know 4 it wasn't done before May -- May 3rd, 2003 as that's 5 the date of the AFE submitted seeking approval of 6 $160,000 -- $106,000 to do the project, including 7 labor. 8 We also know the project wasn't done as of 9 October 1st, 2003 as Mr. Jordan authors a letter on 10 that date stating, 11 "It will be good when the split 12 felts are installed." 13 Although we don't know when this occurred, 14 who was involved or what experimentation occurred, 15 we have the following claims: 1999, $623,000; 2000, 16 248; '01, 158; 2002, 356; 2003, 257 and 2004, 269 17 for $1.9 million. 18 We have a similar situation with Project 19 No. 9, the vat exhaust addition. We have seven 20 drawings from Mr. Robbins providing detail regarding 21 this project, all of which bear dates of 1997. We 22 also have two of Mr. Robbins drawings dated 2005. 23 We have an AFE dated March 28th, '05, again 24 clearly outside the years at issue, requesting 25 $169,000 for this project and the following 26 explanation from Mr. Fraser, 27 "We knew vat exhaust was a problem. 28 We knew we wanted to increase it, so, 91 1 we started conceptually designing what we 2 wanted to do. And our intent was to buy a 3 new fan. In 2004 we found there was a mill 4 in Colorado, in Commerce, Colorado, that 5 shut down and they had a fan that we 6 thought would fit our needs. So, we 7 ended up buying it. We were waiting for 8 a fan and we found one." 9 We have claims -- again, we have claims 10 from 1999 through 2003, years for which there's no 11 documentation of anything having to do with the 12 project, totaling $575,000. 13 No. 5, the Dissolved Air Flotation Project. 14 We have claimed -- we have claimed -- 15 claimed expenses of $527,000 for fiscal years '02 16 and '03. We have -- we have an AFE dated July 10th, 17 2002 requesting funds in the amount of $104,000 and 18 an accompanying memo from Mr. Fraser, which 19 explains, 20 "Attached is an AFE for a dissolved 21 air flotation unit. We currently have 22 one of these units that removes solids 23 from water as part of our water cleaning 24 system. Unfortunately, the current unit 25 is not large enough to supply the amount 26 of clean water we need for our machine 27 showers, seal water application and other 28 miscellaneous cleaning applications. 92 1 "The unit we build will be identical 2 to the existing unit and physically located 3 next to it. This is proven technology we 4 know works in our system. It would also be 5 a relatively simple installation because 6 the inlet and discharge pipes are already 7 in the same area." 8 Project No. 3, the centrifuge. We know 9 from the documentation provided that this was the 10 purchase of a machine to help with the elimination 11 of contaminants from the stock. 12 An AFE dated November 1999 requested 13 $104,000 in funds for it. Mr. Fraser has confirmed 14 that they bought it off the shelf somewhere and ran 15 it for two or three months before trashing the 16 project. 17 We don't know when any of this occurred, 18 who was involved, what they did, et cetera, et 19 cetera, but we have claims covering the centrifuge 20 for the years 2000 through 2004 totaling $408,000. 21 No. 35, the rewinder. Once again there's 22 little or no meaningful documentation showing what 23 was being done or who was doing it. But we have 24 Mr. Fraser telling us that what we were dealing with 25 was -- what they were dealing with was an old, old 26 piece of equipment, which, amongst other things, was 27 not winding paper tightly enough for the wallboard 28 operations in Las Vegas. And that -- that, in turn, 93 1 was creating havoc in the Las Vegas operation. 2 Mr. Fraser also tells us, 3 "I don't remember -- I don't 4 remember exactly the detail because we 5 trashed it when we put the new rewinder 6 in." 7 Once again, no detail as to dates, what's 8 going on, who's doing it or what they're doing. We 9 have claims for all six years, however, in the 10 combined amount of $676,000. 11 No. 43, the Press Replacement. The details 12 pertaining to the press replacement are succinctly 13 described in a project profile prepared by the 14 engineering firm of JH Kelly. The Kelly firm 15 states, 16 "In September 2004, JH Kelly 17 successfully removed and replaced 18 the press section at PABCO Paper 19 Company in Vernon, California. The 20 press section was provided by VAS Paper 21 Machinery, an Italian equipment supplier. 22 JH Kelly worked directly with VAS to 23 install the new equipment and ensure 24 proper compatibility with the existing 25 1940s era Beloit dryer section. The new 26 press section includes a jumbo press that 27 was installed using a special cart and 28 rigging, both supplied by VAS. 94 1 "While the millwrights concentrated 2 on equipment installation, pipe fitters 3 installed separators, high and low pressure 4 shower lines, hydraulic tubing and vacuum 5 lines. Eighteen millwrights worked two 6 12-hour shifts and six pipe fitters 7 worked one 12-hour shift per day. 8 "Due to a highly skilled and focused 9 crew, JH Kelly was able to complete the 10 project ahead of schedule, ahead of 11 budget and without injury." 12 The efforts of the Kelly firm and VAS have 13 produced a claim for $143,000 in QREs for 2004. 14 Like the others, there is no documentation here of 15 what role anyone associated with Vernon had to do 16 with this project, let alone, the 100 percent of the 17 employee base used in the wage calculations. 18 Moving on to Lincoln. The Lincoln plant 19 presents two claims for qualified research expenses. 20 The first is what -- is for what is labeled the Roof 21 Tile Modernization project and the second is for the 22 Pop-Out Project. 23 The roof tile modernization project claim 24 covers five years, 1999 through 2003, for a combined 25 value of $3.6 million. Like the other projects, the 26 primary problem here is a lack of any documentation 27 telling us what the processes of experimentation 28 were, what was done or who was involved with it -- 95 1 let alone showing that the labor, supplies and 2 contract expenses claimed meet the 80 percent test. 3 The problem -- the problem with this claim 4 is -- the problem with claim is underscored by both 5 Mr. Padavona's explanation that it took three to 6 four months for him to put together the proposals, 7 with an approval process involving Mr. Lucchetti of 8 another couple of months. 9 Appellants have provided copies of various 10 documents pertaining to the projects, including a 11 February 5th, 1999 report, which appears to be a 12 combination of both a marketing survey and 13 recommendation for the roof tile project. They have 14 also provided copies of minutes pertaining to 15 project committee meetings, and in particular, one 16 held on June 11th, 1999. 17 Item 1 in those minutes states, 18 "Committee members were reminded 19 that the the completion date goal for 20 the entire project is December 1st, 1999." 21 In addition to these documents, Appellants 22 have provided a January 24th, 2000 Roof Tile 23 Modernization Project Analysis Report, which 24 includes 14 different categories of portions on the 25 project and the relative completion percentages of 26 both the individual categories and the project as a 27 whole. The reported completion percentage of the 14 28 different categories range from a low of 77 percent, 96 1 with seven categories being represented as 100 2 percent completed, with an overall completion 3 percentage reported at 96 percent. 4 That report also indicates that the total 5 amount of Gladding McBean labor expended on the 6 project was $69,748. 7 In addition to the abject lack of 8 documentation regarding the process of 9 experimentation, these documents demonstrate an 10 absence of any basis to present claims for 2001, 11 2002 or 2003, which, by themselves, total more than 12 than $2 million. 13 The second claim, Project 29, is the 14 Pop-Out Project. We know the Pop-Out Project 15 involved Mr. Padavona, Mr. Keating, an outside 16 consultant, Dr. Dinger and, to a much lesser degree, 17 Mr. Stacy and Mr. Schwartz. We know that through 18 their efforts and trying different things, they got 19 to a point where by December 5th, 2002 the problem 20 had been cured or become quite rare. 21 In a document dated May 6, 2003 and 22 entitled "Materials Meeting," there is the following 23 entry, 24 "Pottery mix 137, question on 25 Pop-Outs." 26 There is nothing to say the Pop-Outs are 27 back or that there is any further testing on the 28 topic. The material minutes for August 12th, 2003 97 1 contain the -- contain the following entry, 2 "No Pop-Outs on current batch." 3 There is no documentation of a continuing 4 problem with the Pop-Outs after December 2002, yet 5 we have a claim of more than a million dollars in 6 fiscal year 2004. 7 In addition, there are problems with the 8 wage calculations. Mr. Padavona tells us in no 9 uncertain terms that the people involved were 10 himself, Mr. Keating and, to a much lesser degree, 11 Mr. Schwartz and Mr. Stacy. He also tells us that 12 Mr. Keating was the lead. 13 However, when you look the reconstruction 14 on these two projects, we see that it's based upon 15 96 to 100 percent of all employees, that less than 16 30 percent of Mr. Keating's time is claimed, 17 compared with 100 percent of Mr. Padavona's. 18 The executive summary tells us these 19 projects consumed 76 percent of Mr. Padavona's time, 20 yet the study puts it at 87 percent, which, of 21 course, translates to claiming 100 percent of his 22 wages. 23 The problem once again boils down to a lack 24 of documentation. 25 Pacific Pathways, Appellants present a 26 claim of $2.2 million for fiscal years '01, '02, '03 27 and '04 for purchasing and implementing SAP software 28 so as to harmonize business operation aspects of the 98 1 various entities that comprise Pacific Coast 2 Building Products. 3 In order to prevail on this claim, 4 Appellants must show that they meet the requirements 5 of the three-part high threshold of innovation test. 6 That is, that the research activities are 7 innovative, pose significant economic risk to them 8 and is not available commercially. 9 Appellants simply cannot meet this test. 10 There's no question that the product involved the 11 acquisition of existing SAP software. 12 We know that because documentation provided 13 includes a Power Point presentation dated 8-24-2000 14 which advises as to the availability of SAP support 15 services and things users should do before 16 contacting SAP. 17 In addition, a steering committee agenda 18 dated May 14, 2000, tells of the limitations on use 19 modification of the SAP software as follows: 20 "Further customizing will only 21 take place when there is a business 22 need to do so. SAP functionality will 23 only be enhanced where a strong business 24 case exists. Custom development will 25 only take place where a strong business 26 case exists. And modifications to SAB -- 27 SAP-based code will not be allowed." 28 In addition, there is an article from Mike 99 1 O'Dell, the then manager for the IT and ERP systems 2 for Pacific Coast Building Products, stating 3 that what -- stating that what went on during 2001 4 and thereafter was nothing more than rolling out the 5 system and providing training to the end users. 6 Specifically Mr. O'Dell states, 7 "That after SAP had been selected 8 and limited piling tested (verbatim) has 9 been done at the headquarters, they 10 engaged in team building, et cetera, 11 et cetera, and decided that they were 12 going to roll out the first phase of 13 implementation of the software with the -- 14 with the eight Basalite concrete plants 15 during November of 2001. 16 "The second wave was during 2002. A 17 date chosen because it was a slow 18 business season and disruption would be 19 minimal. 20 "The third group was scheduled to occur 21 in May 2002 and a fourth during the winter 22 of 2002 and 2003." 23 Underscoring the fact that the project was 24 staying within the confines of commercially 25 available software, Mr. O'Dell tells us, 26 "One of our goals that we are on 27 track to achieve was to find simple 28 solutions wherever possible. And we 100 1 were determined not to modify the SAP 2 code. SAP has proven to be flexible 3 enough to accommodate the needs of our 4 wideranging array of businesses." 5 Once again there's no evidence to show that 6 this project involves anything more than 7 commercially available software, let alone the other 8 requirements of the three-prong test. Yet the $2.2 9 million claim -- claim remains. 10 In summary, what we have here are multiple 11 claims laced with multiple flaws. There are claims 12 for projects that were completed before the years in 13 issue. We have claims for projects that weren't 14 untaken -- undertaken until after the years at 15 issue. We have claims for years where the project 16 had previously been abandoned, claims for years 17 where, for whatever reason, the project simply 18 wasn't done. 19 Most importantly, we have claims for 20 millions and millions of dollars in QREs without any 21 documentation to demonstrate a process of 22 experimentation. 23 We have nothing telling us what was done, 24 who did it, when they did it or why. All we have is 25 reconstructive guesstimates of dollar vals -- values 26 arrived (verbatim) from formulas that are based upon 27 nothing but assumptions and and guesswork. 28 This doesn't even take into consideration 101 1 the 80 percent rule, which I simply -- which I 2 submit simply cannot be met in this case. 3 Appellants simply have not provided the 4 documentation substan -- sufficient to substantiate 5 their claims for the research credit in this case. 6 And for those reasons, we request that the 7 you affirm the actions of Respondent. 8 Thank you. 9 ---o0o--- 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 102 1 MR. HORTON: Thank you very much. 2 Members, we're going to take a, um -- a 3 five-minute break. And we will return in five 4 minutes. During that time I would ask the 5 Appellant, as well as the FTB, to take a look at the 6 cases that have been presented to us, uh, the 7 additional cases, to determine if in fact some of 8 these cases are outside of the period in question. 9 If the parties can submit to, uh -- uh, 10 projects that have zero documentation, and -- 11 primarily those that are outside of the -- the 12 period in question. If there can be some 13 concurrence in that regard, that would be helpful in 14 just trying to frame up the various different issues 15 that are before us. 16 Five minutes, Members. 17 (Recess taken.) 18 MR. HORTON: Let us reconvene the meeting 19 of the Board of Equalization. 20 We are now on rebuttal. 21 MR. SPERRING: Right. Super. 22 MR. HORTON: At your convenience, 23 gentlemen. 24 MR. SPERRING: Okay. First, let me pull 25 the mic up. 26 First, I wanted to discuss the ball mill -- 27 uh, the raw materials upgrade ball mill bulk bag 28 handling system that was done at Newark, because FTB 103 1 spent a good ten minutes of their presentation 2 talking about that. 3 MS. YEE: Can you pull the microphone up, 4 please? 5 MR. SPERRING: Sure. Is this better? 6 MS. MANDEL: Turn the tip up; that helps. 7 MR. SPERRING: Okay. Is this better? 8 MR. HORTON: Yes. 9 MS. MANDEL: Yes. 10 MR. SPERRING: So, um -- um, what I wanted 11 to do -- okay, so recall in that -- in those 12 projects there, FTB essentially said, well, they 13 already had this equipment in Vegas and all 14 they were doing is replicating it in Newark, okay. 15 And that is what was evidenced -- or what evidence 16 for that assertion is the AFEs. 17 Now, one thing I think it's very important, 18 vital, that we understand what an AFE is, okay. An 19 AFE is an authorization for funds that is 20 essentially a request for capital, okay, uh, to make 21 a capital expenditure. 22 Obviously what these plant managers do with 23 their people is their decision, not Mr. Lucchetti's. 24 Mr. -- you know, the company's corporate 25 headquarters, they, uh -- uh, you know, just want 26 the products produced, okay, to meet the demand. 27 They have certain goals to meet. But how they 28 deploy their resources, in other words their 104 1 individuals, okay, they have discretion over, but if 2 they want to make a capital expense. 3 So you heard continually through 64 4 projects, uh, that the amount of capital request in 5 the AFE did not match the QRE, okay. And that, in 6 our point, you know, we tried to explain multiple 7 times in the brief we feel that that's a red 8 herring. There's no correlation between the capital 9 expense and the amount of time it took the employees 10 to get the job done. 11 So, for example, a, um, you know, research 12 company, you know, may order five computers and have 13 a bunch of computer -- computer programers they're 14 paying 200,000 a year, you know, to work on the 15 computers. There's no relation between their 16 salaries and the computer costs, okay. So I want to 17 get that clear. 18 But if you look at the declaration, okay, 19 you know, one of the problems we're having is FTB 20 seems to only look at certain documents, not others 21 that are in the file, okay. And it varies 22 project-by-project, okay. 23 But if you look at the declaration, um, for 24 these projects at Newark, okay, what -- what does it 25 say? It says, first of all, we were trying to 26 reduce the aging of the accelerant, okay. We knew 27 that the, uh -- uh, the -- uh, inserting the 28 accelerant in Vegas wasn't the most efficient. And 105 1 they figured if they redesigned it and reconfigured 2 it in Newark, they would get a more efficient use of 3 their accelerant. 4 Accelerants cost money. So if you can get 5 it into the system, okay, sooner, okay, and get it 6 mixed in, then you use less of it. And that's what 7 he details here in his declaration, which I'm -- I'm 8 more than happy to read. 9 But what's interesting, okay -- well, I 10 won't subject you to more declarations. But what's 11 interesting is FTB's response in the -- in their 12 last brief to Mr. Kopilovich's declaration. And 13 here's -- here's what the FTB stated: 14 "Moreover, it is virtually impossible 15 to imagine a peer-reviewed scientific 16 journal accepting a research paper" -- 17 and pap- -- research in quotes -- "paper 18 related to moving equipment from a 19 mezzanine to the ground floor." 20 Recall that the type of contemporaneous 21 documentation the Fudim court accepted as proving a 22 process of experimentation, included scientific 23 letters, contemporaneous journal publications, 24 contemporaneous U.S. patents, that's the standard 25 over and over that we're being held to. 26 And yet, you know if we go to the 27 regulations, right, what -- what does the final 28 Treasury Regulation say? They say there is no such 106 1 recordation requirement. It is your normal books 2 and records. 3 And what do our normal books and records 4 show? That we decreased our use of accelerant. 5 That we increased our production of wallboard. 6 Okay. All this happened, okay, through changing the 7 process. Okay. But there was uncertainty as to how 8 to do it. They had a process in Vegas, they're 9 going to make it better, okay, in Newark. 10 And, you know, we can always call the 11 witnesses to bring them up. But that is the key 12 thing to note here is, yeah, every one of these, at 13 the heart of it, involved a capital purchase. But 14 the question was, How do you deploy that capital 15 purchase, that add and make it better? And that is 16 why the plant managers were paid the big bucks to 17 figure that out. 18 And so now let's talk about the 80 percent. 19 You heard about, well, we need to prove 20 "substantially all," okay. Well, okay, and you also 21 heard a mention of Trinity. What you didn't hear in 22 the mention of Trinity is any mention of the facts, 23 okay. 24 In Trinity, okay, the taxpayer who had lost 25 all their books and records, okay, was able to get 26 uh -- uh, research credit on building an entire 27 ship, okay. It was the first of the kind ship that 28 they built, okay. And they got the credit for 107 1 building the entire ship. And the, uh -- uh -- and 2 for two out of six. 3 The reason why they didn't get it for all 4 six was because they had the 80 percent problem. In 5 other words, you know, yeah, we know that even 6 though you were pick -- you were matching, buying an 7 HVAC and buying a propulsion system, putting it 8 together, and that that's R&D, okay, the question 9 is, Was 80 percent of your activities, okay, as part 10 of an experimentation of trial and error? Was there 11 uncertainty for 80 percent? That's what they 12 couldn't show, okay. 13 But here what we've done is we're not 14 claiming the whole paper mill, okay. We're not 15 claiming the whole machine. Kendall has shrunk it 16 back, okay, to the element. And -- and -- and that 17 has hurt us in this appeal. Because what happens is 18 we have all 64 projects, we have all these names 19 that are -- you know like ball mill. What's a ball 20 mill? Okay. But it's because we've shrunk back the 21 process, okay, for example, of inserting the 22 accelerant into the, um, gypsum. 23 We -- we labeled that three projects. 24 Okay. One of them was zero cost, okay, because it's 25 putting a fan in, okay. But we labeled it three 26 separate projects, okay. So now it's very easy to 27 say, well, all you did was buy these three things. 28 But those three projects allowed them to get the 108 1 accelerant into the gypsum more efficiently and 2 better than it'd ever done before in Vegas. 3 Um, now let's talk about, uh -- um -- uh, 4 Union Carbide, okay, and what is the definition of 5 R&D. Because we, again, we're stuck on this 6 scientific standard, okay. And, again, the facts in 7 Union Carbide, you know, are very good for the 8 taxpayer. There's 10 holdings there, okay. But 9 what was going on in Union Carbide, okay? And some 10 of their projects qualified; some of them didn't. 11 But what you notice is, okay, the ones that 12 did, okay, it was another company, Amico, saying we 13 have some product for you, okay. We think this 14 product will prevent coping, okay. And so we want 15 to put this product in your machine. Our employees 16 will do it. We want you to sign a nondisclosure 17 agreement, okay. And, um -- uh -- you know, the 18 company will assist in it, okay. 19 And that, putting in that uh -- uh -- um, 20 catalyst, okay, was considered R&D, okay. And they 21 laid out a standard because these projects sound 22 very similar, if you read them, between the ones 23 that qualified and the ones that didn't. But the 24 ones that qualified, okay, it said there was 25 uncertainty. The ones that didn't, it said there 26 was -- it was certain. You knew Amico said this was 27 going to solve it. It was a known commodity. It 28 had worked before, and there wasn't uh -- uh -- 109 1 there wasn't that level of uncertainty that's 2 required. It was certain. 3 And so here, for all of our projects, okay, 4 that Kendall shrunk back, okay, there was always 5 that uncertainty of sure, they knew a, uh -- a -- a 6 felt could be split, but the question was, What's 7 the best way to do it efficiently, given their 8 system which was one-of-a-kind? 9 And so, um, the next thing I think that's 10 really important that we have an understanding of is 11 you hear projects, you hear time and again, okay, 12 $3 million, 500,000, 250,000 of QREs, okay. And 13 they went through all 64 projects and added up the 14 QREs. Yet, okay, Ken -- Mr. Fox's study was never 15 done on a project basis. It was cost center, okay. 16 It's cost center and that is the methodology that 17 most taxpayers use, okay. 18 We did provide, at the Board's request, the 19 BOE's request, we did provide a breakdown, okay, of 20 QREs by project that was meant to be best estimate. 21 But that's not what the tax return was based on. It 22 was based on the QREs, uh, that were claimed by cost 23 center. And we have that in your packet. 24 If you would please turn to 4, Tab 4, you 25 see, okay, the cost center broken down by years, 26 okay, and by wages and expenses, okay. And this is 27 how the, um -- the credit should be audited. This 28 is what we should be talking about. This is what 110 1 the first FTB auditor did. This is what the IRS 2 did. 3 I mean the beautiful thing about this case, 4 we've had the benefit of three auditors, okay. 5 Three auditors have looked over it, because recall, 6 the study went from '99 to '05. That's why we have 7 projects, some of them overlap to '05, okay. And -- 8 and the '05 year was filed on original return. 9 Recall, IRS audited '05. They approved all 10 of it, okay. And -- and recall, over 18 of the 11 projects overlap '05 in the earlier years, okay. 12 They approved those projects. 13 And, um -- uh, uh, uh -- but the way the 14 first auditor looked at it and the way the IRS 15 looked at it was they went through these projects -- 16 or excuse me. They went through these cost centers 17 and they determined the amount of QREs claimed by 18 cost center. 19 And -- and -- and when you look at it, 20 okay, what you see is that the numbers, um, vary by 21 plant. The older plants tend to have more projects, 22 okay, and hence, they have more QREs associated with 23 it. The newer plants, like Tracy and Dixon, have 24 less, okay. But, um -- uh, uh, uh -- but 25 nonetheless, the, um, IRS allowed all of the credit. 26 And so then, um -- the next thing I wanted 27 to just touch on is you heard a little bit about, 28 um, Dixon and -- and -- and the reformation -- uh, 111 1 the reformulation of the, um, mix and the testing -- 2 uh, the mix formulations, okay. 3 So, you know, recall here, um, that the 4 products -- uh, Basalite is constantly trying to 5 improve its products, constantly trying to reduce 6 costs. What does reduce cost mean? Maybe replace 7 cement with fly ash. Recall, fly ash is more 8 ecologically green because that's a waste by-product 9 that they can now incorporate into their product. 10 It's also cheaper. 11 And so as they work on test formulations, 12 okay, we have -- and which we have great testing 13 documents on that. And I'd ask you to turn to, 14 um -- um, let me look at the tab here. Tab 11, 15 right. Tab 11, okay. 16 So, um, if you look at Tab 11, you see this 17 testing document. And we -- we have the FTB 18 describe this in the brief as "customer preference," 19 okay, as if we're changing it for, um, you know, to 20 meet customer preference. 21 Customers don't know what's in the product. 22 What they know is, Does it work? Is the mortar 23 sticky? Okay. Does it, uh -- uh, does calcium 24 deposits build on it, okay, or not? And that's what 25 the company is trying to do here in these tests, 26 okay, which we've provided reams of and which have 27 been characterized as, um -- uh, being nothing more 28 than evidence of consumer preference. 112 1 So, you know, part of our frustration here 2 is we have provided lots of records. You've heard 3 FTB read from a lot of the records. And what they 4 have done is they have surmised their opinion, their 5 guestimates, as to what these documents mean rather 6 than what the, um -- uh, uh -- what the declarations 7 say or during the tours, asking our folks. 8 You know, none of these questions that they 9 raised, all legitimate questions, if you will, none 10 of them were asked during the, um -- uh, tours, 11 okay. And, you know, so again, we're stuck here 12 with we have a voluminous file where we have lots 13 of -- of, uh, evidence of the -- of uncertainty, of 14 trial and error. And we have the FTB sitting here 15 cherry-picking documents that benefit them, okay. 16 And, again, there is no effort at all to 17 look at the cost center approach which is, um -- uh, 18 you know, the approach that comes right out of the 19 Audit Manual; and which, by the way, okay, on 20 page -- in Union Carbide, okay, in Union Carbide 21 itself, the wage -- the wage -- they used the wage 22 survey conducted by E&Y, okay, and if you look at 23 the way they did it, they also used estimates, okay, 24 for back years. In fact, it was even further, okay, 25 in the years. It went all the way back to '94. 26 Okay. 27 And so, you know, this -- this whole idea 28 as FTB calls this conjecture, they're second -- you 113 1 heard them second-guess Bill Padavona and saying 2 that, well, his main researcher didn't claim enough 3 time, but he claimed too much time. 4 And yet, the wage surveys, uh, in Union 5 Carbide were accepted by the court. The wage -- we 6 have -- we've enclosed the IRS Audit Techniques 7 Guide which talk about the very methodology Kendall 8 used. It's in the BNA portfolio that Kendall 9 drafted. 10 And, uh, so, you know, we're sort of at a 11 loss that this proven methodology that was audited 12 this year for this taxpayer, for the '05 year, we're 13 at a complete loss as to why, um, this methodology 14 is now being dismissed as wholly unreliable, okay, 15 when we have all these folks testifying under 16 penalty of perjury that that was to their best 17 recollection. 18 And so now I'm going to ask Mr. Fox to talk 19 about the software. Because you heard an assertion 20 that all, um, Pacific Pathways project was -- was, 21 uh, the purchase of -- of Oracle Software and that 22 there was no other integration involved. 23 So, Kendall, can you please discuss that? 24 MR. FOX: Yeah. There's act- -- well, 25 there's actually two software projects. And -- and 26 quickly, I'll touch on the first one. 27 The first one was actually the software 28 used to record the results of the research at 114 1 Basalite. And it was referred to as not meeting the 2 high threshold of innovation standard. However, the 3 statute specifically says that research that is 4 developed to conduct research is accepted out of 5 this. 6 This was software that was used by the 7 company to basically be able to track all of their 8 experiments and expenditures. It's a -- it's 9 qualified research support activity. It's akin to 10 the regulations that allow activities such as 11 writing reports of research activities or cleaning 12 up after research to be direct support, and those 13 are all allowable expenses. 14 So it seems to follow that implementing and 15 using software to track and do basically the same 16 things should qualify. But we didn't claim the cost 17 of any external software. It was only internal 18 costs for configuring, operating, and using the 19 software. 20 The second is the SAP project. And what's 21 important to note about the SAP project and the high 22 threshold innovation standard of which the three 23 tests were talked about, what wasn't talked about 24 was how the three tests are met, and it's right in 25 the documentation. 26 So the innovation standard can be 27 improvements in speed, reduction of costs. Right in 28 the document itself is the discussion of how they're 115 1 going to save $20 million by implementing the 2 software. Clearly the innovation standard of 3 reduction in cost is met. 4 It also talked about significant economic 5 investment. The company spent about 6 $12-and-a-half-million in purchasing, installing and 7 developing the software. We claimed about 2 million 8 of costs which represent only development. 9 And the third standard is it can't be 10 commercially available without significant 11 modification. And that was left out of the 12 discussion is "without significant modification." 13 And it is right in the document, and it did limit 14 when they were going to -- obviously, they didn't 15 want to change -- that many changes to SAP, but they 16 had to write software to fill gaps. And it's 17 discussed, where there's functionality gaps, they're 18 going to have to develop software. 19 And so it's basically writing in that 20 functionality that doesn't exist in SAP, the third 21 test, without modification. So all three of those 22 tests are met. And we only include the cost of 23 development and testing. We didn't include the cost 24 of the software itself or the basic installation 25 configuration of the ERP software, only those costs 26 of development. 27 Um, I also wanted to make just a couple 28 comments on the -- on the disconnect and -- and -- 116 1 and the focus on a lot of documents, like the, um, 2 AFEs that are taken out of context. Because they 3 only represent a small fraction of the activities, 4 and they don't talk to the internal costs because 5 they're -- that's not the purpose of the document. 6 So it doesn't talk about all Bill Fraser's 7 time in designing and inventing solutions, or Bill 8 Padavona's. Um, again, these are limited. So if 9 you only talk about an installation occurred on this 10 date, well, what it doesn't talk about is all of the 11 testing and modification that takes place 12 afterwards, which these people have described, as 13 when it didn't work as anticipated or created some 14 other issue. 15 Um, you know, another example is the glaze 16 spalling was reading from a document, again, taken 17 out of context that says that that problem was 18 solved in 2002; yet, we know in an actual, uh -- um, 19 from Jim Keating in an actual memorandum discussing 20 all of these issues, it goes on to say right in the 21 report: 22 "Glaze spalling first appeared on some 23 refired terra cotta after introduction of 24 mix 182 in September 2004. Pop-outs 25 necessitate a high fire rate, increasing 26 glaze spalling after refire. Clay was 27 reintroduced in December. Spalling 28 problems continued into January and 117 1 appeared 1-4-05." 2 They pointed to a paper that where the 3 company believed they'd solved the problem but 4 hadn't. And they then continued to experience the 5 issue for many years afterwards and have significant 6 test results that were all included as part of the 7 file. 8 So, again, I think when you look at the 9 record as whole and all of the documents, it's a 10 much different picture than what is portrayed taking 11 certain documents out of context. 12 MR. SPERRING: Do we still have more time? 13 Apparently. 14 The only thing I would point out, too, is 15 when we look at, you know, gut check, okay, I mean 16 why did IRS audit our study and approve it a hundred 17 percent? Okay. Well, keep in mind, as I said in my 18 opening, 70 percent of the R&D credit's claimed by 19 manufacturers. 20 But IRS also has statistics on the amount 21 of QREs claimed per revenue, okay, and that is in 22 our Tab 1, I believe -- or Tab 3. And what do you 23 see here? But, uh -- our claims are running at -- 24 at two-thirds to half, okay, of what the national 25 average is. Okay. Evidence, again, the 26 conservative nature of the claim. 27 Somehow, you know, we're to believe -- we 28 believe FTB, we're to believe this company, okay, 118 1 created all these new products, increased their 2 sales by $400 million during these five years, with 3 no R&D. And yet, they have all the same equipment. 4 Okay. 5 So it was just simply replacing an old fan 6 with a new fan, replacing a new duct -- old duct 7 work with new duct work, okay, and throwing on a 8 door. Okay. There was no uncertainty, it was all 9 just simple as can be. And this -- it's just a 10 total outrage the taxpayer could claim eight percent 11 of their wage and, uh -- um, expense on qualified 12 research activities when even that number puts them 13 far below the national average. 14 MR. HORTON: Thank you very much. 15 Discussion? 16 Member Runner. 17 MR. RUNNER: Just a couple quick questions 18 to, um, taxpayer representatives. 19 Um, couple of things I was hearing in 20 regards to kind of the FTB's presentation, um, that 21 were pretty consistent, and that there seemed to be 22 almost a kind of consistent dismissing of executive 23 wages. 24 Um, can you speak to that? I mean, it's 25 almost like it was an executive wage, therefore, it 26 doesn't qualify. 27 MR. SPERRING: Exactly. Yeah. Yeah, 28 there's a use of titles, um, to -- to -- to 119 1 disqualify folks. And I think, you know, what's key 2 here, right, and you look at the cases like Shami, 3 right, you see CEOs with million-dollar salaries 4 claiming R&D credit. Okay. 5 Well, the CEO of this company, okay, 6 Mr. Lucchetti, who's sitting back there, okay, 7 claimed nothing. Okay. The holding company, okay, 8 where the major top executives were -- and you can 9 bear this out by looking at the payroll -- had 10 nothing except the software projects, okay, which 11 was like two percent. Okay, they're the lowest, 12 okay, overall. 13 So what we're talking about is these plant 14 managers, okay, those are the quote/unquote 15 executives. And as, you know, as FTB got to go to 16 the plant managers, you know, got to see them. 17 These folks are not wearing suits, okay. They are 18 today, but they're not out in the plant. They're 19 actually out there making it run. Okay. 20 And that's to the extent -- you know, 21 Vernon's a perfect example. Vernon had no -- very 22 few customers. Its customers were internal, okay. 23 And Vernon was one that claimed the highest QRE by 24 cost center. Okay. 25 So he doesn't have to worry about a market 26 that much. But what he has to worry about is 27 satisfying, okay, his customer and not on a customer 28 relation -- because it's a controlled company, 120 1 right -- but by having his products meet their 2 demand, meet their specs. 3 And so why the plant -- the secret sauce, 4 if you will, in the company is, Mr. Lucchetti has 5 found plant managers that have great expertise in 6 the engineering operations of those plants. 7 MR. RUNNER: So -- so just to summarize 8 then, you -- you would -- your answer to them would 9 be that these individuals were directly engaged in 10 the R&D that was taking place at these particular 11 plants? 12 MR. SPERRING: Exactly. And -- and -- and 13 just as an aside, if you look at Bill Fraser's, 14 uh -- uh, wage survey, he listed every employee by 15 name. He knows them all, all 75. 16 MR. RUNNER: Okay. Let me just ask, too, 17 now, again, the two other audits that bookend 18 this -- the -- the other -- the -- the audit that's 19 being presented here, uh, the first FTB audit and 20 then the IRS audit; let me just ask, in regards to 21 the first FTB audit in 1999 -- right? Yeah -- um, 22 was -- was -- was found to be basically a credit, 23 I think, of 80 percent. 24 MR. SPERRING: Right. 25 MR. RUNNER: What -- what happened? 26 Where -- where would your observation be as to why 27 the 80 percent might even be problematic? What -- 28 what was included and not included in that? 121 1 MR. SPERRING: Right. Great question. 2 Yeah, the first auditor did do a cost center audit 3 and, um -- uh, and really found just two issues 4 with, uh, with -- with the study. And that was the 5 utilities, okay. The auditor took a position that 6 utilities do not apply, okay, cannot be qualified. 7 And also objected to certain titles again, both at 8 the high end and the low end, okay; you know, 9 fork-lift operator, plant manager, okay, those type 10 of high -- you know, those titles. 11 And, um -- uh, first, you know, we showed 12 that the utilities -- at that time the auditor had 13 not been out, uh, to -- to look at the plants. They 14 went out and we were in the process of showing them 15 that we had to run the plant to test it and that 16 those are the utilities we're claiming, only 17 associated with the -- 18 MR. RUNNER: So the utilities that were 19 claimed -- or that were claimed but were not 20 awarded, were utilities specific to the R&D 21 activity. 22 MR. SPERRING: Exactly. 23 MR. RUNNER: Not the -- not the, what we -- 24 what we -- what'd you call it? The regular ongoing 25 utilities that would be happening in the plant. 26 MR. SPERRING: Exactly. 27 MR. RUNNER: It was -- it was utilities 28 directly related to the R&D activity. 122 1 MR. SPERRING: Right. 2 MR. RUNNER: Let me just follow up on 3 the -- that's one side of the audit. 4 The second side then is the -- bookend of 5 the audit, is the -- is the IRS audit. Um, and 6 again, outside of the -- of the -- of the -- 7 What is -- again, I think what I heard you 8 guys -- let me see if I heard this right. The 9 significance of that audit is that it used the same 10 methodology -- 11 MR. SPERRING: Right. 12 MR. RUNNER: -- that was used then in the 13 pre -- in the -- well, both -- well, both of those 14 used the same methodology by the taxpayer -- 15 MR. SPERRING: Right. 16 MR. RUNNER: -- that was used in those 17 middle years. 18 MR. SPERRING: Exactly. 19 MR. RUNNER: And so that's -- that's the 20 clai- -- in terms of the taxpayer's claim, that's 21 what validates, you believe, the numbers that you've 22 come up with, because the methodology is the same. 23 MR. SPERRING: Yeah. 24 MR. RUNNER: Let me just speak to, real 25 quickly here, or ask a question about the 26 methodology. Um, and let me ask Mr. Fox this 27 question. 28 Is the methodology unique? I mean, is this 123 1 a methodology that was unique to this particular 2 company? Or is this a methodology that you feel 3 comfortable and have used, or other folks have used, 4 in establishing valid R&D? 5 MR. FOX: This is not an unusual process or 6 methodology. It's very standard. 7 Um, almost every company that doesn't have 8 project-based records uses this type of methodology. 9 In fact, when the IRS examines taxpayer's research 10 credit claims, sometimes they'll choose to use a 11 sampling approach for employees. They'll send them 12 the same exact type of survey that we've used to 13 quantify and identify research activities. 14 So this is a very standard methodology, and 15 it -- and it's, um, one that is used both by tax -- 16 taxpayers and practitioners and is respected by the 17 IRS as an accepted cost center based approach. 18 MR. RUNNER: Let me just -- my last 19 question is, one of the -- one of the questions that 20 came up, and I think the Chair actually asked that 21 in -- in -- in the closing to look at. And that is, 22 there seem to be some of these claims that fell 23 outside the audit period. Can you explain how that 24 happened, or what the process was for that, how 25 they -- how that worked? 26 MR. FOX: Well, first of all, the study 27 covered all the way through 2005. 28 MR. RUNNER: Mm-hmm. 124 1 MR. FOX: Right. So some of the projects 2 only related to 2005. When we were asked to -- for 3 the study itself, to account for all of the 4 projects, even though those projects may not have 5 had costs associated with them in the earlier year, 6 in order to document and show a hundred percent of 7 the population, we had to include those projects. 8 The other thing is that -- is a little bit 9 misleading is that things occurred before or after 10 the study are relating to dates on specific 11 documents, not when particular activities occurred. 12 Um, so, for example, if you take an AFE 13 that says something was designed and installed on a 14 particular date, if it didn't work as anticipated, 15 you would have ongoing research to modify it and 16 make it work after that point in time. 17 And that's why I talked about some of the 18 disconnects between what's in particular documents 19 and relying only on those and taking those out of 20 context is that you have to understand the whole 21 story, including the testimony of the individuals. 22 So, for example, in Union Carbide, um, on 23 one particular project the -- there is testimony 24 that a particular test took place in September. The 25 IRS tried to argue, well, the last document we have 26 is in like in January or March so there's no 27 evidence this later one took place. And the judge 28 said, no, you -- I've got credible expert witnesses 125 1 that this, in fact, took place and I'm going to 2 accept that based upon his explanation of the 3 project as a whole, including all of the other 4 documentation. 5 So even though the documentation didn't 6 extend to that date, the whole, um -- they found the 7 whole explanation of the research activities to be 8 credible and accepted that they continued to that 9 date. 10 MR. RUNNER: Okay, thank you. 11 MR. HORTON: Member Steel. 12 MS. STEEL: I don't have anything. 13 MR. HORTON: Member Yee. 14 MS. YEE: Thank you, Mr. Chairman. 15 Um, I have a series of questions. But let 16 me start with, um, trying to clarify the various 17 authorities that have been cited so far. And I'm 18 going to probably look to Appeals to lend a hand 19 here. 20 Uh, so we've heard reference to the Trinity 21 case which, uh, I believe really, um, opens the door 22 to, um, the concept of integration as, uh, 23 potentially, uh, constituting qualified research. 24 And that, uh, there can be trial and error in 25 addition to the usual testing of hypotheses. 26 But even with Trinity, there's still the 27 "substantially all" requirement that still has to be 28 met; is that correct, that 80 percent? 126 1 MR. EPOLITE: I'm sorry. Yes, that's 2 correct. 3 MS. YEE: Okay. So, okay, let's put that 4 aside. 5 The Eustace case, uh, which I believe the 6 Franchise Tax Board is relying upon, speaks to 7 experimentation being more than just tinkering and 8 that there has to be the use of a scientific method; 9 is that kind of a -- gist on that? 10 MR. EPOLITE: Yes. 11 MS. YEE: Okay. And then the McFerrin 12 case, uh, I think I may have misheard, but I just -- 13 this one I really do want to clarify. That, uh, in 14 McFerrin -- and I think the Appellants have relied 15 on this case to read that, uh, testimony and 16 institutional knowledge, uh, can be the basis of how 17 we determine qualified research. 18 And -- but I believe in the case that there 19 also was, um, contemporaneous documentation that the 20 courts had looked at. But I thought the case really 21 relied -- really related to how we, uh -- what we -- 22 the basis for estimating expenses rather than what 23 constitutes qualified research. 24 Can you clarify that? 25 MR. EPOLITE: That was my understanding of 26 the case as well. 27 The problem with McFerrin is that the Court 28 of Appeal remanded the case to, uh, the District 127 1 Court because the District Court was applying the 2 wrong definitions of discovering information and 3 process of experimentation. 4 When the court did mention Cohan, it was 5 referencing that if you could show activities that 6 were qualified research, then the court should 7 estimate the expenses associated with those 8 activities. 9 MS. YEE: Mm-hmm. 10 MR. EPOLITE: So -- but you still had to 11 find qualified research and then go to Cohan. 12 MS. YEE: Right. Okay. 13 Uh, any dispute on either side with respect 14 to the authorities? 15 Yeah, Franchise Tax Board. 16 MR. RILEY: If I may, um, I would say 17 Trinity, um, I don't believe that there's -- there's 18 simply no good reason for your Board to follow, uh, 19 Trinity. I mean what the taxpayers -- what the 20 taxpayers have said in their, uh -- in their latest 21 brief is that you should look for a larger 22 context -- 23 MS. YEE: Hold on. Hold on. 24 MS. MANDEL: Can you -- can you hold on for 25 a second? Because you're -- you're -- right now 26 you're saying we shouldn't follow Trinity, but 27 I think the question was whether -- does -- whether 28 the understanding that was just expressed about what 128 1 Trinity itself -- 2 MS. YEE: Itself. 3 MS. MANDEL: -- says or is, can we get -- I 4 thought that was what -- 5 MS. YEE: Yeah. 6 MS. MANDEL: Just -- I mean, I know you 7 have an issue about whether it should be applied, 8 but did you have an issue with how it was explained? 9 MS. YEE: And I'll get to that. Just how 10 it was characterized. 11 MR. RILEY: Um, if -- if Mr. Epolite would 12 just repeat what he said, if -- if I may? 13 MS. YEE: I mean, my -- my question 14 centered around, even though Trinity opened the door 15 to our ability to look at integration as a basis for 16 whether qualified research exists, um, and it also 17 spoke about, um -- uh, trial and error, in addition 18 to the usual testing of the hypotheses, uh, that on 19 top of all that, the 80 percent "substantially all" 20 requirement still has to be met. 21 MR. EPOLITE: Right, yes. 22 MR. RILEY: Sorry. 23 MS. YEE: Okay. All right. 24 MR. SPERRING: Madam -- Madam Board 25 Member. 26 MS. YEE: Mr. Sperring. 27 MR. SPERRING: I do want to clarify on 28 McFerrin, right? 129 1 MS. YEE: Oh, actually let me go 2 one-by-one. 3 MR. SPERRING: Sure. 4 MS. YEE: Um, and I guess the other thing I 5 would say about Trinity is that, uh, even though 6 integration is allowed, that we're not talking about 7 all integration efforts resulting in qualified 8 research. I mean it's -- 9 MR. EPOLITE: That's correct. 10 MS. YEE: Okay. 11 MR. EPOLITE: It may, but not 12 necessarily -- 13 MS. YEE: Okay. 14 MR. EPOLITE: -- the courts said. 15 MS. YEE: All right. Uh -- all right. 16 Mr. Sperring, you were going to comment 17 about McFerrin. 18 MR. SPERRING: Well, two -- two things. 19 MS. YEE: I guess, I mean in relationship 20 to how Appeals has characterized it because I'm 21 going to -- 22 MS. MANDEL: She'll follow up. 23 MS. YEE: I'll follow up. 24 MR. SPERRING: Sure, sure. Yeah. 25 I'd point out that McFerrin also said that 26 Eustace is bad law. So I would ask if Appeals 27 agrees to that. But they also -- 28 MR. HORTON: Uh, stop. 130 1 MS. YEE: Hang on a second. 2 The relationship, Mr. Epolite, to Eustace 3 and McFerrin? 4 MR. EPOLITE: That's correct, that Eustace 5 is no longer good law in light of the fact that the 6 2003 regulations came into play after Eustace so 7 that Eustace is no longer relevant. 8 MS. YEE: Okay. 9 MR. RILEY: If -- if I may add to that 10 about -- 11 MS. YEE: Yes. 12 MR. RILEY: -- that specific point. Union 13 Carbide follows Eustace for the prospect that simple 14 trial and error does not qualify and cites to the 15 portion of Eustace in the decision, at page 907, 16 dealing with the subset of all, uh -- all steps 17 taken to resolve uncertainty. And the part where, 18 uh -- also on page 907, it states that tinkering 19 differs from experimentation. There's a -- there's 20 a large passage on page 907 that Union Carbide 21 relies upon. 22 And so with respect to certain portions 23 of -- of -- of Eustace, yes, the discovery test was 24 specifically overruled or -- or superseded by Union 25 Carbide. But Respondent does not rely on that 26 aspect of the case. 27 MS. YEE: All right. 28 MR. RILEY: And -- and Eustace has 131 1 otherwise positive treatment as it's cited in the 2 IRS's 2008 Research Credit Audit Technique Guide, 3 and it's consistent with the current law requiring a 4 process of experimentation. 5 MS. YEE: Okay. All right. 6 MR. FOX: Can I add a -- okay. 7 MS. YEE: Hang on one second. I want to 8 now take us back, given the authorities that both 9 parties have somewhat relied on. 10 So the initial, um, audit determination 11 that was based on the Appellants, uh, R&D credit 12 study, um, cost center based credit study, did 13 determine that there was qualified research. And I 14 guess I want to hear from the Franchise Tax Board 15 how that was -- how did the auditor arrive at that? 16 MR. RILEY: Well, I think you heard 17 Mr. Sperring say that it was -- it was a cost center 18 audit. They did not look at the qualified 19 activities. 20 Now, the -- the position letter reiterated 21 the -- the statutory requirements for -- for 22 qualified activities. But the study to the -- at 23 that point where the Appellants had provided it, did 24 not rely -- it's -- it is a cost center study. It's 25 all about qualified research expenses. It is not 26 about the activities. 27 MS. YEE: Okay. Um, so given that, how was 28 the auditor able to then proceed to disallow certain 132 1 types of expenses, like wages and -- 2 MR. RILEY: Well, the auditor simply looked 3 into the -- you know, the -- the regulations and 4 said oh, well, it looks here like you're claiming 5 utilities. It says right here that utilities, 6 generally speaking, do not qualify. Utilities are 7 required to be extraordinary additional utilities in 8 order to be considered a qualified research 9 expenditure. 10 Now, the taxpayer has -- they admittedly 11 use natural gas, they use electricity in their 12 operations. But their baseline, their everyday 13 production is high. Just because your everyday 14 production is high does not meet the requirement 15 that your research activities are -- require 16 extraordinary additional utilities. 17 MS. YEE: Okay. All right. 18 Uh, to the Appellants, so given that 19 determination on that initial credit study, did that 20 instruct you in terms of how the subsequent study 21 was done? 22 And I'm trying to get at the comment that 23 you made that what you were looking at in the 24 subsequent study really is a very kind of honed in, 25 kind of, you know, more kind of narrow look, you 26 know, rather than how you believe the Franchise Tax 27 Board characterized, you know, each of the -- the 28 projects and really, you know -- more -- more that 133 1 was going on than you -- you believe there was. 2 MR. SPERRING: Well, I guess -- 3 MS. YEE: So -- so given -- given the 4 initial audit determination, uh, and how the 5 Franchise Tax Board treated that initial cost center 6 study, did that instruct you with respect to how to 7 prepare the subsequent study? 8 MR. SPERRING: Well, yeah, I think there's 9 some confusion, right? 10 MR. FOX: Can I -- 11 MR. SPERRING: Sure. 12 MR. FOX: Sorry. Just a quick answer. 13 The first -- the first year, 1999, was 14 given to the auditor first, with the understanding 15 that if we could work through how to present the 16 information, that would guide the delivery of the 17 rest of the binders. So based upon the discussions 18 and the information that we were given, yes, it did 19 guide how the rest of it was put together. 20 MS. MANDEL: Say that again. 21 MR. FOX: '99 was delivered first -- 22 MS. YEE: Right. 23 MR. FOX: -- on the cost center based 24 approach -- 25 MS. YEE: Right. 26 MR. FOX: -- with the understanding that 27 then the agent could review it, and if that 28 methodology was acceptable, the later binders would 134 1 be -- with the rest of the years would be delivered. 2 And that's exactly what happened. 3 MS. YEE: Okay. So the rest of the years 4 were delivered, similar approach with respect to the 5 study for the subsequent years. And Franchise Tax 6 Board determined that there was no qualified 7 research. 8 MR. SPERRING: Well, after they -- they had 9 a change in auditor. And then the auditor, uh -- if 10 you look at the audit determination letter, it was, 11 we don't accept pre -- quote/unquote prepackaged 12 study. It was all boilerplate. There was no 13 discussion about the specifics. 14 The other thing I would object to is FTB's 15 characterization that the study was all about cost 16 center. The FTB does not understand, apparently, 17 how these studies are conducted. The first, uh, 18 component of the study is the, uh, testing, the 19 qualified research activities occur. And what you 20 do is you -- you test them by cost center. That's 21 the disconnect here. 22 You don't test it by necessarily, um -- or 23 you don't measure it by projects. You do -- you do 24 get a list of the projects, okay, by cost center. 25 Then Kendall will validate that those projects 26 occurred, that there -- that they do qualify as R&D. 27 Then those activities, okay, uh, the 28 research activities then are described to the plant 135 1 managers and, uh, they're the -- and the other 2 experts in -- in the company, and they're the ones 3 who fill out the survey on a cost center basis. 4 So there was no, uh -- there was no effort 5 to, um, capture the QRE by project, okay. What the 6 projects, uh, were designed to do is to assist the 7 plant managers. One -- they were validating -- 8 Kendall had to validate there was R&D. But then the 9 projects would assist the plant managers in 10 reconstructing their time. Okay. Here's what you 11 were doing during this year. How much -- you know, 12 who in your plant were involved in it? How much 13 time did it take? 14 That was the purpose. And that methodology 15 is laid out in, you know, IRS, uh, Audit Techniques 16 Guide, you know. 17 MS. YEE: Okay. To the -- to the Franchise 18 Tax Board, if you know. So what is the audit policy 19 then for reviewing, I guess, cost centers? Because 20 part of, I think, the frustration here is that we've 21 been, uh, discussing this appeal project-by-project. 22 And yet, I don't think there's been -- or at least 23 it's been alleged that there hasn't been the 24 adequate review based on cost centers to help us get 25 to, uh, the bottom line with respect to whether we 26 can verify qualified research activities and 27 expenses. 28 But -- and this is -- it feels like we're 136 1 comparing apples to oranges. But I think we're all 2 trying to get to the same outcome with respect to 3 being able to verify qualified research and 4 expenses. So kind of how -- how do we get there? 5 MR. HILSON: There's a piece that hasn't 6 been looked at. And that is, at the time we had -- 7 after the initial determination letter went out -- 8 MS. YEE: Mm-hmm. 9 MR. HILSON: -- which was rejected by the 10 Appellants and then it just grew from there. And 11 with the changeover in auditor, it was also the time 12 when the IRS came out with its publication be aware 13 of prepackaged credit studies. 14 MS. YEE: Mm-hmm. 15 MR. HILSON: At that point the focus became 16 activity. Not cost center and assumed activity, but 17 proof of activity. And really, here we are. 18 MS. YEE: Mm-hmm. 19 MR. HILSON: And, you know, if the activity 20 is there, fine, you can get into cost center, it's a 21 lot easier. But when the focus is on activity and 22 there's no documentation of the activity, it's very 23 hard to get into any kind of quantification of 24 dollar value associated with it when you don't know 25 who's doing what. 26 MS. YEE: Right. 27 MR. HILSON: Etcetera, etcetera. And to 28 just simply say oh, no, you're wrong because it's 137 1 all in the cost center, well yeah, we are apples and 2 oranges because cost center is not activity. 3 MS. YEE: I'm going to ask the Appellants 4 representatives to respond. But it seems to me 5 there's a valid point there with respect to then how 6 we attribute, um -- uh, expenses because we don't 7 have a sense of the activity and who's doing what. 8 So I guess, given that and given where the 9 IRS was at that point in time, again, I'm going to 10 ask the question, did that instruct, kind of, the -- 11 the study that you did for the subsequent years? 12 Because it's -- it's, um -- again, I think we're all 13 trying to get to the same bottom line in verifying 14 research activity and expenses. But if we don't 15 have, uh -- I mean, we're -- 16 MR. SPERRING: Yeah, I guess two points. 17 MS. YEE: Yeah. 18 MR. SPERRING: Two responses. The first 19 one is that the -- it's our position that FTB is 20 using the expenses to attack our research. 21 They're saying, look at, you can't believe 22 Bill Padavona's testimony because he's claiming it 23 cost $2 million to do this project when the AFE is 24 only for 50,000 bucks. Okay. They're the ones 25 bleeding the costs into the qualified research. 26 We were peer. We did just qualified 27 research. We said, okay, Are you doing qualified 28 research? And we -- and -- and -- and we went and 138 1 looked at it. Okay. And determined, Do these 2 project costs constitute qualified research? That's 3 done before you ever look at the costs, okay. 4 Once a determination is made that there is 5 qualified research, then you go to, okay, uh, you 6 know, estimating by cost center, okay, based on 7 people's recollection and the projects that were 8 done during these years. 9 And that's the way the exact -- great 10 question, Board Member Yee. That's the way the IRS 11 audited it. When they looked at it and brought in 12 their engineer in '05, they wanted to look at the 13 activities. And they determined, yes, those 14 activities are qualified, okay. And then at that 15 point, you know, they looked at the cost center, 16 okay. 17 But what you have all along is FTB using 18 cost to attack our qualified research activities, to 19 basically say you can't believe these plant managers 20 because their costs are so outrageous, okay. And 21 that's when you read their briefs, when you look at 22 everything that they've, again, talked about, it's 23 cost, cost, cost. And our whole point is, wait a 24 minute, let's talk about the project. If we 25 establish that we're doing a qualified research, 26 then we can go to the cost center. 27 But they have been able to, if you will, 28 swamp our projects by tying them into costs that 139 1 they claim are wholly unbelievable. 2 MS. YEE: Yeah, I mean -- well, with all 3 due fairness, I think part of what the frustration 4 is that there isn't, um, consistent hefty 5 substantiation about the activity. And so when you 6 don't have that, uh, it's -- it's like -- I think in 7 some ways they've been kind of working around it, 8 which -- and, of course, it feels like to you 9 they're -- they're attacking it with costs. 10 But I don't think that the process is all 11 that different from the Franchise Tax Board and the 12 IRS. But, um, I think we're -- we're lacking. And 13 certainly as I think about other cases that we've 14 heard, in the R&D realm, there's been a little bit 15 of better substantiation with respect to the 16 activity and, you know, who's doing what and then 17 how we attribute the expenses. 18 But in some ways we're working backwards 19 here. And so I'm -- I think we're -- I'm certainly 20 feeling a little frustrated because, um, I do -- and 21 this is -- I appreciate all the managers being here. 22 I -- I think the testimony's compelling with respect 23 to, you know, what each of the projects was 24 attempting to accomplish. But when there is, uh, 25 lack of documentation that suggests that, uh, you 26 know, there really was experimentation and that, uh, 27 there were certain personnel who were involved and, 28 uh -- and to have to back into that in some ways, 140 1 you know, with the use of the -- the cost center 2 studies, is difficult. Is difficult. 3 MR. SPERRING: Right. Yeah, in response -- 4 well, two-fold. Kendall wants me to point out that 5 the audit occurred in '09, after the change of 6 standards, the IRS audit. 7 MS. YEE: Mm-hmm. 8 MR. SPERRING: Okay. So he's talking about 9 how they changed their standards. We met the new 10 standards. 11 But I think going to your point, um, about 12 is there a, uh, a lack of documentation, okay, 13 right, I would just remind, uh -- uh, the Board that 14 we have the IRS regulations, right. And the 15 regulations specifically say you don't need special 16 documentation. You just need your business records. 17 And our business records, what do they 18 demonstrate? They demonstrate that these costs 19 occurred. They demonstrate that -- the increase in 20 production, okay. They -- they indicate that we 21 changed our formula, that this equipment was 22 purchased. 23 So -- and then -- then you have the plant 24 managers on top of that. So, from our view, we have 25 memos. Uh, Bill Padavona at, um -- um, Gladding 26 McBean wants everything in a memo, okay. Bill 27 Fraser wants everything in a design, drawing, okay. 28 Dale Puskas wants everything, uh, in a testing -- 141 1 all testing document records. He -- he bought an 2 R&D system, a computer system to capture it all. 3 So we have what we feel is one of the best 4 documented R&D cases to ever come before your Board. 5 What's interesting is you look at Union Carbide and 6 Bayer, okay, Union Car- -- Union Carbide had 60 7 binders, okay. And they had over 109 projects. 8 Bayer had something like 80 binders, and they had 9 over a hundred thousand, okay. 10 So we have lots of documents. And we heard 11 FTB read from our documents for an hour straight, 12 mischaracterizing half of them is our position or 13 ninety percent of them. But you can't say we don't 14 have the documents. 15 You -- you -- what you can say is there's 16 not one document, okay, that lays out an entire 17 project, okay. You know, and that covers every 18 piece of it, from start to finish. But we're not 19 required to; the regs make that clear. 20 I mean I really believe that, uh, it is -- 21 you can't refute the fact that we have substantial 22 documentation. Is it for every single project? No. 23 Okay. But on the projects that are not, they're 24 very small. And the regs show projects of, you 25 know, $2,000, 5,000. I mean, how much documentation 26 can you have for a $5,000 project? And that's in 27 the Treasury Reg. 28 MS. YEE. Yeah. 142 1 MR. SPERRING: They realize they're not 2 going to have. And for those ones where we have 3 very low documentation, we have our witnesses talk 4 about it and it makes sense because there's little 5 money. I would be concerned, you know, Madam Board 6 Member, if you saw a $3 million project, okay, with 7 no documentation. But what you see is small dollar 8 projects, okay, that have the weak documentation. 9 MS. YEE: Yeah. 10 MR. SPERRING: The big dollar projects have 11 substantial -- 12 MS. YEE: And, to me, Mr. Sperring, the 13 amounts are really meaningless. I mean, what -- 14 what needs to be evidence is that there is a process 15 of experimentation, however that's demonstrated. 16 MR. SPERRING: Right. 17 MS. YEE: I think the amounts really are 18 irrelevant. It just depends on what the activity 19 is. But it is, uh -- 20 And you're right, we have a lot of 21 documents. We have a lot of documents. And the 22 regs have been -- become more flexible with respect 23 to what you need to establish and verify. 24 But -- and part of why I started out with 25 the questions about the authorities is that, um -- 26 I think, um, at the end of the day, for me, the two, 27 uh, questions that need to be asked and answered is, 28 uh, you know, Was there a process of experimentation 143 1 that existed? And secondly, the "substantially all" 2 test. 3 And, uh -- and I don't know if I'm getting 4 down to the two points of focus accurately, but 5 that -- that's, uh, seems to me with all of the case 6 citations that we've had, those -- those points 7 continue to be what they have in common. 8 Mr. Epolite, any thoughts? 9 MR. EPOLITE: To look at Section 41, 10 41(d)(1) defines what qualified research is, the 11 four-part test. The first element of the test is: 12 "The expenditures must qualify as 13 expenses under IRC Section 174." 14 The expenditures. So you have to know what 15 the expenditures are to determine whether they 16 qualify. 17 With that in mind -- so that's (d)(1) of 18 the statute; (d)(2), directly below, states: 19 "Tests to be applied separately to each 20 business component. 21 "Paragraph (1)" -- the 22 four-part definition -- "Paragraph (1) 23 shall be applied separately to each 24 business component of the taxpayer." 25 So for each business component of the 26 taxpayer, you have to go through the four-part test 27 of (d)(1), one of which is the Section 174 test, 28 which is determining whether the expenditures for 144 1 that activity qualify as expenses under Section 174. 2 So it seems as if you would need to 3 identify what those expenditures are for that 4 activity. 5 ---oOo--- 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 145 1 MR. THOMPSON: Could I -- if I could cut 2 in? 3 Substantially all tests also is present in 4 Subsection (d)(1). So, that (d)(2) says the tests 5 to be applied separately to each business component. 6 And, as Mr. Epolite stated, it's referring 7 to meeting the expense requirements under 174. And 8 one of those Section 1 requirements also was 9 substantially all, meaning that 80 percent of the 10 activities must be -- meet those those -- those 11 requirements for qualified research. 12 So, if you have an activity that may have 13 substantial qualified research, but it doesn't meet 14 that 80 percent threshold, it's our understanding 15 that it would not qualify, notwithstanding that 16 there is some modicum of qualified research in 17 there. 18 MS. MANDEL: Could I just follow up -- 19 MS. YEE: Yeah, of course. 20 MR. HORTON: Member Mandel. 21 MS. MANDEL: -- before I lose them. 22 So, the 1 -- but my understanding, 174 is 23 it's got to be an expense, it's not a capital 24 expenditure. 25 And I thought somewhere along the line what 26 I heard was that the capital expenditures were not 27 being claimed -- costs of capital equipment that was 28 going to last more than a year. 146 1 I'm getting nods of yes, that that's -- 2 okay. 3 MR. EPOLITE: That was the testimony, 4 yes. 5 MS. MANDEL: That was the testimony. 6 On the substantially all test, which is 7 that there has to have been this trial and error, 8 that's more than than mere tinkering -- tinkering is 9 an odd word because it makes me think of peddlers, 10 but -- and that more than 80 percent. 11 I thought there was an explanation by the 12 taxpayer of -- of -- in looking at the projects, if 13 we're looking at the projects, I thought there was 14 an explanation of how they thought they met the 15 80 percent substantially all test, if you were 16 looking on a project basis. 17 So, could you just go back -- 18 MR. FOX: Sure. 19 MS. MANDEL: -- to that again? 20 MR. FOX: Sure. The regulations say that 21 80 percent of the activities have to be research. 22 They give us an example, Example 3. 23 Example 3 refers to the design of a knew 24 manufacturing -- of a new shredded blade. And it 25 goes through the -- 26 MS. MANDEL: Can you speak up? Because I'm 27 going to get metal wheels down this hallway. 28 MR. FOX: I'll wait. 147 1 MS. MANDEL: Or wait 'til they go by? 2 Oh, no, she's -- it's the trash. So, just 3 adjust for the wheels. 4 MR. FOX: All right. 5 Yeah, so -- so, the example in the 6 regulation talks about the design and testing of a 7 new shredded blade. It doesn't give any cost 8 information. 9 But what it does say at the end is that it 10 meets the 80 percent test. And that's because the 11 only activities in the example are the engineering, 12 design and testing of those blades. 13 The next example, Example 4, is an 14 automotive example. That example goes into the 15 re-design of a new automobile model. And in the 16 facts it says that 85 percent of the activities are 17 testing the integration of how these various 18 components work together in order to increase fuel 19 economy. 20 It then says, in the facts, that 15 percent 21 of those activities relate to cosmetic design or 22 seasonal factors, which means designing things in 23 the automobile that have nothing to do do with 24 function, but are purely cosmetic. 25 So, it gives you that breakdown, but it 26 then says that the 85 percent of the activities 27 doing the design and integration testing of those 28 components are all a process of experimentation. 148 1 When we did our study, we shrunk back to 2 only including design and testing and direct support 3 or supervision thereof of those activities. 4 So, we haven't included anything related to 5 style, taste or cosmetic and we haven't included 6 anything in terms of actual capitalized cost or any 7 other costs other than those things that are 8 engineering, design and systematic trial and error. 9 That's why we're comfortable we meet the 10 substantially all standard because we've already 11 shrunk back to the lowest level of activity that is, 12 by definition, a process -- 100 percent a process of 13 experimentation. 14 MS. MANDEL: Did you want to -- 15 MR. RILEY: Please. 16 There's a lot of problems with this. 17 Mr. -- Mr. Fox is saying right now, he's 18 saying, well, we've already shrunk this back. 19 Well, their August 16th brief just said, 20 well, we should view this in a larger context. 21 We're not going to shrink it back, we want to apply 22 the Trinity -- 23 MS. MANDEL: I -- 24 MR. RILEY: -- at 80 percent. The -- 25 MS. MANDEL: -- well, let me tell you how I 26 understand what they were saying when they said 27 that. 28 I mean, what I'm hearing them say today -- 149 1 because I had this question about the substantially 2 all because it didn't -- at least -- there was a lot 3 of stuff to read, but I -- I couldn't recall where 4 it might have been discussed because there was so 5 much focus on was there trial and error happening in 6 any of these situations? 7 So, it -- I always felt like there was a 8 stop before the substantially all test. And what 9 I'm -- what I'm hearing them say is from the moment 10 we had -- realized we had an issue that -- or issue 11 that we wanted to solve, which is what they call 12 their uncertainty -- to the moment that we finally 13 put in place whatever it was that solved that for 14 us, that they're viewing that as that whole time was 15 their process of experimentation, that there was -- 16 that everything was related to whatever the trial 17 and error -- if they've shown some trial and error 18 in a particular project to get to the end. 19 And the way I understood in my -- myself 20 when they talked about look at the larger thing, I 21 thought that's when they were talking about the 22 larger thing is that we had a -- a -- manufacturing 23 line. We put -- we put, you know, we put stock -- 24 or whatever they call it the different plants, raw 25 material, in at the beginning and we get a thing out 26 at the end. And that each of these projects was 27 some piece being inserted somewhere along the line 28 to do something -- whether it was to make sure -- 150 1 try to make sure that they didn't get the junk from 2 a new paper source in with what they wanted to keep 3 to make into the new paper. 4 That's how I understood when they were 5 talking about a larger thing, with the larger -- the 6 larger -- context was my whole manufacturing line 7 and what I was doing at the plant, that -- I mean, 8 unless -- that's how I -- I understood that, not 9 that they were looking at the larger manufacturing 10 line at the plant as take all my costs for that and 11 I have to be 80 percent of that. 12 Am I -- do you -- are you following? 13 MR. HILSON: I think, but going back to the 14 examples. I mean, I think the basic disconnect here 15 is that what we're being told is that the study 16 identified, per se, qualified research. 17 Well, DiCon doesn't say -- DiCon says we 18 don't have to accept that determination. We can 19 look at the activity. 20 So, what we've got is an assumption from a 21 tax -- from a taxpayer saying we were dealing with 22 qualified research, now let's go to numbers. 23 And when we're getting representations that 24 it's been identified by plant managers as to who did 25 what and that what -- what -- and what they've 26 reconstructed is reliable, well, that's not 100 27 percent of the employees. 28 What does -- I am sorry, if we've got 151 1 people that are designing how we're going to split 2 this felt top, what does -- what do the back office 3 people have to do with that? Why -- why are 100 4 percent of the employees included in this? And how 5 do we know what any of them are doing meets the 80 6 percent test? 7 We've got all of this stuff. We've 8 gotten -- we've got no information as to what -- 9 again we go back to the who, what and whens. 10 There's none of this being shown. It's -- 11 it's the problem with documenting the activity and 12 then moving from there to the quantification whereas 13 what we're are getting is the quantification with 14 the assumption of activity beforehand 15 MS. MANDEL: Okay. And as I -- as I 16 understand it from the statute, to show 17 substantially all, they don't have to do it by 18 costs. 19 Because if they had to do it by costs then 20 you'd always only have to do project -- project 21 accounting. 22 MR. HILSON: And I'm fine with that. 23 The problem is where is the activity -- 24 particularly as it gets into being reflected across 25 the board into these costs? 26 If we're talking about qual -- giving 27 qualified research credit for somebody's wages built 28 into that, at a minimum, is that we know who it is 152 1 and what they did. 2 MR. SPERRING: Can I respond? 3 Again this goes to blending costs to attack 4 the qualified research. 5 The qualified research activity, okay, 6 needs to be evaluated on its own. And we've done 7 that. We've provided that. 8 They're now moving in and talking about 9 costs to attack the qualified research activity. 10 If we go to the ball mill project, right, 11 that Mr. Hilson spent a good ten minutes talking 12 about, okay. He characterized that project as 13 replicating what was going on in Vegas. 14 When, in fact, it was something different. 15 It was determining where is the best place to insert 16 the starter or the accelerant, excuse me, insert the 17 accelerant into the process? That was the process 18 of R & D, okay. 19 Now, who was involved in that, that's a 20 second issue, okay. That goes to the costs, okay, 21 associated. 22 But we have identified the four -- the 23 four-part test. We've identified the project, how 24 it meets the four-part test. And we have done that 25 for all 64. 26 Now, again, they attack it by saying, 27 "Well, the costs are unbelievable" But -- but, you 28 know, the point is, okay, here's the standard in 153 1 Union Carbide. 2 You know, Union Carbide said that inserting 3 this polyethylene catalyst that was owned by AAMCO, 4 okay, into their plant did qualify as R and E, okay, 5 because the taxpayer did not have enough information 6 available at the beginning of the project to 7 establish how it should design the process so that 8 use of the new catalyst would improve -- would be an 9 improvement over the existing catalyst in full scale 10 production. 11 And that's each one of our projects, that's 12 what we had to overcome. And we've documented that. 13 We didn't know how we were going to insert the 14 accelerant into the process, okay. 15 And each one we've done that. We've gone 16 through -- it's all in the record. We've -- we've 17 listed every business component for all the 18 projects, all the four-part tests. 19 And what you hear -- he had an hour. And 20 his hour was constantly attacking the costs. 21 MR. HILSON: If I may respond? 22 MR. HORTON: Member Mandel? 23 MS. MANDEL: Yeah, briefly. 24 MR. HILSON: Just looking at the ball mill, 25 even accepting their explanation that this is all 26 about figuring out where to introduce the 27 accelerant, we have got claims for five years -- 28 five years of trying to figure out where we're going 154 1 to add it? 2 I mean, again we're back to who, when, 3 where, what are they doing? There's no 4 documentation of any of this process of 5 experimentation. 6 And yet, before I get accused of again 7 trying to drive it with cost, the fact of the matter 8 is a huge number of claimed expenses associated with 9 it. 10 In the first instance my point is we've got 11 documents telling us what they're doing, why they're 12 doing it and that it's up and operational a few days 13 -- a few weeks later. 14 Where's the process? Where's the 15 documentation of any process of experimentation? 16 It simply isn't there. 17 MS. MANDEL: Uhmm, uhmm, I'm going to ask 18 you very short on Trinity -- 19 MR. RILEY: Yes. 20 MS. MANDEL: -- I don't need a whole 21 speech, but other than the fact that it's a federal 22 District Court from Texas -- or is that the basis on 23 which you think we don't have to follow it? 24 MR. RILEY: I'll just give you the -- 25 the -- the primary reason is that the inexactitude 26 of failing the recordkeeping mandate was because the 27 taxpayer's documents were destroyed by Hurricane 28 Katrina. That's why the taxpayer couldn't meet the 155 1 recordkeeping requirement in that case. 2 That's why the court went and did what they 3 did, because the taxpayer's records, through an 4 inexactitude not of their own making -- 5 MS. MANDEL: Well, many of the records were 6 destroyed. They had some kind of something from 7 which the court was willing to do something on one 8 or two of the ships? 9 MR. RILEY: Correct, but the reason that 10 they -- that the court noted the unusual 11 circumstances of that case. 12 And the reason they did that is because of 13 this destruction of records, which under Cohan, if 14 an -- if -- if records are destroyed or not kept 15 through an inexactitude of the taxpayer's own 16 making, they are not entitled to the deduction or 17 the credit. 18 MR. HORTON: Well, that's not what Cohan 19 says. 20 MS. MANDEL: Okay, all right. 21 So, you were going toward the -- 22 MR. RILEY: Well, the -- 23 MS. MANDEL: -- wait, wait. 24 You were going toward the expense side of 25 the house rather than what Ms. Yee was talking 26 about, which was was open the door on -- on 27 integrating a new system, new parts into your -- 28 your existing system and trying to figure out to 156 1 make it work part? 2 That's -- that's what I'm hearing you say 3 right now. 4 MR. RILEY: I guess the point that I'm 5 trying to make is it's an unusual case because 6 Hurricane Katerina destroyed the records of their 7 activities, or some portion thereof, and that's why 8 the court adopted this. 9 In our case the reason that they don't have 10 records of experimentation, if we -- you know, on 11 the plant tour, Mr. Puskas in Dixon -- in Tracy told 12 us that a lot of this stuff we just were very 13 informal and we keep stuff on napkins or backs of 14 envelopes. And, so, that's why we don't have it 15 'cause at the end the shop would toss it away. 16 That is -- I mean, if you're not going to 17 keep the records to prove that you're engaged in a 18 qualified research activity, that does not meet the 19 recordkeeping mandate. 20 MR. SPERRING: Can I jump in? 21 MR. HORTON: Uhmm -- 22 MS. MANDEL: Mr. Horton, I think your -- 23 MR. HORTON: -- let's see. 24 MS. MANDEL: -- your jump-in is probably 25 just a repetition of what you said before, is my 26 guess. 27 And what you said before was that you think 28 that the recordkeeping, the regular recordkeeping 157 1 requirements, which are the regular recordkeeping -- 2 you think that that's just whatever my business 3 records are and if it's not something I keep, I 4 don't have to keep it? 5 Is that -- 6 MR. SPERRING: Yeah. 7 MS. MANDEL: -- that's my irreverent -- 8 MR. SPERRING: And I would just -- 9 MS. MANDEL: -- recitation of what I've 10 heard you say before. 11 MR. SPERRING: Sure. 12 MR. FOX: I'd like to point out a couple 13 things. 14 One, I think again we're talking about 15 there being a complete absence of records. And 16 that's not true. 17 Like in the roof tile modernization, we 18 have, over two-year period -- or three-year period 19 or three and a half, whatever it was -- all of the 20 design drawings, all of the tests that were 21 conducted on the new products. We have extensive 22 records of experimentation. 23 In Basalite, because of the necessity of -- 24 of documenting the new formulations of products, 25 they have extensive records of all of the product 26 development activities. 27 And at Vernon they have extensive 28 documentation of all of the product development 158 1 activities. 2 So, for many of the projects there is a lot 3 of documentation and a lot of actual recording of 4 research results and experimental trials. 5 Where we don't have as much documentation, 6 even in the case of Vernon, for example, we know 7 that they were designing new pieces of equipment and 8 testing it and refining it, 'cause we have the 9 drawings. We know that. There is documentation. 10 But I want to read something out of the -- 11 out of the Treasury regulations, the preamble, when 12 they deciding, should we have a specific 13 documentation requirement? 14 And the first set of regulations would have 15 required recording the results of each experiment. 16 And what they said is, 17 "Maintaining this requirement is 18 particularly burdensome. Commentators 19 argued that in the industrial or 20 commercial setting the recording of 21 results is no necessarily inherent in 22 a bona fide process of experimentation." 23 So, Treasury realized that in an industrial 24 setting, you might not be recording all these 25 results. A lot of it is through the observation of 26 what actually physically happened, but you know that 27 it happened and you know that, for example, at 28 Vernon the designs were changing. 159 1 This -- so, they specifically said that's 2 not a requirement. We're not going to hold 3 taxpayers to that. But now it seems that -- that it 4 is trying to be reinserted as an example -- as 5 what's always required. 6 And, so, again we have two different types 7 of research here, some of which had extensive 8 documentation. And even on the process side, in the 9 case of the have roof tile we have extensive 10 documentation. 11 MR. HORTON: Okay. To some extent we are 12 somewhat comparing apples to oranges and then 13 integrating different variables and measurements and 14 trying to somewhat make this determination. 15 Willie Brown once wrote a law, a 16 significant law, on the back of a napkin and it was 17 considered acceptable. 18 And I think that the -- and I'm going to 19 pose this in a statement, but at the same time 20 provide Appeals and the taxpayer and Franchise Tax 21 Board an opportunity to sort of respond to these 22 statements, if you will, in the essence of time -- I 23 would normally pose it in the form of a question. 24 And that might take a little while. 25 The -- relative to the standard of 26 evidence, the Treasury has seemed to have concluded 27 that to establish a set absolute standard was 28 inappropriate. It took away from the essence of 160 1 the -- of the research and development, the intent 2 of the research and development. 3 Congress went even one step further to say 4 this ought to be just whatever is fair, whatever 5 happens to be the norm for the industry is what we 6 have to measure the standard of evidence by. 7 And, so, we have a manufacturer that the 8 norm for that particular industry is to conduct 9 themselves in the way to have drafting materials or 10 other documents, that is, in and of itself, 11 acceptable evidence. 12 And then if you look at Cohan, which I 13 think we -- in Cohan I think we sort of 14 mischaracterized that, it did say that in the 15 absence of evidence, that it -- there is a is 16 certain -- that there is a certain compelling 17 obligation to estimate based on the evidence that is 18 available. 19 And -- and, so, I think that is the burden 20 that falls on -- on the -- the Department is to 21 take -- take a look at what is available and -- and 22 determine whether or not that's sufficient, or try 23 to come up with some number of some sort. 24 Section 41 seems to go one step further to 25 deal with the -- in the -- in the law, deal with the 26 four element testing qualified as an expense on the 27 IRC 174 to be undertaken for the purpose of 28 discovery and information, to be undertaken for the 161 1 purpose of discovery information applicable to the 2 intent, to be useful in developing a new and 3 improved business. 4 And it -- I guess that the Department and 5 the taxpayer's stipulating that 1, 2 and 3 has been 6 met. 7 Is that the case? You are not -- 8 MR. RILEY: No, no. 9 MR. HORTON: And so, without 1 and 2 and 3, 10 why go to 4? Why go to the 80 percent rule, if, in 11 fact, it's the Department's position that this is 12 not a qualified expense, theoretically, if that's 13 the threshold you got to get past before you get 14 into the measurement? 15 MR. RILEY: In fact, our -- our March 16 brief, the supplemental brief for this period, is 17 all about how the taxpayer does not meet Step 1 -- 18 MR. HORTON: Okay. 19 MR. RILEY: -- the 174 requirement. 20 MR. HORTON: Okay. 21 To Appeals, in -- in Trinity when the 22 courts was dealing with the 80 percent rule, in 23 Trinity there were a total of six -- six different 24 activities, basically. The courts concluded that 25 two of those were acceptable and four were not. 26 Seems to imply that the 80 percent rule was 27 not inclusive of all six. In fact, it actually 28 informed us that we can look at each activity and 162 1 then within that activity is where the 80 percent 2 begins. 3 Is that your understanding of this? 4 MR. EPOLITE: That's exactly my 5 understanding, yes. 6 MR. HORTON: Okay. So, given that, we have 7 an activity that seems to constitute different type 8 of things that McFerrin and Union Carbide seems to 9 inform us that we can actually combine them all and 10 then we have to look at the total scope of this 11 project to determine whether or not, first, there's 12 qualified research and development and then somehow 13 quantify that and measure it. 14 So, you have, as the Department has 15 eloquently articulated in listing all the different 16 projects, there's quite a bit of acquisition of 17 product -- of equipment that is commonly available 18 in the open market and that was purchased or 19 acquired for a specific purpose, as articulated by 20 the IRS -- I mean the Franchise Tax Board. In many 21 cases there were more environmental purposes to 22 satisfy -- satisfy building codes and structural 23 issues as opposed to research and development. 24 I would go to the Appellant to say, in the 25 acquisition of these off the shelf items, was the 26 intended purpose -- what was the intended purpose of 27 acquiring it? And was that an integral part of the 28 entire process? 163 1 Or can we look at it separately I from your 2 perspective? 3 MR. SPERRING: Yeah, exactly. They 4 purchased the equipment to modify their machines. 5 All -- they were never buying a stand alone 6 machine to operate. It was always to be 7 incorporated in their existing processes and to 8 modify. And that was -- that was the R & D. That 9 was the uncertainty. It was how do you get it in 10 there? 11 Anyone can buy a relay switch. Anyone can 12 buy a ball mill. But the question is, how do you 13 get it inserted into the process to maximize the 14 benefit to the company? 15 That is what -- these are one of a kind 16 processes. And that's what they had to figure out 17 how to do. 18 And, yeah, we have FTB characterize just 19 the act of buying the relay switch is shopping, 20 okay, not realizing that, you know, the genius of 21 it, the R & D of it is where do you incorporate it 22 in the system? 23 I mean, you know, this goes back -- we 24 heard, you know, Tim Cook, the CEO of Apple, say, 25 "Well, we can design an iPhone 26 here in America, but we can't build 27 it in America, even though with a 28 dollar (unintelligible), it would be 164 1 cheaper to build it here, we don't 2 have the technology. We don't have 3 that as -- " 4 MR. HORTON: Not to interrupt you, my 5 apologies. 6 But why not delineate that? Why -- why 7 wouldn't we, the Board, delineate that to say that 8 the acquisition of this property in and of itself is 9 just purchasing property -- equipment; the 10 installation is just installation. And then, at 11 that point, once the property is acquired, it's 12 installed, our determination is that it doesn't 13 meet -- it doesn't solve the problem. 14 And at that point the research and 15 development actually began and that's the point in 16 time which we begin to measure it. 17 MR. FOX: Actually, I think if you listened 18 to the explanation of how it really works in these 19 plants the research process actually many -- in many 20 instances culminates in the purchase and 21 installation, that there's all kinds of research and 22 development that takes place in designing something 23 before you even get to the point of buying anything. 24 So, back to the roof tile modernization, 25 they spent -- and again I don't have these exact 26 dates in front of me -- but they've got a year's 27 worth of drawings where they did research before 28 they bought anything. 165 1 And, so, it really depends upon the 2 particulars of each project whether -- when and 3 where the the research occurs, whether it's before 4 and after or, in many instances, both. 5 So, some of it is -- I think when you go 6 back to the explanation of some of the activities 7 around the Newark plant, a lot of it was -- we have 8 this list of projects, but a lot of them were 9 actually a single -- could be viewed as a single 10 project because it was trying to figure out how do 11 you integrate all these different things together? 12 But, again, we haven't included the actual 13 cost of the capital equipment and the installation, 14 only the engineering and testing effort around 15 figuring out, 1, what will it be? What will it 16 actually buy? How will we make it work -- the 17 research of all of the different potential solutions 18 based upon what might be available and then the 19 integration and testing of it afterwards. 20 MR. HORTON: Does the Department concur 21 with that? 22 MR. HILSON: No, sir. The problem -- the 23 problem with a lot of this is to go back to your 24 example of the equipment is purchased and is in and 25 is that when the research starts? 26 And we've been told, "Well, in lots of 27 times, that is when it ends." 28 None of these projects, with the 166 1 possible -- 2 MR. HORTON: Not to interrupt you, but the 3 testimony that I just heard is the one that I'd like 4 for you to respond to. 5 They seem to imply that the acquisition of 6 the property is an act subsequent to the analysis or 7 the determination or trying to resolve an 8 uncertainty as it relates to a process that they're 9 trying or a particular product. 10 MR. HILSON: And where I was going with 11 that, was to the extent that there's been a 12 suggestion that the purchase of the equipment is the 13 end of the research. 14 I don't think that's the case with any of 15 these projects. Or, moreover -- 16 MR. HORTON: It's somewhere in the middle, 17 I think they're saying. 18 MR. HILSON: -- moreover, the problem with 19 it is if we're going to accept that notion, that -- 20 and the notion that research might be -- occur after 21 as well is where is it? 22 What's the research that's being done? 23 What's being done with the accelerator after the 24 equipment is put in? How many people? When are 25 they doing this? 26 This is where the -- this is where the 27 disconnect is, it's not just -- 28 MR. HORTON: I agree, that's an issue that 167 1 we have to deal with. 2 But the first issue that I'm trying to 3 segregate here, if you will, and come to some 4 conclusion relative to Union Carbide, which seems to 5 imply that the mere acquisition of off the shelf 6 product, in and of itself, does not disqualify 7 research and development. 8 And, so, that in and of itself -- and 9 particularly since they did not claim it -- wouldn't 10 disqualify would sort of imply that at the end of 11 the day if you end up with a new process or you end 12 up with a new product, something had to occur in 13 order for that to happen. 14 I've toured, I think, two of these sites 15 and observed that there was a new product. However, 16 in that observation I also observed that elements of 17 the R & D costs was not necessarily attributed to 18 the research and development, but more so to 19 acquisition, flow of the product and other things 20 that may not -- may be subsequent to research and 21 development. 22 And, so, the question is just -- just Union 23 Carbide, would you agree or disagree that the mere 24 acquisition of off the shelf product, in and of 25 itself, would not disqualify qualified research and 26 development, despite the fact of your position? 27 MR. HILSON: It's a very broad concept, 28 but, in theory, you can buy something and use it in 168 1 a research situation, but you've got to show what 2 the research is. 3 MR. HORTON: Okay. Let me go to Appeals. 4 Same question. 5 MR. EPOLITE: Appellants' position here is 6 that their business component for the vast majority 7 of these projects was the improvement of their 8 manufacturing process. 9 They were -- there's two type of business 10 components, product development and improvement of 11 your manufacturing or process -- improvement or 12 development of manufacturing process. 13 So, in these -- in most of these projects, 14 yes, there was equipment purchased. But what 15 Appellants are saying is don't go way down here and 16 focus on this one task that we did in relationship 17 to this project. 18 What Appellants are saying is pull back and 19 look at the overall scope, because in doing -- in 20 purchasing that equipment and installing it, what we 21 were really doing was we were improving the 22 manufacturing process for that facility. 23 That's what Appellants are arguing. 24 MR. HORTON: No, I get that. 25 MR. EPOLITE: So, the fact that you just 26 purchased equipment does not, in and of itself, make 27 Appellants ineligible for qualified research. 28 MR. HORTON: Okay. 169 1 MR. EPOLITE: Because it's a bigger 2 picture. 3 MR. HORTON: And that's where I'm going is 4 that we've got to look at the larger picture and the 5 scope of the -- all of the activities together in 6 determining as -- as what McFerrin seems to instruct 7 us to do in Trinity, to some degree, by virtue if 8 they were able to isolate the six cases down to two 9 and then determine that the 80 percent rule didn't 10 apply to the entire projects before them, but only 11 two of those. 12 The challenge before -- before the Board 13 here is how do you quantify this? I mean, how do 14 you come up with -- let's presume for a minute that 15 qualified research did exist by virtue that there's 16 an end product. There's an end process that was 17 improved. Certainly as articulated by the 18 Department, there were other things that happened in 19 that -- in that entire process -- one, 20 environmental imp -- I mean meeting environmental 21 requirements, meeting building codes, all of that 22 did occur. 23 But that can occur in research and 24 development. That can be part of the process of 25 research and development. So, that, in and of 26 itself, does not isolate or disqualify the research 27 and development. 28 But at what point do you measure this? Let 170 1 me go to the -- to the Appellant. 2 Your testimony was that you only claimed a 3 percentage of this. You didn't claim it all. Can 4 you speak to how that percentage was developed and 5 determined? 6 MR. FOX: Yes. After -- after we developed 7 the list of qualifying activities, we prepared a -- 8 a time survey, which was done on an annual basis. 9 'Cause again, kind of stepping back, the 10 regulations, once you've identified qualified 11 research, are required to do an allocation between 12 qualified and nonqualified services and it's to be 13 done on an annual basis. 14 So, we developed a survey that included 15 things that -- our elements of a process of 16 experimentation, like designing, the manufacturing 17 line testing and selecting among different 18 alternatives -- 19 MR. HORTON: How -- 20 MR. FOX: -- designing -- 21 MR. HORTON: -- many elements would you 22 have -- believe are qualified? 23 MR. FOX: 1, 2, 3, 4, 5, 6 -- on this list 24 there nine different specific activities related 25 either to design or testing. 26 MR. HORTON: Tell us what they are. 27 MR. FOX: Designing and manufacturing line 28 testing and selecting different machine alternative, 171 1 designing, building, plumbing vacuum waste disposal 2 systems around the machines, developing other 3 manufacturing process enhancements, developing 4 software for internal use purposes, developing new 5 products, product and process testing, end process 6 quality checks for new and/or enhanced products and 7 manufacturing processes, product specification and 8 product development tests, determining product 9 specifications. 10 And then we have a list of the nonqualified 11 or other activities that don't fall into the ones -- 12 the ones in those categories which wouldn't be 13 included in the process of experimentation. 14 And again these were developed for -- for 15 the plants. We then sat down with the general 16 managers or other subject matter experts on an 17 annual basis and they went through their list of 18 employees and determined who were participating in 19 these activities. 20 So, for example, Gladding McBean, the roof 21 tile modernization, who's involved in these 22 projects? 23 Well, there's the actual engineering and 24 design of the process itself, but then there's all 25 the extensive testing that has to take place because 26 they don't have their own separate pilot facility. 27 So, for research they borrow a portion of 28 manufacturing time, which means they put clay 172 1 through and out the other end is the product they 2 need to test. 3 And everyone involved in conducting that 4 experiment, which is basically the plant personnel 5 that operate the machinery, are part of the process. 6 So then Bill would estimate on an annual 7 basis how much of their time was devoted to be taken 8 off of production and into research -- sorry. 9 MR. HORTON: Okay. I think that's clear. 10 I heard testimony and I just want to clear 11 this up, that 100 percent of the employees were 12 included in the estimated -- or qualified research 13 and development at some rate, every employee -- 14 secretary, executive, top executive? 15 MR. FOX: No, that's not accurate. 16 MR. HORTON: To the Department -- 17 MR. RILEY: At Vernon, yes. 18 MR. HORTON: -- at one of the plants that 19 was the case? 20 MR. RILEY: At the Vernon plant and I 21 believe Bill has the statistics on each of the 22 plants here. 23 MR. HORTON: Okay. Can you give us those 24 statistics? 25 MR. HILSON: Muddux ranged -- excuse me, 26 can you hear me? 27 Muddox ranged between 93 to 100 percent of 28 all employees; Dixon, 48 to 73 percent; Tracy, 88 to 173 1 100 percent; Vernon, 100 percent of all; Lincoln, 96 2 to 100 percent. 3 MR. HORTON: And these ranges exist because 4 of what? I mean -- 5 MR. RILEY: Just different years, in, say, 6 2009 it might have been 96 and in 2004 it might have 7 been 100. 8 MR. SPERRING: The only thing -- keep in 9 mind, right, I'm not sure -- I'm not going to agree 10 with that, but keep in mind on Vernon, where he 11 listed every single employee, okay, I think some of 12 them have zeroes, but even if they don't have 13 zeroes, they're going to be 1, 2 percent. 14 So, he's listing, again, employees to run 15 the plant. They had to test the plant, okay. So, 16 what you look at is you see employees who were doing 17 a lot of the research, such as himself, have a 18 higher percentage. And then people who are, you 19 know, running the plant are going to have a lower 20 percentage, okay. 21 So, it would make sense that Vernon, okay, 22 which, you know, is not going to have a large sales 23 force, okay, and they're really -- they really just 24 running that plant for their own operations, okay, 25 you are going to have everyone involved to some 26 degree. 27 Now Bill was very methodical. I saw his 28 wage survey. He went -- he listed every employee 174 1 and gave a percentage. I think some of those might 2 have zero, but even if they don't, they're going to 3 be 1, 2 percent. 4 So, again, this is, you know, another way 5 of just attacking, okay, the qualified activities. 6 MR. FOX: And this is -- also gets back to 7 the first examination. 8 And I don't agree with the characterization 9 she didn't find qualified research, 'cause she did 10 look at the activity documentation. 11 But she's the one -- she then went through 12 each of the -- each of the -- each of the personnel 13 and raised questions about some of the titles, which 14 we responded to. 15 For example, why is a forklift operator? 16 But that was -- the essence of that examination was 17 to get to the -- whether all these costs were 18 qualified, which we believe all or most were. 19 But her initial pass was 80 percent and 20 then we provided her additional documentation and 21 explanation as to why others were included. 22 But that is the approach that she went 23 down, which is why are these people included and is 24 this an allowable cost element -- after we had 25 explained the nature of the activities on a cost 26 center basis. 27 MR. HORTON: Question of the Department. 28 Given the standard of evidence seemed to be 175 1 established by the Treasury regulation and Congress, 2 why not deviate from project cost accounting as far 3 as an assessment or evaluation and conduct the audit 4 based on cost center accounting with -- but 5 evaluating the methodology and the component 6 elements of the test and determining whether or not 7 they should be there, as well as the subsequent 8 interviews and analysis and so forth? 9 Why not at least go down that road in order 10 to impeach, if you will, the evidence before us? 11 MR. HILSON: The focus, Mr. Horton, has 12 been on the activity and the documentation of the 13 activity. 14 The questions have been who, when, what did 15 they do, where's the process of experimentation? 16 Yes, it gets -- this has broken down into a 17 project by project discussion. And, yes, we have 18 gotten into an analysis of the values of the various 19 claims associated with these projects. 20 But in the first instance, the stumbling 21 block is activity. 22 MR. RILEY: Can I respond to that? 23 MR. RUNNER: Can I just follow up on a 24 question there -- 25 MR. HORTON: Yeah. 26 MR. RUNNER: -- Mr. Chairman? 27 I think what I am hearing you ask is why 28 did you not -- why -- 176 1 MR. HORTON: No, I can ask myself. 2 MR. RUNNER: No, no, I just meant -- I -- 3 MR. HORTON: Roll yourself out. 4 MR. RUNNER: -- I believe you've done that 5 to me a few times. 6 MR. HORTON: I have and I apologize. 7 MR. RUNNER: So, l et me start again. 8 MR. HORTON: Thank you, Mr. Runner, I 9 needed that. 10 MR. RUNNER: It's only fair. 11 I think the point, though, I think I was -- 12 is that was the way that FTB did it in 1999. 13 So, the question is why wasn't that a valid 14 method then in the subsequent years? Or why didn't 15 they, at least, even look at that as a valid method? 16 MR. HILSON: I honestly can't explain to 17 you what the auditors did at that point afterwards. 18 As I mentioned before -- 19 MR. RUNNER: I thought you -- hold on -- I 20 thought you guys told us that -- 21 MR. HILSON: -- I told -- 22 MR. RUNNER: -- that the 1999 was -- 23 MR. HILSON: -- I told you what happened 24 was the -- after the offer was rejected and at about 25 the time there was the change in auditors, the IRS 26 advice came out about beware prepackaged credit 27 studies and the focus at that point changed going 28 into activities. 177 1 MR. RUNNER: So, you did not say -- I guess 2 -- let me just clarify that, you did not say that 3 the 1999 audit was based on a cost center method? 4 MR. RILEY: That was Mr. Sperring's -- he 5 stated that in this hearing 6 MR. RUNNER: So, what was the method of -- 7 so, okay. 8 Tell me what was the method -- 9 MR. RILEY: Well -- 10 MR. RUNNER: -- methodology used in the 11 FTB -- in the 1999 -- 12 MR. RILEY: -- in 1999 that's what the 13 auditor looked at. She looked at the -- at the QREs 14 based on the cost center approach. 15 MR. RUNNER: Okay, thank you. 16 MR. RILEY: In -- 17 MR. RUNNER: Okay, thanks. 18 MR. HORTON: Okay. You know, the spirit of 19 Cohan and the essence of the -- of the Treasury -- 20 subsequent Treasury report as well as the statements 21 made by Congress, it all seems to imply that when 22 the evidence is before us that we have to measure 23 that evidence somehow. We can not go down a path 24 that is -- that takes us away -- totally away from 25 that. 26 And, so, if the FTB conducted a test in 27 1999, you can't summarily dismiss that as being 28 wrong without having some type of statement as to 178 1 why that methodology used by the Department -- the 2 Department is one integral agency. 3 We -- we are -- you're not individuals. 4 You're not separate work centers. You're one 5 integral agency. 6 So, if the agency made a decision, there 7 has to be a basis for reversing that decision. 8 And, so, maybe you wants to speak to that? 9 MR. RILEY: If I may? 10 Once the -- once the auditor, the second 11 auditor was placed on the -- on the case, she noted 12 that, look this -- these activities do not qualify 13 for the credit. 14 At that point this became for -- for -- for 15 the subsequent years and then in -- and 1999. So, 16 for the, you know, 2000, 2001, 2002, 2003, those 17 years that were audited, it was a qualified research 18 activity audit, because what -- the problem with the 19 cost center approach is that it skips Step 1, 20 41(d)(1) activity. And it jumps straight into the 21 costs of QREs. 22 And that's -- that's the -- I mean, that is 23 really -- that was the -- the entire focus of our 24 first hearing. That has been our focus throughout 25 the -- the -- the supplemental briefing, the 26 additional briefing with respect to the declarations 27 that the taxpayer has not shown qualified research 28 activity. 179 1 We can't -- the genie is out of the bottle, 2 so to speak. We now know that these things are not 3 qualified research activity. We can't, I guess, 4 pretend that just because in 1999 an auditor doing 5 only a QRE audit, the cost center approach audit, 6 didn't look at the qualified research activities. 7 Once the qualified research activities were 8 examined -- 9 MR. HORTON: You know, you could just say 10 they made a mistake and -- 11 MR. HILSON: Mr. Horton, I think the -- I 12 think the easy answer is that while it -- while the 13 original audit looked at cost center approach, after 14 the fact of the Audit Division changed its policy to 15 make it an activities first analysis. And that's 16 where we are. 17 MR. HORTON: Just to the activity analysis, 18 you know, I don't know who said this, but I think it 19 was my granddaughter, if it quacks like a duck, it's 20 a duck, you know. 21 The -- and the one -- and I seem to go back 22 to that, at least to the -- and it's just how do you 23 measure when the research started? 24 And we cannot be expected to -- to do that. 25 It's not what the Board is designed to do. That is 26 an audit function. 27 And, so, you have two different 28 methodologies here of accounting for, cost center 180 1 versus project cost accounting and then taking a 2 look at the elements in the -- in the activity. 3 But at the end of the day at the plant 4 where they were manufacturing roofing, they came up 5 with an entire new process of developing that tile 6 and an entire new product. 7 Based on my own visual observation there 8 was a product that -- that the chemical components 9 and the science of that project was just 10 different -- the way it all came together, the 11 catalyst, the end product, the color of the tile, 12 the method of processing the tile. Instead of 13 having one tile it now had two that would break off 14 so you could almost double the manufacturing 15 process. 16 Now I would stipulate that there were 17 several activities that were not part of the 18 qualified research and development. So, I don't 19 even -- I don't believe that in and of itself, a 20 hundred percent of that would be qualified. But 21 there is qualified activity that goes on there. 22 So, if we're just are looking at the 23 activity alone, just that project, that would tell 24 us that we now have to go to some form of measuring 25 what that is. 26 And, so, the premise of -- from which you 27 start puts you at a disadvantage if, in fact, the 28 Board determines that some qualified activity 181 1 exists. 2 And you put the Board at a disadvantage 3 because now it's a zero, you know, it's -- it's all 4 or nothing. 5 Okay. So, maybe a re-audit? 6 MR. RUNNER: That would end in another 7 hearing. 8 MR. HORTON: I mean -- I mean, part of me 9 is what somewhat compelled to say to the FTB, let's 10 go out and examine it based on the cost center 11 analysis, but given all of the time that we've 12 invested in this, you know, you know, we may be 13 placing an undue hardship on everyone involved. 14 And, in fact, we may need to use the Cohan 15 approach and just come up with our best estimate as 16 to what is. 17 Unless -- I'm going to go to the Appellant 18 and see if you can give us guidance and then to the 19 FTB and then I think I'm finished. 20 It's your turn. 21 MR. FOX: It's my turn? 22 This isn't directly responsive, but I did 23 want to point out -- 24 MR. HORTON: I would suggest a direct 25 response, but -- 26 MR. FOX: -- it's very short. 27 MR. HORTON: -- first, then point out. 28 MR. FOX: Okay. 182 1 MR. SPERRING: Yeah, uhmm, we would just 2 point out, okay, that we believe that we have proved 3 entitlement to all of the credit, okay, to answer 4 your question. 5 And the reason for that is that we have 6 focused on Step 1 from the beginning the projects, 7 the qualified research activities, okay. 8 There -- we believe there's been an effort 9 to steer us away from that, but we listed out all of 10 the projects. We've shrunk them back. 11 We've done the -- listed all of the 12 business components. We've listed all of the 13 products or all of the uncertainty that was involved 14 in those projects. And the process of 15 experimentation to overcome that uncertainty. 16 And we provided what we believe are to be 17 testimonial evidence as well as contemporaneous 18 documents, okay. 19 We believe that the first auditor got it 20 right and agreed that there was qualified research 21 activity. And then she moved to Step 2, which is 22 cost center. 23 We believe the IRS got it right, that there 24 was qualified research and -- and sustained all of 25 the credit, okay. 26 Their only -- and let's talk about the 27 middle auditor. The middle auditor, if you read the 28 (unintelligible) never even talks about our 183 1 research, okay, never even attempts, just says it's 2 a prepackaged study we won't look at it. 3 It makes no reference to the fact that -- 4 that the projects are listed in the study, okay. 5 And, so, you know, unfortunately, the FTB has taken 6 that tact and basically just spent the whole time 7 talking about cost center and how they don't like 8 the cost center approach. 9 But we have documented our projects and, 10 you know, therefore we believe that we have met our 11 burden. 12 MR. FOX: And I would add quickly that the 13 question was asked, you know, for example, we don't 14 know who, but it's also what's missing from this is 15 a real understanding of what is a cost center? 16 A cost center is a group of people -- 17 MR. HORTON: My apologies, the Members try 18 to ask the questions they're interested in. 19 MR. FOX: Okay. 20 MR. HORTON: To the Department, any -- 21 MR. HILSON: Yes, Mr. Horton, to respond, 22 as we've said repeatedly this afternoon and this 23 evening, really what this has boiled down to is an 24 activities analysis. 25 We know and we went through as many of the 26 projects that we could and we end up in a situation 27 with what is the qualified activity? 28 We know through the documents -- and what 184 1 we're talking about is our analysis of the documents 2 that have been provided by the Appellant and are -- 3 and basically pointing out where they fall short. 4 We know what they did at certain points in 5 time. We know through some of their explanations 6 when they didn't follow through with it. We know 7 when they -- we know that they trashed various 8 projects. 9 The problem is is we don't know what 10 anybody is doing at any particular time. And to the 11 extent that you're going to argue that, hey, I'm 12 researching whether this is going to work, well, at 13 least tell me what you're doing and when you're 14 doing it. 15 And to just simply say it's there and it 16 spanned five or six years and I'm entitled to all of 17 it because we did this study and the study's right, 18 isn't -- doesn't -- I mean, DiCon flat out 19 establishes we don't -- you know, we have the 20 ability in the audit to audit, we've got the 21 obligation to audit. 22 And what we've been looking at is activity. 23 And our position is that the documentation of the 24 activity just falls short. 25 MR. HORTON: Yeah, the challenge -- the 26 challenge in looking at just the activity, it 27 summarily dismisses the -- whether qualified 28 research exists and because if you say the component 185 1 activities in itself don't -- each individual 2 activity doesn't necessarily meet the standards 3 established by the Department. 4 Then if -- if there's a conclusion that the 5 qualified research did exist, something happened. 6 Then it's sort of incumbent upon the Department to 7 measure it. And it puts us again at a disadvantage 8 in that regard. 9 And if you were to just take the site that 10 I visited personally and the fact that I'm -- my 11 observation was that a new product, a new process 12 resulted from some activity, of which they were able 13 to document -- and in some cases documentation, 14 subsequent documentation, but yet, still 15 documentation -- sort of takes us back to Cohan. 16 Once we established that it did exist, if 17 you take that particular plant, then it's sort of 18 incumbent upon us to come up with something. 19 And your method of approaching it won't -- 20 would not allow you to get there and didn't allow 21 you to get there on that particular case, which 22 causes us to have to go back and look at all of 23 these different cases, which is just not what we -- 24 what I think we should be charged with. 25 I think we ought to be charged with the 26 assessment of the law and the essence of the law and 27 that the -- the facts as they exist as directed by 28 Congress and to -- which basically says -- as well 186 1 as Trinity and McFerrin, which basically says -- the 2 documentation as -- is available based on the 3 industry, the professionals in the industry, the 4 type of documentation they maintain. 5 They may not have scientists and all of 6 that type of activity, but yet still enough 7 documentation to support that the process changed. 8 There was an uncertainty. There was a 9 discovery process where they discovered something 10 because they ended up with something different than 11 what they started out with. 12 And I posited that basically addressed the 13 unknown. 14 So, okay. Further discussion? 15 Member Yee. 16 MS. YEE: Just one last question. I just 17 want to be sure that there's -- again I hope there 18 is agreement about this. 19 There was reference made to expenses that 20 were claimed before the start of the project and 21 then expenses after the project was completed. 22 And I wanted to get a sense of whether -- 23 should those be removed, I guess, is my question? 24 MR. HORTON: Yeah. 25 MS. MANDEL: Was that question before the 26 break? 27 MS. YEE: Yeah. 28 MS. YEE: I mean -- 187 1 MR. SPERRING: Well, I guess -- our 2 response is no, there is no -- keep in mind, right, 3 there's the study which the credit was based on and 4 then there is the request that -- that your Board 5 asked us to do, put together a listing of -- of 6 expenses tied to projects, okay. 7 That was done, okay, to be an estimate to 8 allow you, if you wanted to reduce by project, you 9 could. 10 But the bottom line is there are no -- in 11 the study, okay, there are no QREs, okay, tied to 12 projects that didn't occur in those years, okay. 13 We have disputes, factual disputes, FTB 14 says, well, this document is outside the study year 15 and, therefore, we're not going to give you any 16 credit for any additional activities. 17 Our plant managers will swear under oath -- 18 and they have signed declarations that it did occur. 19 So, ultimately, it becomes -- comes down to 20 credibility and whether you want to believe them or 21 not. 22 But there no QREs that are claimed outside 23 the audit periods -- or, excuse me, outside the 24 study period. 25 MR. HORTON: Member Mandel. 26 MS. MANDEL: It just gets -- let me just 27 make sure I understand what you're saying, 'cause if 28 I don't understand what you're saying, I'm not sure 188 1 how to -- so, I -- I made myself a little list from 2 the various pieces we do have in the hearing 3 summary. 4 I think there's a page and a half or 5 something where discrepancies -- this is part of the 6 discrepancies that were noted off the project costs 7 and then the years in which the project was -- 8 supposedly happened. 9 So, like just because I'm open on this page 10 on my own stuff here, Project 11, which is the raw 11 material handling upgrade at Newark, I have a note 12 QREs claimed. And, of course, this is on your -- on 13 the project list that you, you know, did in response 14 to the question from Appeals for fiscal years 15 ending '99 to '02 only, but the project is only for 16 fiscal year year ending '02. 17 So, can you explain why then when you went 18 to answering the question about project costs that 19 you're showing QREs in years that aren't years that 20 you say that the project occurred? 21 Because I think that's part of the 22 disconnect that -- 23 MS. YEE: Uh-huh. 24 MS. MANDEL: -- I don't understand how you 25 did the -- how you went and then assigned to -- 26 that's the kind of thing that we were just asking 27 about. And you were trying to explain. 28 MR. SPERRING: Yeah, yeah, right. 189 1 MS. MANDEL: I just wanted to understand 2 what your -- 3 MR. SPERRING: Our point is you have 4 contemporaneous documents, begin dates, end dates, 5 okay. So, that's one way, okay, of measuring it. 6 And then -- 7 MS. MANDEL: One way of measuring what? 8 MR. SPERRING: The period that the 9 activities occurred in. 10 MS. MANDEL: Okay. But let me stop you 11 right there, because, Mr. Epolite, you wrote the 12 hearing summary. 13 And when it says that a project was only 14 this year or in these years, I thought that that was 15 also taken from that the taxpayer had, at some point 16 in time, identified a begin and end date for the 17 projects? 18 MR. EPOLITE: That's correct. 19 In the additional briefing letter we asked 20 Appellants for that information and the November 21 9th, 2012 spreadsheet that lists the 64 projects -- 22 MS. MANDEL: Correct. 23 MR. EPOLITE: Along with doing that, they 24 listed the beginning and end date of each project. 25 MS. MANDEL: Okay. And, so then the way I 26 understood the chart that you made up, which said, 27 "Gee, there's these discrepancies between the 28 project costs -- between the costs allocated to the 190 1 projects in response to the question and the years 2 that the taxpayer had said this is when I was doing 3 this project." 4 That's where there were these discrepancies 5 on a series of projects. And, so, I think that's 6 part of -- I'm trying to understand how that 7 happened and how that relates to whatever it is 8 we're trying to figure out. 9 MR. EPOLITE: Yes. 10 MS. MANDEL: Did I understand correctly -- 11 MR. EPOLITE: Yeah, just to -- 12 MS. MANDEL: -- how you did that chart? 13 MR. EPOLITE: -- just to complete the 14 thought, let's say the Appellant said -- they gave 15 two dates, a beginning date and an end date. 16 And there was a beginning date in the 17 fiscal year 2000 and an end date in fiscal year 18 2002. So, there's three fiscal years of activity. 19 And what this chart is saying is that, 20 okay, we should be seeing QREs allocated to those 21 three fiscal years. 22 MS. MANDEL: Right. 23 MR. EPOLITE: However, for some of these 24 projects we're also seeing expenses claimed in 25 1999 -- 26 MS. MANDEL: Right. 27 MR. EPOLITE: -- and 2004. 28 MS. MANDEL: Right. 191 1 MS. MANDEL: Do you have a -- okay. 2 MR. FOX: Yeah. I mean in general those 3 start and end dates are the date of the first 4 document and the last document, not necessarily when 5 the project occurred. 6 So, if you look in the record, it's the 7 date of the first document and the last document. 8 MS. YEE: Say that again? 9 MS. MANDEL: Sorry. 10 MR. FOX: Well, to try to -- because, 11 again, keep in mind this was put on a cost center 12 basis and they identified the projects and when they 13 were working on things. 14 But to answer this question and try to 15 answer the project, maybe it's a bad label, but 16 those dates are the date of the first document that 17 mentions the project and the last date -- not 18 necessarily their testimony and their explanation of 19 everything that happened. 20 MR. THOMPSON: This -- if I could jump in 21 here? 22 I think this -- highlights the importance 23 of looking at specific projects. 24 You can't talk about research in the 25 abstract, overall is it sort of researchy? 26 You've got to look at each project and when 27 did it occur and then was it qualified research? 28 Was substantially all of it a process of 192 1 experimentation? And then do we have a reasonable 2 estimate of expenses? 3 Whether it's cost basis -- I mean whether 4 it's cost center, whether it's whatever else, do we 5 have a reasonable basis that we feel comfortable, if 6 you have already determined there's qualified 7 research for that project? 8 If you're not looking at specific projects, 9 then I think that's a -- you run into these problems 10 where you have expenses claimed for projects that -- 11 that began and end, you know, it doesn't match up. 12 It doesn't line up because -- because 13 you're not looking at specific projects 14 MS. YEE: I thought part of -- I thought 15 the project start and end dates were determined by 16 the Appellant after the matter had been before us 17 once? 18 I can't think of -- 19 MR. EPOLITE: That's correct, the 20 additional briefing letter said, 21 "Appellants should also provide 22 the approximate beginning date and 23 ending date of each project, along 24 with all available contemporaneous 25 documentation that supports each 26 project's alleged time frame." 27 So, the -- 28 MS. MANDEL: Okay. And then -- I'm sorry. 193 1 MR. EPOLITE: -- the spreadsheet they 2 submitted, the two columns are identified as 3 beginning date and ending date. 4 And with that in mind, with the question 5 asked, that should be the beginning date and ending 6 date of each project. 7 MS. MANDEL: And what he's saying is what 8 he wrote on the chart was the document beginning 9 date, the first document I happen to have and the 10 last document I happen to have? 11 MR. EPOLITE: Which is not what they were 12 requested to do. 13 MR. SPERRING: Well, he -- may I add 14 something? 15 MS. YEE: (Nodding). 16 MR. SPERRING: Board Member Yee, thank you. 17 I mean, you're hearing a discomfort from, 18 you know, the cost center approach, right? 19 But the IRS realizes that this is the way 20 these things have to be audited. 21 And our problem is we've had a project -- a 22 project accounting imposed on us. And, admittedly, 23 the project accounting and the cost center 24 accounting do not tick and tie to the dollar. 25 And that's -- and the reason for that is 26 based on -- on -- on, you know, you can can look at 27 it by document, okay, and try to, you know, go 28 project by project and lay out all the documents, 194 1 okay, and figure out what was going on. 2 Or you can, you know, talk to the plant 3 managers, right, and get their recollection during 4 this year of how much activities, I think Kendall 5 read off earlier the qualified activities. 6 And, so, their estimates on a cost center 7 basis are based on qualified activities, okay. 8 And now what we're trying to do is 9 reconcile a project accounting -- and we're the only 10 taxpayer we believe in America that's had to do 11 both. We have two studies. You have a cost center 12 and you have a project accounting. And we have 13 reconciled 98 percent. But there's 2 percent where 14 it doesn't reconcile perfect, okay. 15 But it really -- it's at the margins and it 16 just has to do with how do you want to measure the 17 end and start date? 18 Do you want to measure it -- you know, do 19 you want to measure it with the contemporaneous 20 documents in front of you or what the plant managers 21 were saying they were doing during these years, 22 looking at these projects that were going on these 23 years, how much of their time they were spending? 24 MS. YEE: Well, I -- 25 MR. SPERRING: Do you follow that? 26 MS. YEE: Yeah, I do follow and I, 27 personally, would give more weight to the 28 contemporaneous documents because we've got the 195 1 recollection that's happening here is after. 2 But I guess I'm still -- if we're trying to 3 connect reconcile here -- 4 MR. SPERRING: Yeah. 5 MS. YEE: -- and I thought after the 6 request for additional briefing, when we specified 7 that we wanted to see the start and end date for 8 each project, it just seems like a very simple 9 request. 10 When did the project start? And when did 11 the project end? 12 And if it's tied to, you know, kind of the 13 document -- the date of a first document and the 14 date of a last document, what does that represent? 15 MR. SPERRING: Well, we thought that would 16 be easily verifiable. 17 We were trying to put together, per the 18 Board's request, on short notice, you know, an 19 answer to their question to make it easily 20 verifiable. 21 So, that -- that was the thought process. 22 We were just trying to be, you know, accurate, 23 transparent and have it, you know, easily 24 verifiable. 25 So, that's what we did. 26 MS. YEE: Okay. 27 MS. MANDEL: Can I -- can I -- 28 MR. HORTON: Sure. 196 1 MS. MANDEL: -- at the risk of -- okay, 2 two things. 3 The first is the first step about 4 expenditures being 174 expenditures. 5 MR. HORTON: Uh-oh. 6 MS. MANDEL: No, no, I just -- I'm just 7 trying to, you know, keep all the moving parts in 8 my -- I thought that that went to -- that the -- 9 that the expenditures seem like those -- that's -- 10 that's really the QRE side of the house, whereas 11 the -- where the research activities is a process of 12 experimentation may or may not be based on the cost 13 analysis to figure that out. 14 So, if the -- in the study, the three 15 things that it sounded like they were claiming as 16 qualified research expenditures, assuming the first 17 part's the hurdle, that they were claiming wages, 18 they were claiming utilities and then something 19 supplies? 20 So, wages -- are wages going to be -- I'm 21 just, on a broad generalized thing, those three 22 items, I mean I don't hear equipment purchase in 23 there on the 174 question. 24 Because what I remember from, you know, one 25 of those early briefs that you referenced was that 26 it was focused on the equipment purchases and saying 27 every single time that what they -- when they do an 28 AFE and they ask for money to buy a thing that that 197 1 thing should be capitalized and depreciated. 2 But I -- when I look at the items that they 3 say they're claiming -- and if you look at their 4 time estimates and everything -- it's about wages. 5 I don't hear the AFE. 6 So, you, obviously, must have a point of 7 view on that and I don't want to get hung up on that 8 first point. 9 MR. RILEY: I will try to be as -- as quick 10 as possible. I'll just tweet it to you, okay? 11 MS. MANDEL: Okay. 12 ---o0o--- 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 198 1 MR. RILEY: 174 is the deduction. It is a 2 research credit -- I'm sorry, it is a research 3 deduction. It has a lower threshold of you need to 4 meet laboratory experimentation in the scientific or 5 laboratory sense. It is not as stringent as the 41 6 credit. 7 All 41 credit expenses must meet -- first 8 meet -- they must meet this lower hurdle of being 9 eligible for 174. Okay. 10 Are -- are you with me? 11 MS. MANDEL: Yeah. So I guess you're 12 trying to say maybe that you think I'm not -- I'm 13 being too, uh, whatever. Let's make up a bad 14 characterization -- 15 MR. RILEY: No, no. 16 MS. MANDEL: -- between just trying to 17 characterize between an expense and something that 18 should be capitalized. 19 When I read your stuff I kept seeing it 20 should have been capitalized, it should have been 21 capitalized. That's why I'm focused on just, you 22 know, what's -- what's deductible versus what's a 23 capital expense. 24 MR. RILEY: It is -- it is a part of the -- 25 it's a part of a test related to the less stringent 26 deduction that you must meet first -- 27 MS. MANDEL: Okay. 28 MR. RILEY: -- before you get into a 41 199 1 credit -- 2 MS. MANDEL: I -- I understand. 3 MR. RILEY: -- activity. 4 MS. MANDEL: I guess I understand that 5 part. The way that I heard everything that was 6 being said in the briefs about 174 was it was so 7 focused on whether it was really more appropriate as 8 a capital expenditure. 9 MR. RILEY: Well, and that's one of the -- 10 one of the -- the Treasury Regulations for 174 11 instruct -- instruct us that just equipment 12 purchases, that -- that those do not qualify. 13 MS. MANDEL: Correct. 14 MR. RILEY: Okay. So if that equipment 15 purchase doesn't qualify, and what we have here is 16 we have authorization for fund expenditures for the 17 purchase of equipment. 18 MS. MANDEL: Okay. I hear that. What I'm 19 asking is wages. Let's say -- let's say they didn't 20 claim any utilities or supplies. If all they were 21 claiming was wages, that's not going to be a capital 22 expenditure. 23 MR. RILEY: No. Well, but that's -- that's 24 also, you know, step two, 41(b), the wages. 25 MS. MANDEL: Okay. I -- I'm going to give 26 up on that part and go to -- because now it just 27 seems to be -- 28 Um, let me ask you a way broader question. 200 1 Um, your -- your focus is very much, of course, on 2 the first part and whether any of the particular 3 projects meet the process of experimentation and the 4 "substantially all" test for trial and error being 5 substantially -- you know, when does it start and 6 when does it end, that process of experimentation, 7 and was it substantially all of that project? And 8 you say no on pretty much almost all but one. 9 Um, since cost center is, uh -- is 10 allowable, doing cost center or cost center 11 approach, um, that they don't have to do project 12 accounting. Just as a general thematic thing, if -- 13 if, um -- if the "substantially all" process of 14 experimentation test is met -- 15 Let me just pick Gladding McBean because 16 there's only two projects. Um, if -- if both -- if 17 the Board, uh, thought that both those projects met 18 the process of experimentation substantially all 19 test, um, then it's okay to use cost -- a cost 20 approach if you think those are the right numbers on 21 it. It doesn't have to be -- 22 I'm just -- I'm just trying to figure out 23 how -- how, in the sort of real world of looking at 24 R&D credit analysis, if you're allowed to do a cost 25 approach, how do you go from saying these projects 26 are -- we think these projects are okay and meet the 27 R&D standard, now I have to figure out -- 28 MR. RILEY: Well, we would look at the 201 1 nexus between the activities that we think qualify 2 and the costs that they've claimed. 3 So, for instance, if you want to take the 4 pop-out project, because we have said that, you 5 know, Jim Keating, we think he's engaged in 6 qualified research for a certain amount of time, 7 okay. So they claimed for Jim Keating six percent 8 of his wages. 9 MS. MANDEL: Mm-hmm. 10 MR. RILEY: Okay. So we are saying, okay, 11 you can -- we think this is allowable because we 12 have maybe 140 in the 154 pages of documentation 13 showing that Mr. Keating and his -- you know, Louise 14 Braserra and I believe his -- a couple of other 15 people, Jim Schwartz, uh -- uh, were -- were 16 involved in activities. This was -- this would 17 be -- this would have been detailed at pages 30 to 18 48 of our opening brief. 19 MS. MANDEL: Okay. So on that one, on just 20 using that one, you -- what you left out, you didn't 21 give anything for Bill -- Bill P. 22 MR. RILEY: Right. 23 MS. MANDEL: Okay. 24 MR. RILEY: Well, I mean, first of all, 25 because he's an executive and we -- as we -- we 26 MS. MANDEL: But that's -- that's the piece 27 that you left out, pretty much. 28 MR. RILEY: Well, we left that out and then 202 1 we left out the employees that the other -- are 2 there 200 and -- if there's 237 employees at, uh, 3 Gladding McBean, uh, we left out 230 of them because 4 there's no nexus between the documentation that we 5 were given, that -- that Appellants provided and 6 those activities. 7 We know, with respect to the pop-out 8 project, we know that Jim Keating, you know, he was 9 the one engaged in the research. He asked -- he 10 gave direct orders to certain people. And for those 11 people, we are saying, "Okay." 12 MS. MANDEL: Okay. 13 MR. RILEY: So we know that they're engaged 14 in research and, at the very least, direct 15 support. 16 MS. MANDEL: So -- so if you-- 17 So you, I guess -- so then you were, as to 18 particular people, um, that you thought there was 19 the nexus, you didn't have an issue with the cost 20 accounting approach and their estimate? 21 MR. RILEY: No. I mean, if -- if-- okay, 22 so -- 23 MS. MANDEL: In that -- in that particular 24 example? 25 MR. RILEY: Right. If -- if a -- where a 26 taxpayer has proven qualified research activity, 27 I think it's very clear that they are then entitled 28 to, at the very least, an estimate. 203 1 MS. MANDEL: Okay. 2 MR. RILEY: Okay. So in these instances, 3 we have, with those six or seven people, starting 4 with Jim Keating and Jerry Schwartz, uh, and Louise 5 Braserra, those people are entitled, at the very 6 least, to an estimate. So for the purposes of our 7 brief, we -- we said, okay, well, we'll accept their 8 six percent estimate. 9 MS. MANDEL: But there might be a situation 10 where you didn't think the estimate -- 11 MR. RILEY: Right. For instance, with, you 12 know, Mr. Keating in 2003, in fiscal year 2003, they 13 claimed six percent of his wages as direct support 14 and they claimed 20 percent of his wages as internal 15 use software. 16 There's no indication in any of the 17 documentation that we've been given that any 18 internal use software project occurred at Gladding 19 McBean. So for that 20 percent that, you know, I'm 20 sorry, there's no -- there's no internal use 21 software documentation, we're -- we are saying no. 22 But to the -- to the six percent that they 23 claimed for -- for Mr. Keating and the other people 24 on that, you know, that he gave the direct orders 25 to, yeah, we -- we -- we will accept that particular 26 estimate. 27 And while that -- that -- 28 MS. MANDEL: I know you don't necessarily 204 1 agree with the base period, but you're accepting 2 that particular estimate. 3 MR. RILEY: Yes, we'll say arguendo, even 4 if the base period is perfect, okay, then -- then 5 that's what they would be entitled to, the amounts 6 that we articulated in our opening brief at pages 30 7 to 48. 8 MS. MANDEL: I'm trying to figure out maybe 9 if there's an estimate you wouldn't -- I don't know. 10 So you're sort of saying if the estimate 11 had a nexus and seemed reasonable somehow, then 12 that's -- then you were okay with that? 13 MR. RILEY: Yeah. I -- I think that's 14 what -- you know, that's what McFerrin, that's what 15 the line of cases they -- they say you're 16 entitled -- if you prove the activity, you're 17 entitled to an estimate at the very least. 18 MS. MANDEL: Okay. And so, except for that 19 one, you don't think that the activity's been -- 20 MR. RILEY: Correct. 21 MS. MANDEL: -- proved under the 41 22 standard of "Was there trial and error research 23 development activity that was substantially all of 24 this particular project that you're looking at?" 25 MR. RILEY: Correct. 26 MS. MANDEL: Thank you. 27 MR. HORTON: Further -- further discussion, 28 Members? 205 1 Member Yee? 2 MS. YEE: No. 3 MR. HORTON: Hearing none, is there a 4 motion? 5 MS. YEE: Move to take the matter under 6 submission. 7 MR. HORTON: Member Yee moves to take the 8 matter under submission. Member Runner seconds. 9 Without objection, Members, such will be 10 the order. 11 Thank you so very much for appearing before 12 the Board today. The Board will take your matter 13 under consideration later on this evening and send 14 you a written report of our decision. 15 MR. FOX: Thank you. 16 MR. SPERRING: Thank you. 17 ---oOo--- 18 19 20 21 22 23 24 25 26 27 28 206 1 REPORTER'S CERTIFICATE 2 3 State of California ) 4 ) ss 5 County of Sacramento ) 6 7 I, KATHLEEN SKIDGEL, Hearing Reporter for 8 the California State Board of Equalization certify 9 that on October 29, 2013 I recorded verbatim, in 10 shorthand, to the best of my ability, the 11 proceedings in the above-entitled hearing; that I 12 transcribed the shorthand writing into typewriting; 13 and that the preceding pages 1-59, 103-145 and 14 199-206 constitute a complete and accurate 15 transcription of the shorthand writing. 16 17 Dated: December 9, 2013 18 19 20 ____________________________ 21 KATHLEEN SKIDGEL, CSR #9039 22 Hearing Reporter 23 24 25 26 27 28 207 1 REPORTER'S CERTIFICATE 2 3 State of California ) 4 ) ss 5 County of Sacramento ) 6 7 I, JULI PRICE JACKSON, Hearing Reporter for 8 the California State Board of Equalization certify 9 that on OCTOBER 29, 2013 I recorded verbatim, in 10 shorthand, to the best of my ability, the 11 proceedings in the above-entitled hearing; that I 12 transcribed the shorthand writing into typewriting; 13 and that the preceding pages 60-102 and 146-198 14 constitute a complete and accurate transcription of 15 the shorthand writing. 16 17 Dated: December 12, 2013 18 19 20 21 ____________________________ 22 JULI PRICE JACKSON 23 Hearing Reporter 24 25 26 27 28 208