Welcome to the Reed Smith California State Tax Quarterly Update for the 3rd Quarter of 2013. With fall in full swing and summer an almost distant memory, we will update you on recent happenings in the California tax world, including: (1) a long-overdue legislative relief measure for a California incentive program; (2) a recent Superior Court case on unitary business and business income issues; (3) another recent Superior Court case on the sales tax treatment of licensed software; (4) several important property tax decisions involving the taxation of refinery property and intangibles; and (5) recent attempts by Franchise Tax Board (“FTB”) auditors to use taxpayer reports of federal audit changes to improperly raise unrelated issues that would otherwise be out-of-statute.

For more information on any of these developments, contact one of the authors or the Reed Smith State Tax attorney with whom you usually work.

Legislative Update

The Legislature provides relief from retroactive taxation for California investors who qualified for the Qualified Small Business Stock incentives

On October 4, 2013, Governor Brown signed Assembly Bill 1412,1 which provides relief to taxpayers whom the FTB tried to assess for taking Qualified Small Business Stock (“QSBS”) gain exclusions and deferrals under Rev. & Tax. Code sections 18038.5 and 18152.5, respectively, for tax years 2008 through 2012. Those provisions were modeled after federal income tax provisions providing for the exclusion or deferral of gain from the sale or exchange of QSBS.2

The legislation provides relief for taxpayers impacted by the decision in Cutler v. Franchise Tax Board.3 In that case, the Court of Appeal declared unconstitutional the California QSBS requirements that 80 percent eligible businesses’ payroll and assets be in California. The FTB wrongly interpreted the court’s holding to mean that the statutes were entirely unenforceable. As a consequence, the FTB began issuing retroactive notices of proposed assessment to taxpayers that had previously utilized the gain exclusion and deferral provisions—more than four years after the tax years had ended.

The FTB’s actions were a black eye for California, prompting many California investors—who were the financial backbone of the state’s startup businesses—to leave the state. By enacting AB 1412, the legislature ensured that investors who followed the rules would not be punished.

Takeaway: Although AB 1412 affected investors who had already claimed the QSBS gain exclusion or deferral on a previously filed return, it will also ensure that California taxpayers who did not previously claim the QSBS exclusion or deferral can do so for years that are still open by statute. Such individuals should file refund claims to ensure they get the benefit of this incentive. Also, individuals who were contacted by the FTB and paid taxes based on the FTB’s prior policy should request refunds if they are not contacted by the FTB by November 30, 2013.

Comcast trial begins in Los Angeles Superior Court

On September 25, 2013, trial officially began in Comcon Prod. Services I., Inc. v. Franchise Tax Board.4 The case involves two principal issues: (1) whether Comcast was unitary with QVC, its majority-owned subsidiary; and (2) whether Comcast’s receipt of a termination fee as a result of a failed merger constituted business income.

The trial has been highly anticipated since the California State Board of Equalization (“BOE”) issued its decision in February 2012. The BOE voted 3-2 against Comcast, holding that it was unitary with QVC and that the fee Comcast received for a failed merger with MediaOne was apportionable business income. For more on the BOE decision, see our February 2012 alert.

In its trial brief, Comcast asserted that it was not unitary with QVC under any of the tests for unity. Comcast highlighted the fact that it is in the business of providing cable services, which is “in stark contrast to” QVC’s business of being an electronic home shopping provider. While Comcast derived its income from monthly subscription fees, QVC derived its income from the sale of goods and services featured on its channel. It also asserted that even though it owned 57 percent of QVC it did not exercise control of QVC, and that Comcast management had a “hands off” approach to the QVC enterprise.

Comcast also asserted that the income it received from a termination fee stemming from a failed merger between itself and MediaOne was nonbusiness income allocable outside California. The merger agreement between Comcast and MediaOne contained a clause providing that in the event that either party terminated the agreement, the non-terminating party would receive a termination fee of $1.5 billion. MediaOne terminated the agreement and paid the fee. Under California law, income is classified as business income or nonbusiness income based on the application of the two-pronged UDITPA test. Under the UDITPA test, income is classified as business income if it satisfies either a transactional test or a functional test.5 Comcast argued that the termination payment failed the functional test, which examines whether the acquisition, management and disposition of the property that gave rise to the income constituted an integral part of the taxpayer’s regular trade or business, because the property was not an integral part of its business operations. It also contended that it failed the transactional test, which looks at whether the transaction that gave rise to the income arose in the regular course of the taxpayer’s business. It argued that the early termination fee was a “once-in-a-lifetime event,” was not an integral part of its business operations, and was therefore nonbusiness income under California law.6

In contrast, the FTB argued that Comcast and QVC, together, constituted a unitary business. In addition, it argued that because Comcast built its business through acquisitions, the termination fee represented lost profits from its business, and that its rights under the merger agreement constitute property that was integral to Comcast’s expansion efforts.

Stay tuned for updates on the court’s decision and its repercussions for California businesses.

Court sides with taxpayer in dispute over sales taxability of licensed software

In another recent Los Angeles Superior Court case, Lucent Technologies, Inc., et al. v. Board of Equalization,7 the court ruled in favor of the taxpayer, Lucent Technologies, Inc. (“Lucent”), on cross motions for summary judgment. The issues in the case were whether the written agreements pursuant to which Lucent provided software to its customers were “technology transfer agreements”8 and, if so, whether there were triable issues of fact as to the amount of refund due based on the value of the tangible personal property.

Lucent manufactured and sold switching equipment to telephone service providers. The service providers used the switching equipment to provide telephone and other services to end customers. Lucent also owned the rights to the software that was necessary to operate the switching equipment. The telephone service providers that purchased the switching equipment were provided with discs containing the switching software under written agreements. The BOE asserted that a computer code stored on a physical medium is tangible personal property and therefore subject to the sales and use tax.

Lucent had argued that the decision of the Court of Appeal in Nortel Networks, Inc. v. Board of Equalization,9 controlled. In that case, Nortel designed, manufactured, and sold switching equipment to Pacific Bell. The switching equipment required software to operate, which Nortel also sold to Pacific Bell on storage media disks much like the ones that Lucent provided to its customers. The Court of Appeal held that the software sold by Nortel was exempt from the sales tax under the technology transfer agreement statutes because: (1) it was copyrighted; (2) it contained patented processes; and (3) it enabled the licensee to copy the software, and to sell and make products that embodied the patents and copyrights. For more on the Nortel decision, see our May 2011 alert.

Judge Kleinfield granted Lucent’s motion for summary judgment, ruling that the sale of the switching equipment software by Lucent qualified as a technology transfer agreement. Relying on the analysis in Nortel, Judge Kleinfield remarked that “one could almost substitute the names of the plaintiff and the monetary amounts, and the facts would be essentially the same,” and thus, the FTB was simply using the Lucent case to re-litigate Nortel. The court found there were no triable issues of fact and entered a refund judgment for Lucent.

A hearing has been set for November 18, 2013 to determine the amount of prejudgment interest, if any, to which Lucent is entitled.

Takeaway: Taxpayers that have not filed refund claims for California sales or use tax paid on purchases of sales of copyrighted or patented software, based on the Court of Appeal’s decision in Nortel, should consider filing for a refund on the heels of the favorable Lucent decision.

California Supreme Court rules special assessment rule for refineries is invalid—but bases its decision on procedural grounds

In Western States Petroleum Ass’n v. Board of Equalization,11 the California Supreme Court considered a challenge to a BOE rule governing the valuation of petroleum refinery property for property tax purposes. In 1979, in response to the passage of Proposition 13 by California voters, the BOE enacted a rule for assessing the value of most industrial property,12 providing that the value of fixtures, including machinery and equipment, was to be assessed separately from the value of land and improvements. Because petroleum refinery property, usually consisting of land, improvement, and fixtures, was generally sold as a unit, the BOE enacted Rule 474, which provides that the value of petroleum refinery property must be assessed as one unit.13

The Western States Petroleum Association challenged Rule 474’s substantive validity on two grounds: (1) that Rule 474 was inconsistent with Proposition 13 and related statutory enactments and was therefore an unlawful exercise of the BOE’s authority; and (2) that its adoption by the BOE was procedurally deficient because the BOE did not adequately assess the economic impact of the regulation as required by the Administrative Procedures Act (“APA”).14

The Supreme Court determined that, “Rule 474 is consistent with applicable constitutional and statutory provisions, and it is also consistent with the long-standing valuation principle that the proper appraisal unit is the collection of assets that persons in the marketplace normally buy and sell as a single unit.”15 Based on this, the Supreme Court held that the adoption of Rule 474 did not exceed the BOE’s rulemaking authority.

However, the court found that the BOE failed to make an adequate assessment of Rule 474’s economic impact as required under the APA.16 Under the APA, the BOE is required to make a reasoned estimate of all cost impacts of its proposed rule on affected parties. The court found that the BOE did not make the required reasoned estimate of the Rule’s economic impact on businesses. The analysis on which the BOE based its economic impact statement “leaves the reader without an understanding of what the taxes on a representative refinery would have been under the formerly applicable Rule 461(e), and what the taxes would be under the new Rule 474(d)(2).”17

For those reasons, the court held that although it was within the BOE’s authority to promulgate Rule 474, it must invalidate the rule because the BOE failed to make an adequate determination of the rule’s economic impact as required by the APA.

Justice Kennard filed a concurring and dissenting opinion, agreeing with the majority’s holding, but disagreeing that Rule 474 was a quasi-legislative regulation, subject to great judicial deference. Instead, Judge Kennard argued that the rule was just the BOE’s interpretation of the legislature’s definition of real property, and therefore was an interpretive regulation, subject to less judicial deference.

Takeaway: Although the taxpayer was victorious in this case, the court’s holding being based on procedural grounds may lead to another—procedurally proper—attempt to implement the same rule. It may also lead to other challenges to special-industry assessment rules based on the same theories raised in this case. In addition, the holding suggests that other regulations may be invalid based on deficient compliance with APA standards.

California Supreme Court draws bright-line on taxation of intangibles

In Elk Hills Power, LLC v. Board of Equalization,18 California’s highest court drew a bright line and held that assessors cannot include the value of intangibles when assessing taxable property. The decision addressed the proper treatment of emissions reduction credits (“ERCs”), but is applicable to all types of intangible property. Reed Smith filed an amicus brief supporting the taxpayer on behalf of the Institute for Professionals in Taxation.

Takeaway: The Elk Hills decision is a big win for taxpayers. Going forward, taxpayers should examine their property tax assessments and identify any intangibles associated with the property that should have been excluded from the valuation. For more on the Elk Hills decision, see our October 22 alert.

The California Court of Appeal applies Elk Hills

In EHP Glendale v. County of Los Angeles,19 the California Court of Appeal took a second look at an action for a property tax refund. The taxpayers, EHP Glendale and Eagle Hospitality Properties Trust, challenged an assessment by the Los Angeles County Assessment Appeals Board in 2005. In the first appeal, the court reversed the grant of summary judgment to EHP, finding that the trial court improperly rendered a decision on an incomplete record that contained disputed issues of fact. On a remanded bench trial, the trial court affirmed the assessor’s and the Board’s judgment.

EHP purchased a Hilton Hotel in the City of Glendale. The purchase included the hotel property and a franchise agreement for EHP to use the Hilton franchise in exchange for a royalty payment and management contract under which Hilton would continue to manage the hotel for two years. The total purchase price was $79.8 million, which was attributable to the real property, personal property, and intangible rights and assets (including the franchise agreement and management contract) associated with the hotel. After EHP purchased the property, the assessor reassessed the property establishing a Proposition 13 base year value of $79.8 million.

EHP appealed that assessment, contending that the market value of the hotel was $51 million and that the assessor’s methodology was invalid because the assessment impermissibly captured the value of nontaxable intangible assets. To assess the property, the assessor used the income capitalization approach, under which he analyzed the hotel’s historical operating revenue and expenses, and used the data to develop a stabilized income and expense projection for the property as of the 2005 change in ownership date.

EHP argued that the franchise and management agreements and assembled hotel workforce had independent value at the time of sale, and that the assessor was legally required to deduct those values from the purchase price in the agreement. EHP also argued that the hotel’s various services (food and beverage, telecommunications, business center, health club, etc.) were independent businesses whose values should have been deducted from the hotel purchase price.

Ultimately, the Court of Appeal determined that the sole question on appeal was whether substantial evidence supported the original assessment by the appeals board. The court found that the assessor properly complied with Elk Hills by deducting the franchise and management fees from the income stream to remove their values from the valuation of the taxable property. EHP had argued that an insufficient amount was deducted from the income stream to account for the value of intangible assets under Rule 8(e).20 On this point, the court determined that the assessor’s valuation merely reflected the presence of the service centers as an indirect contribution to the operation of a full-service hotel, consistent with the Elk Hills opinion.

Takeaway: Consistent with Elk Hills, taxpayers should examine their property tax assessments and identify any intangibles that should have been excluded from the valuation.

Not so fast – aggressive FTB auditors have been using federal changes to improperly reopen closed periods for issues unrelated to the federal changes.

FTB auditors have become increasingly aggressive in using federal audit determinations as a basis for reopening entire taxpayer returns for otherwise closed periods. Under California law, when a taxpayer reports a federal change, the FTB can only audit those items on the California return that changed as a result of the federal audit determination.21 There have been several incidents in which FTB auditors have attempted to ignore this rule and use reports of federal audit determinations as an opportunity to raise issues unrelated to the federal changes. For example, FTB auditors have attempted to raise issues related to the composition of a taxpayer’s California unitary group in the context of a report of a federal audit change that simply changed the taxpayer’s federal taxable income. Reed Smith’s State Tax Group has been successful in getting the FTB to drop assessments arising from attempts by auditors to untimely raise issues unrelated to federal audit changes.

Meet the Team: Brian Toman

Brian is a partner based in the San Francisco office with a practice focused on state and local tax controversies, tax planning and transactional matters. Brian has extensive experience in California state corporation income tax, personal income tax, sales and use tax, and property tax matters. Prior to entering private practice, Brian held the position of Chief Counsel of the FTB. As Chief Counsel, Brian oversaw the FTB’s litigation cases, which included some of the most complex and sensitive state corporate income tax and personal income tax cases in the nation. He was also responsible for the FTB’s administrative protest and settlement functions and appeal cases before the BOE. Brian continues to maintain extensive contacts within the FTB.

Brian is nationally recognized as a leading authority on the unitary concept and formula apportionment. He has been engaged as an expert witness in both California corporation and personal income tax matters. He has also functioned as the lead attorney, in both public service and private practice, in settling some of the largest and most complex California corporate and personal income tax cases. His experience in the public and private sectors makes him an invaluable member of the Reed Smith State Tax team.
Outside of his practice, Brian enjoys traveling and has visited many countries in Asia, Africa, South America and Europe. Brian is also an avid jogger.

About Reed Smith State Tax

Reed Smith’s state and local tax practice is comprised of more than 30 lawyers across seven offices nationwide. The practice focuses on state and local audit defense and refund appeals (from the administrative level through the appellate courts), as well as planning and transactional matters involving income, franchise, unclaimed property, sales and use, and property tax issues. Click here to view our State Tax team. For more information on Reed Smith’s California tax practice, visit www.reedsmith.com/catax.

1. Stats. 2013, ch. 546, effective January 1, 2014.
2. IRC §§ 1202 (gain exclusion) and 1045 (gain deferral).
3. 208 Cal. App. 4th 1247 (2012).
4. Case No. BC489779 (L.A. Sup. Ct.).
5. Hoechst Celanese Corp. v. Franchise Tax Board, 25 Cal. 4th 508 (2001).
6. Cal. Rev. & Tax. Code § 25120
7. Case Nos. BC 341568 and BC448715 (L.A. Sup. Ct., Sept. 27, 2013)
8. A “technology transfer agreement” is “any agreement under which a person who holds a patent or copyright interest assigns or licenses to another person the right to make and sell a product or to use a process that is subject to the patent or copyright interest.” Cal. Rev. & Tax. Code §§ 6011(c)(10)(D); 6012(c)(10)(D). Intangible personal property transferred with tangible personal property in any technology transfer agreement is exempt from sales and use tax if the technology transfer agreement separately states a reasonable price for the tangible personal property. Cal. Rev. & Tax. Code §§ 6011(c)(10)(A); 6012(c)(10)(A).
9. 191 Cal. App. 4th 1259 (2011)
10. Id. at 1264.
11. S200475, filed August 5, 2013.
12. 18 CCR § 461.
13. 18 CCR § 474.
14. Cal. Gov. Code § 11346 et seq.
15. Opinion at 2.
16. Id.
17. Opinion, quoting Court of Appeal.
18. California Supreme Court, Docket No. S194121 (August 12, 2013).
19. California Court of Appeal, Second Appellate District, Division 8, B244494 (Sept. 18, 2013).
20. Rule 8(e), 18 CCR § 8(e), describes two methods for estimating future income: using recently derived income and recently negotiated rents or royalties of the property or comparable property so long as the rents are reasonably indicative of the income the property will produce at its highest and best use; or, using income from operating a property so long as sufficient income is excluded to provide a return on working capital and other nontaxable operating assets, and to compensate unpaid or underpaid management.
21. Cal. Rev. & Tax. Code § 19059.