A case involving the FTB’s ability to scrutinize the documentation behind Enterprise Zone vouchers has been scheduled on March 6 for argument in the California Supreme Court after a long delay. The following is the summary of the matters at hand from the Court:

Dicon Fiberoptics v. Franchise Tax Bd., S173860. (173 Cal.App.4th 1082; Los Angeles County Superior Court; BC367885.) Petition for review after the Court of Appeal reversed the judgment in a civil action. This case presents the following issues:

(1) When an employer claims an income tax credit under Revenue and Taxation Code section 23622.7 for wages allegedly paid to a “qualified employee” in an enterprise zone, does the certifying voucher obtained from a designated public agency constitute conclusive proof the employer is entitled to the tax credit? (2) If not, does the voucher constitute prima facie evidence that the employer is entitled to the credit and shift to the Franchise Tax Board the burden of proving that the employee was not a “qualified employee”?

The following are Enterprise Zone related stories that have appeared over the last week or so:

CAEZ President Craig Johnson had an Op-Ed published in the Contra Costa Times where he discussed the demise of AB 1278 and said:

If legislators want to find a way to improve the state’s economy, attacking the Enterprise Zone program and it’s job-creating incentives, only diverts their attention from addressing the real impediments to turning around the state’s economic climate.

Speaking of AB 1278, the Mercury-News had a story about labor groups suing to keep VWR from relocating its business from Brisbane to Visalia.

The Chambers of Commerce in both Brawley and Calexico issued press releases praising Assemblyman Manuel Perez for stopping AB 1278.

Both San Bernardino and Los Angeles celebrated new businesses in their Enterprise Zones.

Here is the June 2009 edition of the FTB’s “Tax News” newsletter.

This month’s edition includes an article called, “Enterprise Zone – Nonprofits May be Allowed Net Interest Deduction:”

California provides for special tax incentives to encourage investment in specific geographic areas targeted for economic revitalizing called Enterprise Zones within the state. One of these incentives is the net interest deduction. It is available to banks and other lenders. The requirements are simple. If a bank or lender makes a qualified loan to a qualified debtor, it is allowed to deduct the net interest received from such loan against its California taxable income. To be a qualified transaction, the loan must be made to a debtor that is engaged in a “trade or business” in an Enterprise Zone. The term “trade or business” is generally defined for tax purposes as “an activity engaged in for profit.” When a bank or lender makes an otherwise qualified loan to a nonprofit organization, the question arises as to whether a nonprofit is engaged in a trade or business, and thus considered to be a qualified debtor for the purposes of the net interest deduction.

In the past, we disallowed debts made to nonprofit organizations based on the general presumption that nonprofit organizations are not engaged in a trade or business as defined under various tax provisions in the Internal Revenue Code and the California Revenue and Taxation Code.

However, we recently revised this policy based on statutory authority in the California Corporation Code that suggests a nonprofit could be recognized as being engaged in a trade or business. The California Corporation Code which governs nonprofit entities affirms the nonprofit’s right to “carry on a business at a profit,” and use that profit for any lawful activity.” Many nonprofit organizations accept donations, conduct fundraising activities, or charge fees. This revenue is used to sustain the organization, pay salaries, interest, fund capital improvements, expansions, etc. These activities are similar to a trade or business engaged to earn a profit.

Therefore, qualified loans made to nonprofit organizations can qualify for the Enterprise Zone net interest deduction if the debtor meets all the other required qualifications.

This is clearly related to the appeal before the Board of Equalization in the matter of Farmers and Merchants Bank. See here for more details on that case.

Reproduced with permission from Daily Tax Report, 88 DTR K-2 (May 11, 2009). Copyright 2009 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com.

FTB May Audit EZ Credit Vouchers, But Must Prove Invalidity, Court Says

SACRAMENTO, Calif.—The Franchise Tax Board has the authority to question the validity of tax credit vouchers that local government agencies issue to employers for hiring qualified workers in enterprise zones, but must meet the burden of rebutting a voucher’s prima facie validity to deny the credit, a state appellate court ruled May 7 (Dicon Fiberoptics Inc. v. Franchise Tax Board, Cal. Ct. App., No. B202997, 5/709).

In a case of first impression, the Court of Appeal for the Second Appellate District in Los Angeles reversed an October 2007 decision from the trial court to dismiss the case on the grounds that the plaintiff, Dicon Fiberoptics Inc., failed to state a cause of action (211 DTR K-2, 11/1/07). The three-judge appellate panel sent the case back to Los Angeles County Superior Court, which must now address the question of whether FTB erred in rejecting $1.1 million in EZ hiring credits claimed by Dicon Fiberoptics based on vouchers they received from local agencies. The company’s legal challenge to FTB’s authority to audit EZ tax credit vouchers in the lead case challenges a 2003 change in FTB policy through which the agency is auditing 500 taxpayers and expects to deny about $130 million in claimed EZ hiring credits.

A spokeswoman for FTB told BNA the agency is studying the opinion and does not have a comment. LaShelle Wilson, general counsel for California Credits Group, a consulting firm hired by Dicon when FTB was auditing the company, told BNA the company is pleased with the opinion, but it is not a complete victory for taxpayers.

“Taxpayers need to be careful,” she said.

Audit Authority Extends to Vouchers

In the 14-page opinion, the court agreed with FTB that its overall authority to examine and audit tax returns also permits the agency to audit EZ credit vouchers issued by local agencies and deny credits. It rejected Dicon’s argument that because the Legislature vested local agencies with the authority to issue vouchers when it created the EZ program, FTB cannot overrule or second-guess the validity of the vouchers. Although FTB has the authority to audit the vouchers, the court said the issuance of a voucher from a local agency is prima facie proof that a worker is a qualified employee for purposes of the EZ hiring credit. Once a voucher has been issued to an employer, the burden shifts to FTB to rebut its validity by proving a worker did not meet the criteria to be a qualified employee, the opinion said.

“We do not intend our holding today to restrict FTB’s audit powers, to limit the scope of audits it conducts, or hamstring its authority to gather evidence relevant to the correctness of a return,” the court said in a footnote. “Rather, we direct our holding to the weight FTB must give, in the absence of any other evidence, to vouchers during audits.” Employer Not Required to Provide Documentation FTB cannot base its rejection of a voucher on an employer’s failure to provide documents during an audit that would establish a worker’s circumstances that would make the employer eligible for the credit, the court said.

EZ program rules require the enterprise zone, and not the employer, to maintain documents related to individual employees, mainly based on privacy concerns. A disadvantaged employee may face impediments such as limited literacy or criminal convictions, and that information is not readily shared with an employer, especially years later during an audit.

Wilson said although the ruling shifts the burden to FTB and clarifies that FTB cannot deny a credit based on the failure of an employer to provide supporting documentation, FTB still has broad authority to seek the information.

“That does not mean they’re not going to get it one way or the other,” she said. FTB could demand the information from the vouchering agency or others, and could dispute the validity of a voucher on multiple grounds, she said.

The opinion was authored by Acting Presiding Justice Laurence D. Rubin, with Judge Patricia A. Bigelow and Judge Vincent J. O’Neill concurring. Dicon Fiberoptics is represented by Marty Dakessian of Akerman Senterfitt in Los Angeles and LaShelle Wilson of California Credits Group in Pasadena, Calif. FTB is represented by the office of California Attorney General Edmund G. Brown.

By Laura Mahoney

For background on Dicon Fiberoptics v. FTB see these previous blog posts:

5/9/2007 “New Enterprise Zone Lawsuit.”
6/11/2007 “Dicon Fiberoptics v. FTB Update.”
7/17/2007 “Dicon Fiberoptics v. FTB Update 2.”
10/29/2007 “Dicon v. FTB Dismissed.”
11/13/07 “BNA: “Taxpayer Appeals Dismissal of Suit Challenging FTB’s Tax Credit Voucher Policy”.”

After the case was dismissed in Superior Court, Dicon filed an appeal in October 2007 which was eventually argued before the Court on January 27, 2009.  On May 7, 2009 the Appeals Court issued its decision which, on the one hand upholds FTB’s right to audit Enterprise Zone hiring credit vouchers, but, on the other hand, grants those vouchers a prima facie validity and places the burden of proof on FTB to overturn them.  The Court also sends the Dicon case back to Superior Court to allow Dicon to argue that FTB improperly rejected their vouchers and denied their refund claims.

I have posted a copy of the Court of Appeal’s decision here [PDF].

In its summation the Court wrote:

Dicon Fiberoptics, Inc., appeals from the trial court’s judgment sustaining without leave to amend the demurrer of the Franchise Tax Board to Dicon’s complaint seeking refund of a tax credit for employing disadvantaged workers. To receive the credit, Dicon submitted vouchers to the board certifying Dicon had employed disadvantaged workers. After auditing the vouchers, the board partially denied the tax credit to Dicon. Dicon contends the board has no legal authority to audit its vouchers, a contention we reject. We nevertheless conclude Dicon states a cause of action that the board exercised its audit power improperly, and therefore the trial court erred in sustaining the board’s demurrer. Accordingly, we reverse and remand.

After determining that the lower court inappropriately denied Dicon’s leave to amend their previous complaint, the Appeals Court addresses the main issue of FTB’s role in the auditing of vouchers:

The trial court’s error in sustaining FTB’s demurrer warrants reversal of the court’s judgment and remand for further proceedings. For the trial court’s and parties’ guidance after remand, we address the unanswered legal question looming over these proceedings: Does FTB’s authority to examine and audit tax returns permit FTB to reject a voucher issued by a local employment or social services agency? FTB answers “yes.” Dicon, in contrast, says a local agency’s decision is binding on FTB and answers “no.” Thus, according to Dicon, FTB must limit its review of vouchers to confirming Dicon in fact obtained the voucher from one of the local agencies identified in the statute; FTB may not, Dicon asserts, review the local agency’s underlying decision to issue the voucher. We hold vouchers are prima facie proof a worker is a “qualified employee,” but FTB may audit such vouchers. In such an audit, FTB bears the burden of rebutting the voucher’s prima facie value, typically by proving the worker did not meet the criteria to be a “qualified employee.” In trying to meet that burden, FTB may not rely on the employer’s failure to produce during the audit documents establishing a worker’s eligibility to the extent regulations governing the tax credit charge the enterprise zone, not the employer, with the obligation to maintain documents of workers’ eligibility.

So what is the Court’s conclusion? “We hold vouchers are prima facie proof a worker is a ‘qualified employee,’ but FTB may audit such vouchers.” But if FTB is barred from asking taxpayers for any underlying documentation, what would be the procedure for such an audit? Footnote 7 adds some additional information, but not necessarily more clarity:

We do not intend our holding today to restrict FTB’s audit powers, to limit the scope of the audits it conducts, or hamstring its authority to gather evidence relevant to the correctness of a tax return. Rather, we direct our holding to the weight FTB must give, in the absence of any other evidence, to vouchers during audits.

I think what the Court is getting at, or at least how it will likely be interpreted by FTB, is that in circumstances where FTB has knowledge of the existence of incorrect vouchering practices, they will use that evidence to justify the examination of additional documentation.

The discussion continues:

Although we hold FTB may audit a voucher, we conclude from the statutory framework governing vouchers that they are prima facie evidence an employee is a qualified worker. As prima facie evidence, a voucher shifts to FTB the burden of demonstrating an employee is not a qualified worker for which no voucher should have issued. We conclude FTB properly bears this burden for several reasons. First, an employer who submits a voucher to FTB has followed the statute?s requirements to (1) obtain a voucher from any one of several agencies identified in the statute, and (2) present the voucher to FTB. The employer’s compliance with the statute ought to count for something. Second, the documents supporting a worker’s certification as a “qualified employee” are not ordinarily within the employer’s custody and control, either when initially applying for a voucher from the local agency, or possibly years later during an FTB audit. Surveying the types of workers entitled to “qualified employee” status, we note that many categories involve disadvantaged workers for whom the impediments to employment involve conditions that are potentially embarrassing to a worker, such as limited literacy and criminal convictions. Documents proving such employment obstacles are not readily shared between worker and employer, especially not years later during an audit. Indeed, the statute does not require the employer to retain the documents supporting a worker’s designation of “qualified employee” and administrative regulations require only the Enterprise Zone manager to keep the documents.

Another reason to extend prima facie status to a local agency’s voucher is to promote the tax credit’s purpose of encouraging employers to hire disadvantaged workers. The employer ordinarily has some reassurance of receiving the credit if it knows after having received a voucher that FTB bears the burden of proving the voucher was unjustified. If FTB may reassess perhaps years later a worker’s status as a “qualified employee,” the employer has less confidence in receiving a credit, particularly if the employee no longer works for the employer. Reducing an employer’s confidence in receiving the tax credit is a disincentive to hiring a disadvantaged worker, thereby undermining the reason for the Enterprise Zone.

It is interesting to note the Court’s references to the vouchering regulations which were not in existence neither at the time Dicon received its vouchers nor at the time FTB performed its audit. This may be part of FTB’s basis for arguing that it did have reason to believe that the vouchers were improperly issued.

However, this last argument is particularly interesting as it takes into account the public policy implications of subsequent governmental intervention into the mechanics of a government program. Legislator’s might also do well to contemplate how proposing certain legislation can effect the confidence of the marketplace.

From CalTax.org, the State BOE has ruled that taxpayers may use Enterprise Zone tax credits to reduce Alternative Minimum Tax:

Taxpayers can use enterprise zone tax credits to reduce the alternative minimum tax, the State Board of Equalization ruled by a 4-1 vote on the marquee case on the agenda at its February 25-26 meeting in Culver City. While the issue was presented to the board in the Appeal of Nassco Holdings, Inc., the underlying fight was between the Franchise Tax Board and former Assembly Speaker Willie L. Brown Jr. In 1993, Speaker Brown introduced AB 57 to allow taxpayers to use enterprise zones below the AMT. Former Governor Pete Wilson signed the bill into law.The Senate analysis of the bill said enterprise zone credits could be used to reduce the AMT, as did the legislative counsel.Representing the taxpayer, Jon Sperring of PricewaterhouseCoopers said the FTB was denying the benefit to the very taxpayers the Legislature was trying to help. At issue were five years of disallowed credits totaling more than $2 million. Also making arguments on behalf of the taxpayer was Gail Morse.FTB attorney William Gardner argued that the language of the statute did not allow the credits to be used to reduce the AMT.Board Member Bill Leonard, who was a member of the Legislature when the legislation passed, said the bill was known as the “Taco Bell bill” and its purpose was to allow credits to offset the AMT. He urged the board to use legislative intent in deciding the case.Voting to support the taxpayers’ position were Dr. Judy Chu, Mr. Leonard, Michelle Steel and Marcy Jo Mandel, for Controller John Chiang. Board Member Betty Yee voted “no” on the issue.

AB 1452 is the vehicle for tax code changes in the new budget. Here is the analysis summary of effects on tax credits:

3. Limit business tax credits in 2008-09 and 2009-10: Limits the amounts of business incentive tax credits that can be used to reduce tax liability in 2008-09 and 2009-10. Use of credits will be limited to 50 percent of the taxpayer’s liability, and this increases General Fund revenue by $890 million in 2008-09 and $415 million in 2009-10. Taxpayers with net business income of less than $500,000 will be exempted from this change. Various tax credits are included in these amendments, including the Research and Development credit, the Enterprise Zone credit, and Low-Income Housing credits. Beginning in 2010, these amendments liberalize the use of credits such that businesses could assign credits to any affiliated corporation. This increases the use of tax credits in 2010, and thereafter, resulting in a loss of General Fund revenues.

Here is the audio of the BOE hearing in the case of DeVry we discussed previously:

(If you receive the blog via email, click here to the website where you can access the audio player.)

On Friday I posted the Cal-Tax update regarding the BOE’s recent Enterprise Zone related decision.  Laura Mahoney at BNA’s “Daily Tax Report”  published a more detailed account of the case yesterday.  Thanks to the folks at BNA for allowing its reproduction here.

Reproduced with permission from Daily Tax Report, No. 165 (Aug. 26, 2008), pp. H-2 – H-3. Copyright 2008 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com.

SACRAMENTO, Calif.—The State Board of Equalization Aug. 19 rejected the California Franchise Tax Board’s attempt to revisit the issue of whether newly hired older workers must be economically disadvantaged for employers to be eligible for a tax credit under the state’s enterprise zone program, one year after deciding against FTB in a similar case.

In the Matter of the appeal of Devry Inc. (No. 357029), the board rejected by a 5-0 vote Aug. 19 FTB’s argument that a 1996 directive from the Employment Development Department, which FTB did not present as evidence a year ago in arguing the case of Jessica McClintock Inc., together with a new declaration from an EDD manager, supported its argument that older workers must also be economically disadvantaged for an employer to qualify for the EZ hiring credit. By raising the arguments again in the Devry case, FTB was seeking to change state policy following McClintock.

The board’s decision was consistent with its unanimous decision in the McClintock case, in which it found that up to 10 percent of newly hired older workers can be eligible for the EZ hiring credit even if they are not poor (158 DTR H-1, 8/16/07).

Taxpayer Claimed Credits in Amended Returns.

The taxpayer in the case, Devry Inc., is a for-profit provider of higher education based in Illinois. In amended returns it filed for tax years 1998 through 2001, it claimed $1.2 million in EZ hiring credits for its campus in Long Beach, Calif. On audit, FTB allowed about $700,000 of those credits and disallowed about $500,000. FTB has since conceded to the taxpayer on some of those credits, leaving 36 at issue in the appeal before the board. Of those 36, 31 were credits for hiring older workers, two were credits for hiring disabled workers, and three were credits for hiring workers who were displaced, for a total of $230,937.

As it was in McClintock, the fundamental issue in the Devry case was FTB’s interpretation of eligibility for the EZ hiring credit, which was based during the tax years in question on eligibility for the federal Job Training Partnership Act. JTPA no longer exists, but while it did, the EZ hiring credit eligibility requirements mirrored those of JTPA.

FTB Tax Counsel Ann Hodges said that since the board decided the McClintock case, the agency has become aware of EDD Directive 96-5, which outlined barriers to employment that made an individual eligible for JTPA services. She said the directive supports FTB’s argument that all older workers must also be poor to qualify for the EZ hiring credit.

FTB Relied on Declaration.

Hodges also pointed to an Aug. 12, 2008, declaration from Michael Evashenk, deputy chief of the Workforce Services Division at EDD, that it was his understanding and belief that older workers only qualified for JTPA if they also earned less than 125 percent of the poverty level.

The older workers hired by Devry were primarily displaced aerospace workers who received well-paid jobs as instructors at the school, according to the company. Hodges argued that because they were not poor, the employer was not eligible for the EZ credit.

Attorneys for Devry and California Credits Group, which prepared the amended returns for Devry in which it claimed the credits, argued that FTB’s position was inconsistent with the 1996 directive and a 1998 directive on a similar subject from EDD, the JTPA application form and instructions that accompanied the form, and FTB’s own instructions to auditors.

Marty Dakessian, an attorney with Akerman Senterfitt in Los Angeles, representing CCG, said FTB’s argument amounted to a “fundamental misunderstanding” of JTPA and therefore of eligibility for the EZ hiring credit.

Income Limit Did Not Apply to Everyone.

He and two other attorneys who argued the case pointed to JTPA eligibility requirements, under which up to 10 percent of those eligible must have faced a serious barrier to employment but were not limited by their income. The rules stated also that up to 35 percent of individuals who were eligible must have earned incomes below the federal poverty level, and at least 65 percent could have earned incomes up to 125 percent of the federal poverty level if they also faced serious barriers to employment such as age, disability, layoff, or lack of education.

Older workers who earned less than 125 percent of the federal poverty level were eligible for JTPA under the 65 percent category, the lawyers said. But the credits at issue in the case fell under the so-called “10 percent window,” in which people with barriers to employment did not have to be poor to qualify.

On the EDD form for JTPA assistance in use during the years at issue, one check-off box listed “older worker” as a category under the heading “10 % Window (for non-economically disadvantaged only).” A separate check-off box listed those who were eligible under the federal Older Americans Act as falling under the heading “Economically Disadvantaged,” which would be the 65 percent category of those eligible for JTPA, the attorneys said.

The forms and instructions were written this way because the underlying law allowed older workers who were not poor to qualify for JTPA in the 10 percent window, the attorneys said.

Board Members Questioned FTB’s Logic.

Before voting to grant the taxpayer’s appeal, several board members questioned FTB’s logic in denying the credits.

Members Bill Leonard (R) and Judy Chu (D) both pointed out that the forms and instructions clearly show at least 10 percent of older workers did not face an income requirement to qualify.

“I’d like to ask how you could determine there’s an income requirement on a form that said there is no income requirement,” Leonard said to Hodges.

They also questioned FTB’s reliance on the recent declaration from the EDD manager to bolster its position. “Do you follow the memory of this person who had the affidavit after the fact or the actual handbook that people followed as they were filling out these forms?” Chu said.

“For this man at EDD to say ‘that’s what everybody knew back then’ really defies explanation,” Leonard said. The board also ruled for the taxpayer on the credits dealing with the hiring of disabled and displaced workers. They agreed with the taxpayer that FTB was seeking documentation from Devry that was difficult, impossible, or in the case of the disabled, potentially illegal for the taxpayer to obtain.

Dakessian and LaShelle Wilson, general counsel for California Credits Group, represented CCG. Jon A. Sperring of PricewaterhouseCoopers represented Devry. FTB was represented by Tax Counsel Ann Hodges.

By Laura Mahoney

Cal-Tax is reporting on a new Enterprise Zone related case before the SBOE:

An attempt by the Franchise Tax Board to narrow the scope of the enterprise zone hiring credit by limiting seniors’ eligibility was rejected unanimously in a tax appeal decided by the Board of Equalization on August 19.

In the Appeal of DeVry, Inc., involving a higher-education provider, the Franchise Tax Board contended that the enterprise zone hiring credit for older workers is limited to those who are poor. The taxpayer, represented by Jon Sperring of PricewaterhouseCoopers and attorney Marty Dakessian of the law firm of Akerman Senterfitt, argued that seniors can qualify without income limitations.

Mr. Sperring and Mr. Dakessian also pointed out that the FTB was attempting to limit the number of disabled workers eligible for the credit by claiming the taxpayer failed to file a document that cannot be legally obtained.

Mr. Sperring stated that the FTB was relying on a single Employment Development Department document addressing a specific section of the Job Training Partnership Act eligibility statute which was not applicable to the section at issue in this appeal. He said the directive that the FTB presented specifically stated that it applied to one section, and not the one that was in dispute.

Regardless of the FTB’s assertion that this directive justifies the denial of the credits at hand, Mr. Dakessian also stated that the FTB’s interpretation of the directive conflicts with the EDD form, the instructions to the form, as well as the FTB’s own audit instructions.

Board Chair Dr. Judy Chu said logic doesn’t support the FTB’s position. She observed that there would be no need for a provision separately stating that seniors are eligible if they could qualify for an enterprise zone hiring credit under other provisions as low-income individuals.

DeVry Inc. employs 750 people and has 16 campuses in California.

Thanks to Chris Micheli for the tip.

Last March I reprinted an article from BNA by Laura Mahoney regarding the SBOE decision in the Taiheiyo case.  In the July 11, 2008 edition of BNA Daily Tax Report, Laura reports that the SBOE recently decided to rehear the case.

From the April 2008 FTB Tax News publication:

The November 2007 issue of Tax News included an article regarding the State Board of Equalization (SBE) unpublished decision in the Appeal of Jessica McClintock. Specifically, that article stated that individuals with a documented barrier, as defined under the Job Training Partnership Act (JTPA) 10 percent exception category, could be considered qualified employees for purposes of the enterprise zone hiring credit.Based on information available at the time of the hearing, the SBE determined that “older worker” was a documented barrier for purposes of the JTPA 10 percent exception, regardless of the individual’s economic situation. Since then, Franchise Tax Board (FTB) has obtained Employment Development Department Directive 96-5 that provides program administration information to JTPA administrators, and discusses when an older worker is eligible for JTPA services. This Directive requires that an older worker must be both 55 years or older, and meet low-income guidelines.

FTB has presented this new information to the SBE and requested affirmation that for purposes of the enterprise zone hiring credit, “older worker” as a documented barrier also requires that the individual meet low-income guidelines. We will include information in Tax News on any future updates on this appeal.

Earlier Posts:

• Jessica McClintock – Part 1, August 30, 2007
• Jessica McClintock – Part 2, August 30, 2007
• CAEZ Conference – FTB Updates, October 30, 2007
• FTB on Jessica McClintock Implications, November 5, 2007

Reproduced with permission from Daily Tax Report, No. 46 (Mar. 10, 2008), p. H-3. Copyright 2008 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com:

A cement manufacturer March 3 asked the State Board of Equalization to reconsider its Feb. 1 decision in which SBOE disallowed enterprise zone tax credits for machinery parts because they were expensed instead of capitalized, but backtracked on adopting a formal opinion that would have set a precedent for other similar cases (Appeal of Taiheiyo Cement USA Inc., No. 332855, petition for rehearing filed 3/3/08).

Jess B. Penilla, director of the Multistate Tax Services Group with Deloitte & Touche in Los Angeles, told BNA March 5 he filed a petition for rehearing with SBOE on behalf of Taiheiyo Cement USA Inc., which is seeking almost $2 million in sales and use tax credits for its plant in Riverside County.

If the board had adopted a precedent-setting formal opinion in the case Feb. 1, it would have marked the first time an adopted opinion included a formal dissent. The two Republicans on the board, Bill Leonard and Michelle Steel, strongly disagreed with the three Democrats on the board who voted to sustain the Franchise Tax Board’s position in the case, and sought to use new SBOE rules to include their dissent in the opinion.

But one of the three Democrats, Deputy Controller Marcy Jo Mandel representing State Controller John Chiang, would not vote for the opinion during the Feb. 1 board discussion. Without Mandel’s vote, neither the majority nor the dissenting opinion could be adopted.

Board Asked for Opinion in September

Mandel had previously voted with the two other Democrats, Judy Chu and Betty Yee, to sustain FTB and seek a formal opinion when the board first considered the Taiheiyo case in September (181 DTR H-3, 09/19/07). In September, the board said it wanted to consider adopting a formal opinion that could be cited as precedent because other, similar cases were pending.

But at the Jan. 31-Feb. 1 board meeting at which it considered adopting the opinion, Mandel said she would not be voting for it.

“The formal opinion may or may not reflect all the reasons why we may have voted that day [Sept. 11],” Mandel also said of the opinion SBOE staff presented to the board for adoption.

Mandel also said the controller does not believe many other cases will be coming before the board, and the issues in the case do not warrant a formal opinion.

The board voted 4-1 Jan. 31 to adopt the opinion and the dissent, with Mandel being the only vote against it, but the board rescinded that vote Feb. 1 after staff members advised them that at least three members needed to be signatories to the opinion. Because Leonard and Steel would be signatories on the dissenting opinion, the votes in favor of the opinion from Yee and Chu were not enough to adopt it.

The board then voted 3-2 to sustain the FTB in the case without adopting a formal opinion.

Leonard, who was attempting to adopt a dissenting opinion for the first time at the board, said he was frustrated that Mandel’s decision not to vote for the majority opinion meant the dissent would also go unadopted.

“Your motion is denying me the right to have my opinion published,” Leonard said to Mandel. “That’s contrary to informing the taxpayers of our opinion.”

Ruling Applies Only to Taiheiyo

Without the formal opinion, the board’s decision applies only to Taiheiyo, and with its petition for rehearing the company is continuing to argue the underlying tax policy disagreement between it and the state.

Central to the case is the meaning of the term “placed in service,” and how it applies to machinery parts that Taiheiyo bought and used within one year. The Revenue and Taxation Code does not contain an explicit requirement that property be capitalized to be eligible for the EZ sales and use tax credit, so FTB and the company came up with opposing views on the issue. So far, SBOE has agreed with FTB.

Taiheiyo, the parent company of Portland Cement, operates the Riverside County plant 24 hours a day, seven days a week. At issue are tax credits it claimed for tax years 1998 and 1999, including carryover credits generated in tax years 1990 through 1996.

Taiheiyo said it maintained a constant inventory of the parts because of continuous operations at the plant, where parts that may typically last three years wore out within one year. The company expensed these parts in the year they were purchased and used. Even though the credit is generally allowed for equipment that is capitalized, or depreciated over several years, the lack of an explicit exclusion for expensed parts in RTC in the context of when an item is “placed in service” allows the credit to apply to expensed property, the company argued.

If the Legislature intended to restrict the definition of qualified property to capitalized assets under the EZ statute, it could have done so, the company argued. Lawmakers have explicitly made such distinctions in other statutes, such as a now-expired law that created a manufacturers investment credit similar to the EZ credit.

Opinion Spells Out Reasoning

The unadopted opinion, provided to BNA by Leonard’s office, spells out in more detail FTB’s arguments and the reasoning behind SBOE’s agreement with it. SBOE agreed with FTB’s argument that parts must be depreciated to be eligible for the credit, based on examination of the legislative history and legal meaning of “placed in service.”

Although the term sometimes refers informally to current expense assets, the specific legal meaning of “placed in service” refers to the date that capitalized assets are in the condition or state of readiness or availability, and the date that depreciation of the capital asset is first allowable.

SBOE concluded that the Legislature’s use of “placed in service” in the law indicates its intent to restrict the definition of qualified property to capitalized assets.

Further, RTC Section 23612.2(e) prohibits the taxpayer from taking a credit for sales or use tax paid and adding that tax to the basis of qualified property, according to FTB’s arguments summarized in the unadopted opinion. The reference to “basis” in the law refers to capitalized assets and prevents taxpayers from receiving both a deduction and a credit for purchase of a capital asset. The law prevents no such double benefit for expensed assets.

Therefore, FTB argued, the prohibition on adding sales or use tax to the basis of qualified property is further evidence that the Legislature intended to restrict the credit to capitalized assets.

SBOE also agreed with FTB’s argument that, if it allowed the EZ credit for current expense assets, taxpayers would be able to “double dip” by deducting the cost of the asset against its net income, excluding sales tax paid, and then receive a credit for the tax on the same asset. On the other hand, capital assets are not currently deductible.

“Such an interpretation would favor currently expensed assets over capitalized assets, creating an incentive for taxpayers to find ways to expense property that otherwise ought to be capitalized, “the unadopted opinion said.

Taxpayers Cannot Research Intent, Dissent Says

In their dissent, Leonard and Steel said the plain language of RTC reveals no requirement that property be capitalized to be eligible for the credit. The taxpayer cannot be expected to research legislative history to speculate about legislative intent in order to use the credit, especially when published guidance available in the years in question gave no reason for Taiheiyo to suspect the law was ambiguous, they said.

“[Taiheiyo] has meticulously followed the statutory language and published guidance in pursuing the EZ SUT credit,” the dissent said. “The State of California can demand no more than that from any taxpayer.”

The dissenters argued that the types of parts at issue would normally be capitalized, but were not because of the unusually demanding way in which they were used. “Even if some legislators had silently intended to limit the enterprise zone sales and use tax credit to capital assets, the machinery parts at issue here were likely to have been the sort of assets that they had in mind,” the dissent said.

Leonard and Steel said the term “placed in service” is not used in the EZ SUT provisions of the state tax law to distinguish between certain types of property, but is used only to limit the tax credit to $20 million a year, and to limit the credit to property in use before the expiration of an EZ designation. The distinction between capital assets and expensed assets is not made.

Term Not in Use During Years at Issue

Further, they argued that “placed in service” was not added to the state law until 1997, which is after the time that most of the credits in the appeal were earned and therefore should not apply.

The dissent also faulted FTB’s argument that the term “basis” in the law can only refer to capital assets. FTB’s argument ignores the fact that all property has a basis that is used to calculate gain when property is sold.

“There is simply no foundation to the assertion that the term ‘basis’ can only be used in reference to capitalized assets, even if the term is frequently used in that context,” the dissent said. “We should affirm that ‘basis’ is a general term that applies equally to expensed assets and capital assets (and to any other conceivable thing that can be sold). [FTB's] fears about double benefits will only materialize if we adopt [FTB's] incorrect view that ‘qualified property’ is limited to capitalized assets.”

SBOE will review Taiheiyo’s petition for rehearing, which must include reasons for the request such as arguments that the board made in error of law in reaching its decision or that newly discovered evidence is available. If SBOE denies the petition, the taxpayer has exhausted its administrative remedies and may file suit in state trial court.

By Laura Mahoney

A few weeks ago I reprinted a BNA article by Laura Mahoney discussing the appeal of Dicon v. FTB.   Mahoney contacted me today to alert me to a correction published in relation to that article:

A report on the Oct. 23 appeal of California court decision (Dicon Fiberoptics Inc. v. Franchise Tax Board, Cal. Ct. App., No. B202997), in 211 DTR K-2, 11/1/07, incorrectly stated the amount of credit denials or additional assessments the California Franchise Tax Board is expecting to issue in the process of auditing about 500 taxpayers who have claimed enterprise zone hiring credits. FTB estimated the total to be about $130 million, not $1 billion. As of Dec. 5, FTB estimated the total amount of credit denials and overstatements to be about $60 million, in light of a recent decision striking down the agency’s position that some credits involving economically disadvantaged employees were not allowable. The online version has been corrected.

Mahoney further informed me that the overwhelming majority of that adjustment was due to a math error and not the BOE decision in the Jessica McClintock case.

Below I am reprinting the fine article written by Laura Mahoney of BNA regarding the status of the Dicon v. FTB case I discussed earlier. The article appeared in BNA’s “Daily Tax Report” on 11/1/2007 and was titled “Taxpayer Appeals Dismissal of Suit Challenging FTB’s Tax Credit Voucher Policy.”

Reproduced with permission from Daily Tax Report, No. 211 (Nov. 1, 2007) pp. K-2 – K-3. Copyright 2007 by The Bureau of National Affairs, Inc. (800-372-1033) (http://www.bna.com)

SACRAMENTO, Calif.–A corporate taxpayer Oct. 23 appealed a trial court judge’s decision to dismiss its case against the Franchise Tax Board in which the company claims the board does not have the authority to audit tax credit vouchers it received from local government agencies for hiring workers in designated enterprise zones (Dicon Fiberoptics Inc. v. Franchise Tax Board, Cal. Ct. App., No. B202997, notice of appeal filed 10/23/07).

In a case of first impression, Los Angeles County Superior Court Judge Mel Red Recana Oct. 3 formally dismissed the lawsuit filed by Dicon Fiberoptics Inc. almost two months after sustaining FTB’s demurrer to the company’s complaint.

The company’s appeal makes it the lead case challenging a 2003 change in FTB policy through which the agency is auditing 500 taxpayers and expects to deny about $1 billion in claimed EZ hiring credits.

In sustaining FTB’s demurrer Aug. 17, Recana said he agreed with FTB’s argument that it may, under the Revenue and Taxation Code, “for purposes of administering its duties, including ascertaining the correctness of any return, demand taxpayers to provide information or make available for examination or copying any books, papers, or other data which may be relevant to that purpose.”

Dispute Over Documentation, Scope of Authority

The judge agreed with FTB, which argued that Dicon failed to state a cause of action because the board is not required by law to accept the EZ hiring credit vouchers, issued by local vouchering agencies, and has the authority to require Dicon to provide documentation to support the $1.1 million in claimed credits before allowing them.

Dicon, based in Richmond, Calif., argued that state law giving local agencies the authority to issue the EZ hiring credit vouchers requires only that the taxpayer receiving the voucher provide a copy to FTB. The agency exceeded its authority when it demanded documentation that Dicon was not required to keep once it received the voucher from the local agency, and that was outside Dicon’s possession, custody, and control, according to the company.

Recana rejected Dicon’s argument, saying FTB properly denied the credits after the company did not provide documentation it requested.

At a hearing on the case in August before he sustained the demurrer, Recana suggested to lawyers for FTB and Dicon that they take the case to the Court of Appeal because it is the lead case on the issue. “What’s important is that we have good guidance from the court of appeal,” Recana said, according to a court transcript of the hearing.

Dicon filed its appeal Oct. 23 in the California Court of Appeal, Second District, in Los Angeles. Marty Dakessian, an attorney in Glendale, Calif., representing Dicon, declined to comment to BNA Oct. 31 on the case except to say he disagrees with Recana’s dismissal.

Other Voucher Cases

A spokeswoman for FTB also declined to comment because the case is pending.

Dicon filed its lawsuit in May, five months after the State Board of Equalization issued a formal opinion in a dispute between FTB and Deluxe Corp. on the same issue of whether FTB can examine EZ hiring credit vouchers. SBOE ruled in favor of FTB, saying both tax agencies have the authority to “look behind” the vouchers issued by local agencies (243 DTR H-2, 12/19/06 ). Dakessian represented Deluxe in that case.

Deluxe Corp. also has filed a lawsuit in state trial court challenging FTB’s ruling in that case (Deluxe Corp. v. California Franchise Tax Board, No. CGC 07-462305). A trial is scheduled for April 21, 2008. Deluxe is represented by Amy Silverstein and Edwin Antolin of Silverstein & Pomerantz in San Francisco.

The Deluxe case was the first to reach SBOE on appeal as a result of a change in FTB policy in 2003. From 1994 until 2003, FTB issued EZ tax credits without questioning the vouchers. But the agency changed its policy after a 2003 state audit of the Oakland EZ showed that many hiring credit vouchers may have been issued improperly.

As a result, FTB has audited or is in the process of auditing more than 500 taxpayers on the question of the EZ hiring credit, and expects to deny about $1 billion in credits.

Several other cases have reached SBOE on appeal, and the board ruled most recently in August and September in two other cases involving different enterprise zones credit issues (158 DTR H-1, 8/16/07 ; 181 DTR H-3, 9/19/07 ).

By Laura Mahoney