Welcome to the first edition of a series of quarterly updates from Reed Smith on California state tax developments. Every quarter, we will bring you legal updates and provide some insight on what taxpayers are facing in audits, administrative appeals, and litigation involving the Franchise Tax Board and the State Board of Equalization. We will also provide you updates on our California team, highlighting our members, and letting you know where to find us.
For more information on California developments, please contact any member of the California team: Marty Dakessian, Brian Toman, Kyle Sollie, John Messenger, Mike Shaikh, Shirley Wei, Alex Sampson, or Erin Mariano. For more information on Reed Smith’s California tax practice, visit www.reedsmith.com/catax.
California legislature terminates Enterprise Zone program and replaces it with a new three-part program
Governor Jerry Brown signed into law AB 93, which eliminates the current Enterprise Zone program and replaces it with a new, three-pronged incentive program.
AB 93 repeals the provisions authorizing Enterprise Zones, manufacturing enhancement areas, targeted tax areas, and local agency military base recovery areas for tax years beginning on or after January 1, 2014. The bill also limits the application of hiring and sales and use tax credits to employees hired, or purchases made prior to January 1, 2014. Taxpayers may utilize any carryforward hiring or sales and use tax credits generated prior to 2014 through 2024. The bill also limits the net interest deduction for lenders making loans to businesses in Enterprise Zones to interest received before January 1, 2014.
In place of the Enterprise Zone program, AB 93 provides for a new three-part tax incentive program.
Part 1: New Sales Tax Exemption for Manufacturing Equipment
Effective July 1, 2014, AB 93 adds a new, state-level sales tax exemption for manufacturing equipment. The exemption is also available for purchases of certain equipment primarily used for manufacturing and in research and development. The legislation caps the exemption at $200 million in purchases per taxpayer per year. This cap applies to the cumulative purchases of a single entity or the aggregated purchases of all members of a combined group. The exemption is set to expire January 1, 2021 for purchases of equipment to be used within a former Enterprise Zone or certain designated census tracts, and January 1, 2019 for purchases of equipment to be used elsewhere in California.
Part 2: New Hiring Credit
AB 93 also adds a new hiring credit to replace the old EZ hiring credit. The credit is available on 35 percent of wages between $12 - $28 per hour for companies that employ “hard to hire” workers in certain defined geographic areas of the state. Hard to hire workers include individuals who have been unemployed for six months, previously unemployed veterans, recipients of the federal Earned Income Tax Credit, and ex-offenders. To continue to qualify for the credit, an employer must increase the number of full-time employees employed in the state from one year to the next. The credit may only be claimed on a timely filed original return. Temporary help services, retail trade services, food services, and employers in certain NAICS services are not eligible for the hiring tax credit. The new hiring tax credit applies to tax years beginning on or after January 1, 2014, and before January 1, 2021.
Part 3: New California Competes Credit
The third new incentive is the California Competes Tax Credit, which is negotiated through and administered by the Governor’s Office of Business and Economic Development (GO-Biz). The pool of credits available under the California Competes Credit is limited to a specified sum each fiscal year ($30 million for fiscal year 2013-2014). Businesses compete for the credit based on a number of factors, including the number of jobs to be created, the amount of investment in the state, incentives available to the taxpayer within and outside of California, and the duration of the proposed project. Priority is to be given to taxpayers whose project or business is located or proposed to be located in an area of high unemployment or poverty.
GO-Biz is tasked with negotiating the terms of a written agreement, providing the negotiated terms of the agreement to the California Competes Tax Credit Committee (comprised of the Treasurer, Director of Finance, Director of GO-Biz, and an appointee from both the Senate and the Assembly) for approval, and informing the FTB of executed agreements. If a taxpayer fails to fulfill the terms of an executed agreement, the credit may be recaptured, in whole or in part.
Information regarding executed agreements, including the taxpayer’s name, estimated amount of investment, estimated number of jobs created, amount of credit allocated, and any credit recaptured, will be published on the GO-Biz website.
A quarter of the aggregate amount of the credit is reserved for small businesses. Further, no more than 20 percent of the aggregate credit may be allocated to any one taxpayer. The California Competes Tax Credit is applicable for tax years beginning on or after January 1, 2014 and before January 1, 2025.
FTB’s budget is reduced in another Legislative attempt to distance California from the Multistate Tax Compact
More than 15 years after former State Board of Equalization members Claude Parrish and Dean Andal unsuccessfully introduced legislation to withdraw California from the Multistate Tax Compact, the legislature attempted to formally withdraw last year in response to the Gillette case. Now California is trying to underscore the point. Governor Brown reduced the FTB’s fiscal year 2013-2014 budget to reflect the legislature’s action to withdraw from the Multistate Tax Compact. The FTB’s $718 million budget was reduced by $270,000, since California’s obligation to pay annual dues to the Multistate Tax Commission has presumably terminated as a result of its purported withdrawal from the Compact. Though reduction was small when considered in the context of the FTB’s total budget, it is yet another legislative effort to separate California from the Compact and its apportionment election.
California enacted legislation purporting to withdraw the state from the Compact in June 2012 in an attempt to pre-empt the California Court of Appeal’s ruling in The Gillette Co., et al. v. Franchise Tax Board.1 In Gillette, the court determined that California’s enactment of a statute that requires a three-factor apportionment formula with a double-weighted sales factor did not override or repeal the state’s adoption of the Compact, which permits taxpayers to elect an equally weighted, three-factor apportionment formula. The Gillette case is currently in briefing before the California Supreme Court.
There is still doubt regarding the validity of California’s attempt to withdraw from the Compact. The bill to repeal the state’s membership in the Compact was not passed by the two-thirds vote of the legislature required for revenue-raising measures by Proposition 26.
State Board of Equalization rules that an Indiana-based media company’s sales factor properly included $931 million in gross receipts from the sale of 13 television stations located outside California
In Appeal of Emmis Communications Corporation,2 the taxpayer—a diversified media company—was principally focused on radio broadcasting, but was also engaged in the businesses of publishing magazines and operating television stations, as well as other activities. It was in the process of discontinuing its television operations. By the end of its 2006 fiscal year, it had sold 13 of its 16 television stations, all of which were located outside California. The sale resulted in $931 million of gross receipts, which Emmis included in the denominator of its sales factor. The rest of Emmis’s business operated at a loss in 2006.
The FTB excluded all of those receipts from Emmis’s sales factor under a regulation that excludes from the sales factor substantial amounts of gross receipts that arise from an occasional sale of a fixed asset or other property held or used in the regular course of the taxpayer’s trade or business.3 The FTB argued that the sale of television stations was occasional because the taxpayer primarily generated revenue from selling advertising and was not in the business of divesting whole segments of its operations. The FTB claimed that the substantial nature of the gross receipts was evidenced by the 59 percent difference in the sales factor denominator when the gain from the liquidation of that business was included in the denominator.
Emmis asserted that the acquisition and disposition of the media properties was a part of its operations and overall corporate strategy to acquire and dispose of operation locations in order to maximize its business. Thus, Emmis argued, the sale was not occasional. Emmis also argued that it would be distortive to exclude the receipts from the television station sales from the sales factor denominator because they were the majority of Emmis’ gross receipts for 2006 and represented 100 percent of its income. If the receipts were excluded from the sales factor, the gains would be taxed in California without proper representation in the apportionment formula.
At a Board hearing June 11, 2013, both parties addressed whether the occasional sale rule applied to the taxpayer, and whether excluding the subject receipts resulted in distortion. The Board’s questioning primarily focused on whether the occasional sale rule applied to the taxpayer and the nature of the taxpayer’s business in relation to its overall strategy.4 The Board granted the taxpayer’s petition by a 4-1 vote, finding that the taxpayer properly included the subject receipts in its sales factor denominator. The Board did not provide any explanation on the reasoning for its determination.
Harley-Davidson’s motion for a new trial is denied—next step, the Court of Appeal
In May, we sent an alert about the San Diego Superior Court’s decision in Harley-Davidson, Inc. v. Franchise Tax Board.5 In that case, the court had held that bankruptcy-remote entities formed to hold financial assets in connection with securitization transactions had nexus with California and could be taxed as financial corporations, despite having no physical presence in California.
The taxpayer filed a Motion for New Trial. The reason for this filing was, in part, that the Superior Court’s Statement of Decision did not address the traditional requirement for attributional nexus—that the California activities of an affiliate of the special purpose entities (SPEs) were “significantly associated with the [SPEs’] ability to establish and maintain a market in th[e] state.”6
The court denied Harley-Davidson’s motion. It found that the SPEs and the Harley-Davidson entities with physical presence in California were “agents of each other,” and that finding was sufficient. The court has also clarified, in a sweeping summary statement without further analysis, that “‘substantial nexus’ was found under both the Commerce Clause and the Due Process Clause.”
Nexus wasn’t the only important issue in the Harley-Davidson case. In its complaint, Harley-Davidson also argued that mandatory forced combination for interstate taxpayers is unconstitutional. Wholly intrastate businesses may choose to compute income using either the unitary combined method or a separate entity method.7 But taxpayers conducting activities within and outside of California must use unitary combined reporting. This dichotomy, Harley-Davidson argued, violated the Commerce Clause because it discriminated against interstate unitary businesses to the benefit of California businesses. The FTB filed a demurrer, claiming that this election does not result in discrimination against interstate commerce.
The court granted the FTB’s demurrer. It stated that, “[w]ell settled law shows there is no discrimination to an intrastate [sic] business when it does not have the option to file a return on a separate accounting basis but its intrastate counterpart does.” Without explicitly agreeing, the court noted the FTB’s argument that the election for intrastate businesses simply put them on equal ground with interstate businesses. Before that, intrastate businesses were discriminated against because they could not file a combined report in which income of one entity could be offset by losses of another.
The court’s recent denial of Harley-Davidson’s Motion for New Trial and clarification of its prior Statement of Decision sets up Harley-Davidson arguments on appeal. We expect an appeal to be filed both with respect to the SPE nexus issue and the mandatory combination issue.
Court orders FTB to pay Reed Smith client $1.2 million in attorney fees: tax agency “didn’t do the right thing”
Previously, we reported on Daniel V, Inc. v. Franchise Tax Board 8, in which Reed Smith’s State Tax team first obtained a 100 percent refund of all taxes, interest, and penalties in the amount of $2.3 million, and then won a $1.2 million award of attorneys’ fees for Daniel V. After successfully arguing that Daniel V was commercially domiciled in Nevada in 1997 and 1998, Reed Smith proved that the FTB’s position was not substantially justified, and presented evidence of questionable FTB conduct over the 12 years of this case. Although the FTB “beg[ged] to differ strongly with the court’s opinion,” Los Angeles Superior Court Judge Mooney explained why he granted Reed Smith’s motion for fees:
Before being on the bench, I spent some time in the U.S. Attorney’s Office and one of the great pleasures that I had in representing the government was the notion that, you know, it wasn’t just about winning the case[.] It was about doing the right thing. And, you know, in this case the conduct of the Franchise Tax Board just was not doing the right thing.
The award is the largest known fee order under Revenue and Taxation Code section 19717.
Meet the Team: Erin Mariano
In each of our quarterly updates, we will profile a member of Reed Smith’s California team. This time, we are profiling the newest addition to Reed Smith’s California tax practice.
In July, Reed Smith’s State Tax Group welcomed Erin Mariano to the San Francisco office. Erin joined Reed Smith after completing her LL.M. in Taxation and Certificate in International Taxation at the Georgetown University Law Center in Washington, D.C. While at Georgetown, she was awarded a fellowship at the Council on State Taxation. Prior to that, she clerked for the Honorable Gail L. Menyuk (Ret.) in the New Jersey Tax Court. Erin earned her J.D. from the University of California, Davis, where she was an extern in the Multistate Tax Bureau of the FTB and the Business and Tax Division of the attorney general’s office. She earned her B.A. at Amherst College. When she’s not busy talking tax, Erin enjoys dancing and classical music concerts. We are pleased to have her on board!
Upcoming Speaking Engagements
As always, our team remains busy speaking on the latest tax developments in California and throughout the country. In the coming months, you can hear us at the following places:
- On August 15, Marty Dakessian and Brian Toman will speak at the Council On State Taxation’s Southwest Regional State Tax Seminar in Burbank
- In September 25, Kyle Sollie will speak at the Institution for Professionals in Taxation’s annual Credits & Incentives Symposium in Dallas
- On October 24, Marty Dakessian will speak at the COST annual meeting in Phoenix
- On November 7, Marty Dakessian and Brian Toman will speak at the California Tax Policy Conference in San Jose
If you have questions about any of the items discussed in this update, please contact the authors of this alert, or the Reed Smith lawyer with whom you usually work. For more information on Reed Smith's California tax practice, visit www.reedsmith.com/catax.
1. The Gillette Company & Subs. v. California Franchise Tax Board, CA. Ct. App., 1st Dist, Dkt. No. A130803; appeal from SF Sup. Ct. Dkt. No. CGC-10-495911.
2. Case No. 547964.
3. California Code of Regulations, title 18, § 25137(c)(1)(A).
4. Although the FTB repeatedly argued that the taxpayer was not in the business of selling entire lines of business and that its Form 10-K did not state that taxpayer was in that business, the taxpayer clarified that it has a written and public statement in all of its 10-Ks regarding its strategy and that it acquires underdeveloped media properties, grows their values to increase cash flows, and disposes of them when appropriate as a part of that strategy.
5. Docket No. CASD-37-2011-00100846-CU-MC-CTL.
6. Citing Tyler Pipe Indus. Inc. v. Wash. State Dep’t of Rev., 483 U.S. 232 (1987).
7. Cal. Rev. & Tax. Code § 25101.15.
8. LASC Case No. BC457301.
Client Alert 2013-209