California Tax Developments - A Reed Smith Quarterly Update (1st Quarter 2014)

Case Updates

Superior Court deems Comcast and QVC are not unitary; determines early termination fee is business income. On March 6, 2014, a Los Angeles Superior Court issued its final decision in Comcon Production Services, Inc. v. Franchise Tax Board.1 Two issues were before the court: (1) whether Comcast was unitary with its subsidiary, QVC, and (2) whether an early termination fee received by Comcast as a result of a failed merger with MediaOne was business income subject to apportionment, or non-business income allocable outside California. In a split decision, the court ruled that (1) Comcast and QVC were not a unitary business, and (2) the termination fee was apportionable business income.

On March 28, 2014, the parties lodged a Proposed Statement of Decision with the court but requested additional time to compute the proper amount of refund due to Comcast.

Takeaway: We do not yet have a written decision, but the court’s ruling on the unitary business issue should provide useful guidance to taxpayers in future unitary business analyses. The ruling on the MediaOne termination fee issue extends the realm of activities that generate business income for California tax purposes, and makes the scope of business income in California consistent with its scope in many other states.

Court of Appeal affirms online travel companies are not responsible for collecting local transient occupancy tax on markup costs. On March 27, 2014, a California Court of Appeal filed its opinion in In re Transient Occupancy Tax Cases.2 The issue was whether, under San Diego’s transient occupancy tax (“TOT”) ordinance, various online travel companies (“OTCs”) were responsible for collecting and remitting the TOT on service fees and markups that they charge for reserving hotel rooms through their websites.

San Diego’s TOT ordinance reads as follows: “For the privilege of Occupancy in any Hotel located in the City of San Diego, each Transient is subject to and shall pay a tax in the amount of six percent (6%) of the Rent charged by the Operator.”3 The Court of Appeal stated that the ordinance imposed tax on the amount charged by the hotel operator. Focusing its analysis on the plain language of the statute and its prior decisions on whether OTCs were liable for transient occupancy taxes in other cities,4 the court held that OTCs are not hotel operators. OTCs purchase blocks of rooms at a wholesale price. They then sell those rooms at a price higher than the wholesale price, with at least a portion of the difference being attributable to a service fee charged to the purchaser. Since the OTCs are not operators, those markups and service fees collected by them are not subject to the TOT.

Takeaway: TOTs have been subject to plenty of litigation in California. The local ordinances imposing TOTs come in a variety of types, but this Court of Appeal decision should reduce some of the uncertainty for businesses collecting these taxes.

Motion for Summary Judgment filed in Abercrombie case. In Abercrombie & Fitch Co. & Subsidiaries v. Franchise Tax Board,5 Abercrombie & Fitch filed a refund action with the Fresno County Superior Court alleging that an election available only to taxpayers operating solely in California violates the commerce clause. The election allows California unitary groups to compute their California taxable income using the separate reporting method. That method is unavailable to taxpayers operating in and out of the state.

The taxpayer filed its motion for summary judgment and supporting documents April 18, 2014. Summary judgment is set for July 2, 2014. The FTB has until June 18, 2014 to file opposition to the motion.

Takeaway: This case involves issues similar to those considered in the Court of Appeal’s decision in Cutler v. FTB.6 In that case, litigated by Reed Smith, the Court of Appeal held that an in-state investment requirement for a tax incentive discriminated against interstate commerce. We believe that in light of past litigation, and cases like Abercrombie that are still pending, the legislature should heed a warning that discriminatory tax statutes will be challenged and ultimately struck down.

Trailing nexus at issue in C.V. Starr & Co. v. Franchise Tax Board.7 This case involves the question of when two related corporations stop being unitary. In this case, C.V. Starr and its related entity, AIG, were in the midst of a heated public split. If they were still unitary, dividends received by C.V. Starr from AIG and the subsequent sale of AIG’s stock would both be considered apportionable business income. In the audit, the FTB determined that both the dividends and gain from the sale of stock generated business income through the first half of 2006, and non-business income for the second half of 2006. C.V. Starr took the position that the AIG dividends and gain from the entire year should be classified as non-business income because C.V. Starr and AIG were not unitary.

On February 18, 2014, the FTB filed its Memorandum of Points and Authorities in support of its Motion for Summary Judgment. Chiefly, the FTB argues that under the functional test for determining whether income is business income,8 C.V. Starr had the right to direct and control its ownership interest in AIG, and that the income generated from the dividends and sale of stock materially contributed to generating its business income. And, because that income served an operational function in C.V. Starr’s business, classifying the income as business income does not violate the U.S. Constitution.

Takeaway: The facts of this case are unique in that during the period at issue, AIG and C.V. Starr were going through a deliberate and acrimonious split. Nonetheless, this decision in this case should provide useful guidance in future cases for deciding exactly when a unitary business ceases to exist.

Responses to amicus briefs filed in Gillette v. Franchise Tax Board9 On January 22, 2014, the taxpayers and the FTB both filed briefs in response to the briefs filed by amicus curiae in Gillette v. Franchise Tax Board, including the amicus brief filed by Reed Smith in support of Gillette on behalf of the Institute for Professionals in Taxation.

In its response brief, Gillette responded to the amicus briefs filed by the Multistate Tax Commission and several states by reiterating that the Multistate Tax Compact is a binding interstate compact, the election contained in the Compact is clear and unambiguous, and compact law and the contract clause preclude California from unilaterally eliminating the election. The taxpayers also filed a motion for judicial notice and attached academic articles discussing the relevance of established interstate compact law.

The FTB’s response brief contends that the Compact allows states to change their provisions, that compact law does not require a waiver of rights to enact legislative changes, that the taxpayers’ interpretation of the Compact is incorrect, and that changes to the Compact election do not violate the contract clause.

Takeaway: Now that responses to amicus briefs have been filed, the case should be ready to be scheduled for oral arguments. Typically, the California Supreme Court has scheduled arguments one to two years after briefing finishes.

Gilbert Hyatt sues for injunctive relief against the Franchise Tax Board and State Board of Equalization for dragging feet in a 20+ year audit. On April 4, 2014, Gilbert Hyatt filed a complaint for permanent injunctive relief against the FTB and the SBE in federal court in the Eastern District of California.10 The complaint claims that the FTB violated the due process and equal protection clauses for investigating and assessing amounts on taxes owed as the result of an ongoing residency audit that started in 1993, and an ongoing sourcing assessment that was first made in 2007 for the same six-month period of time and is still stuck at the administrative level. In effect, the FTB is assessing Mr. Hyatt for being a California resident and for being a California nonresident for the same period of time. As a result of the more than 20-year administrative delay, the complaint alleges that Mr. Hyatt has been deprived of his right to a meaningful opportunity to be heard. Mr. Hyatt’s claim is based on the FTB’s inability to provide a full, fair, and timely adjudication of any tax, penalty, or interest he might owe.

At issue in the audit is Mr. Hyatt’s residency status for a six-month period bridging 1991 and 1992, more than 22 years ago. As the result of numerous administrative delays, the audit controversy is still incomplete. However, the interest and penalties that have accrued now total more than $55 million—a staggering amount.11 In earlier litigation, Mr. Hyatt sued the FTB in Nevada state court for tortious conduct during the audit, including fraud, invasion of privacy, intentional infliction of emotional distress, abuse of process, and breach of confidential relationship. Although the FTB denied wrongdoing, Mr. Hyatt was vindicated when a jury found that the FTB acted with malice, fraud, and oppression during its audit, and awarded him $138 million in compensatory damages and $250 million in punitive damages. That case had previously made its way for pretrial review by the U.S. Supreme Court, where Mr. Hyatt won a unanimous decision against the FTB.12

Takeaway: This is the latest installment in the long saga surrounding Mr. Hyatt’s residency dispute with the FTB. The complaint describes in detail the discriminatory treatment he suffered at the hands of the FTB for more than two decades. The filing includes a timeline of events that have transpired over the 20-plus years, and the inexplicable delay by the FTB and SBE in the audit and the continuing administrative appeal.

Legislation

(a) Updates on California’s New Tax Incentive Regime

In an earlier update, we reported on the close of California’s Enterprise Zone program and the inception of the state’s new incentive programs. Below are updates on the progress of each of those incentives.

New Employment Credit The New Employment Credit replaces the Enterprise Zone program’s old hiring credit, which had historically generated controversy over the life of the EZ program. The New Employment Credit is administered by the FTB. To qualify for the credit, employers must hire “hard to hire” employees in certain targeted geographic areas of the state, and they must increase the number of full-time employees every year.

In January 2014, the FTB launched its New Credit Reservation System, through which employers must register themselves and qualifying employees within 30 days of completing Employment Development Department paperwork for the same, to be eligible to receive the credit. In March 2014, the FTB launched the Annual Certification of Employment online system, through which employers must annually register qualified employees.

Employers must complete each step above to qualify for the New Employment Credit. If you have questions about the mechanics or requirements of the credit, please contact one of the members of the California Team.

California Competes Tax Credit Program The new California Competes Tax Credit program is run by Go-Biz, the Governor’s Office of Business and Economic Development. It is an income tax credit available to businesses that want to move to or stay in California. A pool of credits, starting with $30 million through June 2014 and reaching $200 million annually beginning 2016, is allocated to the program every year. As the name implies, businesses compete with one another by promising the most investment in California while requesting the least amount of credit.

There are four general phases to the application process. In the first phase, the applicant answers a series of questions that will be screened through an automated computer review for ranking among applicants. The top phase-one applicants make it to the second phase, where they are evaluated on both qualitative and quantitative metrics. Applicants making it through the first two phases will generally receive the credit. For those applicants, the third phase involves negotiation of credit terms. These terms include claw-backs, length of the contract, and other terms. But the credit amount is not negotiable. Finally, in the last phase, the California Competes Tax Credit Committee (consisting of the Go-Biz Director, Department of Finance Director, State Treasurer, and one appointee each from the Senate and Assembly) will review and approve or disapprove of the tax credit. The last phase will be in a forum open to the public.

Takeaway: The deadline for the first application period ended April 14, 2014. Although that period has now closed, there will be more opportunities to apply for the program in the second half of this year. Go-Biz will announce the next application period before July 1, 2014.

New Manufacturing/Research & Development Regulation The new incentive regime provides a sales tax exemption for manufacturing and R&D equipment.13 The Sales and Use Tax Division of the Board of Equalization has held multiple interested parties meetings since late last year, soliciting input from the public on the scope of a new regulation implementing the exemption. At the April 22, 2014 SBE meeting, the Business Taxes Committee presented the proposed regulation to the Board for approval and authorization; it is now published for review by the public. The SBE is tentatively scheduled to act on the regulation at its July 1, 2014 meeting.

Takeaway: The new regulation impacts a broad range of taxpayers. The new manufacturing and R&D equipment sales tax exemption has the potential to be a lucrative benefit because, unlike the franchise tax credit offered under the Enterprise Zone program, the new manufacturing/R&D exemption provides a partial exemption from tax. Taxpayers qualifying for the sales tax exemption will not have to ensure they meet credit-use limitation requirements based on their franchise tax amount and geographic footprint in the state.

Meet the Team: John Messenger

John is a partner based out of Reed Smith’s San Francisco office. His practice concentrates in state and local tax controversy, and trial and appellate advocacy. His repertoire of work includes income taxes, severance taxes, excise taxes, sales and use taxes, property taxes, and issues surrounding the taxation of oil and gas. John is admitted to practice in Alaska, California and Washington, and he represents clients on state and local tax matters in those states. He has handled cases before local boards, state administrative agencies, and federal and state courts.

Prior to entering private practice, John served as an assistant attorney general for the state of Alaska. He was subsequently appointed deputy commissioner and acting commissioner of revenue for the state of Alaska. His public service and past representation in private practice of the state of Alaska and several municipalities has given him an appreciation of the points of view on issues faced by both sides of any state or local tax controversy; it has also helped him resolve by settlement complex matters involving hundreds of millions of dollars.

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 reedsmith.com/catax/.


  1. Los Angeles Superior Court, Case No. BC489779.
  2. San Diego Superior Court, Case No. B243800.
  3. San Diego Municipal Code § 35.0103.
  4. In re Transient Occupancy Tax Cases (Nov. 1, 2012, B230457) (non-published - Anaheim), (Nov. 1, 2012, B236166) (non-published - Santa Monica).
  5. Fresno Superior Court, Case No. 12CECG03408.
  6. 208 Cal. App. 4th 1247 (2012).
  7. San Francisco Superior Court, Case No. CGC-13-527952.
  8. See Hoechst Celanese Corp. v. Franchise Tax Board, 25 Cal. 4th 508 (2001).
  9. Supreme Court Case No. S206587.
  10. Hyatt v. Chiang, U.S. District Court, Eastern District of California, Case 2:14-cv-00849-GEB-DAD.
  11. Hyatt v. Chiang, U.S. District Court, Eastern District of California, Case 2:14-cv-00849-GEB-DAD, at page 4.
  12. Franchise Tax Board v. Hyatt, 538 U.S. 488 (2003).
  13. Cal. Code Regs. §1525.4.

Topics:  Abercrombie & Fitch, Comcast, Commerce Clause, Fees, Franchise Tax Board, MediaOne, OTC, QVC, Termination, Unitary Business

Published In: Tax Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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