FTB Fights Underground Regulation Determination – Why Won’t It Simply Do What’s Right?

by Allen Matkins

Just last week, the California Taxpayers Association reported:

For at least several months, the Franchise Tax Board has been sending filing enforcement notices to nonresidents of California, including many foreign nonregistered limited liability companies (LLCs), who hold an interest in LLCs doing business in California.

CalTaxletter, page 9, Vol. XXVI, No. 22 (June 14, 2013)

In April, I submitted a petition to the Office of Administrative Law challenging the Franchise Tax Board’s interpretation of “doing business” as set forth in Form 3556.  See The FTB’s “Doing Business” Trap For Foreign LLCs With California Managers, Members Or Agents. My challenge was procedural, not substantive. Regardless of the rectitude of the FTB’s interpretation, I believe that the FTB failed to comply with the rule making provisions of the California Administrative Procedure Act.  These provisions provide critical safeguards to the public by requiring notice and an opportunity to comment.

Regrettably, the OAL decided not to accept my petition, which it has the discretion to do. The OAL’s decision “in no way reflects on the merits of the underlying issue presented by the petition”.  The OAL’s decision “does not constitute a judgment or opinion on any issue raised in the opinion”.   Importantly, the decision does not restrict any right or ability to pursue the matter in court.

Based on information supplied in response to my request under the Public Records Act, I’ve learned that the FTB took a keen interest in my petition, with the FTB’s Chief Executive Officer and Chief Counsel asking about the status.  In addition, I’ve learned that the director of the FTB’s Multistate Tax Bureau, Norman Scott, submitted a lengthy memorandum to the OAL.  Remarkably, the FTB took the position in the memorandum that its interpretation was the only legally tenable interpretation!  (The APA includes an exception for regulations that embody the only legally interpretation of a statute, Cal. Govt. Code § 11340.9(f)).

I expect that most taxpayers and practitioners find the FTB’s interpretation of doing business under Section 23301 to be bizarre, unexpected and contrary to common sense.  The FTB’s argument is further weakened by its citation to a 2008 OAL Determination (No. 22, Aug. 26, 2008) which it failed to note had been overturned by the Court of Appeal in Bollay v. Office of Administrative Law, 193 Cal.App.4th 103 (2011).

The FTB’s memorandum also leans heavily on FTB Legal Ruling 92-2 (December 28, 1992) because Government Code Section 11340.9(b) exempts legal rulings of counsel issued by the FTB or the State Board of Equalization.  It seems to me that this reliance is misplaced because that legal ruling does not attempt to define what exactly constitutes “conducting business in California on behalf of the partnership” whereas the examples in FTB Form 3556 do exactly that.  This is not surprising because the purpose of Rule 92-2 was to “provide guidance on the domestic (nonforeign) nonresident partner withholding requirements”, not define what constitutes “doing business” for purposes of Section 23101.  Moreover Ruling 92-2 predates the State Board of Equalization’s decision in Appeal of Amman & Schmid Finanz AG, et al., 96-SBE-008 (April 11, 1996).

The fundamental question, however, is why is the FTB fighting so strenuously to avoid doing the right thing – comply with the rule making provisions of the APA? Complying with the APA would not only eliminate the surprise of the FTB’s novel interpretation, but would also provide the public with an opportunity to comment on the FTB’s proposed interpretation.  With the OAL declining to weigh in, the question is quis custodiet, ipsos custodes (who should guard, the guards themselves)?


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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