STATE OF CALIFORNIA FRANCHISE TAX BOARD MEETING WEDNESDAY, APRIL 4, 2007 FRANCHISE TAX BOARD 9646 BUTTERFIELD WAY TOWN CENTER, GERALD GOLDBERG AUDITORIUM SACRAMENTO, CALIFORNIA 1:30 P.M. REPORTED BY: SANDRA VON HAENEL CSR No. 11407 1 APPEARANCES 2 FRANCHISE TAX BOARD: 3 Hon. John Chiang, Chair Hon. Michael C. Genest 4 Hon. Betty T. Yee Deputy Controller Marcy Jo Mandel 5 6 FRANCHISE TAX BOARD STAFF: 7 Colleen Berwick Kathy Harker 8 Carl A. Joseph Patrick J. Kusiak 9 Anne Miller Benjamin A. Miller 10 Brian Putler Phil Spilberg 11 Craig Swieso Titus Toyama 12 Geoff Way 13 OTHER PARTICIPANTS: 14 Charles Ajalat - Ajalat, Polley, Ayoob & Matarese James M. Brown - Capitol Group Companies 15 Teresa Casazza - California Taxpayers Association Margaret Egan - Fidelity Investments 16 Greg Garcia - Waddell & Reed Joanne Garvey - Heller Ehrman 17 William G. Hamm - LECG Fred L. Main - Manatt, Phelps & Phillips, LLP 18 John I. McBeth - Franklin Templeton Investments Marnie Niziolek - Morgan Stanley 19 Philip Plant - Allianz of America Neal M. Reilly - Barclays Global Investors 20 Gina Rodriguez - Spidell Publishing, Inc. Ray Rossi - Intel Corporation 21 Patrick Shannon - Greenberg Taurig Robert Steiger - Chevron Corporation 22 Brian W. Toman - Reed Smith LLP Gregory Turner - Nielsen Merksamer, Parrinello, 23 Mueller & Naylor, LLP Jeffrey Vesely - Pillsbury Winthrop 24 Roburt Waldow - Heller Ehrman Barry Weissman - PriceWaterhouseCoopers 25 ---oOo--- 2 1 SACRAMENTO, CALIFORNIA 2 WEDNESDAY, APRIL 4, 2007, 1:30 P.M. 3 ---oOo--- 4 CHAIR CHIANG: Good afternoon. This is the scheduled 5 meeting of the Franchise Tax Board. 6 Would the secretary please call the roll to determine 7 whether a quorum is present. 8 MS. BERWICK: Member Lee? 9 MEMBER LEE: Here. 10 MS. BERWICK: Member Genest? 11 MEMBER GENEST: Here. 12 MS. BERWICK: Chair Chiang? 13 CHAIR CHIANG: Present. 14 First item, please. 15 Approval of the minutes. 16 MEMBER LEE: Mr. Chair, I will not be participating in 17 the approval of these minutes. 18 MEMBER GENEST: I'll move for approval. 19 CHAIR CHIANG: And I'll second. 20 Without objection, the motion passes. 21 Next item, Legislative Matters. 22 MR. PUTLER: Yes. Good afternoon. 23 Brian Putler from the Franchise Tax Board. 24 Since the report on Conformity was prepared for the 25 binders, staff hosted a working Interested Parties meeting 3 1 last week to get consensus on what federal changes should be 2 included in the "date change" conformity bill. About 3 fifteen interested people attended the session, which lasted 4 three hours. I am pleased to report that the day ended with 5 a list of about one hundred federal tax law changes from 6 2005 and 2006 that would be drafted into a conformity "date 7 change" bill for this year. 8 The bill will be authored by Assemblymember Calderon, 9 and the bill number will be AB 1561. 10 And I'd be happy to respond to any questions that you 11 may have. 12 CHAIR CHIANG: Thank you for your work on this item. 13 We have one speaker. Teresa. 14 Welcome, Teresa. You have three minutes. 15 MS. CASAZZA: Thank you. 16 Good afternoon, Mr. Chairman, members. My name is 17 Teresa Casazza. I'm with the California Taxpayers 18 Association. 19 First off, I wanted to thank specifically Brian Putler 20 and John Pavalasky for their work on the Interested Parties 21 Meeting for federal tax conformity. We see that as a really 22 crucial issue. We are hoping that and urging that the 23 Franchise Tax Board actually sponsor the bill. It's really 24 important for, every year, California to take a look at 25 federal conformity. Our whole federal tax code system is 4 1 based on the Internal Revenue Code. 2 The more we are out of conformity with the date change 3 methods, the more difficult it is for taxpayers and for 4 administrators. And I do believe it helps with tax 5 compliance and the tax gap. 6 So I'd like to thank the efforts of the staff and urge 7 you to sponsor the bill. 8 CHAIR CHIANG: Thank you for your words. 9 Next item, please. Filing Season Update. 10 MS. MILLER: Good afternoon. I'm Anne Miller, chief 11 of the Filing Division for Franchise Tax Board. 12 Today I will be providing a brief overview of FTB's 13 progress in completing our 2007 filing season. And I wanted 14 to let you know my presentation has been updated with more 15 current information. This time of year, our numbers change 16 quite rapidly, so I'll be providing you with updates through 17 March 31st. 18 As of March 31st, we've received 8 million personal 19 income tax returns, and with the filing deadline of April 20 17th less than two weeks away, the department expects to 21 receive an additional 6 million returns in the next few 22 weeks. To put it mildly, we are definitely in the middle of 23 our peak processing season. 24 The department continues to experience growth in the 25 number of e-filed returns we've received. We have received 5 1 6.1 million electronically filed returns so far this year. 2 And by the end of the 2007 filing season, we expect to 3 receive 63 percent of all personal income tax returns 4 electronically filed. That's up from 59 percent last year. 5 In addition, I'm happy to report that CalFile, our 6 direct online filing program, is experiencing almost a 7 20 percent growth rate this year. So far we've received 8 89,000 CalFiled returns versus 74,000 CalFiled returns for 9 the same period last year. 10 With respect to our business entity returns, we've 11 received 361,000 business entity returns through March 31st. 12 And as the Board is aware, this is our second year of 13 offering electronic filing for business e-filed returns. 14 In January of 2006, we first offered electronic filing 15 for the general corporate returns. This year we have 16 expanded it to limited liability corporations, partnership 17 returns as well as S corporation returns. And because of 18 that expansion, I'm happy to report we've seen significant 19 growth in the number of business entity e-filed returns. 20 As of March 31, we've received 10,500 electronically 21 filed BE returns in comparison with about 3,000 for the same 22 time last year. 23 With respect to personal income tax refunds, over 5.7 24 million personal income tax refunds have been issued since 25 March 31st, totaling approximately $4 billion. The volume 6 1 of refunds issued this year is up approximately 6 percent, 2 and as far as the average amount of refund, that's also up. 3 The average refund this year is about $700, compared to 4 about $650 for the same period last year. 5 The number of direct deposits have grown by about 6 $350,000, and we expect by the end of this filing season 45 7 percent of all the taxpayers will receive their refund via 8 direct deposit versus a payment check. 9 And although we've made significant inroads with 10 e-file, paper continues to be the payment method of choice. 11 Over 85 percent of all the payments or deposits we received 12 are via paper check. So far we have deposited about $7.8 13 billion through March 31st, which is about 2 percent higher 14 than the dollars we received last year. 15 Moving on to our services. The total volume of calls 16 reaching our general Interactive Voice Response application 17 is 1.7 million contacts this year versus about 1.6 million 18 last year. Our general information call center has answered 19 approximately 450,000 calls. And the average wait time for 20 a call is about 71/2 minutes this year. That compares to 21 slightly over five minutes for last year. 22 The number of calls to our Tax Practitioner Hotline 23 has also increased. Our call center has been experiencing 24 an increased call wait time over the past couple of years, 25 and we attribute this to the fact that, a few years ago, the 7 1 department took a cut, a budget cut with respect to our 2 customer service activities, and there were 80 positions 3 that were eliminated. 4 But I'd like to thank the Board and the Department of 5 Finance for its support in helping us restore our customer 6 service levels. The Governor's proposed budget does include 7 for fiscal year '07/'08, 27 new customer service positions 8 for the department. And with these new positions, we feel 9 it will better allow us to provide good customer service for 10 the next fiscal year. 11 With respect to our Internet services, we've had 12 3.1 million hits to our website, and so far taxpayers have 13 downloaded over 4 million forms and instructions as well as 14 schedules. That's definitely the method of choice as far as 15 receiving our forms. 16 And finally I just wanted to mention a new pilot 17 program that we are doing this year. We are sending out an 18 estimate payment letter to approximately 100,000 taxpayers. 19 And these are taxpayers that we know in the previous year 20 had a problem computing their estimate payments that they 21 paid to the State of California. So we are sending them a 22 letter reminding them of the amount that they've paid. And 23 we hope that when they ultimately file their tax return, 24 we'll see less errors. 25 So, in summary, I would just like to say I think the 8 1 department is making excellent progress towards a successful 2 2007 filing season. 3 And that concludes my report. 4 CHAIR CHIANG: And as we come closer to the filing 5 deadline, historically have we seen an increase in wait time 6 when people call in to seek assistance? 7 MS. MILLER: It may increase just slightly. But 8 typically at this time of year, the calls get a little bit 9 faster. And so I don't think we'll see much deterioration 10 in the call-wait time. Maybe a little bit, but not 11 substantially different than the 71/2 minutes we're 12 experiencing right now. 13 CHAIR CHIANG: And how many calls do we have dropped? 14 Do you mark those? 15 MS. MILLER: Yes, we do. As far as the calls that 16 we've received to date -- we call them calls offered versus 17 calls answered -- we have about 700,000 calls that are 18 offered, and we've answered, like I said, about 450,000. 19 That's level of access, which right now is about 64 percent. 20 CHAIR CHIANG: And in the sense that we pick up the 27 21 additional positions next fiscal year, do you have a sense 22 of what the call time might be? 23 MS. MILLER: We expect that with the additional 24 positions, it should raise our level of access to about 25 80 percent, maybe 83 percent, and the wait time should be, I 9 1 would say, more in the three-minute range. 2 CHAIR CHIANG: Thank you. 3 MS. MILLER: You're welcome. 4 CHAIR CHIANG: Any members have any questions? 5 Thank you very much, Anne. 6 Our next item, please. 7 MR. TOYAMA: Good afternoon, Mr. Chairman and Board 8 Members Yee and Genest. My name is Titus Toyama. I'm here 9 to comment briefly on the Interested Parties Meeting 10 process. There is a handout in your Board binder under 11 Tab 4, and I wanted to comment on a few things concerning 12 the purpose, processes, and results and outcomes of having 13 Interested Parties Meetings. 14 First of all, IPMs are open forums held with external 15 stakeholders to discuss FTB issues where their input is 16 desired or needed to help us make our programs work better. 17 Our topics include sensitive issues or changes that could 18 impact large numbers of taxpayers in specific industries. 19 This can include, for example, implementation of the laws, 20 proposed tax initiatives to ease taxpayer burden, et cetera. 21 In terms of process, IPMs are called by your Board, 22 for individual members of the Board, Administration, 23 Legislature, or any other public advocacy group that has an 24 issue with respect to how we administer taxes. 25 CHAIR CHIANG: I'm sorry to interject. Is your 10 1 microphone on? 2 MR. TOYAMA: I believe it is. 3 Is that better? 4 CHAIR CHIANG: Yes. 5 MR. TOYAMA: So going back to processes. IPMs can be 6 called by the three-member Board, by the individual members, 7 by the Administration, Legislature, or any other advocacy 8 group that has an issue with respect to how we administer 9 taxes. We reach out to stakeholders who have expressed an 10 interest in these topics, and invite them to come to our 11 meetings. We also post announcements, agendas, and results 12 of IPMs on the Franchise Tax Board public website. 13 The handout includes a number of recent IPMs that 14 we've had. I'll just call attention to two. 15 Mr. Brian Putler already mentioned the IPM with 16 respect to the conformity. We also had one last month on 17 the LLC fee issue. 18 Overall, we have had great success in getting valuable 19 input and feedback in how we conduct our business. We try 20 to make the meetings informative and informal and encourage 21 the free and honest exchange of ideas. 22 And, going forward, our staff looks forward to working 23 with the Board and our stakeholders in identifying those 24 issues where having an IPM is appropriate and desirable. 25 I'd be happy to answer any questions you might have 11 1 about the IPM process. 2 CHAIR CHIANG: Well, thank you, Titus. 3 And I wanted to thank the FTB staff. I think this is 4 a very positive and important program. The Franchise Tax 5 Board is a premier taxing agency, and I think it's important 6 that we work with the interested parties in development of 7 the tax laws here in California. So, many kudos to all 8 those who are involved. 9 We have two individuals who have signed up to speak. 10 Again, Teresa, and then Gina Rodriguez from Spidell. 11 MS. CASAZZA: Mr. Chairman, first, Teresa Casazza. 12 I'm with the California Taxpayers Association. 13 Cal-Tax also appreciates the time and the staff work 14 devoted to the Interested Parties Meetings. We would 15 specifically like to thank you, Mr. Chairman, for your 16 leadership with the Interested Parties Meetings, as well as 17 Selvi Stanislaus. 18 We believe that the input from taxpayers on the front 19 end makes for better solutions. So we appreciate your time, 20 and we thank you very much, Mr. Chairman. 21 CHAIR CHIANG: Thank you, Teresa. 22 MS. RODRIGUEZ: Thank you, Mr. Chair, members. 23 Gina Rodriguez with Spidell Publishing. 24 I second everything from Cal-Tax. The only thing I'd 25 like to add is, again, our thanks to Selvi and her staff. I 12 1 know the tremendous amount of work that these are, and we 2 very much appreciate it. And as tax practitioners, we 3 really appreciate getting the information, and encourage the 4 continuance of the Interested Parties Meetings. 5 CHAIR CHIANG: Thank you, Gina. 6 Thank you. 7 Next item, Microsoft/GM Interested Parties Meeting. 8 MR. JOSEPH: Good afternoon, Mr. Chairman, members of 9 the Board. 10 We have held two Interested Parties Meetings on the GM 11 and Microsoft issues. This is in response to the California 12 Supreme Court decisions dealing with the treasury function 13 issue. 14 The first one we held at the end of January. That 15 meeting was very well attended. We had about 49 people 16 there, and at that meeting we discussed whether or not we 17 needed to try to attempt a fix on the Microsoft/GM issue 18 based upon the court decisions being very factually specific 19 and very hard to apply. 20 So we talked about what we would want that change to 21 do. We want a simpler rule, something that could be easily 22 administered, something that taxpayers can apply, that 23 brought certainty to the area. 24 We talked to tax practitioners and the attendees about 25 what they would want as far as whether they would look at 13 1 this as a regulatory fix or whether they would want to look 2 at it as a statutory fix. At that meeting we heard input 3 that they most were sort of in favor of looking at both, 4 sort of a two-track approach, sort of let's try both, the 5 idea being that they were concerned that, through the 6 legislative process, things could get a little bogged down, 7 it might not happen. A regulatory process might well be a 8 little more controllable, and we might well be able to deal 9 with the issue that way. 10 So what we did is we set up another meeting, which 11 happened at the end of March, to discuss some proposed 12 language. We put out two regulatory proposals and two 13 statutory proposals to be discussed at that meeting. And at 14 that meeting, we discussed those two proposals, and comments 15 indicated there was support for a regulatory process, with 16 commenters favoring the approach taken in the second 17 regulatory proposal, which was the simpler sort of fix. 18 Support for that proposal was again based on the speed 19 in which it could probably get done and the ability of the 20 Board to control it and limit the topic, as opposed to 21 having it in the Legislature where things can be added on 22 and the bill can change quite a bit. 23 The consensus seemed to be that Proposal No. 2 Reg was 24 preferable because it contained a throwout rule as opposed 25 to a net income preclusion rule, which is consistent with 14 1 what a lot of other states do statutorily -- 25 states have 2 that -- and it broadly defined the scope of investments that 3 would be covered, so we wouldn't end up having more 4 discussions down the road about what investments were 5 covered by the reg and what investments weren't, as new 6 investment opportunities arise all the time. It seemed that 7 having them sort of enumerated was probably a bad idea, and 8 it was just more broadly limited to intangible assets. 9 There were some areas where commentators wanted to 10 have additions to that Reg Proposal 2 language. They wanted 11 to ensure that we were not getting into banks and financial 12 institutions, and that they were specifically excluded. 13 That's fine. 14 They wanted us to name broker-dealers in that reg 15 proposal, as opposed to just describing people who deal in 16 intangibles, again, making it clear that broker-dealers 17 would not be affected by the reg. 18 They wanted the regulation to be prospective only, 19 that we would pick a date like 1/1/2007 forward for the reg, 20 as to not have to deal with the impact on ongoing litigation 21 for prior years. 22 And there also was discussion about the scope of a 23 hedging alternative that was in there. The Reg Proposal 2 24 said that hedging would not be part of the treasury 25 function. They wanted -- there was some amendment there to 15 1 say that currency hedging would be part of the treasury 2 function, but hedging raw materials would not be. 3 Similar comments were received in regard to the 4 statutory proposals, which really isn't surprising since 5 they are modeled on the same language. On the two statutory 6 proposals, again, the streamlined approach seemed to be 7 better. It was promulgated, at least at that time, it was 8 under 25137. Staff still is of the opinion that we are 9 better off relating it to the preliminary statute fix to be 10 under 25120, where the definition of sales lies. But the 11 same language could be applied there as well, so that's 12 really not much of a problem. 13 But if a regulatory approach is done, we need to do 14 that under 137, because, again, it would not be consistent 15 with the definition of sales. It would be an alternative 16 under 137 to deal with the problem of distortion in the 17 treasury function. It would be a fix based upon the 18 function being distortive as opposed to it being a change in 19 the definition of sales. 20 At this meeting, staff has come forward to ask the 21 Board to request of the Board how it wishes us to proceed. 22 Do you wish us to go into a regulatory hearing environment 23 on one of these proposals? Or do you wish us to go in a 24 different direction? That's where we are today. 25 CHAIR CHIANG: Very good. Thank you. 16 1 We have five individuals who have signed up to 2 testify. First, Charles Ajalat, followed by Greg Turner, 3 and then Ray Rossi. 4 MR. AJALAT: Thank you, Mr. Chair. 5 Charles Ajalat of Ajalat, Polley, Ayoob & Matarese, 6 representing General Motors. 7 Most of the other speakers will probably be in-state 8 companies, because there is a tension on this problem 9 between in-state companies and out-of-state companies. And, 10 for example, in the last Interested Party Meeting, you have 11 done something good, which is to have a phone in. But there 12 were only eleven lines, and an awful lot of the 13 out-of-staters weren't able to get a line to participate. 14 We believe that if there were to be a net receipts 15 rule, it could only be done by legislation, for two reasons 16 that are very clear. The California Supreme Court has said 17 so, we think, quite clearly. I want to quote that by mixing 18 net receipts for a particular set of transactions -- which 19 means the treasury function -- with gross receipts for all 20 other transactions, it minimizes the contribution of those 21 out-of-state transactions to the taxpayers' income and 22 exaggerates the resulting California tax. 23 So the Supreme Court has been very clear that if you 24 use net receipts as a general matter, you're really having a 25 tax increase on the out-of-state companies. And the 17 1 converse is true. You're having a large windfall, we think, 2 if looked at appropriately, probably in the hundreds of 3 millions of dollars' windfall to in-state treasurers. 4 Now, if the Legislature agrees to do that, fine, but 5 what Microsoft also said, in addition to saying you can't do 6 either net receipts or gross receipts in most cases, but you 7 have to include a certain amount of gross receipts, they 8 said, "...in the absence of legislative action." 9 UDITPA can't be amended by anyone else. Regulation 10 interprets existing law. And whether you do it under 25137 11 or any other section, you can't take all gross receipts, 12 which is what the statute says now, and say under 25137 it 13 means all net receipts. 14 This Board, nine years ago, decided exactly that. 15 They decided, just as the California Supreme Court did, that 16 you have to do each case on a case-by-case basis under 17 Section 25137. 18 They had a proposal, the Board had a proposal in 1998 19 very similar to what was just presented to you, and they 20 said as follows: 21 "CHAIRWOMAN CONNELL: The proposal was 22 directly proffered in the plain language of 23 the Code. 24 "BOARD MEMBER MANDEL: We should not approve 25 the regulation. 18 1 "BOARD MEMBER DEZEMBER: What is your response 2 to the assertion that this violates the 3 statute or would require legislative change? 4 "MR. BEN MILLER: It very clearly is 5 inconsistent with the definition of gross 6 receipts in the statute. The more appropriate 7 way to deal with it is a revision of the 8 statute." 9 So we think that if the Board wants to pursue a net 10 receipts formula -- and I think even the staff recognizes it 11 would be a much cleaner-cut solution -- it should go to the 12 Legislature to define net receipts, let everybody's interest 13 of the revenue implications be seen. And there you have it. 14 It is also very bad policy for the Board to interfere 15 with pending litigation. I know both the Legislature and 16 the Governor have taken that position. With regard to the 17 pending litigation is what I mean. 18 The General Motors case has been remanded to the trial 19 court. Hopefully, sometime in the very near future, 20 probably within the next six months, we will know how much 21 gross receipts need to be included. That will allow this 22 Board to draft a regulation that will solve the problem for 23 everyone, without losing revenue to the state. 24 Not only do we believe that there would be a large 25 legislative exemption for in-staters of potentially hundreds 19 1 of millions of dollars, but it raises a number of legal 2 issues: gifts to public funds, discrimination under the 3 commerce clause. 4 MS. BERWICK: Time. 5 MR. AJALAT: So we would ask you to defer this matter. 6 There is no particular rush. Or, if you were going to 7 pursue it, to pursue it through the legislative process, 8 which the highest court has said must be done. 9 CHAIR CHIANG: Thank you very kindly. 10 Do you have a response? 11 MR. JOSEPH: Absolutely. 12 First, a small response on the phone thing. This is a 13 no good deed goes unpunished. 14 We had had some requests by people to be able to come 15 in on the phone a few days before the hearing. We did try 16 to accommodate that. But, unfortunately, at this point we 17 are not able to accommodate as many people as want to call 18 in. 19 Of course, we would take written comments, and we did 20 receive written comments from the out-of-state companies or 21 representative, basically putting forward very similar 22 opposition to Mr. Ajalat's. Mr. Ajalat's firm was indeed 23 represented at the meeting as well. 24 So I think that we can do better on that, and we 25 certainly will try. But it was one of those learning 20 1 experiences that some of our people are working on. 2 In regards to the comments themselves, certainly other 3 states have done this regulatorily. And I believe, the last 4 time I looked, it was seven states had already done this 5 regulatorily. The difference being that under 25137, you 6 can, in fact, use formulas that are inconsistent with the 7 regular apportionment formula. That's the function of the 8 statute. 9 If you have a function or an activity that does not 10 clearly reflect the taxpayer's activities in the state, for 11 instance, there is a clause for occasional sales which can 12 be very large an income amount and receipt amount, but they 13 are not included in the sales factor under 25137. That's 14 inconsistent with the rule under 25120. 15 Certainly, this would also be another one of those 16 opportunities where we would be looking at trying to show 17 that this activity, the treasury function, for the vast 18 majority of taxpayers, leads to distortion. Now, there may 19 well be taxpayers that in the unique circumstances of their 20 own facts that treasury activity might well be very 21 important to them and not ancillary and probably outside the 22 scope of what we might interpret to be a treasury function. 23 If they feel like that reg would apply to them and if the 24 result were to result in unfair reflection of their 25 activities in the state, they would still have the 21 1 opportunity to do exactly what we have done in the 2 litigation, which is come forward and try to change the 3 formula. 4 The problem, of course, with what the Board those 5 years ago did was, of course, it left us in a 6 facts-and-circumstances environment, which is fine when you 7 have an occasional case. But this particular issue has 8 given rise to many, many appeals and many litigation cases, 9 and the cases fall upon a continuum that suggests that most 10 of these cases would be amenable to being done through this 11 regulatory process as opposed to having to go to 12 legislation. 13 MR. MILLER: Mr. Chair, Benjamin F. Miller of the 14 Legal Division. If I could add a couple of comments in 15 respect to that. 16 I think the quotation from the Microsoft case about a 17 legislative solution was really done in a context of the 18 courts were decrying the fact that there was not a 19 legislative solution. Because of that, they had to deal 20 with this on a facts-and-circumstances basis. 21 I have interpreted those comments to invite either a 22 legislative or a regulatory solution to the problem, to take 23 them out of having to deal with them on a case-by-case 24 basis, a factual basis. 25 So I think, in fact, the court endorsed that solution, 22 1 and legislation was mentioned, but also, as Carl pointed 2 out, in a number of states it was regulatory, that would be 3 appropriate. 4 With respect to my comments made at the Board meeting 5 many years ago when we attempted to regulate this area, I 6 think Carl addressed those very specifically in terms of 7 Section 25137 specifically authorizes a variation from the 8 standard code language. That is the purpose of it. That's 9 why it's there. It clearly is permissible. It was 10 contemplated by the Legislature, by the directors of UDITPA 11 when it was formed. So it's perfectly appropriate to 12 regulate under that situation. 13 With respect to pending litigation, one of the 14 suggestions that Carl mentioned came up at the Interested 15 Parties Meetings that made this regulation prospective. 16 That will not disturb any pending litigation, but it will 17 provide certainty going forward, and will allow the problem 18 to be put to rest. 19 Yes, we have a lot of cases we have to deal with. It 20 would be wonderful to get some type of required solution 21 with respect to that. But given the fact we are in court, 22 that argument does not seem to be the appropriate way to go. 23 CHAIR CHIANG: Thank you very kindly. 24 Greg. 25 MR. TURNER: Thank you, Mr. Chair and members. 23 1 Greg Turner of Nielsen Merksamer in Sacramento on 2 behalf of Business for Economic Growth in California. And 3 we're just here to support the staff in asking the Board to 4 at least begin the regulatory process. There isn't a demand 5 on the Board to decide now on whether regulation is 6 appropriate or what the specific language is. There are 7 still some tweaks even to the draft numbers that we would be 8 in favor of that we think would need to be addressed in a 9 regulatory process. 10 So, at least to initiate that process is what we're 11 here to support. In terms of some of the issues that were 12 raised, we certainly would support a prospective fix on the 13 regulations so as not to affect the outstanding interests. 14 I think in terms of, at least from our perspective, 15 one of the perils you face with the potential for a 16 legislative approach -- which we are not opposed to, we 17 believe there is certain support of this new track -- was 18 the approach that we take the 25120 approach on amending the 19 statute. I think that's potentially a two-thirds vote, and 20 that raises serious questions of whether or not that bill 21 ultimately would pass at all. In which case, we are sort of 22 stuck in our current environment which a lot of taxpayers 23 and the FTB are being faced with: potential audits and 24 trying to establish whether or not there is distortion. 25 Ultimately, essentially what we are asking the 24 1 Franchise Tax Board to do is to adopt the reg that says, you 2 know, although the section says gross is essentially or 3 apparently distortive, but still allow those companies that 4 report a gross their opportunity for a hearing. 5 So we support its adoption. That will certainly 6 alleviate a lot of the administrative burden on both 7 California companies and the Franchise Tax Board. 8 That's all of my comments. I think Carl did a very 9 good job of, from our perspective, answering questions 10 raised by some folks as to whether or not wider regulation 11 is not permissible and not really supported by the law under 12 25371. 13 Thanks. 14 CHAIR CHIANG: Thanks, Greg. 15 Ray Rossi. 16 And Brian Toman will be next in the queue. 17 MR. ROSSI: Ray Rossi, Director of External Tax 18 Affairs for Intel Corporation. 19 I'm here also as part of Greg's group that he 20 mentioned but as a company as well, to urge you to enable 21 staff to proceed with a regulatory solution. I believe it 22 does offer a good way for all parties concerned, including 23 the FTB, out of this administrative mire that's been created 24 out of the court case. Thank you. 25 CHAIR CHIANG: Thanks, Ray. 25 1 Brian Toman, followed by Robert Steiger. 2 MR. TOMAN: Mr. Chair, members, I'm Brian Toman, 3 ReedSmith, LLP, in San Francisco. I'm here to testify on my 4 own behalf, and I have two comments. 5 The first comment is the fix for the current situation 6 should be prospective only. The additions to the wording in 7 the regulations on the amendment staff has contain new 8 information, new requirements that is not currently 9 contained in the existing regulations and statutes. And as 10 a matter of law, whenever there is a newly enacted statute 11 or newly enacted regulation, it is presumed to be 12 prospective only. 13 Furthermore, the Microsoft case and the General Motors 14 case were both cases of first impression. And under the 15 concepts of fair notice and reasonable reliance, that would 16 also cause -- be good reason for the regulation or the 17 legislation to be prospective only. 18 As to effective date, whether it be by regulation or 19 legislation, be effective in the first taxable year or be 20 effective as of the filing date of the General Motors and 21 Microsoft decisions, we suggest it would be simpler in terms 22 of tax administration and simpler in terms of filing returns 23 that the regulation or statute change be made operative, 24 first operative by year of the regulation. 25 Secondly, we are of the opinion, I'm of the opinion 26 1 that the best way to go in terms of fixing the situation is 2 through legislation. I have given Carl Joseph my reasons 3 why I think both regulations are open to legal challenge. 4 And I just think it would be more bulletproof for tax 5 administration purposes if the fix was by legislation. 6 Thank you. 7 CHAIR CHIANG: Thank, you Brian. 8 Mr. Steiger. 9 MR. STEIGER: Mr. Chairman and members, my name is 10 Robert Steiger, tax counsel with Chevron Corporation. 11 First off, I want to thank your staff, Ben, Carl, and 12 others for organizing this effort and bringing this 13 initiative before the Board. 14 Chevron strongly supports the staff's efforts to 15 pursue a regulatory solution to remedy the uncertainty and 16 administrative burden associated with proving distortion on 17 a year-after-year basis. This would otherwise result in a 18 significant inefficient use of resources of having to prove 19 distortion on a year-after-year basis. 20 Chevron firmly believes that commencing with this 21 regulatory process is absolutely the right approach, and we 22 urge the Board to initiate this process as soon as possible. 23 Thank you very much. 24 CHAIR CHIANG: Thank you, Robert. 25 Are there any questions or comments? 27 1 MEMBER GENEST: I have a couple of questions. 2 I'm a little bit confused about the revenue. 3 Implications. One, I think it was Mr. Turner who suggested 4 that the bill would require a two-thirds vote. That suggests 5 to me that it would raise revenue. And I believe Mr. Ajalat 6 suggested that it would result in a loss of revenue. 7 Do you have a revenue estimate? 8 MR. JOSEPH: Not at this point. I don't think we have 9 done one for a reg. Have we done one for a statute? 10 MR. MILLER: There were estimates done for the statute 11 that was involved last year. I haven't discussed this 12 matter with our revenue people. And it's a Leg Council 13 call, I guess, as to how the vote comes out on that. But I 14 think, in general, our analysis would be that, in most 15 respects, Microsoft and General Motors are staying within 16 what the department's current practice has been, at least 17 with respect to those cases. 18 That's probably the position we will continue to 19 defend in litigation, because there are no changes 20 occasioned by this regulation or by potential legislation 21 here. So there is probably not in terms of a tax change, so 22 there would be none involved. 23 There is probably going to be change with respect to 24 taxpayer behavior. It is very clear to us that out-of-state 25 taxpayers are now filing returns on a gross basis, where 28 1 previously they had not. So there is going to be a revenue 2 inflow that's going to occur from that, but it's not going 3 to be as a result of a change in the law. It's going to be 4 a matter of applying the Microsoft decision to their facts 5 and circumstances, Microsoft and General Motors decisions. 6 I'm not a revenue estimator. I can speak sort of as 7 to what we think the legal ramifications are, but I think 8 that that remains an open question as to whether it would be 9 simple majority, just a simple-majority bill. 10 MEMBER GENEST: The testimony by Chevron suggests that 11 the burden here is the difficulty with the current situation 12 is having to repeatedly come back and justify that "it" is a 13 distortion. I'm not sure what "it" is. I guess, the 14 existing statute. 15 MR. JOSEPH: Yes. Where we are now is we have an 16 opinion of the Supreme Court which basically said -- well, 17 what they did is they looked at what the core business of 18 the taxpayer -- Microsoft -- was, and then they looked at 19 the activity of the treasury department, which essentially 20 invested their short-term working capital. And then they 21 looked at the effect of that treasury function on income and 22 the effect of that treasury function on gross receipts 23 includable in the sales factor. 24 And when they went through and analyzed that, looking 25 at prior opinions by the Board of Equalization and what 29 1 other states had done and that sort of thing, they held 2 that, under the facts of that case, the treasury function 3 was distortive: it produced very little income, it's not 4 their main line of business, and it moved a lot of income to 5 the location where the treasury management function took 6 place. 7 So, if you're a company like Chevron, for instance, 8 you would have to, on a yearly basis, determine how much 9 income you got through your treasury department, how much of 10 your total business income that represented, how much 11 receipts were generated from that activity as compared to 12 the receipts from the oil business or whatever they do, and 13 then you would do a determination as to whether you look 14 sufficiently like Microsoft that you feel comfort that you 15 can file following the Microsoft case or whether or not you 16 feel that your situation is such that you would either have 17 to, one, petition for relief from us or take a position on 18 your return that it's distortive even though you're not 19 exactly the same as Microsoft. And this would have to be 20 done every year, because every year stands on its own. 21 MR. MILLER: And it gets further complicated by the 22 General Motors decision, while it followed five minutes or 23 hours of the Microsoft position, the same day. But the way 24 the court ordered it, in Microsoft they have a footnote 25 where they listed a whole bunch of different types of 30 1 securities which were involved in the treasury. One of 2 those was repos, repurchase agreements. 3 When it went to the General Motors case where 4 90 percent of the activity involved repurchase agreements, 5 they looked at those themselves, and they made the 6 statement, well, with respect to a loan, you would never 7 include the return of capital, you would only return the net 8 interest income or net gain on that. 9 So, with respect to the repos, they actually analyzed 10 those and said those are loans. And so with respect to 11 those, all you would get is the interest income or net 12 gains, basically the position that the department had been 13 taking. 14 They didn't analyze any other type of security. And 15 so the problem is that, other than making the comment that 16 with respect to loans you only pick up the interest income, 17 our problem is we have to go through and analyze each of the 18 various types of securities and determine whether it is a 19 loan or not, more like a loan or more like something else 20 that these proceeds go into. 21 Because Microsoft did not address that issue at all. 22 And, in fact, you will have an inconsistency between General 23 Motors and Microsoft. It really leaves the question open, 24 to have to analyze each of the various type of investment 25 certificate that comes along. 31 1 Right now we're in litigation with another taxpayer 2 involving the question of whether a certificate of deposit 3 is a part of the treasury function, whether the return of 4 that certificate of deposit constitutes a return of 5 principal which goes into the receipts factor, or whether 6 that constitutes a loan. We don't know the answer to that 7 question. We probably won't know until we get to the 8 appellate court. 9 That's the idea behind the regulation and legislation, 10 so we don't have to address these things instrument by 11 instrument. If we have to go through and litigate each 12 particular instrument to find out, well, is this one a loan, 13 is this one not a loan; do you put it in the returned 14 principal on this one or do you put it just in the income, 15 that's going to be a very burdensome situation because, in 16 the Microsoft opinion, there were probably ten different 17 instruments that were named, though they didn't analyze any 18 of them. And the financial world is evolving. There is 19 always new instruments coming up. 20 And this is one of the comments made in the Interested 21 Parties process. It was, "We don't want to have to go 22 through and keep records year by year as to which type of 23 investment we're making, and wind up having arguments about 24 how to characterize those particular investments." 25 That's the reason why the simple solution, just a 32 1 broad description of intangible assets, was preferred, so we 2 avoid those kinds of questions where year by year we would 3 have a shift. 4 The Microsoft case also suggested, depending upon the 5 particular income of a corporation for a particular year, 6 treasury activity might represent a very large portion of 7 its income for that year of its net income as compared to 8 other activities, would you get a different result in that 9 year than you would in other years. 10 Again, the idea behind the regulatory or legislative 11 solution is to take out that year-by-year variation so we 12 have a consistent flow, a consistent pattern, consistent 13 with the treatment of these cases. 14 MEMBER GENEST: But you said people, under the 15 regulation, could apply for the opposite interpretation on 16 the basis that the new regulation was distortive. 17 MR. MILLER: That's always possible, but it has 18 shifted the burden to prove. It is sort of marked out with 19 different grounds as to what the standard is. Anyone who 20 wants to vary from that has the opportunity to vary from 21 that, but, again, the burden is going to be on them to show 22 why that's necessary. So you've established a different 23 marking and beginning point. 24 MEMBER GENEST: One more question, and that is I 25 didn't understand the answer about whether this could be 33 1 done with legislation. The answer that you gave that other 2 states have done it through regulation isn't very persuasive 3 to me. 4 MR. MILLER: Okay. 5 MEMBER GENEST: Because they have their own 6 constitution and we have ours. 7 MR. MILLER: Certainly. 8 MEMBER GENEST: But the answer that you gave also left 9 me a little uncertain, because essentially you're saying 10 that the statute envisions that a regulation could come 11 along and interpret the statute to be the opposite of what 12 the statute says. 13 Is that what you were saying? 14 MR. MILLER: Not quite. It's close, but not quite. 15 There are two different statutes involved. There is 16 one statute which defines what a receipt is. There is 17 another statute in the section which says in situations 18 where there isn't a fair reflection, you can adopt something 19 different from the standard net. So there is a relief 20 section with respect to it. 21 The proposal for the regulations to do it under that 22 relief section say per se in the area of treasury receipts, 23 that general rule, the definition statute has to be 24 overridden just with respect to that one particular 25 activity. 34 1 A legislative solution would address that section, 2 definition of receipts. It would be less subject to attack 3 than would a regulatory solution. We think the regulatory 4 solution would be effective, would be defensible; however, 5 there probably will be somebody who will attack it, saying 6 that we haven't met the standard, burden of proof to show 7 that the treasury activities per se is distortive. 8 So the best likely way is simply to do it by statute, 9 by redefining what receipts are. 10 MEMBER GENEST: And it's unlikely that should that 11 attack come, it would come from somebody arguing that they 12 paid too little tax. 13 MR. MILLER: That's very unlikely. I haven't seen 14 that case filed yet. 15 MEMBER GENEST: Mr. Chairman, I guess I'm a little bit 16 uncomfortable with doing this through regulation, because we 17 don't know what the revenue implications are and if there 18 is a revenue loss or gain. That is a policy decision, I 19 think. 20 I'm rather inclined to, if we go in, if we do 21 anything -- it sounds like something needs to be done, 22 because there is confusion -- I'd be more supportive of 23 proposed legislation, I think, than I would with regulation, 24 at least from what I've heard so far. 25 CHAIR CHIANG: Member Yee, any comment? 35 1 MEMBER YEE: I do, Mr. Chairman. 2 I actually think the opposite. I think the Board does 3 have authority to pursue regulation pursuant to 25137. And 4 I don't think the regulatory process would preclude further 5 input from all parties. And, in fact, I would like to see a 6 process initiated today. And I think the regulatory process 7 offers flexibility that the legislative process may not 8 offer as it proceeds. 9 So I am prepared to make a motion to that effect, to 10 ask the staff to initiate the formal rulemaking process. 11 And I do think that for the purpose of achieving 12 consistency and some certainty going forward, something has 13 to be done today. 14 CHAIR CHIANG: Is there a motion? 15 MEMBER YEE: I'll make that motion. 16 CHAIR CHIANG: There is a motion by Yee. Is there a 17 second? 18 I'll second it. 19 Take roll on the vote. 20 MS. BERWICK: Member Yee? 21 MEMBER YEE: Aye. 22 MS. BERWICK: Member Genest? 23 MEMBER GENEST: No. 24 MS. BERWICK: Chair Chung? 25 CHAIR CHIANG: Aye. 36 1 Motion passes. 2 MR. MILLER: We will add, you know, we understand that 3 there is a likelihood there may be a legislative solution 4 proposed as well. We will keep you advised of that. 5 And referring to the initial, the first meeting, was 6 "Let's go forward and do a track situation." I think that's 7 fine. When that bill is introduced, obviously we can throw 8 it back to the Board and take a position with respect to 9 that. 10 CHAIR CHIANG: I'm certainly interested in that 11 approach. 12 Do we have a sense of what's taken place down the 13 street? 14 MR. MILLER: Only by rumor. You know how those things 15 are. 16 CHAIR CHIANG: Very good. 17 Next item, please. 18 MS. HARKER: Good afternoon, members of the Board. 19 My name is Kathy Harker with the Franchise Tax Board. 20 I'm here today to discuss requests for an Interested Parties 21 Meeting for the airline transportation regulations. About a 22 month ago at the State Board of Equalization hearing, Alaska 23 Airlines raised concerns of and challenged our approach to 24 our statutory and regulatory -- challenged our statutory and 25 regulatory interpretation of our airline transportation 37 1 regulations. 2 At the end of that hearing, the Board expressed 3 interest in having these areas of law reviewed. To that 4 end, we'd like to ask your request to have an Interested 5 Parties Meeting on this issue. Thank you. 6 CHAIR CHIANG: Very good. Thank you, Kathy. 7 Any questions or comments? 8 Is there a motion? 9 MEMBER YEE: I'll move the separate conditions, which 10 is consistent with both the Board of Equalization and 11 Franchise Tax Board procedure, and I'm going to move the 12 separate conditions which is consistent with what the Board 13 of Equalization had requested. 14 CHAIR CHIANG: We have a motion by Yee, second by 15 Genest. 16 Without objection, motion passes. 17 Thank you, Kathy. 18 Next item, please. 19 MR. JOSEPH: Good afternoon. My name is Carl Joseph. 20 I'm legal counsel for the Multistate Tax Bureau of the 21 Franchise Tax Board. The next item here is the mutual fund 22 regulation. 23 I think I would like to at least start by giving you a 24 little background about this process. This process started 25 in the fall of 2005 with an Interested Parties Meeting, 38 1 involving a lot of industry participation on whether 2 California should go ahead and write a special industry reg 3 for the mutual fund industry. This process was one of the 4 first ones I was involved in where we started the process 5 without having any language, and we basically asked the 6 taxpayer community to come in and tell us what they liked 7 about what other states had done and what they thought we 8 should do. So that was a little different, but it turned 9 out to be a very interesting way of doing it because there 10 are quite a few states that have already done a special 11 industry approach for this particular industry. 12 So we looked at what other states had done. We looked 13 at what they had done regulatorily in this area, and talked 14 about what was good and bad, then we worked on some 15 language. And in the fall of 2006 -- yes, 2006 -- the Board 16 approved us to go into a formal regulatory environment on 17 the language that we had worked with industry on. 18 We did that, and toward the end of the year we had a 19 regulation hearing on this matter. It was very well 20 attended. We had a lot of interesting input from in-state 21 and out-of-state companies. A lot of technical amendments 22 were requested in comments. There were, oh, about twenty 23 comments in writing received, of various lengths, throughout 24 the formal regulatory process. 25 And what we ended up with was, after we did the 15-day 39 1 changes to make the reg a little bit tighter, we ended up 2 with a regulation that essentially is based on shareholder 3 location, which is consistent with at least twelve other 4 states. There might well be a few more that have done that, 5 but I'm not exactly sure where they are in the process. 6 What the regulation essentially does is it removes 7 mutual fund service providers from the regular rules of 8 Section 25136, the sales factor, which is the section that 9 talks about how you assign sales of services. That rule is 10 an income producing activity rule whereby the rule that we 11 have under this regulation is based upon the location of the 12 shareholders who hold the shares of the funds that these 13 companies are managing. 14 This is important because we've had in the past mutual 15 fund service providers request and receive alternative 16 apportionment schemes under 25137 on the basis that the 17 normal rule of income producing activity distorts their 18 activities in the state by essentially just mirroring their 19 payroll and property, rather than really providing any sort 20 of a sense as to where the market is for this fund. 21 So what we did is we did go along and do a shareholder 22 location approach. In the process there were two areas that 23 I'm sure you will hear of today which have brought up 24 complaints or, at least, interest. One is we included a 25 throwback rule. What a throwback rule does is it says if 40 1 you have receipts that are assigned to a location where you 2 are not going to pay tax, you're not taxable there. Whether 3 or not the state actually imposes the tax doesn't matter, 4 it's whether or not you have the ability to pay tax there. 5 So, in other words, Nevada would count. If you have 6 nexus in Nevada, you wouldn't have to throw back. But we 7 included that because any time under these special industry 8 regs, which was most of the time, when we don't have a rule 9 that's based on where employees are performing activities -- 10 employees should be given access -- to a rule that's based 11 upon where your customers are where you may not have nexus, 12 we want to include a throwback rule to reach a result where 13 a hundred percent of the taxpayer's income is being assigned 14 to locations where it is subject to tax. 15 It's included under the normal rules for tangible 16 property which, again, is a customer location rule, and we 17 have also done at least three times under special industry 18 regs where we have gone from the 25136 type rule to a 19 customer location rule. It's a policy thing, i.e., 20 basically just we're trying to make sure that all income 21 gets assigned somewhere where it can be taxed. 22 Now, in talking with industry, in order to make that 23 work with the particular way that their companies tend to do 24 business, they requested that we do so utilizing a Finnigan 25 methodology for whether or not you're taxable in another 41 1 state. What that means is it basically treats the unitary 2 group, the filers, the group as being one taxpayer for 3 purposes of determining whether or not you're taxable in a 4 state. 5 So if you have three taxpaying entities or three 6 members in your group, and one of them had nexus in a state, 7 you would not have throwback for any of the receipts for any 8 of those three entities. 9 The important thing why they needed that, of course, 10 is certain entities within the mutual fund service provider 11 unitary groups tend to have nexus in quite a few places, and 12 certain entities that make a fair amount of receipts, 13 namely, the investment manager companies, tend to have nexus 14 in very few locations. 15 So if you don't include a rule like that, you end up 16 having all of these receipts that we wanted to assign to 17 where the customers are all end up getting thrown back 18 again, and we have the same distortion problem we had to 19 begin with. So they requested, if we're going to do 20 throwback, do Finnigan throwback, which, of course, we 21 agreed with them and said that's fine. 22 Now, what the implication is there is Finnigan also 23 applies to out-of-state mutual fund service providers. 24 That's the other thing that has been raised. And what that 25 means for the out-of-state companies is if they're in a 42 1 state that assigned under shareholder location or even if 2 they're not, you would determine their California 3 shareholder apportionment for every fund, and as long as 4 they had a taxpaying entity in the state, all of the 5 receipts, all of the receipts assigned under the shareholder 6 location methodology would be included in the California 7 numerator. 8 This is really important, too, because what happens 9 here is the majority of states that have strong mutual fund 10 presence in them already have a shareholder location rule. 11 Therefore, when they determine their receipts for their home 12 state, they perform this ratio calculation. The ratio 13 calculation then is, in their home state, how many customers 14 in their home state versus total customers everywhere. 15 If we don't do a Finnigan methodology for them, those 16 receipts that are in their home state formula, assignable 17 not to the home state but to California, based on where the 18 customers are for California, we wouldn't be able to pick up 19 that amount, and those receipts would essentially end up not 20 being included in any sales factor numerator, and they would 21 again lead to there being "nowhere income." The total of 22 the numerators in the states would not match the total 23 denominator. 24 So essentially it's a consistency rule for the 25 out-of-state taxpayers to make sure that their home state 43 1 rules are being followed in California. There are some 2 states that do not have shareholder apportionment rules. 3 The major one would be Pennsylvania. They don't -- from my 4 conversation with that state, they don't tax these companies 5 at all, they have a system whereby they will not be subject 6 to tax. 7 And we did get one commenter from Minnesota. 8 Unfortunately, in that state, they have court opinion that, 9 under their law -- which is neither income producing 10 activity nor shareholder methodology, it's sort of a third 11 way -- they would end up getting double taxed due to the 12 inconsistency with everyone else. 13 The good news is the industry folks have opined to me 14 that if we did shareholder apportionment, 80 percent of all 15 receipts from funds would essentially be assigned under a 16 shareholder location approach. So the vast majority would 17 not be subject to any risk of having them taxed under two 18 schemes, because this is the consistent scheme that states 19 have been applying over time. 20 So that's where we are in the process. I included all 21 the comments so you could see the back and forth on that. 22 There have been issues about what the burden of proof is 23 similar to what you heard in the last reg. We responded to 24 that as well. 25 And we have also had concern raised about revenue 44 1 impact. One of our commentors brought forth an alternative 2 revenue estimate that started out over $300 million, then it 3 was revised, their estimate was revised to a little over a 4 hundred million dollars. We responded to that at the 5 hearing. We responded to that again in the booklet you have 6 today. Some of the other fund companies who didn't agree 7 with that, with that revenue estimate that was done by the 8 third party, went out and hired their own third party who 9 looked at the same area and came back with their conclusion 10 that it was very consistent with our own. 11 So it's been an issue, but I think that we have 12 answered it as best we could. Certainly, we have a little 13 bit better data than what we could get from public means due 14 to our having access to a model that contained the actual 15 taxpayer information. But we believe the revenue estimate 16 is fine. Phil Spilberg is here today if anyone wishes to 17 talk about the revenue estimate with him. 18 And at this point, we'd like to ask the Board to 19 approve this regulation going forward to the Office of 20 Administrative Law to be finalized. It's been a very good 21 process. I think we have come up with a rule that works 22 well and is consistent in its application -- the shareholder 23 ratio method -- to what other states have done. And we'd 24 like to go forward. 25 MR. MILLER: I might add in conjunction with that, as 45 1 a result of the formal hearing comments received, there were 2 changes that were made in that proposed language. They were 3 not substantive changes, they were all 15-day changes. 4 Those have been noticed, and the comment period has gone 5 past. So the regulatory process has worked; the Interested 6 Parties process has worked. We've put together regulation 7 in conjunction with the industry. The administrative 8 process, we have got comments, we've responded favorably to 9 a number of those comments. We believe the regulation is 10 ready to go forward now. 11 CHAIR CHIANG: Very good. Thank you, gentlemen. 12 We have fourteen individuals who have signed up to 13 testify, and the first three are John McBeth, Jim brown, and 14 Jeff Vesely. 15 You have three minutes. 16 MR. McBETH: Good afternoon, Mr. Chairman, members of 17 the Board. My name is John McBeth, senior tax counsel for 18 Franklin Templeton Investments. 19 We again want to thank the Board and the legal staff 20 for giving us and the rest of the mutual fund industry the 21 opportunity to submit comments during each step of this long 22 regulatory process. 23 When the legal staff began this process with a 24 symposium for participants in the industry, we submitted 25 testimony about the nature of our mutual fund business that 46 1 explained why this regulation is necessary. 2 We have also submitted two petitions for relief from 3 the onerous apportionment results that mutual fund companies 4 like ours face when we are required to use cost of 5 performance for sales factor apportionment. 6 As we have stated many times since, cost of 7 performance has three functions or three factors: one, it 8 causes the sales factor in the apportionment calculation to 9 duplicate property and payroll; two, it eliminates any 10 impact from the market for services being performed; and, 11 three, it results in proven distortion that you and the 12 legal staff have confirmed in previous petitions. It is the 13 reason why fourteen other large mutual fund market states 14 have adopted shareholder residency apportionment for this 15 industry. 16 Moving from cost of performance to shareholder 17 residency apportionment for sales is the only way that 18 California can eliminate the distortion that we have 19 justified as being present in the California marketplace. 20 We have also provided commentary on the unique nature 21 of the mutual fund business. Segments of this business are 22 segregated into separate companies to better manage the 23 regulatory oversight functions of federal and state 24 governmental agencies. Mutual fund groups operate as highly 25 integrated dependent organizations that include most, if not 47 1 all, of these functional companies. 2 While shareholder servicing and distribution services 3 are spread amongst most larger mutual fund market and 4 population center states, their highly profitable investment 5 management services are almost always concentrated in each 6 mutual fund group's home state. 7 The result under cost of performance is that 8 California based companies have highly inflated 9 apportionment factors and pay franchise taxes substantially 10 in excess of the scope of their business activities within 11 California, while out-of-state companies pay little or no 12 franchise tax on their highly profitable investment 13 management operations. 14 This distortion creates a major competitive imbalance 15 that strongly encourages out-of-state investment managers to 16 stay out of California and in-state investment managers to 17 move out of California. 18 It is this distortion and competitive imbalance that 19 out-of-state companies would now ask that you ignore by 20 defeating or delaying this regulation. And it is this 21 distortion that the California based mutual fund groups ask 22 that you remember as the underlying support and basis for 23 the adoption of this regulation. 24 Thank you for your consideration. 25 CHAIR CHIANG: Thank you, John. 48 1 Jim Brown. 2 MR. BROWN: Good afternoon. My name is Jim Brown, 3 principal financial officer for Capital Group Companies. 4 The Capital Group is a 75-year-old privately held 5 company headquartered in Los Angeles. Our only business is 6 to provide mutual fund investment management services to 7 American Funds Group mutual funds as well as institutional 8 investors. 9 I want to briefly expand on why this regulation helps 10 level the playing field and removes competitive 11 disadvantages to both mutual fund service providers 12 headquartered in California as well as the State of 13 California. Bear with me for a moment as I mention some of 14 your competitors: New York, Massachusetts, Missouri, 15 New Jersey, Connecticut, Rhode Island, Kentucky, Maryland, 16 Utah, Texas, Kansas, Maine, Georgia, and Wisconsin. 17 What do these fourteen states have in common? They 18 have all adopted a market based approach as opposed to cost 19 of performance for purposes of determining and allocating 20 gross receipts factor for service providers carrying on 21 business in their respective states. 22 Taken together, these fourteen states are home to 23 companies managing approximately 55 percent of the country's 24 mutual fund assets. California is currently home to a 25 further 23 percent of all mutual fund assets. With 49 1 California's adoption of this regulation, service providers 2 representing approximately 80 percent of all mutual fund 3 assets would be taxed under a common method. 4 Absence of uniformity among states creates a 5 competitive imbalance between those companies who must 6 compute their apportionment percentages using cost of 7 performance methods, such as in California, versus service 8 providers that have successfully petitioned their home 9 states for relief and now compute their apportionment 10 percentages using a market based approach. 11 Without consistency between states, California based 12 service providers are faced with a very real possibility of 13 double taxation on the same gross receipts. 14 As you've just heard, the FTB has in fact acknowledged 15 the presence of distortion in the calculation, and 16 recognized the potential for the competitive imbalance. 17 Accordingly, it has granted three Section 25137 petitions in 18 which the sales factor has been modified to use a market 19 based approach. 20 The Capital Group is, in fact, a beneficiary of one of 21 these petitions. We commend the FTB for this action, but 22 would suggest that the adoption of this regulation is a much 23 more efficient and egalitarian remedy to the problem, as it 24 removes the need for both taxpayer, staff, and Board to deal 25 with that position, removes the state of California, the 50 1 only state with apportionment based on cost of performance, 2 puts California in the same position as the majority of 3 competitors, and provides clarity and consistency, and 4 levels the playing field for all mutual fund service 5 providers irrespective of where headquartered. 6 Thank you for your consideration. 7 CHAIR CHIANG: Thank you. 8 Jeff, followed by Robert Walden. 9 MR. VESELY: Good afternoon, Mr. Chairman, members of 10 the Board. My name is Jeffrey Vesely. I'm with Pillsbury, 11 Winthrop, Shaw, Pittman. I'm speaking on behalf of Franklin 12 Resources in support of the proposed regulation. 13 My comments today will supplement our prior written 14 submissions that will focus on three principal areas. 15 First, the need for the proposed regulation; second, 16 the appropriateness of the Finnigan throwback position; and, 17 third, the evidentiary standard to be used for the adoption 18 of the proposed reg. 19 First, the FTB staff has established the need for the 20 proposed regulation. The regulation is necessary to address 21 the unique features of the mutual fund industry and the 22 resulting distortion of the California standard 23 apportionment program when applied to that industry. 24 In the past several years, this Board has recognized 25 the existence of such distortion and have granted a series 51 1 of Section 25137 petitions filed by mutual fund service 2 providers. Rather than continuing this ad hoc process, the 3 proposed regulation would provide consistency and the needed 4 guidance for both FTB staff and the industry in this area. 5 The proposed regulation would also promote uniformity 6 which is mandated under Section 25138. Currently, fourteen 7 states have adopted special apportionment rules similar to 8 the proposed regulation. The assets under management of the 9 mutual fund service providers in these states comprise 10 approximately 55 percent of the total assets for this 11 industry. If California follows this clear trend, that 12 percentage would go up to 80 percent. 13 Firstly, adoption of the proposed regulation would 14 help minimize the double taxation now faced by California 15 based companies by states that already have the shareholder 16 residency rule. 17 Second, if the proposed regulation is to include a 18 throwback provision, the Finnigan approach, not Joyce, is 19 appropriate. Under Finnigan, which has never been overruled 20 by a court or the Board of Equalization, the unitary 21 business tax liability is not affected by whether it has 22 multiple corporations or a single corporation. As such, 23 Finnigan, not Joyce, addresses the new feature of the mutual 24 fund industry, which is highly integrated, often operates 25 through multiple corporations. 52 1 Joyce is not the law in California for purposes of 2 Section 25137, as some have contended. This Board is not 3 required to use a Joyce approach in adopting a regulation 4 under 25137, which allows the use of any other method, if 5 reasonable, to remedy distortion. 6 A Finnigan approach is reasonable in the context of 7 the mutual fund industry and would further apply for 8 purposes of the proposed regulation. 9 Finally, certain proponents have argued that a clear 10 and convincing evidence standard should be applied, and rely 11 on Microsoft for their proposition. Such reliance is 12 misplaced. Microsoft did not establish a clear and 13 convincing evidence standard for the adoption of a special 14 industry formula under Section 25137, since a special 15 formula was not involved in that case. 16 The standard to be applied in this matter is no 17 different than the standard that this Board has applied in 18 adopting numerous other Section 25137 regulations currently 19 in existence. 20 Indeed, for all the reasons noted above, the FTB staff 21 has clearly satisfied the requisite evidentiary standard for 22 adopting the proposed reg. 23 In sum, the proposed regulation should be adopted 24 because it provides for a fair and reasonable alternative 25 apportionment methodology that specifically addresses the 53 1 unique apportionment issues which confront the mutual fund 2 industry. It is consistent with the approach taken by major 3 mutual fund states, it promotes uniformity, it avoids 4 potential for multiple taxation, and provides clear guidance 5 that is most needed in this area. 6 Thank you very much. 7 CHAIR CHIANG: Thank you, Jeff. 8 Robert. 9 MR. WALDOW: Good afternoon, Mr. Chair and members of 10 the Board. My name is Roburt Waldow with Heller Ehrman, 11 speaking on behalf of Barclays Global Investors in support 12 of Proposed Regulation 25137-14. 13 I would like to supplement the comments of Mr. Vesely, 14 specifically those relating to the propriety of the FTB's 15 use of the Finnigan throwback in the proposed regulation. 16 All of those who submitted comments on the proposed 17 regulation appear to agree that the better approach is to 18 have no throwback rule at all, because a shareholder based 19 sales factor properly reflects the relevant market 20 contributions of each state. 21 We recognize, however, fiscal considerations may 22 require that California deviate from what we consider the 23 theoretically most sound approach. We also recognize that 24 the FTB has an additional competing consideration, that of 25 ensuring that any rule it adopts will not breed what it 54 1 calls "nowhere income." 2 Opponents of the proposed regulation will argue that 3 because Section 25136 does not have a throwback provision, 4 the FTB does not have the authority to adopt regulations 5 under 25137 that include a throwback rule for purposes of 6 assigning receipts from sales of other than tangible 7 property. But Section 25137 expressly provides that the FTB 8 may adopt any other method, if reasonable, to remedy 9 distortion caused by application of the standard 10 apportionment rule. 11 Pursuant to this authority, the FTB has three times 12 adopted regs under Section 25137 to include a throwback rule 13 for assignment of receipts from services and intangibles for 14 franchisors, for banks and financial institutions, and for 15 the print media industry. 16 Although none of these regulations uses a Finnigan 17 approach for throwback, the Court of Appeals in Citicorp 18 North America made it clear the valid principal reason to 19 support the rationale of Joyce and the rationale of 20 Finnigan, both being legally permissible approaches. 21 In light of its authority under Section 25137 to adopt 22 any other method to remedy distortion caused by the standard 23 apportionment rules, there can be no doubt that the FTB has 24 the authority to include a Finnigan throwback and any such 25 other method. 55 1 The Finnigan rule fits hand in glove with the heavily 2 regulated and highly integrated mutual fund industry. 3 Dictated by regulatory and other reasons, mutual fund 4 service providers typically provide different services for 5 regulated investment companies through separate 6 corporations. The Finnigan approach does not permit these 7 separate incorporations to affect the state's tax base. 8 Rather, it focuses on the entire unitary business of a 9 mutual fund service provider for purposes of determining 10 whether sales throwback applies. 11 Application of a Joyce throwback rule in this industry 12 would elevate form over substance, and in so doing, would 13 operate to restore the distortion sought to be remedied by 14 the proposed legislation. 15 For these reasons we believe the inclusion of a 16 Finnigan throwback rule in the proposed legislation is 17 proper. 18 Thank you. 19 CHAIR CHIANG: Thank you, Robert. 20 Patrick Shannon, followed by Neal Reilly. 21 MR. SHANNON: Mr. Chairman, Board members, good 22 afternoon. My name is Patrick Shannon, and I'm from 23 Greenberg Taurig, and I represent a coalition of mutual fund 24 companies in support of FTB's legal staff's regulation. 25 In my comments today I will on focus on two points. 56 1 First, to commend the staff and Board for conducting a very 2 open and thorough regulatory process. And, secondly, to 3 offer a point of corroboration of the FTB's fiscal analysis. 4 First, I want to thank the Board and the legal staff 5 for giving the public and the mutual fund industry in 6 particular ample opportunity to comment on the regulation. 7 The hearing today culminates a process in which they had a 8 first ever symposium in advance of the release of a draft 9 regulation on which industry could comment. 10 Also, this process included two rounds of comment, a 11 public hearing, and today marks the second time that this 12 Board has visited this topic. The regulatory process has 13 been a model of openness and transparency, and it's a credit 14 to the staff and to the Board members. 15 This is an important issue which has been the subject 16 of regulation in the other large mutual fund states starting 17 back in the late 1980s. We are pleased that the FTB is 18 addressing this issue today in California with the benefit 19 of knowing the experience in other states and having gone 20 through a deliberative process. 21 As to the fiscal analysis, FTB produced an analysis 22 for forecasting $10 million in revenue from the proposed 23 regulation if it were implemented. In response, the 24 Federated Company commissioned an analysis by Dr. Bill Hamm 25 that posited a $370 million loss for the state. This 57 1 analysis was substantially revised downward and called for a 2 reduction of some $264 million off of that figure, then 3 contending that $106 million of revenue loss would 4 materialize. 5 Now, to help determine whether the FTB's analysis or 6 Dr. Hamm's analysis was more accurate, we commissioned an 7 independent analysis to reach a conclusion, and that was 8 conducted by Dr. Phil Romero, the former dean of the Oregon 9 Business School. 10 The Romero analysis estimated annual revenue gain of 11 $12.6 million from the regulation, an increase in 12 $85 million from non-California companies, minus 13 79 million -- 73 million, rather, from California companies. 14 Now, this independent analysis is very consistent with 15 FTB's $10 million figure. The methodology uses data from 16 the four sponsoring mutual fund complexes supplemented by 17 proxy data from financial publishers, similar to the proxy 18 upon which Dr. Hamm relied. 19 Dr. Romero is present today and is available to 20 comment on the regulation if you have any questions. 21 Now, the Romero analysis provides a point of 22 corroboration for the FTB analysis; however, the FTB 23 analysis is the authoritative one. The FTB does not rely on 24 proxy data. Rather, the FTB uses actual tax return data for 25 both California and non-California mutual fund service 58 1 providers. 2 So the Board can faithfully rely on the FTB analysis 3 because it is based on actual data from individual tax 4 returns and it is further corroborated by the independent 5 analysis from Dr. Romero. 6 Thank you very much for your consideration. 7 CHAIR CHIANG: Thank you. 8 Mr. Reilly, followed by Philip Plant and Maggie Egan. 9 MR. REILLY: Good afternoon. My name is Neal Reilly, 10 and I'm the assistant tax director for Barclays Global 11 Investors. 12 Barclays Global Investors supports the proposed 13 regulation in its current form, and appreciates the efforts 14 of the Franchise Tax Board in developing this regulation. 15 We would like to make three comments on the proposed 16 regulation from a fiscal perspective. My first comment is 17 with regard to the analysis that was prepared by 18 Dr. William Hamm with LECG. 19 There appears to be significant facts and essential 20 flaws in his analysis, which he believes will result in 21 revenue loss to the state. 22 The FTB reviewed the Hamm analysis twice and have 23 provided written comments on their findings. The FTB 24 identified significant tax discrepancies with the taxable 25 base, the effective tax rate, and the apportionment factor 59 1 in the Hamm analysis. In addition, we have also noted other 2 important tax inconsistencies as well as certain tax items 3 that were left out of Dr. Hamm's analysis. Specifically, 4 Dr. Hamm's analysis did not address the throwback 5 requirement included in the proposed regulation. 6 Dr. Hamm's analysis would only be correct if every 7 California mutual fund service provider filed separately and 8 apart from the unitary group in every single state in the 9 United States, and we know this is not true. 10 Contrary to Dr. Hamm's analysis, Professor Romero's 11 analysis estimates the impact from throwback in his economic 12 analysis. Professor Romero's analysis better asserts a 13 significant reduction of the tax cut to these California 14 companies. Mr. Hamm's shows absolutely no impact. 15 Our second comment relates to the fiscal analysis that 16 was prepared by the Franchise Tax Board. We would like to 17 note that the FTB has formulated the analysis based on data 18 from actual tax returns filed by the mutual fund industry, 19 and has concluded that there will be a $10 million increase 20 to the California tax revenue as a result of passing the 21 proposed regulation. 22 This is the data that should be used to evaluate the 23 fiscal impact to the state. The FTB is the only agency that 24 has actual data to perform this computation, and has 25 accurately predicted what impact this will have. 60 1 Finally, we would also like to point out that the FTB 2 has already given tax relief to certain California mutual 3 fund service providers in order to address the competitive 4 inequity that currently exists in the state tax 5 jurisdiction. 6 If Proposed Regulation 25137-14 is not approved and 7 the FTB continues its already established practice of 8 granting tax relief, it will guarantee that California will 9 lose tax revenues in the future without any offsetting 10 revenues from out-of-state mutual fund service providers. 11 CHAIR CHIANG: Thank you very much. 12 Mr. Plant. 13 MR. PLANT: Good afternoon. I'm Philip Plant, 14 attorney representing Allianz of America, a California based 15 industry group member that is subject to this regulation. 16 And in speaking in support of it, we think it's well 17 reasoned, thoughtful, and corrects distortion, and therefore 18 urge its favorable consideration by the Board. 19 Allianz has a significant California presence. Its 20 asset management affiliates are headquartered in California. 21 They employ 1300 California residents who manage over 22 600 billion in assets. It has invested in the past eight 23 years over 5 billion in California based company investments 24 in performing these services. Allianz is part of an 25 industry group, the members of whom have spoken to you just 61 1 ahead of me. That includes Franklin Templeton, Barclays, 2 and the Capital Group. We are all in support of the 3 regulation. 4 Allianz applauds and endorses the technical and policy 5 comments made to date by the representatives of these 6 companies, and particularly we precisely endorse and support 7 the well-reasoned, thoughtful comments of the FTB staff in 8 support of their proposal. 9 In that regard, Allianz does get penalized under the 10 existing law. In the cost of performance standard, it 11 ignores the market oriented aspect of this critical 12 business, and it results in significant double taxation. 13 With regard to throwback, while other states, the 14 combined reporting states that have adopted a shareholder 15 location rule, do not have throwback provisions, we 16 understand the need of the FTB to favorably consider this. 17 We would urge in this context that the staff of FTB address 18 that the Finnigan rule should apply, because only the 19 Finnigan rule recognizes the reality that these entities 20 have to operate in multicorporate form due to regulatory 21 requirements. 22 Again, our thanks to the Board staff, and we urge your 23 support of this regulation. Thank you. 24 CHAIR CHIANG: Thank very much. 25 Maggie Egan, followed by Marnie Niziolek and 62 1 Greg Garcia. 2 UNIDENTIFIED SPEAKER: Mr. Chair, with the Chair's 3 indulgence, could Fred Main speak for the coalition, and the 4 others will just provide additional comments, support 5 comments. 6 Thank you very much. 7 MR. MAIN: Mr. Chair, members, my name is Fred Main 8 with Manatt, Phelps & Phillips, today appearing on behalf of 9 a coalition of out-of-state headquartered mutual fund 10 companies that represent Fidelity, Vanguard, Morgan Stanley, 11 Waddell & Reed, American Century, Putnam, Eaton Vance, 12 Dreyfus, MassMutual, and T. Rowe Price. These companies 13 have a significant presence in California with approximately 14 10,000 employees between the ten different members, and pay 15 a significant amount of corporate, property, and sales tax 16 to the state already. 17 The members of the coalition actively agree that the 18 proposed use of shareholder location for sales factor 19 apportionment is appropriate. As supporters of the 20 regulation have pointed out, it is where many states have 21 already gone and where we believe states are going to be 22 headed as well, and many of the members of their coalition 23 are in states that have already adopted shareholder 24 location. 25 Adoption of shareholder location by California will 63 1 actually have a negative impact on them. They will face 2 greater sales apportionment factors in California, they will 3 have a higher taxable presence in the state, but because it 4 is the move towards uniformity that other states have 5 adopted, they are willing to accept that and support that 6 portion of the regulation, and that testimony and provisions 7 of that have been provided in the prior submissions to the 8 Franchise Tax Board at the December 15th hearing and in the 9 follow-up testimony. 10 However, the coalition members strongly oppose the 11 movement away from Joyce to the Finnigan approach. We think 12 that that's a move away from uniformity where both 13 California treats all other businesses and away from where 14 other states also are treating the mutual fund companies. 15 They do not understand why a single part of the financial 16 services industry is being singled out for Finnigan 17 treatment versus all other types of taxpayers. 18 And even within the mutual fund industry, I think 19 you've heard today that it's the proposal by the staff and 20 of the Franchise Tax Board to have a requirement of 21 throwback, which is not also included in the other states, 22 that prompts the necessity for the support of a Finnigan 23 approach. We think that that is dramatically changing the 24 tax liability and the burden of the out-of-state 25 headquartered companies vis-à-vis their competitors here in 64 1 the state. 2 And I think, if you looked at an estimate of the 3 Franchise Tax Board on the revenue increase, that's actually 4 highlighted. There has already been relief granted to a 5 number of the companies that are in-state. That revenue is 6 not coming already. 7 The proposal would be a $53 million increase on the 8 ten members that I represent as well as others. In the 9 Legislature, as it was pointed out before, that's a 10 two-thirds-vote tax increase. 11 Now, having said that, we are still supportive, again, 12 of a move towards just the provision of shareholder 13 allocation, and believe that it is appropriate. We do think 14 that while there may be the need to move to the regulation 15 of -- 16 MS. BERWICK: Time. 17 MR. MAIN: -- shareholder location, that the Board 18 doesn't have the necessary authority to go beyond that with 19 the provisions on the throwback and Finnigan. 20 Thank you very much. 21 CHAIR CHIANG: Thank you. 22 MR. MAIN: We will now have several members of the 23 coalition make a few brief comments. 24 CHAIR CHIANG: We have Maggie queued up first, 25 followed by Marnie. 65 1 MS. NIZIOLEK: Mr. Chairman, members, thank you very 2 much. I'm Marnie Niziolek from Morgan Stanley, and I will 3 second the sentiments that were expressed by Fred Main. We 4 do agree with shareholder percentage. As has been brought 5 up, there are fourteen other states that if it -- and I 6 would like to point out that those fourteen other states are 7 not all unitary, they do not all impose Finnigan. Some of 8 them are elective for shareholder percentage, some of them 9 require minimum payroll standards. 10 So, while there is some movement towards market based 11 apportionment, we are not establishing one type of 12 apportionment method for the industry, because there are 13 discrepancies among the fourteen states that have already 14 adopted them. 15 So, again, we disagree with the Finnigan approach. I 16 don't believe our industry is unique in terms of how we are 17 structured. There are other services, there are other 18 tangible personal property companies that have themselves 19 established in multiple corporations, so I can't seem to 20 draw the reason behind why we would be treated differently 21 than them. 22 I appreciate the procedure that has taken place on 23 this regulation, and I appreciate also the changes that have 24 been made to date. 25 So thank you very much. 66 1 CHAIR CHIANG: Okay. Next for the coalition. 2 MR. GARCIA: Good afternoon. My name is Greg Garcia. 3 I'm director of corporate tax for Waddell & Reed. Thank you 4 for your time today in speaking about this issue. 5 At Waddell & Reed we are in support of a 6 shareholder-sourced approach for taxation. We've seen that 7 in other states. In fact, in our home state, that was 8 recently adopted in the last couple of years. And while we 9 are not opposed to the shareholder-based approach, we are 10 opposed to the use of the Finnigan approach, because we 11 believe that that results in the unfair taxation for our 12 group of companies. 13 We do file the unitary return within California, and 14 all of our companies' income and profits is included in the 15 tax return. And we feel that the Finnigan approach would, 16 by changing our factors to report an additional numerator 17 for these other companies that have no nexus, no operations 18 in California, would result in unfair taxation for our group 19 of companies. 20 We also feel that this is, again, not a unique 21 industry. Our companies are organized according to their 22 lines of business. And we feel that other companies in 23 other industries have the same opportunities to carve out 24 their lines of business, and they're not being subjected to 25 the Finnigan approach. 67 1 Thank you very much. 2 CHAIR CHIANG: Thank you. 3 MS. EGAN: My name is Maggie Egan. I'm from Fidelity 4 Investments, and I'm going to echo some of the things that 5 you've already heard today. 6 As Marnie and Fred and Greg have already mentioned, we 7 do support shareholder sourcing. It seems to be the trend 8 of how our industry is sourcing in many different states. 9 So we fully support that, even knowing our overall liability 10 is going to increase. 11 Our objection is to the application of Finnigan for 12 our industry. We're concerned that our industry is being 13 singled out as the only industry that is going to have to 14 use the Finnigan approach. And with a lot of our 15 companies, we don't just have mutual fund service providers 16 within our unitary group, we have a lot of other types of 17 businesses within our group. Are these business also going 18 to be required to follow the Finnigan approach and 19 methodology? 20 There seems be a lot of uncertainty, some 21 inconsistencies that we just aren't sure, you know, how 22 actually, when we go to file our returns, how to actually go 23 and file it, under a unitary group, et cetera. So there 24 just seems to be uncertainty. It just seems to be creating 25 an unlevel playing field for our industry. 68 1 Part of the bill is -- in the bill, there is asset 2 management services, as to how they are going to get 3 apportioned. And if you are an asset management company and 4 you are giving advice for non-RIC, you can still use a cost 5 of performance. However, if you're an asset management 6 adviser advising for the RIC, for that fund, you now have to 7 show shareholder sourcing, you now have to have shareholder 8 sourcing -- this is our interpretation -- shareholder 9 sourcing in the Finnigan approach. 10 So, you know, with the way California is -- it has no 11 unitary regime -- all of the income of a consolidated group 12 is in fact in the calculation of what's being taxed in 13 California, you look at your consolidated income in the 14 apportionment. 15 So just one more time I would just like to say we do 16 support your motion generally. We just don't support the 17 Finnigan. 18 Thank you. 19 CHAIR CHIANG: Thank you. 20 Carl, would you like to provide a response? 21 MR. JOSEPH: Just a really short one. 22 What we did was we had concerns by people in the 23 industry who do work for mutual funds and who also do asset 24 management work, you have all these great minds, why limit 25 it to just working for RICs. 69 1 So what we have done in the regulation is the 2 regulation is premised upon if you do perform work for RICs, 3 then you fall under the reg because it's a mutual fund 4 service provider. And then, if you perform work, asset 5 management work for other non-RIC entities, they are also 6 under the reg. This was in response to comments made by, I 7 think, Barclays Global Investors, that we do that so that 8 they could include, in fact, their non-RIC management asset 9 activities under the same rule. 10 So that is provided, and I think it's pretty clear in 11 the reg that that's done in that manner. 12 One other thing that was brought up was if they had 13 other companies, would Finnigan apply to the other 14 companies. I think we made that pretty clear, too. 15 In the section that talks about Finnigan, it basically 16 says if you have nontaxpayer monies that are providing 17 management distribution administrative services to a RIC or 18 you're providing asset management services to people 19 domiciled in the state, then you're subject. 20 So, if you're a bank or something else, and you're not 21 doing this, then it simply wouldn't apply to you. It's only 22 the people that are doing these particular services that 23 that rule applies to. 24 CHAIR CHIANG: Okay. Thank you. 25 Brian Toman, followed by William Hamm and then 70 1 Joanne Garvey. 2 MR. TOMAN: Mr. Chairman, members, my name is 3 Brian Toman. I'm with ReedSmith, LLP, San Francisco, 4 California. Thank you for allowing me to speak today. 5 We have submitted detailed submittals on all of the 6 issues that we think we have in this regulation. I would 7 just like to speak to three. 8 The first of the three are standard of burden of 9 proof, consistency with the law, and uniformity. 10 With respect to standard of burden of proof, it 11 appears that the department has taken the position that 12 there are two burdens, burdens of proof on this singular 13 code section. If the taxpayer wants to implement 25137 on 14 an individual ad hoc basis, the standard of proof for that 15 is clear and convincing evidence. However, if staff wants 16 to regulate under 25137, the standard of proof is what's 17 called substantial. 18 Of the five levels of proof, the easiest to meet is 19 scintilla. The next up from there is substantial. The next 20 one up from there is preponderance of the evidence. Next 21 one up from there is clear and convincing evidence. And the 22 last, the highest, is beyond a reasonable doubt. 23 So with respect to taxpayers who want ad hoc relief, 24 they have the second highest burden to meet. Whereas those 25 in support of regulation, they have the second easiest 71 1 burden to meet. 2 We believe the Microsoft vs. Franchise Tax Board case 3 made it very clear that whoever wants to utilize Section 4 25137 has a burden of proof by clear and convincing 5 evidence. 6 So what we're faced with here is if you have an 7 individual application under 25137, you have the second 8 highest burden to meet. You've got -- the only higher 9 burden is in a homicide case. Whereas if staff wants to 10 implement a regulation, they have the second easiest burden 11 to meet. And we view that as having two separate and 12 substantially different standards of burden of proof under 13 the same code section. So it's illogical, unfair, and it's 14 questionable from a legal perspective. 15 With regard to consistency with the law, consistency 16 is defined as, and I quote, "being in harmony with and not 17 in conflict with or contradictory to existent statutes, 18 court decisions, or provisions of law." 19 We feel the application of the burden of proof in this 20 situation is clearly inconsistent with the Microsoft case. 21 Also with respect to clear and convincing evidence, we 22 submit that arguments and assertions are being relied on in 23 terms of meeting this burden of proof. Whereas, if you look 24 at Microsoft, it kind of looks like there were changes in 25 apportionment percentag