San Francisco--------------------------------------------------Thomas H. Steele 415.268.7039 tsteele@mofo.comAndres Vallejo 415.268.6793 avallejo@mofo.comPeter B. Kanter 415.268.6005 pkanter@mofo.comJames P. Kratochvill 212.336.4007 jkratochvill@mofo.comPilar M. Sansone 415.268.6125 psansone@mofo.comScott M. Reiber 415.269.7630 sreiber@mofo.comJason M. Satterfield 415.268.7074 jsatterfield@mofo.com

Denver--------------------------------------------------Thomas H. Steele 303.592.2243 tsteele@mofo.com

Los Angeles--------------------------------------------------Gary W. Maeder 213.892.5846 gmaeder@mofo.com

New York--------------------------------------------------Paul H. Frankel 212.468.8034 pfrankel@mofo.comHollis L. Hyans 212.468.8050 hhyans@mofo.comCraig B. Fields 212.468.8193 cfields@mofo.comIrwin M. Slomka 212.468.8048 islomka@mofo.comMichael A. Pearl 212.468.8135 mpearl@mofo.comAmy F. Nogid 212.468.8226 anogid@mofo.comRoberta Moseley Nero 212.506.7214 rnero@mofo.comMitchell A. Newmark 212.468.8103 mnewmark@mofo.comMichael W. McLoughlin 212.468.8240 mmcloughlin@mofo.comMichael J. Duffy 212.336.4261 mduffy@mofo.comR. Gregory Roberts 212.336.8486 rroberts@mofo.comAaron Russell 212.336.4308 arussell@mofo.com

Sacramento--------------------------------------------------Eric J. Coffill 916.325.1324 ecoffill@mofo.comCarley A. Roberts 916.325.1316 croberts@mofo.comDavid Ziring 916.448.3200 dziring@mofo.com

Washington, D.C.--------------------------------------------------Linda A. Arnsbarger 202.887.1598 arnsbarger@mofo.com

State & Local Tax Group

State & Local Tax Insights

Mitchell A. Newmark and Pilar M. Sansone, Co-Editors Spring 2008

Inside --------------------------

2Gain From Sale Held Not Apportionable IncomeBy Paul H. Frankel, Michael A. Pearl and Amy F. Nogid

--------------------------

3Upcoming Conferences--------------------------

5California SBE Adopts New Rules for FTB Tax AppealsBy Eric J. Coffill

--------------------------

7 Alabama’s VFJ Case: The Trial Court Got It Right! By Thomas H. Steele and Pilar M. Sansone

--------------------------

9California Court of Appeal Affirms that LLC “Fee” Violated Commerce ClauseBy Peter B. Kanter and Scott M. Reiber

--------------------------

11The New Internet Tax Freedom ActBy James P. Kratochvill and Pilar M. Sansone

--------------------------

Morrison & Foerster Wins Mead

Continued on Page 2

The U.S. Supreme Court handed Morrison & Foerster a victory in a significant case concerning the constitutional limitations

on a State’s power to tax multistate businesses.

Morrison & Foerster represented MeadWestvaco Corporation in a dispute over whether the Due Process and Commerce Clauses preclude a State from taxing a nondomiciliary business on a capital transaction that occurred outside of the State. The State of Illinois attempted to tax a portion of a $1 billion capital gain from MeadWestvaco’s sale of its separate division Lexis/Nexis. The State appellate court sustained the tax, but the U.S. Supreme Court vacated that decision.1

Writing for a unanimous Court, Justice Alito explained that where a State seeks to tax a nondomiciliary corporation for its activities that occur outside the taxing state, such as the sale of MeadWestvaco’s Lexis/Nexis investment, the Court “must determine whether ‘intrastate and extrastate activities formed part of a single unitary business.’”2

The Court noted that, contrary to these principles, the State appellate court created an “operational purpose” exception to the unitary business principle, by expanding upon U.S. Supreme Court decisions indicating that certain assets can be part of a unitary business if they serve an operational function to that business. The Court rejected the Illinois court’s attempt to so expand the unitary business test, and held that “[w]here, as here, the asset in question is another business, we have described the ‘hallmarks’ of a unitary relationship as functional integration, centralized management, and economies of scale.”3

Page 2

Justice Thomas filed a concurring opinion.

This decision is significant because States have, in recent years, sought to expand the requirements of the unitary business test by creating a separate and expanded operational function or operational purpose test. Under the Court’s ruling, some of these state taxes may have exceeded a State’s constitutional authority to tax multistate businesses and may require state courts to revisit prior rulings.

Paul H. Frankel is counsel of record for MeadWestvaco. Other Morrison & Foerster attorneys involved in the case at the State courts and/or the U.S. Supreme Court level included Beth S. Brinkmann, Craig B. Fields, Roberta Moseley Nero, Brian R. Matsui, Nicole Devero McGrew, and Marc A. Hearron.

–––––––––1 MeadWestvaco Corp. v. Illinois Dep’t of Revenue, No. 06-1413, 2008 U.S. LEXIS 3473 (Apr. 15, 2008).2 Id. at *16 (quoting Mobil Oil Corp. v. Comm’r of Taxes of Vt, 445 U.S. 425, 438-39 (1980)).3 Id. at *24.

–––––––––

MeadContinued from Page 1

Gain From Sale Held Not Apportionable IncomeBy Paul H. Frankel, Michael A. Pearl and Amy F. Nogid

To ensure compliance with requirements imposed by the IRS, Morrison & Foerster LLP informs you that, if any advice concerning one or more U.S. federal tax issues is contained in this publication, such advice is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein. For information about this legend, go to http://www.mofo.com/Circular230.html.

Recently, in Tate & Lyle Ingredients Americas, Inc.,1 Alabama’s Chief

Administrative Law Judge Thompson held that a taxpayer’s gain from its sale of its one-third interest in a foreign corporation to its parent, which owned the other two-thirds of the foreign corporation, was not apportionable “business income” under the Alabama statute, and that Alabama is constitutionally barred from taxing the income “earned in the course of activities unrelated to the Taxpayer’s business in Alabama.”

The Department, citing Container,2 relied on “an administrative presumption that corporations engaged in the same line of business are unitary” and the fact that the taxpayer and the foreign company, Amylum Group (“Amylum”), were owned by the same parent holding company. Judge Thompson, however, rejected the Department’s presumptions and view of Container and, based upon a complete analysis of the facts, determined that not only were the taxpayer and Amylum not unitary, but also the Amylum stock did not serve an operational function under Allied-Signal.3

The facts relied on by Judge Thompson were as follows. In 1960, the taxpayer, Tate & Lyle Ingredients Americas, Inc., formerly known as A.E. Staley Manufacturing Co., an

Illinois-based manufacturer of cereal sweeteners and starch products used by food manufacturing and industrial companies, acquired a one-third interest in Amylum, a family-run Belgium manufacturer of cereal sweeteners. The taxpayer produced its products from corn and served the North American market, while Amylum produced its products from wheat and served the European market.

In 1988, the taxpayer was acquired by Tate & Lyle PLC (“Tate & Lyle”), a U.K. holding company that owned numerous industrial ingredients manufacturing businesses, including a one-third interest in Amylum. In 2000, Tate & Lyle acquired the remaining one-third interest in Amylum that had been in private hands, and in 2005, Tate & Lyle purchased the taxpayer’s one-third interest in Amylum at a price determined by an independent appraiser. On its 2005 Alabama return, the taxpayer excluded the gain from its apportionable business income on the basis that it was nonapportionable, nonbusiness, investment income.

The facts supporting the determination that Amylum was not part of the taxpayer’s unitary business operations were substantial. For the five years prior to the sale, no officer or director of the taxpayer served as an officer or director of Amylum, and no Amylum

Page 3

officer or director served as an officer or director of the taxpayer. Judge Thompson found that actual control of Amylum by the taxpayer did not exist because “[t]he Taxpayer and Amylum had their own independent management teams, and were in no way involved in the management of the other”; therefore, “the fact that they are in the same general line of business is . . . irrelevant.”

Further, Amylum did not conduct business in Alabama or the United States, and the taxpayer conducted no business in Europe. Each company independently manufactured, marketed and sold its products on different continents. There were no shared facilities and each company provided its own administrative and corporate services. Each company purchased its own raw materials, and the only intercompany sales were the arm’s-length purchases by each company of finished product for resale, representing 1% of sales. In the absence of functional integration, centralized management, and economies of scale, the Judge concluded, “[t]he companies were independent business enterprises, and there was no flow of value between the companies as required for the entities to be unitary.”

Judge Thompson found the Supreme Court’s decision in Allied-Signal to be factually similar to this case. In both cases, there was a small amount of intercompany sales of products at arm’s length, and whereas Bendix had two directors

Continued on Page 4

MAY 9American Bar Association Tax Section Washington, D.C. Hollis L. Hyans

MAY 15-18Georgetown Advanced State & Local Tax InstituteWashington, D.C.Paul H. Frankel, Hollis L. Hyans, Craig B. Fields, Carley A. Roberts

MAY 20Tax Executives Institute State Tax Day, Dallas ChapterDallas, Texas Eric J. Coffill, Hollis L. Hyans

MAY 20Tax Executives Institute Chief Tax Officers ConferenceChesapeake, Maryland Mitchell A. Newmark

MAY 21Tax Executives Institute State Tax School, Houston ChapterHouston, Texas Craig B. Fields Mitchell A. Newmark

MAY 22Council on State Taxation Income Tax ConferencePortland, OregonPaul H. Frankel

MAY 29MoFo Palo AltoPalo Alto, California Eric J. Coffill, Thomas H. Steele, Andres Vallejo, Carley A. Roberts, Pilar M. Sansone

Upcoming 2008 ConferencesFollowing is a list of SALT conferences through November 2008, in which Morrison & Foerster attorneys will be participating.

MAY 30Tax Executives Institute New Jersey State Tax DayMorristown, New Jersey Paul H. Frankel

JuNe 9 Federation of Tax Administrators Conference Philadelphia, Pennsylvania Paul H. Frankel

JuNe 19University of Wisconsin/Deloitte Tax ConferenceMilwaukee, WisconsinPaul H. Frankel

JuLY 14 Southeastern Association of Tax Administrators Conference Williamsburg, Virginia Paul H. Frankel

JuLY 31 - AuguSt 1Council on State Taxation “Great Issues” ConferenceBeaver Creek, ColoradoPaul H. Frankel, Thomas H. Steele, Hollis L. Hyans, Trevor James and Andres Vallejo

NoveMber 6-8California Tax Policy ConferenceSan Francisco, CaliforniaCarley A. Roberts Paul H. Frankel

Continued on Page 4

Page 4

on ASARCO’s board, there were no common directors in this case. Reaching the same conclusion as the Supreme Court in Allied-Signal, Judge Thompson held that “it is clear that the Taxpayer and Amylum were separate and unrelated businesses that were not unitary.”

Judge Thompson also rejected as “speculative and unsupported by the evidence” the Department’s assertion that, even if Amylum was not unitary with the taxpayer, Amylum’s stock served an “operational purpose,” by allowing access into an otherwise closed European market.

Judge Thompson discussed the two examples given in Allied-Signal where income from the sale of an intangible asset is apportionable because it serves an “operational function.” In Allied-Signal, the Court provided two examples of “operational assets,” short-term deposits of working capital and hedging transactions, such as those identified in Corn Products Refining Co. v. Commissioner.4 In Corn Products, the Court found that corn futures purchased were “vitally important to the company’s business,”5 strongly suggesting that an inextricable relationship between the investment and the fundamental operations of the taxpayer must be present before an “operational relationship” can be

found to exist. Judge Thompson correctly discerned that the taxpayer’s gain on its investment in the Amylum stock held for 45 years clearly was not a short-term investment, and that the Amylum stock was neither purchased nor used for purposes related to the taxpayer’s business in Alabama. Based on his determinations that no unitary relationship existed between the taxpayer and Amylum and that the Amylum stock did not serve an operational purpose, Judge Thompson concluded that “[t]he Department is thus constitutionally barred from taxing the gain.”

Judge Thompson also determined that the gain was not “business income” under any of the three alternative tests in the Alabama statute6 – the “transactional test,” the “functional test,” or the “operationally related test.” The gain did not satisfy the “transactional test” because the sale of Amylum stock — held for 45 years — was an infrequent transaction, not in the taxpayer’s regular course of business. The gain also did not constitute business income under the “functional” test because the stock was not acquired, managed or disposed of as an integral part of the taxpayer’s regular business.

The Alabama legislature added the “operational-function” test to codify the U.S. Supreme Court–created alternative basis for finding apportionable income in the absence of a unitary relationship. As discussed earlier, the U.S. Supreme Court’s Allied-Signal “operational-

function test” was not satisfied with respect to taxpayer’s investment in the Amylum stock. Therefore, the income was nonbusiness income and not apportionable to Alabama under Alabama’s statutory test.

Prior to issuing his Opinion, Judge Thompson issued a preliminary order denying the Department’s Motion to hold this case in abeyance pending a decision by the U.S. Supreme Court in Mead.7 Judge Thompson rejected the Department’s argument that the Supreme Court’s decision in Mead could “affect the holding and/or constitutional and/or factual analysis of any decision regarding this appeal,” stating that “the constitutional issue in dispute has been decided by the U.S. Supreme Court in numerous cases,” and that Mead “is also not controlling on the separate issue of whether [the taxpayer’s] income . . . is apportionable ‘business income’ under Alabama’s definition of the terms.”

–––––––––1 Tate & Lyle Ingredients Americas, Inc. v. Alabama Dep’t of Revenue, No. CORP. 07-162 (Ala. Admin. Law Div. Jan. 15, 2008). Paul Frankel and Michael Pearl, with Bruce Ely and James Long, represented the taxpayer in this case.2 Container Corp. of Am. v. Franchise Tax Bd., 463 U.S. 159 (1983).3 Allied-Signal, Inc. v. Director, Div. of Taxation, 504 U.S. 768 (1992). 4 350 U.S. 46 (1955).5 Id. at 50.6 Ala. Code § 40-27-1.1.7 Mead Corp. v. Department of Revenue, 861 N.E.2d 1131 (Ill. App. Ct. 1st Dist.), appeal denied, 862 N.E.2d 235 (Ill.), vacated and remanded sub nom. by MeadWestvaco Corp. v. Illinois Dep’t of Revenue, No. 06-1413, 2008 U.S. LEXIS 3473 (Apr. 15, 2008). Morrison & Foerster LLP represents Mead, now known as MeadWestvaco, in that case.

–––––––––

Gain Not Apportionable

Continued from Page 3

Page 5

California State Board of Equalization Adopts New Rules for Franchise Tax Board Tax AppealsBy Eric J. Coffill

Effective February 6, 2008, the California State Board of Equalization

(“SBE”) has adopted new Rules for Tax Appeals (“RTA”), which are found in Title 18 of the California Code of Regulations, beginning at section 5000. The new RTAs are intended to establish a comprehensive set of procedural regulations that cover all of the SBE’s administrative review functions, including the SBE’s appellate review authority with respect to appeals from actions of the California Franchise Tax Board (“FTB”). Prior regulations existed, but the SBE desired a complete restructuring of the procedures applicable to the SBE’s appeal processes, and decided to undertake that process in a single project on the theory that the prior regulations were not well-suited to piecemeal amendment. The new RTAs are the result of a very thorough, two-year review, drafting and approval process that included more than 25 drafts, multiple interested party meetings, and 10 SBE Board meetings.1 Our compliments to the Board members and Board staff, and especially to Senior Tax

Counsel Bradley Heller, who was instrumental in the project.

This article will focus exclusively on how the new RTAs impact basic aspects of appeals to the SBE from actions of the FTB. Chapter 4 of the RTAs provides rules applicable only to appeals from actions of the FTB. Chapter 5 provides rules for general Board hearing procedures. Where there is a conflict between Chapter 4 and Chapter 5, the provisions of Chapter 4 control. RTA 5410(b).

FiLinG The AppeAL

There are very few statutory rules regarding the filing and prosecution of an SBE appeal from a decision by the FTB. California Revenue and Taxation Code section (“section”) 19045 states an FTB Notice of Action upon a protest (in either a corporate or personal income tax matter) becomes final 30 days from the date when it is mailed to the taxpayer, “unless within that 30-day period the taxpayer appeals in writing from the action of the Franchise Tax Board to the board,” i.e., to the SBE.2 Section 19046 states that two copies of the appeal and supporting documents must be sent to the SBE (and

Continued on Page 6

MoFo Attorney News

Morrison & Foerster’s State and Local Tax Group would like to welcome the following new attorneys to the firm:

Gary W. Maeder joins us as a •partner in the Los Angeles

Michael J. Duffy joins us as of •counsel in the New York office

Aaron Russell joins us as an •associate in the New York office

Jason M. Satterfield joins us as •an associate in the San Francisco office

The State and Local Tax Group would also like to congratulate Andres Vallejo on becoming a partner. Andres resides in the San Francisco office.

Page 6

New SBE RulesContinued from Page 5

the SBE then provides one of those copies to the FTB). Regarding the appeal itself, section 19047 states simply and in full: “The board shall hear and determine the appeal and thereafter shall forthwith notify the taxpayer and the Franchise Tax Board of its determination and the reasons therefor.” Regarding FTB’s notice of action on a claim for refund (corporate or personal income tax), section 19324 provides that such action is final 90 days from the mailing of the notice unless within that 90-day period the taxpayer appeals in writing to the SBE.

Various publications, including FTB Publication 7277, “Personal Income Tax Notice of Action Information”; the FTB’s recent (i.e., 9/07) Publication 965, “Appeal/Protest/Appeals (The Process)”; and SBE Publication 81, “Franchise and Personal Income Tax Appeals,” all provide helpful, but informal, guidance on the appeals process. Like all California tax forms and informational booklets, the information found within these publications does not rise to the level of binding legal advice. Accordingly, in view of the nonbinding nature of the tax agencies’ publications and in view of the lack of a detailed and comprehensive statutory scheme on the subject, the RTAs take on a

heightened significance regarding the mechanics of appealing from an adverse FTB decision. Such regulations are presumed valid (Freeman v. Contra Costa County Water Dist., 18 Cal. App. 3d 404, 408 (1971)) and the SBE is also bound by its own regulations (see Bonn v. Cal. State University, Chico, 88 Cal. App. 3d 985, 990 (1979)).

RTA 5420 sets forth the appeal filing requirements. Consistent with sections 19045 and 19324, the appeal must be in writing, and RTA 5420 goes on to set forth what must be contained in the appeal:

(1) The name of the appellant, or appel-

lants, filing the appeal;

(2) The social security number or taxpayer

identification number, whichever is

applicable, of each appellant filing the

appeal;

(3) The address and telephone number of

each appellant and, if applicable, each

appellant’s authorized representative;

(4) The amount involved, including tax,

penalties, fees, and interest (whichever is

applicable);

(5) The year(s) involved;

(6) A copy of the Franchise Tax Board’s

notice from which the appeal

is made, unless the Franchise Tax Board

has failed to act on a claim for refund

or a request for interest abatement, in

which case the appellant must provide a

copy of the claim for refund or request

for interest abatement;

(7) The facts involved and the legal authori-

ties upon which the appellant relies,

including any relevant statutes, regula-

tions, and judicial and administrative

decisions;

(8) Any portion of the amount at issue

conceded by the appellant; and

(9) The signature of each appellant who

is filing the appeal, whether jointly or

separately, or the signature of an autho-

rized representative made on behalf of

each appellant who is filing the appeal.3

The RTAs “encourage” filing the appeal by electronic means (“e.g., facsimile, e-mail, etc.”), and also provide rules for filing by mail or by hand delivery. RTA 5421. RTA 5423(b), “Accepting the Appeal,” provides that if the SBE’s Chief of Board Proceedings or the Chief Counsel determines that the SBE has jurisdiction to hear the appeal and that the appeal is timely, “or that there is a genuine, material issue relating to jurisdiction or timeliness,” the Chief of Board Proceedings must accept the appeal. Note that acceptance is not based on the completeness of the appeal under the requirements of RTA 5420. RTA 5424 addresses “Perfecting an Appeal,” and provides that the briefing and resolution of an appeal cannot begin until the appeal is perfected, and an appeal is “perfected” if it contains “substantially all” of the information requested by RTA 5420. RTA 5424 goes on to provide that if an appeal is accepted and not perfected, the SBE will notify the appellant of the need to perfect the appeal and will

Page 7

Alabama’s VFJ Case: The Trial Court Got It Right! By Thomas H. Steele and Pilar M. Sansone The authors wish to acknowledge that this article will be published in an upcoming edition of State Tax Notes.

Last year, the Montgomery Circuit Court (“trial court”) held that VFJ Ventures,

Inc. (“VFJ”) was entitled to claim the reasonableness exception to Alabama’s add back statute with respect to royalty payments VFJ made to its affiliates.1 The trial court’s decision concluded that VFJ was entitled to claim this exception because the add back statute would otherwise operate to deny VFJ a deduction for necessary costs of doing business in Alabama, and thus tax income fairly attributable to other states.

The Alabama Court of Civil Appeals recently reversed the trial court’s decision in Surtees v. VFJ Ventures, Inc.2 The Court of Civil Appeals concluded that although the trial court’s judgment included a finding that VFJ’s income would be distorted by the application of the add back statute, the trial court made this decision based upon its determination that the underlying transactions had a valid business purpose and economic substance. The Court of Civil Appeals disagreed with this standard and held that VFJ did not qualify for any of Alabama’s exceptions to the add back rule and that the statute was constitutional. The Supreme

Court of Alabama has granted VFJ’s petition for writ of certiorari.

ALAbAmA’S Add bAck STATuTe

Alabama enacted its add back statute in 2001. The statute requires corporations to add back otherwise deductible interest and intangible expenses paid to or incurred with respect to related members.3 There are several exceptions to this rule. For example, an exception applies if application of the add back statute would be unreasonable.4 The “subject-to-tax” exception applies if the corporation establishes that the related member was subject to tax on such income by Alabama, another state, or a foreign country that has an income tax treaty with the United States.5 An exception is also available if the related member is not primarily engaged in the acquisition, use, licensing, maintenance, management, ownership, sale, exchange, or any other disposition of intangible property, or in the financing of related entities, and the transaction did not have the avoidance of Alabama tax as its principal purpose.6

Continued on Page 8Continued on Page 16

provide the taxpayer 90 days from the date of the SBE’s notice for that purpose. In addition, RTA 5424(b)(1) states the Chief of Board Proceedings may extend the deadline for perfecting an appeal “upon a showing of extreme hardship or upon written agreement by the parties.”

FiLinG The brieFS

RTA 5430 sets forth the basic rules for briefing the appeal. All briefs filed in the SBE appeal are subject to a 30-page limitation – double-spaced, 8.5” by 11” pages, at least 10 point font. Briefs that do not comply with the requirements may be returned to the filing party for corrections. RTA 5430(e). The 30-page limitation excludes any table of contents, table of authorities and exhibits. RTA 5430(e). Indeed, there are no limitations under the RTAs on the length, size, or number of exhibits. Based on the SBE’s admonition in Appeal of Sierra Production Service, Inc., 90-SBE-010 (Sept. 12, 1990), “that a taxpayer who appeals to this board should always submit to us each item of evidence that will support its case, even though that evidence has already been submitted to (and rejected by) the Franchise Tax Board,” a taxpayer always should err on the side of providing more, not less, evidence and documentation in the form of exhibits. See also Appeal of Merry Mary Fabrics, 93-SBE-007 (Apr. 22, 1993) on same point. Finally, RTA 5430(e) provides the Chief of Board Proceedings may grant an exception to these page requirements upon written request “that establishes why an exception is necessary.”

Page 8

VFJ’S cASe

VFJ is a manufacturer and marketer of jeanswear, and paid royalties to H.D. Lee Company, Inc. (“Lee”) and Wrangler Clothing Corp. (“Wrangler”) for the use of their trademarks. VFJ deducted these royalties as ordinary and necessary business expenses for federal income tax purposes. However, because VFJ, Lee and Wrangler were direct or indirect subsidiaries of V.F. Corporation (“VF”) and qualified as related members under Alabama’s add back statute, VFJ was required to add back those amounts when calculating its taxable income for Alabama’s corporate income tax unless one of the above-mentioned exceptions applied.

Lee and Wrangler are Delaware corporations engaged in the business of owning, managing and licensing trademarks (“intangible management companies” or “IMCOs”). The trial court acknowledged that establishment of Lee, Wrangler and other IMCOs reduced the VF corporate family’s state tax liability by sourcing their royalty income to Delaware, where the IMCOs were not subject to an income tax, and creating deductions in states where operating entities such as VFJ were subject to tax. However, the trial court found that the IMCOs also had several other purposes. For example, the trial court found that segregating the ownership and management of trademarks in the

IMCOs created numerous efficiencies, facilitated the coordination and management of trademark licensing to third parties, facilitated the sale of various business lines, and created a more flexible business structure. The trial court also found that the IMCOs had numerous employees and carried on substantial activities.

The trial court noted that states were rightfully concerned about corporate families creating “shell” or “sham” corporations in low-tax jurisdictions and shifting substantial amounts of income to those states without any real business activities taking place in those jurisdictions, and that many states had passed add back statutes to address such abusive transactions. Having determined that Lee and Wrangler had several business purposes and carried on substantial activities, the trial court concluded that it would be unreasonable to require VFJ to add back its royalty expenses, and that disallowing these deductions would distort the amount of income fairly attributable to Alabama. The trial court thus held that VFJ was entitled to claim the reasonableness exception.

The Court of Civil Appeals held that the trial court’s interpretation of the reasonableness exception to require only a showing of business purpose and economic substance was too broad, noting that this interpretation would effectively render meaningless Alabama’s exception for payments to related members that were not IMCOs. The Court of Civil Appeals instead adopted the Department of Revenue’s interpretation of reasonableness, which examines whether the application of the add back would result in taxation

that was out of proportion to the corporation’s activities in Alabama.7 Finding that VFJ had not presented evidence demonstrating that this standard was met, the Court of Civil Appeals held that VFJ did not qualify for the reasonableness exception.

The Court of Civil Appeals also examined whether VFJ qualified for the subject-to-tax exception. As discussed above, this exception applies if the related member is “subject to a tax based on or measured by the related member’s net income” where “the receipt of the payment by the recipient related member is reported and included in income for purposes of a tax on net income, and not offset or eliminated in a combined or consolidated return which includes the payor.”8 VFJ argued that the subject-to-tax exception should be interpreted to mean the entire amount of federal taxable income the IMCOs included on their separate-return state tax returns prior to apportioning that income to the state. The Court of Civil Appeals disagreed, concluding that “included in income for the purposes of a tax on net income” means “that the income at issue is actually taxed as a part of a tax on net income” and thus applied to income on a post-apportionment basis. The court thus rejected VFJ’s argument that it was entitled to claim the subject-to-tax exception simply because Lee and Wrangler had filed in one separate-return state (i.e., North Carolina) and paid tax on the income apportioned to that state.9

The Court of Civil Appeals also addressed VFJ’s constitutional arguments. The court first rejected VFJ’s argument that the add back statute was effectively an attempt to

Alabama VFJ CaseContinued from Page 7

Page 9

Continued on Page 10Continued on Page 15

California Court of Appeal Affirms that LLC “Fee” Violated Commerce ClauseBy Peter B. Kanter and Scott M. Reiber

On January 31, 2008, the California Court of Appeal issued a

decision in Northwest Energetic Services, LLC v. Franchise Tax Board (“Northwest”).1 As described below, the court of appeal upheld in part and reversed in part the trial court’s decision,2 which struck down California’s LLC Levy3 under Revenue and Taxation Code former Section 17942.4 Most importantly, the court of appeal affirmed the portion of the trial court’s decision finding that the LLC Levy was an unconstitutional tax in violation of the Dormant Commerce Clause of the United States Constitution.

bAckGround

The Levy imposed by former Section 17942 was referred to as an “annual fee” by the statute, and was imposed on “every limited liability company subject to tax under Section 17941.” Thus, the Levy applied to any LLC that did business in California during the tax year or that had registered to do business in California with the Secretary of State. The amount of the Levy ranged from a minimum of $900 to a maximum of $11,790 per year. Pursuant to former Section 17942, the amount owed depended on the taxpayer’s “total income from all sources reportable to [California] for the taxable

year,” which the Franchise Tax Board (“FTB”) construed to mean gross receipts earned anywhere in the world.

Northwest Energetic Services, LLC (“NES”) was a Washington LLC in the business of distributing explosives and providing explosive-related services. It had no operations, property, inventory, employees, agents, independent contractors, nor a place of business in California, solicited no customers in California, and made no deliveries to California. Nevertheless, it was subject to the Levy in former Section 17942 by virtue of having registered to do business in California with the Secretary of State in 1997. While it paid the $800 minimum tax under Section 17941 for the years at issue, NES did not pay the amount due under former Section 17942 until the FTB sent notice that NES was liable for $27,458.13, plus penalties and interest, for tax years 1997, 1999, 2000, and 2001. After paying this amount and exhausting its administrative remedies, NES filed a claim for refund with the superior court on the grounds that the Levy imposed by former Section 17942 was unconstitutional because it violated the Commerce Clause and Due Process Clause of the United States Constitution. The superior court agreed with NES and granted

tax the income of the IMCOs that Alabama lacked nexus to tax, noting that the add back statute disallowed a deduction sought by the taxpayer and that deductions are a matter of legislative grace. The court next rejected VFJ’s argument that the add back statute caused Alabama’s tax to be unfairly apportioned and lacked external consistency, finding that there was no showing that the tax was out of proportion to VFJ’s activities in Alabama or that the resulting tax reached beyond the portion of value attributable to Alabama. The court finally rejected VFJ’s argument that the add back statute discriminated against interstate commerce, noting that the subject-to-tax exception applied regardless of whether the related member was subject to tax in Alabama, another state or a foreign country with a U.S. income tax treaty.

GenerAL obSerVATionS

Three aspects of the Court of Civil Appeals’ decision are particularly troubling. First, as the trial court noted, add back statutes were initially enacted to curb potentially abusive transactions. Narrowing the reasonableness exception to reach only instances where the tax resulting from the add back is out of proportion to the corporation’s activities in Alabama does not ensure this purpose is met. Moreover, the Court of Civil Appeals’ interpretation of Alabama’s reasonableness exception would effectively render meaningless Alabama’s analog to section 18 of the Uniform Division of Income for Tax Purposes Act, which allows taxpayers and tax administrators to petition for the use of alternative methods

Page 10

California LLC CaseContinued from Page 9

its claim for refund for the full amounts paid under former Section 17942. The superior court also awarded NES attorneys’ fees under California Code of Civil Procedure (“CCCP”) Section 1021.5 and the common fund doctrine.

The FTB appealed the decision of the superior court with respect to its decision both on the constitutionality of former Section 17942 and on its award of attorneys’ fees. With respect to the constitutionality of former Section 17942, the FTB contended that, because the Levy was a fee and not a tax, the Levy did not violate the Commerce Clause and Due Process Clause of the United States Constitution. With respect to the attorneys’ fees issue, the FTB argued that: (1) CCCP Section 1021.5 and the common fund doctrine were inapplicable to NES’s claim for refund; (2) NES did not satisfy the requirements of CCCP Section 1021.5 and the common fund doctrine; and (3) the trial court erred in its determination of the amount of the attorneys’ fees awarded.

The LeVy in Former SecTion 17942 WAS unconSTiTuTionAL AS AppLied To neS

The court of appeal first affirmed that former Section 17942 imposed a tax and not a fee, despite the fact that the former statute referred to the Levy as

an annual “fee.”5 The court stated that the relevant analysis in determining whether the Levy was a tax or a fee was “whether the Levy [was] a compulsory payment imposed for the purpose of raising revenues for general governmental purposes, or whether it fund[ed] a regulatory program or compensate[d] for government services or benefits voluntarily sought by the LLC.”6

The court of appeal noted that the legislative history of the California Limited Liability Company Act demonstrated that the Levy was promulgated for general revenue purposes, the proceeds from the Levy were deposited into the general fund, and the Legislature specified that the Levy was to be administered in the same manner as California’s income taxes, rather than under procedures specific to the administration of fees. The court also rejected the FTB’s arguments that the Levy was intended to fund a regulatory program because there was no indication in the evidence that this was the case, and there was no nexus between the Levy and any regulatory program expense. Additionally, the court concluded that the Levy was not required in exchange for benefits NES received from California.

After finding that the Levy was a tax, the court of appeal then concluded that the tax, as applied to NES during the years at issue, violated the Commerce Clause of the United States Constitution.7 The court of appeal indicated that former Section 17942 violated both the internal and external consistency tests, which are used to determine whether a tax is fairly

apportioned under the Commerce Clause, as interpreted by the Supreme Court in Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977). The court of appeal found that the Levy was internally inconsistent because if the same levy were imposed in every state, “an LLC engaging in business in multiple states with the same total income as Northwest would pay the maximum levy in every state in which it did business or registered to do business. An LLC operating only in one state would pay the maximum levy only once.”8 Similarly, the court of appeal found the Levy to be externally inconsistent because it “‘reach[ed] beyond that portion of value that is fairly attributable to economic activity within the taxing State.’”9 Because the Levy violated both the internal and external consistency tests, the court of appeal concluded that it violated the Commerce Clause.10

The court of appeal thus affirmed the trial court’s decision granting NES’s claim for refund. However, the court of appeal cautioned that “[a]s a general matter, only the portion of the Levy that exceeds Commerce Clause limits must be refunded.”11 While this amounted to all of the amounts paid by NES under former Section 17942 because none of NES’s gross receipts would have been apportioned to California, it suggests that the courts may apply an apportionment formula retroactively to those taxpayers that conducted business both within and outside California.12 Indeed, current Section 17942, which was amended in response to the trial court’s decision in this case, provides that its apportionment provision will apply

Page 11

The New Internet Tax Freedom ActBy James P. Kratochvill and Pilar M. Sansone

President George W. Bush signed into law on October 31, 2007 legislation

(House Bill 3678,1 the Internet Tax Freedom Act Amendments Act of 2007) that extends for another seven years, until November 1, 2014, the moratorium precluding state and local taxes on Internet access and multiple and discriminatory taxes on electronic commerce.2 The new Internet Tax Freedom Act (hereinafter the “2007 ITFA”) also amends the previous law in several significant ways. Among the most important changes are that the 2007 ITFA: (1) amends the definition of “Internet access” to help clarify the nature and scope of services protected from state taxation under the moratorium; (2) extends for seven years but clarifies, both retroactively back to November 1, 2003 and going forward, the provisions grandfathering certain states that have historically taxed Internet access; and (3) excepts certain general business gross receipts taxes from the scope of prohibited taxes on Internet access.

The deFiniTion oF “inTerneT AcceSS”

The definition of “Internet access” has evolved since the original Internet Tax Freedom Act was enacted in 1998 (the “1998 ITFA”). The 1998 ITFA generally defined “Internet access” as a service that enables users to access content, information, electronic mail, or other services offered over the Internet, except for telecommunications services.3

The definition of “Internet access” was first amended in 2004, pursuant to the Internet Tax Nondiscrimination Act (“2004 ITNA”), to extend to telecommunications services purchased, used, or sold by an Internet Service Provider (“ISP”) to provide Internet access.4 The 2004 amendment was made for two reasons. First, Congress sought to prevent states from taxing Internet access differently depending on how an ISP assembled and delivered the service to consumers (for example, some states previously taxed digital subscriber line (“DSL”) transmission services sold with Internet access but did not tax cable broadband transmission services

retroactively. It is unclear whether such retroactive application will pass constitutional muster, however, as discussed in the court of appeal’s decision in City of Modesto v. National Med, Inc., 128 Cal. App. 4th 518 2005) (“NMI”) (finding that the Due Process Clause prohibited the City’s attempt to apply a retroactive apportionment scheme to a previously unapportioned tax).13

The imporTAnce oF The deciSion

The court of appeal found that while NES is entitled to attorneys’ fees, the superior court erred in its determination of the amount of such fees to award. NES’s attorneys represented the taxpayer on a contingency-fee basis, and the superior court awarded NES $3.5 million in attorneys’ fees under CCCP Section 1021.5 and the common fund doctrine. Section 1021.5 provides a means by which taxpayers may bring suits where the amount at issue for them personally may not justify the attorneys’ fees required to litigate the case, but where the benefits of the litigation to the public or a class of persons are sufficient to justify such attorneys’ fees. The court of appeal agreed that CCCP Section 1021.5 applied to NES’s case because of the substantial benefits the litigation conferred on other LLCs that did business in or were registered to do business in California.14 However, the court of appeal reversed the trial court’s upward adjustment of the calculated hourly fees of NES’s attorneys from $219,566.95 to $3.5 million because it found that the trial court had not provided sufficient explanation for the adjustment. The court of appeal therefore remanded the attorneys’ fees

Continued on Page 19 Continued on Page 12

Page 12

New ITFAContinued from Page 11

sold with Internet access). Second, Congress sought to prevent states from taxing the “wholesale” purchase of “backbone” telecommunications services used to provide Internet access (i.e., the underlying telecommunications services purchased and used by ISPs to provide end users with Internet access).

The 2007 ITFA further amends the definition of “Internet access” to address numerous concerns raised by taxpayers and tax administrators regarding their understanding of the previous definition. The new definition provides that Internet access refers to the service that connects users to the Internet, and also includes closely related Internet communications services, such as electronic mail, home pages and instant messaging, whether provided as incidental to or separate from the core Internet access service.5 Services and products sold by vendors over the Internet are not included within the definition of “Internet access.”6

The new definition also more affirmatively clarifies Congress’s intent to include “backbone” telecommunications services purchased and used by ISPs to provide Internet access services to consumers.7 This

clarification was made in response to a study issued by the Government Accounting Office (“GAO”) in 2006 in which the GAO took the position that the telecommunications services included within the definition of “Internet access” only included telecommunications services purchased and resold by the ISP to end users as part of the Internet access bundle, and that Internet access did not include

other “backbone” telecommunications services purchased by the ISP.8

Finally, even though the 2004 ITNA provided that “nothing in this Act shall be construed to affect the imposition of tax on a charge for voice or similar service using Internet protocol,”9 the new definition expressly removes from the scope of protected services voice, audio or video programming that utilizes Internet or successor protocols for which there is a charge, making it clear that states and localities will be free to tax Voice over Internet Protocol (“VoIP”) and similar services.10

GrAndFATher proViSionS

Since its inception in 1998, the moratorium has grandfathered states that previously taxed Internet access. The 2007 ITFA extends these provisions but also clarifies them to address and correct conflicting interpretations that arose when the grandfather provisions were amended in 2004.

The 2004 ITNA included two grandfathering provisions allowing states that had taxed “Internet access” prior to certain dates to continue doing so for set periods of time.11 The first grandfather provision applied to taxes on Internet access imposed and enforced prior to October 1, 1998 (the original date of the 1998 ITFA) and excluded such taxes from the moratorium until the 2004 ITNA’s expiration on November 1, 2007 (the “2007 Grandfather”). The second grandfather provision applied to taxes on Internet access imposed and

The new definition [of Internet access] also

more affirmatively clarifies Congress’s intent to

include “backbone” telecommunications services

purchased and used by ISPs to provide Internet

access services to consumers.

Page 13

Continued on Page 14

enforced as of November 1, 2003 (the effective date of the 2004 ITNA’s amendments) and excluded such taxes from the moratorium until November 1, 2005 (the “2005 Grandfather”).

The legislative history and purpose of the 2004 ITNA’s amendments indicate that the 2007 Grandfather was intended to apply to “Internet access” as that term was defined by the 1998 ITFA, and that the 2005 Grandfather was intended to apply to “Internet access” as that term was redefined and expanded in 2004. However, because both the 2007 Grandfather and the 2005 Grandfather used the same term, “Internet access,” some states adopted a “plain-language” reading of the 2005 and 2007 Grandfathers and took the position that “Internet access” referred to “Internet access” as that term was redefined in 2004 with respect to both of these provisions. This plain-language reading of the 2005 and 2007 Grandfathers appeared to undermine Congress’s entire purpose for expanding the definition of “Internet access” to include and protect telecommunications services purchased, used, or sold by an ISP, because the vast majority of taxes imposed upon such telecommunications services would be allowed until the 2004 ITNA expired.12

The 2007 ITFA expressly clarifies the definition of “Internet access” for each of these grandfather provisions in a manner consistent with the legislative intent of the 2004 ITNA. Specifically, the 2007 ITFA provides that, effective

November 1, 2003, the term “Internet access” used in the 2007 Grandfather shall mean “Internet access” as defined in the 1998 ITFA13 and that the term “Internet access” used in the 2005 Grandfather shall mean “Internet access” as that term was redefined by the 2004 ITNA.14

The 2007 ITFA makes two exceptions to this definitional clarification (the

“excepted taxes”). First, excepted taxes include taxes on telecommunications services purchased, used or sold by ISPs if the state (or political subdivision) issued a public ruling prior to July 1, 2007 applying the tax to such services in a manner inconsistent with the definitional clarification.15 Second, excepted taxes include taxes that were

the subject of litigation instituted in a judicial court prior to July 1, 2007 where the state (or political subdivision) was seeking to enforce such taxes in a manner inconsistent with the definitional clarification.16 Finally, with respect to such “excepted taxes,” the 2007 ITFA states that “[n]o inference of legislative construction shall be drawn from this subsection or the [definitional clarification] for any period prior to June 30, 2008.”17

It may appear at first under the 2007 ITFA exceptions that those states imposing excepted taxes will not have to defend their administrative positions to impose the excepted taxes after November 1, 2005. Although the legislative history of the 2007 ITFA suggests that Congress intended to hold those states harmless until November 1, 2007,18 upon close reading, the new language does not appear to foreclose future taxpayer challenges to the “plain-language” interpretation by those states or court decisions rejecting such interpretation. Rather, the definitional clarification simply cannot be used to interpret the 2005 and 2007 Grandfathers prior to November 1, 2007. Thus, states imposing excepted taxes after November 1, 2005 may still have to sustain their plain-language interpretation based upon the language contained in the 2005 and 2007 Grandfather provisions, and taxpayers in those states are still entitled to argue that the 2005 and 2007 Grandfathers

The 2007 ITFA

expressly clarifies the

definition of “Internet

access” for each of

these grandfather

provisions in a manner

consistent with the

legislative intent of the

2004 ITNA.

Page 14

New ITFAContinued from Page 13

as enacted should be interpreted in a manner consistent with the legislative history and purpose of the 2004 ITNA.

excepTion For cerTAin GenerAL buSineSS TAxeS

The other major change enacted by the 2007 ITFA is a specific exception to the scope of prohibited taxes on Internet access. The 2007 ITFA specifies that, effective November 1, 2007, prohibited taxes on Internet access shall not include recently enacted general business taxes in states meeting certain narrow criteria.19 The legislative history explains that this provision was enacted in response to a small group of states that recently enacted gross receipts taxes that apply to almost all large businesses in the state, with the intention that such taxes apply to ISPs as well as other businesses.20

The new gross receipts taxes in these states, including Michigan, Texas, and Ohio, as well as the venerable Washington B&O tax enacted more than seventy years ago, either substitute for or supplement the corporate income tax currently in place in those states, whereas in most other states, the corporate income tax alone serves as the general business tax. The problem identified by Congress regarding those

four states is that both the 1998 ITFA

and the 2004 ITNA contained an

explicit exception for corporate income

taxes imposed on Internet access

providers, but contained no exception

for gross receipts taxes. Thus, it was

thought that these states could suffer

a disproportionate loss under the

moratorium because their approach

to general business taxation is not

protected, while the more prevalent

approach, a tax on corporate profits,

was protected and could be used to tax

profits earned from providing Internet

access services.

The amendment addresses this problem

by creating an exception for states that

have enacted gross receipts taxes as a

substitute for state corporate income

taxes and not as taxes directed to

Internet access. To be exempt, the

state law must meet certain criteria.

First, the law must have been enacted

between June 20, 2005 and November

1, 2007, or, in the case of a state

business and occupation tax (i.e., the

Washington B&O tax), enacted after

January 1, 1932 and before January

1, 1936.21 Second, the law must

replace, in whole or in part, a modified

value-added tax or a tax levied upon or

measured by net income, capital stock,

or net worth.22 Finally, the law must be

imposed on a broad range of business

activity and must not be discriminatory

in its application to providers of

communication services, Internet access,

or telecommunications.23

–––––––––1 H.R. 3678, 110th Cong. (1st Sess. 2007).2 47 U.S.C.S. § 151 note at § 1100 et seq. (2000 & Supp. 4 2005).3 Id. at § 1104(5).4 47 U.S.C.S § 151 note at § 1105(5) (2000 & Supp. 4 2005).

5 47 U.S.C.S. § 151 note at § 1105(5)(C), (E) (2007).6 47 U.S.C.S. § 151 note at § 1105(5)(A) (2007).7 47 U.S.C.S. § 151 note at § 1105(5)(B)(i) (2007).8 United States Government Accountability Office, Report to Congressional Committees GAO-06-273, Internet Access Tax Moratorium: Revenues Impacts Will Vary by State (Jan. 2006).9 47 U.S.C.S § 151 note at § 1108 (2000 & Supp. 4 2005).10 47 U.S.C.S. § 151 note at § 1105(5)(D) (2007).11 47 U.S.C.S § 151 note at § 1104(a)(1), (b)(1) (2000 & Supp. 4 2005).12 For a detailed analysis of this issue, see J. Kratochvill and P. Sansone, Too Many Grandfathers Spoil the Broth: The Failure of the Internet Tax Nondiscrimination Act?, 46 State Tax Notes 1 (Oct. 1, 2007).13 47 U.S.C.S. § 151 note at § 1104(c)(1)(A) (2007).14 47 U.S.C.S. § 151 note at § 1104(c)(1)(B) (2007).15 47 U.S.C.S. § 151 note at § 1104(c)(2)(A) (2007).16 47 U.S.C.S. § 151 note at § 1104(c)(2)(B) (2007).17 47 U.S.C.S. § 151 note at § 1104(c)(3).18 H.R. Rep. No. 110-372 (2007).19 47 U.S.C.S. § 151 note at § 1105(10)(C) (2007).20 H.R. Rep. No. 110-372 (2007).21 47 U.S.C.S. § 151 note at § 1105(10)(C)(i)(I) (2007).22 47 U.S.C.S. § 151 note at § 1105(10)(C)(i)(II) (2007).23 47 U.S.C.S. § 151 note at § 1105(10)(C)(i)(III), (IV) (2007).

–––––––––

Page 15

Alabama VFJ CaseContinued from Page 9

where the standard allocation and apportionment provisions fail to fairly represent the extent of the taxpayer’s business activity in the state.10

Second, the Court of Civil Appeals reasoned that the add back statute disallowed a deduction sought by the taxpayer, and thus dismissed VFJ’s argument that the add back statute was effectively an attempt to tax the income of the IMCOs that Alabama lacked nexus to tax. However, as the United States Supreme Court recognized in Hunt-Wesson, Inc. v. Franchise Tax Board,11 the denial of a deduction may constitute an impermissible taxation of income outside the state’s jurisdictional reach, particularly where the deduction disallowed is effectively matched with that income. Accordingly, Alabama’s attempt to reach and tax Lee’s and Wrangler’s royalty income via an add back statute applied to VFJ should be subject to the same scrutiny and constitutional constraints, including nexus and factor representation, as if Alabama had sought to tax this income directly.

This conclusion is strengthened by the United States Supreme Court’s recent decision in MeadWestvaco Corp. v. Illinois Department of Revenue, which confirmed the need for a connection between the apportionment formula used by the State and the income the State seeks to tax.12

Finally, we remain troubled by the question whether a state, through its tax regime, may effectively penalize a taxpayer for doing business with an affiliate that operates in another state with a favorable tax regime. Should Alabama be permitted to condition a taxpayer’s right to a deduction upon whether Delaware or Nevada exercises its right to tax the corresponding item of income or whether the recipient is located in a state that employs combined reporting? Similarly, should other separate-company filing states, such as Maryland or Massachusetts, be permitted to condition a taxpayer’s right to a deduction upon whether such income was taxed at a sufficiently high rate?13 Although add back statutes such as Alabama’s may not discriminate against interstate commerce on their face, the add back requirement only arises in response to the related member’s decision to conduct business outside the add back state’s jurisdiction because, under Alabama’s exception, where the recipient is in Alabama, the add back does not apply. The fact that the same exception applies where the recipient chooses to operate in a state that Alabama views as imposing an acceptable tax does not change the fact that the add back influences the conduct of interstate commerce by discriminating against taxpayers doing business in the other non-approved states. While states may have some license to design their tax systems to prevent abusive tax planning, that license should be construed narrowly to prevent a state from discriminating based upon another state’s decision to adopt a more favorable tax regime. In our view, the Alabama trial court had

it right: Alabama’s add back statute should be limited to cases where the arrangement lacked business purpose and economic substance.

VFJ represents the first of several cases challenging states’ add back statutes.14 The implications of VFJ remain to be seen, as each state’s add back statute and exceptions vary significantly, as do the specific facts of taxpayers challenging these statutes.15 These questions are likely to be raised and answered in future cases contemplating the scope and constitutionality of such statutes.

–––––––––

1 VFJ Ventures, Inc. v. Surtees, No. CV-03-3172, Ala. Tax Rep. (CCH) ¶ 201-181 (Ala. Cir. Ct., Montgomery County, Jan. 24, 2007).2 No. 2060478, 2008 Ala. Civ. App. LEXIS 50 (Ala. Civ. App., Feb. 8, 2008).3 Ala. Code § 40-18-35(b)(1) (2007).4 Ala. Code § 40-18-35(b)(2) (2007).5 Ala. Code § 40-18-35(b)(1) (2007).6 Ala. Code § 40-18-35(b)(3) (2007).7 See Ala. Admin. Code r. 810-3-35.02(3)(h) (adopted in 2003).8 Ala. Code § 40-18-35(b)(1) (2007).9 Although the trial court was not required to reach this question, the court noted in its opinion that if the Legislature had intended the subject-to-tax exception to apply to post-apportionment income, then the Legislature would have stated so in the statute. 10 Ala. Code § 40-27-1, art. IV(18) (2007).11 528 U.S. 458 (2000).12 No. 06-1413, 2008 U.S. LEXIS 3473 (Apr. 15, 2008).13 Md. Code Ann., [Tax – Gen] § 10-306.1(c)(3)(ii); Mass. Gen. Laws Ann. ch. 63, § 31J (2007).14 See, e.g., Family Dollar Stores of Ohio, Inc. v. Wilkins, No. 2005-V-469, Ohio Tax Rep. (CCH) ¶ 403-786 (Ohio Bd. of Tax Appeals Jan.4, 2008); Deluxe Fin. Servs., Inc. v. Director, Div., of Taxation, No. 005522-2006 (N.J. T.C., filed May 30, 2006).15 H.R. 350, 2008 Reg. Sess. (Ala.), which is currently pending before the Alabama Legislature, would amend Alabama Code section 40-18-35 to “clarify” that the subject-to-tax exception applies to income subject to tax on a post-apportionment basis and that the reasonableness exception is intended as a savings clause to protect only against violations of the U.S. Constitution.

–––––––––

Page 16

The “perfected appeal” is the taxpayer’s opening brief. RTA 5431(b)(1). Once the taxpayer’s opening brief has been filed, the FTB has 90 days to file its opening brief. RTA 5431(b)(2). The taxpayer then may file a reply brief no later than 30 days after the FTB’s opening brief, which is limited to “points of disagreement with the Respondent’s Opening Brief.” RTA 5431(c)(1). Then, upon request and with permission, the FTB may file a reply brief, which may only address “points of disagreement with the Appellant’s Reply Brief.” RTA 5431(c)(2). If the FTB is permitted to file a reply brief, the taxpayer may then file a supplemental brief as well. RTA 5431(c)(3). Finally, additional briefing may be requested by SBE staff, by individual SBE Board members, or by the SBE Board. RTA 5435. In a change from the prior rules, all time limits for filing a brief may be extended, and deferrals of briefing may be granted for “reasonable cause.” RTAs 5430(c) & 5522.8(b).4

The SBE has long permitted non-parties to file briefs in FTB appeal cases in support of a party, and that practice continues under the new RTAs. RTA 5430(g) provides that briefs may be filed by non-parties, i.e., amicus curiae briefs, subject to any applicable conditions regarding briefing

in general. Any individual or entity may file a Non-Party Brief, whether unsolicited or upon the request of the Appeals Division. No individual or entity may file more than one Non-Party Brief, unless the Appeals Division specifically allows otherwise. Unless the Appeals Division specifically allows otherwise, all Non-Party Briefs must be filed prior to the conclusion of briefing by the parties under RTA 5431. Parties may file briefs in response to a Non-Party brief, as specified. RTA 5430(g).

The orAL heArinG

Every taxpayer in an appeal from an FTB action has a right to an oral hearing. RTA 5440; see also RTA 5522.5 An oral hearing must be requested no later than 30 days after the conclusion of briefing, but an untimely request may be accepted. RTA 5440(a). Upon the scheduling and noticing of an oral hearing, the SBE Appeals Division staff will prepare a Hearing Summary, which is intended to assist the Board in its consideration and decision of the appeal. RTA 5444(a). A copy of the Hearing Summary is provided to all parties. RTA 5444(b). Multiple matters may be consolidated for hearing or decision if the facts and issues are similar and no substantial right of any party will be prejudiced. RTA 5522.4(a).

A new provision in the RTAs allows Appeals Division staff to meet with parties to an appeal from actions of the FTB prior to the oral hearing. Under

RTA 5443, any party may now request a Pre-Hearing Conference, as specified, the purpose of which is to obtain additional facts and evidence, obtain stipulations of fact, and narrow questions of law, in order to facilitate a more efficient and productive oral hearing.

Oral hearings (as well as briefing) may be postponed or deferred under specified circumstances. There are three deferral provisions. First, RTA 5522.8(b)(1) provides the Chief Counsel of Board Proceedings may grant a deferral or postponement of the due date of any brief or a hearing for a period of 90 days or less in his or her “sole discretion” or for a period of more than 90 days with the consent of the Chief Counsel in certain specific circumstances. Those circumstances include: (1) an unavoidable scheduling conflict; (2) when all parties desire a deferral or postponement; and (3) any other facts or circumstances determined by the Chief of Board Proceedings and the Chief Counsel to constitute “reasonable cause.” RTA 5522.8(b)(1).6 Second, RTA 5522.8(b)(3) provides the Chief Counsel may, in his or her discretion, grant a deferral or postponement for a determined period of time if the Chief Counsel determines that (1) related civil or criminal litigation is pending in state or federal court, the outcome of which is likely to have a bearing on the matter being deferred or postponed; or (2) unrelated civil or criminal litigation pending in federal or state court contains issues similar to those claimed by parties to a matter and that the outcome of

New SBE RulesContinued from Page 7

Page 17

the unrelated litigation is likely to have a bearing on the matter being deferred or postponed. Third, as a “catch all” provision, RTA 5522.8(b)(5) provides the Chief Counsel “may, with the consent of the Board Chair, grant a deferral or postponement for any reason.”

Taxpayers may represent themselves at the oral hearing or may be represented by authorized persons including, but not limited to, attorneys and accountants. RTA 5523. Evidence and exhibits may be presented (RTA 5523.6) and witnesses may testify (RTA 5523.7) at the hearing. In terms of evidentiary standards and admissibility, RTA 5523.6(a) provides in pertinent part: “Any relevant evidence, including affidavits, declarations under penalty of perjury, and hearsay evidence, may be presented to the Board at a hearing” (emphasis added).7 The RTAs also state “the burden of proof is upon the taxpayer as to all issues of fact” [with the exception of the issue of fraud]. RTA 5541.

RTA 5523.5(c) provides the Chief of Board Proceedings will generally allocate a total of 35 minutes per hearing and will inform the parties of the time allocation. RTA 5523.5 did not change the SBE’s prior hearing rules regarding time allocation. Under the prior rules (and presumably under the new rules as well), a party scheduled for a hearing would receive a form letter from the SBE stating that 35 minutes have been reserved for the hearing, with the following time allocation: (1) 10 minutes for

the taxpayer to present its case; (2) 10 minutes for the FTB to present its case; (3) 5 minutes for the taxpayer for rebuttal; and (4) 10 minutes allotted for Board Members to ask questions of both parties. Accordingly, a taxpayer is typically allocated only 15 minutes for oral presentation of its entire case. However, RTA 5523.5 gives the Board Chair discretion to grant a party additional time to complete its presentation during the hearing.

The regulations also contain a provision by which parties may seek additional time. RTA 5523.5(d) provides a request for additional time must be submitted to the Board Proceedings Division in writing no less than 15 days prior to the hearing and state the reason(s) why additional time is needed. The Chief of Board Proceedings must submit requests for additional time to the Board Chair for approval. The Board Chair may grant a party whatever additional time the Board Chair “determines the party needs to present a complex matter.” (Emphasis added.) Unfortunately, no guidance is offered in the RTAs regarding what constitutes a “complex matter.”

As is evident from the brevity of the oral hearings themselves, appeals to the SBE are designed under the RTAs to be decided principally on the documentation before the SBE, e.g., briefs and exhibits, as opposed to what happens and what is presented at the oral hearing itself. Accordingly, an SBE hearing should not be thought of as

the equivalent of a court trial or even a typical administrative hearing before an administrative law judge, where the record is made and the case is largely presented through live testimony and the admission of exhibits. One cannot plan to make one’s case on appeal with the SBE by the use of witnesses or any time-consuming exhibits, which makes the briefing in the case absolutely essential.

The deciSion

The Board issues three types of decisions, but there are no time requirements in the RTAs for the Board to issue its decision in a case. First, there is the “Summary Decision,” which consists of findings of fact and conclusions of law that form the basis of the Board’s decision. RTA 5451. The RTAs provide that Summary Decisions may not be cited as precedent in any appeal or other proceeding before the SBE, a position consistent with SBE decisional law. RTA 5451(d); see Appeal of Fowlks, 88-SBE-023-A (Oct. 31, 1989).8 Second, there is the “Formal Opinion,” which is “intended to set precedent” and generally may be cited as precedent. RTA 5452(a) & (f ). Unlike the prior Board rules, the RTAs now provide a list of non-exclusive factors as to when a Formal Opinion would be appropriate, such as to establish a new rule of law, modify or repeal an existing rule, resolve conflicts in the law, or make a significant contribution to the law. RTA 5452(e).9 Finally, there is the “Letter Decision,” which is adopted by

Continued on Page 18

Page 18

New SBE RulesContinued from Page 17

the Board when it decides an appeal without adopting a Summary Decision or a Formal Opinion and which is also non-precedential. RTA 5450. Once an opinion is issued, a party may file within 30 days a petition for hearing. RTA 5561 & 5562.

Ex PartE communicATionS WiTh boArd memberS

Finally, one of the most controversial provisions of the new RTAs is the ability for taxpayers10 to communicate directly with Board members regarding a pending appeal case. RTA 5523.8, entitled “Communications with Board Members,” states in full:

The Board Members shall remain acces-

sible to their constituents, their subor-

dinates, other government agencies, and

taxpayers at all times in order to execute

their constitutional and statutory du-

ties. Therefore, such persons and their

authorized representatives, including

members of the State Bar, may contact

Board Members and a Board Member’s

Staff at any time, including while a mat-

ter involving such persons is awaiting an

oral hearing before the Board.

(Emphasis added). The review and approval of RTA 5523.8 was one of the major reasons why the SBE’s regulation project took two years of hearings and drafting. The SBE’s Final Statement of

Reasons/Non-Controlling Summary of the new regulations states, “The purpose of this section is to codify and provide notice of the Board’s longstanding policy permitting constituents and their representatives, other agencies’ staff, and Board staff to contact the Board members at any time.” Id. at 54 (emphasis added). However, no comparable written provision was found in the SBE’s previous hearing regulations, and some practitioners, especially California Bar members, saw potential ethical concerns over ex parte communications with Board members while a matter was pending before them. Any such concerns are now resolved as a result of the language in new RTA 5523.8 specifically referring to and permitting such communications by “members of the State Bar.” In drafting regulation 5523.8, the SBE considered and rejected two alternatives. First, it rejected an alternative provided by the FTB which would have prohibited Board members from communicating with any party to an appeal from actions of the FTB while such appeal was pending without offering the other party an opportunity to participate in the communication, required summaries of any such communications to be provided to parties that did not participate, and required copies of any written communications to be distributed to all the parties. Second, the SBE rejected an alternative offered by the California Tax Reform Association which would have had the practical effect of prohibiting virtually all non-governmental communications between

Board members and persons who have pending appeals before the Board. See SBE’s Final Statement of Reasons/Non-Controlling Summary at 54.

––––––––– 1 Indeed, the author’s copy of the rule-making materials for the RTAs occupies over three linear feet of shelving.2 Section 19045 also requires an FTB Notice of Action to include the date determined by the FTB as the last day on which the taxpayer may file an SBE appeal.3 RTA 5523.1 sets forth rules for powers of attorney.4 Former SBE Regulation 5075(g) provided that “a reasonable extension of time for the filing of briefs may be granted by the Chief of Board Proceedings, upon a showing of extreme hardship” (emphasis added).5 In the absence of an oral hearing, i.e., where the taxpayer waived the right to a hearing, the case will be submitted for decision based on the written record. RTA 5441.6 Another circumstance under RTA 5522.8(b)(1)(D) is when the Chief of Board Proceedings has been informed by the FTB that the matter is being reviewed for possible settlement consideration. See FTB Notice 2007-2, “Settlement of Administrative Civil Tax Matters in Dispute” (June 27, 2007).7 The RTAs do not offer a definition of relevancy, but presumably the definition found in California Evidence Code section 210 would apply: “‘Relevant evidence’ means evidence, including evidence relevant to the credibility of a witness or hearsay declarant, having any tendency in reason to prove or disprove any disputed fact that is of consequence to the determination of the action.”8 Nevertheless, Summary Decisions are instructive on the Board’s thinking on a given issue at a given time. 9 One can hope new RTA 5452(e) and its criteria for publishing precedential, citable appeals will act to increase the number of published decisions in appeals from actions by the FTB. Historically, the number of published decisions has been dropping. For example, there were 156 published decisions in 1985, 16 published decisions in 1995, and just 2 published decisions in 2005. The trend reversed somewhat for 2006, in which there were 4 published decisions. See California State Board of Equalization, Franchise and Income Tax Formal Legal Opinions, http://www.boe.ca.gov/legal/legalopcont.htm> (last visited Apr. 23, 2008).10 Note that new RTA 5523.8 also permits FTB staff to be in direct ex parte contact with Board members regarding a pending appeal.

–––––––––

Page 19

issue to the trial court for further consideration of the appropriate upward adjustment, if any.

Unless the FTB successfully petitions the California Supreme Court to review the court of appeal’s decision, the ruling should resolve for good the constitutionality of former Section 17942. However, taxpayers and tax authorities are anxiously awaiting the court of appeal’s decision in the other case brought to challenge former Section 17942, under facts whereby the taxpayer had income attributable to California as well as to other states. That case, Ventas Finance I, LLC v. Franchise Tax Board (“Ventas”),15 will likely decide the issue of whether the FTB and other tax authorities may limit refunds issued for unconstitutionally unapportioned taxes to the amounts the taxpayer would not have paid had the tax been apportioned at the outset.

cLAimS For reFund bASed on NOrtHWESt

LLCs that had no business activities in California and LLCs that did business both within and outside of California should consider filing refund claims soon with the FTB to ensure that any open claims are not barred by the statute of limitations. The FTB recently published FTB Notice 2008-2, which lists the information that LLCs with facts similar to NES (i.e., no activities

in California) must provide in their refund claims in order to have such refund claims processed. The notice also lists additional information that LLCs that previously filed refund claims must provide to show that they did no business in California so that their refund claims may be processed immediately, rather than waiting for a final decision in Ventas. FTB Notice 2008-2 may be found at http://www.ftb.ca.gov/law/notices/2008/2008_2.pdf.

––––––––– 1 Northwest Energetic Servs., LLC v. Franchise Tax Bd., 159 Cal. App. 4th 841 (Cal. App. 2008).2 The trial court’s decision is discussed in detail in Peter B. Kanter, California’s LLC Tax: Current Litigation and Retroactive Legislation, Morrison & Foerster Legal Updates & News, March 2007, http://www.mofo.com/news/updates/files/8917.html. 3 Taxpayers and the FTB had disagreed as to whether former Section 17942 imposed a “fee” or a “tax.” For simplicity, we will follow the court of appeal’s practice and use the term “Levy.”4 As the court of appeal in Northwest noted, Section 17942 was amended in 2007 to apportion the LLC Levy. See 2007 Cal. Stat. ch. 381, § 2. As in the court of appeal’s decision, we will refer to the statute at issue in this case as “former Section 17942.” All further section references in this article are to the California Revenue and Taxation Code, unless otherwise noted.5 While the court ultimately concluded that the Levy was a tax and not a fee, in footnote 12 of the decision it indicated that “we do not share the view that it makes a difference whether the Levy is characterized as a tax or a fee for Commerce Clause purposes.” 6 Northwest, 159 Cal. App. 4th at 854.7 Because this determination disposed of the case, the court of appeal did not reach the question whether former Section 17942 was unconstitutional on its face, or whether it violated the Due Process Clause.8 Northwest, 159 Cal. App. 4th at 862.9 Northwest, 159 Cal. App. 4th at 864. (quoting Oklahoma Tax Comm’n v. Jefferson Lines, Inc., 514 U.S. 175, 185 (1995)).10 The FTB raised arguments that the Levy was constitutionally valid under the balancing test enumerated in Pike v. Bruce Church, Inc., 397 U.S. 137 (1970) (“Pike”), and that NES could have chosen to operate as a corporation, rather than an LLC, such that it would not

have been subject to the unapportioned tax (relying on United States Borax & Chemical Corp. v. Carpentier, 150 N.E.2d 818 (Ill. 1958) (“Carpentier”)). The court of appeal dismissed the argument under Pike on the grounds that Pike did not involve a tax or fee, so it was inapplicable to NES’s claims and, even if it were applicable, the Levy would not satisfy Pike’s balancing test. See Pike, 397 U.S. at 142. The court of appeal dismissed the argument under Carpentier because the taxpayer’s choice in Carpentier (i.e., whether to be taxed based upon its property and business in the state or based upon the taxpayer’s entire stated capital and paid-in surplus) was fundamentally different from a taxpayer’s choice to operate as an LLC. See Carpentier, 150 N.E.2d at 825-27. 11 Northwest, 159 Cal. App. 4th at 868 n.16 (citing Macy’s Dep’t Stores, Inc. v. City & County of San Francisco, 143 Cal. App. 4th 1444, 1449-50 (Cal. Ct. App. 2006) (“Macy’s”)). Although the court of appeal cites Macy’s for the proposition that the remedy may be limited to the amount that the tax exceeded the limits of the Commerce Clause, an LLC that has conducted business both within and outside California may distinguish Macy’s on the grounds that the Macy’s decision dealt with tandem taxes, in which the taxes were only unconstitutional when applied in conjunction with each other, and there was no issue with respect to the calculation of the tax that Macy’s would have owed had the tax scheme been applied in a constitutional manner. See City of Modesto v. National Med, Inc., 128 Cal. App. 4th 518 (Cal. Ct. App. 2005) (“NMI”) (ruling that applying retroactive apportionment to remedy an unconstitutional tax may violate due process requirements due to the inherent difficulties in calculating proper apportionment for past years).12 In Ventas Finance I, LLC v. Franchise Tax Board, A116277 (Cal. Ct. App., 1st App. Dist., filed May 16, 2007) (“Ventas”), an LLC that conducted business both within and outside California challenged the LLC Levy on grounds similar to those of the taxpayer in Northwest. Ventas is currently pending before the court of appeal and will likely determine the issue of the remedy for taxpayers that conducted business both within and outside California.13 A more complete analysis of the NMI decision’s application to the retroactive LLC fee may be found at Peter B. Kanter, California’s LLC Tax: Current Litigation and Retroactive Legislation, Morrison & Foerster Legal Updates & News, March 2007, http://www.mofo.com/news/updates/files/8917.html. 14 While the court of appeal agreed that CCCP Section 1021.5 applied to NES’s case, it determined that NES did not meet the requirements of the common fund doctrine because there was no common fund for it to preserve. See Serrano v. Priest, 20 Cal. 3d 25 (Cal. 1977).15 Ventas Finance I, LLC v. Franchise Tax Bd., No. A116277 (Cal. Ct. App., 1st App. Dist., filed May 16, 2007).

–––––––––

California LLC CaseContinued from Page 11

This newsletter addresses recent state and local tax developments. Because of its generality, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations. If you wish to change an address, add a subscriber, or comment on this newsletter, please write to Mitchell A. Newmark at Morrison & Foerster LLP, 1290 Avenue of the Americas, New York, New York 10104-0050, or Pilar M. Sansone at Morrison & Foerster LLP, 425 Market Street, San Francisco, California 94105-2482, or e-mail them at mnewmark@mofo.com or psansone@mofo.com.

www.mofo.com© 2008 Morrison & Foerster LLP. All Rights Reserved.

©2008 MoRRISoN & FoERSTER llP

When these companies had difficult state tax cases, they sought out Morrison & Foerster lawyers.

Shouldn’t you?

ABB v. MissouriAlbany International Corp. v. WisconsinAllied-Signal v. California American Power Conversion Corp. v. Rhode IslandBrooklyn Navy Yard v. New YorkCiticorp v. CaliforniaColgate Palmolive Co. v. CaliforniaConsolidated Freightways v. CaliforniaContainer Corp. v. CaliforniaCrocker National Bank v. San FranciscoCurrent, Inc. v. California Deluxe Corp. v. CaliforniaDIRECTV, Inc. v. IndianaDow Chemical Company v. IllinoisExpress, Inc. v. New YorkFarmer Bros. v. CaliforniaGeneral Motors v. DenverGTE v. Kentucky Hallmark v. New YorkHercules Inc. v. IllinoisHercules Inc. v. KansasHercules Inc. v. MarylandHercules Inc. v. MinnesotaHoechst Celanese v. CaliforniaHunt-Wesson Inc. v. CaliforniaIntel Corp. v. New MexicoJohnson Controls v. KentuckyKohl’s v. IndianaKroger v. ColoradoLanco v. New JerseyMcGraw-Hill, Inc. v. New YorkMCI Airsignal, Inc. v. California McLane v. Colorado Mead v. IllinoisNabisco v. oregonNational Med, Inc. v. Modesto NewChannels Corp. v. New YorkOfficeMax v. New YorkOsram v. Pennsylvania Pier 39 v. San FranciscoQwest v. TexasReynolds Metals v. New YorkR.J. Reynolds Tobacco Co. v. New York San Francisco Giants v. San Francisco Sears, Roebuck and Co. v. New York Shell Oil Company v. CaliforniaSherwin-Williams v. MassachusettsSparks Nugget, Inc. v. Nevada Tate & Lyle v. AlabamaToys “R” Us-NYTEX, Inc. v. New YorkUnion Carbide Corp. v. North CarolinaUnited States Tobacco v. CaliforniaUSV Pharmaceutical Corp. v. New YorkUSX Corp. v. KentuckyVerizon Yellow Pages v. New YorkW.R. Grace & Co. – Conn. v. MassachusettsW.R. Grace & Co. v. MichiganW.R. Grace & Co. v. New YorkW.R. Grace & Co. v. Wisconsin

For more information, please contact Paul H. Frankel at (212) 468-8034 or Thomas H. Steele at (415) 268-7039.