Case Updates

California's taxing agency gets reprimanded again; ordered to pay $2.6 million in attorneys' fees. We previously  reported on the Los Angeles Superior Court case Lucent Technologies, Inc., et al. v. Board of Equalization,1 in which Judge Kleifield chastised the State Board of Equalization ("BOE") for re-litigating the same sales tax issues resolved by the Court of Appeal in Nortel Networks, Inc. v. State Board of Equalization.2 Both the Nortel and Lucent cases involved whether agreements providing customers with access to software for the operation of switching agreements were tax-free "technology transfer agreements or taxable transfers of tangible personal property."

On April 18, Judge Kleifield ruled that the Nortel case was so similar to the Lucent case that the BOE must pay $2.6 million in attorneys' fees to Lucent, because re-litigating the same issue was not substantially justified. In his decision, Judge Kleifield noted that, "there was nothing to try; the transactions in question were not taxable as a matter of law based on binding precedent" set by Nortel, and "in situations where there is clear binding precedent...it would be poor public policy to cause the taxpayer to pay these taxes on the basis that the BOE wants to further 'test the waters.'" At Lucent's request, Reed Smith submitted a declaration in support of the motion for attorneys' fees.

Takeaway: The court recognized that taxing authorities have a duty not to re-litigate settled issues. And it affirmed that with the state's vast resources and power comes great responsibility—a responsibility to exercise discretion in litigation and to accept and implement judicial decisions. In this case, Nortel held that sales of prewritten software can be tax-exempt in California if intellectual property interests are transferred along with the sale. Although the BOE may believe that Nortel provides insufficient guidance, it must implement the decision by allowing software refunds until the Legislature steps in and changes the law. The BOE will be appealing the Lucent decision, and there is no sign of any change in policy at this point.

More bright lines for intangibles in property taxation. On On May 22, the First District Court of Appeal, Division 5, decided SHC Half Moon Bay, LLC v. County of San Mateo.3 The main issue before the court was whether the property tax assessment of the taxpayer's hotel property improperly included the value of intangibles. The San Mateo County Assessor valued the property using an income approach known as the "Rushmore method." This method subtracts management and franchise fees from the income stream of a property before capitalization to exclude the value associated with the management function and the hotel franchise from the valuation. The court held that the Rushmore method was flawed, because it did not identify and exclude other intangible assets from the assessment, as required by California law. In particular, the court noted that under the Rushmore method, the assessed value of the property improperly included the value of a number of intangibles, such as the hotel's assembled workforce, the hotel's leasehold in the employee parking lot, and the hotel's agreement with a golf course operator.

The court relied heavily on the recent decision, Elk Hills Power, LLC v. Board of Equalization.4 (Reed Smith represented the Institution for Professionals in Taxation in that litigation as an amicus.) As discussed in our prior Alert, the California Supreme Court held, in that case, that the value of intangibles cannot be included when assessing taxable real property. By relying on Elk Hills, the court emphasized that intangible assets are exempt from property tax, and that the value of intangibles that directly enhance the income stream cannot be subsumed in the valuation of taxable property.5

Takeaway: The California Constitution provides a clear prohibition on taxing intangible property, and that prohibition must be applied when reviewing statutes as well. California courts have been very active in clarifying what can and cannot be taxed. This is a significant decision where the court understood and properly applied the Constitutional prohibition at the statutory level.

Supreme Court rules that plaintiffs miss the mark in Target. On May 1, the California Supreme Court issued a 4–3 decision in Loeffler v. Target Corp.6 Ostensibly, the case involved the narrow issue of whether Target was over-charging its customers for sales tax on coffee sold in its California stores. But the real importance of the Target case was that the court decided whether a consumer class action can be brought against a business alleged to have overcollected California sales tax. California's high court held that the plaintiffs could not use consumer class action provisions based on unfair competition and consumer protection laws to circumvent the refund provisions of the Revenue and Taxation Code, which allow for class actions in more limited circumstances.

Takeaway: Had Target lost this case, California retailers would have been between a rock and a hard place. If they undercollected California sales tax they would owe the difference to the state, but if they overcollected the tax, they would have to pay the difference back to the consumer with potentially no recourse from the BOE for amounts already remitted to the state. We are informed that this controversy is not yet over, and that the plaintiffs in Loeffler and other cases are pursuing similar theories that do not depend on actual overcollection of tax, but rely instead upon an alleged failure to challenge or investigate taxability. We will keep you posted.

Plaintiffs file opening brief in LLC tax refund case. On June 26, the plaintiffs filed their opening brief in Bakersfield Mall, LLC v. Franchise Tax Board.7 The plaintiffs are seeking to determine the proper remedy owed to limited liability companies as the result of Northwest Energetic Services, LLC v. Franchise Tax Board8 and Ventas Finance I, LLC v. Franchise Tax Board.9 In those cases, the First District Court of Appeal determined that California's limited liability company fee imposed under Revenue & Taxation Code section 17942 was unconstitutional as applied to limited liability companies engaged in business either wholly or partially outside California. In Bakersfield Mall, the plaintiffs are asking the Court of Appeal to decide whether limited liability companies engaged in business either wholly or partially outside of California are entitled a refund of the entire fee paid, or a smaller refund computed by apportioning the fee based on where the limited liability company earned its gross receipts.

Procedurally, the plaintiffs are appealing the trial court's denial of their motion for class certification. The plaintiffs had argued that the class includes all taxpayers who had filed refund claims in response to the Ventas and Northwest Energetic decisions. The appeal involves the issue of whether the lower court's denial of class certification was an abuse of discretion. The FTB's reply brief is due August 26.

Legislation

California has become serious about offering tax credits to encourage businesses to remain in the Golden State. Businesses should monitor the following pending tax credit legislation:

Film and Television Credits Under California's current Film and Television Incentive Program, the California Film Commission can award film and television companies income and sales tax credits for qualified expenditures associated with independent films, films with budgets between $500,000 and $75 million, and certain television series.10 These credits are limited to between 20 percent and 25 percent of the qualified expenditures attributable to a qualifying production in California, and the total amount of credits awarded annually under the program is limited to $100 million. The current program is set to expire July 1, 2015.

Earlier this year, Assembly members Mike Gatto and Raul Bocanegra introduced legislation to extend and expand the program. Their bill would expand the credit to include qualified expenditures on films with budgets of up to $100 million, as well as a broader range of television series, pilots, and productions that take place outside of a 30-mile zone in Los Angeles. The bill would also expand the credit to include expenditures for motion picture music scoring, editing, and special effects. Assemblymember Adrin Nazarian introduced similar legislation last year. Lawmakers will decide on whether to extend the credit later this summer.

Takeaway: California's film and television tax credit program plays an important role in keeping the motion picture and television industry's jobs and spending in California. A July 2014 report released by the California Film Commission concluded that film and television productions that did not get awarded the credit spent $2 billion outside of California. In light of this conclusion, California is seeking to reestablish its golden, Hollywood-friendly image.

Sales tax exemption for manufacturing and research & development As we reported in previous updates ( May 2014 and July 2013), California's new sales tax exemption for purchases of manufacturing and research and development equipment, contained in Revenue and Taxation Code section 6377.1, went into effect July 1, 2014.11 The BOE adopted a regulation12 implementing the exemption July 17, 2014. As indicated in the BOE's notice proposing to adopt the regulation, the next step will be for the BOE to prepare a Final Statement of Reasons that it will make available to the public. The BOE has until May 29, 2015 to submit its rulemaking action to the Office of Administrative Law.

The regulation defines and provides authority for certain phrases that were left unclear in the statute, most notably the term "primarily engaged," as qualified persons must be primarily engaged in one of the enumerated lines of business to qualify for the exemption. Under the regulation, a legal entity, or an establishment within a legal entity, is "primarily engaged" in one of the qualifying lines of business described in the statute (e.g., manufacturing or research and development) if, in the prior financial year, it derived 50 percent or more of gross revenue from, or expended 50 percent or more of its operating expenses in, a line of business described in a qualifying NAICS code. Alternatively, an establishment within a legal entity is "primarily engaged" in one of the qualifying lines of business described in the statute if, in the prior financial year, the establishment allocated or assigned 50 percent or more of any of either: (1) employee salaries and wages, or (2) number of employees based on a full-time equivalency to a qualifying line of business, or derived 50 percent or more of its value of production from a qualifying line of business.

The regulation also explains how the exemption applies in the context of lease transactions and construction contracts, and provides the form for the partial exemption certificate referenced in the statute.

Takeaway: The new exemption for manufacturing and research and development is particularly lucrative, because it is a complete exemption from sales and use tax for qualifying purchases made by qualified persons engaged in certain lines of business. In contrast, the former Enterprise Zone sales and use tax incentive for manufacturing and renewable-energy-type equipment provided for a credit on manufacturing equipment purchased for use by a taxpayer located in an Enterprise Zone.

California Competes tax credit On June 19, the newly created Governor's Office of Business and Economic Development ("GO-Biz") released the list of companies recommended for the first allocation of California Competes tax credits. The list includes the amount of credit awarded to each company, the number of jobs each company is projected to create, the amount of investments, locations, and links to each tax credit agreement. The initial awards totaled $30 million, $7.4 million of which went to small businesses.

On June 30, GO-Biz announced that $150 million in tax credits are currently available through the program for the 2013–2014 fiscal year. As detailed in a previous Alert, there are set windows within which taxpayers can apply for the credit each year, with corresponding amounts of credit available for each window:

  • For a yet-to-be determined application period prior to January 5, 2015, $45 million in credits are available
  • For the January 5, 2015 through February 2, 2015 period, $75 million in credits are available
  • For the March 9 through April 6, 2015 period, $30 million in credits are available, plus any unallocated amount from the previous two periods

Interestingly, the GO-Biz announcement noted that the application period for the $45 million in credits will be announced pending the finalization of the new regulations. GO-Biz released draft regulations in November 2013. Although it solicited public comment, those regulations are still in draft form and have not been finalized. It is unclear when they will go final.

Takeaway: The application process for the California Competes credit is rigid, and taxpayers must stay on top of the application windows or miss the opportunity to apply for this lucrative credit. Contact a member of Reed Smith's California tax practice if you are interested in learning how any of the credit and incentives programs affects your business.

Meet the Team: Shirley Wei

Shirley is an associate in the Los Angeles office. She represents individuals and business entities—corporations, partnerships, and limited liability companies through all stages of state and local tax controversy: from initial inquiries and audits through appeals and litigation. She also advises on corporate income taxes, franchise tax, sales and use taxes, personal income taxes, property taxes, local taxes, and various other taxes arising in connection with business operations and during the controversy process. Shirley also actively represents clients through the firm's pro bono program.

Prior to joining Reed Smith, Shirley worked in multistate tax controversy and consulting at a Big 4 public accounting firm.

About Reed Smith State Tax

Reed Smith's state and local tax practice is comprised of more than 30 lawyers across seven offices nationwide. The practice focuses on state and local audit defense and refund appeals (from the administrative level through the appellate courts), as well as planning and transactional matters involving income, franchise, unclaimed property, sales and use, and property tax issues. Click here to view our  State Tax team. For more information on Reed Smith's California tax practice, visit State Tax - California.


  1. Case No. BC402036.
  2. 191 Cal. App. 4th 1259 (2011).
  3. 226 Cal. App. 4th 471 (2014).
  4. 57 Cal. 4th 593 (2013).
  5. Rev. & Tax. Code §§ 110(d); 210(c).
  6. Supreme Court No. S173972.
  7. California Court of Appeal, Case No. A140518. The appeal was consolidated with a related case, CA-Centerside II, LLC v. Franchise Tax Board, Fresno Sup. Ct. No. 10CECG00434.
  8. 159 Cal. App. 4th 841 (2008).
  9. 165 Cal. App. 4th 1207 (2008).
  10. Rev. & Tax. Code § 6902.5.
  11. Rev. & Tax. Code § 6377.1.
  12. Cal. Code Regs. § 1525.4.

This article is presented for informational purposes only and is not intended to constitute legal advice.