Office of Tax Appeals

After Rehearing a Petition for Rehearing, OTA Reinstates Taxpayer’s Win in Excise Tax Dispute

OTA with State Seal

After a two-year appeals process that involved rehearing a petition for rehearing, the Office of Tax Appeals this week posted an opinion upholding the taxpayer’s unanimous victory in the Appeal of Starbuzz International Inc., relating to tobacco taxes.

The opinion was one of the 56 posted to the OTA’s website May 1. The 45 franchise and income tax appeals and 11 business tax appeals included just one precedential opinion, a unanimous decision supporting the Franchise Tax Board’s denial of the “other state tax credit” (the Appeal of J. Buehler and D. Buehler).

In the Starbuzz case, the issue in the underlying appeal was California’s tobacco products excise tax, enacted by the voters through Proposition 99 of 1988 and amended by Revenue and Taxation Code section 30121(b), stating that: “Tobacco products includes, but is not limited to, all forms of cigars, smoking tobacco, chewing tobacco, snuff, and any other articles or products made of, or containing at least 50 percent, tobacco, but does not include cigarettes.”

The California Department of Tax and Fee Administration imposed the excise tax on shisha – a hookah product containing molasses, flavorings, and approximately 16 percent tobacco – sold by Starbuzz Tobacco Inc. and Starbuzz International Inc.

The taxpayer, represented by Marty Dakessian of Dakessian Law Ltd., argued that under the statute as it read prior to April 1, 2017, when it was amended by Proposition 56 in 2016, shisha is not subject to the tax because the tobacco content is well below the 50 percent threshold.

Additionally, the taxpayer argued that under California tax law, any ambiguity in the law must be resolved in favor of the taxpayer.

In April 2021, a three-member panel of the OTA’s administrative law judges unanimously granted the taxpayer’s appeal, finding that because shisha contains less than 50 percent tobacco, it did not meet the definition of a “tobacco product” under state law. The OTA panel ruled that the taxpayer was entitled to a refund of the excise tax paid to the CDTFA.

The CDTFA filed a petition for rehearing, claiming that the opinion was “opposite to the plain language of the statute … and creates an absurd result.” In September 2021, a new OTA panel – composed of one administrative law judge from the original panel and two new ALJs – granted the CDTFA’s petition for a rehearing in a split decision (with the original judge dissenting) and stated that “the findings expressed in the [original] opinion are contrary to the plain reading of the statute.”

The taxpayer challenged this decision in court, arguing that the OTA had no legal basis upon which to order a rehearing, as the original hearing was conducted properly and resulted in a decision supported by the law.

“The CDTFA, perhaps sensing that it had no legitimate grounds for requesting a rehearing, simply attacked the legal analysis contained in the opinions,” the taxpayers wrote in their court filing. “In so doing, it never even bothered to articulate the contrary-to-law standard or explain how the opinion was unsupported by the evidentiary record.”

The litigation was resolved in a settlement, and proceedings before the OTA resumed with briefing and argument over whether the CDTFA’s petition for rehearing should have been granted.

A new panel of administrative law judges heard arguments in January and issued an opinion in March – not released to the public until this week – unanimously reinstating the original opinion.

The previous panel of ALJs erred when it granted the CDTFA’s petition for rehearing, the new panel opined, because the CDTFA “failed to establish that a ground for granting the rehearing exists.” The new panel found that former Revenue and Taxation Code section 30121(b) is ambiguous and there is no direct and binding authority on this issue, so the original opinion could not be found to be contrary to law.

“This was an issue of first impression,” the new opinion explained. “It is important to note that OTA’s role in a PFR [petition for rehearing] is not one in which a new panel can re-evaluate the underlying appeal. Instead, Regulation section 30604 provides the only grounds for which a PFR can be granted. While the majority in the PFR Panel concluded that the Original Opinion was contrary to law, the majority based this conclusion on an independent analysis of the law. There was no finding of a directly controlling California Supreme Court or appellate court decision that rendered the Original Opinion as being invalid according to the law. In other words, there was no discussion of whether the Original Opinion could or could not be valid. Instead, the majority of the PFR Panel relied upon their interpretation of former R&TC section 30121(b) when determining whether the Original Opinion was contrary to law. Therefore, the PFR Panel made an error in granting the PFR.”

The taxpayer’s claims for refund of the erroneously imposed excise tax “are granted in full,” the final opinion stated.

Other notable OTA opinions released this week:

OTA Upholds FTB in Dispute Over Other State Tax Credit, Despite Likelihood of Double-Taxation. In the only pending precedential decision, the OTA unanimously ruled that the appellants did not show error in the FTB’s denial of the other state tax credit (OSTC) for more than $391,000 in income tax paid to Massachusetts on the net gain from the sale of a limited liability company membership interest (the Appeal of J. Buehler and D. Buehler). The OTA acknowledged that its decision could result in double-taxation of the income in question.

For a California resident taxpayer to be entitled to the OSTC, “income taxes paid to the nonresident state (here, Massachusetts) must be based on income sourced to that nonresident state using California’s nonresident sourcing rules,” the OTA wrote.

“There are two relevant nonresident sourcing provisions for purposes of resolving the issue here. R&TC section 17952 provides that nonresident income from intangible personal property is not income from sources within California, unless the property has acquired a business situs in this state …,” the OTA explained. “California Code of Regulations, title 18, section 17951-4(d) provides rules when ‘a nonresident is a partner in a partnership which carries on a unitary business, trade or profession within and without this state.’ To determine a nonresident partner’s California source income, Regulation section 17951-4(d) essentially requires the nonresident partner’s distributive share of a multistate partnership’s business income to be apportioned by formula using the partnership’s apportionment factors.”

The appellants argued that they are entitled to the OSTC for income taxes paid to Massachusetts because the gain at issue has a source in Massachusetts using California’s nonresident sourcing rules. The FTB argued that the appellant-husband’s sale of his interest in the LLC is the sale of intangible personal property, and the resulting gain should be sourced to his California residence.

The parties also differed on the question of whether the appellant’s membership interest in the LLC acquired a business situs in Massachusetts.

The OTA supported the FTB on all issues, concluding that the taxpayers did not meet their burden of proving that the agency erred.

“[W]hile it may be true that FTB’s denial of the OSTC to appellants will result in the income at issue being double taxed, R&TC section 18001 is not ‘a panacea for all double taxation,’” the OTA added. “Rather, [R&TC] section 18001 is narrowly drawn, applying only to cases which include the required elements, and the goal of limited protection against double taxation cannot be used to invoke the provision where California law establishes a California situs for the source of the income.”

OTA Upholds 40 Percent Penalty Imposed on Restaurant Owner. In the Appeal of Dash and a Handful, the question was whether a 40 percent penalty was warranted for unpaid tax as a result of unreported sales by a Vietnamese restaurant in Palm Springs.

The OTA affirmed the California Department of Tax and Fee Administration’s finding that there were unreported taxable sales and that the 40 percent penalty – amounting to more than $140,000 – was correctly imposed.

In an audit conducted for 2014 through 2017, the CDTFA determined that there was reasonable evidence to assume sales had been underreported, because the gross receipts reported on the taxpayer’s federal income tax returns exceeded the total sales reported on the sales and use tax returns by more than $2.4 million. Additionally, the restaurant and catering sales recorded in the taxpayer’s profit and loss statements exceeded the reportable taxable sales by more than $3.5 million.

The CTDFA imposed the 40 percent penalty established in Revenue and Taxation Code section 6597(a) for the failure to pay the tax reimbursement within the specified timeframe.

The taxpayer argued that the penalty is for fraud or intent to evade the tax, “and thus … to impose the penalty there must be ‘clear and convincing evidence of fraud’ and CTDFA has not shown clear and convincing evidence.”

The CDTFA initially regarded the 40 percent penalty as a “fraud penalty,” but changed its position and argued that the penalty “does not require a showing of fraud or an intent to evade the tax.”

Section 6597(a) “provides for circumstances where the penalty may be relieved if a taxpayer exercises reasonable care and not willful neglect,” the OTA wrote, adding: “It may be inferred that if the penalty were intended to be a fraud penalty, then it could not be relieved due to the exercise of ordinary care.”

The OTA determined that regardless of whether the CDTFA intended the penalty to be a fraud penalty, if a case meets the requirements of section 6597, the penalty is fairly imposed.

OTA Finds That FTB Improperly Denied Refund Claim, but Taxpayer Still Isn’t Entitled to a Refund. The OTA unanimously rejected the Appeal of K. Henderson, in which the taxpayer sought a personal income tax refund of just under $7,800, but also opined that the FTB erroneously denied the refund claim.

The FTB denied the claim for refund for the 2014 tax year because the filing status on the taxpayer’s return (married filing separately) did not match that on her federal income tax return (married filing jointly). The FTB cited Revenue and Taxation Code section 18521, which requires taxpayers to use the same filing status on their California income tax return as on their federal return.

This is not a proper basis for denying a refund, the OTA ruled.

“There is no requirement that a claim for refund, even if the claim is made on an income tax return form, meet the requirements of a valid income tax return filing,” the OTA wrote. “In fact, the requirements of a valid claim for refund are less onerous. … R&TC section 19322 states three requirements for a valid claim for refund: that a claim for refund be in writing, signed by the taxpayer or the taxpayer’s representative and state the specific grounds upon which it is founded.”

In this case, the taxpayer’s July 8, 2019, return was not a valid income tax return filing, but “it was still a valid refund claim – it was in writing, signed by the taxpayer and stated the grounds upon which the claim was founded,” the OTA stated.

“[The FTB] did not reevaluate its position or attempt to reach the correct substantive result,” the OTA added. “Rather, it denied appellant’s claim for refund for an administrative misstep. Thus, OTA finds respondent erred in rejecting appellant’s claim for refund for failure to meet the requirements of filing a valid income tax return, as appellant met the statutory requirements of a proper claim for refund pursuant to R&TC section 19322.”

The second question in the OTA’s review was whether the taxpayer showed that she is entitled to a refund. On appeal, the FTB “provided information and testimony showing that [its] income estimate was accurate; thus, although respondent erred in its reasoning to deny her claim for refund, appellant has not met her burden to show she is entitled to a refund,” the OTA concluded.

The OTA noted that the taxpayer failed to provide detailed documentation of her income and her ex-spouse’s income for the tax year in question, and added, “A taxpayer is not in a good position to criticize respondent’s estimate of his or her liability when he or she fails to file a required return and, in addition, subsequently refuses to submit information upon request.”

FTB Disallows Entire Deduction for Jewelry Loss Despite Police Report and Testimony. In the Appeal of D. Fusi, the dispute was whether the taxpayer was allowed to take a deduction for the value of expensive jewelry stolen during a home-invasion robbery, and if so, how much.

The taxpayer’s recommended deduction: $528,713. The amount allowed by the FTB: $0.

The taxpayer submitted a police report, testimony from those who were in his house during the robbery (the taxpayer was not home, but his ex-wife was there, wearing a Rolex watch and diamond ring), and appraisals from the expert who sold the various gems to the taxpayer in the first place. The police report indicated that at least 15 pieces of jewelry were stolen from the home, the taxpayer’s ex-wife had scratches on her face from the barrel of a handgun, and the ex-wife estimated the value of the stolen items at approximately $263,000. The appraiser later estimated the value to be just over $600,000.

Citing his divorce agreement and pre-nuptial agreement, the taxpayer argued that the jewelry was his personal property, and he was allowed to claim the theft loss deduction.

The FTB argued that the taxpayer did not own the jewelry at the time of the theft, but rather the ex-wife was the owner based on the tax agency’s interpretation of the legal agreements.

The OTA found that the jewelry was the appellant’s property, not community property or the ex-wife’s property, so he was eligible for the deduction.

As to the amount, the OTA concluded that “there are discrepancies between jewelry descriptions and valuations set forth in the police report and the appraisals,” but “[n]evertheless, the evidence in the record does not indicate that the loss should be zero, as FTB contends.”

“Accordingly, the Cohan rule will be applied to make a reasonable estimate of the stolen jewelry’s cost basis and fair market value,” the OTA ruled. “It is well settled that valuation is necessarily an approximation; it is not necessary that the value arrived at is a figure for which there is specificity, if it is within the range of figures that properly may be deduced from the evidence.”

Using this method, the OTA ruled that the theft loss totaled $225,000, and the taxpayer is eligible to claim a deduction of $147,713 after accounting for required adjustments. The OTA also abated an $11,745 accuracy-related penalty that had been imposed by the FTB.

The OTA denied the taxpayer’s petition for a rehearing of the jewelry valuation.

OTA Rules That it Lacks Jurisdiction to Rule on What it Describes as an Invalid FTB Notice of Action. The OTA’s opinion in the Appeal of G. Davis flatly states that the FTB “erred in issuing” a notice of action (NOA) “because it should not have acted administratively by denying the claim for refund for lack of substantiation until appellant had made full payment of the amount of tax he claimed to be due to him as a refund for the 2012 tax year.”

Still, the OTA sided with the FTB, opining that it does not have jurisdiction to hear and decide the appeal because the taxpayer “has not made full payment of tax to perfect his refund claim.”

“Although respondent made the mistake of acting administratively on the claim for refund for the 2012 tax year before full payment was made, we are aware of no legal authority (and the parties have pointed to none) which permits us, or respondent for that matter, to treat respondent’s error as a waiver of the full payment requirement,” the OTA added.

The appeal also involved a dispute over the taxpayer’s residency in 2011. The FTB argued that he was a California resident, while the taxpayer claimed to be a Florida resident. The OTA opined that the taxpayer’s contentions “are unsupported because he has submitted no evidence,” while the FTB’s position was buttressed by the fact that the taxpayer registered a vehicle, owned homes, and maintained a license to practice law in California long after he claimed to have moved out of the state.

The OTA also denied the taxpayer’s petition for rehearing.

Missed Deadline Is Costly for Taxpayer. In the Appeal of C. Goldfarb, the OTA unanimously ruled that the taxpayer’s claim for refund was barred by the statute of limitations – a fact that cost her more than $19,000.

The taxpayer failed to file a return for the 2016 tax year and did not respond to FTB notices. The tax agency discovered that she held a business license, and estimated her income based on the business’ sales tax returns and the average gross profit for her line of business. In 2019, the FTB seized funds from her bank account to cover the estimated tax liability.

The taxpayer finally filed her 2016 return in 2021, reporting zero tax liability, and the FTB accepted the return as filed. However, the tax agency refused to return the $19,000 that was seized, stating that her return – treated as a claim for refund – was filed approximately three months after the statute of limitations expired.

“[E]ven when, as shown here, FTB based its tax assessment on an estimated amount of income that was later proved to be inaccurate, there is no recourse to refund taxes paid when the claim for refund is untimely,” the OTA wrote. “This is because, without a timely refund claim, FTB does not have the statutory authority to refund amounts paid and OTA does not have statutory authority to require FTB to do so.”

Homeless Appellant Loses $2,194 Refund Due to Missed Deadline. The Appeal of M. France involved another missed deadline, this time by a taxpayer who testified that she is homeless and desperately needs the state to refund the $2,194 that she overpaid for the 2015 tax year. The FTB rejected her plea, arguing that she filed her refund claim nearly a year and a half too late.

The OTA unanimously sided with the FTB, writing: “There is no reasonable or equitable basis for suspending the statute of limitations. A taxpayer’s untimely filing of a refund claim for any reason bars a refund even if the tax is alleged to have been erroneously, illegally, or wrongfully collected. This is true even when it is later shown that the tax was not owed in the first place.”

In a footnote, the OTA added: “Appellant also alleges that she is homeless and on disability; however, she has not submitted any evidence to show that she is ‘financially disabled,’ as defined in R&TC section 19316.”