OTA Again Rejects FTB’s Interpretation of When ‘Demand Penalty’ Is Allowed

The Office of Tax Appeals posted 42 new opinions to its website November 7, including one in which the OTA again unanimously rejected the Franchise Tax Board’s longstanding interpretation of when a “demand penalty” can be imposed – and another in which two of the agency’s administrative law judges reached the opposite conclusion.

The Appeal of Ronna J. Robertson marks the third time this year the OTA ruled that the FTB has expanded the penalty by ignoring the plain wording of its own regulation. The other cases are the Appeal of Jacob A. Ely and the Appeal of Jack Atkins and Yvonne Darling-Atkins.)

However, in the Appeal of Andrej Maihorn and Angelita Billman Maihorn, a different panel of ALJs reached a very different conclusion on the same issue, siding with the FTB’s interpretation of the regulation.

FTB Regulation 19133 states that the demand penalty will be imposed only if the individual fails to respond to a current demand for a tax return and the FTB has proposed a request or demand for a return “at any time during the four-taxable-year period preceding the taxable year for which the current Demand for Tax Return is issued.”

In the Robertson appeal, the OTA wrote: “The taxable year for which FTB desires to impose the demand penalty is 2015. In order to apply the demand penalty under the regulation, appellant’s failure to respond to a prior Demand that resulted in an NPA having been issued, must have occurred in either 2011, 2012, 2013, or 2014 (during the four tax years preceding 2015). However, in this case, appellant’s failure to respond to FTB’s prior Request (for tax year 2014) occurred … on or after March 30, 2016, which was not during one of the four taxable years preceding 2015.”

As in the past appeals, the OTA chastised the FTB for applying the regulation “in a manner that would substitute the word ‘for’ in place of ‘during,’” thus subjecting more taxpayers to the penalty.

The OTA additionally criticized one of the examples provided by the FTB in the regulation, stating that the “illustrative example conflicts with the plain language of the regulation.” In a footnote, the OTA added that the FTB staff’s interpretation of the regulation “operates in a way that was expressly rejected by the FTB’s three-member board,” because it “does not provide the notice to taxpayers intended by the regulation, nor does it effectively ‘target … only repeat nonfilers.’”

As was the case in the two prior appeals, the FTB petitioned for rehearing but the OTA rejected the petition with a unanimous vote.

In the Maihorn appeal, however, ALJ Linda Cheng not only agreed with the FTB’s interpretation, but also cited the example that was criticized by the other ALJs, saying its language should be controlling. ALJ Nguyen Dang agreed that the penalty was properly imposed, while ALJ Daniel Cho dissented, writing that the FTB misinterpreted the regulation. Addressing the example in the regulation, Cho wrote: “I do not believe it is entitled to any persuasive authority.”

Despite the 2-1 support for the FTB’s interpretation of when the penalty can be imposed, the Maihorns won their appeal on another issue. Cheng opined that the demand penalty should be abated due to reasonable cause and the absence of willful neglect. The taxpayers testified that they never received a vital notice from the FTB, and provided a variety of evidence to back up their claim that the U.S. Postal Service’s delivery to their home is unreliable. Cheng found the testimony credible. Cho concurred with the result – abating the penalty – but did not address the mail issue in his opinion. Dang, meanwhile, wrote a separate opinion supporting imposition of the penalty, stating that he didn’t find the taxpayers’ testimony credible.

The FTB recently began the process of amending the regulation. In the notice for a November 13 interested parties meeting on the issue, the FTB said it is working on a “potential clarifying modification” the regulation, and added that “the proposed amendments do not alter how the FTB interprets and applies the regulation.”

The OTA’s opinion in the underlying appeal is dated April 23, but wasn’t posted to the agency’s website until this week, at the same time the September 23 opinion in the petition for rehearing was posted.

Most of the opinions posted this week carry issuance dates in late September, but some date back as far as April 5.

The key opinions:

Dissenter Says Majority Improperly Denied Tax Exemption for Farm Equipment. In the Consolidated Appeals of California Wood Recycling Inc., Silvas Oil Company Inc. and Quinn Company, the OTA ruled 2-1 that the California Department of Tax and Fee Administration properly denied the taxpayers’ claim for a partial sales and use tax exemption for use of certain equipment and diesel fuel.

California Wood Recycling produces mulch from green waste and plant materials. It entered into lease agreements with farmers for the use of land where it could receive waste and plant materials from waste disposal companies. It converted the waste into mulch, and spread approximately 85 percent of the mulch on land on which the farmers cultivated and harvested food products for human consumption. The rest was sold to others.

Citing Revenue and Taxation Code Sections 6356.5(a) and 6357.1, the company sought a refund for use tax and diesel fuel tax paid in connection with its purchase and use of the equipment used to perform the recycling, processing and conversion of the waste into usable mulch and other “soil amendment” products. The CDTFA denied the refund claim.

The company argued that all of its activities at issue occurred on farmland and were integrated into one activity – producing mulch that would be applied to farmland. Thus, the equipment and fuel qualified for the exemption for farm equipment, the taxpayer contended.

The OTA’s majority – Administrative Law Judges Jeffrey Angeja and Linda Cheng – disagreed, finding that the company would qualify only if the equipment was used 50 percent or more of the time in the act of “staging” the mulch (spreading it in the fields), which was not proven. “[A]ppellant’s production of the mulch is not a qualifying activity, only the staging activities are qualifying activities, and appellant has not submitted evidence to establish what percentage of the time its equipment and vehicles were engaged in that activity,” the majority opinion stated. “Furthermore, most of the equipment appellant identified … relates to the production of the mulch, not the hauling of the mulch to staging locations.”

ALJ Douglas Bramhall dissented, writing: “Since appellant’s permits require the application of the majority of the products produced with the waste to be spread on the land to which it is delivered, a fact omitted from the majority analysis, the receipt and processing of that waste were all part of the primary activity of appellant – primarily ‘providing other services for improving the soil.’ And this activity was defined by the Legislature as one that qualifies to be provided by a person who assists a qualified person.”

Bramhall said he would find that the machinery and equipment qualifies for the partial sales and use tax exemption to the extent the company documents tax actually paid on the items claimed, but said he agreed with the majority opinion rejecting the claim for a partial exemption for diesel fuel.

FTB’s Introduced New Matter Five Years After NPA Was Issued, Shifting the Burden of Proof. The Appeal of B.B.C.A.F. Inc. yielded three separate opinions on a variety of complex issues, primarily concerning whether the burden of proof shifted to the FTB when the agency introduced a new matter during the appeal – approximately five years after it issued the notices of proposed assessment that triggered the appeal.

In 2011, the FTB issued NPAs for the 2005 and 2006 tax years, taking the position that the appellant and a trust located in the United Kingdom were part of a single unitary business, and that loans from the trust were not bona fide indebtedness, but instead should be characterized for tax purposes as capital contributions, resulting in interest deductions being disallowed. The NPA was the result of an audit that commenced in 2008.

In 2016, during the appeal, the FTB took a completely new position, conceding that the loans were bona fide debt but limiting the amount of deductible interest expense to those expenses that are attributable to activities subject to California tax.

The taxpayer argued that the FTB should be barred from raising its new position because the statute of limitations had expired. The taxpayer additionally contended that if the FTB was allowed to raise its new position, the burden of proof must be shifted to the FTB as the law requires if a “new issue” is raised.

ALJ Jeffrey Margolis opined that the FTB is entitled to raise its new position, but bears the burden of proof. He additionally accepted concessions made by both parties, established the percentage of interest the taxpayer is entitled to deduct, and rejected the taxpayer’s request to abate interest because of alleged unreasonable delays by the FTB.

ALJ Kenneth Gast wrote separately to concur with the result but to express disagreement with some of the computations of interest expenses. Gast also noted that “FTB itself has historically wavered on its current litigating position” regarding which of two laws relating to interest income is controlling.

ALJ Tommy Leung also concurred with the ultimate outcome of the appeal, but dissented on the issue of whether the burden of proof shifted. There was no “new matter” triggering a shift, he wrote. “Simply put, FTB’s action began as an interest expense denial case, and it remains an interest expense denial case,” Leung stated. On the issue of which code section is controlling, Leung criticized the FTB for an “extra-judicial attempt” to change the law via a notice that “is nothing more than an underground regulation” because it did not comply with the state’s Administrative Procedure Act.

Taxpayer Wins Unanimous Decision in Appeal Over California-Source Income. The OTA unanimously granted the Appeal of Christopher J. Wood, finding that the out-of-state taxpayer’s income did not come from a California source and cannot be taxed in this state. Wood, an independent contractor/sole proprietor who works out of his home in Texas, performed software design for Christopher Konrad Consulting, a California LLC that in turn provided services to another company.

The FTB argued that because Konrad is based in California, all the income Wood received from the contract must be sourced to California. The OTA disagreed, concluding that the benefit of the work was received by Konrad’s customer, and there was no evidence that the benefit was received in California.

“[W]e conclude FTB’s proposed assessment is not reasonable and rational …,” the OTA opined. “Under the Agreement, appellant’s direct customer is Konrad, but, upon closer examination, it appears that appellant’s services are being provided for the benefit of Konrad’s customer ….”

Dissenting Judge Says FTB’s Estimate of Income Wasn’t Reasonable and Rational. In the Appeal of Belle Beauty Boutique Inc., the OTA issued a 2-1 ruling sustaining most of the FTB’s proposed assessment, which was based on information received from the IRS.

In a dissent, however, ALJ Jeffrey Margolis said he would grant the appeal of the Delaware-based corporation because the FTB “has not made a reasonable and rational estimate of appellant’s ‘net income’ from the information available to it.”

Margolis said he agreed that the corporation was doing business in California and was obligated to file a California return, but opined that it was liable only for the $800 annual minimum tax and penalties based on that amount.

“FTB’s estimate of appellant’s net income as $60,558, instead of the net income of zero that was reported on appellant’s federal return (from which FTB drew its income estimate), lacks a reasonable and rational foundation …,” Margolis wrote. “FTB’s error in not allowing (perhaps inadvertently) all the deductions claimed and allowed on appellant’s federal return is erroneous and unreasonable. The error in FTB’s action is best highlighted by the fact that FTB did not allow the $15,737 expense claimed for officer compensation paid to appellant’s president, Ms. Cappelletti, while it simultaneously – and inconsistently – argues that this payment proves that Ms. Cappelletti was performing services in California on appellant’s behalf.”

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