California Tax Developments - A Reed Smith Quarterly Update (2nd Quarter 2014)

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...