1 BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 2 450 N STREET 3 SACRAMENTO, CALIFORNIA 4 5 6 7 8 REPORTER'S TRANSCRIPT 9 AUGUST 30, 2016 10 11 SALES AND USE TAX APPEAL HEARING 12 APPEAL OF 13 PAULA TRUST 14 NO. 759422 15 AGAINST PROPOSED ASSESSMENT OF 16 SALES AND USE TAX 17 18 19 20 21 22 23 24 25 26 27 Reported by: Jillian Sumner 28 CSR No. 13619 1 1 P R E S E N T 2 For the Board of Equalization: Fiona Ma, CPA 3 Chairwoman 4 Diane L. HARKEY Vice Chair 5 Jerome E. HORTON 6 Member 7 Sen. George Runner (Ret.) Member 8 Yvette Stowers 9 Appearing for Betty T. Yee, State Controller 10 (per Government Code Section 7.9) 11 Joann Richmond 12 Chief Board Proceedings 13 Division For Board of 14 Equalization Staff: Jeff Angeja Tax Counsel IV 15 Legal Department 16 For the Department: Sonia Woodruff Tax Counsel 17 Doug Powers 18 Tax Counsel 19 Natasha Page Tax Counsel 20 For Petitioner: Andrew McCullough 21 Representative 22 Edwin P. Antolin Attorney 23 Prentiss Willson 24 Attorney 25 ---oOo--- 26 27 28 2 1 450 N STREET 2 SACRAMENTO, CALIFORNIA 3 AUGUST 30, 2016 4 ---oOo--- 5 MS. MA: Thank you, Ms. Richmond. Please 6 call our next item. 7 MS. RICHMOND: Our next item is B, 8 Corporate Franchise Personal Income Tax Appeals 9 Hearing, Item B-1, Paula Trust is already seated at 10 the table. 11 Board Proceedings has received contribution 12 schools and forms for today's hearings from the 13 parties, participants, and agents. All forms were 14 properly completed and signed. No disqualifying 15 contributions were disclosed. 16 All parties, participants and agents are on 17 the alpha listing provided to your office. 18 Each person sitting at the table will be 19 asked to introduce themselves, and if necessary, 20 their affiliation with the taxpayer for the record. 21 Ten minutes is allocated for the taxpayer's 22 opening presentation; followed by ten minutes for 23 the Franchise Tax Board's presentation; and five 24 minutes is allocated to the taxpayer for rebuttal. 25 This taxpayer was granted an additional ten 26 minutes for their presentation. 27 Ms. Ma. 28 MS. MA: So we're going to have 20 3 1 minutes -- 2 MS. RICHMOND: Yes. 3 MS. MA: -- on each side. 4 Okay. Mr. Thompson, will you please 5 introduce the issues in this case. 6 MR. THOMPSON: Yes. 7 Good morning, Members of the Board. 8 The issue in this appeal is whether 9 Appellant Paula Trust is taxable on all of its 10 income as contended by FTB either on the basis of 11 source or per FTB's alternative contention, on the 12 basis of the residence of the beneficiary. 13 Or, as Appellant contends, whether Paula 14 Trust is taxable on one-half of its income based on 15 the residence of its fiduciaries. 16 MS. MA: Okay. Thank you. 17 To the Appellants, welcome to the Board of 18 Equalization. 19 You have been granted additional time for 20 your opening presentation. You'll have 20 minutes 21 to make your initial presentation; you'll have an 22 additional five minutes on rebuttal. 23 Please introduce yourselves for the record 24 and please present, uh -- begin your presentation. 25 MR. ANTOLIN: Good morning, Chairman Ma -- 26 or Chairwoman Ma and Members of the Board. 27 My name is Edwin Antolin, counsel for 28 Appellant Paula Trust. 4 1 MR. WILLSON: Prentiss Willson, counsel for 2 Paula Trust. 3 MR. McCULLOUGH: And Andrew McCullough, 4 representative for Paula Trust. 5 MR. WILLSON: All right. I'd like to start 6 and provide a 10,000 foot overview of the argument, 7 and then Ed will lead us through the slides that you 8 have. 9 As we see it, this is a very simple case. 10 There's only one statute that applies to tell how 11 the trust is taxed in this case. Its rule is clear. 12 It's an apportionment rule based on the location of 13 the two trustees; one in the state, and one out of 14 the state. 15 FTB seems to acknowledge that that one 16 statute, the only one in the rules that -- that 17 would arguably apply on its face, doesn't apply but 18 points to a regulation that has both the support -- 19 the same apportionment rule, and has a California 20 sourcing rule. 21 We will show two things about the 22 regulation: 23 First, by its terms, it doesn't apply. By 24 its literal terms, just reading the reg. 25 And, secondly, that it goes beyond the 26 statute to which it is attached. 27 It turns out to be very understandable how 28 this disconnect between the statute and the 5 1 regulation came about. 2 The statute was enacted in 1935 and the 3 Legislature put into play both the apportionment 4 rule and the sourcing rule. 5 The FTB drafted a regulation in 1936 that 6 reflected both of those. The Legislature amended 7 the code in 1937 to take out the sourcing rule, and 8 the regulation has never been changed. 9 Moreover -- and this is a very, very 10 important point -- when the statute was modified in 11 1937, removing the sourcing rule at the level of the 12 trust, the Legislature added a sourcing rule at the 13 beneficiary level -- at the nonresident beneficiary 14 level, so that there would be no escaping of tax 15 ultimately. 16 The loophole that the three public comments 17 that have come in at the last minute seem fearful of 18 was addressed and solved by the Legislature in 1937. 19 This income source to California will be taxed when 20 it's ultimately distributed. 21 We will show there's no other sourcing rule 22 or even a need for one. We will show that the 23 attenuated arguments that the FTB makes in which 24 they try to graft onto the provisions, the trust 25 sourcing -- try to draft onto the trust rules, a 26 sourcing provision from elsewhere failed completely. 27 We will show you that the Legislature knows 28 how to do this. They knew how to do it back in the 6 1 '30s. And they know how to provide apportionment 2 and sourcing rules in other areas; sole 3 proprietorships, partnerships, corporations. They 4 know how to do that and they do it explicitly. 5 We'll remind you that as taxpayers, we're 6 entitled to a certain amount of certainty in the 7 code itself. And our view is that the -- the fact 8 that the -- California will ultimately be able to 9 tax this income no matter where the beneficiary 10 resides at the time of the distribution. 11 I think our reading of the Legislature's 12 handiwork is not absurd, as FTB has characterized 13 it, or specious, as each of the three public letters 14 did. 15 And, finally, we'll demonstrate how FTB's 16 construction of the regulation, ignoring the change 17 in the statute, makes the regulation itself 18 unconstitutional. 19 The statute's not unconstitutional -- it's 20 fine -- but the regulation is, which suggests that 21 the regulation has gone well beyond what the statute 22 would permit. 23 But you don't have to get there. As I said 24 at the outset, it's really a very simple case, and 25 there's a very clear statute that applies. 26 And Ed will now lead you through this. 27 MR. ANTOLIN: Thank you, Prentiss. 28 So turning to the first slide, the facts 7 1 are not in dispute in this case. The Appellant is 2 an irrevocable trust formed in 1971. There are two 3 trustees; one is a California resident, one is a 4 Maryland resident. The beneficiary is a California 5 resident. 6 The beneficiary's only interest in this 7 trust is contingent, and that is expressed in the 8 terms of the trust instrument. 9 Turning to Slide Number 2, the issue is, as 10 kind of a -- oh -- 11 MS. MA: Ms. Harkey. 12 MS. HARKEY: I'm sorry. I'm not seeing the 13 slides. 14 Are they supposed to be displayed where we 15 can see them as well? 16 MR. ANTOLIN: We have handed the -- 17 MR. WILLSON: No -- 18 MS. RICHMOND: That was the material that 19 was passed out. 20 MS. MA: Why don't you -- 21 MS. RICHMOND: It's in your material that 22 was passed out. 23 MR. WILLSON: They're not all here in -- in 24 blowup. They're -- 25 MR. ANTOLIN: Yeah, we have -- we have a 26 packet here to hand out. 27 MS. HARKEY: Okay. Sorry. I just want to 28 be sure I'm following along. 8 1 MR. ANTOLIN: Yes, of course. 2 Does anyone else need a copy of our slides? 3 MS. WOODRUFF: Oh, we need a copy of the 4 slides. 5 MR. ANTOLIN: Okay. 6 So to continue, Slide Number 2, raise -- we 7 raised the issue, what is -- what issue -- the issue 8 is what rules apply for determining the amount of 9 Paula Trust income that is taxed by California. 10 On the one hand, the FTB says that it's a 11 two-part rule; you first determine California source 12 income, as if the trust were a nonresident 13 individual. And then whatever is remaining that's 14 not taxed by California, California can tax an 15 apportioned piece of that. 16 Our view is that that is not correct. 17 There is only a single rule, and it is an 18 apportionment rule that should be applied. 19 Turning to Slide Number 3, so this is our 20 argument, there is a very simple statute that 21 applies. It is Section 17743. And by its terms, it 22 says that a trust like Paula Trust is subject to tax 23 on an apportioned basis, according to the number of 24 fiduciaries who are resident in California versus 25 the total number of fiduciaries. 26 In this case, Paula Trust had one fiduciary 27 that was a California resident and one that was not. 28 So, therefore, under the statute, only one-half of 9 1 Paula Trust income is subject to tax. 2 It's a very simple rule. It's 3 straightforward. It is very clear. 4 Now, to -- speaking to the three letters 5 that were submitted as public comments in this case, 6 as Prentiss explained, there is absolutely no tax 7 loophole and no tax avoidance in this case. 8 Why is that? 9 The Legislature has enacted statutory 10 provisions to ensure that California source income 11 is taxed when earned by the trust. But it's not 12 taxed at the trust level, it is taxed at -- when 13 that income is distributed to the nonresident 14 beneficiaries. That is an express provision enacted 15 by the Legislature in Section 17734, and it's also 16 set forth in another section enacted by the 17 Legislature, Section 17953. 18 Both of those provisions, together, ensure 19 that there is absolutely no avoidance of tax by 20 California on California source income in this case. 21 And on top of that, California has a 22 withholding requirement for trusts. So when this 23 trust distributes income from a California source to 24 a nonresident, California law requires that the 25 trust withhold California tax on those distributions 26 as a second statutory requirement to ensure that 27 California tax is absolutely paid on those 28 distributions from the trust. 10 1 And that requirement is also set forth in 2 the FTB's own trust tax return instructions, which 3 direct trustees to make that withholding on 4 distributions of California source income. 5 Now, in this case the -- the beneficiary is 6 a California resident. And when the income is 7 distributed to a California resident beneficiary, 8 there's another provision that the Legislature 9 enacted to ensure that California gets all of the 10 tax on the income earned by that trust. And that is 11 Section 17745(b). 12 And what that provision says is when 13 California distributes income to a beneficiary, that 14 beneficiary is taxable on any income that was -- 15 that was not already taxed at the trust level. 16 So this scheme is very coherent. And what 17 it means is that -- that California absolutely is 18 not losing out on any of the -- the tax earned by 19 the trust on California source income. 20 Turning to Slide Number 4, the legislative 21 history informs how the statute and the regulation 22 became disconnected. And as Prentiss stated, in 23 1935 the Legislature very clearly said: 24 "We are going to tax a trust on both 25 sourced income and -- and on an apportionment 26 method." 27 And then one year later in 1936, the 28 Department at that time issued regulations 11 1 consistent with that two-part taxation rule. 2 In 1937 the Legislature revisited the 3 Personal Income Tax Act, and it amended the statute, 4 and it repealed the sourcing rule for trust. 5 The Legislature said: 6 "We will not tax trust on California source 7 income, we will only apply an apportionment method." 8 But the regulations that were issued after 9 that legislative change did not reflect that repeal 10 by the Legislature. 11 And, again, this is very important. At the 12 same time in 1937 when the Legislature repealed the 13 trust-source rule, the -- the Legislature must have 14 recognized that California source income might not 15 be taxed. 16 So what did it do? 17 It added a provision to the code in 1937 18 that said nonresident beneficiaries will be taxed 19 when they receive California source income, ensuring 20 that California is not going to lose any tax on 21 trusts that earn California source income. 22 And that same scheme has carried forward 23 all the way to today. It's a very coherent scheme. 24 And here is how it applies to Paula Trust: 25 First, a trust like Paula Trust is taxed at 26 the trust level based on an apportionment method. 27 Second, if the trust distributes income 28 from a California source to a nonresident 12 1 beneficiary, the nonresident beneficiary is taxed by 2 California under 17743 and 17953. 3 And moreover, the trust will have to 4 withhold tax to ensure that California gets paid -- 5 is taxed on that amount. 6 And then third, if the trust distributes 7 income to a resident beneficiary, like in our case, 8 like in Paula Trust's case, there's also a provision 9 that says: 10 "If any income distributed from the trust 11 was not taxed by California, then the beneficiary 12 will pay tax upon distribution." 13 That scheme is completely coherent, and it 14 is sensible. 15 So what does the FTB argue? 16 In turning to Slide Number 5, FTB raises 17 three arguments. 18 First, that there is a regulation that 19 requires this two-part sourcing rule. 20 Second, that there are other statutes 21 somewhere in the code that impose this two-step and 22 the nonresident sourcing rule on trusts. 23 And, third, that it is absurd not to apply 24 those rules -- or not -- it is absurd not to tax 25 California source income at the trust level. 26 Each of those arguments fails, and here's 27 why: 28 Turning to Slide Number 6, the regulation 13 1 on its face does not apply. The regulation -- this 2 is the first sentence in that regulation. It says 3 that it applies only if all the beneficiaries are 4 nonresidents. And in this case, the only 5 beneficiary is a California resident. 6 So by its terms, we don't even have to get 7 past that introductory language in the regulation. 8 It just does not apply. 9 In addition, even if you could somehow 10 overcome that language and say that the rules in the 11 regulation apply, the regulation is in direct 12 conflict with the statute, Section 17734 -- or, I'm 13 sorry -- 17743. And because of that, it cannot 14 stand. The regulation cannot override what the 15 Legislature has enacted in, uh -- in the statutory 16 law. 17 Next, Slide Number 7, the FTB raises or 18 cites the various statutory provisions, and claims 19 that we can somehow knit together various provisions 20 in the Rev and Tax Code to impose the nonresident 21 sourcing rules on trusts. And that is just not the 22 case. 23 First, there is no clear and express 24 statute that says nonresident sourcing rules apply 25 to trusts. And as Prentiss noted, as taxpay -- tax 26 laws have to be clear and express when they are 27 imposing a tax imposition on taxpayers. And if 28 there is any ambiguity, then the tax provisions must 14 1 be construed strictly against the state and in favor 2 of the taxpayer. 3 So there is no provision -- we've searched 4 the code very carefully -- that says a trust is 5 subject to the nonresident sourcing rules. 6 Now, second, we know when the Legislature 7 wants to impose the nonresident sourcing rule, it 8 does so in a very clear and very straightforward 9 way. 10 We have examples: 11 When the Legislature wants to impose the 12 nonresident sourcing rules on nonresidents, for 13 example, the Legislature just says so. 14 In 17041(i), it says so in one sentence. 15 It's very clear. We don't need to weave through the 16 code and find -- and put that argument -- put that 17 together. The Legislature just says so. 18 And, again, when the Legislature wants to 19 impose those sourcing rules on nonresident 20 beneficiaries, again, the Legislature is very clear 21 in 17734, providing expressly that those rules apply 22 when a nonresident beneficiary receives a 23 distribution of California source income from a 24 trust. 25 Third, if we accept the FTB's position that 26 a trust is taxed on all California source income at 27 the trust level, then the provision that says 28 non-beneficiary -- nonresident beneficiaries are 15 1 taxed when they receive California source income is 2 completely superfluous and would never apply. 3 Because it -- that income would already have been 4 taxed at the trust level. 5 So then -- what -- so -- and finally, 6 turning to Slide Number 8, when the Legislature 7 wants to tax a certain entity, like a trust or a 8 partnership or a corporation, it knows how to do, 9 and it does so in a very logical and methodical way. 10 What it does is it first says, "Okay. This 11 is how you compute the taxable income." For 12 example, for partnerships and for corporations, the 13 Legislature said, "Look to federal law to figure out 14 how to compute taxable income." 15 The Legislature did the same thing with 16 trust. It said, "Look to federal law to determine 17 trust taxable income." 18 And then the Legislature said, "You need 19 special rules to figure out how much of that income 20 is taxed by California." 21 So in the case of a partnership or a 22 corporation, the Legislature has very clear and 23 simple rules that say how much income gets sourced 24 or apportioned to California. 25 And in the case of Trust -- in -- in the 26 case of Trust, the Legislature did the same thing. 27 It enacted 17743, which is a very clear and simple 28 apportionment rule. And that's com -- completely 16 1 consistent with what -- the way that the Legislature 2 explained and -- and set forth the tax scheme for 3 other types of taxpayers. 4 But what the FTB is proposing is that the 5 Legislature set forth a clear rule for trusts, but 6 then also set forth a very obtuse and implied rule 7 that we have to somehow discern from other 8 provisions in the code. And that is very unusual 9 and not like, um, the Legislature taxes other types 10 of, um, taxpayers. 11 So in sum, we have this coherent tax 12 scheme. There -- there is no clear statutory 13 provision that applies to, um, apply the nonresident 14 sourcing rules to trust. 15 Now, the next argument the FTB makes is 16 that, well, it's just absurd if California cannot 17 tax trust income from a California source. And 18 that's absolutely not the case. 19 MR. WILLSON: With Slide 9, it's really 20 only the second point we need to make that's new. 21 Imagine if everything was the same in Paula 22 Trust, but the property in question had been in 23 Maryland. And it sold in Maryland, and the gain is 24 realized there. California will tax half of it. 25 We would agree with that under the 26 apportionment rule: one trustee out of state; one 27 in, they get 50 percent. That's the rule the 28 Legislature adopted. They're gonna get some -- some 17 1 of it if it's outside of the state; they're gonna 2 get some of it if it's inside the state. But they 3 don't get it all. 4 Nothing absurd about that methodology for 5 apportionment at all. 6 And point three, we both hit you with that. 7 There is no avoidance of the income here. It will 8 be taxed ultimately on distribution. 9 Now, there's a deferral that depends when 10 the distribution takes place. The code is full of 11 deferral provisions; property distributed by 12 partnerships, typically not subject to tax; 1031 13 exchanges, all kinds of corporate reorganizations. 14 It's commonplace in the code to have what is 15 essentially a realization event, but for whatever 16 reason we have chosen not to tax. 17 In 1935 they did decide to tax, but in 1937 18 they changed. And in this case, California source 19 income going to a nonresident will not be taxed 20 until the -- until the distribution. 21 And, um, Slide 10, at the risk of 22 complicating this unnecessarily, but just to make 23 the point, nothing's unconstitutional about the 24 statute as we see it. The apportionment works just 25 fine. Maryland would get their half; California 26 would get their half; and ultimately California will 27 get it again when distributed to the beneficiary. 28 But California's -- the reg, that 18 1 interpretation actually makes the whole scheme 2 unconstitutional. And the reason -- and that comes 3 up in -- in a test -- in an internal consistency 4 test, which is -- ironically, comes from a case that 5 California prevailed in in the U.S. Supreme Court in 6 1983, in which we were looking at apportionment 7 formulas. And we were claiming California was so 8 out of step with the rest of the world in their 9 worldwide apportionment that the formula should be 10 struck down. And the Court said: 11 "No. There's a lot of leeway for how you 12 do formulas, we're not gonna say there's a single 13 correct one." 14 But they did say there is -- that doesn't 15 mean you can do anything. And there is a way that 16 we test the constitutionality of apportionment 17 schemes, and that's this internal consistency. 18 Is it internally consistent, and how do we 19 apply that test? 20 We say, suppose all of the relevant 21 jurisdictions had exactly the same taxing scheme. 22 If it results in more than 100 percent tax, it's not 23 internally consistent. Because an internally 24 consistent one applied everywhere should lead to 100 25 percent tax. 26 What happens in this case, California would 27 get, in their view, 100 percent on the sourcing 28 rule, and Maryland would get one-half on the 19 1 apportionment rule. And so 150 percent would be 2 subject to tax. And that -- that in -- therein is 3 the internal consistency violation. 4 MR. ANTOLIN: Thanks. 5 So turning to our last slide -- and we have 6 it up here as well -- Slide Number 11. Just in 7 summary. 8 So why should Paula Trust prevail? 9 Well, this is not a complicated case, as 10 we -- as we've been saying and repeating. There is 11 a single statute that applies, and it's a very 12 simple apportionment formula in that statute. And 13 that is all that the Legislature has set forth as 14 the rule that should apply to trusts. 15 Now, FTB has raised these three arguments: 16 The regulation itself doesn't apply by its 17 terms; there is no other statute that is clear and 18 express, um -- in its -- on its -- in its terms that 19 says that a trust is taxed on California's source 20 income. 21 And, finally, as Prentiss just explained, 22 it is not absurd to apply an apportionment formula 23 in this case. In some cases a trust pays more tax 24 compared with a nonresident individual. 25 For example, if all of this property held 26 by the Paula Trust had been sourced to another 27 state, California would still tax half of that even 28 though a nonresident individual would not -- would 20 1 not be taxed on any of that in California. 2 And in some cases a tax pays less than a 3 nonresident individual would pay. But -- and this 4 is important -- California is never a loser on the 5 tax side. In all cases, California will get tax on 6 all California source income earned by that trust. 7 Because it will be taxed when the beneficiary 8 receives that income, whether the beneficiary is a 9 nonresident or a resident, California will get its 10 tax. 11 So, finally, it is a core principle of tax 12 law that tax and position statutes must be clear and 13 express. 14 If that is not the case, then taxpayers 15 will have no certainty, and there is risk of 16 unfairness and governmental mischief as this case 17 demonstrates. 18 The FTB proposes that Paula Trust search 19 the code for these unstated or inferred tax rules, 20 and we should not be required to do that. 21 We are only asking your Board to enforce 22 the tax statutes as written. There is no loophole; 23 there is no risk of California losing any tax 24 revenue. 25 Thank you. 26 MS. MA: Okay. Thank you. 27 Um, Franchise Tax Board. 28 MS. WOODRUFF: Thank you, Chairwoman Ma and 21 1 Members of the Board. 2 My name is Sonia Woodruff, and sitting with 3 me today are Doug Powers and Natasha Page, and we 4 represent the Franchise Tax Board on this matter. 5 In 2007 Appellants received distributive 6 share income from California-based pass-through 7 entities. So the income was gained from the sale of 8 stock in Century Theaters Incorporated, a theater 9 chain originally founded in Vallejo, California. 10 Now, Appellants have agreed not to dispute 11 that all of the income of the trust was from a 12 California source. So their only argument is that 13 this income is not fully taxable by California even 14 though it's from a source within the state. Because 15 trusts are somehow exempt from tax based on sourcing 16 jurisdiction. 17 In fact, trusts are subject to tax in 18 California when they receive California source 19 income, just like individuals and estates. 20 So to give an example of just how absurd 21 Appellant's position is, under their interpretation 22 of the code, an individual could place California 23 real property in a trust for their own benefit, name 24 a trustee who lives out of state, and when the trust 25 sells that property, it is no longer subject to 26 California tax, even though it is California real 27 property. 28 Meanwhile, an individual or estate selling 22 1 that same real property would be subject to tax 2 entirely in California. Appellants' interpretation 3 would enable the easiest tax -- California tax 4 shelter to ever exist. 5 Um, the result, it would create a bizarrely 6 favorable result for trusts with nonresident 7 fiduciaries. And this result also contradicts 8 California's right to tax source income as permitted 9 by the U.S. Constitution. 10 Almost 100 years ago in Shaffer v. Carter, 11 U.S. Supreme Court laid out the foundation for 12 states to tax income produced within its borders. 13 Um, the Court in Shaffer told us that states may 14 exercise their sovereign power to tax income 15 produced within its borders and to tax residents 16 within its borders. 17 So it's these two foundational principles 18 that form California's taxation of individuals, 19 estates and trusts. And its power to tax stems from 20 the benefits and protections conferred by the taxing 21 state. 22 Um, as the California Supreme Court stated 23 in McCulloch v. Franchise Tax Board, trust income is 24 afforded protection in its production receipt and 25 enjoyment to the same extent as other income. 26 So for 80 years Respondent has correctly 27 applied the law to tax trusts just like individuals. 28 Trusts are taxable on all of their California source 23 1 income, and on a portion of any remaining income 2 that reflects their residency connection to 3 California. 4 Such treatment is not only consistent with 5 the way that all other taxpayers are taxed under 6 part 10 of the Revenue and Taxation Code, it's the 7 only correct reading of the relevant statutes. 8 Taxing trust on both source and residency 9 is well established and supported by the code. 10 Now, please bear with me a little as I 11 address each relevant statute in the code. It 12 sounds highly technical, but the overall premise is 13 simple. Treat trusts just like individuals and tax 14 them on source and residence. 15 Appellants main error is their claim that 16 Chapter 9 of part 10 is the only basis for taxing 17 trusts, but it is not. In fact, when you examine 18 the statutory language closely, it's clear that 19 California's trust taxation statutes are expansive 20 and were knowingly crafted to tax trusts to the 21 fullest extent permitted under the U.S. 22 Constitution. 23 California's taxation of trusts begins with 24 Revenue and Taxation Code Section 17041 25 subdivision E. Now, that in -- that section imposes 26 tax on the taxable income of every estate, trust, or 27 common trust fund in an amount equal to the amount 28 computed under subdivision A for an individual 24 1 having the same amount of taxable income. 2 The subdivision does not limit itself to 3 trusts with a particular -- particular cal -- 4 connection to California such as source of income or 5 residency. It expressly provides that there shall 6 be a tax imposed on every trust estate or common 7 trust fund, and then it continues to tell us the 8 amount. 9 So literally this means every single trust 10 out there in the world is subject to California tax 11 on taxable income. 12 Now, Appellants have argued that 17041(e) 13 just gives us the rates to apply to trusts. But 14 this ignores the clear imposition language of 15 subdivision E. So this is our imposition statute, 16 and it is broad. 17 Now, obviously we know that California 18 cannot and does not tax every single trust out there 19 in the world, so we have to keep reading. 20 We then move to Chapter 9 for more specific 21 rules on taxing trusts and beneficiaries. Beginning 22 with Section 17731, which conforms to Internal 23 Revenue Code Sec -- uh, subchapter J, including 24 Section 641. 25 IRC Section 641 subsection B plainly states 26 that the taxable income of an estate or trust shall 27 be computed in the same manner as an individual. 28 And Section 17731 does not in any way 25 1 modify IRC Section 641. We conform completely to 2 this rule that says to treat trusts just like 3 individuals. 4 So in computing the taxable income subject 5 to tax for every trust as provided in Rev and Tax 6 Code Section 17041(e), we are going to compute 7 taxable income in the same way as we do for 8 individuals. 9 And how do we compute taxable income for 10 individuals? 11 We apply all of the regular rules that we 12 also conform to under IRC Section 63. But in -- in 13 addition to those rules, Section 17041 14 subdivision I, tells us that taxable income of a 15 nonresident will only include income derived from a 16 source within the state. 17 Now, Appellant's entire argument hangs on 18 their assertion that Section 17041(i) only applies 19 to nonresidents, and nonresidents can only be 20 individuals. 21 But remember that IRC Section 641(b), which 22 we conform to, clearly states that the taxable 23 income of a trust shall be computed in the same 24 manner as in the case of an individual. 25 So when you compute taxable income of a 26 trust, you must apply all the same rules that apply 27 to individuals, including Section 17041(i). 28 So to sum up, 17041(e) broadly taxes all 26 1 trusts on taxable income. IRC Section 641(b) tells 2 us we compute that taxable income in the same manner 3 as in the case of an individual. 4 17041(i) states the taxable income is only 5 going to include income from a California source for 6 nonresidence, and following that path of taxable 7 income there's only one clear result. Trust, just 8 like individuals, will always be taxed on their 9 California source income, even when they're not 10 residents in the state. 11 So when is the trust going to be taxed 12 based on its residence in California? 13 This is the question that's answered in 14 Section 17742 through 17744. 15 Now, Appellants have attempted to ignore 16 the general imposition statutes and argue that 17 Section 17742 through 17744 are the only means of 18 taxing trusts in California. But these sections 19 make clear from their language that they are nothing 20 more than residency rules for trusts. 21 Um, because trusts necessarily involved at 22 least two parties, a fiduciary and a beneficiary, we 23 need a special rule to tell us how they're going to 24 be taxed on a residency basis. 25 So Section 17742 provides that rule that a 26 trust will be taxable on its entire taxable income 27 if the fiduciary or -- fiduciary or beneficiary is a 28 California resident. 27 1 So that section does not state that its the 2 sole means of tax and trust in California, nor does 3 it replace or supersede Section 17401(e). It merely 4 provides that starting point for taxing trust in 5 California on a residency basis. 6 And the next two sections, 17743 and 17744, 7 slightly limits Section 17742's application when 8 they're are multiple fiduciaries or beneficiaries. 9 But the language of those sections makes very clear 10 that they only apply to income tax based on 11 residence. 12 Section 17743 begins by stating where the 13 taxability of income under this chapter depends on 14 the residence of the fiduciary. 15 So by these varied terms, Section 7 -- 16 17743 is acknowledging that there is taxability of 17 trust income under a different chapter. And of 18 course that chapter is Chapter 2, Imposition of Tax, 19 Section 17041(e). 20 Next, Section 17743 continues to say that 21 where there are two or more fiduciaries for the 22 trust, the income taxable under Section 17742 shall 23 be apportioned according to the number of 24 fiduciaries. 25 So, again, the language of the statute 26 expressly limits its own application to the income 27 being taxed under Section 17742. And that is income 28 tax by virtue of the residence of the fiduciary or 28 1 beneficiary. 2 Section 17743 could have said that all the 3 trust's income would have been apportioned. Or it 4 could have stated that the income taxable under 5 Section 17041(e) shall be apportioned. But it 6 doesn't. It specifically and carefully carves out 7 the apportionment rule only to inconvene tax based 8 on residence. 9 So Appellants argue that this is somehow 10 too complex or too con -- confusing. But what is 11 not confusing is this, California has the 12 constitutional grounds to tax trusts just like 13 individuals on all source income and on all incomes 14 for residence. And there's nothing in the code to 15 suggest that the California Legislature intended to 16 relinquish any of its power to tax trusts. 17 If this Board overturns its prior decision, 18 that decision would effectively eliminate this 19 state's constitutional power to tax income produced 20 within its borders when earned by a trust. 21 So if the Legislature had intended to take 22 this unprecedented action of foregoing source 23 taxation on trusts, that action would have been 24 explicitly stated. And it is nowhere stated in the 25 code. 26 As for the 1937 statutory amendment that 27 Appellants have addressed, that amendment did not in 28 any way alter California's taxation of source income 29 1 for a trust. That amended -- amendment did remove 2 some superfluous language. But just like our 3 current statutory scheme, the new language expressly 4 carved out the apportionment rule only to inconvene 5 taxed based on residence. 6 While the remaining language in the statute 7 clearly stated the taxes imposed by this act upon 8 individuals shall apply to and be imposed upon the 9 income of estate or any kind of property held in 10 trusts. 11 So the code, then as now, taxed nonresident 12 individuals and trusts on all source income. The 13 rule remained unchanged with regard to source 14 income. 15 Now, today Appellants have raised some 16 constitutional questions regarding internal 17 consistency under the Commerce Clause. 18 At first I want to note that this Board has 19 determined that it does not have jurisdiction to 20 decide whether a California statute or regulation is 21 invalid or enforceable under the federal or 22 California constitutions. 23 And that's the BOE Rules of Tax Appeals 24 Sections 5412. 25 This Board also has a long-standing 26 practice of not making con -- these types of 27 constitutional decisions. So the Commerce Clause 28 argument is really not appropriate for this Board to 30 1 consider. 2 Second, the argument Appellants are raising 3 is a theoretical one, um -- that does not apply to 4 this trust. As far as I know, Appellants have never 5 alleged that the income of this trust was 6 double-taxed. 7 Um, all of the income from this trust is 8 from a California source, and the U.S. Supreme Court 9 has clearly held that states may tax income produced 10 within its borders. 11 So the argument that Appellants make about 12 internal consistency can only be raised when the 13 trust has income that's not sourced to California 14 and is taxed elsewhere. Um, and that's not the case 15 here. 16 Finally, this is the reason that California 17 has an "Other State Tax Credit." The OSTC is 18 designed to address potential double-taxation of 19 income, and trust may claim the credit pursuant to 20 Revenue and Taxation Code Section 18004. 21 Um, and in addition, Maryland also appears 22 to have a similar tax credit. So if the trust is 23 taxed in Maryland, um, on the California source 24 income, there is a credit available to them. 25 As for Section 17734, that section is 26 perfectly consistent with Respondent's position that 27 residents are taxed on their entire taxable income 28 and nonresidents are taxed on their income derived 31 1 from a California source. 2 17735 -- excuse me -- 17734 just clarifies 3 the rule that non -- a nonresident beneficiary will 4 be taxed only on their income from a source within 5 the state. 6 And, in fact, the only reason that section 7 exists is because trusts are taxed on both source 8 and residence. So 17734 clarifies the rule that 9 nonresident beneficiaries are only gonna be subject 10 to that source portion. 11 It's also important to remember that trusts 12 are only subject to one level of tax. So it makes 13 no sense to tax trusts on source and residency, but 14 then have a different rule applying to the 15 beneficiaries once they receive the income. 16 Further, Appellants argue that the rule in 17 17734 only came into existence in 1937. And I have 18 the 1935 code here, um, and the rule regarding 19 nonresident beneficiaries was exactly the same in 20 1935 as it was in 1937. Um, it was just renumbered 21 into a different code section. And I have that here 22 if you'd like to look at that. 23 If this Board determines to overturn its 24 prior decision, Respondent respectfully requests a 25 published opinion, so that we know how to implement 26 this Board's decision for the 171 remaining trust 27 appeals. 28 Accordingly, Respondent requests that this 32 1 Board upholds its prior decision. 2 Thank you. 3 MS. MA: Okay. Thank you. 4 To the Appellants, you have five minutes on 5 your rebuttal. 6 MR. ANTOLIN: Thank you. 7 So, first, we are not contesting whether or 8 not California has the power to tax a trust on 9 California's source income. California absolutely 10 has the power to do it. The question is, has it 11 done it? 12 It did it in 1935. It stopped doing it in 13 1937 very clearly, and it has not ever again enacted 14 a statute that exercises its power to tax a trust on 15 California's source income. 16 In fact, it has shifted that tax burden to 17 the nonresident beneficiaries when they receive that 18 income from a trust. 19 The tax is absolutely paid, but it is not 20 taxed at the trust level, it is now taxed at the 21 nonresident beneficiary level. 22 In response to counsel for FTB's argument 23 that the intent in the code is to tax the trust just 24 like individuals, that is not the way -- that is not 25 true. 26 Trusts are taxed, according to the FTB, in 27 a very, very unique way. 28 First, a trust is taxed on non -- or on 33 1 California's source income as if it were an 2 individual nonresident. 3 But, second, trusts are taxed on an 4 apportionment method on -- so all income, wherever 5 earned, that is not already taxed by California, now 6 gets apportioned to California based on the 7 residence of the beneficiaries or the fiduciaries. 8 No other taxpayer, and certainly no other 9 individual, is taxed in that way. 10 If FTB were right, a nonresident individual 11 would be -- would be taxed on California-source 12 income, say, a Nevada resident. They would be taxed 13 on Nevada -- on California source income. But then 14 that Nevada resident would also be taxed on all of 15 his or her wages in Nevada based on some 16 apportionment method. 17 Now, California doesn't -- individuals are 18 not taxed in the same way as trusts. And that's the 19 point, that trusts are -- have been treated in a 20 very unique way by the Legislature, because the 21 Legislature has enacted both an apportionment 22 provision that applies, and then originally they 23 also enacted the sourcing rule that applies. 24 Then the Legislature decided, perhaps 25 because that was overreaching or overly complicated, 26 to remove the sourcing rule, um, at the trust level, 27 and just have it apply at the nonresident level. 28 The FTB's example that this -- this will 34 1 create a gaping loophole, um, for trusts in 2 California is not true. 3 In the FTB's example, they -- they suggest 4 that a person could simply put a piece of property 5 into a trust and have it escape California taxation. 6 That's not true. 7 In that example, that would be technically 8 a grantor trust, and the per -- the grantor would 9 still be taxable as if he or she owned that 10 property. 11 This is a very unique fact pattern that 12 rarely, I believe, comes up. It is an irrevocable 13 trust; not a grantor trust. It is a trust with 14 multiple trustees within or without California, and 15 it is a trust with only contingent beneficiaries, 16 not noncontingent beneficiaries. 17 It is in this very unique fact pattern that 18 the Legislature said, Okay. We will still tax the 19 trust, but only on an apportioned basis. And not on 20 any California source income when the trust receives 21 it, but only tax the California source income when 22 that income is distributed to, um, the -- the 23 beneficiaries. 24 So turning briefly to the statutory 25 arguments raised, um, by FTB. FTB argues that, 26 "Look, Section 17731 says we incorporate the 27 Internal Revenue Code of Chapter J, compute trust 28 income, and the federal law says we tax trusts as 35 1 individuals." 2 That's correct. But both the California 3 Section 17731 and the federal law say unless or 4 except as otherwise provided. 5 In this case, the Legislature has expressly 6 provided for different rules to apply to tell us how 7 to compute the income that is, um, sourced -- or 8 taxable by California. 9 So those provisions do not inform the 10 analysis, and they certainly are not clear and 11 express in the same way that the Legislature was 12 when it was imposing the sourcing rules on 13 nonresidence. 14 Where in a single sentence the Legislature 15 says a nonresident is taxed pursuant to these 16 sourcing provisions. The Legislature could have 17 said the exact same thing for trusts, and it did not 18 do that. 19 Thank you. 20 MS. MA: Okay. 21 Members. 22 Mr. Runner. 23 MR. RUNNER: Yeah, just -- let me just 24 start with a couple of quick questions, and I'm sure 25 we'll be in discussions, um, further down here, too. 26 But let me -- let me just ask, um, some of 27 the -- the basic issues, some of the basic 28 discussion here, um, in regards to whether or not 36 1 this is just a timing of when tax was paid. Um, and 2 as a -- as a result of the -- of the trust. 3 Um, I think that's what you would be 4 arguing; is that correct? 5 MR. ANTOLIN: Yes. 6 MR. RUNNER: Um, why is that not an issue 7 in regards to a -- or a clarification that there's 8 not a -- this is not an issue as to whether or not 9 there's a tax loophole or not in regards to tax 10 being overpaid, but indeed it's just a matter of 11 deferral based upon the statute. 12 MS. WOODRUFF: Mm-hm. 13 Well, there are some instances where 14 deferral is allowed under the code, but that needs 15 to be expressly and explicitly stated by a statute. 16 And we have no such statute here that says it's 17 permissible to defer the income, which is a valuable 18 tax benefit. 19 Um, and just to add to -- 20 MR. RUNNER: So you would believe that 21 there is no deferral here. If we were to find it 22 for the taxpayer, you would believe that there would 23 be no future tax to be -- to be collected? 24 MS. WOODRUFF: Well, under 17745, which 25 Appellants had argued is part of why there is no 26 deferral -- or there is no problem here. 27 17745 states that if the tax is unpaid by 28 the trust, then when it's further distributed to the 37 1 beneficiaries, it will be taxed. 2 MR. RUNNER: Okay. 3 MS. WOODRUFF: The problem is that, in this 4 case, the -- the income will be taxed. It will be 5 taxed 50 percent, um, at the trust level. So you 6 can't really say that it's gonna be untaxed income 7 under 17745. 8 MR. RUNNER: I'm sorry. Go back again. 9 I'm -- I'm -- I'm -- my -- my question, 10 though, if we were to find the argument for the 11 taxpayer here, I'm -- I'm -- I'm -- and would -- 12 would -- would there be the escape of tax then 13 later? 14 MS. WOODRUFF: And I think there could -- 15 there could be. 16 MR. RUNNER: And tell me -- again, tell me 17 why. Because I think you went back and undermined 18 -- I mean -- and disagreed with their argument as to 19 whether or not it was taxable at -- at -- at that 20 point. 21 MS. WOODRUFF: Right. 22 MR. RUNNER: But if indeed we found that it 23 was indeed found for the taxpayer, and then when the 24 -- when it was distributed it was then taxed, why 25 would California -- why would that not just be a 26 deferral of tax as opposed to an avoidance of tax? 27 MS. WOODRUFF: Well, I think there could be 28 situations where it would be an avoidance of tax 38 1 altogether under 17745. 2 But to -- to address the deferral issue, 3 that is a significant -- that, in itself -- even if 4 there is only a deferral, even if it's only a timing 5 issue, that in itself is a significant benefit. And 6 there just isn't any express provision in the code 7 providing that benefit to trusts. 8 MR. POWERS: Um, Mr. Runner, if I can add. 9 MR. RUNNER: Mm-hm. 10 MR. POWERS: Fundamentally, what -- what it 11 allows, the deferral -- what the deferral allows is 12 the opportunity for the trust and the beneficiaries 13 to sever all connections with California, so that 14 when the -- when the income is ultimately 15 distributed to the nonresident beneficiaries, um, we 16 have to presume compliance. 17 In fact, it's the same issue we have with 18 1031 exchanges when the property moves out of state 19 and the taxpayer later sells it with no other 20 connection to California. Even though when they 21 sell it, there's a theoretical component to 22 California source gain in that property. It's 23 embedded. It's really a collection issue more than 24 anything. 25 MR. RUNNER: Okay. 26 Let me hear from the taxpayers rep to -- in 27 terms of the issue of it being deferral versus 28 avoidance. 39 1 MR. ANTOLIN: Well, there would 2 definitely -- definitely not be tax avoidance, 3 because the Legislature has anticipated that there 4 will be situations where a trust earns income from a 5 California source, and the trust doesn't pay tax on 6 it. 7 MR. RUNNER: The argument was that then 8 that gives time for the taxpayer to readjust or redo 9 their trust or -- or -- 10 MR. ANTOLIN: And -- and -- 11 MR. RUNNER: -- change residencies or 12 whatever to avoid that. How do -- can you -- could 13 that happen? 14 MR. ANTOLIN: It could not. Because the 15 Legislature actually anticipated just that exact 16 situation as well. 17 In 17734 the Legislature says, if a trust 18 distributes California source income to a 19 nonresident -- so you've already reshuffled -- 20 MR. RUNNER: Mm-hm. 21 MR. ANTOLIN: -- and beneficiaries moved 22 out of state to a nonresident, that is California 23 source income subject to tax. That is 17734. 24 In addition, the Legislature has the 25 withholding provisions that requires the trust to 26 withhold California tax upon distribution to ensure 27 from an administrative point of view that the tax is 28 paid to California. 40 1 MR. RUNNER: Okay. Let me go back. 2 Why does that not -- 3 MR. ANTOLIN: Oh. 4 MR. RUNNER: -- solve the avoidance issue? 5 MR. POWERS: So 17745, which I call a last 6 gas -- gas collection statute. Okay. What that 7 allows is, if we have a trust that for whatever 8 reason hasn't been filing and paying their taxes 9 over the years, maybe there's an honest mistake -- 10 MR. RUNNER: Mm-hm. 11 MR. POWERS: -- whatever, that provision 12 provides that when the distribution is made to the 13 beneficiary, California can then assert the tax that 14 should have been paid by the trust. 15 The reason that provision is there 16 fundamentally is because we have trusts that we 17 don't know about. And in this situation, he's 18 positing a circumstances where only the 19 beneficiary's a nonresident, and there would be a 20 withholding obligation. But if the trust is 21 administered in Maryland by now, we don't know about 22 it anymore. We don't track that. We can't track 23 that. It's the same problem we have in 1031. 24 And that's why 177 -- 17745 was put there 25 for that reason, but it's not a -- it's not a 26 solution -- it's not an effective solution in all 27 circumstances. 28 So if, for instance, if -- and an example 41 1 was posited before, if you owned a significant piece 2 of real estate in California that had substantially 3 depreciated, you can put it into a complex trust, 4 and, with all nonresident beneficiaries, administer 5 the trust out of state and wait a couple years, and 6 unless the Franchise Tax Board is actually tracking 7 that, or their self-compliance, the tax is gone. 8 Because we would get it on a source basis, under 9 their -- under -- I mean, I -- we would get it under 10 source basis on our -- on our theory upfront. But 11 if we can't tax on source, and only on a residency 12 of the fiduciaries or beneficiaries, my example, 13 there are no -- there's no residence here. So 14 there's no current taxation on that sale. And if 15 you wait long enough -- oh, um, my co-counsel wants 16 to finish -- 17 MS. PAGE: Sorry. 18 Also, there's an issue of federal 19 conformity. And that indicates that there's no 20 deferral -- or there's no deferral mechanism at 21 either the federal level or the state level because 22 we conform to the federal trust rules. 23 So upon distribution at the trust -- once 24 the trust distributes, because there's not a 25 recognition of that, there wouldn't be a reason to 26 tax this trust-sourced income. So we have a 27 conformity issue as well . 28 MR. RUNNER: Okay. Let me get one more 42 1 shot back over here, then I've got another question. 2 MR. ANTOLIN: Thank you. 3 So -- so speaking to the administration 4 arguments raised by the FTB's counsel, those 5 administration issues are real. I -- I think that 6 we would all acknowledge that. But that does not 7 give California the right to do something that is 8 not -- 9 MR. RUNNER: The fact that the tax may be 10 harder to find -- 11 MR. ANTOLIN: Yes. 12 MR. RUNNER: -- does not necessarily make 13 it right to tax it inappropriately. 14 MR. ANTOLIN: Exactly. Calif -- the 15 Legislature has done what it can do, which is to 16 enact the statute that says if you are a nonresident 17 beneficiary and you are receiving California source 18 income, you are taxable on it. 19 There is also the withholding mechanism. 20 And the fact that there is even a withholding 21 mechanism strongly indicates that the Legislature 22 knew that California sourced income would not be 23 taxed when earned and would have to be -- there 24 would have to be withholdings. 25 MR. RUNNER: Okay. Let me -- let me go 26 up -- follow up on one other item, and then I'll let 27 other Members ask their questions. 28 Um, the -- the interesting -- at least what 43 1 I thought I heard -- and this is where it kind of is 2 fundamental to the taxpayer's discussion here. It 3 was in the stat -- the 1935 statute compared to the 4 1937 statute. 5 I thought I heard you say that -- that 6 there was not a change in language, but it was just 7 a numbering issue. 8 Is that what I heard you say? 9 MS. WOODRUFF: That is for, um -- he was 10 saying that 17734, I believe, the predecessor 11 statute to that was added in 19 -- in 1937. And I 12 have the 1935 code here, and I see that that's the 13 very same language in the 1935 codes, but it was 14 renumbered. So that's not talking about -- 15 MR. RUNNER: So you -- you -- you would 16 agree that there was a change in language? 17 MS. WOODRUFF: Not for 17734. Not for the 18 lang -- the predecessor statute to 17734. 19 I agree that there was a change in language 20 for section -- what is now Section 17742. 21 MR. RUNNER: Okay. 22 MS. WOODRUFF: So where they removed the 23 source language. 24 MR. RUNNER: Okay. Okay. Okay. 25 I just want -- wanted to clarify that 26 because I wasn't -- I was -- I just wanted to 27 clarify that. 28 Comment? 44 1 MR. ANTOLIN: We don't see that language. 2 And if you could point us to it. We have the 1935 3 code as well, and it does not -- that provision 4 taxing nonresident beneficiaries was not in 5 Section 7 of the 1935 code. 6 MR. RUNNER: Okay. Okay. 7 MS. MA: Are you done? 8 MR. RUNNER: Yeah, I'm -- I'm -- I'm -- 9 yeah. 10 At this point I think the -- the taxpayers 11 and -- and FTB are passing around language to which 12 we don't have. 13 MR. ANTOLIN: Well, I'm sorry. Just one 14 comment. Just -- I'm sorry. 15 MR. RUNNER: Well, I'm just concerned about 16 that at that point. You guys are exchanging 17 language, and we don't have it. 18 MR. ANTOLIN: Well, I -- I will read it. 19 MR. RUNNER: Well, actually how about if 20 we -- maybe -- maybe -- maybe he can -- 21 MR. THOMPSON: Well, just for the record, 22 I'm Grant Thompson for the Appeals Division. 23 MR. RUNNER: Yeah. 24 MR. THOMPSON: Both the original statute 25 and 37 statute are attached to the original hearing 26 summary. 27 MR. RUNNER: Okay. So I have it somewhere, 28 huh? 45 1 MR. THOMPSON: So it is in the record. 2 And, uh, I -- I appreciate that it's not right in 3 front of you. 4 MR. RUNNER: Okay. Okay. 5 MR. THOMPSON: However, I -- you know, 6 I -- I would be interested to know as well the 7 provision referenced by FTB. I'm not sure which 8 provision they're referencing in the 35 act. 9 MR. RUNNER: Okay. Hang on. 10 Let's -- let's -- let's -- let's -- let's -- 11 let's -- let me, um, think how we're gonna get 12 through this. 13 How about if we make copies of that and 14 distribute it. And then you can come back, and we 15 can ask, and you guys can talk about -- 16 MR. ANTOLIN: Thank you. 17 MR. RUNNER: -- its inappropriateness or 18 its appropriateness. 19 MS. MA: Okay. 20 MR. RUNNER: How's that? 21 MS. MA: Mr. Horton. 22 MR. HORTON: Madam Chair, I just wanted to 23 make sure that the conversations discussed between 24 the, uh, two parties is on record if it is to be 25 considered by this Board. 26 MS. MA: Ms. Stowers. 27 MR. HORTON: And that we avoid colloquy. 28 MS. MA: Okay. 46 1 Ms. Stowers. 2 MS. STOWERS: Okay. 3 FTB, first, you said you have a statute and 4 it's being copied. I have a copy of the 35 and 37 5 in front of me as well. Give me the subjection and 6 sections you're referring to. 7 MS. WOODRUFF: Okay. Um, well, the 8 language that we're -- I'm referring to is the 9 language that gives us the rule that we have in 10 current Section 17734. So that would be Article 11 12(d)-2. I guess that's subsection B -- oh, I'm 12 sorry -- right -- this is the 1937 statute. 13 MS. STOWERS: Start with -- start with 14 1935, please. 15 MR. POWERS: We just gave -- we just gave 16 them the copy, but I think it's 12(c)-2. 17 MR. RUNNER: Let's just wait until we get 18 the language. 19 MS. STOWERS: Okay. Then -- then wait 20 until we get the language and then -- we'll wait 21 until we get the language. 22 Well, then I will hold onto my question, 23 because my question -- I really wanted to get a 24 history lesson between, um, 1935 and the minutes to 25 1937 kind of overlay -- and this is for both 26 parties -- overlay, um, the tax statutes from 35 to 27 37 to the current statutes that we're looking at 28 here. 47 1 And -- and -- and I want to see where the 2 change took place, specifically, to a place where 3 you say that they removed the sourcing provisions. 4 And I believe, um, you're referring to Section 12 5 subsection B. 6 So I really want to see where it says that 7 you use our sourcing rules in 35 and those asserted 8 sourcing rules were eliminated in 37. 9 MS. MA: So I'm just going to chime in. I 10 mean, you have four Members that have been on the 11 Legislature. 12 During my whole six years I think I've seen 13 consistently that California tries to capture as 14 much income as they can. Whether it's, um, you 15 know, ordering online products, we always try to 16 figure out what the nexus is to California. Um, you 17 know, if the buyers are here in California. I mean, 18 that's pretty much been consistent with California. 19 And the argument that the Legislature, you 20 know, deliberately created this new exception where 21 you can now move all the trustees out of state, the 22 contingent beneficiaries out of state, and, 23 therefore, not recognize any income on the trust. 24 Where the trust -- or the Franchise Tax Board now 25 has to keep track of when, um, this income is being 26 distributed to these out-of-state trustees or 27 out-of-state beneficiaries, basically, to me, sounds 28 like a loophole that wasn't necessarily intended by 48 1 the beneficiary -- um, by the Legislature. 2 But what the Legislature probably wanted to 3 do was to capture more of the income. That if there 4 were nonresident trustees, nonresident 5 beneficiaries, how do we capture it here in 6 California so that we don't have to go and track for 7 a number of years to make sure that we're getting 8 the taxes back for California. 9 So that's kind of where I have a problem 10 here is that, um, if we vote with the taxpayers, 11 allowing one trustee to be out of state, why doesn't 12 all the trusts now create all the trustees -- change 13 all the trustees to be out of state, so that now 14 there's no tax generated here in California. 15 That's kind of my -- where it doesn't sit 16 right with me. And I understand, you know -- I'm 17 gonna go with the ducky-bunny argument, um, that, 18 you know -- we're talking about the 1935 code and 19 1937 code. But, you know, when you break it down, 20 we are trying to, you know -- it's a 21 California-sourced income taxed to California. 22 California, you know, wants to, um, you 23 know, tax the income first and foremost, similar to 24 individuals. And that's where I'm having a little 25 bit of difficulty, um, with the argument 26 MR. WILLSON: If I could address that just 27 a little bit, which is to just think, let's go back 28 to 1935. We didn't have a society in which people 49 1 were moving around all the time. And -- and what 2 we're looking at is what did the Legislature do back 3 then since we don't have changes that have come up 4 since then. 5 And I don't think it's fair to assume 6 somehow they were -- this is all they were thinking 7 about and worried about. And the question in front 8 of you is what did the statutes actually say now. 9 And one thing I would like to underscore 10 that Ed said is the very existence of these 11 withholding rules suggests that there must be 12 taxable income sourced to California not taxed to 13 the trust. Because as they acknowledged, we only 14 tax one place or the other. We tax the trust or we 15 tax the beneficiaries when they receive income that 16 hasn't been taxed to the trust. 17 If -- if the rule is that all the 18 California source income would have been taxed to 19 the trust, I don't know what the situation is where 20 those withholding rules would ever come into play. 21 Because they would already -- the sourced income 22 would already have been taxed. And yet, they're 23 clearly there. That seems to contemplate that the 24 Legislature had something in mind. 25 MS. MA: So, um, I guess to the taxpayers, 26 um, the -- the trust was formed in 1971? 27 MR. ANTOLIN: Correct. 28 MS. MA: And at what point did the 50 1 trustees, one of them, move out of state? 2 MR. ANTOLIN: So originally there were two 3 California trustees, and in 1994, I believe -- and 4 that's an exhibit to our, um, opening brief -- the, 5 um -- a non-California trustee was appointed. 6 So 13 years before the -- the year at issue 7 here. 8 MS. MA: So 1930 -- 1994? 9 MR. ANTOLIN: '94 . 10 MS. MA: And then how did you file in 1994 11 until 2007? Or how was the trust filed? 12 MR. ANTOLIN: Right. 13 So -- so in -- in the year at issue, the 14 trust originally, on its original return, reported 15 all of the income sourced or taxable by California 16 pursuant to the instructions that were set forth on 17 the, um -- on the tax return. 18 Later it realized that that might not be 19 right according to what the statutes require and 20 then filed amended returns, refund claims. 21 And it continues to file consistent with 22 the refund claim method, the apportionment method 23 from -- for tax years 2007 through today. 24 MS. MA: So 2007, I also saw that, um, they 25 amended the return, not only for the nonresident 26 beneficiary issue, but also for -- to claim some 27 sort of small business trust calculation exemption. 28 I'm not sure. 51 1 Can you explain that to me? 2 MR. ANTOLIN: Well, I think all that I can 3 really explain is that there was a confrontational 4 error that was identified also. And that, um, it 5 hasn't really been at issue. 6 MS. MA: Okay. Because we tried to look up 7 what that small business trust exemption or 8 apportionment or calculation was. Because the 9 amended return was completely different than the 10 original return. 11 MR. ANTOLIN: That's true. 12 MS. MA: Yeah. 13 Ms. Harkey. 14 MS. HARKEY: Okay. When we first started 15 this analysis, one of the issues was, is the 16 beneficiary noncontingent or contingent beneficiary. 17 Are -- um -- so explain that concept as to 18 why it applies, why it's important or not. Because 19 we did not get any of that here. 20 MR. ANTOLIN: So -- so just to set the 21 facts. The beneficiary in this case has a 22 completely contingent interest. 23 Under California law, if there -- there is 24 only a -- one beneficiary, as in this case, and if 25 that beneficiary had a noncontingent interest, then 26 under California law, all of the trust income would 27 be taxed by California. 28 So it is important to know whether the 52 1 beneficiary's interest is contingent or 2 noncontingent, because if it's noncontingent, we 3 wouldn't be here. California would have taxed under 4 Section 17742 all of the trust's income. 5 But because the beneficiaries interest is 6 contingent, then that beneficiary is not the reason 7 California taxes the income. We have to look 8 further. And we go to the fiduciaries. And we have 9 two fiduciaries; one within and one without, and the 10 rule requires that we apportion based on the 11 residence of the fiduciaries. 12 MS. HARKEY: Okay. And what the state is 13 saying is they apportion on the basis the source is 14 the income. 15 So are you -- are you -- um, this is for 16 the Franchise Tax Board. I'm sorry. 17 Are you disputing that this is a 18 noncontingent beneficiary? 19 MS. WOODRUFF: Mm-hm. Well, yeah, I think 20 there are -- there are a few indications that maybe 21 this beneficiary was noncontingent. 22 First, the language of the trust doesn't 23 just say the distributions are subject to the sole 24 discretion of the trustee. Um, it -- it states that 25 trustee may make distributions for the comfort and 26 convenience of the beneficiary, and then it goes on 27 to define comfort and convenience later on in the 28 trust language. 53 1 That is really more indicative of, like, a 2 standard that a trustee would be held to in making 3 distributions. 4 And, second, I think it's important to 5 remember that this beneficiary did receive, um, 6 significant distributions, I believe about $750,000 7 worth of distributions from the trust in that year. 8 So she wouldn't -- the trust cannot be considered 9 contingent to the extent of those distributions. 10 MS. HARKEY: Okay. And were those 11 distributions separate from the sale of the 12 property, which is, I believe, the issue here. 13 MS. WOODRUFF: I believe it may have been 14 from the same -- very same income. 15 MS. HARKEY: Thank you. 16 Um, going back to the Appellant. 17 What -- the FTB has explained a credit 18 method on a tax return. What would occur -- what do 19 you think would occur if the Paula Trust had all 20 nonresident fiduciaries? What would happen? How 21 would you be -- 22 MR. ANTOLIN: So if Paula Trust had 23 nonresident fiduciaries, then the trust would not be 24 taxable on any of its income. Because none of the 25 fiduciaries would be California residents, and none 26 of the beneficiaries, noncontingent beneficiaries 27 would be California residents. 28 But if the trust were earning income from 54 1 California sources, that income would be taxed 2 ultimately when distributed to either a nonresident 3 beneficiary or to a California resident beneficiary. 4 MS. HARKEY: And how -- you -- you claimed 5 there was an area here where there'd be 150 percent 6 taxation. But the FTB said there would be a credit 7 that the trust could take back and forth between 8 states depending on where it needed to be. 9 MR. ANTOLIN: Right. And so that argument 10 really speaks to the -- the -- the problem with the 11 rule set forth in the regulation. 12 Our view is that if that rule were adopted 13 by every single state under the United States 14 Supreme Court Internal Consistency Test, that rule 15 would be found to be unconstitutional. Because if 16 every state followed California's rule, California 17 would tax 100 percent in this case, which is FTB's 18 position. And Maryland would tax 50 percent in this 19 case. And that would equal 150 percent tax by -- of 20 the trust income, in violation of the Commerce 21 Clause and the Internal Consistency Test. 22 Now, we have also looked very carefully at 23 the credit provisions in the code. And our best 24 reading of those provisions is that they would not 25 apply in this case, because they only apply when a 26 trust or an estate is a resident of more than one 27 state. And in this case, the trust is not a 28 resident of either state. It is only being taxed on 55 1 its source income in California, and its source 2 income in Maryland. 3 MS. HARKEY: FTB, can you respond to that? 4 MR. POWERS: Well, in fact, the example 5 they posited was a Maryland trust with California 6 source income. There is no -- there is no 7 California taxation of that trust on a residency 8 basis. 9 Maryland is the residence state, would 10 normally yield to another state tax credit 11 mechanism. 12 It's the same rule that would apply to an 13 individual in the same circumstance. A Maryland -- 14 a resident of Maryland who sells a piece of 15 California real estate, California would assert 100 16 percent tax and jurisdiction on that on a source 17 basis, and Maryland as a resident state would 18 provide another state tax credit to the extent they 19 provided it. That avoids the double taxation 20 problem. 21 It's never perfect, but the -- the Court's 22 have considered these issues, and have generally 23 upheld the schemes. 24 MR. WILLSON: Can I respond to the pickup 25 just a little -- 26 MS. MA: Please. Please 27 MR. WILLSON: It's not how we read the 28 section, but even the acknowledgment that it's not 56 1 perfect would mean that -- that it fails under the 2 U.S. Supreme Court's cases. 3 I can give you two easy examples. One was 4 a case involving used tax collection and the state 5 of Arkansas tried to make it easy for out-of-state 6 vendors, and figured out a single rate to collect, 7 no matter which jurisdiction into Arkansas you 8 shipped your product, we were going to give you a 9 rate that's in the middle of the overall. 10 So they were trying to be quite fair. The 11 Court struck it down because it meant that you would 12 be selling into a jurisdiction occasionally in which 13 you paid more than that jurisdiction's rate, because 14 you were paying some blended rate. 15 In a way it seemed odd to all of us because 16 it was such a good faith effort on the part of the 17 state, but the Court has been very diligent about 18 this, and it must work with precision. So the 19 failure of the credit mechanism to be merely not 20 perfect, I think means that it would not save an 21 otherwise unconstitutional tax. 22 By the way, there's a recent case. When? 23 Two years ago, in the state of Maryland, and it 24 involved residents being taxed. And they -- there 25 was both a tax at the state level and at the city or 26 county level, sub-jurisdiction level. And they 27 provided a credit, so you're a resident of Maryland, 28 you do work in another jurisdiction. You pay taxes 57 1 in that jurisdiction, you did get a credit because 2 that was a source-based tax, but the credit was only 3 against the overall state rate and not against the 4 state rate plus the subdivision rate. And the Court 5 struck that down as unconstitutional under internal 6 consistencies. 7 They've been very, very diligent about this 8 test ever since coming up with this test in 9 California's victory in the case that created it. 10 MS. HARKEY: Okay. 11 So if I can summarize, I believe the 12 biggest problem the FTB has raised is that there 13 could be tax escapes because they don't have the 14 ability to chase it down. Because, you know, both 15 the RTC Section 17734 and 17795 tax nonresident 16 beneficiaries when they receive a distribution. 17 In addition, California resident 18 beneficiary is taxed on any distribution, and 19 California law requires that trust withhold 20 California tax on distribution to nonresident 21 beneficiaries. 22 So we've got three levels of taxation that 23 will all -- that we'll eventually get, but that 24 seems to be the crux of the argument that even with 25 these three levels, with the withholding provision 26 is just kind of a quick grab bag to help protect 27 you, but you can't collect on it. 28 Is that true? 58 1 MS. PAGE: It actually is a little bit more 2 than the transferability -- transfer reliability 3 that we spoke about. It also has to do with IRC 4 conformity. If something is not deferred at the IRC 5 level, then it's not deferred for -- for our 6 Franchise Tax Board level. 7 So there would not be, as -- as you're 8 aware, when we conform to the federal law, we use 9 AGI from the -- from your federal returns to move it 10 into the state return and work from there for the 11 fed-state differences. And if we don't collect tax 12 on California taxable income when it is recognized 13 at the federal level, then later when it finally 14 hits the trust -- or the grantee or the 15 beneficiary's income return, if there's no federal 16 recognition event, then we're not gonna -- it's not 17 a recognition event for California purposes either. 18 MS. HARKEY: Do you have anything else? 19 MR. POWERS: Yeah, I just want to finish. 20 I wanted to add also that I don't think we 21 acknowledged that there really is a deferral 22 provision here. I just want to clarify that. So 23 we're not agreeing that this operates as a deferral 24 provision. 25 I think there's another way to reach 17734 26 logically, which is, what 17734 is doing is it's 27 acknowledging that there may be circumstances where 28 a nonresident beneficiary receives a distribution in 59 1 the same year that the trust recognizes the income. 2 To the extent the trust pays income tax at the trust 3 level on a residency basis, what 17734 does, is it 4 recognizes that we have a constitutional limitation 5 on our ability to tax nonresident limited to source 6 income. 7 So if the -- if the source income was $50 8 out of the $100 the trust paid tax on that year, 9 let's assume the entire trust income was taxable. 10 If the trust distributes $100, the nonresident 11 beneficiary could only be taxed on the $50. The 12 trust is gonna get a -- is gonna get a deduction 13 under trust accounting rules for distribution when 14 it's made in the same year. 15 MS. HARKEY: Thank you. 16 Do you have any response? 17 MR. ANTOLIN: Just one response. 18 To the issue of whether or not California 19 conforms to federal tax law, there -- there is in 20 general conformity, but there is not perfect 21 conformity between California tax law and federal 22 tax law. There are many, many areas where 23 California does not conform, and there are many 24 areas where California needs to supplement the 25 federal law, as in this case. Because for federal 26 purposes, we all know, we would compute worldwide 27 income. But California cannot tax a taxpayer's 28 worldwide income. 60 1 We need to supplement the federal rules 2 with specific and clear provisions that tell 3 California how much income from the worldwide income 4 can be taxed by California. 5 And as far as the -- the lack of triggering 6 the -- there was a mention that you need to have a 7 triggering statute to know when to impose the tax 8 when it's distributed to a nonresident beneficiary. 9 Well, there is a statute, it's 17734. That is the 10 trigger. 11 When there is a distribution, the taxes 12 trigger. And that's why -- that's when FTB will 13 know to impose the tax, that's when taxpayers and 14 trusts will know to withhold the tax, and taxpayers, 15 nonresident beneficiary taxpayers will know when to 16 pay the tax. 17 MS. HARKEY: FTB, respond to the trigger 18 mechanism. 19 MR. POWERS: This -- so let me contrast 20 the language. 21 17734 is a rule that tells us how to source 22 income received by a nonresident beneficiary from a 23 trust. There is no realization trigger in that -- 24 in that statute. 25 And contrast that with 17745, which is the 26 statute where the trust has never filed returns or 27 hasn't reported income, and then there's a 28 distribution to a nonresident beneficiary that 61 1 allows California to pursue the tax against the 2 nonresident. 3 That statute contains express language in 4 it, which actually creates the constitutional 5 realization of that in order for California to tax 6 all of that income. 7 In the absence of that, we wouldn't be able 8 to, because it would be a distribution. It's just a 9 distribution. A distribution may or may not be 10 income, but it's gonna depend upon the particular 11 circumstances from which the distribution was made. 12 So on the case of a trust, if the trust is 13 already been taxed on the income, the trust is gonna 14 get a deduction, and it's not gonna be taxable, 15 then, to the recipient to that extent. 16 MS. WOODRUFF: Right. 17 So if the -- if the trust accumulated the 18 income, and the trust is responsible for paying the 19 tax, then when the trust eventually makes a 20 distribution of that accumulated income to the 21 beneficiary, it's not going to be taxed again. It's 22 going to be distributed as a tax-free distribution 23 of principle, because it's already been taxed at the 24 trust level. So it's important to remember that as 25 well. 26 17734 only applies to the income and 27 deductions derived through one state or trust. So 28 it's really not going to reach those circumstances 62 1 where the trust is accumulated income and making 2 distributions of previously taxed principle. 3 MR. POWERS: Because it won't be taxed at 4 that time. 5 MS. PAGE: Also, as you all might be aware 6 or you are dealing with quite often is when we have 7 income reported from the federal government to us, 8 that we then use to determine whether there's been 9 an adjustment based on the federal audit, or there's 10 been unreported income, that speaks to the fact that 11 we do conform to federal timing issues. 12 And in this case, we do conform to 13 subchapter J of the IRC. 14 So the timing in -- the timing of trust 15 income conforms to federal rules. So although we 16 don't fully conform as the Appellant might say to 17 the sourcing differences, if we don't -- if we don't 18 have differences in timing of recognition events, 19 sourcing is -- is -- is done as an overlay, but 20 not -- we don't -- we don't require taxpayers to 21 figure out what year something happened. If it 22 happened for the feds a certain year, it happened 23 for -- for their state tax return as well. 24 MS. HARKEY: Okay. Thank you. 25 MS. MA: Mr. Horton. 26 MR. HORTON: Thank you, Madam Chair. 27 I really didn't have a comment or a 28 question. 63 1 For me, this is rather simple. Um, you 2 know, the constitution, I believe, is relatively 3 clear as to the sovereignty of the state to tax 4 individuals who have benefited from the laws and the 5 rules and the public schools and public safety of 6 the state. 7 The constitution also provides that income 8 generated in California that has relatively 9 benefited from the protection of the laws of the 10 state of California and the roads and everything 11 else the state of California provides for that 12 individual to be able to generate those revenues 13 that they have a right to tax it. 14 And I see no provisions in the law that 15 overturns the internal revenue codes or says that we 16 are not to be in conformity. 17 In fact, if you look, the comp -- the -- 18 the discussion relative to worldwide income is 19 business income. You know, it's generated worldwide 20 and certainly is an apportionment. But it still -- 21 the bottom line is where the resource is actually 22 generated. So it's apportioned based on where that 23 business income is generated in various different 24 multi-states. 25 So, for me, it's relatively simple from a 26 constitutional prospective, California law 27 perspective. But I've enjoyed the discussion. 28 MS. MA: Okay. Seeing no further 64 1 discussions, Members, do I have a motion? 2 MR. HORTON: We'll take the matter under 3 submission -- oh, well -- I move in favor of the 4 FTB. 5 MS. STOWERS: I -- I second that motion. 6 Um, and I'd like to state the reasons why. 7 I'm just -- I'm looking at California 8 Supreme Court cases, and they all say that we give 9 significant weight to the Franchise Tax Board 10 long-standing statutory construction in considering 11 that FTB has interpreted for at least 80 years, that 12 a trust is subject to California source income. 13 Um, that's the reason why I second the 14 motion that the Franchise Tax Board application of 15 taxing Paula Trust is correct. 16 MS. MA: Okay. We have a motion, and a 17 second, by Mr. Horton, Ms. Stowers. 18 Madam Clerk, please call the role to -- 19 MS. RICHMOND: Ms. Ma. 20 MS. MA: -- sustain the FTB. 21 MS. RICHMOND: Ms. Ma. 22 MS. MA: I. 23 MS. RICHMOND: Ms. Harkey. 24 MS. HARKEY: Um, I. 25 MS. RICHMOND: Mr. Runner -- oh, I'm 26 sorry -- Mr. Horton. 27 MR. HORTON: I. 28 MS. RICHMOND: Mr. Runner. 65 1 MR. RUNNER: I. 2 MS. RICHMOND: Ms. Stowers. 3 MS. STOWERS: I. 4 MS. RICHMOND: Motion carries. 5 MR. ANTOLIN: Thank you. 6 ---o0o--- 7 . 8 . 9 . 10 . 11 . 12 . 13 . 14 . 15 . 16 . 17 . 18 . 19 . 20 . 21 . 22 . 23 . 24 . 25 . 26 . 27 . 28 66 1 REPORTER'S CERTIFICATE 2 3 State of California ) 4 ) ss 5 County of Sacramento ) 6 7 I, Jillian Sumner, Hearing Reporter for 8 the California State Board of Equalization certify 9 that on August 30, 2016 I recorded verbatim, in 10 shorthand, to the best of my ability, the 11 proceedings in the above-entitled hearing; that I 12 transcribed the shorthand writing into typewriting; 13 and that the preceding pages 1 through 66 14 constitute a complete and accurate transcription of 15 the shorthand writing. 16 17 Dated: October 24, 2016 18 19 20 ____________________________ 21 JILLIAN SUMNER, CSR #13619 22 Hearing Reporter 23 24 25 26 27 28 67