1 BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 2 1 CIVIC CENTER PLAZA 3 IRVINE, CALIFORNIA 4 5 6 7 REPORTER'S TRANSCRIPT 8 JULY 27, 2017 9 10 CORPORATE FRANCHISE AND PERSONAL INCOME TAX HEARING 11 APPEAL OF 12 FUSCOE ENGINEERING, INC., 668149 13 ERIC ARMSTRONG and NANCY ARMSTRONG, 668151 14 JOHN OLIVIER and CYNTHIA OLIVIER, 668188 15 RAYMOND S. TOKIHIRO and THU CUC, 668193 16 PATRICK R. FUSCOE and BONNIE K. FUSCOE, 668203 17 18 AGAINST PROPOSED ASSESSMENT OF 19 ADDITIONAL INCOME TAX 20 21 22 23 24 25 26 27 Reported by: Kathleen Skidgel 28 CSR NO. 9039 1 1 P R E S E N T 2 For the Board of Equalization: Diane L. Harkey 3 Chairwoman 4 Sen. George Runner (Ret.) Vice Chair 5 Fiona Ma, CPA 6 Member 7 Jerome E. Horton 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 14 For Board of 15 Equalization Staff: Anthony Epolite Tax Counsel IV 16 Legal Department 17 For Franchise Tax Board: Craig Scott 18 Bureau Director 19 Jason Riley Tax Counsel 20 Jaclyn Zumaeta 21 Tax Counsel 22 For Appellant: Patrick R. Fuscoe 23 Taxpayer 24 Annika K. Vanghagen Attorney 25 26 ---oOo--- 27 28 2 1 1 CIVIC CENTER PLAZA 2 IRVINE, CALIFORNIA 3 JULY 27, 2017 4 ---oOo--- 5 MS. RICHMOND: Our next item is B2a Fuscoe 6 Engineering, Inc., B2b Eric Armstrong and Nancy 7 Armstrong; B2c John Olivier and Cynthia Olivier; B2d 8 Raymond S. Tokihiro and Thu Cuc; and B2e Patrick R. 9 Fuscoe and Bonnie K. Fuscoe. 10 Please come forward. 11 This taxpayer has also been granted an 12 additional ten minutes to present their 13 presentation. 14 MS. HARKEY: Okay. Thank you. 15 Mr. Epolite, will you please introduce the 16 issues in this case? 17 MR. HORTON: Madam Chair. 18 MS. HARKEY: Oh, we need -- we need 19 statements. Statements from attorney. 20 MS. MARKS: Yes, I will ask the -- the 21 Members of the Board if -- with respect to the 22 matter before it, if there have been any oral or 23 written communications that have been received that 24 are outside the record? In other words, 25 communications that have -- to which the other side 26 has not been a party? 27 Go down the line to answer that question. 28 MS. HARKEY: Okay. I will disclose that we 3 1 have had conversations. We discussed the issues 2 that were in the briefing, both by the taxpayer and 3 the Department. 4 We have not done briefing outside -- or 5 we've used the information from the briefing, from 6 the files. And I think that's it. 7 MR. HORTON: To the best of my knowledge 8 I've had no communications with the appellant. And 9 my staff, to the best of my knowledge, has not had 10 any communications with the appellant. I am 11 currently awaiting a response from my staff in that 12 regard. 13 MS. STOWERS: On June 26, 2017 I had 14 communication with the appellant and his rep -- and 15 the owner of the company. We discussed the case 16 based on information included in the briefing. They 17 provided documentation titled "Project R&D 18 Activities 2003-2006" which are included in the 19 record as provided today as an exhibit. 20 Since appellant indicated a desire for FTB 21 settlement after July 1st, 2017, I notified the 22 Franchise Tax Board about appellants' desire to 23 discuss settlement options. I did not discuss 24 settlement options with the Franchise Tax Board. 25 MR. RUNNER: I have not had communication, 26 written or oral, with this taxpayer, nor the 27 Department, since July 1st when I believe this law 28 took effect. And I believe any conversations that 4 1 may have taken place prior to July 1st are not 2 applicable under the law. 3 MS. HARKEY: Ditto. 4 MS. MA: On Friday June 23rd my staff 5 Natasha Ralston Ratcliff, Emily Vena, via telephone, 6 and Kathryn Asprey, via telephone, met with Patrick 7 Fuscoe and Annika Vanghagen, taxpayers' 8 representative, to discuss the issues in this case. 9 Taxpayers provided several documents, which I 10 believe were already included in the record. 11 Taxpayer confirmed, or can confirm or correct this. 12 Subsequent to the meeting, Mr. Fuscoe 13 e-mailed Natasha Ralston Ratcliff, thanking her for 14 the meeting and providing two videos. The first 15 discussed Fuscoe Engineering's business. The second 16 was footage regarding the Desert Palm property. 17 Ms. Vanghagen also e-mailed Natasha Ralston 18 Ratcliff documents regarding the fixed-fee 19 settlement numbers. She copied a representative 20 from the Board Proceedings. And those documents 21 appear to be part of the record. 22 That is it. I have not met with them. 23 MS. MARKS: Then I would ask the taxpayers 24 whether or not there are any communications that 25 they're aware of that they have made to the Board 26 Members that are inconsistent or in addition to 27 anything that has been disclosed? 28 MR. FUSCOE: Not inconsistent or in 5 1 addition. But as a clarification -- it's on your 2 agenda, by the way. I anticipated this -- we met 3 with many of the Board Members totally and only 4 because our case depends entirely on these projects, 5 and there are 12 of them, and it takes about a half 6 hour to go through each one. There's not time in 7 the hearing. So we wanted to get to each Board 8 Member and go through that detail. 9 So that's -- that was the extent and all 10 that we talked about. 11 MS. MARKS: Then I would ask the 12 representatives of the Board whether or not they're 13 aware of any communications that they have made to 14 the Board Members that are inconsistent or in 15 addition to with what has been disclosed? 16 MR. SCOTT: I am not aware of any other 17 discussions. 18 And I do want to clarify -- and maybe I 19 didn't do that in our last hearing -- but that we're 20 aware of the discussions, but we're certainly not 21 waiving any objection to it, depending upon what 22 your opinion ends up being. 23 MS. MARKS: And then I want to go back and 24 ask -- 25 MS. HARKEY: See? 26 MS. MARKS: Then I would ask both the -- 27 MS. HARKEY: That's not right. 28 MS. MARKS: -- appellants whether or not 6 1 you'd like an opportunity to respond to any of the 2 communications that have been disclosed? 3 MR. SCOTT: Not at this time. 4 MS. MARKS: Okay. I asked that of the 5 taxpayers, and I'll ask the appellants -- I'll ask 6 the same question. Are you asking for an 7 opportunity to respond to or comment on any of the 8 communications that have been disclosed? 9 MR. FUSCOE: No. 10 MR. RUNNER: Can I ask -- 11 MS. HARKEY: Okay, are we -- 12 MR. RUNNER: I have a question -- 13 MS. HARKEY: Go ahead. 14 MR. RUNNER: -- to FTB, in regards to 15 some -- the -- how to apply that statement, in 16 regards to decisions that are to be made then? 17 MR. SCOTT: Well, I just wanted to clarify 18 and make sure that we are still looking at the 19 waiver issue. 20 MR. RUNNER: Okay. 21 MR. SCOTT: And anything that we did here, 22 I didn't want to suggest that we were actually 23 waiving anything that we haven't -- 24 MR. RUNNER: Gotcha. Gotcha. Thank you. 25 MS. HARKEY: Okay. All right. We've 26 introduced the items. 27 MR. HORTON: Madam Chair, let me ask a 28 question I just thought of. 7 1 Given that Appeals -- and prior to 7/1/17 2 conversations would go through Appeals to the 3 Franchise Tax Board in the form of a Member inquiry, 4 would it be appropriate -- would your response 5 include such inquiries? 6 MR. SCOTT: Well, those are generally in 7 writing, aren't they, if there's a Board Member 8 inquiry? So I think that's a part of the record. 9 MR. HORTON: Right. And your response is 10 generally in writing as well. 11 MR. SCOTT: Our response would be in 12 writing and part of the record. 13 MR. HORTON: And typically the appellant 14 has privy to your response? 15 MR. SCOTT: If we received a Board Member 16 inquiry, they would have our response. 17 MR. HORTON: And they in turn would be able 18 to respond as well. 19 Did any of that take place, Appeals, in 20 this case? 21 MR. EPOLITE: There were no Board Member 22 inquiries regarding this appeal. 23 MR. HORTON: All right. 24 Ms. Marks, I would encourage that you add 25 that to the questioning, just to make sure that all 26 bases covered here. 27 All right, thank you. 28 MS. HARKEY: Okay. To the appellants, 8 1 please introduce yourself for the record -- 2 MR. EPOLITE: Ms. Harkey? 3 MS. HARKEY: Yes. 4 MR. EPOLITE: May I introduce the -- 5 MS. HARKEY: Oh, that's right. You haven't 6 introduced items yet. We had to disclose. 7 Okay. Go ahead. 8 MR. EPOLITE: Thank you. 9 MS. HARKEY: Mr. Epolite. 10 MR. EPOLITE: There are three issues before 11 the Board Members in this appeal: 12 First, whether appellants have presented 13 evidence sufficient to establish that Fuscoe 14 conducted activities that constituted qualified 15 research, as defined in Internal Revenue Code 16 section 41(d); 17 Second, whether appellants have established 18 that Fuscoe engaged in qualified research, as 19 defined in Internal Revenue Code section 41(d), have 20 appellants met their burden of proving qualified 21 research expenses for the tax years at issue; 22 And third, whether appellants have 23 substantiated Fuscoe's fixed-base percentage, as 24 required by Internal Revenue Code section 25 41(c)(3)(A). 26 Thank you. 27 MS. HARKEY: Thank you. 28 Okay. Now, you're on. You have ten 9 1 minutes. Please introduce yourself -- or actually, 2 I think you got extra time, did you not? 3 MS. VANGHAGEN: We asked for an extra ten 4 minutes. We did. 5 MS. HARKEY: Okay. So you've got a total 6 of 20 minutes. 7 MS. RICHMOND: Twenty minutes. 8 MR. FUSCOE: Don't worry, we can do it. 9 MS. HARKEY: Okay. Thank you very, very 10 much. Twenty minutes to introduce your items -- 11 MR. FUSCOE: Yes. 12 MS. HARKEY: -- or to explain your case. 13 Thank you. 14 MR. FUSCOE: Now? 15 MS. HARKEY: Yes. 16 MR. FUSCOE: Hi. Good afternoon. I'm Pat 17 Fuscoe. I'm the CEO and founder of Fuscoe 18 Engineering. 19 You have in front of you an agenda. I gave 20 you an agenda because, if you're like me, as you 21 listen to me you want to know how close you are to 22 the end. So now you can see. And my role and the 23 reason I am personally here is not because I'm the 24 founder and CEO of Fuscoe; it's because I am in 25 charge of research and development and I am the guy 26 who leads the technology we develop in our company. 27 How do you like that? So it's so important 28 in our little company that the CEO runs it. 10 1 This is Annika Vanghagen. She's our 2 counsel, just by way of introduction. 3 And I also want to say, with regards to 4 this ex parte discussion, that we did meet with most 5 of you, as I said a moment ago, mainly to just 6 review these projects, which are very detailed and 7 time-consuming. But today I will repeat everything 8 I said to you in those meetings, just really quick. 9 So stand by for news. 10 I did get something -- I learned a lot from 11 you when I met with you personally. I found out 12 what your priorities were, and I think it's 13 relevant. 14 Most of you really care about the 15 environment. Well, guess what, so do we. We are 16 the engineer everybody knows that is eco-adaptive. 17 We trademarked it because it was our brand. We are 18 the guys that know how to engineer things to fit 19 into nature in a harmonious way. So I thought that 20 was relevant because the only way you can do that is 21 through a lot of research. 22 Secondly, we found out that you care about 23 alternative energy. Ten percent of our top line 24 revenues is alternative energy, a very emerging 25 industry. Very hard to predict; everything's 26 changing every day. Guess what, trial and error 27 experimentation. 28 And lastly, I learned that you all care 11 1 about water, and that there's a need for water 2 conservation in this state, thanks to the droughts. 3 Well, guess what, we spend a ton of research on 4 water, figuring out ways to use it twice. I have a 5 graduate-degreed scientist full-time on my payroll 6 that does nothing but research water. Okay. 7 So now, I'd like to tell you about our 8 company. There they are. There's 200 professional 9 people, and they own the company. This is an 10 employee-owned company. They are all professionals, 11 and 70 percent of them have licenses. Most all of 12 them have a degree. 13 Why is that relevant? Because it takes 14 very bright people to invent new solutions and be 15 creative and come up with -- go through this 16 scientific process of trial and error, trial and 17 error. You can't do it with robots or with people 18 that just draw. So I think it's relevant. 19 By the way, I'm not bragging, but half the 20 staff are women. Engineering, half are women, 21 twelve ethnic cultures represented. I'm not 22 bragging about it. It's relevant. Because I found 23 out that you get creativity when you have diversity. 24 If you take a business student, an engineering 25 student and an artist and you put 'em on a team, 26 you're going to get a better outcome than if they're 27 all business students or they're all engineers. So 28 that's what we do by design in our makeup. 12 1 Now, let me tell you what we do. We make 2 places. We make places where people live, we make 3 where they play, where they work, where they learn, 4 where they go for healthcare. 5 We make places. And you think, "Ah, it's 6 cookie-cutter, Pat. You guys just do a shopping 7 center and you just can repeat it everywhere." Or a 8 house, right? Just copycat it. 9 Wrong. Architects can do that because they 10 can have a green house here and a blue house there. 11 But it's where the site is, is always unique. If 12 it's in the mountains of Aspen, I've got to deal 13 with rock slides and freezing water pipes and 14 avalanches. If it's on the beach in Santa Monica, I 15 got to worry about tsunamis, I got to worry about 16 salt water corrosion. 17 Every site is unique. It's unique in our 18 world. And so guess what, we have to attack it with 19 a process. We have no go, "Oh, what are all the 20 constraints? What are all the opportunities? What 21 are the regulations?" And then we have to compile 22 all that and start experimenting with solutions that 23 will meet all those things. 24 And that's the process that we do every day 25 in our core business, and I think it deserves and 26 earns the R&D credit. 27 Now, there's one more aspect to that; we 28 don't get paid for our failures, which is relevant 13 1 because you guys -- that's part of your deal. 2 If I was just getting paid T&M, time and 3 material, to experiment all day long, I'm not 4 begging for the credit. But we don't. 5 Our clients say, "Pat, solve this," and 6 they pay for solution one. If it takes me seven 7 ways to skin that cat until I get to that solution, 8 that's on me. And so that's why I think we deserve 9 this. 10 So let me also add -- and this is really 11 special -- in your handout you'll see this little 12 Denny's menu. It's a Denny's menu, I call it. This 13 has got six pieces of technology in it that we 14 developed and that we deliver to the public and to 15 our clients. This is important stuff because all of 16 this came out of the -- out of the thin air. 17 We have six full-time people -- that's 18 right, six full-time people -- that do nothing but 19 develop technology in our firm. Two of these six 20 things we have U.S. patents pending on. No one in 21 the world can do it, except us. It took us six 22 years to get it developed and to put it to play and 23 now it's disruptive in our world. 24 Thank you, Pat. 25 So I think that also adds to the argument 26 that we are really a firm that does a lot of R&D. 27 And I can -- if there's other time, I can put you 28 guys on the 3-d goggles and you can tour through a 14 1 house, okay. 2 But let me go to the projects now, if you 3 don't mind. 4 Do you want to do this, Annika? Thank 5 you. 6 So real quick, there's 10 or 12 projects on 7 the list, but I picked three. All of these projects 8 were done in the year 2005. It was a long time ago, 9 but these are great examples of what I was just 10 telling you, the process of trial and error. 11 On the right -- you can barely see from 12 where you're sitting, I'm sorry -- but in your 13 handout you'll see eight-and-a-half-by-elevens of a 14 project called Mountain Park. I picked this, it's 15 on the list that the staff reviewed, because it was 16 remarkable. 17 I worked on it personally. It was one of 18 the most challenging assignments I ever had. Why? 19 Because it's 3,000 acres that the Irvine Company -- 20 the pre-eminent developer in the world, by the 21 way -- wanted to build a community in the mountains 22 in the Cleveland National Forest. And they said, 23 "Pat, you're the guy to do this because you guys are 24 eco-adaptive. You're the guys that can figure out 25 how to put a couple thousand people, with schools 26 and parks, into the mountains and leave the mountain 27 lions alone, and so everybody's happy." Okay, 28 great. 15 1 Well, it wasn't so easy. So there's like 2 drainage where we have to have flood control for all 3 the new houses, but the water's dirty and we don't 4 want to mix it with the natural water because then 5 we can't turn it loose in the river, right? 6 So we had to separate the water from the 7 dirty houses, if you will, the driveways and roofs, 8 from the water that falls on the plants, which is 9 clean and nice. So we invented a dual storm drain 10 system, one that has nature's water and one that has 11 people's water. And the county adopted and approved 12 it and now that is the standard of practice in the 13 county. 14 My favorite story though is the -- is the 15 peanut butter and jelly sandwich. We had to build a 16 bridge over the freeway, the 9 -- the 70 -- the 241 17 tollway that comes into the 91. Oh, great. 18 Caltrans fighting with the City of Anaheim fighting 19 with the Irvine Company. Who's going to own and be 20 responsible for this bridge? 21 So we kept designing it, like 15 times, to 22 get these three agencies to all agree on it and 23 they're never coming together. 24 So I finally said, "Tell you what, you 25 guys, we're going to do it like a sandwich. The 26 bottom, the brace of the bridge will be Caltrans, 27 and all they have to worry about is that it stays 28 up. Number two, on top of that is a road, a plain 16 1 Jane regular old road like you drove on to get here 2 today. The city has roads all over, we're going to 3 give that to the city, and that's all they have to 4 worry about is the road. It's the bologna in the 5 sandwich. And then on the top of the road are the 6 cute little streetlights, the plants and the signs 7 and all that stuff, and that belongs to the Irvine 8 Company." 9 And they all high-fived each other and that 10 was the end of it. So thank you, Pat, for coming up 11 with an invention like that. 12 Okay. Next to it -- this is Annika's 13 favorite story. And some of you will remember about 14 the frogs. 15 Okay. This is the San Mateo Creek; it's in 16 the Camp Pendleton. I got a call from the US 17 Marines, "Pat, come down here. We know you're the 18 eco-adaptive guy." 19 "What's the problem?" 20 "We got 18-year-olds driving Sherman tanks 21 through the marshes and they're squashing the arroyo 22 toads." 23 Well, arroyo toads are endangered species. 24 And they're big, like dinner plates, these giant 25 frogs. 26 I go "Oh. Well, let's put a fence. Let's 27 just put a fence up and that'll be the end of it." 28 Well, all the biologists said, "You can't 17 1 do that because then the bobcats, the raccoons, the 2 coyotes, they can't get through. You ruin the whole 3 ecosystem." 4 Oh, okay. So then we got to work. What is 5 it about the arroyo toads? I had to read and study 6 everything there is to know about arroyo toads in 7 order to engineer a solution. What's that? Is 8 anybody paying me to do that? No. I'm researching 9 the snot out of a frog, okay. 10 But guess what -- anybody wants to know, 11 I'll tell you all about them -- but what I learned 12 is they don't hop. They can't hop. They crawl on 13 the ground. So I made a fence six inches high. 14 It's amazing. Looks like a Barbie doll fence. And 15 it worked. The frogs can't get through, the bobcats 16 step right over it. It's a miracle. 17 Okay, great. Thanks, Pat. 18 And by the way, that is now a proved arroyo 19 toad fence for the world to copycat. 20 All right. The last project -- 21 Do you want to switch for me? 22 MS. VANGHAGEN: Oh, right. 23 MR. FUSCOE: -- is the great park right 24 here in Irvine. I lived in this room for ten years 25 with the City of Irvine doing this park. Why is it 26 relevant? Because it's another great example of my 27 life. We get -- the El Toro Marine Corps Air 28 Station is a project to turn it into a park. Well, 18 1 the Marines just contaminated the living hell out of 2 it. It wasn't malicious. They just dumped jet fuel 3 on the ground for five decades. 4 So guess what? "Pat, figure out how to put 5 lakes and buildings full of kids and all kinds of 6 stuff in here. Just figure it out." 7 Okay, great. So I had to study like how 8 ground water behaves so that I could put a lake in 9 there, and when the water percolates from the lake 10 it doesn't grab the pollutants and contaminate our 11 drinking water. 12 So I had to -- I mean we must have done a 13 hundred models of this groundwater aquifer until we 14 found a way to do it. So I'm just -- I could go on 15 and on but there's not time. 16 The great park also had a wildlife 17 corridor, which is the first time ever in the 18 history, I think, anywhere except in Switzerland 19 where you -- we were going to connect the Cleveland 20 National forest to the Laguna Canyon coast. Now 21 this is 2005, folks. This is right in the middle of 22 this period of time that we're asking you for 23 indulgence on our credit. 24 We designed a wildlife corridor that got 25 every agency's approval; fish and wildlife, 26 California Fish and Game, everybody, EPA, everybody 27 did it. And no one's ever designed a wildlife 28 corridor. I had to do it. 19 1 It was amazing. There's -- I could go on 2 and on, on it. I'm very proud of it actually. But 3 there's fundamentally three habitats in there. 4 There's aquatic, for the fish and the frogs. 5 There's riparian that's up on the banks; the 6 emergent, they call it. That's where all the little 7 critters live that eat the fish and frogs. And 8 then, believe it or not, there's the bugs. "We got 9 to have the bugs, Pat. We got to take care of the 10 bugs up on the high meadows in the woodland." 11 I said, "Well, what do I have to do?" 12 They said, "You have to grade the ground 13 and make little, tiny habitats for the bugs, little 14 piles of wood and rocks and stuff." 15 And so we're designing this. Are you 16 kidding me? And we're making plans, which show 17 exactly how to do it everywhere. And people are 18 going to build it. 19 So that's just my quick run-through on 20 three projects. They're all in your book. I know 21 you don't want to read it, so I'm just surfing 22 through it. But, please, read it if you're 23 interested, especially the frog. If you want to 24 read a cute story, read the -- read the part about 25 the arroyo frog. 26 So I'm concluding now, so I'm on time. We 27 meet your four-part test, okay. We meet this. I'll 28 take anybody on that wants to argue whether we do 20 1 these things. 2 We also meet your AE qualifiers, right, 3 which is the stipulations of what our architect or 4 engineer should be doing to qualify for this. 5 And our results have public benefit, which 6 is one of your criteria. In other words, if I was 7 solving all these funny little things about frogs 8 and bridges and it just went to bed somewhere in a 9 hole, it's no good to the public. But these are. 10 We did -- there's a board over there, 11 Annika, if you would. There's two more; green 12 streets and my brand. 13 This is a -- a book that has 12 features of 14 what we call green streets. This is how to build a 15 street that breathes, people. This is how to build 16 a street that's conducive to nature. 17 Where did I get this? How did I come up 18 with this? I spent two years researching and coming 19 up with stuff. Took it to the City of Irvine and 20 they adopted it. Here it is. This is their policy 21 now. If you build a street in Irvine, you're 22 supposed to follow these guidelines. So it goes 23 into the public domain and makes a difference in 24 people's worlds. 25 So one more thing, our brand. Next board, 26 please. It's underneath there. Thank you, Vanna 27 White. 28 Okay. Every company has a brand if they're 21 1 any good, Coca-Cola, Nike. Well, we do too. This 2 is our brand. If you call any one of my clients and 3 say, "What is Fuscoe Engineering's brand?" they're 4 going to say, "Oh, those guys have that crazy full 5 circle thinking brand." 6 There it is. There's our little logo on 7 it. Look -- what's the top bar say, everyone? 8 "Research." It means get smart on the site. Know 9 everything there is to know about the regulations, 10 the client, the goals of the project, the 11 constraints, the weather, everything. Know it all, 12 then design. 13 What does it say there? It says, "Ask the 14 question 'What if?'" What if we don't do Laguna 15 Canyon channel as a concrete trapezoidal channel 16 that's ugly and horrible to nature? What if, 17 instead, we leave it as a natural creek and we put 18 gabions in there and build riffles and rocks to slow 19 the water down and have it function just like the 20 concrete channel, but instead it's full of life? 21 That's why -- that's what that's about. 22 It's about asking: What if we do it this way? What 23 if we do it that way? What if we do it another way? 24 And in comparing and picking, and that's what we do 25 every day. 26 Then we build the things. And trust me, 27 we're not done. Because when we go out there, 28 remember, all the sites are different. Remember 22 1 that? They're all unique. And sure enough we get 2 out there and, oh, we thought that bridge was gonna 3 fit and it doesn't. Now what? Quick like a bunny, 4 solve it. And so we do that during construction. 5 And finally, we really -- this is like 6 nobody does this, but you go back after it's done 7 and see how it works. 8 I got a quick story that's really cute. 9 Costco is one of our biggest jobs. We've done all 10 the Costcos south of San Luis Obispo, 300 of them. 11 The very first one I did 28 years ago, I 12 was so proud of myself, I put a little half-inch 13 curb in front of the front door so the water 14 wouldn't, when it rains, go in the door. And I got 15 out there for the day it opened. All the people are 16 there, have hot dogs and Cokes and they had their 17 stuff. And I saw this little gal push one of those 18 giant trolleys, and she hit that curb and all the 19 mayonnaise and Wesson oil fell off her trolley. And 20 I thought to myself, "No more curbs." Because I 21 paid attention to it after it was built to see how 22 it actually worked. 23 And I learned never to do that again. And 24 if you go to a Costco today and you go to walk in 25 the front door, look, and you'll see it's a panel 26 curb, it's flatter than a pancake so those wheels 27 roll right up. 28 So that's just an examples of what the last 23 1 thing is on our brand. 2 Thank you very much for your time and for 3 listening to me. 4 This is Annika Vanghagen. She's our 5 counsel. She has a couple minutes to tag on for 6 legal purposes. 7 MS. VANGHAGEN: Yeah. I'd just like to 8 offer a couple items here. 9 One, in reference to items one and two, 10 evidence of qualified research and that the 11 taxpayers are actually engaged in qualified 12 research, I'd like to offer that it's our position 13 that between the thousands of pages of 14 substantiation that we've provided, in addition to 15 Mr. Fuscoe's testimony, that we have not only shown 16 that Fuscoe has engaged in qualified research, but 17 we've also substantiated it. 18 I should also note that the conversation 19 that you just heard, or the information that you 20 were just given by Mr. Fuscoe, was never given to 21 the FTB on exam. These types of, you know, sort of 22 back-and-forths where he could actually offer 23 information on perhaps what some of these plans are 24 indicating, the plans being the substantiation that 25 we provided for each of these projects, that never 26 took place. So I guess I'm offering that to -- 27 well, to opine, I guess, on the fact that it's 28 possible that exam didn't really understand what 24 1 they were looking at when they were given, you know, 2 pages and pages of -- 3 MR. FUSCOE: They're looking at a frog 4 fence. You hope they can figure that out. 5 MS. VANGHAGEN: Right. CAD data and just, 6 you know, different versions of plans, which would 7 illustrate basically different iterations of design, 8 it's possible that exam did not necessarily 9 understand what they were looking at because, again, 10 this type of conversation didn't take place. 11 Today I've -- hopefully you have a couple 12 of additional exhibits in reference to a couple 13 items which go to the qualification of the research. 14 Exhibit 2 is in reference to the funding analysis, 2 15 and 3 are both -- both pertain to the funding 16 analysis. 17 Exhibit 2 is in reference to the financial 18 risk portion of funding. And essentially it's just 19 sort of a distillation of the sort of current and 20 most prevalent controlling case law, which is 21 Geosyntec. And this is being offered in conjunction 22 with -- it doesn't have a number, but it was the 23 exhibit that -- I think it said fixed-fee settlement 24 numbers on there. This is being offered in 25 conjunction with that, to support that proposal. 26 And it basically highlights why fixed fees -- or how 27 the courts would've determined that fixed-fee 28 contracts can qualify for the credit. 25 1 In brief summary, they basically 2 indicate -- the court indicated that fixed-fee 3 contracts confer maximum risk on a contractor 4 because when you're -- when you're performing a 5 service or even constructing a widget for a fixed 6 fee, in the process of providing that service or 7 constructing the widget to the extent that you bump 8 into issues or errors or have to go back to the 9 drawing board, that is on your -- that comes out of 10 your pocket. That is not accounted for in terms of 11 the overall contract price. You have to eat -- eat 12 those costs of basically reperformance until you 13 actually conform with the contract specifications. 14 So in an overall picture or global picture 15 in terms of the contract, that makes the contractor 16 at risk for the overall profit and/or loss of that 17 contract. That's what the courts said. 18 So the court initially -- I mean, not 19 initially. The court held that fixed-fee contracts 20 are inherently risky. The court then said there are 21 terms in the contracts that add risk in addition to 22 the fee structure, that add risk. Terms that allow 23 for Fuscoe's clients to accept the work or reject 24 the work or make payment -- that specifically state 25 that payment will be conditional upon acceptance of 26 the work or that they can withhold payment if they 27 are not -- if they disapprove of any portion of the 28 work. That's an additional risk. 26 1 And then two others which the court 2 indicated were minor risks in terms of contract 3 clauses were a warranty clause and a default clause. 4 And the warranty obviously just said would warranty 5 services for -- you know, that they would be free 6 from defects over a period of time. 7 MS. HARKEY: Pull your mic a little closer 8 to your mouth. 9 MS. VANGHAGEN: And dispute mechanism -- 10 sorry -- a dispute mechanism would allow, um -- 11 would allow his client to -- would dictate sort of 12 how disputes in terms of if they're held -- 13 unaccepted or accepted services would be handled, I 14 guess, going forward. So those two are minor ones. 15 I'd like to offer that in one of the 16 exhibits I handed you today, which also does not 17 have a number on it, but it's a contract from the 18 Irvine Company. And this is actually the Sakioka 19 contract, which is one of the contracts that the FTB 20 sampled on exam. And there's two portions to it. 21 This is probably -- this is -- the first 22 one is just a four-page -- four-pager, which 23 outlines the different phases and the actual fees 24 associated with each phase. 25 The larger portion of the contract is 26 actually basically the Master Service Agreement, 27 which contains all the, you know, applicable terms 28 and conditions. And for your reference I've 27 1 highlighted, with little green stickies, the terms 2 in this contract that are applicable, those same 3 terms that Geosyntec referenced. 4 So the first, on Page 4, would be that the 5 Irvine Company can refuse to approve any portion of 6 Fuscoe's payment and has the right to withhold 7 payment to the extent that the portion of that 8 payment application is disproved. 9 There's a dispute mechanism in there, too. 10 And then the last -- the last green sticky is for 11 the rates portion. 12 But I'm offering this to just show that 13 these fixed-fee contracts line up with the current 14 case structure, basically, in terms of what -- what 15 courts would consider allowable or not in contracts 16 on a -- on an R&D case. 17 MS. RICHMOND: Time's expired. 18 MS. HARKEY: Okay, thank you very much. 19 To the Department, please introduce 20 yourself to the record and -- 21 MR. HORTON: Madam Chair, if I may, the 22 appellant has indicated that this is somewhat new 23 information. And some of it is new to me, based on 24 my review of the record, and helpful by the way. 25 Has the Department heard and seen all of 26 this? 27 MR. RILEY: So we received it this morning 28 and I've looked it over this morning. And so I 28 1 think we can address it. 2 MR. HORTON: You're good with proceeding? 3 MR. RILEY: Yes. 4 MS. HARKEY: All right. 5 MR. RILEY: Good afternoon, Madam Chair 6 Members of the Board. I'm Jason Riley and this is 7 Jaclyn Zumaeta and Craig Scott, and we represent 8 Franchise Tax Board in this matter. 9 Taxpayer must establish several elements to 10 qualify for the California research credit. He must 11 engage in qualified research activity and he must 12 avoid excluded activities that this disqualify their 13 credit claim. 14 Appellant Fuscoe Engineering provides civil 15 engineering services to their clients such as land 16 surveying, planning subdivisions, and submitting for 17 state and local agency permits. For those services 18 appellants claim California research credit, but 19 this credit claim -- this -- this claim fails for 20 any of the following five reasons: 21 One, it's disqualified as funded research; 22 Two, it's disqualified as an adaptation; 23 Three, appellants failed to identify their 24 business components; 25 Four, they failed to engage in a process of 26 experimentation; 27 And five, there's no nexus between their 28 activities and the expenses. 29 1 So let's examine reason one. Even where 2 qualified research activity occurred, a taxpayer is 3 not allowed research credit where the activity is 4 funded by the client because that would be a double 5 payment. 6 This funded research exception is the 7 threshold issue before your Board today. If the 8 activity is funded, it's disqualified and the 9 inquiry ends; there's no credit. And under this 10 exception it makes no difference whether appellants 11 established that qualified research activity 12 occurred because someone else paid for it. 13 The research credit statute was designed to 14 encourage investment in prospective research 15 projects by reducing the cost of the project's rate 16 tax credit, essentially to change a taxpayer's 17 decision from no research is too expensive to yes, 18 the research credit helps defray research costs. So 19 with respect to funded research, it would clearly 20 violate Congress's intent when it enacted the law if 21 a taxpayer seeks research credit for activities 22 someone else already paid for. 23 When examining a contract for funded 24 research, the law in the line of cases from 25 Fairchild to Lockheed Martin, Geosyntec and Dynetics 26 dictate that the inquiry turns on who bears the 27 research costs upon failure, not whether the 28 researcher is likely to succeed. Where there is no 30 1 economic risk, the activity is funded. 2 The contract determines who is entitled to 3 the tax credit and the line of cases following 4 Fairchild have developed certain hallmarks of risk 5 that must be present in a contract to avoid funded 6 research exception. On balance where these 7 hallmarks of risk are not present, the research is 8 deemed to be funded and a research credit is not 9 available. 10 Often a, quote, "fixed-price contract" 11 places economic risk on a taxpayer. It's one thing 12 to call a contract a fixed-price contract, but the 13 courts examined how the contract provisions actually 14 operate by specifically removing these hallmarks of 15 risk. 16 Here, respondent and appellants entered 17 into a random sampling -- into random sampling 18 agreements to examine nine of appellants' contracts 19 and to apply the results to appellants' entire 20 claim. First, let's look at a contract from -- that 21 the tax court in Geosyntec held was not excluded as 22 funded research, the Rare Earth's contract, which is 23 included and on exhibit -- hearing exhibit H-2. And 24 it's highlighted in green. 25 This contract required both repayment on 26 termination and required that taxpayer to pay a 27 portion of the contract price, ten percent, as a 28 liquidated damage of the penalty. 31 1 The client in the Rare Earth's contract had 2 the right to withhold payment until a milestone was 3 achieved. There's also a specific warranty 4 requiring the client to accept a satisfactory 5 research performance prior to payment, and the 6 taxpayer was required to repair or replace any 7 defects. And the Rare Earth's contract contemplated 8 research. These are clear and material differences 9 from the contracts at issue in this appeal; 10 differences which was placed the economic risk upon 11 the taxpayers in Geosyntec. 12 So let's dissect appellants' Pad E 13 contract, which is highlighted in red on Exhibit 14 H-2. 15 Because the hallmarks of risk are 16 completely absent, you'll notice on Exhibit H-2 that 17 each element is the opposite of the Rare Earth's 18 contract. For example, what happens on termination 19 in the Pad E contract? Well, the taxpayer was paid 20 for all services, all reimbursable expenses and all 21 termination expenses. So there is no risk on 22 appellants. They get paid for any services they 23 provide. 24 In addition, the fee for any remaining 25 services will be, quote, equitably adjusted. Plus, 26 appellants would receive 25 percent profit on 27 termination. There's no liquidated damages penalty. 28 There's no warranty clause for a client right to 32 1 withhold payment. There's no repayment on 2 termination clause and the listed services are not 3 qualified research. 4 With respect to payment, the contract 5 indicates, quote, fees and hourly estimates if the 6 clients may allow estimated budget costs to be 7 exceeded. So in this contract the ceiling price is 8 not immovable; that is, additional compensation was 9 available for additional work. 10 According to the contract, appellants would 11 be paid for any services they provided that were not 12 covered by the contract price. So whatever work 13 appellants did, the client would pay them. This 14 contract did not function like a fixed-price 15 contract. Appellants were paid for all work 16 completed. Allowing a tax credit without economic 17 risk would pay them twice. 18 In sum, each of appellants' nine contracts 19 fall squarely within the funded research exception. 20 The hallmarks of risk are not present. Appellants 21 were paid for their work, they didn't use their own 22 money, and allowing the credit here amounts to a 23 double payment. Where activities are funded 24 research, the inquiry ends; appellants do not 25 qualify for the California research credit. 26 Reason two, appellants' services are 27 procedures and methods that someone else created and 28 approved. So appellants failed to qualify for the 33 1 credit under another exception, adaptation of an 2 existing business component. For example, 3 appellants, in their Sakioka contract, did not 4 develop the research protocols for completing a 5 hydrology analysis. 6 Appellants have simply used the methods as 7 created and directed by local and state agencies. 8 They adapted engineering formulas such as those 9 approved and required by the Orange County Hydrology 10 Manual for an individual client's project. By law, 11 this kind of activity is specifically excluded from 12 the research credit. 13 So even if your Board were to find some 14 activity was not excluded under either the funded 15 research or adaptation exceptions, appellants must 16 then meet the other requirements of the research 17 credit statute, and they have not. 18 To date, appellants have failed to prove 19 that they engaged in actual qualified research 20 activity. So they've failed to prove entitled to 21 the credit. 22 Which brings us to reason three. 23 Appellants are required by law to isolate and 24 identify their discrete business components; that is 25 the product, process or technique for which they 26 claimed the credit. Appellants identified projects, 27 yet they failed to identify the particular elements 28 within each project that might then qualify for the 34 1 credit. 2 Appellants have avoided this identifying 3 discrete business components by citing to Trinity 4 vs. United States. In this, appellants are 5 misguided, and Trinity is easily distinguishable 6 from the present appeal. You see, the Trinity court 7 only allowed that taxpayer to avoid the legal 8 requirements because their records had been 9 destroyed by Hurricane Katrina. Here, there was no 10 act of God that destroyed appellants' records. 11 Where a taxpayer fails to meet one part of 12 the qualifying activities statute, the taxpayer's 13 not entitled to the credit. Failure to identify 14 discrete business components is fail to appellants' 15 claim. 16 Reason four, the problem throughout this 17 audit and the appeal is that appellants assume what 18 they seek to prove, in particular, that their 19 services involved qualified research. But what did 20 appellants actually do? 21 Let's look at appellants' Seabrook contract 22 and what they claimed to be qualified research. 23 That their services involved, quote, provide 24 coordination between the owner, local agency, 25 client's legal counsel, and the title company during 26 the process of the condominium plans. 27 Objectively, this coordination of agency 28 approval in no way involves a scientific process of 35 1 experimentation and so it's not qualified research. 2 And neither is surveying and marking out the 3 location where a structure will be built on a 4 client's property. 5 Appellants' services employed techniques 6 developed and required by state and municipal 7 agencies. There's no uncertainty and such activity 8 is not qualified research. 9 Failure to engage in a process of 10 experimentation is fatal to appellants' claim of 11 California research credit. Again, should your 12 Board agree on this point, the inquiry ends; 13 appellants do not -- are not entitled to the claimed 14 California research credit. 15 And reason five, even if your Board finds 16 that some qualified research occurred and was not 17 excluded, by law appellants must prove a connection 18 between the qualified research and the qualified 19 wages. 20 While appellants employ -- while 21 appellants' employees spent time working on various 22 projects, appellants have yet to demonstrate that 23 any of those projects involved qualified research 24 activities. Thus, there was no connection, there 25 was no nexus, between claimed wages and any 26 qualified research as required by law. 27 In conclusion, appellants' claim of 28 California research credit fails for five reasons. 36 1 The hallmarks at risk are not present in appellants 2 contract, so appellants do not escape the 3 disqualification under the funded research 4 exception. And their services fail the adaptation 5 exception. Appellants neither identified their 6 business components, nor prove that navigating local 7 agency requirements involved a process of 8 experimentation. And they've shown no nexus between 9 the claimed wages and any qualified research. 10 But first and foremost, this appeal boils 11 down to funded research. If it's funded, it fails, 12 and your Board's inquiry ends; respondent's 13 determination was correct and appellants are not 14 entitled to their claim of California research 15 credit. 16 Respondent will address any of the other 17 contracts from the random sampling agreements at 18 issue in this appeal should your Board have any 19 additional questions. But I would like to address a 20 couple of things that the taxpayer brought up during 21 their -- during their presentation. 22 Several -- there are three projects that 23 are listed in appellants' -- in their exhibits today 24 that were not part of the sampling agreement, the 25 sampling agreements that they signed with the 26 Franchise Tax Board. 27 Our universe in this case is these nine 28 contracts. The taxpayer and respondent Franchise 37 1 Tax Board agree that in order to keep the audit to a 2 reasonable size, that we would only look at these 3 nine projects. This was for their benefit, so they 4 only had to provide a certain amount of 5 documentation. And it was for respondent's benefit, 6 so that we only had a limited scope of -- to keep 7 the examination reasonable. 8 So projects like the Great Park that you 9 saw some exhibits on today, those are not relevant 10 to this case today. 11 With respect to the arroyo toads, the 12 arroyo toads were -- if anything, they were a subset 13 of a project that appellants had, at audit, 14 identified only as the Sakioka contract. However, 15 the arroyo toads, this was an activity that was done 16 in conjunction with a -- with some biologists. And 17 if so, these biologists -- this would have been a -- 18 what we call contract research, which is where 19 you -- you don't do the research yourself, but 20 someone else does it for you and you get to claim 65 21 percent of what those people went and researched. 22 Now, the interesting thing here in this 23 case is that the taxpayers did not claim any 24 contract research. So they didn't claim anything 25 with respect to the arroyo toads or -- or, you know, 26 indeed they haven't even proved that that activity 27 involved a process of experimentation. We don't 28 know what subset of this discrete business component 38 1 this would involve. Or indeed if, you know, if 2 this -- if this was anything more than the 3 biologists compiling known research about a -- about 4 these toads, their behavior. Compiling some 5 other -- you know, compiling sources of research 6 into a single document, that may be library 7 research, but that is not qualified research and 8 there is a -- there is a difference. 9 And, again, the Green Streets project, 10 while impressive, again, that is beyond the scope of 11 the, um -- of the -- our nine project universe 12 that's at issue in this appeal and that respondent 13 and the taxpayer agreed to apply to the whole 14 population of their projects. 15 And so, again, if -- if your Board has any 16 questions, I'm happy to address them. 17 Thank you. 18 MS. HARKEY: Thank you. 19 Okay. Back to the respondent -- or back to 20 the -- to the appellant. You have a rebuttal 21 time. 22 MR. FUSCOE: Yeah. I'm just going to surf 23 over those real fast. And I'll let Annika do the 24 legal mumbo jumbo. 25 MS. HARKEY: Okay. Be sure you guys speak 26 into the mics. 27 MR. FUSCOE: Yes. I'm just going to surf 28 real fast over your counsel's comments. 39 1 The pivot, he's saying, is we got paid and 2 therefore we're -- it's a -- you can't give us the 3 credit. I understand. That makes sense. 4 I'm telling you, we don't always get paid, 5 okay. And in fact -- and I could substantiate 6 this if I have nothing to do and I can go do this 7 for like a trial with tons of data. But about 80 8 percent of our contracts are fixed-fee, 80 percent. 9 We do $35 million a year. We do about 200 projects 10 a year. So figure 200 contracts; 80 percent of them 11 are fixed-fee. That means were guaranteeing the 12 maximum cost. 13 Our clients are quite good at what they do, 14 so we take that chance. But we don't -- like I 15 said, we don't get paid for the 17 iterations that 16 we do to get to the final solution. 17 Now, if we lost money every time, we 18 wouldn't be in business, I wouldn't be here. So the 19 fact is we do make money on some, we lose money on 20 others, and we come out slightly ahead and some 21 still here. 22 So -- and I heard about this contract 23 that's very flexible and covers every possible thing 24 that goes wrong and I get paid for it. Great. Show 25 me that one, because I don't know where that is. 26 All my contracts are generally -- somebody 27 could find some oddball one. But they're generally 28 what I just said. They're, "Pat, you're going to do 40 1 all the engineering on this project for $500,000 and 2 that's it." And that's just how I do it. And then 3 everything I have to research, experiment, or trial 4 and error is on me. Whether you believe me or not, 5 that's -- that's there. 6 I don't know about this completely absent 7 risk thing. I don't -- I disagree. I'm sorry. I 8 always have risk. I take risk every day; I have a 9 huge insurance policy because of it. 10 If the building's in the wrong place, guess 11 who they go after? So I don't know about that 12 either. 13 So I disagree with the fact that there's -- 14 I get paid and that this is a funded thing and 15 therefore I'm DQ'd. 16 Number two, on adaptation, yeah, you're 17 right, it's an adaptation. What isn't? Okay, I 18 went out and bought a drone six years ago, before 19 anybody had them. What did I do? I adapted the 20 drone by putting a laser on it so that it could 21 survey the ground, and suddenly I had a 3-D model. 22 "Well, that's an adaptation, Pat. We're 23 not paying you for that." 24 That took me a year to figure out how to 25 do, on my own nickel, okay. So, sure, if you want 26 to say that an adaptation DQ's me for this, then 27 okay, because pretty much everything is an 28 adaptation. Even software. I have two code-writers 41 1 and all they do is take existing software and change 2 it and make it different and better. So I 3 understand, but I don't see that as a -- as a real 4 argument. 5 Number three, the business aspect, 6 something about the fact that I have to isolate and 7 document all of this trial and error experimentation 8 stuff that I don't get paid for. I just don't do 9 that as a matter of course. So that's why I'm here 10 in person to just testify on a stack of Bibles that 11 it's what we do. Believe me or not. 12 But the business process of me designing a 13 storm drain that everybody says, "Oh, that's just a 14 plain Jane county standard thing," well, if I had to 15 do it six different ways to get it to fit and work 16 right, I don't keep the five failures. I don't put 17 those in a box and write on top of it "$26,000 of 18 experimentation" and put it in a drawer and have it 19 for you. It's gone. It's useless. So we just turn 20 our back on it and move on. 21 So, I'm sorry. If you believe that, fine. 22 But I can -- I can isolate our R&D process on any 23 project. If you tell me in advance, I can box it in 24 and keep it. But we don't, as a matter of course, 25 because it's useless. 26 Number four, the experimentation test; I 27 agree, the Seabrook project's a poor example. It 28 turns out that the sampling, the grabbag that the 42 1 staff picked out of our basket was just a bunch of 2 children of a lesser god, is all there is to it. 3 I'm sorry. There was just a bunch of sort of plain 4 Jane stuff in there. It was just a miracle. 5 I'm telling you, the projects that I showed 6 you today were the biggest projects in our firm, 7 that I had 30 or 40 people working on in the same 8 time period. So I'm just trying to say, sure, you 9 can go pick around and find some little gas station 10 I did that had nothing special about it and I did 11 very little error in experimentation. Yes, you're 12 going to find -- there's 200 contracts. I'll bet 13 you you can find 20 of them that are like that. 14 But I'm just showing you today the big 15 ones, the million-dollar contracts that really are 16 what make us go. So it's just a bad example that he 17 shared with you, and I understand. That's what it 18 is. It's just the runt of the litter that he 19 picked. 20 Okay. So lastly, this thing about a nexus 21 of cost. So if you're saying I -- I -- most of my 22 costs are wages. All those people you saw, they're 23 all highly paid, by the way, six-figure kind of 24 people. It's like 80 percent of our costs, it all 25 goes out the door every night. 26 So, yes, I pay them to do this work. And 27 like I said, when they're just researching for me 28 like that -- the woman I hired that's a scientist 43 1 that does nothing but research water, that's -- so I 2 can go get her W-2 and hand it to you and say, here, 3 and see how much time she billed during the year. 4 Maybe she billed 10 or 20 percent of her time. 5 If that's what you need to make a decision, 6 then I'll -- we'll go to work getting you all that. 7 I'm just here today to tell you that's what it is if 8 you want a shortcut. 9 So I disagree. I think there is a nexus of 10 cost. It's wages; that's the biggest cost I have. 11 I pay these people well. And some of them, that's 12 all they do. I have two people full-time that do 13 nothing but R&D. They don't bill anything. 14 So, there you go, that's my quick surf. 15 Go ahead, Annika. 16 MS. RICHMOND: Time's expired. 17 MS. HARKEY: Let's allow for at least two 18 more minutes. 19 MS. VANGHAGEN: Thank you. 20 MS. HARKEY: I think we could have allowed 21 really 10 minutes on rebuttal since we had 20. But 22 let's just -- 23 MS. VANGHAGEN: Thank you. 24 MS. HARKEY: -- a few minutes. 25 MS. VANGHAGEN: Just a couple items here. 26 There was a couple issues that, um -- that 27 counsel referred to on the Rare Earth contract for 28 Geosyntec that actually never made it into the 44 1 court's opinion. So those terms -- and I'm not 2 recalling exactly what they are -- but those terms 3 that he referenced that were other than the terms 4 that I referenced which were acceptance, warranty 5 and default, anything extraneous from that never 6 made it into the court's opinion. So I, therefore, 7 conclude that that was not necessarily part of the 8 court's thinking in terms of coming up with a 9 determination as to why those fixed-fees contracts 10 were qualified. 11 Secondly, the, um -- the Pad E contract 12 that he referred to is one of those contracts that 13 we actually conceded in the settlement numbers, the 14 fixed-fee settlements. 15 So we agree that since the time that 16 this -- that these credits were originally filed 17 for, case law has changed. And so those fixed-fee 18 numbers at 47.4 percent -- is 47.4 percent of the 19 entire population of contracts that were claimed in 20 this three to six period -- 2003 to 2006 period that 21 represent fixed-fee contracts. We now concur that 22 that time & materials type contracts and cost-plus 23 or cost-plus-to-max, anything like that is no longer 24 qualified. That's why we offered that settlement. 25 I mean we obviously can't argue against something 26 that simply we have no record for. 27 The, uh -- counsel offered sort of a 28 summary opinion of what Mr. Fuscoe does in terms of 45 1 qualifying activity and whether or not, you know, 2 there was scientists engaged on a project and who 3 performed what. 4 MR. FUSCOE: You should work with 5 scientists if you want a real thrill. 6 MS. VANGHAGEN: But, you know, I'd offer 7 that obviously Mr. Fuscoe's testimony here today is 8 that he actually performed a lot of this R&D 9 himself, and/or other people in-house performed it 10 on behalf of Fuscoe Engineering, people that were 11 not subcontracted out. 12 Mr. Fuscoe, I think, again, his testimony 13 goes to support that his process of experimentation, 14 none of these projects -- although he did -- he 15 conceded that there's adaptation, but he -- I'd like 16 to offer that he's not an attorney and he's not 17 speaking to adaptation as defined by this law. 18 And so he can't take a design from one 19 site, spin it around and apply it to the next site. 20 In that spin is the adaptation and, therefore, 21 obviously that wouldn't qualify. I get that. But 22 that's not what happens. 23 What happens is he has an idea of what a 24 drain should be, and he approaches, you know, a new 25 site, given all the project constraints, and has to 26 make something work given all the competing 27 constraints, regulations, everything like that. He 28 can speak more to that than I can, obviously, but -- 46 1 but there's no adaptation here. 2 Additionally, to the extent that there's a 3 process of experimentation, how can there be an 4 adaptation? To the extent that -- to the extent 5 that the solution is not immediately known from the 6 outset and there involves sort of an iterative 7 process of design, how can that be an adaptation if 8 there has to be a trial and error process to arrive 9 at a workable solution? 10 The nexus issue actually -- 11 Oh, we did -- we did identify business 12 components by the way. And the business components 13 are the subtasks and phases of these projects. They 14 are identified in the project records. This is all 15 part of the record. But this is, again, if you want 16 to pull up Exhibit 4, it'll give you an idea. 17 But this runs through -- this is 18 basically -- Exhibit 4 is a time-keeping record on a 19 project. And this runs through. This is only 20 time-keeping records from phases that were captured 21 as part of this R&D, so -- and only for people that 22 worked in a trial and error process on this project. 23 So this is only reflective of a portion of 24 the project that was captured. This is not the 25 entire time-keeping record. But what this does is 26 it identifies in the phase name the business 27 component that an employee project manager, Donald 28 Butler, who is working on, and it logs his time by 47 1 day on this project per hour. And it shows you that 2 there's a direct correlation between the activity, 3 i.e. rough grading plan, and the qualifying expense 4 which is -- which is determined from these hours 5 when we apply sort of a multiple of their salary. 6 The missing link between I think what he's 7 referring to, the missing link in terms of how, you 8 know, this may or may not substantiate nexus between 9 the qualifying activity and the expense is the 10 testimony from -- 11 MR. FUSCOE: (Inaudible). 12 MS. VANGHAGEN: And -- and -- and in coming 13 up with these numbers and -- and, uh -- and the 14 allocations for the time spent, qualifying time 15 spent on here, it's people like Mr. Fuscoe that were 16 interviewed and all his project managers that said, 17 "Okay, Donald Butler, what did you do on rough grade 18 plan? What does that involve?" 19 Okay. If you were trying to, you know, 20 create a solution, there's this trial and error 21 process. And so there's this give and take 22 conversation where -- 23 MS. HARKEY: Okay. I'm going to ask you -- 24 MR. FUSCOE: Well, I just -- 25 MS. HARKEY: I'm going to ask you to put a 26 cap on it so that we can -- 27 MR. FUSCOE: Jason's comment about the 28 storm drain being a plain Jane cookie-cutter thing, 48 1 let me just pick on that for a minute. 2 MS. HARKEY: Okay. You will -- I'm sorry, 3 Mr. Fuscoe, you will both get a chance, because I'm 4 sure the Board is going to have plenty of questions 5 for you. 6 Thank you. 7 Yes. 8 MR. EPOLITE: Ms. Harkey, if I may 9 interrupt just for a second to ask a question. 10 Appellant just mentioned just now about a 11 concession. Back on July 6th appellant made a 12 submission regarding a concession they were making 13 about revising their refund claim. 14 And I was wondering if it was possible now 15 to inquire of appellant -- back on July 6th 16 regarding the fixed cost -- fixed price, the funded 17 contract question, this issue, appellant made a 18 submission back on July 6th revising the refund 19 claim, adjusting it. 20 The original refund claim was for $765,364 21 and at that time stated that they were revising the 22 refund claim to 47.4 percent of the original amount 23 to revise refund claim of $362,809. 24 And just wanted to see if we could get some 25 clarification today that it was appellants' position 26 today that that was their official revised refund 27 claim. Because -- and what was so important about 28 that is the original refund claim, that this is a 49 1 Section 40 appeal before the Board and that, you 2 know, that has significance for this Board, Section 3 40 appeals. And that before this goes to a vote -- 4 MS. HARKEY: So what you're saying is if 5 it's -- if the appellant is actually revising their 6 claim, which is what we have here and what was 7 already -- what was in the file, if they're revising 8 their claim to the -- let me see, assuming that 9 there was a change in the law and that the claim was 10 revised downward from the 700 and -- 11 MR. EPOLITE: 65,000. 12 MS. HARKEY: -- 65,000 downward to 362,809, 13 that it would no longer be a Section 40? 14 MR. EPOLITE: That's correct. And so it 15 would be nice if we knew that now before the Board 16 voted. 17 MS. HARKEY: Can we get some clarification 18 from appellant, Mr. Fuscoe, or his client? Are you 19 revising your appeal down from the 765,364 to the 20 362,809? 21 MS. VANGHAGEN: Yes, that is correct. 22 What is Section 40? 23 MS. HARKEY: Section 40 just means it needs 24 an opinion or an actual analysis done as to what the 25 vote, what the issues were and it gets published. 26 MS. VANGHAGEN: Gotcha. 27 MS. HARKEY: Okay. So it makes it -- 28 MR. EPOLITE: Right. It's a requirement 50 1 upon the Board at the end of the appeal that the 2 Board is obligated to publish an opinion on its 3 website. 4 MS. HARKEY: But it's no longer a Section 5 40, which means it's under a half a million 6 dollars -- 7 MR. EPOLITE: Right. 8 MS. HARKEY: -- is that correct? 9 MR. EPOLITE: If the amount in controversy 10 is $500,000 or more, the Board is obligated -- 11 MS. HARKEY: Then it's not anything that 12 has to be published. 13 MS. VANGHAGEN: Right. Got it. Okay. 14 MS. HARKEY: Okay. So that's what 15 you're -- you're doing the 362,809 is the amount of 16 the appeal. 17 MS. VANGHAGEN: Right. 18 MS. HARKEY: The 47 percent of the refund. 19 Okay. 20 MR. EPOLITE: Thank you. 21 MS. STOWERS: (Inaudible). 22 MS. HARKEY: Pardon? 23 MS. STOWERS: I have one question related 24 to the concession. 25 MS. HARKEY: Sure. 26 MS. STOWERS: Just real quick. 27 Just comparing the two schedules, to the 28 appellant, are you saying that the Pad E billing 51 1 Anaheim is or is not funded research? 2 On this -- on your exhibit it says 3 "unfunded," but I believe in your presentation -- 4 MS. VANGHAGEN: You know, I -- I misspoke 5 before. I'm looking at mine. It -- it was not 6 the -- one of the ones that we were -- by virtue of 7 being a time and materials. 8 MS. STOWERS: Okay. 9 MS. VANGHAGEN: So it is unfunded. 10 MS. STOWERS: It is unfunded. 11 MS. HARKEY: Okay. I think we're on now to 12 the Members. 13 I have a lot of work into this only because 14 I found the case extremely interesting and it was 15 very confusing to get my hands around. 16 Somebody else wants to go first, I'm more 17 than happy to allow that. Otherwise, I'll hand out 18 stuff from the file that was easy for me to kind of 19 grasp what I was doing and what I was looking at 20 with the help of my staff. 21 And we did not get anything new. We did 22 not talk to anyone after the drop-dead date of July 23 1st. This is all from the file. 24 There were roughly 15,000 pages of 25 documents. And the problem was not a lack of 26 documentation, the problem was coordinating it so 27 that it was digestible. And we tried to do that 28 because we couldn't have any conversations. 52 1 So we actually went through the 15,000 2 documents to see what -- what would work in my 3 ducky-bunny presentation, because that's how I have 4 to have this. I have to have it really clean as to 5 what we're looking at. 6 So I've got one for the Department, too. 7 You can see this is all -- these are all items that 8 you have -- that we got off your file. And I'll 9 just -- 10 MR. HORTON: Madam Chair, while you're 11 doing that, just want a point of clarification. 12 The respondent indicated that the -- some 13 of the examples provided today was not part of your 14 original scope? 15 MS. HARKEY: That's true. 16 MR. HORTON: And -- and, uh -- but you went 17 further to suggest that because it wasn't part of 18 your original scope, it's not relevant to this case? 19 MR. RILEY: Correct. 20 MR. HORTON: Did you mean to say that? 21 MR. RILEY: I did mean to say that. 22 We have a -- we have signed sampling 23 agreements with the taxpayer, a method of the 24 Internal Revenue Service that the Franchise Tax 25 Board uses in order to keep an audit to a reasonable 26 size. 27 MR. HORTON: Further point of 28 clarification, to Appeals, I don't know that this 53 1 body's limited to that. 2 MR. EPOLITE: That's correct. The sampling 3 agreement was between the parties, but that does not 4 limit the Board. 5 MR. HORTON: Okay. 6 MR. RILEY: If I may -- 7 MR. HORTON: It has -- 8 Yes. Go ahead. 9 MR. RILEY: If I may, the problem with that 10 is that the -- the only items for which there is 11 evidence in the record are these nine contracts. 12 MR. HORTON: Well, that was -- 13 MR. RILEY: There were 1200 other alleged 14 contracts for which there is no evidence in the 15 record. The Franchise Tax Board did not have access 16 to -- or at audit that we did not have access to at 17 appeal. And so it is a bunch of -- it is 18 unexamined -- 19 MR. HORTON: No, I -- 20 MR. RILEY: -- evidence. 21 MR. HORTON: I appreciate your concern, 22 which was the reason that the question was asked. 23 Given this new information, is the respondent okay? 24 They reviewed it and are they okay with it and 25 they're prepared to move forward? 26 Because evidence presented at this time, 27 the body can take it under consideration. How the 28 Department deals with the conclusion, if there is a 54 1 conclusion that says the evidence has merit, is kind 2 of up to you. But -- 3 MR. RILEY: Well -- 4 MR. HORTON: I don't believe it's true that 5 we -- 6 MS. ZUMAETA: Mr. Horton? 7 MR. HORTON: -- can't take it under 8 consideration. 9 Yes? 10 MS. HARKEY: We are -- we are limited in 11 this audit by the nine projects, I believe it was, 12 that were chosen. 13 MR. HORTON: Well, we're not limited. 14 MS. HARKEY: Well, we're not limited to 15 testimony, but these are the projects we're going to 16 be reviewing and these are the projects that -- 17 MR. HORTON: That's not true either. 18 MS. ZUMAETA: Mr. Horton, can I just kind 19 of mention something that -- the tax court looked at 20 this issue in Union Carbide. And in Union Carbide 21 the taxpayer attempted to remove -- they -- they -- 22 I'm sorry, let me back up. 23 They had entered into an agreement with the 24 Internal Revenue Service to sample five of their 25 contracts. And the results of those five contracts 26 were going to be applied across the entire 27 population. And they attempted then to amend their 28 petition to remove one of those contracts and to 55 1 remove all the qualifying research expenses because 2 they no longer wanted to claim the research expenses 3 for that contract. 4 And the tax court denied them that 5 opportunity because they said that it was inherently 6 unfair to allow the taxpayer to unilaterally change 7 the agreement that they had with the IRS. 8 So that's just sort of the -- what we've 9 been operating under is that guidance from the tax 10 court. 11 MR. RILEY: And if -- if I may add, you 12 know, the -- the letter of July 5th essentially 13 requests a do-over. It asks to go to square one, 14 pretend none of the audit happened, none of -- none 15 of anything happened, and redo the entire audit 16 based on the entire population. 17 And -- well, and also, without the 18 Franchise Tax Board having access to those 1200 19 contracts. So just toss out the random sampling 20 agreements that the taxpayer and Franchise Tax Board 21 agreed to be bound by in, uh -- in the audit. 22 MR. HORTON: Well, I don't -- I mean I 23 somewhat recall Union Carbide in that the courts 24 actually kind of said that they will take it under 25 consideration. 26 But let me go to Appeals. Can you respond 27 to that? 28 You originally said that these -- this 56 1 additional -- which I think is important, because 2 it's been entered as evidence, these additional 3 transactions. And can this body take those 4 additional transactions under consideration in their 5 deliberation? 6 MR. EPOLITE: Original transactions, 7 referring to? 8 MR. HORTON: The ones that they presented 9 today. 10 MS. STOWERS: The projects that were not 11 part of the original -- 12 MR. HORTON: The projects that are not part 13 of the original agreement and scope of the audit. 14 MR. EPOLITE: Because that's part of the 15 appeal years, so -- 16 MS. STOWERS: Yeah. 17 MR. EPOLITE: Because the entire -- the 18 claims for refunds are all the -- that's part of the 19 appeal years. So that is the entirety -- that's 20 part of the entirety of the appeal years, so yes. 21 MR. HORTON: And your thoughts in response 22 to respondent's Union Carbide argument? 23 MR. EPOLITE: Well, that's how the parties 24 perform the audit. But -- so that they can do an 25 audit. But the Board's not bound by that in 26 adjudicating the appeal. 27 MS. ZUMAETA: In Union Carbide the, um -- 28 the court actually denied them permission to amend 57 1 their claim. 2 MR. HORTON: Was that taken up under 3 appeal? 4 MS. ZUMAETA: I'm sorry. The -- 5 MR. HORTON: Was the Union Carbide case 6 you're referencing taken up under appeal? 7 MS. ZUMAETA: That issue was not taken up 8 under appeal. 9 MR. HORTON: I'm sorry, I couldn't hear 10 you. 11 MS. ZUMAETA: No, that issue was not taken 12 up under appeal. It was decided in a motion for 13 summary judgment. 14 MR. HORTON: Motion for summary judgment? 15 MR. EPOLITE: Well, and the Board wasn't a 16 party to the audit between the parties. So the 17 Board's not bound by the audit. 18 MR. HORTON: All right. Thank you. 19 MS. STOWERS: Kind of follow-up on that. 20 So if I understand, so we're not bound by the 21 settlement -- excuse me, the sampling agreement -- 22 MR. EPOLITE: Right. 23 MS. STOWERS: -- that the Franchise Tax 24 Board and the appellant did. 25 MR. EPOLITE: Correct. 26 MS. STOWERS: So in our deliberations we 27 can consider the three parts that they described and 28 whether or not that satisfied the requirement for 58 1 qualified research. 2 I understand the concessions that the 3 appellant made with respect to what they say is 4 fixed or unfunded contracts. But in the record 5 today we do not have the benefit of reviewing those 6 contracts. We just have your verbal statements, 7 correct? 8 MS. VANGHAGEN: That is correct. However, 9 we can provide those contracts. 10 MR. FUSCOE: Well, Annika, but they have 11 this. This is -- this is a better cross sampling of 12 that period of time in our firm. And I distilled it 13 for you so you didn't have to read through all the 14 gobbledygook. 15 MS. STOWERS: You mean -- what do you -- 16 what is "this"? 17 MS. VANGHAGEN: This is sort of a reference 18 to the process of experimentation and technical 19 uncertainty. It doesn't have contracts in it or 20 contract terms. 21 MR. FUSCOE: No. I'm sorry, it doesn't. 22 I'm just talking about whether it's a qualifying -- 23 MS. STOWERS: Right. I'm focusing more on 24 whether or not it's funded. So we don't have the 25 benefit of all those contracts in the record to 26 review them. 27 MS. VANGHAGEN: I can, if it's helpful, 28 offer how we determined, how we came up with that 59 1 sort of, uh -- the settlement percentage of 47.4. 2 Which is, in his -- in Fuscoe's time-keeping records 3 the people record their time to each project. And 4 part of those time-keeping records have a billing 5 fee associated with each contract that an employee 6 is billing time to. 7 And so for that time period, those project 8 accounting records are culled through, and we only 9 pulled out those contracts that had a percentage of 10 completion billing associated with it; which is a 11 fixed fee because you're billing according to a 12 percent of completion of the project. So that 47.4 13 percent was derived from direct -- I mean I can -- 14 what I'm saying is I have documentation to show you 15 that that 47 point -- what each of those projects 16 are that make up that 47.4 percent. 17 MS. STOWERS: Okay. 18 MR. HORTON: So the appellant's not 19 amending their claim. They're just providing 20 additional evidence. But, just in the interest 21 of -- 22 MS. HARKEY: They are amending their claim 23 down to the 362 because the law had changed. 24 MR. HORTON: Relative to the cases, that 25 was just -- 26 But to our counsel, we've got Appeals 27 saying we can take this under consideration. You've 28 got the respondent saying you can't take these under 60 1 consideration. 2 What say you? 3 MR. EPOLITE: Ms. Stowers -- 4 MS. MARKS: I'm sorry. I couldn't quite 5 hear the question. Is it, uh -- is this about the 6 particular process that you follow? 7 MR. HORTON: No. 8 The, uh -- the appellant has provided 9 additional evidence to support their position. They 10 entered into an agreement with the respondent, an 11 audit agreement, which the respondent believes 12 should be honored at this point and the additional 13 cases should not be taken under consideration. 14 Appeals has indicated that Board is not 15 party to that agreement between the parties and 16 shouldn't -- are not required to take that under 17 consideration. 18 I'm just looking for a little bit of 19 direction. 20 I mean I can say what I believe and I can 21 say what I believe about Union Carbide. I'm very 22 much familiar with the case. But just for the 23 record I'd like somebody to say -- 24 MR. RILEY: Mr. Horton? 25 MR. EPOLITE: And I'm addressing your 26 question that you weren't -- the Board wasn't a 27 party to the -- to that agreement. 28 MR. HORTON: I understand that. 61 1 MR. EPOLITE: So you're not bound by it. 2 MR. HORTON: I understand what you're 3 saying. You're repeating what you said before. I'm 4 asking our Chief Counsel to give us counsel. 5 MS. MARKS: I think this is relevant to the 6 rules that govern these proceedings, which is not 7 within my purview. 8 MS. HARKEY: Okay. 9 MR. RILEY: Mr. Horton, if I may. 10 MS. HARKEY: If you wouldn't mind -- if you 11 wouldn't mind, I'll continue on with the projects in 12 question. I've got data to present the projects in 13 question, because I've been combing through those 14 particular projects. 15 If the Members would like to consider other 16 data to support another kind of conclusion or -- 17 or -- or more data, then that's -- seems like I 18 heard that's acceptable; we can do that. But the 19 Department is focusing on their sampling and I 20 focused on the sampling. 21 MR. HORTON: Well, that's respectful. But 22 in the interest of fairness to the Department and to 23 the appellant, I believe that the additional 24 evidence can be taken into consideration. 25 MS. HARKEY: I think that's what we heard 26 from Mr. Epolite. 27 MR. HORTON: And I believe that if this 28 body is going to do that, that the appellant should 62 1 be in a position to be able to respond to that 2 additional evidence. And that's why I've asked the 3 question in the beginning: Are they prepared, are 4 they okay with that, do they need additional time? 5 Do you want to look at it? 6 MR. RILEY: I guess I didn't realize that 7 we would be entering into an agreement to accept 8 that the 1200 contracts that are not before us or 9 that your Board doesn't have access to -- 10 MR. HORTON: (Inaudible). 11 MR. RILEY: -- that that would be 12 evidence. 13 MS. HARKEY: Excuse me. If we could -- if 14 we could continue on with the appeal as is, and then 15 maybe circle back to what else we might want to 16 consider or why you're wanting to consider other 17 than the contracts that are currently here. 18 I think that the appellant has gone through 19 all of their contracts, or I know that from what 20 they submitted that's part of the record and part of 21 the file. They submitted this based -- that 22 supports their 47 percent. And reason -- the way 23 that they did that was they took all of their fixed 24 fee, all of their lump sum, all of their time and 25 materials, they got a grand total, and then they 26 figured out what percentage of their total contracts 27 was that. And that's how they got to the 47.75 28 number, based on the changes in the law. 63 1 So I think you can look at a lot of 2 contracts or no contracts or just the ones here to 3 kind of support some of this. And so if we could -- 4 if we could continue. And then I would be happy to 5 allow you to make a point for an additional contract 6 if you want to. 7 Right now I'm looking at the ones that we 8 were asked to look at based on the audit. But I 9 think you can use the information, based on Mr. 10 Epolite, to make another decision or an 11 additional -- you can use the additional information 12 just for consideration. 13 But I did not consider this as new evidence 14 because -- 15 MR. HORTON: Well, this point of law is 16 important because I do consider it new evidence. I 17 do consider it relevant. And it does change my 18 original perspective. And I'd like the Department 19 to be able to respond to that. 20 In addition, the fact that new evidence has 21 been entered into the record, it's been considered, 22 and opens this up for a re-audit, where the 23 Department can request a re-audit, the appellant can 24 request a re-audit, and this just becomes an 25 exercise. 26 So I think we probably should get some 27 clarity. I'm not -- 28 MS. HARKEY: Which is why -- which is why I 64 1 wanted to stick to the projects. 2 Why don't you let me go through the 3 projects and then you decide if you still need 4 additional information and you want to allow what 5 you just heard to really change your mind one way or 6 the other. 7 MR. RILEY: If I can just pop in for one 8 second. 9 If you're asking us to consider the 10 additional contracts that are not in the -- that 11 were not in the record during the audit, that we 12 would need additional time to examine those 13 contracts. 14 MS. HARKEY: That's why I think we've 15 waited a long time to get to this. 16 MR. RUNNER: Can I -- can I -- I just got a 17 quick question. I'm going to digress because 18 it's -- I just -- again, we're all trying to figure 19 out what the rules are and jobs here. But I'm 20 concerned of what I just heard from the attorney. 21 Is the -- is the attorney -- are you 22 sitting there as our attorney on all matters as 23 we're dealing with these issues today if we ask you 24 an opinion on something? Or are you sitting there 25 just as an attorney on -- on, uh, you know, 26 Bagley-Keene and ex parte? What is your role? 27 MS. MARKS: The -- the MOU between DCA and 28 BOE covers Bagley-Keene and, um -- and the APA. 65 1 MR. RUNNER: I'm sorry. 2 MS. MARKS: The Administrative Procedures 3 Act with respect to ex parte communications. 4 MR. RUNNER: So in regards to legal opinion 5 that we may turn to you on in regards to some aspect 6 of law and whatnot, that's not part of the MOU? 7 MS. MARKS: Questions such as evidentiary 8 questions is not part of the MOU. 9 MR. RUNNER: So we're sitting here right 10 now without an attorney to give us interpretation of 11 the law. 12 MS. MARKS: I was under the impression that 13 the Appeals Bureau did that. 14 MR. RUNNER: At times. At times. And 15 oftentimes we turn to the Chief Counsel. 16 Okay, thank you. Just for clarification. 17 MS. HARKEY: Okay. Let me -- let me start, 18 if you wouldn't mind. Because I -- I, uh -- I think 19 if you'll open up your first book, or your book, the 20 first thing you will see in the book that I provided 21 you is with regard to Pad E. 22 And in all of these cases I have one of 23 these cheat sheets for the Members to use, which I 24 used, which basically says that qualified research 25 expense has three categories for analysis. 26 The first one is the Internal Revenue Code 27 section 41 test, which is four parts: 28 A) Claimed research must qualify as 66 1 expenses for new or improved processes. And these 2 are new and improved processes to the appellant, not 3 necessarily to the whole world, but they can be. 4 And as you see, we've got some patented items and 5 whatnot; 6 The research must be used to discover 7 information that is technical; 8 The research activity is taken with a 9 purpose of discovering information which is useful, 10 has to have a solution for developing a new or 11 improved process; 12 And substantially all of the research must 13 be elements of the process of experimentation for a 14 qualified purpose. 15 Now, the second part is the wages or 16 expenses claimed -- in this case it's wages -- must 17 have a nexus to the qualified research expense. 18 The third part is the contract analysis 19 must show risk, fixed fee versus time and materials. 20 So it has to be a risk of loss of failure of the 21 research and the appellant needs to have the rights 22 to use the research. 23 So, on the first one that I went through -- 24 yeah, it's a long process, but this is a -- this is 25 a big case. Pad E building, you will see the 26 page -- first, you see the description and the 27 picture of the project. And you can read, if you 28 choose, all of the different things that the 67 1 appellant provided on these projects. This is all 2 from the file. 3 The next page is -- is just a typed page, 4 as this, which goes into -- which goes into the IRC 5 section Code 41. That's what this is about. 6 Section Code 41, the qualified research activities 7 rules that has four parts. If you recall, I said 8 there's four parts to that. 9 So the first one on this in my analysis is 10 that section 174 is a very low test. It's present 11 in this project because there were unknown variables 12 that had to be resolved due to the characteristics 13 of the land to be developed, the desires of the 14 developer, local regulations. Fuscoe was uncertain 15 at the outset as to appropriate design of the land, 16 water drainage, water quality, utilities and other 17 infrastructure. 18 The expenses claimed included a breakdown 19 of wages by project, by phase, by person, and only a 20 portion of the wages were attributable to the 21 research performed to find a new or improved 22 process. 23 The second part of the four-part test is 24 the technological information test. The research is 25 used to discover information that's technical. And 26 we found that the design and/or restore a creek is 27 inherently technical in nature, that it involved 28 principles of civil engineering, soil sciences, 68 1 hydrology and environmental engineering. 2 The business component test. The research 3 activity must be undertaken for the purpose of 4 discovering information which is useful in the 5 development of new and improved process, a solution. 6 This was the very first project for Fuscoe 7 started in 1992. Everything was new to the 8 business, and the way that they adapted this was 9 new. 10 The process of experimentation test. 11 Substantially all of the research activities must be 12 elements of the process of experimentation for a 13 qualified purpose. 14 An old mall, which was what this Pad E is, 15 it's an old mall, covered the entire 50-acre site, 16 needed to be demolished and all materials recycled 17 for use in new projects. Dozens of alternatives 18 were explored for consideration of recycle aggregate 19 base, concrete, asphalt and sand, predicted several 20 alternative layouts for Caltrans and finalized a 21 retaining wall, a design that would fit all of them. 22 Sensitivity studies were conducted for 23 drainage solutions when dealing with flood flows 24 onto an old 1948 home tract, and other flood inu -- 25 inundations, I guess it is. And interactive 26 analysis of various water quality BMP's was 27 conducted to discover the most effective solution 28 given unique soils, regulations, site constraints. 69 1 Careful and precise grading studies were 2 completed to allow for ADA. And the very nature of 3 the engineering firm is to develop and evaluate 4 alternatives and with the engineering principles. 5 So I felt that that first test, that first 6 one test, IRC section 41 test, they met the four 7 parts here. 8 The next thing was to -- the wages. And 9 what we've provided -- what was provided to the 10 Department and what was provided to all of us in the 11 file of 15,000 pages were these wages, wage 12 statements, where they broke out exactly what was 13 the qualified research expense of the engineers. 14 We also were able to find in the file the 15 resumes of the engineers, showing that they were 16 truly not just sitting around. These are really 17 highly paid people doing very technical jobs. 18 That's in there for you; you can see all of the 19 resumes. 20 So I felt that given their 47-whatever 21 percent and the resumes that we had here, that that 22 really fell under kind of the Cohan Rule where they 23 did provide, in my mind, enough evidence that these 24 were technical in nature, that these were research 25 people, that they weren't just out there doing 26 standard engineering jobs, and that they broke off a 27 portion of it, a portion of it, and they allocated 28 it. 70 1 And the research -- these engineers 2 actually had to fill out time sheets as kind of 3 testifying as to what they did at the time. And 4 that was all in our file of 15,000 pages. But I've 5 presented just for you what I had. 6 The next is the Pad E Anaheim contract. 7 And in that contract, if you go to -- I just -- I 8 just included a couple pages for you. I did not 9 include the entire contract, although I do have 10 that. 11 The scope -- scope of services. And you 12 can see that when you look through all of these 13 tasks, that there are items that are fixed fee, 14 they're fee, and then there's an hourly estimate. 15 So if you go to the very end, you can see 16 that the curb gutter stakes are probably -- they're 17 not experimental, so you can deduct the curb gutter 18 stakes that were in here. 19 We just went through everything, and 20 there's a total proposed fees of 19,250, which 21 hourly estimate $1500 and construction staking was 22 7,100, so minus that. So you've got some at risk. 23 We did feel there were at risk here. 24 And so that's -- that was -- that was Pad 25 E. And that's what I went through with Pad E that I 26 felt that it met all of the four requirements. 27 Sakioka -- Sakioka, I believe is the next 28 project. That was 890 units, 46 building apartment 71 1 complexes, a total of 40 acres on farm land in Costa 2 Mesa. Again, you can see the picture, all of the 3 grading, the ground water site. It was truly a 4 unique site. I kind of remember that because it's 5 right here in Costa Mesa, right by the freeway, in 6 South Coast Plaza area. And so I do remember that 7 being a -- being farm land. 8 But anyway, again, I went through the 9 four-part test -- or the three-part test. The first 10 one being the IRC section 41. And you can see on 11 your sheet there for Sakioka Costa Mesa that, again, 12 the characteristics of the land, the desires of 13 developer. 14 Fuscoe was uncertain at the outset of 15 appropriate design of the land, water drainage, 16 water quality, utilities and other infrastructure. 17 The expenses claimed were attributable to 18 research based on the -- the information in the 19 file. And they did -- they did build or use -- it 20 was research that was technical. It was technical 21 in nature. It involved principles of civil 22 engineering, soil science, hydrology and 23 environmental engineering. 24 It was a very difficult project, site 25 grading, groundwater water quality. Required 26 site -- unique site specific solutions. And they 27 worked with the City of Costa Mesa to apply new 28 regs, innovative roof, rain water drainage system, 72 1 difficult -- let me see, groundwater water quality, 2 etcetera, innovative roof, rain water drainage 3 systems. And so they had some innovative new 4 designs for this project. 5 Again, when I looked at -- from the file, 6 we had this, which is a lot of names. But there's 7 more compressed into one here that showed what 8 they -- what they thought was the qualified research 9 expense, which is basically payrolls. 10 And then again, you get the engineering -- 11 the engineers biographies, resumes that kind of tell 12 what they did, how they did it or who they are. And 13 you can tell, again, they are not just -- you know, 14 they're not out digging ditches. This is pretty 15 technical stuff. 16 So then we got to the contract, fixed fee 17 or qualified time and materials. Again, we had to 18 break that up. We looked at what was fee, what was 19 not, the hourly estimates. I photoed that for you, 20 just pieces of the contract. 21 And so, again, I found out that -- I found 22 that I thought it did meet all of the four 23 requirements. 24 Now, on the next project, Seabrook, I -- 25 MS. VANGHAGEN: Madam Chair? 26 MS. HARKEY: Yes. 27 MS. VANGHAGEN: Pardon me. I'm sorry. 28 If I can ask for your indulgence for a 73 1 second. I, uh -- I'm wondering if it might be 2 possible to take just a few minutes recess. 3 I flew in here for this hearing. 4 MS. HARKEY: A long time ago. 5 MR. FUSCOE: She's going to miss her 6 flight. 7 MS. VANGHAGEN: If I might be able to see 8 if I could reschedule so I could fly out later 9 tonight. But would have sort of a deadline. My 10 flight'S at, like, 3:30. 11 MS. HARKEY: Okay. Well, we will continue 12 on with the hearing. So what are you requesting? 13 MR. FUSCOE: She just wants go out and -- 14 MS. VANGHAGEN: I just want to run out and 15 see if I can change my flight. 16 MS. HARKEY: Oh, okay. I don't know if 17 anybody else wants maybe five minutes. 18 MS. VANGHAGEN: I guess if you're just 19 going to continue on with this, maybe we don't need 20 a recess and I can just run out. But if there's 21 going to be a Q and A, then I need -- 22 MS. HARKEY: Okay, that's fine. Why don't 23 you just run out. 24 I'm going to go through my projects and 25 then we'll talk to you -- or the projects that I 26 looked at. And then we'll -- I will open up for 27 questions to you. 28 On Seabrook, I did not find that it met the 74 1 four -- IRC 41 test. And I did not see a nexus for 2 wages. 3 Seabrook seemed to be just a lump sum. It 4 was a lump sum contract, it met that. But it was 5 just -- seemed to be a standard mapping process. I 6 did not see it had to -- it satisfied the qualified 7 research. And the appellant can argue that, yes or 8 no. 9 But so being that I didn't believe it 10 qualified, even though it was a lump sum contract, I 11 did not consider that. 12 Mountain -- 13 And I don't think you have anything in your 14 file for that, that I found out. 15 Mountain Park. Now Mountain Park was a 16 3,000-acre mountainous development. It says it used 17 cutting edge solutions, that's their talk, but you 18 can see all of the, uh -- the maps that were in the, 19 uh -- the file provided to all. And, um, in 20 Mountain Park -- let me just get to -- 21 Okay. The 174 test, the four-part test, go 22 through that. I think I've said this before, land, 23 water drainage, water quality, utilities, other 24 infrastructure. Very unique piece of property. 25 They present breakdown of their wages. It was 26 technical, I believe, because all of the different 27 principles of civil engineering, soil sciences, 28 hydrology, environmental engineering and any 75 1 contributions thereto. 2 The business component test. It did create 3 an improved process or solution. New designs were 4 developed from research to meet strict criteria 5 established by the U.S. Army Corps of Engineers, 6 U.S. Fish and Wildlife, California Fish and Game. 7 You can tell that project, 3,000 acres of mountain, 8 very difficult site, needed a lot of different 9 uses. 10 Process of experimentation. It was a 11 nontypical land form, grading that masks the 12 development slopes and integrated sites into the 13 mountain water shed. Experimentation techniques for 14 drainage, optimization of buildable areas and 15 habitat preservation. A unique design for land form 16 and earth work, dual storm drainage system, which 17 was discussed by the appellant. Unique flood 18 control design that was supposedly never done 19 before. We can ask about that. 20 The, um -- the wages and expense, item 21 number two, have to have a nexus to the qualified. 22 Again, we got supplied with the time sheets and the 23 amount of work that the appellant claims was 24 qualified. Again, we've got the bios of the 25 engineers. And -- and again, they filled out their 26 time sheets, they -- versus what they did, which is 27 kind of like a testimony. 28 If you go to the contract -- 76 1 MS. STOWERS: Madam Chair, may I 2 interrupt -- 3 MS. HARKEY: Yes. 4 MS. STOWERS: -- real quick? 5 MS. HARKEY: Sure. 6 MS. STOWERS: I follow what you're doing, 7 and you're looking at the nine that was part of the 8 sampling agreement. And I was just wondering, in 9 the spirit of time, if you can focus on the ones 10 that they're only arguing for now? Because on their 11 Exhibit 2, for an example, they are no longer saying 12 that Mountain Park qualifies. 13 Perhaps we could only look at the ones that 14 they are including in their calculation. 15 MS. HARKEY: Oh, I -- I am missing that. 16 Is Mountain Park no longer considered? 17 MR. FUSCOE: I -- I'm sorry if it's not, 18 because it should be. It was probably the biggest 19 contract we did during the 2003 to 2006 time 20 period. 21 MR. RUNNER: Said it's not. 22 MR. FUSCOE: And it certainly is -- 23 MS. HARKEY: Who said it was not? 24 MR. FUSCOE: I don't know. I'm just the 25 guy that does the work. 26 MS. ZUMAETA: I think that appellants' 27 counsel indicated that it was -- that she had 28 removed it from the group because it was funded 77 1 research. 2 MS. HARKEY: Okay. 3 MR. FUSCOE: Anything that -- anything we 4 got paid for -- 5 MS. HARKEY: Anything that was funded does 6 not qualify. I didn't find it all funded, but 7 that's okay. If you admit that it's -- you say it's 8 funded, then Mountain Park doesn't work. 9 MR. HORTON: Well, I mean -- personally, 10 I'd like to hear -- if the Member believes it wasn't 11 funded, I'd like to hear what she's saying. 12 MS. STOWERS: I think that's -- 13 MS. HARKEY: Oh, okay. Well, I -- I do 14 think it was -- it wasn't funded. We had, um -- 15 Okay. Mountain Park. Let me see. Is that 16 what this is? 17 Okay. There's a -- it says in the contract 18 if either the time and materials or the both 19 fixed-fee and time and materials blocks under item 20 one above are checked, then all amounts listed in 21 this exhibit are not to exceed any amount shown with 22 the owner's written contract change order. 23 So you'd have to make a change order. So 24 both fixed-fee and time and materials were checked. 25 And so that indicated risk to us of an unfunded 26 contract. Because it states in here that, you know, 27 you have to have the owner's written change order. 28 So the contract is 15 -- 15,000 for that. 78 1 So that's why we thought it included that. 2 But that can be a -- a subject for discussion, 3 maybe, with the appellant. 4 San Mateo Creek, now that's the frog? 5 MR. FUSCOE: That's the frog. Or toad. 6 MS. HARKEY: That's the frogs. 7 MR. FUSCOE: Frog's hop, toads don't. 8 MS. HARKEY: Again, I went through the 9 whole thing for San Mateo Creek and see the piece of 10 land, where it was. The four-part test activity, I 11 went through all of the four-part test. I thought 12 it met the IRC section 41 test. 13 The wages and expense, again, was another 14 sheet that they provided based on the time sheets 15 and the multiple things we've gotten, about 15,000 16 pages. So I just broke out the easier ones because 17 we did review a lot of that. 18 And, um, for the contract, I gave you 19 pieces of the contract, or maybe the entire 20 contract. But you can see that it's fee, fee, fee. 21 That's what it says in the contract, it's fee. 22 So I don't see -- hourly estimate was for 23 meeting and coordination, and hourly estimate for 24 construction field phase inspections. But basically 25 it was a fee contract, with risk. 26 And in all of these cases Fuscoe retained 27 the right to -- to use the research. They can use 28 it again if they choose or it's -- it's theirs. And 79 1 you could see that in one of the items that were 2 brought. 3 The Palm Springs, Delano-Palm Springs, I am 4 a little -- I'm just -- I'm not really sure, and I 5 will ask the appellant later after you all have your 6 chance, but Delano-Palm Springs is the one that I'm 7 not sure about the contract. I think you can see 8 where it was, what they were doing, the engineering, 9 all of the four-part test. I did feel that they met 10 the four-part test in the first IRC section 41. 11 They did the same with the wages. They 12 broke out what was qualified for the Q -- for the 13 qualified research expense. 14 Again, all of the resumes, etcetera, 15 showing the caliber of the education and the fees 16 that -- or the criteria that was required to work 17 on -- on the qualified research. 18 The contract, fixed-fee or hourly. But, 19 you know, there are some areas here that I will want 20 the appellant to explain, to show me where they 21 thought the risk was in the contract. Because I'm 22 still not -- I'm not sure on that one. 23 National City Costco, sounds like just 24 putting up a Costco. I think if you look at that, 25 you will find that that really wasn't what it was. 26 It was quite a undertaking from below the building. 27 And, uh, the same thing, I do believe it 28 met the four-part test of section -- IRC section 41. 80 1 The wages and expenses, again, I think they 2 provided the -- a listing of what they thought was 3 the qualified research expense based on their 4 time-keeping. 5 We've got the -- you know, what we could 6 drag from the file were the resumes there. And then 7 we've got the contract from Costco that does say 8 it's -- it's a fixed-fee, Exhibit A, a fixed-fee. 9 So I think that that's a pretty good indication. 10 It says that -- on Exhibit A, it says 11 "Fuscoe will perform the services on a fixed-fee 12 basis, except where noted." And there are a couple 13 notations, but it all -- that's -- that kind of 14 speaks for itself. 15 So I do think they met all of the 16 qualifications on the Costco. 17 Merriam Mountains. I had a little bit of 18 problem on Merriam Mountains on the funded or not 19 funded. So I would probably want an explanation on 20 that as well. 21 I think all of the other tests worked, but 22 funded and not funded was a problem for me. I'm 23 just not sure. I would need the appellant to 24 explain that. 25 And Sapphire Towers, we did not have a 26 contract in the file, so I can't opine on that. So 27 I would have to, based on current evidence that we 28 have or current file documentation, I could not deal 81 1 with Sapphire Towers or -- or grant Sapphire Towers 2 because I just -- we don't have a contract. 3 So, I guess -- I guess that's that. I 4 think that gives the Members and the staff a lot of 5 what we -- what I focused on and what might help 6 guide some of the questions. 7 And so, with that, I will let the Members 8 ask whatever questions they want. I'll entertain 9 that. And then I will come back to the client if 10 you -- or the client -- the appellant, if you don't, 11 regarding the projects that I was uncertain on. 12 Thank you. 13 Member Horton? 14 MR. HORTON: Yes. Thank you, Madam Chair. 15 I would like to ask the respondent to 16 provide input on Chairwoman's description of these 17 items. 18 MR. RILEY: So -- I mean I -- there's a lot 19 to, um -- to talk about. And I guess we can start 20 with, um -- I guess let's start with the contracts 21 because we've got -- we've got each of those 22 contracts, with the exception of the Sapphire Towers 23 contract. 24 But we don't just look for the word "fee." 25 We don't just look for the word "fee" in a contract 26 to determine whether it is a fixed-price contract 27 or -- or a not fixed-price contract. 28 You know, we -- 82 1 MR. HORTON: Apologies, but we can't hear 2 you. 3 MR. RILEY: Sorry. 4 We don't look -- just look for the word 5 "fee" in a contract to determine whether or not it's 6 funded. The courts are very clear that we look for 7 all these elements, you know. And on balance if 8 those elements are present, then a contract is 9 funded. For example -- 10 MS. HARKEY: Let me -- let me just clarify. 11 I only pulled out little portions of the contract. 12 We did review the entire contracts, and that's where 13 I came up with the determinations that I did. I 14 pulled out just things that would say "fee" so that 15 it might be easier to digest. 16 But just, before you go on about how 17 ignorant my presentation was, I just want to be sure 18 on the record that you know we did -- we did -- my 19 staff did review the contracts. And I just got, you 20 know, a note that there's something on Delano-Palm 21 Springs that I did not see. 22 So I think -- I just wanted to clarify that 23 for the record. 24 MR. RILEY: I -- yeah. In no way am I -- 25 MS. HARKEY: Thank you. 26 MR. RILEY: Didn't mean to suggest that. 27 MS. HARKEY: No harm, no foul. 28 MR. RILEY: But, you know, especially with 83 1 respect to the Pad E contract, what happens when -- 2 when -- if the contract's terminated, you know? 3 We -- we look, and the clause here says 4 that, you know, they -- they will get paid for 5 whatever they do. And, in addition, they're 6 entitled to 25 percent of the profit, 25 percent of 7 their anticipated profit on the value of the 8 services that they performed. 9 So there's no risk that they're not going 10 to get paid. Even where -- even where a contract is 11 terminated, they're going to get paid for whatever 12 work they did up until the point of termination. 13 So that is a risk that the courts looked 14 at. And so simply by virtue of -- you know, we 15 can't just say because there is a fee, that it's -- 16 that it is funded. 17 Um, if we look at, um, say the Sakioka 18 contract, I think you mentioned that they retained 19 substantial rights in that contract. In fact one of 20 the pages tabbed by appellants is the ownership and 21 use of project documents. And it states here: "All 22 of the plans, designs, sketches, photographs, 23 presentations and renderings related to the 24 professional services are and shall remain exclusive 25 property of the owner." So not of Fuscoe 26 Engineering. 27 But Fuscoe did retain the right to use the 28 materials for publicity purposes. But publicity is 84 1 not a substantial right for which the courts or the 2 Treasury regulations allow, a right in some 3 contracts. And where a contract has -- where a 4 taxpayer does not retain rights, they are not -- it 5 is also funded. 6 Again, you know, I think the Seabrook 7 contract was -- was dealt with. 8 MS. HARKEY: You will have a chance to 9 respond. But right now Member Horton has asked the 10 FTB about some issues. 11 MR. RILEY: While that contract -- 12 So we'll -- we'll move on to the Mountain 13 Park contract. What does that contract -- what is 14 that contract actually for? If we look at the scope 15 of the services, consultant shall provide staking as 16 needed for grading limits sufficient to -- for 17 intervisibility at or -- or at 250-foot intervals, 18 including appurtenances. 19 So they have to put a stake within visible 20 sight of the next stake, and they have to mark out 21 the appurtenances. So any -- you know, any 22 easements, any encumbrances on the property. 23 That activity, that's the only activity 24 that is, you know, here in the Mountain Park 25 contract that we have. That's certainly not 26 qualified research. 27 MR. FUSCOE: Do you want me to answer these 28 or -- 85 1 MS. HARKEY: If you will -- 2 MR. FUSCOE: -- do you want me to try and 3 accumulate them? 4 MS. HARKEY: Why don't -- why don't you 5 accumulate them and -- because, let him go through. 6 MR. FUSCOE: All right. 7 MS. HARKEY: And then it will be your turn 8 to respond. And Member Horton will allow you a 9 chance to respond. 10 MR. FUSCOE: Okay. 11 MR. RILEY: With respect to -- you know, 12 with respect to Delano, they are claiming just about 13 every single thing that -- that they did, whether or 14 not that included a, you know, aerial topography, so 15 your -- your -- you know, your mapping out the 16 location. You know, that's not -- that does not 17 necessarily involve a qualified research, you know. 18 A sewer plan to the city. This sounds like 19 a regulatory item: Water improvement plan to the 20 Desert Water Agency; a storm drain plan to the city; 21 off-site street improvement to the city; notice of 22 intent to the State Water Resources Control Board; 23 the Fire Master Plan to identify hydrant locations 24 to the city; and project coordination, which 25 includes, you know, government agency processing. 26 Again, those are all activities that are 27 not qualified research within the terms of the 28 statute. 86 1 If we look at the Merriam Mountain 2 contract, it's primarily an estimated, an hourly 3 estimated cost. So if something is an estimate, 4 that is subject to change. And so it's not a 5 fixed -- it's -- you know, it's an estimated fee. 6 MS. HARKEY: I agreed with you on that one. 7 But we'll let the appellant respond. 8 MR. RILEY: And with respect to the 9 National City Costo, that's a time and materials 10 contract. I believe that even appellants in their 11 May 22nd, 2015 additional briefing stated that that 12 was a time and materials contract. And so it was a 13 funded contract. 14 And, you know, that contract includes the 15 same terms as many of the other ones that they are 16 claiming, you know. In the event of termination, 17 the client shall pay the consultant for all services 18 rendered to the date of termination, all 19 reimbursable expenses and any -- and reimbursable 20 termination expenses. 21 So in each case while -- while the 22 contracts do include the word "fee" sometimes, the 23 contracts don't act like fixed-fee contracts. And 24 the taxpayer, it would -- it would appear from these 25 contracts, that the taxpayers have a way of being 26 paid. 27 MS. HARKEY: Member Horton, do you mind -- 28 MR. HORTON: No. 87 1 MS. HARKEY: -- if Ms. Ma -- 2 MR. HORTON: Please. 3 MS. HARKEY: -- asks a question? 4 MS. MA: So -- so I think the taxpayer has 5 an unusual type of company. And I just want to 6 focus, instead of trying to figure out did they 7 qualify for one of the four, let's go maybe the 8 other way. 9 And if you go to the Franchise Tax Board's 10 publication, or at least the research and 11 development frequently asked questions, Number 5, 12 there's 14 items that say what research activities 13 do not qualify for California's R&D credit. The 14 following research activities are specifically 15 excluded by the statute. And you go through the 16 different ones. 17 I could read it to you, but I think the 18 Number 14 is the one where we are in dispute, or the 19 bone of contention is, the funded research; any 20 research funded by grant, contract or otherwise by 21 another person or governmental entity. Right? 22 And then if you go to the Geosyntec v. 23 Commissioner case, I think what it talks about, you 24 know, what is funded versus not funded. Number one, 25 taxpayer must retain substantially all of the rights 26 of research. And I just want to ask the taxpayers, 27 do you retain substantially all the rights of your 28 research? 88 1 MS. VANGHAGEN: Yes, we do. 2 And actually, there's an exhibit that I 3 didn't get to in my diatribe, Exhibit 3 that is in 4 reference to the funding analysis. And it gives 5 you -- it walks you through a handful of the 6 contracts, and the sample contracts. Not all of 7 them. I believe I removed the ones that we pulled 8 out for time and materials. 9 So I believe that what you're looking at on 10 Exhibit 3 are the sample contracts that are fixed 11 fee. And they -- this references -- 12 MS. MA: Okay. Do you retain substantially 13 all of the rights of your research? 14 MS. VANGHAGEN: Yes. 15 MS. MA: Okay. 16 Number two, the amounts payable to the 17 taxpayer under contract must be contingent on the 18 success of the research. Taxpayer must bear 19 economic risk of loss. 20 MS. VANGHAGEN: Yes, we do. 21 MS. MA: Okay. 22 That, I think we've been going back and 23 forth, right? Cost-plus contracts, funded, lump sum 24 contracts, fixed term, not funded, cost-plus 25 contracts subject to maximum. That was in the case, 26 right? This was in the Geosyntec case. 27 So, I don't know. I mean I think they 28 qualify, that they substantially retain all the 89 1 rights and that they're contingent on the success of 2 the research, and that they bear economic risk of 3 loss. 4 And is the Franchise Tax Board, are you 5 saying that is not true? 6 MR. RILEY: We are -- it is our reading of 7 the contracts that they do not have -- that they do 8 not have economic risk as it is defined in -- in the 9 regs and in Geosyntec. 10 MS. ZUMAETA: And, also, that they do not 11 retain substantial rights. 12 MS. HARKEY: Okay. Would the -- 13 Mr. Fuscoe, you've been -- 14 MR. FUSCOE: Yes. 15 MS. HARKEY: -- waiting to respond. 16 MR. FUSCOE: Well, you know, I'm going to 17 just cut to the chase. That's just my nature, I 18 apologize. But it's how I got to be CEO. 19 Our contracts, I've been writing them for 20 40 years. And all of the clients have slightly 21 different language. And if you go into these 17- or 22 37-page contracts and pull out little paragraphs 23 like they're doing, you can build a construct of 24 anything. 25 But fundamentally, I'm just testifying 26 under oath, or however you want to put it, that the 27 way it works is 80 percent of the work is usually 28 fixed-fee, that's what they call it. I tell them 90 1 it's $30,000 for me to do your storm drain system, 2 and I tell them it's 40,000 to do your sewer, and so 3 on. That's a G-max, if you will. 4 And the contracts that they're giving you 5 the snippets from, all will say "as per Exhibit A." 6 So you got to go look at Exhibit A to really see 7 what the work is. And that's our list of tasks. 8 There's usually 10 to 30 tasks in every 9 contract. And sure enough, there's two or three T&M 10 items, almost on every contract. It's meetings and 11 processing at the city, things that are just so 12 vague we have no idea. 13 All the clients get that. And they just 14 say, "Well, what do you think it will take, Pat?" 15 And I give them a number. And then they kind of try 16 to hold me to that, but it's -- I go back begging 17 for more when bad things happen. 18 So there's fixed-fee, there's T&M. It's 19 about 80/20 ratio in all of our contracts. And then 20 there's the ability to do a change order, which 21 they're rightfully bringing up. 22 If the circumstances change halfway to the 23 end and it wasn't our fault or our doing, it was 24 someone else's, then I have a leg to stand on to go 25 to them and beg for more money. And they will -- if 26 they're fair, they'll give it to me because it's not 27 my fault. But if it's my fault in their view, 28 they'll say no. 91 1 So of the change -- we probably write five 2 to eight change orders on every contract, and we 3 probably get four of them or something like this. 4 So we have a -- we have some losses there, too. 5 So when the day is done, it's fixed-fee, 6 T&M and change orders, and that's it. There's no 7 such thing as a cost-plus contract in my life, in my 8 company. You won't find one. 9 And there is risk in every contract, 10 regardless of what the boilerplate language says. 11 Those fees and those tasks, how I write that task, 12 if I say 6,000 lineal feet of storm drain will be 13 designed in these plans and it turns out to be 14 7,000, then I can go back and say see, see, it's 15 different. 16 So that's my world. I just want to -- he 17 also picked on Mountain Park. I don't know where he 18 found it, but that was like a $3 million contract 19 that we had 30 people working on for five years. 20 And at the very -- you know, one little teeny task 21 in the middle of all that work was for our surveyors 22 to go out and set stakes in the ground. And 23 somebody found that in the contract and pulled it 24 out and said this is just rote, robotic work that 25 has nothing to do with research or experimentation. 26 That's right. It is. It's one of like a 27 thousand tasks that we did. And so, great, somebody 28 took a fine-tooth comb and found a task that was, 92 1 you know, not qualified. And I wouldn't even beg 2 you for a credit for that. 3 The fact is, that project was fixed-fee 80 4 percent, and we got into so many things that we 5 didn't anticipate. And the Irvine Company's kind of 6 saying, "Hey Pat, you're the experts. You're 7 supposed to know all that." 8 So we beg and we plead, and sometimes they 9 give us a little more money. But in the end we 10 don't get it all, and that's why I'm asking for the 11 credit. That's all. 12 I'm not asking for credit on anything I got 13 paid for. Ever. It's not right; I wouldn't do it. 14 Okay. I'm sorry. Since -- I might as well 15 finish with these other things. 16 So there was this discussion about the 17 Delano. It's confusing, I guess, and I'm sorry. 18 It's another one of those sort of runt of the litter 19 things. 20 But we give them a fixed fee for what's 21 called a precise grading plan. It's the teeny-weeny 22 little detail of every little thing in that 53-unit 23 subdivision; all the little gutters and zillions of 24 little data points. And we say, here's the number. 25 And then we found out that we couldn't get 26 the water out of the yards. I remember this because 27 I remember the guys coming to me going, "Oh crap, 28 Pat. What are we gonna do?" 93 1 So we went to the city, and I don't know 2 how -- it was a miracle -- but we convinced them to 3 let us put the drain pipes under the houses, which 4 they never allowed. But they did. 5 Then we had to design this real crazy sort 6 of Byzantine layout of pipes that ran all over the 7 place under those houses. There's no way the 8 client's paying me for that. They said, "You 9 should've known that, Pat." 10 So that's the answer to the Delano, if you 11 will. It's a -- you could say it's my mistake, I 12 should have known that. Well, some things you just 13 can't foresee. Who would have thought that they'd 14 design their layout so that all the water got 15 trapped in every yard? I -- I just couldn't foresee 16 that. 17 The Merriam Mountain project, same thing 18 again, folks. I'm sure we had a lot of T&M on that 19 because we were in the county and they were asking 20 for things, and it's a brand new thing the county 21 had never dealt with. 22 But in the end there's -- we got paid 23 fixed-fee and we got paid some T&M. And then we 24 spent extra time and money to develop the first 25 hydro-modification report and approval in the 26 county, and in the state by the way. 27 So no one had ever done this before. They 28 just said, "You guys go figure it out." And I told 94 1 our client what I thought it might cost, and then 2 she said fine. And then it took five times as much 3 and I couldn't get her to pay five times as much, so 4 we ate all that. 5 But we're very proud of it and we brag 6 about it and try to get value from it by showing 7 everybody in the state that we were the first and 8 all that. 9 So that's my answer on Merriam. 10 Sapphire, I'm sorry, there's no contract 11 for it. But, again, I gave you the little 12 description in there of planting that 32-story 13 building into the -- basically the ocean. You know, 14 to sea level was only a few feet below the ground 15 and so we had to put 11 feet of concrete in the 16 bottom of that building just to ballast the 17 building, like a boat, if you will. And nobody 18 foresaw that. So, whoops, you know, we had to just 19 do it. 20 So, I'm sorry, I'm done. 21 MS. VANGHAGEN: If I can just add a couple 22 things to that. 23 In reference to the substantial rights and 24 retaining thereof, in this type of industry and in 25 Fuscoe's provision of services there's two types of 26 intellectual or, I guess, property rights that are 27 created by virtue of his services: Tangible rights 28 and intangible rights. 95 1 I -- I walked in, and I'm not sure if I 2 caught everything, but what I think I overheard was 3 opposing counsel refer to a term in the contract 4 that references documents, ownership of documents, 5 plans, drawings, stuff like that. That's the 6 tangible result of his work product. That's his 7 ideas reduced to paper. 8 There's another half of that property that 9 is developed, which is basically all of the 10 concepts, the ideas, the know-how, the trade 11 secrets, everything that goes into what is actually 12 on that piece of paper that he retains, that he can 13 therefore use on future projects. That's why he 14 becomes an expert. 15 That's where all of his -- you know, that's 16 where his knowledge base comes from. It's working 17 on that over and over and over again. That's why he 18 can approach a project and say, I've bumped into an 19 issue like this before and on that project this 20 solution worked. Maybe this solution won't work 21 here, but let's try it. And then, you know, he 22 can -- he can try and use that in the future. 23 Those are the rights that he retains. And 24 if you look at the contracts, the contracts are 25 either silent as to any rights or they reference 26 specifically only documents, only tangible items 27 that you can, um -- you know, items that you can, 28 you know, touch and feel in terms of anything that 96 1 Fuscoe would transfer to their client. 2 And, again, it's -- there's some terms that 3 are highlighted in Exhibit 3, and also terms, 4 comparison there to a case where it was decided not 5 in favor to the taxpayer as a distinguishable item. 6 In reference to change orders, change 7 orders are offered or come up when the scope of work 8 that was originally contemplated is being exceeded. 9 Meaning he pitched a -- he pitched a project for 10 50 grand to do these three things. 11 All of the sudden a fourth thing comes up. 12 They're not going to do number four for the same 13 50 grand, so we have to add a change order. That's 14 typically where they come up. 15 They have, you know, their own pricing. 16 They're still typically controlled by the same 17 Master Service Agreement, the same, you know, terms 18 and conditions. But that's where change orders come 19 in. 20 Additionally, I'd like to offer that even 21 the Geosyntec Rare Earth contract that opposing 22 counsel referred to had a provision in there for 23 later authorized change orders. And that contract 24 was still held to be unfunded. So change orders are 25 not dispositive of risk. 26 Third, in reference to activities that are 27 found in the contracts that may not qualify, like 28 survey and staking, in the production of -- or in 97 1 the implementation of this R&D credit, those items 2 on any given project were culled out of the actual 3 QREs. 4 So Fuscoe is not claiming a credit for 5 those items that do not qualify. Fuscoe is only 6 claiming a credit -- and we can show you the project 7 accounting data, which -- which activities were -- 8 the QREs were derived from. Fuscoe's only claiming 9 QREs for those activities that involved a process of 10 experimentation to resolve the technical 11 uncertainty. And we wholeheartedly agree that 12 survey and staking are not part of that. 13 That's it. 14 MR. RUNNER: Yeah, just to clarify. To me 15 this comes down to some of the discussion that we're 16 clearly having in regards to the idea of potential 17 of economic risk, um, and responsibility that -- 18 that would go into -- which would go into the 19 project. 20 And I guess where I'm kind of -- again, 21 it's, you know, tedious right now to go through 22 these. Obviously it may be necessary, but it's 23 tedious to go through these in a project-by-project 24 basis. 25 But the point, to me, is trying to figure 26 out where it is there was economic loss, potential 27 economic loss, because of the -- because of the 28 research that was done. Or it was -- or it was -- 98 1 or it was just the responsibility of the company to 2 do, knowing that there would not be economic benefit 3 at that point, to be used either in that project or 4 in later projects. Or not used at all because it 5 didn't work the way they thought it was going to 6 work. 7 Can you articulate for me, one of you, how 8 would you -- how would you explain quickly the, 9 um -- the risk of loss? 10 MR. FUSCOE: The risk of loss. 11 MR. RUNNER: The risk of loss in these -- 12 in a project that you would go into. 13 MS. VANGHAGEN: In these contracts -- and, 14 again, in the amended, I guess, contract amount 15 where we're focusing on fixed-fee contracts, the 16 risk of loss is that he's pitching a solution to a 17 project. He's providing a solution for a fixed fee. 18 If he can't provide that solution within that price, 19 he has to keep working until he can provide that 20 solution. 21 He has to correct errors at his own cost. 22 He has to basically, you know, go -- 23 MR. RUNNER: Why is that not any different 24 than any other contract? 25 MS. VANGHAGEN: Because there's a time and 26 material type contract where you're basically just 27 billing for each hour. 28 So you can basically -- you know, if he 99 1 bumps into an issue under a time and material 2 contract, a design issue that he has to, you know, 3 go through numerous iterations of design processes, 4 he gets paid for each hour, for each iteration. 5 MR. FUSCOE: Most of the time. Not 6 always. 7 MS. VANGHAGEN: But under the terms of the 8 T&M type contract, you're submitting a bill for the 9 hours that your employees incur. 10 Under a fixed-fee type contract, you're 11 only submitting a bill to the client based on a 12 percentage of completion of the project. So you're 13 saying, I'm 20 percent complete on this project. If 14 you get to the point where you're 80 percent and you 15 can't get anymore but you're still working and 16 working and working and trying to come up with a 17 solution, that's all the costs that he eats. 18 MR. RUNNER: Is there ever an effort to 19 where they, again, the company would try to seek 20 reimbursement through a change order? 21 MR. FUSCOE: Oh, yeah. All the time. 22 MR. RUNNER: Okay. And so the one -- so 23 basically the path could be there's a potential 24 process or path of reimbursement. However, that's 25 at the discretion then of who you're doing your 26 business with, therefore it could get turned down. 27 MR. FUSCOE: Well -- 28 MR. RUNNER: Therefore it was not 100 1 reimbursable. 2 MS. VANGHAGEN: Right. It's at the 3 discretion. But per the terms of the contract, the 4 change orders technically are not allowable unless 5 there's a change in the scope. Meaning, unless the 6 scope exceeds -- unless the new thing exceeds the 7 original scope that was contemplated under that 8 original fixed fee. Does that make sense? 9 MR. RUNNER: Yeah, it does. But the 10 definition of scope sometimes would be, I assume, 11 with the company there and you'd try to go ahead and 12 do a change order. 13 MS. VANGHAGEN: Right. 14 MR. RUNNER: And ultimately they'd say yes 15 or no. 16 MS. VANGHAGEN: Yeah. 17 MR. FUSCOE: You know, I just -- I'm giving 18 you anecdotally the reality. How the words are all 19 put together is one thing. Like the 20 hydro-modification study on Merriam, is a good 21 example. 22 I wrote that proposal, that scope, without 23 it because it didn't exists. In my experience I 24 have never seen such a -- and so I didn't think we 25 would need it, right? I mean because it's like 26 something landed from Mars. 27 We get halfway through the process and the 28 county says the state just changed, the State Water 101 1 Resources Board just changed the rules and 2 they're -- they figured out that all your storm 3 drains, Pat, are dumping water in these creeks and 4 it changes the creek's behavior and the character of 5 the water. Well, that -- son of a gun, we should 6 have thought of that. 7 So now, Pat, you have to go back to your 8 storm drain system that was maybe standard practice, 9 if you will, and you have to fix it so that it 10 doesn't change the character of the water in that 11 creek. 12 Oh. 13 So then I go back to my client. 14 So to your question, where's my risk, 15 probably a third of the time when I come back to a 16 client with that story and say, "Gosh, you guys. 17 I'm a really good engineer, I've been doing this for 18 40 years, but I never saw this coming. And it's 50 19 or $80,000 of the work; can you sign this change 20 order, please, for it?" 21 Half the time they look at me and go, "Hey 22 you're the expert. You should have known that. You 23 should have known that that was going to happen." 24 And I get into arguments and I appeal to 25 them and all that. But I'm just telling you, I 26 don't win all the time. I win half the time. And 27 it's usually because the client -- 28 MR. RUNNER: Is that, by definition, 102 1 research? 2 MR. FUSCOE: Does that apply to research? 3 MR. RUNNER: Yeah. 4 MR. FUSCOE: Yeah. 5 MR. RUNNER: Okay. How does that apply to 6 research, I mean if somebody changes the rules? 7 MR. FUSCOE: How would it apply? Yeah, 8 well, on research it's a little different. They're 9 assuming I know how to do everything. So they'll 10 say, "What are you going to charge me to do these 11 ten task?" And I tell them. 12 And then I go about doing it and I 13 discover -- as I told you every site is unique and 14 different. I'd find unforeseen circumstances 15 physically on the site or regulatorily, like I was 16 just explaining how the State Water Resources just 17 sort of dumped this new thing on us. 18 And again, it's -- so now, not only is it a 19 contract issue what we're talking about -- is there 20 risk for me, I'll lose money -- but then I got to 21 know how to do it. And nobody had ever done this 22 hydro-modifications thing. 23 So whoa, wait a minute, Pat. Okay. I'll 24 pay you to do it, but you have to know how to do it. 25 I'm not going to pay you to go to school and learn 26 how to do it. I'm just going to pay you for that 27 finished document that Annika just described. 28 That's all they want, and they don't care how much I 103 1 have to learn. 2 So that's where the research goes on. I 3 have hydrologists, that's all they do, you know. 4 And they go study and figure it out on my nickel or 5 on the company's nickel and come back. And then 6 they come up with a -- a solution from trial and 7 error and whatever. And then we go try it on the 8 agency. And if we get through, we win. 9 And we get paid for that solution only. 10 MR. RUNNER: Mm-hmm. 11 MR. FUSCOE: Not all the research that we 12 had to do. 13 MR. RUNNER: Thank you. 14 MR. FUSCOE: Yeah. 15 MS. HARKEY: Any other questions, Board 16 Members? 17 MR. HORTON: Yeah, I guess so. 18 MS. HARKEY: Member Horton. 19 MR. HORTON: Question of the appellant. 20 When you are doing your research and designing and 21 your analysis to come up with the process by which 22 your client can use to accomplish the objective of 23 the contract, at the end of that contract and you 24 come up with a process for a product of some sort, 25 do you market that product to other clients? 26 MR. FUSCOE: I wish I could. It's not -- 27 most -- almost nothing I do is -- I can replicate 28 anywhere else. I tried to explain that in my 104 1 presentation. But I could use an extreme example. 2 If I go to Alaska on the side of Mount Denali -- 3 MR. HORTON: Let me retract, if I may. 4 MR. FUSCOE: All right. I'm sorry. 5 MR. HORTON: Take the breathing road, for 6 example, did you come up with a end product or an 7 end process that allows the road to breathe? 8 MR. FUSCOE: Yes. 9 MR. HORTON: And then as a result of that, 10 you have now a process that you could patent if you 11 wanted, or you may have patented that process, and 12 then you turn around and you sell it to other 13 cities. 14 MR. FUSCOE: I think I follow what you're 15 saying. So, yes, the -- the -- 16 MR. HORTON: Let me sort of indicate that 17 these are really leading questions. That might be 18 helpful. 19 MR. FUSCOE: This is what I got paid for. 20 But I did -- 21 MR. HORTON: I understand that. You got 22 paid for that. You were -- that fact that you got 23 paid for it, for that is an indication of a funded 24 contract. 25 MR. FUSCOE: That's right. But I -- but I 26 didn't get paid -- I did not get paid for all the 27 research I had to go study on permeable/impermeable 28 materials, on high albedo/low albedo. Which is 105 1 not -- has anything to do with sex; has to do with 2 color on the concrete. Heat gain -- 3 MR. HORTON: In doing that -- 4 MR. FUSCOE: Yes, I'm sorry. 5 MR. HORTON: In doing that research -- 6 MR. FUSCOE: Yes. 7 MR. HORTON: -- did you end up -- did you 8 come up with a process that you didn't get paid for, 9 a process for a product or a prototype that you now 10 could, in turn, turn around and use again and get 11 compensated for providing that product or that 12 process? 13 MR. FUSCOE: Not quite. But I follow what 14 you're thinking and it makes sense to ask. 15 So this is now in the public realm, the 16 green streets. Anybody can do them. I just did 17 them for the City of Burbank. It's not like I take 18 what I did in Irvine and just plant it in Burbank. 19 It doesn't work quite that way. 20 But, I know how to do it now. It's like a 21 recipe for cooking spaghetti and you get really good 22 at making spaghetti, right? So now if you want me 23 to make you spaghetti, I'm going to do it pretty 24 fast and pretty well because I've been doing it. 25 But I had to learn how to cook it myself. 26 So I can't resell the research I did on 27 heat gain on payments. It's not a thing in a little 28 box I can sell multiple times. 106 1 It's knowledge that I have that enables me 2 now to do it again and again, maybe a little faster, 3 but each time I just ask, here's what I can do for 4 you, these three tasks for this much money, and they 5 pay me. 6 And that's fine, and I'm not asking for a 7 credit for that. I'm asking for a credit for the 8 research I did to figure out how to do it, that 9 I can't sell, and that I'm -- I'm putting in the 10 public domain and making it beneficial for 11 everybody. 12 MR. HORTON: So there are -- there are -- 13 can you give us some -- give me some examples where 14 you were hired to perform research in order to 15 accomplish a particular objective, and as a result 16 of that, you were compensated but there is research 17 activity that took place that you were not 18 compensated for, they didn't compensate you, but 19 it's a process that you used to compensate it, the 20 process that you ultimately sold to someone else? 21 MS. VANGHAGEN: If I can just highlight two 22 things here. I'm a little concerned that we're 23 equating payment with funding. 24 MR. HORTON: I'm not. 25 MS. VANGHAGEN: Okay. 26 MR. HORTON: I'm okay with you -- I'm okay 27 with you developing something in your line of 28 business of developing a prototype -- 107 1 MR. FUSCOE: Right. 2 MR. HORTON: -- and that's your business of 3 developing this prototype. And then you're now 4 using that process, that knowledge somehow in your 5 market. You don't have to ever be compensated -- 6 MR. FUSCOE: Yeah. 7 MR. HORTON: -- for it, but your actual 8 market. 9 MR. FUSCOE: There is a -- there is a 10 fraction of what we're asking for here that is in 11 that box. 12 MR. HORTON: Falls in that box? 13 MR. FUSCOE: Yeah. Most of it is not 14 though. Most of it is what I tried to describe a 15 couple times, trial and error, experimentation. 16 It's not really like developing a new 17 technology, you know, like a -- a widget. It's just 18 trying things. 19 Like on Jason's storm drain that thinks -- 20 everybody thinks it's a standard thing. It's not, 21 you know. 22 All -- all that is standard in doing a 23 storm drain is the process. The county says, "Pat, 24 you have to figure out -- you have to use this 25 intensity of rain, this often per year when the rain 26 storms come. And this is your time and 27 concentration criteria. Go knock yourself out." 28 They don't give me any drawings to copy or 108 1 anything. I have to go then, sit down and figure 2 out should I divert some of the flow? Should I 3 turn -- if I turn this much of it down that street, 4 then I only have this much coming this way, and so 5 on. 6 And so I sit there and I do trial and 7 error, back and forth, sensitivity tests, try this, 8 try that, basins, underground pipes. Try a 9 different kind of pipe, concrete pipe, try ABS 10 plastic pipe, see what happens. 11 So all of that I do as trial and error 12 experimentation. That's our normal wheelhouse stuff 13 that I'm asking for. 14 Now over here on the side is this more 15 esoteric research, like the hydro-modification, 16 which I'm very proud of. That was a specialized 17 thing that we had to go put Ph.D people on. That's 18 not as common, everyday, if that helps. 19 MR. HORTON: It may help a little bit. 20 I'm going to go to the Department and just 21 sort of qualify this. It sounds to me as if though 22 the appellant is arguing somewhat in line with the 23 Fairchild case, that there is experimentation that 24 takes place that is not part of the original 25 contract, that has a value, and that it is 26 ultimately resold. Barring whether it's exper -- 27 presuming that the experimentation exists. I didn't 28 get into that yet. 109 1 MR. RILEY: So to that point, two things. 2 Part of the problem when we're talking about storm 3 drains, okay, is that they haven't identified 4 exactly what is the widget, what is the -- what is 5 the product within the storm drain -- 6 MR. HORTON: The product or process. 7 MR. RILEY: The product or process for 8 which they're claiming the research credit. They're 9 just claiming storm drain, okay. In addition to 10 storm drain, they're claiming sewer plan and these 11 other, you know, all these other items. 12 But if -- 13 MR. HORTON: I think -- not to interrupt 14 you, but I think their testimony is, is that even 15 though they are ending up with a -- a drain, a 16 standard -- at the end of the day they end up with a 17 product that one would argue is just the same thing, 18 just done a different way, I guess, is that in that 19 process they're doing research that is developing a 20 process that is far different than any other process 21 that has ever taken place. 22 MR. RILEY: Right. And this is -- but this 23 goes down to the -- what's called the shrinking back 24 rule. So the entire sewer system may not qualify, 25 but some subset, some part that, hey, we actually 26 did this research and here's our, you know -- 27 MR. HORTON: When you say the shrinking 28 back rule, are you referring to substantially all? 110 1 Is that -- 2 MR. RILEY: No. I'm referring -- there's 3 a -- there's a -- it's called the shrinking back 4 rule in the Treasury regulations. 5 MR. HORTON: Okay. 6 MR. RILEY: If you take -- you know, if you 7 take a motorcycle -- or you take the storm drain, 8 the entire storm drain doesn't qualify, okay. But 9 perhaps there is some subset. You keep shrinking it 10 back until you find the part of this storm drain 11 that is -- that meets the requirements of Section 12 41. 13 And so -- and where there is a process -- 14 you know, 90 percent of this storm drain -- I'm 15 just -- you know, I'm just giving you a hypothetical 16 here -- but might not qualify. But there might be 17 some, you know, some special run-off device that 18 they developed in the course of this. 19 So this subset, you shrink it back from the 20 entire storm drain, you shrink it back to this part, 21 and that's what the law says that would qualify, 22 okay. 23 But the problem is, is that I kept 24 mentioning that they haven't identified their 25 business components. They haven't identified -- you 26 know, they just say "storm drain." They don't say 27 it's this part of the storm drain that we really did 28 all the research on; i.e., he has know-how from all 111 1 these other projects. 2 MR. HORTON: That's an audit issue, it's 3 not a legal issue. That's -- I mean it's a legal 4 issue by virtue that the law requires them to 5 identify it. But they can identify it through some 6 audit process. 7 So, um, that's interesting. 8 MR. RILEY: But that's one of the 9 requirements of 41(d)(1). 10 MR. HORTON: I know. 11 So, are you saying that you would conclude 12 that if there was a portion of this process or 13 project that ended up with a new process that was 14 not funded, but a new process that -- and possibly a 15 new product of some sort, that was part of the 16 original contract, but that the appellant could 17 actually use that process in other projects to be 18 compensated for that process, that that would 19 qualify? Or would that be funded or nonfunded? And 20 would it get -- presuming that all the other 21 experimentation is there and the research is there 22 and so forth. 23 MR. RILEY: Well, I -- you know, part of 24 the problem is that we don't have the -- you know, 25 the taxpayers haven't gone back and identified that 26 part. That's -- that was a major part of my 27 presentation today was that, you know, they haven't 28 identified these business components. 112 1 MR. HORTON: And if they were able to, what 2 then say you? 3 MR. RILEY: And so if -- you know, saying 4 they did -- they do have it and they have 5 sufficiently identified the business component, and 6 it otherwise meets the requirements of Section 41 7 and it's not funded, then they could take the credit 8 for it. 9 But in this case I think that these 10 contracts don't act like fixed-fee contracts. Many 11 of them -- 12 MR. HORTON: And -- and given that, the 13 second part of that would be the rule regarding 14 substantially all, would the Department then say 15 that it would have to be substantially all? Or 16 would, under the shrinking rule, you would allow to 17 isolate that. 18 MR. RILEY: No. Under the shrinking back 19 rule we -- I mean the substantially all thing was -- 20 that was the Trinity court applied that because 21 the -- the records had been destroyed by Hurricane 22 Katrina. 23 MR. HORTON: Right. 24 MR. RILEY: So they had no other way of 25 determining, you know, whether or not this big ship 26 qualified. 27 MR. HORTON: Right. 28 MR. RILEY: Here, you know, I -- you know, 113 1 it's probably possible for the taxpayer to go and 2 identify their discrete business component as it 3 says in the -- in the regulations. 4 MR. HORTON: Okay. 5 Do you understand what the respondent is 6 saying? 7 MS. VANGHAGEN: I do. And I'd like to 8 offer that I think we have a sort of different 9 interpretation then, I guess, in the definition of 10 business component. Because it's our position that 11 we have identified the business component. And they 12 are the sub -- the designs basically, as a whole, 13 but they're identified more specifically by the 14 subtasks of each project. So rough grading plan, 15 sewer drain, items like that, those are the business 16 components. 17 Now, when we took the credit for a business 18 component like that, let's say the drain, we did not 19 take a hundred percent of the hours that were 20 incurred on that drain, in producing that drain. 21 We -- we basically -- the shrink back rule 22 is not necessarily applicable to this appeal because 23 the way that we captured the qualifying expenses 24 were so detailed that we only captured expenses for 25 individuals that were performing a process of 26 experimentation on these sub -- individual 27 qualifying subtasks. 28 So we're not taking -- we're not taking 80 114 1 percent of -- of Merriam Mountains. We're taking 2 maybe 60 percent of Donald Butler's time on -- on 3 his -- you know, 1.5 hours spent on, you know, on 4 May 4th, 2006, on the rough grading plan. 5 So we're not taking a hundred percent or 6 any type of -- actually -- yeah. 7 MR. HORTON: Yeah, I know. 8 MS. VANGHAGEN: We culled out the 9 nonqualifying, and we're not -- 10 MR. HORTON: Respondent is -- what I'm 11 looking for is a distinction between when there is 12 funded, not funded, the activities that are not 13 funded. And those activities that are not funded 14 that have an experimental scientific value that 15 meets all the criteria, and then you have -- you use 16 that, there's a value to that, that you're using in 17 your business, in subsequent business activities. 18 MR. FUSCOE: So we're not getting paid for 19 all of the work that we did. 20 Unfortunately, I didn't create, under my 21 contract tasks, a task called R&D where somebody 22 would -- one of these college-educated licensed 23 professionals will go, "Oh, I'm -- I'm no longer 24 working on the drain. I'm now researching it. I 25 should put my time over here." 26 We just didn't do that; I'm sorry. We just 27 said put your time on the drain. So then we have a 28 $10,000 agreed price for the drain and we spend 115 1 30,000. And we go in and go, "What the hell 2 happened?" And they go, "Oh, I had to go figure 3 this all out and research this and that." 4 We did that. Okay. And then we isolated 5 the part that we think qualifies, and that's what 6 we're asking for only. We're not asking for the 7 part we got paid, and we're not asking for any 8 overage that we did on something that was our -- 9 just somebody made a mistake and they were fixing 10 it. Okay. 11 MR. HORTON: Be mindful, being compensated 12 for it does not -- would not distinguish this as 13 funded versus nonfunded. 14 MR. FUSCOE: Okay. Well, I'm just trying 15 to help. 16 MR. HORTON: If you have a contract and you 17 end up with over-runs of some sort -- 18 MR. FUSCOE: Right. 19 MR. HORTON: -- it's just a loss, profit 20 and loss. 21 MR. FUSCOE: Right. And I'm saying we -- 22 we are segregating errors or just some kid that we 23 hired who's learning. You know, we're not -- I'm 24 just saying we've already segregated that. 25 MR. HORTON: In the cases that you 26 presented to us, the frog case, coming up with 27 this -- this fence -- 28 MR. FUSCOE: Yeah. 116 1 MR. HORTON: -- was there -- was there some 2 sort of hat-in-the-bowl design or something with 3 this? 4 MR. FUSCOE: No. It's just a fence. You 5 can't patent orange juice. You can only patent. 6 MR. HORTON: You don't want to say that. 7 MR. FUSCOE: Well, I'm sorry. 8 MR. HORTON: You don't want to say that. I 9 mean that works against you, what you're about to 10 say. 11 MR. FUSCOE: All right. 12 MR. HORTON: All right. For this point let 13 me -- 14 MS. HARKEY: The research decree. 15 Did you have something to add? 16 MS. VANGHAGEN: Um, I'm thinking. 17 MS. HARKEY: Okay. Is there -- are there 18 any other questions from Members? 19 MS. STOWERS: Move to take the matter under 20 submission. 21 MS. HARKEY: Okay. Is there a second? 22 MS. MA: I think we need a -- do we need to 23 have a motion where you're going with your research 24 and your analysis? 25 MS. HARKEY: Where I'm going? We can't -- 26 we can't -- 27 MS. MA: Discuss it later. 28 MS. HARKEY: We can discuss it before we 117 1 vote again -- 2 MS. MA: Okay. 3 MS. HARKEY: If you'd like to. 4 I'm -- I'm -- by my sheets, I think you can 5 pretty much see that I'm thinking it will qualify. 6 I was -- a couple, because I needed 7 explanation from -- from the appellant. And one of 8 the problems we have is we can't -- we could not 9 call them and ask them for certain specific items. 10 We had to find it in the file. 11 And we did find as much as we could in the 12 file, but that doesn't mean we found every part of 13 the contract or everything. We took the points that 14 we thought justified. And when we didn't find a 15 contract, we just had to say we didn't. And I asked 16 for explanations on Merriam Mountain, explanations 17 on Seabrook and Sapphire Towers, which I think we 18 got. 19 But I'm not -- you know, they're asking for 20 47-point-something percent, which is because the law 21 changed from the time they had submitted, as I read 22 this. 23 It says, in 2008 Fuscoe filed -- Fuscoe, et 24 al., pardon me, filed amended tax returns, claimed 25 research and development for 2003-'06. The credit 26 claims identified the amended returns were based on 27 regulations and existing case law in effect at that 28 time. 118 1 The taxpayer since acknowledged -- which 2 was July 5th, we received this in the file. We did 3 not request this. This was sent to the FTB. 4 The taxpayer acknowledged that since 2008, 5 the applicable case law has changed and advanced. 6 Based on recent holding on Geosyntec case we know 7 that certain fee structures are no longer eligible 8 and were held to be funded. 9 Which is how they then went through every 10 contract again from what they -- what they had, and 11 they figured out what, under the new law, was 12 funded/unfunded. And then of all of their 13 contracts, be it 741 that's in the file or 1200, 14 whatever we've decided that they've done, out of all 15 of their contracts they figured they had a 47 16 percent of all the contracts of unfunded. And 17 that's what they were asking for. 18 Originally, they were applying for credit 19 for all of it. And so this is the pertinent part 20 that was an addendum, or sent later to the FTB that 21 is in the file. I'd be happy to share that with 22 you. But that's how they arrived at their 47 23 percent. 24 So that's kind of what we're looking at. 25 MR. RUNNER: So -- so to clarify, what we 26 need -- if we take this under submission, then the 27 point would be that as it would come back up for a 28 vote, if indeed we go this direction once we get 119 1 clarification, there can be certainly time for 2 discussion and clarifying of these issues in an 3 ongoing discussion to kind of -- 4 MS. HARKEY: Right. 5 MR. RUNNER: -- differentiate what's in, 6 what's out? 7 MS. HARKEY: Right. 8 MR. RUNNER: Right? 9 MS. HARKEY: I would -- I would encourage 10 Members, though, because the appellant is here, that 11 if they have any questions -- 12 MR. RUNNER: Right. 13 MS. HARKEY: -- at all on anything, like I 14 did on these contracts, we can't -- I can't ask for 15 any additional information at this point. But I 16 sure do wish I had absolutely every. 17 MS. STOWERS: I do have a question on 18 that. 19 MS. HARKEY: Okay, thank you. 20 MS. STOWERS: To appellant, I'm looking at 21 your Exhibit 2, Funding Analysis Financial Risk. 22 MS. VANGHAGEN: Mm-hmm. 23 MS. STOWERS: On the second page, you only 24 list four contracts -- one, two, three, four -- as 25 not being funded? 26 MS. VANGHAGEN: Correct. 27 MS. STOWERS: So that's for the original 28 nine; so the other five you're saying are funded 120 1 contracts? 2 MS. VANGHAGEN: Um, I believe that's -- 3 that was my thinking in that. That I pulled -- I 4 pulled those out because -- 5 MS. HARKEY: Be sure before you respond. 6 You will not get a chance to correct your answer. 7 MS. VANGHAGEN: Okay. 8 MS. HARKEY: So don't guess right now. 9 MS. VANGHAGEN: That was the intent. I can 10 double-check, um, on whether or not I got that 11 right. 12 MS. HARKEY: This is -- these nine, I 13 know -- nine or whatever we've got. I know we all 14 understand are just a sampling. So, um, that was an 15 agreed-upon sampling. 16 MS. VANGHAGEN: So I -- I left out San 17 Mateo and Seabrook. 18 MS. STOWERS: San Mateo and Seabrook. So 19 you're saying that San Mateo and Seabrook are 20 unfunded contracts? 21 MS. VANGHAGEN: Yes. 22 MS. STOWERS: But they're not on this 23 exhibit. 24 MS. VANGHAGEN: Yes. 25 MS. STOWERS: Seabrook is on this exhibit. 26 MS. VANGHAGEN: Oh. 27 MS. HARKEY: San Mateo Creek is here, too. 28 That's the frogs. 121 1 MR. FUSCOE: They're both in this -- 2 MS. VANGHAGEN: Seabrook -- well, but 3 they're not on the -- they're not on the chart that 4 she's referring to. Or San Mateo is not on the 5 chart. 6 One, two, three, four. 7 MS. HARKEY: I don't know what chart -- 8 what chart are we talking about? 9 MS. STOWERS: Appellants Exhibit 2 that 10 they presented today. 11 MS. VANGHAGEN: You know what, I left off, 12 I left off -- I think I left off Pad E and -- 13 MS. STOWERS: Well, there's several -- 14 wait. So this exhibit, I hate to say it, but I'm 15 having a hard time relying on it. It's not complete 16 based on your analysis? 17 MS. VANGHAGEN: I -- I -- I did -- no, Pad 18 E is in there. 19 One, two, three, four. 20 MS. HARKEY: I don't know what was turned 21 in today. I'm a bit confused. There was something 22 turned in today. That's why I just went to what we 23 have, because I'm probably not considering too much 24 of what was turned in today. 25 MS. VANGHAGEN: San Mateo -- 26 MS. STOWERS: I'm -- I'm -- I restate my 27 motion. 28 I don't have anymore questions at this time 122 1 for the appellants or for the Franchise Tax Board. 2 MS. HARKEY: Funding analysis -- let me see 3 this. Funding analysis. 4 Okay. Well, if you want to elaborate on 5 that, this is the time to do it. 6 I think, again, these were sample projects. 7 They're not -- and we're looking at -- we're looking 8 at the -- we're looking at them just for a 9 guestimate as to where they were. They were part of 10 the -- part of the audit sampling. But they had 11 1200, or how many projects? A lot of other 12 projects, and so this is just to break it down and 13 make it easy. 14 And who chose the projects -- 15 MS. VANGHAGEN: FTB. 16 MS. HARKEY: -- to be examined? 17 MR. RILEY: Well, these were -- 18 MS. HARKEY: FTB chose the projects. 19 MR. RILEY: These were a random sampling. 20 The taxpayer provided a list of all of their 21 projects and Franchise Tax Board simply picked every 22 124th project. 23 MS. HARKEY: Yeah. I get that they were 24 random sampling, but I know that the FTB did choose 25 the projects. And some of them, you know, are a 26 little more difficult to -- than others. 27 MS. STOWERS: Actually -- excuse me, Madam 28 Chair -- I'm actually reading this sampling 123 1 agreement letter dated March 30, 2009. And it 2 states that the samples selected from the 2003-2006 3 year of qualified projects listed on their report. 4 This sample will include the first project listed 5 and every 125 projects listed thereafter. 6 So that's how it came about. It wasn't -- 7 MS. HARKEY: Right. 8 MS. STOWERS: -- where FTB had some insight 9 on just picking the smaller projects. 10 MS. HARKEY: Well, these aren't small. 11 Some of them aren't small. I didn't say that. 12 I just -- some of them are -- are -- I 13 think the description was runt of the litter, so -- 14 and I would -- I would expect that. 15 You know, I mean I think when you look at 16 Costco, who -- who -- who could say that Costco was 17 unique? Well, I think we understood by the 18 positioning and the ground and stuff that this 19 National City one was a little bit different than a 20 standard Costco. 21 So that's what -- you know, when you first 22 looked at the file, there wasn't much. And then I 23 started, like, you know, asking my staff to tell me 24 what are we really talking about here? And -- 25 because you can read it. But then that's where I 26 came up with my test, the three-part -- three 27 categories for analysis. And if you get through 28 one, then you go to the next. And I think on just 124 1 about every -- every one of the sampling I came up 2 with something that I believed fulfilled the -- the 3 test requirements. 4 But since we're not voting, we will leave 5 that up to the Members to cogitate. And when we 6 come back, hopefully tomorrow, we can cast a vote on 7 this. 8 And so, I heard a motion to take the matter 9 under submission? 10 MS. STOWERS: Move to take the matter under 11 submission. 12 MS. HARKEY: Is there anyone seconding 13 that? 14 MR. RUNNER: Second. 15 MS. HARKEY: Second by Member Runner. 16 MS. MARKS: Can I just get some 17 clarification on that motion, please? 18 So what you're saying is that you're 19 closing the record for today and you're continuing 20 this to the agenda tomorrow? 21 MS. HARKEY: We will be voting tomorrow. 22 And there may be some comment after. If somebody 23 makes a motion and a second, then it's always open 24 for discussion up here, among the Members. 25 MS. MARKS: I just wanted to clarify the 26 motion that you're talking about continuing the 27 matter until tomorrow, discussion on the matter. 28 MS. HARKEY: Yes. Not continuing the 125 1 hearing, but continuing to the vote. 2 Okay. And discussion among the council -- 3 or the council. Pardon me, I'm not City Council. 4 Discussion among the Board could ensue once 5 a motion and a second are present. 6 MR. HORTON: Madam Chair, just for point of 7 clarification. 8 MS. HARKEY: Oh, excuse me. Was there any 9 objection to that? 10 No. Okay, such will be the order. 11 Okay. 12 MR. HORTON: If the taxpayer or the -- I 13 only hesitate because new information that evolves 14 out of these types of discussions have not really 15 been fully briefed. But I get it's the world that 16 we're in. 17 But under normal circumstances we could 18 indicate to the appellant that if they had 19 additional evidence or information, that they could 20 share that with Appeals and Appeals could -- 21 MS. HARKEY: Yeah, but we don't have 22 30/30/30s, under my mind, anymore. I don't really 23 want to -- 24 MR. HORTON: Can't decide it on a 30/30, 25 why don't we take the matter under submission -- 26 I don't know if that can happen now, Mr. 27 Epolite? 28 MS. HARKEY: I would be very concerned, to 126 1 be honest, to reopen up issues only because -- 2 MR. HORTON: Again, this is a point of 3 clarification. It has nothing to do with the case. 4 But, Mr. Epolite? 5 It's these new rules. I know how to do it 6 under the normal rule. 7 MR. EPOLITE: Well, I mean, that would be 8 up to the Board to, you know, do additional 9 briefing. The concern just being how soon the 10 matter would come back to the Board for 11 consideration. 12 MS. HARKEY: It's coming back tomorrow. 13 So -- 14 MR. EPOLITE: For consideration. 15 MS. HARKEY: I -- I -- I think -- excuse 16 me. 17 MR. EPOLITE: But, you know, I would just 18 consider the fact that we have a lot of evidence 19 before you in the record, and so -- 20 MS. HARKEY: Yeah. There's 15,000 pages in 21 the record, a lot of data. And that's why there 22 were a couple things that we were missing when we 23 reviewed it. 24 We could not call and ask for it. We 25 actually had to grind through. I asked my staff to 26 please justify, not just tell me. I wanted to see 27 some kind of paper justification or evidence that 28 these tests were met. And that's the task that they 127 1 set upon doing since we don't have that many 2 constituent issues anymore, they had plenty of time. 3 And two of them really dug into this. Actually more 4 than that, dug into finding, researching and the 5 1500 pages. 6 So that's why I presented kind of a small 7 encapsulated summary for all of you as to -- as to 8 what I was looking at. Hopefully it helped. 9 Anyway, so we have a motion, we had a 10 second. We had a vote. 11 Thank you so very much. And thank you for 12 waiting through all of the reorganizational issues 13 that we're having. 14 I hope everybody understands we are under 15 open meeting laws, so we really can't get together 16 and discuss issues that affect the administration of 17 the Board. So when we get a memo that's a problem 18 or we can't really discuss cases with more than one 19 other Member, and since we don't want to even get 20 caught, we don't. 21 And so it just was very, very difficult 22 start. And I -- I thank you very much for your 23 patience. You were here early and on time. Thank 24 you so much. 25 MS. VANGHAGEN: Thank you. 26 MR. FUSCOE: You're welcome. 27 ---oOo--- 28 128 1 REPORTER'S CERTIFICATE 2 3 State of California ) 4 ) ss 5 County of Sacramento ) 6 7 I, Kathleen Skidgel, Hearing Reporter for 8 the California State Board of Equalization certify 9 that on July 27, 2017 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 128 14 constitute a complete and accurate transcription of 15 the shorthand writing. 16 17 Dated: August 15, 2017 18 19 20 ____________________________ 21 KATHLEEN SKIDGEL, CSR #9039 22 Hearing Reporter 23 24 25 26 27 28 129