June 2002

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Guest Commentary 

Chris Micheli is an attorney and registered lobbyist for the Sacramento governmental relations firm of Carpenter Snodgrass & Associates, where he specializes in tax legislative matters (916/447-2251).

FTB’s Arguments

The following arguments made by the FTB are taken from briefs filed with the SBE:

Notwithstanding the SBE’s action in the Appeal of Save Mart Supermarkets & Subsidiary (2002-SBE-002, decided on February 6, 2002), the SBE lacks the legal authority to invalidate a duly adopted FTB regulation. Under the Administrative Procedures Act (APA) contained in Government Code Sections 11340, et. seq., that authority is reserved to the Office of Administrative Law (OAL), the Governor's Office or the judiciary. The authority to invalidate a regulation does not extend to any other state agency, even where that agency, such as the SBE, is acting in a quasi-judicial capacity.

Prior to the SBE’s decision in Appeal of Save Mart Supermarkets, the last time the SBE invalidated a Franchise Tax Board regulation was in the Appeal of Standard Oil Company of California (1983-SBE-068, decided on March 2, 1983). In that case, the SBE reviewed a regulation adopted by the FTB in 1971. Provisions governing administrative rules and regulations were adopted as part of the original APA in 1945.

However, subsequent to the FTB's adoption of the regulation at issue in Standard Oil, California's current rulemaking procedures, which are much broader in scope than the original APA, were adopted in 1979.  The OAL was created as part of this 1979 statutory revision and began functioning on July 1, 1980. The OAL was created in part because there was no central office in state government with "the power and duty to review regulations to ensure that they are written in a comprehensible manner, and are authorized by statute and are consistent with other law." (Gov. Code § 11340(e).)

The APA provides the exclusive statutory scheme for the adoption and repeal of regulations. That exclusive statutory scheme provides that OAL shall review all proposed agency regulatory actions for necessity, authority, clarity, consistency, reference and nonduplication. (Gov. Code § 11349.1(a).) OAL is given express authority to either approve or disapprove any regulation submitted to it for review.  (Gov. Code § 11349.3(a).) Any agency may request a review of an OAL disapproval of a submitted regulation by filing a written request (appeal) with the Governor's Office. (Gov. Code § 11349.5.) OAL may also initiate a repeal of any regulation based upon the repeal of the statutory authority for the regulation. (Gov. Code § 11349.10.) Moreover, the APA contains a specific article on judicial review of regulations adopted by state agencies. (Gov. Code § 11350, et. seq.)

Except for OAL, there is simply no provision in the APA authorizing one state agency to declare invalid or void the regulations of another state agency. As stated in the APA, "[i]t is the intent of the Legislature that neither the Office of Administrative Law nor the court should substitute its judgment for that of the rulemaking agency as expressed in the substantive content of adopted regulations." (Gov. Code § 11340.1.)

This conclusion is consistent with the SBE’s statutory authority with respect to FTB appeals. CRTC Section 19333 states that "[t]he board shall hear and determine the appeal and thereafter shall notify the taxpayer and the Franchise Tax Board of its determination and the reasons therefore." The express statutory authority of the SBE is limited to determining the appeal and does not grant any legal authority to the SBE to invalidate FTB regulations. The SBE is specifically created under the California Constitution to measure and conform county assessment levels and annually assess specified types of property. (Cal. Const., Art. XIII, §§ 18, 19.)

The grant of constitutional authority does not extend beyond these specified activities. Moreover, the fact that CRTC Section 19333 was enacted in 1943 is a clear indication that the SBE does not have inherent constitutional authority with respect to FTB appeals and thus specific statutory authorization to hear these appeals was necessary.  So, while the SBE has the authority to "hear and determine" the specific appeal before it, the SBE lacks the legal authority to invalidate a regulation in connection with that determination.

This conclusion is consistent with the California Supreme Court's decision in Yamaha Corp. of America, where the court cites Bodinson Mfg. Co. which states that "[t]he ultimate interpretation of a statute is an exercise of the judicial power . . . conferred upon the courts by the Constitution and, in the absence of a constitutional provision, cannot be exercised by any other body." (Yamaha Corp. of America v. State Bd. of Equalization (1998) 19 Cal.4th 1, 7, citing Bodinson Mfg. Co. v. California E. Com. (1941) 17 Cal.2d 321, 325-326.)

The FTB's position on this issue is also consistent with the language in A. M. Castle & Co. v. Franchise Tax Bd., which states "[a]dministrative tribunals such as the State Board of Equalization do not make precedents that are binding on this court." (A. M. Castle & Co. v. Franchise Tax Bd. (1995) 36 Cal.App.4th 1794, 1808, citing 9 Witkin, Cal. Procedure (3d ed. 1985) Appeal, §763, p. 730.)

Accordingly, in the event a court were to review any action of the SBE connected with "invalidating" a FTB regulation, the decision by the SBE with respect to the validity of the FTB regulation would not be binding on the court and the court would independently review the validity of the regulation. With respect to the SBE’s policy of abstention from deciding constitutional issues in an appeal (which predated the adoption of Article III, Section 3.5 of the California Constitution), the SBE stated: "This policy is based upon the absence of any specific statutory authority which would allow the Franchise Tax Board to obtain judicial review of a decision in such cases and upon our belief that judicial review should be available for questions of constitutional importance." (Appeal of Aimor Corporation, 1983-SBE-221, Oct. 26, 1983, p. 326.) The FTB believes the same policy should be adopted with respect to the invalidity of FTB regulations so that the courts can consider the issue, which is the proper legal forum for these issues.

While the SBE must construe and interpret the regulatory language in light of the statute and apply the facts of this appeal, the SBE may not simply ignore or purport to invalidate the language of the regulation. As a result, a request to hold a regulation "void and of no effect" should be rejected as that action exceeds the legal authority of the SBE. The FTB maintains that in whatever decision the SBE renders, the SBE should recognize in its decision that it does not have the legal authority to invalidate a duly adopted FTB regulation.

SBE’s Save Mart Decision

The following arguments in rebuttal to the FTB’s position are taken from the SBE’s decision in the Appeal of Save Mart Supermarkets:

With respect to our review of the validity of the MIC Regulation, both parties cite our previous decision in the Appeal of Standard Oil Company of California, decided March 2, 1983, which states the applicable standard of review as whether the regulation is arbitrary and capricious or has a reasonable or rational basis. The FTB contends, however, the more recent California Supreme Court decision of Yamaha Corp. of America v. State Board of Equalization (1998) 19 Cal.4th 1, holds that the standard of review depends on whether the regulation is quasi-legislative or interpretive.  FTB concedes the regulation at issue is merely interpretative, and thus receives lesser judicial deference. Despite this lesser deference, the FTB asserts the regulation is valid.

After a thorough review of the Appeal of Standard Oil Company of California (Standard Oil), and Yamaha Corp. of America v. State Board of Equalization (Yamaha), we conclude that, although the standard of review discussed and applied in Standard Oil is not incorrect, it may be incomplete under the applicable precedent.  The California Supreme Court in Yamaha offers a broader, as well as an updated, review of the various precedents determining the appropriate standard of review, which guides our review of Regulation Section 23649-3. It is clear, and FTB agrees, that the regulation at issue herein is interpretative, rather than quasi-legislative.

Our review of the regulation, therefore, is guided by two categories of factors:  1) Those factors indicating the FTB holds a comparative interpretive advantage; and 2) those factors indicating the FTB’s interpretation is probably correct.[1] (Yamaha Corp. of America v. State Board of Equalization, 19 Cal.4th at p. 12.) After reviewing the language of Section 23649, subdivision (c)(1), and the requirements set forth in Regulation Section 23649-3 in light of the factors guiding our review as discussed in Yamaha, we cannot escape the conclusion that Regulation Section 23649-3 alters and enlarges on the words of the statute, and is thus invalid.  (Whitcomb Hotel, Inc. v. California Employment Com., 24 Cal.2d at p. 757; see Gov. Code, § 11342.2.)

Although we understand the FTB’s interpretation of Section 23649, subdivision (c)(1), and laud the FTB’s efforts to timely and thoughtfully set forth an appropriate regulation, we conclude Regulation Section 23649-3, by incorporating the entire SIC Manual classification scheme, imposes requirements on taxpayers not contemplated by the statute. As a result, the regulation includes provisions not reasonably necessary to effectuate the purpose of the statute. (Gov. Code, § 11342.2.) In fact, given our opinion (apparently concurred in by both parties) that the MIC legislation should be interpreted liberally in favor of taxpayers in order to effectuate the purposes of the legislation, the regulation actually hinders such interpretation, and thus hinders the legislative purpose of encouraging manufacturing in the state.

Arguments in Favor of SBE Authority

The following arguments in rebuttal to the FTB’s position are taken from briefs filed with the SBE:

The foundation for rebuttal of the FTB’s arguments must be the SBE’s formal published opinion in Appeal of Save Mart Supermarkets & Subsidiary (2002-SBE-002). The SBE is well aware that Save Mart found and concluded that the FTB had over-restricted the intended application of the MIC statute (§  23649(c)(1)) in its regulation and had unreasonably limited the statute’s definition of “qualified taxpayer.” As the SBE explicitly pointed out, Government Code § 11342.2 , covering the “validity of regulations,” dictated its conclusion on the invalidity of the FTB’s Reg. 23649-3:

§11342.2. Validity of Regulations

Whenever by the express or implied terms of any statute of a state agency has authority to adopt regulations to implement, interpret, make specific or otherwise carry out the provisions of the statute, no regulation adopted is valid or effective unless consistent and not in conflict with the statute and reasonably necessary to effectuate the purpose of the statute. [Emphasis supplied] (Added by Stats.1979, c. 567, § 1, operative July 1, 1980.) West’s Anno. Calif. Codes, Vol. 32C.

The SBE followed its citation of § 11342.2 with this statement: “. . . given our opinion (apparently concurred in by both parties) that the MIC legislation should be interpreted liberally in favor of Taxpayers in order to effectuate the purposes of the legislation, the regulation actually hinders such interpretation, and thus hinders the legislative purpose of encouraging manufacturing in the state.” [Emphasis supplied]

The FTB’s newly-minted argument that the SBE has no “legal authority to invalidate a duly adopted Franchise Tax Board regulation” flies in the face of what the SBE has held in Save Mart and earlier, in Appeal of Standard Oil Company of California (1983-SBE-068, pp. 216-217, issued March 3, 1983), where it stated, in considering the FTB regulation there in question (which departed from the statutory definition of “business income” in relation to “dividends”): “To the extent that [the regulation] purports to lay down a general rule for taxpayers other than dealers in securities, it is neither reasonable nor rational and must be rejected as invalid.”

Twenty years later, the SBE in Save Mart, after applying the factors set forth by the California Supreme Court for the appropriate standard of review of a regulation in Yamaha Corp. of America v. State Board of Equalization, 19 Cal.4th 1 (1998), concluded: “we cannot escape the conclusion that Regulation section 23649-3 alters and enlarges on the words of the statute, and is thus invalid.”  [Emphasis added]

There is a mercifully short answer to the elaborate argument posited by the FTB that the 1979-adopted Administrative Procedures Act (APA) on how regulations are to be made undermines the SBE’s ability (“its legal authority”) to decide a specific corporation income tax appeal before it and in doing so conclude and hold that a particular FTB-adopted regulation is invalid under Govt. Code § 11342.2.

The answer is that the FTB, as a losing administrative litigant that believes the SBE has exceeded its authority in so ruling, may certainly seek review of the SBE’s action through a writ of mandamus brought before a California court. The hand wringing of the FTB  in arguing that, in any case in which the SBE holds an FTB regulation invalid (as it has done, post the APA’s 1979 enactment, in 1983 and now in 2002), there is an “inability of the Franchise Tax Board to obtain judicial review of a decision in such case,” is simply not credible.

The standing of one agency to obtain judicial review of the decision of another agency exercising appellate functions over its actions is judicially established in California.  See, for example, the authorities discussed in California Administrative Mandamus, 2nd ed. Continuing Education of the Bar, Berkeley, § 5.11  (II. Agency as Petitioner; A. Statewide Agencies) at pp. 220-221.  Martin v. Alcoholic Beverage Control Appeals Board, 52 Cal.2d 238 (1959)

It is our understanding that the FTB, within the past two months, voted to decline its staff’s recommendation to pursue such judicial review respecting the SBE’s holding invalid the regulation involved in Save Mart, and that the formal opinion and decision is now final and is accordingly precedential under state law.

Conclusion

This issue should be closely watched by tax practitioners, particularly in light of upcoming MIC appeals that directly challenge the validity of the FTB’s MIC regulations. Cases on appeal to the SBE are commonly arguing that the FTB’s regulations impermissibly narrow the scope of the MIC statute and thwart the intent of the Legislature to broadly apply this important targeted tax incentive.

[1] The factors found in the first category “assume the agency has expertise and technical knowledge, especially where the legal text to be interpreted is technical, obscure, complex, open-ended, or entwined with issues of fact, policy, and discretion.” (Yamaha Corp. of America v. State Board of Equalization, supra, 19 Cal.4th 1, 12.)  The factors found in the second category “include indications of careful consideration by senior agency officials . . . , evidence that the agency ‘has consistently maintained the interpretation in question, especially if [it] is long-standing . . ., and indications that the agency’s interpretation was contemporaneous with legislative enactment of the statute being interpreted.” (Id., at p. 13.) Further, “[I]f an agency has adopted an interpretive rule in accordance with Administrative Procedure Act provisions . . . that circumstance weighs in favor of judicial deference.” (Id.)