Milhous v. Franchise Tax Bd.

• Decision Date: 12 August 2005
• Docket Number: No. D043058.,D043058.
• Court: California Court of Appeals Court of Appeals
• Parties: Robert E. MILHOUS et al., Plaintiffs and Respondents, v. FRANCHISE TAX BOARD, Defendant and Appellant.

32 Cal.Rptr.3d 640

131 Cal.App.4th 1260

Robert E. MILHOUS et al., Plaintiffs and Respondents, v. FRANCHISE TAX BOARD, Defendant and Appellant.

No. D043058.

Court of Appeal, Fourth District, Division 1.

August 12, 2005.

Bill Lockyer, Attorney General, W. Dean Freeman and Leslie Branman-Smith, Deputy Attorneys General, for Defendant and Appellant.

Bewley, Lassleben & Miller, Kevin P. Duthoy, Joseph A. Vinatieri, Jason C. Demille and Jeffrey S. Baird, Whittier; Law Offices of Paul D. Draper and Paul D. Draper, Capistrano Beach, for Plaintiffs and Respondents.

BENKE, J.

In this tax case the plaintiffs and respondents paid taxes assessed by defendant and appellant Franchise Tax Board (the FTB) on income from a covenant not to compete. After paying the assessed taxes, the plaintiffs brought this action for a refund. The trial court found that the covenant not to compete had no value in California and produced no income attributable to California.

For the first time on appeal, the FTB argues that because the plaintiffs did not pay the interest due on the assessed taxes, as well as the taxes themselves, the trial court had no subject matter jurisdiction over plaintiffs' case. While it is true that in tax cases California has adopted the "pay first, litigate later" rule (see Cal. Const., art. XIII, § 32; Rev. & Tax.Code,¹ § 19382), that rule does not govern the trial court's subject matter jurisdiction but instead is a procedural condition on the refund remedy which, if not asserted, is waived. Thus, even if we accept the FTB's contention that by amendment to the code the Legislature could and did include interest within the taxes which must be paid before a refund action can be commenced, the FTB may not raise this argument for the first time on appeal.

The trial court's determination that the covenant not to compete had no value in California which would support California's right to tax payments generated by the covenant is supported by substantial evidence and is consistent with constitutional considerations governing the tax treatment of intangibles.

Accordingly, we affirm the trial court's judgment.

SUMMARY

In the late 1960's, while still residents of California, plaintiffs Robert E. Milhous and Paul B. Milhous purchased an advertising business known as Treasure Chest Advertising Company, Inc. (Treasure Chest). The Milhouses developed Treasure Chest into a business which specialized in printing circulars, flyers and advertising inserts for newspapers. In 1973 they incorporated Treasure Chest as a California corporation.

In 1987 Treasure Chest was reorganized as a Delaware corporation, with its headquarters in Glendora, California. In 1988 the Milhouses moved to Florida where they have maintained their residency. By the 1980's Treasure Chest was largely run by a professional management team the Milhouses had retained.

In 1993 Treasure Chest sold its assets to another corporation, TCA. At that point Treasure Chest was the largest printer of advertising circulars, Sunday comics and TV listings in the western United States. Treasure Chest provided inserts for 100 percent of the newspapers in California and 85 percent of the newspapers west of the Rocky Mountains. Treasure Chest had 20 percent of the business east of the Rocky Mountains. Treasure Chest operated 13 printing presses to service its business.

Through a number of family trusts the Milhouses controlled 76 percent of the shares of Treasure Chest at the time of the sale. TCA paid a total of $120 million for Treasure Chest's assets. TCA attributed $30 million of the amount it paid to a covenant not to compete which the Milhouses executed. The covenant prevented the Milhouses from going to work for any competitor of Treasure Chest, revealing any trade secrets or confidential information of the corporation, hiring any Treasure Chest employees or investing in any competitor. The covenant had a five-year term and covered all of the United States, Canada and Mexico.

In 1996 the FTB completed an audit and determined that the income the Milhouses received from the covenant was in part attributable to activities in California and therefore in part taxable as California income. In particular, the FTB found that because Treasure Chest had reported that 25.0538 percent of its income was attributable to California activities, 25.0538 percent of the income the Milhouses received from the covenant not to compete should be attributed to California.

The Milhouses sought administrative review of the assessment before the State Board of Equalization, which agreed with the FTB.

On January 31, 2001, and February 5, 2001, the Milhouses paid the FTB the total assessed taxes of $898,000. The Milhouses did not pay any accrued interest on the taxes. The Milhouses then made claims for refunds, which were denied.

The Milhouses filed suit in superior court demanding that the amounts that they paid be refunded.² After the trial court denied the parties' cross-motions for summary judgment, the case went to trial.

At trial the Milhouses relied upon the testimony of an economist, Dr. Alan Shapiro. He testified that because Treasure Chest had 100 percent of the market in California at the time of the sale, the covenant had no value in California. He concluded that, given the narrow profit margins of the business and the large investment in capital needed to acquire the printing presses used in the business, it would not be practical for anyone to attempt to compete with Treasure Chest in California.

The FTB relied upon Treasure Chest's apportionment of 25.0538 percent of its income to California in arguing that the covenant not to compete should be apportioned on the same basis. Treasure Chest's apportionment was done by application of the Uniform Division of Income for Tax Purposed Act (UDITPA) which applies to corporations with multi-state activities. (§§ 25128-25136.) Under UDITPA a corporation's income is apportioned based on the proportion of the corporation's payroll, property and sales in the taxing state. (Ibid.)

Because the covenant had no value in California, the trial court found that imposition of the tax violated the requirement of the commerce clause of the United States Constitution (Const. art. I, § 8, cl.3) that taxes imposed by the states be fairly apportioned. (See Complete Auto Transit, Inc. v. Brady (1977) 430 U.S. 274, 279, 97 S.Ct. 1076, 51 L.Ed.2d 326.)

The FTB filed a timely notice of appeal.

I

In its first argument on appeal the FTB contends that because the Milhouses did not pay the interest accrued on the taxes assessed by the FTB, the trial court had no subject matter jurisdiction over the Milhouses' complaint. Notably, the FTB did not raise this issue in the trial court.

The FTB relies upon article XIII, section 32³ of the California Constitution and section 19382,⁴ which together embody California's adoption of the "pay now, litigate later" rule in tax cases. Under the rule a taxpayer may not obtain judicial review of the validity of a tax which is due but has not been paid. (State Bd. of Equalization v. Superior Court (1985) 39 Cal.3d 633, 638, 217 Cal.Rptr. 238, 703 P.2d 1131.) This rule serves the important goal of assuring that governmental agencies have a reliable source of income with which to fund vital public services. (Ibid.; Pacific Gas & Electric Co. v. State Bd. of Equalization (1980) 27 Cal.3d 277, 283, 165 Cal.Rptr. 122, 611 P.2d 463; Modern Barber Col. v. Cal. Emp. Stab. Com. (1948) 31 Cal.2d 720, 731-732, 192 P.2d 916 (Modern Barber).)

Prior to January 1, 2001, the law was clear that for purposes of applying the "pay now, litigate later" rule, the required payment of an assessed tax did not include payment of any accrued interest. (Agnew v. State Bd. of Equalization (1999) 21 Cal.4th 310, 333-334, 87 Cal.Rptr.2d 423, 981 P.2d 52; Chen v. Franchise Tax Bd. (1999) 75 Cal.App.4th 1110, 1122, 90 Cal.Rptr.2d 268.) However, as of January 1, 2001, section 19101, subdivision (c), was amended to provide in pertinent part: "Any reference in Part 10 (commencing with Section 17001) . . . or this part (except Article 3 (commencing with Section 19031), relating to deficiency assessments), to any tax imposed by Part 10 (commencing with Section 17001) or Part 11 (commencing with Section 23001) shall be deemed also to refer to interest imposed by this article on that tax." (Italics added.) Because both section 19101 and section 19382 are in Part 10.2 of the code, the FTB argues that as of January 1, 2001, the Milhouses were required to pay both the tax assessed and the accrued interest before commencing their refund action. As we have noted, the Milhouses paid the assessed taxes after January 1, 2001.

The FTB concedes that it did not raise the interest issue in the trial court or in any other manner give the Milhouses notice that they were required to pay interest as well as taxes before commencing this action. Nonetheless, the FTB argues that any failure by the Milhouses to meet the requirements of the "pay now, litigate later" rule deprived the trial court of subject matter jurisdiction over the Milhouses' claim and that the usual rules which prevent us from considering an issue not raised in the trial court have no application. We disagree with FTB's premise. The "pay now, litigate later" rule, while important, is not a matter of subject matter jurisdiction.

In State Bd. of Equalization v. Superior Court, supra, 39 Cal.3d at page 639, 217 Cal.Rptr. 238, 703 P.2d 1131, the court noted that in Modern Barber, it had previously considered a statutory version of the "pay now, litigate later" rule. Importantly, the court in State Bd. of Equalization v. Superior Court found that the statutory version of the rule considered in Modern Barber is virtually identical to article 13, section 32 of the Constitution. (State Bd. of Equalization v. Superior Court, supra, 39 Cal.3d at p. 639, 217 Cal.Rptr. 238, 703 P.2d 1131.) Thus the discussion...