In Appeal of Colambaarchchi (OTA Case No. 21017152; 2023-OTA-302), a California-based retailer was audited by the California Department of Tax and Fee Administration (CDTFA) for years 2016 through 2019. Upon audit, CDTFA determined that taxable sales went unreported. In calculating the extent of the underreporting, CDTFA used various indirect methods for different periods in the audit years and applied a method to each period that maximized the amount of tax due. The Office of Tax Appeals (OTA) found that this methodology was utilized simply to create the largest underreporting, was inconsistent and lacked the required minimum rational and reasonable basis.
Colambaarchchi operated two perfume retail stores. During its audit, CDTFA performed various sales tests that suggested unreported sales. To compute the taxable measure, CDTFA used a combination of the federal income tax returns (FITR) method and the bank deposits method. Specifically, CDTFA used the bank deposits method for 2016, switched to the FITR method for 2017, then switched back to the bank method for 2018 and Q1 2019. In the audit work papers, CDTFA noted that the “[a]uditor used the higher of FITR or bank deposit difference to arrive at audited taxable sales.” In other words, CDTFA alternated between the two methodologies simply to maximize the tax liability.
CDTFA subsequently issued a notice of determination, which the company timely appealed. At the prehearing conference, OTA placed the parties on notice that, in deciding the appeal, the OTA may consider “[w]hether respondent was justified in selecting the bank deposit method for 2016, 2018 and the first quarter of 2019 and gross receipts from the [FITR] for 2017.” Accordingly, bearing the initial burden of showing that its decision to switch between two methods was reasonable and rational, CDTFA argued that it “selected the FITR method for 2017 because ‘the bank deposits may not have all cash deposited into the bank’ in 2017, and that it may have selected the bank deposits method for 2016, 2018 and 1Q19 because the income tax returns ‘may not be accurate because obviously there are additional [bank] deposits in addition to what they reported on their income tax returns.’”
OTA rejected this argument because it found “no support in the record for CDTFA’s assumption that the bank deposits method is less accurate in 2017 than in the other periods such that it would be reasonable and rational for CDTFA to switch to the FITR method in 2017.” According to OTA, CDTFA “cannot assume that one indirect audit method is more accurate in one period than another just because it produces a higher result.” OTA further stated that “this arbitrary selection made solely to increase unreported taxable sales is not reasonable and rational. Where CDTFA alternates between indirect audit methods because one method produces a higher result, CDTFA is no longer attempting to estimate the correct measure of tax but instead is arbitrarily increasing the tax measure.” Consequently, OTA held that CDTFA failed to meet its burden of proof, and CDTFA was ordered to utilize the bank deposits method to calculate the liability for the entire period.
In a dissenting opinion, OTA panel member Andrew Kwee, former tax counsel at the Board of Equalization, ignored the duty of OTA to find the correct tax liability and argued that notwithstanding that CDTFA’s methodology was simply to find the higher tax liability—since CDTFA’s initial burden is minimal—it was justified in applying inconsistent methodologies because such an approach may be reasonable and rational.
While CDTFA is authorized to use any information in its possession to estimate taxable sales when records are inadequate (R&TC § 6481), taxing agencies have a responsibility to find the most accurate tax liability, not simply the highest. We applaud OTA for identifying and addressing the arbitrary approach at issue in this case and urge CDTFA to implement measures to avoid such indiscriminate audit practices in the future.
Further, we encourage OTA to reconsider its designation of the opinion as nonprecedential as the legal issue here—how to properly apply indirect estimation methods in a business tax audit—is one of continuing public interest. (18 CCR § 30502.) Moreover, as the Supreme Court of the United States has aptly cautioned, “[l]iberty finds no refuge in a jurisprudence of doubt.” Here, the OTA’s inconsistent practices regarding the designation of its opinions as precedential (particularly those in favor of taxpayers) has increasingly fostered a jurisprudence of doubt. OTA should remove this uncertainty by granting Appeal of Colambaarchchi precedential status, thereby elevating the opinion, advancing the law in this important area and providing taxpayers and CDTFA with clear guidance for the future.
Judd Oliver Baguioro, a summer associate in the San Francisco office, also contributed to this blog post.