BILL NUMBER: AB 263 CHAPTERED 09/29/04 CHAPTER 868 FILED WITH SECRETARY OF STATE SEPTEMBER 29, 2004 APPROVED BY GOVERNOR SEPTEMBER 29, 2004 PASSED THE ASSEMBLY AUGUST 25, 2004 PASSED THE SENATE AUGUST 18, 2004 AMENDED IN SENATE AUGUST 17, 2004 AMENDED IN SENATE JUNE 16, 2004 AMENDED IN ASSEMBLY JUNE 2, 2003 AMENDED IN ASSEMBLY MAY 20, 2003 AMENDED IN ASSEMBLY MARCH 25, 2003 INTRODUCED BY Assembly Member Oropeza (Coauthors: Assembly Members Firebaugh, Strickland, and Wyland) (Coauthor: Senator Alpert) FEBRUARY 4, 2003 An act to amend Section 24425 of, to add Sections 24465 and 24900 to, and to repeal and add Section 24410 of, the Revenue and Taxation Code, relating to taxation, to take effect immediately, tax levy. LEGISLATIVE COUNSEL'S DIGEST AB 263, Oropeza. Corporation taxes: deduction: insurance company dividends. The Corporation Tax Law allows various deductions in computing the income that is subject to the taxes imposed by that law. This bill would allow a dividends received deduction with respect to qualified dividends, as defined, received by a corporation during the taxable year from a corporation that is an insurer, whether or not the insurer is engaged in business in California, if at the time of each payment at least 80% of each class of stock of the insurer was owned by the corporation receiving the dividend. The amount of the deduction would be equal to 80% or 85%, as applicable to specified taxable years, of the amount of the qualified dividends received. This bill would apply special rules to dividends received from an insurance company that insures risks of a member of the insurance company's commonly controlled groups, as defined. This bill would provide that no deduction is allowed for specified expenses paid or incurred to an insurer, if the insurer is a member of the taxpayer's commonly controlled group and the amount paid or incurred would constitute income to the insurer if the insurer were subject to the California income or franchise tax. This bill would, in connection with specified exchanges, provide that if a taxpayer transfers property to an insurer, the insurer shall not, for purposes of gain recognition, be considered to be a corporation for purposes of the Corporation Tax Law. This bill would authorize the Franchise Tax Board to include in the gross income of the taxpayer (or a member of the taxpayer's combined reporting group) in that taxable year the taxpayer's pro rata share (or the pro rata share of a member of the taxpayer's combined reporting group) of any of those insurers' current earnings and profits in that taxable year, but not to exceed an amount equal to the specific insurer's net income attributable to investment income for that year minus that insurer's net written premiums received in that same taxable year, if specified criteria applies. This bill would make legislative findings and declarations, including the public purposes that would be served by the bill. This bill would require the Legislative Analyst to conduct a study of its impact with respect to overcapitalization of insurance companies and to report to the Legislature, as provided. This bill would take effect immediately as a tax levy. THE PEOPLE OF THE STATE OF CALIFORNIA DO ENACT AS FOLLOWS: SECTION 1. Section 24410 of the Revenue and Taxation Code is repealed. SEC. 2. Section 24410 is added to the Revenue and Taxation Code, to read: 24410. (a) For taxable years commencing on or after January 1, 2004, the allowable dividends received deduction with respect to qualified dividends received by a corporation during the taxable year from a corporation that is an insurer within the meaning of Section 28 of Article XIII of the California Constitution, whether or not the insurer is engaged in business in California, if at the time of each dividend payment at least 80 percent of each class of the stock of the insurer was owned, directly or indirectly, by the corporation receiving the dividend shall equal the percentage specified in paragraph (1) of the amount of the qualified dividends received. (1) For purposes of this subdivision, the percentage is equal to: (A) Eighty percent for taxable years beginning on or after January 1, 2004, and before January 1, 2008. (B) Eighty-five percent for taxable years beginning on or after January 1, 2008, and thereafter. (b) (1) For all taxable years ending on or after December 1, 1997, and commencing before January 1, 2004, a taxpayer may elect to determine its deduction under this section for dividends received by the taxpayer (or the members of the taxpayer's commonly controlled group, if any) during each taxable year from a corporation that is an insurer within the meaning of Section 28 of Article XIII of the California Constitution, whether or not the insurer is engaged in business in California, in an amount equal to 80 percent of the qualified dividends received, if at the time of each dividend payment at least 80 percent of each class of stock of the insurer was owned, directly or indirectly, by the corporation receiving the dividend. (2) A taxpayer shall make the election under this subdivision by timely filing a return for at least one taxable year ending on or after December 1, 1997, and commencing before January 1, 2004, expressly electing to be subject to the dividends received deduction in accordance with the percentage set forth in paragraph (1), and reporting and remitting any amounts due pursuant to that election. (3) A return is timely filed for purposes of paragraph (2) if it is filed within 180 days of the effective date of the act adding this section. (4) By making the election pursuant to this subdivision, the taxpayer agrees to all of the following: (A) To be subject to the dividends received deduction in accordance with the percentage set forth in paragraph (1) for all taxable years ending on or after December 1, 1997, and commencing before January 1, 2004, for which the Franchise Tax Board may propose an assessment or allow a claim for refund, or in which the final determination of tax for the taxable year has not been made because of a dispute related to the dividends received deduction or the application of Section 24425 to any expense related to that dividends received deduction. (B) (i) Except as provided in clause (ii), to file a return (or amended return) and remit any amounts due pursuant to the election for all taxable years ending on or after December 1, 1997, and commencing before January 1, 2004, for which the Franchise Tax Board may propose an assessment or allow a claim for refund, within 180 days of the effective date of the act adding this section. (ii) In the case of a taxable year for which the due date of the return is more than 180 days after the effective date of the act adding this section, to file the return and remit any amounts due pursuant to the election under this subdivision on or before the due date of the return. (5) For purposes of determining taxable income on the return (or amended returns) filed pursuant to the election set forth in paragraph (1), Section 24425 does not apply to the amount of the dividends received deduction. (6) The election is irrevocable. With respect to electing taxpayers, no refund, credit, or offset may be allowed for a deduction for dividends received from an insurance company in excess of the amounts allowed under this subdivision for taxable years ending on or after December 1, 1997, and beginning before January 1, 2004. (c) For purposes of determining the allowable dividend received deduction under this section, a qualified dividend received during the taxable year means a dividend received by the taxpayer during the taxable year multiplied by the percentage prescribed under paragraph (1), (2), or (3) of this subdivision, as the case may be. (1) If the ratio of the five-year average net written premiums for all insurance companies in a commonly controlled group to the five-year average total income for all insurance companies in the commonly controlled group for the taxable year is greater than or equal to the applicable percentage, then the percentage under this subdivision shall be 100 percent. (2) If the ratio of the five-year average net written premiums for all insurance companies in a commonly controlled group to the five-year average total income for all insurance companies in the commonly controlled group for the taxable year is less than the applicable percentage and greater than 10 percent, then the percentage under this subdivision shall be equal to the following fraction, expressed as a percentage: (A) The numerator is the five-year average net written premiums for the taxable year. (B) The denominator is the applicable percentage times the five-year average total income for that taxable year. (3) If the ratio of the five-year average net written premiums for all insurance companies in a commonly controlled group to the five-year average total income for all insurance companies in the commonly controlled group for the taxable year is equal to or less than 10 percent, the percentage under this subdivision shall be zero. (4) For purposes of this subdivision: (A) The "five-year average" means the aggregate net written premiums or total income, as the case may be, over the five immediately preceding calendar or fiscal years, divided by five. For purposes of this computation, if an insurance company in the commonly controlled group has been in existence for fewer than five years, its aggregate net written premiums and total income shall each be multiplied by five and divided by the number of years of its existence. If an insurance company does not have a regulatory filing requirement, the period covered shall be the fiscal year used for the insurance company's financial statements. The use of either the calendar year or fiscal year, as the case may be, for determination of the five-year average shall, for the first taxable year in which it is computed, be treated as an accounting method under this part and may thereafter only be changed with the written consent of the Franchise Tax Board. (B) For taxable years beginning before January 1, 2008, the applicable percentage shall be 60 percent. For taxable years beginning on or after January 1, 2008, the applicable percentage shall be 70 percent. (d) The following rules apply with respect to the application of this section to dividends received from an insurance company that insures risks of a member of the insurance company's commonly controlled group. (1) Notwithstanding paragraph (2), for purposes of determining the amount of the deduction authorized by subdivisions (a) and (b), no deduction is allowed for dividends attributable to premiums received or accrued by the insurance company from a member of the insurance company's commonly controlled group. For purposes of this paragraph, dividends attributable to premiums received or accrued from a member of a commonly controlled group is equal to total dividends received multiplied by the greater of either of the following: (A) The ratio of net written premiums from a member of the insurance company's commonly controlled group divided by total net written premiums. (B) (i) For a property casualty insurer, the ratio of the underwriting risk associated with a member of the commonly controlled group's insurance contracts to the insurance company's total underwriting risks for all insurance contracts. The underwriting risk is the underwriting risk reserves (losses plus expense risk-based capital after discount) as calculated using the "RBC Instructions." (ii) For a life insurer, the ratio of aggregate reserves for life, accident, and health contracts plus liability for deposit type contracts plus contract claims held for policies issued to members of the insurance company's commonly controlled group divided by total aggregate reserves for life, accident, and health contracts plus liability for deposit type contracts plus contract claims. (2) Net written premiums do not include premiums received or accrued from another member of the insurance company's commonly controlled group. Premiums from another member of the commonly controlled group is the greater of either of the following: (A) Net written premiums from a member of the insurance company's commonly controlled group. (B) (i) For a property casualty insurer, the net written premiums received or accrued by the insurance company multiplied by the ratio of the underwriting risk associated with the member of the commonly controlled group's insurance contracts to the insurance company's total underwriting risks for all insurance contracts. The underwriting risk is the underwriting risk reserves (loss plus expense risk-based capital after discount) as calculated using the "RBC Instructions." (ii) For a life insurer, net written premiums received or accrued by the insurance company multiplied by the ratio of aggregate reserves for life, accident, and health contracts plus liability for deposit type contracts plus contract claims held for policies issued to members of the insurance company's commonly controlled group divided by total aggregate reserves for life, accident, and health contracts plus liability for deposit type contracts plus contract claims. (3) For purposes of this section, investment income shall be limited to that portion of investment income equal to the ratio of net written premiums (determined under paragraph (2)) to total net written premiums (determined without regard to paragraph (2)). (4) For purposes of the limitations described in this subdivision, premiums received or accrued from a member of the insurance company' s commonly controlled group does not include premiums where the direct insurance risks ceded by affiliates and assumed by the insurance company originated with a person that is not a member of the insurance company's commonly controlled group. (e) For purposes of this section: (1) "Net written premiums" means direct written premiums plus premiums from reinsurance assumed, less premiums ceded to a reinsurance company, as would be required to be reported in an insurer's Statutory Annual Statement in accordance with the Annual Statement Instructions and Accounting Practices and Procedures Manual promulgated by the National Association of Insurance Commissioners. Net written premiums from life insurance contracts shall be determined by multiplying the net written premiums received, assumed, or ceded by 1.3. Net written premiums from financial guaranty insurance contracts shall be determined by multiplying the net written premiums received, assumed, or ceded by the lesser of 2.3 or an amount that would cause the ratio of the five-year average net written premiums for all financial guaranty insurance companies in the commonly controlled group to the five-year average total income for all financial guaranty insurance companies in the commonly controlled group to be equal to the applicable percentage. Paragraph (4) of subdivision (c) applies for purposes of the preceding sentence. (A) "Direct written premiums" means amounts written by an insurance company in consideration for insurance and annuity contracts issued to policyholders. (B) "Premiums from reinsurance assumed" means amounts received or accrued by an insurance company in consideration for liabilities it assumes from another insurance company. (C) "Premiums ceded" means insurance premiums paid or accrued by an insurance company to a reinsurer to support the liabilities assumed by the reinsurer. (2) "Total income" means net written premiums plus investment income. (3) "Investment income" means an insurance company's earnings from its investment portfolio, including interest, dividends, realized gains (or losses), and rent, as would be required to be reported in an insurer's Statutory Annual Statement in accordance with the Annual Statement Instructions and Accounting Practices and Procedures Manual promulgated by the National Association of Insurance Commissioners, except as otherwise provided. (A) Except for reinsurance transactions, realized gains (or losses) do not include losses incurred in transactions with a person that is a member of the taxpayer's or the insurance company's commonly controlled group. (B) Investment income does not include dividends from a person that is a member of the commonly controlled group. Intercompany dividends that have been eliminated from investment income as would be required to be reported in the Statutory Annual Statement in accordance with the Annual Statement Instructions and Accounting Practices and Procedures Manual promulgated by the National Association of Insurance Commissioners shall not again be eliminated for this purpose. (C) Investment income does not include income included in the taxpayer's combined report filed in accordance with Chapter 17 (commencing with Section 25101) of this part. (4) For taxable years beginning before January 1, 2004, the "RBC Instructions" as defined in Section 739 of the Insurance Code means the Risk Based Capital Instructions and Report as promulgated by the National Association of Insurance Commissioners, as it read on January 1, 2004. For taxable years beginning on or after January 1, 2004, the "RBC Instructions" as defined in Section 739 of the Insurance Code means the Risk Based Capital Instructions and Report as promulgated by the National Association of Insurance Commissioners, or any substantially equivalent successor instructions and report, as it read on January 1 of the year in which the taxpayer's taxable year begins. (5) The phrase "commonly controlled group" shall have the same meaning as that phrase has under Section 25105. (f) The Franchise Tax Board may prescribe those regulations that may be necessary to provide for the following: (1) Establishment of a comparable weighting factor as described in paragraph 1 of subdivision (e) for new lines of insurance not described in the act adding this subdivision. (2) For purposes of determining the applicable ratios described in subdivisions (c) and (d), the inclusion or exclusion of items of investment income to eliminate the effects of devices designed to manipulate those ratios for purposes of avoiding the tax imposed under this part. (3) For purposes of determining the applicable ratios described in subdivisions (c) and (d), the inclusion or exclusion of items of investment income to prevent distortion causing significant reduction in those ratios. SEC. 3. Section 24425 of the Revenue and Taxation Code is amended to read: 24425. (a) No deduction shall be allowed for any amount otherwise allowable as a deduction which is allocable to one or more classes of income not included in the measure of the tax imposed by this part, regardless of whether that income was received or accrued during the taxable year. (b) No deduction shall be allowed for any expense described in paragraphs (1) or (2) that is paid or incurred to an insurer if the insurer is a member of the taxpayer's commonly controlled group and the amount paid or incurred would constitute income to the insurer if the insurer were subject to the California income or franchise tax. (1) An expense described in this paragraph means any of the following interest amounts payable to an insurer in the same commonly controlled group: (A) (i) Interest paid or incurred to an insurer in the taxpayer's commonly controlled group with respect to indebtedness (other than qualified marketable debt instruments), the principal amount of which is attributable to a contribution of money by a noninsurer member of the taxpayer's commonly controlled group to the capital of an insurer member of that group, including the principal amount of a loan arising from a direct or indirect transfer of money from that contribution to capital from one insurer to another insurer of the same commonly controlled group. (ii) Interest paid or incurred to an insurer with respect to a note or other debt instrument (other than qualified marketable debt instruments) contributed to the capital of an insurer with respect to its stock by a noninsurer member of the commonly controlled group. (iii) For purposes of this subparagraph, "qualified marketable debt instruments" means publicly available debt instruments of all noninsurer members of the commonly controlled group issued, but only to the extent that the aggregate principal amount of publicly available debt instruments held by all insurer members of the commonly controlled group constitutes less than 10 percent of the total outstanding principal amount of publicly available debt instruments issued by all noninsurer members. (iv) For purposes of this subparagraph, "publicly available debt instruments" means debt instruments available to the general public, including bonds, debentures, and negotiable instruments (as defined in Section 3104 of the California Commercial Code) that are rated by a nationally recognized statistical rating agency (as that term is used in Rule 15c3-1(c)(2)(vi)(F) under the Securities Exchange Act of 1934) in one of its generic rating categories that signifies investment grade. (B) Interest paid or incurred within five years after the direct or indirect acquisition of the insurer by a member of the commonly controlled group (other than interest on qualified marketable debt instruments as defined in clause (iii) of subparagraph (A)). (C) The amount of interest paid or incurred during the taxable year to any insurer in the commonly controlled group multiplied by the disqualifying percentage. The disqualifying percentage is an amount equal to 100 percent less the percentage described in paragraph (1), (2), or (3) of subdivision (c) of Section 24410 (as the case may be) for that taxable year whether or not a dividend is paid or accrued. (D) An amount of interest determined by multiplying the amount of interest paid or incurred to an insurer in the commonly controlled group by the ratio of the commonly controlled group determined under paragraph (1) of subdivision (d) of Section 24410 for the taxable year (whether or not a dividend was paid or accrued in that year). (2) An expense described in this paragraph means any expense other than interest described by paragraph (1), that is either of the following: (A) Attributable to property formerly held by the taxpayer or a member of the taxpayer's commonly controlled group that was acquired by the insurer in a transaction in which gain was realized but not recognized (including for this purpose any income deferred under Section 24465) by the taxpayer or a member of its commonly controlled group. (B) Attributable to property purchased with the proceeds attributable to a contribution by a noninsurer member of the taxpayers' commonly controlled group to the capital of an insurer member of that group, including amounts attributable to a direct or indirect transfer of money from that contribution from one insurer to another insurer in the same group. (3) For purposes of this subdivision, amounts that are described in more than one subparagraph of either paragraph (1) or (2) shall be included only in that subparagraph that will result in the highest disallowance amount. (4) For purposes of this subdivision, the phrase "commonly controlled group" shall have the same meaning as that phrase has under Section 25105. (5) For purposes of this subdivision, an insurer is an insurer within the meaning of Section 28 of Article XIII of the California Constitution, whether or not the insurer is engaged in business in California. SEC. 4. Section 24465 is added to the Revenue and Taxation Code, to read: 24465. (a) (1) If, in connection with any exchange described in Section 332, 351, 354, 356, or 361 of the Internal Revenue Code, a taxpayer transfers property to an insurer, the insurer shall not, for purposes of determining the extent to which gain shall be recognized on that transfer, be considered to be a corporation for purposes of this part. (2) Paragraph (1) shall not apply to any of the following types of transactions, unless that transaction has the effect (directly or indirectly) of transferring appreciated property from a taxpayer subject to tax under this part (or a member of the taxpayer's combined reporting group) to an insurer: (A) An exchange or transfer pursuant to Section 368(a)(2)(D) or Section 368(a)(2)(E) of the Internal Revenue Code. (B) A transfer of stock in an 80 percent-owned insurer for the purpose of filing a consolidated tax return or for financial or regulatory reporting. (C) A transfer or exchange of publicly owned stock of the parent corporation. (3) If a transaction described in paragraph (2) would qualify under that paragraph but for the fact that the transaction has the effect (directly or indirectly) of transferring appreciated property from a taxpayer subject to tax under this part (or a member of the taxpayer's combined reporting group) to an insurer, then, if the property is used in the active trade or business of the insurer, subdivision (b) shall be deemed to apply to that transfer. (4) For purposes of this subdivision, "appreciated property" means property whose fair market value, as of the date of the transfer subject to this section, exceeds its adjusted basis as of that date. (b) (1) Except as provided in subdivision (c), or as otherwise provided by regulations prescribed by the Franchise Tax Board, if property subject to paragraph (1) of subdivision (a) or to subdivision (g) is transferred to an insurer for use in the active conduct of a trade or business of the insurer, then any gain otherwise required to be recognized under that subdivision shall be deferred until the date that the property is no longer owned by an insurer in the taxpayer's commonly controlled group (or a member of the taxpayer's combined reporting group), or the property is no longer used in the active conduct of the insurer's trade or business (or the trade or business of another member in the taxpayer's combined reporting group), or the holder of the property is no longer held by an insurer in the commonly controlled group of the transferor (or a member of the taxpayer's combined reporting group). (2) Any of the events described in paragraph (1) shall be treated as a disposition of the property under this subdivision, irrespective of whether any other provision in this part or in the Internal Revenue Code would otherwise permit nonrecognition treatment of the transaction described in this subdivision. (3) Notwithstanding paragraph (2) of this subdivision, an insurer that becomes a member of the taxpayer's commonly controlled group or a corporation that becomes a member of the taxpayer's combined reporting group, as a result of a transaction of which a transfer referred to in this subdivision is a part, shall be treated as a member of the taxpayer's commonly controlled group or a member of the taxpayer's combined reporting group at the time of the transfer for purposes of this subdivision. (4) For purposes of this subdivision, stock of an insurance subsidiary constitutes property used in the active trade or business of the insurer. (5) If the deferred gain required to be taken into account under this subdivision is business income (as defined by subdivision (a) of Section 25120), the gain shall be apportioned using the apportionment percentage for the taxable year that the gain is required to be taken into account under this subdivision. Except as provided in regulations under Section 25137, for purposes of the sales factor for that taxable year, the transaction giving rise to that gain shall be treated as a sale occurring in the taxable year the gain is taken into account. The amount of any gain required to be recognized under this subdivision upon any disposition described in this subdivision shall not exceed the lesser of the deferred gain or the gain realized in the transaction in which gain is required to be recognized under this subdivision. (6) For purposes of computing the amount of gain required to be recognized under this subdivision, appropriate adjustments may be made, pursuant to regulations issued by the Franchise Tax Board, to the basis of stock to reflect the disallowance of any expenses under paragraph (2) of subdivision (b) of Section 24425. (c) The Franchise Tax Board may prescribe regulations providing for an annual reporting requirement in the form of a statement or other form, to be attached to the transferor taxpayer's return, regarding the current ownership of any property for which any gains were previously deferred pursuant to subdivision (b). If the transferor taxpayer fails to provide any information required by the Franchise Tax Board pursuant to the preceding sentence, the Franchise Tax Board may, in lieu of the year described by subdivision (b), require that the transferor taxpayer take those gains into account in the first taxable year in which the current ownership of the property is not reported. The preceding sentence shall not apply so long as the property is still owned by the transferee and the failure to provide the information was due to reasonable cause and not willful neglect. Notwithstanding any other provision of law, if a taxpayer fails to satisfy the reporting requirements of this subdivision, then a notice of proposed deficiency assessment resulting from adjustments attributable to gains previously deferred pursuant to subdivision (b) with respect to which the reporting requirements were not satisfied may be mailed to the taxpayer within four years from the date on which the reporting requirements are satisfied by the taxpayer. (d) Subdivision (b) shall not apply to any property described by Section 367(a)(3)(B) of the Internal Revenue Code. (e) Except as provided by regulations prescribed by the Franchise Tax Board, a transfer by a taxpayer of an interest in a partnership to an insurer in a transaction described in subdivision (a) shall be treated as a transfer to that insurer of the taxpayer's pro rata share of the assets of the partnership. (f) For purposes of this section, any distribution described by Section 355 of the Internal Revenue Code (or so much of Section 356 of the Internal Revenue Code as it relates to Section 355 of the Internal Revenue Code) shall be treated as an exchange under this section, whether or not the distribution is an exchange. This subdivision shall not apply to any distribution in which either of the following applies: (1) The distributing corporation is an insurer. (2) The distributee is a person other than an insurer. (g) For purposes of this part, any transfer of property to an insurer as a contribution to capital of that insurer by one or more persons who, immediately after the transfer, own (within the meaning of Section 318 of the Internal Revenue Code) stock possessing at least 80 percent of the total combined voting power of all classes of stock of that insurer that are entitled to vote shall be treated as an exchange of that property for stock of the insurer equal in value to the fair market value of the property transferred. (h) (1) In the case of any distribution described in Section 355 of the Internal Revenue Code (or so much of Section 356 of the Internal Revenue Code as it relates to Section 355 of the Internal Revenue Code) by a taxpayer to an insurer, to the extent provided in regulations prescribed by the Franchise Tax Board, gain shall be recognized under principles similar to the principles of this section. (2) In the case of any liquidation to which Section 332 of the Internal Revenue Code applies, except as provided in regulations prescribed by the Franchise Tax Board, both of the following shall apply: (A) Sections 337(a) and 337(b)(1) of the Internal Revenue Code shall not apply, where the 80 percent distributee is an insurer. (B) Where the distributor is an insurer, the distributee shall treat the distribution as a distribution from the insurer's earnings and profits, to the extent thereof. (3) For purposes of the preceding paragraph, the deemed distribution from earnings and profits shall be treated as a dividend eligible for a deduction, to the extent otherwise provided in Section 24410, as if actually distributed as a dividend. (i) For purposes of this section, the following definitions shall apply: (1) An insurer is any insurer within the meaning of Section 28 of Article XIII of the California Constitution, whether or not the insurer is engaged in business in California. (2) The phrase "commonly controlled group" shall have the same meaning as that phrase has under Section 25105. (3) The phrase "combined reporting group" means those corporations whose income is required to be included in the same combined report pursuant to Section 25101 or 25110. (j) The Franchise Tax Board may prescribe any regulations that may be appropriate to carry out the purpose of this section, which purpose is to prevent the removal of gain inherent in property at the time of a transfer from taxation under this part. Those regulations may provide for appropriate adjustments to the amount of deferred income described in subdivision (b) to avoid the double inclusion of income for situations, including but not limited to, the property transferred to an insurer member of the commonly controlled group is later acquired by a noninsurer member of the taxpayer's combined reporting group. (k) Upon an adequate showing by a taxpayer that a transaction referred to in subdivision (a) or (h) would not violate the purposes of this section to prevent the removal of gain inherent in property at the time of a transfer from taxation under this part, the Franchise Tax Board may grant relief from the application of this section. In an appeal filed with the State Board of Equalization, or an action filed under Section 19382 or 19385, the State Board of Equalization or the court, as the case may be, shall have jurisdiction to grant that relief only upon a specific finding that the transfer did not remove gain inherent in property at the time of transfer from taxation under this part. (l) This section applies to transactions entered into on or after June 23, 2004, or transactions entered into after June 23, 2004, pursuant to a binding written contract in existence on June 23, 2004. For purposes of this subdivision, transactions entered into on or after June 23, 2004, that were given final approval by a regulatory insurance commissioner before June 23, 2004, shall be considered a transaction entered into before June 23, 2004, pursuant to a binding written contract in existence on June 23, 2004. SEC. 5. Section 24900 is added to the Revenue and Taxation Code, to read: 24900. (a) The Franchise Tax Board may include in the gross income of the taxpayer (or a member of the taxpayer's combined reporting group) in that taxable year the taxpayer's pro rata share (or the pro rata share of a member of the taxpayer's combined reporting group) of any of those insurers' current earnings and profits in that taxable year, but not to exceed an amount equal to the specific insurer's net income attributable to investment income for that year minus that insurer's net written premiums received in that same taxable year, if all of the following apply: (1) For any taxable year an insurer is a member of a taxpayer's commonly controlled group. (2) The ratio of the five-year average net written premiums to the five-year average total income of all insurers in the commonly controlled group is equal to or less than 0.10 (or, for taxable years beginning on or after January 1, 2008, 0.15). (3) The accumulation of earnings and profits of the insurers in the commonly controlled group had a substantial purpose of avoidance of taxes on, according to, or measured by income, of this state or any other state. The amount so included shall be treated as a dividend received from an insurance company during the taxable year, and to the extent applicable, Section 24410 shall apply to that amount. (b) If the insurer members of the commonly controlled group constitute a predominantly captive insurance group (as defined in paragraph (6) of subdivision (e)), then the ratio described in subdivision (a) shall be 0.40. (c) To the extent that amounts are included in the gross income of a taxpayer (or a member of the taxpayer's combined reporting group) pursuant to subdivision (a), those amounts shall not again be considered as investment income in the application of the ratio described in paragraph (2) of subdivision (a). (d) The amounts included in gross income under subdivision (a) shall not again be included in gross income when subsequent distributions are made to the taxpayer (or a member of the taxpayer's combined reporting group), or another taxpayer that acquires an interest in the stock of the taxpayer (or a member of the taxpayer's combined reporting group with respect to which subdivision (a) was applied), or any successor or assign of the respective taxpayers (or a member of the taxpayer's combined reporting group) described in this subdivision. For purposes of applying this subdivision, distributions from an insurer shall be considered first made from amounts included under subdivision (a). (e) For purposes of this section, the following definitions shall apply: (1) Except as otherwise provided, the phrases "net written premiums," "five-year average net written premiums" and the "five-year average total income" shall each have the same meaning, respectively, as applicable for purposes of subdivision (c) of Section 24410, whether or not a dividend is actually received from any insurer member of the taxpayer's commonly controlled group in that taxable year. (2) "Net income attributable to investment income" means net income of the insurer multiplied by a ratio, the numerator of which is the insurer's gross investment income from interest, dividends (other than dividends from members of the taxpayer's commonly controlled group), rent, and realized gains or losses, and the denominator of which is the insurer's gross income (other than dividends from members of the taxpayer's commonly controlled group) from all sources. In the application of the preceding sentence, if an insurer is required to file a Statutory Annual Statement pursuant to the Annual Statement Instructions and Accounting Practices and Procedures Manual promulgated by the National Association of Insurance Commissioners, "net income" means net income required to be reported in the insurer's Statutory Annual Statement. (3) An insurer is any insurer within the meaning of Section 28 of Article XIII of the California Constitution, whether or not the insurer is engaged in business in California. (4) The phrase "commonly controlled group" shall have the same meaning as that phrase has under Section 25105. (5) The phrase "combined reporting group" means those corporations whose income is required to be included in the same combined report pursuant to Section 25101 or 25110. (6) A "predominantly captive insurance group" means the insurer members of a commonly controlled group where the insurers receive more than 50 percent of their net written premiums (without regard to the weighting factors in paragraph (1) of subdivision (e) of Section 24410) from members of the commonly controlled group or the ratios in clause (i) or clause (ii) of subparagraph (B) of paragraph (1) of subdivision (d) of Section 24410 is greater than 50 percent. The provisions of paragraph (4) of subdivision (d) of Section 24410 shall apply for purposes of this paragraph. (7) (A) The taxpayer's "pro rata share" of the current earnings and profits of an insurer member of a commonly controlled group is the amount that would have been received as a dividend by the taxpayer (or a member of the taxpayer's combined reporting group) if both of the following apply: (i) The insurer had directly distributed its current earnings and profits with respect to its stock held by the taxpayer (or member of the taxpayer's combined reporting group). (ii) In the case of an insurer holding the stock of another insurer, all other insurer members of the taxpayer's commonly controlled group had distributed the same current earnings and profits with respect to their stock, in the same taxable year, until amounts were received as a dividend by the taxpayer (or a member of the taxpayer's combined reporting group) from an insurer member of the commonly controlled group. (B) In the application of this section, amounts treated as a dividend received by a partnership shall be considered a dividend received by each partner that is a member of the commonly controlled group, either directly or through a series of tiered partnerships. (f) The Franchise Tax Board may prescribe those regulations that are appropriate to describe conditions under which the accumulation of earnings and profits of those insurers described in paragraph (2) of subdivision (a) do not have the substantial purpose of avoidance of taxes on, according to, or measured by income, of this state or any other state. (g) If this section or any portion of this section is held invalid, or the application of this section to any person or circumstance is held invalid, that invalidity shall not affect other provisions of the act adding this section, or the provisions of this section that are severable. SEC. 6. (a) The Legislature finds and declares that the changes made by this act with respect to Section 24410 of the Revenue and Taxation Code serve a public purpose and are necessary to provide for the equitable tax treatment of insurance company dividends in light of the following circumstances: (1) The California Court of Appeal in a final decision in the case of Ceridian Corp. v. Franchise Tax Board (2000) 85 Cal.App.4th 875 held that provisions of Section 24410 of the Revenue and Taxation Code that limited a deduction with respect to dividends received from subsidiaries engaged in the insurance business to corporations "commercially domiciled" in California, and to insurance company dividends paid from "income from California sources," violated the commerce clause of the United States Constitution. (2) In general, insurance companies are not subject to the Corporation Tax Law (Part 11 (commencing with Section 23001) of Division 2 of the Revenue and Taxation Code) and cannot be included in the combined report used to determine the California income of related corporations that are subject to the Corporation Tax Law. Consequently, dividends that are paid by insurance companies do not qualify for a deduction under Section 24402 of the Revenue and Taxation Code and are not eligible for elimination from income as provided for in Section 25106 of the Revenue and Taxation Code. (3) After the decision in Ceridian Corp. v. Franchise Tax Board, a number of corporations filed returns with the Franchise Tax Board in which they claimed deductions for all or part of the dividends that they received from insurance subsidiaries. It is the position of these corporations that the Ceridian Corp. v. Franchise Tax Board decision results in a 100 percent deduction for any dividend received from any insurance company. It is the position of the Legislative Counsel and the Franchise Tax Board that the Ceridian Corp. v. Franchise Tax Board decision makes Section 24410 of the Revenue and Taxation Code inoperable, and that no deduction is allowed for dividends received from an insurance company. If the corporations are not entitled to those deductions claimed with respect to those dividends, additional taxes and interest will be due. (4) The Legislature finds and declares that the changes made by this act with respect to Section 24410 of the Revenue and Taxation Code serve a public purpose and are in furtherance of the public interest in avoiding the denial of a deduction with respect to a portion of the dividends paid by insurance companies. Denial of a deduction with respect to those dividends will have a detrimental effect upon the economy of California. (5) The Legislature further finds and declares that the application of this act to taxable years ending on or after December 1, 1997, and beginning before January 1, 2004, serves a public purpose and is in furtherance of legislative intent underlying the enactment of Section 24410 of the Revenue and Taxation Code. The Legislature further finds and declares that the application of the changes made with respect to Section 24410 of the Revenue and Taxation Code made by this act promote a public purpose and sound tax policy by affording equitable tax relief to many taxpayers who relied upon the literal language of Section 24410 of the Revenue and Taxation Code in the expectation that they would be entitled to a deduction with respect to a portion of the dividends received from insurance companies. (b) The Legislature further finds and declares all of the following: (1) Section 24425 of the Revenue and Taxation Code denies a deduction with respect to any amount otherwise allowable as a deduction that is allocable to a class of income that is not included in the measure of tax. In general, the Franchise Tax Board maintains, and the State Board of Equalization has upheld, that Section 24425 of the Revenue and Taxation Code applies to limit expense deductions associated with insurance company dividends to the extent those dividends are deductible under Section 24410 of the Revenue and Taxation Code. Some taxpayers contend that Section 24425 of the Revenue and Taxation Code does not apply to a deduction arising under Section 24410 of the Revenue and Taxation Code under any circumstance. (2) The determination of the amount of an otherwise allowable deduction that is allocable to a class of income that is not included in the measure of tax can be a difficult and subjective judgment and often is not resolved without litigation. (3) Paragraph (5) of subdivision (b) of Section 24410 of the Revenue and Taxation Code, that declares Section 24425 of the Revenue and Taxation Code inapplicable to the dividends received deduction for tax years ending on or after December 1, 1997, and commencing before January 1, 2004, represents an integral part of the legislative resolution of the uncertainty created by the Ceridian Corp. v. Franchise Tax Board decision, and is accordingly added by this act in furtherance of the same valid public purposes identified above. (4) For tax years ending prior to December 1, 1997, however, the Ceridian Corp. v. Franchise Tax Board decision has required a full dividends received deduction under Section 24410 of the Revenue and Taxation Code for taxpayers procedurally entitled to assert a claim for refund thereto, and the Franchise Tax Board maintains that Section 24425 of the Revenue and Taxation Code applies to limit deductions allocable to these dividends. No inferences should arise from the provisions of subdivision (b) of Section 24410 of the Revenue and Taxation Code as added by this act with respect to the application of Section 24425 of the Revenue and Taxation Code to deductions allocable to the dividends deductible under Section 24410 of the Revenue and Taxation Code for tax years ending before December 1, 1997, or commencing on or after January 1, 2004. (c) The Legislature further declares that the tax treatment of insurance company dividends under Section 24410 of the Revenue and Taxation Code, as amended by this act, is unrelated to and distinguishable from the tax treatment of general corporation dividends under Section 24402 of the Revenue and Taxation Code and from the application of Section 24425 of the Revenue and Taxation Code to deductions allocable to those dividends. The Legislature further finds and declares that no inference with respect to Section 24402 of the Revenue and Taxation Code or the application of Section 24425 of the Revenue and Taxation Code to deductions allocable to those dividends should be drawn from the changes made with respect to Section 24410 of the Revenue and Taxation Code by this act. SEC. 7. (a) The Legislative Analyst, in consultation with the Department of Finance, the Department of Insurance, and the Franchise Tax Board, shall conduct a study of this act's impact on the income and franchise tax under Part 11 resulting from overcapitalization of insurance companies and the fact that income from overcapitalization of an insurance company is exempt from the tax imposed under the Corporation Tax Law (Part 11 (commencing with Section 23001) of Division 2 of the Revenue and Taxation Code) by virtue of subdivision (f) of Section 28 of Article XIII of the California Constitution. The Legislative Analyst's Office may consult with the insurance industry to obtain necessary information and data. The report shall be submitted to the Legislature no later than January 1, 2008, and shall include, but not be limited to, the impact of new Section 24900 of the Revenue and Taxation Code on taxpayers' ability to avoid state franchise or income tax through the ownership of an insurance company. The report shall address whether the ratio described in paragraph (2) of subdivision (a) of Section 24900 of the Revenue and Taxation Code should be decreased from 0.15 (as effective for years beginning on or after January 1, 2008) to 0.10 on the basis that the problems related to overcapitalization of insurance companies that were targeted by Section 24900 of the Revenue and Taxation Code have and will have been adequately curtailed by reducing the ratio specified in paragraph (2) of subdivision (a) of Section 24900 of the Revenue and Taxation Code to 0.10. The study shall also address the amount of gross premiums taxes paid by the insurance industry and compare the method of collection and amount of payment to the corporation income or franchise tax. (b) Unless the report referred to in subdivision (a) demonstrates that the ratio referred to in paragraph (2) of subdivision (a) of Section 24900 of the Revenue and Taxation Code at the level of 0.10 is or was insufficient to curtail the excessive capitalization of insurance companies that was targeted by Section 24900 of the Revenue and Taxation Code, the Legislature would urge the enactment of legislation to reduce the ratio described in paragraph (2) of subdivision (a) of Section 24900 of the Revenue and Taxation Code from 0.15 to 0.10. SEC. 8. This act provides for a tax levy within the meaning of Article IV of the Constitution and shall go into immediate effect.