BILL ANALYSIS SB 401 Page 1 Date of Hearing: July 6, 2009 ASSEMBLY COMMITTEE ON REVENUE AND TAXATION Charles M. Calderon, Chair SB 401 (Wolk) - As Amended: July 1, 2009 Majority vote. Fiscal committee. SENATE VOTE : 22-15 SUBJECT : Administration of taxes: abusive tax avoidance transactions: transactions of interest. SUMMARY : Provides a single, consistent definition for abusive tax shelters (ATS) and modifies the ATS-use penalty. Specifically, this bill : 1)Replaces the term "ATS" with the phrase "abusive tax avoidance transactions" and defines an "abusive tax avoidance transaction" as any of the following: a) A tax shelter, as defined in Internal Revenue Code (IRC) Section 6662(d)(2)(C); b) A reportable transaction, as defined in IRC Section 6706A(c)(1), which is undisclosed; c) A listed transaction, as defined in IRC Section 6707A(c)(2); d) A gross misstatement within the meaning of IRC Section 6404(g)(2)(D); or, e) A transaction subject to the "non-economic substance transaction" understatement penalty. 2)Expands the definition of "reportable transactions" for California tax purposes by creating a new category of those transactions - "a transaction of interest." 3)Defines a "transaction of interest" as a transaction that is the same as, or substantially similar to, one of the types of transactions that the Franchise Tax Board (FTB) has identified by notice or regulation as a transaction of interest. SB 401 Page 2 Requires that the transactions of interest be identified and published on the FTB's website. 4)Specifies that the expanded definition of "reportable transactions" applies only to transactions of interest published on or after the effective date of this bill and only to taxable years beginning on or after that effective date. 5)Coordinates the definition of "ATS" with the application of the eight-year statute of limitations, the ATS-use penalty, and the authority to issue subpoenas. The definition of "an abusive tax avoidance transaction" would apply to the eight-year statute of limitations for filing deficiency assessments related to tax avoidance schemes, the specified ATS-use penalty, interest suspension rules that apply to certain taxpayers that have been contacted regarding an ATS, and the authority to issue subpoenas to prevent the marketing of an ATS. 6)Modifies the ATS-use penalty by imposing a 50% of the penalty when a taxpayer files an amended return reporting an abusive tax avoidance transaction after the taxpayer was contacted by the FTB but before a deficiency notice is issued. Specifies that the penalty amount is equal to 50% of the interest applicable to any additional tax reflected in the amended return and attributable to that abusive tax avoidance transaction. Applies to notices mailed on or after the effective date of this bill. 7)Provides that the new 50% penalty applies to amended returns filed more than 180 days after the effective date of this bill with respect to taxable years beginning on or after that effective date. 8)Authorizes the Chief Counsel of the FTB to compromise all or any portion of the 50% penalty and specifies that the Chief Counsel's ruling may not be reviewed in any judicial or administrative proceeding. 9)Provides that a legal tax structure of an limited liability company or an S corporation shall not by itself be "abusive" solely because of the choice of entity. EXISTING LAW : SB 401 Page 3 1)Imposes various penalties in connection with tax avoidance and ATS, including reportable transactions. 2)Conforms to federal law regarding the requirements for tax shelter organizers, sellers, material advisors, and promoters to register tax shelters, maintain investor lists, and provide information returns. Modifies this conformity to additionally apply registration and reporting requirements to organizers, sellers, material advisors, and promoters with respect to any shelter that meets any of the following criteria: organized in California, does business in California, derives income from sources in California, or has a California taxpayer as at least one of its investors. 3)Uses the following definitions and provisions to curtail the use of ATS: a) A "potentially abusive tax avoidance transaction" is defined as any tax shelter or a plan or arrangement which is of a type that the Secretary of the Treasury or the FTB determines by regulation as having a potential for tax avoidance or evasion. b) A "reportable transaction" is defined as any transaction with respect to which information is required to be included with a return or statement because that transaction is of a type that the Secretary of the Treasury [i.e., the IRS] or FTB determines as having a potential for tax avoidance or evasion. c) A "listed transaction" is defined as a reportable transaction that is the same as or is substantially similar to a transaction specifically identified by the IRS for federal income tax purposes or by FTB for federal or state income tax purposes as a tax avoidance transaction. d) "Gross misstatement" is defined, by reference to the federal law, as the reporting of any item on the original or any amended return if that item is attributable to a gross valuation misstatement as defined in IRC Section 6662(h), a substantial omission of income as described in IRC Section 6501(e)(1) or Section 6229(c), or a frivolous position or a desire to delay or impede the administration of the federal income tax laws as described in IRC Section 6702. (Treasury Regulations 301.6404-4). SB 401 Page 4 4)Imposes a penalty for any understatement attributable to any transaction that lacks economic substance. A "noneconomic substance transaction understatement" is a reportable transaction understatement, or an understatement resulting from the disallowance of any loss, deduction or credit, or addition to income that is attributable to a determination that the arrangement lacks economic substance. A transaction is treated as lacking economic substance if the taxpayer does not have a valid nontax business purpose for entering into the transaction. The penalty rate equals 20% of the understatement if the taxpayer adequately discloses all relevant facts on his/her tax return, 30% if all relevant facts are not disclosed, and 40% if the transaction lacks economic substance. The penalty applies to the entire amount of the understatement, even if the benefit is not recognized on a current-year return. For example, if a taxpayer reports a $100 million capitol loss resulting from a transaction that lacks economic substance, but only utilizes $10 million of the loss in the current year due to the capitol loss limitations, the penalty is based on $100 million, the total understated amount. 5)Imposes an "ATS-use" penalty if the FTB contacts a taxpayer regarding a deficiency that results from the use of an undisclosed reportable transaction, a listed transaction, or a gross misstatement. The penalty is 100% of the interest payable up to the date that a notice of proposed deficiency is mailed. Because the ATS-use penalty is based on the amount of interest on a deficiency, a taxpayer may avoid the penalty by filing an amended return prior to FTB issuing a deficiency notice. 6)Provides that the imposition of penalties and interest may be subject to temporary suspension if FTB does not issue a notice within 18 months from the date of a timely-filed return. Thus, interest may not be computed on the additional proposed tax from the day after that 18-month period until 15 days after the notice is issued. However, this rule does not apply to taxpayers with income greater than $200,000 and that have been contacted by FTB regarding a "potentially ATS". FTB is also not required to suspend any interest or penalties imposed on those taxpayers, if these taxpayers have been contacted by FTB regarding the use of a reportable transaction or any listed transaction and FTB fails to notify these taxpayers of SB 401 Page 5 their liabilities within 18 months of the due date of the return or the date the return is filed, whichever is later. 7)Extends the statute of limitations on deficiencies resulting from tax shelter investments to eight years from the date the return is filed, effective for returns filed on or after January 1, 2000. Thus, if the FTB identifies an adjustment relating to an "abusive tax avoidance transaction," the FTB may notify the taxpayer of a proposed deficiency assessment up to eight years after the taxpayer has filed the return, rather than the normal four-year statute of limitations. 8)Allows the Executive Officer of FTB or his/her designee or any designee of FTB to subpoena taxpayers who have been contacted by FTB regarding the use of a potentially ATS. FISCAL EFFECT : The FTB staff estimates that this bill will result in a gain of $5.9 million in fiscal year (FY) 2008-09 and $1.5 million in FY 2010-11, and a loss of $1.8 million in FY 2009-10. COMMENTS : 1)Purpose of this bill . The author's office states that the purpose of this bill is to curtail the use of ATS with no economic purpose except to evade taxes in this state. Five years ago the state launched the most successful program in the nation to curtail ATS. Since that time taxpayers, both individuals and corporations, have found ways around the state's laws by filing amended returns before a penalty could be assessed or using inconsistencies in state laws to avoid fully reporting questionable transactions. The intent of this bill is to ensure that the state can stop those transactions that are, in fact, abusive and have no business or economic purpose and to warn other taxpayers of the consequences. This bill discourages tax avoidance and the use of ATS by defining a "potentially abusive tax avoidance transaction" as: (a) a tax shelter; (b) an undisclosed reportable transaction; (c) a listed transaction; (d) a gross misstatement; or, (e) a transaction subject to the noneconomic substance transaction understatement penalty, as specified. In addition, this bill would modify the ATS use penalty to no longer allow taxpayers to avoid the penalty by filing an amended return prior to the FTB's issuing a deficiency notice; instead, this bill would SB 401 Page 6 impose 50% of the penalty. 2)Arguments in support . Supporters argue that this bill clarifies state tax laws that apply to potentially abusive tax avoidance transactions and improves the effectiveness of the ATS use penalty. They argue that the state not only needs to improve collections but also act as an example to the rest of the nation in curtailing ATS as it did in 2003. 3)Arguments in opposition . The opponents argue that this bill is overly punitive and broad and unfairly imposes an excessive penalty for transactions that are already subject to onerous existing penalties. 4)What is a "tax shelter"? Under both the Personal Income Tax Law and the Corporation Tax Law, taxpayers are able to shelter certain income from taxation. For example, individual taxpayers are entitled to take a deduction for the mortgage interest, an individual retirement account or pension contributions, or a charitable contribution, among others, that are explicitly allowed under the law. While some tax shelters are legal and represent creative utilization of tax laws to reduce tax liability, other tax shelters are not specifically identified in federal or state tax laws. A tax shelter is a legal technique used by taxpayers to reduce taxable income. Some of the tax sheltering activities identified by the IRS or the FTB are disallowed and treated as an ATS. However, there are far more tax shelters in existence than the IRS or FTB have been able to identify. For that reason, there may be many tax shelters that are ultimately found to be illegal. 5)Definition of an ATS . Because there are many types of ATS, it is quite difficult to identify and define those transactions. However, despite the absence of a uniform and exact standard as to what constitutes an ATS, there exist statutory provisions, judicial doctrines, and administrative guidance that limit and define such transactions. The IRC, for example, defines a "tax shelter" as a partnership or other entity (such as a corporation or trust), an investment plan or arrangement, or any other plan or arrangement the significant purpose of which is avoiding or evading tax. [IRC Section 6662(d)(2)(C)(ii)]. Tax-shelter transactions are generally structured with one or more of the following characteristics: (a) little or no motive of realization of economic gain; (b) SB 401 Page 7 intentional mismatching of income and deductions; (c) overvalued assets or assets with values subject to substantial uncertainty are included; (d) non-recourse financing and financing techniques that do not conform to standard commercial business practices; or, (e) mischaracterization of the substance of the transaction. Courts have developed several doctrines that have been used to deny tax benefits arising from certain transactions. One common law doctrine that has been applied with increasing frequency is called the economic substance doctrine. In general, this doctrine denies tax benefits arising from transactions that do not result in a meaningful change to the taxpayer's economic position other than a purported reduction in income tax. Closely related doctrines include the "sham transaction doctrine" and the "business purpose doctrine", which requires that the transaction's business purpose must be separate and distinct from any tax consequences. Generally, an ATS has no business purpose other than reducing taxes and is promoted with the promise of tax benefits, predictable tax losses or tax consequences, and no related economic loss experienced with respect to the taxpayer's income or assets. An ATS is, often, cloaked in a series of transactions to make it appear to have a business purpose or is structured to create an incidental business purpose. In contrast, a transaction is considered to have economic substance and, therefore, satisfy the economic substance doctrine, if (a) the taxpayer establishes that the transaction changes the taxpayers economic position in a meaningful way other than as a result of its tax consequences; and, (b) the taxpayer has a substantial non-tax purpose for entering into the transaction, and the transaction is a reasonable means of achieving that purpose. The FTB and the IRS have also identified certain characteristics of ATS such as separation of income and expenses, use of pass-through entities or third-party facilitators, utilization of offshore foreign accounts or facilitators, or allowance of double benefits from a single tax loss. 6)Examples of ATS . An ATS is usually structured simply as a way to reduce tax, and not to generate income. A legitimate tax shelter, usually, is set up with the primary purpose of producing income. SB 401 Page 8 a) Basis Shifting. This tax scheme uses foreign corporations (in tax haven countries) and instruments to artificially increase and shift the basis of foreign shareholder stock [not subject to United States (U.S.) taxation] to stock owned by U.S. shareholders. By applying tax laws in a manner inconsistent with legislative intent, U.S. taxpayers ultimately sell their stock and report an inflated loss, despite incurring no economic loss. b) Inflated Partnership Basis Transaction. These schemes use transactions that are "contingent" (not completed) to inflate an owner's basis (ownership interest/true economic risk) in a pass-through entity investment. The taxpayer contributes cash or securities and a "contingent" liability or obligation to the pass-through entity. The taxpayer does not reduce his/her basis in the pass-through entity for the contingent liability under the contention that the liability item is "contingent" for tax purposes. Thus, the taxpayer creates an artificially inflated basis for the pass through entity interest, which is then used to deduct losses received from the pass through entity (losses are only deductible against the owner's basis in a pass-through entity). c) Commercial Domicile. This scheme promises taxpayers that if they incorporate in non-income taxing states, such as Nevada or Delaware, they can avoid California income taxes. This scheme requires an S corporation doing business in California to reincorporate in Nevada. Promoters of this reincorporation scheme argue that the source of the S corporation income is Nevada, regardless of its business activity in California. However, a corporation doing business in California remains subject to California franchise tax, and a California resident is taxable on income from all sources, including sources in Nevada. In this situation, neither the S corporation has terminated its business activity in California, nor has the individual taxpayer terminated his/her California residency. d) Sale of Charitable Remainder Trusts Interest. This transaction was identified by the IRS as a transaction of interest in which a sale of all interests in a charitable remainder trust results in the grantor or other noncharitable recipient receiving the value of that person's trust interest while claiming little or no taxable SB 401 Page 9 gain. e) Subpart F Income Partnership Blocker. This sheme uses a domestic partnership to prevent the inclusion of Subpart F income. A U.S. taxpayer that owns controlled foreing corporations (CFCs) that hold stock a lower-tier CFC through a domestic partnership takes the position that Subpart F income of the lower-tier CFC does not result in income inclusion for the U.S. taxpayer. f) Abusive Roth IRA Transactions. This plan allows individual taxpayers to contribute to a Roth IRA more than the annual contribution level allowed under federal and state laws. The ATS involves the establisment of a closely held corporation owned by the Roth IRA. When valuable assets are transferred to the Roth corporation and, subsequently, sold, no tax is owed by the Roth corporation. Thus, income escapes taxation because no tax is paid on the transfer of assets or on the withdrawal. 7)Who invests in abusive tax schemes? Individuals and business entities with large, constant streams of income or with substantial gains from one-time events may invest in abusive tax schemes. 8)California's ATS Law. In 2003, in an effort to curb the use of ATS activity, the Legislature enacted AB 1601 (Frommer), Chapter 654, Statutes of 2003, and SB 614 (Cedillo), Chapter 656, Statutes of 2003. The legislation provided a limited amnesty for participants in ATS, increased reporting requirements for ATS participants and penalties following the amnesty period, and expanded the state's ability to take legal action against ATS participants. That amnesty, which was in effect from January 1, 2004 until April 15, 2004, resulted in payments from businesses and individual taxpayers of about $1.4 billion, of which $700 million represented the state's net revenue gain. A total of 1,202 taxpayers participated in the amnesty. That legislation was designed to curtail the use of then existing assortment of illegal tax shelters by offering an amnesty period and to restrict the availability of new tax shelter activities by increasing detection efforts and enforcement activities. It also sought to increase the level of overall tax compliance by taxpayers and was undertaken in the hope that it would generate substantial revenue for the state. Thus, it created a whole range of new penalties to SB 401 Page 10 provide an incentive to participate in the amnesty as well as to discourage additional ATS-related behaviors. Major penalty increases included a penalty for failure to report a "reportable transaction" for understated tax in connection with transactions lacking economic substance, an accuracy-related penalty for tax returns with reportable transactions, and a penalty for failure to report or register a tax shelter. 9)What is a "reportable transaction"? A reportable transaction is generally any transaction that has a potential for avoiding or evading tax and the transaction is required to be included a return or statement. The current categories of reportable transactions include listed transactions; transactions of interest; confidential transactions; transactions with contractual protection; and loss transactions. Federal law requires a taxpayer who participated in a reportable transaction to disclose the transaction on an original or amended return for any taxable year the taxpayer participates in the transaction. 4)What is a "listed transaction"? A listed transaction is a transaction that has been identified by the IRS or the FTB to be a tax-avoidance transaction (i.e. an ATS). 5)What does this bill do? This bill consolidates existing definitions of various ATS into a single, consistent definition and modifies the existing penalty imposed on a taxpayer who has failed to report a use of an ATS on the tax return. Currently, the penalty is equal to 100% of the interest imposed on a deficiency attributable to the taxpayer's use of the ATS. Existing law allows the taxpayer to avoid that penalty by filing an amended return after the taxpayer was contacted by the FTB but prior to the FTB's issuing a deficiency notice. However, some argue that this opportunity for the taxpayer to file an amended return to avoid the penalty lessens the effectiveness of the penalty and encourages taxpayers to play "audit roulette" where the cost of getting caught is minor compared to the savings. The proponents posit that a 50% (instead of 0% or 100%) penalty would still provide an incentive for taxpayers to file an amended return and pay the tax, but the most egregious transactions would be subject to a significant penalty. 6)Suggested technical amendment. SB 401 Page 11 Amendment 1 On page 8, strike out lines 2 to 8, inclusive REGISTERED SUPPORT / OPPOSITION : Support None on file Opposition California Taxpayers' Association California Bankers Association California Chamber of Commerce California Manufacturers and Technology Association TechAmerica Analysis Prepared by : Oksana Jaffe / REV. & TAX. / (916) 319-2098