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.   








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            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  :









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          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).  








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          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  








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            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  








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            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)  








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            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.  
          








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             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  








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               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  








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            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.  








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          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