BILL ANALYSIS                                                                                                                                                                                                    



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        SENATE THIRD READING
        SB 401 (Wolk)
        As Amended  August 31 2009
        Majority vote. 

         SENATE VOTE  :22-15  
         
         REVENUE & TAXATION  6-2         APPROPRIATIONS      12-5        
         
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        |Ayes:|Charles Calderon, Beall,  |Ayes:|De Leon, Ammiano,         |
        |     |Coto, Ma, Portantino,     |     |Charles Calderon, Coto,   |
        |     |Saldana                   |     |Davis,                    |
        |     |                          |     |Fuentes, Hall, John A.    |
        |     |                          |     |Perez,                    |
        |     |                          |     |Skinner, Solorio,         |
        |     |                          |     |Torlakson, Hill           |
        |     |                          |     |                          |
        |-----+--------------------------+-----+--------------------------|
        |Nays:|Harkey, Hagman            |Nays:|Conway, Harkey, Miller,   |
        |     |                          |     |Nielsen,                  |
        |     |                          |     |Audra Strickland          |
        |     |                          |     |                          |
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         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, 









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           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.  Requires that  
          the transactions of interest be identified and published on the  
          FTB's Web site. 

        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  








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          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 a limited liability company  
          or an S corporation shall not by itself be "abusive" solely  
          because of the choice of entity.

        10)Contains double-jointing language to avoid chaptering out  
          problems with AB 1580 (Revenue and Taxation Committee), pending in  
          the Senate.

         FISCAL EFFECT  :  

        The FTB staff estimates that this bill will result in a gain of $6.4  
        million in fiscal year (FY) 2009-10 and $0.1 million in FY 2010-11,  
        and about $12 million annually in subsequent years.  

         COMMENTS  :  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:  1) a tax  
        shelter; 2) an undisclosed reportable transaction; 3) a listed  
        transaction; 4) a gross misstatement; or, 5) 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 impose 50% of the penalty.  

        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.   








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        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.

        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.   

        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 Internal Revenue Service (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.  

        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:  1)  
        little or no motive of realization of economic gain; 2) intentional  
        mismatching of income and deductions; 3) overvalued assets or assets  
        with values subject to substantial uncertainty are included; 4)  
        non-recourse financing and financing techniques that do not conform  
        to standard commercial business practices; or, 5)  
        mischaracterization of the substance of the transaction.  









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        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 1) 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, 2) 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.  
        
        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.  
        
        1)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. 

        2)Inflated Partnership Basis Transaction.  These schemes use  
          transactions that are "contingent" (not completed) to inflate an  








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          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).

        3)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.

        4)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 gain.  

        5)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.

        6)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  








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          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.  

        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.

        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 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.  

        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  








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        amended return for any taxable year the taxpayer participates in the  
        transaction. 

        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). 

        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.  

        Related legislation.  The provisions of this bill were included in  
        the package adopted by the Conference Committee on the Budget and  
        included in SB 75 (Senate Budget and Fiscal Review) and AB 75  
        (Assembly Budget).  The provisions were not, however, included in  
        the final budget package.


         Analysis Prepared by  :  Oksana Jaffe / REV. & TAX. / (916) 319-2098    
                                         


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