BILL ANALYSIS Ó
SENATE GOVERNANCE & FINANCE COMMITTEE
Senator Lois Wolk, Chair
BILL NO: AB 1423 HEARING: 7/6/11
AUTHOR: Perea FISCAL: Yes
VERSION: 6/16/11 TAX LEVY: No
CONSULTANT: Grinnell
INCOME TAXES: FEDERAL CONFORMITY: REGULATED INVESTMENT
COMPANY MODERNIZATION ACT OF 2010 (URGENCY)
Conforms state law to the Regulated Investment Company
Modernization Act of 2010.
Background and Proposed Law
Under federal and state law, mutual funds pass through
gains and losses on its investments to the individuals
owning its shares, instead of paying tax on its earnings,
so long as they meet the definition and requirements for
Regulated Investment Companies (RICs) set forth under
Subchapter M of the Internal Revenue Code. Generally, as
long as a RIC pays out 90% of its earnings in dividends to
its shareholders, the RIC deducts all the dividends it pays
to its shareholders from its taxable income. Shareholding
taxpayers report the distributed income on their own
personal income tax returns, and retain the character of
the income, such as tax-exempt interest or long or
short-term capital gains. Whenever a fund fails to comply
with Subchapter M, federal and state law applies the
corporate income tax to the fund, and its shareholders must
include RIC earnings distributions as ordinary income,
which federal law taxes at a higher rate than capital gains
income. California taxes all income at the same rate.
In December, 2010, Congress enacted the RIC Modernization
Act of 2010 (RIC Act), which comprehensively recast and
restructured tax laws guiding mutual funds. California
generally conforms its tax law to federal changes, most
recently with SB 401 (Wolk, 2010.)
Assembly Bill 1423 conforms state law to the RIC Act by
conforming state law to the following federal changes:
I. Capital Loss Carryovers. Previously, RICs could only
AB 1423 - 6/16/11 - Page 2
carry over capital losses for eight taxable years after the
year the loss is incurred. The RIC Act allowed RICs to
carry over losses indefinitely, mirroring carryover
treatment allowed for personal income taxpayers. The RIC
Act also changed the treatment of the loss to reflect its
character (short-term or long-term) instead of always being
classified as short term. Additionally, the RIC Act
required taxpayers to first use losses incurred after the
RIC Act's enactment before they could use losses from
taxable years prior to enactment.
II. Asset and gross income tests. To ensure its
classification as a RIC, the mutual fund must pass an asset
test at the end of each quarter of the taxable year, and at
the end of the year. If the RIC doesn't meet the tests,
they have 30 days to remedy the violation or lose its
classification. The tests have different criteria:
For the quarterly test, a mutual fund must hold at
least 50% of its assets in cash, cash items,
government securities, securities of other RICs, and
other securities, so long as the share of one issuer's
securities doesn't exceed 50% of the RIC's total
assets, and the RIC doesn't hold more than 10% of any
one issuer's outstanding voting securities.
For the annual test, not more than 25% of the RIC's
total value can be in invested in any one issuer's
securities, or the securities of two or more issuers
that are engaged in a similar trade or business and
under control of the RIC.
The RIC Act instead allows for de minimis asset test
failures when the assets owned that violate the test don't
exceed the lesser of 1% of RIC's total assets or $10
million. When a RIC falls within the de minimis failure,
it has six months to dispose of the assets which triggered
the test failure. Additionally, when the RIC fails the
test outside of the de minimis range, the RIC can cure the
failure if:
The RIC describes each asset which caused the
failure in a schedule filed with the Secretary of the
Treasury.
The failure is due to reasonable cause, not willful
neglect.
The RIC disposes of the assets that triggered the
AB 1423 - 6/16/11 - Page 3
failure and complies with the test within six months
after the last day of the quarter in which it failed
the test.
Pays a tax on the income that resulted from the
failure.
RICs must also derive 90% of its gross income from
qualifying income. The RIC Act allows the RIC to cure the
failure if:
The RIC describes each item of income in a schedule
filed with the Secretary of the Treasury.
The failure is due to reasonable cause, not willful
neglect.
Pays a tax on the income that resulted from the
failure.
III. Capital Gains Treatment. RICs may classify dividends
as capital gains dividends when the amount paid does not
exceed the RIC's net capital gain. RICs can also designate
dividends as tax-exempt interest dividends when at least
half of its assets are tax-exempt municipal bonds, except
when the dividends exceed the total amount of tax-exempt
interest the RIC received. RICs can also pass through to
shareholders foreign tax credits, credits for tax-exempt
bonds, and specified dividends.
The RIC Act allows a different treatment when dividends
paid exceed net income in the taxable year for RICs that
have taxable years over more than one calendar year. The
RIC Act allows RICs to allocate net income to the
post-December portion of the taxable year.
RICs must notify its shareholders in a written notice
within 60 days of the close of its taxable year of any of
the above classifications or events. The RIC Act allows
RICs to satisfy the above requirement by reporting the
information to its shareholders with a form 1099.
IV. Earnings and Profits. Previously, RICs could not use
deductions associated with tax-exempt securities to reduce
current earnings and profits, which resulted in taxable
dividends to shareholders for income that was not
economically a return of capital. The RIC Act allows
deducts associated with tax-exempt income and net capital
losses against current earnings and profits.
AB 1423 - 6/16/11 - Page 4
V. Pass Through of Exempt-Interest Dividends and Foreign
Tax Credits. Some RICs holds stock in other RICs.
Previously, when one RIC pays a dividend to another, the
character of the income stays the same on the way to the
shareholder. One exception is for exempt-interest
dividends which can only be passed through when 50% of its
total assets consist of tax-exempt securities, and foreign
tax credits which can only be passed through when 50% or
more of the RICs holdings are stock or securities in
foreign corporations. RICs with more than 50% of its
assets invested in stock of other RICs cannot pass through
these benefits because of those tests. The RIC Act allows
these benefits to be passed through when 50% of its assets
invested in stock of other RICs.
VI. Spillover Dividends. RICs can choose to have some
dividends paid after the close of the taxable year included
in the taxable year to comply with the 90% distribution
requirement and to determine taxable income, known as
"spillover dividends." To qualify, the RIC must declare
the spillover dividend before they file their tax return,
and distribute it to shareholders after the close of the
taxable year but before the next dividend payment. The RIC
Act moves the declaration deadline back to the later of the
15th day of the 9th month following the close of the
taxable year or the extended due date for filing the
return, and the distribution deadline back to the date of
the next dividend payment after the declaration for that
kind of dividend.
VII. Return of Capital Distributions. RICs must
distribute dividends during the year in which they generate
the net income, or else the distribution is deemed a return
to capital, which adjusts the taxpayer's basis in the RIC
stock and must be allocated proportionally among all
distributions made during the year. The RIC Act requires
RICs that distribute more than they make in net income to
allocate earnings and profits first to distributions made
before January.
VIII. Share Redemption. Previous law did not clearly
classify as an exchange the redemption of some, but not
all, shares in open-ended RICs; when an investor sells
stock in a RIC, he or she is selling it back to the RIC,
not another investor. The RIC act makes the clarification.
Additionally, for a RIC that owns shares in another RIC
when both are in the same controlled group of corporations,
AB 1423 - 6/16/11 - Page 5
the loss must be deferred until the shares are sold to
someone outside the group. The RIC Act allows the capital
loss when redeeming stock in a RIC that issues stock
redeemable at any time, and a shareholding RIC demands
redemption.
IX. Preferential Dividends. Previous law disallows RIC
deductions that are "preferential," when the RIC pays
dividends to some shareholders in a class but not others,
or more quickly than others. The RIC Act repeals these
rules, defaulting to Securities and Exchange Act
enforcement.
X. Deferral of late-year losses. RICs pay capital gains
dividends to shareholders of 98% of its net capital gains
by December 31st each year, and must pay an excise tax of
4% of the difference between the dividends that were paid
and the dividends that should have been paid if they don't.
The RIC pays the dividends based on its net capital gains
from the previous year ending on October 31st. However,
RICs with a taxable year ending on June 30th can lose money
between October 1st and the end of the taxable year,
changing the dividends into returns on capital. Previous
law required RICs to push forward the losses to the next
taxable year, but applied unevenly and made basis tracking
difficult. The RIC Act allows RICs to "push forward" some
or all of these losses to the first day of the next taxable
year, instead of requiring them to do so.
XI. Claiming losses. Previously, investors paid
exempt-interest dividends had to hold stock in the RIC for
six months to be able to claim a loss, if one occurs. The
RIC Act deleted the rule.
XII. Sales Load Basis Deferral Rule. When brokers sell
mutual fund shares, the RIC may charge a load charge to
compensate the brokers. Investors may pay reduced load
charges when acquiring rights to sell the initial stock and
reinvest in a different stock offered by the same RIC.
When investors pay reduced load charges to acquire
reinvestment rights then dispose of the stock within 90
days, the load charge was not used to determine loss or
gain on the initial stock purchased; instead, it was
treated as a cost for acquiring the stock pursuant to the
reinvestment right. The RMA Act limits the rule only to
those cases when the investor acquires the reinvested stock
AB 1423 - 6/16/11 - Page 6
on or before January 31st. `
State Revenue Impact
According to the Franchise Tax Board, AB 1423's provisions
have the following revenue effects:
---------------------------------------------------------------
|Provision | 2011-12 | 2012-13 | 2013-14 |
|---------------------------------+---------+---------+---------|
|Capital Loss Carryovers of | $0 |$250,000 |$450,000 |
|Regulated Investment Companies | | | |
|---------------------------------+---------+---------+---------|
|Savings Provisions for Failures |Negligibl|Negligibl|Negligibl|
|of Regulated Investment | e gain | e gain | e gain |
|Companies to Satisfy Gross | | | |
|Income and Asset Tests | | | |
|---------------------------------+---------+---------+---------|
|Modification of Dividend | -$1,000 | -$500 | -$500 |
|Designation Requirements and | | | |
|Allocation Rules for Regulated | | | |
|Investment Companies | | | |
|---------------------------------+---------+---------+---------|
|Earnings and Profits of | -$3,000 | -$2,000 | -$2,000 |
|Regulated Investment Companies | | | |
|---------------------------------+---------+---------+---------|
|Pass-Thru of Exempt-Interest |-$100,000|-$80,000 |-$70,000 |
|Dividends and Foreign Tax | | | |
|Credits in Fund of Funds | | | |
|Structure | | | |
|---------------------------------+---------+---------+---------|
|Modification of Rules for |Negligibl|Negligibl|Negligibl|
|Spillover Dividends of Regulated | e | e | e |
|Investment Companies | Loss | Loss | Loss |
|---------------------------------+---------+---------+---------|
|Return of Capital Distributions |Negligibl|Negligibl|Negligibl|
|of Regulated Investment | e | e | e |
|Companies | Gain | Gain | Gain |
AB 1423 - 6/16/11 - Page 7
|---------------------------------+---------+---------+---------|
|Distributions in Redemption of |-$450,000|-$350,000|-$350,000|
|Stock of a Regulated Investment | | | |
|Company | | | |
|---------------------------------+---------+---------+---------|
|Repeal of Preferential Dividend |Negligibl|Negligibl|Negligibl|
|Rule for Publicly Offered | e | e | e |
|Regulated Investment Companies | Loss | Loss | Loss |
|---------------------------------+---------+---------+---------|
|Elective Deferral of Certain | -$1,000 | -$1,000 | -$1,000 |
|Late-Year Losses of Regulated | | | |
|Investment Companies | | | |
|---------------------------------+---------+---------+---------|
|Exception to Holding Period |Negligibl|Negligibl|Negligibl|
|Requirement for Certain | e | e | e |
|Regularly Declared | Loss | Loss | Loss |
|Exempt-Interest Dividends | | | |
|---------------------------------+---------+---------+---------|
|Capital Loss Carryovers of | N/A | N/A | N/A |
|Regulated Investment Companies | | | |
|---------------------------------+---------+---------+---------|
|Modification of Sales Load Basis |-$370,000|-$200,000|-$100,000|
|Deferral Rule for Regulated | | | |
|Investment Companies | | | |
|---------------------------------+---------+---------+---------|
| Totals: |-$925,000|-$383,500|-$73,500 |
| | | | |
---------------------------------------------------------------
Comments
1. Purpose of the bill . According to the Author, "The
purpose of AB 1423 is to conform California's tax laws
governing mutual fund companies to the provisions of the
federal Regulated Investment Company Modernization Act
enacted on December 22, 2010. This bill does not change
any tax rates, but rather incorporates federal changes that
update numerous tax-related provisions that have been
determined to be obsolete, unworkable, inefficient or
disproportionate. These changes will create operational
efficiencies for California-based mutual funds and will
benefit their shareholders by, among other things, ensuring
that the shareholders will receive the same tax treatment
under both federal and California laws. The vast majority
AB 1423 - 6/16/11 - Page 8
of other states automatically conform their tax laws to
federal changes relating to mutual fund taxation.
California requires specific conformity legislation and has
historically passed such legislation to achieve conformity
in this area. If California does not conform in 2011 to
the federal changes, many California-based mutual funds
will be subject to different (and, in some cases, possibly
inconsistent) federal and California tax requirements. The
inconsistency may lead to significant, and, in some
instances, insurmountable, operational problems and costs
for the affected mutual funds and to widespread confusion
among shareholders about the manner in which they are taxed
on distributions received from the mutual funds. It will
also put California-based mutual funds at a competitive
disadvantage vis-à-vis their peers located in other
states."
2. Rikki don't lose that number . Before the RIC Act, RICs
that fell out of compliance with Subchapter M requirements
were subject to a severe penalty: loss of its dividends
paid deduction, and application of federal and state
corporate income taxes to its earnings. Simple
mathematical mistakes could result in severe consequences:
a mutual fund that faced no entity level tax would be hit
with a combined rate up to 43.84% of its income, and its
shareholders would no longer pay preferential rates on
earnings from dividends, a significant hit at the federal
level. AB 1423 conforms to the RIC Act's changes, making
compliance easier for RICs, and in many cases preventing
shareholders from having to file amended returns when the
character of income changes because of the previous rules.
Conforming California law would provide safe harbor for
some mistakes, and ensure that mutual funds in the state
wouldn't have to play by two different sets of rules.
3. Fitting in . California does not automatically conform
to changes in federal law, except under specified
circumstances. Instead, the Legislature must affirmatively
conform to federal changes. Conformity legislation is
introduced either as individual tax bills to conform to
specific federal changes or as one omnibus bill to conform
to the federal law as of a certain date with specified
exceptions. State tax law did not conform to changes made
in federal law after 2005 until last year, when the
Legislature enacted a bill conforming to changes through
January 1, 2009 (SB 401, Wolk). Conformity is difficult
AB 1423 - 6/16/11 - Page 9
despite its advantages and reduced tax compliance costs,
because the state may disagree with Congress's tax policy
changes, and conformity can also significantly impact state
revenues. AB 1423 only conforms to one specific federal
act, and the Committee will also hear AB 242 (Perea) at its
July 6th hearing, which conforms state law to change made
last year as part of health care reform efforts.
4. Urgency . AB 1423 would take effect immediately as an
urgency statute.
5. Technical amendments needed . FTB and Committee Staff
recommend the following technical amendments:
On page 3, line 22, strikeout "Law 111-325) shall
apply", and insert: "Law 111-325), shall apply"
On page 3, line 38, strikeout "the general rule",
and insert: "general rule"
On page 6, line 37, on page 7, line 9, on page 8,
line 11, and on page 8, line 23, after
"distributions", strikeout "made."
Assembly Actions
Not relevant to the June 16th, 2011 version of the bill.
Support and Opposition (6/30/11)
Support : Association of California Life and Health
Insurance Companies, Pacific Life, California Taxpayers'
Association, Investment Company Institute, Securities
Industry and Financial Markets Association, Franklin
Templeton Investments, California Chamber of Commerce,
Fireman's Fund Insurance Company, Spidell Publishing,
Pacific Investment Management Company, BlackRock, Capital
Group Companies, Dodge and Cox Funds, California Retailers
Association, California Bankers Association, Charles
Schwab, California Society of Enrolled Agents.
Opposition : Unknown.