BILL ANALYSIS Ó Senate Appropriations Committee Fiscal Summary Senator Christine Kehoe, Chair AB 1423 (Perea) Hearing Date: 08/25/2011 Amended: 07/12/2011 Consultant: Mark McKenzie Policy Vote: G&F 9-0 _________________________________________________________________ ____ BILL SUMMARY: AB 1423, an urgency bill, would conform state laws to recent federal changes that affect the tax treatment of regulated investment companies, which are mutual funds and other similar investment companies. _________________________________________________________________ ____ Fiscal Impact (in thousands) Major Provisions 2011-12 2012-13 2013-14 Fund Net revenue impacts $925 $384 $74 General* (see chart below for a full breakdown of estimated revenue impacts) ____________ * FTB estimates revenue gains of $36,500 in 2014-15 and $156,500 in 2015-16, with additional gains through 2017-18. There would be ongoing revenue losses of approximately $8 million in 2018-19, declining to $1 million to $2 million annually over five to seven years (see staff comments). _________________________________________________________________ ____ STAFF COMMENTS: SUSPENSE FILE. 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 AB 1423 (Perea) Page 1 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 (Public Law 111-325), which comprehensively recast and restructured tax laws guiding mutual funds. AB 1423 would conform California law to the following changes in the RIC Act: Capital loss carryovers (Section 101 of RIC Act) Savings provisions related to failure of RIC to satisfy gross income and asset tests (Section 201, conform with modifications) Modification of dividend designation requirements and allocation rules (Section 301) Earnings and profits (Section 302) Pass-through of exempt-interest dividends and foreign tax credits in fund of funds structure (Section 303) Modification of rules for spillover dividends (Section 304) Return of capital distributions (Section 305) Distributions in redemption of stock (Section 306) Repeal of preferential dividend rule (Section 307) Elective deferral of specified late-year losses (Section 308) Exception to holding period requirement for certain exempt-interest dividends (Section 309) Modification of sales load basis deferral rule (Section 502) FTB estimates the following fiscal impact of each provision: --------------------------------------------------------------- |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 | AB 1423 (Perea) Page 2 |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 | |---------------------------------+---------+---------+---------| |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 | | | | |---------------------------------+---------+---------+---------| |Modification of Sales Load Basis |-$370,000|-$200,000|-$100,000| |Deferral Rule for Regulated | | | | |Investment Companies | | | | |---------------------------------+---------+---------+---------| | Totals: |-$925,000|-$383,500|-$73,500 | | | | | | --------------------------------------------------------------- Staff notes that the Franchise Tax Board's (FTB) report titled "Summary of Federal Income Tax changes - 2010" includes a detailed discussion of the federal and state tax laws affected by this bill ( http://www.ftb.ca.gov/law/legis/10FedTax.pdf ). AB 1423 (Perea) Page 3 Generally, when changes are made to federal tax laws, state legislation is needed to conform to those federal changes. The purpose of conformity is to simplify both the preparation of California income tax returns and the administration of state income tax laws. Current state law provides modified conformity to the Internal Revenue Code as of January 1, 2009 for federal laws enacted after January 1, 2005 and before January 1, 2009 ÝSB 401 (Wolk), Chapter 14 of 2010]. Staff notes that the administrative benefits to the state and taxpayers as a result of conformity must be weighed against the General Fund impacts. Prior to the passage of Proposition 26 in November of 2010, conformity legislation usually contained numerous provisions to update state tax laws with federal changes that had been enacted since the previous state omnibus tax conformity bill. While individual provisions may have had a positive or negative revenue impact, the bills were generally designed to be net revenue neutral overall so that they could be passed on a majority vote. Proposition 26 requires that any bill that imposes increased taxes on any taxpayer requires passage by a two-thirds vote of both houses of the Legislature. With the political difficulties associated with achieving a two-thirds vote on a bill that includes tax increases, it is likely that most, if not all conformity bills introduced after the passage of Proposition 26 will be subject-specific and result in net tax revenue losses. It will be much more difficult to include any tax conformity provisions that result in revenue gains, which is likely to complicate the state tax code for both taxpayers and the FTB as state tax laws diverge from federal laws in future years. Staff notes that the bill would result in a three-year revenue loss, followed by four years of revenue gains, and more significant revenue losses of approximately $8 million beginning in 2018-19, which would eventually drop to $1 million to $2 million per year. These out-year revenue losses are a result of the provisions that change the carry over rules for RIC losses. Under current law, RIC losses may be carried over for up to 8 years. Under the RIC Act, however, RIC losses may be carried over indefinitely, which is similar to net capital loss carryovers applicable to individual taxpayers. For losses realized in 2011, the new law would not affect carryover loss claims until 2019, when the current eight year window would expire. Since the losses no longer expire under current federal AB 1423 (Perea) Page 4 law, conformity to this provision would allow RICs to use remaining losses to offset capital gains income and reduce tax liabilities beginning in 2019. As shares are redeemed, the revenue losses would be partially mitigated Numerous mutual fund companies have operations in California; there are over 1,150 California-based mutual fund companies, accounting for over one quarter of the $14.5 trillion in assets under management by U.S.-based mutual fund companies. The impacts of non-conformity would impose a clear and costly disadvantage on those companies, as most other states automatically conform to the RIC Act. For example, California-based companies would be subject to different rules related to the calculation of RIC-level income, shareholder distributions and the tax treatment of those distributions, and the timing and character of shareholder gains and losses on the disposition of RIC shares. Additional costs for RICs to maintain segregated accounting systems could impact profit margins and investment returns. Non-conformity would also impact California taxpayers who are RIC investors. While FTB does not calculate the costs of non-conformity, the independent taxpayers' rights advocate indicates that a lack of conformity to federal tax laws leads to low taxpayer self-compliance and greater costs of administering and enforcing income tax laws. Staff notes that, absent the bill, FTB would likely experience a higher volume of amended returns. The magnitude of state impacts as a result of non-conformity are unknown.