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 








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          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 |








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          |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  ).  









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          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 








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          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.