BILL ANALYSIS                                                                                                                                                                                                    Ó



                                                                AB 1423
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        CONCURRENCE IN SENATE AMENDMENTS
        AB 1423 (Perea)
        As Amended  July 12, 2011
        2/3 vote.  Urgency
         
         
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        |ASSEMBLY: |     |(May 16, 2011)  |SENATE: |38-0 |(August 31, 2011)    |
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                                  (vote not relevant)


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        |COMMITTEE VOTE:  |7-0  |(September 8, 2011) |RECOMMENDATION: |Concur    |
        |                 |     |                    |                |          |
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        Original Committee Reference:    REV. & TAX.  

         SUMMARY  :  Conforms several provisions of state income tax law to 
        the federal Regulated Investment Company (RIC) Modernization Act of 
        2010. 
         
        The Senate amendments  delete the Assembly version of this bill and, 
        instead, in conformity with the federal RIC Modernization Act of 
        2010:

        1)Revise the California income tax laws to treat RICs similarly to 
          individuals with regard to capital loss carryover, thus, allowing 
          RICs to carry over capital losses for an unlimited number of 
          years.  

         2)Allow a RIC, upon identifying a de minimis asset test failure, as 
          defined, at the end of the quarter, to maintain its status as a 
          RIC, provided that, within six months, the RIC fulfills the 
          requirements of the asset test, as prescribed.  Allow a RIC, 
          which fails either the "gross income" test or the "asset test" 
          (outside of the de minimis range), to cure the failure by paying 
          tax and satisfying certain specified requirements. 
         
         3)Replace the requirement to designate distributions as certain 
          types of income with a requirement for RICs to report, in a 
          written statement furnished to shareholders, the designations of 
          capital gain dividends and other pass-through items.  Allow RICs 
          to satisfy the reporting requirement by issuing to shareholders 








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          Form 1099.  
         
         4)Allow a capital loss carryover of a RIC to be taken into account 
          in determining the RIC's current and accumulated earnings and 
          profits.  Provide that deductions associated with tax-exempt 
          interest income of a RIC may be taken into account in computing 
          current earnings and profits, thus allowing dividend 
          distributions to shareholders in excess of tax-exempt interest to 
          be treated as a return of capital gain rather than ordinary 
          taxable dividends.  

         5)Allow RICs with 50% or more of the value of its total assets 
          invested in other RICs to pass through exempt-interest dividends 
          and foreign tax credits to shareholders, as specified.  

         6)Authorize a RIC to declare a "spillover dividend," as defined, by 
          the 15th day of the 9th month following the close of the taxable 
          year to which the spillover dividend relates, or the extended due 
          date for filing the RIC's tax return, whichever is later.  
          Require spillover dividends, once declared, to be paid by the 
          date of the next dividend payment of the same type, but no later 
          than 12 months after the end of the tax year to which the 
          spillover dividend relates.  

         7)Specify that, if a RIC distributes dividends in a taxable year 
          that, in the aggregate, exceed the RIC's current and accumulated 
          earnings and profits, the current earnings and profits are 
          allocated first to distributions made prior to January 1st.  
         
        8)Treat the redemption of a publicly offered RIC stock as an 
          exchange, rather than a distribution of property, for tax 
          purposes, if the redemption is upon the demand of the shareholder 
          and the RIC issues only stock that is redeemable upon the 
          shareholder demand.  Specifies that a "publicly offered RIC" is a 
          RIC that offers its shares publicly, trades on an established 
          securities market, or has at least 500 persons holding shares at 
          all times. 

        9)Provide that a publicly offered RIC, as defined, is not required 
          to follow the "preferential dividend" rule, as specified.
         
         10)Authorize a RIC to choose whether or not to postpone 
          post-October capital losses and qualified late-year ordinary 
          losses to the first day of the next taxable year.  









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         11)Allow a RIC shareholder to claim a loss on the sale or exchange 
          of the stock held for six months or less, to the extent of the 
          amount of the exempt-interest dividend, if certain requirements 
          are satisfied.  
         
        12)Limit the application of the Sales Load Basis Deferral rule only 
          to those cases where a RIC shareholder disposes of the RIC stock 
          within 90 days of the acquisition but subsequently acquires RIC 
          stock in the same fund family without incurring a new sales load, 
          pursuant to the shareholder's reinvestment rights, before January 
          31 of the calendar year following the year of the disposal of the 
          original stock.
         
         13)Add the urgency clause. 

         AS PASSED BY THE ASSEMBLY  , this bill deleted obsolete provisions of 
        the Sales and Use Tax (SUT) Law, and made technical amendments to 
        existing SUT exemption provisions as a matter of code maintenance.  


         FISCAL EFFECT  :  The Franchise Tax Board estimates that this bill 
        will result in an annual General Fund revenue loss of $925,000 in 
        fiscal year (FY) 2011-2012, $383,500 in FY 2012-2013, and $73,500 
        in FY 2013-2014, followed by revenue gains from FY 2014-15 until FY 
        2017-18. 

         COMMENTS  :  

         The Author's Statement  .   The author states that, "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 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 








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        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."

         Arguments in Support  .  The proponents of this bill argue that AB 
        1423 "is crucial to the continual competitiveness of California's 
        mutual fund industry" and that, without conformity to the RIC 
        Modernization Act, California-based companies would "face severe 
        sanctions if they were to fail to meet both California and federal 
        law" and would be "put at a serious competitive disadvantage" as 
        compared to funds based elsewhere in the country.  The proponents 
        believe that this competitive disadvantage will result in less 
        investment in California-based mutual funds, "meaning fewer jobs, 
        income, and profits." Currently, "California management companies 
        pay approximately $300 million per year to California and any loss 
        of market share could translate into a significant decrease in tax 
        revenue to California."

        The proponents also contend that the "burdens of nonconformity 
        would fall not only on mutual funds, but also on their investors 
        and the Franchise Tax Board."  Non-conformity will result in delays 
        and additional revisions to 1099 forms, requiring individual 
        investors to file several amended tax returns, at additional costs 
        to taxpayers and the FTB.  Furthermore, of "even greater 
        consequence is the threat that investors would elect to move their 
        investments to an out-of-state fund to avoid having to keep a 
        different set of books to track the highly-technical differences 
        for their California return and avoid any confusion and increased 
        tax preparation costs that would go along with it."  Finally, the 
        proponents state that the "mutual fund industry is extremely 
        important to the California economy and represents an important 
        source of investment in California's state and local bonds."

         How Important Is Conformity to Federal Tax Law?   When changes are 
        made to the federal income tax law, California generally does not 
        automatically adopt such provisions.  Instead, state legislation is 
        needed to conform to most of those 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, a so-called 








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        "conformity" bill.  

        The last California-federal conformity bill was enacted in 2010 ÝSB 
        401 (Wolk), Chapter 14, Statutes of 2010].  Generally, businesses, 
        tax practitioners and state tax agencies advocate to conform state 
        tax laws to ever-changing federal tax laws.  Businesses prefer 
        conformity to federal tax laws because it reduces their state tax 
        compliance costs.  The tax practitioners argue that failure to 
        conform to federal law in some areas may lead to improper tax 
        reporting to California and extra costs to the taxpayers.  Finally, 
        conformity legislation is also important to state agencies.  It 
        eases the burden, and reduces the costs, of tax administration 
        because the state may rely on federal audits, federal case law, and 
        regulations.   

        While state conformity to federal income tax provisions offers 
        certain advantages and reduces tax compliance costs, it can also 
        significantly impact state revenues.  Thus, it would be difficult 
        to achieve complete conformity with federal income tax rules.  
        Often, the Legislature needs to increase tax rates to find funding 
        for a new or expanded existing credit or deduction allowed for 
        federal income tax purposes.  Tax credits, deductions, and 
        exemptions are designed to provide incentives for taxpayers that 
        incur certain expenses or to influence behavior, including business 
        practices and decisions.  Both the Federal and state governments 
        often use tax policy to influence taxpayers' behavior.  However, 
        federal tax incentives may not necessarily produce the same effect 
        on the taxpayer's behavior at the state level, if adopted by the 
        state government, as they do on the federal level.  Furthermore, 
        unlike the Federal government, California cannot print money to 
        subsidize its budget.  Therefore, the Legislature must be mindful 
        of fiscal effects of conforming to federal tax laws, even if those 
        may not trigger significant fiscal concerns in Congress. 

         The RIC Modernization Act of 2010:  Background  .  On December 22, 
        2010, President Obama signed into law the RIC Modernization Act of 
        2010 (P.L. 111-325) (Act), which revised Subchapter M of the 
        Internal Revenue Code (IRC) governing the taxation of RICs and 
        their shareholders.  In general, a RIC is an electing domestic 
        corporation that either meets or is excepted from certain 
        registration requirements under the Investment Company Act of 1940, 
        that derives at least 90% of its ordinary income from specified 
        sources considered passive investment income, has a portfolio of 
        investments that meet certain diversification requirements, and 
        satisfies certain other conditions. 








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        Corporations or entities treated as such for tax purposes are 
        subject to many of the regular rules of corporate tax, both on 
        federal and state level.  However, RICs, most of which are more 
        commonly known as mutual funds, qualify for a special tax treatment 
        under Subchapter M of the IRC and specified provisions of the 
        Revenue and Taxation Code.  The Subchapter M prescribes the rules 
        that a corporate entity must satisfy in order to qualify as a RIC 
        for the taxable year and provides a special tax treatment for a 
        qualified RIC and its shareholders. Specifically, a RIC that 
        distributes at least 90% of its net ordinary income and net 
        tax-exempt interest to the shareholders may deduct the dividend 
        amount in computing its tax.  While no corporate income tax is 
        imposed on RIC's income distributed to the shareholders, the 
        dividends are generally included in the income of the shareholders, 
        and thus, the shareholders must report the distributions on their 
        own personal income tax returns.  Those distributions may be 
        characterized as long-term or short-term capital gains or 
        tax-exempt interest and this characterization depends on the type 
        of income distributed by the RIC.  The RIC may pass through to its 
        shareholders the character of its long-term capital gain income by 
        paying "capital gain dividend" and tax-exempt interest by paying 
        "exempt-interest dividends."  A RIC may also pass-through foreign 
        tax credits and credits on tax-credit bonds, as well as certain 
        other income received by the RIC.  If a RIC fails to comply with 
        the provisions of Subchapter M, it may be subject to the federal 
        and state corporate income taxes.  In addition, its distributions 
        to the shareholders will be characterized as "ordinary income" 
        instead of "capital gain" or "tax-exempt interest," and thus will 
        result in a greater amount of tax payable to the federal and state 
        governments. 

        The Act has not affected the fundamentals of the tax treatment 
        afforded to RICs and their shareholders; instead, it updated the 
        applicable tax rules, which were originally enacted in 1936, to 
        alleviate the unnecessary tax compliance burdens and to reflect the 
        realities of the modern economy.  The Act revised certain 
        provisions of the federal tax law that affect a RIC's 
        characterization as a RIC and the manner in which a RIC's 
        shareholders are taxed on the distributions received from the RIC 
        and gains that may be realized when the shareholders dispose of RIC 
        shares.  


        Analysis Prepared by  :    Oksana G. Jaffe / REV. & TAX. / (916) 








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        319-2098 
        FN: 0002833