BILL ANALYSIS Ó AB 1423 Page 1 CONCURRENCE IN SENATE AMENDMENTS AB 1423 (Perea) As Amended July 12, 2011 2/3 vote. Urgency ---------------------------------------------------------------------- |ASSEMBLY: | |(May 16, 2011) |SENATE: |38-0 |(August 31, 2011) | ---------------------------------------------------------------------- (vote not relevant) ------------------------------------------------------------------------ |COMMITTEE VOTE: |7-0 |(September 8, 2011) |RECOMMENDATION: |Concur | | | | | | | ------------------------------------------------------------------------ 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 AB 1423 Page 2 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. AB 1423 Page 3 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 AB 1423 Page 4 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 AB 1423 Page 5 "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. AB 1423 Page 6 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) AB 1423 Page 7 319-2098 FN: 0002833