BILL ANALYSIS Ó
AB 2490
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Date of Hearing: May 9, 2016
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Sebastian Ridley-Thomas, Chair
AB 2490
(Gatto) - As Amended April 26, 2016
Majority vote. Tax levy. Fiscal committee.
SUBJECT: Corporation Tax Law: exemption: regulated investment
company
SUMMARY: Exempts from the Corporation Tax (CT) a regulated
investment company (RIC) that is a mutual fund investment
management company owned by investors in the mutual fund that it
serves. Specifically, this bill:
1)Provides that, notwithstanding any other law, a RIC, as
defined in Internal Revenue Code (IRC) Section 851, is exempt
from the CT if the RIC meets both of the following
requirements:
a) Is a mutual fund investment management company; and,
b) Is owned by investors in the mutual funds that it
serves.
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2)Specifies that the exemption does not apply with respect to
the RIC's unrelated business income, if any, as provided for
in Revenue and Taxation Code (R&TC) Section 23731 et seq.
3)Authorizes the Franchise Tax Board (FTB) to promulgate
regulations as necessary or appropriate, as specified.
4)Takes immediate effect as a tax levy.
EXISTING FEDERAL LAW allows a RIC to elect a special tax regime
under IRC Section 851, as long as all of the applicable
requirements are met.
EXISTING STATE LAW:
1)Conforms generally to the federal treatment of RICs.
2)Imposes tax on the unrelated trade or business income of a
tax-exempt organization that regularly carries on a trade or
business not substantially related to its exempt purpose.
FISCAL EFFECT: The FTB states that providing a revenue estimate
would violate the FTB's taxpayer confidentiality rules because
this bill would impact less than three taxpayers.
COMMENTS:
1)The Author's statement : The author has provided the
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following statement in support of this bill:
At this time, the federal government (I.R.S.) is still
considering the arguments both for and against Vanguard.
And, while a New York judge dismissed the case against the
mutual fund company, it settled with Texas by paying $2.3
million, a $117,000 paycheck for the whistleblower.
Unfortunately, California may be following in Texas's
footsteps. In November, the Franchise Tax Board notified
the whistleblower that his complaint against Vanguard
warranted assigning criminal investigators, and that the
mutual fund company may be on the hook for approximately
$750 million. While legislation at the state level will not
alleviate Vanguard of a potential tax liability at the
federal level, explicit acknowledgment of its non-profit
activities and an exemption from state tax law will protect
this business model and help maintain low investor fees.
It is important to protect this model of investing because
it currently provides a great savings opportunity for about
20 million Americans. This would not only have an impact on
the company, but more importantly, for those seniors or
Americans who have invested their retirement in Vanguard,
there is the potential of an expensive unplanned shock. If
the lawsuit were to be successful, these customers would
suffer fee raises to cover the newly imposed taxes.
2)Committee staff comments :
a) Federal and state tax treatment of RICs : In general, a
RIC is an electing domestic corporation that either meets,
or is exempt 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
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investments that meet certain diversification requirements,
and satisfies certain other conditions. Corporations or
entities treated as such for tax purposes are subject to
many of the regular rules of corporate tax, both on the
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 R&TC.
Subchapter M prescribes the rules that a corporate entity
must satisfy to qualify as a RIC for the taxable year and
provides 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 shareholders may deduct the dividend amount in
computing its tax. While no corporate income tax is
imposed on a RIC's income distributed to 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 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.
On December 22, 2010, President Obama signed into law the RIC
Modernization Act of 2010 (P.L. 111-325) (Act), which
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revised Subchapter M of the IRC governing the taxation of
RICs and their shareholders. 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
unnecessary tax compliance burdens and to reflect the
realities of the modern economy. The Act revised certain
provisions of the federal tax law affecting 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.
In 2011, the Legislature revised California's income tax
laws to conform to several provisions of the Act, including
provisions allowing for an unlimited carryover of net
capital losses, the modified "asset diversification" and
"qualifying income" tests, and revised dividend designation
requirements, among others. [AB 1423 (Perea), Chapter 490,
Statutes of 2011.]
b) Mutual funds and their operations : Simply stated,
mutual funds are companies that pool money from many
investors and invest these funds in securities such as
stocks, bonds and short-term debt. Mutual funds have
allowed millions of individual investors to participate in
the stock market. Mutual funds receive millions of dollars
from small investors, purchase stock or debt in several
companies, and attempt to produce capital gains and income
for the investors. In exchange for this service, managers
of the mutual funds charge fees, which include "shareholder
fees" and "expense ratios." To the extent these mutual
funds are qualified RICs meeting all of the applicable
requirements, they are not subject to either federal or
state income tax. The mutual fund manager, however, if
organized as a "C" corporation, is subject to both state
and federal taxes on the profits earned at the entity
level.
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c) The Vanguard structure : One of the largest mutual funds
in the country is the Vanguard Group, which is a
Pennsylvania corporation with its principal place of
business in Malvern, Pennsylvania. Vanguard's primary
business is providing investment management and other
services to a number of United States (U.S.) funds that are
treated as RICs under federal and state laws. Vanguard
provides brokerage services to fund investors through
Vanguard Marketing Corporation, a wholly owned subsidiary,
and it has more than $3 trillion in assets under
management.<1> Some attribute Vanguard's success and its
ability to charge lower costs than its competitors to its
structure, which is unique in the mutual fund industry.<2>
Most mutual funds are sold by an investment company, which is
created to make a profit for its shareholders. Vanguard's
founder, Jack Bogle, recognized an inherent conflict of
interest between the investment manager's duty to maximize
the returns for fund investors and the obligation to
increase profits for the investment company's shareholders.
As a result, Bogle established Vanguard as a "mutual
ownership" company, where the investment manager, Vanguard,
is owned by the funds in proportion to their net asset
value.<3> The funds sought and received an exemption from
the Securities and Exchange Commission to provide certain
non-investment advisory services to affiliated funds at "no
cost" and to have the affiliated funds own the Vanguard.
Since 1975, Vanguard has charged its domestic funds only
the "costs" of providing services, including investment
management and advisory services. The important fact is
that these costs include wages and other administrative
expenses but no profit or a return on capital. Vanguard is
the investment manager and advisor for all of its index
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<1> Expert Report of Prof. Reuven S. Avi-Yohan on the Estimated
Federal Tax Liability of the Vanguard Group, Inc., September 21,
2015, p. 2.
<2> Id., p. 3.
<3> Ibid.
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funds and most of its actively managed mutual funds. Thus,
the Vanguard Group is not an independent company: investors
in Vanguard mutual funds are the ultimate owners of the
Vanguard Group, which provides services to the individual
funds, and one board of directors oversees both.
Vanguard's overall fees are the lowest in the industry,
averaging expense ratios of only 0.16% annually (the
average is 1.16% for the industry). As a corollary to the
low fees, Vanguard shows little or no net income on its
federal and state tax returns because of the "at cost"
structure.
d) The Vanguard dilemma: Section 482 of the IRC : In 2015,
Vanguard found itself at the center of a curious
controversy and several whistleblower lawsuits claiming
that the company owes billions in unpaid federal and state
tax liabilities. A former tax counsel at Vanguard alleged
that because the Vanguard Group is organized as a "C"
corporation and is a for-profit entity, it should have paid
both federal and state taxes on the profits it never
charged, but should have charged, the fund investors. In
other words, the company is required to account for the
profits that it could have earned had it charged the fund
investors the industry-wide higher fees. If the
whistleblower claim is successful, Vanguard may owe
billions of dollars in taxes on uncollected revenue.<4>
To understand this argument, one must begin with IRC Section
482, which deals with "transfer pricing". This section was
enacted by Congress to prevent avoidance of taxes in the
case of transactions between affiliated or
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<4> The claim is that the estimated tax with interest and
penalties for the 2007-2014 period is approximately $34.6
billion. It is based on the assumption that Vanguard should
have charged its affiliated mutual funds on average a fee in a
range of 0.71% to 0.82%. Id., p.8
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commonly-controlled companies.<5> Transfer pricing
problems usually arise when two affiliated companies (which
are part of the same corporate group) enter into a
transaction at a certain price, with the purpose of
shifting income to minimize the group's overall tax
liability. Section 482 is intended to correct the
potential abuse of transfer pricing by requiring a
determination of the true taxable income of each taxpayer
in the transaction. The main standard to determine the
"true taxable income" of a controlled taxpayer is that of a
taxpayer dealing at arm's length with an uncontrolled
taxpayer. The standard is met if the results of the
controlled transaction are consistent with the results that
would have been realized if uncontrolled taxpayers had
engaged in the same transaction under the same
circumstances (arms' length result). The whistleblower
argued that Vanguard is bound by law to charge its funds,
which are affiliated companies, the prices (fees for its
management services) that would have been paid by unrelated
parties. He asserted that Vanguard is not a tax-exempt
organization and could never legally operate as such
because Vanguard's investment management activities do not
qualify as any of the exempt purposes under IRC Section
501(c)(3).<6>
Vanguard and its domestic subsidiaries are taxable
corporations under Subchapter C of the IRC. The Vanguard
Board of Directors is identical to the Trustees of the
funds, and the Board of Directors and Trustees manage
Vanguard and the funds with a common purpose. The funds
are RICs, and therefore are not taxable at the entity level
--------------------------
<5> "The purpose of section 482 is to ensure that taxpayers
clearly reflect income attributable to controlled transactions
and to prevent the avoidance of taxes with respect to such
transactions. Section 482 places a controlled taxpayer on a tax
parity with an uncontrolled taxpayer by determining the true
taxable income of the controlled taxpayer." Treas. Reg.
1.482-1(a)(1).
<6> Expert Report of Prof. Reuven S. Avi-Yohan on the
Estimated Federal Tax Liability of the Vanguard Group, Inc.,
September 21, 2015, p. 4.
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if they meet the requirements of Subchapter M of the IRC,
including distributing 90% of their income to fund
investors annually. However, Vanguard, which is wholly
owned by its more than 150 U.S. mutual funds, is not a RIC
and therefore is subject to corporate tax.
e) The proposed resolution : This bill is intended to
protect Vanguard from the state corporate tax. To that
end, this bill proposes to exempt from the CT any RIC that
is a mutual fund investment management company owned by the
mutual funds that it serves. As described above, however,
current law already exempts qualified RIC from both the
federal and state corporate tax. The problem is that
Vanguard, the management company, is not a RIC. The
Committee may wish to consider amending this bill to
clarify that it is a "C" corporation that may be exempt
from the state CT if it is an investment management company
wholly owned by the mutual funds it serves.
While legislation at the state level will not help Vanguard
with the potential federal income tax liability, the author
believes that explicit acknowledgment of Vanguard's
non-profit activities and an exemption from state tax will
protect this unique business structure and will help
maintain low investor fees.
f) How important is conformity to federal tax law ?
Conformity with federal law reduces taxpayer errors and
eases tax filing and administration. This bill would
create a state and federal difference, which adds
complexity to the tax return as the income excluded by this
bill may still subject to federal income tax. In the
absence of similar federal treatment, taxpayers will need
to keep separate accounting for state and federal tax
purposes.
g) FTB implementation concerns : The FTB staff notes that
the phrase "mutual fund investment management company" is
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undefined. The absence of a definition could lead to
disputes with taxpayers and would complicate the
administration of this bill. Furthermore, the FTB staff
notes that this bill does not specify whether an exempt RIC
would have to comply with the current information return
filing requirements. Compliance enforcement would be
difficult for the FTB within such filing requirements.
h) Potential sunset date : The Committee may wish to
consider the inclusion of a five-year sunset date for this
proposed exemption, to ensure application and foregone
revenues are in line with legislative intent.
REGISTERED SUPPORT / OPPOSITION:
Support
None on file
Opposition
California Tax Reform Association
Analysis Prepared by:M. David Ruff / REV. & TAX. / (916)
319-2098
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