BILL ANALYSIS
AB 11
Page 1
Date of Hearing: April 13, 2009
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Charles M. Calderon, Chair
AB 11 (De Leon) - As Amended: March 9, 2008
Majority vote
SUBJECT : Corporate reorganizations: banks: built-in losses
SUMMARY : Declares that Internal Revenue Service (IRS) Notice
2008-83, which exempts banks from the restrictions of Internal
Revenue Code (IRC) Section 382, constitutes a substantive change
in law and directs the Franchise Tax Board (FTB) not to apply
this notice for purposes of state income tax laws.
Specifically, this bill :
1)Includes the following legislative findings and declarations:
a) California conforms to various provisions of the IRC, as
enacted on a specified date, and, for taxable years
beginning on or after January 1, 2005, the conformity date
prescribed in the Revenue and Taxation Code (R&TC) for
those referenced provisions is January 1, 2005.
b) California conforms to IRC Section 382, as enacted
January 1, 2005, relating to limitations on net operating
loss carry forwards and certain built-in losses following
ownership change, and, as of January 1, 2005, IRC Section
382 applied to financial institutions.
c) On October 20, 2008, the IRS issued Notice 2008-83,
2008-42 I.R.B. 905 (Notice 2008-83) stating that, after an
ownership change, any deduction properly allowed to a bank
with respect to losses on loans or bad debts would not be
subject to the limitations of IRC Section 382.
d) Notice 2008-83 constitutes a substantial change to IRC
Section 382 and, while California conforms to IRC Section
382, as enacted on January 1, 2005, it has not conformed to
any changes to that section as set forth in Notice 2008-83.
e) The American Recovery and Reinvestment Act of 2009
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(Public Law 111-5), signed by President Obama on February
17, 2009, questioned the legal authority of Notice 2008-83
and repealed it. Notice 2008-83 was repealed prospectively
only, in order to protect the reliability of guidance
letters generally, and to avoid punishing taxpayers that
had relied on the guidance.
f) California should not conform to the construction of IRC
Section 382 as described in Notice 2008-83, inasmuch as the
legality of that construction has been questioned in
federal statute.
2)Directs FTB not to apply the provisions of Notice 2008-83 for
purposes of the Personal Income Tax (PIT) Law or Corporation
Tax (CT) Law.
EXISTING FEDERAL LAW allows a corporate taxpayer to carry
forward a net operating loss (NOL) for 20 years, or carry it
back for two years, to reduce future or past taxable income, as
long as the corporation's legal identity is maintained. After
certain asset acquisitions in which the acquired corporation
goes out of existence, the acquired corporation's NOL carry
forwards, generally, are inherited by the acquiring corporation.
However, in order to limit tax-motivated acquisitions of loss
corporations, the use of those NOLs and other carry forwards may
be subject to special limitations. Acquired losses also include
what is called an "unrealized built-in loss", which is the
amount of the value of assets reported on the acquired
corporation's books that exceeds the fair market value of its
assets immediately before the corporation is acquired.
IRC Section 382 limits the amount of acquired losses that the
acquiring corporation may use to offset its income in the year
of acquisition and the following years. Generally, the
acquiring corporation may use the acquired corporation's losses
in the amount equal to the value of the acquired corporation,
measured by the value of its stock immediately before the
acquisition, multiplied by the long-term tax exempt rate, a base
interest rate computed by the IRS.
In 2003, the IRS published Notice 2003-65 to explain two
alternative methods for identifying built-in gains and losses
(also known as the 1374 approach and the 388 approach).
Taxpayers were permitted to rely upon Notice 2003-65 until the
IRS and the United States Treasury Department issued temporary
or final regulations. In 2008, the Treasury Department issued
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Notice 2008-83, in which it indicated that it is studying the
proper treatment of built-in losses allowed after an ownership
change for a bank. The Notice further provided that any
deduction properly allowed, after an ownership change, to a bank
with respect to losses on loans or bad debts (including any
deduction for a reasonable addition to a reserve for bad debt)
will not be treated as a built-in loss or a deduction that is
attributable to periods before the change date and, therefore,
would not be subject to IRC Section 382 limitations, thus,
allowing banks to utilize the acquired losses fully in the year
of acquisition. The Notice was clear that banks may rely on the
treatment allowed by this Notice unless and until additional
guidance is issued, meaning that any bank acquisition done
before or after the Notice would qualify for this treatment.
While no final or temporary regulations have been issued by the
Treasury Department, on February 17, 2009, President Obama
signed the American Recovery and Reinvestment Act of 2009 (Act)
(Public Law 111-5), which stated that Notice 2008-83 is
inconsistent with the congressional intent in enacting IRC
Section 382. The Act declared that the IRS was not authorized
under federal law to provide exemptions or special rules that
are restricted to particular industries or classes of taxpayers
and repealed Notice 2008-83. However, Congress grandfathered in
transactions that occurred on or before January 16, 2009, in
order to protect taxpayers that have relied upon the guidance.
EXISTING STATE LAW conforms to the IRC either by reference to
federal law as of a "specified date" or by stand-alone language
that mirrors the federal provision. Currently, certain
provisions of the PIT Law and CT Law are conformed to the IRC as
of January 1, 2005, unless otherwise provided. AB 115 (Klehs),
Chapter 691, Statutes of 2005 was the last California/federal
conformity bill. Where state law conforms to federal law, R&CT
Sections 17024.5 and 23051 provide that temporary and final
regulations issued by the Treasury Department apply to
California, unless the regulations conflict with state law or
state regulations. Even though the R&TC is silent with respect
to other federal administrative guidance and pronouncements,
such as IRS notices, FTB has consistently followed such
guidance.
FISCAL EFFECT : FTB's legal staff concludes that Notice 2008-83
has no legal effect for purposes of California tax laws and,
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therefore, FTB staff estimates that this bill will have not
revenue impact.
Proposition 98 Fiscal Effect : None
COMMENTS :
1)The author states that ,"On December 1, 2008, I introduced AB
11 to protect California's budget from the recent guidance
letter by the U.S. Treasury Department designed to provide a
new federal tax break for bank mergers. While then-Secretary
Paulson may have had substantial reason to unilaterally
rewrite federal tax law to facilitate the takeover of failing
banks, our state's General Fund should not be adversely
impacted by that decision. Unfortunately, state law requires
the State to conform with Internal Revenue Services (IRS) tax
regulations. California should take explicit action to ensure
that the Franchise Tax Board does not conform to this ruling.
According to the Franchise Tax Board's estimates, if we were
to conform with this federal tax break, the state would lose
approximately $300 Million in tax revenue during the current
fiscal year, and up to $2 Billion in future years.
"California was not consulted on this breathtaking tax break.
Although recently enacted federal statute (HR 1) now asserts
that Treasury exceeded its legal authority in issuing IRS
Notice 2008-83, and declares that the ruling shall have not
force or effect after January 16, 2009, AB 11 will ensure that
our state's budget is absolutely protected from the massive
corporate tax give away. It is anticipated that the Franchise
Tax Board will adopt regulations in March 2009, to affirm that
California will not comply with IRS Notice 2008-83, AB 11
would add assurances that FTB's actions cannot be challenged."
2)The proponents believe that this measure is necessary to
protect California's General Fund from losing
desperately-needed tax revenue. Proponents argue that, while
the FTB has already taken regulatory action to address this
issue, this bill will bolster FTB's efforts and will provide
heightened legal assurances to the FTB's actions against any
legal challenges.
3)Committee staff notes all of the following:
a) Background . IRC Section 382, originally added to the
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IRC in 1954 and completely re-written in 1986, was enacted
to limit tax-motivated acquisitions of loss corporations.
Prior to the enactment of IRC Section 382, corporations
with large losses were attractive to buyers with large
taxable income simply because the acquired corporation's
losses could be used to reduce the buyer's taxable income
and, effectively, the cost of acquisition. The limitations
currently in place preclude a buyer from using the NOLs and
built-in losses of the acquired entity at a rate that is
faster than the rate at which the acquired corporation
could have used them if it had sold its assets and invested
the proceeds in tax-exempt governmental obligations.
Built-in losses are also subject to special limitations
because they are economically equivalent to pre-acquisition
NOL carry forwards. If "built-in losses were not subject
to limitations, taxpayers could reduce or eliminate the
impact of the general rules by causing a loss corporation
(following an ownership change) to recognize its built-in
losses free of the special limitations" and "then invest
the proceeds in assets similar to the assets sold."
(General Explanation of the Tax Reform Act of 1986, Joint
Committee on Taxation, p. 298, May 4, 1987). The purpose
of this IRC Section 382 limitation is to make losses a
neutral factor in a corporate acquisition.
b) Controversial History of Notice 2008-83 . Generally, IRS
administrative pronouncements are issued without much
notice from the public, but the issuance of Notice 2008-83
created quite a controversy. The questions were raised
regarding the circumstances under which the notice was
issued and the Treasury Department's legal authority to
substantively change a 22-year old tax law that limits the
use of losses by banks following acquisitions. Some
current and former congressional staff members, as well as
many tax attorneys, concluded that the Treasury Department
had no authority to issue the notice (See, e.g., A Quiet
Windfall for U.S. Banks, by Amit R. Paley, Washington Post,
Page A01, November 10, 2008). Lawmakers were looking at
"whether the notice was introduced to benefit specific
banks, as well as whether it inappropriately accelerated
bank takeovers." (Id.). On November 18, 2008, Senator
Chuck Grassley, ranking member of the Committee on Finance,
asked Eric Thorson, the Treasury Department's Inspector
General, to review the circumstances and any possible
conflicts of interest involving the Treasury Department's
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administrative move that gives a big tax break to banks
that acquire poorly performing banks. (Senate Finance
Committee Release, Grassley Seeks Inspector General Review
of Treasury Bank Merger Move, 110th Congress, November 18,
2008). Senator Charles E. Schumer and Senator Max Baucus
also wrote to Mr. Paulson asking similar questions
regarding the Treasury Department's authority to enact the
tax break without Congressional review and expressing
concerns over the subsidy. The Treasury Department,
however, insisted that the new tax break was not intended
to benefit any particular bank and had been under
"development for many, many weeks." (See, e.g., Bush's tax
breaks for banks could cost California $2 billion, Evan
Harper, Los Angeles Times, November 11, 2008). Finally,
Congress put the controversy to rest when it enacted the
Act, which President Obama signed on February 17, 2009.
The Act clearly states that Notice 2008-83 was inconsistent
with the congressional intent in enacting IRC Section 382
and that the Treasury Department's legal authority to
prescribe the notice was doubtful. Therefore, the Act
repealed the Notice, but grandfathered in the acquisitions
that occurred prior to January 16, 2009. The Notice is
also effective for acquisitions that occurred after January
16, 2009, if any ownership change was pursuant to a written
binding contract entered on or before that date, or under a
written agreement entered into on or before that date, if
the agreement was described on or before January 16, 2009,
in a public announcement or in a filing with the Securities
and Exchange Commission required by reason of such
ownership change.
c) IRS's Contribution to the Federal Bailout Efforts.
There seems to be an emerging trend for the IRS to issue
notices that are friendly to taxpayers with losses. While
Notice 2008-83 is, by far, the most questionable and
controversial administrative guidance, it was just one of
the several recent notices issued by the IRS. Those recent
notices interpret the tax rules to allow certain taxpayers
flexibility during the current economic downturn,
particularly taxpayers with losses. For example, in Notice
2008-78, the IRS announced its intent to issue regulations
that would, effectively, eliminate the presumption that
capital contributions to a loss corporation within two
years prior to an ownership change are part of a plan to
avoid or increase the IRC Section 382 limitation. As
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discussed, if an ownership change has occurred, the annual
amount of taxable income that can be "sheltered" by an NOL
that arose prior to the ownership change (the 'annual NOL
limitation') is limited to the fair market value of the
corporation's stock times the federal long-term tax-exempt
rate. The rules for computing the annual NOL limitation
provide that any contribution to a loss company that is
made for the purpose of avoiding or increasing IRC Section
382 limitations is disregarded in computing the fair market
value of the corporation's stock. The statutory language
of IRC Section 382 imposes a presumption that any
contribution, within two years before a change, is made for
that purpose - except as provided in regulations. Notice
2008-78 announces that future regulations will relax this
rule, repeals the two-year presumption, and provides that a
capital contribution will be treated as a disregarded
transaction only if the facts and circumstances indicate an
impermissible purpose. As another example, Notice 2008-100
protects against a potential "ownership change" for
purposes of IRC Section 382 limitation by reason of a
bank's issuance of stock or warrants to the government
under the Troubled Assets Relief Program Capital Purchase
Program (CPP). It also provides that any capital
contribution made by the Treasury Department to a loss
corporation pursuant to the CPP is not a disregarded
transaction. Similarly, Notice 2008-76 exempts the
government conservatorship of Fannie Mae and Freddie Mac
from a "change of ownership", allowing those institutions
to use their preexisting losses. Notice 2008-84 allows the
same tax treatment in the case of the acquisition by the
government of a more-than-50-percent interest in any
corporation, including upon the exercise of warrants or
convertible securities.
d) Does FTB have existing authority to disregard Notice
2008-83 ? Yes. California law [R&TC Section 17024.5(d), in
the case of the PIT Law, and R&TC Section 23051.5(d), in
the case of CT Law] expressly provides that, for purposes
of applying those provisions of the IRC to which California
conforms, federal final or temporary regulations apply, but
only to the extent that those federal regulations do not
conflict with California law or with regulations issued by
FTB. No federal regulations have ever been issued to
address the change in law effectuated by Notice 2008-83.
Moreover, Congress repealed the notice, stating that the
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notice was inconsistent with the congressional intent in
enacting IRC Section 382 and that IRC Section 382 provided
no specific authority for the Secretary of the U.S.
Treasury Department to exempt specific types of businesses
from the limitation otherwise applicable to deductions of
built-in losses. Clearly, Notice 2008-83 constitutes a
substantive change in law and a significant change in the
application of IRC Section 382 that was not contemplated by
the California Legislature in its conformity action. When
California conformed to IRC Section 382, the limitations
applied to banks, and state law contains no specific
authority that allowed for an exemption for banks. As
such, Notice 2008-83 is in conflict with existing
California law, and FTB does not have the authority to
apply this notice for California tax purposes.
On December 4, 2008, FTB directed its staff to begin
regulatory action to make Notice 2008-83 inapplicable for
California purposes. At its March 19, 2009 meeting, FTB
authorized staff to proceed with formal procedures under
the Administrative Procedures Act to adopt this regulation.
Thus, the author may wish to amend this bill to state in
the affirmative that Notice 2008-83 has no legal effect for
California tax purposes, neither prospectively nor
retroactively, instead of directing FTB not to apply the
notice.
e) Retroactive Application of the Notice . Even though
Notice 2008-83 was repealed by Congress as of January 16,
2009, a few bank acquisitions that took place prior to that
date still qualify for the preferential tax treatment
bestowed on them by the U. S. Treasury Department, albeit
illegally. Thus, for federal tax purposes, the Notice
applies retroactively for all open years; apparently, it
was done to protect the reliability of guidance letters,
generally, and to avoid punishing taxpayers that relied on
the Notice. No such problems exist for California. The
FTB did not issue that Notice and, even though as a
practical matter, FTB has consistently followed federal
administrative guidance in the past, including notices,
there was no reason for taxpayers to rely on Notice 2008-83
for California tax purposes because it was clearly
indefensible as a matter of substantive law. If California
were to conform to the policy articulated by the IRS in
Notice 2008-83, or were to allow the notice to apply
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retroactively, it would, in effect, be using state revenue
to help fund federal bank bailouts that took place before
January 16, 2009.
f) Significance of this bill . While FTB is currently
working on the regulations that would clarify that Notice
2008-83 has no legal effect for California tax purposes
(either prospectively or retroactively), a legislative act,
such as this bill, would protect FTB's position, and this
state, from any potential legal challenge seeking to
invalidate those regulations.
g) Lessons Learned from Notice 2008-83. Federal and state
laws are very complex and taxpayers are often overburdened
with, if not overwhelmed by, the differences in California
and federal tax laws. Generally, conformity to federal law
improves taxpayer compliance and reduces administrative
costs incurred by tax agencies in auditing taxpayers. The
issuance of Notice 2008-83, however, highlighted the risks
of conforming to federal law and federal administrative
pronouncements. When, on those rare occasions, a federal
agency unwittingly exceeds its authority to interpret
existing law, California may suffer disastrous consequences
and lose revenues, without ever being consulted on the
matter.
h) Similar Legislation .
AB 692 (Calderon), introduced in the 2009-10 Regular
Legislative Session, declares that Notice 2008-83 is not
applicable to California law. AB 692 also clarifies that
FTB has authority to provide that any federal tax
regulations or other administrative guidance do not apply
if the legal authority of the federal interpretation is
doubtful and automatic conformity to the federal
interpretation may infringe on the Legislature's authority
to make laws involving significant policy issues. AB 692
is scheduled to be heard in this Committee on April 13,
2009.
ABx1 1 (Calderon), introduced in the 2009-10 First
Extraordinary Session, is similar to this bill, but it is
an urgency measure.
ABx1 14 (De Leon), introduced in the 2009-10 First
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Extraordinary Session, and ABx3 21(De Leon), introduced in
the 2009-10 Third Extraordinary Session, are almost
identical to this bill.
ABx4 6 (Laird), introduced in the 2007-08 Fourth
Extraordinary Session, directed FTB not to apply Notice
2008-83 nor any other administrative guidance issued after
October 20, 2008, that have the same or similar effect for
purposes of the PIT Law and CT Law. ABx4 6 died in the
Assembly.
ABx4 18 (Calderon), introduced in the 2007-08 Fourth
Extraordinary Session, is similar to this bill. ABx4 18
died in the Assembly.
AB 2998 (Frommer), introduced in the 2005-06 Regular
Legislative Session, would have amended current law that
limits the usage of deductions, losses, and tax credits
from acquired corporations by taking the federal limitation
on acquired NOLs and multiplying it by average of the
acquired corporation's California apportionment percentages
for the year of the acquisition and the two immediately
preceding tax years. AB 2998 was never heard by a
Committee.
4)FTB staff suggests that this bill be amended to clarify that
FTB shall not apply Notice 2008-83 for the same taxable
periods to which any federal guidance described in Notice
2008-83 is applicable.
REGISTERED SUPPORT / OPPOSITION :
Support
California Tax Reform Association
Services Employees International Union (SEIU)
Opposition
None on file
Analysis Prepared by : Oksana Jaffe / REV. & TAX. / (916)
319-2098