BILL ANALYSIS
AB 692
Page 1
Date of Hearing: April 13, 2009
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Charles M. Calderon, Chair
AB 692 (Charles Calderon) - As Amended: April 2, 2009
Majority vote.
SUBJECT : Taxation: corporate reorganizations: built-in losses
SUMMARY : Declares that the 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 does not apply for purposes of
state income tax laws. Authorizes the Franchise Tax Board (FTB)
not to apply a federal income tax regulation or administrative
guidance for California tax purposes, under specified
circumstances. 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.
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e) The American Recovery and Reinvestment Act of 2009 (Act)
(Public Law 111-5), signed by President Obama on February
17, 2009, repealed the notice and made the following
congressional findings:
i) The delegation authority to the Secretary of the
Treasury under IRC Section 382(m) does not authorize the
Secretary to provide exemptions or special rules that are
restricted to particular industries or classes of
taxpayers;
ii) Notice 2008-83 is inconsistent with the
congressional intent in enacting IRC Section 382(m);
iii) The legal authority to prescribe Notice 2008-83 is
doubtful; and
iv) As taxpayers should generally be able to rely on
guidance issued by the Secretary of the Treasury,
legislation is necessary to clarify the force and effect
of Notice 2008-83 and restore the proper application
under the IRC of the limitation on built-in losses
following an ownership change of a bank.
f) The Act has limited the force and effect of Notice
2008-83 to the period ending on January 16, 2009.
g) The congressional findings provide additional
confirmation that California did not, and should not,
conform to the substantive changes to IRC Section 382 that
were attempted to be made by Notice 2008-83.
1)Provides that Notice 2008-83, or any other administrative
guidance issued by the IRS and any federal Treasury Department
regulations that have the same or similar effect regarding the
application of IRC Section 382 shall not apply for purposes of
the Personal Income Tax (PIT) Law or Corporation Tax (CT) Law.
2)Specifies that Notice 2008-83 applies neither prospectively
nor retroactively for purposes of PIT Law and CT Law.
3)Clarifies that FTB may provide that any federal income tax
regulation, rule, notice, or other federal interpretation of
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federal income tax laws shall not apply in both of the
following circumstances:
a) The legal authority of the federal interpretation is
doubtful.
b) Automatic conformity to the federal interpretation may
infringe on the Legislature's authority to make laws
involving significant policy issues.
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 issue temporary or
final regulations. In 2008, the Treasury Department issued
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)
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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 and the following years. 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.
No final or temporary regulations have been issued by the
Treasury Department following the Notice, but 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 concluded that Notice 2008-83
has no legal effect for purposes of California tax laws and,
therefore, FTB staff estimates that this bill will have no
revenue impact with regard to the Notice. The provision
authorizing FTB to make a determination with respect to certain
federal income regulations or other administrative guidance may
impact PIT or CT revenue in the future. However, the impact of
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that provision cannot be estimated at this point.
COMMENTS :
1)According to the author, the purpose of this bill is to
protect California from any legal challenge seeking to
invalidate the FTB's regulation that makes Notice 2008-83,
which provided a tax break to banks, inapplicable for
California tax purposes. This bill is also needed to ensure
that, in the future, the Legislature's authority to enact laws
is not impinged by any federal notice or guidance of doubtful
legal authority and that General Fund revenues are protected."
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
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."
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(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
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). It was
reported, however, that days after the tax rule was
changed, "Wells Fargo moved to acquire Wachovia Corp.,
whose losses on loans could reach more than $70 billion,"
and "PNC Financial Services Croup, which recently acquired
National City Corp, could receive as much as $5 billion in
tax savings." (Id.).
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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' Own 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
several recent notices issued by the IRS. Those 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
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
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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 (TARP) 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
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 allows an exemption for banks. As such,
Notice 2008-83 is in conflict with existing California law,
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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.
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
retroactively it would, in effect, be using state revenue
to help fund federal bank bailouts that took place before
January 16, 2009.
f) Lessons Learned from Notice 2008-83 and the Significance
of this Bill. 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 guidance and
pronouncements. When, on those rare occasions, a federal
agency unwittingly exceeds its authority to interpret
existing federal law, California may suffer disastrous
consequences and lose revenues, without ever being
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consulted on the matter. This bill authorizes FTB to find
a federal income tax regulation, rule, notice, or other
administrative guidance inapplicable for California tax
purposes if its legal authority is doubtful or automatic
conformity to the federal interpretation may infringe on
the Legislature's authority to enact laws. By allowing FTB
to make that type of a determination with regard to federal
administrative interpretations of law to which California
conforms, this bill will provide additional safeguards
against future "Notices 2008-83". Further, 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) Similar Legislation .
AB 11 (De Leon), introduced in the 2009-10 Regular
Legislative Session, makes legislative findings and
declarations similar to those made in this bill and directs
FTB not to apply Notice 2008-83 for purposes of California
tax laws. AB 11 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
Extraordinary Session, and ABx3 21(De Leon), introduced in
the 2009-10 Third Extraordinary Session, are similar to
this bill in that they direct FTB not to apply Notice
2008-83 for the PIT Law and CT Law.
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
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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 has raised some implementation concerns over the
lack of definitions and standards for the terms used in this
bill, such as "doubtful legal authority" and "automatic
conformity". The author is working with FTB staff to resolve
those concerns and other technical considerations addressed in
FTB's analysis of this bill.
REGISTERED SUPPORT / OPPOSITION :
Support
American Federation of State, County and Municipal Employees,
AFL-CIO
California Tax Reform Association
Opposition
None on file
Analysis Prepared by : Oksana Jaffe / REV. & TAX. / (916)
319-2098