BILL ANALYSIS
AB 2725
Page 1
Date of Hearing: April 19, 2010
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Anthony J. Portantino, Chair
AB 2725 (Nestande) - As Amended: April 14, 2010
Majority vote. Fiscal committee.
SUBJECT : Corporation Tax Law: understatement penalty
SUMMARY : Repeals the 20% corporate understatement penalty by
deleting Revenue and Taxation Code (R&TC) Section 19138 in its
entirety.
EXISTING LAW :
1)Provides, under R&TC Section 19138, that any taxpayer subject
to the Corporation Tax (CT) Law with an "understatement of
tax" exceeding $1 million for any taxable year shall be
subject to a penalty equal to 20% of the understatement.
2)Defines "understatement of tax" as the amount by which the tax
imposed by the CT Law exceeds the amount of tax shown on an
original return or on an amended return filed on or before the
original or extended due date of the return for the taxable
year.
3)Provides that the penalty shall be in addition to any other
penalty imposed under the CT Law.
4)Provides that a refund or credit for any amount paid to
satisfy the penalty may only be allowed if the penalty was
improperly computed by the Franchise Tax Board (FTB).
5)Provides that no penalty shall be imposed on any
understatement to the extent that the understatement is
attributable to a change in law that is enacted after the
earlier of either of the following dates:
a) The date the taxpayer files the return for the taxable
year for which the change is operative; or,
b) The extended due date for the return for the taxable
year for which the change is operative.
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6)Provides that no penalty shall be imposed to the extent that a
taxpayer's understatement is attributable to the taxpayer's
reasonable reliance on written advice of FTB in the form of a
legal ruling by the Chief Counsel.
7)Requires FTB to implement the penalty provisions in a
reasonable manner.
8)Provides that the penalty provisions apply to each taxable
year beginning on or after January 1, 2003, for which the
statute of limitations on assessment has not expired.
FISCAL EFFECT : Assuming this bill eliminates the penalty for
taxable years beginning on or after January 1, 2011, FTB
estimates revenue losses of $240 million in fiscal year (FY)
2010-11, $520 million in FY 2011-12, and $550 million in FY
2012-13.
COMMENTS :
1)The author has provided the following statement in support of
this bill:
SBX1 28 (2008) imposed draconian penalties on California
taxpayers without a hearing and public comment. These new
retroactive penalties only further hurt the businesses in
our state at a time when we should be stimulating the
economy. Businesses are the economic engine of our state
and we need them to be employing [Californians], not having
them fear such a large penalty that they overestimate their
taxes and thus have less to invest and employ workers.
2)Committee Staff Comments:
a) Origin of the Corporate Understatement Penalty : On
October 1, 2008, Governor Schwarzenegger signed into law
SBx1 28 (Committee on Budget and Fiscal Review), Chapter 1,
Statues of 2007-08, which implemented a wide range of
revenue provisions as part of the 2008-09 Budget Agreement.
Among other things, SBx1 28 created a new corporate
understatement penalty for open taxable years beginning on
or after January 1, 2003. Specifically, the penalty
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applies to taxpayers with an understatement of tax in
excess of $1 million and is in addition to all other
applicable penalties. The penalty is assessed on an
"understatement of tax" at the rate of 20%. An
"understatement of tax," in turn, is defined as the
difference between the amount of tax imposed by the CT Law
and the amount of tax shown by the taxpayer on its return.
By its own provisions, the penalty did not apply to
understatements for any taxable year beginning before
January 1, 2008, provided the taxpayer filed an amended
return and paid the correct amount of tax liability by May
31, 2009. Finally, as noted in the Assembly Floor Analysis
for SBx1 28, no "reasonable cause" exception is available
to taxpayers to avoid the imposition of the penalty.
b) FTB's Revenue Projections : At the time of SBx1 28's
passage, FTB estimated that the penalty provisions would
increase General Fund (GF) revenues by roughly $1.44
billion in fiscal year (FY) 2007-08, $75 million in FY
2008-09, $45 million in FY 2009-10, and $30 million in FY
2010-11. As it turns out, these projections turned out to
be quite conservative. The penalty provisions actually
increased GF revenues by over $2.5 billion for FY 2007-08.
c) Arguments in Support of the Penalty : At the time of
SBx1 28's passage, FTB estimated that the penalty would
improve compliance and accelerate payments of corporate
taxes owed but underpaid. It should also be noted that the
penalty is targeted in nature, applying only to large,
sophisticated corporations with an understatement of tax
exceeding $1 million in a taxable year.
d) Arguments in Opposition to the Penalty : Following
enactment, the penalty was widely criticized by both
industry representatives and tax practitioners alike. At
an Interested Parties Meeting held on December 5, 2008,
many attendees called on FTB to seek legislative repeal of
the penalty or, barring that, to interpret its provisions
as broadly as possible in favor of corporate taxpayers.
(Roberts and Gustafson, Exploring California's Infamous
Corporate 20% Understatement Penalty, Emerging Issues, June
18, 2009.) Among other things, many attendees argued that
the penalty would lead to intentional overstatements of CT
liability, thereby subjecting corporations (and CT
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preparers) to perjury liability. Id. Practitioners also
argued, "Not only does the Penalty provide a perverse
incentive to deliberately overstate income or understate a
particular deduction, the Penalty places even the most
conservative taxpayer in the undesirable position of having
to reconsider any and all legally defensible positions
which may have been taken and successfully defended but for
the existence of the new Penalty." Id.
e) The Lawsuit : In February 2009, the California
Taxpayers' Association (Cal-Tax) filed a lawsuit in
Superior Court challenging the understatement penalty on
numerous grounds. Among other things, Cal-Tax argued that
the penalty was, in reality, a tax designed solely to
generate revenue. As such, the suit claimed that SBx1 28
should have been subject to the 2/3 vote requirement
mandated by the California Constitution. The suit also
challenged the penalty on substantive due process grounds,
claiming the penalty's retroactive application lacked a
"rational legislative purpose." The court rejected these
arguments by giving deference to the penalty designation
and noting that the penalty was designed to encourage
taxpayers that had taken questionable positions to come
forward and amend their returns. Finally, Cal-Tax argued
that the penalty precluded both pre-payment and
post-payment review and therefore deprived taxpayers of
procedural due process. The court rejected this argument
as well, stating that, when read in conjunction with R&TC
Section 19382, the law provides a "post-deprivation remedy
in the form of a refund action in which taxpayers may
contest the validity of the tax penalty." Id. Committee
staff is informed that this case is currently on appeal.
f) How Does it End? : As noted above, the penalty
provisions are contained in R&TC Section 19138. This bill,
in turn, would delete Section 19138 it its entirely.
Ostensibly, this deletion would be effective January 1,
2011. This may create confusion regarding when the penalty
ceases to apply. For the sake of clarity, the author may
wish to take amendments clarifying that the penalty
deletion will be effective for taxable years beginning on
or before January 1, 2011.
REGISTERED SUPPORT / OPPOSITION :
AB 2725
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Support
None on file
Opposition
None on file
Analysis Prepared by : M. David Ruff / REV. & TAX. / (916)
319-2098