BILL ANALYSIS
SENATE REVENUE & TAXATION COMMITTEE
Senator Lois Wolk, Chair
SB 401 - Wolk
Amended: As Proposed to Be Amended
Hearing: April 22, 2009 Fiscal: Yes
SUMMARY: Provides a single, consistent definition for
abusive tax shelters, which would be referred to
as "potentially abusive tax avoidance
transactions." Adopts the federal reportable
transaction category for "transactions of
interest."
EXISTING LAW
Current California Law
Uses the following definitions and provisions to curtail
the use of abusive tax shelters:
o Potentially Abusive Tax Avoidance Transaction - is
defined as any tax shelter or a plan or arrangement
which is of a type that the Secretary of the Treasury
or the Franchise Tax Board (FTB) determines by
regulation as having a potential for tax avoidance or
evasion.
o Eight-Year Statute - if the FTB identifies an
adjustment relating to an "abusive tax avoidance
transaction," the FTB may notify the taxpayer of a
proposed deficiency assessment up to eight years after
the taxpayer has filed the return, rather than the
normal four-year statute of limitations.
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o Abusive-Tax-Shelter-Use Penalty - applies if the
FTB contacts a taxpayer regarding a deficiency that
results from the use of an undisclosed reportable
transaction, a listed transaction, or a gross
misstatement. The penalty is 100-percent of the
interest payable up to the date that a notice of
proposed deficiency is mailed.
Because the abusive-tax-shelter-use penalty is based
on the amount of interest on a deficiency, a taxpayer
may avoid the penalty by filing an amended return
prior to FTB issuing a deficiency notice.
o Interest Suspension - generally, the imposition of
penalties and interest may be subject to temporary
suspension if FTB does not issue a notice within 18
months from the date of a timely-filed return.
Interest may not be computed on the additional
proposed tax from the day after that 18-month period
until 15 days after the notice is issued. This rule
does not apply to taxpayers with income greater than
$200,000 and that have been contacted by FTB regarding
a "potentially abusive tax shelter." This provision
refers to abusive-tax-shelter-use penalty rules for
the definition of a "potentially abusive tax shelter."
o Noneconomic Substance Transaction Understatement
(NEST) Penalty - California imposes a penalty
(commonly referred to as the NEST penalty) for any
understatement attributable to any transaction that
lacks economic substance. A "noneconomic substance
transaction understatement" is a reportable
transaction understatement, or an understatement
resulting from the disallowance of any loss, deduction
or credit or addition to income that is attributable
to a determination that the arrangement lacks economic
substance. A transaction is treated as lacking
economic substance if the taxpayer does not have a
valid nontax business purpose for entering into the
transaction.
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Current Law imposes the following penalties:
The penalty is 40 percent of the understatement if the
transaction is not disclosed, and 20 percent for
disclosed transactions. The penalty applies to the
entire amount of the understatement, even if the
benefit is not recognized on a current-year return.
For example, if a taxpayer reports a $100 million
capitol loss resulting from a transaction that lacks
economic substance, but only utilizes $10 million of
the loss in the current year due to the capitol loss
limitations, the penalty is based on $100 million, the
total understated amount.
THIS BILL
Provides a single definition for abusive tax shelters,
which would be referred to as "potentially abusive tax
avoidance transactions." The single definition would mean
any of the following:
1. A federal tax shelter;
2. An undisclosed reportable transaction;
3. A listed transaction;
4. Any entity, transaction, plan or arrangement that
the Secretary of the Treasury or the FTB identifies by
regulations, notices, issue papers, or other official
public notification as having a potential for tax
avoidance or evasion.
5. A gross misstatement; or
6. A transaction subject to the noneconomic substance
transaction understatement penalty.
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Coordinates the definition of "potentially abusive tax
shelters" in the application of:
o The eight-year statute of limitations,
o The abusive-tax-shelter-use penalty,
o The interest-suspension rule, and
o The authority to issue subpoenas.
Modifies the abusive-tax-shelter-use penalty by imposing a
50-percent of the penalty when an amended return is filed
before a deficiency notice is issued.
Provides that a legal tax structure of an LLC or an S
corporation shall not by itself be 'potentially abusive'
solely because of the choice of entity.
Adopts the federal reportable transaction category for
"transactions of interest" for California purposes, and
provide similar authority to the FTB to determine
transactions of interest for California income or franchise
tax purposes.
FISCAL EFFECT:
The FTB estimates the following revenue associated with
this bill
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| Estimated Revenue Impact of SB 401 |
| |
|--------------------------------------|
| Assumed operative on January 1, 2010 |
| |
|--------------------------------------|
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| Assumed Enacted After June 30, 2009 |
| |
|--------------------------------------|
| ($ in Millions) |
| |
--------------------------------------
--------------------------------------
| 2008/09 | 2009/10 | 2010/11 |
| | | |
|-----------+------------+-------------|
| $3.5 | -$3.6 |-$1.7 |
| | | |
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In general, the FTB estimates that California has lost
between $2.4 and $4 billion over the last four years due to
abusive tax shelters.
COMMENTS:
A. Purpose of the Bill
Abusive tax shelters are transactions intended evade income
taxes through a transaction that generates a paper loss
with no business or economic substance. Sophisticated
taxpayers use these transactions to evade taxes; they are
increasingly difficult to detect due to the customization
of these shelters and the fact that they are hidden within
the tax forms. The author states that the purpose of this
bill is to curtail the use of abusive tax shelters with no
economic purpose except to evade taxes in this state. Five
years ago the state launched the most successful program in
the nation to curtail abusive tax shelters. Since that
time taxpayers, both individuals and corporations, have
found ways around the state's laws by filing amended
returns before a penalty could be assessed or using
inconsistencies in state laws to avoid fully reporting
questionable transactions. The intent of this bill is to
ensure that the state understands the transactions that are
in fact abusive with no business or economic purpose not
only so that the state can stop these transactions from
occurring but also so it can warn other taxpayers of the
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consequences.
In order to create a tax structure with more integrity the
state needs to work to change the cost-benefit analysis of
taxpayers so that penalties ensure that it is no longer
worth the risk to play "audit roulette" where the cost of
getting caught is minor compared to the savings; high
penalties ensure that paying taxes owed makes more sense
than playing games.
In addition, this bill would modify the
abusive-tax-shelter-use penalty to no longer allow
taxpayers to avoid the penalty by filing an amended return
prior to FTB issuing a deficiency notice; instead, this
bill would impose 50-percent of the penalty in such
situations.
B. Author's Amendments
The author will take the following amendments in committee
as author's amendments; the bill has been analyzed as
though the bill were amended:
1. Provide that the legal tax structure of an LLC or an S
corporation shall not by itself be 'potentially
abusive' solely because of the choice of entity.
On page 7, after line 20, insert:
(e) The provisions of paragraph (4) of subdivision (b)
shall not apply solely on the basis that a limited
liability company or an S corporation is used in the
structure of an investment plan or arrangement, or other
plan or arrangement. If, however, a limited liability
company or an S corporation is used to facilitate a
potentially abusive tax avoidance transaction, the
preceding sentence shall not apply.
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2. Adopt the federal reportable transaction category for
"transactions of interest" for California purposes,
and provide similar authority to the Franchise Tax
Board to determine transactions of interest for
California income or franchise tax purposes.
On page 1, before line 1, insert:
SECTION 1. Section 18407.5 is added to the Revenue and
Taxation Code to read:
18407.5. (a) The term "reportable transactions," as
defined in paragraph (3) of subdivision (a) of Section
18407, shall also include any transaction of a type that
the Secretary of the Treasury under Section 6011 of the
Internal Revenue Code for federal income tax purposes or
the Franchise Tax Board under this section for California
income or franchise tax purposes determines is a
transaction of interest, and shall be reported on the
return or the statement required to be made.
(b) The term "transactions of interest" includes any
transaction that is the same as, or substantially similar
to, a transaction specifically identified by the Secretary
of the Treasury under Section 6011 of the Internal Revenue
Code for federal income tax purposes or by the Franchise
Tax Board under this section for California income or
franchise tax purposes, as a transaction having a potential
for tax avoidance or evasion including deductions, basis,
credits, entity classification, dividend elimination, or
omission of income.
(c) The Franchise Tax Board shall identify and
publish transactions of interest (whether identified by the
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Secretary of the Treasury under Section 6011 of the
Internal Revenue Code for federal income tax purposes or by
the Franchise Tax Board) through the use of Franchise Tax
Board Notices or other published positions. In addition,
the transactions of interest identified and published
pursuant to the preceding sentence shall be published on
the Web site of the Franchise Tax Board.
(d) This section shall apply to transactions of
interest published on or after the effective date of the
act adding this section.
C. What is an abusive tax scheme?
Generally, an abusive tax scheme has no business purpose
other than reducing taxes and is promoted with:
The promise of tax benefits.
Predictable tax losses or tax consequences.
No related economic loss experienced with respect to the
taxpayer's income or assets.
Who invests in abusive tax schemes?
Individuals and business entities with large,
constant streams of income or with substantial gains
from one-time events may invest in abusive tax
schemes.
Why did abusive tax schemes become so common?
Abusive tax schemes multiplied in the 1990's for
various reasons:
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Taxpayers had large capital gains or other income subject
to income tax.
Internal Revenue Service compliance activity decreased.
Promoters increased the marketing of abusive tax schemes
as 'legally defensible' ways to minimize tax burdens.
Penalties for participating in abusive tax schemes were
too small to have a deterrent effect.
There was no efficient disclosure and reporting system
for abusive tax schemes.
D. Examples of abusive tax shelter schemes identified:
Basis Shifting This tax scheme uses foreign
corporations (in tax haven countries) and instruments
to artificially increase and shift the basis of
foreign shareholder stock (not subject to U.S.
taxation) to stock owned by U.S. shareholders. By
applying tax laws in a manner inconsistent with
legislative intent, U.S. taxpayers ultimately sell
their stock and report an inflated loss, despite
incurring no economic loss.
Inflated Basis These schemes use transactions that
are "contingent" (not completed) to inflate an
owner's basis (ownership interest/true economic risk)
in a pass-through entity investment. The taxpayer
contributes cash or securities and a "contingent"
liability or obligation to the pass-through entity.
The taxpayer does not reduce his basis in the
pass-through entity for the contingent liability
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under the contention that the liability item is
"contingent" for tax purposes. Thus, the taxpayer
creates an artificially inflated basis for the pass
through entity interest, which is then used to deduct
losses received from the pass through entity (losses
are only deductible against the owner's basis in a
pass-through entity).
Commercial Domicile This scheme promises taxpayers
that if they incorporate in non-income taxing states,
such as Nevada or Delaware, they can avoid California
income taxes. This scheme requires an S corporation
doing business in California to reincorporate in
Nevada. Promoters of this reincorporation scheme
argue that the source of the S corporation income is
Nevada regardless of its business activity in
California. However, a corporation doing business in
California remains subject to California franchise
tax, and a California resident is taxable on income
from all sources, including sources in Nevada. In
this situation, neither the S corporation has
terminated its business activity in California, nor
has the individual taxpayer terminated his or her
California residency.
E. Tax Shelters in General
A "tax shelter" is generally a partnership or other entity
(such as a corporation or trust), an investment plan or
arrangement, or any other plan or arrangement used for the
principal purpose of avoiding or evading tax. These
transactions generally have no business purpose other than
reducing tax; however, a tax shelter is often cloaked in a
series of transactions to make it appear to have a business
purpose or structured to create an incidental business
purpose. The Treasury Regulations provide that the
principal purpose of an entity, plan or arrangement is to
avoid or evade federal income tax if that purpose exceeds
any other purpose. Tax-shelter transactions are generally
structured with one or more of the following
characteristics:
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o Little or no motive of realization of economic
gain;
o Intentional mismatching of income and deductions;
o Overvalued assets or assets with values subject to
substantial uncertainty are included.
o Non-recourse financing and financing techniques
that do not conform to standard commercial business
practices.
o Mischaracterization of the substance of the
transaction.
Reportable Transactions
A reportable transaction is generally any transaction that
has a potential for avoiding or evading tax and the
transaction is required to be included a return or
statement. The current categories of reportable
transactions include:
o Listed transactions;
o Transactions of interest;
o Confidential transactions;
o Transactions with contractual protection; and,
o Loss transactions.
Federal law requires a taxpayer who participated in a
reportable transaction to disclose the transaction on an
original or amended return for any taxable year the
taxpayer participates in the transaction.
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Listed Transactions
A listed transaction is a transaction that has been
identified by the IRS or the FTB to be a tax-avoidance
transaction (i.e. an abusive tax shelter).
Interest Suspension
In general, the IRC requires the payment of interest on any
amount of tax imposed that is not paid on or before the
last date prescribed for payment of tax. The IRC precludes
taxpayers from filing administrative claims for abatement
with respect to income, estate or gift taxes. However, the
IRC provides an exception to the general rule under the
interest-suspension rule. The interest-suspension rule
suspends the accrual of interest and time-sensitive
penalties if the Secretary of the Treasury does not provide
notice to the taxpayer specifically stating the amount due
and the basis for the liability within 36 months of the
later of the due date of the return (without regard to
extensions) or the date the return is filed. The
interest-suspension rule does not apply to any interest,
penalty, and addition to tax, or additional amount with
respect to any undisclosed reportable transaction, listed
transaction, or gross misstatement.
F. Arguments in Support
Supporters argue that this bill clarifies state tax laws
that apply to potentially abusive tax avoidance
transactions and improves the effectiveness of the
abusive-tax-shelter-use penalty. They argue that the state
not only needs to improve collections but also act as an
example to the rest of the nation in curtailing abusive tax
shelters as it did in 2003.
G. Arguments in Opposition
The opposition argues that the measure is overly punitive
and broad and that legal tax structures such as LLCs and
S-Corporations could be penalized for their existence. The
opposition also argues that the term "potentially abusive"
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is overly broad. These concerns were noted before the bill
was amended.
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Support and Opposition
Support:Franchise Tax Board
California School Employee's Association
California Tax Reform Association
Oppose:California Taxpayer's Association
California Chamber of Commerce
California Banker's Association
Tech America
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Consultant: Gayle Miller