BILL ANALYSIS
SB 401
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Date of Hearing: July 6, 2009
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Charles M. Calderon, Chair
SB 401 (Wolk) - As Amended: July 1, 2009
Majority vote. Fiscal committee.
SENATE VOTE : 22-15
SUBJECT : Administration of taxes: abusive tax avoidance
transactions: transactions of interest.
SUMMARY : Provides a single, consistent definition for abusive
tax shelters (ATS) and modifies the ATS-use penalty.
Specifically, this bill :
1)Replaces the term "ATS" with the phrase "abusive tax avoidance
transactions" and defines an "abusive tax avoidance
transaction" as any of the following:
a) A tax shelter, as defined in Internal Revenue Code (IRC)
Section 6662(d)(2)(C);
b) A reportable transaction, as defined in IRC Section
6706A(c)(1), which is undisclosed;
c) A listed transaction, as defined in IRC Section
6707A(c)(2);
d) A gross misstatement within the meaning of IRC Section
6404(g)(2)(D); or,
e) A transaction subject to the "non-economic substance
transaction" understatement penalty.
2)Expands the definition of "reportable transactions" for
California tax purposes by creating a new category of those
transactions - "a transaction of interest."
3)Defines a "transaction of interest" as a transaction that is
the same as, or substantially similar to, one of the types of
transactions that the Franchise Tax Board (FTB) has identified
by notice or regulation as a transaction of interest.
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Requires that the transactions of interest be identified and
published on the FTB's website.
4)Specifies that the expanded definition of "reportable
transactions" applies only to transactions of interest
published on or after the effective date of this bill and only
to taxable years beginning on or after that effective date.
5)Coordinates the definition of "ATS" with the application of
the eight-year statute of limitations, the ATS-use penalty,
and the authority to issue subpoenas. The definition of "an
abusive tax avoidance transaction" would apply to the
eight-year statute of limitations for filing deficiency
assessments related to tax avoidance schemes, the specified
ATS-use penalty, interest suspension rules that apply to
certain taxpayers that have been contacted regarding an ATS,
and the authority to issue subpoenas to prevent the marketing
of an ATS.
6)Modifies the ATS-use penalty by imposing a 50% of the penalty
when a taxpayer files an amended return reporting an abusive
tax avoidance transaction after the taxpayer was contacted by
the FTB but before a deficiency notice is issued. Specifies
that the penalty amount is equal to 50% of the interest
applicable to any additional tax reflected in the amended
return and attributable to that abusive tax avoidance
transaction. Applies to notices mailed on or after the
effective date of this bill.
7)Provides that the new 50% penalty applies to amended returns
filed more than 180 days after the effective date of this bill
with respect to taxable years beginning on or after that
effective date.
8)Authorizes the Chief Counsel of the FTB to compromise all or
any portion of the 50% penalty and specifies that the Chief
Counsel's ruling may not be reviewed in any judicial or
administrative proceeding.
9)Provides that a legal tax structure of an limited liability
company or an S corporation shall not by itself be "abusive"
solely because of the choice of entity.
EXISTING LAW :
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1)Imposes various penalties in connection with tax avoidance and
ATS, including reportable transactions.
2)Conforms to federal law regarding the requirements for tax
shelter organizers, sellers, material advisors, and promoters
to register tax shelters, maintain investor lists, and provide
information returns. Modifies this conformity to additionally
apply registration and reporting requirements to organizers,
sellers, material advisors, and promoters with respect to any
shelter that meets any of the following criteria: organized
in California, does business in California, derives income
from sources in California, or has a California taxpayer as at
least one of its investors.
3)Uses the following definitions and provisions to curtail the
use of ATS:
a) A "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 FTB
determines by regulation as having a potential for tax
avoidance or evasion.
b) A "reportable transaction" is defined as any transaction
with respect to which information is required to be
included with a return or statement because that
transaction is of a type that the Secretary of the Treasury
[i.e., the IRS] or FTB determines as having a potential for
tax avoidance or evasion.
c) A "listed transaction" is defined as a reportable
transaction that is the same as or is substantially similar
to a transaction specifically identified by the IRS for
federal income tax purposes or by FTB for federal or
state income tax purposes as a tax avoidance transaction.
d) "Gross misstatement" is defined, by reference to the
federal law, as the reporting of any item on the original
or any amended return if that item is attributable to a
gross valuation misstatement as defined in IRC Section
6662(h), a substantial omission of income as described in
IRC Section 6501(e)(1) or Section 6229(c), or a frivolous
position or a desire to delay or impede the administration
of the federal income tax laws as described in IRC Section
6702. (Treasury Regulations 301.6404-4).
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4)Imposes a 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. The penalty rate equals 20% of the
understatement if the taxpayer adequately discloses all
relevant facts on his/her tax return, 30% if all relevant
facts are not disclosed, and 40% if the transaction lacks
economic substance. 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.
5)Imposes an "ATS-use" penalty 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% of the interest
payable up to the date that a notice of proposed deficiency is
mailed. Because the ATS-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.
6)Provides that 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.
Thus, 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. However, this rule does not apply
to taxpayers with income greater than $200,000 and that have
been contacted by FTB regarding a "potentially ATS". FTB is
also not required to suspend any interest or penalties imposed
on those taxpayers, if these taxpayers have been contacted by
FTB regarding the use of a reportable transaction or any
listed transaction and FTB fails to notify these taxpayers of
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their liabilities within 18 months of the due date of the
return or the date the return is filed, whichever is later.
7)Extends the statute of limitations on deficiencies resulting
from tax shelter investments to eight years from the date the
return is filed, effective for returns filed on or after
January 1, 2000. Thus, 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.
8)Allows the Executive Officer of FTB or his/her designee or any
designee of FTB to subpoena taxpayers who have been contacted
by FTB regarding the use of a potentially ATS.
FISCAL EFFECT : The FTB staff estimates that this bill will
result in a gain of $5.9 million in fiscal year (FY) 2008-09 and
$1.5 million in FY 2010-11, and a loss of $1.8 million in FY
2009-10.
COMMENTS :
1)Purpose of this bill . The author's office states that the
purpose of this bill is to curtail the use of ATS 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 ATS. 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 can stop those transactions
that are, in fact, abusive and have no business or economic
purpose and to warn other taxpayers of the consequences.
This bill discourages tax avoidance and the use of ATS by
defining a "potentially abusive tax avoidance transaction" as:
(a) a tax shelter; (b) an undisclosed reportable transaction;
(c) a listed transaction; (d) a gross misstatement; or, (e) a
transaction subject to the noneconomic substance transaction
understatement penalty, as specified. In addition, this bill
would modify the ATS use penalty to no longer allow taxpayers
to avoid the penalty by filing an amended return prior to the
FTB's issuing a deficiency notice; instead, this bill would
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impose 50% of the penalty.
2)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
ATS 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 ATS as it did in 2003.
3)Arguments in opposition . The opponents argue that this bill
is overly punitive and broad and unfairly imposes an excessive
penalty for transactions that are already subject to onerous
existing penalties.
4)What is a "tax shelter"? Under both the Personal Income Tax
Law and the Corporation Tax Law, taxpayers are able to shelter
certain income from taxation. For example, individual
taxpayers are entitled to take a deduction for the mortgage
interest, an individual retirement account or pension
contributions, or a charitable contribution, among others,
that are explicitly allowed under the law. While some tax
shelters are legal and represent creative utilization of tax
laws to reduce tax liability, other tax shelters are not
specifically identified in federal or state tax laws. A tax
shelter is a legal technique used by taxpayers to reduce
taxable income. Some of the tax sheltering activities
identified by the IRS or the FTB are disallowed and treated as
an ATS. However, there are far more tax shelters in existence
than the IRS or FTB have been able to identify. For that
reason, there may be many tax shelters that are ultimately
found to be illegal.
5)Definition of an ATS . Because there are many types of ATS, it
is quite difficult to identify and define those transactions.
However, despite the absence of a uniform and exact standard
as to what constitutes an ATS, there exist statutory
provisions, judicial doctrines, and administrative guidance
that limit and define such transactions. The IRC, for
example, defines a "tax shelter" as a partnership or other
entity (such as a corporation or trust), an investment plan or
arrangement, or any other plan or arrangement the significant
purpose of which is avoiding or evading tax. [IRC Section
6662(d)(2)(C)(ii)]. Tax-shelter transactions are generally
structured with one or more of the following characteristics:
(a) little or no motive of realization of economic gain; (b)
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intentional mismatching of income and deductions; (c)
overvalued assets or assets with values subject to substantial
uncertainty are included; (d) non-recourse financing and
financing techniques that do not conform to standard
commercial business practices; or, (e) mischaracterization of
the substance of the transaction.
Courts have developed several doctrines that have been used to
deny tax benefits arising from certain transactions. One
common law doctrine that has been applied with increasing
frequency is called the economic substance doctrine. In
general, this doctrine denies tax benefits arising from
transactions that do not result in a meaningful change to the
taxpayer's economic position other than a purported reduction
in income tax. Closely related doctrines include the "sham
transaction doctrine" and the "business purpose doctrine",
which requires that the transaction's business purpose must be
separate and distinct from any tax consequences. Generally,
an ATS has no business purpose other than reducing taxes and
is promoted with the promise of tax benefits, predictable tax
losses or tax consequences, and no related economic loss
experienced with respect to the taxpayer's income or assets.
An ATS is, often, cloaked in a series of transactions to make
it appear to have a business purpose or is structured to
create an incidental business purpose. In contrast, a
transaction is considered to have economic substance and,
therefore, satisfy the economic substance doctrine, if (a) the
taxpayer establishes that the transaction changes the
taxpayers economic position in a meaningful way other than as
a result of its tax consequences; and, (b) the taxpayer has a
substantial non-tax purpose for entering into the transaction,
and the transaction is a reasonable means of achieving that
purpose.
The FTB and the IRS have also identified certain characteristics
of ATS such as separation of income and expenses, use of
pass-through entities or third-party facilitators, utilization
of offshore foreign accounts or facilitators, or allowance of
double benefits from a single tax loss.
6)Examples of ATS . An ATS is usually structured simply as a way
to reduce tax, and not to generate income. A legitimate tax
shelter, usually, is set up with the primary purpose of
producing income.
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a) 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 United States (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.
b) Inflated Partnership Basis Transaction. 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/her basis in the pass-through entity
for the contingent liability 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).
c) 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/her California residency.
d) Sale of Charitable Remainder Trusts Interest. This
transaction was identified by the IRS as a transaction of
interest in which a sale of all interests in a charitable
remainder trust results in the grantor or other
noncharitable recipient receiving the value of that
person's trust interest while claiming little or no taxable
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gain.
e) Subpart F Income Partnership Blocker. This sheme uses a
domestic partnership to prevent the inclusion of Subpart F
income. A U.S. taxpayer that owns controlled foreing
corporations (CFCs) that hold stock a lower-tier CFC
through a domestic partnership takes the position that
Subpart F income of the lower-tier CFC does not result in
income inclusion for the U.S. taxpayer.
f) Abusive Roth IRA Transactions. This plan allows
individual taxpayers to contribute to a Roth IRA more than
the annual contribution level allowed under federal and
state laws. The ATS involves the establisment of a closely
held corporation owned by the Roth IRA. When valuable
assets are transferred to the Roth corporation and,
subsequently, sold, no tax is owed by the Roth corporation.
Thus, income escapes taxation because no tax is paid on
the transfer of assets or on the withdrawal.
7)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.
8)California's ATS Law. In 2003, in an effort to curb the use
of ATS activity, the Legislature enacted AB 1601 (Frommer),
Chapter 654, Statutes of 2003, and SB 614 (Cedillo), Chapter
656, Statutes of 2003. The legislation provided a limited
amnesty for participants in ATS, increased reporting
requirements for ATS participants and penalties following the
amnesty period, and expanded the state's ability to take legal
action against ATS participants. That amnesty, which was in
effect from January 1, 2004 until April 15, 2004, resulted in
payments from businesses and individual taxpayers of about
$1.4 billion, of which $700 million represented the state's
net revenue gain. A total of 1,202 taxpayers participated in
the amnesty. That legislation was designed to curtail the use
of then existing assortment of illegal tax shelters by
offering an amnesty period and to restrict the availability of
new tax shelter activities by increasing detection efforts and
enforcement activities. It also sought to increase the level
of overall tax compliance by taxpayers and was undertaken in
the hope that it would generate substantial revenue for the
state. Thus, it created a whole range of new penalties to
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provide an incentive to participate in the amnesty as well as
to discourage additional ATS-related behaviors. Major penalty
increases included a penalty for failure to report a
"reportable transaction" for understated tax in connection
with transactions lacking economic substance, an
accuracy-related penalty for tax returns with reportable
transactions, and a penalty for failure to report or register
a tax shelter.
9)What is a "reportable transaction"? 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 listed transactions; transactions of
interest; confidential transactions; transactions with
contractual protection; and 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.
4)What is a "listed transaction"? 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 ATS).
5)What does this bill do? This bill consolidates existing
definitions of various ATS into a single, consistent
definition and modifies the existing penalty imposed on a
taxpayer who has failed to report a use of an ATS on the tax
return. Currently, the penalty is equal to 100% of the
interest imposed on a deficiency attributable to the
taxpayer's use of the ATS. Existing law allows the taxpayer
to avoid that penalty by filing an amended return after the
taxpayer was contacted by the FTB but prior to the FTB's
issuing a deficiency notice. However, some argue that this
opportunity for the taxpayer to file an amended return to
avoid the penalty lessens the effectiveness of the penalty and
encourages taxpayers to play "audit roulette" where the cost
of getting caught is minor compared to the savings. The
proponents posit that a 50% (instead of 0% or 100%) penalty
would still provide an incentive for taxpayers to file an
amended return and pay the tax, but the most egregious
transactions would be subject to a significant penalty.
6)Suggested technical amendment.
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Amendment 1
On page 8, strike out lines 2 to 8, inclusive
REGISTERED SUPPORT / OPPOSITION :
Support
None on file
Opposition
California Taxpayers' Association
California Bankers Association
California Chamber of Commerce
California Manufacturers and Technology Association
TechAmerica
Analysis Prepared by : Oksana Jaffe / REV. & TAX. / (916)
319-2098