BILL ANALYSIS
SB 401
Page 1
SENATE THIRD READING
SB 401 (Wolk)
As Amended August 31 2009
Majority vote.
SENATE VOTE :22-15
REVENUE & TAXATION 6-2 APPROPRIATIONS 12-5
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|Ayes:|Charles Calderon, Beall, |Ayes:|De Leon, Ammiano, |
| |Coto, Ma, Portantino, | |Charles Calderon, Coto, |
| |Saldana | |Davis, |
| | | |Fuentes, Hall, John A. |
| | | |Perez, |
| | | |Skinner, Solorio, |
| | | |Torlakson, Hill |
| | | | |
|-----+--------------------------+-----+--------------------------|
|Nays:|Harkey, Hagman |Nays:|Conway, Harkey, Miller, |
| | | |Nielsen, |
| | | |Audra Strickland |
| | | | |
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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,
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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. Requires that
the transactions of interest be identified and published on the
FTB's Web site.
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
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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 a limited liability company
or an S corporation shall not by itself be "abusive" solely
because of the choice of entity.
10)Contains double-jointing language to avoid chaptering out
problems with AB 1580 (Revenue and Taxation Committee), pending in
the Senate.
FISCAL EFFECT :
The FTB staff estimates that this bill will result in a gain of $6.4
million in fiscal year (FY) 2009-10 and $0.1 million in FY 2010-11,
and about $12 million annually in subsequent years.
COMMENTS : 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: 1) a tax
shelter; 2) an undisclosed reportable transaction; 3) a listed
transaction; 4) a gross misstatement; or, 5) 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 impose 50% of the penalty.
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.
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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.
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.
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 Internal Revenue Service (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.
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: 1)
little or no motive of realization of economic gain; 2) intentional
mismatching of income and deductions; 3) overvalued assets or assets
with values subject to substantial uncertainty are included; 4)
non-recourse financing and financing techniques that do not conform
to standard commercial business practices; or, 5)
mischaracterization of the substance of the transaction.
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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 1) 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, 2) 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.
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.
1)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.
2)Inflated Partnership Basis Transaction. These schemes use
transactions that are "contingent" (not completed) to inflate an
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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).
3)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.
4)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 gain.
5)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.
6)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
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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.
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.
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 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.
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
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amended return for any taxable year the taxpayer participates in the
transaction.
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).
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.
Related legislation. The provisions of this bill were included in
the package adopted by the Conference Committee on the Budget and
included in SB 75 (Senate Budget and Fiscal Review) and AB 75
(Assembly Budget). The provisions were not, however, included in
the final budget package.
Analysis Prepared by : Oksana Jaffe / REV. & TAX. / (916) 319-2098
FN:
0002558