BILL ANALYSIS �
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|SENATE RULES COMMITTEE | AB 1423|
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THIRD READING
Bill No: AB 1423
Author: Perea (D)
Amended: 7/12/11 in Senate
Vote: 27 - Urgency
SENATE GOVERNANCE & FINANCE COMMITTEE : 9-0, 07/06/11
AYES: Wolk, Huff, DeSaulnier, Fuller, Hancock, Hernandez,
Kehoe, La Malfa, Liu
SENATE APPROPRIATIONS COMMITTEE : 9-0, 08/25/11
AYES: Kehoe, Walters, Alquist, Emmerson, Lieu, Pavley,
Price, Runner, Steinberg
ASSEMBLY FLOOR : 77-0, 05/16/11 (Consent) - See last page
for vote
SUBJECT : Income taxes: federal conformity: Regulated
Investment
Company Modernization Act of 2010
SOURCE : Author
DIGEST : This bill conforms state laws to recent federal
changes that affect the tax treatment of regulated
investment companies, which are mutual funds and other
similar investment companies.
ANALYSIS : Under federal and state law, mutual funds pass
through gains and losses on its investments to the
individuals owning its shares, instead of paying tax on its
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earnings, so long as they meet the definition and
requirements for Regulated Investment Companies (RICs) set
forth under Subchapter M of the Internal Revenue Code.
Generally, as long as a RIC pays out 90 percent of its
earnings in dividends to its shareholders, the RIC deducts
all the dividends it pays to its shareholders from its
taxable income. Shareholding taxpayers report the
distributed income on their own personal income tax
returns, and retain the character of the income, such as
tax-exempt interest or long or short-term capital gains.
Whenever a fund fails to comply with Subchapter M, federal
and state law applies the corporate income tax to the fund,
and its shareholders must include RIC earnings
distributions as ordinary income, which federal law taxes
at a higher rate than capital gains income. California
taxes all income at the same rate.
In December, 2010, Congress enacted the RIC Modernization
Act of 2010 (RIC Act), which comprehensively recast and
restructured tax laws guiding mutual funds. California
generally conforms its tax law to federal changes, most
recently with SB 401 (Wolk) Chapter 14, Statutes of 2010.
This bill conforms state law to the RIC Act by conforming
state law to the following federal changes:
I. Capital Loss Carryovers . Previously, RICs could only
carry over capital losses for eight taxable years after the
year the loss is incurred. The RIC Act allowed RICs to
carry over losses indefinitely, mirroring carryover
treatment allowed for personal income taxpayers. The RIC
Act also changed the treatment of the loss to reflect its
character (short-term or long-term) instead of always being
classified as short term. Additionally, the RIC Act
required taxpayers to first use losses incurred after the
RIC Act's enactment before they could use losses from
taxable years prior to enactment.
II. Asset and gross income tests . To ensure its
classification as a RIC, the mutual fund must pass an asset
test at the end of each quarter of the taxable year, and at
the end of the year. If the RIC doesn't meet the tests,
they have 30 days to remedy the violation or lose its
classification. The tests have different criteria:
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For the quarterly test, a mutual fund must hold at
least 50 percent of its assets in cash, cash items,
government securities, securities of other RICs, and
other securities, so long as the share of one issuer's
securities doesn't exceed 50 percent of the RIC's
total assets, and the RIC doesn't hold more than 10
percent of any one issuer's outstanding voting
securities.
For the annual test, not more than 25 percent of
the RIC's total value can be in invested in any one
issuer's securities, or the securities of two or more
issuers that are engaged in a similar trade or
business and under control of the RIC.
The RIC Act instead allows for de minimis asset test
failures when the assets owned that violate the test don't
exceed the lesser of one percent of RIC's total assets or
$10 million. When a RIC falls within the de minimis
failure, it has six months to dispose of the assets which
triggered the test failure. Additionally, when the RIC
fails the test outside of the de minimis range, the RIC can
cure the failure if:
The RIC describes each asset which caused the
failure in a schedule filed with the Secretary of the
Treasury.
The failure is due to reasonable cause, not willful
neglect.
The RIC disposes of the assets that triggered the
failure and complies with the test within six months
after the last day of the quarter in which it failed
the test.
Pays a tax on the income that resulted from the
failure.
RICs must also derive 90 percent of its gross income from
qualifying income. The RIC Act allows the RIC to cure the
failure if:
The RIC describes each item of income in a schedule
filed with the Secretary of the Treasury.
The failure is due to reasonable cause, not willful
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neglect.
Pays a tax on the income that resulted from the
failure.
III. Capital Gains Treatment . RICs may classify dividends
as capital gains dividends when the amount paid does not
exceed the RIC's net capital gain. RICs can also designate
dividends as tax-exempt interest dividends when at least
half of its assets are tax-exempt municipal bonds, except
when the dividends exceed the total amount of tax-exempt
interest the RIC received. RICs can also pass through to
shareholders foreign tax credits, credits for tax-exempt
bonds, and specified dividends.
The RIC Act allows a different treatment when dividends
paid exceed net income in the taxable year for RICs that
have taxable years over more than one calendar year. The
RIC Act allows RICs to allocate net income to the
post-December portion of the taxable year.
RICs must notify its shareholders in a written notice
within 60 days of the close of its taxable year of any of
the above classifications or events. The RIC Act allows
RICs to satisfy the above requirement by reporting the
information to its shareholders with a form 1099.
IV. Earnings and Profits. Previously, RICs could not use
deductions associated with tax-exempt securities to reduce
current earnings and profits, which resulted in taxable
dividends to shareholders for income that was not
economically a return of capital. The RIC Act allows
deducts associated with tax-exempt income and net capital
losses against current earnings and profits.
V. Pass Through of Exempt-Interest Dividends and Foreign
Tax Credits. Some RICs holds stock in other RICs.
Previously, when one RIC pays a dividend to another, the
character of the income stays the same on the way to the
shareholder. One exception is for exempt-interest
dividends which can only be passed through when 50 percent
of its total assets consist of tax-exempt securities, and
foreign tax credits which can only be passed through when
50 percent or more of the RICs holdings are stock or
securities in foreign corporations. RICs with more than 50
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percent of its assets invested in stock of other RICs
cannot pass through these benefits because of those tests.
The RIC Act allows these benefits to be passed through when
50 percent of its assets invested in stock of other RICs.
VI. Spillover Dividends. RICs can choose to have some
dividends paid after the close of the taxable year included
in the taxable year to comply with the 90 percent
distribution requirement and to determine taxable income,
known as "spillover dividends." To qualify, the RIC must
declare the spillover dividend before they file their tax
return, and distribute it to shareholders after the close
of the taxable year but before the next dividend payment.
The RIC Act moves the declaration deadline back to the
later of the 15th day of the 9th month following the close
of the taxable year or the extended due date for filing the
return, and the distribution deadline back to the date of
the next dividend payment after the declaration for that
kind of dividend.
VII. Return of Capital Distributions. RICs must
distribute dividends during the year in which they generate
the net income, or else the distribution is deemed a return
to capital, which adjusts the taxpayer's basis in the RIC
stock and must be allocated proportionally among all
distributions made during the year. The RIC Act requires
RICs that distribute more than they make in net income to
allocate earnings and profits first to distributions made
before January.
VIII. Share Redemption. Previous law did not clearly
classify as an exchange the redemption of some, but not
all, shares in open-ended RICs; when an investor sells
stock in a RIC, he or she is selling it back to the RIC,
not another investor. The RIC act makes the clarification.
Additionally, for a RIC that owns shares in another RIC
when both are in the same controlled group of corporations,
the loss must be deferred until the shares are sold to
someone outside the group. The RIC Act allows the capital
loss when redeeming stock in a RIC that issues stock
redeemable at any time, and a shareholding RIC demands
redemption.
IX. Preferential Dividends. Previous law disallows RIC
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deductions that are "preferential," when the RIC pays
dividends to some shareholders in a class but not others,
or more quickly than others. The RIC Act repeals these
rules, defaulting to Securities and Exchange Act
enforcement.
X. Deferral of late-year losses. RICs pay capital gains
dividends to shareholders of 98 percent of its net capital
gains by December 31 each year, and must pay an excise tax
of four percent of the difference between the dividends
that were paid and the dividends that should have been paid
if they don't. The RIC pays the dividends based on its net
capital gains from the previous year ending on October 31.
However, RICs with a taxable year ending on June 30 can
lose money between October 1 and the end of the taxable
year, changing the dividends into returns on capital.
Previous law required RICs to push forward the losses to
the next taxable year, but applied unevenly and made basis
tracking difficult. The RIC Act allows RICs to "push
forward" some or all of these losses to the first day of
the next taxable year, instead of requiring them to do so.
XI. Claiming losses. Previously, investors paid
exempt-interest dividends had to hold stock in the RIC for
six months to be able to claim a loss, if one occurs. The
RIC Act deleted the rule.
XII. Sales Load Basis Deferral Rule. When brokers sell
mutual fund shares, the RIC may charge a load charge to
compensate the brokers. Investors may pay reduced load
charges when acquiring rights to sell the initial stock and
reinvest in a different stock offered by the same RIC.
When investors pay reduced load charges to acquire
reinvestment rights then dispose of the stock within 90
days, the load charge was not used to determine loss or
gain on the initial stock purchased; instead, it was
treated as a cost for acquiring the stock pursuant to the
reinvestment right. The RMA Act limits the rule only to
those cases when the investor acquires the reinvested stock
on or before January 31.
Comments
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Before the RIC Act, RICs that fell out of compliance with
Subchapter M requirements were subject to a severe penalty:
loss of its dividends paid deduction, and application of
federal and state corporate income taxes to its earnings.
Simple mathematical mistakes could result in severe
consequences: a mutual fund that faced no entity level tax
would be hit with a combined rate up to 43.84 percent of
its income, and its shareholders would no longer pay
preferential rates on earnings from dividends, a
significant hit at the federal level. This bill conforms
to the RIC Act's changes, making compliance easier for
RICs, and in many cases preventing shareholders from having
to file amended returns when the character of income
changes because of the previous rules. Conforming
California law would provide safe harbor for some mistakes,
and ensure that mutual funds in the state wouldn't have to
play by two different sets of rules.
California does not automatically conform to changes in
federal law, except under specified circumstances.
Instead, the Legislature must affirmatively conform to
federal changes. Conformity legislation is introduced
either as individual tax bills to conform to specific
federal changes or as one omnibus bill to conform to the
federal law as of a certain date with specified exceptions.
State tax law did not conform to changes made in federal
law after 2005 until last year, when the Legislature
enacted a bill conforming to changes through January 1,
2009 (SB 401, Wolk, Chapter 14, Statutes of 2010).
Conformity is difficult despite its advantages and reduced
tax compliance costs, because the state may disagree with
Congress's tax policy changes, and conformity can also
significantly impact state revenues. This bill only
conforms to one specific federal act.
Related Legislation
AB 242 (Perea) conforms state law to changes made last year
as part of health care reform efforts.
FISCAL EFFECT : Appropriation: No Fiscal Com.: Yes
Local: No
According to the Senate Appropriations Committee, in
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December 2010, Congress enacted the RIC Modernization Act
of 2010 (Public Law 111-325), which comprehensively recast
and restructured tax laws guiding mutual funds. This bill
conforms California law to the following changes in the RIC
Act:
Capital loss carryovers (Section 101 of RIC Act)
Savings provisions related to failure of RIC to
satisfy gross income and asset tests (Section 201,
conform with modifications)
Modification of dividend designation requirements
and allocation rules (Section 301)
Earnings and profits (Section 302)
Pass-through of exempt-interest dividends and
foreign tax credits in fund of funds structure
(Section 303)
Modification of rules for spillover dividends
(Section 304)
Return of capital distributions (Section 305)
Distributions in redemption of stock (Section 306)
Repeal of preferential dividend rule (Section 307)
Elective deferral of specified late-year losses
(Section 308)
Exception to holding period requirement for certain
exempt-interest dividends (Section 309)
Modification of sales load basis deferral rule
(Section 502)
Senate Appropriations Committee staff notes that this bill
would result in a three-year revenue loss, followed by four
years of revenue gains, and more significant revenue losses
of approximately $8 million beginning in 2018-19, which
would eventually drop to $1 million to $2 million per year.
These out-year revenue losses are a result of the
provisions that change the carry over rules for RIC losses.
Under current law, RIC losses may be carried over for up
to 8 years. Under the RIC Act, however, RIC losses may be
carried over indefinitely, which is similar to net capital
loss carryovers applicable to individual taxpayers. For
losses realized in 2011, the new law would not affect
carryover loss claims until 2019, when the current eight
year window would expire. Since the losses no longer
expire under current federal law, conformity to this
provision would allow RICs to use remaining losses to
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offset capital gains income and reduce tax liabilities
beginning in 2019. As shares are redeemed, the revenue
losses would be partially mitigated.
Note: The Franchise Tax Board's (FTB) report titled
"Summary of Federal Income Tax changes - 2010"
includes a detailed discussion of the federal and
state tax laws affected by this bill
(http://www.ftb.ca.gov/law/ legis/10FedTax.pdf).
SUPPORT : (Verified 8/29/11)
Pacific Life Insurance Company
California Taxpayers' Association
Investment Company Institute
Securities Industry and Financial Markets Association
Franklin Templeton Investments
California Chamber of Commerce
Fireman's Fund Insurance Company
Spidell Publishing, Inc.
Pacific Investment Management Company (PIMCO)
BlackRock
Capital Group Companies
Dodge and Cox Funds
California Retailers Association
California Bankers Association
Charles Schwab Corporation
California Society of Enrolled Agents
ARGUMENTS IN SUPPORT : According to the author, "AB 1423
would update California's personal income and corporate tax
laws relating to mutual funds to conform to the recently
revised federal income tax law. This measure would ensure
that mutual funds are treated the same under both the
federal and state income tax laws, thus allowing mutual
funds to be more efficient and stay competitive with other
states."
ASSEMBLY FLOOR : 77-0, 05/16/11 (Consent)
AYES: Achadjian, Alejo, Allen, Ammiano, Atkins, Beall,
Bill Berryhill, Block, Blumenfield, Bonilla, Bradford,
Brownley, Buchanan, Butler, Charles Calderon, Campos,
Carter, Cedillo, Chesbro, Conway, Cook, Davis, Dickinson,
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Donnelly, Eng, Feuer, Fletcher, Fong, Fuentes, Furutani,
Beth Gaines, Galgiani, Garrick, Gatto, Gordon, Grove,
Hagman, Halderman, Hall, Harkey, Hayashi, Roger
Hern�ndez, Hill, Huber, Hueso, Huffman, Jeffries, Jones,
Knight, Lara, Logue, Bonnie Lowenthal, Ma, Mendoza,
Miller, Mitchell, Monning, Morrell, Nestande, Nielsen,
Olsen, Pan, Perea, V. Manuel P�rez, Portantino, Silva,
Skinner, Smyth, Solorio, Swanson, Torres, Valadao,
Wagner, Wieckowski, Williams, Yamada, John A. P�rez
NO VOTE RECORDED: Gorell, Mansoor, Norby
AGB:nl 8/29/11 Senate Floor Analyses
SUPPORT/OPPOSITION: SEE ABOVE
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