BILL ANALYSIS �
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Date of Hearing: April 21, 2014
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Raul Bocanegra, Chair
AB 1651 (Donnelly) - As Amended: April 2, 2014
Majority vote. Fiscal committee.
SUBJECT : Income taxes: deductions: loss of fair market value
SUMMARY : Allows a deduction, under both the Personal Income
Tax (PIT) Law and the Corporation Tax (CT) Law, in an amount
equal to the loss in fair market value (FMV) of any tangible
personal property (TPP), as specified. Specifically, this bill :
1)Allows a deduction equal to the loss in FMV, as determined by
the taxpayer, of any TPP attributable to a rule or regulation
promulgated by a California state agency or a statute enacted
by the California Legislature that took effect in the taxable
year in which the deduction is claimed.
2)Provides that the term "fair market value" means "full cash
value of "fair market value," as defined in Revenue and
Taxation Code (R&TC) Section 110.
3)Defines "tangible personal property" as privately owned
property that has physical substance and can be touched.
Requires that the TPP be located in California.
4)Specifies that the provisions of this bill will apply only to
a rule or regulation promulgated by a California state agency
or a statute enacted by the California Legislature promulgated
or enacted on or after the effective date of this bill.
5)Provides that the deduction allowed by this bill is in lieu of
any other deduction which the taxpayer may otherwise claim
with respect to the depreciation of TPP.
6)Applies to taxable years beginning on or after January 1,
2014.
7)Takes immediate effect as a tax levy.
EXISTING LAW :
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1)Authorizes various deductions in computing income that is
subject to tax, including a deduction for losses related to
TPP as casualty, disaster or theft losses.
2)Allows a depreciation deduction for the obsolescence or wear
and tear of property used in the production of income or
property used in a trade or business.
FISCAL EFFECT : Unknown. The Franchise Tax Board (FTB) notes
the following in its staff analysis of this bill:
To determine the potential impact of this proposal to the
General Fund would require predicting the frequency, number
and nature of future statutes, rules, or regulations. It
would also require knowledge of the tangible personal
property impacted, including the value before and after the
loss, as well as the income characteristics of qualified
taxpayers using the deduction. Since it is impractical to
predict these future events, the revenue impact to the
General Fund is undeterminable.
COMMENTS :
1)The Author's Statement . The author has provided the following
statement in support of this bill:
Everyday regulations and laws are passed that directly
affect citizens['] privately owned property. It is time
that we take responsibility for that loss and compensate
those who have suffered from these excessive regulations.
2)The Purpose of this Bill . According to the author, this bill
is intended to provide relief to those "who suffer from
regulations or laws implemented in California." Specifically,
this bill allows a business or individual to claim a deduction
on the California income tax return for the decline in the FMV
of the property. For example, if "a property owner has a
high-valued piece of land ruled unbuildable or unusable
because of an EPA ruling, the value of the property is going
to substantially decrease." This bill is the first step in
trying to compensate for the future financial loss of
citizens' property; and if enacted, this bill will force the
government "to think twice before regulating the people."
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3)Arguments in Opposition . The opponents state that this bill
"undermines the legitimate and long-settled purpose of all
government; purposes recognized by our Founders, who in our
federal constitution, balanced the rights of property owners
and the needs of the majority by requiring compensation for a
regulatory taking but not compensation for regulations that
did not amount to a specific taking." The opponents assert
that "while deceptively straightforward [this bill] is
completely nonsensical and would be impossible to enforce."
They maintain that "[i]t is the beauty of democracy that
majority interests are balanced against individual rights,
with private gains sometimes given up to achieve a common
good" and that giving "every individual or corporation in the
state the right to argue exactly what dollar amount they have
lost in a year due to any number of the thousands of new laws
and regulations introduced each year would paralyze the
government with a deluge of litigation and would make even the
basic functions of governance all but impossible." In
addition, the opponents argue that, just as "those whose
property increases in value because of generally applicable
legislation (think, property casualty companies benefitting
from minimum financial liability requirements for car
insurance) should not pay an additional income tax reflecting
the increase in the unrealized fair market value of their
businesses, neither should those who have seen the value of
their businesses decline because of such legislation see a
reduction in their taxes." Finally, "as a matter of tax
policy ? the explosion of lawsuits based on the application of
this measure will be enormous."
4)The "Realization Event" Tax System vs. a "Mark-to-Market" Tax
System . Under existing federal and state income tax laws,
any appreciation or decline in the value of a taxpayer's asset
generally is not taking into account for purposes of computing
the taxpayer's income tax until the taxpayer disposes of that
asset. This concept of a "realization event," which means a
sale or other disposition of property, is one of the basic
tenets of the United States (U.S.) income tax system. A
realization event results in the taxpayer having a different
legal entitlement than she or he had before the exchange.
Almost a century ago, the U.S. Supreme Court pronounced that
the income tax laws "do not charge for appreciation of
property or allow a loss from a fall in market value unless
realized in money by a sale." [Weiss v. Wiener (1929) 279
U.S. 333, 335 (emphasis added).] Accordingly, the tax on
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asset appreciation is deferred until the occurrence of a
realization event. Similarly, a deduction of a loss from a
decline in the FMV of an asset is not allowed unless a
realization event has occurred.<1>
Many critics have pointed out that the realization requirement
is "an undesirable element of the income tax, at least in
theory," and that an ideal income tax system would tax any
increase in a taxpayer's wealth - or asset appreciation - when
it occurs.<2> Under existing law, both federal and state, the
realization requirement is deferred until appreciated property
is transferred for a tangible benefit. In addition to the
deferral, current law also provides that the accrued gain may
be shifted to other taxpayer when inter vivos gifts occur<3>
or may be completely eliminated if appreciated property is
transferred to charity or held by the taxpayer until his/her
death.<4> This preferential tax treatment of asset
appreciation, as compared to other types of income (such as
wages, interest, or dividends, for example), violates the
horizontal as well vertical equity and distorts investment
decisions due to a "lock in" effect after appreciating assets
are acquired.<5> Many commentators highlighted the inequities
of the realization requirement and some proposed to substitute
a "mark-to-market" approach for the realization requirement.
A mark-to-market system, which taxes asset appreciation as it
accrues, does not suffer from the same infirmities that
afflict the current "realization event" system and would
eliminate the inequity and inefficiency of a realization-based
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<1> To the extent that the gain or loss is realized from a sale
of property for cash, or from the exchange of property for other
property differing materially either in kind or in extent, it is
treated as income or as loss sustained.
<2> Kwall, J., When Should Asset Appreciation Be Taxed? The Case
for a Disposition Standard of Realization, Indiana Law Journal,
p. 83.
<3> IRC Section 1015allows a donee to have a transferred basis
in the appreciated property, which includes appreciated gains.
<4> IRC Section 1014 eliminates the tax on accrued gains in
property that is transferred at death by establishing a
fair-market-value basis in the property.
<5> Kwall, J., When Should Asset Appreciation Be Taxed? The Case
for a Disposition Standard of Realization, Indiana Law Journal,
p. 93 (explaining the horizontal and vertical equity)
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system by terminating the tax deferral.<6> However, inasmuch
as this system would provide a more accurate assessment of any
increase or decrease in a taxpayer's wealth, it would also
present serious administrative and implementation issues.
First of all, all assets would have to be appraised each year,
which would be burdensome for both taxpayers and tax agencies.
The mark-to-market system has also been criticized for taxing
"paper gains,"<7> meaning that it would impose tax at a time
when the taxpayer may have no cash to pay the tax. Finally, a
comprehensive mark-to-market tax system may not be politically
feasible and may not receive popular support.<8>
1)Types and Deductibility of Losses . Any loss sustained during
the taxable year and not compensated for by insurance or
otherwise is allowed as a deduction. In the case of an
individual, the deductible losses are limited to: (a) losses
incurred in a trade or business, (b) investment losses, i.e.
those incurred in any transaction entered into for profit,
though not connected with a trade or business, and (c)
personal casualty or theft losses.<9>
The first type of losses results from a trade or business
activity in which expenses exceed gross receipts, subject to
certain restrictions. Investment losses are incurred in
activities entered into for profit, even if the activity does
not rise to the level of trade or business. Personal casualty
losses may result from a number of events in which property is
damaged or lost, including among others earthquakes, storms,
fires, floods, terrorist attacks, government-ordered
demolition or relocation of a home that is unsafe to use
because of a disaster, and vandalism. A disaster loss occurs
when property is destroyed as a result of a fire, storm,
flood, or other natural event in an area proclaimed to be a
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<6> Id., p. 91
<7> Ibid.
<8> D. Schenk, A Positive Account of the Realization Rule, 57
TAX L. REV. 355, 377-78 (2204) (suggesting that people do not
view paper profits as income); D. Schizer, Realization as
Subsidy, 73 N.Y.U. L. Rev. 1549, 1606 (1998) (an attempt to
repeal realization "would create ? a firestorm of political
opposition).
<9> IRC Section 165(c).
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disaster by the President of the United States, or, for
California state law purposes, by the Governor. While the
casualty losses are deductible during the taxable year in
which the loss occurred, disaster losses may be deducted
either in the year in which the loss occurred or in the
preceding year. Any loss arising from theft is treated as
sustained during the taxable year in which the taxpayer
discovers such loss.<10> The taking of property must be
illegal under the law of the state where it occurred and it
must have been done with criminal intent.
As discussed above, in order to be deductible for tax purposes,
a loss must be first "realized" and there must be no
reasonable likelihood that the taxpayer will ever recoup or
recover the loss. Once it has been established that a
realization event occurred, the taxpayer must determine
whether he/she realized gain or loss and the character of that
loss or gain realized on the transaction. However, a loss on
the sale or exchange of property between related persons is
not deductible. Similarly, a loss from the sale or exchange
of property held for personal use is not deductible, unless
the loss results from a casualty or theft. Losses and gains
are classified as either capital or ordinary, depending on
whether the property is a capital or noncapital asset for tax
purposes.
1)What Does This Bill Do ? This bill essentially proposes to
replace the realization requirement tax system with a
mark-to-market system but only for losses incurred by a
taxpayer due to a decline in the asset's value that has
resulted from the enactment of a new state statute or an
administrative rule or regulation. In other words, no sale or
other disposition of the property is required for the taxpayer
to be able to claim this deduction. The deduction would be
allowed in the amount of any loss of the fair market value of
any TPP located in California, including TPP held for personal
use. However, land would be excluded from the definition of
property eligible for the deduction.
It appears that the amount of loss would be determined by the
taxpayer, but the character of the loss would still be
dictated by the existing law. Either an individual or
corporate taxpayer may claim this deduction but no
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<10> IRC Section 165(e). The deduction for casualty or theft
losses is limited to the taxpayer's basis in the property.
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depreciation deduction would be allowed with respect to the
same TPP.
2)A Depreciation Deduction . Existing laws allow a depreciation
deduction for the obsolescence or wear and tear of property
used in the production of income or property used in a trade
or business. Obsolescence may be attributed to a number of
causes, including technological improvements, reasonable
foreseeable economic changes and legislative or regulatory
action that prohibits or otherwise limits use of the property
for its intended purpose. When property becomes obsolete, the
property's estimated useful life is revised and the remaining
basis is deducted over the revised useful life. In the case
of property with no remaining useful life, 100% of the
remaining basis would be deductible in the year of
obsolescence. The Committee may wish to consider whether the
existing depreciation system adequately compensates taxpayers
for any loss in the value of their TPPs due to a legislative
or regulatory action.
3)The Determination of FMV and the Amount of Loss . Under this
bill, the amount of loss eligible for the proposed deduction
would be determined by the taxpayer. It is unclear to the
Committee staff whether an appraisal by an independent
third-party would be required or whether the taxpayer will be
the one estimating the FMV of the TPP as well as its decline.
Would the taxpayer be required to retain some documentation
substantiating the amount of loss? Furthermore, would the
taxpayer be required to reduce his/her tax basis in the asset
to reflect the deduction? Generally, the amount of loss is
calculated by reference to the taxpayer's adjusted basis in
the asset, i.e. it is computed as a difference between the
amount realized on the sale or exchange and the taxpayer's
adjusted basis in the property. How would the amount of loss
be calculated if this bill becomes law? Would the taxpayer
compare the FMV of the property as of the date of appraisal
with his/her adjusted basis in the property or with the
property's FMV as of the preceding taxable year? Potentially,
the asset value may fluctuate from year to year. It is also
conceivable that the taxpayer could claim a deduction for the
loss even though he/she has not suffered any real economic
loss, meaning his/her adjusted basis in the property is still
lower than the property's FMV, even after taking into
consideration the decline in its value. The Committee may wish
to consider whether taxpayers who have not suffered real
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economic loss should be eligible for the proposed deduction.
Finally, in a pure mark-to-market system, both gains and
losses are accounted for annually. The Committee may wish to
consider whether it is advisable to treat the recognition of
gains and losses for tax purposes differently.
4)Who Will Decide if the Loss is Attributable to the State's
Actions ? This bill contemplates that a decline in the FMV of
a taxpayer's TPP must be attributable to a "rule or regulation
promulgated by a California state agency or a statute enacted
by the California Legislature that took effect in the taxable
year in which the deduction is claimed." It is unclear to the
Committee staff whether the term "attributable to" connotes a
direct causation or an indirect impact that might have been
reasonably avoided by the taxpayer. Additionally, how will
the taxpayer substantiate the necessary connection between the
legislative or administrative action and a decline in the
property's value? Finally, it is unclear to the Committee
staff whether the taxpayer would be able to claim a deduction
for the decline in the FMV of his/her property that occurred
in any year subsequent to the taxable year in which a
particular rule or regulation was implemented. Is it a
one-time deduction? It is plausible that a decline in
property's value may not occur until a year or two after the
enactment of a statute or implementation of a rule.
5)A Potential Constitutional Challenge ? This bill would also
limit the application of the deduction to TPP located in
California. By limiting the credit to in-state activity, this
credit could arguably be susceptible to challenge under the
dormant commerce clause of the U.S. Constitution.
The U.S. Constitution authorizes Congress to regulate commerce
with foreign nations, and among the several states. (U.S.
Constitution, Article I, Section 8, Clause 3.) While the
commerce clause is phrased as a positive grant of regulatory
power, it "has long been seen as a limitation on state
regulatory powers, as well as an affirmative grant of
congressional authority." [Fulton Corp. v. Faulkner (1996)
516 U.S. 325, 330.] This negative aspect, commonly referred
to as the "dormant commerce clause," prohibits economic
protectionism in the form of state regulation that benefits
"instate economic interests by burdening out-of-state
competitors." (Ibid.)
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Both the U.S. Supreme Court and the California courts have
addressed challenges to various state tax provisions on
dormant commerce clause grounds. Most recently, the Court of
Appeal struck down a California statute that allowed taxpayers
a deferral for income received from the sale of stock in
corporations maintaining assets and payroll in California,
while providing no such deferral for income from the sale of
stock in corporations maintaining assets and payroll
elsewhere. [Cutler v. Franchise Tax Board (2012) 208
Cal.App.4th 1247, 1250.] Specifically, the court held that
"the deferral provision discriminates on its face on the basis
of an interstate element in violation of the commerce clause."
(Ibid.)
While no court decision has yet invalidated, as a general
matter, a state income tax credit that provides an incentive
for in-state activity, i.e., property placed in service,
targeted tax incentives such as the ones proposed by this bill
may be subject to constitutional challenge, as noted by the
FTB staff.
6)The FTB's Implementation Concerns . The FTB staff, in its
analysis of this bill, noted that AB 1651 lacks administrative
details necessary to implement this bill.
REGISTERED SUPPORT / OPPOSITION :
Support
None on file
Opposition
California School Employees Association
The Service Employees International Union (SEIU)
The American Federation of State, County and Municipal
Employees, AFL-CIO
The California Tax Reform Association
Analysis Prepared by : Oksana G. Jaffe / REV. & TAX. / (916)
319-2098
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