An overview of California's 2003 tax shelter and abusive tax shelter legislation

Tax Executive, The, Jan-Feb, 2004 by Eric J. Coffill

In the fall of 2003, the California Legislature passed, and Governor Gray Davis signed, Senate Bill 614 (1) and Assembly Bill 1601. (2) As characterized by the California Franchise Tax Board, "[n]ew California law authorizes the Franchise Tax Board to aggressively combat abusive tax shelters and transactions by adding substantial penalties, along with new registration and reporting requirements for both investors and promoters of abusive tax shelters." (3) This article summarizes the major provisions of the legislation, including the FTB's Voluntary Compliance Initiative, which is effective from January 1, 2004 through April 15, 2004. (4)

Background

On April 21, 2003, Senators Cedillo and Burton replaced the provisions of pending Senate Bill 614 with language intended to curtail the use of what the Legislature and the FTB perceived as abusive tax shelters. The bill proceeded through many iterations, with the most significant substantive dispute focusing on the proposed codification of the so-called economic substance doctrine. Largely as a result of public comments, (5) the bill was amended in September 2003 to remove the proposed codification of the economic substance doctrine. The California tax shelter legislation was originally based upon Senator Grassley's CARE Act of 2003 (S. 476), which passed the U.S. Senate 95-5 in March 2003. The CARE Act contained tax shelter provisions similar to the provisions of the California legislation. While S. 476 stalled in Congress, however, the California legislation proceeded. Indeed, Governor Davis emphasized in the Press Release surrounding his signing of Assembly Bill 1601 and Senate Bill 614 on October 2, 2003, that "[o]nce again, California is ahead of the pack. In fact, we are taking action before the federal government to curtail the use of abusive tax shelters." (6)

As will be seen below, the clear thrusts of the legislation are to create new penalties and registration requirements, and to stiffen existing penalties and registration requirements, as they relate to tax shelters and potentially abusive tax shelters. As also will be discussed below, a major component of the Legislature's "carrot and stick" approach under the legislation is the VCI, which will expire on April 15, 2004.

The Major Provisions of the Legislation

1. Disclosure of Certain Items on Tax Returns

California Revenue and Taxation Code (CRTC) [section] 18407 conforms to section 6011 of the Internal Revenue Code, thus requiring a taxpayer to disclose with its tax return certain information with respect to each "reportable transaction" in which the taxpayer participates. (7) The section defines "reportable transaction" to include any transaction of a type that the Secretary of the Treasury or the FTB "determines as having a potential for tax avoidance or evasion including deductions, basis, credits, entity classification, dividend elimination, or omission of income and shall be reported on the return or statement required to be made." (8) Under the Treasury regulations, there are currently six categories of reportable transactions. (9) The first such category is any transaction identified by Treasury as a tax avoidance transaction whose tax benefits are subject to disallowance under present law (referred to as a "listed transaction"). FTB has authority under the legislation to identify "reportable transactions" and "listed transactions" beyond those identified by the Treasury Department, for California income or franchise tax purposes. (10)

The FTB is directed by the legislation to publish "listed transactions," whether identified by the IRS or the FTB, on the FTB website, and in FTB notices or other published positions. (11) The FTB's first such publication is Chief Counsel Announcement 2003-1 (December 31, 2003). Briefly, it states that "California 'Listed Transactions' include all federal Listed Transactions," and it lists two "other" California Listed Transactions: (1) Certain Real Estate Investment Trust (REIT) Transactions and (2) Certain Regulated Investment Company (RIC) Transactions.

The effective date of this provision is complex. FTB states the provision is effective January 1, 2004. (12) Except for persons that invest in a tax shelter that becomes a listed transaction, this section applies to taxable years beginning on or after January 1, 2003. For the purpose of applying CRTC [section] 19778, relating to a higher interest rate for understatements of tax related to using a reportable transaction (which applies for taxable years beginning after December 31, 1998), the section applies for taxable years beginning after December 31, 1998.

2. Maintaining Tax Shelter Investor Lists

The legislation enacted CRTC [section] 18648, which conforms to the federal requirements of IRC [section] 6112, with modifications. This requires organizers, sellers, and material advisers of potentially abusive tax shelters to keep and provide lists of investors. Modifications include maintaining lists regarding potentially abusive tax shelters organized in California, doing business in California or deriving income from sources in California or where at least one of its investors is a California taxpayer. (13)