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California Mischief: Budget Tax Proposals Repeal Credits, Limit Apportionment Methods

Ever the trendsetter, California is hip to transparency and has posted proposed budget trailer bill language on the Department of Finance Web site, www.dof.ca.gov. The language confirms what taxpayers already knew:

February 22, 2011

Ever the trendsetter, California is hip to transparency and has posted proposed budget trailer bill language on the Department of Finance Web site, www.dof.ca.gov. The language confirms what taxpayers already knew: A target is on their backs as budget negotiations begin. The tax provisions specific to business taxpayers include a repeal of California’s Enterprise Zone Program and all related credit carryovers; mandatory single sales factor apportionment; mandatory market sourcing; tax shelter amnesty; and a financial institutions records match (FIRM) program. Other language includes a legislative constitutional amendment to extend current tax rates for five years. All of these proposals require a two-thirds legislative vote. However, the tax shelter amnesty and FIRM provisions could be enacted with a mere majority vote.

Repeal of Enterprise Zone Tax Benefits

California currently offers many personal and corporate income tax benefits to businesses that locate in enterprise zones (EZs), targeted tax areas (TTAs), local agency military base recovery areas (LAMBRAs), and manufacturing enhancement areas (MEAs). These benefits include a hiring credit of up to 50 percent of an eligible employee’s qualified wages, a credit for sales tax paid on machinery and equipment used in manufacturing, and a net interest deduction for loans given to support business activity in the zone. 

The proposed trailer bill language would render inoperative all tax benefits available to taxpayers located in EZs, TTAs, LAMBRAs and MEAs, retroactive to January 1, 2011, and repeal them as of December 1, 2011. In addition, it would disallow all credit carryovers, effective January 1, 2011. Whether the state can disallow accrued credits is legally questionable under the Due Process Clause, and we can expect to see litigation if this part of the budget package is enacted into law.

Mandatory Single Sales Factor/Market Sourcing

As of January 1, 2011, elective single sales factor apportionment is available to taxpayers under legislation enacted in February 2009. Under current law, taxpayers that elect the single sales factor apportionment formula must also source receipts from sales of intangibles and services to the location of the customer, also known as “market sourcing.” Those that elect the four-factor apportionment formula (property, payroll, and double-weighted sales) must source these same receipts using the costs-of-performance method.

Under the proposed trailer bill language, effective January 1, 2011, the sales-only apportionment formula and market sourcing provisions would become mandatory with limited exceptions. This budget proposal likely will be the most controversial provision for the business community. Tax liability will rise or fall under the proposed language depending on taxpayers’ facts and circumstances.

Tax Shelter Amnesty

Over the last eight years, California taxpayers have endured three amnesty  programs. In 2004, the state instituted the Voluntary Compliance Initiative for “abusive tax shelters.” In 2005, taxpayers were coerced into a tax amnesty program that imposed a strict liability, 50 percent interest penalty for failure to participate. In 2009, the Legislature imposed a limited amnesty program designed to force taxpayers to pay questionable liabilities to avoid a strict liability understatement penalty imposed on understatements of $1 million. With all this amnesty going on, one would think taxpayers would be happy. After all, amnesty literally means “forgiveness” or “pardon.”

The numerous elements of the proposed legislation are as follows:

  • Expands Statute of Limitations. Expands to 12 years the current eight-year statute of limitations on abusive tax avoidance transactions.
  • Accuracy Related Penalty on Non-Economic Substance Transactions (NEST). Imposes the existing 20 percent accuracy-related penalty to non-economic substance transactions, as applied under newly amended I.R.C. § 6662.
  • Strict Liability NEST Penalty. Conforms to the federal definition of non-economic substance and removes the reasonable cause exception to the accuracy-related penalty under I.R.C. § 6662 if it is imposed on an understatement resulting from a non-economic substance transaction.
  • Dual Liability NEST Penalty. Imposes dual liability at the state level if an accuracy-related penalty under I.R.C. § 6662 is assessed on a NEST transaction understatement at the federal level. Allows taxpayers relief from the penalty upon proof that its imposition was clearly erroneous.
  • Abusive Tax Avoidance Transaction. Creates a new category of transactions, so-called “abusive tax avoidance transactions” (ATATs), subject to the 100 percent interest penalty under § 19777 of the California Revenue and Taxation Code. Defines ATAT as:

    • A tax shelter as defined in I.R.C. § 6662(d)(2)(c).
    • An undisclosed reportable transaction as defined in I.R.C. § 6707A(c)(1).
    • A listed transaction as defined in I.R.C. § 6707A(c)(2).
    • A gross misstatement, within the meaning of I.R.C. § 6404(g)(2)(D).
    • Any transaction to which the state-level NEST penalty applies under California Revenue and Taxation Code § 19774.
  • Offshore Financial Arrangement. Defines “offshore financial arrangement” as “any transaction involving financial arrangements that in any manner rely on the use of offshore payment cards, including credit, debit, or charge cards, issued by banks in foreign jurisdictions or offshore financial arrangements, including arrangements with foreign banks, financial institutions, corporations, partnerships, trusts, or other entities to avoid or evade income or franchise tax.”
  • New 50 Percent Interest Penalty. If a taxpayer has been contacted by the Franchise Tax Board about an ATAT before a notice of proposed assessment has been issued, complete penalty relief would no longer be available. Rather, a penalty would apply in the amount of 50 percent of the interest payable on the additional tax related to the ATAT.
  • Effective Date. Applies to notices mailed on or after the effective date of the act and to amended returns filed more than 90 days after that effective date on open years.
  • Amnesty Period and Terms. Establishes a three-month period (August 1, 2011, to October 31, 2011) wherein taxpayers that have liabilities attributable to ATATs or offshore financial arrangements and participate in the amnesty program can be relieved of all penalties except: (1) the strict liability large corporate understatement penalty under California Revenue and Taxation Code § 19138; and (2) the 50 percent interest penalty imposed under § 19777.5 on taxpayers that were eligible, but did not participate in the 2005 tax amnesty program. Taxpayers that participate in amnesty would not be entitled to refunds of unreported income attributable to ATATs or offshore financial arrangements.
  • Cautionary Note. If taxpayers settle under this amnesty program, they would be required to “cooperate fully” with the Franchise Tax Board’s inquiries “into the facts and circumstances related to the use of” ATATs and offshore financial arrangements reported under the amnesty program. If taxpayers decline to “cooperate,” they would lose the penalty waivers associated with amnesty.

Financial Institutions Records Match (FIRM)

The FIRM program would be new to California and would require financial institutions to provide to the Franchise Tax Board on a quarterly basis, “the name, record address, and other addresses, social security number or other taxpayer identification number and other identifying information for each delinquent tax debtor, as identified by the Franchise Tax Board by name and social security number or other taxpayer identification number, who maintains an account at the institution.”  Financial institutions that do not meet one of the enumerated exceptions to this requirement would be subject to a penalty of $50 for each record not provided up to $100,000 in a calendar year.

The proposed language allows a financial institution to be reimbursed by the Franchise Tax Board for actual costs to implement the program.  This reimbursement is limited, however, to $2,500 for start-up costs and an additional $250 per calendar quarter for data match costs.  Implementation would take place four months after the effective date of the legislation.

Proposed Tax Increase Extension

The Governor’s proposal to extend the existing temporary taxes by five years has taken the form of a legislative constitutional amendment. 

Some have suggested that the Legislature could place a measure on the ballot to extend the current tax increases by a mere majority vote, but doing so could lead to litigation under the recently enacted Proposition 26 and other constitutional provisions governing the Legislature’s power to amend existing initiatives.

Although the trailer bills are quite detailed, they are only the starting point for budget discussions.  It is important, however, for taxpayers to be aware of these proposals to avoid being blindsided by the final budget and, to the extent possible, advocate for a different or modified approach before the budget is finalized.

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