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

• Author: Coffill, Eric J.

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)

   For transactions entered into on or after February 28, 2000, that become federal listed transactions at any time, the lists shall be provided to the FTB no later than the later of 60 days after entering into the transaction; 60 days after the transaction becomes a listed transaction, or April 30, 2004. (14) In addition, lists shall be provided to the FTB under the same time frame above for transactions that become California-only listed transactions entered into on or after September 2, 2003. (15)

   The FTB states this provision is effective January 1, 2004. (16) Except for persons that are material advisers for tax shelters that become listed transactions, this section applies on or after January 1, 2004. For transactions entered into on or after February 28, 2000, that become federal listed transactions at any time, the registration required by the section cannot be due any earlier than April 30, 2004. The section does net apply to a licensed attorney for transactions entered into before January 1, 2004, if the attorney became a material adviser solely because of the practice of law.

3. Tax Shelter Registration

   The legislation amends CRTC [section] 18628 to conform to the federal tax shelter registration requirements of IRC [section] 6111, with modifications. Modifications include the registration in California of a tax shelter 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. (17) A transaction entered into on or after February 28, 2000, that becomes a federal listed transaction at any time must be registered by the later of 60 days after entering into the transaction, 60 days after the transaction becomes a listed transaction, or April 30, 2004. (18) Transactions that become California-only listed transactions at any time are required to register under the same time frames, if the transaction was entered into on or after September 2, 2003. (19) CRTC [section] 18628(b)(2)(A) allows the FTB to require information in addition to the information required for federal purposes. Pursuant to this authority, FTB has issued FTB Notice 2004-1 (January 30, 2004), which states that persons submitting information required by section 18628 shall also provide the applicable California business entity number. In the event the business entity is a corporation included in a group return for a combined reporting group, the California business entity number of the key corporation must also be provided.

   FTB states the provision is generally effective January 1, 2004. (20) Except for persons that organize tax shelters that become listed transactions, this provision applies on or after January 1, 2004. For any transactions entered into on or after February 28, 2000, that become federal listed transactions at any rime, the registration required by the section cannot be due any earlier than April 30, 2004.

4. Reportable Transactions Understatement Penalty

   The legislation creates a new reportable transactions understatement penalty under CRTC [section] 19773, which applies to listed or reportable transactions. This penalty is a significant addition to the California law, and is one of the most important provisions of the legislation.

   For disclosed transactions, in general, a 20-percent accuracy-related penalty is imposed on any understatement attributable to an adequately disclosed listed transaction or reportable transaction. (21) The only exception to the penalty is if the taxpayer satisfies a heightened reasonable cause and good faith exception, which the FTB characterizes as the "strengthened reasonable cause" exception. For taxpayers contacted by the FTB, the strengthened reasonable cause exception is available only if (1) there was adequate disclosure of the...