Client Alert

California's Pending "Anti-Tax Shelter" Legislation Threatens to Add Substantial Hurdles and Penalties for Tax Planning


Legislation currently pending in California threatens to impose a restrictive economic substance rule and increased penalties on taxpayers. Dubbed the "Anti-Tax Shelter & Tax Avoidance Initiative" by the Franchise Tax Board ("FTB"), Senate Bill 614, 2003-2004 Leg., Reg. Sess. (pending in Cal. Asm. Appropriations Comm. July 10, 2003) ("S.B. 614") which was introduced on May 12, 2003, has recently passed the floor vote in the Senate and is currently in committee in the Assembly.

The bill is aimed at what its supporters have labeled "abusive tax shelters." However, the bill's broad definition of what constitutes an "abusive tax shelter" could surprise many taxpayers. As stated in the FTB's legislative analysis: "Specifically, this bill modifies existing statutes and enhances penalties to mitigate the attractiveness of these shelters to tax preparers, promoters and participants. Finally, the bill provides a chance for participants to avoid enhanced penalties this bill would create, if the participants pay all tax and interest underpaid from using these transactions." The legislation contains several provisions targeting taxpayers that are deemed to have employed abusive tax shelters or engaged in "tax avoidance." It also provides penalties and reporting requirements for tax preparers and advisors who promote the use of tax shelters or assist taxpayers in effecting them. Additionally, the bill provides a "voluntary compliance" program that allows taxpayers to avoid many of the new penalties if the taxpayer files amended returns reversing the tax benefits sought in prior years by use of a tax avoidance transaction, and if the taxpayer waives the right to protest or seek refunds.

Although the bill contains no express definition for "abusive tax shelter," it does provide a codification of the "economic substance doctrine" ("ESD"), which would be used to determine whether a taxpayer has engaged in an invalid tax avoidance transaction. The legislation's formulation of the ESD would require taxpayers to meet the most stringent application of that doctrine as it is currently applied by some courts. For example, S.B. 614 would require taxpayers to establish both a "meaningful change in economic position," as well as a "substantial non-tax purpose" to avoid application of the ESD. Moreover, the proposed legislation would not allow a taxpayer to establish a meaningful change in economic position with evidence of favorable non-California income tax benefits, such as foreign tax or estate tax planning.

Several other provisions currently in the bill could threaten not only current and future planning, but planning for prior years as well. For example:

  • The bill applies in a number of instances to transactions occurring after January 1, 1999 and thus is retroactive in effect.
  • The bill would create a 40% penalty (reduced to 20% if relevant facts were adequately disclosed on the tax return) for understatements from transactions lacking economic substance (or which are overturned under a similar rule of law such as "sham transaction"). The new penalty apparently would apply even if the taxpayer had substantial authority for the transaction, because, as currently drafted, the penalty is a strict liability penalty and can be waived only by approval of senior management at the FTB. The penalty would apply to "determinations" made after January 1, 2004 (which thus could involve transactions that occurred after January 1, 1999).
  • The bill would impose for the first time a penalty for failure to file a return disclosing "reportable transactions," which are defined by reference to the federal temporary regulations implementing Internal Revenue Code section 6011.
  • The bill would create several reporting requirements and potential penalties for "material advisors" and tax preparers, and it would exclude communications regarding tax shelters between a taxpayer and a federally authorized tax practitioner from the privilege provided by existing confidentiality provisions.
  • The bill would extend the statute of limitations for "abusive tax shelters" from four to eight years, and would expand the FTB's authority to issue subpoenas.
  • The bill introduces a "voluntary compliance initiative" (effective from January 1, 2004, through March 31, 2004) whereby taxpayers may file amended returns reversing the tax benefits sought in prior years, pay the additional tax and thereby avoid the new penalties and interest contained in the legislation.
If enacted in its current form, S.B. 614 would also threaten taxpayers with penalties for past, present and future tax years.

We will be watching the bill closely and will report on its status in a future issue. If you have any specific questions regarding S.B. 614, please contact Peter Kanter.




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