December 2002

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Cal-Tax Commentary 

Greg Turner is Cal-Tax general counsel.

As the state budget deficit grows, a chilling new Franchise Tax Board staff tactic has emerged as a way to leverage taxpayers in income tax disputes, and avoid the two-thirds vote requirement for tax increases to boot.

In early 2002, the staff of the Franchise Tax Board made a proposal for FTB-sponsored legislation concerning the treatment of dividends received from a bank-owned Regulated Investment Company (RIC). The staff proposed that the RIC rules be amended to explicitly provide that dividends paid by a RIC to California corporate shareholders may not obtain the benefit of the exclusion from income tax under Revenue and Taxation Code Section 25106 (with limited exceptions). The outrageous tactic, however, was to insist that the change in the law was "declaratory of existing law" as of January 1, 1993.

In other words, what the FTB staff was proposing was that if they were engaged in a dispute with taxpayers over the meaning of the tax code, instead of engaging in the normal process of audit, assessment, and appeal, the staff would merely go to the Legislature, change the law retroactively, and claim that the law always read the way they claimed it now read.

Justifiably, board members were greatly concerned about the loss of integrity this approach would cause to the normal system of tax administration, and declined to sponsor the legislation.

On November 26, however, the proposal emerged again. The only change in the staff proposal was the substitution of new language for the "declaratory of existing law" section. Instead the proposed bill would read that even though effective for tax years beginning on or after January 1, 2003, "no inference should be drawn" from the amendments as to the state of the law for prior tax years.

Again the board, concerned about the integrity of the audit and appeals process, as well the fact that no meetings have ever occurred between the banking industry and the board concerning this issue, declined to take action in November. However, the board did encourage staff to meet with industry to better define the issues and possible remedies and bring the proposal back in late December, or before the new board in January.

Robert Naylor, speaking for a coalition of banks which organized RICs as a means of expanding core capital, spoke against the proposal on the grounds that the "no inference" clause was nothing more than a milder attempt to give the change retroactive effect. In other words, he said, the staff was still attempting to use the legislative process to undermine the taxpayers’ position in potential audits that the RIC dividends are clearly excluded from the banks’ income under current law.

Mr. Naylor pointed out in a letter to the board that California is not alone in allowing some form of exclusion of RIC dividends paid to unitary corporate shareholders.  New York, Florida, Massachusetts and Illinois allow analogous treatment, he wrote.

The FTB staff analysis asserted that "some banks are taking the position that the interest income on their loan portfolio disappears from the California tax base when they utilize a RIC structure." This occurs because dividends from a unitary subsidiary are generally "eliminated" under Revenue and Taxation Code Section 25106 relating to intercompany dividends.

Moreover, FTB staff asserted that the purpose of Section 25106 "is to ensure that income is not ‘double counted’ in the taxable income of members of a unitary group" but the section "is not intended to allow income to be untaxed." They further claim a bank that contacted the FTB agreed with the staff interpretation of the law and this same bank started the process by contacting the Senate Revenue and Taxation Committee.

But as information began to emerge on the issue, it became apparent that the banks have a strong legal foundation for their position.  In 1993, the Legislature explicitly changed the real estate investment trust (REIT) provision (R&T Code Section 24872) to make Section 25106 inapplicable to REIT dividends. The same bill amended the RIC Section (R&T Code Section 24871) but did not include the same reference to Section 25106. The banks can credibly claim that they are "following the plain letter of the law" in asserting the Section 25106 "elimination" rule applies to RICs that are unitary with the parent.

Moreover, the California Bankers Association produced a letter from one of the top law firms in America refuting the legal claims of staff and of the one bank agreeing with the staff. At the end of the day, it was clear that this issue was little more than a typical dispute between staff and taxpayers over an interpretation of the law.

But this matter and the staff's tactics in pursuing it raise three issues:

How far can the FTB go in ignoring what appears to be a plain difference in tax treatment between REITs and RICs, even if it was arguably a legislative mistake? The state Supreme Court, in Lennane v. FTB  9 Cal 4^th 263 (1994), in a similarly arcane tax dispute over whether the gain from the sale of small business stock should be excluded from preference income, sided with the taxpayers’ reading on that statute on the grounds that it "does not depend upon an implicit, not readily apparent, and convoluted interaction" of subdivisions. The unanimous court relied instead on the general rule that "to ascertain intent, we look first to the words of the statute" and "if there is no ambiguity in the language of the statute, ‘then the Legislature is presumed to have meant what it said, and the plain meaning of the language governs.’"

Second, is it appropriate for the FTB, when it gets into a dispute with a taxpayer and finds itself on weak ground, to rush to the Legislature and attempt to change the law retroactively, as was proposed in this case? Is it appropriate for the FTB to avoid the clear inference to be drawn from changing the law prospectively by inserting the kind of "no inference" language proposed by the staff? We think it is emphatically inappropriate. Even if the Legislature decides that a change in the law is good public policy going forward, it would be both unfair, and potentially violative of due process, to suggest that it be applied retroactively. And the audit process should be left to itself as a professional, objective dispute resolution mechanism – free from legislative interventions.

Finally, by characterizing this legislative proposal as anything but a "change in law," the FTB staff and a revenue-hungry Legislature are able to avoid having to label the proposal as an increase in state taxes requiring a two-thirds vote of both houses of the Legislature. For months, the Capitol has been abuzz with rumors of the different "regulatory fees" or "mitigation payments" the Legislature would dream up to avoid having to abide by the two-thirds vote requirement for a tax increase. This is a perfect example of just that type of creativity we feared would be employed. It begs the question:  How much violence will the Legislature be willing to do to the Constitution in order to raise taxes?

This is one issue to watch closely in the coming months.