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State & Local Tax Bulletin (May 2004)

California Tax Shelter Rules




By Jeffrey M. Vesely and Kerne H. O. Matsubara, tax partners, and Annie H. Huang, tax associate, all from the San Francisco office of Pillsbury Winthrop Shaw Pittman LLP. This outline formed the basis of their presentation at the Orange County Chapter of the Tax Executive Institute at Irvine, California on May 5, 2004.

If you have or can obtain the Acrobat Reader, or have an Acrobat-enabled web browser, you may wish to download or view our May 2004 State & Local Tax Bulletin (a 385K pdf file), containing a printed version of this outline and also available via ftp at:

    ftp.pmstax.com/state/bull0405.pdf.

This bulletin concerning state and local tax matters is part of the Tax Page, a World Wide Web demonstration project, no portion of which is intended and cannot be construed as legal or tax advice. Comments are welcome on the design or content of this material.

  1. Tax Shelter Disclosure Rules. California generally has adopted the federal tax shelter disclosure rules under IRC § 6011 with modifications (RTC § 18407).

    1. Federal disclosure rules. Income Tax Regs. § 1.6011-4 requires taxpayers that participate in a "reportable transaction" to disclose such participation to the IRS. The following rules generally reflect the final federal regulations under IRC § 6011, which were issued February 23, 2003.

      1. Reportable transactions. The six types of reportable transactions are:

        1. Listed transactions.

          1. Transactions—or substantially similar transactions—that the IRS has identified by published guidance. Currently approximately 30 transactions (e.g., IRS Notice 2003-76).

        2. Confidential transactions.

          1. A transaction is offered under conditions of confidentiality if the advisor (a) is paid a minimum fee ($250,000 if the taxpayer is a corporation) and (b) places a limitation on disclosure by the taxpayer of the tax treatment or tax structure of the transaction and the limitation on disclosure protects the confidentiality of that advisor's tax strategies.

          2. Does not include transactions labeled as "proprietary" or "exclusive" if the advisor confirms to the taxpayer that there is no limitation on disclosure of the tax treatment or tax structure of the transaction.

          3. These rules on confidential transactions reflect T.D. 9108 (December 29, 2003), which scaled back the confidentiality "trigger" to carve out routine commercial transactions that normally include elements of privacy.

        3. Transactions with contractual protection.

          1. Transactions in which the taxpayer or related party has the right to a full or partial refund of fees if all or part of the intended tax consequences are not sustained.

          2. Also, transactions in which the fees are contingent on the taxpayer's realization of tax benefits from the transaction.

        4. Loss transactions.

          1. Transactions resulting in a corporate taxpayer claiming a loss under IRC § 165 of at least $10 million in any single taxable year or $20 million in any combination of tax years.

          2. Lesser threshold amounts for partnerships, S corporation, trusts and individuals.

        5. Transactions with a significant book-tax difference.

          1. Transactions in which the amount for tax purposes of any item or items of income, gain, expense or loss differs by more than $10 million (on a gross basis) from the amount of the item or items for book purposes.

          2. The book-tax category generally applies only to large business entities (i.e., reporting companies under the SEC and business entities with $250 million or more of gross assets).

        6. Transactions involving a brief asset holding period.

          1. Transactions resulting in the taxpayer claiming a tax credit exceeding $250,000 if the underlying asset giving rise to the credit is held by the taxpayer for 45 days or less.

      2. Exceptions. Transactions that fall within one of the above categories must be disclosed irrespective of the taxpayer's motive or whether the transaction is "abusive." Limited exceptions have been provided in published guidance, e.g., certain losses (Rev. Proc. 2003-24) and certain book-tax differences (Rev. Proc. 2003-25).

      3. Who is a participant? Income Tax Regs. § 1.6011-4(c)(3) defines participation with respect to each reportable transaction category. In general, a taxpayer has participated in the transaction if the taxpayer's tax return reflects tax consequences of the transaction (e.g., listed transactions) or reflects a tax benefit from the transaction (e.g., confidential transactions and transactions with contractual protection).

        1. Participation also includes indirect participation as a partner in a partnership, a shareholder in an S corporation, or through a trust.

        2. Certain exceptions apply with respect to pass-through entities (e.g., where the partner, S shareholder or beneficiary is not individually subject to a confidentiality limitation or does not individually possess the right to a refund of fees).

      4. Disclosure procedures.

        1. Form 8886. Disclosure is made by attaching Form 8886, Reportable Transaction Disclosure Statement, to the taxpayer's return for the affected tax year. In addition, Form 8886 should be attached to each amended return that reflects a taxpayer's participation in a reportable transaction.

        2. OTSA. A copy of Form 8886 must be sent to the Office of Tax Shelter Analysis (IRS) at the same time that any Form 8886 is first filed by the taxpayer.

        3. "Springing" listed transactions. If a transaction engaged in by a taxpayer becomes a listed transaction after the filing of the taxpayer's tax return (and before the end of the statute of limitations period for that return), then the taxpayer must file Form 8886 with its next filed tax return.

        4. Rulings and protective disclosures. A taxpayer may submit a request to the IRS for a ruling as to whether a transaction is subject to the disclosure requirements. In addition, if a taxpayer is uncertain whether a transaction must be disclosed, the taxpayer may disclose the transaction and indicate that it was uncertain whether the transaction was required to be disclosed and that the disclosure is being filed on a protective basis.

        5. Retention of documents. The taxpayer must retain a copy of all documents and other records related to a transaction subject to disclosure that are material to an understanding of the tax treatment or tax structure of the transaction.

          1. Documents should be retained until the expiration of the statute of limitations.

          2. Documents include the following: marketing materials, written analyses, correspondence and agreements between the taxpayer and any advisor, documents related to the tax benefits and documents referring to the business purpose.

          3. Taxpayer is not required to retain earlier drafts of a document if the taxpayer retains a copy of the final document (or most recent draft, if no final document exists) and the final/most recent document contains all the information in the earlier drafts that is material to an understanding of the tax treatment or tax structure.

        6. Effective date. The disclosure regulations under IRC § 6011 generally apply to federal income tax returns filed after February 28, 2000.

    2. California modifications.

      1. FTB authority. For California income and franchise tax purposes, "reportable transactions" and "listed transactions" include transactions designated as such by the FTB.

        1. Chief Counsel Announcement 2003-1. Issued December 31, 2003 identifying as California "listed transactions" (i) all federal listed transactions, (ii) certain real estate investment trust (REIT) transactions and (iii) certain regulated investment company (RIC) transactions.

          1. FTB's position on the REIT structure is that California does not conform to consent dividends for purposes of the REIT dividends paid deduction.

          2. FTB attacks the RIC structure on the basis that certain wholly owned or controlled RICs are "shams."

        2. Office of Administrative Law. The normal rulemaking rules under Cal. Gov't. Code § 11340, et seq. do not apply to FTB notices or rules.

      2. Effective date. For California purposes, the disclosure rules (RTC § 18407) are generally effective for taxable years beginning on or after January 1, 2003.

  2. Tax Shelter Registration (Confidential Corporate Tax Shelters). California generally follows the federal tax shelter registration rules under IRC § 6111, with certain modifications (RTC § 18628).

    1. Federal registration rules. In general, any tax shelter organizer must register the tax shelter with the IRS no later than the day on which the first offering for sale of an interest in such tax shelter occurs. For registration purposes, a "tax shelter" is an investment that has a greater than 2 to 1 "tax shelter ratio," which is the ratio that the aggregate amount of deductions and 200% of the credits allowable to an investor bears to the investment base. In addition, "confidential corporate tax shelters"—the focus of this section—are treated as tax shelter subject to the registration requirement.

      1. Defining characteristics. Any transaction with the following three characteristics ("a," "b" and "c") is a confidential corporate tax shelter requiring registration (IRC § 6111(d)):

        1. Avoidance or evasion of federal income tax. Transaction in which a significant purpose of the structure is the avoidance or evasion of federal income tax for a direct or indirect corporate participant.

          1. In general: (a) listed (or substantially similar) transaction or (b) any other tax-structured transaction that has been structured to produce federal income tax benefits that constitute an important part of the transaction and the tax shelter promoter reasonably expects the transaction to be presented in the same or substantially similar form to more than one participant.

          2. Except: if (a) the potential participant is expected to participate in the ordinary course of its business in a form consistent with customary commercial practice and (b) there is a generally accepted understanding (e.g., rulings) that the expected federal income tax benefits from the transaction are properly allowable under the IRC for substantially similar transactions.

          3. Other exceptions: if (a) the tax shelter promoter reasonably determines that there is no reasonable basis under federal tax law for denial of any significant portion of the expected federal income tax benefits from the transaction, (b) the IRS makes a determination by published guidance that the transaction is not subject to the registration requirement, or (c) the IRS makes a determination by individual ruling (e.g., PLR) that the specific transaction is not subject to the registration requirements for the taxpayer requesting the ruling.

        2. Offered under conditions of confidentiality. Transactions that are offered to any potential participant under conditions of confidentiality, with exceptions for (i) disclosures restricted by securities law and (ii) certain merger and acquisition situations.

        3. Possible receipt of fees in excess of $100,000. Transactions in which the tax shelter promoters may receive fees in excess of $100,000 in the aggregate. (A "promoter" is any person or any related person who participates in the organization, management or sale of the tax shelter.)

      2. Registration procedures.

        1. Time for registering. A tax shelter must be registered not later than the day on which the first offering for sale of interests in the shelter occurs.

        2. Form 8264. Use Form 8264, Application for Registration of a Tax Shelter.

        3. Person required to register. The principal tax shelter promoter is generally the party responsible for registering the confidential corporate tax shelter. If, however, the principal tax shelter promoter does not register the confidential corporate tax shelter, other parties may become responsible for registering the shelter.

    2. California rules.

      1. California additions. RTC § 18628 modifies the federal rules by including the avoidance or evasion of "California income or franchise tax." In addition, the federal definition of "tax shelter" under IRC § 6111(d) is modified to include any federal or California listed transaction.

      2. Registration. In general, a tax shelter organizer must send a duplicate of the federal registration information, or the same information required for federal tax shelters in the case of California tax shelters, to the FTB no later than the day on which the sale of interests in the tax shelter is first offered.

        1. FTB Notice 2004-1: The FTB also requires that the applicable California business entity number be provided.

      3. What is a California shelter? The California registration requirements apply to tax shelters that satisfies any of the following:

        1. Organized in this state,

        2. Doing business in this state,

        3. Deriving income from sources in this state,

        4. At least one of its investors is a California taxpayer.

      4. Nexus issues. FTB's position is that the nexus of the promoter is irrelevant to the registration requirements on the basis that the nexus of the taxpayer and the transaction determines whether the promoter has an obligation to register the shelter. FTB also maintains that each member of a unitary group that reports to California an abusive tax shelter transaction impacting unitary business income subject to apportionment "participates" in that abusive tax shelter.

      5. Effective date.

        1. General. Effective January 1, 2004.

        2. Federal listed transactions. Any federal listed transaction entered into on or after February 28, 2000 that became a listed transaction at any time must be registered with the FTB by the later of:

          1. 60 days after entering into the transaction,

          2. 60 days after the transaction becomes a listed transaction,

          3. April 30, 2004

        3. California listed transactions. Any California listed transaction entered into on or after September 2, 2003 that became a listed transaction at any time must be registered with the FTB by the later of:

          1. 60 days after entering into the transaction,

          2. 60 days after the transaction becomes a listed transaction,

          3. April 30, 2004

  3. List Maintenance. California generally follows the federal list maintenance rules under IRC § 6112, with certain modifications (RTC § 18648).

    1. Federal list maintenance. In general, each organizer and seller of a transaction that is a potentially abusive tax shelter must prepare and maintain a list of persons (that possess certain characteristics—e.g., persons that would be required to disclose their participation in the transaction) to whom the advisor provides a tax statement with respect to the transaction.

      1. Defining characteristics. A potentially abusive tax shelter is any transaction that is an IRC § 6111 tax shelter (e.g., confidential corporate tax shelters or certain shelters with a 2:1 tax shelter ratio) or a transaction that has potential for tax avoidance or evasion.

        1. IRC § 6111 tax shelter. An IRC § 6111 tax shelter is any transaction that is required to be registered with the IRS under that section, regardless of whether that tax shelter is properly registered.

        2. Avoidance or evasion of federal income tax. A transaction that has potential for tax avoidance or evasion includes any of the following:

          1. Any listed transaction under the disclosure rules,

          2. Any transaction that a potential material advisor knows is or reasonably expects will become a reportable transaction under the five other categories of reportable transactions,

          3. Certain stepped transactions (i.e., subsequent transfer of an interest in a transaction) where the transferor knows or reasonably expects the transferee will sell or transfer an interest and the transferred interest of the transaction would be a listed or reportable transaction.

      2. Organizer and seller. A person is an organizer of, or a seller of an interest in, a transaction that is a potentially abusive tax shelter if that person is a material advisor with respect to that transaction.

        1. Material advisor. A person is a material advisor with respect to a transaction that is a potentially abusive tax shelter if the person is required to register the transaction under IRC § 6111, or the person receives or expects to receive at least a minimum fee—$250,000 where all the advisees with respect to the transaction are corporations, or $50,000 where all of the advisees are not—and the person makes a tax statement for the benefit of:

          1. A taxpayer who is reasonably expected to disclose the transaction,

          2. A person who is required to register the transaction under IRC § 6111,

          3. A person who purchases or acquires an interest in an IRC § 6111 tax shelter, or

          4. A transferee of an interest whereby the transferred interest would be a listed or reportable transaction.

        2. Tax statement. A tax statement means any statement, oral or written, that relates to a tax aspect of a transaction that causes the transaction to be a reportable transaction.

        3. Designation agreements. If more than one material advisor is required to maintain a list of persons relating to a potentially abusive tax shelter, the material advisors may designate by written agreement a single material advisor to maintain the list or a portion of the list. Further, the designation of one material advisor to maintain the list does not relieve the other material advisors from their obligation to furnish the list if the designated material advisor fails to furnish the list to the IRS in a timely manner.

      3. List maintenance procedures.

        1. Contents. Each list must contain the following information:

          1. The name of each transaction that is a potentially abusive tax shelter and the registration number, if any, obtained under IRC § 6111,

          2. The taxpayer identification number (TIN), if any, of each transaction,

          3. The name, address and TIN of each person required to be on the list,

          4. The number of units acquired by each person required to be on the list, if known,

          5. The amount invested in each transaction by each person required to be on the list, if known,

          6. A summary or schedule of the tax treatment that each person is intended or expected to derive from participation in each transaction, if known,

          7. Copies of any additional written materials (e.g., opinions) relating to each transaction that are material to an understanding of the purported tax treatment or tax structure of the transaction that have been shown to any person (or agent of such person) who acquired or may acquire an interest in the transaction and

          8. For each person required to be on the list, the name of the person from whom the interest was acquired if the interest in the transaction was not acquired from the material advisor maintaining the list.

        2. Retention and furnishing of lists. In general, each material advisor must maintain the list for seven years following the earlier of the date on which the material advisor last made a tax statement relating to the transaction, or the date the transaction was entered into. Further, each material advisor responsible for maintaining a list of persons, must upon written request by the IRS, furnish the list to the IRS within 20 days from the day on which the request is provided.

        3. Limited claim of privilege. Under the IRC § 6112 regulations, material advisors are subject to the list maintenance rules despite claims of attorney-client privilege or the confidentiality privilege. Current cases on the extent of such privileges are pending.

        4. Ruling requests. A person may submit a request to the IRS for a ruling as to whether a transaction will be considered a potentially abusive tax shelter and whether that person is a material advisor with respect to that transaction.

    2. California rules.

      1. Application. The California list maintenance requirements apply to any organizer, seller or material advisor of a potentially abusive tax shelter (within the meaning of IRC § 6112) that additionally satisfies any of the following conditions:

        1. Organized in this state,

        2. Doing business in this state,

        3. Deriving income from sources in this state,

        4. At least one of its investors is a California taxpayer.

      2. Additional requirements. The list shall be maintained in the form and manner prescribed by the FTB. In contrast to the federal rules which require lists to be furnished upon request by the IRS, California lists involving listed transactions must be provided to the FTB.

        1. FTB's position is that RTC § 18648 requires the organizer or promoter to maintain a list of all investors regardless of the investor's physical address.

      3. Effective date. In general, see registration rules above.

  4. California Penalties.

    1. Penalty for failure to disclose. California imposes a penalty (RTC § 19772) on any "large entity" or "high net worth individual" who fails to disclose a reportable transaction in accordance with the rules under IRC § 6011, as modified by RTC § 18407.

      1. Large entity. A large entity is a person (other than an individual) with gross receipts in excess of $10,000,000 for either the taxable year in which the transaction occurs or in the preceding taxable year.

      2. Individuals. A high net worth individual is an individual whose net worth exceeds $2,000,000 immediately before the transaction.

      3. Penalty amount. The penalty is $15,000 for each omission. For listed transactions, the penalty is $30,000 for each omission. The penalty is in addition to any other penalty that may be imposed.

      4. Waiver. The penalty may be rescinded at the sole discretion (i.e., without administrative or judicial review) of the FTB Chief Counsel if the following conditions apply:

        1. The transaction is not a listed transaction;

        2. The taxpayer has a history of compliance with the tax shelter rules and the California franchise and income tax law;

        3. The violation is due to an unintentional mistake of fact;

        4. Imposing the penalty would be against equity and good conscience;

        5. Rescinding the penalty would promote compliance with the tax shelter rules and the California franchise and income tax law and effective tax administration.

      5. Effective date. The penalty generally applies to taxable years beginning on or after January 1, 2003. The penalty also applies to persons (otherwise subject to the penalty) who invested in a federal listed transaction after February 28, 2000 and before January 1, 2004, where the transaction becomes listed at any time. For California listed transactions, the FTB's position is that the penalty applies to transactions entered into on or after September 2, 2003.

    2. Registration and list maintenance penalties.

      1. Failure to register. The penalty for the failure to timely register a tax shelter or show the required information is generally $15,000. In the case of a "listed transaction" the penalty is the greater of (a) $100,000 or (b) 50% of the gross income that the organizer or material advisor derived from that activity (75% in the case of intentional disregard) (RTC § 19173(b)).

      2. Failure to maintain or provide list. For reportable transactions, the penalty for the failure to furnish the list within 20 days of an FTB request or show the information required to be provided on such list is:

        1. $10,000 per day for each day after the 20th day that the organizer or material advisor has failed to make the list available to the FTB upon written request;

        2. In the case of a listed transaction, the greater of (i) $100,000 or (ii) 50% of the gross income that the organizer or material advisor derived from that activity (75% in the case of intentional disregard).

      3. Application and effective date. The registration and list maintenance penalties are in addition to any other penalty. In general, the penalties are effective January 1, 2004 on any return for which the statute of limitations has not expired.

    3. Understatement penalties. The California understatement penalties include an accuracyrelated penalty, a penalty for understatements relating to a reportable transaction and a penalty for understatements relating to a transaction that lacks economic substance. An understatement penalty generally will apply to the extent that another understatement penalty has not been applied.

      1. Accuracy-related penalty. In general, California conforms to the federal accuracy-related penalty (IRC § 6662), with specified modifications (RTC § 19164).

        1. Federal rules. Under federal rules, a 20% accuracyrelated penalty is imposed on understatements of tax attributable to negligence, "substantial understatements" of tax or "substantial valuation misstatements" (40% in the case of "gross valuation misstatements").

          1. "Substantial understatement" is an understatement of tax for the taxable year which exceeds the greater of (a) 10% of the correct amount of tax or (b) $5,000 ($10,000 in the case of corporations).

          2. Substantial authority or adequate disclosure: An "understatement" does not include any portion attributable to the tax treatment of an item for which there is (a) substantial authority or (b) an adequate disclosure on the return by the taxpayer. In the case of a tax shelter, "(b)" does not apply and "(a)" only applies if the taxpayer reasonably believed that its tax treatment of the item was more likely than not the proper tax treatment.

          3. Reasonable cause exception: The reasonable cause and good faith exception may apply with respect to all or any portion of an underpayment, including, for example, reliance on a tax opinion or advice (IRC § 6664). However, in the case of tax shelter items of a corporation, at a minimum, the substantial authority requirement and the belief requirement (greater than 50% likelihood of success on the merits) must be satisfied. Minimum requirements are not dispositive if, for example, the taxpayer's participation in the tax shelter lacked significant business purpose, the claimed tax benefits are unreasonable in comparison to the taxpayer's investment in the shelter or the taxpayer agreed to protect the confidentiality of the tax aspects of the shelter (Income Tax Regs. § 1.6664-4(f)).

        2. California modifications.

          1. Lower threshold for certain corporations: Corporations (other than S corporations) that have been contacted by the FTB regarding the use of a "potentially abusive tax shelter" (see RTC § 19177) are subject to the accuracyrelated penalty if the understatement exceeds the lesser of (a) 10% of the correct tax (or, if greater, $2,500) or (b) $5,000,000.

          2. "Listed transactions": FTB is authorized to prescribe a list of positions for which there is not substantial authority or there is no reasonable belief that the tax treatment is more likely than not the proper tax treatment.

          3. Fraud penalty: A fraud penalty (75% of the underpayment) may apply to the portion of any underpayment of tax due to fraud (IRC § 6663 and RTC § 19164(c)).

          4. Effective date. All taxable years beginning on or after January 1, 1990 and any other taxable year for which an assessment is made after July 16, 1991.

      2. Reportable transaction understatement penalty. In general, California imposes a 30% penalty on a "reportable transaction understatement," which is reduced to 20% if there is adequate disclosure (RTC § 19773).

        1. Application. The penalty applies to any listed transaction and any reportable transaction (other than a listed transaction) if a significant purpose of that transaction is the avoidance or evasion of California income or franchise tax.

        2. Reportable transaction understatement—defined as the sum of the following:

          1. (The increase, if any, in taxable income due to the difference between the proper treatment and the taxpayer's treatment) x (the highest marginal tax rate applicable to the taxpayer), and

          2. The decrease, if any, in the aggregate amount of credits determined under the RTC that result from a difference between the taxpayer's treatment of an item and the proper treatment.

        3. Reasonable cause exception. The reasonable cause and good faith exception under IRC § 6664 generally applies if all of the following requirements are satisfied (RTC § 19164(d)(2)):

          1. Adequate disclosure of the tax treatment of the item, including any tax shelter identification number, (or if the RTC § 19772 penalty is rescinded);

          2. Substantial authority for that treatment; and

          3. Reasonable belief by the taxpayer that the tax treatment was more likely than not the proper treatment, which requires that the belief be based on the facts and law that exist at the time the return is filed and not take into account the likelihood of FTB audit of the return or settlement outcomes. In addition, a taxpayer cannot rely on a tax opinion to establish reasonable belief if either

            1. the tax advisor:

              • is a material advisor who participates in the organization, management, promotion or sale of the transaction, or is related to any person who so participates,

              • is compensated directly or indirectly by a material advisor with respect to the transaction,

              • has a fee arrangement with respect to the transaction that is contingent on all or part of the intended tax benefits from the transaction or

              • has a continuing financial interest with respect to the transaction as determined by Treasury or FTB regulations; or

            2. the tax opinion:

              • is based on unreasonable factual or legal assumptions (including assumptions as to future events),

              • unreasonably relies on representations, statements, findings or agreements of the taxpayer or any other person,

              • does not identify and consider all relevant facts or

              • fails to meet any other requirements as the IRS or FTB may prescribe.

          4. Adequate disclosure. For purposes of the reduction in the penalty from 30% to 20%, the disclosure rules under IRC § 6011, as modified by RTC § 18407, generally apply.

          5. Chief Counsel discretion. If the penalty applies, only the FTB Chief Counsel, at his or her own sole discretion without delegation, may abate all or a portion of the penalty. The Chief Counsel's decision is not subject to administrative or judicial review.

          6. Effective date. The penalty applies to taxable years beginning on or after January 1, 2003. For California listed transactions, the FTB's position is that the penalty applies to transactions entered into on or after September 2, 2003.

        4. Noneconomic substance transaction understatement penalty. In general, California imposes a 40% penalty on a "noneconomic substance transaction understatement," which is reduced to 20% if there is adequate disclosure (RTC § 19774).

          1. Application. The term "noneconomic substance transaction understatement" means any amount which would be a "reportable transaction understatement" taking into account items attributable to "noneconomic substance transactions" rather than reportable transactions.

          2. Reportable transaction—includes a transaction or arrangement that lacks economic substance or in which an entity is disregarded as lacking economic substance. A transaction is treated as lacking economic substance if the taxpayer does not have a valid nontax California business purpose for entering into the transaction.

            1. Common law: Federal case law, in particular, Ninth Circuit cases, e.g., Sacks v. Commissioner, 69 F.3d 982, 991 (9th Cir. 1995) (rejecting the IRS's argument that a tax-subsidized transaction lacked economic substance because it resulted in a pre-tax loss, holding that the "investment did not become a sham just because its profitability was based on after-tax instead of pre-tax projections"); Casebeer v. Commissioner, 909 F.2d 1360, 1363 (9th Cir. 1990) (looking to both "objective economic substance" and "subjective business motivation" in determining whether a transaction has sufficient economic substance and noting that a "sham transaction" has "no business purpose or economic effect other than the creation of tax deductions").

            2. Proposed federal codification: Under proposed new IRC § 7701(n) (S. 1637), a transaction would have "economic substance" under the common law doctrine only if:

              1. the transaction changes in a meaningful way (apart from federal tax effects) the taxpayer's economic position, and

              2. the taxpayer has a substantial nontax purpose for entering into such transaction and the transaction is a reasonable means of accomplishing such purpose.

              In addition, a transaction would not be treated as having economic substance by reason of having a potential for profit unless the present value of the expected pretax profit from the transaction must be substantial in relation to the present value of the expected tax benefits, and the pretax profit potential must exceed a risk-free rate of return.

          3. Chief Counsel discretion. If the penalty applies, only the FTB Chief Counsel, at his or her own sole discretion without delegation, may abate all or a portion of the penalty. The Chief Counsel's decision is not subject to administrative or judicial review.

          4. Effective date. The penalty generally applies with respect to any penalty assessed on or after January 1, 2004, on any return for which the statute of limitations on assessment has not expired.

      3. Other tax shelter penalties.

        1. "100% interest" penalty. Taxpayers that have been contacted by the FTB regarding the use of a potentially abusive tax shelter and who have a deficiency are subject to a penalty in an amount equal to 100% of the interest payable for the period beginning on the due date for payment of tax (i.e., generally, the return filing date without regard to extensions) and ending on the date that the notice of proposed assessment (NPA) is mailed (RTC § 19777).

          1. A "potentially abusive tax shelter" is defined as (i) any tax shelter for which registration is required under IRC § 6111 or (ii) any entity, investment plan or arrangement, or other plan or arrangement which is of a type that Treasury or FTB determines by regulations as having a potential for tax avoidance or evasion.

          2. Application. The penalty is in addition to any other penalty that may be imposed. The statute is unclear whether the penalty only applies to the portion of interest attributable to the deficiency arising as a result of the potentially abusive tax shelter.

          3. Effective date. Generally effective with respect to any penalty assessed on or after January 1, 2004, on any return for which the statute of limitations has not expired.

        2. Higher interest in other situations. For an amended return for taxable years beginning after December 31, 1998 filed after April 15, 2004, and before the taxpayer is contacted by the IRS or FTB regarding a potentially abusive tax shelter, the taxpayer is subject to applicable interest but at a rate of 150% of the adjusted annual rate with respect to any understatement of tax relating to the use of a reportable transaction (RTC § 19778).

      4. Frivolous return and submission penalties.

        1. Frivolous return. California generally conforms to the federal penalty (IRC § 6702) for filing a frivolous return, except that in the case of any taxpayer that has been contacted by the FTB regarding the use of a potentially abusive tax shelter, the penalty has been increased from $500 to $5,000 (RTC § 19179(a), (b)). The penalty applies to:

          1. Filings based on a position that is frivolous or is based on a position that the FTB has identified as frivolous, or

          2. The filing reflects a desire to delay or impede the administration of the federal or California tax laws

        2. Frivolous submission. Any person who submits a "specified frivolous submission" is subject to a $5,000 penalty (RTC § 19179(d)). A specified frivolous submission is any protest, request for hearing or applications relating to installment payment of tax liability, compromises or actions of the Taxpayer Right's Advocate, if the submission is based on a position that the FTB has identified as frivolous or reflects a desire to delay or impede administration of the tax laws.

      5. Promoter and preparer penalties.

        1. Promoter penalty. California generally conforms to the federal penalty (IRC § 6700) for promoting abusive tax shelters (RTC § 19177). In general, promoters of tax shelters are subject to a penalty if the person makes a "gross valuation overstatement" (generally 200% of the correct valuation) or makes a statement with respect to the allowability of any deduction or credit that the person knows or has reason to know is false. In the case of the making of a false statement, the California penalty is 50% of the gross income derived from the activity on which the penalty is imposed.

        2. Tax return preparer penalty. California also conforms, with modifications, to the federal penalty (IRC § 6694) imposed on certain tax return preparers (RTC § 19166). The California penalty is imposed on return preparers who take a position for which there was no reasonable belief that the tax treatment was more likely than not the proper tax treatment (cf. federal standard of "no realistic possibility of success"), the preparer knew or reasonably should have known of such position and the position was not properly disclosed.

    4. Other Tax Shelter-Related Rules.

      1. Statute of limitations. For California income and franchise tax purposes, the statute of limitations for proposed deficiency assessments relating to an "abusive tax avoidance transaction," which includes, but is not limited to, listed transactions, is extended to eight years after the return was filed (RTC § 19755). This provision applies to returns filed on or after January 1, 2000.

      2. Subpoena. The FTB power to subpoena documents in tax shelter cases has been expanded. For taxpayers that have been contacted by the FTB regarding the use of a potentially abusive tax shelter, the subpoena may be signed any FTB board member, the FTB Executive Officer "or any designee" (RTC § 19504).

        1. On April 14, 2004, the FTB announced that it issued shelter-related subpoenas to two insurance companies demanding the names of all California persons who were issued insurance policies or who sought to buy policies insuring against government enforcement actions related to the use of shelters.

    5. Voluntary Compliance Initiative (VCI).

      1. Summary. During the limited period from January 1, 2004 through April 15, 2004, taxpayers had the opportunity to file amended returns and pay tax liabilities and applicable interest relating to the use of abusive tax avoidance transactions (which include without limitation listed transactions) for open taxable years beginning before January 1, 2003 (RTC § 19751). Taxpayers were given two options under VCI: with appeal rights and without appeal rights. If the taxpayer opted for VCI without appeal rights, no claim for refund may be filed and all penalties are waived or abated. Under VCI with appeal rights, the taxpayer preserves its right to file a refund claim and all penalties, except the accuracy-related penalty, are waived or abated.

        1. As of April 28, 2004, VCI brought in approximately $1.2 billion from corporations and individuals, more than $800 million of which was paid with notices of appeal.

      2. Refund of amounts paid with VCI.

        1. If the taxpayer pays less than 100% of the tax liability and interest due to the use of a tax shelter (e.g., due to non-shelter offsetting issues) and such offsetting amounts are later held to be invalid, the taxpayer will remain subject to penalties on the invalid amounts.

        2. No portion of an amount paid in connection with VCI without appeal rights may be refunded to the taxpayer, even if the taxpayer has claims with respect to non-shelter items (RTC § 19752(a)(4)).

        3. Amounts paid in connection with VCI with appeal rights may be refunded to the taxpayer, including with respect to claims for non-shelter items.

      3. VCI with appeal rights—Now what?

        1. Accuracy-related penalty. Though subject to the accuracy-related penalty under this option, the taxpayer does not pay the penalty with the VCI amended return. The penalty may be assessed (a) when the FTB takes action on the claim or (b) when a federal determination becomes final for the same issue, in which case the penalty will be assessed if the penalty was assessed at the federal level. The penalty is due and payable upon notice and demand.

        2. Claim for refund. Under this option, taxpayers could elect to either treat the amended return filed pursuant to VCI as a claim for refund or file a claim for refund at a later date. The normal procedures for refund claims apply (RTC § 19752(b)(4)).

        3. Statute of limitations. If taxpayers elected to file a refund claim at a later date, the claim should be filed within the statute of limitations for refund claims—generally, the later of (a) one year after the VCI payment was made, (b) four years after the due date of the original return, (c) the expiration date under California waivers or (d) the expiration date under federal waivers, plus six months.

        4. Appeal to SBE. Notwithstanding the "deemed denial" rule (i.e., taxpayer may deem a claim denied if the FTB fails to act within 6 months and appeal to SBE), the taxpayer may not file an SBE appeal until after either of the following:

          1. the date the FTB takes action on the claim for refund or

          2. the later of the following: (i) 180 days after the date of a final IRS determination with respect to the shelter transaction or (ii) four years after the date the refund claim was filed or one year after full payment of all tax, including penalty and interest was made, whichever date is later.

        5. Suit for refund in court.

    6. FTB and IRS Cooperation. Most states, including California, have entered into agreements with the IRS and with each other to cooperate and share information regarding taxpayers that may be engaged in tax shelters. These efforts are expected to result in a greater sharing of information, more structured and efficient channels of communication and earlier sharing at the front-end of taxpayer audits. In addition, a multiple-nation task force (U.S., Canada, Australia, U.K.) has been formed to increase collaboration and coordinate information about abusive tax transactions.


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