State & Local Tax Alert Breaking state and local tax developments from Grant Thornton LLP

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1 State & Local Tax Alert Breaking state and local tax developments from Grant Thornton LLP Release date May 16, 2011 States California California Enacts Voluntary Compliance Initiative, Expands Tax Shelter Penalties, Authorizes Use Tax Tables California Governor Jerry Brown has signed budget trailer legislation that directs the Franchise Tax Board (FTB) to establish a voluntary compliance initiative (VCI) to operate from August 1 to October 31, The VCI applies to taxpayers that have participated in transactions characterized as abusive tax avoidance transactions and offshore financial arrangements. In addition, the legislation increases the already lengthy statute of limitations period during which the FTB may mail a proposed deficiency assessment related to an abusive tax avoidance transaction. The legislation also amends some penalty provisions concerning tax shelters. If a taxpayer files an amended return reporting an abusive tax avoidance transaction after it is contacted by the FTB, but before a notice of proposed assessment is issued, a penalty is imposed that equals 50 percent of the interest payable on any additional tax due. California penalties are added to transactions that violate the federal economic substance standards. Further, some individuals will have the option of determining their use tax obligation by using a table of estimated use tax based on their adjusted gross income. Voluntary Compliance Initiative In 2003, the Internal Revenue Service (IRS) offered an Offshore Voluntary Compliance Initiative for taxpayers that had underreported their U.S. income tax liability through financial arrangements that relied on the use of offshore payment cards issued by banks in foreign jurisdictions or offshore financial arrangements. 2 For participants in the program, the IRS waived certain civil penalties. In 2004, California offered its own Voluntary Compliance Initiative (VCI 1) that applied to tax liabilities attributable to the use of abusive tax avoidance transactions for taxable years beginning before January 1, In 2009, the IRS offered an Offshore Voluntary Disclosure Initiative that ended on October 15, The IRS announced a new Offshore Voluntary Disclosure Initiative earlier this year that will be available through August 31, Issue/Topic Corporate Franchise Tax; Personal Income Tax; Sales and Use Tax Contact details Scot Grierson Irvine T E scot.grierson@us.gt.com David Griffiths Irvine T E david.griffiths@us.gt.com Eddie Delgado Los Angeles T E eddie.delgado@us.gt.com Maria Tran Los Angeles T E maria.tran@us.gt.com Giles Sutton Charlotte T E giles.sutton@us.gt.com Jamie C. Yesnowitz Washington, DC T E jamie.yesnowitz@us.gt.com Chuck Jones Chicago T E chuck.jones@us.gt.com 1 Ch. 14 (S.B. 86), Laws 2011; Bill Analysis for SB 86, Senate Budget and Fiscal Review Committee, March 17, Rev. Proc Former CAL. REV. & TAX. CODE VCI 1 was conducted from January 1 to April 15, IR , Internal Revenue Service, Feb. 8, 2011.

2 Grant Thornton LLP - 2 Recent California legislation directs the FTB to conduct a new VCI (VCI 2) from August 1 to October 31, The initiative applies to tax liabilities attributable to the use of abusive tax avoidance transactions and to unreported income from the use of offshore financial arrangements for taxable years beginning before January 1, An abusive tax avoidance transaction means any of the following: A tax shelter as defined in Internal Revenue Code (IRC) Section 6662(d)(2)(C); A reportable transaction as defined in IRC Section 6707A(c)(1) when certain requirements have not been met; A listed transaction as defined in IRC Section 6707A(c)(2); A gross misstatement within the meaning of IRC Section 6404(g)(2)(D); or A transaction subject to a penalty for a noneconomic substance transaction understatement. 6 An offshore financial arrangement means 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. 7 Election to Participate VCI 2 applies to taxpayers that elect to participate in the program. 8 Taxpayers must file an amended return for each taxable year for which the taxpayer has previously filed a return using an abusive tax avoidance transaction or an offshore financial arrangement to underreport tax liability or failed to include income from the offshore financial arrangement. 9 Each amended return must report all income from all sources, without regard to the abusive tax avoidance transaction, including all income from offshore financial arrangements. Taxpayers generally must pay all taxes and interest due in full, but the FTB may enter into installment payment agreements with a taxpayer CAL. REV. & TAX. CODE CAL. REV. & TAX. CODE 19763(c), CAL. REV. & TAX. CODE 19764(a)(1)(B). 8 CAL. REV. & TAX. CODE The California provisions for making an election do not reference the federal election. However, we presume the state election is dependent upon the federal election. 9 CAL. REV. & TAX. CODE Id. An installment payment agreement only is allowed if final payment is due and paid by June 15, Also, the agreement must include interest on the unpaid amount.

3 Grant Thornton LLP - 3 Waiver of Penalties For all taxable years where the taxpayer elects to participate in VCI 2, the FTB generally will waive or abate the penalties incurred as a result of the unreported tax liabilities attributable to the use of abusive tax avoidance transactions and to unreported income from the use of offshore financial arrangements. 11 However, the FTB may not waive the large corporate underpayment penalty 12 or the tax amnesty penalty. 13 Also, no penalty assessed after July 31, 2011 may be waived or abated if the penalty is attributable to an assessment of taxes that become final prior to this date. No refund or credit will be allowed for amounts paid in connection with abusive tax avoidance transactions or unreported income from the use of offshore financial arrangements. Finally, no criminal action may be brought against the taxpayer for the taxable years with respect to issues for which the taxpayer participated in the VCI. 14 Limitations The initiative does not apply to violations for which, as of July 31, 2011, a criminal complaint was filed against the taxpayer, or the taxpayer is the subject of a criminal investigation, in connection with an abusive tax avoidance transaction or unreported income from the use of an offshore financial arrangement. 15 No refund or credit is allowed for any penalty paid prior to the time the taxpayer participates in the voluntary compliance initiative. 16 Lengthy Statute of Limitations Increased for Tax Shelters For notices mailed on or after August 1, 2011, the FTB may mail a proposed deficiency assessment related to an abusive tax avoidance transaction to a taxpayer within 12 years after the return was filed. 17 Previously, the FTB was required to mail the proposed deficiency assessment within eight years after the return was filed. 11 CAL. REV. & TAX. CODE CAL. REV. & TAX. CODE This penalty applies to taxpayers with an understatement of tax that exceeds the greater of the following: (1) $1 million or (2) 20 percent of the tax shown on an original or amended return filed on or before the original or extended due date of the return for the taxable year. The penalty equals 20 percent of the understatement of tax. 13 CAL. REV. & TAX. CODE Under this provision, the following must be added to the tax for each taxable year for which amnesty could have been requested: (1) for amounts that are due and payable on the last day of the amnesty period, an amount equal to 50 percent of the accrued interest payable under CAL. REV. & TAX. CODE (the standard interest penalty on unpaid tax) for the period beginning on the last date prescribed by law for the payment of that tax and ending on the last day of the amnesty period specified in CAL. REV. & TAX. CODE (March 31, 2005) and (2) for amounts that become due and payable after the last date of the amnesty period, an amount equal to 50 percent of the interest computed under CAL. REV. & TAX. CODE on any final amount for the period ending on the last date prescribed by law for the payment of the tax for the year of the deficiency and ending on the last date of the amnesty period specified in CAL. REV. & TAX. CODE (March 31, 2005). 14 CAL. REV. & TAX. CODE CAL. REV. & TAX. CODE Id. 17 CAL. REV. & TAX. CODE 19755(a).

4 Grant Thornton LLP - 4 Tax Shelter Penalty Provisions Amended If a taxpayer files an amended return reporting an abusive tax avoidance transaction after it is contacted by the FTB, but before a notice of proposed assessment is issued, a penalty is imposed that equals 50 percent of the interest payable on any additional tax due. 18 Previously, a taxpayer could avoid the penalty completely by filing an amended return after being contacted, but prior to the FTB issuing a deficiency notice. 19 This amendment applies to notices mailed on or after March 24, 2011, and to amended returns filed more than 90 days after this date for taxable years for which the statute of limitations for mailing a notice of proposed assessment has not expired. 20 Federal Economic Substance Standard Adopted Under existing law, a taxpayer with a noneconomic substance transaction understatement is subject to a penalty of 40 percent of the understatement. 21 However, this penalty is reduced to 20 percent if the relevant facts are adequately disclosed. The definition of noneconomic substance transaction is expanded to include any disallowance of claimed tax benefits by reason of a transaction lacking economic substance under federal law. 22 If a penalty has been assessed for federal income tax purposes 23 on an underpayment attributable to the disallowance of claimed tax benefits by reason of a transaction lacking economic substance, California imposes a penalty on the portion of an understatement attributable to that transaction. 24 This penalty only may be abated if the taxpayer can establish that the imposition of the federal penalty for the underpayment attributable to the transaction was clearly erroneous. These amendments apply to notices mailed on or after March 24, CAL. REV. & TAX. CODE 19777(d). 19 Bill Analysis for SB 86, Senate Budget and Fiscal Review Committee, March 17, CAL. REV. & TAX. CODE 19777(e). 21 CAL. REV. & TAX. CODE CAL. REV. & TAX. CODE 19774(c)(2)(B). Specifically, the California statute is amended to provide a noneconomic substance transaction includes [a]ny disallowance of claimed tax benefits by reason of a transaction lacking economic substance, within the meaning of Section 7701(o) of the Internal Revenue Code, relating to clarification of economic substance doctrine, as added by Section 1409(a) of the Health Care and Education Reconciliation Act of 2010 (Public Law ), except as otherwise provided. IRC 7701(o)(1) provides that in the case of any transaction to which the economic substance doctrine is relevant, the transaction is treated as having economic substance only if (1) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer s economic position and (2) the taxpayer has a substantial purposes (apart from the federal income tax effects) for entering into the transaction. Under the California statute, the phrase apart from state tax effects is substituted for the phrase apart from federal income tax effects in each place it appears in IRC 7701(o)(1). IRC 7701(o)(3) provides that for purposes of IRC 7701(o)(1), any state or local income tax effect which is related to a federal income tax effect shall be treated in the same manner as a federal income tax effect. Under the California statute, the phrase any federal or local income tax effect which is related to a state income tax effect shall be treated in the same manner as a state income tax effect is substituted for the phrase any state or local income tax effect which is related to a federal income tax effect shall be treated in the same manner as a federal income tax effect in IRC 7701(o)(3). 23 This federal penalty is imposed by IRC 6662(b)(6). 24 CAL. REV. & TAX. CODE 19774(e). 25 Id.

5 Grant Thornton LLP - 5 For notices mailed on or after January 1, 2012, the accuracy-related penalty is expanded to include underpayments resulting from violations of the federal economic substance doctrine. 26 A new uniform definition of abusive tax avoidance transaction is added to the penalty provisions to simplify administration and avoid confusion. 27 This same definition is adopted by the VCI statutes. 28 Use Tax Look-Up Table Option Added Under existing law, use tax is owed on purchases made out-of-state or through mail order or the Internet when tax is not collected by a registered retailer. 29 Individuals who owe use tax may pay the tax directly to the California State Board Equalization (SBE) or declare and pay the tax by using the use tax line on the individual income tax return. For purchases of tangible personal property made on or after January 1, 2011, individuals with one or more nonbusiness purchases with a sales price of less than $1,000 each may satisfy their tax liability by using a look-up table prepared by the SBE and included in the income tax return instructions. The look-up table will contain estimated amounts of use tax due as calculated by the SBE according to an individual s adjusted gross income. 30 Commentary Many of the provisions in this legislation are designed to discourage the use of abusive tax avoidance transactions and unreported income from offshore financial arrangements. Taxpayers that have engaged in these types of transactions and are participating in the federal VCI should seriously consider participating in VCI Compared to the California VCI that was available in 2004, the definition of abusive tax avoidance transaction has been expanded. Also, the new initiative includes unreported income from the use of offshore financial arrangements. Participation in the program will result in the waiver of most penalties associated with these transactions. However, VCI 2 does not allow for the waiver of the potentially significant large corporate underpayment penalty or tax amnesty penalty. 32 In the past, states have seemed to follow each other in offering this type of initiative. Thus, it is possible that other states may enact similar initiatives this year if they perceive a value in offering this type of initiative. It also is significant that California is expanding its noneconomic substance transaction provisions by expressly adopting the federal economic substance standard provided by 26 CAL. REV. & TAX. CODE CAL. REV. & TAX. CODE 19777(b); Bill Analysis for SB 86, Senate Budget and Fiscal Review Committee, March 17, CAL. REV. & TAX. CODE 19763(c). See the VCI discussion above for the uniform definition of abusive tax avoidance transaction. 29 CAL. REV. & TAX. CODE ; Bill Analysis for SB 86, Senate Budget and Fiscal Review Committee, March 17, Id. 31 Note that there may be less interest in the new federal VCI program because of less favorable terms than the previous VCI program. 32 Due to possible reduced interest in the new federal program and the fact that two significant penalties may not be waived under the new California program, the level of participation in California VCI 2 may be limited.

6 Grant Thornton LLP - 6 IRC Section 7701(o) that was enacted by the Health Care and Education Reconciliation Act of 2010 (Public Law ). In general, for tax years beginning on or after January 1, 2010, California adopts the IRC as in effect on January 1, However, the current legislation adopts the federal economic substance standard that was enacted after the January 1, 2009 conformity date. Taxpayers need to be particularly careful in structuring their transactions to ensure that they have economic substance. Note that the tax periods covered by VCI 1 also are covered by VCI Eligible taxpayers that did not participate in VCI 1 may be able to participate in VCI 2, but any large corporate underpayment penalty or tax amnesty penalty will not be waived. Thus, some taxpayers will have a second opportunity to participate in the program. Because VCI 2 participants do not have appellate rights, they should carefully consider the strength of their position before deciding to participate in the program. The lengthening of the statute of limitations period from eight years to 12 years suddenly may expose taxpayers to deficiency assessments for abusive tax avoidance transactions that previously were protected by the statute of limitations. For example, under prior law, the state could not issue a deficiency assessment for an abusive tax avoidance transaction that was conducted 11 years ago. Under the amended statute, this abusive tax avoidance transaction may be subject to a deficiency assessment. The information contained herein is general in nature and based on authorities that are subject to change. It is not intended and should not be construed as legal, accounting or tax advice or opinion provided by Grant Thornton LLP to the reader. This material may not be applicable to or suitable for specific circumstances or needs and may require consideration of nontax and other tax factors. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Grant Thornton LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. No part of this document may be reproduced, retransmitted or otherwise redistributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, re-keying or using any information storage and retrieval system without written permission from Grant Thornton LLP. 33 CAL. REV. & TAX. CODE (a)(1), (a)(1). Due to the approval of Proposition 26 by California voters on November 2, 2010, the validity of the legislation advancing the IRC conformity date from January 1, 2005 to January 1, 2009 is questionable. There is a possibility that California s conformity date may revert from January 1, 2009 to January 5, Legal Division Guidance , California Franchise Tax Board, Jan. 12, VCI 1 applied to tax years beginning before January 1, 2003 and VCI 2 applies to tax years beginning before January 1, Thus, both initiatives apply to tax years beginning before January 1, 2003.

7 Grant Thornton LLP - 7 Tax professional standards statement This document supports the marketing of professional services by Grant Thornton LLP. It is not written tax advice directed at the particular facts and circumstances of any person. Persons interested in the subject of this document should contact Grant Thornton or their tax advisor to discuss the potential application of this subject matter to their particular facts and circumstances. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed. To the extent this document may be considered written tax advice, in accordance with applicable professional regulations, unless expressly stated otherwise, any written advice contained in, forwarded with, or attached to this document is not intended or written by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding any penalties that may be imposed under the Internal Revenue Code.