California taxpayer disclosure requirements.

In October 2003, California enacted legislation imposing a complex set of reporting and disclosure requirements (2003 Cal. SB 614/AB 1601). Commonly referred to as "tax shelter legislation," these new provisions incorporate into California law several categories of transactions (e.g., tax shelters, reportable transactions, listed transactions, abusive tax avoidance transactions and noneconomic substance transactions), requiring various levels of disclosure. The legislation also imposes stiff penalties for noncompliance.

To date, taxpayers' attention to the legislation primarily focused on the recently concluded Voluntary Compliance Initiative (VCI). The VCI was an amnesty-like program in which participants filed amended returns for tax years beginning before 2003 and paid tax and interest on reversing "abusive tax avoidance transactions." For many taxpayers, participation in the VCI, which ended April 15, 2004, required considerable effort and expense.

Yet, while the dust from the VCI has barely settled, taxpayers now have to turn their attention to the provisions under the legislation for disclosing certain transactions on their 2003 California returns. For calendar-year corporate and individual taxpayers, extended 2003 California franchise (income) returns are due Oct. 15, 2004. The disclosure requirements are complex, entailing significant analysis. In light of the looming deadline, this column outlines the new requirements and the issues that taxpayers should consider in determining how and which transactions to disclose.

New Rules

It is important to distinguish the VCI, which was essentially a one-time event for pre-2003 transactions, from the new disclosure requirements, which may be annual and recurring. Under the new legislation, if taxpayers participate during the tax year in a transaction subject to disclosure, they must disclose the transaction on that year's return. If, in the following year, taxpayers again engage in the same transaction or the transaction otherwise affects that year's return, they must again disclose the transaction.

Federal reportable transactions: California's disclosure requirements are embodied in new California Rev. & Tax Code (CRTC) Section 18407, which explicitly adopts Internal Revenue Code (IRC) Sec. 6011 for California personal income and corporate franchise (income) tax purposes. IRC Sec. 6011(a) requires taxpayers to provide returns or statements as prescribed by regulations. CRTC Section 23051.5(d) provides that whenever an IRC provision is adopted for California tax purposes, the corresponding final or temporary Treasury regulations also are adopted. This has resulted in California adopting Regs. Sec. 1.6011-4, which provides that taxpayers participating in a reportable transaction during the tax year must attach a disclosure statement to their Federal return. Accordingly, CRTC Section 18407 requires California taxpayers to disclose transactions subject to Federal disclosure with their state return, for tax years beginning after 2002; see SB 614/AB 1601, Section 15(b) and the discussion below for special rules applicable to listed transactions.

Regs. Sec. 1.6011-4(b)(2)-(7) provides six categories of reportable transactions. In general, these categories capture a transaction that:

1. Is the same or substantially similar to one specifically "listed" by the IRS as a tax avoidance transaction. To date, more than 30 such "listed transactions" have been identified.

2. Is offered to a taxpayer under conditions of confidentiality.

3. Provides the taxpayer with contractual protection (i.e., a right to a refund of the fees paid or a contingent fee arrangement) if all or part of the intended tax consequences of the transaction are not sustained.

4. Results in a taxpayer claiming a Sec. 165 loss in excess of a threshold.

5. Generates a book-tax difference of greater than $10 million.

6. Involves a taxpayer claiming a tax credit exceeding $250,000 for an asset with a brief holding period (i.e., 45 days or less).

However, Regs. Sec. 1.6011-4, as well as other published guidance (e.g., Rev. Proc. 2003-25, regarding significant book-tax differences), provides various operative rules and exceptions to these six general categories. While a discussion of these is beyond this column's scope, any transaction that fits the general descriptions provided above should be carefully scrutinized. (For a discussion of the Treasury regulations, see Mendelson and Emilian, "Tax Shelter Final Regs.," TTA, June 2003, p. 338).

Kegs. Sec. 1.6011-4(a) requires disclosure in any tax year in which taxpayers have "participated" in a reportable transaction. According to Kegs. Sec. 1.6011-4(c)(3)(i)(A)-(F), participation includes any year in which a taxpayer's return reflects the transaction's tax consequences or benefits, not just the transaction year. For example, a contractually protected transaction must be disclosed in every year in which a taxpayer claims a tax benefit on a return. Regs. Sec. 1.6011-4(c)(6) deems benefits to be deductions, exclusions, gain nonrecognition, credits, basis adjustments or other consequences that may affect a taxpayer's tax liability. Not all categories of reportable transactions are triggered by the reflection of tax benefits. Listed transactions and book-tax differences, for instance, may not produce any tax benefits in a particular tax year, but still may be subject to disclosure; see Regs. Sec. 1.6011-4(c)(3)(i)(A) and (E).

California reportable transactions: California's adoption of IRC Sec. 6011 also creates a category of "California reportable transactions." This stems from the Franchise Tax Board's (FTB's) interpretation of the effect of CRTC Sections 17024.5(h)(71 and 23051.5(h)(7) on CRTC Section 18407. Under those provisions, taxpayers have to account for obvious differences in Federal and state terminology when applying the IRC and Treasury regulations for California tax purposes. As a result, they must evaluate the six categories of reportable transactions in Regs. Sec. 1.6011-4(b), by liberally substituting references to "California franchise (income) tax" for "Federal income tax," in determining whether they have participated hi such transactions.

For example, a corporate taxpayer may have to disclose with its 2003 California franchise (income) tax return a contractually protected transaction that favorably affected its California apportionment factor, even though the transaction created no Federal tax benefit. Or, a transaction may create a significant book-tax difference for California, but not Federal, purposes, due to differences resulting from IRC provisions to which California does not conform. In other words, California taxpayers have to apply the Regs. Sec. 1.60ll-4 tests twice to identify reportable transactions subject to California disclosure--once, as the rules relate to a transaction's Federal income tax effect, and then again as they relate to California tax effect.

Federal listed transactions: As part of the disclosure of reportable transactions, California taxpayers have to disclose transactions that are the same as or substantially similar to certain specific "listed transactions." Although listed transactions actually are a subset of reportable transactions, their disclosure requirements are somewhat more rigorous, warranting a separate discussion. As was noted, California taxpayers that participated in a Federal listed transaction during the 2003 tax year have to disclose it with their 2003 California franchise (income) tax return.

California taxpayers also have to disclose certain listed transactions in which they participated in previous tax years, even though the general disclosure requirements for reportable transactions are effective only for tax years after 2002. This requirement arises through the legislation's effective date, which specifies that for any transaction invested in after Feb. 28, 2000, and before 2004, that becomes "listed" at any time, a penalty may he assessed under CRTC Section 19772 for failure to disclose; see SB 614/AB 1601, Section 15(c)(1).

This requirement also is embodied in CRTC Section 18407, through its adoption of Regs. Sec. 1.6011-4. Under Regs. Sec. 1.6011-4(e)(2)(i), if a transaction becomes listed after the return is filed for the applicable tax year of participation, but before the end of the statute of limitations (SOL) period for that year, a disclosure statement must be attached to the next filed return, even if the taxpayer does not participate in the transaction in the disclosure year. Unless disclosed during the VCI, the first opportunity for most taxpayers to disclose listed transactions invested in after Feb. 28, 2000, will be their 2003 California returns. Thus, taxpayers that do not disclose prior-year Federal listed transactions may be subject to penalties (unless sufficient disclosure was made during the VCI).

California listed transactions: CRTC Section 184(17(a) (4) also defines a listed transaction as any transaction that is the same as or substantially similar to one specifically designated as such by the FTB. Again, the "California listed transaction" is just a subset of California reportable transactions and is required to be disclosed under CRTC Section 18407. On Dec. 31, 2003, the FTB identified two such transactions in, FTB Chief Counsel Announcement Notice 2003-1. The first one involves certain real estate investment trusts that use consent dividends; the second involves certain closely held regulated investment companies.

The legislation itself appears to impose the same disclosure requirement for a post-Feb. 28, 2000, California listed transaction as it does for a post-Feb. 28, 2000, Federal listed transaction; see SB 614/AB 1601, Section 15(c)(1). However, the FTB's website (www.ftb.ca.gov/law/tax_shelter/ reporting.html) explicitly states that a California listed transaction entered into before Sept. 2, 2003, is not required to be disclosed under CRTC Section 18407, unless it meets one of the other five categories of reportable transactions in Regs. Sec. 1.6011-4. Presumably, this refers to the categories of California reportable transactions and applies only to transactions in which a taxpayer participated during the 2003 tax year (consistent with the effective date for disclosing such transactions). Nevertheless, taxpayers should be aware that while they may not necessarily have to disclose such prior-year transactions with their 2003 returns, there is no guarantee that the FTB will not subsequently impose a penalty that is not directly tied to the statutory disclosure requirements on a transaction (e.g., the noneconomic-substance-transaction understatement penalty under CRTC Section 19774). Taxpayers should take note that the potential severity of this penalty can be reduced if they adequately disclose the transaction on their return, even though they may not be explicitly required to do so.

Tax shelters: The California legislation also adopted the tax shelter registration rules of IRC Sec. 6111 and the regulations thereunder; see CRTC Sections 18628 and 23051.5(d) and SB 614/AB 1601, Section 15(a); for the definition of "tax shelter" see Sec. 6111(c) and (d) and the modifications made by CRTC Section 18628(e) and (f). Sec. 6111 (b)(2) requires taxpayers claiming a deduction, credit or other tax benefit by reason of a tax shelter, to include the tax shelter's identification number on their return. The requirement to register a tax shelter with the IRS or the FTB is the responsibility of the tax shelter organizer; however, Sec. 6111(b)(1) also requires the shelter organizer to provide the identification number to the investor.

According to SB 614/AB 1601, Section 15(a), California's adoption of Sec. 6111 was effective Jan. 1,2004. As a result, the identification number disclosure requirement applies to all returns filed on or after that date (including returns for pre-2004 tax years, if the taxpayer either is in possession of a tax shelter identification number or aware that one has been applied for at the time the return is filed). Note: the FTB also required organizers to register, by April 30, 2004, Federal listed transactions offered for sale between Feb. 28, 2000, and Jan. 1, 2004, and California listed transactions offered for sale between Sept. 2, 2003, and Jan. 1, 2004; see SB 614/AB 1601, Section 15(c)(2)(A) and www.ftb.ca.gov/law/ tax_shelter/ reporting.html. Accordingly, taxpayers that invested in a listed transaction with a tax shelter organizer within the above time frames should be aware that a California tax shelter identification number should be forthcoming.

Disclosure--Practical Considerations

Internally generated transactions: As if sorting through the various statutory requirements of the new legislation was not enough, there are numerous additional considerations and ambiguities that complicate compliance with the SB 614/AB 1601 disclosure requirements. For example, taxpayers must not overlook that the universe of transactions subject to disclosure is not limited to those for which fees have been paid to tax advisers. A taxpayer can just as easily trip the disclosure requirements by engaging in a transaction on its own. True, it may be difficult (if not impossible) for a taxpayer to offer itself a transaction under conditions of confidentiality. However, a taxpayer can clearly undertake a transaction that creates a significant book-tax difference or that results in a brief asset holding period, without assistance from a tax adviser. Moreover, such transactions have the potential to occur during the course of complex business transactions. Because such internally generated transactions may be difficult to identify, taxpayers should be especially vigilant in establishing procedures to discover such transactions and analyze whether they require disclosure.

Who is a taxpayer? California's disclosure rules apply to persons liable for California tax; see CRTC Section 18407(a) (1). For individuals, this is easy enough to identify. For corporations that are part of a unitary business group filing a California combined report (see CRTC Section 25101), the answer is more complex. All members of a California unitary combined reporting group are not considered California "taxpayers" even though a single combined report is filed. For example, corporations that lack substantial nexus with California or are protected from California franchise (income) tax by P.L. 86-272, would not be considered California taxpayers, even though their net incomes would be aggregated with the net incomes of other unitary group members in determining the group's overall California franchise (income) tax liability. Mechanically, the group's overall California franchise (income) tax liability is allocated back only to the unitary group members having nexus with California, and only they are considered to be California taxpayers; see Cal. Code Regs., tit. 18, Section 25106.5.

As California's disclosure rules apply only to California taxpayers, a reportable or listed transaction might appear not to be subject to the disclosure rules if undertaken by a unitary group member falling outside California's taxing jurisdiction. However, the FTB takes the position that the disclosure rules apply to reportable or listed transactions in which any unitary group member participates. Thus, California taxpayers should be aware that the FTB may impose nondisclosure penalties if unitary group members that are not California taxpayers fail to disclose reportable or listed transactions. Further, not disclosing a transaction also could affect the potential severity of penalties (e.g., the reportable transaction or noneconomic-substance-transaction understatement penalties (both discussed below)), which are indifferent as to the group member required to disclose a transaction.

Disclosure of "other" transactions: What about transactions not subject to disclosure under CRTC Section 18407? As alluded to above, the legislation imposes several penalties affected by the disclosure of reportable transactions. However, the noneconomic-substance-transaction understatement penalty is not tied to whether a transaction is reportable. The basic penalty under CRTC Section 19774(a) is 40% of the noneconomic-substance-transaction understatement for any tax year. However, according to CP, TC Section 19774(b)(1), the penalty drops to 20% if the transaction is adequately disclosed with the taxpayer's return. This penalty potentially applies to all open tax years (see SB 614/AB 1601 Section 15(a)), even though it seems implausible that a taxpayer could have or would have disclosed a transaction before the legislation's enactment. Accordingly, when filing 2003 returns, taxpayers should consider whether to disclose current and past transactions that do not necessarily trip any of the CRTC Section 18407 disclosure requirements, but may be vulnerable to a noneconomic-substance-transaction challenge.

Consequences of nondisclosure: A comprehensive analysis of the penalties associated with this legislation is beyond this column's scope. Suffice it to say, the consequences of noncompliance are very serious. First, large entities (gross receipts greater than $10 million) and high-net-worth individuals (net worth greater than $2 million) are subject to penalty under CRTC Section 19772 for failure to provide the required information for reportable or listed transactions. The penalty is $15,000 for each reportable transaction and $30,000 for each listed transaction. Second, the aforementioned reportable transaction understatement penalty under CRTC Section 19773 is 20% of any tax understatement related to a listed transaction or a reportable transaction with a significant purpose of avoiding or evading California franchise (income) tax, but increases to 30% without adequate disclosure. Further, a good faith/reasonable cause exception to the reportable transaction understatement penalty explicitly is not available if the transaction was not adequately disclosed; see CRTC Section 19164(d)(2). However, unlike the noneconomic-substance-transaction understatement penalty (for which the perils of nondisclosure were discussed above), the reportable transaction understatement penalty applies only to tax years after 2002.

Third, for purposes of the good faith/reasonable cause exception to California's existing 20% accuracy-related penalty, which is based on IRC Sec. 6662, the nondisclosure of a reportable transaction is a strong indication of a lack of good faith; see CRTC Section 19164 and Regs. Sec. 1.6664-4(d). Unlike the reportable transaction understatement, this penalty potentially applies to all years open under the SOL. Finally, the new legislation interprets "adequate disclosure" to include disclosure of a transaction's tax shelter identification number with a return; see CRTC Sections 19164(d)(2)(A)(iii) and 19774(b)(2).

How to disclose: Reportable transactions are disclosed by filing a copy of Federal Form 8886, Reportable Transaction Disclosure Statement, with the California return. This form also should be completed to disclose any California reportable transactions. The first time a reportable transaction is disclosed, a duplicate of Form 8886 should be sent to: Tax Shelter Filing, Franchise Tax Board, PO Box 1673, Sacramento, CA 95812-1673; see CRTC Section 18407 and www.ftb.ca.gov/law/tax_shelter/ reporting.html. Investors in Federal or California registered tax shelters must also attach a completed copy of Federal Form 8271, Investor Reporting of "Fax Shelter Registration Number, to their California return; see CRTC Section 18628.

Conclusion

The disclosure requirements facing California taxpayers in preparing their 2003 returns is daunting, and this is merely the first chapter in what is expected to be a long story for taxpayers. Many aspects of the California disclosure requirements may be revisited, including the possibility of an increase in some of the noncompliance penalties. In addition, other states are looking closely at California's system. During 2004, New York, Illinois, Connecticut, New Jersey and South Carolina all have engaged in legislative and/or administrative activity involving taxpayer disclosure. As of mid-summer, legislation had been passed in Illinois and was still pending in New York.

California's disclosure rules and associated penalties are complex and require significant attention and analysis. Ongoing activity there and in other states reinforces the need to carefully evaluate not only the current and future requirements that may be imposed for disclosing transactions, but also the transactions that will potentially trigger such requirements.

Editor's note: Mr. Salmon is a member of the AICPA Tax Division's State & Local Tax Technical Resource Panel (TRP). Mr. Peterson chairs that TRP. For more information about this column, contact Mr. Salmon at [e-mail] or Ms. Amitay at [e-mail].

Scott Salmon, CPA 

Director

KMPG LLP 

Washington National Tax

Washington, DC

Sharlene Amitay, J.D., CPA

Senior Manager

KMPG LLP

Washington National Tax

Washington, DC