Taxpayers should be aware of the ramifications of Section 19138 and take several factors into account when responding to the legislation.
The California Franchise Tax Board (FTB) held an interested parties meeting on December 5, 2008, to discuss implementation of S.B. No. 28, a new bill that added section 19138 to the California Revenue and Taxation Code. That section imposes a 20 percent penalty on an understatement of tax in excess of $1 million (computed on a combined basis where a combined return is filed) for tax years commencing after January 1, 2003. Taxes paid with an amended return for years prior to 2008 filed on or before May 31, 2009, are treated as the amount of tax shown on an original return. The penalty does not have a reasonable cause exception and no provision is made for administrative or judicial review (other than for correction of errors in the computation of the penalty). There are only two exceptions to the penalty. First, the penalty will not be imposed if an understatement is attributable to a change in law after the return filing date of a return or an extended due date, and, second, the penalty will not be imposed if an understatement is attributable to the taxpayer’s reasonable reliance on the written advice of a Chief Counsel ruling.
More than 50 people attended the interested parties meeting. Many of the comments made at the meeting were regarded by the moderator as objections to the statute, while the purpose of the meeting was to discuss how to implement the statute. Representatives of large taxpayers that have routinely paid significant amounts of California franchise tax argued that the $1 million threshold should be supplemented with a requirement that the adjustment exceed a certain percentage of tax. Another representative objected to the imposition of a penalty where the taxpayer complies with the Revenue and Taxation Code but where the FTB successfully asserts a modification to the standard apportionment formula under section 25137 (Section 18 of UDITPA). That situation arose in the recent Microsoft case.
A common denominator of many comments was that compliant taxpayers may be subject to adjustments that cannot be foreseen.
The Unexpected Statutory Construction by FTB Staff
Prior to the interested parties meeting, the general consensus was that section 19138 was enacted in order to raise revenue quickly: in order to avoid the penalty, corporations would overpay their liabilities to create a “cushion.” The moderator of the interested parties meeting surprised most persons in attendance by stating that the legislative purpose was to encourage taxpayers to file correct tax returns and that it was not a revenue acceleration measure designed to address the significant budget deficit. Moreover, the moderator stated that the FTB intended to implement section 19138 to effect this interpretation of the legislative purpose.
The consequences of this construction by the FTB were regarded as draconian by taxpayers and their representatives at the meeting. Several taxpayers had previously suggested alternative approaches for meeting the standard for submission. One approach was for the FTB to accept as correct a return that included a separately identified overpayment cushion to absorb potential future tax adjustments that are difficult or impossible to determine at the time tax returns are filed. The FTB staff rejected this approach, perhaps because it flies against the purported purpose of encouraging “correct” filings, and said an amended return must meet conventional standards for a qualified amended return, which, in general, requires identification of specific adjustments.
Representatives of national CPA firms that prepare tax returns were particularly concerned that to avoid the 20 percent penalty, both the accounting firm and the taxpayer/client would have to file returns under penalty of perjury that they did not believe to be correct. If an amended return were filed to provide a cushion to avoid a penalty, the FTB would not accept the payment as a valid amended return unless specific adjustments were identified. If the nature and timing of any adjustment is purely speculative, taxpayers seem to be required to specify adjustments they do not believe to be true, and then attest to the amended return.
The FTB Staff’s Interpretation of Legislative Intent Is Suspect
S.B. 28 was a “midnight special.” It was not even printed until the day after it was passed by the legislature, and the 20 percent penalty was a surprise late addition to the budget bill. It effectively replaced an amnesty proposal that earlier was floated as a revenue enhancement provision. No one even knows who proposed the 20 percent penalty, but one suggestion was that it may be attributed to a representative of the Department of Finance. The director of the Department of Finance is one of three members of the governing Franchise Tax Board. Some parties objected to the characterization by the moderator of the purpose of the legislation, as all objective indicia of legislative intent pointed to acceleration of receipt of tax revenue. Separate, uncommunicated attitudes of those participating in the tense budget negotiations are, of course, not admissible evidence of legislative intent. In general, materials that were communicated to the legislature as a whole are informative and admissible, while uncommunicated opinions of individual legislators and communications to the governor after a bill has passed the legislature are not.
Responding to Section 19138
Taxpayers should evaluate and respond to Section 19138.
Technical Corrections Bill
One suggestion was to immediately pursue a technical corrections bill that addresses what will be regarded as a proper amended return. It may be possible to clarify that an amended return that does not specify precise items of income, deduction or credit is sufficient for purposes of avoiding the penalty. Better yet, taxpayers may seek the use of a deposit, not to reduce understatement interest, but to reduce the understatement penalty. A deposit mechanism would be particularly useful where a potential adjustment exists, but the year of recognition is uncertain. Otherwise multiple, duplicate tax payments might have to be made to avoid the penalty.
A technical corrections bill may be considered a long shot. Prior efforts at a technical corrections bill for the amnesty program were futile. Also, many practitioners sensed that some FTB staff favored the interpretation that requires taxpayers to identify all issues or potential issues in a return.
It was pointed out in the interested parties meeting that section 19138, drafted in haste, provides that Article 3 (relating to deficiency assessments) of Part 10.2 (relating to the administration of franchise and income tax laws) of the Revenue and Taxation Code shall not apply, presumably to eliminate the availability of administrative review and the use of a tax deposit mechanism. However, the provision for assessment and collection of penalties is also included in Article 3, so there may be a good reason for the FTB to join in a technical corrections bill effort to address this statutory disconnect.
Should Amended Returns Be Filed?
If a taxpayer can identify the year and amount of an expected adjustment for tax years beginning with 2003, consideration should be given to filing an amended return prior to May 31, 2009, rather than waiting for federal and state audits to run their normal course.
If a taxpayer can identify an issue for which a Chief Counsel’s ruling may be obtained, consideration should be given to filing a request for a ruling. A question presented at the interested parties meeting was how the FTB would respond to a year in which a ruling has been requested, but the Chief Counsel has yet to act on the request. The moderator acknowledged the problem as one that may be addressed in the forthcoming FAQ guidance. As an amended return for years 2003-2007 must be filed by May 31, 2009, consideration of this alternative should be a matter of first priority. There are many tactical issues to consider in making a ruling request, including whether the matter can be the subject of a ruling.
Taxpayers must be aware of the financial cost of neither filing an amended return nor seeking a Chief Counsel’s ruling. The penalty is 20 percent of any deficiency over $1 million, but the amount of the penalty does not bear interest until the date the penalty is assessed. If the penalty is assessed, say, eight years after the original due date of the return, the penalty represents an addition to tax of 2 to 1/2 percent a year (20 percent divided by eight years). At the present time, interest rates on underpayments of tax are approximately 5 percent greater than interest rates on overpayments. Before taking into account the nondeductibility of a penalty, a penalty that is imposed eight years after a tax year makes the differential between overpayments and underpayments increase to more than 7.5 percent. That incremental cost may not be enough to compel filing an amended return, particularly where a taxpayer believes it should prevail on the merits of an uncertain tax position. The cost of funds to the taxpayer may influence its decision, as well as the negative implications of imposition of a penalty, which may suggest questionable corporate governance. Some practitioners are reluctant to recommend payment of disputed amounts in advance in the belief that strapped states are reluctant to refund money already in the till. This concern may apply with less force in California, as evidenced by the treatment of claims for refund filed after payments were made in the recent amnesty program. At the California Tax Policy Conference, the Chief Counsel of the FTB observed that the level of current audits and subsequent Notices of Proposed Assessment of Additional Tax was significantly reduced as a result of the assignment of auditors to respond to the wave of protective claims for refunds that were filed.