United States: California Franchise Tax Board Identifies "Circular Cash Flow" Transactions As Listed Transactions

In California Franchise Tax Board (FTB) Notice 2011-03 (Notice),¹ the FTB alerts taxpayers that certain "circular cash flow" transactions and substantially similar transactions are tax avoidance transactions, and are identified as "listed transactions" for purposes of California Revenue and Taxation Code (CRTC) Sec. 18407(a)(4)(A).

Circular Cash Flow Transaction

The circular cash flow transactions described in the Notice consists of a series of transactions in which a parent corporation (Parent) increases its basis in the stock of its wholly-owned subsidiary corporation (Subsidiary) without any outlay of cash or property prior to Parent selling the stock of Subsidiary to an unrelated third party. Specifically, this is accomplished by Parent contributing a promissory note or other instrument to Subsidiary intended to qualify as a contribution to capital under Internal Revenue Code (IRC) Sec. 351 (applicable due to operation of CRTC Sec. 24451, which provides for general conformity with Subchapter C of the IRC). Subsidiary then takes steps to generate earnings and profits in order for a subsequent distribution to Parent to be treated as a dividend and deductible or excludable from Parent's income. Subsidiary purportedly generates earnings and profits by forming a second-tier subsidiary (Subsidiary 2) and selling the promissory note to Subsidiary 2 in exchange for a new promissory note. Subsidiary's basis in the old note is zero, and Subsidiary claims earnings and profits for the full value of the new note. Concurrently, Parent pays off the promissory note issued to Subsidiary. Soon thereafter, Subsidiary distributes the cash received from Parent to pay off the promissory note back to Parent. Parent characterizes the distribution as a nontaxable dividend and does not reduce its basis in Subsidiary. Following the transaction, Parent can claim an increased basis in Subsidiary for its contribution of the promissory note, which is no longer with Subsidiary, and therefore reduce its gain on the future sale of Subsidiary.

Stated FTB Grounds for Challenge

The FTB argues that California's nonconformity to Treas. Reg. Secs. 1.1502-32 and -33, relating to earnings and profits and stock basis within the consolidated group context, is motivating taxpayers to engage in the circular cash flow transactions that are the subject of the Notice. In California, a corporation's earnings and profits and stock basis are determined separately and not with relation to its subsidiaries. In the FTB's view, this distinction is resulting in Parent artificially inflating its basis in its stock of Subsidiary without actual out-of-pocket cost to Parent.

Accordingly, the FTB intends to challenge the purported tax benefits from this type of transaction, and other substantially similar circular cash flow transactions based on the application of various statutory provisions and judicial doctrines such as substance over form, sham transaction, and step transaction doctrines. By doing so, the FTB could wholly disregard the effect of the circular cash flow transactions. In addition, the FTB reserves the right to challenge these transactions on the basis that such transactions lack economic substance and/or valid non-tax business purposes, violate CRTC Sec. 24431(a) (the anti-abuse rule parallels IRC Sec. 269(a)(1)), or do not meet CRTC Sec. 24451 (which parallels IRC Sec. 351) because the contribution is illusory and is only temporarily contributed to Subsidiary. Further, the FTB does not concede that earnings and profits are being created through this type of transaction, and substantially similar variations.

Disclosure Obligations and Potential Penalties

In the Notice, the FTB states that taxpayers involved in these transactions, as well as substantially similar transactions, must comply with applicable reporting requirements, and those who do not are subject to several types of penalties imposed by California, including the penalty for failure to disclose reportable transactions, the accuracy-related penalty, the noneconomic substance transaction penalty, the 100% interest-based penalty, and potentially the fraud penalty.² Material advisors must comply with reporting and list maintenance requirements,³ and those who do not are subject to penalties for failure to maintain and/or furnish investor information, failure to disclose reportable transactions, and potentially penalties for promoting abusive tax shelters.⁴

In light of the fact that taxpayers and material advisors who were involved with the Notice transactions may have upcoming disclosure obligations with the FTB, the FTB recently released a publication on its Web site detailing the rules governing disclosures of California listed transactions.⁵

Disclosure rules for taxpayers. A taxpayer is required to file IRS Form 8886, "Reportable Transaction Disclosure Statement," to disclose California listed transactions. Form 8886 is required to be attached to the taxpayer's original or amended tax return for each taxable year for which the taxpayer participates in a reportable or listed transaction. A copy of the disclosure must be mailed to the FTB's Abusive Tax Shelter Unit if the Form 8886 is being filed for the initial year of participation. The date on which the California listed transaction is entered into is vitally important, as it governs when a taxpayer must file its disclosure:

• For transactions entered into prior to September 2, 2003 that later are designated as California listed transactions by the FTB, no disclosure is necessary unless it is another type of federally defined reportable transaction;
• For transactions entered into between September 2, 2003 and August 2, 2007 that later are designated as California listed transactions by the FTB, the taxpayer must file Form 8886 with the next filed California return after the transaction is listed;
• For transactions entered into on or after August 3, 2007 that later are designated as California listed transactions by the FTB, the taxpayer must file Form 8886 within 90 calendar days of the date listing the transaction in the FTB notice.⁶

As the particular transaction described in the Notice was listed on April 22, 2011, any listed transactions entered into on or after August 3, 2007 that were described in the Notice would have to be reported by a taxpayer by July 21, 2011.

Disclosure rules for material advisors. For transactions entered into on or after September 2, 2003 that later are designated as California listed transactions by the FTB, a material advisor with connections to California must file IRS Form 8918, "Material Advisor Disclosure Statement," with the FTB by the later of (i) 60 days after entering into the transaction; or (ii) 60 days after the transaction becomes listed.⁷ Further, a list of advisees must be provided by a material advisor with connections to California to the FTB by the later of: (i) 60 days after the investor enters into the transaction; or (ii) 60 days after the transaction becomes listed.⁸

For the particular transactions described in the Notice, June 21, 2011 would be the relevant due date for a material advisor's past transactions, for purposes of the reporting and listing requirements.

Commentary

The Notice follows closely on the heels of another FTB notice issued earlier this year characterizing certain transactions between corporations and partnerships undertaken to improperly inflate the denominator of the California sales factor, and substantially similar transactions as listed transactions,⁹ as well as the FTB's publication on its Web site detailing the rules governing disclosures of California listed transactions. As noted in our Alert covering the release of these publications,¹⁰ it appears that the FTB is signaling that it will be more active in creating a number of listed transaction designations for transactions consummated with California tax planning in mind. The inclusion of substantially similar transactions as part of this new class of listed transactions could make it difficult for taxpayers and practitioners alike to distinguish between transactions that are perfectly acceptable and those that are being targeted by the FTB. Also, it is interesting to note that the FTB chose to police these types of transactions through the listed transaction process rather than going the regulatory route and conforming to Treas. Reg. Secs. 1.1502-32 and -33 to the extent necessary to prevent the tax planning described in the Notice.

Footnotes

1 FTB Notice 2011-03, Abusive Tax Shelters – California Listed Transactions – Circular Cash Flow (April 22, 2011), available at www.ftb.ca.gov/law/notices/2011/2011_03.pdf.

2 See CAL. REV. & TAX. CODE §§ 19772; 19164(a); 19774; 19777; and 19164(c), respectively.

3 See CAL. REV. & TAX. CODE §§ 18628 and 18648, respectively.

4 See CAL. REV. & TAX. CODE §§ 19173; 19182; and 19177, respectively.

5 California Franchise Tax Board, "California Disclosure Obligations for Taxpayers and Material Advisors" (http://www.ftb.ca.gov/professionals/Tax_News_Flash/2011/Flash_01.shtml).

6 Note that the 90-day disclosure rule is pursuant to CAL. REV. & TAX. CODE §§ 18407, which is the California analog to IRC § 6011. The 90-day rule is actually contained in TREAS. REG. § 1.6011-4(e)(2)(i).

7 Pursuant to CAL. REV. & TAX. CODE § 18628(f) (note that CAL. REV. & TAX. CODE § 18628 is the California analog to IRC § 6111).

8 Pursuant to CAL. REV. & TAX. CODE § 18648(d)(4) (note that CAL. REV. & TAX. CODE § 18648 is the California analog to IRC § 6112).

9 FTB Notice 2011-01, Abusive Tax Shelters – California Listed Transactions – Abusive Sales Factor Manipulation (Jan. 6, 2011), available at www.ftb.ca.gov/law/notices/2011/2011_01.pdf.

10 See GT SALT Alert, "California FTB Designates State-Specific Listed Transaction and Reminds Taxpayers and Material Advisors of Disclosure Obligations," Feb. 21, 2011. http://www.gt.com/staticfiles/GTCom/Tax/SALT%20Alert%20files/GrantThornton_SALTAlert_02-21-11_CA.pdf

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.