California Board Takes Back Tax Benefit, Demands Retroactive Payments and Interest

 
 
February 13, 2013

For the past 20 years, California has allowed a diminished rate on capital gains tax for sale or exchange of qualified small business stock. In order to qualify for the discounted rate, businesses needed to show that at least 80 percent of the company’s assets were located in California, and that 80 percent of the payroll expenses were spent in the state.

The California Court of Appeals has invalidated the reduced rate, finding that the law violated the US Constitution’s Commerce Clause for rewarding in-state investment but not out-of-state investment. As we have noted in the past, the Commerce Clause requires competitive neutrality, taxing cross-border activities equally well or equally badly as in-state activities.

So with the choice of expanding the tax benefit to all investment or taking it back from those who had benefitted, the California Franchise Tax Board (FTB) decided to take it back and impose retroactive liability on everyone who paid a reduced rate going back to 2008. Falsely claiming its hands were tied, the FTB is seeking to collect these “unpaid” taxes as well as interest on the tax.

While the FTB claims that the Court order forced the FTB to impose back taxes, this exercise of California’s taxing power creates uncertainty for taxpayers who relied on the provision. Ordinarily, when the legislature changes tax law, those adversely affected by the change are afforded “transition relief.” Such relief is important to those taxpayers who made business plans by relying on prior legislation. Transition assures taxpayers that they will not be subject to arbitrary changes to a state’s laws. Such relief avoids the uncertainty caused by additional, unexpected taxes. It not only reduces the chance that the state will face legal challenges to such a tax, but it creates a favorable and consistent business climate.

This is exactly the kind of relief California should provide those who relied on the California statute to their detriment. Taxpayers should not be subject to a $120 million unforeseen liability which resulted from the state’s mistake. The FTB claims that it must enforce the court ruling by collecting a large sum, but this is self-serving. It seems at least possible that the FTB could disallow the deduction going forward. Instead, the FTB claims that only the California legislature may provide relief. No word from the Legislature on whether they will act to relieve taxpayers from the unexpected burden of a failure in the State’s legislation.

For more on transition relief, check out Department of the Treasury, Blueprints for Basic Tax Reform, Chapter 6, Transition (U.S. Government Printing Office, 1977), and An Economic Analysis of Legal Transitions, 99 Harv. L. Rev. 509 (1986).

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