• California Franchise Tax Board Attacks REITs and RICs
  • February 11, 2004
  • Law Firm: Manatt, Phelps & Phillips, LLP - Palo Alto Office
  • In Chief Counsel Announcement 2003-1 the California Franchise Tax Board (FTB) launched an attack against a consent dividend tax strategy that was marketed to many banks in California. Under the strategy, the bank formed a captive real estate investment trust (REIT). The REIT engaged in the consent dividend procedure for federal income tax purposes whereby the REIT deducted the consent dividend and the bank took the consent dividend into income. In contrast, for California tax purposes, the REIT deducted the consent dividend but the bank did not take the consent dividend into income.

    The FTB announcement attacks the California deduction claimed by the REIT on the basis that California has no counterpart to the consent dividend that is permitted by federal tax law. Under recent California anti-tax shelter legislation, the FTB has taken steps to disallow the deduction and possibly to impose severe penalties.

    The same Chief Counsel Announcement also attacks a regulated investment company (RIC) strategy that was utilized by certain California banks. Under the RIC strategy, the bank formed a wholly owned corporation and transferred income-producing assets to it. The RIC registered with the SEC as a regulated investment company and took steps to be classified as a RIC for tax purposes. The RIC claimed a dividends-paid deduction for distributions to the bank and the bank claimed an intercompany dividends-received deduction on the basis that it was engaged in a unitary business with the RIC. Thus, no income or franchise tax was paid to California on the income earned by the income-producing assets contributed to the RIC. In the Chief Counsel Announcement, the FTB asserts that the formation and registration of these RICs were sham transactions designed to avoid tax. The FTB position is that the RICs should be treated as non-RIC entities that are not entitled to a dividends-paid deduction.

    Banks that employed the REIT or RIC strategy have options concerning how to deal with the FTB in this area. For example, there are two forms of voluntary compliance initiatives available for a limited time under the California legislation. Banks that employed the REIT or RIC strategy should assume that the FTB already is aware, or soon will become aware, that the bank participated in the strategy because other parts of the recent California legislation will force disclosure.