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California Franchise Tax Board Announces Penalty Waiver Programme - International Law Office

International Law Office

White Collar Crime - USA

California Franchise Tax Board Announces Penalty Waiver Programme

July 21 2008

Tax Compliance Efforts

Voluntary Disclosure Programme
New Filing Compliance Agreement


On April 25 2008 the California Franchise Tax Board announced another opportunity for taxpayers who have not filed their California tax returns and have California tax liabilities to satisfy their obligations with the benefit of penalty waivers. Unlike earlier California tax compliance initiatives, this programme may have particular appeal to the international audience as it is restricted to out-of-state corporations and trusts that might have California tax obligations. In addition, the programme may offer comfort to taxpayers and their advisers as to any potential criminal exposure. In light of California’s aggressive enforcement efforts both within and outside California, those eligible to participate in the new programme and their advisers should seriously consider the new Filing Compliance Agreement Programme (FCAP). This update summarizes the key elements of California’s new initiative, as well as the related Voluntary Disclosure Programme (VDP).

Tax Compliance Efforts

According to the headline on the board's website announcing the new FCAP, the programme is “aimed at those unaware of filing requirements” in California. “Tax laws can be complicated when business operations cross state lines,” said State Controller and Board Chair John Chiang. “Those who are unsure of their past tax liabilities should take a second look at their books to see if this programme can help them.”

This initiative is the latest in a series of steps by California to enhance state revenues and give taxpayers an opportunity to satisfy their obligations to California before the state finds them and imposes large penalties, in addition to collecting unpaid taxes, or possibly prosecutes them for violation of the applicable criminal statutes. As many California residents and most tax practitioners know, California is aggressive in finding and pursuing individuals, corporations, partnerships and trusts with unfulfilled filing and payment obligations. Indeed, California is often ahead of the Internal Revenue Service on many compliance issues, most notably tax shelters. Recently, California turned a page in its historical pursuit of individual residency issues by actively pursuing trusts that are not filing returns or paying California tax, but that the state believes are subject to California tax due to the existence of either a California resident beneficiary or fiduciary. California also often pursues criminal prosecutions, including non-filer cases, especially in egregious situations. The FCAP is part of this enforcement effort and is a follow-up to the recent VDP, which had specific statutory requirements that many taxpayers found difficult to meet. Under the FCAP, those taxpayers now have the chance to obtain penalty relief and resolve any concerns about criminal exposure and meet their obligations before California finds them. Below are some of the key features of the FCAP and the VDP.

Voluntary Disclosure Programme

In order to understand the new FCAP, it is useful first to understand its predecessor, the VDP. The VDP is specifically defined in Sections 19191 to 19194 of the California Revenue and Taxation Code. Under Section 19191, the board may enter into a voluntary disclosure agreement with any “qualified entity, qualified shareholder, qualified member or qualified beneficiary”. These terms are defined in Section 19192. By way of example, a 'qualified entity' is defined as an entity that:

  • is a corporation or a qualified trust;
  • has never filed a return with the board;
  • has never been the subject of an inquiry by the board with respect to liability for any taxes; and
  • voluntarily came forward, prior to any unilateral contact with the board, to make both an application for a voluntary disclosure agreement and a full and accurate statement of its activities in California for the six immediately preceding taxable or income years.

Even if an entity meets all these criteria, it will be ineligible to participate in the VDP if it:

  • is organized and exists under the laws of California;
  • is qualified or registered with the Office of the Secretary of State of California; or
  • maintains and staffs a permanent facility in California.

With respect to trusts, a 'qualified trust' is a trust that has never performed its administration duties in California and has had no resident beneficiaries (other than a beneficiary whose interest in that trust is contingent).

The VDP agreement is binding on both the board and the qualified taxpayer. Under the VDP agreement, the board could waive penalties going back as far as six years from the date of the VDP agreement. The penalties that the board could waive include the following:

  • failure to make and file a return (Section 19131);
  • failure to pay any amount due by the date prescribed for payment (Section 19132);
  • underpayment of estimated tax (Section 19136);
  • Secretary of State penalty (Section 19141);
  • failure to furnish information or maintain records (Section 19141.5);
  • underpayment of tax (Section 19142);
  • failure to file information returns (Section 19183);
  • late filing of partnership returns (Section 19172); and
  • contract voidability penalty (Section 23305.1).

Qualified entities, shareholders or beneficiaries that choose to participate in the VDP must complete an application for voluntary disclosure (Form FTB 4925). In order to qualify for a VDP agreement, the qualified taxpayer must voluntarily and fully disclose on its application for the programme all material facts pertinent to the taxpayer’s liability for the years for which an agreement is sought. Once the agreement is signed, the taxpayer must then file within 30 days all returns required and pay any tax, interest and penalties due, excluding the penalties waived under the agreement. The board may allow additional time to file the returns and pay the amounts due. The board also requires that participants in the VDP agree to comply with California tax laws on a going-forward basis. The VDP agreement will be declared null and void if the taxpayer:

  • fails to comply with California tax laws on a going-forward basis;
  • misrepresents material facts relevant to the agreement;
  • fails to file the returns due under the agreement or pay the taxes due;
  • reneges on an instalment arrangement set up related to the agreement; or
  • understates any tax liabilities covered by the agreement, in the absence of a showing of good faith.

One important feature of the VDP is that a taxpayer may remain anonymous during the application phase. To remain anonymous, programme applicants may have a representative contact the board. Company representatives should not reveal the name of the company or shareholders or any information that could readily identify the company to the board until the agreement is executed. The completed application for voluntary disclosure and required documentation is mailed to Voluntary Disclosure Programme, Franchise Tax Board, PO Box 942857, Rancho Cordova CA 94257-0540, United States.

New Filing Compliance Agreement

Where a taxpayer concludes that it does not qualify for a VDP agreement, the new FCAP may offer a beneficial alternative. According to the board, the FCAP:

provides taxpayers the opportunity to come forward voluntarily and enter into a filing compliance agreement (FCA) if they have an unfulfilled filing requirement for past years, and an unpaid California tax liability. Qualified taxpayers eligible to enter into an FCA must voluntarily disclose [and] file [all required returns], and make full payment to [the] Franchise Tax Board for all years in which they failed to file a California return. Based upon a showing of reasonable cause, [the] Franchise Tax Board will waive various penalties for which reasonable cause is a [defence] associated with the return filings identified in the agreement.

Unlike the VDP, the authority for the filing compliance agreement is found in Sections 19131 and 19132 of the California Revenue and Taxation Code, which provide the board with general authority to abate certain penalties for reasonable cause. Thus, the FCAP is theoretically less restrictive in its eligibility requirements. Similar to the VDP, the class of taxpayers eligible for a penalty-relieving filing compliance agreement is generally limited to certain corporations, limited liability companies and trusts. According to the board, if a taxpayer is in the class of taxpayers described in Section 19192 of the code, but has concluded that it is otherwise not eligible for the VDP, it may apply to enter into a filing compliance agreement. Thus, the FCAP offers an alternative to out-of-state businesses and trusts which do not qualify for the VDP. Moreover, unlike the VDP, the FCAP is not limited to a six-year period and can include earlier tax years.

According to the board:

the determination to waive penalties will be made on a case-by-case basis and is limited to penalties for which reasonable cause is a defence. The most commonly waived penalties are the failure to file penalty under Revenue and Taxation Code Section 19131, and the failure to pay tax penalty under Revenue and Taxation Code Section 19132. However, the Franchise Tax Board may also waive other penalties for which reasonable cause is a [defence]. The Franchise Tax Board cannot waive underpayment of estimated tax or amnesty penalties for reasonable cause.

The Franchise Tax Board will also not waive interest under a filing compliance agreement.

Although not a focus of the board’s announcement, the FCAP offers a hidden benefit to taxpayers and their advisers who are concerned about potential criminal exposure for failure to file returns in California. Although under the programme a taxpayer that has already been contacted by California as part of a criminal investigation is not eligible to participate, assuming that there is no prior contact a taxpayer or its adviser could attempt to participate in the programme, and in doing so get comfort as to the lack of any criminal exposure. Obviously, if the board is willing to waive penalties under the FCAP there would be no criminal exposure. Indeed, even if the board determined that the taxpayer did not qualify for a penalty waiver as part of the FCAP, the taxpayer would at least have the benefit of having come forward voluntarily to the board, which would weigh against any later contemplated criminal prosecution.

The new FCAP raises the question of how it differs from any normal audit where a taxpayer is free to raise reasonable cause as a defence to penalties. The main benefit would appear to be the advance determination regarding penalties without the burden of a regular audit. Moreover, presumably a taxpayer seeking a filing compliance agreement, who the board has not yet audited, may be given some credit, or the benefit of the doubt in a close case, for having come forward voluntarily. However, this remains to be seen as the programme unfolds. Given this uncertainty, the ability to proceed anonymously under the FCAP, as is the case with the VDP, is critical.

To obtain a filing compliance agreement, taxpayers or their representatives should send a letter requesting to enter into a filing compliance agreement with the board, along with supporting documentation, to Legal, Attention of Craig Scott, Franchise Tax Board, PO Box 1720, Rancho Cordova, CA 95741-1720, United States.

The letter should include an explanation as to why there is an unfulfilled filing requirement for past years and an unpaid California tax liability, and should specify the years for which relief is sought. The letter should also include detailed facts as to why the taxpayer’s situation qualifies for a waiver of penalties under reasonable cause. As with the VDP, taxpayers can pursue a filing compliance agreement anonymously. If the board accepts the taxpayer’s request for a filing compliance agreement, generally the taxpayer must file the required tax returns and make full payment within 30 days, or whatever deadline is set forth in the filing compliance agreement. As with the VDP, an instalment arrangement may be approved if the taxpayer qualifies under the applicable rules. Also similar to the VDP, the board may declare a filing compliance agreement null and void if it later discovers that any of the information submitted by the taxpayer to qualify for the filing compliance agreement was false, in which case the board is free to pursue all applicable penalties, including potentially criminal penalties.

More information about the new FCAP is available on the board's website at ftb.ca.gov by searching for 'filing compliance agreement'.

For further information on this topic please contact Steven M Katz or Emily J Kingston at Sideman & Bancroft LLP by telephone (+1 415 392 1960) or by fax (+1 415 392 0827) or by email (skatz@sideman.com or ekingston@sideman.com).

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