On September 5, 2012, the California State Board of Equalization’s (“Board”) legal staff (“Staff”) issued a legal opinion letter (“Letter”) in which the Staff reversed a Proposition 13 (“Prop 13”) property tax change in ownership rule for transfers of interests in legal entities that the Board had adopted and followed for more than 25 years. Although the Staff almost immediately recalled the Letter and said that it would more fully consider the proposed change in position and would likely present the issue to the Board for consideration, the proposed new rule, if adopted, would be a sea change in the Board’s approach to the change in ownership rules governing legal entity transactions. If the Letter is republished adopting the new rule, it would create substantial uncertainty among taxpayers who need to determine the potential property tax effects of transfers and acquisitions of interests in legal entities, including corporate shares of stock and partnership or limited liability company interests. Moreover, because the Letter would not have the binding effect of a statutory or regulatory provision, the proposed change would create uncertainty among taxpayers, who would not know which of the rules would govern their transactions: the one the Board has followed since Prop 13’s inception or the newly stated one?
Prop 13’s Change in Ownership Rule
Under Prop 13 change in ownership system, real property assessments are capped by the property’s “base year value.”1 Base year values were established by the assessed values for the 1975 tax year, but are reset upon any subsequent “change in ownership” of any real property.2 (In addition, a property’s base year value might be adjusted by the removal or new construction of improvements on the property, but those base year value adjustments are not at issue in the Letter.) Because the provisional language of Prop 13 did not define what a “change in ownership” includes, shortly after Prop 13 was passed by the voters in 1978 to amend the California Constitution, a task force (“Task Force”) was convened to advise the Legislature on how it should define “change in ownership.”
One of the biggest questions the Task Force addressed was how to treat property held by legal entities, such as corporations and partnerships. The Task Force grappled with two distinct approaches: the “ultimate control” theory and the “separate entity” theory. In short, under the ultimate control theory, a change in ownership would occur when an investor obtained “majority control” of a legal entity that owned real property when the investor did not already have control over that entity. Under the separate entity theory, transfers of interests in legal entities would not trigger a change in ownership; only transfers of real property between legal entities would trigger a change in ownership, even if the entities were 100% affiliates. The Task Force recommended that the Legislature adopt the separate entity approach; however, the Legislature ultimately adopted a mixed separate entity and ultimate control approach.3 The enacted rule generally follows the separate entity approach, but directs that a change in ownership occurs when an investor obtains majority ownership or control over a legal entity.4
Multi-tiered Legal Entities
In 1989, a case was decided by the California Supreme Court that addressed whether a transfer of shares of a parent corporation that caused an investor to obtain more than 50% of the voting stock of the parent would trigger a change in ownership of the real property held not only by the parent entity, but by its “controlled” subsidiaries. In Title Insurance & Trust Company. v. County of Riverside (the “TICOR” case), the court ruled:
[I]f one corporation either directly or indirectly obtains control over another by the transfer or purchase of stock, a change of ownership occurs as to the real property owned by the corporation over which it has obtained direct or indirect control. Here, Southern Pacific obtained indirect control of TI as a result of the purchase of Ticor stock, since the merger resulted in Southern Pacific’s ownership of Ticor, a wholly owned subsidiary of Southern Pacific, and TI was Ticor’s wholly owned subsidiary. Ergo, such indirect control over TI resulted in a change of ownership of TI’s property for purposes of section 64(c).5
In the argument before the court in the TICOR case, amicus curiae supporting the taxpayer argued against a rule that would aggregate a parent entity’s ownership interests in its subsidiaries to determine whether a Prop 13 change in ownership occurred because the parent held or obtained “control” of a subsidiary that owned California real property. The amicus, Institute of Property Taxation (“IPT”), presented a series of hypothetical transaction structures to the court in which a parent entity held varying percentage ownership of different levels of subsidiaries and posed the difficulties that might arise if assessors needed to aggregate interests in subsidiaries to determine whether a parent entity or investor ultimately obtained control over a property owning subsidiary. In response to these hypotheticals, the Board filed a reply brief in which it took the position that for purposes of determining whether a change in ownership has occurred, the property of a subsidiary, or the interests in another entity held by that subsidiary, would only be attributed to the subsidiary’s immediate parent if the parent owned more than 50% of the subsidiary. Thus, according to the Board, if a corporation (“Parent”) acquired 51% of Subsidiary 1, which held 51% of Subsidiary 2, Parent would obtain indirect control over Subsidiary 2 through its acquisition of majority interests in Subsidiary 1 and the property of both subsidiaries would be deemed to have undergone a change in ownership. However, according to the Board’s responses to IPT’s hypotheticals, if under the same scenario Parent instead acquired only 49% of Subsidiary 1, this would not trigger a change in ownership of the property held by Subsidiary 2, because Parent would not be deemed to have obtained control (i.e., more than 50%) of Subsidiary 1 and, therefore, its interests in Subsidiary 2 could not be attributed to Parent. The same result would be reached (i.e., no change in ownership) even if Parent also had or obtained a direct 49% interest in Subsidiary 2. According to the Board, even though it would appear that Parent would then have most of the economic interests in Subsidiary 2, the 51% interest in Subsidiary 2 held by Subsidiary 1 could not be attributed to Parent because Parent held less than 50% of Subsidiary 1.
The following diagrams should help clarify the position the Board presented to the court in the TICOR case:
Click here to view the diagrams.
Although the court in the TICOR case did not address whether the Board’s position was the only appropriate method for calculating control, the Board’s position– that a subsidiary’s interests in property or in a lower tier entity could not be attributed to an investor in the subsidiary unless the investor held more than 50% of the subsidiary’s interests–was expressed in various legal opinion letters dating back at least to 1986. However, this past September, the Staff issued the Letter in which it altered its longstanding 50% threshold position. In the Letter, the Staff opined that there should be two different ways of calculating whether a change in ownership is triggered by the acquisition of interests in multitiered affiliated entities, depending on whether the entities involved are corporations or other types of entities, such as partnerships and limited liability companies (“LLCs”).
In essence, the Letter states that for partnerships and LLCs, only a “percentage attribution method” (“PAM”) should be used to determine whether a change in control of a partnership or LLC has occurred, rather than a “full attribution method” (“FAM”), which the Letter acknowledges had been the method the Board previously prescribed in its opinion letters. The Letter argues that because the statutory provision and the regulation promulgated by the Board, both governing change in ownership for legal entities, direct that control of a partnership or LLC shall be measured by the interests in capital and profits and because partnerships and LLCs are “pass-through” entities for income tax purposes, the proper means for calculating whether an investor has obtained indirect control over such an entity should be through the PAM.6 Under the PAM, the profits and capital interests are traced up through multiple tiers and attributed to the ultimate top tier investors to reflect the actual economic interests that the top tier investors have in the underlying property-owning entity. The example below illustrates the PAM method of calculating direct and indirect interest in partnerships and LLCs as explained in the Letter:
Click here to view the diagram.
According to the Staff’s Letter, A should be deemed to have 25.5% interest in PS2, and therefore, there should be no change in ownership when it acquires 51% of PS1.
In the above example, taken from the Letter itself, the Staff concluded that under their newly proposed PAM, Investor A would be deemed to have acquired a 25.5% (i.e., 51% of 50%) economic interest in PS2. The Staff noted that under the FAM that the Staff had previously endorsed, because A acquired more than 50% of PS1, all of PS1’s interests in PS2 would be attributed to A. However, because PS1 held only 50% of PS2 (i.e., not more than 50%), PS1 would not be deemed to have control of PS2 and, therefore, no interests in PS2 would be attributed to A. Under the FAM, had PS1 held 51% of PS2, then A’s acquisition of 51% of PS1 would have triggered a change in ownership of real property held by PS2 because, under the FAM, once PS1’s interests in PS2 rose above 50%, it would be deemed to control PS2 and any investor obtaining more than 50% of PS1 would be deemed to have obtained direct control of PS1 and indirect control of PS2.
The Letter then opined that although the PAM should be the only appropriate method for determining change of ownership by acquisition of indirect control over partnerships and LLCs, both the PAM and the FAM should apply for making change in ownership determinations for corporations. According to the Staff’s reasoning in the Letter, the language of California Revenue and Taxation Code Section 64(c) specifies two ways that acquisition of interests in corporations could trigger a change in ownership of real property held by the corporation, because for corporations the statute states that a change in control occurs whenever a person or legal entity obtains “control through direct or indirect ownership or control of more than 50 percent of a corporation’s voting stock.”7 Thus, starting from the example provided above, if PS1 and PS2 were corporations and A acquired 51% of PS1, which held 51% of PS2, there would be a change in ownership of real property held by PS2, because PS1 is deemed to control PS2 by virtue of holding more than 50% of the voting stock of PS2 and A is deemed to control PS1 for the same reason. However, if PS1 and PS2 are partnerships or LLCs, then under the reasoning of the Letter, A’s acquisition of 51% of PS1 should not cause a change in ownership, because A would only have acquired approximately 26% of the economic interests (i.e., ownership interests) in PS2.
Moreover, the Staff opines in the Letter that for corporations, if an investor obtains a greater than 50% interest in a corporation’s voting stock under either the PAM or the FAM, it should trigger a change in ownership. Thus, if PS1 and PS2 are both corporations in the example above and PS1 holds 80% of PS2 and A acquires a 40% interest in PS1 and a direct 20% interest in PS2, there should be a change in ownership because, under the PAM, A would be deemed to have acquired a 52% direct and indirect ownership interest in the voting shares of PS2 (i.e., 80% of 40% indirect, plus 20% direct).
The Letter clearly reflects a change in a longstanding Board position that the interests held by a legal entity in either real property or a lower tier entity should be attributed to an upper tier entity only if the upper tier entity holds directly more than 50% of the interests in the lower tier entity and the Letter acknowledges that change. While it is true that the language of the statute (i.e., Section 64) and of the Board’s rule (i.e., Rule 462.180) do not expressly prohibit utilization of the PAM as the method for calculating indirect control, the Staff’s newly proposed PAM would reflect a further shift away from the separate entity approach and it would introduce a different methodology for calculating changes in control for corporations than for partnerships and LLCs. Moreover, the proposed rule would likely lead to both administrative and compliance difficulties. For example, investors who make investments in large, multi-tiered funds and who also own direct investments in property owning entities, would have to track indirect proportional interests through all of their investments to determine whether they have indirectly acquired a greater than 50% economic interest in an entity. If such majority “ownership” is created through the acquisition of interests by a fund in which the investor holds only minor interests, this could be nearly impossible to monitor and identify. For assessors, identifying such acquisitions of indirect majority ownership through attribution of all indirect investments, even minor ones, would prove even more difficult.
But perhaps even more problematic would be the uncertainty that would be created among assessors and taxpayers if the Board were to reissue the Letter without adopting the change in its position through a properly promulgated regulation. Because the Board’s current regulation fails to expressly address the question of whether the PAM or FAM should be used for corporations, partnerships or LLCs and because the Board’s opinion letters are not binding authority for either the assessors or for the courts, if the Board changes its position, taxpayers would not know which method an assessor might choose to adopt for any specific transaction. In some instances, an acquisition of interests would lead to a change in ownership under the PAM but not under the FAM and vice versa. Without a clear authoritative statement in either a statute or a regulation, assessors could choose to follow either method and rely upon whichever Board position supports that method. If this were to happen, the Board would not be acting to fulfill its responsibility to clarify the property tax laws for assessors and taxpayers. To the contrary, it would be clouding those laws.