The Franchise Tax Board (“FTB”) will begin implementing California’s recently-enacted Voluntary Compliance Initiative for reporting Abusive Tax Avoidance Transactions (“ATATs”) and certain offshore financial arrangements (“OFAs”) on August 1, 2011.1

On March 24, 2011, California enacted Senate Bill (“SB”) 86,2 directing the FTB to administer a tax amnesty program known as Voluntary Compliance Initiative 2 (“VCI 2”).3 Taxpayers who engaged in ATATs or certain OFAs may report those transactions under VCI 2 by amended return between August 1, 2011 and October 31, 2011 to avoid certain penalties and criminal prosecution.4

An ATAT includes tax shelters, reportable transactions, listed transactions, or gross misstatements, as those terms are defined under federal law, as well as any transactions subject to California’s noneconomic substance transaction (“NEST”) penalty.5 An OFA is any transaction involving the use of offshore payment cards, including credit, debit, or charge cards issued by banks in foreign jurisdictions, or any arrangements made with foreign entities to avoid or evade income or franchise tax.6

Under VCI 2, taxpayers may file amended returns for tax years beginning before January 1, 2011 to report all income from all sources without regard to the ATAT and including all income from OFAs, and pay in full all taxes and interest.7 Taxpayers participating in VCI 2 will not be allowed a refund or credit of amounts paid in connection with VCI 2.8 Interest suspension rules provided under Section 19116 do not apply to assessments of additional tax relating to ATATs or OFAs,9 and transaction costs associated with the ATATs or OFAs may not be deducted on the amended returns.10

In exchange, taxpayers will have all applicable penalties waived, except for the large corporate understatement penalty,11 the post-amnesty penalty,12 any penalty assessed after July 31, 2011 attributable to an assessment of taxes that became final prior to July 31, 2011,13 and any penalty paid prior to the time the taxpayer participates in VCI 2.14 Taxpayers participating in VCI 2 will avoid criminal liability with respect to the transactions disclosed in the voluntary disclosure process that are not the subject of a criminal complaint or investigation as of July 31, 2011.15

Taxpayers must submit amended returns and a Participation Agreement to the FTB after August 1, 2011, and by October 31, 2011, to participate in VCI 2.16 Taxpayers that filed amended returns reversing ATATs or OFAs before August 1, 2011, may participate in VCI 2 by submitting a copy of the amended return with a completed Participation Agreement by October 31, 2011.17 Taxpayers that have protested the imposition of the NEST penalty and made a tax deposit for that amount may also participate in VCI 2, and request the deposit be returned by filing an FTB Form 3581.18 Taxpayers with current audits, protests, and appeals relating to ATATs or OFAs are eligible for VCI 2;19 however the initiative is unavailable for transactions and amounts disclosed under VCI 1.20

Taxpayers must cooperate fully with any FTB inquiry into the facts and circumstances related to the use of the ATAT or OFA reported under VCI 2.21 Failure to cooperate shall render the waiver of penalties under VCI 2 void.22

Other Newly Enacted Tax Shelter Provisions

Transactions subject to the NEST penalty expanded. The definition of a NEST has been modified to include any transaction that lacks economic substance under Internal Revenue Code section 7701(o).23 If a penalty has been assessed for federal income tax purposes for a transaction lacking economic substance, the NEST penalty applies to any underpayment of tax attributable to the transaction, unless the taxpayer establishes that the imposition of the federal penalty was clearly erroneous.24 These expanded NEST provisions apply to notices mailed on or after the March 24, 2011 effective date of SB 86.25

Extended statute of limitations (“SOL”) on assessments for ATATs. The period of time within which the FTB must issue a Notice of Proposed Assessment (“NPA”) for ATATs has been extended from 8 years to 12 years from the later of when the return was filed or due.26 This extended SOL period is effective for all returns filed on or after January 1, 2000, but does not apply to tax years for which the SOL has expired or has otherwise closed as of August 1, 2011.27

Interest Suspension Rules Inapplicable to Interest-Based Penalty. Section 19116 generally suspends the accrual of interest on deficiencies for individuals if the FTB does not provide a written notice of tax liability within three years after the return was filed. For NPAs issued or amended returns filed on or after January 1, 2012, those interest suspension rules do not apply to any interest, penalty, addition to tax, or additional amount relating to an ATAT, including, for example, the calculation of the 100-percent interest-based penalty imposed on ATATs.28

Change in 100-percent interest based-penalty for ATATs. Previously, taxpayers could avoid the 100-percent interest-based penalty imposed on ATATs by reporting the ATATs on amended returns prior to the issuance of a NPA.29 Effective for NPAs issued on or after March 24, 2011, taxpayers will now be subject to a 50-percent interest-based penalty in such circumstances, and will continue to be subject to the 100-percent interest-based penalty if a NPA is issued prior to the filing of amended returns reporting the ATATs. 30