California State Board Oaffirms Use Of Non-Economic Substance Penalty On Tax Shelter Ttransaction

The California State Board of Equalization (SBE) has upheld an action of the Franchise Tax Board (FTB) decision which disallowed a flow-through loss generated by a tax shelter transaction, disregarded a Nevada corporation as a separate entity, and imposed a 40 percent noneconomic substance transaction (NEST) penalty for California personal income tax purposes.1

Background

The taxpayer, a Nevada resident, engaged in a complex series of transactions in 2001 involving the purchase and sale of foreign currency options that essentially offset one another, but resulted in the taxpayer recognizing a loss for federal income tax purposes without realizing much, if any, economic loss or detriment.2 Similar transactions have been a subject of considerable controversy with the Internal Revenue Service (IRS) and some of them have been referred to as "Son of BOSS" tax shelter transactions.

The taxpayer was the sole shareholder of Mantra, an S corporation for federal and state income tax purposes, which was incorporated in 1998 and engaged in the business of film production and distribution. Mantra conducted business only in California. The taxpayer was also the sole shareholder of Sands, which was incorporated in Nevada in 2001 and was also an S corporation for federal and state income tax purposes. Sands purportedly acquired advertising and media time in 2001 on behalf of Mantra pursuant to a "Media Placement Agreement" which provided that Mantra pay a commission of 10 percent of the "gross media invoices" as well as an unspecified amount as a "consulting commission." According to the evidence presented, Sands charged Mantra a 750 percent mark-up on the cost of media purchased. Mantra did not make any payments for media purchases other than through Sands, and Sands did not receive payments from any other entity. The IRS challenged the transactions for federal income tax purposes, and the taxpayer ultimately entered into a stipulated settlement agreement with the IRS.3 As for the California income tax treatment of the transactions, Mantra filed a California return reporting a significant amount of "media" expenses and reporting net taxable income of approximately $1.8 million in net income subject to tax at the S corporation level. Sands did not file a California tax return for 2001, but reported net taxable income of $22 million for federal income tax purposes.

The taxpayer was audited by the FTB for tax year 2001 and assessed tax of more than $2 million as well as penalties of $1.6 million. The taxpayer protested the assessment. At issue in the appeal were: (i) whether the taxpayer demonstrated that the FTB erred by disallowing a $23 million flow-through loss generated by the transactions and by allocating a gain generated by the entity used to facilitate the transactions; (ii) whether the taxpayer showed that the FTB erred in disregarding Sands as a separate entity and allocating its income to Mantra, which flows through to the taxpayer as California-source income; and (iii) whether the taxpayer demonstrated that the NEST penalty was...