By Avi M. Lev
Buried in Gov. Deval L. Patrick's otherwise progressive "tax fairness bill" is a misguided tax proposal.
If passed, the bill would transform the basic Massachusetts deeds excise into a predatory tariff that would impact business transactions of all kinds, not just transfers of real estate. Moreover, the proposal has built-in ambiguities that will make compliance expensive for taxpayers and enforcement difficult for the commonwealth.
In Massachusetts, as in a majority of states, the deeds excise has long provided a simple, stable and enforceable tax on transfers of real property. Expansion of this excise would, according to Patrick, provide affordable housing, improve education and generate jobs in our state.
He proposes to augment the deeds excise with a "controlling interest transfer tax" or "CIT tax." It would tax transfers of a 50 percent or greater interest in any entity (corporation, partnership or trust) if 80 percent or more of the assets of the entity comprise real estate or real estate interests, wherever located.
The rationale for the new CIT tax is to keep sellers of real property from putting their property into a "sham" legal entity just to evade the deeds excise. The use of such sham entities, however, is already proscribed by current law.
The Governor's Office estimates that the proposed "loophole closing" tax will raise more than $12 million annually. This is likely accurate, since the effect of the proposed law would be to tax sales of businesses, and such sales occur on a regular basis.
Original purpose of CIT tax
The promise of a greatly expanded tax base is the real motivation for imposing CIT taxes today. However, this was not the original purpose of CIT taxes.
The first CIT tax in America was developed by the State of New York in 1986, in response to a single incident of obvious abuse. A deeds excise on the conveyance of the Pan Am Building — a Manhattan landmark and, at the time, the largest commercial office building in the world — was intentionally avoided by a clever artifice: The sellers formed a corporation, contributed the building to the corporation (which fell within an exemption to the New York deeds excise as then in force), and then sold all of the shares of the new corporation to the buyer.
The buyer hence acquired the economic benefit of the real property without directly holding title and without paying the deeds excise.
The New York Legislature corrected this evident abuse (and then some!) by extending the excise to cover the conveyance of any "controlling interest" in any entity that owns or leases any real property.
Several other states soon followed suit, and before long discovered that this "loophole closing" had an unexpected benefit: These CIT laws greatly expanded their tax base, creating what is essentially a tariff on most business transfers.
Fortunately, what happened in New York in the 1960s cannot happen in Massachusetts today. We already have a law to prevent such an obvious "end run" around of any of our tax laws.
Since the early 1990s, Massachusetts courts have clearly recognized the "sham transaction doctrine," which gives the commissioner of revenue the authority to disregard transactions that have no economic substance or business purpose other than tax avoidance.
This judicially created doctrine generally works to prevent taxpayers from claiming the tax benefits of transactions that, although within the language of the tax code, are not the type of transactions the law intended to favor with the benefit. This law prevents the type of abuse evident in the Pan Am Building case.
For many years, the sham transaction doctrine has been applied specifically to the Massachusetts deeds excise. For example, in 1995 the Department of Revenue determined in Directive 95-5 that transfers of beneficial interests in a "nominee" trust (one whose only function is to hold real estate) are subject to the deeds excise.
The use of nominee trusts to evade the deeds excise, which was sometimes seen in the 1980s, has gone the way of dinosaurs. Today, under existing law, the deeds excise must be paid when a beneficial interest in a nominee trust is transferred, even if the transfer is not made by deed.
Unnecessary and expensive
The proposed CIT tax is not only unnecessary, it would also be expensive. A serious burden would be imposed on taxpayers by the ambiguity of the "80-percent test" under the proposed law.
The purpose of the 80-percent test is to identify those entities that are really shams for the transfer of real estate, but the test doesn't work. Instead, every time a large interest in a company changes hands, the company must determine the fair market value of both all of its real estate and all of its other assets. This can be done with confidence only by engaging appraisers and accountants, which would add large costs to the transaction, as well as interpose considerable delay.
Moreover, many Massachusetts companies hold extensive intangible assets, such as technology and medical patents, which are very difficult to value. The proposed test is hence a very expensive and time-consuming way to determine whether or not a company is just a sham trying to end-run the deeds tax. Multiply that cost by the number of business transactions that occur every year, and the result is a very large expenditure — not for education or affordable housing, but to cover the cost of administering the tax itself.
Furthermore, the 80-percent test is ineffective in determining if a transaction is tax-motivated. In Massachusetts our economy is bound up in technology, so that many companies quite legitimately hold more than 80 percent of their assets in real property.
For example, a typical high-tech company might own a building worth $5 million, a few computers worth $1 million and very little else. If the company is successful and issues an initial public offering, it will meet the 80-percent test and have to pay the CIT tax, even though the IPO is clearly not a sham to avoid the deeds excise.
Similar problems arise in applying the "50-percent test" to determine whether the interest being transferred is a controlling interest. Today, almost every enterprise has at least two classes of investors. If owners transfer 40 percent of the common stock and 10 percent of the preferred stock in a small company, has 50 percent of the interest in the company been transferred? Again, the company has to hire expensive experts to determine whether it is subject to the tax.
The tax fairness bill promises to generate jobs, but the jobs generated may just be for accountants and appraisers. The CIT tax is supposedly "not anti-business," yet it is apparent that business transactions are precisely the target of the expanded tax. The new tax is described as a "loophole-closing reform," but this particular loophole was closed a decade ago.
If the governor really wants to direct resources to affordable housing and better schools, he should remove the CIT tax from the tax fairness bill.
A senior tax attorney with Davis, Malm & D’Agostine in Boston, Avi M. Lev is a member of the firm’s business law group and the trusts and estates group. He also teaches tax planning at Northeastern University’s Graduate School of Professional Accounting.
May 21, 2007
