Legislature(2001 - 2002)

03/21/2002 03:35 PM Senate STA

Audio Topic
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
                                                                                                                                
                   SJR 13-CONST. AM: PERMANENT FUND                                                                         
                                                                                                                                
CHAIRMAN   THERRIAULT   said  he  would   like  to  discuss  some   of  the                                                     
information    they   received   from   the   Permanent    Fund   Trustees                                                      
regarding   the  tax  problems   that  might  be  triggered   if  anything                                                      
was  done  to  guarantee    any  part  of  the  dividend   in  the  Alaska                                                      
State  Constitution.    He asked   Mr. Balash   to distribute   copies   of                                                     
the  legal   opinions   the   trustees   have  gotten   from   Morrison   &                                                     
Foerster   LLP over  the  years.  He  understood   the trustee's   concern                                                      
and  desire  to  let  the Legislature    know that  if  anything   is done                                                      
regarding   ensuring  any  kind of  dividend,  there  is  a potential   tax                                                     
problem.   His reading   of  the legal   opinions  leads  him  to  believe                                                      
it is not an absolute.                                                                                                          
                                                                                                                                
Mr.  Balash  conducted  research   based  on discussions   from  the legal                                                      
memos   and  developed   a  grid   sheet   comparing   funds   from  other                                                      
states.  He  also prepared   a paper  that  discusses  the  Integral  Part                                                      
Theory,   which  is  a legal   theory  that  protects   state  activities                                                       
from taxation.                                                                                                                  
                                                                                                                                
MR.  BALASH,  staff  to  Senate  State  Affairs  Committee,   established                                                       
the  report  given  to  the  trustees  was  conducted   by a  tax  firm  in                                                     
Washington    D.C.   The   letter   was   addressed    to   the   Attorney                                                      
General's   office   because   that  office   is  statutorily   the  legal                                                      
counsel   to  the   Permanent   Fund   Corporation.    They  discussed    a                                                     
variety   of ways   the Permanent   Fund  can  claim   an  exemption  from                                                      
federal   taxation.    Primarily   they   focus  on   the  Integral   Part                                                      
Theory;   the  underlying    doctrine   is  that  Congress   can  tax   the                                                     
income  of  states   if they  expressly   say  so,  but  they  have  never                                                      
chosen  to  do so.  Additionally,   an entity  that  is  an integral  part                                                      
of   the   state   is   not   subject   to   taxation   unless    Congress                                                      
specifically   subjects   it to  taxation.   This has  been  a successful                                                       
defense  against   taxation   with  the IRS  in  a number   of instances.                                                       
Primarily they look at three points.                                                                                            
                                                                                                                                
   1. First they look at the type of entity. Is it a public                                                                     
           corporation, a state agency or a type of fund within the                                                             
      treasury or even apart from the treasury?                                                                                 
   2. Second they look at state creation, control and domination                                                                
           of the entity. Did the state create the fund and does the                                                            
            state maintain strict control over or domination of the                                                             
      entity?                                                                                                                   
   3. Third they look at both the source and destination of the                                                                 
         funds. Where did the money come from that is in the fund and                                                           
      what is the destination of the proceeds or assets?                                                                        
                                                                                                                                
There  is  no  single  determinant    factor;  rather   the IRS  looks   at                                                     
all  three   factors  and  sometimes    there  has  been  negotiation    of                                                     
what  features   the  state  needed   to have  to  create   the  different                                                      
disaster   insurance   funds   and  insulate   them   from  taxation    and                                                     
qualify for the Integral Part Theory.                                                                                           
                                                                                                                                
Of  particular    concern   is  the  third   part  of   the  test  or   the                                                     
destination.    In  Alaska   the   primary   destination   has   been   the                                                     
dividend.   Whether  or  not that  counts  as  a private   benefit  or  the                                                     
creation  of  a private  benefit   causes  some concern   because  anytime                                                      
the   destination     is   a   private   benefit    the   IRS    carefully                                                      
scrutinizes that benefit.                                                                                                       
                                                                                                                                
MR.  BALASH  referred   to  the  grid  sheet   found  at  the  end  of  the                                                     
minutes  to  discuss  and  compare  funds   from other  states   according                                                      
to the Integral Part Theory                                                                                                     
                                                                                                                                
For  example,   the   State  of  Michigan    set  up  a  prepaid   tuition                                                      
program   where   parents  invested    a  set  amount   of  money  into   a                                                     
public  corporation.   That  money  was invested   and returns   were paid                                                      
out  to  the  beneficiaries    that  were   designated   by  the  original                                                      
investors.   The  state  argued  it was  an  integral  part  of  the state                                                      
while  the  IRS held  that  it  was an  investment   scheme  in  which  the                                                     
investors   were  using  the  cloak  of  the  state's  tax-exempt   status                                                      
to  hide  their  gains.   Of particular   concern   to  the  IRS was  that                                                      
individuals   invested   their  personal   money,   earned  a  return   and                                                     
then got a benefit.                                                                                                             
                                                                                                                                
CHAIRMAN   THERRIAULT   pointed  out  that  it  was  largely   due  to  the                                                     
IRS  rejection  that  Congress   took  specific  action  to  approve  such                                                      
funds.                                                                                                                          
                                                                                                                                
MR.  BALASH   concurred   and  added  that  when   the  IRS  rejected   the                                                     
supposition    that   they   were  an   integral   part   of  the   state,                                                      
Michigan   filed  a  tax  return,   asked  for  a  refund  and  sued  when                                                      
they  didn't   get  it.  Although   they  lost   in  the  first  round   of                                                     
litigation,   the   Sixth  Circuit   Court  of  Appeals   ruled  in  their                                                      
favor.  The  court   ruled  it  was  serving  a  public  purpose;   it  was                                                     
used  in  the  State  of  Michigan   and  was  an  integral   part  of  the                                                     
state.  The  IRS  disregarded   the  court  and  simply  stopped   issuing                                                      
private  letter  rulings   on the  subject.  Other  states  wanted  to  get                                                     
similar   benefits  for  their  residents,   which  led  to  the  lobbying                                                      
effort  and  subsequent    passage  of  the  specific   exemption   in  the                                                     
IRS code.                                                                                                                       
                                                                                                                                
SENATOR  STEVENS   asked  if it  wasn't  a  specific  exemption   for just                                                      
Michigan.                                                                                                                       
                                                                                                                                
CHAIRMAN THERRIAULT stressed it was for that type of activity.                                                                  
                                                                                                                                
MR.  BALASH   added   that  Alaska   began   a  similar  program   at   the                                                     
University of Alaska.                                                                                                           
                                                                                                                                
CHAIRMAN  THERRIAULT   confirmed   it is  private  individuals   investing                                                      
their  money   and  those  private   individuals   specifically    receive                                                      
the benefit.                                                                                                                    
                                                                                                                                
He asked Mr. Balash to discuss the hurricane and disaster funds.                                                                
                                                                                                                                
                                                                                                                                
MR.  BALASH  explained  that  Florida,  Hawaii,   and California   are  all                                                     
states   where  natural   disasters   are  not  uncommon  or  unexpected.                                                       
Florida    and    Hawaii    have    hurricanes    and    California     has                                                     
earthquakes.    Those  states   have  established   entities   from  which                                                      
individuals   or insurance   companies  purchase   premiums.  The  premium                                                      
revenues  are  invested  to  earn  a return  and  if a disaster   strikes,                                                      
reimbursement    is  made   for  the   amount   of  the  policy.   If   you                                                     
purchased   a premium,  you  would  receive  a benefit   but you  wouldn't                                                      
if  you hadn't   purchased  a  premium.  Just  as in  the  Michigan  case,                                                      
individuals   or  individual   companies   invest   their  money   and  are                                                     
using  the  state's   tax-exempt   status  to  receive  a  benefit.  Those                                                      
states  negotiated   with   the  IRS  to ensure   the  funds  wouldn't   be                                                     
rejected.   The  IRS  wanted   the  states   to  contribute   some  public                                                      
money   into  the   funds  so  they   wouldn't   be  viewed   as  just   an                                                     
investment scheme.                                                                                                              
                                                                                                                                
It  is  clear  that  the  source   and  destination   is  key  to  the  IRS                                                     
determination.     As   stated   in   the   Alaska    Constitution,     the                                                     
Permanent   Fund  belongs   to the  state.   It does  not  belong   to  any                                                     
individuals,    corporation,   or  agency,   but  a  corporation   manages                                                      
it.  The  managing  corporation   always   refers  to  the  assets  of  the                                                     
fund  and  the  returns  of  the fund  in  its  annual  reports   and news                                                      
releases   in order  to  clearly   make  the distinction    that  the fund                                                      
belongs   to  the  state  and  not   the  corporation.   The  corporation                                                       
board  is  comprised   of state   officials  and  individuals   that  were                                                      
appointed   by  the executive   and  the  employees   of the  corporation                                                       
are state employees.                                                                                                            
                                                                                                                                
It   is  easy   to   demonstrate    that   the  state    has  controlling                                                       
domination    of  the   fund   because    the  Legislature    statutorily                                                       
restricts   how  the  corporation   can  invest   the  fund.  For  example                                                      
they  are  currently    able  to  invest  no  more   that  55  percent   in                                                     
equities.   Also,  the  Legislative    Budget  and  Audit   Committee   has                                                     
oversight of the fund and the corporation.                                                                                      
                                                                                                                                
The  source  and  destination   is different   for  the Alaska   Permanent                                                      
Fund  than  the  other  examples.   The  source  of the  fund  comes  from                                                      
state  royalties,   some  settlements    and  approximately   2.7  billion                                                      
general  fund  dollars  that  were  deposited  in  the early  1980's.   For                                                     
the  last   20  years,  Alaska   has  paid   out  a  benefit   to  private                                                      
individuals   in  the  state  so  there  is  clearly   a private   benefit                                                      
from  the  payment.  However,   the  individuals   receiving  the  benefit                                                      
never  put  any  of their  own  money  in  the  fund  and  never  used  the                                                     
fund  as  a tax  shield.   Thus,  the  source  and  destination   question                                                      
of the Alaska Permanent Fund has not been posed to the IRS.                                                                     
                                                                                                                                
CHAIRMAN   THERRIAULT   stated  that   according   to  the  Integral  Part                                                      
Theory,  it  is clear  to  him that  the  Permanent  Fund  is an  integral                                                      
part  of   the  State   of  Alaska.   Compared   to  the  disaster   funds                                                      
discussed,   Alaska  has a  much stronger   case  than the  others  due  to                                                     
the   structure   and   source   of   the   fund.   The   payout   is   not                                                     
necessarily   to  individuals   because  they  are  not  able  to  control                                                      
or  demand  it,  which  gives  Alaska  a  good  basis  to argue   that  the                                                     
fund  earnings   should   not  be  taxed  unless  Congress   specifically                                                       
authorizes    it.  Although    Congress   has   that   power,   they  must                                                      
explicitly   say  that  is  what  they  want   to do  and  they  have   not                                                     
done so.                                                                                                                        
                                                                                                                                
The  question   now is  whether   guaranteeing   some  level  of  dividend                                                      
is  enough   for   the   IRS  to   say  there   is  no   public   purpose.                                                      
Currently   some  parts  of the  operating   budget  are funded   with  the                                                     
earnings,   which  does  point  to  a  state  purpose.   Also,  if  all  of                                                     
the  earnings  aren't  used  for  a state   dividend  they  certainly   are                                                     
available   for  the Legislature    to use,  which  is  a  state  purpose.                                                      
Under  the  proposed   percent  of  market  value  methodology,    it says                                                      
that  if  a draw  is  made  it must  be  limited  to  five  percent.  That                                                      
draw  is permissive,   it  is not  dictated   that  a draw  must  be made.                                                      
The  state  could   elect  not  to  make  a  draw  and  that  money  would                                                      
remain  available   to  the  Legislature   or  to  the  citizens   if they                                                      
elected   to change   the  Constitution   and  put  that  money  toward   a                                                     
public purpose.                                                                                                                 
                                                                                                                                
Although   the  Legislature    and  the  trustees   have  been   counseled                                                      
that  guaranteeing   any kind  of  dividend  would  result  in a  negative                                                      
tax  ruling,  he's  not so  sure.  His reading  of  the  legal opinion   as                                                     
well   as   examining    some   of  the   cases    discussed   gives    him                                                     
confidence that the state would prevail.                                                                                        
                                                                                                                                
CHAIRMAN   THERRIAULT    stated   that  the   percent   of  market   value                                                      
proposal   from  the   Permanent   Fund  Corporation    has  been  in   the                                                     
committee   for some  time.  He wanted  to  have  the discussion   so that                                                      
members  would  be  apprised  of his  interpretation   and  give  them  the                                                     
opportunity    to  study   the  information    and   come  to   their   own                                                     
conclusion.   With  this  done,  the  committee   could  consider   taking                                                      
final action on SJR 13 in the next several weeks.                                                                               
                                                                                                                                
CHAIRMAN THERRIAULT held SJR 13 in committee.                                                                                   

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