Legislature(2001 - 2002)
03/21/2002 03:35 PM Senate STA
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* first hearing in first committee of referral
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+ 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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