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.