LYNNE BARR
Lingering dispute

The state’s proposal to close the budget gap by prohibiting the use of real estate investment trusts as a tax shelter has sparked a constitutional debate between business leaders officials and the Massachusetts Legislature.

According to banks, which saw heightened tax-free profits after setting up REIT subsidiaries in the 1990s, Gov. Mitt Romney’s legislation prohibiting tax deductions related to REITs retroactively to tax year 1999 is unconstitutional and unfair.

“Businesses have an opportunity to take full advantage of existing codes and there was nothing to preclude banks or other organizations [from taking advantage] of REITs. If the state has a problem with the provisions then they can pass prospective laws,” said Brian Gilmore, executive vice president of the Associated Industries of Massachusetts, a group that works on behalf of Massachusetts employers to improve the business climate and economy.

According to state officials, however, banks were misled by accountants who told them the state constitution provided for the tax-free use of REITs. Such protections were never allowed in the first place, they claim.

The debate between banks and the state Legislature hinges on whether new legislation, which is aimed at closing what Romney calls tax loopholes in an effort to generate funds for the fiscal year 2003, is an unconstitutional retroactive tax or simply substantiates a law that has been in effect since 1999.

“The banks believe they had the ability to take the dividends-received reduction and they firmly believe that there is no [justification] for the commonwealth to pass the law on retroactivity,” said Lynne Barr, legislative counsel to the Massachusetts Bankers Association and partner at Goodwin Procter in Boston, who is advising individual banks in the state on the issue. “This has been a dispute for a while. Clearly, the tax law going forward is in the governor’s and Legislature’s hands, but [doing it] retroactively is a completely different thing.”

According to a letter from the state Department of Revenue to House Chairman of the Joint Committee on Taxation Paul Casey, D-Middlesex, dated Feb. 4, 2003, the REIT dividend deduction was never allowed by state law.

Revenue Commissioner Alan LeBovidge said in the letter, “The DOR is currently examining how to best move forward against these businesses.”

The DOR was asked by the Joint Committee on Taxation to explain why the REIT proposal has an effective date of the 1999 tax year. LeBovidge said in his letter that following the bank tax reform in 1995, when all businesses involved in the same activities as traditional banks were made subject to the same tax provisions, the bank excise tax was lowered from its rate of 12.54 percent to the present rate of 10.5 percent, with an effective date of Jan. 1, 1999.

Romney’s new proposal, which would help bridge the estimated 2003 state budget gap of $3.2 billion, calls for the state to regain $140 million from banks that set up tax shelters through REITs since 1999.

According to LeBovidge, the DOR has in excess of $117 million in pending assessments for tax years 1999 through 2001.

“The issue has been building as more and more banks have been using REITs, so the amount of money in dispute between the Department of Revenue and banks has been growing,” said Widmer. “The idea of clarifying the state’s intent then, by disallowing the use of REITs, should be done prospectively.”

The DOR said the adoption of an effective date other than tax year 1999 could give taxpayers an “unintended benefit … and the taxpayers may well argue that their interpretation is correct because the Legislature, by adopting a later effective date, had blessed the validity of their earlier position.” LeBovidge said that argument would result in a $117 million windfall for banks.

According to the DOR, many institutions subject to the bank excise tax moved real estate-related assets, usually mortgages, into a separate controlled subsidiary as a means to exempt income from taxes.

The DOR claims that these taxpayers then “took the position on the returns, starting in 1999, that the subsidiary was a REIT and that Massachusetts tax law, unlike federal law, allowed the distribution from this entity to be received basically tax-free by the parent corporation.”

Although some banks have been taking REIT-related tax deductions since the early 1990s, LeBovidge said the DOR’s rationale for seeking back taxes dating back to 1999 was “as Massachusetts follows current federal law for corporate and financial institutions and federal law allows no such exclusion for REIT payments, these monies were subject to tax.”

‘Fair Resolution’

But Michael Widmer, president of the Massachusetts Taxpayers Foundation, said the new policy is more about a new Legislature flexing muscle then it is a debate on fixing the budget.

“It is certainly one thing to change the law and clarify the policy going forward, it’s quite another to go back four tax years and change the rules in mid-stream,” said Widmer. “The state Legislature is trying to strengthen their hand by changing the rules and going [back] to 1999 because they are trying to get some money for fiscal year 2003. From our perspective, if this is going to be contested in court the state is going to get very little money in 2003 anyway.”

The Massachusetts Bankers Association plans to test the validity of the retroactive provision of the budget plan by challenging it in court if necessary, according to MBA spokesman Bruce Spitzer.

“This is part of the tax administration, and that’s fine, but using legislative power to change the rules after the fact is an extremely serious issue and sends a negative message to the business community across the country,” said Widmer. “It has echoes of an earlier era of unpredictable tax policies. It’s unfair to change the rules – this will be settled through the courts, if need be, and we will let the courts decide.”

State Sen. Andrea Nuciforo, D-Pittsfield, chairman of the Senate Banks and Banking Committee, said the matter should be allowed in court only after other attempts to reconcile have been made.

“I have agreed to work with members of the banking community and members of the Legislature to try and find some fair resolution to this without having to go to court,” said Nuciforo. “I’m not asking any party to claim right or wrong, but the reason we did this in the first place was to realize revenue for this fiscal year 2003. If we can’t reconcile the [differing interpretations of the plan], it will be tied up in court and no one will see the money.”

Widmer said the Massachusetts Taxpayer Foundation proposes to eliminate the retroactive component of the tax and look ahead, preferably starting with the tax year beginning Jan. 1, 2003, but would be willing to discuss going back to 2002 if necessary, saying “changing the legislation specifically, and going back four years, is unfair. The constitutionality is up in the air and it’s unwise and misguided.”

While the Massachusetts Taxpayers Foundation, the MBA, A.I.M. and other business community activists continue to question the legal right of the state to retroactively collect taxes on REIT investments made by banks, Widmer said the real fight must come from the banks.

“It’s unprecedented, but it is up to the banks – individually or as a group – to take this forward [in the court system],” said Widmer.

As industry insiders continue their debate on Beacon Hill, Nuciforo said he would continue to do what he can to educate the business community and work with both sides to reach an amicable decision before heading to court.

“I don’t feel we should be doing these types of things,” said Nuciforo. “We need to maintain an environment in which people in the business community can maintain a fair and accurate reading of the law.”

Melanie Nayer may be reached at mnayer@thewarrengroup.com.