What Is a ‘Loophole’ in California Tax Laws?

For years around the State Capitol, and this year in particular, we have heard the claim of tax increase proponents in the Legislature or proposed initiatives on the ballot are simply “closing a tax loophole.” So, what exactly is a “loophole” in the tax laws?

According to a dictionary definition:

loop·hole

/ˈlo͞opˌ(h)ōl/

noun

an ambiguity or inadequacy in the law or a set of rules.

Similarly, according to Wikipedia, “A loophole is an ambiguity or inadequacy in a system, such as a law or security, which can be used to circumvent or otherwise avoid the purpose, implied or explicitly stated, of the system.” Other observers have defined a loophole as “basically a technicality that allows one to escape violating the law through some activity.”

My takeaway from these definitions, as well as my own sense after working in tax law for more than thirty years in California, is that a tax loophole is when a taxpayer, whether an individual or a corporation, utilizes the tax law for something that was clearly not intended by the law’s provisions.

Unfortunately, those who want to change California’s tax laws that adversely impact individual and corporate taxpayers often loosely throw out the “tax loophole” claim when advocating their position.

However, when a tax law is being used exactly how it was intended and in compliance with what the law provides, then the definition of loophole” is simply not met. In other words, it is wrong for critics to claim there is a “loophole” when companies claim a tax credit or exemption when these companies clearly qualify for the particular tax incentive.

For example, in recent years when there were suspensions of the net operating loss deduction and limitations on the use of tax credits, we heard proponents claiming the research and development tax credit, for example, is a “tax loophole” for tech companies to avoid paying their “fair share” of taxes to the state. What nonsense!

Now we are hearing the same when it comes to the binding, 7-year “water’s-edge election.” There are a number of complexities and nuances to consider before making the California water’s edge election for a multinational corporation (i.e., a corporation with operations inside and outside the United States). Much consideration must go into making this determination that is clearly allowed under California’s Revenue and Taxation Code, as well as the forms and “Water’s-Edge Manual” (over several hundred pages) from the Franchise Tax Board. Hardly is this election a “loophole” in the state’s tax law. And, nearly all states with combined reporting regimes include a water’s-edge method.

While it is appropriate for proponents to advocate for tax law changes to increase taxes, the least they can do is not misrepresent the current state of the tax laws and misleadingly claim that the lawful conduct of California businesses is a “loophole.”