State Says Banks Kept Millions From Taxes

California tax authorities are auditing more than a dozen banks and other corporations that used special investment funds to shelter hundreds of millions of dollars in corporate income from state tax, officials said Thursday.

Calling the probe “a major initiative,” Franchise Tax Board spokeswoman Denise Azimi said, “We are auditing all abusive shelters.”

State authorities are barred from speaking about specific companies under audit.

However, officials at several banks said the audits are focused on the use of the shelters in their industry, as first reported Thursday by the Wall Street Journal.

The banks, which include such prominent California players as Charlotte, N.C.-based Bank of America Corp., Seattle-based Washington Mutual Inc. and Beverly Hills-based City National Corp., denied any improper use of the tax-sheltered funds. The institutions said they set up the special funds in 1999 and 2000 but have since closed them.

With the exception of Bank of America, the banks set up the funds on the advice of accounting firm KPMG, whose tax-shelter practices also are under scrutiny by the Internal Revenue Service.

In a statement, KPMG said the funds were “legitimate business transactions,” and expressed confidence that “ultimately, the tax consequences associated with the transactions will be sustained.”

Caglar M. Caglayan, the tax board’s assistant chief counsel, said the agency is looking into two types of transactions in which a corporation transfers property or investments to subsidiaries. The subsidiaries, formed under special securities laws aimed at helping small investors, are able to deduct the cost of paying dividends, which normally would be taxed as income to the recipient.

However, under a loophole in California law, dividends paid from one corporate entity to another are not taxable under some circumstances. That allows the subsidiary to deduct a dividend that is never claimed on state returns, creating an artificial loss.

State auditors testified to the Franchise Tax Board last year that the main tactic used by the banks, involving the pooling of loans in so-called registered investment companies, or RICs, cost the state about $45.6 million in 2000.

Officials had no estimate of the cost of a similar tactic that involves companies putting real estate such as their corporate headquarters into real estate investment trusts. REITs can then pay dividends to the parent, which like the income paid by RICs are free of state taxes because of the loophole.

Companies are entitled to do what they can to save taxes as long as the underlying business transactions have legitimate businesses purposes. Bank of America and San Marino-based East West Bancorp Inc. said RICs enabled them to get high credit ratings on pools of loans, thereby saving money on interest.

An executive at one of the banks, speaking on condition of anonymity, said the funds had been set up “four years ago in a completely different environment.” After the shockwaves registered by accounting scandals at such companies as Enron Corp., “People are looking at this stuff in a totally different light,” the executive said.

The FTB last year asked for legislation to close the loophole, but it didn’t pass. The banks lobbied especially hard against a provision that would have made the closure retroactive.

California Controller Steve Westly intends to support new legislation aimed at closing the loophole, a spokeswoman said.