Chief Judge Roger L. Efremsky • Clerk of Court Edward Emmons

Memorandum Decision re Subordination of Tax Penalties

Tuesday, July 25, 2000




In February 1998, the Tax Collector of the County of Contra Costa (the "Tax Collector") filed a proof of claim against Shako Real Estate Management, Inc. ("Debtor") for certain unpaid real property taxes, penalties and interest thereon; the proof claim asserted a secured claim in the amount of $160,346.30. Charles E. Sims, Chapter 7 trustee in the above-captioned consolidated cases ("Trustee") objected to the Tax Collector's claim, alleging that the delinquency penalties and redemption penalties should be subordinated to general unsecured claims pursuant to 11 U.S.C. § 726(a)(4).(1) Even though the Tax Collector denominated approximately $51,681 as redemption penalties, he argued that they were not punitive impositions but "interest" on a secured claim not subject to subordination under section 726(a)(4). In making this argument, the Tax Collector relied on California Revenue and Taxation Code section 4103(b), which provides:

For purposes of an administrative hearing or any claim in a bankruptcy proceeding pertaining to the property being redeemed, the assessment of penalties determined pursuant to subdivision (a) with respect to redemption of that property constitutes the assessment of interest.

Cal. Rev. & Tax. Code § 4103.

As noted by the Trustee in his reply, a state statute's characterization of an assessment as "interest" rather than as a "penalty" is not relevant in determining whether the assessment is a penalty for the purposes of the Bankruptcy Code:

[The state tax collection agency] correctly maintains that courts distinguishing between taxes and penalties in the bankruptcy context should look to the actual operation of the provision in question; indeed, the Supreme Court recently reaffirmed this principle. [Citations omitted]. Therefore, to determine whether [the taxing agency's] assessments are noncompensatory penalties, we look behind the statutory label ("penalty") and examine the "actual effects" of the assessments. [Citation omitted]. The Supreme Court summarized this functional analysis as follows: 'A tax is an enforced contribution to provide for the support of government; a penalty, as the word is here used, is an exaction imposed by statute for an unlawful act.'

State of Washington v. Hovan, Inc. (In re Hovan, Inc.), 96 F.3d 1254, 1257 (9th Cir. 1996), quoting United States v. Reorganized CF & I Fabricators of Utah, Inc., 518 U.S. 213 (1996). If the assessment "has no direct relation to any specific costs incurred by the state," its "actual effect" is generally punitive and not compensatory in effect. Hovan, 96 F.3d at 1257.

In this case, the "actual effect" of the redemption penalties at issue is to punish a delinquent taxpayer, rather than to compensate the Tax Collector for actual losses. The penalty is imposed at a flat rate of 18 percent per year, and bears no "direct relation to any specific costs incurred" by the Tax Collector. Id. Moreover, section 4103 does not refer to specific costs which are to be compensated by the penalty; rather, the California Revenue and Taxation Code contains two other provisions authorizing the assessment of delinquent costs, thereby compensating the Tax Collector for costs associated with the delinquency. See Cal. Rev. & Tax. Code §§ 2657 and 3351. Finally, the California Supreme Court has also recognized the true purpose of section 4103: "the statutory scheme, when considered as a whole, clearly indicates that redemption penalties are merely what the name implies -- charges for the exercise of the privilege of redeeming sold property." Weston Investment Co. v. State of California, 31 Cal.2d 390, 394, 189 P.2d 262, 264 (Cal. 1948). Because the "redemption penalties" were correctly designated as such and are punitive in nature, they must be accorded fourth priority under 11 U.S.C. § 726(a)(4).

In any event, under the Supremacy Clause of the United States Constitution, the attempted bankruptcy carve-out of section 4103 is unenforceable. Section 4103's designation of redemption penalties as interest "for purposes of . . . any claim in a bankruptcy proceeding" seemingly reflects an effort by the state legislature to avoid the priority scheme of Bankruptcy Code section 726 (in particular, subsection (a)(4)). To the extent that section 4103 adopts a bankruptcy-specific exception, it "stands as an obstacle to the accomplishment and execution of the full purposes and objectives of Congress and is pre-empted by federal bankruptcy law. See Hillsborough County v. Automated Medical Labs, Inc., 471 U.S. 707, 713 (1985). Section 4103's "express reference" to bankruptcy claims "supports the conclusion that its purpose is to carve out an exception" to the priority scheme of section 726(a)(4). See DiGiorgio v. Lee (In re Di Giorgio), 200 B.R. 664, 670 (C.D. Cal. 1996), vacated on other grounds, 134 F.3d 971 (9th Cir. 1998) (provision of California Code of Civil Procedure permitting enforcement of writs of possession "notwithstanding receipt of a notice of the filing by the defendant of a bankruptcy proceeding" was preempted by the automatic stay provisions of the Bankruptcy Code). Accordingly, this court finds that the priority scheme of the Bankruptcy Code (as found in section 726) preempts section 4103.(2)

In light of the foregoing, the court will enter an order subordinating the Tax Collector's claim for redemption and delinquency penalties to general unsecured claims and requiring the Tax Collector to refund the any amounts paid for these penalties to the Trustee. The Trustee should prepare an order in accordance with this memorandum decision, and comply with B.L.R. 9021-1 and 9022-1.

Dated: July 24, 2000 ______________________________ Dennis Montali United States Bankruptcy Judge

1. Section 726(a)(4) provides:

(a) Except as otherwise provided in section 510 of this title, property of the estate shall be distributed --

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(4) fourth, in payment of any allowed claim, whether secured or unsecured, for any fine, penalty, or forfeiture, or for multiple, exemplary. Or punitive damages, arising before the earlier of the order for relief or the appointment of a trustee, to the extent that such fine, penalty, forfeiture, or damages are not compensation for actual pecuniary loss suffered by the holder of such claim.

2. The court requested the parties to address the meaning of the reference to "administrative hearing" in section 4103 in order to learn whether the concept of penalties deemed interest applied in any meaningful way beyond the bankruptcy setting. While the Trustee's counsel offered some suggestions, the Tax Collector's counsel could not identify any administrative hearings where penalties might be subordinated. This reinforces the court's belief that section 4103(b) constitutes an impermissable attempt to subvert the priorities established by the Bankruptcy Code.