BILL ANALYSIS AB 2218 Page 1 Date of Hearing: May 1, 2006 ASSEMBLY COMMITTEE ON REVENUE AND TAXATION Johan Klehs, Chair AB 2218 (Torrico) - As Introduced: February 22, 2006 Majority vote. Tax Levy. Fiscal Committee. SUBJECT : Sales and Use Tax: Exemption: Manufacturing Equipment SUMMARY : Creates a state sales and use tax (SUT) exemption (5.25%) for purchases of manufacturing equipment for calendar years beginning on or after January 1, 2007. Specifically, this bill : 1)States legislative intent to enact a Job Retention and Economic Recovery Act that would provide for an exemption of purchases of manufacturing equipment used in the manufacturing process from the state sales and use taxes. 2)Specifies that for calendar years beginning on or after January 1, 2007, the following tangible personal property (TPP) is exempt from SUT: a) Purchased by a qualified person to be used primarily in any stage of the manufacturing, processing, refining, fabricating, or recycling of property. b) Purchased by a contractor either as an agent of a qualified person or for resale to a qualified person for use in the performance of a construction contract for a qualified person who will use TPP as an integral part of the manufacturing, processing, refining, fabricating, or recycling process, or as a research or storage facility for use in connection with the manufacturing process. 3)Provides that the exemption does not apply to TPP that is used primarily in administration, general management, or marketing. 4)Defines "fabricating" as making, building, creating, producing, or assembling components or property to work in a new or different manner. AB 2218 Page 2 5)Defines "manufacturing" as the activity of converting or conditioning property by changing the form, composition, quality, or character of the property for ultimate sale at retail or use in the manufacturing of a product to be ultimately sold at retail. Manufacturing includes any improvements to TPP that result in a greater service life or greater functionality than that of the original property. 6)Defines "primarily" as TPP used 50% or more of the time in an activity described above. 7)Defines "process" to mean the period beginning at the point at which any raw materials are received by the qualified taxpayer and introduced into the manufacturing, processing, refining, fabricating, or recycling activity of the qualified taxpayer, and ending at the point at which the qualified activity has altered TPP to its completed form. Raw materials are considered to have been introduced into the process when the raw materials are stored on the same premises where the qualified activity is conducted. 8)Defines "processing" as the physical application of the materials and labor necessary to modify or change the characteristics of property. 9)Defines "qualified person" as a person who is engaged in those lines of business described in Codes of the North American Industrial Classification System (NAICS) Manual, 2002 edition, and an affiliate of a qualified person, as specified. 10)Defines "refining" as the process of converting a natural resource to an intermediate or finished product. 11)Specifies that TPP would not include: a) Consumables with a normal useful life of less than one year, except for fuels used in the manufacturing process; and b) Furniture, inventory, equipment used in the extraction process, or equipment used to store finished products that have completed the manufacturing process. 12)Provides that "TPP" includes, but is not limited to, machinery, equipment, devices, property used in pollution AB 2218 Page 3 control that meets or exceeds state or local standards, special purpose buildings, and fuels. 13)Requires the purchaser to furnish the retailer with an exemption certificate, containing the sales price of the exempt machinery or equipment, and in accordance with instructions and forms from the Board of Equalization (BOE). 14)Does not apply to any tax levied by a county, city, or district. 15)Denies the exemption if the qualified property is removed from California or from the exempt use within one year of the date of purchase. Provides for a recapture of the tax in this case. 16)Applies to leases of TPP up to a period of six years beginning with commencement of the lease. At the close of the six-year period, lease receipts are subject to SUT without exemption. 17)Remains in effect for 10 calendar years. EXISTING LAW : 1)Imposes a tax on the gross receipts from the sale in California, or the storage, use, or other consumption in this state of TPP, and provides various exemptions from the tax. 2)Treats leases of TPP as continuing sales, and imposes sales tax based on the lease payment. 3)Does not provide special tax treatment for entities engaged in manufacturing activities that make purchases of equipment and other supplies. PRIOR STATE LAW contained until January 1, 2004 various tax incentives, referred to as the Manufacturer's Investment Credit (MIC), to encourage investment in manufacturing equipment to be used in California. The MIC provided for an exemption from the state share of SUT for purchases of manufacturing equipment, or a credit against the personal income tax (PIT) or corporate tax (CT) liability (equal to 6%) of the amount paid or incurred for qualified property placed in service in California. Specifically: AB 2218 Page 4 1)Defined a "qualified taxpayer" as any taxpayer engaged in the manufacturing activities described in specific Standard Industrial Classification (SIC) Manual Codes. 2)Limited the availability of SUT exemption to a qualified taxpayer engaged in a new trade or business, i.e., one that has been conducted by the taxpayer for not more than 36 months. 3)Defined "qualified property" as equipment used primarily for manufacturing, refining, processing, fabricating, or recycling; for research and development; for maintenance, repair, measurement, or testing of qualified property; and, for pollution control meeting state or federal standards. Special purpose buildings were also included as qualified property. 4)Provided that the MIC was repealed on the later of January 2001 or on January 1 of the earliest subsequent year if total manufacturing jobs in California, as determined by the Employment Development Department (EDD) on the preceding January 1, did not exceed the total manufacturing jobs in California on January 1, 1994 by 100,000 jobs. FISCAL EFFECT : Board of Equalization (BOE) staff estimate an annual revenue loss of $683 million. Proposition 98 Fiscal Effect : Based upon the anticipated Budget for FY 2006-07, this bill will have no revenue impact on funding for K-14 schools in FY 2006-07. Committee staff estimate a revenue loss to K-14 school funding of $369 million in FY 2007-08, and between $273 million and $410 million in FY 2008-09. COMMENTS : 1)Background : Prior to January 1, 2004, California tax law contained various tax incentives referred to as the MIC to encourage investment in manufacturing equipment to be used in California. The MIC expired on January 1, 2004 pursuant to a finding by EDD that total manufacturing jobs on the preceding January 1 did not exceed the total manufacturing jobs in California on January 1, 1994 by 100,000 jobs. AB 2218 Page 5 a) The total employment in manufacturing for the years 1994 to 2002: ----------------------------------------------------------- |Time Period |Total |Increase from | | |Manufacturing |January 1, 1994 | | |Employment | | |-------------------+-------------------+-------------------| |January 1, 1994 |1,550,250 |N/A | |-------------------+-------------------+-------------------| |January 1, 1995 |1,585,750 | 35,500 | |-------------------+-------------------+-------------------| |January 1, 1996 |1,642,350 | 92,100 | |-------------------+-------------------+-------------------| |January 1, 1997 |1,694,900 |144,650 | |-------------------+-------------------+-------------------| |January 1, 1998 |1,763,900 |213,650 | |-------------------+-------------------+-------------------| |January 1, 1999 |1,744,650 |194,400 | |-------------------+-------------------+-------------------| |January 1, 2000 |1,761,850 |211,600 | |-------------------+-------------------+-------------------| |January 1, 2001 |1,814,950 |264,700 | |-------------------+-------------------+-------------------| |January 1, 2002 |1,694,150 |143,900 | ----------------------------------------------------------- b) According to the Legislative Analyst's Office (LAO): i) Most studies conducted on manufacturing jobs created by tax incentives show revenue reductions were greater than revenue increases. ii) Industry representatives noted that a SUT exemption is preferable to an income tax credit, since it would be less complicated to calculate, result in less administrative work and auditing, and not be limited only to firms with taxable income. LAO noted that a partial exemption of the state SUT may even be preferable in some respects to an income tax credit as provided under the previous MIC. 1)Committee staff note several implementation and policy concerns with this bill. Specifically: AB 2218 Page 6 a) It does not contain specific NAICS codes in the definition of "qualified person", thereby allowing any type of business to qualify for the exemption. It is recommended the codes be specified to limit this bill to specific types of businesses. However, Committee staff note that BOE included only those businesses classified as manufacturers (NAICS codes 31-33) in their revenue calculation. b) Long-term leases of qualifying property would not enjoy the same tax privileges that this bill would provide to actual purchasers of the same property, as the exemption for specified leases of qualified property is limited to a six-year period. c) This bill does not require the manufacturer to notify BOE if the property is removed from California or converted from an exempt use within one year, and there is currently no means, other than an audit, through which BOE would learn of the new sales tax liability. d) There is no mechanism specified for determining an item's "useful life". e) This bill contains legislative intent to enact a Job Retention and Economic Recovery Act; however, there is no further reference to jobs nor is there a job retention or creation requirement attached to this SUT exemption. 2)Proponents cite the need for California to compete with incentivized opportunities in other states, as California is one of the only states that taxes manufacturing equipment with no credit or exemption. 3)Opponents state that a portion of the exemption and credit will go to companies which would have made the same investments, regardless of the tax incentive, as they operate in market-oriented industries. Opponents urge the author to amend the bill to limit it to specific types of businesses. 4)Several bills have been introduced in this legislative session that would reinstate the expired exemption for specific manufacturing or research and development property. AB 2395 (Villines), pending in this committee and set to be heard May 8, 2006, would provide a SUT for TPP purchased for use by AB 2218 Page 7 manufacturers that have "gross aggregate gross assets" used in manufacturing that do not exceed $5 million. SB 1291 (Alquist), currently pending in Senate Revenue and Taxation Committee, would provide a SUT for purchases used by entities engaged in manufacturing, research and development, software production, and printing, and for semiconductor, biotechnology and pharmaceuticals cleanrooms and equipments. SB 1643 (Runner), currently pending in Senate Revenue and Taxation Committee, would allow a SUT for TPP used by new manufacturers and computer programmers in the manufacturing, processing, refining, fabricating, or recycling of property. REGISTERED SUPPORT / OPPOSITION : Support AeA BIOCOM California Chamber of Commerce California Healthcare Institute California Manufacturers & Technology Association (Sponsor) California Taxpayers' Association Intel Corporation Lockheed Martin Space Systems Silicon Valley Leadership Group Opposition California Tax Reform Association Analysis Prepared by : Sabrina Landreth / REV. & TAX. / (916) 319-2098