BILL ANALYSIS                                                                                                                                                                                                    



                                                                       



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                              UNFINISHED BUSINESS


          Bill No:  SB 663
          Author:   Migden (D), et al
          Amended:  3/13/05
          Vote:     21

           
           SENATE REVENUE & TAXATION COMMITTEE  :  5-3, 4/27/05
          AYES:  Machado, Alquist, Bowen, Cedillo, Scott
          NOES:  Dutton, Poochigian, Runner

           SENATE APPROPRIATIOSN COMMITTEE  :  Senate Rule 28.8

           SENATE FLOOR  :  25-15, 5/26/05
          AYES:  Alarcon, Alquist, Bowen, Cedillo, Chesbro, Ducheny,  
            Dunn, Escutia, Figueroa, Florez, Kehoe, Kuehl, Lowenthal,  
            Machado, Migden, Murray, Ortiz, Perata, Romero, Scott,  
            Simitian, Soto, Speier, Torlakson, Vincent
          NOES: Aanestad, Ackerman, Ashburn, Battin, Campbell, Cox,  
            Denham, Dutton, Hollingsworth, Maldonado, Margett,  
            McClintock, Morrow, Poochigian, Runner

           ASSEMBLY FLOOR  :  42-33, 4/3/06 - See last page for vote


           SUBJECT  :    Corporation taxes:  waters-edge election:  
          foreign affiliated

           SOURCE  :     Franchise Tax Board


           DIGEST  :    This bill clarifies that a corporation that has  
          both effectively connected income (income earned in the  
          U.S.) and Subpart F income must take both sources of income  
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          into account in determining its water's edge income base.   
          The bill also conforms with federal law by requiring the  
          Franchise Tax Board to coordinate the U.S.-source-income  
          and Subpart F income provisions so as to prevent under - or  
          over-counting such income.  This bill declares that the  
          intent of the legislation that the clarification be  
          operative for taxable years stating on or after January 1,  
          2006.

           Assembly Amendments  makes clarifying changes to the intent  
          language and adds co-authors.

           ANALYSIS  :    Existing law requires California's share of  
          the income of multinational groups of corporations to be  
          determined through use of the unitary three-factor formula  
          (California's percentage shares of worldwide payroll,  
          property and sales, averaged, becomes California's  
          percentage share of worldwide income, to which our 8.84  
          percent franchise tax applies).

          An alternative procedure, the so-called "water's edge"  
          method, attempts to draw a rough line around the United  
          States, and only requires application of the three-factor  
          unitary formula to activities within that line.

          The law requires inclusion within the "water's edge" (1)  
          certain foreign corporations that have "effectively  
          connected income" (income earned in the U.S.) but only to  
          the extent of that income; and (2) "controlled foreign  
          corporations" (corporations formed outside the U.S., but  
          owned by U.S. parent corporations) with "Subpart F" income  
          (income from tax haven countries or income otherwise  
          considered to be tax-sheltered).

          An inconsistency exists in the water's edge law that may be  
          interpreted to permit a controlled foreign corporation with  
          Subpart F income to file with the Secretary of State as an  
          "admitted corporation" (eligible to do business in  
          California), pay the $800 minimum corporation tax, and  
          totally escape inclusion of a portion of its Subpart F  
          income within the water's edge apportionable income base  
          (i.e., avoid paying any taxes on its tax haven income).   
          The Franchise Tax Board (FTB) staff believe that some  
          corporations have begun to take advantage of this  

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          inconsistency and that some Subpart F income has been  
          excluded from the water's edge.

          Specifically, SB 663:

           1.  Requires a controlled foreign corporation (CFC) that  
            is a California taxpayer or has United States (U.S.)  
            source income to include its Internal Revenue Code (IRC)  
            Subpart F income (in general, dividends, interest,  
            royalties, rents) in the combined report.

           2.  Coordinates existing laws dealing with Subpart F  
            income and U.S.-source income rules so that they operate  
            simultaneously and consistently, regardless of whether  
            corporations are taxpayers for California tax purposes.

           3.  Provides various implementation rules regarding  
            document production and treatment of dividends as  
            business income in certain, enumerated circumstances.

           4.  Provides that the provisions apply to taxpayers that  
            make a water's-edge election on or after January 1, 2006.

           5.Provides a "phase-in" period so that the provisions will  
            not apply to taxpayers that made a water's-edge election  
            prior to January 1, 2006, until the taxpayer is able to  
            elect out of the water's-edge provisions without the  
            consent of the Franchise Tax Board (FTB).

           6.States legislative intent with respect to taxpayers to  
            whom this bill applies as follows: 

             A.    For any return containing a water's-edge  
                combined report filed on or before January 1, 2006,  
                a taxpayer that excluded income of its CFC because  
                the CFC had technical tax nexus to California or  
                had U.S.-source income shall be deemed in  
                compliance with the law before the amendments  
                provided by this bill, provided that the taxpayer  
                otherwise complied with the statute.

             B.    For any return containing a water's-edge  
                combined report filed after January 1, 2006, no  
                inference be drawn from this bill with respect to  

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                the correctness of the taxpayer's return position. 

          A proposal similar to this one was included in AB 1469  
          (Ortiz), in 1998, as part of a "taxpayer bill of rights"  
          package.  The bill (passed in the last two weeks of  
          session) was unopposed when heard in this committee, but  
          was vetoed by Governor Wilson when business interests  
          erroneously asserted to the Governor that the existing law  
          is as intended to be by the Legislature, and that various  
          taxpayers were utilizing it to reduce their tax  
          liabilities. In fact, the inconsistency is not intentional,  
          and at the time of the veto no taxpayers had attempted to  
          use it.

          A virtually identical bill, SB 1571 (Alpert), of 2004,  
          reached the Assembly Floor but the author did not ask that  
          it be taken up for vote.

           FISCAL EFFECT  :    Appropriation:  No   Fiscal Com.:  Yes    
          Local:  No

          FTB estimates the revenue loss from the implementation  
          provisions of this bill will be $1 million for fiscal year  
          (FY) 2006-07 and minor revenue losses (less than $500,000)  
          for each of FY 2007-08 and FY 2008-09. FTB notes a recent  
          trend in returns filed by multinational corporations to  
          exclude income from CFCs, contrary to FTB's position on the  
          issue.  The clarification contained in this bill eliminates  
          any risk that taxpayers' positions will be sustained in  
          court and FTB estimates that this bill potentially will  
          save $50 million annually, commencing after FY 2008-09,  
          plus the costs of extended litigation.

           Note  that the bill is keyed "majority vote" (i.e., not a  
          tax increase), as Legislative Counsel agrees with FTB that  
          the bill clarifies rather than changes current law.

           SUPPORT  :   (Verified  4/5/06)

          Franchise Tax Board (source)
          American Federation of State
          County and Municipal Employees
          AFL-CIO
          SEIU, Local 1000

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           OPPOSITION  :    (Verified  4/5/06)

          California Bankers Association
          California Chamber of Commerce
          California Taxpayers Association
          Johnson and Johnson

           ARGUMENTS IN SUPPORT  :    According to the author's office,  
          the purpose of this bill is to clarify existing law, reduce  
          taxpayer confusion, and eliminate unintended opportunities  
          for tax avoidance.

          FTB is concerned that an existing inconsistency and  
          ambiguity in our tax law may be used by taxpayers to avoid  
          including in the their water's edge group  
          otherwise-includible tax haven activities (Subpart F  
          income) by establishing a de minimus tax presence in  
          California.

           ARGUMENTS IN OPPOSITION  :    According to the California  
          Chamber of Commerce, the taxpayers affected by this bill  
          already made their decisions to enter into a water's edge  
          election based on the exclusion of Subpart F income.   
          Moreover, these taxpayers entered into seven-year  
          agreements with the state (which is required by law when  
          making a water's edge election).  As a result, they believe  
          it is only fair to apply this proposed change in the law on  
          a prospective basis.  They are also concerned about FTB's  
          revenue estimate of a $50 million increase and that the  
          bill is only a majority vote bill.  
           
          ASSEMBLY FLOOR  :
          AYES:  Arambula, Bass, Berg, Bermudez, Calderon,  
            Canciamilla, Chavez, Chu, Cohn, Coto, De La Torre,  
            Dymally, Evans, Frommer, Goldberg, Hancock, Jerome  
            Horton, Jones, Karnette, Klehs, Koretz, Laird, Leno,  
            Levine, Lieber, Lieu, Matthews, Montanez, Mullin, Nation,  
            Nava, Oropeza, Pavley, Ridley-Thomas, Ruskin, Saldana,  
            Salinas, Torrico, Vargas, Wolk, Yee, Nunez
          NOES:  Baca, Benoit, Blakeslee, Bogh, Cogdill, Daucher,  
            DeVore, Emmerson, Garcia, Harman, Shirley Horton,  
            Houston, Huff, Keene, La Malfa, La Suer, Leslie, Maze,  
            McCarthy, Mountjoy, Nakanishi, Negrete McLeod, Niello,  

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            Parra, Plescia, Richman, Sharon Runner, Spitzer,  
            Strickland, Tran, Umberg, Villines, Wyland
          NO VOTE RECORDED:  Aghazarian, Chan, Haynes, Liu, Walters


          DLW:do  4/5/06   Senate Floor Analyses 

                         SUPPORT/OPPOSITION:  SEE ABOVE

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