BILL ANALYSIS ------------------------------------------------------------ |SENATE RULES COMMITTEE | SB 663| |Office of Senate Floor Analyses | | |1020 N Street, Suite 524 | | |(916) 445-6614 Fax: (916) | | |327-4478 | | ------------------------------------------------------------ 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 CONTINUED SB 663 Page 2 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 CONTINUED SB 663 Page 3 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 CONTINUED SB 663 Page 4 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 CONTINUED SB 663 Page 5 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, CONTINUED SB 663 Page 6 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 **** END **** CONTINUED