BILL ANALYSIS Ó SENATE GOVERNANCE & FINANCE COMMITTEE Senator Lois Wolk, Chair BILL NO: SB 116 HEARING: 7/13/11 AUTHOR: de León FISCAL: Yes VERSION: 7/7/11 TAX LEVY: No CONSULTANT: Miller MANDATORY SINGLE SALES FACTOR (1) Makes single sales factor mandatory; (2) Expands the 2009 jobs credit; (3) Adds a manufacturing equipment sales & use tax exemption; (4) Creates a new education credit; (5) Changes the cost of performance/market rule for cable companies; (6) Allows an election of single factor or 3 factor only when the tax is greater under the 3 factor formula. Existing Law I. Apportionment Formula . A multistate firm generates profits based on its operations in many states, and has a right under the U.S. Constitution to divide income between these states for tax purposes, a process known as "apportionment," to ensure that no state taxes more than its fair share of that firm's income. The 1957 Uniform Division of Income for Tax Purposes Act (UDITPA) created the three-factor double weighted apportionment framework to capture the factors of production; specifically, property to represent capital, payroll to represent labor, and sales to represent market presence. In 1966, California adopted UDITPA where each of the three factors had an equal weight of one-third. In 1993, California adopted a "double-weighted" formula, reducing the formula's weights on both property and payroll from 33.3% to 25%, but increasing the weight on sales from 33.3% to 50%, thereby reducing that share of a the firm's income apportioned to states where it employs relatively more people and produces more goods in the state compared to its sales. Under the change, a firm with all or most of its production and payroll in California, but a smaller share of its sales, benefits from the change, whereas a firm that either employs few or no people or owns little to no property here, but sells into California, pays more tax. SB 116 -- 7/7/11 -- Page 2 Many other states also changed the apportionment weights in the 1980s and 1990s to induce firms to maintain or relocate facilities and employees in the state. Starting in 2011, California's apportionment formula allows multi-state firms to annually choose either the above apportionment formula or to use only its sales, commonly known as the "single sales factor." Each of the factors in the apportionment formula is a fraction: the numerator is the value of the item in California and the denominator is the value of the item everywhere. The property factor generally includes all tangible property owned or rented during the taxable year. The payroll factor includes all forms of compensation paid to employees. The sales factor includes all gross receipts from the sale of tangible and intangible property. Since 1993, the apportionment formula for most taxpayers has been a three-factor double weighted formula consisting of payroll, property and double weighted sales as illustrated below. --------------------------------------------------------- | Average | + |Average |+ |Californ|) | California | |Californi| |Californ| (2x| ia | = |Apportionment| | a | | ia | | Sales | | Formula | |Property | |Payroll | | | | | |---------+----+--------+------+--------+---+-------------| | Average | |Average | | Total | | | | Total | | Total | | Sales | | | |Property | |Payroll | | | | | --------------------------------------------------------- The only exceptions to this rule are four industries: agriculture, extraction, including oil, savings and loan and financial services. These four industries must use the three factor formula without the double weighted sales factor. Beginning in 2011, as illustrated below, a qualified business may elect to use a single sales factor based on 100 percent sales, instead of the three factor formula described above. The industries listed above still do not qualify for the single sales factor. SB 116 -- 7/7/11 -- Page 3 --------------------------- |Californi| = |California | | a Sales | |Apportionmen| | | | t Formula | |---------+----+------------| | Total | | | | Sales | | | --------------------------- II. Intangible Sourcing . As part of the budget agreement of 2010 (SB 858, Committee on Budget & Fiscal Review, 2010), taxpayers electing the three-factor, double-weighted sales formula must use the cost of performance method to source sales of intangible items starting with the 2011 taxable year; taxpayers electing sales factor-only apportionment of income must source the sales of intangibles to California using the market rule. Intangibles are everything that isn't "stuff", and include all services, such as online stockbrokers and telecommunications, and licenses to operate software programs, among others. Sales of Intangibles - "Costs of Performance ." A company includes no revenue from its sales of intangibles to California in the sales factor if the firm incurs a plurality of the costs associated with developing these products or services in another state; if the plurality occurs in California, then the company includes all of its sales in its California sales factor. For example, a company that produces streaming video may spend $500,000 in California and $520,000 in Oregon when developing the service. The firm does not include any sales of its sales of streaming video in this state in its California sales factor, because it incurred most of its costs of performance outside the state. Had the firm incurred most of its costs of performance in California, the taxpayer must include all of its sales of the video service in its California sales factor. Sales of Intangibles - "The Market Rule ." Under the competitively-neutral market rule, all firms source these sales based on the state in which the product or service is ultimately used, so all firms report sales based on how much they sell in the state, instead of where they invested when developing the intangible item or service. Each license for an operating system used on a California SB 116 -- 7/7/11 -- Page 4 personal computer would be included in the software firm's California sales factor. In the example above, the firm would include its sales of the video service to customers in this state in its California sales factor. The following chart summarizes California's history of both apportionment and intangibles. ---------------------------------------------------------- | |1966 - |1993-2010 |2011 | | |1992 | | | |-------------+-----------+--------------+-----------------| |Apportionment|3-factor |3-factor |Elective | | |formula |formula |(3-factor | | | |(double-weight|formula with | | | |ed sales |double weighted | | | |factor) |sales or single | | | | |sales factor) | |-------------+-----------+--------------+-----------------| |Intangibles |Costs of |Costs of |Cost of | | |performance|performance |performance if | | | | |elect 3-factor; | | | | |formula; market | | | | |rule if single | | | | |sales factor | | | | |elected | | | | | | ---------------------------------------------------------- III. Jobs Tax Credit . Current state law, SB x 3 15 (Calderon, 2009) allows a credit for taxable years beginning on or after January 1, 2009, for a qualified employer in the amount of $3,000 for each qualified full-time employee hired in the taxable year, determined on an annual full-time equivalent basis. The calculation of annual full-time would be the total number of hours worked for the taxpayer by the employee (not to exceed 2,000 hours per employee) divided by 2,000. This credit is allocated by the Franchise Tax Board (FTB) and has a cap of $400 million for all taxable years. The credit remains in effect until December 1 of the calendar year after the year in which the cumulative credit limit has been reached and is repealed after that date. Any credits not used in the taxable year may be carried forward up to eight taxable years. SB 116 -- 7/7/11 -- Page 5 A qualified employer is a taxpayer employing 20 or less employees. In addition, both the Personal Income Tax Law (PITL) and Corporation Tax Law (CTL) provisions regarding this credit contain certain anti-abuse rules. These rules were designed to prevent an existing business from being treated as first commencing business in the state when the business simply changed structure, i.e. changed from a sole proprietor to an S-corporation. IV. Sales & Use Tax . Existing law provides no special tax treatment to entities engaged in manufacturing or software production for purchases of equipment and other supplies. Business entities engaged in manufacturing, research and development, and software producing activities that make purchases of equipment and supplies for use in the conduct of their manufacturing and related activities are required to pay sales and use tax on their purchases to the same extent as any other person either engaged in business in California. The state sales and use tax rate is 8.25% as detailed below. Cities and Counties may increase the sales and use tax rate up to 2% for either specific or general purposes with a vote of the people. --------------------------------------- |4.75%| State |Goes to State's General | | | | Fund | | | | (Total General Fund is | | | | 6%) | |-----+--------+------------------------| |0.25%| State |Goes to State's General | | | | Fund | | | | (Total General Fund is | | | | 6%) | |-----+--------+------------------------| |0.25%| State | Goes Towards State's | | | | Fiscal Recovery Fund, | | | | to pay off Economic | | | | Recovery Bonds (2004) | |-----+--------+------------------------| |0.50%| State | Goes to Local Public | SB 116 -- 7/7/11 -- Page 6 | | | Safety Fund to support | | | | local criminal justice | | | | activities (1993) | |-----+--------+------------------------| |0.50%| State | Goes to Local Revenue | | | | Fund to support local | | | | health and social | | | |services programs (1991 | | | | Realignment) | |-----+--------+------------------------| |1.00%| Local | 0.25% Goes to county | | | | transportation funds | | | | 0.75% Goes to city and | | | | county operations | |-----+--------+------------------------| |Total| | | | : | | | |-----+--------+------------------------| |7.25%|State/Lo| Total Statewide Base | | | cal |Tax Rate | | | | | --------------------------------------- For a ten-year period ending December 31, 2003, California law provided a partial (General Fund only) sales and use tax exemption for purchases of equipment and machinery by new manufacturers, and income and corporation tax credits for existing manufacturers' investments (MIC) in equipment (SB 671, Alquist, 1993). The bill provided an exemption to the state tax portion for sales and purchases of qualifying property, and the income tax credit was equal to six percent of the amount paid for qualified property placed in service in California. Qualified property was depreciable 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. The MIC had a conditional sunset date which required that the provisions sunset in any year following a year when manufacturing employment (as determined by the Employment Development Department) did not manufacturing employment by more than 100,000. On January 1, 2003, manufacturing employment, less aerospace, did not exceed the 1994 SB 116 -- 7/7/11 -- Page 7 employment number by more than 100,000 (it was less than the 1994 number by over 10,000), and therefore the MIC and partial sales tax exemption sunset at the end of 2003. Proposed Law I. Apportionment Formula . As amended, this bill amends the apportionment formula in two ways: 1. Single Sales Factor : This bill makes the single sales factor apportionment formula mandatory for all taxpayers except those in a qualified business activity (extractive, agricultural, savings and loans, and banks and financial services) for taxable years beginning on or after January 1, 2011. 2. Elective Single Sales Factor & 50% assignment of intangibles to this state . As introduced, SB 116 required all taxpayers to use the mandatory single sales factor. As amended, this bill allows taxpayers to choose the 3-factor formula only when it results in a greater amount of tax owed. II. Intangible Sourcing. 50/50 market costs of performance . SB 858 (Committee on Budget, 2010) requires that companies that elect single sales factor choose the "market" rule and source all intangible property to this state and taxpayers that elect to pay taxes under the 3-factor formula source intangible property to where the goods originate. SB 116 as amended, allows cable companies to choose either that have a "minimum investment" in this state of $250 million or more, to assign 50% of their intangible property to "this state" under the market rule and 50% shall "not be assigned to this state." III. Jobs Tax Credit . SB 116 expands the eligibility for the jobs credit to employers with 50 or fewer employees, and also increases the amount of the credit from $3,000 to $4,000 for each new hire. IV. Manufacturing Equipment Sales Tax Exemption . Current law provides that all tangible personal property in this SB 116 -- 7/7/11 -- Page 8 state is subject to the sales and use tax. SB 116 creates a new manufacturing sales & use tax exemption. The bill provides that starting in 2012-13, companies would be given a 1% exemption from the General Fund Sales and Use Tax (SUT) for equipment, and start-up companies would be eligible for a 5% exemption. V. K-12 Education Investment and Higher Education Investment Tax Credit Programs . Existing law provides for a deduction against net tax for any charitable contribution. The law also provides for various credits with the intent of changing behavior or encouraging investment. SB 116 creates a new credit against net tax. The bill sets up a special fund within the general fund to which taxpayers may contribute. The bill provides a 75% credit for contributions to the special fund. This credit may not be combined with any other deduction or charitable contribution. VI. Urgency Clause . SB 116 adds urgency clause State Revenue Impact ---------------------------------------------------------------- | Estimated Revenue Impact of SB 116 as Amended on 7/7/2011 | |----------------------------------------------------------------| | For Tax Years Beginning On Or After January 1, 2011 | |----------------------------------------------------------------| | Enactment Assumed After June 30, 2011 | |----------------------------------------------------------------| | | ---------------------------------------------------------------- |-------------+-----------+------------+------------+------------| | | 2011-12 | 2012-13 | 2013-14 | 2014-15 | |-------------+-----------+------------+------------+------------| | Job Tax | -45,000,| 22,000,00| 45,000,00| 55,000,00| | Credit | 000 | 0 | 0 | 0 | |-------------+-----------+------------+------------+------------| | Education | -420,000| -900,000,| -950,000,| -950,000,| | credit | ,000 | 000 | 000 | 000 | ---------------------------------------------------------------- SB 116 -- 7/7/11 -- Page 9 | Mandatory | 1,300,00| $1,100,00| $1,100,00| $1,000,00| | SSF | 0,000 | 0,000 | 0,000 | 0,000 | ---------------------------------------------------------------- | Special | -38,000,| -38,000,0| -37,000,0| -39,000,0| | sales | 000 | 00 | 00 | 00 | | rule-cab| | | | | | le | | | | | | corps | | | | | ---------------------------------------------------------------- | Sales and | -261,000| -275,000,| -291,000,| -301,000,| | Use Tax | ,000 | 000 | 000 | 000 | | | | | | | |-------------+-----------+------------+------------+------------| | Net | 536,000,| -91,000,0| -133,000,| -235,000,| | Fiscal Impact| 000 | 00 | 000 |000 | | | | | | | ---------------------------------------------------------------- Comments 1. Purpose of the bill . SB 116 seeks to stop rewarding companies that move jobs out of state, incentivize job creation here at home, and save California taxpayers over $1 Billion annually through the implementation of a mandatory single sales factor in the calculation of corporate taxes owed to the state. The trend around the country is states moving towards the "single sales factor" method for the calculation of taxes. However, in California's adoption of this method in 2009, instead of adopting a mandatory single sales factor like the vast majority of other states-including Texas, New York, Michigan, Illinois, Oregon, Washington, and just last April, New Jersey-our tax law has an annual elective single sales factor. Allowing corporations to choose the three-factor, double weighted formula, which lowers their tax liability the smaller their California presence, unfairly benefits companies that move jobs or base the bulk of their operations out-of-state-at the expense of $1 Billion/year to California's taxpayers. In order to eliminate this competitive disadvantage and level the playing field for California-based companies, we need to make the single sales factor mandatory. SB 116 is about putting California first-we should be encouraging job creation and greater investment here in our home state, instead of rewarding out-of-state corporations and California companies that move jobs out of state. SB 116 -- 7/7/11 -- Page 10 According to the recent Legislative Analyst's Office (LAO) report, Reconsidering the Optional Single Sales Factor (2010), adoption of a mandatory single sales factor would result in a net gain of tens of thousands of jobs in California. Other components of SB 116 also seek to facilitate job creation and assist in California's economic recovery by expanding eligibility for the existing Jobs Credit, and providing a sales tax exemption on the purchase of manufacturing equipment. In addition, two new tax credit programs-the K-12 Education Investment Tax Credit and the Higher Education Investment Tax Credit-would provide taxpayers with access to $1 Billion in tax credits, and direct funds generated towards our under-funded public education systems. State budget solutions over the last several fiscal years have included deep cuts and payment deferrals to K-12 Education and the University of California, California State University, and California Community College systems. These tax credit programs will help in the repayment of money owed to schools under Proposition 98, and help rebuild the state's investment in education. 2. Shot through the heart . In an opposition letter, the California Chamber of Commerce, the California Manufacturers & Technology Association and CalTax state that the elective single sales factor was a "remarkable, although rare, bright spot in California's notoriously bad business climate." The three groups state that the state was correct in making the single sales factor elective in 2009 and that the attempt to make it mandatory negates the importance of business contributions to the state's overall economic health. Furthermore, the opposition states that not all business models fit easily into a single sales calculation, but these companies have significant investments of property and payroll in California. The size of their sales in one of the largest markets in the world renders those investments moot by comparison. Finally, they state that SB 116 will "cut the heart out of an already weakened California economy." 3. Of Fractions of Loaves . As introduced, SB 116 implemented Governor Brown's proposal in his January Budget to remove the ability for firms to choose which apportionment formula leads to paying the lowest tax, and require all firms to source sales of intangible goods SB 116 -- 7/7/11 -- Page 11 according to the market rule instead of the former "costs of performance" method. The Legislature did not enact the change in income apportionment as part of the Budget, which are contained in AB 103 (Committee on Budget) and SB 79 (Committee on Budget and Fiscal Review). As amended, the measure is less aggressive: allowing firms to still choose the three-factor, double weighted method if they'd rather apply accrued tax credits (only if they would owe more tax), partially carving cable companies out of the impact of the change to the market rule, adding a tax credit for donations to public education, and providing a limited sales and use tax exemption. These sweeteners come on top of considerable tax breaks the Legislature has enacted in recent years, such as house purchase tax credits (SBx2 15, Ashburn, 2009), motion picture production tax credits (ABx3 15, Krekorian, SBx3 15, Calderon, 2009), sales and use tax exemptions for solar manufacturing (SB 71, Padilla, 2010), tax credit sharing and net operating loss carrybacks (AB 1452, Committee on Budget 2008), as well as a safe harbor from the large corporate understatement penalty, and waiving NOL suspensions for single taxpayers (SB 858, Committee on Budget, 2010). As introduced, the measure raised more than $1 billion, now it raises only negative $235 million when fully implemented in 2014-15, no accounting for the contributions to the General Fund through the education credit. The Committee may wish to consider whether abandoning the Governor's Proposal in favor of a measure that implements its changes in a less ambitious way in exchange for new tax breaks for specified taxpayers is merited in these times of continued fiscal stress and the recent history of adding more and more taxpayer-specific benefits to the tax code. 4. There's a first time for everything . SB 116 creates a new credit for education expenses in this state through contributions to the general fund. For example, a taxpayer would give $100 to a special fund within the general fund specifically for education but he or she would not be able to designate a school or program for the funds. In return, the taxpayer receives a $75 credit for the funds while the state keeps a full $25 of the original $100. Generally, credits are given to influence or change behavior, this credit is to fund state programs. The Committee may wish to consider the utilization of such a credit and what information is necessary to encourage taxpayers to contribute. SB 116 -- 7/7/11 -- Page 12 5. Which way ? Currently, taxpayers can take the charitable deduction for "public purpose" donations to the general fund. Taxpayers can reduce their income by an average of 30% for state and federal purposes, subject to limitations and the Alternative Minimum Tax. This bill allows taxpayers to take a 75% credit plus the federal deduction. Does a credit allow a greater benefit that we will see more contributions than we would have under a charitable donation? Why identify public education donations as special when health and human services have suffered far deeper budget cuts, lack the Constitutional funding protection of Proposition 98, and voters appear far less willing to enact special taxes for health and human services than for education? The Committee may wish to consider whether this credit is necessary; additionally, it may also wish to consider the efficacy of limiting it to one public service. 6. Let them pay more . This bill allows only one group of taxpayers to choose between the single sales factor and the 3-factor formula: those businesses that would pay more under the 3-factor formula. The author argues that some companies need this option in order to fully utilize their available credits. The Committee may wish to consider if there is a possibility that taxpayers would still pay less under less under the 3-factor formula because of the availability of credits which the calculation in this bill does not consider. 7. If you build it, they will come . AB 116 includes a partial sales and use tax exemption for manufacturing similar to the one the Governor proposed in his May revision. Starting in 2012-13, companies would be given a 1% exemption from the General Fund Sales and Use Tax for equipment, and start-up companies would be eligible for a 5% exemption. Since purchases of tangible property used in manufacturing is subject to the sales and use tax, and the output of manufacturing is also subject to sales and use tax when products are sold, there is a "double-taxation" that is levied on corporations. The proposed sales tax exemption seeks to alleviate this cost and provide an incentive for buying capital and locating manufacturing equipment here in California. The Governor's May Revision, however, required that the exemption be conditioned on the sales and use tax 1% extension which expired on July 1st of SB 116 -- 7/7/11 -- Page 13 this year. The Committee may wish to consider whether a sales and use tax exemption, absent the tax extensions makes sense. 8. What a way to make a living. The jobs credit SB 116 seeks to amend has been in effect since 2009 and there is little evidence that it has affected unemployment in this state. California experienced steep employment declines during the recent recession and the state's unemployment rate is persistently higher than the national average. Academic literature suggests that no state tax policy can affect high unemployment in this state. A recent study by David Neumark at the Public Policy Institute of California (PPIC) suggests two direct job creation policies: hiring credits and worker subsidies such as the federal Earned Income Tax Credit. At the February 16th hearing of this committee, Mr. Neumark presented his findings. He argues that hiring credits act to increase the demand for labor and are the best policy response to spur a recovery from the recession. He suggests that hiring credits should focus broadly on the recently unemployed and establish incentives for new hires rather than increases in the work hours of existing employees. In order to be effective, the credits would need to be between $9,100 to $75,000 per employee so state funding would contribute only modestly at best to the credit. The author argues that this bill makes the credit more efficient and only spends the money allocated for the purpose. The Committee may wish to consider whether there are better ways to create a jobs credit or even if it makes sense to supplant existing credits, such as enterprise zones, with this credit. 9. Dr. Frankenstein's Creation . As Edward Kleibard, former chief of staff to the Joint Committee on Taxation, recently wrote: "The tax system is a window into the soul of our society, because we use tax law as our principal tool of industrial policy, wage support and income redistribution. Our tax structure tells more about what we as a society believe to be fundamentally fair than does any other aspect of government." Applying this quote to California's tax law leads to the conclusion that California is one of the most taxpayer-friendly states in the nation, and one that provides unique benefits to out-of-state firms, in stark contrast to its history of treating all multistate corporations equally. When SB 116 -- 7/7/11 -- Page 14 California adopted the elective single sales factor in 2008, it departed from every other state save Missouri by allowing taxpayers to choose to use the old formula if it resulted in a lower tax in any given year. Allowing firms with more property and payroll to benefit from the old formula negates the incentive for them to move more property and payroll to California, thereby reducing the share of its income it has to apportion to other three factor states. Additionally, an out-of-state firm that mostly or exclusively sells intangibles that apportions under the three-factor, double weighted formula and allocates intangibles under the cost of performance rule, yielding a sales factor close to or equal to zero, enjoys a competitive advantage over a California firm electing single sales factor and allocates intangibles under the market rule because it cannot reduce its sales factor below the percentage of its sales in California. SB 116 proposes two major changes to the rules. First, all firms must apportion income to California under the single sales factor, except firms can still choose the three-factor, double weighted formula only when they would pay more tax. Supporters state that this change is preferable because firms can then use more of their accrued tax credits, such as Research and Development Credit, which can't currently be used because they lack the tax liability to apply the credit under single-sales factor, and using those credits allows them to reduce the amount of deferred tax assets on its financial statements. Never before have apportionment formulas taken credit application into account. The Committee may wish to consider the merits of structuring California's apportionment formula, the foundation of its corporate tax system, to please some firms and its investors. Second, the measure applies the market rule to all taxpayers, except for cable companies which would have to allocate half of its sales based on that percentage of its sales in California compared to its total sales if it met qualified investment targets. Generally, tax systems treat should apply the same rules to all taxpayers. Also, cable companies primarily invest in California to serve customer demand, and have consistently avoided California with its discretionary investments, resulting in its opposition to the market rule and support for the cost of performance method. The Committee may wish to consider why a separate SB 116 -- 7/7/11 -- Page 15 set of rules should apply to cable companies. 10. Amendments. The bill is unclear on several items; the author may wish to clarify the following: The cut-off dates for the education credits are unclear. The language does not specify that the cut-off date would be the quarter that the $1,000,000,000 in credits would be reached. There would be costs incurred to modify systems to track and store the credit information and publish that information. The costs have not been determined at this time. The bill language does not specify what agency would be responsible for the administration of the special funds. The language in Section 25136.1 excludes those taxpayers electing to use the four-factor formula; if their "tax" before credits using the four-factor formula is greater than if they use the single sales factor formula for apportioning business income. This is not an implementation concern for the FTB, but wanted to point out that it may be confusing to some taxpayers. The jobs tax credit portion of the bill cuts off claims if (1) the $400 million cap is reached or (2) 12/31/2012. In specifying the cutoff date, however, the bill requires the submission of a timely filed original tax return prior to this date. Since 12/31/2012 is the last day of the tax year for most taxpayers, they will be unable to claim the jobs tax credit for tax year 2012. SB 116 -- 7/7/11 -- Page 16 11. Been there . This bill recalls three four bills this committee has already seen: The Committee approved SB 156 (Emmerson) earlier this year which makes an identical change to the Governor's May Revision proposal. The Committee approved SB 640 (Runner) which enacts a credit equal to $500 for each formerly unemployed person a taxpayer employs. The Committee approved SB (Dutton) which created a sales and use tax exemption for manufacturing products. The Committee approved AB 1195 (Allen) which makes the identical changes to the jobs credit that this bill does as well. Support and Opposition (7/11/11) Support : Unknown. Opposition : California Taxpayers' Association.