BILL ANALYSIS SB 1880 Date of Hearing: June 20, 1994 ASSEMBLY COMMITTEE ON REVENUE AND TAXATION Johan Klehs, Chair SB 1880 (Campbell) - As Amended: June 14, 1994 SUBJECT Requires certain financial corporations to apportion income based on an equally-weighted three factor formula DIGEST Tax Levy. Majority Vote Required. Fiscal Committee. Under existing law, when a corporation operates both within and outside šof California, it is necessary to determine what portion of total corporate šincome is earned in California and is subject to tax in this state. šCalifornia corporations are required to make this determination using a "three-factor" šformula. Specifically, businesses calculate the percentage of their total property, špayroll and sales which occur in California. A "weighted" average of these šfactors is then calculated, where the sales factor accounts for one-half of šthe average, and the property and payroll factors each make up one-quarter šweighting in the calculation. This combined average factor is applied šagainst a corporation's total income to determine California income. The š9.3% corporate tax rate is then applied to this California income figure to šdetermine the business' tax liability. An apportionment factor calculated in the above fashion is usually referred što as the "double-weighted" sales factor method, because the sales factor šis given twice the weight of the property and payroll factors in the šcalculation. (See Attachment I for an example of this calculation) Multistate corporations are generally required to use the double-weighted šsales apportionment formula, but an exception is made for those businesses šwhich derive more than 50% of their gross receipts from conducting either šextractive or agricultural activities. Agricultural and extractive firms šinstead are required to use an "equally-weighted" apportionment formula. šThus, for extractive and agricultural firms, the property, payroll and šsales factors each account for one-third of the total apportionment factor, šversus the double-weighted sales formula described above. - continued - SB 1880 Page 1 SB 1880 Prior to last year's enactment of SB 1176 (Kopp), Chapter 946, all šmultistate firms were required to use an equally-weighted apportionment šformula. However, SB 1176 instead made the double-weighted sales factor šthe standard apportionment calculation, with an exception made for either šextractive or agricultural firms. This bill establishes an additional exception to the double-weighted šsales factor apportionment formula for the savings and loan industry. šThese financial firms, along with extractive and agricultural companies, šwould instead use the equal-weighted three factor apportionment formula. šSpecifically, this bill: 1) Requires financial corporations that have more than 65% of their gross business receipts derived from conducting residential lending activity (savings and loans) to use an equal-weighted apportionment formula. 2) Provides that all other financial firms (primarily banks) shall continue to use the double-weighted sales apportionment formula until the Franchise Tax Board (FTB) adopts the proposed Multistate Tax Commission's (MTC) uniform apportionment rules for financial institutions. Once FTB adopts the MTC's proposed apportionment rules, banks and other financial corporations would join savings and loans in using the standard equal-weighted three factor formula. 3) Defines residential lending activity as activity directly or indirectly related to acquiring mortgage debt secured by residential real property. 4) Takes effect immediately as a tax levy, and thus provide that savings and loans would use an equal-weighted three factor apportionment formula in determining California income for tax years beginning on or after January 1, 1994. FISCAL EFFECT State: The FTB estimates that requiring savings and loans to use an š equally-weighted three factor apportionment formula would result in General Fund revenue losses in the range of $500,000 annually. Additionally, if the MTC's proposed apportionment regulations are adopted, and thus banks also are required to use an equal- weighted apportionment formula, there would be an additional revenue effect. FTB is unable to estimate this effect, but it is likely to be a gain or loss of several million dollars. Local: None. - continued - SB 1880 Page 2 SB 1880 COMMENTS 1) Purpose Of The Bill This bill is intended to provide financial relief to the savings and loan industry by reversing a tax increase imposed on this group by last year's SB 1176. Although adoption of a double-weighted sales factor apportionment formula was generally intended to subsidize California- based companies with sales predominantly out-of-state, some firms which "look" like California- based companies also were negatively effected. Specifically, California- based savings and loans that operate on a multistate basis generally had their California tax liability increased as a result of SB 1176. The California League of Savings Institutions, the sponsors of this bill, believe they were not the intended victims of SB 1176, and thus the relief provided by this measure is appropriate. The sponsors note that under the regulations which determine how a financial corporation determines its sales factor, sales are based primarily on interest income from loan payments. Generally, this results in all sales being assigned to the corporation's home state. A California-based savings and loan will have a sales factor which is relatively high, and thus double-weighting that factor will tend to result in more income being apportioned to California. 2) Should Another Exception Be Made to Double-Weighting? Prior to last year's enactment of SB 1176, all multistate corporations were required to use an equally-weighted apportionment formula. However, SB 1176 instead made the double-weighted sales factor formula the standard, but with exceptions created for both extractive and agricultural firms. The exception for extractive and agricultural firms was explained as a point of fairness based on the inability of those businesses to shift their sales out of California. This bill creates another exception to the newly adopted double- weighted sales formula based on similar arguments. Should another exception to the apportionment formula be created? While it can be argued that sourcing income for financial corporations tends be different than other industries, will creation of this exception create even more requests? 3) Should Similar Taxpayers Be Treated Differently? This bill requires savings and loans to apportion their income based on an equally-weighted three factor formula. However, banks would continue to use a double-weighted sales factor calculation. - continued - SB 1880 Page 3 SB 1880 Again, while it can be argued that sourcing income for financial corporations tends to be different than other industries, should distinctions in the standard apportionment formula be made within the same basic industry? What is sufficiently different about savings and loan and bank operations which would justify making a distinction between these industry segments for apportionment purposes? 4) How Many Firms Are Effected? The sponsors of the bill indicate that there are approximately 100 California-domiciled savings and loans operating in California. However, most of these firms do not have multistate operations, and thus would not be effected by the apportionment formula changes made in this bill. Only about six to eight California savings and loans operate outside the state and are effected. 5) Should Changes to Bank Apportionment Formulas Be Contingent Upon MTC Regulations? The Multistate Tax Commission (of which California is an active member) has been working for several years on a proposed uniform apportionment formula for financial corporations. One component of this proposed uniform system would be an equally-weighted three factor formula. The regulations also modify how the sales factor is calculated so that the location of a borrower (e.g., out-of-state loans) enters into the determination of where a sale is deemed to have occurred. The final MTC proposal will be presented at an annual meeting this July. This bill provides that if FTB adopts the proposed MTC regulations for financial corporations, then banks would no longer use a double- weighted sales formula, but instead would return to an equally-weighted three factor formula under the MTC proposed rules. While adoption of the MTC's proposed financial apportionment formula is probably desirable, should the apportionment method prescribed for banks be made contingent upon adoption of these regulations? The FTB indicates that if banks change their apportionment formula from the current double-weighted sales calculation to the single-weighted based MTC proposal, that there will be a multi-million dollar revenue effect which could be either positive or negative. Should any change to the apportionment formula be delayed until the MTC regulations are finalized and more information is available? 6) FTB Technicals The FTB proposes several technical amendments which should be adopted. The most significant amendment clarifies how a financial corporation operating in a unitary group should apportion income. - continued - SB 1880 Page 4 SB 1880 ATTACHMENT I EXAMPLE: USE OF UNITARY APPORTIONMENT FORMULA FOR A MYTHICAL CORPORATION 1) Compute ratio of corporate assets in California to assets worldwide: In Total Ratio of California California Everywhere to Total Sales $1,000,000 $20,000,000 5% Property 4,000,000 40,000,000 10% Payroll 2,000,000 10,000,000 20% 2) Take average of 3 ratios to determine apportionment factor: 5% + 10% + 20% = 35% divided by 3 = 11.6666% for agricultural and extractive industries 5% + 5% + 10% + 20% = 40% divided by 4 = 10% for all others 3) Apply apportionment factor to total corporate net income to determine income apportioned to California: Agricultural/ extractive All others Worldwide Net Income of Corporation: $ 5,000,000 $5,000,000 times Unitary Apportionment Factor: x 11.6666% x 10% Net Income Apportioned to California: $ 583,330 $ 500,000 4) Apply California tax rate to determine tax: Income Apportioned to California: $ 583,330 $ 500,000 times Bank and Corporation Tax Rate: x 9.3% x 9.3% Tax Due to California: $ 54,250 $ 46,500 - continued - SB 1880 Page 5