BILL ANALYSIS
SENATE REVENUE & TAXATION COMMITTEE
Senator Michael Machado, Chair AB 115 - Klehs
Amended: June 20, 2005
Hearing: June 29, 2005 Tax Levy Fiscal: YES
SUBJECT: Income & Corporation Taxes: Conformity with
federal law
EXISTING LAW bases much of the tax code on the federal
Internal Revenue Code. California does not automatically
conform to new federal legislation. Rather, California may
conform to specific enactments at the federal lever, or may
conform to the IRC as of a specified date. The latest IRC
to which California has conformed is that in effect as of
January 1, 2001. Since the last "date change" legislation,
California has adopted several provisions of federal
legislation, but there remain many federal tax provisions
representing selected areas of nonconformity, as explicitly
stated in the California Revenue & Taxation Code.
THIS BILL generally conforms California personal
income tax and corporation tax laws to federal tax laws as
set forth in the Internal Revenue Code as of January 1,
2005, with specific exceptions. Specifically, the bill:
Conforms to may provisions of the numerous
federal tax bills that have been enacted since the
last conformity date, including: (1) expansion of
the exclusion from income for qualified foster care
payments and (2) creation of Health Savings
Accounts.
Adopts the uniform definition of "child,"
extension of provisions regarding Archer MSAs, and
technical amendments related to the Working Families
Tax Relief Act of 2004 (WFTRA).
Conforms to numerous provisions of the American
Jobs Creation Act of 2004 (AJCA), including: (1)
miscellaneous technical and administrative
provisions dealing with S corporations and real
estate investment trusts; (2) transfers of certain
AB 115 - Klehs
Page 5
losses relating to divorce; (3) special rules for
livestock sold on account of weather-related
conditions; (4) expensing of reforestation
expenditures; (5) modification of class life of
certain track facilities; (6) changes related to
charitable deductions including limitations on the
amount of deduction for contributions of motor
vehicles, boats and airplanes to the amount the
charity receives on subsequent sale; (7) provisions
related to reportable transactions and tax shelters;
(8) limitation of employer deductions for
entertainment expenses; (9) provisions allowing
current expensing of capital costs relating to
compliance with EPA sulfur regulations; (9) credits
related to the EPA regulations.
Does NOT conform to various provisions,
including: (1) various depreciation-related
provisions; (2) provisions related to foreign
corporations and foreign tax credits; (3) deductions
for dividends repatriated to the United States form
foreign subsidiaries.
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FISCAL EFFECT:
Franchise Tax Board prepared the following estimates:
-------------------------------------------------------------
| | Revenue Impact ($ |
| | Millions) |
| | |
-------------------------------------------------------------
|------------------------------------+--------+-------+--------|
| |2005-06 |2006-07|2007-08 |
| | | | |
| | | | |
|------------------------------------+--------+-------+--------|
|Expansion of exclusion from income |-$4 |-$3 |-$3 |
|for qualified foster care payments | | | |
| | | | |
|------------------------------------+--------+-------+--------|
|Deduction of student loan interest |0 |-8 |-15 |
| | | | |
|------------------------------------+--------+-------+--------|
|Health Savings Accounts |-29 |-18 |-23 |
| | | | |
|------------------------------------+--------+-------+--------|
|Uniform definition of "child" and |-10 |-7 |-7 |
|other WFTRA provisions | | | |
| | | | |
|------------------------------------+--------+-------+--------|
|Miscellaneous provisions of AJCA |+30.4 |+39.1 |+37.2 |
| | | | |
|------------------------------------+--------+-------+--------|
|Conformity with EPA sulfur |-.4 |-1.1 |-1.2 |
|regulation, etc. | | | |
| | | | |
|------------------------------------+--------+-------+--------|
|TOTALS |-$13 |$2 |-$12 |
| | | | |
--------------------------------------------------------------
COMMENTS:
AB 115 - Klehs
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A. Purpose of the bill
The author indicates that there have been no fewer
than five federal tax bills during the period since
California last conformed its tax laws to the IRC.
California has adopted some of the tax law changes in a
piece-meal fashion, but has not considered a general
conformity measure for several years. Federal tax
legislation enacted in late 2004 was so substantial as to
warrant serious consideration of a "date change" conformity
measure. The author proffers this "date change" conformity
measure so that California will be one step closer to
federal tax law, which should enhance compliance with the
California tax laws.
B. Why conform with federal tax laws?
Failure to conform to federal law in some areas but
not in other related areas can be confusing and may lead to
improper tax reporting to California. Other areas of tax
law should be adopted so that taxpayers who follow federal
laws will not automatically violate California laws. An
example is the ability to roll-over balances in an Archer
MSA to a new HSA without triggering liability at the
federal level, but would constitute a disqualified
distribution for state purposes, subjecting taxpayers to
tax and penalties for the transfer.
Another desirable area of conformity involves
definitions. For example, the federal tax law adopted a
uniform definition of "child" for purposes of all
provisions that provide tax benefits with respect to
children (including head of household filing status,
dependent care credit, child care credit, earned income
credit, and the dependency exemption). The state and
federal statutes use differing definitions or separate
criteria, which cause some persons to be classified as a
child for some tax purposes but not for others.
C. Health Savings Accounts
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HSAs were created by the Medicare bill signed by President
Bush on December 8, 2003 and are designed to help
individuals save for future qualified medical and retiree
health expenses on a tax-free basis. Opponents of these
accounts are concerned that it could result in employers no
longer offering low deductible health plans, opting for
high deductible plans instead, and shifting the costs to
employees. The opponents further state that "high
deductible health plans and savings accounts hurt poor
people who simply cannot afford to buy high deductibles and
are barely making ends meet." Opponents further state that
HSAs are an example of adverse selection where one healthy
group of people is more likely to use the high deductible
programs than a less healthy group of people that cannot
afford the deductibles.
Proponents, however, note that this type of product offers
consumers another option and flexibility when making health
care coverage choices.
The committee may wish to consider amending this provision
out of the bill in order to consider the policy issues.
D. Tax Credit for Sulfur
The credit for sulfur operates in the following manner:
The credit is awarded as follows:
Between January 1, 2006-January 1, 2018 there would
be a tax credit equal to five cents for each gallon of
ultra low sulfur diesel produced. The credit cannot
exceed 25% of the qualified capital costs.
Qualified Capital Costs mean item that has been
certified by CARB under compliance with the EPA or
CARB regulations (Highway Diesel Fuel Sulfur Control
Requirements) of reducing sulfur particulates from 500
to 15.
Small refiner (for California purposes) is:
A refiner that since 1978 has not had a capacity
greater than 55,000 per stream day.
Has not owned another refiner that produces more
than 55,000 per stream day
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Has not been owned by a refiner that has a capacity
greater than 137,500 barrels per stream day
The in-lieu deduction works as follows:
Small refiners may elect to deduct 75% of the
qualified capital costs paid or incurred during the
period beginning on January 1, 2004 and ending on
January 1, 2009. The basis of the items would be
required to be reduced by the amount deducted during
the taxable year.
Discussion of the Credit
California does not automatically conform to federal law;
however, the state attempts to conform to items that make
the administration of taxes easier. Credits, as a general
rule, have not fallen into this category. This committee
generally analyzes credits based on the effect they will
have on behavior and whether they will provide an economic
incentive. This credit certainly provides an economic
reward which proponents state will increase state revenues
by $40 million. However, it is unclear whether this credit
will have an effect on behavior; that is, between the
in-lieu depreciation and the fact that the credit complies
with existing regulation, refiners seem to have no choice
but to comply.
E. Alternatives to the H.S.A. Provisions
Passive Activity Losses
On May 2, 2005 this bill included provisions to conform to
the exception for passive activity loss rules for real
estate professionals; that provision was subsequently
amended out of the bill.
The passive activity loss (PAL) rules limit deductions and
credits from passive trade or business activities.
Deductions attributable to passive activities, to the
extent they exceed income from passive activities,
generally may not be deducted against other income, such as
wages, portfolio income, or business income that is not
derived from a passive activity. A similar rule applies to
credits. Deductions and credits that are suspended under
these rules are carried forward and treated as deductions
and credits from passive activities in the next year. The
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suspended losses from a passive activity are allowed in
full when a taxpayer disposes of his or her entire interest
in the passive activity to an unrelated person.
The PAL rules apply to individuals, estates, trusts,
closely held C corporations, and personal service
corporations. A special rule permits closely held C
corporations to apply passive activity losses and credits
against active business income (or tax liability allocable
thereto) but not against portfolio income.
Passive activities are defined to include trade or business
activities in which the taxpayer does not materially
participate. Rental activities (including rental real
estate activities) are also treated as passive activities,
regardless of the level of the taxpayer's participation. A
special federal rule permits the deduction of up to $25,000
of losses from rental real estate activities (even though
they are considered passive), if the taxpayer actively
participates in them. This $25,000 amount is allowed for
taxpayers with adjusted gross incomes (AGI) of $100,000 or
less, and is phased out for taxpayers with AGI between
$100,000 and $150,000.
Conformity would provide an exception to passive activity
loss rules for real estate professionals.
The fiscal effect on this provision would be $35 million
loss in 2005-06; and a $25 million loss thereafter.
Real Estate Withholding
Before the 2002 Budget Act, nonresidents who sold
California real estate were subject to withholding on the
proceeds; the buyer of the property was required to
withhold 3 1/3% of the sales price and remit the money to
FTB by April 15th of the following year. The Budget Act
intended to subject residents to the same treatment of
withholding as nonresidents. The new law, however,
requires the purchaser to withhold 3 1/3% of the property
sales price and withhold 3 1/3% at the time of sale.
The committee may wish to consider amending this law to
allow the taxpayer to withhold either 3 1/3% of the sales
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price or the marginal rate of the profit.
The revenue loss associated with this provision would be
$35 million in the 2005-06 budget year and $4 million each
year thereafter.
Support and Opposition
Support:Franchise Tax Board
Kern Oil & Refining Co.
Paramount Petroleum
Oppose:California Tax Reform Association (H.S.A.
Provision)
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Consultants: Martin Helmke & Gayle Miller
08/16/05 16:15