BILL ANALYSIS Senate Appropriations Committee Fiscal Summary Senator Christine Kehoe, Chair 759 (Ma) Hearing Date: 08/27/2009 Amended: 07/15/2009 Consultant: Mark McKenzie Policy Vote: Rev&Tax 5-3 _________________________________________________________________ ____ BILL SUMMARY: AB 759 would simplify the method used to report a water's-edge taxpayer's portion of its "controlled foreign corporation" (CFC) income under the Corporation Tax Law by conforming to the federal Subpart F rules for computing the amount of income that is included in a shareholder's income. This bill would also prohibit a foreign incorporated entity domiciled in a jurisdiction that does not have an income tax treaty in force with the United States from contracting with a state agency. _________________________________________________________________ ____ Fiscal Impact (in thousands) Major Provisions 2009-10 2010-11 2011-12 Fund Water's-edge provision $100 $400 $400 General FTB audits/administration potentially significant administrative savings General Expatriate corporationsunknown, potential increase in state contract Various costs to the extent more companies are prohibited from contracting with the state (see staff comments) _________________________________________________________________ ____ STAFF COMMENTS: SUSPENSE FILE. Water's-edge provision Existing federal law generally requires a U.S. corporation to be taxed on all of its income, and provides a credit for taxes paid to a foreign country. Foreign corporations only file returns in the United States for income effectively connected with a trade or business in the United States, or income from specified U.S investments, called noneffectively connected income. Existing federal law also defines a "controlled foreign corporation" (CFC) as any foreign corporation with more than 50 percent ownership held by U.S. shareholders. Federal law guiding CFCs, known as "Subpart F," seeks to curtail abuses where companies assign income to offshore tax havens. U.S shareholders must include income from CFCs, and federal law treats that income as a dividend paid by the CFC. A U.S. shareholder's income from a CFC cannot exceed the CFC's earnings and profits for that year. Existing state law uses the "world-wide unitary method" for purposes of identifying the taxable income of all multinational corporations doing business in California. Taxpayers file a combined report for the unitary group or subsidiaries and affiliates showing income, payroll, property and sales both in California and worldwide, and the amount attributable to California is calculated for taxation purposes. Alternatively, state law allows corporations to determine their business income on a "water's edge" basis, which generally excludes foreign corporations from the calculation of business income but does not exclude CFCs with Subpart F income. Page 2 AB 759 (Ma) Existing state law conforms to federal definitions of CFC and U.S shareholder, but does not conform to federal Subpart F income provisions, instead requiring a CFC to include a portion of its net income and apportionment factors included in the water's edge filing based on an inclusion ratio, which determines the amount of a CFC's business and non-business income and apportionment factors (property, payroll, and sales) a taxpayer includes in the tax return. AB 759 would delete California's current law for calculating CFC income by deleting the inclusion ratios and instead conform to federal Subpart F provisions that specify the amount of a CFC's subpart F income included in a water's edge taxpayer's income would be treated as a "deemed dividend," and could be excluded under the state's dividend exclusion and deduction laws. The measure would allow a 27% dividend deduction against the CFC's Subpart F income that is included in the water's-edge taxpayer's income. Any income previously taxed as Subpart F income before the bill's effective date would be deemed previously taxed for state purposes, and federal adjustments to the CFC's stock basis would become the new stock basis for state purposes. This bill also specifies that state law does not conform to rules guiding the gain from certain sales or exchanges of CFC stock, the temporary 85% divided received deduction from CFCs, or the foreign tax credit. When a taxpayer terminates a water's edge election, Subpart F rules no longer apply and only the previously taxed income and stock basis adjustments remain the same. Staff notes that the revenue impact of this provision would depend on the difference in the amounts included in the water's edge group tax filing under current state law, which provides for partial inclusion of Subpart F income and unitary factors, as opposed to provisions of federal law, which specifies that Subpart F income is treated as dividends. The particular dividend reduction percentage was specifically chosen to minimize the net impact on corporation tax revenues. Using a statistically representative sample of 2004 water's edge filers reporting CFC income on a foreign dividend deduction, FTB estimates that this provision would result in a tax revenue loss of approximately $100,000 in 2009-10 and $400,000 annually thereafter. Due to the complexity of calculations involving the treatment of Subpart F income, FTB has found particularly low compliance related to proper reporting requirements. Moreover, CFC inclusion ratios are burdensome to administer and FTB audit staff spend many hours recalculating incorrect methods used by taxpayers to include a CFC's income and factors in the water's edge group tax filing often only to discover that the audit adjustments have minor tax revenue impact. Staff notes that the simplified reporting requirements proposed by AB 759 would likely result in increased taxpayer reporting compliance and unknown administrative savings for FTB. Audit staff currently engaged in reviewing CFC taxpayer calculations could be utilized for more cost-beneficial purposes. AB 759 would simplify reporting of income from CFCs by changing from California's inclusion ratios to the simpler federal standard. FTB notes that although the net tax effect for this provision is roughly revenue neutral, more corporations in the sample pool of taxpayers reviewed by FTB would experience a decrease in tax liability. Specifically, Page 3 AB 759 (Ma) 44% would experience decreased tax liability while 25% would experience an increase and 31% would have a negligible impact. All affected corporations would benefit from the simplified reporting procedures. Expatriate corporations & state contracts Existing law prohibits the state from entering into any contract with an expatriate corporation, defined as a foreign incorporated entity that is publicly traded in the United States and to which all of the following apply: The United States is the principal market for the public trading of the foreign incorporated entity. The foreign incorporated entity has no substantial business activities in the place of incorporation compared to the business activity of its subsidiary or subsidiaries. The foreign entity was incorporated through a transaction or a series of transactions in which it acquired substantially all of the properties held by a domestic corporation or partnership and immediately after the acquisition more than 50 percent of the publicly traded stock was transferred to the same shareholders or partners that owned the domestic corporation or partnership. Existing law permits the chief executive of a state agency or a designee to waive the ineligibility of a vendor that meets the above test by making a written finding that the contract is necessary to meet a "compelling public interest." AB 759 would include a foreign incorporated entity domiciled in a jurisdiction that does not have an income tax treaty in force with the United States in the definition of "expatriate corporation," thereby prohibiting such an entity from contracting with the state, except as specified. The United States maintains an extensive network of bilateral income tax treaties that currently includes comprehensive treaties covering 66 countries. Bilateral income tax treaties remove barriers to cross-border investment and trade by allocating taxing jurisdiction between countries with residence-and source-based claims to tax the income from such investment and trade. Bilateral income tax treaties also provide a framework for the exchange of information between taxing authorities in an effort to prevent tax avoidance and evasion. This provision is intended to tighten the restrictions of the California Taxpayer and Shareholder Protection Act of 2003 [SB 640 (Burton), Chapter 657 of 2003] by expanding the definition of "expatriate corporation" for purposes of prohibiting state contracts with such entities. It is unknown whether the state contracts with any entities that are domiciled in a jurisdiction that does not have a bilateral tax treaty in force that currently do not fall under the definition of an "expatriate corporation." If this bill limits the number of bidders on some state contracts, there could be an increase in state contract costs due to reduced competition. These potential costs are unquantifiable.