BILL ANALYSIS AB 1178 Page 1 Date of Hearing: January 11, 2010 ASSEMBLY COMMITTEE ON REVENUE AND TAXATION Charles M. Calderon, Chair AB 1178 (Block) - As Amended: January 6, 2010 Majority vote. Tax levy. Fiscal committee. SUBJECT : Water's-edge election: sales and use taxes: exemption. SUMMARY : Requires multinational corporations that elect to file tax returns based only on income earned inside the United States (U.S.), known as the water's-edge method, to include, for tax years beginning on or after July 1, 2011 and before July 1, 2014, the income of a related corporation located in a tax haven country. Provides a partial exemption from the sales and use taxes (SUT), on and after July 1, 2011, and before January 1, 2015, for the purchases of college textbooks and supplies by college students, as defined. Specifically, this bill : 1)Requires a corporate taxpayer, for taxable years beginning on and after July 1, 2011, and before July 1, 2015, to include in the taxpayer's water's-edge return the entire income and apportionment factors of any affiliated corporation that was doing business in, or had income derived from or attributable to, a tax haven. 2)Defines the term "tax haven" by reference to 39 jurisdictions identified as tax havens by the Organization for Economic Cooperation and Development (OECD) as of December, 2002. 3)Allows a taxpayer to petition the Franchise Tax Board (FTB) to exclude the income and apportionment factors of a tax haven corporation from the water's-edge return if that corporation's activities in a tax haven jurisdiction constitute either a "substantial economic presence" or " significant economic activity." 4)Authorizes the FTB to prescribe regulations necessary to carry out the purposes of this bill. 5)Requires the FTB to issue a notice identifying the jurisdictions that are considered tax havens. AB 1178 Page 2 6)Requires the Legislative Analyst, in consultation with the FTB, to conduct a study regarding the jurisdictions identified by the OECD as tax havens and report to the Legislature no later than January 1, 2011, as to whether the definition of the term "tax haven" should be revised. 7)Provides a partial exemption from SUT, on and after July 1, 2011, and before January 1, 2015, for the sale of, and the storage, use, or other consumption of, textbooks and supplies purchased by a student enrolled in an institution of higher education. Specifically, it provides that: a) For purchases made between July 1, 2011, and before July 1, 2012, the state portion of SUT otherwise applicable to those purchases is reduced to 2%. b) Purchases made on or after July 1, 2012, and before January 1, 2015, are exempted from the state portion of SUT. c) The exemption does not apply to any of the following taxes: i) Tax imposed pursuant to Revenue and Taxation Code (R&TC) Section 6051.2 and Section 6201.2, dedicated to local governments to fund health and welfare programs (Local Revenue Fund); ii) Tax imposed pursuant to R&TC Section 6051.5 and Section 6201.5, dedicated to the repayment of the Economic Recovery Bonds (Fiscal Recovery Fund); iii) Tax imposed pursuant to Section 35 of Article XIII of the California Constitution, dedicated to local government to fund public safety services (Local Public Safety Fund); and, iv) Any tax levied by a county, city, or district pursuant to the Bradley-Burns Uniform Local SUT Law or the Transactions and Use Tax Law. 8)Defines "institution of higher education" as the University of California, the California State University, or a California community college. AB 1178 Page 3 9)Defines "supplies" as pens, paper, blue books, notebooks, art supplies, uniforms, safety equipment, tools, computer paper, and flash drives necessary for the course of study in which a student is enrolled at the institution of higher education. The definition of "supplies" does not include computers, printers, or related hardware and software. 10)Defines "textbooks" as any published material that is principally designed for use by a student at an institution of higher education as a source of instructional material and includes any book or edition of a book that is directed or recommended by an instructor at an institution of higher education to a student to purchase for use as a basis for a course of study in which that student is enrolled at that institution. 11)Takes effect immediately as a tax levy. EXISTING FEDERAL INCOME TAX LAW : 1)Imposes a tax on all of the U.S. corporation's income, regardless of source and allows a credit for any taxes paid to a foreign country on its foreign-source income. 2)Imposes taxes on "Subpart F income" of a controlled foreign corporation (CFC). Defines "Subpart F income" as passive income, such as dividends, interest, royalties and rents, as well as shipping income, oil related income, insurance income, and income from certain sales of goods that neither manufactured nor sold for use in the CFC's home country. Defines a "CFC" as a foreign company 50% of which is owned by U.S. shareholders. 3)Provides that a foreign corporation may be subject to tax on its U.S.-source income (income derived from sources within the U.S.). U.S.-source income includes income earned by a foreign corporation's sales office located in the U.S., royalties paid from a U.S. corporation to a foreign corporation, and interest paid from a U.S. corporation to a foreign corporation. EXISTING STATE LAW : 1)The Corporation Tax Law: AB 1178 Page 4 a) Imposes an annual tax on corporations measured by income sourced to California, unless otherwise exempted. Income sourced to California from corporations operating both within and outside of the state is determined on a worldwide basis applying the unitary method of taxation. The unitary method combines the income of affiliated corporations that are members of a unitary business and apportions the combined income to California based upon the average of four factors (the property factor, the payroll factor, and two sales factors). This four-factor formula identifies the relative levels of business activity in the state and apportions the combined income to California using the determined share of California business activity. For taxable years beginning on or after January 1, 2011, certain corporate taxpayers may make an annual election to apportion its income to California using a single sales factor apportionment formula. Corporations that are engaged in agricultural, extractive, savings and loan, and banking or financial business activities are prohibited from electing the single sales factor apportionment formula. b) Allows taxpayers with worldwide business activities to elect to report income to California on a water's-edge basis. Taxpayers that make a water's-edge election include income and apportionment factors of businesses operating only within the U. S., plus a few other jurisdictions, thereby generally excluding the income and apportionment factors of most foreign affiliates. In exchange for this election to file on a water's-edge basis, a taxpayer agrees to file consistently using the water's-edge method for at least seven years. c) Provides that the entire income and apportionment factors of certain affiliated entities, which are unitary with an entity that is the water's-edge taxpayer, are includable in the water's-edge return. The list of affiliated entities includes a foreign incorporated entity (other than banks) if the average of its property, payroll, and sales factors within the U.S. is 20% or more. Even if the average is less than 20%, the foreign corporation's income and apportionment factors would still be incorporated in a water's-edge return to the extent its U.S.-source income and its apportionment factors are assignable to a location within the U.S... Furthermore, AB 1178 Page 5 the list also includes a CFC with Subpart F income. The income and apportionment factors of a CFC are included in the water's-edge return based on a ratio of the CFC's current year Subpart F income determined under federal law to the CFC's current earnings and profits. 2)The SUT Law: a) Imposes a sales tax on retailers for the privilege of selling tangible personal property (TPP), absent a specific exemption. The tax is based upon the gross receipts from sales of TPP in this state. b) Imposes a use tax on the storage, use, or other consumption in this state of TPP purchased from any retailer for storage, use, or other consumption in this state, absent a specific exemption. c) Provides that the sale of books and school supplies are subject to the SUT to the same extent as the sale of any other TPP not specifically exempted or excluded from SUT by statute. FISCAL EFFECT : The FTB staff estimates that the water's-edge provisions of this bill will result in an annual gain of $70 million in the fiscal year (FY) 2011-12, $120 million in FY 2012-13, and $120 million in FY 2013-14. The State Board of Equalization (BOE) staff estimates that SUT provisions of this bill will result in an annual loss of $70 million in FY 2011-12, $122 million in FY 2012-13, $128 million in FY 2013-14, and $48 million in FY 2014-15. COMMENTS : 1)The Author's Statement . The author states that, "AB 1178 would close a loophole currently used by corporations that set up affiliates in listed tax haven countries to primarily park their income to avoid paying their equitable share of California taxes. These corporations' tax evasions through this loophole result in fewer dollars for education, health, and public safety programs on which Californians depend. The Franchise Tax Board (FTB) estimates that closure of this loophole would generate approximately $120 million per year in additional revenue to help address the substantial increased costs to students and families in obtaining a higher AB 1178 Page 6 education. The bill would simultaneously reduce the sales tax burden imposed on textbooks and supplies purchased by students at a UC, CSU, or California Community College store by a partial exemption of the state sales tax. According to the Board of Equalization, this would result in a reduction of approximately $120 million per year in revenue. Therefore, this bill would yield no net change in state revenue, while it improves the affordability of materials required by students to attend public higher education institutions. Local sales tax revenues would not be affected." 2)Arguments in Support . The proponents of this bill argue that, "as California prepares to make more devastating cuts to social and human services programs in 2010, the necessity to shut down abusive off-shoring practices that simply pad the bottom lines of multibillion dollar corporations has never been greater." Proponents believe that moneys derived from closing corporate tax loopholes could be put to better use as tax relief for already struggling college students in California. 3)Arguments in Opposition . The opponents state that this bill runs contrary to the intent of the water's-edge election, could adversely impact foreign relations, and would penalize California-based U.S. companies for doing business in certain countries with which the U.S. has diplomatic ties. The opponents argue that this bill violates the Foreign Commerce Clause, has no definition of "substantial economic presence" or "significant economic activity," provides for no process to appeal FTB's determination, and potentially subjects unsuspecting taxpayers to a 20% corporate understatement penalty for behavior that they did not know was improper upon filing the original return. 4)What Exactly Does this Bill Propose to Do ? This bill does two things: it partially exempts from SUT the purchases of textbooks and supplies by college students and it revises the water's-edge provisions to include the income and apportionment factors of affiliated companies that are doing business in, or derive income from, a tax haven country. 5)The partial SUT exemption . The proposed exemption would apply only to textbooks and supplies purchased by students enrolled in the University of California, the California State University, or a California community college. Furthermore, AB 1178 Page 7 only textbooks required or recommended for a course at an eligible institution would be exempted from SUT. The intent of this bill is to make college textbooks and supplies more affordable for college students. However, purchases by students enrolled in a private university or college would not be eligible for this exemption. Under current law, the statewide base SUT rate is 8.25%, which is comprised of 5% General Fund (GF) state rate, 1% GF state rate (until July 1, 2011), 0.25% Fiscal Recovery Fund rate, 0.50% Local Revenue Fund rate, 0.50% Local Public Safety Fund rate, 0.75% city and county operations rate and 0.25% county transportation rate. In addition to the statewide base rate of 8.25%, cities and counties are authorized to impose additional voter-approved taxes. This bill would reduce the state rate of 5% to 2% for purchases of eligible textbooks and supplies between July 1, 2011 and June 30, 2012. On and after July 1, 2012 and until January 1, 2015, those purchases would be completely exempted from the state portion of SUT. However, this partial exemption would not apply to the Bradley-Burns local taxes, transactions and use taxes, the 0.25% tax dedicated to the repayment of Economic Recovery Bonds, the 0.50% dedicated to local government for funding of local health and welfare programs or the 0.50% tax dedicated to funding local public safety services. 6)The Water's-Edge Provision . Under existing law, a corporate taxpayer with worldwide business activities may elect to report income to California on a "water's-edge" basis. A water's-edge election, generally, allows the taxpayer to exclude from its tax return the income and apportionment factors of taxpayer's foreign affiliates. Currently, in order to be included in the taxpayer's water's-edge return, a foreign affiliated company must be a domestic international sales corporation, a foreign sales corporation, an export trade corporation, a CFC with Subpart F income, or must have U.S.-source income or some U.S. presence (i.e. an average of the property, payroll, and sales factors within the U.S. of 20% or more). This bill would expand the list of foreign affiliated companies whose income and apportionment factors must be included in the taxpayer's water's-edge tax return. It would require any foreign affiliated company doing business in, or deriving income attributable to, a tax haven country to AB 1178 Page 8 be on that list, which means that a foreign company that has neither U.S.-source income nor U.S. presence (no payroll, property or sales factor) would qualify for the inclusion. Furthermore, all income and apportionment factors of a CFC would be included in the taxpayer's return, instead of the percentage based on the ratio of its Subpart F income to the current year earnings and profits. It should be remembered, however, that this proposal would apply only to the taxpayer's affiliated foreign companies, i.e. companies that are members of a commonly controlled group, that are unitary with the taxpayer. 7)What is the Problem with Having an Affiliated Corporation in a Tax Haven Country ? Some corporations and individuals use tax havens to avoid payment of U.S. taxes. Generally, a tax haven is a foreign jurisdiction that maintains corporate, bank, and tax secrecy laws and industry practices that make it very difficult for other countries to find out whether their citizens are using the tax haven to avoid paying their taxes. (Statement of U.S. Senator Carl Levin on Introducing The Stop Tax Haven Abuse Act, Tax Analyst, December 2009, p. 4). Data released by the Commerce Department indicates that, as of 2001, almost half of all foreign profits of U.S. corporations were in tax havens. Further, a study released by Tax Notes, September 2004, found that American companies were able to shift $149 billion of profits to 18 tax haven countries in 2002, up 68% from $88 billion in 1999. In January 2009, a report issued by the Government Accounting Office (GAO) shows that out of the 100 largest U.S. publicly traded corporations, 83 have subsidiaries in tax havens. For example, Morgan Stanley has 273, Citigroup has 427, and Oracle has 77 tax haven subsidiaries. U.S. Senator Levin, in his statement, gives a simplified example of how U.S. corporations may transfer taxable income from the U.S. to tax havens to escape taxation. He states that, "Suppose a profitable U.S. corporation establishes a shell corporation in a tax haven. The shell corporation has no office or employees, just a mailbox address. The U.S. parent transfers a valuable patent to the shell corporation? [and then] begin to pay a hefty fee to the shell corporation for use of the patent, reducing its U.S. income through deducting the patent fees and thus shifting taxable income out of the United States to the shell corporation. The shell corporation declares a portion of the fees as profit, but pays no U.S. tax AB 1178 Page 9 since it is a tax haven resident." In addition, the shell corporation may lend its funds to the U.S. parent that, in turn, will pay interest on the loan to the shell corporation, shifting more taxable income out of the U.S. to the tax haven. Often, those subsidiaries of U.S. companies are shell corporations that are engaged in no or very little business activity." (Id, at p. 6). Since tax haven countries have no or nominal taxes, some U.S. corporations have aggressively set transfer prices (i.e. prices that related companies charge on intercompany transactions) to move income to offshore jurisdictions to avoid U.S. taxes. As discussed, under existing California law, income and apportionment factors of those companies located in tax haven countries are not included in the water's-edge return of the related U.S. company, unless they fall within the definition of certain affiliated entities. Consequently, corporations that manage to shift some of its income to their subsidiaries or other affiliated companies in tax haven countries will pay less tax to California. 8)Proposed Federal Legislation . Section 103 of the proposed federal Stop Tax Haven Abuse Act (Act) would deny tax benefits for foreign corporations managed and controlled in the U.S... It focuses on the situation where a corporation is incorporated in a tax haven as a mere shell operation with little or no physical presence or employees in the jurisdiction. The impetus for this legislation came from a hearing held by the U.S. Senate Finance Committee in July 2008. The Committee considered the findings made by the GAO with regard to the infamous Ugland House, a five-story building that is located in the Cayman Islands and is the official address for over 18,800 registered companies. The GAO determined that about half of the alleged Ugland House tenants have a billing address in the U.S. and were not actual occupants of the building. In fact, the GAO found that none of the nearly 19,000 companies registered at the Ugland House was an actual occupant. The only occupant of that building was a Cayman law firm that established and registered those companies. Section 103 of the Act states that, if a corporation is publicly traded or has aggregate gross assets of $50 million or more, and its management and control occurs primarily within the U.S., then that corporation will be treated as a U.S. domestic AB 1178 Page 10 corporation for income tax purposes. Section 103 provides an exception for foreign corporation with U.S. parents but makes clear that mere existence of a U.S. parent corporation is not sufficient to shield a foreign corporation from being treated as a domestic corporation. According to U.S. Senator Levin, the proposed federal legislation "would put an end to the unfair situation where some U.S.-based companies pay their fair share of taxes, while others who set up a shell corporation in a tax haven are able to defer or escape taxation, despite the fact that their foreign status is nothing more than a paper fiction." (Statement of Senator Carl Levin on Introducing The Stop Tax Haven Abuse Act, Tax Analyst, December 2009, p. 13). The Act requires the Secretary of the Treasury to identify offshore secrecy jurisdictions, based upon the practical experience of the Internal Revenue Service (IRS) in obtaining needed information from the relevant country, but it lists 34 offshore jurisdictions taken from the actual IRS court filings in court proceedings as a starting point. 9)List of Tax Haven Countries . In its report titled "Large U.S. Corporations and Federal Contractors with Subsidiaries in Jurisdictions Listed as Tax Havens or Financial Privacy Jurisdictions," December 2008, the GAO identified three sources listing tax havens: The OECD, a National Bureau of Economic Research working paper (NBER), and a U.S. District Court order granting leave for the Internal Revenue Service to serve a "John Doe" summons. In a report issued in 2000, the OECD identified over 40 jurisdictions as tax havens according to criteria it had established. The four key factors were (a) no or nominal tax on the relevant income, (b) lack of effective exchange of information, (c) lack of transparency, and (d) no substantial activities. Between the year 2000 and May 2009, all of those jurisdictions made formal commitments to implement the OECD's standards of transparency and exchange of information. As a result, no jurisdiction is currently listed as an un-cooperative tax haven by the OECD's Committee on Fiscal Affairs. However, the OECD list of tax haven is still valid, even though it should be seen in its historical context. The NBER paper identified 40 tax havens, based on a 1994 article in The Quarterly Journal of Economics. AB 1178 Page 11 10)Implementation Concerns and Considerations . In its analysis of this bill, FTB staff noted a few implementation considerations and suggested amendments to resolve certain technical concerns. Specifically, FTB staff noted that the terms "doing business in a tax haven," "substantial economic presence" and "significant economic activity" are not defined, which could lead to disputes between taxpayers and FTB and would complicate the administration of the water's-edge provisions. Another suggestion of FTB to list all of the tax haven countries in this bill because FTB staff was unable to confirm the OECD's December 2002 list of tax havens. Finally, FTB staff recommended that the author consider adding the language to prescribe the form and manner of a petition that a taxpayer may file with the FTB to exclude the income and apportionment factors of a tax haven corporation from the water's-edge return. The staff at BOE observes that a partial exemption to SUT would create administrative burdens for both BOE and the retailer. The affected retailer would have to determine, first, if the purchaser was a qualified student enrolled in at a specified college or university, calculate the applicable SUT and then segregate these partially exempt sales from other sales in order to properly complete its SUT return. BOE staff also notes that the definition of "supplies" needs clarification and that the institution or course instructor would need to provide retailers with a list of required or recommended supply items, in order for BOE to administer the proposed exemption effectively. 11)Similar Legislation: Water's-Edge Provisions . AJR 12 (Block), introduced in the 2009 legislative session, would request that the President and the U.S. Congress enact legislation that closes the corporate federal tax loopholes relating to tax haven countries. AJR 12 is in the Senate Revenue and Taxation Committee. AB 34 (Ruskin), introduced in the 2005-06 legislative session, was nearly identical to AB 1178 and would have required taxpayers filing on a water's-edge basis to include the income and apportionment factors of affiliated corporations doing AB 1178 Page 12 business in, or having income derived from or attributable to, a tax haven. AB 34 failed to pass out of the Assembly. AB 441 (Chu), introduced in the 2005-06 legislative session, would have required a corporation that makes a water's-edge election to include the income and apportionment factors of certain foreign affiliates. AB 441 failed to pass out of the Assembly. SB 663 (Migden), Chapter 22, Statutes of 2006, clarified specific provisions of the franchise tax law relating to water's-edge taxpayer and reformed the water's-edge procedure by replacing existing rules creating a contract between the taxpayer and FTB with election procedures. SB 663 applies to a taxpayer making a water's-edge election on or after January 1, 2006, and to those taxpayers that made a water's-edge election before January 1, 2006, but not until the expiration of the seven-year period during which a taxpayer is prohibited from terminating that election without the consent of the FTB. 12)Similar Legislation: SUT Exemption for Purchases of Textbooks and Supplies . AB 2636 (Leonard), introduced in the 2001-02 legislative session, would have provided a state SUT exemption for the purchase of any instructional materials, as defined, by any qualifying school entity, as defined. AB 2636 was held under submission in this Committee. AB 1077 (Mountjoy), introduced in the 2001-02 legislative session, would have provided a state SUT exemption for the purchase of any TPP by a K-12 public school or school district for use by that school or district. AB 1077 was held under submission in this Committee. AB 1246 (Leonard), introduced in the 2001-02 legislation session, would have provided a SUT exemption for any textbook that is purchased by a student at an institution of higher education or from an entity whose primary purpose is to provide textbooks to students attending institutions of higher education, for use as a learning resource in any course of study at that institution. AB 1246 was held under submission in the Assembly Committee on Appropriations. AB 1178 Page 13 SB 546 (McClintock), introduced in the 2001-02 legislative session, would have provided a SUT exemption for the sale and purchase of any textbook, as defined, purchased by a K-12 public school or school district, or an accredited private school, or sold to a student of an accredited private school or institution of higher education. SB 546 failed passage in the Senate Revenue and Taxation Committee. 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