BILL ANALYSIS                                                                                                                                                                                                    



                                                                  AB 1178
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          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.








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          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. 








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          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:









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             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,  








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               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  








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            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,  








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            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  








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            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  








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            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  








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            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.








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           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  








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            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. 
           








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          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. 

           REGISTERED SUPPORT / OPPOSITION  :   

           Support 
           
          California Labor Federation
          California Professional Firefighters

           Opposition 
           
          California Taxpayers' Association
          California Bankers Association
          California Chamber of Commerce
          California Manufacturers and Technology Association
          Council on State Taxation
          TechAmerica
          Western States Petroleum Association
           
          Analysis Prepared by  :  Oksana Jaffe / REV. & TAX. / (916)  
          319-2098