BILL ANALYSIS AB 1178 Page 1 Date of Hearing: January 21, 2010 ASSEMBLY COMMITTEE ON APPROPRIATIONS Kevin De Leon, Chair AB 1178 (Block) - As Amended: January 13, 2010 Policy Committee: Revenue and Taxation Vote: 5-3 Urgency: No State Mandated Local Program: No Reimbursable: SUMMARY This bill (a) requires multinational companies to include operations located in foreign "tax havens" in their combined income report for California's corporation tax, and (b) provides a partial sales and use tax exemption for purchases of textbooks and supplies by students of the University of California (UC), California State Universities (CSU), and California Community Colleges (CCC). FISCAL EFFECT 1)No impact in 2010-11. 2)According to FTB, the corporate tax provisions will raise revenues by $70 million in 2011-12, $120 million in 2012-13 and in 2013-14, and $50 million in 2014-15. 3)According to BOE, the sale exemption for textbooks and supplies will reduce revenues by $70 million in 2011-12, $122 million in 2012-13, $128 million in 2013-14, and $48 million in 2014-15. SUMMARY (Continued) Specifically, the bill: 1)Requires multinational corporations that elect to file tax returns based only on income earned inside the U.S., known as the water's-edge method, to include the income and operations of affiliates doing business in tax-haven countries in its combined income reports. AB 1178 Page 2 2)Defines the term "tax haven" by reference to jurisdictions identified in Table 1 of Appendix I to the December 2008 Report of the United States Government Accountability Office (GAO) on International Taxation. 3)Allows a taxpayer to petition the Franchise Tax Board (FTB) to exclude the income and operations of an affiliated corporation doing business in a tax haven from the water's-edge return if that corporation is engaged in the active conduct of a trade or business in the tax haven. 4)Requires the Legislative Analyst, in consultation with the FTB, to conduct a study regarding whether the jurisdictions identified by the GAO are appropriate, or whether the definition of the term "tax haven" should be revised. 5)Provides an exemption from part or all of the GF portion of the sales and use tax for textbooks and supplies purchased anywhere by students of UC, CSU, and CCC. The first three percent of the portion sales tax would be exempt between July 1, 2011 and June 30, 2012, and the full five percent portion would be exempt from July 1, 2012 through December 31, 2014. 6)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. 7)Defines "textbooks" as any published material that, among other things, is principally designed for use by a student at an institution of higher education as a source of instructional material. 8)Specifies that the provisions affecting corporate taxes are in effect for tax years beginning on or after July 1, 2011 and before July 1, 2014. Provisions affecting the sales tax are in effect from July 1, 2011 through December 31, 2014. COMMENTS 1)Rationale . According to the author, the purpose of the bill is to close a corporate loophole and use the proceeds to AB 1178 Page 3 provide financial relief to higher education students who have faced major fee increases and financial hardship. The author asserts that the corporate loophole has resulted in fewer dollars for education, health, and public safety programs. He also indicates that the fiscal effects of the bill's two provisions are largely offsetting, thereby placing no significant burden on the GF. 2)Opponents , including the California Taxpayers' Association and a variety of business groups, 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. 3)Background - combined income reporting and water's edge election . A key issue relating to state-level corporation franchise taxes involves the determination of California income for large companies (and affiliated groups of companies) that have operations throughout the country or around the world. Given the numerous challenges involved in separately determining receipts and expenses that are attributable to a multi-jurisdictional company's operations in each state, California and virtually all other states levying a corporation tax determine the income attributable to each state through a two-step process. This involves (a) calculation of combined income from all the company's operations, and (b) apportionment of the combined income to the state using formulas that take into account the state's share of the companies' combined property, payroll, and sales, or some subset of these factors. Since 1987, California has allowed corporate taxpayers with worldwide business activities to elect to report on a "water's-edge" basis. A water's-edge election allows the taxpayer to exclude from its tax return the income and apportionment factors of taxpayers' foreign affiliates. However, there are certain exceptions to this foreign exclusion, such as income from a domestic international sales corporation, a foreign sales corporation, an export trade corporation. This bill would add affiliated companies doing business in a tax haven country to the list of foreign operations that must be included in the combined income report of a company electing to report on water's edge basis. AB 1178 Page 4 4)Background - tax havens . Generally, a tax haven is a foreign country that maintains corporate, bank, and tax secrecy laws and industry practices that make it difficult for other countries to find out whether their citizens are using the tax haven to avoid paying their taxes. Such havens also generally have low or non-existent taxes on income and royalties. In a report issued in 2000, the Organization for Economic Cooperation and Development (OECD) identified over 40 jurisdictions as tax havens. U.S. companies can use affiliated companies in tax havens to minimize their U.S. tax liabilities in a variety of ways. As one example, they can set prices on assets transferred between the two entities at levels that artificially reduce profits of U.S. operations and raise profits of the affiliate in the low- or no-tax region. As another example, a U.S company and its financial subsidiary operating in a tax haven can set the terms of a loan in a way that shifts income out of the U.S. Under existing California law, the income and apportionment factors of affiliated tax haven companies are generally not included in the water's-edge return of the California company, unless the affiliated companies themselves have economic presence in California. Consequently, corporations that manage to shift some income to these subsidiaries will pay less tax to California. Analysis Prepared by : Brad Williams / APPR. / (916) 319-2081