BILL ANALYSIS Ó AB 780 Page A Date of Hearing: May 2, 2011 ASSEMBLY COMMITTEE ON REVENUE AND TAXATION Henry T. Perea, Chair AB 780 (Charles Calderon) - As Amended: March 15, 2011 VOTE ONLY Majority vote. Fiscal committee. SUBJECT : Public contracts: fixed price contracts: sales and use taxes rate changes: transactions and use taxes SUMMARY : Requires a "fixed price" contract between a "government entity" and a contractor to authorize payment for a change in the contract price attributable to an increase or decrease in taxes imposed by the Sales and Use Tax (SUT) Law. Specifically, this bill : 1)Provides that this increase or decrease shall be paid in accordance with the provisions of the contract governing payment for changes in the work or, if no provisions are set forth, payment shall be as agreed to by the parties. 2)Applies only to an increase or decrease in the SUT rate imposed with respect to the following: a) Gross receipts from the sale of, and the storage, use, or other consumption in this state of, the following: i) Tangible personal property (TPP) obligated pursuant to a contract entered into for a "fixed price" before the operative date of the SUT rate change; or, ii) Materials and fixtures obligated pursuant to a construction contract entered into for a "fixed price" before the operative date of the SUT rate change. b) A lease of TPP, to a "government entity," that is a continuing sale of the property for any period of time for which the lessor is obligated to lease the property for an amount fixed by the lease before the operative date of the SUT rate change. AB 780 Page B c) The possession of, or the exercise of any right or power over, TPP pursuant to a lease, to a "government entity," that is a continuing purchase of the property for any period of time for which the lessee is obligated to lease the property for an amount fixed by a lease entered into before the operative date of the "increase in the ÝSUT] rate." 3)Defines "fixed price" to mean either of the following: a) "The price or prices specified in the contract or lease, and the contract or lease does not authorize an increase or decrease in price due to an increase or decrease in the ÝSUT] rate"; or, b) The prices or price specified in the construction contract is a lump sum price or a stated unit price or a guaranteed maximum price, and the construction contract does not authorize an increase or decrease in price due to an increase or decrease in the SUT rate. 4)Defines a "government entity" as the State of California, or any city, county, or city and county, community college district, school district, county superintendent of schools, or special district in this state. 5)Applies only to an increase or decrease in the SUT rate that occurs on or after the bill's effective date. 6)Provides that, if the SUT rate imposed pursuant to Revenue and Taxation Code (R&TC) Sections 6051.7 and 6201.7, or any portion thereof, is extended beyond July 1, 2011, the extension shall be regarded as an increase in the SUT rate for purposes of this bill. 7)Amends the Transactions and Use Tax (TUT) Law to provide that: a) The sale or lease of TPP shall not be deemed obligated pursuant to a contract or lease for any period of time for which the seller or lessor (instead of either party to the contract or lease) has the unconditional right to terminate the contract or lease upon notice. b) The storage, use, or other consumption of, or possession of, or exercise of any right or power over, TPP shall not AB 780 Page C be deemed obligated pursuant to a contract or lease for any period of time for which the purchaser or lessee (instead of either party to the contract or lease) has the unconditional right to terminate the contract or lease upon notice. 8)Provides that, notwithstanding existing law, the state shall not reimburse any local agency for any SUT revenues lost as a result of this bill. 9)Provides that, if the Commission on State Mandates determines that this bill contains costs mandated by the state, reimbursement to local agencies and school districts shall be made according to existing law. EXISTING LAW imposes a: 1)Sales tax on retailers for the privilege of selling TPP, absent a specific exemption. The tax is based upon the retailer's gross receipts from TPP sales in this state. 2)Complementary use tax on the storage, use, or other consumption in this state of TPP purchased from any retailer. The use tax is imposed on the purchaser, and unless the purchaser pays the use tax to a retailer registered to collect the California use tax, the purchaser remains liable for the tax, unless the use is exempted. The use tax is set at the same rate as the state's sales tax and must be remitted to the State Board of Equalization (BOE). FISCAL EFFECT : The BOE estimates that this bill would have no impact on existing district tax revenues, since the provisions would only apply to future district tax rate changes. Committee staff notes, however, that this bill's "change order" provisions would increase contract costs for government entities that enter into fixed price contracts prior to an increase in the state SUT rate. COMMENTS : 1)The author has provided the following statement in support of this bill: AB 780 would add a provision in the Public Contract Code that requires fixed price contracts between a contractor AB 780 Page D and a government entity to authorize payment for a change in the contract price that is a result of a future increase or decrease in the state sales and use tax rate. 2)This bill is sponsored by the Associated General Contractors and the Engineering and Utility Contractors Association. The sponsors state, "AB 780 provides that, in the event of a future increase or decrease in the state sales tax, public works contracts that were bid and entered into on a fixed price basis prior to the tax change must provide for an adjustment in the contract to compensate the contractor for the increase that could not be factored into the contract and to compensate the public agency in the event of a decrease in the sales tax." 3)Proponents state, "When a contractor and customer enter into a fixed price contract, the contractor assumes the risk of a subsequent increase in costs after the contract is signed. Thus, the potential for a subsequent cost increase is part of the settled expectations of the parties when negotiating the contract. Unlike the risk of an increase of the cost of materials, labor, etc., the risk of a sales tax increase is not part of the expectations of the parties upon entering the contract." 4)The BOE notes the following in its staff analysis of this bill: a) "Under existing law, when a state sales and use tax rate increases, a retailer is required to remit tax on all sales made on or after the date of the rate increase at the rate in effect at the time of sale, regardless of whether or not the retailer is locked into a fixed price contract before the rate increase, and regardless of whether or not the retailer may reimburse himself or herself for the tax. Existing state sales and use tax law does not provide an exemption from the increased sales or use tax on sales made after a rate increase pursuant to fixed price contracts entered into prior to a rate increase." b) "However, a general fixed price contract exemption is contained in the Transactions and Use Tax Law (and has been since 1979) for purposes of exempting all sales of property obligated pursuant to fixed price contracts from the AB 780 Page E various city and county tax (district) rate increases when those contracts are entered into prior to the operative date of those rate increases (see Revenue and Taxation Code Sections 7261(g) and 7262(f)). Under these provisions, tangible personal property is not deemed obligated pursuant to fixed price contracts (and the sale or purchase is not exempted from the district rate increase) if either party to the contract has the unconditional right to terminate the contract. Accordingly, if either a purchaser or a seller may terminate a contract, the contract is not regarded as a qualifying fixed price contract, and the exemption from the increased district tax is not allowable." c) "The proposed changes in the Transactions and Use Tax Law would broaden the scope of the existing exemption. A fixed price contract exemption is designed to protect the business expectations of the parties when they entered into the contract and protect them from an unplanned increase in Ýthe] tax rate. Under a fixed price contract, the contractor assumes all of the cost variation risk and reward. If the cost exceeds the contract price, the difference comes out of the contractor's pocket. Absent an exemption for fixed price contracts, when state or local sales and use tax rates increase, for existing contracts entered into prior to the rate increase, the contractors are liable for the increase in the sales and use tax rate on any purchases and sales made pursuant to the contract on or after the date of the rate change. However, due to the nature of a fixed price contract, the contractor may not pass that increase on to the customer or recoup his or her costs in any other manner. Consequently, the contractor alone must bear the out-of-pocket cost of the rate increase. The Transactions and Use Tax Law provides a remedy to this, by allowing an exemption from the local district rate increase, Ýfor] certain sales made after the rate increase pursuant to fixed price contracts entered into prior to the rate increase." d) "The changes proposed in this bill to the Transactions and Use Tax Law were requested by the sponsors, as they indicate that currently, government entities may not enter into contracts for which they do not have the unconditional right to terminate the contract. Consequently, the existing district tax exemption would never apply to contracts with AB 780 Page F government entities, since the law is specific that neither party may have the unconditional right to terminate the contract in order for the exemption to apply." e) "Enactment of these changes would assure that a contractor's liability for transactions and use taxes in connection with fixed price contracts or leases entered into prior to a local district rate increase would be limited to the tax rate in effect at the time the contractor and his or her customer entered into the contract." 5)Committee Staff Comments: a) Background : On February 20, 2009, Governor Schwarzenegger signed into law AB 3 X3 (Evans), Chapter 18, Statutes of 2009. Among other things, AB 3 X3 temporarily increased the General Fund SUT rate by 1% effective April 1, 2009. Unlike prior bills increasing the SUT rate, AB 3 X3 did not provide an exemption for sales of TPP obligated pursuant to fixed price contracts entered into before the rate increase.<1> Instead of providing an exemption for sales of TPP obligated under a fixed price contract, this bill would allow contractors with fixed price public contracts to obtain a change order compensating them for an unanticipated increase in the state SUT rate. This bill would also ostensibly entitle government entities to a reduction of the fixed contract price in cases where the state SUT rate is reduced. b) Outstanding issues : Committee staff has identified the following technical concerns with this bill: i) What happens in the case of a SUT rate reduction ? This bill applies to any increase or decrease in the SUT rate imposed with respect to TPP obligated pursuant to a ------------------------- <1> Past SUT rate increases have been accompanied by legislative provisions exempting fixed price contracts from the rate increase. For example, in July 1991, California increased its state SUT rate in response to budget shortfalls, and enacted fixed price contract exemption provisions to cover the increase. In addition, BOE notes that a general fixed price contract exemption is also contained in the TUT Law. AB 780 Page G fixed price contract with a government entity. (Page 3, lines 14-18). This bill further specifies that TPP shall not be considered obligated pursuant to a contract "for any period of time for which the contractor has the right to terminate the contract . . . ." (Page 3, lines 21-24). Thus, if a contractor possesses the right to terminate the underlying agreement, the contractor would not be entitled to an additive change order following a SUT rate increase. Instead, the contractor would be given the choice of either bearing the cost of the SUT increase or terminating the agreement. It is unclear to Committee staff, however, what would happen in the case of a SUT rate reduction. Given that this bill refers to both increases and decreases in the SUT rate, government entities would seemingly be entitled to a change order lowering the contract price in such circumstances. Again, however, this bill refers to TPP "obligated pursuant to a contract" and states that TPP shall not be considered obligated when the contractor has the right to terminate the agreement. As such, would government entities be entitled to a reduction in the contract price in cases where the contractor has termination rights? It seems inherently inequitable to predicate the government's right to a change order on the contractor's ability to terminate the contract. ii) What happens if the temporary 1% SUT component is extended beyond July 1, 2011 ? The temporary 1% SUT increase is currently set to expire on July 1, 2011. This bill provides, however, that if the 1% component is extended beyond July 1, 2011, this extension shall be regarded as an increase for purposes of this bill. This seems odd given that this bill would only become operative on January 1, 2012. Specifically, it is not clear to Committee staff how this provision would operate. Let's assume a public works contractor enters into a fixed price contract on May 1, 2011. Let's further assume that, thereafter, the Legislature acts to extend the temporary 1% SUT component for two years beyond July 1, 2011. Finally, let's assume that the contractor closes out its public contract in July 2012. Under this scenario, would the contractor be entitled to an additive change order covering the entire period from July 1, 2011 through July 2012? Or would the contractor AB 780 Page H only be entitled to a change order covering the period from this bill's effective date (January 1, 2012) through July 2012? Moreover, would an attempt to retroactively impose a change order requirement constitute the improper impairment of an existing contract? To address these issues and alleviate uncertainty, Committee staff suggests eliminating these provisions, and narrowing the scope of this bill to operate prospectively. iii) This bill's definition of a "fixed price" contract creates an internal inconsistency . As noted above, this bill requires certain "fixed price" contracts to authorize payment for a change in the contract price attributable to an increase or decrease in the state SUT rate. At the same time, this bill defines a "fixed price" contract as one that does not authorize an increase or decrease in price due to an increase or decrease in the SUT rate. In light of this contradiction, the author may wish to amend this bill's definition of a "fixed price" contract. Moreover, it is not entirely clear what types of contracts this bill's definition of "fixed price" is designed to cover. This bill defines a "fixed price" contract as one that "does not authorize an increase or decrease in price" due to a change in the SUT rate. Clearly, this would seem to cover standard fixed price contracts where the question of a SUT rate increase is simply not addressed. But what would happen, under this bill, if a public works contract explicitly provided that the contractor bore the risk of an increase in the applicable SUT rate? Would this bill's provisions render the clause invalid, despite the fact that both parties contemplated the issue and agreed to be bound by the contract's terms? Committee staff is available to work with the author to address these and any other technical issues identified in the future c) Is this bill's approach preferable to the standard exemption provisions passed with prior SUT rate increases ? Past SUT rate increases have been accompanied by legislative provisions exempting fixed price contracts from the rate increase. Such provisions were designed to AB 780 Page I protect the expectations expressed by both contracting parties. Specifically, under standard exemption provisions, the contractor would continue to bear the same SUT burden (and, all things being equal, maintain the same profit margin) and the government entity would experience no change in its bargained-for contract price. Of course, such exemption provisions necessarily entailed the loss of certain SUT revenues. This bill attempts to address the same fundamental problem without causing a similar reduction in SUT moneys. Specifically, this bill would do nothing to change the underlying SUT rate applied to fixed price contracts, but would entitle public works contractors to an additive change order in cases where the state SUT rate unexpectedly increases. Thus, while this bill serves to preserve the expectations of the public works contractor, it necessarily also serves to disrupt the expectations of the government entity by shifting the risk of a SUT rate increase to that government entity. Thus, the Committee is essentially presented with the question of whether it is preferable to preserve the expectations of both parties though an exemption that results in SUT revenue losses, or whether it is preferable to shift the risk to government entities, which would potentially result in those entities paying more for public works contracts. d) Related legislation : i) AB 1523 (Charles Calderon), of the 2009-10 Legislative Session, would have relieved parties who entered into a fixed price contract or a fixed price lease prior to the 1% SUT increase. AB 1523 was held in the Assembly Appropriations Committee. ii) AB 2060 (Charles Calderon), of the 2009-10 Legislative Session, contained provisions nearly identical to those in this bill. Governor Schwarzenegger vetoed AB 2060, noting: First, I can understand the impact of new taxes on businesses and the frustration that contractors may have when they are not exempted from sales tax increases. This is one of the reasons I have continued to oppose raising additional taxes because it slows our state's economic recovery efforts and dampens job creation. However, this bill seeks an AB 780 Page J overly broad and permanent exemption which effectively shifts the burden of paying both state and local sales tax increases from the contractor to the government entity and ultimately, on California's taxpayers. In addition, I believe this bill is unnecessary because current law allows an exemption to fixed-price contracts for city and county tax increases, and such exemptions have been allowed on past statewide sales and use tax increases. I believe this process is appropriate and does not affect district tax revenues, as this bill would propose to do. REGISTERED SUPPORT / OPPOSITION : Support Associated General Contractors (co-sponsor) Engineering and Utility Contractors Association (co-sponsor) Asphalt Pavement Association of California Associated Builders and Contractors of California California Chapter of the American Fence Association California Fence Contractors' Association California Landscape Contractors Association California Legislative Conference of the Plumbing, Heating and Piping Industry California Nevada Cement Association California Precast Concrete Association California State Council of Laborers California Taxpayers' Association Concrete Contractors Association Engineering Contractors' Association Engineering & Utility Contractors Association Flasher Barricade Association Golden State Builders Exchange Marin Builders' Association National Electrical Contractors Association (California chapters) Opposition None on file Analysis Prepared by : M. David Ruff / REV. & TAX. / (916) 319-2098 AB 780 Page K