BILL ANALYSIS Ó Senate Appropriations Committee Fiscal Summary Senator Christine Kehoe, Chair AB 1500 (J. Perez) - Mandatory single sales factor apportionment: Middle Class Scholarship Fund. Amended: May 25, 2012 Policy Vote: G&F n/a Urgency: Yes Mandate: No Hearing Date: August 16, 2012 Consultant: Mark McKenzie SUSPENSE FILE. Bill Summary: AB 1500, an urgency measure, would require multistate companies to apportion income to California using the single sales factor methodology, except as specified. The bill would also revise rules for assigning sales to California, and require revenue in an amount equal to the estimated amounts derived from these tax changes to be deposited into a new Middle Class Scholarship Fund for purposes of providing scholarship grants to qualified students pursuant to AB 1501 (J. Perez). Fiscal Impact: The Franchise Tax Board (FTB) estimates that this bill would result in tax revenue gains of $1.2 billion in 2012-13, $950 million in 2013-14, and $950 million in 2014-15 (General Fund). The bill would require the transfer of an equivalent amount to the Middle Class Scholarship Fund from the General Fund. Potential additional General Fund impact in the hundreds of millions of dollars annually if the new revenue generated by the bill is subject to Proposition 98 minimum funding guarantees, and net revenues generated by the bill's tax changes, after deduction of amounts dedicated to Proposition 98, are insufficient to offset amounts annually transferred to the Middle Class Scholarship Fund. Potential substantial cashflow deficits to the extent that revenues are transferred to the Middle Class Scholarship Fund on September 1 exceed amounts available to cover various mandated state payments. This could also create additional General Fund impacts related to short term borrowing costs. AB 1500 (J. Perez) Page 1 Background: Apportionment Formula. A multistate firm generates profits based on its operations in multiple states and has a right under the U.S. Constitution to divide, or apportion, income among those states for tax purposes to ensure that each state only taxes its fair share of the firm's income. Since 1993, state law has generally required multistate firms to use a three factor formula to apportion income associated with a company's payroll, property, and sales (with a double-weighted sales factor) to California for purposes of state taxation, except for companies that derive more than 50 percent of income from specified activities (extraction, agriculture, savings and loan, and banks and financials). These companies use the three factor formula but the sales factor is not double-weighted. The double-weighted sales formula reduces the share of a the firm's income apportioned to states where it employs relatively more people and produces more goods in the state compared to its sales. Under the formula, a firm with all or most of its production and payroll in California, but a smaller share of its sales, benefits, whereas a firm that either employs few or no people or owns little to no property here, but sells into California, pays more tax. Many other states changed the apportionment weights in the 1980s and 1990s to induce firms to maintain or relocate facilities and employees in the state. The February 2009 state budget agreement included provisions that revised the formula that multistate firms use to determine the share of total income that is taxable in California (ABx3 15, Krekorian, and SBx3 15, Calderon). As noted above, firms previously used a weighted average of their California sales, property, and payroll compared to its totals. Starting in 2011, state law allows multistate firms to annually choose between either the three factor, double-weighted sales apportionment formula or to use only its sales factor, while ignoring property or payroll factors, commonly known as the "single sales factor," to determine income apportioned to California for purposes of taxation. The Legislative Analyst's Office (LAO) report, Reconsidering the Optional Single Sales Factor (May 26, 2010), recommends that "the state require all firms to use the single sales factor, which would help the state's competitiveness while limiting the cost to the budget." The LAO report indicates that the elective AB 1500 (J. Perez) Page 2 single sales factor allows the taxpayer to essentially choose the tax it pays, creating an inequity allowing taxpayers who operate in more than one state two different ways to calculate their income. Multistate firms can choose the formula that will yield a lower tax each year, while businesses that operate wholly inside California have no such option. This disparate treatment puts the wholly in-state businesses, as well as balanced multistate firms that would pay roughly the same taxes under either formula, at a competitive disadvantage to its multistate competitors that are primarily based out of state, which tend to be larger companies. Furthermore, since the single sales factor methodology is the dominant apportionment formula among large states, making the single sales factor mandatory in California would remove incentives for firms to base operations elsewhere. To this point, the LAO report notes that conformity with other large states' apportionment formulas would prevent California firms from being placed at a competitive disadvantage. While this bill is intended to remove competitive barriers and encourage investment in California, the state may lose some investments by those firms that would have a higher tax liability as a result of this bill to the extent that the benefits of current law would encourage investment in California by those firms. Staff notes that 24 other states have implemented or are in the process of phasing in a single sales factor apportionment methodology. Among these, 18 states require the use of a single sales factor and only Missouri allows an annual election of either the single sales factor or the traditional three factor formula. Intangible Sourcing. As part of the budget agreement of 2010 (SB 858, Committee on Budget & Fiscal Review, Chap 721/2010), taxpayers electing the three-factor, double-weighted sales formula must use the "cost of performance" method to source sales of intangible items starting with the 2011 taxable year; taxpayers electing sales factor-only apportionment of income must source the sales of intangibles to California using the "market rule." Intangible assets are not considered tangible personal property, and include items and services such as: online stockbrokers and telecommunications; patents, trademarks, and copyrights; and licenses to operate software programs. Under the "cost of performance" methodology, a company includes no revenue from its sales of intangibles to California in the sales factor if the firm incurs a plurality of the costs associated with developing these products or services in another AB 1500 (J. Perez) Page 3 state; if the plurality occurs in California, then the company includes all of its sales in its California sales factor. Under the competitively-neutral "market rule," all firms source these sales based on the state in which the product or service is ultimately used, so all firms report sales based on how much they sell in the state, instead of where they invested when developing the intangible item or service. Proposed Law: AB 1500 would repeal the authority for companies to elect to use the single-sales factor apportionment methodology, and generally impose a mandatory single-sales factor methodology for assigning sales to California. Specifically, this bill would make the following changes to apportionment formulas: Repeal the annual election to use single sales factor apportionment formulas for years beginning on or after January 1, 2012. Require specified corporations to use the "single sales factor" apportionment formula for taxable years beginning on or after January 1, 2012, as specified, except for those deriving more than 50% of income from a qualified business activity (extractive, agricultural, savings and loans, and banks and financials). Allow taxpayers to continue to use the traditional 3-factor formula, with double-weighted sales, if it results in a greater amount of tax owed. Require all corporations to use the "market rule" when assigning sales of intangible goods to the state for purposes of determining taxable income, as specified. Allow cable companies that have a minimum investment in this state of $250 million or more, to assign 50% of their intangible property to California under the market rule, and 50% would "not be assigned to this state." This bill would also require FTB to annually report a preliminary estimate of the amount of revenue expected to be generated by these tax changes to the Department of Finance (DOF), on a schedule that DOF determines, for the 2012-13 through 2015-16 fiscal years. FTB would use a different specified method for estimating revenues for subsequent years. DOF would then direct the State Controller to deposit an amount equal to FTB's estimate into the newly-established Middle Class Scholarship Fund, by September 1 each year, beginning in 2012. Funds deposited into this new special fund would be available, AB 1500 (J. Perez) Page 4 upon appropriation by the Legislature, for the purpose of increasing the affordability of higher education. This bill is contingent upon the enactment of AB 1501 (J. Perez). Related Legislation: AB 1501 (J. Perez), currently on the Suspense File in this Committee, would establish the Middle Class Scholarship Program, to be administered by the California Student Aid Commission, to provide scholarships for mandatory systemwide fees at the University of California and California State University systems, and to fund grants for fees, books, and other educational costs at the California Community Colleges. AB 1501 is contingent upon the enactment of AB 1500. Since the enactment of elective single sales factor rules as part of the February 2009 budget agreement, several bills have been introduced to revise apportionment formulas, including the following: ABX1 40 (Fuentes & Fletcher), introduced in the 2011 1st Extraordinary Session, would have mandated the use of the single sales factor formula for all companies except for certain qualified business activities (extractive, agricultural, banks and financials, and savings and loan) and would have allowed qualified cable industry companies to assign 50% of their mandatory sales to California. This bill failed to pass out of the Senate by the constitutional deadline. SB 116 (De Leon), introduced in the 2011 Legislative Session, would have mandated the use of the single sales factor formula for all companies except for certain qualified business activities (extractive, agricultural, banks and financials, and savings and loan) and would have allowed qualified cable industry companies to assign 50% of their mandatory sales to California. This bill failed to pass out of the Senate by the constitutional deadline. AB 1935 (de Leon), introduced in the 2010 Legislature Session, would have mandated the use of the single sales factor for all companies except for financial institutions and oil companies, which, as under current law, would continue to use the three-factor formula. This bill was held under submission in the Assembly Appropriations Committee. Staff Comments: According to the FTB, this bill is expected to increase General Fund revenues by approximately $1.2 billion in 2012-13, and about $950 million to $1 billion annually ongoing. AB 1500 (J. Perez) Page 5 An equivalent amount of General Fund would be deposited into the Middle Class Scholarship Fund on September 1 of the fiscal year in which the estimated revenues are expected to be generated. The timing of these advance payments, especially the initial transfer of funds in 2012, would appear to create substantial cashflow deficits that could temporarily inhibit the ability of the Controller to make mandated payments. It will likely take some time for taxpayers to adjust to the changes in this bill and make any tax payments resulting from the mandatory single sales factor apportionment formulas. In addition, calendar year taxpayers are not required to make estimated payments for the third quarter. This could result in additional General Fund expenditures related to short-term borrowing to cover any insufficient cashflows until tax payments are received. In addition, the bill does not include a "settle-up" mechanism to reconcile the estimated revenues to actual amounts generated by the enacted tax changes. The Committee may wish to consider whether it would be preferable to transfer revenues to the Middle Class Scholarship Fund based upon actual amounts received over the 2012-13 fiscal year, and make those revenues available beginning in the 2013-14 academic year, upon appropriation by the Legislature in the Budget Act. As proceeds of taxes, the revenues generated by the mandatory single sales factor provisions in this bill would appear to be subject to inclusion in Proposition 98 calculations and minimum funding guarantees for K-14 schools. The specific effect will vary from year to year, and depend significantly on the year-to-year change in General Fund revenues. Based upon the formulas in Proposition 98, the amount of funding owed to schools in arrears (referred to as the "maintenance factor"), and the maintenance factor approach adopted in the 2012-13 budget, between 40 percent and 95 percent of any new revenues could go to satisfy Proposition 98 obligations in test 1 years. Since AB 1500 bill would require the full amount of the anticipated revenue increases from the tax changes enacted in the bill to be transferred to the Middle Class Scholarship Fund, the bill could create General Fund losses of hundreds of millions of dollars if it is determined that a large proportion of actual tax revenues collected must be dedicated to Proposition 98 obligations instead of filling the hole created by the diversion of funds to the scholarship program. Proposition 39, the "California Clean Energy Jobs Act," is an AB 1500 (J. Perez) Page 6 initiative sponsored by Tom Steyer that will appear on the November, 2012 ballot. Beginning on January 1, 2013, the initiative proposes imposing a mandatory single sales factor on California corporations and dedicating up to $550,000,000 annually for five years for the Job Creation Fund. These revenues would be used to fund projects that create jobs in California, improve energy efficiency, and expand clean energy production. Retrofitting schools and public facilities to be more energy efficient, job training in the clean energy sector, and nourishing public-private partnerships to promote job creation and clean energy expansion are examples of possible projects. The remaining revenues derived from the imposition of a mandatory single sales factor apportionment methodology would be deposited in the General Fund. If both this bill and Proposition 39 pass, the initiative would chapter out AB 1500 as of November 6, 2012. However, this bill, if enacted, would go into effect immediately and apply the mandatory single sales factor apportionment method for the 2012 taxable year. Pursuant to the bill's provisions, over $1 billion would be transferred to the Middle Class Scholarship Fund prior to the potential date in which AB 1500 is superseded by Proposition 39. Certain provisions of AB 1500 provide special treatment for two types of taxpayers. For example, the bill would apply the market rule to all taxpayers with respect to sourcing the sales of intangibles, except for cable companies which would have to allocate half of its sales based on that percentage of its sales in California compared to its total sales if it met qualified investment targets. According to the Senate Governance and Finance Committee analysis, cable companies primarily invest in California to serve customer demand, and have consistently avoided California with its discretionary investments, resulting in its opposition to the market rule and support for the cost of performance method. This so-called "cable fix" has been in all previous bills proposing to impose a mandatory single sales factor methodology as well as Proposition 39, noted above. The revenue loss related to the cable company carve out is $20 million 2012-13, $34 million in 2013-14 and $35 million in 2014-15, which is incorporated into FTB's overall revenue estimate. AB 1500 also contains a so-called "Silicon Valley fix," which allows companies that, before the application of any credits, would pay the same or more under the 4-factor formula to choose to pay taxes under that method, rather than the mandatory single sales factor formula. This is intended to AB 1500 (J. Perez) Page 7 allow companies to show shareholders that their tax credits, which often may only be monetized for 8 years according to accounting rules, still have viability and may be fully utilized because they may still use them under the higher tax scenario. The FTB estimates no additional cost or revenue loss associated with this change. The Committee may wish to consider whether these complications to the tax system should be enacted in a bill that is intended to raise revenue for scholarship grants for higher education. Staff notes that there are several key inconsistencies between this bill and AB 1501 that need to be reconciled. AB 1500 specifies that the revenues in the Middle Class Scholarship Fund would only be available upon appropriation by the Legislature, while AB 1501 specifies that specified amounts are continuously appropriated from the Middle Class Scholarship Fund to the Student Aid Commission for allocations, as specified. AB 1501 also specifies that the Middle Class Scholarship Fund is established by Section 70026 of the Education Code, but that special fund is established by Section 70201 in AB 1500.