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.








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          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 








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          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 








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          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, 








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          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.  








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          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 








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          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 








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          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.