BILL ANALYSIS Ó AB 1326 Page 1 Date of Hearing: May 13, 2013 ASSEMBLY COMMITTEE ON REVENUE AND TAXATION Raul Bocanegra, Chair AB 1326 (Gorell) - As Amended: April 29, 2013 SUSPENSE Majority vote. Tax levy. Fiscal committee. SUBJECT : Sales and use taxes: exemptions: unmanned aerial vehicle manufacturing: income taxes: credits: wages SUMMARY : Establishes a sales and use tax (SUT) exemption for tangible personal property (TPP) used in unmanned aerial vehicle (UAV) manufacturing, and allows UAV manufacturers an income tax credit based on qualified wages paid to employees. Specifically, this bill : 1)Exempts from SUT TPP purchased: a) For use in UAV manufacturing by a qualified person "to be used primarily in any stage of the manufacturing of property," as specified; or, b) By a contractor in the performance of a construction contract for the qualified person that will use the qualified TPP as an integral part of the manufacturing process, or as a facility for use in connection with the manufacturing process. 2)Defines TPP to include, without limitation, all of the following: a) Machinery and equipment, including component parts and contrivances such as belts, shafts, moving parts, and operating structures; b) Equipment or devices used or required to operate, control, regulate, or maintain the machinery including, without limitation, computers, data processing equipment, and computer software, together with all repair and replacement parts with a useful life of one or more years; AB 1326 Page 2 c) Property used in pollution control, as specified; d) Special purpose buildings and foundations, as specified; and, e) Fuels used or consumed in the manufacturing process. 3)Specifies that TPP does not include: a) Consumables with a normal useful life of less than one year, except for fuels used in the manufacturing process; b) Furniture, inventory, and equipment used in the extraction process, or equipment used to store finished products that have completed the manufacturing process; or, c) TPP used primarily in administration, general management, or marketing. 4)Defines a "qualified person" as either of the following: a) A person engaged in the line of business described in Industry Group 336411 of the North American Industry Classification System (NAICS) published by the United States (U.S.) Office of Management and Budget (OMB), 2012 edition, that manufactures UAVs; or, b) An affiliate of a person described above, as specified. 5)Defines "manufacturing" as the activity of converting or conditioning property by changing the form, composition, quality, or character of the property for ultimate sale at retail or use in the manufacturing of a product to be ultimately sold at retail. Manufacturing includes any improvements to TPP that result in a greater service life or greater functionality than that of the original property. 6)Defines "primarily" to mean TPP used 50% or more of the time in an activity that qualifies the taxpayer for the SUT exemption. 7)Defines "process" to mean the period beginning at the point at which raw materials are received by the qualified person and introduced into the manufacturing activity of the qualified AB 1326 Page 3 person and ending at the point at which the qualified activity has altered the TPP to its completed form. Raw materials are considered introduced into the process when the raw materials are stored on the same premises where the qualified activity is conducted. 8)Provides that the SUT exemption shall apply on and after January 1, 2014, and before January 1, 2024. 9)Provides that the state shall not reimburse local agencies for any SUT revenues lost as a result of this exemption. 10)Allows, for taxable years beginning on or after January 1, 2014, and before January 1, 2024, an income tax credit in an amount equal to the following: a) 50% of "qualified wages" paid or incurred during any taxable year beginning on or after January 1, 2014, and before January 1, 2016; b) 40% of "qualified wages" paid or incurred during any taxable year beginning on or after January 1, 2016, and before January 1, 2018; c) 30% of "qualified wages" paid or incurred during any taxable year beginning on or after January 1, 2018, and before January 1, 2020; d) 20% of "qualified wages" paid or incurred during any taxable year beginning on or after January 1, 2020, and before January 1, 2022; and, e) 10% of "qualified wages" paid or incurred during any taxable year beginning on or after January 1, 2022, and before January 1, 2024. 11)Defines a "qualified taxpayer" as any taxpayer engaged in the line of business described in Industry Group 336411 of the NAICS published by the OMB, 2012 edition, that manufacturers UAVs. 12)Defines a "qualified employee" as an individual whose services for the qualified taxpayer are performed in this state and are at least 90% directly related to the qualified taxpayer's manufacturing of UAVs. AB 1326 Page 4 13)Defines "qualified wages" as that portion of wages paid or incurred by the qualified taxpayer during the taxable year with respect to qualified employees that are direct costs, as defined, allocable to property manufactured in this state by the qualified taxpayer. 14) Caps the credit at $20,000 per year, per qualified employee. 15)Provides that, in cases where the credit exceeds the taxpayer's tax liability, the excess credit amount may be carried over to reduce the taxpayer's tax liability for up to eight years, until the credit is exhausted. 16)Takes immediate effect as a tax levy. EXISTING FEDERAL LAW authorizes Congress, under the commerce clause of the U.S. Constitution, to regulate commerce with foreign nations, and among the several states. The U.S. Supreme Court has held that the "negative" or "dormant" commerce clause also prohibits states from enacting laws that unduly burden or discriminate against interstate commerce. EXISTING STATE LAW : 1)Imposes a 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)Imposes a 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 generally be remitted to the State Board of Equalization (BOE). 3)Allows various tax credits under both the Personal Income Tax Law and the Corporation Tax Law. These credits are generally designed to encourage socially beneficial behavior or to provide relief to taxpayers who incur specified expenses. 4)Establishes the following geographically-targeted economic AB 1326 Page 5 development areas (G-TEDAs): Enterprise Zones, Manufacturing Enhancement Areas, Targeted Tax Areas, and Local Agency Military Base Recovery Areas. Special tax incentives are provided to taxpayers conducting business activities within a G-TEDA. These incentives include a hiring credit equal to a percentage of wages paid to qualified employees. 5)Allows a New Jobs Tax Credit for taxable years beginning on or after January 1, 2009, to qualified employers equal to $3,000 for each net increase in qualified full-time employees hired during the taxable year. The credit is limited to small businesses (i.e., taxpayers with 20 or fewer employees as of the last day of the preceding taxable year). The credit is capped at roughly $400 million for all taxable years. 6)Allows taxpayers engaged in a trade or business to deduct expenses that are considered ordinary and necessary in conducting that trade or business. FISCAL EFFECT : 1)SUT exemption : The BOE estimates that this bill's SUT exemption provisions would result in state and local revenue losses of $6.9 million in fiscal year (FY) 2013-14, $15.9 million in FY 2014-15, and $17.2 million in FY 2015-16. 2)Income tax credit : The Franchise Tax Board (FTB) estimates that this bill's income tax credit provisions would result in General Fund revenue losses of $31 million in FY 2013-14, $40 million in FY 2014-15, and $60 million in FY 2015-16. COMMENTS : 1)The author has provided the following statement in support of this bill: The unmanned aerial vehicle (UAV) market is expected to grow tremendously in the near future. By 2018, the market is expected to grow by 700%. Forecasts indicate that 30,000 drones will fill the nation's skies in the next 20 years. With the natural resources and the aerospace infrastructure already in California's possession, we should have a competitive advantage over other states to capture the manufacturing industry, but the regulatory and business climate continues to be an impediment. As a AB 1326 Page 6 result, other states have an opportunity to capture UAV manufacturers as they aggressively seek to position themselves and compete for their attention. California has an opportunity to be on [the] forefront of an emerging sector and reap the tremendous benefits if it can create a favorable environment for the industry. The benefits include [a] substantial increase in jobs and tax revenue. In California, one report indicates that the UAV industry can potentially account for a $14 billion economic impact, $83 million in tax revenue, and over 18,000 jobs between 2015 and 2025. As the domestic and international uses for UAVs continue to grow with the advancement of technology, the market will continue to expand and provide more middle-class jobs for Californians. 2)Proponents of this bill note: The Federal Aviation Administration (FAA) expects more than 30,000 drones to fill the nation's skies over the next 20-years. The FAA is mandating to integrate [sic] Unmanned Aerial Systems (UAS) into the national airspace (NAS) by 2015. According to a recent study by the Association for Unmanned Vehicle Systems International (AUVSI), California is projected to create over 18,000 new direct and indirect jobs, generate $14 billion in economic activity and produce $82 million in new tax revenue - as UAS integration proceeds over the next decade. [ . . . ] States that provide industry incentives and a favorable regulatory and business climate for the UAV industry will be poised to benefit for many years to come. AB 1326 puts California on solid footing to accommodate this new growth and makes the state far more attractive to the emerging UAV industry. 3)Opponents of this bill note: Counties receive almost 45 percent of the revenue sales tax generates, depending on where the sale takes place. Importantly, this includes 1.0625 cents to fund 2011 Realignment. It also includes a half-cent for 1991 AB 1326 Page 7 Realignment, most of another half-cent for Proposition 172 public safety services, a quarter-cent that funds county transportation activities, and of course the site-dependent penny for Bradley-Burns (part of which is currently redirected to the state but reimbursed through property taxes). If favoring these purchases is an issue of statewide concern, as passing this bill would indicate, then the state should use statewide revenues to reimburse counties and other local agencies for their losses, as provided by statute. Alternatively, the bill could exempt the local portions of the tax from the special treatment the bill would confer. 4)The BOE notes the following with respect to this bill's SUT exemption provisions: a) Code 336411 includes aircraft manufacturers : "Specifically, this code describes establishments primarily engaged in one or more of the following: (1) manufacturing or assembling complete aircraft; (2) developing and making aircraft prototypes; (3) aircraft conversion (i.e., major modifications to systems); and (4) complete aircraft overhaul and rebuilding (i.e., periodic restoration of aircraft to original design specifications). However, the proposed exemption is limited to purchases for UAV manufacturing by these establishments." b) What about ground control station manufacturing? : "UAVs are aircraft piloted through ground control stations. The bill does not specify whether the proposed exemption additionally applies to qualifying tangible personal property purchased for use in ground control station manufacturing. Without such specificity, the exemption may not apply. This distinction is illustrated in the sales and use tax exemption for aircraft sold to foreign governments or non-California residents for use outside this state. With respect to [Revenue and Taxation Code] Section 6366, a question arose whether ground control stations used to operate the exempt aircraft also qualified. The Legislature addressed this issue by specifically adding ground control stations to the exemption. If the author intends to include ground control manufacturing, it is suggested that the bill so AB 1326 Page 8 specify." 5)The FTB notes the following with respect to this bill's income tax credit provisions: a) "The bill defines a qualified employee as an individual whose services for the qualified taxpayer are performed in this state and are at least 90 percent directly related to the qualified taxpayer's line of business. However, the bill fails to define "directly related," which could lead to disputes between taxpayers and the department regarding whether an employee would qualify for the credit. It is also unclear whether this requirement is designed to prevent non-manufacturing jobs (i.e., administrative, accounting, legal, or secretarial) from qualifying for this credit. The author may wish to amend the bill for clarity." b) "This bill would allow a credit for wages that are currently deductible as business expenses. Generally, a credit is allowed in lieu of any deduction or credit already allowable for the same item of expense in order to eliminate multiple tax benefits for the same item of expense." c) "Tax credits generally are designed to provide incentives for taxpayers to perform various actions or activities that they may not otherwise undertake. This bill could incentivize behavior that has occurred in the past because the bill fails to specify the date that an individual must begin employment with the qualified employer in order to be considered a qualified employee. As a result, a qualified employer may be eligible for a credit for all or part of their existing workforce." 6)Committee Staff Comments on the SUT Exemption: a) Is the proposed SUT exemption for manufacturing equipment good tax policy? : Businesses currently pay about one-third of the state's SUT. A business pays SUT when it is considered to be the final consumer of TPP. Any SUT paid by a business will, however, be factored into the prices it charges for goods which, in turn, may be subject to taxation. This results in end consumers paying a tax on a tax (i.e., pyramiding), making the overall tax system less transparent. Requiring businesses to pay SUT on their AB 1326 Page 9 manufacturing equipment also increases the cost of production in California, placing the state at a competitive disadvantage vis-à-vis other states that provide exemptions for certain manufacturing equipment. Thus, nearly all economists and tax experts agree that taxing manufacturing equipment represents poor tax policy. Indeed, during this Committee's March 23, 2009 informational hearing on "Tax Policy in a Time of Economic Crisis," presenters unanimously agreed that it would make sense to eliminate the SUT on most business purchases. Such a change, however, should likely be considered in the context of the state's overall tax structure. A SUT exemption would obviously result in a significant reduction of state revenues. For this reason, Dr. Charles McClure, a Senior Fellow with the Hoover Institute, stated during the Committee's March 23 hearing that the SUT base should be expanded and the rate increased to compensate for the loss in revenues accompanying a manufacturing exemption. b) Would a manufacturing exemption lead to job growth? : While a manufacturing exemption represents sound tax policy, past experience suggests that it, by itself, may not lead to large scale job creation. Prior to January 1, 2004, California had a similar tax incentive known as the Manufacturers' Investment Credit (MIC), which was enacted in response to the state's economic downturn during the late 80s and early 90s. During this period, the state lost about 300,000 jobs and had a 45% reduction in aerospace alone. The MIC expired on January 1, 2004, after the Employment Development Department (EDD) determined that jobs on the preceding January 1 did not exceed the total manufacturing jobs in California on January 1, 1994 by more than 100,000. The EDD stated that from January 1, 1994 to January 1, 2002, the total net increase in manufacturing employment was 35,150. c) Defining a normal useful life : This bill excludes from the definition of exempt TPP consumables with a normal useful life of less than one year. This bill, however, does not provide any guidance on how normal useful life is to be measured. This bill should reference a clear and objective standard for determining the useful life of an item. The BOE has suggested amendments in its staff analysis of this bill to address this issue. AB 1326 Page 10 d) Notification requirement : This bill includes a provision eliminating the SUT exemption if the purchased property is removed from California or converted to a non-exempt use within one year of the purchase date. This bill allows the BOE to collect taxes not paid if any of the above occurs, but AB 1326 does not provide a method for notifying the BOE. Short of an audit, the BOE would have no means of learning of the liability. e) Where do all those exemption certificates go? : This bill requires retailers to provide the BOE a copy of each exemption certificate received from a purchaser. The BOE staff recommends eliminating this requirement. Instead, BOE staff suggests requiring retailers to retain exemption certificates in their records for subsequent BOE examination upon request. f) Additional technical concerns : Committee staff has identified additional technical concerns with this bill's SUT provisions, and will work with the author to address these issues and any others that may be identified in the future. 7)Committee Staff Comments on the Income Tax Credit: a) What is a "tax expenditure"? : Existing law provides various credits, deductions, exclusions, and exemptions for particular taxpayer groups. In the late 1960s, U.S. Treasury officials began arguing that these features of the tax law should be referred to as "expenditures," since they are generally enacted to accomplish some governmental purpose and there is a determinable cost associated with each (in the form of foregone revenues). This bill would enact a new tax expenditure program, in the form of an income tax credit, to incentivize the hiring and retention of employees engaged in drone manufacturing. b) How is a tax expenditure different from a direct expenditure? : As the Department of Finance notes in its annual Tax Expenditure Report, there are several key differences between tax expenditures and direct expenditures. First, tax expenditures are reviewed less frequently than direct expenditures once they are put in place. This can offer taxpayers greater certainty, but it can also result in tax expenditures remaining a part of the AB 1326 Page 11 tax code without demonstrating any public benefit. Second, there is generally no control over the amount of revenue losses associated with any given tax expenditure. Finally, it should also be noted that, once enacted, it takes a two-thirds vote to rescind an existing tax expenditure absent a sunset date. This effectively results in a "one-way ratchet" whereby tax expenditures can be conferred by majority vote, but cannot be rescinded, irrespective of their efficacy, without a supermajority vote. c) The not-so-dormant commerce clause : The credit this bill proposes is only available for wages paid to employees whose services are performed in California. By limiting the credit to in-state activity, this credit could arguably be susceptible to challenge under the dormant commerce clause of the U.S. Constitution. The U.S. Constitution authorizes Congress to regulate commerce with foreign nations, and among the several states. (U.S. Constitution, Article I, Section 8, Clause 3). While the commerce clause is phrased as a positive grant of regulatory power, it "has long been seen as a limitation on state regulatory powers, as well as an affirmative grant of congressional authority." [Fulton Corp. v. Faulkner (1996) 516 U.S. 325, 330.] This negative aspect, commonly referred to as the dormant commerce clause, prohibits economic protectionism in the form of state regulation that benefits "instate economic interests by burdening out-of-state competitors." (Ibid.) Both the U.S. Supreme Court and the California courts have addressed challenges to various state tax provisions on dormant commerce clause grounds. Most recently, the Court of Appeal struck down a California statute that allowed taxpayers a deferral for income received from the sale of stock in corporations maintaining assets and payroll in California, while providing no such deferral for income from the sale of stock in corporations maintaining assets and payroll elsewhere. [Cutler v. Franchise Tax Board (2012) 208 Cal.App.4th 1247, 1250.] Specifically, the court held that "the deferral provision discriminates on its face on the basis of an interstate element in violation of the commerce clause." (Ibid.) While noting that no court decision has yet invalidated, as AB 1326 Page 12 a general matter, a state income tax credit that provides an incentive for in-state activity, the FTB notes that such credits "may be subject to constitutional challenge." REGISTERED SUPPORT / OPPOSITION : Support California Chamber of Commerce California Manufacturers & Technology Association California State Council of Laborers Camarillo Chamber of Commerce Chambers of Commerce Alliance of Ventura & Santa Barbara Counties Simi Valley Chamber of Commerce South Bay Association of Chambers of Commerce Southwest California Legislative Council Opposition California State Association of Counties Santa Cruz County Peace and Freedom Party Analysis Prepared by : M. David Ruff / REV. & TAX. / (916) 319-2098