BILL ANALYSIS                                                                                                                                                                                                    Ó



                                                                  AB 1326
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          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;









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             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  








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            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.  








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          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  








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            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  








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               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  








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               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  








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               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  








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               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.   









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              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  
                              







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               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  








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               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