BILL ANALYSIS                                                                                                                                                                                                    Ó



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          ASSEMBLY THIRD READING


          AB  
          437 (Atkins)


          As Amended  May 28, 2015


          2/3 vote


           ------------------------------------------------------------------ 
          |Committee       |Votes |Ayes                   |Noes              |
          |                |      |                       |                  |
          |                |      |                       |                  |
          |----------------+------+-----------------------+------------------|
          |Revenue &       |9-0   |Ting, Brough,          |                  |
          |Taxation        |      |Dababneh, Gipson,      |                  |
          |                |      |Roger Hernández,       |                  |
          |                |      |Mullin, Patterson,     |                  |
          |                |      |Quirk, Wagner          |                  |
          |                |      |                       |                  |
          |----------------+------+-----------------------+------------------|
          |Appropriations  |17-0  |Gomez, Bigelow, Bonta, |                  |
          |                |      |Calderon, Chang, Daly, |                  |
          |                |      |Eggman, Gallagher,     |                  |
          |                |      |Eduardo Garcia,        |                  |
          |                |      |Gordon, Holden, Jones, |                  |
          |                |      |Quirk, Rendon, Wagner, |                  |
          |                |      |Weber, Wood            |                  |
          |                |      |                       |                  |
          |                |      |                       |                  |
           ------------------------------------------------------------------ 


          SUMMARY:  Establishes a Research and Development-Small Business  
          Grant Program (Grant Program) providing grants, equal to a  








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          percentage of unused Research and Development credits, to  
          qualifying small business, as specified.  Specifically, this bill:  
           


          1)Provides, on or after January 1, 2016, that a qualified small  
            business may apply for and receive a one-time grant in an amount  
            equal to 10% of the excess credit amount that is attributable to  
            taxable years beginning on or after January 1, 2014, and before  
            January 1, 2016, available for carryover into taxable years  
            beginning on or after January 1, 2016.  


          2)Requires, in order to receive a one-time grant, a qualified  
            small business, partner, or "S" corporation shareholder of a  
            qualified small business to apply for the grant on a timely  
            filed original return.  The return must be filed with the  
            Franchise Tax Board (FTB) using electronic technology in a form  
            and manner prescribed by the FTB for the taxable year beginning  
            on or after January 1, 2015.  The application must indicate the  
            amount equal to 10% of the excess credit that is attributable to  
            taxable years beginning on or after January 1, 2014, and before  
            January 1, 2016.  The FTB shall provide a certificate within 90  
            days of receiving the application. 


          3)Provides, on or after January 1, 2016, and before January 1,  
            2021, that a qualified small business may annually apply for a  
            grant in an amount equal to 15% of the excess credit amount  
            attributable to the taxable year in which the credit is allowed.  
             


          4)Requires, in order to receive a grant, a qualified small  
            business to apply for the grant on a timely field original  
            return.  The return must be field with the FTB using electronic  
            technology in a form and manner prescribed by the FTB for each  
            taxable year beginning on or after January 1, 2016.  The return  
            must indicate the amount equal to 15% of any excess credit  








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            amount that is attributable to the taxable year in which a  
            credit is allowed, and available for carryover to the following  
            year.  The FTB shall provide a certificate within 90 days of  
            receiving the return.


          5)Provides that, under the Personal Income Tax (PIT) Law, for  
            taxable years beginning on or after January 1, 2016, in the case  
            where the FTB has issued a certificate for a grant, the  
            following shall apply:


             a)   The excess credit amount that may be carried over by a  
               taxpayer shall be reduced by the amount reflected on a  
               certificate issued by the FTB;  


             b)   In the case of a pass-thru entity, the amount of credit  
               that may be passed through shall be reduced by the amount  
               reflected on a certificate issued by the FTB;


             c)   Defines a "pass-thru entity" as a partnership or "S"  
               corporation; and,


             d)   If a credit allowed is less than the amount of the credit  
               that provided the basis for a grant, the amount of the grant  
               attributable to the credit not allowed shall be treated as a  
               deficiency.


          6)Provides that, under the Corporation Tax (CT) Law, for taxable  
            years beginning on or after January 1, 2016, in the case where  
            the FTB has issued a certificate for a grant, the following  
            shall apply:


             a)   The excess credit amount that may be carried over by a  








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               taxpayer shall be reduced by the amount reflected on a  
               certificate issued by the FTB;  


             b)   In the case of a pass-thru entity, the amount of credit  
               that may be passed through to a partner shall be reduced by  
               the amount reflected on a certificate issued by the FTB; 


             c)   Defines a "pass-thru entity" as a partnership; and,


             d)   If a credit allowed is less than the amount of the credit  
               that provided the basis for a grant, the amount of the grant  
               attributable to the credit not allowed shall be treated as a  
               deficiency.


          7)Defines a "qualified small business" as a taxpayer that was  
            allowed a California Research Credit under the PIT or CT Law and  
            has gross receipts of $5 million or less for the taxable year.


          8)Provides that a qualified small business may not be an  
            affiliated corporation that is treated as a member of a combined  
            reporting group.


          9)Provides that no grant may be awarded with respect to a credit  
            that may be assigned.


          10)Provides the qualified small business to be certified by the  
            Governor's Office of Business and Economic Development (GO-Biz)  
            as an eligible qualified small business.


          11)Provides for taxable years beginning on or after January 1,  
            2016, and before January 1, 2023, that gross income does not  








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            include a grant received by the Grant Program.


          12)Defines gross receipts as having the same meaning as provided  
            for under Internal Revenue Code (IRC) Section 41(c)(7).


          13)Requires the FTB to allocate the certified amounts based on the  
            aggregate applicable amount for the calendar year in which the  
            certificate is issued.  


          14)Provides that the aggregate applicable amount that may be  
            certified for the calendar year beginning January 1, 2016, shall  
            be $100 million, not to exceed $50 million for each taxable year  
            beginning January 1, 2014 and January 1, 2015.


          15)Provides that the aggregate applicable amount shall not exceed  
            $50 million each calendar year beginning on or after January 1,  
            2017, and before January 1, 2023, regardless of taxable year to  
            which the grant relates.


          16)Requires the FTB to allocate the certificates to the qualified  
            small business, or partnership or "S" corporation, on a  
            first-come-first-serve basis, determined by the date the  
            taxpayer's original tax return is received by the FTB.  If two  
            or more returns are received on the same day and the amount of  
            credit remaining to be allocated is insufficient to be allocated  
            fully to each, the credit remaining shall be allocated to those  
            qualified small businesses on a pro rata basis.


          17)Provides that the FTB shall determine the date an application  
            or return is received.  The determination as to the date an  
            application or return is received or whether the application or  
            return has been timely filed may not be reviewed in any  
            administrative or judicial proceeding.








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          18)Provides the following for pass-thru entities:


             a)   Defines a "pass-thru entity" as a partnership or "S"  
               corporation under the PIT, and as a partnership under the CT.


             b)   Requires the FTB to issue a certificate to the qualified  
               small business, partners, or "S" corporation shareholders  
               with respect to grants for taxable years beginning on or  
               after January 1, 2014, and before January 1, 2016.  


             c)   Requires the FTB to issue a certificate to the partnership  
               or "S" corporation with respect to taxable years on or after  
               January 1, 2016.  


             d)   Provides that a certificate shall not be issued to an "S"  
               corporation with respect to the credit allowed under the CT  
               California Research Credit.


          19)Requires the Controller, upon receipt of a certificate issued  
            to a qualified small business, partner, or "S" corporation  
            shareholder, to pay the qualified small business the grant  
            amount indicated on the certificate.  


          20)Provides that grants are continuously appropriated from the  
            General Fund.  


          21)Requires the Controller, on or before January 1, 2017, and each  
            January 1 thereafter, to issue a report to the Assembly Revenue  
            and Taxation Committee, which includes a list of grant  
            recipients for the previous calendar year and the grant amount  








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            each recipient received.


          22)Requires, on or after January 1, 2016, that the Governor's  
            Office of Business and Economic Development, upon application by  
            the taxpayer, to certify that the taxpayer meets all the  
            requirements of a qualified small business.


          23)Provides that the FTB may prescribe rules, guidelines, or  
            procedures necessary or appropriate to carry out the purposes of  
            this division, including any guidelines regarding the allocation  
            of the certificates issued.


          24)Provides that the grant shall remain in effect only until  
            January 1, 2023, and as of that date is repealed, unless a later  
            enacted statute, that is enacted before January 1, 2023, deletes  
            or extends that date.


          FISCAL EFFECT:  According to the Assembly Appropriations  
          Committee, 


          1)One-time General Fund (GF) costs of approximately $225,000 and  
            ongoing annual costs of approximately $525,000 to GO-Biz to  
            develop program and regulations, and ongoing administration;  
            significant GF costs to FTB and Controller to administer changes  
            to systems and procedures.


          2)Estimated GF revenue decreases of $22 million, $27 million, and  
            $27 million in fiscal year (FY) 2015-16, FY 2016-17, and FY  
            2017-18, respectively.


          COMMENTS:  









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          1)Author's Statement:  The author has provided the following  
            statement in support of this bill:


               AB 437 allows small businesses to receive a grant  
               from the state in proportion to the amount of the  
               research and development tax credits they have  
               earned.  Research and Development Tax Credits (R &  
               D) were created in California back in 1987 to put  
               more dollars in the wallets of innovative businesses  
               - money businesses used to create new jobs, and  
               expand product lines.  However, data from the  
               Franchise Tax Board shows that often small and  
               medium sized companies are able to earn the R &D tax  
               credits but not able to receive their monetary  
               benefit because these businesses don't have enough  
               taxable liabilities.  These startups have the  
               potential of being the next big thing but without  
               some way of monetizing earned R&D tax credits, they  
               may never reach their full potential.  AB 437 is not  
               a reimbursable credit.  It is a grant program which  
               uses the R & D tax credit to determine how much  
               investment the state should provide the small  
               business.  Specifically, the bill authorizes  
               eligible businesses to receive a grant for 15% of  
               the credits generated starting in 2016.  The bill  
               also allows a two year look back period for which  
               small business can receive a grant for 10% of all  
               tax credits received in 2014 and 2015.     


          2)R&D Credit Background:  California enacted the credit for  
            research expenses in 1987 as part of two general federal tax  
            conformity bills [AB 1172 (Klehs), Chapter 1138, Statutes of  
            1987; and SB 572 (Garamendi), Chapter 1139, Statutes of 1987.]   
            The original credit percentage was 8% of qualified research  
            expenses.  Since that time, the California R&D credit rate was  
            amended several times and finally was increased from 12% to 15%  








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            in 2000 [AB 511 (Alquist), Chapter 107, Statutes of 2000.]  The  
            alternative incremental computation of the R&D credit was  
            adopted in 1997 [AB 1042 (Wayne), Chapter 613, Statutes of 1997]  
            and was subsequently amended to reflect the changes to the  
            California research credit percentage [AB 2798 (Machado),  
            Chapter 323, Statutes of 1998].  Unlike the federal R&D credit,  
            the California R&D credit is permanent.


          3)The Scope of the California R&D Credit.  The California R&D  
            credit is very similar to the federal R&D credit and is  
            generally available with respect to incremental increases in  
            qualified research.  "Qualified research expenses" eligible for  
            the credit consist of in-house expenses for wages and supplies  
            attributable to that research, certain time-sharing costs for  
            computer use, and 65% of the contract research expenses.   
            However, "qualified research expenses" include 100% of amounts  
            paid by the taxpayer to an eligible small business, university,  
            or federal laboratory for qualified energy research.  Under  
            California law, qualified research includes only research  
            conducted in California. 


            Under the regular credit, the amount of the California R&D  
            credit equals to the sum of:  a) 15% of the amount by which the  
            taxpayer's qualified research expenses for a taxable year exceed  
            its "base amount for that year", and b) 15% of the taxpayer's  
            expenditures on research undertaken by an energy research  
            consortium (the so-called 'energy research credit').  The energy  
            research credit applies to all qualified expenditures, not just  
            those in excess of a base amount.  In addition, corporate  
            taxpayers are also allowed a credit of 24% (in contrast to 20%  
            allowed under federal law) of expenses paid to fund basic  
            research at universities and certain nonprofit scientific  
            research organizations.  


          4)Purpose of the R&D Credit:  There are various reasons why the  
            R&D credit was enacted at the federal and state level.  First,  








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            the R&D credit is intended to reduce the after-tax cost of R&D  
            investments, which is expected to lead to an increase in R&D  
            activity and to encourage taxpayers to conduct R&D in the United  
            States rather than in another country.  Similarly, the  
            California R&D credit is designed to increase R&D activity and  
            to encourage manufacturing related to R&D to be undertaken in  
            California rather than elsewhere.  The California's R&D credit  
            provides a powerful incentive for firms to conduct R&D in  
            California because of its high credit percentages that exceed  
            that of other states.  The creation of additional R&D economic  
            activity in California is arguably more desirable than increased  
            economic activity from other industries.  Additional economic  
            activity in California also allows other local businesses to  
            adopt innovations more rapidly than innovations developed  
            elsewhere.  As explained by the FTB, the advantage to California  
            "may come through something economists call economies of  
            agglomeration," which can be described as the benefits several  
            firms receive when locating in close proximity.  (California  
            Income Tax Expenditures, Compendium of Individual Provisions,  
            Updated December 2009, FTB.)  Specifically, the cost of  
            production may significantly decline because there is a greater  
            chance for specialization and division of labor.  If this is the  
            case, many California businesses, not just those receiving this  
            credit, will gain an advantage over their rivals in other  
            states.


          5)Why subsidize R&D?  Positive externalities are benefits  
            resulting from an economic activity that are enjoyed by third  
            parties, a benefit not received directly by the seller or the  
            buyer.  California's R&D credit creates a number of positive  
            externalities such as reducing the costs of other firms'  
            innovative activity and providing newer, better, and less  
            expensive products to the market.  (Bronwyn Hall and Marta  
            Wosinka, The California R&D Tax Credit:  Description, History,  
            and Economic Analysis, June 1999.)  For example, research  
            conducted by a bio company may lead to the new medication, which  
            can increase sales, but the benefits may also include an overall  
            healthier population.  Because the bio company does not  








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            necessarily receive a direct benefit from having a healthier  
            population, it may limit itself from conducting additional R&D  
            even though a greater amount of research would be better for  
            society.    


            In a supply and demand model, the supply curve can be thought of  
            as marginal cost and the demand curve can be thought of as  
            marginal benefit.  Equilibrium is reached where the marginal  
            cost equals marginal benefit.  Everything to the left of the  
            equilibrium point and between the marginal benefit and marginal  
            cost curves is a benefit to society because the marginal benefit  
            is greater than the marginal cost.  However, in terms of R&D,  
            the marginal benefit curve of a firm investing in research may  
            not necessarily capture the positive externalities received by  
            society.  Because of this, a company may choose to curtail R&D  
            investment.  Ideally, society would want the private marginal  
            benefit curve to be the same as society's marginal benefit  
            curve.  The disparity can be thought of as a "market failure"  
            because the amount of research conducted by individual firms is  
            less than what is needed to capture the additional marginal  
            benefits enjoyed by society.  This disparity could be remedied  
            by providing a subsidy to a researching firm.  The subsidy will  
            lower the cost of production and increasing the amount of  
            research conducted by a firm.  The subsidy works so long as  
            investment is increased up to the point where the marginal  
            social benefit equals marginal cost.  Assuming current  
            investment in research is less than the optimal level, providing  
            a grant based on a percentage of unused R&D credit can provide a  
            larger benefit to society than the cost of the subsidy.  


          6)Grant Program:  This bill establishes a Grant Program to provide  
            grants to qualifying small businesses with unused R&D credit.   
            During the first year of enactment, the Grant Program will  
            provide a qualifying small business with a grant equal to 10% of  
            all unused R&D tax credits earned for taxable years 2014 and  
            2015.  Going forward, the Grant Program will provide qualifying  
            small businesses with a grant equal to 15% of unused R&D credit  








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            earned during the taxable year.  By creating a grant program  
            instead of a utilizing the current R&D tax credit, companies  
            with little or no tax liability to offset would be able to  
            monetize at least a portion of unused R&D tax credits.  


            As explained above, subsidizing R&D, in this case through a  
            grant program, works so long as investment in research is  
            increased up to the point where the marginal social benefit  
            equals marginal cost.  According to the Joint Committee on  
            Taxation, "[T]here is evidence that the current level of  
            research undertaken in the United States, and worldwide, is too  
            little to maximize society's well-being."  (Joint Committee on  
            Taxation, Description of Revenue Provisions Contained in the  
            President's Fiscal Year 2010 Budget Proposal, Part Two:   
            Business Tax Provisions, JCS-3-09, p. 11.)  This is especially  
            true for smaller companies, such as those contemplated within  
            this bill, that receive little or no benefit from the existing  
            R&D tax credit program.  As explained by FTB, for 2012 companies  
            with gross receipts between $1 and $10 million generated a total  
            of $100 million in R&D tax credits.  Eighty-seven million  
            dollars' worth of credits were earned by companies that were  
            completely unable to utilize the credit.  The remaining $13  
            million worth of credits were earned by companies that were only  
            able to utilize $3 million of earned credit.  The remaining $10  
            million will need to be carried forward.  In total, companies  
            with gross receipts between $1 and $10 million were only able to  
            utilize 3% of the R&D tax credits earned.  The bulk of R&D tax  
            credits are earned by large companies.  According to FTB's most  
            recent annual income tax expenditure report, companies with  
            gross receipts of more than $1 billion claimed a total of $1.7  
            billion in R&D credits, or 95.5% of all credits allowed.   
            (California Income Tax Expenditures, Compendium of Individual  
            Provisions, 2011, FTB.)


          7)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  








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            expenditures and direct expenditures.  First, tax expenditures  
            are reviewed less frequently than direct expenditures once they  
            are put in place.  Second, there is generally no control over  
            the amount of revenue losses associated with any given tax  
            expenditure.  Finally, once enacted, it takes a two-thirds vote  
            to rescind an existing tax expenditure absent a sunset date.   
            The Grant Program is a hybrid of both a tax and a direct  
            expenditure.  The State Controller is required, upon receiving a  
            certificate issued by the FTB, to pay the qualified small  
            business the grant amount indicated on the certificate.   
            Additionally, grant amounts paid to the qualifying small  
            business are calculated based on earned R&D tax credit, and the  
            amount of grant paid reduces the amount of excess credit the  
            qualifying small business can carryforward by the amount  
            reflected on the certificate.  Because of the tax implications,  
            a two-thirds vote is required in order to rescind the Grant  
            Program.  Even though the Grant Program contains a sunset date,  
            the length of time allowed before the Grant Program sunsets is  
            much longer than has generally been allowed by this Committee  
            when considering other tax expenditures in the past.  For this  
            reason, the Committee may wish to consider reducing the sunset  
            provision to five-years. 




          Analysis Prepared by:                                               
                          Carlos Anguiano / REV. & TAX. / (916) 319-2098   
          FN: 0000695


















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