BILL ANALYSIS Ó SENATE COMMITTEE ON GOVERNANCE AND FINANCE Senator Robert M. Hertzberg, Chair 2015 - 2016 Regular ------------------------------------------------------------------ |Bill No: |AB 437 |Hearing |7/8/15 | | | |Date: | | |----------+---------------------------------+-----------+---------| |Author: |Atkins |Tax Levy: |No | |----------+---------------------------------+-----------+---------| |Version: |5/28/15 |Fiscal: |Yes | ------------------------------------------------------------------ ----------------------------------------------------------------- |Consultant|Grinnell | |: | | ----------------------------------------------------------------- RESEARCH AND DEVELOPMENT: SMALL BUSINESS GRANT PROGRAM Allows qualified small businesses to convert research and development credits into cash grants. Background and Existing Law California law allows various income tax credits, deductions, and sales and use tax exemptions to provide incentives to compensate taxpayers that incur certain expenses, such as child adoption, or to influence behavior, including business practices and decisions, such as motion picture production credits. The Legislature typically enacts such tax incentives to encourage taxpayers to do something that but for the tax credit, they would not do. The Department of Finance is required to annually publish a list of tax expenditures, currently totaling around $51 billion per year. Similar to federal law, California allows taxpayers a research and development credit designed to provide incentives for taxpayers to increase their year-over-year spending on research and development. In 2011, the credit resulted in $1.77 billion in foregone revenue, 95% of which is attributable to firms with more than $1 billion in annual gross receipts. To qualify for the credit, research expenses must be conducted in California, and: Qualify as expenses under Internal Revenue Code §174, AB 437 (Atkins) 5/28/15 Page 2 of ? Must be undertaken for the purpose of discovering information that is technological in nature, Must be undertaken for the purpose of discovering information the application of which is intended to be useful in the development of a new or improved business component of the taxpayer, Substantially all of the research activities must constitute elements of a process of experimentation for a qualified purpose. The R&D credit is an incremental credit, which increases as the taxpayer incrementally grows its research expenditures over a comparable base-year period. To calculate the credit, taxpayers multiply the credit rate (generally 15%) by the amount by which their current year research expenditures exceeds the "base amount," which is derived by multiplying its "fixed base percentage" (the ratio that its total qualified research expenses for the 1984-1988 period bears to its total gross receipts for that period, with a 16% maximum) by its average gross receipts for the four previous taxable years. The base amount can't be less than 50% of qualified research expenditures for the credit year. For example, Computer Chips Inc., had an average of $20 million in gross receipts and $2.5 million in research expenditures from 1984-1988, for a fixed based percentage of 12.5%. However, the company grew to have $80 million in average gross receipts in the past four years, and $20 million in research spending last year. Computer Chips, Inc. can claim a research credit of $1.5 million this year [15% x $10 million ($20 million - $80 million x 12.5%). Taxpayers who weren't in business from 1984-1988 are assigned a fixed-base percentage of three percent for each of its first five taxable years after 1993 in which it incurs qualified research expenses, then for its sixth through tenth taxable years after 1993, its fixed-base percentage is a phased-in ratio based on the firm's actual research experience. For all subsequent taxable years, the taxpayer's fixed-base percentage is its actual ratio of qualified research expenses to gross receipts for any five years selected by the taxpayer from its fifth through tenth taxable years after 1993. If the taxpayer has no gross receipts, defined as the sales of tangible personal property in the state, they can use the minimum base amount of 50% of qualified research expenditures, AB 437 (Atkins) 5/28/15 Page 3 of ? according to Franchise Tax Board (FTB) Legal Division Guidance 2012-03-01, after it initially stated that such companies couldn't claim the credit (Legal Division Guidance 2011-06-01). Due to this ruling, if Computer Chips, Inc. instead split into a sales company and a research company (which didn't sell tangible property in California), the research company would generate credits of $10 million instead of $1.5 million. The research company could then assign the credit to the sales company to reduce its tax generated from the sales of computers, based on authority added by the Legislature in 2008 that allows corporation taxpayers to assign credits within their unitary or combined groups (AB 1452, Committee on Budget). Taxpayers can also elect to calculate the credit using a different method, known as the "Alternative Incremental Credit" (AIC). Taxpayers claiming the AIC instead use graduated percentages of 1.5%, 2%, or 2.5%, as applied to a percentage of expenses in excess of a specified percentage of average annual gross receipts. Congress has since repealed the AIC for federal purposes, and replaced it with the "Alternative Simplified Credit," (ASC) equal to 14% of qualified research expenses that exceed 50 percent of the average qualified research expenses for the three previous years, or 6% of qualified research expenses if a taxpayer has no qualified research expenses in any one of the three preceding taxable years. California does not conform to the ASC, but unlike the federal credit, California's doesn't have a sunset clause. If a business taxpayer's expenses exceed its gross receipts in a taxable year, it doesn't pay income tax, so it cannot make use of a tax credit that year. Many California companies are in this situation, with products or services not yet ready for market, but having spent funds on research expenses in the hopes of developing it, yet it need of the capital necessary to experiment further or start manufacturing a product. While state law allows taxpayers to carry forward most credits to a specified number of taxable years, the only refundable tax credit is the newly-enacted Earned Income Tax Credit, which allows taxpayers to receive a refund equal to difference left over after using the credit to reduce the tax due below zero when appropriated by the Legislature (SB 80, Committee on Budget and Fiscal Review, 2015). The author wants to allow small firms with research and development credits to convert them into cash grants. AB 437 (Atkins) 5/28/15 Page 4 of ? Proposed Law Assembly 437 allows a qualified small business to convert into cash grants 10% of the value of research and development credits carried over from the 2014 and 2015 taxable years to the 2016 year, or 15% for credits generated in the 2016 to 2021 taxable years, remaining after reducing tax for the year to zero. The measure also provides that its grants are not taxable income for California purposes. Taxpayers apply for grants by timely filing an original return with FTB, who allocates grants on a first-come, first-served basis, and can allocate $100 million in credits for the 2016 tax year, with not more than $50 million of that amount for the 2014 and 2015 years, and $50 million each year starting in 2017 and ending in 2023. FTB can only allocate credits to taxpayers: Certified as qualified small businesses by the Governor's Office of Business and Economic Development (GO-Biz), With less than $5 million in gross receipts in the taxable year using the Internal Revenue Code's definition, and not California's definition; and Who are not members of combined group of corporations for tax purposes. FTB must provide taxpayers with certificates within 90 days of receiving the return with the application. Taxpayers cannot share grants under the authority to share credits within unitary or combined groups of corporations. The bill directs the Controller to pay the taxpayer upon receipt of the certificate, and continuously appropriates funds from the General Fund necessary to do so. The Controller must report to the Assembly Committee on Revenue and Taxation regarding the recipients of the grants for the previous calendar year and the grant amount each recipient received. The measure applies rules for pass through entities, treats as a deficiency any grant amount the taxpayer subsequently claims as a credit, and allows FTB to issue any rules and regulations necessary to implement the credit. The bill also makes AB 437 (Atkins) 5/28/15 Page 5 of ? technical and conforming changes, and sunsets on January 1, 2023. State Revenue Impact According to FTB, AB 437 results in revenue losses of $22 million in 2015-16, $27 million in 2016-17 and 2017-18. Comments 1. Purpose of the bill . According to the author, "AB 437 allows small businesses to receive a grant from the state in proportion to the amount of research and development tax credits they have earned. This will allow small businesses to reinvest real dollars in further research and development projects as well as business expansion. According to data from the FTB, for taxpayers that have $1 million - $10 million in gross receipts there was $100 million in tax credits were generated. Of that amount, $87 million of those credits were not used. This data shows that often small and medium sized companies are able to earn the tax credits but not able to use them and reinvest those resources in to more R&D efforts because they don't have enough taxable liabilities. 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. This will allow small businesses to reinvest in further research and development projects. 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." 2. Highest and best ? AB 437 would set a significant precedent in state tax law by allowing small businesses to convert tax credits into cash, accelerating the taxpayer's ability to monetize the credits. As such, the measure prioritizes these cash grants above all other state spending, as moneys that the Controller must spend to provide the grants comes out of the General Fund before the Legislature appropriates what's left in the Budget Act. While the firms that AB 437 would help with cash grants will likely claim the credits against net income in the future, or transfer them to a firm that subsequently acquires or merges with it, the bill transfers the time value of money to the taxpayer at the expense of the Legislature, who AB 437 (Atkins) 5/28/15 Page 6 of ? won't have those funds available today for other state priorities such as education, health care, and public safety. However, the Legislature will likely have more funds in whichever years the taxpayer would've eventually claimed the credit, and the business can put the grant funds to work right away. Additionally, some of the firms that obtain AB 437 grants may never generate sufficient income, or go out of business, before they could ever monetize the credit, in which case the measure would result in a fiscal loss. The Committee may wish to consider the preceded AB 437 sets, and whether grants to these businesses represents the highest and best use of state funds. 3. Benefits and costs . In 2005, the Federal Reserve Bank of San Francisco studied California's research and development credit, and found that it was both effective in increasing research and development in the state, and does so by drawing away research and development that would've taken place in other states that lack a credit ("Beggar Thy Neighbor? The In-State, Out-of-State, and Aggregate Effects of R&D Tax Credits." Daniel J. Wilson, August, 2007). However, the Legislative Analyst Office (LAO) recommended reducing the state's credit or phasing it out over time, because measuring the credit's benefits are not enough to offset its substantial revenue loss. Additionally, direct research related spending through California's public universities could be a more cost-effective way of subsidizing R&D. 4. Slippery slope . In recent years, accounting firms and tax consultants have stretched the definition of "qualified research" to encompass products and services not generally considered scientific. According to Citizens for Tax Justice, Deloitte advertises the credit to food service companies developing new or redesigning existing packaging, while another firm, R&D Tax Savers, advertises the credit on its website by pointing to Starbuck's, Pepsi, and Coke using it for costs to make new soda machines, and Chili's to cut more than 40 hours of labor each week. Its website states: "In addition, many states are considering raises to the minimum wage, including the wage of tipped workers. Meanwhile, fast food workers in cities like New York have staged protests and walk-outs regarding issues of compensation. The AB 437 (Atkins) 5/28/15 Page 7 of ? ability to reduce labor needs through machine innovation is therefore a major way restaurants can continue `to maintain margins." Additionally, recent decisions from the State Board of Equalization have expanded the kinds of products that qualify as research expenditures. In the recent appeal of Pacific Coast Building Products, BOE overturned FTB's denial of research and development Credits for normal manufacturing equipment used to make building products, which the company claimed on amended returns generated by a PriceWaterhouseCoopers tax credit study of the company's operations despite any documentation of experimentation. The Committee may wish to consider whether the definition of qualified research should be limited to genuine scientific research and experimentation before allowing cash grants in-lieu of credits. 5. Taxing . The United States Tax Court ruled in 2015 that tax credits where the state allows taxpayers to claim a credit without paying tax are considered grants, and therefore taxable income for federal purposes in Maines v. Commissioner, 144 T.C. No. 8. As such, AB 437 will allow qualified small businesses to obtain cash grants in-lieu of credits, but these businesses will have to include the grant amount in income for federal purposes. However, because the measure includes an explicit exclusion, grant amounts won't be included for California purposes. 6. Who certifies ? AB 437 calls on Go-Biz to certify small businesses; however, the information necessary to certify, such as gross receipts on whether the business is part of a unitary or combined group, will be on the return submitted to FTB. As such, it's unclear why the measure should assign administrative responsibility to Go-Biz instead of FTB, especially when Go-Biz would be entirely reliant on FTB information to fulfil the responsibility. 7. Parity . AB 437 directs the Controller to report to the Assembly Committee on Revenue and Taxation regarding the recipients of the grants for the previous calendar year and the grant amount each recipient received, a surely unintentional oversight of the Senate. While the Committee on Governance and Finance dutifully reads all reports state law requires be sent to it, perhaps the measure should instead direct the Controller AB 437 (Atkins) 5/28/15 Page 8 of ? to send the report to the Joint Legislative Budget Committee instead, which is the recipient of similar reports. Assembly Actions Assembly Floor 79-0 Assembly Appropriations 17-0 Assembly Revenue and Taxation 9-0 Support and Opposition (7/2/15) Support : BIOCOM, California Asian Chamber of Commerce, California Association for Microenterprise Opportunity, California Chamber of Commerce, California Healthcare Institute, California Life Sciences Association, California Metals Coalition, Flex Tech Alliance, National Federation of Independent Business, SEMI, Small Business California, Opposition : California Tax Reform Assocition. -- END --