BILL ANALYSIS Ó
SENATE COMMITTEE ON GOVERNANCE AND FINANCE
Senator Robert M. Hertzberg, Chair
2015 - 2016 Regular
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|Bill No: |AB 437 |Hearing |7/8/15 |
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|Author: |Atkins |Tax Levy: |No |
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|Version: |5/28/15 |Fiscal: |Yes |
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|Consultant|Grinnell |
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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
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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
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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
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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
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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
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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
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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
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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.
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