BILL ANALYSIS                                                                                                                                                                                                    Ó



                                                                     AB 437


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          CONCURRENCE IN SENATE AMENDMENTS


          AB  
          437 (Atkins)


          As Amended  August 31, 2015


          2/3 vote


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          |ASSEMBLY:  | 79-0 |(June 2, 2015) |SENATE: | 32-0 |(September 1,    |
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          Original Committee Reference:  REV. & TAX.




          SUMMARY:  Establishes a Research and Development-Small Business  
          Grant Program (Grant Program) providing grants, equal to a  
          percentage of unused Research and Development credits, to  
          qualifying small business, as specified.  




          The Senate amendments:




          1)Delay the operative date by one year.










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          2)Require the State Controller to also provide the report to the  
            Committee on Governance and Finance, or its successor.




          3)Delete the requirement that the Governor's Office of Business  
            and Economic Development (GO-Biz) certify that the taxpayer is  
            a qualified small business and meets all requirements.




          4)Require a "qualified small business" to be organized as one of  
            the following business entities:




             a)   Corporation;




             b)   Partnership;




             c)   Limited Partnership; or,




             d)   Limited Liability Company, whether classified as a  
               corporation, partnership, or disregarded as a separate  
               entity.











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          5)Require a "qualified small business" to be in existence and  
            have filed income tax returns for the two taxable years  
            preceding the taxable year for which the taxpayer applies for  
            a grant.




          AS PASSED BY THE ASSEMBLY, this bill:  


          1)Provided, 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)Required, 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)Provided, 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)Required, in order to receive a grant, a qualified small  
            business to apply for the grant on a timely field original  








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            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 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)Provided 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)Provided 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:










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


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


          10)Provided the qualified small business to be certified by the  
            GO-Biz as an eligible qualified small business.


          11)Provided for taxable years beginning on or after January 1,  
            2016, and before January 1, 2023, that gross income does not  
            include a grant received by the Grant Program.









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


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


          14)Provided 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)Provided 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)Required 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)Provided 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.


          18)Provided the following for pass-thru entities:









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


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


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


          19)Required 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)Provided that grants are continuously appropriated from the  
            General Fund.  


          21)Required 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  
            each recipient received.


          22)Required, on or after January 1, 2016, that GO-Biz, upon  
            application by the taxpayer, to certify that the taxpayer  
            meets all the requirements of a qualified small business.








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          23)Provided 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)Provided 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 Senate Appropriations  
          Committee:


          1)The FTB estimates that the previous version of this bill would  
            result in General Fund revenue losses of $22 million in  
            2015-16, and $27 million in 2016-17.  By delaying the  
            implementation date one year, the revenue impacts would  
            themselves be delayed by one year, and would likely be of  
            similar magnitude.


          2)The FTB estimates that this bill would result in one-time  
            General Fund administrative costs of $664,000, related to the  
            creation of the grant program.  Ongoing costs would be  
            $344,000 annually, beginning in 2017-18.  


          COMMENTS:  


          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  








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               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% 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  








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            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,  
            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  








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            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 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  








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            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  
            2015 and 2016.  Going forward, the Grant Program will provide  
            qualifying small businesses with a grant equal to 15% of  
            unused R&D credit 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  








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            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 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.     










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          Analysis Prepared by:                                             
                          Carlos Anguiano / REV. & TAX. / (916) 319-2098    
                                                                    FN:  
          0001904