BILL ANALYSIS                                                                                                                                                                                                    Ó



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          Date of Hearing:  May 18, 2015





                     ASSEMBLY COMMITTEE ON REVENUE AND TAXATION


                                 Philip Ting, Chair





          AB 544  
          (Mullin) - As Amended May 11, 2015


          


          2/3 vote.  Fiscal committee.  Tax levy.


          SUBJECT:  Income taxes: credits: research activities.


          SUMMARY:  Conforms, under the Personal Income Tax (PIT) Law and  
          the Corporation Tax (CT), to the federal alternative simplified  
          credit (ASC), repeals the alternative incremental credit (AIRC),  
          and conforms to recent federal changes related to acquisitions,  
          dispositions, and aggregations.  Specifically, this bill:  


          1)Repeals, on or after January 1, 2016, state conformity to  
            Internal Revenue Code (IRC) Section 41(c)(A)(4), relating to  
            the alternative incremental credit.









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          2)Conforms to IRC Section 41(c)(5), relating to the alternative  
            simplified credit, except as follows:


             a)   On or after January 1, 2016, and before January 1, 2019,  
               the reference to "14 percent" in IRC Section 41(c)(5)(A) is  
               modified to read "5 percent";


             b)   On or after January 1, 2019, and before January 1, 2022,  
               the reference to "14 percent" in IRC Section 41(c)(5)(A) is  
               modified to read "7.75 percent"; and,


             c)   On or after January 1, 2022, and before January 1, 2023,  
               the reference to "14 percent" in IRC Section 41(c)(5)(A) is  
               modified to read "10.5 percent."


             d)   On or after January 1, 2016, and before January 1, 2023,  
               the reference to "6 percent" in IRC Section 41(c)(5)(B)(ii)  
               is modified to read "4.5 percent."


          3)Provides that an election to use the ASC would apply to all  
            succeeding taxable years, on or after January 1, 2016, and  
            before January 1, 2023, unless revoked with the consent of the  
            Franchise Tax Board (FTB).


          4)Conforms to federal law relating to the inclusion of qualified  
            research expenses and gross receipts of an acquired person and  
            aggregation of expenditures.


          EXISTING LAW:  










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          1)Allows taxpayers engaged in a trade or business to deduct all  
            of the ordinary and necessary business expenses incurred.

          2)Allows a R&D tax credit that is combined with several other  
            credits to form the general business credit.  The R&D credit  
            is designed to encourage companies to increase their R&D  
            activities.   

          3)Specifies that the R&D credit is equal to 20% of the qualified  
            research expenses that exceed the base year amount, as  
            defined, plus 20% of the amount paid or incurred during the  
            taxable year on research undertaken by an energy research  
            consortium.

          4)Defines "base year amount" as the product of the average  
            annual gross receipt of the taxpayer for the four taxable  
            years preceding the taxable year the credit is earned times a  
            fixed percentage, but under no circumstances may the base year  
            amount be less than 50% of the qualified research for the  
            taxable year. 

          5)Authorizes an additional credit to corporate taxpayers equal  
            to 20% of expenses paid to fund "basic research" at  
            universities and certain nonprofit scientific research  
            organizations. 

          6)States that a taxpayer was allowed, prior to January 1, 2009,  
            to elect an alternative incremental research credit for  
            determining its R&D credit.  The federal percentages are 3%,  
            4%, and 5%.  

          7)Allows an alternative simplified credit equal to 14% of  
            research expenses that exceed 50% of the average research  
            costs for the three preceding taxable year. 

          8)Specifies that, in order to qualify for the R&D credit,  
            research expenses must qualify as an expense or be subject to  
            amortization, be conducted in the U.S. and be paid by the  
            taxpayer. 








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          9)Provides that "qualified research" is research that is:

             a)   Undertaken to discover information that is technological  
               in nature; 

             b)   Primarily involves experimentation related to quality or  
               to a new or improved function or performance; and, 

             c)   Its application will be useful in developing new or  
               improved business components for the taxpayer.

          EXISTING STATE LAW:


          1)Allows various tax credits designed to either provide tax  
            relief for taxpayers who incur certain expenses or to  
            influence taxpayers' behavior.  

          2)Conforms California to the federal R&D credit but with the  
            following modifications:

             a)   The state R&D credit is not combined with other business  
               credits.

             b)   Both "qualified research" and "basic research" must be  
               undertaken in California.

             c)   The credit percentage for increasing qualified research  
               activities in California is 15%.

          3)Provides an alternative credit of 24% (versus the 20% federal  
            credit) for "basic research", available for "C" corporations  
            only.

          4)Sets the percentages for the alternative incremental research  
            portion of the credit lower than those of the federal credit. 

          5)Allows the R&D credit, which is permanent, for taxable years  








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            beginning on or after January 1, 1987. 

          6)Allows taxpayers that are members of a combined reporting  
            group to make a one-time irrevocable assignment of eligible  
            credits to another member.  However, the assigned credits may  
            be utilized to reduce tax only for taxable years beginning on  
            or after January 1, 2010.

          FISCAL EFFECT:  Unknown 


          COMMENTS:  


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


               California has long been a national and global leader in  
               research and development (R&D).  To ensure the continued  
               growth and development of R&D, our tax code should offer  
               effective incentives for these investments.  The state  
               currently offers an R&D Tax Credit that dates back to a  
               1987 federal law.  Over time, the federal credit has been  
               updated in important ways, while California's credit  
               remains largely unchanged.  These discrepancies burden  
               research firms, as they must decode state and federal law  
               separately and are often subject to duplicative audits from  
               both levels of government.


               This bill conforms California's credit calculation methods  
               to federal law by allowing firms to calculate their credit  
               amount using the "simplified method."  The simplified  
               method was created federally in 2007 to modernize and  
               streamline the credit calculation process.  Bringing it to  
               California would likewise improve our state's R&D credit  
               calculation system.  This legislation has received  
               widespread support from the tech and biotech industries, as  








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               well as from the California Franchise Tax Board.  Please  
               join me in coauthoring this important measure.


           2)Arguments in Support  :  Hewlett-Packard states that, "A.B. 544  
            is a simpler and better method of calculating the R&D credit.   
            Calculating the credit under A.B. 544 would rely only upon R&D  
            conducted in relatively recent years, in line with the Federal  
            simplified credit. When the standard method is used, the  
            interaction of R&D activity with revenue generation can lead  
            to unintended consequences (such as generating a larger credit  
            by shifting revenue-generating activity outside of California  
            and similar competitors getting significantly different credit  
            amounts depending upon their characteristics in the mid-1980's  
            rather than today)."


           3)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.


           4)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  








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            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:  (i) 15% of the amount by which  
            the taxpayer's qualified research expenses for a taxable year  
            exceed its "base amount for that year", and (ii) 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.


           5)What is a "tax expenditure"  ?  Existing law provides various  
            credits, deductions, exclusions, and exemptions for particular  
            taxpayer groups.  In the late 1960s, United States 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 replace an existing  
            method of calculating the R&D credit, as provided for under  
            the AIRC, by conforming to the federal ASC.


           6)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  








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            taxpayers greater certainty, but it can also result in tax  
            expenditures remaining a part of the 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 generally 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.  This bill conforms, with certain  
            modifications, to the ASC beginning on or after January 1,  
            2016, and before January 1, 2023.  In order to increase the  
            frequency of legislative review, the Committee has generally  
            required that all tax expenditures sunset within five years.   
            Therefore, the Committee may wish to sunset the provisions in  
            this bill on January 1, 2021.


           7)What does this bill do  ?  This bill would bring California into  
            conformity with the federal calculation methods by allowing  
            taxpayers to elect the ASC and eliminate the use of the AIRC.   
            This bill modifies conformity by establishing a phase-in  
            period for the normal ASC by providing 5% of the federal  
            credit for the first three taxable years, 7.75% for the next  
            three taxable years, and 10.5% in the final year.   
            Additionally, this bill provides 4.5% of the federal credit  
            for entities that have no QREs in the last three years.  This  
            bill also conforms to recent federal modifications to the  
            special rules that apply for computing the R&D credit when a  
            major portion of a trade or business changes hands, and for  
            the aggregation of expenditures among commonly-controlled or  
            otherwise-related entities.


           8)Base Year Calculation  .  In 2009, the Government and  
            Accountability Office (GAO) released a report analyzing the  
            effectiveness of the R&D Credit.  In general, the GAO found  
            serious disparities in the incentives provided to different  








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            taxpayers.  The GAO also found that a large number of the  
            credit dollars to be a windfall because they were based on  
            expenditures that would have occurred in the absence of the  
            credit.  In its conclusion, the GAO pointed to the use of the  
            84'-88' base year as a key reason for such disparities and  
            results that were inconsistent with the program's intent.   
            (GAO, Tax Policy:  The Research Tax Credit's Design and  
            Administration Can Be Improved, Nov. 2009.)  As a way of  
            rectifying the base year problem, Congress enacted the AIRC  
            and provided for the use of a rolling base year.  Later, it  
            enacted the ASC and removed gross receipts from the method of  
            calculation, which allowed for a simpler method of calculating  
            the rolling average.


           9)Calculating the Credit  :  

              a)   Regular Credit  .  Under the regular credit, the credit is  
               calculated as follows:

               Credit = 20% ? [current-year QREs - base QREs], 


                    Base QREs = greater of:


                    [Sum of QREs for 1984 to 1988 / the sum of gross  
                    receipts for 1984 to 1988] ? average gross receipts  
                    for the 4 tax years immediately preceding the current  
                    one; or,


                    50% ? current-year QREs


              b)   AIRC  .  Under the AIRC, the credit is calculated as  
               follows:   

               Credit = 3% of Qualified Research Expenses (QRE) that are  








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                    above 1% but not greater than 1.5% of average annual  
                    gross receipts in the 4 preceding tax years.


                    + 4% of QREs that are above 1.5% but not greater than  
                    2% of average annual gross receipts in the 4 preceding  
                    tax years


                    + 5% of QREs that are above 2% of average annual gross  
                    receipts in the 4 preceding tax years


                    In California, the applicable AIRC rates are 1.49%,  
                    1.98%, and 2.48%, respectively.


              c)   ASC  .  Under ASC, the credit is calculated as follows:  

               Credit = 14% ? [current-year QREs - 50% ? average QREs in  
               the 3 preceding tax years]


                    If a taxpayer has no QREs in any of its 3 preceding  
                    tax years, then the credit is equal to 6% of its QREs  
                    in the current tax year.  In California, the  
                    simplified credit is not allowed.


                    This bill establishes a phase-in period for the normal  
                    ASC by providing 5% of the federal credit for the  
                    first three taxable years, 7.75% of the federal credit  
                    for the next three taxable years, and 10.5% of the  
                    federal credit in year seven.  Additionally, this bill  
                    provides a credit of 4.5% of the federal credit for  
                    entities that have no QREs in the last three years.


           10)Benefits of ASC  .  As the name implies, calculation of the ASC  








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            is much easier for taxpayers to calculate.  Unlike the  
            incremental method, which relied on tiered system of average  
            annual gross receipts, the ASC allows for a 14% of research  
            expenses that exceed 50% of the average research costs for the  
            three preceding taxable year.  By conforming to the ASC,  
            taxpayers will be much less likely to make mistakes, it would  
            make it easier for FTB to conduct an audit, and it would allow  
            companies to take advantage of the rolling average base  
            without the difficulties of a tiered calculation.   
            Furthermore, many companies that currently utilize the AIRC do  
            so because they tend to have a relatively high fixed-base year  
            percentages, spend less in research, or have sales growing at  
            a faster rate than their research spending.  (Gary Guenther,  
            Research Tax Credits:  Current Law, Legislation in the 112th  
            Congress, and Policy Issues, Congressional Research Service,  
            Nov., 2011)  The enactment of the ASC will also maintain the  
            benefits associated with an AIRC but with an easier method of  
            calculation.


           11)Percentage of California Credit  .  This bill establishes a  
            phase-in period for the normal ASC by providing 5% of the  
            federal credit for the first three taxable years, 7.75% of the  
            federal credit for the next three taxable years, and 10.5% of  
            the federal credit in year seven.  Additionally, this bill  
            provides a credit of 4.5% of the federal credit for entities  
            that have no QREs in the last three years.  The final credit  
            percentage of 10.5% for the ASC is 75% of the federal ASC.   
            This is in line with the credit percentage that California  
            provides for the regular credit, but not in line with the  
            percentage California provides for the current AIRC.  The  
            federal AIRC provides a tiered credit of 3%, 4%, and 5%.  The  
            applicable AIRC rates in California are 1.49%, 1.98%, and  
            2.48%, or roughly 49.6% of the federal credit.  Because this  
            bill replaces the AIRC with the ASC, Committee may wish to  
            consider lowering the proposed state ASC credit percentages to  
            more closely align with the credit percentages currently  
            available under AIRC.  









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           12)Conformity Issues  .  This bill only conforms to the federal  
            provisions relating to the ASC.  California does not  
            automatically conform to federal law, but instead considers  
            each provision individually.  The last California-federal  
            conformity bill was enacted in 2010 [SB 401 (Wolk), Chapter  
            14, Statutes of 2010].  An omnibus California-federal  
            conformity bill may be a more appropriate vehicle for  
            comprehensively reviewing California's R&D tax credit regime  
            and the ways in which it differs from federal law.  For  
            example, California's definition of "gross receipts" excludes  
            gross receipts other than those that are "sales of property  
            held by the taxpayer primarily for sale to customers in the  
            ordinary course of the taxpayer's trade or business that is  
            delivered or shipped to a purchaser within this state."  (R&TC  
            Section 17052.12.)  The decision to adopt a  
            California-specific definition of "gross receipts" was made  
            decades ago.  The Committee may wish to consider whether this  
            definition is still merited in light of recent legal and  
            economic developments.  To this end, the Court of Appeal  
            recently 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.]  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.)  In light of this decision, the Committee may wish to  
            consider whether the existing definition of "gross receipts"  
            is legally sound.


           13)The R&D credit  :  There are two main purposes for the federal  
            and California R&D credit.  First, the 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 U.S. rather than in  








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            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 and because it is permanent.  This credit, unlike  
            many other tax incentives, does not serve as a reward for past  
            behavior since it could only be claimed for incremental  
            increases in the taxpayer's research activity.  As explained  
            by the Joint Committee on Taxation's Report, "incremental  
            credits attempt not to reward projects that would have been  
            undertaken in any event but to target incentives to marginal  
                                                            projects."  (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. 17.)  It is impossible, however, to determine  
            which projects would be undertaken without the credit and,  
            thus, "most incremental credit proposals rely on some measure  
            of the taxpayer's previous experience as a proxy for a  
            taxpayer's total qualified expenditures in the absence of a  
            credit", i.e. "a base amount."  (Id., p.18.)  Nonetheless, the  
            incentive effects of incremental credits per dollar of revenue  
            loss can be many times larger than those of a flat credit.



          The California R&D credit is believed to create additional R&D  
            economic activity in the state, which, arguably, is more  
            desirable than jobs in other industries.  The credit also  
            allows other California businesses to adopt innovations  
            developed locally 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, p.17.)   
            Specifically, the cost of production may significantly decline  








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            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.
           14)Prior Legislation  :

             a)   AB 2330 (Mullin), of the 2013-14 Legislative Session,  
               would have conformed, under the PIT Law and the Corporation  
               Tax CT, to the federal ASC, repeals the alternative  
               incremental credit AIRC, and conforms to recent federal  
               changes related to acquisitions, dispositions, and  
               aggregations.  AB 2330 was held on the Assembly  
               Appropriation Committee's Suspense file. 

             b)   AB 1564 (V. Manuel Pérez), of the 2013-14 Legislative  
               Session, would have temporarily increased the rates of the  
               general research credit and the university "basic research"  
               credit and allowed taxpayers to sell and purchase research  
               credits, as provided, under the Research and Development  
               Tax Credit Trade Program.  AB 1564 was held on the Assembly  
               Appropriation Committee's Suspense file.

             c)   AB 653 (V. Manuel Pérez), of the 2013-14 Legislative  
               Session, would have temporarily provided incremental  
               increases to the general research credit percentage using  
               the regular calculation method, up to a maximum credit rate  
               of 30 percent, and would have temporarily provided  
               incremental increases to the university "basic research"  
               credit percentage, up to a maximum credit rate of 40%.  AB  
               653 was held on the Assembly Appropriation Committee's  
               Suspense file. 

             d)   AB 486 (Mullin), of the 2013-14 Legislative Session,  
               would have provided manufacturers, software producers,  
               biotechnology and life, engineering, and physical  
               researchers and developers, a SUT exemption for qualifying  
               TPP.  AB 486 was held on the Assembly Appropriation  
               Committee's Suspense file.









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          REGISTERED SUPPORT / OPPOSITION:




          Support


          California Chamber of Commerce


          California Healthcare Institute


          California Manufacturers and Technology Association


          California Taxpayer Association 


          Silicon Valley Leadership Group


          Hewlett-Packard Company 


          TechAmerica




          Opposition


          None on file












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