BILL ANALYSIS Ó
AB 544
Page 1
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.
AB 544
Page 2
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:
AB 544
Page 3
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.
AB 544
Page 4
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
AB 544
Page 5
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
AB 544
Page 6
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
AB 544
Page 7
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
AB 544
Page 8
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
AB 544
Page 9
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
AB 544
Page 10
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
AB 544
Page 11
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.
AB 544
Page 12
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
AB 544
Page 13
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
AB 544
Page 14
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.
AB 544
Page 15
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
AB 544
Page 16
Analysis Prepared by:Carlos Anguiano / REV. & TAX. / (916)
319-2098