BILL ANALYSIS Ó
AB 2771
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Date of Hearing: May 9, 2016
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Sebastian Ridley-Thomas, Chair
AB 2771
(Irwin) - As Amended April 11, 2016
Majority vote. Fiscal committee. Tax levy.
SUBJECT: Personal income taxes: credits: taxes paid to
another state
SUMMARY: Modifies the rules for determining the amount of
credit allowed, under the Personal Income Tax (PIT) Law, to a
California resident for taxes paid to other states.
Specifically, this bill:
1)Provides that, for purposes of calculating a credit for the
taxes paid by a California resident to another state,
California's apportionment rules, and the regulations
thereunder, shall not apply in lieu of that other state's
apportionment rules.
2)Takes immediate effect as a tax levy.
EXISTING LAW:
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1)Imposes an income tax on all income of a California resident,
including income derived from sources outside California.
2)Allows generally an income tax credit for net income taxes
paid to other states (hereinafter "Other State Tax Credit" or
"OSTC").
3)Specifies that a credit is allowed for net income taxes
imposed by and paid to another state only on income that has a
source within the other state. No credit is authorized if the
other state allows California residents a credit for net
income taxes paid to California.
4)Requires the use of California's sourcing principles, case
law, and regulations in calculating the amount of the OSTC,
even if they are contrary to the other states' sourcing rules.
FISCAL EFFECT: Unknown, but Franchise Tax Board (FTB) staff
estimates that for every one percent of taxpayers impacted, the
measure would result in a revenue loss of approximately $8.8
million.
COMMENTS:
1)Author's Statement : The author has provided the following
statement in support of this bill:
AB 2771 will amend the OSTC calculation using the other
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state's apportionment rules instead of California's. This
will simplify the tax code and align it with other states
like New York that have implemented similar changes.
California tax laws should not unnecessarily burden
taxpayers who wish to comply but lack the expert knowledge
and resources to do so. This bill ensures that certain
taxpayers can use the amount of income taxes they paid in
other states as a credit against income taxes owed in
California, reducing the chance of double taxation for
California residents.
2)Committee Staff Comments :
a) Arguments in support : The proponents state that this
bill will "make compliance with the Other State Tax Credit
less burdensome, and more accessible to taxpayers who are
eligible for the credit but may lack the technical ability
to utilize it under the current rules." They argue that
"[u]sing the apportionment and allocation rules of the
state where the tax was paid when calculating the credit
also will help ensure that taxpayers are not being unfairly
double-taxed, and will more fully realize the original
intent of the Other State Tax Credit."
b) Other State Tax Credit (OSTC) background : States have
very broad taxing power over their residents. A state with
a personal income tax will generally impose the tax on all
of a resident's income, including the income derived from
other states or countries.<1> The state, however, would
allow a credit for net income taxes paid to another state,
to avoid instances of double taxation. For example, an
individual who lives in California but works elsewhere
would still be subject to California's personal income tax.
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<1> Part-year residents in California pay tax on all income
generated while they are residents, including from sources
outside the state. Nonresidents pay tax based on all income
from California sources.
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Yet, to the extent that the individual has paid an income
tax to another state where he or she works, the individual
may be entitled to receive a credit to offset California
income tax liability. While it may seem simple in the case
of an individual taxpayer with a "basic" type of income,
such as interest, dividends, or even wages, it becomes much
more complicated when the income is derived from a
multistate trade or business. The application of the OSTC
provisions is more complex because, unlike many other
states, California requires taxpayers to re-compute the
amount of tax paid to another state if the tax was paid on
apportioned or allocated income from a trade or business.
Specifically, under Revenue and Taxation Code (R&TC)
Section 18001, the recalculation must be done using
California's apportionment and allocation rules, instead of
the other state's rules. Put differently, instead of using
the actual amount of tax paid to other states, California
requires the taxpayer to recalculate the amount of tax that
would have been paid to the other state had that state
adopted California's rules.<2> The credit amount is
limited to the lesser of the actual amount of tax paid or
the amount that would have been due to the other state
under California's rules.
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<2> Under R&TC Section 18001, the OSTC is allowed only for net
income taxes paid to another state "on income derived from
sources within that state." In computing the actual amount of
credit, Section 18001(c) specifies that "'income derived from
sources within that state' shall be determined by applying the
nonresident sourcing rules for determining income from sources
within [California] ?, as specified in Chapter 11 (commencing
with Section 17951), and the regulations thereunder." The
regulations issued under Section 17951 state that if a unitary
business, trade, or profession (conducted through either a sole
proprietorship or a partnership) is carried on within and
without California, income from California sources is determined
in accordance with the Uniform Division of Income for Tax
Purposes Act (UDITPA) as adopted in Section 25120 through 25139
of the R&TC.
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c) What is the problem ? Arguably, the disregard of other
states' apportionment and allocation rules may result not
only in administrative complexity and burdensome
compliance, but also in significant double taxation of
California residents. This issue was first raised by the
practitioners who participated in the State Bar of
California 2015 Sacramento Delegation<3> (the Sacramento
Delegation paper) and was later discussed at the Eagles
Lodge West conference in April 2015. The greater the
difference is between California's and the other state's
apportionment and allocation rules, the more potential
there is for double taxation of income. This point is well
illustrated by two examples provided in the Sacramento
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<3> See The 2015 Sacramento Tax Delegation Paper, Reforming
California's Personal Income Tax Credit for Taxes Paid to
Another State to Fairly Account for Differences in State
Apportionment Rules and Reduce the Administrative Burden of
Calculating the Credit, V. Dickerson, J. Grossman, Deloitte Tax
LLP, 2015.
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Delegation paper.<4> Both examples assume a single sales
factor apportionment formula in other states. If, however,
the assumption is that the other state has a three-factor
apportionment formula, then the calculations become even
more complex and time-consuming. The taxpayer would first
have to calculate the amount of tax using the other state's
apportionment formula, and then re-calculate that amount
under the California single sales apportionment rules to
determine the OSTC amount. Some argue that the requirement
to collect information that may be difficult or impossible
to obtain is unreasonable and leads to non-compliance
altogether, especially in the case of a small sole
proprietor (who may not have the means) or a limited
partner (who may not have access to the required
information).
According to the author's office, individuals with even a
small stake in a company that does business in other states
and is treated as a pass-through entity is required to have
knowledge of the sourcing rules for the states from which
the company's income is derived. They need access to
technical data that only the company has and may not be
able to obtain the information necessary to complete the
re-calculations of the taxes paid in other states by the
company.
d) The proposed solution : This bill proposes a narrow
change to the existing OSTC calculation requirements. This
bill would still require taxpayers to re-calculate the
amount of income derived from the other state (and the
applicable tax due in the other state) using the
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<4> Id., pp. 4-6, Example 1: California Resident Sole
Proprietor
A California resident, "Cal R. Esident" (call him "Cal" for
short) is a small business owner providing online advertising
services to customers in California and its neighboring "State
A." Under State A's applicable tax laws, income from
advertising services is assigned to State A when the customer's
billing address is in State A. In contrast, California's
market-based sourcing rules would assign the same income from
advertising services to California based on the number of times
the advertisement is viewed or clicked on by internet users
located in California. Further, suppose that 80% of Cal's
customers have a State A billing address; but Cal's ads are
viewed equally between residents of California and Residents of
State A (i.e., 50% of ad views are from internet users in
California and 50% are from internet users in State A).
Finally, suppose that California and State A have identical
personal income tax rates of 10%, and that Cal has $100 of
income in 2013 solely from providing internet advertising
services.
Based on the billing addresses of Cal's customers, State A
determines 80% of Cal's income to be derived from sources in
State A, and Cal pays $8 of tax to State A. As a California
resident, Cal is taxed on 100% of his income and owes $10 of tax
to California which may be reduced by the OSTC. Under CRTC
Section 18001(c), Cal limits the OSTC to the tax that would have
been paid to State A if it assigned income from online
advertising services based on an in-state viewership (i.e., had
it used the same rule as California). If State A employed this
assignment methodology, 50% of Cal's income would have been
considered to be derived from within State A and Cal's
redetermined tax due would have been $5. Consequently, Cal will
be able to claim a $5 OSTC in California, and will pay $5 of tax
to California. In the aggregate, Cal pays $5 of tax to
California, $8 of tax to State A, and is taxable on 130% of his
income.
Example 2: California Resident Owning a Partnership Interest
Now, suppose that Cal owns an interest in a unitary partnership
that is doing business in California and "State B," and that Cal
plans to sell his partnership interest. Further, suppose that
State B sources receipts from the sale of intangible property
using a costs-of-performance (COP) methodology which includes
the costs incurred at the location where the negotiations take
place, but does not include the costs incurred over time that
caused the value of the intangibles to increase. In contrast,
California's market-based sourcing rules assign receipts from
the sale of a partnership interest based on the partnership's
prior year apportionment formula sales factor. Additionally,
assume that California and State B have identical personal
income tax rates of 10% and that, under California's
market-based sourcing rules, the partnership had a 90% sales
factor in California and a 10% sales factor in State B in the
current and prior year. Finally, suppose that Cal's only item
of income in 2013 is a gain of $100 from selling his partnership
interest and the only significant "costs of performance" were
those incurred during negotiations that took place in entirely
in State B.
Under State B's COP rules, all $100 of gain from the partnership
will be sourced to State B because that is where the sale
negotiations (i.e., the only significant costs of selling the
intangible property) took place. Consequently, Cal pays $10 of
tax to State B. As a California resident, Cal is taxed on 100%
of his income and owes $10 of tax to California which may be
reduced by the OSTC. The same as before, Cal's OSTC is limited
to the tax that would have been paid to State B if it assigned
from the sale of a partnership based on California's rules,
which in this case look to the partnership's sales factor in the
prior year. If State B used this assignment methodology, 10% of
Cal's income would have been considered to be derived from State
B and Cal's re-determined tax would have been $1. Consequently,
Cal will receive a $1 OSTC in California, and pays $9 of tax to
California. Due to California's current OSTC calculation rules,
Cal pays $9 of tax to California, $10 of tax to State B, and is
taxable on 190% of his income.
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nonresident sourcing rules, as provided. However, the
California apportionment rules would not apply. While this
bill would ease the burden of compliance, it will not
eliminate the requirement that income derived from other
states be calculated using California's allocation rules,
which means that the taxpayers in the examples cited in
footnote 3 would still be significantly double taxed. The
Committee may wish to consider whether the scope of this
bill should be expanded to include the application of the
other state's allocation rules, in addition to
apportionment rules, in determining the amount of tax paid
to the other state.
e) The Wynne Case : The issue of double taxation in the
context of the state's personal income tax was recently
analyzed by the Supreme Court of the United States in
Maryland Comptroller of the Treasury v. Wynne (2015) 135 S.
Ct. 1787. The Court explored the limits of state taxing
authority exercised by the State with respect to its own
residents. Central to the Court's decision in Wynne was the
question of whether the dormant commerce clause of the U.S.
Constitution protects resident individuals from their own
state's tax laws. The State of Maryland argued that there
was no constitutional requirement for the State to provide
a credit for income taxes paid by its residents to another
state and that the state may tax its residents on a 100% of
their income. The U.S. Supreme Court disagreed. The Court
held that Maryland's tax scheme, which imposed a tax on
income that Maryland residents earned outside the State,
violated the dormant Commerce Clause of the U.S.
Constitution because it did not offer Maryland residents a
full credit against the income taxes they paid to the other
State. The Maryland tax structure failed the "internal
consistency" test. This test looks to the structure of a
particular tax system to determine whether its identical
application by every State in the Union would place
interstate commerce at a disadvantage as compared with
intrastate commerce. In Wynne, the Maryland tax scheme
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failed because it had created an incentive for Maryland
taxpayers to opt for intrastate rather than interstate
economic activity. It is unclear whether California's OSTC
provisions would be similarly held to violate the internal
consistency test. While some believe that the OSTC
provisions would not fail this test, this issue is not free
from doubt and has not been settled by the courts.
f) OSTC rules in other states : FTB staff, in its analysis
of this bill, reviewed the income tax laws of Illinois,
Massachusetts, Michigan, Minnesota, and New York, because
these states' laws are most similar to California's income
tax laws. With the exception of New York, these states do
not require a recalculation of the tax paid to other states
for purposes of determining the OSTC amount. In the case
of New York,<5> it seems that the amount of tax paid to
another state must be re-determined using New York's
nonresident sourcing rules. However, the New York
Department of Taxation and Finance issued Audit Guidelines
clarifying that this requirement does not apply when a
resident is claiming a credit for taxes paid to another
state on flow through income, such as from a
partnership.<6> In fact, for NY purposes, regardless what
method the other state uses, "a resident would be allowed a
resident credit for the actual taxes paid to the other
state" and the auditor "should not recompute the
partnership income taxable by the other state using New
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<5> The term "income derived from sources within" another state
is "construed as to accord with the definition of the term
'derived from or connected with New York State sources,' as set
forth in Section 631 of the Tax Law in relation to the New York
source income of a nonresident individual." 20 NYCRR 120.4(d).
<6> "[T]his regulation addresses only the type of income for
which a resident would generally be allowed the credit and not
necessarily how the income is calculated in the other state." NY
Department of Taxation and Finance Nonresident Audit Guidelines,
Section VII. Resident Credit (Revised June, 2012).
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York's rules."<7>
Tax practitioners argue that California should be better
aligned with states like New York, "which have adopted
guidance that is both administratively feasible and fair to
residents by looking to taxes actually paid to other states
in computing the OSTC, rather than requiring "as if" home
state apportionment or allocation computations for all the
other states in which those residents pay tax."<8>
g) Related Legislation : SB 1449 (Nguyen) is similar to
this bill. SB 1449 is pending hearing by the Senate
Committee on Appropriations.
REGISTERED SUPPORT / OPPOSITION:
Support
California Taxpayers' Association
Opposition
None on file
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<7> Ibid.
<8> The 2015 Sacramento Delegation Paper., p. 10.
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Analysis Prepared by:M. David Ruff / REV. & TAX. / (916)
319-2098