BILL ANALYSIS
AB 1178
Page 1
Date of Hearing: January 11, 2010
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Charles M. Calderon, Chair
AB 1178 (Block) - As Amended: January 6, 2010
Majority vote. Tax levy. Fiscal committee.
SUBJECT : Water's-edge election: sales and use taxes:
exemption.
SUMMARY : Requires multinational corporations that elect to file
tax returns based only on income earned inside the United States
(U.S.), known as the water's-edge method, to include, for tax
years beginning on or after July 1, 2011 and before July 1,
2014, the income of a related corporation located in a tax haven
country. Provides a partial exemption from the sales and use
taxes (SUT), on and after July 1, 2011, and before January 1,
2015, for the purchases of college textbooks and supplies by
college students, as defined. Specifically, this bill :
1)Requires a corporate taxpayer, for taxable years beginning on
and after July 1, 2011, and before July 1, 2015, to include in
the taxpayer's water's-edge return the entire income and
apportionment factors of any affiliated corporation that was
doing business in, or had income derived from or attributable
to, a tax haven.
2)Defines the term "tax haven" by reference to 39 jurisdictions
identified as tax havens by the Organization for Economic
Cooperation and Development (OECD) as of December, 2002.
3)Allows a taxpayer to petition the Franchise Tax Board (FTB) to
exclude the income and apportionment factors of a tax haven
corporation from the water's-edge return if that corporation's
activities in a tax haven jurisdiction constitute either a
"substantial economic presence" or " significant economic
activity."
4)Authorizes the FTB to prescribe regulations necessary to carry
out the purposes of this bill.
5)Requires the FTB to issue a notice identifying the
jurisdictions that are considered tax havens.
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6)Requires the Legislative Analyst, in consultation with the
FTB, to conduct a study regarding the jurisdictions identified
by the OECD as tax havens and report to the Legislature no
later than January 1, 2011, as to whether the definition of
the term "tax haven" should be revised.
7)Provides a partial exemption from SUT, on and after July 1,
2011, and before January 1, 2015, for the sale of, and the
storage, use, or other consumption of, textbooks and supplies
purchased by a student enrolled in an institution of higher
education. Specifically, it provides that:
a) For purchases made between July 1, 2011, and before July
1, 2012, the state portion of SUT otherwise applicable to
those purchases is reduced to 2%.
b) Purchases made on or after July 1, 2012, and before
January 1, 2015, are exempted from the state portion of
SUT.
c) The exemption does not apply to any of the following
taxes:
i) Tax imposed pursuant to Revenue and Taxation Code
(R&TC) Section 6051.2 and Section 6201.2, dedicated to
local governments to fund health and welfare programs
(Local Revenue Fund);
ii) Tax imposed pursuant to R&TC Section 6051.5 and
Section 6201.5, dedicated to the repayment of the
Economic Recovery Bonds (Fiscal Recovery Fund);
iii) Tax imposed pursuant to Section 35 of Article XIII
of the California Constitution, dedicated to local
government to fund public safety services (Local Public
Safety Fund); and,
iv) Any tax levied by a county, city, or district
pursuant to the Bradley-Burns Uniform Local SUT Law or
the Transactions and Use Tax Law.
8)Defines "institution of higher education" as the University of
California, the California State University, or a California
community college.
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9)Defines "supplies" as pens, paper, blue books, notebooks, art
supplies, uniforms, safety equipment, tools, computer paper,
and flash drives necessary for the course of study in which a
student is enrolled at the institution of higher education.
The definition of "supplies" does not include computers,
printers, or related hardware and software.
10)Defines "textbooks" as any published material that is
principally designed for use by a student at an institution of
higher education as a source of instructional material and
includes any book or edition of a book that is directed or
recommended by an instructor at an institution of higher
education to a student to purchase for use as a basis for a
course of study in which that student is enrolled at that
institution.
11)Takes effect immediately as a tax levy.
EXISTING FEDERAL INCOME TAX LAW :
1)Imposes a tax on all of the U.S. corporation's income,
regardless of source and allows a credit for any taxes paid to
a foreign country on its foreign-source income.
2)Imposes taxes on "Subpart F income" of a controlled foreign
corporation (CFC). Defines "Subpart F income" as passive
income, such as dividends, interest, royalties and rents, as
well as shipping income, oil related income, insurance income,
and income from certain sales of goods that neither
manufactured nor sold for use in the CFC's home country.
Defines a "CFC" as a foreign company 50% of which is owned by
U.S. shareholders.
3)Provides that a foreign corporation may be subject to tax on
its U.S.-source income (income derived from sources within the
U.S.). U.S.-source income includes income earned by a foreign
corporation's sales office located in the U.S., royalties paid
from a U.S. corporation to a foreign corporation, and interest
paid from a U.S. corporation to a foreign corporation.
EXISTING STATE LAW :
1)The Corporation Tax Law:
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a) Imposes an annual tax on corporations measured by income
sourced to California, unless otherwise exempted. Income
sourced to California from corporations operating both
within and outside of the state is determined on a
worldwide basis applying the unitary method of taxation.
The unitary method combines the income of affiliated
corporations that are members of a unitary business and
apportions the combined income to California based upon the
average of four factors (the property factor, the payroll
factor, and two sales factors). This four-factor formula
identifies the relative levels of business activity in the
state and apportions the combined income to California
using the determined share of California business activity.
For taxable years beginning on or after January 1, 2011,
certain corporate taxpayers may make an annual election to
apportion its income to California using a single sales
factor apportionment formula. Corporations that are
engaged in agricultural, extractive, savings and loan, and
banking or financial business activities are prohibited
from electing the single sales factor apportionment
formula.
b) Allows taxpayers with worldwide business activities to
elect to report income to California on a water's-edge
basis. Taxpayers that make a water's-edge election include
income and apportionment factors of businesses operating
only within the U. S., plus a few other jurisdictions,
thereby generally excluding the income and apportionment
factors of most foreign affiliates. In exchange for this
election to file on a water's-edge basis, a taxpayer agrees
to file consistently using the water's-edge method for at
least seven years.
c) Provides that the entire income and apportionment
factors of certain affiliated entities, which are unitary
with an entity that is the water's-edge taxpayer, are
includable in the water's-edge return. The list of
affiliated entities includes a foreign incorporated entity
(other than banks) if the average of its property, payroll,
and sales factors within the U.S. is 20% or more. Even if
the average is less than 20%, the foreign corporation's
income and apportionment factors would still be
incorporated in a water's-edge return to the extent its
U.S.-source income and its apportionment factors are
assignable to a location within the U.S... Furthermore,
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the list also includes a CFC with Subpart F income. The
income and apportionment factors of a CFC are included in
the water's-edge return based on a ratio of the CFC's
current year Subpart F income determined under federal law
to the CFC's current earnings and profits.
2)The SUT Law:
a) Imposes a sales tax on retailers for the privilege of
selling tangible personal property (TPP), absent a specific
exemption. The tax is based upon the gross receipts from
sales of TPP in this state.
b) Imposes a use tax on the storage, use, or other
consumption in this state of TPP purchased from any
retailer for storage, use, or other consumption in this
state, absent a specific exemption.
c) Provides that the sale of books and school supplies are
subject to the SUT to the same extent as the sale of any
other TPP not specifically exempted or excluded from SUT by
statute.
FISCAL EFFECT : The FTB staff estimates that the water's-edge
provisions of this bill will result in an annual gain of $70
million in the fiscal year (FY) 2011-12, $120 million in FY
2012-13, and $120 million in FY 2013-14. The State Board of
Equalization (BOE) staff estimates that SUT provisions of this
bill will result in an annual loss of $70 million in FY 2011-12,
$122 million in FY 2012-13, $128 million in FY 2013-14, and $48
million in FY 2014-15.
COMMENTS :
1)The Author's Statement . The author states that, "AB 1178
would close a loophole currently used by corporations that set
up affiliates in listed tax haven countries to primarily park
their income to avoid paying their equitable share of
California taxes. These corporations' tax evasions through
this loophole result in fewer dollars for education, health,
and public safety programs on which Californians depend. The
Franchise Tax Board (FTB) estimates that closure of this
loophole would generate approximately $120 million per year in
additional revenue to help address the substantial increased
costs to students and families in obtaining a higher
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education. The bill would simultaneously reduce the sales tax
burden imposed on textbooks and supplies purchased by students
at a UC, CSU, or California Community College store by a
partial exemption of the state sales tax. According to the
Board of Equalization, this would result in a reduction of
approximately $120 million per year in revenue. Therefore,
this bill would yield no net change in state revenue, while it
improves the affordability of materials required by students
to attend public higher education institutions. Local sales
tax revenues would not be affected."
2)Arguments in Support . The proponents of this bill argue that,
"as California prepares to make more devastating cuts to
social and human services programs in 2010, the necessity to
shut down abusive off-shoring practices that simply pad the
bottom lines of multibillion dollar corporations has never
been greater." Proponents believe that moneys derived from
closing corporate tax loopholes could be put to better use as
tax relief for already struggling college students in
California.
3)Arguments in Opposition . The opponents state that this bill
runs contrary to the intent of the water's-edge election,
could adversely impact foreign relations, and would penalize
California-based U.S. companies for doing business in certain
countries with which the U.S. has diplomatic ties. The
opponents argue that this bill violates the Foreign Commerce
Clause, has no definition of "substantial economic presence"
or "significant economic activity," provides for no process to
appeal FTB's determination, and potentially subjects
unsuspecting taxpayers to a 20% corporate understatement
penalty for behavior that they did not know was improper upon
filing the original return.
4)What Exactly Does this Bill Propose to Do ? This bill does two
things: it partially exempts from SUT the purchases of
textbooks and supplies by college students and it revises the
water's-edge provisions to include the income and
apportionment factors of affiliated companies that are doing
business in, or derive income from, a tax haven country.
5)The partial SUT exemption . The proposed exemption would apply
only to textbooks and supplies purchased by students enrolled
in the University of California, the California State
University, or a California community college. Furthermore,
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only textbooks required or recommended for a course at an
eligible institution would be exempted from SUT. The intent
of this bill is to make college textbooks and supplies more
affordable for college students. However, purchases by
students enrolled in a private university or college would not
be eligible for this exemption.
Under current law, the statewide base SUT rate is 8.25%, which
is comprised of 5% General Fund (GF) state rate, 1% GF state
rate (until July 1, 2011), 0.25% Fiscal Recovery Fund rate,
0.50% Local Revenue Fund rate, 0.50% Local Public Safety Fund
rate, 0.75% city and county operations rate and 0.25% county
transportation rate. In addition to the statewide base rate
of 8.25%, cities and counties are authorized to impose
additional voter-approved taxes.
This bill would reduce the state rate of 5% to 2% for purchases
of eligible textbooks and supplies between July 1, 2011 and
June 30, 2012. On and after July 1, 2012 and until January 1,
2015, those purchases would be completely exempted from the
state portion of SUT. However, this partial exemption would
not apply to the Bradley-Burns local taxes, transactions and
use taxes, the 0.25% tax dedicated to the repayment of
Economic Recovery Bonds, the 0.50% dedicated to local
government for funding of local health and welfare programs or
the 0.50% tax dedicated to funding local public safety
services.
6)The Water's-Edge Provision . Under existing law, a corporate
taxpayer with worldwide business activities may elect to
report income to California on a "water's-edge" basis. A
water's-edge election, generally, allows the taxpayer to
exclude from its tax return the income and apportionment
factors of taxpayer's foreign affiliates. Currently, in order
to be included in the taxpayer's water's-edge return, a
foreign affiliated company must be a domestic international
sales corporation, a foreign sales corporation, an export
trade corporation, a CFC with Subpart F income, or must have
U.S.-source income or some U.S. presence (i.e. an average of
the property, payroll, and sales factors within the U.S. of
20% or more). This bill would expand the list of foreign
affiliated companies whose income and apportionment factors
must be included in the taxpayer's water's-edge tax return.
It would require any foreign affiliated company doing business
in, or deriving income attributable to, a tax haven country to
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be on that list, which means that a foreign company that has
neither U.S.-source income nor U.S. presence (no payroll,
property or sales factor) would qualify for the inclusion.
Furthermore, all income and apportionment factors of a CFC
would be included in the taxpayer's return, instead of the
percentage based on the ratio of its Subpart F income to the
current year earnings and profits. It should be remembered,
however, that this proposal would apply only to the taxpayer's
affiliated foreign companies, i.e. companies that are members
of a commonly controlled group, that are unitary with the
taxpayer.
7)What is the Problem with Having an Affiliated Corporation in a
Tax Haven Country ? Some corporations and individuals use tax
havens to avoid payment of U.S. taxes. Generally, a tax haven
is a foreign jurisdiction that maintains corporate, bank, and
tax secrecy laws and industry practices that make it very
difficult for other countries to find out whether their
citizens are using the tax haven to avoid paying their taxes.
(Statement of U.S. Senator Carl Levin on Introducing The Stop
Tax Haven Abuse Act, Tax Analyst, December 2009, p. 4). Data
released by the Commerce Department indicates that, as of
2001, almost half of all foreign profits of U.S. corporations
were in tax havens. Further, a study released by Tax Notes,
September 2004, found that American companies were able to
shift $149 billion of profits to 18 tax haven countries in
2002, up 68% from $88 billion in 1999. In January 2009, a
report issued by the Government Accounting Office (GAO) shows
that out of the 100 largest U.S. publicly traded corporations,
83 have subsidiaries in tax havens. For example, Morgan
Stanley has 273, Citigroup has 427, and Oracle has 77 tax
haven subsidiaries.
U.S. Senator Levin, in his statement, gives a simplified example
of how U.S. corporations may transfer taxable income from the
U.S. to tax havens to escape taxation. He states that,
"Suppose a profitable U.S. corporation establishes a shell
corporation in a tax haven. The shell corporation has no
office or employees, just a mailbox address. The U.S. parent
transfers a valuable patent to the shell corporation? [and
then] begin to pay a hefty fee to the shell corporation for
use of the patent, reducing its U.S. income through deducting
the patent fees and thus shifting taxable income out of the
United States to the shell corporation. The shell corporation
declares a portion of the fees as profit, but pays no U.S. tax
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since it is a tax haven resident." In addition, the shell
corporation may lend its funds to the U.S. parent that, in
turn, will pay interest on the loan to the shell corporation,
shifting more taxable income out of the U.S. to the tax haven.
Often, those subsidiaries of U.S. companies are shell
corporations that are engaged in no or very little business
activity." (Id, at p. 6).
Since tax haven countries have no or nominal taxes, some U.S.
corporations have aggressively set transfer prices (i.e.
prices that related companies charge on intercompany
transactions) to move income to offshore jurisdictions to
avoid U.S. taxes. As discussed, under existing California
law, income and apportionment factors of those companies
located in tax haven countries are not included in the
water's-edge return of the related U.S. company, unless they
fall within the definition of certain affiliated entities.
Consequently, corporations that manage to shift some of its
income to their subsidiaries or other affiliated companies in
tax haven countries will pay less tax to California.
8)Proposed Federal Legislation . Section 103 of the proposed
federal Stop Tax Haven Abuse Act (Act) would deny tax benefits
for foreign corporations managed and controlled in the U.S...
It focuses on the situation where a corporation is
incorporated in a tax haven as a mere shell operation with
little or no physical presence or employees in the
jurisdiction. The impetus for this legislation came from a
hearing held by the U.S. Senate Finance Committee in July
2008. The Committee considered the findings made by the GAO
with regard to the infamous Ugland House, a five-story
building that is located in the Cayman Islands and is the
official address for over 18,800 registered companies. The
GAO determined that about half of the alleged Ugland House
tenants have a billing address in the U.S. and were not actual
occupants of the building. In fact, the GAO found that none
of the nearly 19,000 companies registered at the Ugland House
was an actual occupant. The only occupant of that building
was a Cayman law firm that established and registered those
companies.
Section 103 of the Act states that, if a corporation is publicly
traded or has aggregate gross assets of $50 million or more,
and its management and control occurs primarily within the
U.S., then that corporation will be treated as a U.S. domestic
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corporation for income tax purposes. Section 103 provides an
exception for foreign corporation with U.S. parents but makes
clear that mere existence of a U.S. parent corporation is not
sufficient to shield a foreign corporation from being treated
as a domestic corporation. According to U.S. Senator Levin,
the proposed federal legislation "would put an end to the
unfair situation where some U.S.-based companies pay their
fair share of taxes, while others who set up a shell
corporation in a tax haven are able to defer or escape
taxation, despite the fact that their foreign status is
nothing more than a paper fiction." (Statement of Senator
Carl Levin on Introducing The Stop Tax Haven Abuse Act, Tax
Analyst, December 2009, p. 13).
The Act requires the Secretary of the Treasury to identify
offshore secrecy jurisdictions, based upon the practical
experience of the Internal Revenue Service (IRS) in obtaining
needed information from the relevant country, but it lists 34
offshore jurisdictions taken from the actual IRS court filings
in court proceedings as a starting point.
9)List of Tax Haven Countries . In its report titled "Large U.S.
Corporations and Federal Contractors with Subsidiaries in
Jurisdictions Listed as Tax Havens or Financial Privacy
Jurisdictions," December 2008, the GAO identified three
sources listing tax havens: The OECD, a National Bureau of
Economic Research working paper (NBER), and a U.S. District
Court order granting leave for the Internal Revenue Service to
serve a "John Doe" summons.
In a report issued in 2000, the OECD identified over 40
jurisdictions as tax havens according to criteria it had
established. The four key factors were (a) no or nominal tax
on the relevant income, (b) lack of effective exchange of
information, (c) lack of transparency, and (d) no substantial
activities. Between the year 2000 and May 2009, all of those
jurisdictions made formal commitments to implement the OECD's
standards of transparency and exchange of information. As a
result, no jurisdiction is currently listed as an
un-cooperative tax haven by the OECD's Committee on Fiscal
Affairs. However, the OECD list of tax haven is still valid,
even though it should be seen in its historical context.
The NBER paper identified 40 tax havens, based on a 1994 article
in The Quarterly Journal of Economics.
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10)Implementation Concerns and Considerations .
In its analysis of this bill, FTB staff noted a few
implementation considerations and suggested amendments to
resolve certain technical concerns. Specifically, FTB staff
noted that the terms "doing business in a tax haven,"
"substantial economic presence" and "significant economic
activity" are not defined, which could lead to disputes
between taxpayers and FTB and would complicate the
administration of the water's-edge provisions. Another
suggestion of FTB to list all of the tax haven countries in
this bill because FTB staff was unable to confirm the OECD's
December 2002 list of tax havens. Finally, FTB staff
recommended that the author consider adding the language to
prescribe the form and manner of a petition that a taxpayer
may file with the FTB to exclude the income and apportionment
factors of a tax haven corporation from the water's-edge
return.
The staff at BOE observes that a partial exemption to SUT would
create administrative burdens for both BOE and the retailer.
The affected retailer would have to determine, first, if the
purchaser was a qualified student enrolled in at a specified
college or university, calculate the applicable SUT and then
segregate these partially exempt sales from other sales in
order to properly complete its SUT return. BOE staff also
notes that the definition of "supplies" needs clarification
and that the institution or course instructor would need to
provide retailers with a list of required or recommended
supply items, in order for BOE to administer the proposed
exemption effectively.
11)Similar Legislation: Water's-Edge Provisions .
AJR 12 (Block), introduced in the 2009 legislative session,
would request that the President and the U.S. Congress enact
legislation that closes the corporate federal tax loopholes
relating to tax haven countries. AJR 12 is in the Senate
Revenue and Taxation Committee.
AB 34 (Ruskin), introduced in the 2005-06 legislative session,
was nearly identical to AB 1178 and would have required
taxpayers filing on a water's-edge basis to include the income
and apportionment factors of affiliated corporations doing
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business in, or having income derived from or attributable to,
a tax haven. AB 34 failed to pass out of the Assembly.
AB 441 (Chu), introduced in the 2005-06 legislative session,
would have required a corporation that makes a water's-edge
election to include the income and apportionment factors of
certain foreign affiliates. AB 441 failed to pass out of the
Assembly.
SB 663 (Migden), Chapter 22, Statutes of 2006, clarified
specific provisions of the franchise tax law relating to
water's-edge taxpayer and reformed the water's-edge procedure
by replacing existing rules creating a contract between the
taxpayer and FTB with election procedures. SB 663 applies to
a taxpayer making a water's-edge election on or after January
1, 2006, and to those taxpayers that made a water's-edge
election before January 1, 2006, but not until the expiration
of the seven-year period during which a taxpayer is prohibited
from terminating that election without the consent of the FTB.
12)Similar Legislation: SUT Exemption for Purchases of
Textbooks and Supplies .
AB 2636 (Leonard), introduced in the 2001-02 legislative
session, would have provided a state SUT exemption for the
purchase of any instructional materials, as defined, by any
qualifying school entity, as defined. AB 2636 was held under
submission in this Committee.
AB 1077 (Mountjoy), introduced in the 2001-02 legislative
session, would have provided a state SUT exemption for the
purchase of any TPP by a K-12 public school or school district
for use by that school or district. AB 1077 was held under
submission in this Committee.
AB 1246 (Leonard), introduced in the 2001-02 legislation
session, would have provided a SUT exemption for any textbook
that is purchased by a student at an institution of higher
education or from an entity whose primary purpose is to
provide textbooks to students attending institutions of higher
education, for use as a learning resource in any course of
study at that institution. AB 1246 was held under submission
in the Assembly Committee on Appropriations.
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SB 546 (McClintock), introduced in the 2001-02 legislative
session, would have provided a SUT exemption for the sale and
purchase of any textbook, as defined, purchased by a K-12
public school or school district, or an accredited private
school, or sold to a student of an accredited private school
or institution of higher education. SB 546 failed passage in
the Senate Revenue and Taxation Committee.
REGISTERED SUPPORT / OPPOSITION :
Support
California Labor Federation
California Professional Firefighters
Opposition
California Taxpayers' Association
California Bankers Association
California Chamber of Commerce
California Manufacturers and Technology Association
Council on State Taxation
TechAmerica
Western States Petroleum Association
Analysis Prepared by : Oksana Jaffe / REV. & TAX. / (916)
319-2098