BILL ANALYSIS
AB 2278
Page 1
Date of Hearing: May 10, 2010
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Anthony J. Portantino, Chair
AB 2278 (Anderson) - As Amended: April 14, 2010
VOTE ONLY
Majority vote. Tax levy. Fiscal committee.
SUBJECT : Income tax: credits: research and development
SUMMARY : Conforms to the federal credit percentage for
increasing research activities and conforms to the federal
alternative incremental research credit (AIRC) percentages, as
of January 1, 2007. Specifically, this bill :
1)Increases, for taxable years beginning on or after January 1,
2010, the California credit rate for increasing research
expenses from 15% to 20%.
2)Conforms to the federal AIRC percentages that were in effect
as of January 1, 2007, by increasing the California
incremental percentages to 3% from 1.49%, 4% from 1.98%, and
5% from 2.48%.
3)Applies to taxable years beginning on or after January 1,
2010.
4)Takes effect immediately as a tax levy.
EXISTING FEDERAL LAW :
1)Allows taxpayers engaged in a trade or business to deduct all
of the ordinary and necessary business expenses incurred.
2)Allows a research and development (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
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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)Allowed a taxpayer, prior to January 1, 2009, to elect an AIRC
for determining its R&D credit. The current federal
percentages are 3%, 4%, and 5%.
7)Allows an alternative simplified (AS) 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 United States (U.S.) and be
paid by the taxpayer.
9)Provides that "qualified research" is research that a) is
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)Conforms to the federal R&D credit but with the following
modifications:
a) The state R&D credit is not combined with other business
credits.
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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%.
2)Provides an alternative credit of 24% (versus the 20% federal
credit) for "basic research", available for "C" corporations
only.
3)Sets the percentages for the alternative incremental research
portion of the credit lower than those of the federal credit.
4)Allows the R&D credit for taxable years beginning on or after
January 1, 1987, and is permanent.
5)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 : The Franchise Tax Board (FTB) staff estimates
that this bill will result in an annual revenue loss of $90
million in fiscal year (FY) 2010-11, $80 million in FY 2011-12,
$75 million in FY 2012-13, and $75 million in FY 2013-14.
COMMENTS :
1)The Author's Statement . The author states that, "Assembly
Bill 2278 is a jobs-creation bill, inviting economic growth in
California's high-tech industries. This measure proposes to
increase the current tax credit for research expenses from
fifteen percent to twenty percent, which would expand business
productivity in our state."
2)Arguments in Support . Proponents state that this bill "sends
a signal that California still wants to be the location of
choice for companies with major research activities." The
proponents believe that "encouraging and maintaining research
and development activity in this state will increase the
likelihood that the new technology and products derived
therefrom will be manufactured here." Finally, the proponents
argue that the R&D credit is a jobs credit and it is
imperative that California increase efforts to adopt policies
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to encourage companies to research, develop, and manufacture
in California.
3)Arguments in Opposition . The opponents argue that California
already has the most generous R&D and development credit in
the country, and, in fact, it is so generous relative to the
amount of corporation tax, that "many companies already zero
out their entire state tax liability." The opponents further
state that income can now be sheltered even more because of
the last year's budget agreement permitting the sharing of R&D
credit among affiliated corporations. Finally, the opponents
assert that the state corporation tax is one-fourth the
federal rate, which is why state tax credits are usually so
much lower, and that there is no evidence that the current
rate of R&D credit is somehow ineffective in increasing R&D
activity in California.
4)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.
5)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
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.
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a) General Rule . 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.
b) AIRC Regime . Taxpayers are allowed to elect an AIRC
regime, in which case the taxpayer is assigned a
three-tiered fixed-base percentage and the credit rate,
likewise, is reduced. For example, under federal law, for
amounts paid after 2006, a credit rate of 3% applies to the
extent that a taxpayer's current-year research expenses
exceed a base amount computed by using a fixed-base
percentage of 1% (i.e., the base amount equals 1% of the
taxpayer's average gross receipts for the four preceding
years) but do not exceed a base amount computed by using a
fixed-base percentage of 1.5%. The other two applicable
tier percentages are 4% (of expenses between 1.5% and 2% of
the base amount) and 5% (of expenses exceeding 2% of the
base amount). In California, the applicable AIRC rates are
1.49%, 1.98%, and 2.48%, respectively. The federal AIRC,
unlike the California AIRC, does not apply to any expenses
paid or incurred after December 31, 2009.
c) AS Credit . Under federal law, a taxpayer may elect to
claim an AS credit for qualified research expenses. For
taxable years beginning on or after January 1, 2009, the
credit amount is equal to 14% of qualified research
expenses that exceed 50% of the average qualified research
expenses for the three preceding taxable years. The rate
is reduced to 6% if a taxpayer has no qualified research
expenses in any one of the three preceding taxable years.
An election applies to all subsequent taxable years, unless
revoked with the consent of the Secretary of the U.S.
Treasury. In California, an AS credit is not allowed.
d) Deduction of research expenses . Under both the federal
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and California laws, research and experimental expenditures
may be deducted currently, or may be amortized over a
60-month period at the election of the taxpayer.
Deductions allowed to a taxpayer are reduced by an amount
equal to 100% of the taxpayer's R&D tax credit determined
for the taxable year. Taxpayers may elect to claim a
reduced R&D credit amount in lieu of reducing the
deductions.
6)The R&D Credit and Its Impact on the Economy . It is believed
that an individual business is not able to capture the full
benefits from research or prevent such benefits from being
used by competitors without some sort of government
assistance, because an R&D activity often produces "positive
externalities," i.e., benefits to people other than the person
doing the R&D. Thus, most economists agree that a tax benefit
or direct government spending encourages businesses to invest
in research to the extent that would be optimal for society.
(See, e.g., Joint Committee on Taxation, Description of
Revenue Provisions Contained in the President's Fiscal Year
2010 Budget Proposal, Part Two: Business Tax Provisions,
JCS-3-09, p. 11).
The purpose of the federal R&D credit is twofold: it 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 another country. The federal expenditure related to the
R&D tax credit was $4.9 billion in 2008 and is expected to
grow to $7.8 billion in 2012. Similarly, the California R&D
credit is designed to increase an overall R&D activity and to
encourage R&D activity, and possibly 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 this state because of its high credit
percentages that exceed other states' R&D credit percentages
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."
(JCS-3-09, p.17). It is impossible, however, to determine
which projects would be undertaken without the credit, and
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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 quite popular. In 2006, California
taxpayers claimed over $1.4 billion in state R&D credits, of
which 85% of the total credits were utilized by firms with
gross receipts greater than $1 billion and 73% were claimed by
the manufacturing sector. Even though the R&D subsidy in
California seems unusually high in comparison to the federal
R&D credit, i.e. almost 1/3 of the federal amount, federal
subsidies and other outlays for research activities
substantially exceed the amount of the federal R&D tax credit.
For example, in 2008, the Federal government spent
approximately $122 billion on R&D in the U.S.
In attracting the R&D business to California, the R&D credit
is believed to create additional R&D jobs in the state, which,
arguably, are more desirable than jobs in other industries.
It 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," defined as "a reduction in
production costs that results when firms in the same or
related industries locate near one another." (California
Income Tax Expenditures, Compendium of Individual Provisions,
Updated December 2009, Franchise Tax Board, p.17). If this is
the case, many California businesses, not just those receiving
this credit, will gain an advantage over their rivals in other
states. Finally, the California R&D credit is said to provide
new, better, and less expensive products for consumers.
(Bronwyn Hall and Marta Wosinka, The California R&D Tax
Credit: Description, History, and Economic Analysis, June
1999).
7)Should the Rate of California R&D Credit Be Increased ? With
respect to the federal R&D credit, the Joint Committee on
Taxation concluded that, "while all published studies report
that the research credit induced increases in research
spending, early evidence generally indicated that the price
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elasticity for research is substantially less than one."
(JCS-3-09, pp.20-22). According to the report, while there is
some evidence that the current level of research undertaken in
the U.S. is too little to maximize society's well-being, "[it]
is difficult to determine whether, at the present levels and
allocation of government subsidies for research, further
government spending on research or additional tax benefits for
research would increase or decrease overall economic
efficiency." (Id., p.11).
Since California's contribution to total R&D spending is
smaller than the federal government's contribution (which
includes direct subsidies), whether California's R&D credit
substantially increases global R&D activity is somewhat less
important to state policy than federal policy. In contrast,
the amount of R&D activity undertaken in California, i.e.
regional competition, seems to be vital for state policy. It
has been recently reported that state R&D credits are, indeed,
effective at increasing R&D in the state. (D. Wilson, Beggar
thy Neighbor? The In-State, Out-of-State, and Aggregate
Effects of R&D Tax Credits, Federal Reserve Bank of San
Francisco, January 2008). Specifically, it has been found
that a 1% point increase in a state's effective R&D credit
rate leads, in the long run, to a 3%-4% in R&D spending within
the state. (Id., pp. 14-15). However, the study has shown
that nearly all of this R&D increase "comes at the expense of
reduced R&D spending in other states," such that R&D
nationwide, essentially, has remained unchanged. (Ibid).
Undoubtedly, it is easier for some R&D firms to move their
activity to another state than it would be for them to move it
to another country. Thus, a California credit appears to be
necessary for the state to remain competitive with other
states in attracting and maintaining research and development
business activity, which not only creates desirable jobs but
also allows other California businesses to adopt innovations
developed locally more rapidly. But the question remains,
however, as to whether a percentage increase in the rate of
the California R&D credit is absolutely crucial for the state
to remain competitive.
The R&D credit may be viewed as successfully maintaining the
competitiveness of the
California R&D industry only if R&D activity is undertaken in
California that would not
have been undertaken here in the absence of the credit.
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However, partly because all of the taxpayers' information is
confidential, it is impossible to estimate the amount of
California R&D activity that would not have taken place in
California in the absence of the credit. Thus, the extent to
which the existing state tax policy has increased the research
activity in California is largely uncertain. Secondly,
California currently has one of the highest rates of R&D
credit and, recently, has allowed taxpayers to assign R&D
credits within the unitary group, thus, largely increasing the
utilization rate of the existing credit. Given the
California's generous R&D rate and the fact that the credit is
permanent (in contrast to the federal R&D credit), it is
unclear whether an increase in the state's credit rate would
produce any additional benefits in the form of an additional
R&D activity or other positive externalities.
Furthermore, even if it is known that additional state
subsidies for research are warranted as a general matter, as
with the federal R&D credit, misallocation of research dollars
across competing sectors of the economy could diminish
economic efficiency. (JCS-3-09, p.11). In contrast to grants
that are given to projects that are chosen based on the
taxpayer's assessment of future profit potential, the R&D tax
credit provides a subsidy to any eligible project undertaken
by a qualified taxpayer. The ratio of direct federal spending
on R&D activity in the form of grants and other outlays to the
federal R&D credit, which is almost 25 to 1, suggests that
direct spending may be a more efficient way of allocating
state research dollars and attracting certain targeted sectors
of the state's economy.
Finally, in light of California's grim fiscal realities, the
Committee may wish to consider whether the benefits of the
marginal increase in the amount of California research
activities that may result, in the long run, from an increase
in the R&D credit rate outweigh the costs of reduced state
funding for public services now, including schools and
universities that produce highly skilled workforce for R&D
companies. In 2003, The Legislative Analyst's Office (LAO)
prepared an overview of the California R&D Tax Credit and
suggested that no further expansion of the state R&D tax
credit occur without convincing evidence that it is warranted.
The LAO further recommended that the Legislature consider
reducing the credit or phasing it out over time, especially in
light of the substantial direct revenue losses of the existing
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R&D tax credit and the state's budgetary position.
8)Out-of-Conformity ? Under this bill, California companies would
be allowed the AIRC, in conformity to the federal AIRC
percentages as in effect on January 1, 2007, even though under
federal law, the AIRC was terminated for taxable years
beginning after December 31, 2008. Thus, this bill would
place California out of conformity with federal law, thereby
increasing the complexity of California tax return
preparation. If conformity with federal law is the author's
intent, the author may wish to amend this bill to eliminate
the AIRC election and, instead, allow the AS credit.
9)Related Legislation .
AB 1484 (Anderson), introduced in the 2009 legislative session,
is identical to this bill. AB 1484 was never heard in this
Committee.
SBx6 9 (Dutton), introduced in the 6th Extraordinary Session,
is identical to this bill. SBx6 9 is currently pending in the
Senate Committee on Rules.
SBx8 58 (Dutton & Runner), introduced in the 8th Extraordinary
Session, is identical to this bill. ABx8 58 failed to pass
out of the Senate Committee on Rules.
SB 444 (Ashburn), introduced in the 2009 legislative session,
is identical to this bill, with the exception that it would
have applied to taxable years beginning on or after January 1,
2009. SB 444 was held in the Senate Committee on Revenue and
Taxation.
AB 751 (Lieu), introduced in the 2007-08 legislative session,
is identical to this bill, with the exception that AB 751
would have applied to taxable years beginning on or after
January 1, 2007. AB 751 held under submission in this
Committee.
SB 928 (Harman), introduced in the 2007-08 legislative
session, would have, among other things, raised the credit for
increasing qualified research expenses from 15 percent to 20
percent and conformed to the federal AIC rates for taxable
years beginning on or after January 1, 2007. SB 928 died in
the Senate Committee on Revenue and Taxation.
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SB 359 (Runner), introduced in the 2007-08 legislative
session, would have, among other things, increased the credit
for increasing research expenses from 15 percent to 16 percent
and conformed to the federal AIC. SB 359 died in the Senate
Committee on Revenue and Taxation.
REGISTERED SUPPORT / OPPOSITION :
Support
BayBio
BIOCOM
California Space Authority
California Taxpayers' Association
TechAmerica
Tragara Pharmaceuticals
Opposition
California Tax Reform Association
Analysis Prepared by : Oksana Jaffe / REV. & TAX. / (916)
319-2098