BILL ANALYSIS Ó
SENATE GOVERNANCE & FINANCE COMMITTEE
Senator Lois Wolk, Chair
BILL NO: SB 116 HEARING: 3/23/11
AUTHOR: De León FISCAL: Yes
VERSION: 2/23/11 TAX LEVY: Yes
CONSULTANT: Miller
INCOME TAXES: SINGLE SALES FACTOR
Makes the single sales apportionment formula mandatory for
specified taxpayers and requires that all taxpayers use the
"market rule" to source intangibles.
Background and Existing Law
The February 2009, state budget agreement changed the
formula that multistate firms use to determine the share of
its total income that is taxable in California (ABx3 15,
Krekorian and SBx3 15, Calderon). Previously, firms used a
weighted average of their California sales, property, and
payroll compared to its totals. Starting in 2011, firms
may choose to apportion using the sales factor, with the
intent to encourage firms to locate payroll and property in
California.
This year, the Governor proposed making the single sales
factor mandatory for qualified industries as a part of his
2011-2012 budget.
Apportionment Formula. A multistate firm generates profits
based on its operations in many states and has a right
under the U.S. Constitution to divide income between these
states for tax purposes, a process known as
"apportionment," to ensure that no state taxes more than
its fair share of that firm's income. The 1957 Uniform
Division of Income for Tax Purposes Act (UDITPA) created
the three-factor apportionment framework to capture the
factors of production; specifically, property to represent
capital, payroll to represent labor, and sales to represent
market presence.
In 1966, California adopted UDITPA where each of the three
factors had an equal weight of one-third. In 1993,
California adopted a "double-weighted" formula, reducing
SB 116 -- 2/23/11 -- Page 2
the formula's weights on both property and payroll from
33.3% to 25%, but increasing the weight on sales from
33.3% to 50%, thereby reducing that share of a the firm's
income apportioned to states where it employs relatively
more people and produces more goods in the state compared
to its sales. Under the change, a firm with all or most of
its production and payroll in California, but a smaller
share of its sales, benefits from the change, whereas a
firm that either employs few or no people or owns little to
no property here, but sells into California, pays more tax.
Many other states also changed the apportionment weights
in the 1980s and 1990s to induce firms to maintain or
relocate facilities and employees in the state.
Starting in 2011, California's apportionment formula allows
multi-state firms to annually choose either the above
apportionment formula or to use only its sales, commonly
known as the "single sales factor."
Each of the factors in the apportionment formula is a
fraction: the numerator is the value of the item in
California and the denominator is the value of the item
everywhere. The property factor generally includes all
tangible property owned or rented during the taxable year.
The payroll factor includes all forms of compensation paid
to employees. The sales factor includes all gross receipts
from the sale of tangible and intangible property.
Since 1993, the apportionment formula for most taxpayers
has been a three-factor formula consisting of payroll,
property and double weighted sales as illustrated below.
---------------------------------------------------------
| Average | + |Average |+ |Californ|) | California |
|Californi| |Californ| (2x| ia | = |Apportionment|
| a | | ia | | Sales | | Formula |
|Property | |Payroll | | | | |
|---------+----+--------+------+--------+---+-------------|
| Average | |Average | | Total | | |
| Total | | Total | | Sales | | |
|Property | |Payroll | | | | |
---------------------------------------------------------
The only exceptions to this rule are four industries:
agriculture, extraction, including oil, savings and loan
and financial services. These four industries must use the
SB 116 -- 2/23/11 -- Page 3
three factor formula without the double weighted sales
factor.
Beginning in 2011, as illustrated below, a qualified
business may elect to use a single sales factor based on
100 percent sales, instead of the three factor formula
described above. The industries listed above still do not
qualify for the single sales factor.
---------------------------
|Californi| = |California |
| a Sales | |Apportionmen|
| | | t Formula |
|---------+----+------------|
| Total | | |
| Sales | | |
---------------------------
Intangible Sourcing. As part of the budget agreement of
2010 (SB 858, Committee on Budget & Fiscal Review, 2010),
taxpayers electing the three-factor, double-weighted sales
formula must use the cost of performance method to source
sales of intangible items starting with the 2011 taxable
year; taxpayers electing sales factor-only apportionment of
income must source the sales of intangibles to California
using the market rule. Intangibles are everything that
isn't "stuff", and include all services, such as online
stockbrokers and telecommunications, and licenses to
operate software programs, among others.
Sales of Intangibles - "Costs of Performance." A company
includes no revenue from its sales of intangibles to
California in the sales factor if the firm incurs a
plurality of the costs associated with developing these
products or services in another state; if the plurality
occurs in California, then the company includes all of its
sales in its California sales factor. For example, a
company that produces streaming video may spend $500,000 in
California and $520,000 in Oregon when developing the
service. The firm does not include any sales of its sales
of streaming video in this state in its California sales
factor, because it incurred most of its costs of
performance outside the state. Had the firm incurred most
of its costs of performance in California, the taxpayer
must include all of its sales of the video service in its
California sales factor.
SB 116 -- 2/23/11 -- Page 4
Sales of Intangibles - "The Market Rule." Under the
competitively-neutral market rule, all firms source these
sales based on the state in which the product or service is
ultimately used, so all firms report sales based on how
much they sell in the state, instead of where they invested
when developing the intangible item or service. Each
license for an operating system used on a California
personal computer would be included in the software firm's
California sales factor. In the example above, the firm
would include its sales of the video service to customers
in this state in its California sales factor.
The following chart summarizes California's history of both
apportionment and intangibles.
----------------------------------------------------------
| |1966 - |1993-2010 |2011 |
| |1992 | | |
|-------------+-----------+--------------+-----------------|
|Apportionment|3-factor |3-factor |Elective |
| |formula |formula |(3-factor |
| | |(double-weight|formula with |
| | |ed sales |double weighted |
| | |factor) |sales or single |
| | | |sales factor) |
|-------------+-----------+--------------+-----------------|
|Intangibles |Costs of |Costs of |Cost of |
| |performance|performance |performance if |
| | | |elect 3-factor; |
| | | |formula; market |
| | | |rule if single |
| | | |sales factor |
| | | |elected |
| | | | |
----------------------------------------------------------
Proposed Law
Single Sales Factor: This bill makes the single sales
factor apportionment formula mandatory for all taxpayers
except those in a qualified business activity (extractive,
agricultural, savings and loans, and banks and financial
services) for taxable years beginning on or after January
1, 2011.
SB 116 -- 2/23/11 -- Page 5
Intangible Sourcing: This bill changes the way
corporations assign sales of intangible goods to the state
by requiring that all taxpayers, including those not in
qualified business activities, use the "market rule."
Therefore, all corporations will have to assign sales from
services to California to the extent the purchaser derives
benefit of the service in California or the property is
used in California. For example, if a movie is viewed in
California but originates in Delaware, that movie would be
sourced to California under the market rule. If a customer
of marketable securities is in California, that sale would
also be sourced to California under the market rule.
Consistent with existing law, real property, including
leases and rentals, would also all be assigned to
California.
State Revenue Impact
According to the Franchise Tax Board, this bill will result
in the following revenue gains:
2011-12: $1.3 billion
2012-13: $1.1 billion
2013-14: $1.1 billion
Comments
1. Purpose of the bill . According to the author's office:
SB 116 seeks to encourage investment and job creation in
California, and generate upwards of $1 Billion annually in
desperately-needed revenues through the implementation of a
mandatory single sales factor in the calculation of
corporate taxes owed to the state.
On the issue of corporate tax apportionment, the trend
around the country is states moving towards the "single
sales factor" method for the calculation of taxes.
However, in California's adoption of this method in 2009,
instead of adopting a mandatory single sales factor like
the vast majority of other states-including Texas, New
York, Michigan, Illinois, Oregon, and just last April,
Washington state-our tax law has an annual elective single
sales factor.
Allowing corporations to choose the three-factor formula,
which lowers their tax liability the smaller their
SB 116 -- 2/23/11 -- Page 6
California presence, unfairly benefits companies that move
jobs or base the bulk of their operations out-of-state-at
the expense of $1 Billion/year to California's taxpayers.
In order to eliminate this competitive advantage and level
the playing field for California-based companies, we need
to make the single sales factor mandatory. This tax
proposal is about putting California first-we should be
encouraging job creation and greater investment here in our
home state, instead of rewarding out-of-state corporations.
According to the recent Legislative Analyst's Office (LAO)
report, Reconsidering the Optional Single Sales Factor
(2010), adoption of a mandatory single sales factor would
result in a net gain of about 40,000 jobs in California.
2. The Governor's Budget. The Governor's Budget proposal
requires all firms to report taxes based only on the sales
factor. The budget summary states:
The goal of moving to a single sales
factor was to eliminate any tax
disincentives that can arise due to
investment in new plant (property) and
payroll in the state. There is a good
argument to be made that in order for
California to be competitive with other
states, it should allow taxpayers to
apportion using a single sales factor.
However, there is no reason-from an
economic development perspective-to allow
businesses to choose how their income
will be apportioned. Requiring mostly
"in-state" firms to use single sales
factor removes a disincentive that they
face, under double weighted
apportionment, moving economic activity
in California. Requiring "out of state'
firms to use the single sales factor
accomplishes the exact same thing. It
removes a disincentive that they face,
under double weighted sales
apportionment, from moving economic
activity into California.
SB 116 -- 2/23/11 -- Page 7
The LAO agrees with the Governor that elective single sales
factor allows the taxpayer to essentially choose the tax it
pays, creating an inequity allowing taxpayers who operate
in more than one state two different ways to calculate
their income. Multistate firms can choose the formula
that will yield a lower tax than the other, while
businesses that operate wholly inside California have no
such option. This disparate treatment puts the wholly
in-state businesses at a competitive disadvantage to its
multi-state competitors, which tend to be larger.
In its January 6th, 2011 letter to Senator de León which
suggests a mandatory single sales factor, the LAO describes
scenarios for a hypothetical California company considering
expansion in California or another state. The examples
assume that the company operates in two states-Oregon with
a mandatory single sales factor apportionment method and
California with an elective method-and expands by doubling
its property and payroll.
The company's sales and pretax profits are held constant,
but varying them would not affect the relative tax burden
in the two states as long as sales increased
proportionately in both states. Initially, as shown in
Figure 1, the company has 90% of its property and payroll
and 75 % of its sales in California. With a lower sales
factor than property and payroll factors, this particular
company elects to use the optional single sales factor
apportionment method available to companies under existing
California law beginning in 2011.
------------------------------------------------------------------
|Figure 1 |
|------------------------------------------------------------------|
|Hypothetical California Firm With Some Operations in Oregon |
|------------------------------------------------------------------|
|(Dollars In Millions) |
------------------------------------------------------------------
------------------------------------------------------------------
| | California | | Oregon |
------------------------------------------------------------------
SB 116 -- 2/23/11 -- Page 8
-------------------------------------------------------------------
| | | Existing Optional Single | | Mandatory Single Sales |
| | | Sales Apportionment Formula | | Apportionment Formula |
-------------------------------------------------------------------
-------------------------------------------------------------------------------------------------------------
| | | Amount | State's | Weight | Share | | Amount | State's | Weight | Share |
| | |In State |Share of | In Tax | Times | |In State |Share of | In Tax | Times |
| | | |National | Formula | Weight | | |National | Formula | Weight |
| | | | Amount | | in Tax | | | Amount | | in Tax |
| | | | | | Formula | | | | | Formula |
-------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------
|Sales | $ 150 | 75% | 100% | 75% | | $ 50 | 25% | 100% | 25% |
|Payroll | | | | | | | | | |
|Property | | | | | | | | | |
---------------------------------------------------------------------------------------------------
| | 180 | 90 | | | | 20 | 10 | | |
|---------+---------+---------+---------+---------+---------+---------+---------+---------+---------|
| | 900 | 90 | | | | 100 | 10 | | |
---------------------------------------------------------------------------------------------------
-------------------------------------------------------------------
| |California | | |Oregon | |
| |Apportionment ratio | 75% | |Apportionment Ratio | 25% |
-------------------------------------------------------------------
| |X Total national | $200 | |X Total national | $200 |
| |profits | | |profits | |
-------------------------------------------------------------------
| |California taxable | $150 | |Oregon taxable | $50 |
| |profits | | |profits | |
-------------------------------------------------------------------
| |X California | 8.84% | |X Oregon corporate | 7.90% |
| |corporate tax rate | | |tax rate | |
|-----+--------------------+--------+-+--------------------+--------|
| |California Tax | $13 | |Oregon Tax Payment |$4 |
| |Payment | | | | |
-------------------------------------------------------------------
The letter concludes that under the optional single sales
factor apportionment in California, the company would
choose to expand in Oregon as explained below.
Optional Single Sales: Lower California Taxes if Company
Expands in Oregon . By contrast, if the company expands in
Oregon, its sales factor in California would then be higher
than its property and payroll factors (see Figure 5). It
presumably would then not elect to use California's
SB 116 -- 2/23/11 -- Page 9
optional single sales factor. As a result, the company's
California tax bill would fall-from $13 million in the
prior figures to $11 million in Figure 5-as a result of the
Oregon expansion.
------------------------------------------------------------------
|Figure 5 |
|------------------------------------------------------------------|
|Optional Single Sales: Less California Taxes if Company Expands |
|In Oregon |
|------------------------------------------------------------------|
|(Dollars In Millions) |
------------------------------------------------------------------
------------------------------------------------------------------
| | California | | Oregon |
------------------------------------------------------------------
-------------------------------------------------------------------
| | | Existing Optional Single | | Mandatory Single Sales |
| | | Sales Apportionment Formula | | Apportionment Formula |
-------------------------------------------------------------------
-------------------------------------------------------------------------------------------------------------
| | | Amount | State's | Weight | Share | | Amount | State's | Weight | Share |
| | |In State |Share of | In Tax | Times | |In State |Share of | In Tax | Times |
| | | |National | Formula | Weight | | |National | Formula | Weight |
| | | | Amount | | in Tax | | | Amount | | in Tax |
| | | | | | Formula | | | | | Formula |
-------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------
|Sales | $ 150 | 75% | 50% | 38% | | $ 50 | 25% | 100% | 25% |
|Payroll | | | | | | | | | |
|Property | | | | | | | | | |
---------------------------------------------------------------------------------------------------
| | 180 | 45 | 25 | | | 220 | 55 | | |
| | | | |11 | | | | | |
|---------+---------+---------+---------+---------+---------+---------+---------+---------+---------|
| | 900 | 45 | 25 | | | 1,100 | 55 | | |
| | | | |11 | | | | | |
---------------------------------------------------------------------------------------------------
-------------------------------------------------------------------
| |California | | |Oregon | |
| |Apportionment ratio | 60% | |Apportionment Ratio | 25% |
-------------------------------------------------------------------
| |X Total national | $200 | |X Total national | $200 |
| |profits | | |profits | |
-------------------------------------------------------------------
SB 116 -- 2/23/11 -- Page 10
| |California taxable | $120 | |Oregon taxable | |
| |profits | | |profits |$50 |
-------------------------------------------------------------------
| |X California | 8.84% | |X Oregon corporate | 7.90% |
| |corporate tax rate | | |tax rate | |
|-----+--------------------+--------+-+--------------------+--------|
| |California Tax | $11 | |Oregon Tax Payment |$4 |
| |Payment | | | | |
-------------------------------------------------------------------
3. Shot through the heart. In an opposition letter, the
California Chamber of Commerce, the California
Manufacturers & Technology Association and CalTax state
that the elective single sales factor was a "remarkable,
although rare, bright spot in California's notoriously bad
business climate." The three groups state that the state
was correct in making the single sales factor elective in
2009 and that the attempt to make it mandatory negates the
importance of business contributions to the state's overall
economic health. Furthermore, the opposition states that
not all business models fit easily into a single sales
calculation, but these companies have significant
investments of property and payroll in California. The
size of their sales in one of the largest markets in the
world renders those investments moot by comparison.
Finally, they state that SB 116 will "cut the heart out of
an already weakened California economy."
4. Can't touch this. While there is much debate over
whether the single sales factor should be mandatory or
elective there is almost as much debate over the issue of
intangibles and the so called "market rule" versus the
"cost of performance." The two methods determine to which
state a taxpayer sources the sale of intangible items.
Intangible assets are not physical in nature and include
patents, trademarks, copyrights, business methodologies,
goodwill and brand recognition. Other examples include
software and streaming video, services, and market
securities. If the income producing activity is performed
within and outside the state, the sales from intangibles
and all other services are assigned to California only if
the greater cost of performance of the income producing
activity is performed in this state. Under the market
rule , the sales from services are assigned to California to
the extent the purchaser of the service receives the
benefit of the service in California.
SB 116 -- 2/23/11 -- Page 11
For example, Consulting Crew Are Us provides technology
consulting to a client in California but incurs direct
costs such as salaries and equipment in Oregon and
California. The total cost of the service is $10,000 with
$5,200 (52%) in Oregon and $48,000 (48%) in California.
Under the cost of performance rules, 100 percent of the
receipts for the service provided to the California client
would be assigned to Oregon.
Under the market rule, 100 percent of the receipts for the
service provided would be assigned to California.
5. Market not mark it. The Governor's Budget proposal
assumes a mandatory market rule for all businesses in the
state citing the competitive advantage for in-state
businesses. The Governor's budget summary argues that the
cost of performance sourcing of intangibles rewards firms
for avoiding California with its investment decisions by
excluding sales made in the state from its sales factor,
thereby lowering its California tax.
Some tax experts criticize the costs of performance because
its vague language results in disputes between taxpayers
and tax enforcement agencies. The market rule has its own
implementation difficulties, as evidenced by FTB's recent
interested parties meetings regarding developing market
rule regulations. Additionally, the cost of performance
method is a winner-take-all system. If the Kentucky
software firm incurred some of the costs of creating a new
program in California but more there, the firm sources no
sales made to its California customers here. By moving
halfway back from market rule to costs of performance,
California gives up an important share of future revenue
from the sales of intangibles and services as these items
grow as a share of the economy and as sales of tangible
items fall.
In its opposition letter, the California Cable &
Telecommunications Association (CCTA) cites the cost of
performance allocation methodology which was part of the
2010 budget deal as recognition of its significant
contributions to the state's economy through investment in
infrastructure, taxes paid and people hired. CCTA states
that the elimination of the cost of performance methodology
for the industry results in an increased tax liability of
SB 116 -- 2/23/11 -- Page 12
$35 to $50 million, reducing its ability to grow in this
state.
This committee received no other letters of opposition
specific to the issue of cost of performance versus the
market rule.
Support and Opposition (3/17/11)
Support : AFSCME, Apple Inc., BayBio, BIOCOM, California
Healthcare Institute, California Labor Federation, AFL-CIO,
California-Nevada Conference of Operating Engineers,
California Nurses Association, California Partnership,
California School Employees Association, California
Professional Firefighters, Genentech, PowerPAC, Service
Employees International Union, California State Council,
St. Mary's Center, State Building and Construction Trades
Council, AFL-CIO, Qualcomm, United Firefighters of Los
Angeles City (Local 112, IAFF).
Opposition : California Cable & Telecommunications
Association, California Chamber of Commerce, California
Manufacturers & Technology