BILL ANALYSIS �
AB 2330
Page 1
Date of Hearing: May 5, 2014
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Raul Bocanegra, Chair
AB 2330 (Mullin) - As Amended: April 30, 2014
2/3 vote. Fiscal committee. Tax levy.
SUBJECT : Income taxes: credits: research activities
SUMMARY : Conforms, under the Personal Income Tax (PIT) Law and
the Corporation Tax (CT), to the federal alternative simplified
credit (ASC), repeals the alternative incremental credit (AIRC),
and conforms to recent federal changes related to acquisitions,
dispositions, and aggregations. Specifically, this bill :
1)Repeals, on or after January 1, 2014, state conformity to
Internal Revenue Code (IRC) Section 41(c)(A)(4), relating to
the alternative incremental credit.
2)Conforms, on or after January 1, 2014, to IRC Section
41(c)(5), relating to the alternative simplified credit,
except as follows:
a) The reference to "14 percent" in IRC Section 41(c)(5)(A)
is modified to read "10.5 percent"; and,
b) The reference to "6 percent" in IRC Section
41(c)(5)(B)(ii) is modified to read "4.5 percent."
3)Provides that an election to use the ASC would apply to all
succeeding taxable years unless revoked with the consent of
the Franchise Tax Board (FTB).
4)Conforms to federal law relating to the inclusion of qualified
research expenses and gross receipts of an acquired person and
aggregation of expenditures
EXISTING FEDERAL LAW
1)Allows taxpayers engaged in a trade or business to deduct all
of the ordinary and necessary business expenses incurred.
AB 2330
Page 2
2)Allows a R&D tax credit that is combined with several other
credits to form the general business credit. The R&D credit
is designed to encourage companies to increase their R&D
activities.
3)Specifies that the R&D credit is equal to 20% of the qualified
research expenses that exceed the base year amount, as
defined, plus 20% of the amount paid or incurred during the
taxable year on research undertaken by an energy research
consortium.
4)Defines "base year amount" as the product of the average
annual gross receipt of the taxpayer for the four taxable
years preceding the taxable year the credit is earned times a
fixed percentage, but under no circumstances may the base year
amount be less than 50% of the qualified research for the
taxable year.
5)Authorizes an additional credit to corporate taxpayers equal
to 20% of expenses paid to fund "basic research" at
universities and certain nonprofit scientific research
organizations.
6)States that a taxpayer was allowed, prior to January 1, 2009,
to elect an alternative incremental research credit for
determining its R&D credit. The federal percentages are 3%,
4%, and 5%.
7)Allows an alternative simplified credit equal to 14% of
research expenses that exceed 50% of the average research
costs for the three preceding taxable year.
8)Specifies that, in order to qualify for the R&D credit,
research expenses must qualify as an expense or be subject to
amortization, be conducted in the U.S. and be paid by the
taxpayer.
9)Provides that "qualified research" is research that is:
a) Undertaken to discover information that is technological
in nature;
b) Primarily involves experimentation related to quality or
to a new or improved function or performance; and,
AB 2330
Page 3
c) Its application will be useful in developing new or
improved business components for the taxpayer.
EXISTING STATE LAW :
1)Allows various tax credits designed to either provide tax
relief for taxpayers who incur certain expenses or to
influence taxpayers' behavior.
2)Conforms California to the federal R&D credit but with the
following modifications:
a) The state R&D credit is not combined with other business
credits.
b) Both "qualified research" and "basic research" must be
undertaken in California.
c) The credit percentage for increasing qualified research
activities in California is 15%.
3)Provides an alternative credit of 24% (versus the 20% federal
credit) for "basic research", available for "C" corporations
only.
4)Sets the percentages for the alternative incremental research
portion of the credit lower than those of the federal credit.
5)Allows the R&D credit, which is permanent, for taxable years
beginning on or after January 1, 1987.
6)Allows taxpayers that are members of a combined reporting
group to make a one-time irrevocable assignment of eligible
credits to another member. However, the assigned credits may
be utilized to reduce tax only for taxable years beginning on
or after January 1, 2010
FISCAL EFFECT : The FTB estimates that this bill will reduce
general fund revenues by $75 million in fiscal year (FY)
2014-15, $80 million in FY 2015-16, and $80 million in FY
2016-17.
COMMENTS :
AB 2330
Page 4
1)Author's Statement . The author has provided the following
statement in support of this bill:
California has long been a national and global leader in
[R&D]. To ensure the continued growth and development of
R&D, our tax code should offer effective incentives for
these types of investments. California currently offers a
[R&D] Tax Credit that is modeled on a federal version and
dates back to 1987. Over time, the federal credit has been
updated in important ways, while California's credit has
lagged behind. These discrepancies are burdensome on R&D
firms, as they have to decode state and federal law
separately and are often subject to duplicative audits from
both levels of government.
This bill would bring conformity to an important
discrepancy: the calculation methods used to determine the
amount of credit a firm can claim. In California, the list
of allowable calculation methods is outdated and does not
include what is known as the "simplified method," which is
generally easier to calculate and would encourage greater
program participation. This bill brings California into
conformity with federal law by allowing firms to opt for
the simplified method, should they choose it. In addition,
the bill includes conformity provisions for several recent
federal modifications to acquisitions, dispositions, and
aggregations of expenditures.
2)Arguments in Support . Proponents argue that "AB 2330 has many
benefits. It simplifies the calculation of the R&D credit for
California. It conforms to the federal rules for the
Alternative Simplified Credit, which will make it easier to
administer for both taxpayer and the [FTB]. It modernizes the
R&D credit, providing an alternative to the fixed base
percentage methodology of current law that refers back to a
base period from the 1980's. It also simplifies the law by
repealing a third calculation method, the 'alternative
incremental method,' that expired for federal purposes in 2008
but which is still used in California and that would become
unnecessary if California passes AB 2330."
3)R&D credit background : California enacted the credit for
research expenses in 1987 as part of two general federal tax
conformity bills [AB 1172 (Klehs), Chapter 1138, Statutes of
1987 and SB 572 (Garamendi), Chapter 1139, Statutes of 1987.]
AB 2330
Page 5
The original credit percentage was 8% of qualified research
expenses. Since that time, the California R&D credit rate was
amended several times and, finally, was increased from 12% to
15% in 2000 [AB 511 (Alquist), Chapter 107, Statutes of 2000.]
The alternative incremental computation of the R&D credit was
adopted in 1997 [AB 1042 (Wayne), Chapter 613, Statutes of
1997] and was subsequently amended to reflect the changes to
the California research credit percentage [AB 2798 (Machado),
Chapter 323, Statutes of 1998]. Unlike the federal R&D
credit, the California R&D credit is permanent.
4)The Scope of the California R&D Credit . The California R&D
credit is very similar to the federal R&D credit and is,
generally, available with respect to incremental increases in
qualified research. "Qualified research expenses" eligible
for the credit consist of in-house expenses for wages and
supplies attributable to that research, certain time-sharing
costs for computer use, and 65% of the contract research
expenses. However, "qualified research expenses" include 100%
of amounts paid by the taxpayer to an eligible small business,
university, or Federal laboratory for qualified energy
research. Under California law, qualified research includes
only research conducted in California.
Under the regular credit, the amount of the California R&D
credit equals to the sum of: (i) 15% of the amount by which
the taxpayer's qualified research expenses for a taxable year
exceed its "base amount for that year", and (ii) 15% of the
taxpayer's expenditures on research undertaken by an energy
research consortium (the so-called 'energy research credit').
The energy research credit applies to all qualified
expenditures, not just those in excess of a base amount. In
addition, corporate taxpayers are also allowed a credit of 24%
(in contrast to 20% allowed under federal law) of expenses
paid to fund basic research at universities and certain
nonprofit scientific research organizations.
5)What is a "tax expenditure" ? Existing law provides various
credits, deductions, exclusions, and exemptions for particular
taxpayer groups. In the late 1960s, United States Treasury
officials began arguing that these features of the tax law
should be referred to as "expenditures," since they are
generally enacted to accomplish some governmental purpose and
there is a determinable cost associated with each (in the form
of foregone revenues). This bill would replace an existing
AB 2330
Page 6
method of calculating the R&D credit, as provided for under
the AIRC, by conforming to the federal ASC.
6)How is a tax expenditure different from a direct expenditure ?
As the Department of Finance notes in its annual Tax
Expenditure Report, there are several key differences between
tax expenditures and direct expenditures. First, tax
expenditures are reviewed less frequently than direct
expenditures once they are put in place. This can offer
taxpayers greater certainty, but it can also result in tax
expenditures remaining a part of the tax code without
demonstrating any public benefit. Second, there is generally
no control over the amount of revenue losses associated with
any given tax expenditure. Finally, it should also be noted
that, once enacted, it generally takes a two-thirds vote to
rescind an existing tax expenditure absent a sunset date.
This effectively results in a "one-way ratchet" whereby tax
expenditures can be conferred by majority vote, but cannot be
rescinded, irrespective of their efficacy, without a
supermajority vote. Therefore, because it is so difficult to
replace an existing tax credit, even when conforming to
federal law, the author may wish to include a sunset date for
the ASC.
7)Reward or Incentive ? Generally, tax credits are designed to
either influence taxpayer behavior or provide tax relief.
Because this bill applies to taxable years beginning on or
after January 1, 2014, this bill would be providing a credit
for behavior that had already taken place before this bill's
enactment. The Committee may wish to consider the policy
implications of providing such an incentive for the 2014
taxable year.
8)What does this bill do ? This bill would bring California into
conformity with the federal calculation methods by allowing
taxpayers to elect the ASC and eliminate the use of the AIRC.
However, this bill modifies conformity by ensuring that all
qualified research is conducted in California, and by
providing a credit equal to 10.5% of California qualified
research expenses over a base amount. This bill also conforms
to recent federal modifications to the special rules that
apply for computing the R&D credit when a major portion of a
trade or business changes hands, and for the aggregation of
expenditures among commonly-controlled or otherwise-related
entities.
AB 2330
Page 7
9)Base Year Calculation . In 2009, the Government and
Accountability Office (GAO) released a report analyzing the
effectiveness of the R&D Credit. In general, the GAO found
serious disparities in the incentives provided to different
taxpayers. It also found that a large number of the credit
dollars to be a windfall because they were based on
expenditures that would have occurred in the absence of the
credit. In its conclusion, the GAO pointed to the use of the
84'-88' base year as a key reason for such disparities and
results that were inconsistent with the program's intent.
(GAO, Tax Policy: The Research Tax Credit's Design and
Administration Can Be Improved, Nov. 2009.) As a way of
rectifying the base year problem, Congress enacted the AIRC
and provided for the use of a rolling base year. Later, it
enacted the ASC and removed gross receipts from the method of
calculation, which allowed for a simpler method of calculating
the rolling average.
10)Calculating the Credit :
a) Regular Credit . Under the regular credit, the credit is
calculated as follows:
Credit = 20% ? [current-year QREs - base QREs],
Base QREs = greater of:
[Sum of QREs for 1984 to 1988 / the sum of gross
receipts for 1984 to 1988] ? average gross receipts
for the 4 tax years immediately preceding the current
one; or,
50% ? current-year QREs
b) AIRC . Under the AIRC, the credit is calculated as
follows:
Credit = 3% of Qualified Research Expenses (QRE) that are
above 1% but not greater than 1.5% of average annual
gross receipts in the 4 preceding tax years.
+ 4% of QREs that are above 1.5% but not greater than
2% of average annual gross receipts in the 4 preceding
AB 2330
Page 8
tax years
+ 5% of QREs that are above 2% of average annual gross
receipts in the 4 preceding tax years
In California, the applicable AIRC rates are 1.49%,
1.98%, and 2.48%, respectively.
c) ASC . Under ASC, the credit is calculated as follows:
Credit = 14% ? [current-year QREs - 50% ? average QREs in
the 3 preceding tax years]
If a taxpayer has no QREs in any of its 3 preceding
tax years, then the credit is equal to 6% of its QREs
in the current tax year. In California, the
simplified credit is not allowed.
This bill would provide for a credit of 10.5% and a
credit of 4.5% if the taxpayer has no QREs in the
previous three tax years.
11)Benefits of ASC . As the name implies, calculation of the ASC
is much easier for taxpayers to complete. Unlike the
incremental method, which relied on tiered system of average
annual gross receipts, the ASC allows for a 14% of research
expenses that exceed 50% of the average research costs for the
three preceding taxable year. By conforming to the ASC,
taxpayers will be much less likely to make mistakes, it would
make it easier for FTB to conduct an audit, and it would allow
companies to take advantage of the rolling average base
without the difficulties of a tiered calculation.
Furthermore, many companies that currently utilize the AIRC do
so because they tend to have a relatively high fixed-base year
percentages, spend less in research, or have sales growing at
a faster rate than their research spending. (Gary Guenther,
Research Tax Credits: Current Law, Legislation in the 112th
Congress, and Policy Issues, Congressional Research Service,
Nov., 2011) The enactment of the ASC will also maintain these
benefits but with an easier method of calculation.
12)Percentage of California Credit . According to the FTB's
staff, a credit of 10.5% for the ASC was chosen because it is
75% of the federal ASC. This is in line with the credit
percentage that California provides for the regular credit,
AB 2330
Page 9
but it is not in line with the percentage California provides
for the current AIRC. The federal AIRC provides a tiered
credit of 3%, 4%, and 5%. The applicable AIRC rates in
California are 1.49%, 1.98%, and 2.48%, or roughly 49.6% of
the federal credit. Because this bill replaces the AIRC with
the ASC, Committee may consider lowering the proposed ASC
credit from 75% to 49.6% of the federal ASC. This would
reduce the credit percentages allowed to 6.94% (14 x .496 =
6.94) for the normal ASC calculation and to 2.98% (6 x .496 =
2.98) for entities that have no QREs in the last three years.
13)Conformity Issues . This bill only conforms to the federal
provisions relating to the ASC. California does not
automatically conform to federal law, but instead considers
each provision individually. The last California-federal
conformity bill was enacted in 2010 [SB 401 (Wolk), Chapter
14, Statutes of 2010]. An omnibus California-federal
conformity bill may be a more appropriate vehicle for
comprehensively reviewing California's R&D tax credit regime
and the ways in which it differs from federal law. For
example, California's definition of "gross receipts" excludes
gross receipts other than those that are "sales of property
held by the taxpayer primarily for sale to customers in the
ordinary course of the taxpayer's trade or business that is
delivered or shipped to a purchaser within this state." (R&TC
Section 17052.12.) The decision to adopt a
California-specific definition of gross receipts was made
decades ago. The Committee may wish to consider whether this
definition is still merited in light of recent legal and
economic developments. To this end, the Court of Appeal
recently struck down a California statute that allowed
taxpayers a deferral for income received from the sale of
stock in corporations maintaining assets and payroll in
California, while providing no such deferral for income from
the sale of stock in corporations maintaining assets and
payroll elsewhere. [Cutler v. Franchise Tax Board (2012) 208
Cal.App.4th 1247, 1250.] The Court held that "the deferral
provision discriminates on its face on the basis of an
interstate element in violation of the commerce clause."
(Ibid.) In light of this decision, the Committee may wish to
consider whether the existing definition of "gross receipts"
is legally sound.
14)The R&D credit : There are two main purposes for the federal
and California R&D credit. First, it is intended to reduce
AB 2330
Page 10
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.
Similarly, the California R&D credit is designed to increase
R&D activity and to encourage manufacturing related to R&D to
be undertaken in California rather than elsewhere. The
California's R&D credit provides a powerful incentive for
firms to conduct R&D in this state because of its high credit
percentages that exceed that of other states and because it is
permanent. This credit, unlike many other tax incentives,
does not serve as a reward for past behavior since it could
only be claimed for incremental increases in the taxpayer's
research activity. As explained by the Joint Committee on
Taxation's Report, "incremental credits attempt not to reward
projects that would have been undertaken in any event but to
target incentives to marginal projects." (Joint Committee on
Taxation, Description of Revenue Provisions Contained in the
President's Fiscal Year 2010 Budget Proposal, Part Two:
Business Tax Provisions, JCS-3-09, p. 17.) It is impossible,
however, to determine which projects would be undertaken
without the credit and, thus, "most incremental credit
proposals rely on some measure of the taxpayer's previous
experience as a proxy for a taxpayer's total qualified
expenditures in the absence of a credit", i.e. "a base
amount." (Id., p.18.) Nonetheless, the incentive effects of
incremental credits per dollar of revenue loss can be many
times larger than those of a flat credit.
The California R&D credit is believed to create additional R&D
economic activity in the state, which, arguably, is more
desirable than jobs in other industries. 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,"
which can be described as the benefits several firms receive
when locating in close proximity. (California Income Tax
Expenditures, Compendium of Individual Provisions, Updated
December 2009, FTB, p.17.) Specifically, cost of production
may significantly decline because there is a greater chance
for specialization and division of labor. If this is the
case, many California businesses, not just those receiving
this credit, will gain an advantage over their rivals in other
states.
AB 2330
Page 11
15)Related Legislation .
a) AB 1564 (V. Manuel P�rez) would have temporarily
increased the rates of the general research credit and the
university "basic research" credit and allowed taxpayers to
sell and purchase research credits, as provided, under the
Research and Development Tax Credit Trade Program. AB 1564
is currently in the Assembly Appropriations Committee.
b) AB 653 (V. Manuel P�rez) would have temporarily provided
incremental increases to the general research credit
percentage using the regular calculation method, up to a
maximum credit rate of 30 percent, and would have
temporarily provided incremental increases to the
university "basic research" credit percentage, up to a
maximum credit rate of 40%. AB 653 was held in the
Assembly Appropriations Committee.
c) AB 486 (Mullin) provides manufacturers, software
producers, biotechnology and life, engineering, and
physical researchers and developers, a SUT exemption for
qualifying TPP. AB 486 was held in the Assembly Committee
on Appropriations.
d) SB 235 (Wyland) would have increased the general
research credit percentage using the regular calculation
method to the federal credit rate of 20%, and would have
increased the incremental credit rates to the federal
credit rates of three, four, and five percent. SB 235
failed passage in the Senate Committee on Governance and
Finance
16)Prior Legislation .
a) AB 2278 (Anderson), of the 2009-10 Legislative Session,
conforms to the federal credit percentage for increasing
research activities and conforms to the federal alternative
incremental research credit. AB 2278 was held in this
Committee.
b) AB 1484 (Anderson), of the 2009-10 Legislative Session,
conforms to the federal credit percentage for increasing
research activities and conforms to the federal alternative
incremental research credit. AB 1484 was never heard by
this Committee
AB 2330
Page 12
REGISTERED SUPPORT / OPPOSITION :
Support
California Chamber of Commerce
California Healthcare Institute
California Manufacturers & Technology Association
California Taxpayers Association
Hewlett-Packard
Pharmaceutical Research and Manufacturers of America
Regional Economic Association Leaders Coalition
Silicon Valley Leadership Group
Opposition
None on file
Analysis Prepared by : Carlos Anguiano / Oksana Jaffe / REV. &
TAX. / (916) 319-2098