The Great California TaxQuake!

The Commission on the 21st Century Economy Identifies Sweeping Tax Reforms That Could Shake Things Up for all California Taxpayers

On September 29, 2009, the Commission on the 21st Century Economy published its report to Governor Schwarzenegger outlining recommendations for a major shift in California’s tax structure. The Governor created the Commission on October 30, 2008 when he signed Executive Order S-12-08 (later revised by S-15-09). This Commission’s directive was to study and re-examine California’s out of date revenue and taxation laws that contribute to California’s feast-or-famine state budget cycles.

The Commission was established with six principles in mind:

  1. Establish a 21st century tax structure that fits with the state’s 21st century economy
  2. Stabilize state revenues and reduce volatility
  3. Promote the long-term economic prosperity of the state and its citizens
  4. Improve California’s ability to successfully compete with other states and nations for jobs and investments
  5. Reflect principles of sound tax policy including simplicity, competitiveness, efficiency, predictability, stability, and ease of compliance and administration
  6. Ensure that tax structure is fair and equitable

Since October, 2008 the Commission has met several times in order to craft a proposal and to hear public comment. The Commission hired an independent firm to analyze different states’ alternative based taxes such as the Texas Margin Tax, the Ohio Commercial Activity Tax (CAT), and the Michigan Business Tax (MBT) to draw from the experience of states that have shifted away from a reliance on income taxes.

Overview of Proposal

The Commission divided its report into three sections:

  1. Recommendations with consensus support of the Commission that require a change in statutory law and may be enacted by majority vote of the legislature (a revenue neutral package)

    The Commission’s proposed plan for a new tax system that may require only a change in statutory law contains the following elements:

    • Simplify and reduce the personal income tax
    • Eliminate the corporate income tax and $800 minimum franchise tax completely
    • Eliminate the 5(1) percent state portion of the sales and use tax (the local county and district portion of the Sales Tax would remain intact)
    • Implement a new Business Net Receipts Tax (BNRT) to expand the tax base and keep revenues constant
    • Establish an independent tax court

    The new BNRT would expand the tax base to cover more taxpayers thereby spreading the overall tax burden over more taxpayers. Because the BNRT is not based on or measured by net income, it is intended to avoid significant swings in tax revenues that California has experienced over the last two decades. The revenue generated by the BNRT would replace the corporate income tax, the state portion of the sales and use tax, and reduced personal income taxes.

  2. Recommendations with consensus support of the Commission that require a change in the state constitution or a ballot initiative:
    • Establish a Rainy Day Reserve Fund with a target reserve increased from 5 percent of revenues to 12.5 percent of revenues, plus a reserve for certain surpluses
    • Place restrictions on the ability to transfer funds into and out of the fund
  3. Ideas worthy of further review but not recommended:
    • Earn revenue from royalties for offshore oil drilling leases
    • Require a new minimum tax on all residents and businesses
    • Merge the Board of Equalization and the Franchise Tax Board

The Main Proposal: A Sweeping Change to California’s Taxes

Under the proposal by the Commission, the personal income tax would be simplified. The personal income tax changes would be phased-in and take effect in year three of the plan. The number of tax brackets would be reduced from six to two. Credits would be eliminated with the exception of taxes paid to other states. Deductions would be limited to mortgage interest, property taxes, and charitable contributions. Two tax rates would exist: 2.75 percent of income up to $56,000 for joint filers ($28,000 for single filers), and 6.50 percent of income above these amounts. The standard deduction would be $45,000 for joint filers and $22,500 for single filers.

The corporate income tax would be completely eliminated for tax years starting on or before January 1, 2012. The state portion of the sales and use tax would be phased-out beginning with a 1 percent reduction in the initial year of the plan, and a 1 percent reduction during each of the four following years. This phased reduction of the rate contains a “safety valve” feature: the sales tax rate reduction is contingent upon equivalent tax revenue generated by a new BNRT, described below. If revenues fall short of projections, then the sales and use tax rate reduction would be adjusted to compensate.

Business Net Receipts Tax

The BNRT is designed to tax the value a business adds to the production of products and services sold in California. The BNRT is expected to shift $7 billion of tax liability outside of the state to those businesses selling into the California marketplace. The BNRT expands the tax base to impose the BNRT on business entities not currently subject to an income tax, and upon goods and services that currently escape sales or use taxes.

The BNRT would be imposed on all businesses deemed to be doing business in California if any of the following conditions are met:

  • The business is organized or commercially domiciled in California.
  • Sales by the business in California exceed the lesser of $500,000 or 25 percent of a taxpayer’s total sales.
  • The real property and tangible personal property of the business in California exceed the lesser of $50,000 or 25 percent of a taxpayer’s total real property or tangible personal property.
  • The amount paid in California by the employer for compensation exceeds the lesser of $50,000 or 25 percent of the total compensation paid by the taxpayer.

For pass-through entities, the BNRT liability would be deductible against the pass-through entity’s income for purposes of calculating a partner’s income tax liability. Thus, the partner’s personal income tax base would include the pass-through income net of BNRT paid at the entity level.

The BNRT formula would be:

  1. Gross Receipts – Purchases from Other Firms = Net Receipts
  2. Net Receipts * BNRT Rate = BNRT Liability

The BNRT phase-in would be five years with the first year rate expected to be 1.6 percent. The Commission has also agreed on the need for a maximum tax rate which is expected to top off at 4 percent. There are several important points to recognize regarding this formula. There is no deduction for compensation or benefits for officers or employees. Any net operating loss, capital loss, and credit carryovers existing as of January 1, 2012, would be limited to 5 percent of a taxpayer’s annual business net receipts, but could be carried forward 20 years until exhausted. However, in order to promote investment in California, the Commission has proposed to retain the research and development (R&D) credit.

  • BNRT Gross Receipts and Purchases for Non-Financials
    The definition of gross receipts is meant to be interpreted broadly, but within the context of goods and services sold by the taxpayer and consumed in the state. Thus, gross receipts include the sale and exchange of property, the performance of services, or the use of property or capital, including rents and royalties, in the trade or business of the taxpayer. Gross receipts would not include any receipts included in the measure of tax paid by any other taxpayer. Gross receipts would also exclude extraneous transactions that are not related to the sale of products or services, largely resulting from financial transactions. Some examples of the gross receipts exclusions are interest and dividends, maturity of a bond, or repayment of principal of a loan.

    Purchases include only rents, royalties, inventory purchased for resale, materials and supplies, services purchased during the year and assets placed in service during the year. The amount deductible each year is limited to the amount immediately expensed or depreciated, amortized, or depleted during the year in accordance with federal law plus interest.

  • BNRT and Financial Businesses
    Financial companies pose unique challenges to the BNRT. Because of these challenges the Commission has developed four potential options for taxing financial companies:
    1. Base the tax on the current corporation franchise and income tax laws.
    2. Base the tax on the calculation of BNRT on net income as defined under the provisions of the corporation franchise and income tax laws plus employee compensation.
    3. Base the tax on the calculation of BNRT using the same gross receipts factor as included for non-financials with the addition of interest amounts received pursuant to financial transactions and using the same purchases factor as included for non-financials with the addition of interest expenses on financial transactions.
    4. In addition to revenues and purchases in 3 above, include as revenues bank deposits and all proceeds from financial transactions and include as purchases loan amounts and financial purchases, except the purchase of own stock.
  • Unitary and Multi-State Business
    The unitary method would still apply to unitary groups and multi-state businesses under the BNRT and it would still be water’s edge. Multi-state apportionment would use a single sales factor. The taxpayer would have the option to base the apportionment calculation on just the current tax year’s numbers or elect to use an average of the last five years.

Conclusion

The Commission report contains recommendations for sweeping changes to the California tax system, the merits of which will be considered by the legislature. It is too early to tell whether such a sweeping change would garner the required support to pass any or all of the Commission’s recommendations. However, the undertaking itself has sent tremors across the State and beyond, potentially impacting all California taxpayers.

(1) It appears that the Commission bases this proposal on a 5% state sales and use tax rate (instead of the current 6% rate) in anticipation of a 1% reduction effective July 1, 2011.