California tries a new direction on corporate taxation

When state legislators finally hashed out a budget deal in February, among the concessions won by business interests was the biggest change in California’s corporate tax law in a generation. Defenders of the new method say it will spur investment in the state, while one key detractor said it will have a price tag that will grow past $1.5 billion a year.

At issue is the new “elective sales factor,” a system for determining how much tax a company should pay in the state. Up to now, California’s tax system taxed corporations using a formula based on employment, property and sales in the state, sometimes know as a “triple factor” system.

Many companies have long argued that this traditional way of calculating taxes punishes companies that invest in the state and create jobs, but critics disagree. Under the new elective system, set to go into place for the 2011 tax year, companies can choose to pay under either the triple factor formula or via the  “single sales factor” system, based entirely on their sales in California.

“The policy behind a single sales factor formula is you reward the companies that heavily invest property and payroll in the state,” said lobbyist Chris Micheli, who represents numerous corporate clients with his firm, Aprea & Micheli. He said he did not personally lobby on the elective sales factor provisions.

The most vocal critic of these changes is Lenny Goldberg, executive director of the California Tax Reform Association. He said he is opposed to single sales in the first place—but that allowing companies to choose which system they use is even worse. He said companies will now be able to report more revenue to the state in good years and move losses into the state in bad ones.

“Tax policy should be consistently applied,” Goldberg said. “But we’ve given this elective that provides for infinite manipulation.”

The changes were part of a budget trailer bill, ABX3 15, authored by Assemblyman Paul Krekorian, D-Burbank, and a related bill from the Senate, SBX3 15 by Senator Ron Calderon, D-Montabello. Goldberg said these bills negotiated behind closed doors, without hearings, during rushed budget negotiations—leading to a very bad deal for the state.

“This is the gutting of the state corporate tax,” said “In fact, they did it so badly that lawyers are chuckling about the opportunities for tax avoidance.”

Over 20 states have now moved to versions of the single sales factor model, which taxes a company based on their actual sales in the state. But none, Goldberg said, currently let companies choose between the two systems.  

Goldberg also disputes the official analysis, which he said underestimates the likely losses to the state. An Assembly Budget Committee analysis said the elective single sales factor will cost $750 million in the 2012-13 budget year. A Franchise Tax Board Analysis puts the loss for that budget year at $800 million.

Assembly Budget Committee vice chair Roger Niello, R-Sacramento, argues the state will get a nice return on this investment. He said the current system “discourages” companies from building in California. He pointed to one of the state’s leading technology powerhouses, microchip maker Intel, which hasn’t built a new production plant in California since the mid-1990s. Then he jokingly asked where Goldberg would break ground if he had to build a factory.  

“If he’s as smart as I think Lenny is, I think he’s going to build it in Arizona,” Niello said.

But Niello did agree with Goldberg on one thing—there should be more light shed on the budget process. In fact, he said, he has put forth several proposals to do just that—for instance, increasing the size of the budget conference committee and requiring a supermajority to pass out individual budget items—but his ideas have been shot down by Democrats.

The sales factor change has long been sought by many in-state companies, particularly in the technology sector. Versions of the single sales factor reform have been bouncing around the legislature for years, originally pushed by conservatives like Republican former Assemblyman Bill Campbell.

But in more recent years, Democrats whose districts depend on affected industries have picked up the idea. Last session, Assemblywoman Fiona Ma, D-San Francisco, carried AB 1521, which would have installed the elective sales factor. Her district contains numerous high tech companies.

Krekorian, meanwhile, represents Burbank, which will benefit from another tax break passed in the bill, the so-called “runaway production” credit to Hollywood studios. This offers $100 million in tax credits annually for productions shot in California up through 2014.

But the elective sales factor is permanent—and will take a two-thirds vote to overturn, something which would be unlikely to happen even without the bipartisan support the idea currently enjoys.

Micheli points out that the budget deal agreed on last September contained numerous tax changes that corporations didn’t much like. For instance, a Budget Committee bill, suspending the net operating loss deduction for businesses making more than $500,000 for the 2008 and 2009 tax years.

These provisions, Micheli said, amounted to a $1.7 billion tax increase over that time. The bill also placed limits on tax write-offs for research and development. The Budget Committee analysis estimated that these and other provisions of the bill would bring in an extra $3 billion over two years.

“There was a multi-billion dollar tax increase in September that seems to have gone largely unnoticed, most of which was directed at the biz community,” Micheli said.

The pair of budget bills passed in February also included provisions that corporations didn’t like. The most significant was the market-based sourcing rule. Under the old rules, when a company sold a product, that sale was apportioned to wherever most of the work was done to create it.

Under the new rule, a sale is considered to apply wherever the customer is—something Goldberg said he is in favor of, because it makes it harder for companies to manipulate the system. This is likely to particularly affect software companies, who sell many of their products via internet downloads.