On October 8, 2010, California Governor Arnold Schwarzenegger signed into law the California budget—more than 100 days late. As part of the budget package, the California Legislature sent Senate Bill 858, a trailer bill to the budget containing significant tax legislation, to enrollment. Under the legislation, which will be immediately effective upon enactment, the 2008 net operating loss (NOL) suspension will be extended an additional two years, cost of performance rules impacting the calculation of the sales factor will be applied in certain circumstances, and other tax related provisions are expected to be implemented.1 These changes must be considered in conjunction with the potential passage of Proposition 24 on November 2, a voter initiative, which would make significant changes to the California NOL and sales factor rules.2

2010-2011 NOL Suspension and Deferral of Carryback

Existing Law

California historically has allowed taxpayers to calculate a California NOL with substantial modifications from the federal NOL regime.3 As part of the 2008 California budget, California suspended the use of NOLs in the 2008 and 2009 tax years.4 However, taxpayers with less than $500,000 in post-apportioned net business income determined on an entity-by-entity basis were exempted from this suspension.5 In addition to the temporary two-year suspension of NOLs, California extended the carryforward of NOLs from 10 to 20 years, and beginning with the 2011 tax year, California was scheduled to allow NOLs to be carried back to prior taxable years, subject to certain limitations.6

New Legislation

The trailer bill suspends the ability of taxpayers to use NOLs in the 2010 and 2011 taxable years, and extends the 20-year carryforward periods to account for the suspension period.7 California again allows for an exception to this rule with modified limitations. The 2010 and 2011 NOL suspension does not apply to personal income taxpayers with less than $300,000 in modified adjusted gross income, or corporate taxpayers with less than $300,000 in pre-apportioned income (net business and nonbusiness income before apportionment and allocation) on a combined basis.8

The trailer bill would also repeal the two-year carryback of NOLs attributable to taxable years beginning on or after January 1, 2011. Instead, a two-year carryback of NOLs attributable to taxable years beginning on or after January, 2013 is allowed.9 The revised carryback provision would permit a 50 percent carryback of NOLs attributable to 2013, a 75 percent carryback of NOLs attributable to 2014, and a 100 percent carryback of NOLs attributable to post-2014 tax years.10

In addition, for taxable years beginning on or after January 1, 2011, California is specifically decoupling from Internal Revenue Code Sections 172(b)(1)(J), which relates to rules regarding certain losses attributable to federally declared disasters, and 172(j), which relates to rules regarding qualified disaster losses.11

Potential Effect of Proposition 24

If passed by a majority of the California electorate on November 2, Proposition 24 would prospectively repeal the two-year NOL carryback provisions and reduce the NOL carryforward period from 20 years to 10 years.

Sourcing of Services and Intangibles: Return of Costs of Performance Rules for Taxpayers Not Electing Single Sales Factor

Existing Law

Formulary Apportionment and Single Sales Factor

In California, multistate businesses must apportion income according to a formula consisting of payroll, property, and sales, with sales double-weighted for most taxpayers.12 Beginning in the 2011 taxable year, taxpayers were scheduled to be allowed to make an annual, irrevocable election to determine their California apportionment by using either the standard formula or electing to use a single sales factor apportionment formula.13

Sales Factor Sourcing

In general, California's conformity to the Uniform Division of Income Tax Purposes Act (UDITPA) results in sales of tangible personal property being sourced to California if the property is shipped to a purchaser within the state, and sales of intangible personal property or services are sourced based on the taxpayer's costs of performance.14 Beginning in the 2011 taxable year, the cost of performance methodology is scheduled to be repealed and replaced with the following sourcing rules: "

  • Sales from services are sourced to California to the extent the purchaser of the service received the benefit of the service in California;
  • Sales from intangibles are in California to the extent the property is used in California;
  • Sales from marketable securities are in California if the customer is in California;
  • Sales from the sale, lease, rental or licensing of real property are in California if the real property is located in California; and
  • Sales from the rental, lease or licensing of tangible personal property are in California if the property is located in California.15

New Legislation

Cost of Performance Rules

Pursuant to the trailer bill, the new sourcing rules would only be available to taxpayers who elect to use a single sales factor apportionment formula when that election is available beginning in 2011.16 Taxpayers who do not elect to use a single factor apportionment formula must source sales from items other than the sale of tangible personal property toCalifornia if the income-producing activity is performed in California, or in situations where the income-producing activity occurs both within and outside California, if a greater proportion of the income-producing activity is performed in California, based on costs of performance.17

Economic Nexus

The trailer bill also requires sales under the new sourcing rules to be used when measuring whether a taxpayer is subject to tax in California.18 A taxpayer will be considered to be "doing business" in California if the taxpayer's sales in California exceed the lesser of: (i) $500,000, including the sales of its independent contractors and agents; or (ii) 25 percent of the taxpayer's total sales are in California.19

Potential Effect of Proposition 24

If passed by a majority of the California electorate on November 2, Proposition 24 would prospectively repeal the election to use a single sales factor apportionment formula in lieu of three-factor apportionment. The trailer bill provides that if Proposition 24 passes and the election to use the single sales factor is eliminated, then all taxpayers will be subject to cost of performance rules for sales of other than tangible personal property.20 However, the use of the new sourcing rules will be retained for purposes of determining whether a taxpayer has economic nexus with California.21

Other Tax Provisions

Large Corporate Understatement Penalty Modified

The trailer bill modifies the large corporate understatement penalty, which currently imposes a 20 percent penalty on taxpayers (including combined groups) whenever there is an understatement of tax in excess of $1 million. The penalty will apply only to understatements that exceed the greater of: (i) $1 million or (ii) 20 percent of the tax shown on an original return or amended return.22

Use Tax Reporting

The trailer bill reauthorizes taxpayers to report use tax on their California income tax return.23

Cost Recovery Fee

The trailer bill authorizes the State Board of Equalization to impose and collect a collection cost recovery fee on any person or company that fails to pay amounts due and owing.24

Commentary

Although California passed its budget relying on the enactment of the proposed changes to tax legislation in the trailer bill, the trailer bill has not been enacted to date. Until the trailer bill is approved by the Legislature and signed by the Governor, the trailer bill is subject to modification. It will be interesting to see whether the trailer bill is signed before the results of Proposition 24 are announced. As noted above, if Proposition 24 passes, the cost of performance methodology that all taxpayers thought was going to go away will continue to be important for taxpayers that have a significant amount of sales of items other than tangible personal property.

With the abundance of corporation income tax changes that will occur as a result of the budget process, and potentially with the passage of Proposition 24, taxpayers are going to have many questions with respect to estimated payments and treatment of adjustments and potential restatements under Accounting Standards Codification (ASC) 740 (formerly Financial Accounting Standards Board (FASB) Statement No. 109 (FAS 109), as interpreted by FASB Interpretation No. 108 (FIN 48)). Taxpayers that have made estimated tax payments based on the utilization of NOLs may owe additional tax for the 2010 tax year. However, penalties for underpayment of estimated taxes are not imposed if the underpayment was created by any provision of law that is chaptered or operative for the taxable year of the underpayment.25 As for ASC 740 considerations, deferred tax assets and liabilities are going to be in flux if Proposition 24 passes, particularly for companies that expected to utilize the election to use a single sales factor in conjunction with a sourcing methodology concentrating on where their customers received the benefit of a service, rather than the primary location of their costs in performing the service.

Footnotes

1 S.B. 858, amended in Assembly on October 7, 2010 (companion bill A.B. 1618 amended by Senate on October 6, 2010).

2 Proposition 24 is entitled the "Repeal Corporate Tax Loopholes Act."

3 CAL. REV. & TAX. CODE §§ 17276 et seq.; 24416 et seq.

4 Former CAL. REV. & TAX. CODE §§ 17276.9; 24416.9.

5 Former CAL. REV. & TAX. CODE §§ 17276.9(d); 24416.9(d).

6 Former CAL. REV. & TAX. CODE §§ 17276.10; 24416.10. A two-year NOL carryback was scheduled to be provided with the following restrictions: "

  • For NOLs generated in the 2011 taxable year, taxpayers would have been able to carry back 50 percent of the loss to the 2009 and 2010 taxable years. "
  • For NOLs generated in the 2012 taxable year, taxpayers would have been able to carry back 75 percent of the loss to the 2010 and 2011 taxable years. "
  • For NOLs generated in the 2013 taxable year and thereafter, taxpayers would have been able to carry back 100 percent of the loss to the 2011 taxable year and thereafter. Former CAL. REV. & TAX. CODE §§ 17276(e)(2); 24416(d)(2).

7 CAL. REV. & TAX. CODE §§ 17276.21(a), (b); 17276.22; 24416.21(a), (b); 24416.22.

8 CAL. REV. & TAX. CODE §§ 17276.21(d)(2); 24416.21(e)(1).

9 CAL. REV. & TAX. CODE §§ 17276.20(c)(1); 17276.22; 24416.20(d)(1); 24416.22.

10 CAL. REV. & TAX. CODE §§ 17276.20(c)(2); 24416.20(d)(2).

11 CAL. REV. & TAX. CODE §§ 17276.05; 24416.05.

12 CAL. REV. & TAX. CODE §§ 25120 et seq.

13 CAL. REV. & TAX. CODE § 25128.5.

14 CAL. REV. & TAX. CODE § 25136(a).

15 CAL. REV. & TAX. CODE § 25136(b)(1)-(4).

16 CAL. REV. & TAX. CODE § 25136(b)(5).

17 CAL. REV. & TAX. CODE § 25136(a).

18 CAL. REV. & TAX. CODE § 23101(a)(2)

19 Id.

20 CAL. REV. & TAX. CODE § 25136(a)(3).

21 CAL. REV. & TAX. CODE § 25136(b)(5)(C).

22 CAL. REV. & TAX. CODE § 19138(a)(1).

23 CAL. REV. & TAX. CODE § 18510.

24 CAL. REV. & TAX. CODE §§ 6833; 9035; 11534; 30354.7; 32390; 38577; 40168; 41127.8; 43449; 45610; 46446; 50138.8; 55211; 60495.

25 CAL. REV. & TAX. CODE § 19142.

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