The Personal Income Tax Law provides a credit against the taxes imposed by that law to residents for specified taxes paid to another state on income derived from sources within that state. Existing law, for purposes of a calculation used in determining the credit amount, determines that income by applying the nonresident sourcing rules for determining income from sources within California, including the single sales factor apportionment formula.

This bill bill, for purposes of the above-described calculation, would provide that Californias single sales factor apportionment formula, and the regulations issued thereunder, shall not be applied in lieu of another states apportionment rules when determining income derived from sources in that state.

The Personal Income Tax Law provides a credit against the taxes imposed by that law to residents for specified taxes paid to another state on income derived from sources within that state. Existing law determines that income by applying the nonresident sourcing rules for determining income from sources within California, including the single sales factor apportionment formula.

This bill would provide that Californias single sales factor apportionment formula, and the regulations issued thereunder, shall not be applied in lieu of another states apportionment rules when determining income derived from sources in that state.

This bill would declare that it is to take effect immediately as an urgency statute.

Date of Hearing: May 18, 2016

ASSEMBLY COMMITTEE ON APPROPRIATIONS

Lorena Gonzalez, Chair

ABPCA Bill Id:AB 2771

Author:(Irwin) – As Amended Ver:April 11, 2016

Urgency: No State Mandated Local Program: No Reimbursable: No

SUMMARY:

This bill modifies the rules for determining the amount of credit allowed, under the Personal Income Tax (PIT) Law, to a California resident for taxes paid to other states. This bill provides that for purposes of calculating a credit for the taxes paid by a California resident to another state, California's apportionment rules will not apply in lieu of that other state's apportionment rules.

FISCAL EFFECT:

Unknown fiscal impact because of the lack of data available on the number of taxpayers affected by this bill. For every 1% of taxpayers affected, there would be a GF revenue loss of approximately $8.8 million.

COMMENTS:

1. Background. California residents are taxed on all income, including income from sources outside of California. In some cases, taxpayers are taxed by both California and another state on the same income. To prevent the income from being taxed twice, California or the other state will allow a credit to offset the taxes paid to the other state.

California residents may claim a credit for net income taxes imposed by and paid to another state only on income which has a source within the other state. No credit is allowed if the other state allows California residents credit for net income taxes paid to California.

For the purposes of calculating the other state’s tax credit, California’s sourcing principles apply even though the results may be contrary to other states’ principles. For example: A California taxpayer may have income from a multistate trade or business. Some of that income was generated another state, and so that taxpayer pays the other state’s income taxes on that portion of income. Under California rules, that taxpayer may claim a credit for those income taxes, but the taxpayer must recalculate the tax owed for that income under California’s sourcing rules. The greater the difference is between California’s and other state’s apportionment and allocation rules, the more potential there is for double taxation of income.

1. Purpose. This bill is intended to simplify the tax code and align it with other state’s apportionment rules instead of California’s rules. The author notes that other states like New York have implemented similar changes.

Analysis Prepared by: Luke Reidenbach / APPR. / (916) 319-2081

Date of Hearing: May 9, 2016

ASSEMBLY COMMITTEE ON REVENUE AND TAXATION

Sebastian Ridley-Thomas, Chair

ABPCA Bill Id:AB 2771 (

Author:Irwin) – As Amended Ver:April 11, 2016

Majority vote. Fiscal committee. Tax levy.

SUBJECT: Personal income taxes: credits: taxes paid to another state

SUMMARY: Modifies the rules for determining the amount of credit allowed, under the Personal Income Tax (PIT) Law, to a California resident for taxes paid to other states. Specifically, this bill:

1. Provides that, for purposes of calculating a credit for the taxes paid by a California resident to another state, California's apportionment rules, and the regulations thereunder, shall not apply in lieu of that other state's apportionment rules.
2. Takes immediate effect as a tax levy.

EXISTING LAW:

1. Imposes an income tax on all income of a California resident, including income derived from sources outside California.
2. Allows generally an income tax credit for net income taxes paid to other states (hereinafter "Other State Tax Credit" or "OSTC").
3. Specifies that a credit is allowed for net income taxes imposed by and paid to another state only on income that has a source within the other state. No credit is authorized if the other state allows California residents a credit for net income taxes paid to California.
4. Requires the use of California's sourcing principles, case law, and regulations in calculating the amount of the OSTC, even if they are contrary to the other states' sourcing rules.

FISCAL EFFECT: Unknown, but Franchise Tax Board (FTB) staff estimates that for every one percent of taxpayers impacted, the measure would result in a revenue loss of approximately $8.8 million.

COMMENTS:

1. Author's Statement: The author has provided the following statement in support of this bill:

AB 2771 will amend the OSTC calculation using the other state's apportionment rules instead of California's. This will simplify the tax code and align it with other states like New York that have implemented similar changes.

California tax laws should not unnecessarily burden taxpayers who wish to comply but lack the expert knowledge and resources to do so. This bill ensures that certain taxpayers can use the amount of income taxes they paid in other states as a credit against income taxes owed in California, reducing the chance of double taxation for California residents.

1. Committee Staff Comments:
   1. Arguments in support: The proponents state that this bill will "make compliance with the Other State Tax Credit less burdensome, and more accessible to taxpayers who are eligible for the credit but may lack the technical ability to utilize it under the current rules." They argue that "[u]sing the apportionment and allocation rules of the state where the tax was paid when calculating the credit also will help ensure that taxpayers are not being unfairly double-taxed, and will more fully realize the original intent of the Other State Tax Credit."
   2. Other State Tax Credit (OSTC) background: States have very broad taxing power over their residents. A state with a personal income tax will generally impose the tax on all of a resident's income, including the income derived from other states or countries.^[1] The state, however, would allow a credit for net income taxes paid to another state, to avoid instances of double taxation. For example, an individual who lives in California but works elsewhere would still be subject to California's personal income tax. Yet, to the extent that the individual has paid an income tax to another state where he or she works, the individual may be entitled to receive a credit to offset California income tax liability. While it may seem simple in the case of an individual taxpayer with a "basic" type of income, such as interest, dividends, or even wages, it becomes much more complicated when the income is derived from a multistate trade or business. The application of the OSTC provisions is more complex because, unlike many other states, California requires taxpayers to re-compute the amount of tax paid to another state if the tax was paid on apportioned or allocated income from a trade or business. Specifically, under Revenue and Taxation Code (R&TC) Section 18001, the recalculation must be done using California's apportionment and allocation rules, instead of the other state's rules. Put differently, instead of using the actual amount of tax paid to other states, California requires the taxpayer to recalculate the amount of tax that would have been paid to the other state had that state adopted California's rules.^[2] The credit amount is limited to the lesser of the actual amount of tax paid or the amount that would have been due to the other state under California's rules.
   3. What is the problem? Arguably, the disregard of other states' apportionment and allocation rules may result not only in administrative complexity and burdensome compliance, but also in significant double taxation of California residents. This issue was first raised by the practitioners who participated in the State Bar of California 2015 Sacramento Delegation^[3] (the Sacramento Delegation paper) and was later discussed at the Eagles Lodge West conference in April 2015. The greater the difference is between California's and the other state's apportionment and allocation rules, the more potential there is for double taxation of income. This point is well illustrated by two examples provided in the Sacramento Delegation paper.^[4] Both examples assume a single sales factor apportionment formula in other states. If, however, the assumption is that the other state has a three-factor apportionment formula, then the calculations become even more complex and time-consuming. The taxpayer would first have to calculate the amount of tax using the other state's apportionment formula, and then re-calculate that amount under the California single sales apportionment rules to determine the OSTC amount. Some argue that the requirement to collect information that may be difficult or impossible to obtain is unreasonable and leads to non-compliance altogether, especially in the case of a small sole proprietor (who may not have the means) or a limited partner (who may not have access to the required information).
      
      According to the author's office, individuals with even a small stake in a company that does business in other states and is treated as a pass-through entity is required to have knowledge of the sourcing rules for the states from which the company's income is derived. They need access to technical data that only the company has and may not be able to obtain the information necessary to complete the re-calculations of the taxes paid in other states by the company.
   4. The proposed solution: This bill proposes a narrow change to the existing OSTC calculation requirements. This bill would still require taxpayers to re-calculate the amount of income derived from the other state (and the applicable tax due in the other state) using the nonresident sourcing rules, as provided. However, the California apportionment rules would not apply. While this bill would ease the burden of compliance, it will not eliminate the requirement that income derived from other states be calculated using California's allocation rules, which means that the taxpayers in the examples cited in footnote 3 would still be significantly double taxed. The Committee may wish to consider whether the scope of this bill should be expanded to include the application of the other state's allocation rules, in addition to apportionment rules, in determining the amount of tax paid to the other state.
   5. The Wynne Case: The issue of double taxation in the context of the state's personal income tax was recently analyzed by the Supreme Court of the United States in Maryland Comptroller of the Treasury v. Wynne (2015) 135 S. Ct. 1787. The Court explored the limits of state taxing authority exercised by the State with respect to its own residents. Central to the Court's decision in Wynne was the question of whether the dormant commerce clause of the U.S. Constitution protects resident individuals from their own state's tax laws. The State of Maryland argued that there was no constitutional requirement for the State to provide a credit for income taxes paid by its residents to another state and that the state may tax its residents on a 100% of their income. The U.S. Supreme Court disagreed. The Court held that Maryland's tax scheme, which imposed a tax on income that Maryland residents earned outside the State, violated the dormant Commerce Clause of the U.S. Constitution because it did not offer Maryland residents a full credit against the income taxes they paid to the other State. The Maryland tax structure failed the "internal consistency" test. This test looks to the structure of a particular tax system to determine whether its identical application by every State in the Union would place interstate commerce at a disadvantage as compared with intrastate commerce. In Wynne, the Maryland tax scheme failed because it had created an incentive for Maryland taxpayers to opt for intrastate rather than interstate economic activity. It is unclear whether California's OSTC provisions would be similarly held to violate the internal consistency test. While some believe that the OSTC provisions would not fail this test, this issue is not free from doubt and has not been settled by the courts.
   6. OSTC rules in other states: FTB staff, in its analysis of this bill, reviewed the income tax laws of Illinois, Massachusetts, Michigan, Minnesota, and New York, because these states' laws are most similar to California's income tax laws. With the exception of New York, these states do not require a recalculation of the tax paid to other states for purposes of determining the OSTC amount. In the case of New York,^[5] it seems that the amount of tax paid to another state must be re-determined using New York's nonresident sourcing rules. However, the New York Department of Taxation and Finance issued Audit Guidelines clarifying that this requirement does not apply when a resident is claiming a credit for taxes paid to another state on flow through income, such as from a partnership.^[6] In fact, for NY purposes, regardless what method the other state uses, "a resident would be allowed a resident credit for the actual taxes paid to the other state" and the auditor "should not recompute the partnership income taxable by the other state using New York's rules."^[7]
      
      Tax practitioners argue that California should be better aligned with states like New York, "which have adopted guidance that is both administratively feasible and fair to residents by looking to taxes actually paid to other states in computing the OSTC, rather than requiring "as if" home state apportionment or allocation computations for all the other states in which those residents pay tax."^[8]
   7. Related Legislation: SB 1449 (Nguyen) is similar to this bill. SB 1449 is pending hearing by the Senate Committee on Appropriations.

REGISTERED SUPPORT / OPPOSITION:

Support

California Taxpayers' Association

Opposition

None on file

Analysis Prepared by: M. David Ruff / REV. & TAX. / (916) 319-2098

1. Part-year residents in California pay tax on all income generated while they are residents, including from sources outside the state. Nonresidents pay tax based on all income from California sources. ↑

2. Under R&TC Section 18001, the OSTC is allowed only for net income taxes paid to another state "on income derived from sources within that state." In computing the actual amount of credit, Section 18001(c) specifies that "'income derived from sources within that state' shall be determined by applying the nonresident sourcing rules for determining income from sources within [California] …, as specified in Chapter 11 (commencing with Section 17951), and the regulations thereunder." The regulations issued under Section 17951 state that if a unitary business, trade, or profession (conducted through either a sole proprietorship or a partnership) is carried on within and without California, income from California sources is determined in accordance with the Uniform Division of Income for Tax Purposes Act (UDITPA) as adopted in Section 25120 through 25139 of the R&TC. ↑

3. See The 2015 Sacramento Tax Delegation Paper, Reforming California's Personal Income Tax Credit for Taxes Paid to Another State to Fairly Account for Differences in State Apportionment Rules and Reduce the Administrative Burden of Calculating the Credit, V. Dickerson, J. Grossman, Deloitte Tax LLP, 2015.
   ↑

4. Id., pp. 4-6, Example 1: California Resident Sole Proprietor
   

   A California resident, "Cal R. Esident" (call him "Cal" for short) is a small business owner providing online advertising services to customers in California and its neighboring "State A." Under State A's applicable tax laws, income from advertising services is assigned to State A when the customer's billing address is in State A. In contrast, California's market-based sourcing rules would assign the same income from advertising services to California based on the number of times the advertisement is viewed or clicked on by internet users located in California. Further, suppose that 80% of Cal's customers have a State A billing address; but Cal's ads are viewed equally between residents of California and Residents of State A (i.e., 50% of ad views are from internet users in California and 50% are from internet users in State A). Finally, suppose that California and State A have identical personal income tax rates of 10%, and that Cal has $100 of income in 2013 solely from providing internet advertising services.
   

   Based on the billing addresses of Cal's customers, State A determines 80% of Cal's income to be derived from sources in State A, and Cal pays $8 of tax to State A. As a California resident, Cal is taxed on 100% of his income and owes $10 of tax to California which may be reduced by the OSTC. Under CRTC Section 18001(c), Cal limits the OSTC to the tax that would have been paid to State A if it assigned income from online advertising services based on an in-state viewership (i.e., had it used the same rule as California). If State A employed this assignment methodology, 50% of Cal’s income would have been considered to be derived from within State A and Cal's redetermined tax due would have been $5. Consequently, Cal will be able to claim a $5 OSTC in California, and will pay $5 of tax to California. In the aggregate, Cal pays $5 of tax to California, $8 of tax to State A, and is taxable on 130% of his income.
   

   Example 2: California Resident Owning a Partnership Interest

   Now, suppose that Cal owns an interest in a unitary partnership that is doing business in California and "State B," and that Cal plans to sell his partnership interest. Further, suppose that State B sources receipts from the sale of intangible property using a costs-of-performance (COP) methodology which includes the costs incurred at the location where the negotiations take place, but does not include the costs incurred over time that caused the value of the intangibles to increase. In contrast, California's market-based sourcing rules assign receipts from the sale of a partnership interest based on the partnership's prior year apportionment formula sales factor. Additionally, assume that California and State B have identical personal income tax rates of 10% and that, under California's market-based sourcing rules, the partnership had a 90% sales factor in California and a 10% sales factor in State B in the current and prior year. Finally, suppose that Cal's only item of income in 2013 is a gain of $100 from selling his partnership interest and the only significant "costs of performance" were those incurred during negotiations that took place in entirely in State B.
   

   Under State B's COP rules, all $100 of gain from the partnership will be sourced to State B because that is where the sale negotiations (i.e., the only significant costs of selling the intangible property) took place. Consequently, Cal pays $10 of tax to State B. As a California resident, Cal is taxed on 100% of his income and owes $10 of tax to California which may be reduced by the OSTC. The same as before, Cal's OSTC is limited to the tax that would have been paid to State B if it assigned from the sale of a partnership based on California's rules, which in this case look to the partnership's sales factor in the prior year. If State B used this assignment methodology, 10% of Cal's income would have been considered to be derived from State B and Cal's re-determined tax would have been $1. Consequently, Cal will receive a $1 OSTC in California, and pays $9 of tax to California. Due to California's current OSTC calculation rules, Cal pays $9 of tax to California, $10 of tax to State B, and is taxable on 190% of his income. ↑

5. The term "income derived from sources within" another state is "construed as to accord with the definition of the term 'derived from or connected with New York State sources,' as set forth in Section 631 of the Tax Law in relation to the New York source income of a nonresident individual." 20 NYCRR 120.4(d). ↑

6. "[T]his regulation addresses only the type of income for which a resident would generally be allowed the credit and not necessarily how the income is calculated in the other state." NY Department of Taxation and Finance Nonresident Audit Guidelines, Section VII. Resident Credit (Revised June, 2012). ↑

7. Ibid. ↑

8. The 2015 Sacramento Delegation Paper., p. 10. ↑