Existing state sales and use tax laws impose a tax on retailers measured by the gross receipts from the sale of tangible personal property sold at retail in this state, or on the storage, use, or other consumption in this state of tangible personal property purchased from a retailer for storage, use, or other consumption in this state. The Sales and Use Tax Law provides various exemptions from those taxes.

This bill would exempt from those taxes, on and after January 1, 2019, before January 1, 2024, the gross receipts from the sale of, and the storage, use, or other consumption of, tangible personal property purchased for use by a qualified person primarily in the research and development and design of digital interactive media, and tangible personal property purchased for use by a qualified person primarily to maintain, repair, measure, or test that property.

The Bradley-Burns Uniform Local Sales and Use Tax Law authorizes counties and cities to impose local sales and use taxes in conformity with the Sales and Use Tax Law, and existing law authorizes districts, as specified, to impose transactions and use taxes in conformity with the Transactions and Use Tax Law, which conforms to the Sales and Use Tax Law. Exemptions from state sales and use taxes are incorporated into these laws.

This bill would specify that this exemption does not apply to local sales and use taxes and transactions and use taxes.

Existing property tax law requires every assessor to assess all property subject to general property taxation at its full value.

This bill would make a nonsubstantive change to that provision.

Date of Hearing: May 23, 2018

ASSEMBLY COMMITTEE ON APPROPRIATIONS

Lorena Gonzalez Fletcher, Chair

ABPCA Bill Id:AB 2574

Author:(Bloom) – As Amended Ver:May 16, 2018

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

SUMMARY:

This bill establishes, until January 1, 2024, a partial sales-and-use tax (SUT) exemption for tangible personal property purchased for the development and design of digital interactive media property.

FISCAL EFFECT:

Annual General Fund revenue loss of $2.5 million in 2018-19 and $5.2 million in 2019-20.

COMMENTS:

1. Purpose. The video game industry is bigger in California than it is any other state. The author points to data showing that while California is home to more than 900 video game companies, California’s share of the industry is also shrinking. According to the author, competition from abroad and from other states offering tax incentives means that California will need to explore policies. AB 2574 will create a new tax expenditure program for purchases of goods used for the development and design of digital interactive media.
2. Digital interactive media. AB 2574 defines “digital interactive media” as interactive software that is produced for distribution on or accessed via electronic media, includes an appreciable quantify to text, sound, music, fixed images, animated images, or 3-D geometry, and with which users interact through an electronic device.
3. Affected industries. AB 2547 provides a SUT exemption for qualified purchases by a person in any of specified sectors within the software industry. These sectors include establishments primarily engaged in: a) computer software publishing or publishing and reproduction; b) providing specialized motion picture or video postproduction services, such as editing, film/tape transfers, subtitling, credits, closed captioning, and animation and special effects; and, c) providing expertise in the field of information technologies through specified activities.

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

Date of Hearing: May 14, 2018

ASSEMBLY COMMITTEE ON REVENUE AND TAXATION

Autumn R. Burke, Chairwoman

ABPCA Bill Id:AB 2574 (

Author:Bloom) – As Amended Ver:April 30, 2018

vote. Tax levy. Fiscal committee.

SUBJECT: Sales and use taxes: exemption: research and development: design: digital interactive media

SUMMARY: Establishes a partial sales and use tax (SUT) exemption for specified "digital interactive media" property. Specifically, this bill:

1. Provides, on and after January 1, 2019, a SUT exemption for any of the following:
   1. "Tangible personal property" (TPP) purchased for use by a "qualified person" to be used "primarily" in the "research and development", and "design" of "digital interactive media"; or,
   2. "TPP" purchased for use by a "qualified person" to be used "primarily" to maintain, repair, measure, or test any property described above.
2. Provides that this exemption shall not apply to any "TPP" that is used "primarily" in administration, general management, or marketing.
3. Defines "digital interactive media" as interactive software that meets all of the following requirements:
   1. Is produced for distribution on or accessed via electronic media, including, but not limited to, software that may be accessed via or downloaded from the Internet or mobile networks and software that is distributed on optical media or embedded in or downloadable to electronic devices, including, but not limited to, mobile phones, game systems, personal digital assistants, or other handheld electronic devices or similar technology in existence now or hereafter developed;
   2. Users may interact with the software via an electronic device, which may include, but is not limited to, a computer, a game system, a mobile phone, a personal digital assistant, or other handheld electronic devices, in order to achieve a goal or set of goals and objectives; and,
   3. Include an appreciable quantity of text, sound, music, fixed images, animated images, or 3-D geometry.
4. Provides that "digital interactive media" does not include media that contains obscene matter. For purposes of this bill, "obscene matter" means any media that depicts sexually explicit conduct as enumerated in Section 2256 of Title 18 of the United States Code and as defined in Penal Code Section 311.
5. Provides that "TPP" includes, but is not limited to, all of the following:
   1. Machinery and equipment, including component parts; and,
   2. All equipment or devices used or required to research and develop and design, operate, control, regulate, or maintain the machinery for digital interactive media, including, but not limited to, computers, data processing equipment, computer servers, workstations, server racks, hard drives, optical drives, monitors, keyboards, integrated video and audio equipment, networking routers, switches, network cabling, and computer software, and other similar technology now or hereafter developed, together with all repair and replacement parts with a useful life of one or more years, whether purchased separately or in conjunction with a complete machine and regardless of whether the machine or component parts are assembled by the taxpayers or another party.
6. Provides that "TPP" does not include furniture, inventory, or equipment used to store products.
7. Defines a "qualified person" as any person that is "primarily" engaged in "research and development" and "design" of digital interactive media that are described in Codes 511210, 512191, and 54151 of the North American Industry Classification System Manual published by the United States Office of Management and Budget, 2017 edition.
8. Defines "primarily" as TPP used 50% or more of the time in the specified activity.
9. Provides that "research and development" shall have the same meaning as "basic research" under Revenue and Taxation Code (R&TC) Section 23609.
10. Defines "design" as the process of designing the content and rules of digital interactive media in the preproduction stage and designing the game play environment, storytime, and characters in the production stage.
11. Provides that no exemption shall be allowed unless the purchaser furnishes the retailer with an exemption certificate, as specified.
12. Provides that notwithstanding any provision of the Bradley-Burns Uniform Local SUT Law or the Transactions and Use Tax Law, the exemption shall not apply with respect to any tax levied by a county, city, or district pursuant to either of these laws.
13. Specifies that the exemption shall not apply to any sale or use of property that, within one year from purchase, is either removed from California or converted to a non-qualifying use.
14. Takes immediate effect as a tax levy.

EXISTING LAW:

1. Imposes a sales tax on retailers for the privilege of selling TPP, absent a specific exemption. The tax is based upon the retailer's gross receipts from TPP sales in this state.
2. Imposes a complimentary use tax on the storage, use, or other consumption of TPP purchased out-of-state and brought into California. The use tax is imposed on the purchaser; and unless the purchaser pays the use tax to an out-of-state retailer registered to collect California's use tax, the purchaser remains liable for the tax. The use tax is set at the same rate as the state's sales tax and must generally be remitted to the California Department of Tax and Fee Administration (CDTFA).
   
3. Provides a partial SUT exemption, on or after July 1, 2014, and before July 1, 2030, for specified TPP used in research and development, manufacturing, and other specified activities. Specifically, the exemption applies to qualified TPP purchased for use by a:
   
   1. Qualified person to be used primarily in any stage of the manufacturing, processing, refining, fabricating, or recycling of TPP, as specified;
      
   2. Qualified person to be used primarily in research and development;
      
   3. Qualified person to be used primarily to maintain, repair, measure, or test any qualified TPP described above;
      
   4. Contractor purchasing that property for use in the performance of a construction contract for the qualified person, as specified; and,
      
   5. Qualified person to be used primarily in the generation or production, or storage and distribution, of electric power.

FISCAL EFFECT: Unknown

COMMENTS:

1. The author has provided the following statement in support of this bill:

California is synonymous with the video game industry just as we are with the film and television industry. As with film and television production, other states are poaching our video game innovators and developers, most of whom are small businesses and startups. We need to stay competitive and act fast so that we can keep this multi-billion dollar industry right here in our backyard.

Global consumer revenue in the video game industry was approximately $116 billion in 2017. In California, the software industry contributed approximately $32 billion to the state's gross domestic product and $13.2 billion in California wages. California is also home to more than 900 video game companies with a workforce of 33,000. These numbers are more than the next four states combined. In fact, Texas, the second leading state has approximately 275 companies and 4,300 employees.

However, California's share of the industry shrunk from 38% to 21% from 2009 to 2012. While that number increased to 27% between 2012 and 2015, California's market share gap compared to the next four states combined decreased from 4% to 2% in that same time. Also, 50 states now have a share of the market.

While California still remains the hub for the video game industry, it does not provide tax incentives, grants or rebates that are available in 21 other states and two Canadian provinces. To remain a leader in the video game industry and the economic boon it provides California will need to explore policies that foster a more competitive business climate.

1. Committee Staff Comments:
   1. What is a "tax expenditure"? Existing law provides various credits, deductions, exclusions, and exemptions for particular taxpayer groups. In the late 1960s, U.S. 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).
      
   2. 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. 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 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 or cost, without a supermajority vote.
   3. An overview of the SUT Law: California's SUT Law imposes a sales tax on retailers for the privilege of selling TPP, absent a specific exemption. The tax is based upon a retailer's gross receipts from TPP sales in California. The SUT Law also imposes a mirror "use tax" on the storage, use, or other consumption of TPP purchased out-of-state and brought into California. The use tax is imposed on the purchaser, and unless the purchaser pays the use tax to an out-of-state retailer registered to collect California's use tax, the purchaser remains liable for the tax. The use tax is set at the same rate as the state's sales tax and must generally be remitted to the CDTFA.

The SUT represents the state's second largest source of General Fund (GF) revenues. Nevertheless, the past 60 years have seen a dramatic reduction in the state's reliance on the SUT and a corresponding increase in its reliance on personal income tax revenues. In fiscal year (FY) 2016-17, SUT revenues were estimated to comprise roughly 20% of the state's GF revenues, down from nearly 60% in FY 1950-51.

• 1. What accounts for the state's reduced reliance on SUT revenues? The SUT Law was enacted in a very different era. In the 1930s, California's economy was largely dominated by manufacturing, and residents mostly bought and sold tangible goods. Thus, in establishing the base for a new consumption tax, it made sense to impose the tax on sales of TPP, defined as personal property that may be "seen, weighed, measured, felt, or touched." Over the past 80 years, however, California's economy has seen dramatic growth in the service and information sectors, resulting in a significant erosion of the SUT base. For example, the Commission on the 21^st Century Economy noted that spending on taxable goods represented 34.6% of personal income in 2008, down from 55.4% in 1980. As a result, tax experts and economists from across the political spectrum argue that California should expand its SUT base.

It could be argued that, while well-intentioned, additional SUT exemptions further erode an already shrinking SUT base. This, in turn, increases fiscal pressures to maintain or even increase California's relatively high SUT rate. High rates arguably promote non-compliance and encourage out-of-state purchases, placing California retailers at a competitive disadvantage. High rates also risk impacting consumer decision-making, which runs counter to widely accepted principles of sound tax policy.

• 1. What would this bill do? This bill would establish a new tax expenditure program in the form of a SUT exemption for specified "digital interactive media" property. Specifically, the exemption would apply to TPP purchased by a "qualified person" for use primarily in the research and development (or design) of digital interactive media. This bill defines a "qualified person", in part, by reference to specified codes published by the North American Industry Classification System Manual: Codes 511210, 512191, and 54151. These codes, in turn, correspond to specific sectors of the software industry, as follows:
     1. Code 511210: This industry comprises establishments primarily engaged in computer software publishing or publishing and reproduction;
     2. Code 512191: This U.S. industry comprises establishments primarily engaged in providing specialized motion picture or video postproduction services, such as editing, film/tape transfers, subtitling, credits, closed captioning, and animation and special effects; and,
     3. Code 54151: This industry comprises establishments primarily engaged in providing expertise in the field of information technologies through one or more of the following activities: (1) writing, modifying, testing, and supporting software to meet the needs of a particular customer; (2) planning and designing computer systems that integrate computer hardware, software, and communication technologies; (3) on-site management and operation of clients' computer systems and/or data processing facilities; and, (4) other professional and technical computer related advice and services.
  2. Why the video game industry? The author argues that the video gaming sector comprises a critical industry in California. Despite this industry's historical ties to the state, the author contends that California's preeminence is being challenged by other states like Texas that are experiencing strong growth in the field. As such, the author argues that it is essential to provide industry support, in the form of tax relief, to ensure that video gaming businesses continue to open and grow in California. In support of his arguments, the author points to a 2018 study published by the Milken Institute and entitled, "Future-Proofing the Video Game Industry in California". Among other things, this report notes:
     1. With global consumer revenues of roughly $116 billion in 2017, the video game industry continues to grow at a robust pace;
     2. California currently leads the industry domestically, with more than three times the number of companies and seven times the number of employees compared to the second leading state, Texas; and,
     3. California nevertheless faces increased domestic and foreign competition, and should consider ways to improve its business climate to attract and retain jobs in this sector.
  3. Are SUT exemptions for business inputs generally considered good tax policy? Businesses currently pay a significant portion of the state's SUT. A business pays SUT when it is considered to be the final consumer of TPP. Any SUT paid by a business will necessarily be factored into the prices it charges for goods, which, in turn, may be subject to taxation. This can result in a consumer paying a tax on a tax (i.e., "pyramiding"), which makes the overall tax system less transparent. Requiring a business in California to pay SUT on its business equipment also increases the cost of production and potentially places California at a competitive disadvantage vis-à-vis other states.
  4. What might critics argue? Critics might argue that the "pyramiding" argument is not particularly persuasive in connection with the video game industry because most consumer purchases of video game software escape sales tax. For example, if a consumer purchases a video game by downloading it directly from the Internet, the purchase is not considered a sale of TPP and, thus, no sales tax is charged. From a policy standpoint, it might make sense to exempt software industry inputs but tax the industry's end products to ensure they are treated the same as other consumer purchases and to minimize attendant revenue losses. Critics might also question the wisdom of enacting industry-specific tax benefits, which tend to pit state against state and encourage a proverbial "race to the bottom". For this reason, the Legislative Analyst's Office has generally argued that such industry-specific inducements represent poor tax policy.
  5. The technical stuff: Committee staff has identified numerous areas where this bill could potentially benefit from further refinement. For example:
     1. This bill's definition of "digital interactive media" is remarkably broad and could potentially be read to include not just video games, but most other forms of software. In addition, the definition includes references to future technologies that have not yet been developed. Thus, the scope of this exemption, and its future application, is rather open-ended. If this is contrary to the author's intent, clarifying amendments should be adopted;
     2. This bill's exemption would apply on or after January 1, 2019. If this bill were to be enacted in late 2018, however, the CDTFA may not have sufficient lead time to inform impacted taxpayers and develop appropriate forms and publications. For this reason, it may be preferable to provide a delayed operative date for the exemption;
     3. This bill provides for a partial, rather than a complete, SUT exemption. While this may reduce the fiscal impact to local governments, it may also increase administrative complexities for both retailers and the CDTFA as similar partial exemptions have resulted in significant errors in proper SUT reporting; and,
     4. This bill includes references to the State Board of Equalization, which is no longer charged with administering the SUT Law. References to the "board" should be replaced with appropriate references to the CDTFA.
  6. A note on sunsets: This bill currently provides for an indefinite SUT exemption. This Committee, however, has a longstanding policy favoring the inclusion of appropriate sunset dates to allow for proper legislative review of new tax expenditure programs. As such, the Committee may wish to consider adding a five-year sunset date to this bill.

REGISTERED SUPPORT / OPPOSITION:

Support

Entertainment Software Association

Opposition

None on file

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