Existing law makes it a felony to recklessly or maliciously have in a persons possession any destructive device or explosive in specified places.

This bill would make a technical, nonsubstantive change to those provisions.

SENATE COMMITTEE ON GOVERNANCE AND FINANCE

Senator Mike McGuire, Chair

2019 - 2020 Regular

Corporation taxes: tax rates

Creates a new corporate tax rate schedule for firms with more than $10 million in apportioned net income that increases the rate in accordance with the taxpayer’s “compensation ratio.”

Background

California taxes at a rate of 8.84% the net apportioned business income and allocated net nonbusiness income of corporations doing business in California, or imposes the $800 minimum tax, whichever is greater, with some exceptions. Because federal law and the California Constitution limits the state and local agencies from imposing non-income taxes on banks, banks pay a higher rate to compensate, currently 10.84%. The tax rate is the same for firms those that are required to register with and report to the Securities and Exchange Commission (SEC) under the Securities Act of 1933, which generally regulates “publicly-traded” firms whose ownership shares are offered for public sale, and privately-held companies, which are not generally subject to the Act.

California applies the combined report method of corporate taxation, which requires a corporation computing its California tax liability to include the tax returns of its unitary subsidiaries and affiliates into one report, and divide the corporation’s overall income among the taxing jurisdictions in which it does business. While determining whether a subsidiary or affiliate is unitary for tax purposes is often subject to disputes, the combined report method generally allows for the cancellation of any intercompany transactions, such as dividends paid from a subsidiary to its corporate parent. However, taxpaying corporations can elect to exclude the income and expenses of its foreign subsidiaries from its combined report, called the “water’s edge” election, with some exceptions.

Recent studies show income inequality and corporate executive compensation increasing, while wages for most nonexecutive employees struggling to keep pace with inflation. The author wants to revise California’s corporate income tax rates to increase commensurate with the ratio between the compensation levels of its highest-paid executives and its median worker.

Proposed Law

Senate Bill 37 creates a new corporate tax rate schedule for firms with more than $10 million in apportioned net income, effective in the 2020 taxable year. SB 37’s schedule imposes a rate that increases commensurate with a corporation taxpayer’s compensation ratio as follows:

For banks, the rates in the above schedule are increased by 2%. Additionally, the bill provides that the rates above are increased an additional 50% if the taxpayer reduces its total number of full-time employees in the United States in the taxable year by more than 10% compared to the preceding taxable year, while during the same taxable year also increasing its total number of contracted or foreign full-time employees. The bill directs that for purposes of the additional 50% rate increase, that full-time employment be determined on a full-time equivalent basis. The measure sets forth a methodology to calculate full-time equivalents.

The compensation ratio is derived by dividing the numerator by the denominator. The numerator is equal to the greater of the compensation of the chief executive officer, chief operating officer, or the highest paid employee of the taxpayer averaged over the three calendar years preceding the taxable year. The denominator is equal to the median compensation of all employees employed by the taxpayer including all contracted employees under contract with the taxpayer in the United States for the calendar year preceding the taxable year.

The bill defines compensation for purposes of the numerator and the denominator differently. Taxpayers must calculate employee compensation according to the Internal Revenue Code’s provisions for Social Security Taxes, which includes almost any kind of compensation paid by the taxpayer to the employee, such as wages, benefit contributions, the value of stock options and deferred compensation. For executives, compensation is based on the Summary Compensation Table the firm reports to the Securities and Exchange Commission, and includes salary, bonus, grants of stock options and stock appreciation rights, long-term incentive plan awards, pension plans, and employment contracts and related arrangements.

Instead of calculating a compensation ratio for each taxpayer within the combined report, the bill requires the taxpayer calculate one ratio for all taxpayers authorized to be included in the combined report. The measure requires taxpayers to provide a detailed compensation report to the Franchise Tax Board (FTB).

SB 37 allows FTB to prescribe rules, guidelines, and procedures to implement the bill that are exempt from the Administrative Procedures Act. The measure defines several terms, and prescribes a methodology for measuring full-time equivalents.

The bill also states that after reserving amounts for the Proposition 2 reserve, and Proposition 98’s education funding guarantee, any remaining revenues generated by the bill should flow to the General Fund to offset the fiscal impact of any child tax credit, as well as for the Legislature to appropriate to support early childhood programs and other educational program. The bill also states that its rate increase is inoperative for any taxable year in which the federal corporate income tax rate is 35% or more.

State Revenue Impact

According to FTB, SB 37 results in revenue increases of $1 billion in 2019-20, $3.5 billion in 2020-21, and $4.1 billion in 2021-22. However, these estimates assumed the measure would be enacted in 2019.

Comments

1. Purpose of the bill. According to the author, “Income inequality today is extreme; among states California now has the 4th biggest gap between rich and poor. The gap between rich and poor keeps widening during a time when corporate profits are at an all-time time high. In 1980 the average CEO made less than $2 million a year while the average worker made about $50,000. In 2018 the average CEO pockets $17 million or more and the average worker remains at about 1980s levels, making about $56,000 a year—a salary that’s 300 times less than the Executive Suite. Today, when compared to 1970s levels, Executive Suite pay has skyrocketed by 940%. SB 37 is an innovative approach to address income inequality with a tax structure that incentivizes corporations to shrink the gap between CEO pay and average worker pay. SB 37 redesigns the corporate tax rate structure to reward corporations that either have a low gap between CEO pay and average employee pay or are willing to lower that gap. SB 37 only applies to corporations with a net income of $10 million or above, about 0.2% of corporations that do business in the state. It adds a progressive increase to these large corporations’ tax rate based on the disparity between the company’s executive pay and its average worker pay.”

2. Sure, but will it work?. In an effort to address income inequality, the City of Portland in 2016 imposed a surcharge of 10 percent on top of its gross receipts business license tax on publicly traded companies that pay their Chief Executive Officers (CEOs) 100 to 250 times more than their median worker, based on the firms’ SEC disclosures. Companies with a CEO pay ratio above 250 times must pay a 25 percent surcharge. A recent article in the Oregonian indicated that no evidence exists to indicate that the surcharge has affected CEO compensation among firms doing business in Portland, citing a recent pay package awarded to the CEO of the Intel Corporation.^[1] While SB 37 would apply to any firm doing business in California, and could significantly increase tax rates on companies with high pay ratios, the Committee may wish to consider whether the measure will be effective in limiting CEO pay, or otherwise ameliorating income inequality.

3. Compliance and enforcement burden. SB 37’s direction to taxpayers to calculate its ratio will add to the general compliance burden, as well as test FTB’s finite resources to ensure that the corporation is paying the correct amount of tax. Each year, corporations file almost one million tax returns with FTB. For small corporations, a return can be reasonably simple, but larger corporations have returns that can include thousands of subsidiaries and affiliates around the world, involve complex unitary group determinations and apportionment computations, and apply millions of dollars in tax credits based on a variety of circumstances. While the bill only applies to firms with more than $10 million in net income, the compliance burden to correctly calculate the ratio will be significant. The bill directs taxpayers to compute the ratio’s denominator by determining the wages paid to the firm’s median worker – a single person - when a firm can have hundreds if not thousands of subsidiaries and affiliates, and potentially hundreds if not thousands of employees or contract workers. Employees enter into and out of employment and contract work several times in a year, at various levels and models of compensation. Additionally, companies create, merge, and dissolve subsidiaries and affiliates all the time. FTB must verify that taxpayers correctly calculate SB 37’s ratio as part of its duty to ensure that each corporation has paid the correct amount of tax for that tax year, which will require significant investments of personnel and information technology, and perhaps an audit. Firms will also file claims for refund for past taxes paid if it thinks its calculations regarding the compensation amounts that derived the rate were not accurate at the time it filed the return, which FTB will again be compelled to verify. The Committee may wish to consider whether FTB can administer SB 37 with current resources, as well as the compliance burden it poses taxpayers.

4. Who is affected? While individuals pay tax based on income from whatever source derived unless exempt or excluded, corporations generally pay taxes based only on their net income, or their gross receipts less deductions. As a result, SB 37’s potential rate increase will likely result in higher tax payments for corporations with high compensation ratios, but only when they generate positive net income in a taxable year; a corporation with no taxable net income is unlikely to be affected by a rate increase. According to FTB, 936,211 corporations filed returns in California for the 2017 taxable year, of which 557,853, or about 60%, reported net income. Additionally, SB 37 only affects taxpayers with more than $10 million in apportioned net income in a taxable year. According to FTB, only 2,020 corporations reported income of more than $10 million in 2017, comprising 0.2% of all corporations filing returns that year. While constituting a small share of total corporations, these taxpayers paid almost $6 billion, or 2/3, of total corporation tax revenues.

5. AB 91. In the early 1990s, Congress limited a corporation’s ability to deduct executive compensation that exceeded $1 million, unless the compensation is pegged to performance, in which case it is fully deductible. The disconnection of the limit on performance-based compensation resulted in more than $30 billion in revenue losses to the federal government between 2007 and 2010, according to the Economic Policy Institute. In 2017, Congress enacted HR 1, which comprehensively changed federal personal income and corporation taxes, including a provision that eliminated the exception for performance-based compensation subject to the deduction limit. Last year, the Legislature enacted the Loophole Closure and Small Business and Working Families Tax Relief Act of 2019, which conformed state law to HR 1’s limitation on the deductibility of executive compensation (AB 91, Burke).

6. SEC requirement. In 2015, the SEC adopted a final rule that requires a public company to disclose the ratio of the compensation of its chief executive officer to the median compensation of its employees. The rule required firms to report these ratios for the first fiscal year beginning on or after January 1, 2017, so researchers have been able to make some observations regarding these ratios. In October, 2018, the Harvard Business School published “the CEO Pay Ratio: Data and Perspectives from the 2018 Proxy Season,” which found, among other conclusions:

• The pay ratio averaged 144:1 with a median of 69. There were quite a few cases where the ratio was at or near zero, which were outliers in cases where the CEOs either declined to receive pay or were paid a nominal sum.
• Companies in the consumer discretionary and consumer staples sectors were at the higher end at 384 and 295 on average, respectively. Energy, financials, and utilities, had average ratios ranging from 59 to 80.
• For those companies under $300 million in annual revenue, the average pay ratio was 32, as compared to those companies at $3 billion and higher, where ratios average close to 290.
• Companies with fewer than 500 employees had an average pay ratio of 36, compared to those with employee populations over 10,000 with average pay ratios of 337.
• One of the strongest correlations and predictors of pay ratio was the percent of company employees located overseas. The lowest pay ratio band had roughly 9% of its employees located outside of the US, while those companies with a pay ratio of over 150 had more than a third of their workforce overseas.
• The lowest average three-year total shareholder return (TSR) was associated with the lowest pay ratio band. While the highest average three-year TSR correlated with the band of ratios between 35 and 74, it then dropped off as the ratio increased.

7. Deductibility. Among other changes, HR 1 limited the deduction from income for state and local taxes paid by individuals to $10,000 per taxable year, not indexed for inflation. HR 1 did not affect the deduction for state and local taxes paid when carrying out a trade or business. The Joint Committee on Taxation estimated that the change would result in an additional $70 - $100 billion in federal revenues annually, mostly from higher-tax states such as California: in 2015, more than five million Californians deducted more than $80 billion in state and local taxes from their federal returns, according to the IRS. As a result, California taxpayers cannot offset any increase in personal income or property taxes by deducting these taxes from income for federal tax purposes, as had been the case before HR 1. However, businesses could continue to deduct any additional business taxes for federal purposes, such as SB 37’s corporate tax rate increase.

8. Fair share? HR 1 enacted several changes that significantly reduced federal taxes on corporations, including lowering the statutory rate from 35% to 21%, allowing immediate expensing when purchasing or leasing new equipment, and adopting a “territorial” system that mostly excludes from tax the income of a U.S. company’s foreign subsidiaries. As a result of these changes, the Institute on Taxation and Economic Policy recently found in a sample of 397 companies for the 2018 taxable year that the effective federal income tax rate is only 11.3%, or less than half of the new statutory rate, with many prominent firms paying no federal taxes at all. In California, the Legislative Analyst’s Office (LAO) has found that the corporation tax’s share of total general fund revenues has declined from 16% in the 1950s and 60s to 9% in the early 2010s.^[2] LAO states that changes in state law made since the mid-to-late 1980s and increased usage of tax credits reduced annual revenues by approximately $3 billion annually. The Committee may wish to consider SB 37 in the context of determining whether corporate taxpayers are paying a sufficient share of the costs of public services.

9. Related legislation. In 2014, the Committee approved SB 1372 (DeSaulnier), which was similar to this bill. The measure subsequently failed passage on the Senate Floor.

10. Scope. SB 1372 and Portland’s pay ratio tax applied solely to publicly-traded firms, but SB 37 applies to both publicly-traded and privately held firms. As a result, privately held firms would have to disclose new information to FTB to ensure the correct calculation of the applicable rate under SB 37. Because the ratio would be used to calculate the rate on its tax return, any ratio used for tax purposes under SB 37 would be confidential, and not subject to public disclosure.

11. Technicals. FTB and Committee staff recommend the following technical amendments:

• Restore stricken language on Page 4, lines 5 and 6.
• Clarify that the measure applies only to C corporations, and not all entities considered corporations for tax purposes, such as limited liability companies electing to be taxed as corporations.
• Change the measure’s definition of wages to mean compensation as defined under the Internal Revenue Code.
• Add “or incurred” after “paid” on Page 5, line 13.
• Add references to R&TC sections 25102, 25104, and 25110 on Page 5, line 33, to include other applicable combined reports.
• Add a definition for “detailed compensation report.”
• Clarify that the potential rate increase of 50% is an increase of 50% of the applicable rate (14.84% to 22.26%), not an explicit addition of 50% to the bill’s revised rate (14.84% to 64.84%).
• Clarify that the trigger for the potential rate increase measures foreign full-time employment or contract employees separately, not in combination.
• Strike “within the meaning of Section 515 of the Labor Code,” on Page 7, line 3, as FTB does not have access to sufficient information to make a legal determination regarding whether an employee meets the standards of that definition.

Support and Opposition

(1/10/20)

Support: American Federation Of State, County And Municipal Employees Local 3299; Berkeley Federation of Teachers, Local 1078, AFL-CIO; CA Conference Board of the Amalgamated Transit Union; California Conference of Machinists; California Labor Federation; California School Boards Association; California State PTA; California Teachers Association; California Voices For Progress; Canyon Democrats; Colusa County Democratic Central Committee; Contra Costa AFL-CIO Labor Council; Courage Campaign; Democrats of the Desert; Engineers and Scientists of CA, IFPTE Local 20, AFL-CIO; Inlandboatmen's Union of the Pacific; La Jolla Democrat Club; Professional and Technical Engineers, IFPTE, Local 21, AFL-CIO; San Francisco Labor Council; San Mateo County Central Labor Council; South Beach District 6 Democratic Club of San Francisco; Stanislaus and Tuolumne County's Central Labor Council; Stonewall Young Democrats; UDW/AFSCME, Local 3930; United Teachers of Pasadena; UNITED-HERE, AFL-CIO; Utility Workers of America; Wellstone Democratic Renewal Club.

Opposition: Advanced Medical Technology Association (ADVAMED); Bay Area Council; Biocom; Building Owners and Managers Association of California; California Bankers Association; California Business Properties Association; California Business Roundtable; California Chamber of Commerce; California Forestry Association; California Independent Petroleum Association (CIPA); California Life Sciences Association; California Manufacturers & Technology Association; California Railroads; California Restaurant Association; California Retailers Association; California Taxpayers Association (CALTAX); California Trucking Association; Chamber of Commerce Alliance of Ventura and Santa Barbara Counties; Chino Valley Chamber of Commerce; Contra Costa Taxpayers Association; Council on State Taxation; Family Business Association of California; Fontana Chamber of Commerce; Greater Coachella Valley Chamber of Commerce; Greater Ontario Business Council; Hesperia Chamber of Commerce; Inland Empire Economic Partnership (IEEP); International Council of Shopping Centers; Kern County Taxpayers Association; Moreno Valley Chamber of Commerce; Murrieta Wildomar Chamber of Commerce; Naiop of California, the Commercial Real Estate Development Association; National Federation of Independent Business (NFIB); Orange County Business Council; Orange County Taxpayers Association; Rancho Cucamonga Chamber of Commerce; Redlands Chamber of Commerce; San Gabriel Valley Economic Partnership; Santa Maria Valley Chamber of Commerce; Securities Industry and Financial Markets Association; Silicon Valley Leadership Group; Solano County Taxpayers Association; Spidell Publishing, Inc.; Technet; Upland Chamber of Commerce; Valley Industry and Commerce Association; Victor Valley Chamber of Commerce; West Coast Lumber & Building Material Association; Western States Petroleum Association.

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1. “Portland expects up to $3.5 million from unique CEO tax,” The Oregonian, February 2, 2019. ↑

2. Letter to Honorable Mark Leno, March 12, 2014. ↑