California Reconsidering Optional Single Sales Factor

On May 26, 2010, the Legislative Analyst's Office released, Reconsidering the Optional Single Sales Factor. It describes the February 2009 legislative change included as part of the budget agreement to allow multistate businesses to decide between (1) the current apportionment factors (double weighted sales and single weighted property and payroll) and (2) sales only apportionment starting in 2011. Some legislators are not pleased with the 2009 change finding it gives too much leeway to businesses in choosing and is too costly.

The LAO report concludes that apportionment formulas with greater weight on sales "promotes job growth to some extent." It also points out that with other states also placing more weight on the sales factor, California is almost forced to have to do the same to be competitive. Finally, the LAO states that "allowing firms to choose their formula every year arbitrarily favors some firms over others." The LAO recommends that any apportionment change be delayed for two years due to the current $20 billion budget shortfall (page 12).

This short report is also interesting in these aspects:

1. Its definition of income tax nexus - on page 6 - ""Nexus" (Basically, physical presence) in the state." This is the nexus definition for sales tax, not income tax. Public Law 86-272 governs income tax nexus for sales of tangible personal property. Under this law, a physical location in a state will create nexus, but a physical presence of sales staff who have no corporate office in the state and only solicit sales for orders that are approved and filled from outside of the state, does not create nexus. Many states today apply an economic nexus standard when PL 86-272 does not apply (such as for sales of intangibles or services). Even California has adopted a factor presence standard where starting in 2011, a non-present company with over $500,000 of sales in California will be considered to be "doing business" for income tax purposes (R&T Section 23101).
2. There is no mention of Public Law 86-272 in the report. An entity only needs to apply a state's apportionment factors if it has nexus in the state (is doing business in the state). This seems important in understanding who is subject to the single sales factor option that starts in 2011 - which is also when the broader nexus standard of Sec. 23101 applies (see above) for entities that do more than sell tangible personal property. I think the LAO's conclusions and comparisons of how apportionment formulas operate given varying levels of property, payroll and sales in different states is still fine (and assumes that the entities have nexus in the states), it just seems that more should have been devoted to how the new apportionment formula operates along with the revised Sec. 23101 when it will be harder for some non-present entities to avoid income tax nexus in the state (such as because they have over $500,000 of sales into California).

The topic is also interesting from various policy perspectives. Generally, the reason why a business should pay income taxes in a state is because it is using state services. That is most likely when the business has property and payroll in the state. But, a sales only apportionment scheme, is really more of an economic development approach where in-state businesses are encouraged to put all of their property and payroll in the state and make lots of sales outside of the state to keep their California income tax low. The property and payroll in the state should result in greater tax collections compared to if these factors were located outside of California.

For more pros and cons on the single sales factor approach:

• Con - California Budget Project - To Have and Have Not (6/09) which points out that the biggest benefit of the single sales factor option will benefit a small number of very large companies.
• Pro - The Business Council of New York

A list of the apportionment formulas used in the states can be found at the website of the Federation of Tax Administrators.

What do you think the legislators should do -

• Delay the effective date of the elective single sales factor option?
• Repeal the single sales factor option?
• Require a particular approach rather than give businesses an option of which to use?
• Add an accountability measure of some sort to use single sales factor, such as having so many jobs in California per some revenue amount generated (such as 10 California jobs per $500,000 of sales anywhere)?
• Something else?