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Friday, July 17, 2009

Proposal for a Business Net Receipts Tax for California Businesses - A Good Move?

The California Commission on the 21st Century Economy created by Governor Schwarzenegger and the state legislature is wrapping up its work. It is looking at some bold proposals that would make significant changes in the state's tax structure. One intriguing proposal is to create a subtraction method VAT called a "net receipts tax" for California businesses that would replace some existing taxes.

Here are a few observations I've got on this particular proposal. I hope you'll leave comments on what you think of the proposal and my observations.

The California Commission on the 21st Century Economy is looking at a variety of tax changes for CA. Tax Package 1 includes modifications to the personal income tax, elimination of the corporate income tax and state general fund sales tax, and addition of a business net receipts tax (BNRT).

Is the BNRT a sales tax?

No, although it has some similarities and differences.

It is similar because it is a subtraction method VAT. Theoretically, a VAT will raise the same amount as a sales tax but will be collected in a different manner. [Click here for background information on consumption taxes and VATs.]

Because the BNRT applies to firms selling services, intangibles and tangible personal property, it has a broader reach than the CA sales tax which today only applies to a subset of tangible personal property (for example, food is exempt).

Application of nexus, and unitary and apportionment rules will cause the BNRT to have some different effects than the existing California sales tax.

Nexus: The Commission's BNRT proposal calls for a factor presence nexus standard (per R&T §23101(b), this will be the standard in CA after 2010 if Public Law 86-272 does not apply to the business). In contrast, the nexus standard for sales tax is a physical presence. (For income tax nexus for businesses that sell tangible personal property, the standard is that of Public Law 86-272.)

Example: AB Corporation has sales of $7,000,000 to CA customers, but has no physical presence in California. AB would be liable for the CA BNRT, but today it is not liable to collect CA sales tax on sales to CA customers (the customers are required though to self-report use tax on these purchases).

Example: CD Corporation has $30,000 of property in CA which represents less than 25% of its total property. CD has no employees in CA and its sales in CA are less than $500,000 and 25% of its total sales. CD is liable to collect sales tax in CA (or it could voluntarily chose to collect sales tax) but would not be required to pay BNRT. [Note: The AB example would be far more common than the CD example.]

Unitary and apportionment: If a unitary business only has sales and operations in California, the BNRT base will be similar to the sales tax base. However, many businesses have operations and sales in more than one state. For a business with sales within and without CA, they would be subject to apportionment to determine their CA BNRT base. The Commission's BNRT proposal would apportion using only a sales factor. The numerator of the sales factor would be gross receipts in CA (presumably sales where the destination was CA) and the denominator would be gross receipts everywhere.

If the BNRT were instead a gross receipts tax (GRT), unitary reporting and apportionment should not be needed because it would be fairly easy to determine the sales with a destination in CA and the broadened nexus standard would make most businesses with CA customers subject to tax in CA. However, because there are deductions from gross receipts for the BNRT, there is a need to determine what expenses are attributable to CA versus other states. Generally, a separate accounting method will not work because of the challenges of allocating many types of expenses among operations in multiple states. Thus, the question becomes, what is the best approach for determining how much of the combined group's BNRT base represents sales in CA. The Commission proposes to use just a sales factor (percent of sales everywhere that are CA sales). That seems like a logical approach because if payroll and/or property were factored in, it would likely be distortive because the location of sales is not solely dependent on where a firm's property and payroll are located.

However, it really only seems logical if one is trying to equate the BNRT to a sales tax. The BNRT, designed as a subtraction method VAT, is supposed to be taxing value added by a firm. The value a firm adds to the inputs it buys from other firms, is primarily labor. So, why isn't payroll factored into the formula to determine how much value a firm added in CA? The reason is that the BNRT creators are trying to tie the BNRT to be a sales and use tax substitute.

Example: X Corporation has operations in CA and 3 other states. X computes its total net receipts tax base and multiplies it by a fraction where the numerator is its sales to CA and the denominator is sales everywhere. The result is X's CA BNRT base. The BNRT should be the same whether X has most of its labor in CA or a different state.

The BNRT will apply to almost all types of businesses (some financial services firms and insurance companies are excluded) while today's CA sales tax only applies to a subset of tangible personal property.

A sales tax is a very visible tax because it is added to a customer's bill at the time of sale. A BNRT would not be included on a customer's bill, although some portion of it would likely be included in the price charged. If a credit method VAT were used instead, it would be noted on invoices.

Is the BNRT an income tax?

No. The BNRT is a consumption tax. While the formula for a subtraction method VAT looks like an income tax (except there is no deduction for labor costs, depreciation or interest expense, and fixed assets are expensed), it is not an income tax because it is not based on net income and it exempts savings from tax.

Because it is not an income tax, businesses selling tangible personal property do not get the nexus protections (clarifications) of PL 86-272. The nexus standard for the BNRT must meet constitutional requirements (of the due process and commerce clauses), which might be an economic presence (making a market in the state). Thus, more businesses will be subject to the CA BNRT than are subject to the California corporate or personal income tax.

However, if the current congressional proposal to modernize PL 86-272 were ever to be enacted, businesses would only be subject to a business activity tax (such as perhaps, the BNRT) if they were present in the state for at least 15 days during the year (that is a very brief summary of H.R. 1083). Under that version of PL 86-272, far fewer businesses would have BNRT obligations in California and the desired revenue goals would not be achieved.

Some questions and observations about the proposed BNRT and its formula:

Instead of expensing assets when acquired, an accelerated depreciation system is used in the Commission proposal. This is contrary to a consumption tax. If this adjustment is made due to the desire to raise a certain amount of revenue, it would be better to raise the tax rate rather than make the BNRT a combination of an income and consumption tax.

The Commission calls for the Finnigan rule to be used to source sales of the combined/unitary group. This likely has little impact given that the nexus standard is broadened for the BNRT making it more likely that any firm with sales in CA will have nexus in the state and its sales would go into the CA sales factor numerator anyway. However, the Finnigan throwback approach should reduce the throwback sales that are included in the CA sales factor numerator making that a more attractive approach than the Joyce rule.

Will any credits be usable against the BNRT?

What happens to NOL and credit carryovers that corporations have from the corporate income tax?

With a single sales factor apportionment (after 2010) and various tax credits, such as for research, today's CA corporate income tax has significant economic development elements to it. The current system should encourage businesses to locate payroll and property in CA and sell to people outside of the state. Without the credits, it is not clear if CA would be a desirable place to locate unless you have lots of sales outside of CA and CA's BNRT is lower than what the business would pay in other states. If the BNRT is enacted along with repeal of both the corporate income tax and the state-level general sales tax, CA should become more attractive to capital intensive firms such as manufacturers (although many states already exempt manufacturing equipment from sales tax). The state might not be as attractive for labor intensive firms who already pay little sales tax, but have significant labor costs which do not reduce the BNRT base. However, the labor intensive firm would gain little from moving its labor force outside of the state because, having CA sales, it would still be subject to the BNRT. Also, because payroll is not used to apportion the combined/unitary BNRT base, there should be no change in its CA BNRT.

Could the BNRT be viewed as a sales tax rather than a business tax? If yes, then a physical presence nexus standard would apply. Also, the tax might not be applicable to food under the CA constitution. When Ohio enacted its gross receipts tax (called a Commercial Activity Tax) a few years ago, food vendors were successful at the trial court level in holding that the tax was really a transaction tax which under Ohio law cannot be imposed on food (see Tax Notes article on this). California's constitutional restriction is narrow prohibiting only a sales and use tax: Article XIII, Section 34 of the California Constitution reads: “Neither the State of California nor any of its political subdivisions shall levy or collect a sales or use tax on the sale of, or the storage, use or other consumption in this State of food products for human consumption except as provided by statute as of the effective date of this section.” Could the NRT be viewed as a sales tax?

The BNRT is similar to the Michigan Single Business Tax (SBT) that it had for many years, but recently replaced with a different tax. Why did Michigan abandon its SBT and what lessons can we learn from that state's experience? [For some background on this – see the Michigan tax agency website, a 2003 Michigan report on the SBT and a 2007 Tax Foundation report.]

It would be interesting for firms to calculate their CA tax liability under the BNRT to get a sense of how the BNRT would change tax liabilities for CA firms.

What might businesses do to reduce their BNRT liability?

  • Increase sales to other states and countries.
  • Hire contractors rather than employees so they get to deduct those labor costs (wages and payroll taxes do not reduce the BNRT base).

Additional information:

What do you think (about the proposals and the accuracy and completeness of my observations)?


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