As part of its overall enactment of the state budget, California enacted the revenue trailer bill for the 2024-25 budget, S.B. 167, on June 27, 2024.1 This legislation suspends the use of net operating losses (NOLs) and limits the use of business credits to $5 million for the 2024-2026 tax years. Also, the legislation effectively reverses the California Office of Tax Appeals (OTA) decision in Microsoft Corp. holding that a water’s-edge filer could include the gross amount of repatriated dividends in the sales factor. The legislation also repeals income tax credits and deductions related to the extraction of natural resources for energy. In addition, the legislation eliminates the sales and use tax bad debt deduction for affiliates of retailers and lenders.
On June 29, 2024, California enacted a second trailer bill, S.B. 175, which contains certain modifications to the first trailer bill. This legislation provides that the NOL suspension and credit limitations will not apply for the 2025 and 2026 tax years if certain budget goals are met.2 Furthermore, S.B. 175 provides for refundable business credits for amounts that exceed the $5 million limitation.
Income tax
NOL suspension
S.B. 167 adds corporate tax and personal income tax statutes which suspend the use of NOLs for most California taxpayers for tax years beginning in 2024-2026 unless they qualify for limited small business exceptions.3 To the extent that the NOL utilization is suspended by the new statutes, a corollary extension of the NOL carryover period is provided for each year of disallowance.4 For purposes of the corporate tax, the NOL suspension does not apply if the taxpayer has income subject to corporate tax of less than $1 million for the taxable year.5 For personal income tax purposes, the NOL suspension does not apply if a taxpayer has either “net business income” or “modified adjusted gross income” of less than $1 million for the taxable year.6
As amended by S.B. 175, the NOL suspension for corporate tax and personal income tax purposes will not apply for the 2025 and 2026 tax years if the California Director of Finance determines that the general fund money over the multiyear forecast is sufficient without the revenue from the NOL suspension and credit limitation, and there is legislation in the annual Budget Act to not apply these provisions.7
Business credit limitation
For tax years beginning in 2024-2026, S.B. 167 adds corporate tax and personal income tax statutes that limit the utilization of tax credits.8 Concerning the corporate tax credit limitation, for taxpayers not included in a combined report, the total of all credits otherwise allowable under the tax credit provisions, including the carryover of any credit, cannot reduce tax by more than $5 million in tax years beginning in 2024-2026.9 The same dollar limitation applies to combined groups, which for the same period cannot use credits to reduce the aggregate amount of tax for all group members by more than $5 million per year.10 This limitation applies to all credits that may be taken for corporate tax purposes, with the exception of the low-income housing credit, which is specifically excluded from the limitation.11
With respect to the personal income tax credit limitation, similar to corporations, S.B. 167 provides that individuals cannot reduce net tax with “business credits” by more than $5 million.12 “Business credit” is broadly defined to be any credit allowable under any provision of Chapter 2 of the California Revenue and Tax Code other than certain enumerated exclusions.13 Like the corporate tax credit limitation, the personal income tax credit limitation provides that the credit carryover period will be increased by the number of years the credit (or portion of the credit) was not allowed due to the limitation.14
As amended by S.B. 175, consistent with the provision added for the NOL suspension, the business credit limitation for corporate tax and personal income tax purposes will not apply for the 2025 and 2026 tax years if the California Director of Finance determines that the general fund money over the multiyear forecast is sufficient without the revenue from the NOL suspension and credit limitation, and there is legislation in the annual Budget Act to not apply these provisions.15
Refundable business credits
Under S.B. 175, for tax years beginning in 2024-2026, taxpayers subject to the corporate tax and personal income tax may make an irrevocable election to receive a non-assignable annual refundable credit amount, beginning the third taxable year after the election is made, equal to 20% of the qualified credits that would have otherwise been available to the taxpayer but for the $5 million limitation.16 For a qualified taxpayer who elects to receive a specified refund under the motion picture credit,17 the amount of the credit that exceeds the $5 million limitation will be refunded in the first taxable year that the limitation is not operative.18
Microsoft apportionment case overruled
For taxable years beginning on or after June 27, 2024, S.B. 167 overrules the California OTA’s Microsoft decision holding that a water’s-edge group could include the gross amount of repatriated dividends in the denominator of its sales factor without taking the 75% qualifying dividend deduction.19 In Microsoft, the OTA rejected Legal Ruling 2006-01 issued by the California Franchise Tax Board (FTB) providing that the sales factor includes only the net dividends after applying the qualifying dividend deduction.20 The legislation expressly provides that Legal Ruling 2006-01 applies to apportionment factors attributable to corporate taxpayers.21 A transaction or activity, to the extent it generates income or loss not included in “net income,” subject to apportionment, is excluded from the apportionment formula.22
The new statute clarifies the weight of authority accorded to regulations and sub-regulatory guidance issued by the FTB. Specifically, the FTB may adopt regulations that are necessary or appropriate to carry out the purpose of the statute, which is to prevent inclusion within the apportionment formula of transactions and activities that give rise to income that is not subject to apportionment.23 The new statute further clarifies that the California Administrative Procedure Act does not apply to any regulation or any other sub-regulatory guidance established or issued by the FTB under this statute.24
Natural resource extraction credits and deductions eliminated
S.B. 167 eliminates certain tax incentives for extracting natural resources for energy. First, the legislation limits the tax credit of up to 5% for qualified enhanced oil recovery costs to tax years beginning before Jan. 1, 2024, and repeals the credit effective Dec. 1, 2024.25 Also, the legislation repeals the deduction for intangible drilling and development costs for oil and gas wells paid or incurred on or after Jan. 1, 2024.26 For taxable years beginning on or after Jan. 1, 2024, the legislation disallows the calculation of the deduction for the depletion of natural resource deposits as a percentage of gross income from the property for specified natural resources, including coal, oil, oil shale, and gas.27
Sales and use tax
Bad debt deduction eliminated for affiliates and lenders
Under existing law, a retailer is relieved of sales and use tax liability, insofar as the measure of the tax is represented by accounts that have been found to be worthless and charged off, either for income tax purposes or based on generally accepted accounting principles (GAAP).28 A retailer that previously paid the tax may take a deduction for the amount found to be worthless and charged off by the retailer. Current law provides that “retailer” includes certain affiliated entities. If an account is held by a lender, existing law entitles a retailer or lender that makes a proper election to a deduction or refund of the tax that the retailer has previously reported and paid if certain conditions are met, including that the account has been found worthless and written off by the lender.
Beginning Jan. 1, 2025, S.B. 167 amends the definition of “retailer” to exclude affiliates.29 For accounts held by lenders, the account must be found worthless and written off before Jan. 1, 2025, in order to receive a deduction or refund. Thus, a retailer’s affiliate or a lender is no longer eligible to receive a bad debt deduction or refund. Effective Jan. 1, 2028, a new version of the statutes is enacted that no longer includes the deduction and refund provisions for accounts held by a lender.
'In lieu' credit for motion picture production
Under existing sales and use tax law, in lieu of specified corporate tax and personal income tax credits for qualified expenditures paid or incurred by a taxpayer for producing a qualified motion picture,30 qualified taxpayers or affiliates are allowed to make an irrevocable election to apply the income tax credit amount against qualified sales and use tax imposed in the reporting period in the following five years.31 S.B. 167 amends the statute to apply the $5 million limitation for tax years beginning in 2024-2026, but taxpayers may elect to obtain a refund of the qualified sales and use tax paid or offset that excess credit amount against the qualified sales and use tax imposed.32 S.B. 175 further amends the statute to provide that the limitation applies to the 2024-2026 calendar years. Also, the tax credit limitation will not apply for the 2025 and 2026 calendar years if the California Director of Finance determines that the general fund money over the multiyear forecast is sufficient without the revenue from the NOL suspension and credit limitation, and there is legislation in the annual Budget Act to not apply these provisions.33
Commentary
The budget trailer legislation makes some significant changes that are intended to address state budget concerns. The three-year NOL suspension and business credit limitation provisions for the 2024-2026 tax years should be familiar to taxpayers because a similar approach historically has been followed on several occasions.34 Most recently, in 2020, legislation was enacted that suspended NOLs and limited business credits for the 2020-2022 tax years,35 but legislation was enacted in 2022 providing that the NOL suspension and credit limitation did not apply to the 2022 tax year.36 There is a possibility that the NOL suspension and business credit limitation will not apply for the 2025 or 2026 tax year if certain budget goals are met. The addition of the refundable business tax credit provision in the second trailer bill should provide some relief for taxpayers with credits exceeding the $5 million limitation. The NOL suspension and business credit limitation are intended to provide fiscal relief for the state, but the unpredictable nature of these provisions from year to year will make tax planning difficult for many taxpayers. Taxpayers should immediately consider these provisions because they first apply to the 2024 tax year on a retroactive basis.
The California OTA’s taxpayer-favorable decision in Microsoft received considerable attention and undoubtedly encouraged some taxpayers to seek refund claims. However, obtaining these refunds became more challenging in April 2024 when the OTA decided to make the decision nonprecedential, essentially requiring taxpayers to apply for refund claims without the benefit of relying upon Microsoft as precedential authority. The recent legislation goes further and permanently precludes refund opportunities by rejecting the OTA’s holding and reaffirming the validity of the FTB’s Legal Ruling 2006-01 providing that the sales factor includes only the net dividends after applying the qualifying dividend deduction. This provision is intended to prevent a negative revenue impact of up to $1.3 billion over multiple years based on similar filings from past tax years, and an estimated $200 million in potential refund claims generated in each tax year prospectively.37 There has been some uncertainty concerning the current validity of Legal Ruling 2006-01. This legislation clarifies that this ruling continues to be in effect. However, this legislation is of concern because the legislature decided to reject the OTA’s holding due to its ramifications on the state’s budget.
1 Ch. 34 (S.B. 167), Laws 2024.
2 Ch. 42 (S.B. 175), Laws 2024. This SALT Alert is intended to highlight the major income tax and sales and use tax provisions of both bills, but does not cover all of the amendments made by the legislation. It should be noted that S.B. 175 amends some of the same statutes that were amended by S.B. 167, so overall statutory citations to items originally added or amended in S.B. 167 may have changed as a result of S.B. 175.
3 CAL. REV. & TAX. CODE §§ 17276.24(a); 24416.24(a).
4 CAL. REV. & TAX. CODE §§ 17276.24(b); 24416.24(b).
5 CAL. REV. & TAX. CODE § 24416.24(c).
6 CAL. REV. & TAX. CODE § 17276.24(c), (d). “Business income” means any of the following: (i) income from a trade or business, whether conducted by the taxpayer or by a pass-through entity owned directly or indirectly by the taxpayer; (ii) income from rental activity; and (iii) income attributable to a farming business. “Modified adjusted gross income” means federal adjusted gross income determined without the federal NOL deduction.
7 CAL. REV. & TAX. CODE §§ 17276.24(e); 24416.24(d). This determination is made separately for each of the tax years.
8 CAL. REV. & TAX. CODE §§ 17039.4; 23036.4.
9 CAL. REV. & TAX. CODE § 23036.4(a).
10 CAL. REV. & TAX. CODE § 23036.4(b).
11 CAL. REV. & TAX. CODE § 23036.4(d).
12 CAL. REV. & TAX. CODE § 17039.4(a), (b).
13 These excluded credits include CAL. REV. & TAX. CODE §§ 17052; 17052.1; 17052.6; 17052.25; 17052.5; and 17058. See CAL. REV. & TAX. CODE § 17039.4(c)(1)-(12), which incorporates a full list of the exclusions from the definition of “business credit.”
14 CAL. REV. & TAX. CODE § 17039.4(f).
15 CAL. REV. & TAX. CODE §§ 17039.4(k); 23036.4(j). This determination is made separately for each of the tax years.
16 CAL. REV. & TAX. CODE §§ 17039.5; 23036.5. Note that S.B. 167 expressed a legislative intent to enact the refundable business tax credit. S.B. 167, § 45.
17 See CAL. REV. & TAX. CODE § 17053.98.1.
18 35 ILL. COMP. STAT. 120/2-12(5.5).
19 CAL. REV. & TAX. CODE § 25128.9. In re Microsoft Corp., California Office of Tax Appeals, No. 21037336, July 27, 2023, rehearing denied, Feb. 14, 2024, posted on OTA’s website on April 2, 2024, and designated as nonprecedential. For further discussion of this decision, see GT SALT Alert: California OTA confirms earlier repatriated dividends ruling and GT SALT Summary: California OTA designates Microsoft decisions as nonprecedential.
20 Legal Ruling 2006-01, California Franchise Tax Board, April 28, 2006. Under this ruling, a domestic corporation that received dividends from a unitary controlled foreign corporation excluded from the water’s-edge group is only allowed to include in the sales factor denominator the net dividends after applying the qualifying dividend deduction.
21 CAL. REV. & TAX. CODE § 25128.9(a)(3), (4).
22 CAL. REV. & TAX. CODE § 25128.9(b)(1). “Not included in net income” means income from activities that is not included in net income subject to apportionment for any reason, including, but not limited to, exclusion, deduction, exemption, elimination or nonrecognition. CAL. REV. & TAX. CODE § 25128.9(b)(2).
23 CAL. REV. & TAX. CODE § 25128.9(c)(1).
24 CAL. REV. & TAX. CODE § 25128.9(c)(2). This legislation apparently is intended to increase the level of deference provided to the FTB’s apportionment regulations and sub-regulatory guidance, possibly due to recent U.S. Supreme Court and state court decisions. The U.S. Supreme Court recently overruled its long-standing decision in Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984), which held that a federal agency’s interpretation of a federal statute is entitled to judicial deference. Loper Bright Enterprises v. Raimondo, U.S. Supreme Court, No. 22-451, June 28, 2024. In addition, in American Catalog Mailers Ass’n v. Franchise Tax Board, California Superior Court, San Francisco County, No. CGC-22-601363, Dec. 13, 2023, the California Superior Court for San Francisco County struck down guidance released by the FTB on Public Law 86-272 protection because it constituted a regulation that was not promulgated in compliance with the requirements of the California Administrative Procedure Act. For further discussion of this case, see GT SALT Alert: California court invalidates FTB’s P.L. 86-272 guidance.
25 CAL. REV. & TAX. CODE §§ 17052.8; 23604.
26 CAL. REV. & TAX. CODE § 24423 (repealed).
27 CAL. REV. & TAX. CODE §§ 17681; 24831. The legislation also eliminates provisions allowing the state to decouple from federal law that prevents large crude oil producers from calculating a depletion deduction as a percentage of gross income. CAL. REV. & TAX. CODE §§ 17681.3; 17681.6; 24831.3; 24831.6 (repealed).
28 CAL. REV. & TAX. CODE §§ 6055; 6203.5.
29 Id.
30 CAL. REV. & TAX. CODE §§ 17053.85; 17053.95; 17053.98; 23685; 23695; 23698. S.B. 175 adds CAL. REV. & TAX. CODE §§ 17053.98.1 and 23698.1 to this list.
31 CAL. REV. & TAX. CODE § 6902.5.
32 CAL. REV. & TAX. CODE § 6902.5(g).
33 CAL. REV. & TAX. CODE § 6902.5(m). This determination is made separately for each of the calendar years.
34 The NOL suspension and tax credit limitation are estimated to increase state revenue by $5.95 billion in 2024-25, $5.5 billion in 2025-26, and $3.4 billion in 2026-27. California Senate Floor Analysis for S.B. 167, June 13, 2024.
35 Ch. 8 (A.B. 85), Laws 2020, enacting CAL. REV. & TAX. CODE §§ 17039.3; 17276.23; 23036.3; 24416.23.
36 Ch. 3 (S.B. 113), Laws 2022, amending CAL. REV. & TAX. CODE §§ 17039.3; 17276.23; 23036.3; 24416.23.
37 California Senate Floor Analysis for S.B. 167, June 13, 2024.
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