California Bill May Cross Line on Business Taxes

California Bill May Cross Line on Business Taxes

While President Donald Trump has put an end to the Trans Pacific Partnership and set his sights on the North American Free Trade Agreement, business groups in California are concerned that a bill introduced last month in the state Legislature could start a trade war all by itself.

SB 567 would, among other things, remove a multinational company’s choice to pay state taxes only on income generated within the state. They instead would have to pay taxes on all of their worldwide affiliates as one entity.

This could result in more than $2 billion a year in additional state taxes paid by multinational companies, both those based in California and foreign entities with affiliates/operations in the state, according to the state’s Department of Finance.

“U.S. corporations shouldn’t be able to slash their tax bill by hiding their profits in overseas subsidiaries,” the bill’s author, state Sen. Ricardo Lara, D-Bell Gardens, said in an email.

The bill, which Lara has dubbed the “Millionaire Tax Accountability Act,” also targets seven-figure compensation for corporate executives by removing the tax-deductibility status from compensation in excess of $1 million tied to performance – including the exercise of performance-based stock options.

But the proposal to change treatment of overseas income is stirring the most concern.

Business groups said eliminating the option for companies with international earnings only to pay taxes on the portion of income generated in California – known as the “water’s edge” election – would not only force major exporters to pay more in taxes, it could curtail foreign investment and prompt other nations to retaliate with higher fees and tariffs on California exports.

“Passing this bill would start a trade war and that won’t be good for anyone,” said David Kline, spokesman for the California Taxpayers Association, which is opposing the legislation.

The bill is set for its first hearing in the state Senate next month. While it may galvanize heavy business opposition, Lara has the political clout to potentially push the measure to the full Senate in his post as chairman of the Appropriations Committee. Lara is a declared candidate for state insurance commissioner next year.

Trade threat

The bill would upend a delicate compromise reached 30 years ago between the state and its most prominent trading partners at the time, Britain and Japan. For decades before that, California was one of only a handful of states that taxed global income of multinational corporations. This applied not only to California companies selling products and services overseas, but also to foreign companies investing in the state, such as Toyota Motor Corp., which had set up its U.S. sales headquarters in Torrance.

When the state Franchise Tax Board stepped up enforcement of this tax provision in the 1980s, the British and Japanese governments threatened to take their investments to more friendly states unless there was a change in tax policy.

The Legislature in 1986 gave companies a choice: They could either continue to pay taxes on their income from global affiliates or they could elect only to pay taxes on their U.S. sales and operations, essentially stopping at the “water’s edge.” The option lasts for seven years at a time, after which the company must file paperwork renewing its choice.

The state Department of Finance noted in a recent report that in 2013 it received about 15,000 corporate returns using the water’s edge option. That option is expected to result, the department estimated, in the state foregoing $2.3 billion in tax revenue for the 2016-17 fiscal year ending June 30.

Under SB 567, the water’s edge provision would be phased out over seven years, allowing those companies that are using it to continue through the seven-year term. But starting with the 2017 tax year, no companies would be able to initiate or renew their water’s edge choice.

Mattel hit?

Exactly how the new tax policy would pencil out would likely vary for companies.

For example, Mattel Inc., the El Segundo-based maker of Barbie dolls and other toy products, reported sales last year of $6.07 billion, of which $3.39 billion came from the United States.

Under the water’s edge election, $2.68 billion, or 44 percent, of Mattel’s sales are exempted from California taxation. If that exemption were removed, Mattel would have to pay taxes – likely at the state corporate tax rate of 8.84 percent – on some portion of those global sales.

Exactly how much the additional tax bill would be is hard to calculate, since other exemptions and adjustments would have to be determined.

Mattel spokesman Alex Clark said the company had no comment on either its taxation options or Lara’s bill.

The California Manufacturers and Technology Association, which has expressed concerns about the bill but has yet to take a formal position, said this higher tax burden could prompt some manufacturers to scale back their investments in the state.

Spokesman Gino DiCaro said there’s another concern: double taxation. Since most California companies doing business abroad already pay taxes in the countries where they sell their products or services, a decision by California authorities to tax those same products or services here is tantamount to double taxation.

“(I)t would be inconsistent with federal tax law leading to higher tax compliance costs for California manufacturers, hurting investment rates.” he said in an email.

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