Governor Arnold Schwarzenegger has called a special session of the California Legislature to consider a long awaited package of recommendations contained in a September 29th report by a blue-ribbon commission created to overhaul California’s creaky tax system.

The 14-member Commission on the 21st Century Economy was created by Executive Order of Governor Schwarzenegger in October of 2008 to address concerns that California’s tax code had become outdated and needed to be revamped to better reflect a post-industrial economy, where services and information technology have largely replaced the production and sale of manufactured goods and agricultural commodities. The commission’s charge was to recommend revenue-neutral actions to modernize and simplify the tax structure while simultaneously stabilizing revenues and improving the state’s economic competitiveness.

Six core elements are contained in the commission’s report: (1) reducing personal income tax rates to a maximum of 6.5 percent and eliminating all deductions and credits except for mortgage interest, property taxes, and charitable contributions, (2) eliminating the 8.8 percent corporate income tax and the $800 franchise minimum tax, (3) phasing out the state’s 5 percent general purpose sales tax, except for sales of gasoline and diesel fuels, (4) establishing a business net receipts tax, (5) creating an independent tax dispute forum, and (6) increasing the state’s “rainy day fund” for fiscal emergencies from 5 percent to 12.5 percent of general fund revenues.

Business Net Receipts Tax

By far the most controversial aspect of the commission’s recommendations is a new business net receipts tax (BNRT), which is intended to offset revenue losses from reducing or eliminating income and sales taxes and would ultimately comprise almost half of the state’s total tax revenues.

The BNRT would levy a tax on the value a business adds to its production of goods or services. The tax is intended to be imposed on all for-profit entities doing business in California, including Internet retailers without a physical presence in the state. A business would be deemed to be “doing business” in the state for purposes of the BNRT if any of the following conditions exist:

  • The business is organized or commercially domiciled in California.
  • Sales in California exceed the lesser of $500,000 or 25 percent of the taxpayer’s total sales.
  • The business owns real property or tangible personal property in the state exceeding the lesser of $50,000 or 25 percent of a taxpayer’s total real property or tangible personal property.
  • Compensation paid to employees in California exceeds the lesser of $50,000 or 25 percent of the total employee compensation paid by the taxpayer.

Small businesses with gross receipts of $500,000 or less would be exempt from filing a BNRT return. No tax would be owed regardless of the amount of gross receipts if the business realized net receipts of $250,000 or less using a credit mechanism that would be phased out as receipts rose above that threshold.

The base for calculating the BNRT would be determined by first aggregating the gross amount a business receives from the sale of its products or services and then subtracting purchases from other firms, wages and benefits paid to its own employees, and interest expenses. It appears that purchases of business equipment and machinery would be fully deductible when made, rather than capitalized and depreciated as is generally the case under income tax laws. Businesses commercially domiciled in California would add all non-business income, such as interest income and proceeds from the sale of securities in calculating their tax. It is unclear how the BNRT would treat income or gains from the sale of non-business securities held by a business as investments.

Gross receipts for non-financial business would be broadly defined to include receipts from the sale or exchange of tangible property, the performance of services, and the use of property or capital, including receipt of rents or royalties, used in the taxpayer’s business. The cost of raw materials, supplies and capital equipment would be deductible from gross receipts; the cost of employee compensation and employee taxes would not. The commission proposes that the BNRT rate be phased in over a 5-year period beginning in 2012 but that it not exceed 4 percent of a business’ net receipts when fully implemented. The simple formula is:

Gross Receipts — Purchases from Other Firms = Net Receipts

Net Receipts x Tax Rate (4%) = BNRT Liability

In the case of financial businesses, interest income and expenses would be included in the business gross receipts base but the report is silent on how the BNRT would be applied to financial transactions involving the trading of securities, commodities, and derivatives.

Multi-State Businesses

For businesses operating inside and outside of the state, the BNRT would use a unitary method of taxation similar to how California currently taxes multi-state businesses under the corporate income tax system, except that the tax would apply to all types of entities. Generally this requires businesses to aggregate their net receipts of both in-state and out-of-state operations and apportion the tax based on the proportion of sales in California. The formula is:

Net Receipts x (California Sales/Sales Everywhere) = California Apportioned Net Receipts

California Apportioned Net Receipts + Non-Business Receipts (if commercially domiciled in California) = California Total Net Receipts

California Total Net Receipts x Tax Rate (4% or less) = BNRT

In the case of multi-entity groups operating as a “unitary business” the tax base would first be aggregated on a group basis, and then allocated among the group members based on their respective ratios of Californiaapportioned sales to total sales of the group everywhere.

The commission believes that the BNRT would be fully deductible against the business entity’s federal income tax. It also believes that the BNRT could be constitutionally imposed on any out-of-state business that sells goods or services to California businesses or residents regardless of whether that business has a physical nexus, although many tax experts question whether this assumption would survive court challenges.

Initial Reaction

As the final proposal took shape over the summer of 2009 it quickly drew fire from all quarters. Business interests liked the elimination of state sales and corporate taxes but expressed wariness of the unproven BNRT. Labor saw the BNRT as an effective tax on wages and benefits that would effectively incentivize employers to contract out for lower cost workers. Tax reformers on the right saw the BNRT as a “hidden tax” and were suspicious that reduced income and sales tax rates would only be temporary unless there was a hard cap on spending. Tax reform groups on the left criticized multi-billion dollar income tax breaks for the wealthiest 5 percent of taxpayers. Nearly everybody saw large risks in making the untested BNRT responsible for more than 40 percent of the state’s general fund revenue. Because of these concerns and the inability to reach unanimous agreement (only 9 of 14 commissioners signed the report), the commission’s recommendations were not presented as a stand alone package for an immediate vote as the governor had originally intended, but rather as tax reforms that the legislature should consider only after further study and review.

What’s Next

Governor Schwarzenegger quickly embraced all of the commission’s recommendations, but legislative leaders have responded cautiously and scheduled a two-month long series of informational hearings before taking action on any specific reforms. The special session on tax reform, which allows revenue-neutral bills to be passed by majority vote, will continue until adjourned by both houses of the legislature or November 30, 2010, whichever occurs earlier. While it is unlikely that all or even most of the commission’s recommendations will be enacted, the report has set in motion a debate that could lead to profound changes in California’s tax system and potentially trigger efforts to overhaul tax structures in other states as well.