TAX NEWS - 2010

US Tax: Companies shouldn't be able to cherry-pick tax rate

When the latest round of ballot-measure politicking begins in the fall, Californians can expect to hear a great deal about a new Genentech facility in suburban Portland that opened earlier this year.

It will likely be Exhibit A in the argument to defeat Proposition 24, a ballot initiative that asks voters to repeal $2 billion in corporate tax breaks approved by the Legislature last year.

The tax breaks came in a package of three separate laws, all of which are complicated and dull to anyone except CPAs and tax attorneys. But one of the provisions may lend itself to the dumbed-down simplicity of ballot-measure advertising — and that's where Genentech's new Oregon campus could come into play.

One of the tax breaks, scheduled to take effect Jan. 1 unless voters overturn it, will allow multistate corporations to change the way they determine how much of their profits nationwide are subject to California corporate income taxes.

The way things now work, a corporation's state tax liability is determined by a formula that takes into account how much of the company's property is in the state, how much of its payroll and what percentage of its sales.

The new law would allow companies to continue to use that formula, or instead choose to make a determination based solely on what percentage of their sales were in California.

Better yet for corporate tax lawyers, they can use one formula one year and the other the next, depending on which produces a lower tax bill.

The difference can be significant.

In evaluating the change, the nonpartisan Legislative Analyst's Office calculated the tax liability of a hypothetical company with $10 million in profits that has 80 percent of its operations based in California. Under the existing formula, that company would owe $442,000 in state taxes. The company could reduce its state tax bill by 60 percent — down to $176,800 — by calculating its taxes using the single-sales formula.

Clearly, that's something Genentech's accountants figured out back in 2006 when the company decided to locate its new drug-processing facility and West Coast distribution facility in Oregon.

The company's physical presence was already heavily concentrated in California, with its campuses in South San Francisco, Oceanside and Vacaville. By expanding in Oregon and thus lowering the percentage of its property and payroll in California, it was able to reduce its state tax liability under the existing formula.

On the flip side, out-of-state companies with a small presence in California realize substantial tax savings by using the existing formula — an arrangement that provides a disincentive for them to bring more operations into the state.

The legislative analyst concludes that converting to a sales-only formula would produce "a small but noticeable increase in economic activity" by encouraging companies to expand in California, producing "an eventual net gain of 40,000 jobs." A study last month touted by Gov. Schwarzenegger is more optimistic — unsurprisingly, since it was produced by a group of high-tech and biotech companies. It finds that use of the single-sales factor could produce 144,000 jobs in California.

Unfortunately, that study and the Genentech anecdote only tell half the story — because they address only half of the new California law. The tax change does not simply convert California to the single-sales formula. It creates an option that allows companies to pick and choose how they want to calculate their taxes in any given year.

And that, says the legislative analyst's report, will create nonsensical distortions.

If the same hypothetical company has a bad year and loses $10 million, it would use whichever formula maximizes its losses, generating credits that can be deducted against past or future profitable years.

"Allowing a choice between single sales and double-weighted sales arbitrarily favors firms with disproportionately high or low California sales relative to property and payroll," the report concludes. The result, it notes, would be to favor out-of-state companies and penalize firms that operate only in California.

In other words, if you hear in the fall about how California tax law provided an incentive for a large California biotech firm to expand in Oregon you'll only be hearing half the story.

The Genentech story makes a fair argument to do what the legislative analyst recommends and what the Legislature should have done last year, which is to switch to a sales-only formula for determining California taxes owed by multistate corporations.

It does not, however, argue for a law that allows major corporations to manipulate their state income taxes at a time when California faces a $20 billion budget shortfall.