TWIST - This Week in State Tax

Senate Bill 167, which has passed both chambers of the California legislature, makes several tax changes designed to alleviate the 2024-25 budget shortfall of $27.6 billion and the projected $ 28.4 deficit for the 2025-26 budget year. Details on key changes affecting business taxpayers are below.  

NOL Suspension and Limits on Credits: California lawmakers have regularly limited the use of business credits and suspended the deduction of net operating losses during deficit years.  For taxable years beginning on or after January 1, 2024 and before January 1, 2027, net operating losses (NOLs) are suspended for both corporate and personal income taxes. The suspension will not apply to any taxpayer with net business income or modified adjusted income of less than $1 million. The existing 20-year carryforward period for NOLs is extended for up to three years if losses are not used due to the NOL suspension.

Another provision in Senate Bill 167 limits the use of credits for taxable years beginning on or after January 1, 2024 and before January 1, 2027. During this period, a business (including all taxpayers that are members of a combined report) may claim a total of $5 million in credits only under both the Corporation and Personal Income Tax laws (including the carryover of any business credit).  Most business credits, including the California R&D credit, are subject to this limitation.  However, certain personal income tax credits and the low-income housing credit that applies to both corporate and personal income taxpayers are excluded. The carryover periods (if applicable) are extended by the number of years that a credit is disallowed by reason of this limitation. 

Microsoft Fix: In Microsoft, the California Office of Tax Appeals concluded that the full amount of qualifying dividends deducted from income under R&TC section 24411 were includable in the taxpayer’s sales factor. Senate Bill 167 adopts Legal Ruling 2006-1, which the FTB relied on in Microsoft as support for its position that only the portion of the qualifying dividends that remained in the tax base were included in the sales factor. In addition, the law is amended to provide that a transaction or activity, to the extent that it generates income or loss not included in “net income,” subject to apportionment, shall be excluded from the apportionment formula.  “Not included in net income’” means income from transactions and 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. This change, which Senate Bill 167 specifies does not constitute a change in law, applies to taxable years beginning before, on, or after the effective date of the bill.

Oil and Gas Provisions: Effective beginning with the 2024 tax year, Senate Bill 167 repeals the state’s Enhanced Oil Recovery Cost Credit, which is modeled after the credit allowed under IRC section 43. California R&TC section 24423, which provides that the provisions of IRC section 263(i) apply to intangible drilling and development costs incurred outside the US, is repealed. Several provisions of the IRC that affect oil companies are no longer operative for California purposes as of January 1, 2024, including IRC sections 613(b)(2)(B) (in the case of oil shale), 613(b)(4) (relating to coal), and 613A (relating to limitations on percentage depletion in the case of oil and gas wells).

Sales Tax Bad Debt Deduction: California allows a bad debt deduction for sales and use taxes remitted to the state that relate to accounts that have been found to be worthless and charged off for income tax purposes or under GAAP for taxpayers not required to file income tax returns. A “retailer” includes certain entities affiliated with the retailer. Further, if an account is held by a lender, either the retailer or lender (if an election is made) is entitled to a deduction or a refund of the tax that the retailer has previously reported and paid if certain conditions are met. Senate Bill 167 suspends the bad debt deduction for affiliates of retailers on January 1, 2025. Further, electing lenders would not be entitled to the bad debt deduction unless the relevant account was found worthless and written off before January 1, 2025. On January 1, 2028, the current statute allowing a retailers and lenders a bad debt deduction is repealed entirely and only retailers (not including affiliates) will be entitled to the deduction going forward.

Administrative Changes: Senate Bill 167 amends current law to provide that the state’s Administrative Procedure Act or APA is not applicable to legal ruling of counsel issued by the California Department of Tax and Fee Administration. The Act is currently not applicable to a counsel ruling issued by the Franchise Tax Board. Finally, going forward, the Director of Finance, as opposed to the Franchise Tax Board, will determine whether a taxpayer is affected by a state of emergency.

Please contact David Bertsch with corporate tax questions, or Jim Kuhl with questions on sales tax.

Currently, banking institutions are required to apportion their income to Rhode Island using a three-factor formula consisting of property, payroll, and receipts. General corporations use a single-sales factor apportionment formula. Under legislation (House Bill 7927) that has passed both chambers of the legislature, effective for tax years beginning on or after January 1, 2025, a banking institution would be able to elect to apportion income using a single receipts factor formula. Once made, the election would be effective for all subsequent tax years. After five years, a taxpayer would be able to apply to the tax administrator to revoke the election. To the extent that the banking institution has made the election and would be part of a unitary combined group if not for the exclusion for banks from the group, the electing bank would be subject to new addback rules.  All business expense transactions between the taxpayer and the members of the unitary business would be added to the net income of the taxpayer bank unless to do so would result in duplicate taxation in violation of the law, or an exception applied, such as the taxpayer establishing by clear and convincing evidence that the disallowance of the deduction was unreasonable, or the taxpayer and the tax administrator agree in writing to the use of an alternative method of apportionment.

Finally, the pending legislation authorizes a combined reporting study for banks. As part of its tax return for the taxable year beginning after December 31, 2023, but before January 1, 2026, each banking institution that is part of a unitary business must file a report for the combined group containing the combined net income of the combined group. For each tax year, the report must include, at a minimum: (i) The difference in tax owed as a result of filing a combined report compared to the tax owed under the current filing requirements; (ii) Volume of sales in the state and worldwide; and (iii) Taxable income in the state and worldwide. Certain foreign banks and banks with significant foreign activity would be excluded from the reports. A banking institution that files a false report or fails to file a report may be assessed a penalty not to exceed $10,000.  The information reported would be incorporated into a study to be submitted to the legislature addressing the policy and fiscal ramifications of changing the bank excise tax statute to a combined method of reporting. Please contact Jamie Posterro with questions on these changes.

The South Carolina Court of Appeals recently affirmed an Administrative Law Court (ALC) decision holding that the taxpayer, a home improvement retailer, was properly assessed approximately $2.6 million of retail sales tax on purchases of items that it subsequently installed in customer’s homes. Under South Carolina law, contractors are the retail purchasers of materials used in the performance of construction contracts. Contractors do not purchase materials used in construction contracts for resale, and construction services are not taxable services. The taxpayer at issue purchased building materials and appliances at wholesale (using a resale certificate) and sold them at retail to customers. Some customers wished the taxpayer to install the materials/items. In these cases, after a customer selected materials for a project, or items to install (e.g., a new appliance), the taxpayer engaged a third-party subcontractor to provide a quote for the installation services, prepared a contract that separately identified the labor and material costs, and executed the contract with the homeowner. The contract included all materials and items, such as appliances to be installed, at the retail price regularly charged in the store, and the customer paid the entire contract price upon execution. No sales tax was included in the payment as it was treated as an installation contract. The taxpayer then remitted use tax on the materials/items identified in the contract based on its wholesale cost. On audit, the Department disagreed with this position, and the matter eventually came before the Administrative Law Court, which ruled in the Department’s favor.

On appeal, the taxpayer asserted that it operated as a contractor when using materials in connection with installation services contracts, and the taxable sale of such materials occurred when it purchased the materials at wholesale. The court disagreed, finding that the taxpayer was making retail sales to customers when it sold materials in connection with an installation services contract. The court noted that the purchase of the materials was delineated as a separate line item in the contract, which supported the ALC’s finding the purchases were retail sales, and the sale of materials to the contracting customer was the last sale in the chain of transactions. The court also rejected the taxpayer’s assertion that it was a contractor.

The taxpayer provided installation services only when the materials/goods were purchased at its store, and stand-alone installation services were never provided. Further, the taxpayer’s own documentation described it as a retailer and not a general contractor. Finally, the taxpayer argued that the assessment violated the Equal Protection Clause because the state was treating it differently than other similarly situated contractors that did not make retail sales. In the court’s view, traditional contractors were not similarly situated because such contractors were not permitted to purchase their materials at wholesale. Please contact Nicole Umpleby at 714-335-5586 for more information on Lowe’s Home Center, LLC v. South Carolina Department of Revenue.