California passes legislation in response to the Microsoft decision

Background

California’s Governor approved SB-167 (the Legislation) and SB-175 which include many significant tax changes. From a corporate income tax perspective, a few notable changes include the suspension of Net Operating Losses (NOLs) for specific taxpayers, limitations to credit utilization and apportionment formula clarifications in response to the recent Microsoft case.

NOL suspension

The Legislation suspends NOL deductions for taxpayers with $1 million or more in net business income or modified adjusted gross income for the tax year. These changes are effective for tax years beginning on or after Jan. 1, 2024, and before Jan. 1, 2027.

For any NOL or carryover of a NOL for which a deduction is denied, the carryover period under Section 172 of the Internal Revenue Code shall be extended as follows:

• By one year, for losses incurred in taxable years beginning on or after Jan. 1, 2025, and before Jan. 1, 2026.
• By two years, for losses incurred in taxable years beginning on or after Jan. 1, 2024, and before Jan. 1, 2025.
• By three years, for losses incurred in taxable years beginning before Jan. 1, 2024.

California’s trailer legislation, SB 175, provides for a potential early termination of the NOL suspension for 2025 and/or 2026 if the Director of Finance determines that the General Fund money over a multiyear forecast is sufficient without the revenue impact of the NOL suspension and credit limitation detailed in the Legislation.

Credit limitation:

Beginning on or after Jan. 1, 2024, and before Jan. 1, 2027, the Legislation limits the use of business credits to no more than $5 million in one taxable year, unless an exemption applies. For taxpayers filing a combined report, no more than $5 million of credits may be used to offset the aggregate amount of tax. The carryover period for any credit that is not allowed due to this limitation will be increased by the number of taxable years the credit or any portion thereof was not allowed.

Similar to the NOL suspension provision, SB 175 provides for a potential early termination of the credit utilization limitation for 2025 and/or 2026 if the Director of Finance determines that the General Fund money over a multiyear forecast is sufficient without the revenue impact of the NOL suspension and credit limitation detailed in the Legislation.

Additionally, SB 175 also provides that for tax years beginning on or after Jan. 1, 2024, and before Jan. 1, 2027, a taxpayer may make an irrevocable election to receive an annual refundable credit amount, equal to 20% of the qualified credits that would have been available to the taxpayer but for the limitation imposed by the Legislation.

The “refundable period” is the first five consecutive taxable years beginning the third taxable year after the taxpayer makes the election. The annual refundable credit amount shall be allowed as a credit against the “net tax” computed for the taxable year, and the excess, if any, shall be credited against other amounts due, if any, and the balance, if any, shall be paid to the taxpayer. The election is irrevocable and is made on an original timely filed return. Additionally, no portion of the annual refundable credit amount can be assigned to another taxpayer.

Apportionment of deductible income changes:

This Legislation modified the apportionment language in light of the recent Office of Tax Appeals’ decision in the Microsoft case, stating that a transaction or activity, to the extent that it generates income or loss not included in “net income” subject to apportionment, will be excluded from the apportionment formula. “Not included in net income” is defined as “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.”

The Legislation states “this section does not constitute a change in, but is declaratory of existing law,” specifically Franchise Tax Board Legal Ruling 2006-1.

Further, the Legislation states “The Franchise Tax Board may adopt regulations that are necessary or appropriate to carry out the purpose of this section, which is to prevent inclusion within the apportionment formula of transactions and activities that give rise to income that is not subject to apportionment.” The Legislation further states the Administrative Procedure Act does not apply “to any regulation, standard, criterion, procedure, determination, rule, notice, guideline, or other guidance established or issued by the Franchise Tax Board pursuant to this section.”

Per the Legislation, this clarification applies to taxable years beginning before, on, and after the effective date of the Legislation.

What’s next?

In addition to the above provisions, the Legislation also includes other industry specific provisions (e.g. oil and gas and cannabis businesses) along with non-income tax provisions (e.g. sales tax bad debt deduction limitation).

As such, please contact your Baker Tilly tax advisor to discuss the Legislation and the impact on your business' California filings.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.