This article is from Cal-Tax Digest, published
by the California Taxpayers' Association.
Cal-Tax Home Page | About Cal-Tax | Subscribe

As part of a large-scale tax cut - $1.7 billion over three years - the California Legislature enacted several measures in 1997 to provide tax relief to personal and corporate taxpayers. Among the provisions enacted last year was a bill to conform state law to federal provisions of the research and development (R&D) tax credit. In addition, this year the Legislature proposed an increase in the amount of the credit.

Among last year's tax package was AB 1042 (Wayne), conforming California law to federal law on the R&D tax credit. Governor Pete Wilson signed the measure on October 3 of last year. Due to a chaptering problem, however, the bill's provisions took effect on January 1, 1997, rather than at the beginning of 1998.

This year, in AB 2798 (Machado, Stats. 1998 Ch. 323), the Legislature increased the percentages in the three-tier alternative incremental R&D tax credit to equal 80 percent of the federal percentages. However, this provision would be voided if voters approve Proposition 7 on the November 3 statewide ballot.

(At the behest of Senate President Pro Tem John Burton, AB 2798 was written so that 10 tax relief provisions for business, including the R&D credit, will dissolve if voters approve Proposition 7. This is the Planning and Conservation League's "Clean Air" initiative that would require the California Air Resources Board to grant tax credit certificates totaling up to $218 million annually from 1999 through 2010 to fund emission-reduction efforts. These would include the purchase or retrofit of equipment and vehicles. Credits would be awarded in certain amounts based upon specific categories and potential for reducing emissions. Mr. Burton argued that the state could not afford the tax cuts in the legislation and the initiative, so voters would have to choose.)

This article reviews the current status of California's R&D tax credit provisions, examines the legislative efforts in 1997 and 1998 to enhance the credit, and explains how an additional year of credit was inadvertently provided to taxpayers.

Current State and Federal Laws
California law provides a tax credit for certain increased research and experimentation expenditures.

California has conformed to the federal R&D tax credit (Internal Revenue Code Section 41) as of January 1, 1998 with specific modifications. These modifications are:
(1) the research must be conducted in California;
(2) the percentage for the qualified research credit is 11, rather than 20;
(3) the percentage for the basic research credit is 24, rather than 20;
(4) the credit may not be combined with other business credits; and
(5) the definitions of gross receipts and basic research differ from federal law.

As amended by the Small Business Job Protection Act of 1996, the federal law was changed to adopt an alternative method of computing the research credit using three tiers of incremental credit. These changes to IRC Section 41 were extended from June 1, 1997 through June 30, 1998 by the Taxpayer Relief Act of 1997.

This alternative formula is designed to nullify the anomalous effects of the credit for those who opt for the alternative method. In effect, the new alternative computation provides a much smaller credit on a much larger share of research expenditures, thus helping those for whom the "increment" calculation thwarted accrual of the credit.

Chris Micheli is an attorney and registered lobbyist with the Sacramento governmental relations firm of Carpenter Snodgrass & Associates (916/447-2251). He is a regular contributor to tax periodicals about California tax law developments.

The federal law was also amended to correct the special formula for computing the research credit for "start-up" companies by including those that had research expenditures, but very little sales (gross income) during the base period. California conformed to this provision effective January 1, 1997.

Finally, the federal law was amended to increase the credit for research contracted to a research consortium. Prior law imposed a 65 percent limit on the inclusion of contract research expenses in the calculation of "qualified research expenses." The new law increases this limit to 75 percent for research conducted at research consortia. California conformed to this provision effective January 1, 1997.

1997 State Conformity Efforts
Early in the 1997 California legislative session, three issues needed to be addressed for purposes of drafting the state conformity provisions to IRC Section 41. The following decisions were made to modify the federal credit when, and if, California conformed:

(1) Provide a relative percentage of the federal alternative credit amounts to keep the conformity to this provision in line with the existing state R&D credit conformity.
(2) Allow California taxpayers to make the alternative credit election at any time, instead of providing a window period comparable to the federal credit.
(3) Allow taxpayers to make a separate state election for the alternative credit, instead of having them be bound by their federal election.

Like the federal credit's prohibition against revoking the election without prior approval by the Internal Revenue Service, the state credit election cannot be changed without prior approval of the Franchise Tax Board.

As the 1997 legislative session drew to a close in the early morning hours of September 13, the issue of a start date was contemplated. The pending conformity legislation (AB 1356) commenced state conformity for taxable years beginning on or after January 1, 1997.

However, in an effort to defer the fiscal impact to the state's general fund, conformity was set to commence on January 1, 1998. While the commencement date was deferred, California's conformity to IRC Section 41 is permanent and is not dependent upon the re-enactment of the alternative credit under federal law.

An Extra Year of R&D Credit
On September 13, 1997, the Legislature passed two measures with conflicting provisions and, on October 3, 1997, Governor Wilson signed SB 455 and AB 1042, which had conflicting provisions related to California's R&D tax credit.

SB 455 made two changes in state law applicable to the R&D credit: (1) It changed the effective date of California conformity to the Internal Revenue Code that was in effect on January 1, 1997 (i.e., before the changes made to the IRC by the Taxpayer Relief Act of 1997), and (2) It specified that the changes made to IRC Section 41 shall not be applicable.

After enactment of SB 455 (and the two provisions cited above), AB 1042 was enacted, which conformed California law to the changes made to IRC Section 41 effective January 1, 1998. Those changes included the three-tier alternative incremental credit (but substituted lower percentage rates than those contained in the federal law), the 75 percent credit for research consortia payments, and the start-up definition.

To make sense of this matter, an official written opinion was issued by the California Legislative Counsel (in which the Franchise Tax Board concurs) at the request of legislators. According to the opinion, as a result of the chaptering of AB 1042 after SB 455, the provision preventing state conformity to IRC Section 41 contained in SB 455 was "chaptered out."

Hence, because the effective date of the California Revenue & Taxation Code reference to the IRC was January 1, 1997 under SB 455, California law conforms to IRC Section 41 that was in effect on January 1, 1997 (including the higher federal percentages in the three-tier credit).

SB 455 retained the other limitations on California's R&D tax credit. Then, on January 1, 1998, the contents of AB 1042 took effect. As a result, the lower percentages for the three-tier credit took effect at that time.

It should be noted that, according to the Legislative Counsel opinion, California did not conform to the federal 20 percent credit for the basic and university-based research credits. It did conform to the federal percentages for the three-tier alternative incremental credit for the 1997 tax year only.

Alternative Credit Percentages
Earlier this year, the Legislature considered AB 1356 (Figueroa/Cunneen), which would have conformed the state's three-tier alternative credit percentages to those under the federal R&D credit. That measure was discussed as part of the two-house conference committee on business tax incentives, as well as within the context of state budget negotiations.

As a result of those discussions, the governor and legislative leaders decided to conform the state's three-tier alternative credit percentages to the equivalent of 80 percent of the federal percentages. As a result, these percentages were placed in the statute. Unfortunately, this provision of AB 2798 will not take effect unless Proposition 7 is defeated.

Under AB 2798, the following amendments were made to California Revenue and Taxation Code Sections 17052.12 and 23609 (strikeouts indicate deleted language; underlined indicates new language):

(g) (1) For each taxable year beginning on or after January 1, 1998:
(A) The reference to "1.65 percent" in Section 41(c)(4)(A)(i) of the Internal Revenue Code is modified to read "ninety-one "one and thirty-two hundredths of one percent."
(B) The reference to "2.2 percent" in Section 41(c)(4)(A)(ii) of the Internal Revenue Code is modified to read "one and twenty-one seventy-six hundredths percent."
(C) The reference to "2.75 percent" in Section 41(c)(4)(A)(iii) of the Internal Revenue Code is modified to read "one and fifty-one hundredths "two and two-tenths of one percent."
(g)(2) requires written consent of the FTB to revoke the election.

Again, these provisions will take effect only if Proposition 7 is defeated.

Conclusion
California has made its research and development tax credit attractive to R&D-dependent businesses, including those in the high-tech, biotech and aerospace industries. California needs to remain vigilant in its attempts to maintain and attract jobs in these important growth fields. It can only hope to do so if it continues its efforts to enhance the state's R&D tax credits.