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California budget includes significant tax provisions
June 2024
Update: S.B. 167 was signed into law on June 27, 2024. For information on subsequent budget legislation (S.B. 175), see PwC's Insight, here.
In brief
What happened?
California budget “trailer” legislation passed by the Legislature on June 13 suspends NOL deductions and limits credit utilization for 2024-2026, seeks to retroactively overturn judicial findings with respect to apportionment representation for deductible income, and suspends the sales tax bad debt deduction for retailers, among other provisions. [S.B. 167, passed Assembly and Senate, 6/13/24]
Why is it relevant?
The budget legislation may impact taxpayers with NOLs or significant California tax credits, water’s-edge filers with foreign dividend income, certain oil and gas energy companies, and retailers applying the sales tax bad debt deduction, among other taxpayers.
Actions to consider
Companies might consider actions in response to the NOL and credit limitations, such as amending tax returns for open years or making prospective accounting method elections. Taxpayers also may consider refund claims or original filing positions taken in reliance on precedent concerning apportionment representation for deductible income, such as foreign dividends. Retailers may consider the applicability of the sales tax bad debt deduction for charge-offs taking place prior to January 1, 2025, the effective date of the bad debt deduction suspension.
In detail
NOL suspension and credit limitation
The legislation suspends net operating loss deductions for tax years beginning on or after January 1, 2024 and before January 1, 2027 for taxpayers with net business income or modified adjusted gross income of at least $1 million for the tax year.
For any net operating loss or carryover of a net operating loss for which a deduction is denied due to the NOL suspension, the carryover period under Section 172 will be extended as follows:
- By one year, for losses incurred in tax years beginning on or after January 1, 2025, and before January 1, 2026.
- By two years, for losses incurred in tax years beginning on or after January 1, 2024, and before January 1, 2025.
- By three years, for losses incurred in tax years beginning before January 1, 2024.
Further, the legislation limits the aggregate use of otherwise allowable business credits to $5 million for each tax year beginning on or after January 1, 2024 and before January 1, 2027 (except for certain credits not subject to the limitation). For combined reports, the $5 million credit limitation is applied to the aggregate amount of “tax,” as defined in Cal. Rev. and Tax. Code Section 23036, of all combined group members. The carryover period for any credit that is not allowed due to the application of the $5 million limitation will be increased by the number of tax years the credit or any portion thereof was not allowed.
A separate $5 million limit applies to income and franchise tax credits for qualified motion picture production expenditures when an election is made to apply such credits against qualified sales and use taxes.
The legislation states an intent to enact future legislation to allow taxpayers subject to the credit limitation to receive a refund of credit amounts that would have been used but for the limitation period.
Observation: The final budget begins the NOL suspension and credit limitation one year earlier than proposed by Governor Newsom. Further, the final budget does not provide a mechanism whereby sufficient revenue may trigger an earlier sunsetting of these provisions.
For consideration: As a result of these changes, companies should consider how amending tax returns for open years or making prospective accounting method elections could free up deductions for use during the 2024-2026 limitation period.
Apportionment of deductible income
The legislation provides that a transaction or activity, to the extent that it generates income or loss not included in “net income” subject to apportionment, is excluded from the applicable 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. These changes are applicable to tax years beginning before, on, or after the effective date of the legislation.
Observation: These changes are a response to the Office of Tax Appeals’ decision in Appeal of Microsoft Corp. and Subsidiaries, No. 21037336 (7/27/23), finding that the full amount of deductible foreign dividends are includable as gross receipts in the California sales factor. (Click here for PwC’s Insight on this decision.) Rehearing in that case was denied on February 14; however, the decision was issued as nonprecedential.
For consideration: Taxpayers should consider the impact of this legislation on any refund claims or original filing positions taken in reliance on the Microsoft decision and any potential challenges to the retroactive nature of these provisions. The stated intent of the Legislature is that its position “does not constitute a change in, but is declaratory of, existing law,” in particular, FTB Legal Ruling 2006-1.
The legislation grants the Franchise Tax Board the authority to adopt regulations that are “necessary or appropriate to carry out the purpose” of these changes, “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 Administrative Procedure Act (APA) will not apply to "any regulation, standard, criterion, procedure, determination, rule, notice, guideline, or any other guidance established or issued by the Franchise Tax Board” pursuant to this authority.
Observation: These provisions are a response to the California Superior Court decision in Am. Catalog Mailers Ass’n v. Franchise Tax Bd., Cal. Super. Ct., No. CGC-22-601363, (2/13/24), in which the court found certain FTB guidance to be invalid because it failed to go through the rulemaking procedures laid out in the APA.
Intangible drilling cost deduction and other energy provisions
The legislation provides that Section 263(c), regarding the option to deduct as expenses intangible drilling and development costs, will not apply to intangible drilling and development costs for oil and gas wells that are paid or incurred on or after January 1, 2024.
The legislation also disallows, for tax years beginning on or after January 1, 2024, the calculation of depletion as a percentage of gross income from the property for specified natural resources, including coal, oil, oil shale, and gas.
Further, the legislation repeals the credit based on a taxpayer’s qualified enhanced oil recovery costs effective December 1, 2024.
Sales tax bad debt deduction limitation and suspension
The legislation amends the retailer definition for purposes of the bad debt deduction from sales and use tax. Prior to January 1, 2025, the term "retailer" includes any entity affiliated with the retailer.
Beginning January 1, 2025, a retailer cannot claim a bad debt deduction. The disallowance of the bad debt deduction sunsets on January 1, 2028. However, the reinstated bad debt deduction does not apply to an entity affiliated with a retailer.
Observation: Up until January 1, 2025, California allows retailers, lenders, and retailers’ affiliates to claim a bad debt deduction. According to the Governor’s Budget Summary, California joins “the majority of states in disallowing deductions for non-retailer lenders for sales tax paid on bad debts.”
Be aware: These provisions do not impact charge-offs taking place prior to January 1, 2025. Current and future claims for accounts charged-off up to and including December 31, 2024 are still eligible for the sales tax bad debt deduction for retailers and lenders, alike.
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