SB 567 Represents a Massive Tax Increase and a Potential International Trade War

Chris Micheli
Attorney and Lobbyist at the Sacramento government relations firm of Aprea & Micheli, Inc.

Despite multiple tax increases being adopted by voters just last November, SB 567 (Lara) was introduced that, if enacted, will result in another multi-billion dollar tax increase on businesses and individuals. And, the bill could once again raise the ire of major international trading partners, including Great Britain and Japan.

With the newly-acquired super-majority status of Democrats in both the State Assembly and State Senate, the business community has been concerned about potential tax increases brewing in the Legislature. SB 567 represents the biggest threat so far.

SB 567 would make four major changes to California tax law. According to the bill’s author, this measure “will close four popular loopholes that benefit millionaires and ensure high income earners making above one-million-dollars annually, pay their fair share in taxes.” Senator Lara also claims “Millionaires have mastered our tax code to take advantage of popular loopholes. As a result, the super-rich and the largest corporations in California do not pay their fair share in taxes.”

The approach of seeking new sources of revenue, such as that contained in SB 567, seems counter-intuitive after the electorate adopted multi-billion tax increases just a few months ago by passing Prop. 55 (12-year extension of the Prop. 30 personal income tax increases), Prop. 56 (a $2 tax imposed on each pack of cigarettes), and Prop. 64 (which includes several tax increases on marijuana and marijuana products).

What is different for the 2017 Session is that Democrats have achieved the necessary 2/3 majorities in the State Senate and Assembly to pass tax increases without any Republican involvement under the requirements of Prop. 26 (amending Article XIIIA, Section 3(a) of the California Constitution), assuming signature by the governor – or enough votes to override a gubernatorial veto. California is one of just a handful of states that requires a 2/3 majority for increasing taxes by a vote of the Legislature.

What does SB 567 propose? As introduced, the bill contains four significant tax increase provisions. First, for tax years beginning January 1, 2018, SB 567 would require charitable remainder trusts (CRTs) to be at least 40% of the initial fair market value of all of the property placed in trust. Existing state law exempts from state tax any charitable remainder trust including that the value of the trust must be at least 10% of the initial fair market value of all the property placed in trust.

A CRT is an irrevocable trust that generates an income stream for the donor to the CRT with the remainder of the donated assets going to charity. Unfortunately, proponents claim CRTs benefit charities but allow taxpayers to avoid paying taxes. The bill would raise the amount going to the charity by 300%. It would make a CRT less attractive and adversely impact charitable giving. It would also take California out of conformity with federal law, which creates administrative burdens for both taxpayers and the Franchise Tax Board in administering the law.

Second, for persons who died on or after January 1, 2018, SB 567 would revise the law so that no adjustment is allowed where the person who acquires the property has an adjusted gross income or net income over a specified amount. Existing state law, for the purpose of calculating the gain or loss upon the disposition of property, generally the basis of property acquired from a decedent is the fair market value at the date of death.

California conforms to federal tax law on the “step-up in basis” for appreciated property that has been inherited. SB 567 would eliminate this provision of federal law for those with income above $1 million, once again targeting those upon whom the State of California is ever dependent upon financially. As a result, the bill would create different rules for California taxpayers complying with federal law and force those individuals to pay capital gains on inherited property that has appreciated in value.

Third, SB 567 would retroactively to January 1, 2017 eliminate the deduction for compensation paid to CEOs for pay based on commission or on meeting certain performance goals. Retroactive tax law changes are fundamentally unfair to taxpayers as they change the rules midstream. This creates undue hardship and confusion for residents.

Existing state law, in conformity with federal tax law, provides that a publicly held corporation may not deduct remuneration paid to the CEO to the extent the amount of compensation exceeds $1 million, except where the amount is based on commission or on meeting certain performance goals. As such, a deduction for that compensation is permitted on that basis even if it exceeds $1 million. This change in law would take California out of conformity with federal income tax law by disallowing the deduction for publicly-traded corporations.

Fourth, SB 567 would retroactively to January 1, 2017 remove the water’s-edge election and specify that all existing electors would be unable to file using the water’s-edge method for tax years beginning on or after January 1, 2023, thereby forcing all corporations to file on a worldwide unitary basis. Existing state law allows corporations to elect whether their income is determined on a water’s-edge or worldwide unitary basis.

While the U.S. Supreme Court upheld California’s use of “worldwide combined reporting,” the state allowed a “water’s-edge election” beginning in 1987 due to pressure from foreign governments and multinational corporations, as well as sound tax policy. SB 567 would re-open this debate and cause countries like England and Japan to again propose retaliatory measures against U.S. corporations.

The claim by proponents of this tax law change is that corporations stash money in tax haven countries and worldwide combined reporting is the only way to tax those revenues. SB 567 would repeal the water’s-edge election and force all corporations to pay much more in corporate taxes to California. Under this approach, California companies would end up paying taxes on foreign income earned outside the U.S. which would be inappropriately apportioned to California. The bill would represent a massive tax increase disguised as “fairness” in taxation.

Moreover, SB 567 would grant California the ability to tax income earned outside of the water’s-edge of the United States, a practice which is not followed by any other state in the nation. The practical effect would be to allow the state to tax income that has already been subject to taxation by a foreign jurisdiction. And California-based companies would be subject to retaliatory tax measures by other countries in which they are conducting business.

As the Legislative Counsel has correctly determined, SB 567 makes multiple changes in state statutes that would result in a taxpayer paying a higher tax within the meaning of Article XIIIA, Section 3 of the California Constitution and thus requires a 2/3 majority vote of both houses of the Legislature in order to reach the Governor’s Desk. Hopefully, the Legislature will reject this measure.

Chris Micheli is a lobbyist with the Sacramento governmental relations firm of Aprea & Micheli, Inc. He can be reached at cmicheli@apreamicheli.com or 916-448-3075.

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