On May 10, 2024, California Governor Gavin Newsom released a revised budget for 2024-2025 that includes, among other changes, a temporary suspension on the use of net operating losses (NOLs) for businesses with California income in excess of $1 million and limitations on business incentive tax credits for tax years 2025, 2026, and 2027. On May 29, 2024, California Senate and Assembly leaders announced a budget agreement that includes these changes but accelerates the suspension on the use of NOLs and limitations on tax credits by one year, for tax years 2024, 2025, and 2026. Notably, since these rules would be in effect for the entire 2024 taxable year, taxpayers may have already concluded transactions that would implicate these rules. While the budget has not been finalized, the similarity between the Governor’s proposal and the budget agreement released by the Legislature suggests that these provisions are likely to be included in the final budget in some form. Companies with California source income should be aware of the impact to them of these potential changes.
Under the temporary suspension on the use of NOL deductions, taxpayers who have historically operated at a loss, but who have business income in excess of $1 million in any of the affected years, will not be able to use their historical NOLs to offset income for California tax purposes. This provision could implicate companies that have a significant increase in business income from year to year, e.g., as a result of a one-time sale of assets or cancellation of debt income arising from restructuring debt or that enter into large, milestone-based contracts with a substantial upfront payment. These taxpayers may now be faced with California tax on income recognized in the affected years that is apportioned to California, even though NOLs are largely available to offset the income for federal tax purposes. California previously implemented a similar temporary suspension on the use of NOL deductions in 2008 and 2020.
The budget agreement also limits the use of business incentive tax credits, including R&D tax credits, to offset no more than $5 million of tax liability in the affected years. The Low-Income Housing tax credit and the Pass-Through Entity Elective tax credit are exempt from this limitation.
Further, Governor Newsom’s budget proposal included a provision intended to “clarify” existing law such that a corporation that receives income that is excluded from taxable business income must exclude this income from its apportionment factor. This provision appears to target the Office of Tax Appeals’ holdings in two recent cases1 that income that is deductible from a taxpayer’s tax base is nevertheless included in the sales factor numerator and denominator for California state apportionment purposes.
Business taxpayers who have recognized or anticipate recognizing significant California income (including as a result of debt restructuring) in 2024 and subsequent years should consult a Wilson Sonsini tax attorney or other tax adviser regarding the impact of these rules. Wilson Sonsini will continue to monitor the California budget process and will post updates as the provisions are finalized.
For more information, please contact Myra Sutanto Shen (msutantoshen@wsgr.com, 650-565-3815); Greg Broome (gbroome@wsgr.com, 415-947-2139); or any member of the tax practice at Wilson Sonsini.
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Update, June 28, 2024:
As expected, California enacted SB-167, which suspends the use of NOLs to offset California business income in taxable 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 $1 million or more. The statute extends the expiration date for NOLs that are suspended pursuant to this provision. In addition, SB-167 limits the use of business incentive credits to offset a maximum of $5 million of tax (subject to exceptions, including for the Pass-Through Entity Elective tax credit), but extends the expiration date of such credits. Finally, SB-167 provides that transactions or activities that generate income or loss not included in “net income” are excluded from both the numerator and the denominator in the apportionment formulas.
The California Legislature also approved SB-175, which has been presented to Governor Newsom for signing. SB-175 allows taxpayers that are subject to the limitation on business credits to make an election in the year of limitation to treat the suspended credit amount as a refundable credit. The refundable credit can then be claimed ratably over the five-year period beginning the third taxable year after the year in which the election is made, and because the credit is refundable, it is available even if the taxpayer does not owe California tax in that year. In addition, SB-175 provides that the limitations on the use of NOLs and the business incentive credits described above can sunset for tax years 2025 and/or 2026 upon determination by the Director of Finance that there is sufficient money in the General Fund over the multiyear forecast to eliminate the limitations.
[1] In The Matter of the Appeal of Microsoft Corporation and Subsidiaries, 2024-OTA-130 (Cal. OTA July 27, 2023) and In the Matter of the Appeal of Southern Minnesota Beet Sugar Co-op., 2023-OTA-342P (Cal. OTA March 17, 2023).
