California - Voters approve San Francisco business tax reform

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1 No November 13, 2012 California - Voters approve San Francisco business tax reform November 13: San Francisco voters on November 6, 2012, approved by 70% a local ballot measure Proposition E replacing the current payroll expense tax with a gross receipts tax (GRT) and making significant changes to the annual business registration fee structure. The new business tax structure is expected to generate an additional $28.5 million in revenue annually. Overview San Francisco currently imposes a 1.5% tax on the payroll expense of entities doing business in the city with an exemption for small businesses with less than $250,000 in payroll expense. The newly approved measure [PDF 2.67 MB] consists of three significant changes: Phasing out the payroll tax Phasing in the GRT Altering the business registration fee structure Proposition E is effective January 1, The phase out of the payroll tax and the phase in of the GRT will occur over multiple years at varying rates depending on actual revenue collected over that period, with the final phase-in / phase-out rates effective by The basic rationale underlying the phase-in and phase-out rates is that the combined revenues received from the GRT and the payroll tax would remain relatively revenue neutral (based on what the city would have collected under the former payroll tax regime). The tax achieves this purpose using two checks: First, if less than the expected revenue is collected, the payroll tax will be phased out at a slower pace, but if excess revenue is collected, the payroll tax rate will be reduced to zero faster.

2 Second, the only potential adjustment to the GRT phase-in rate will occur in the year after any year in which the payroll tax rate is reduced to zero (which may never occur). The actual GRT and payroll tax rates to be applied during the phase-out / phase-in period will be computed by the City Controller and published annually by September 1 in the year preceding the tax year. Payroll tax phase out In 2014, the payroll tax rate will be 1.35%--down from the current 1.5%. In , the payroll tax rates will depend on whether (and the extent to which) the payroll tax, GRT, and business registration fees (i.e., combined revenue ) exceed expected revenue. For each of these years, a base rate is established (see table below) which is then adjusted based on revenue collections. If combined revenue exceeds expected revenue, the payroll tax rate in the subsequent year will be less than the base rate specified. If combined revenue does not meet expected revenue, the payroll tax rate in the subsequent year will be greater than the specified base rate for that year. The payroll tax will be eliminated beginning with the first year that the required adjustments cause the base rate to decline to zero. If the required adjustments do not take the payroll tax to zero by 2018, the payroll tax will remain in place at the rate computed for In other words, the payroll tax may not completely phase out if the combined revenues do not meet the expected targets.

3 Gross receipts tax (GRT) Beginning in 2014, persons engaged in business in San Francisco will be subject to a privilege tax based on gross receipts. Certain businesses, such as small businesses (less than $1 million in gross receipts), passive investment entities, non-profit organizations (except to the extent they have UBTI), and entities otherwise exempt from local taxes under federal or state law (e.g., transportation and motor carriers), are not subject to the GRT. The term gross receipts generally includes all amounts received or accrued by a person from whatever source derived. Certain amounts, however, are excluded from gross receipts such as taxes imposed on retail sales, amounts received from related parties, grants from governmental entities, investment receipts, and allocations from pass-through entities. There are also certain industry-specific exclusions from gross receipts. Certain taxpayers engaged in administrative office business activities will not be subject to the gross receipts tax (or the phasing out of the payroll tax), but instead will pay a 1.4% tax on total payroll expense. A person is taxed under this regime if: Over 50% of the business payroll expense within the city of that person and its related entities for the preceding tax year was associated with providing administrative or management services exclusively to that person or related entities The total number of employees of that person and its related entities within the United States as of the last day of the preceding tax year exceeded 1,000 and The total combined gross receipts of that person and its related entities reported on a U.S. federal income tax return for the preceding tax year exceeded $1 billion. The term administrative or management services includes executive office oversight, company business strategy, recordkeeping, risk management, personnel administration, legal, accounting, market research and analysis, and training services. Allocation and apportionment Depending on a taxpayer s business (defined with reference to certain NAICS codes), there are three different methodologies used to attribute receipts to San Francisco:

4 A single-payroll apportionment factor A dual factor payroll and sales formula A property formula Under the single-payroll factor apportionment method, the taxpayer apportions its gross receipts by a fraction, the numerator of which is the total amount paid for compensation in the city and the denominator of which is payroll everywhere. Examples of industries that use single-payroll factor apportionment include financial services; insurance; professional, scientific and technical services; private education and health services; and personal and laundry services. Under the dual factor payroll and sales formula, gross receipts subject to tax are determined by averaging two amounts: (1) apportioned gross receipts applying the single-payroll factor apportionment method described above; and (2) allocated gross receipts based on sales sourcing rules. The sourcing rules provide, for example, that gross receipts from the sale of tangible personal property are in the city if the property is delivered or shipped to a purchaser in the city. The rules adopt market sourcing for gross receipts from sales of services (sourced to the city to the extent that the purchaser receives the benefit of the services in the city) and intangibles (sourced to the city to the extent the property is used in the city). The dual factor payroll and sales formula is equivalent to a two-factor apportionment formula consisting of a payroll factor and a sales factor. Examples of industries required to use the dual factor payroll and sales methodology include retail and wholesale trade; manufacturing; transportation and warehousing; information; clean technology; and biotechnology. Some businesses accommodations, real estate, and rental and leasing services allocate gross receipts to the city if the receipts are derived from or related to property located or used within the city. Rates and phase-in provisions The GRT rates vary based on industry and are graduated based on gross receipts. The rates in the table below are the maximum rates that could apply in For 2014, the GRT rate is 10% of the maximum rate listed in the table below.

5 Unless the payroll tax is fully phased out, the GRT rates in 2015 will be 25% of maximum rates, increasing to: 50% in % in % in 2018 The GRT rates will freeze if and when the payroll tax is eliminated. Mandatory combined returns All GRT returns will be required to be filed on a combined basis, as a single return, with that taxpayer s related entities. A person is a related entity if that person and the taxpayer are permitted or required to file a combined report for California income tax purposes. Multiple business activities If a person or a combined group engages in more than one business activity to which different GRT rates apply, special rules are used to determine the rates. If greater than 80% of gross receipts are derived from one business activity, then the applicable rate for that business activity applies to all gross receipts derived from all business activities. If no one business activity comprises 80% of gross receipts, then the GRT is computed separately for each set of business activities. Gross receipts from a business activity that generate less than 20% of the total

6 gross receipts may be combined with the business activity of the taxpayer that is taxed at the highest rate. The applicable rate for each set of business activities is determined in the order listed in the maximum rate table above, with rates applicable to any set of activities after the first determined, by adding together the gross receipts determined for all previous sets of activities and applying the rate scale commencing with the total gross receipts (so that graduated rates are applied to entities engaged in more than one activity). Payroll expense tax exclusion credit Certain credits are currently available under the payroll tax for qualifying taxpayers. The measure outlines how such credits could be applied under the new GRT. Specifically, a person that would have been entitled to the Enterprise Zone Credit, the Biotechnology Exclusion, and/or the Clean Technology Business Exclusion could claim such credit against its combined business tax liability with some limitations. Returns, payments of tax The measure will require that the payroll tax and GRT be paid in quarterly installments paid by April 30, July 31, October 31, of the subject tax year, with the fourth installment due by the last day of February of the following tax year. For tax years beginning January 1, 2014, the first three installments of payroll tax and GRT will be computed using the unadjusted payroll tax and GRT rates. The fourth quarterly payment will be the person s total payroll tax and GRT liability under the actual adjusted rates less the installment payments made. Annual business registration fees The measure also alters the calculation of annual business registration fees. Currently, business registration fees ranging from $25 to $500 are imposed annually based upon the amount of the taxpayer s payroll tax liability for the preceding year. For registration years beginning July 1, 2014, and ending June 30, 2015, fees range from $75 for taxpayers with $0 in payroll expense to $35,000 for taxpayers with more than $40 million in payroll expense for the preceding tax year. After June 30, 2015, the registration fees will no longer be based on payroll expense (except for administrative office business activity); rather, the fee schedule will be based on gross receipts. There are also three rate schedules that

7 apply as follows: General rule The registration fee begins at $90 for businesses with less than $100,000, and increases to $35,000 for businesses with more than $200 million, based on gross receipts for the immediately preceding tax year. Retail trade, wholesale trade, and certain services The registration fee begins at $75 for businesses with less than $100,000, and increases to $30,000 for businesses with more than $200 million, based on gross receipts for the immediately preceding tax year. Administrative office business activity The registration fee begins at $15,000 for businesses with $2.5 million or less, and increases to $35,000 for businesses with $25 million or more, based on payroll expense for the immediately preceding tax year. For more information, contact a tax professional with KPMG s State and Local Tax practice: Francois Chadwick, (415) Jennifer Petersen, (415) ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. KPMG International is a Swiss cooperative that serves as a coordinating entity for a network of independent member firms. KPMG International provides no audit or other client services. Such services are provided solely by member firms in their respective geographic areas. KPMG International and its member firms are legally distinct and separate entities. They are not and nothing contained herein shall be construed to place these entities in the relationship of parents, subsidiaries, agents, partners, or joint venturers. No member firm has any authority (actual, apparent, implied or otherwise) to obligate or bind KPMG International or any member firm in any manner whatsoever. The information contained in TaxNewsFlash-United States is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. Direct comments, including requests for subscriptions, to US-KPMGWNT@kpmg.com. For more information, contact KPMG s Federal Tax Legislative and Regulatory Services Group at , 1801 K Street NW, Washington, DC To unsubscribe from TaxNewsFlash-United States, reply to US-KPMGWNT@kpmg.com. Privacy Legal