California’s 2024-2025 Budget Seeks to Block $1.3 Billion of Refunds for Water’s Edge Taxpayers, Suspend NOL Deductions, and Limit Tax Credit Utilization May Revision of California’s 2024-2025 state budget seeks to block refund claims, worth approximately $1.3 billion for historical tax years, and $200 million per year going forward, by codifying informal guidance recently rejected by the Office of Tax Appeal’s (OTA) decision in the Matter of the Appeal of Microsoft Corporation & Subsidiaries (Appeal of Microsoft) and by granting the Franchise Tax Board’s (FTB) quasi-legislative rulemaking authority exempt from the procedural protections afforded by the Administrative Procedure Act.  The May Revision also proposes to suspend net operating loss (NOL) deductions and limit tax credit utilization to $5 million per year for tax years 2025-2027; however, the legislature proposes to apply the changes to tax years 2024-2026 instead..

In the Appeal of Microsoft, the OTA held 100 percent of repatriated dividends under the Tax Cuts and Jobs Act were gross receipts and must be included in the taxpayer’s sales factor denominator.  In so holding, the OTA rejected the FTB’s reliance on FTB Legal Ruling 2006-01, which states only net dividends are includable in the sales factor based on the rationale that the sales factor should only include receipts that produce business income included in the apportioned tax base.  The OTA specifically dismissed FTB Legal Ruling 2006-01 as nonbinding, unpersuasive, and inconsistent with well-established law.  For additional detail, refer to our previous discussion here.

Reversing the OTA’s Decision in the Appeal of Microsoft

The May Revision contains a trailer bill that proposes to retroactively provide support for the denial of approximately $1.3 billion in anticipated refund claims mentioned above by explicitly providing a legislative endorsement of FTB Legal Ruling 2006-01; adding a statute (Revenue and Taxation Code Section 25128.9) excluding all apportionment factors related to income excluded, deducted, exempt, eliminated or otherwise not apportioned for any reason; and granting the FTB broad authority under that section to create quasi-legislative regulations and rules exempt from all procedural protections that would otherwise be required under the Administrative Procedure Act.  The trailer bill states the provisions of the bill are not a change in law, but rather are declaratory of existing law.  Therefore, the bill would apply both retroactively and prospectively to all tax years, and only require a majority vote to pass.

On May 16, 2024, members of the Senate Budget Subcommittee No. 4 indicated they had no concerns with this proposal.  Under the California Constitution, the legislature must pass the budget by June 15, 2024.

Net Operating Loss Suspension and Credit Limitation for Tax Years 2025-2027

The May Revision includes a trailer bill that proposes to suspend the use of NOL deductions for taxpayers with income over $1 million and limit the amount of most business tax credits any taxpayer could claim to $5 million business credits.  The Assembly’s summary of the legislature’s budget proposal, and the Senate budget subcommittee’s legislative staff summary, indicate the legislature seeks to make these changes effective for tax years 2024-2026.  These NOL and credit limits were previously in place for tax years 2020 and 2021, but then removed for the 2022 tax year.  The legislature also proposes to remove a trigger in the Governor’s May Revision that would have lifted the NOL suspension if certain budget numbers were hit, which was part of the previous NOL suspension.

In its presentation to the Senate Budget Subcommittee No. 4, the Legislative Analyst’s Office urged the subcommittee to consider alternatives to suspending NOL deductions because it has the effect of treating similarly situated taxpayers unequally based on whether a taxpayer has steady or fluctuating profits each year, with the latter bearing a higher tax burden.