California Suspends NOLs and Caps Credit Usage for Three Years

Executive Summary

California makes several important tax changes as it looks to increase revenue.

In late June, California Acting Gov. Eleni Kounalakis and Gov. Gavin Newsom signed Senate Bill 167 and Senate Bill 175, respectively, suspending the net operating loss deduction for businesses with greater than $1 million in income, limiting business tax credit utilization, and retroactively reversing the holding of the recent Microsoft decision from the California Office of Tax Appeals (OTA). The tax changes included in the bills are summarized below.

Net operating losses suspended

The tax bills suspend the net operating loss (NOL) deduction for tax years beginning on or after Jan. 1, 2024, and before Jan. 1, 2027. The suspension applies to taxpayers with greater than $1 million in net income for the tax year. To the extent that any NOL deduction is denied as a result of this suspension, the allowable carryforward period for these NOLs is extended by the following:

• Three years for losses incurred in tax years beginning prior to Jan. 1, 2024
• Two years for losses incurred in tax years beginning on or after Jan. 1, 2024, and prior to Jan. 1, 2025
• One year for losses incurred in tax years beginning on or after Jan. 1, 2025, and prior to Jan 1, 2026

Additionally, Senate Bill 175 includes an annual revenue trigger provision restoring the deduction for 2025 and/or 2026 if, for each year individually, it is determined by May 14 that the general fund is sufficient without the impact of the NOL suspension and credit limitation. The suspension pause for the respective year must also be accounted for in the annual budget.

Limitation on credit utilization

The tax bills also include a limitation on the utilization of certain business tax credits to offset California net income. For taxable years beginning on or after Jan. 1, 2024, and before Jan. 1, 2027, credits may not be used to offset more than $5 million in taxable income per year, unless a specific exemption applies. Most exemptions relate to personal income tax credits such as for earned income, low-income housing and foster youths, and the credit for the elective pass-through entity tax. The $5 million limit applies in aggregate to members of a group filing a California corporate income tax return on a combined basis. The carryforward period for any credits disallowed as a result of the limitation is extended by the number of tax years that any portion of the credit was disallowed.

Senate Bill 175 allows taxpayers to make an irrevocable election to receive an annual refundable credit amount over a five-year period, beginning the third taxable year after the election is made. The refundable credit is equal to 20% of the qualified credits that would otherwise have been available to the taxpayer but for the $5,000,000 limitation.

Similar to the NOL suspension, the credit limitation will not apply for tax years beginning on or after Jan. 1, 2025, and before Jan. 1, 2027 if an annual revenue trigger is met and provided for in the respective annual budget.

Response to the Microsoft decision

Senate Bill 167 specifically excludes from the sales factor apportionment any items of income that are not included in the taxpayer’s California net income. The change is a swift response to the decision of the OTA in favor of the taxpayer in the Microsoft case. In Microsoft, the OTA held that foreign dividends were includable in the sales factor denominator despite not being included in the taxpayer’s net income subject to apportionment. The decision was issued as non-precedential, leaving taxpayers uncertain as to whether to pursue a similar position for refund claims or on an originally filed return. Instead, the bill codifies a 2006 ruling from the Franchise Tax Board (FTB) that excludes from the apportionment formula any amount that does not give rise to apportionable income, effectively reversing the finding of the OTA in Microsoft. The bill explicitly states that this provision is not a change in law or practice of the FTB but is simply a declaration of existing law.

Although the decision was non-precedential, other similarly situated multinational companies had considered and/or submitted refund claims applying the reasoning in Microsoft, including foreign dividends in its sales factor denominator thereby reducing the California sales factor. Senate Bill 167 forecloses these refund claims from taxpayers.

Industry specific business tax provisions

Senate Bill 167 includes other industry-specific provisions affecting corporate and business taxpayers. First, it extends existing law that allows state-licensed cannabis businesses to deduct their ordinary and necessary business expenses for state tax purposes through tax year 2030. Such expenses are not deductible for federal purposes.

Second, certain tax subsidies for the oil and gas industry are eliminated:

• Eliminates the deduction for drilling and development costs incurred on or after Jan. 1, 2024
• Eliminates the depletion deduction for refiners of crude oil with average daily refinery runs for a taxable year that are greater than 75,000 barrels
• Provides that the credit for qualified oil recovery costs only applies for tax years beginning prior to Jan. 1, 2024, with full repeal of the credit effective Dec. 1, 2024.

Elimination of refund for sales tax obligations on bad debt

Under current law, retailers and certain affiliates under section 1504 of the IRC are allowed to take a California sales and use tax bad debt deduction. Senate Bill 167 suspends the deduction for three years. Beginning Jan. 1, 2028, the deduction is reinstated but excludes the previously expanded inclusion of affiliates, such as lenders. Bad debt deductions are eligible for accounts found worthless and written off by Dec. 31, 2024.

Takeaways

California’s budget for the fiscal year aims to raise revenue through tax increases on corporate and other business taxpayers. The state is attempting to close its budget deficit without enacting any broad-based tax increases on individuals. Business taxpayers with significant attributes will be most impacted by the changes, as the tax bill includes a suspension of the NOL deduction as well as a limitation on tax credit utilization. The tax legislation is closely aligned to an earlier version proposed by Gov. Newsom, with one key difference being an acceleration of the NOL suspension and credit limitation by one year in the bill that was passed by the legislature. Corporate taxpayers should consider the impact of Senate Bills 167 and 175 in their financial statements for the second quarter of 2024.

California taxpayers with questions about this year’s tax legislation should consult with their state and local tax advisers.