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California Governor Gavin Newsom's Revised Budget summary proposes suspending California net operating loss (NOL) utilization and imposing a cap on the amount of business incentive tax credits companies can utilize, effective for tax years 2020, 2021 and 2022. In response to budgetary crises in the past, California has used similar NOL suspensions and tax credit limitations.

NOL suspension for medium and large businesses

Recently released NOL suspension draft language for the California Revenue and Taxation Code provides that NOLs would be suspended for tax years beginning on or after January 1, 2020 and before January 1, 2023. Similar to California's previous NOL suspensions, the draft language includes an extended carryover period for the suspended NOLs with an additional year carryforward for each year of suspension.

Currently, the draft language does not include a requirement that the taxpayer must have been able to use at least part of the NOL carryforward during the suspension period to be eligible for the extended carryover period. However, based on the prior experience with California NOL suspensions and the controversy on the extended carryover period, it is possible that a similar requirement will be added as the budget bill goes through the legislative process.

The draft language includes a carve out from the NOL suspension for small businesses (i.e., a taxpayer with net business income of less than $1 million dollars for the tax year). A similar relaxation of the NOL suspension rules appeared in earlier enactments.

The proposed suspension would apply only to California NOLs for 2020, 2021 and 2022. Accordingly, for 2019, corporate taxpayers will still be able to utilize NOL carryforwards on their California returns. California conforms to the federal Tax Cuts and Jobs Act's (P.L. 115-97) (TCJA) elimination of NOL carrybacks applicable to NOLs attributable to tax years beginning after December 31, 2018, but does not conform to the TCJA's other changes to the NOL provisions (i.e., unlimited carryforward, 80% deduction limitation)¹ or to the NOL changes made by the CARES Act. Thus, for 2018, NOLs must be carried back two years by filing amended returns to claim the NOL carryback unless a timely election was made to waive the carryback.

Limit on business incentive tax credits

While draft language has been released for the proposed NOL suspension, as of the date of this Tax Alert, no further guidance has been provided on limiting business incentive tax credits. The Full Budget summary proposes to limit business incentive tax credits from offsetting more than $5 million of tax liability for 2020, 2021 and 2022. An explanatory paragraph states:

Business incentive tax credits directly reduce corporate tax liability and are generally intended to encourage a certain type of behavior, such as research and development, which may occur to a lesser extent in the absence of the credit. In 2018, businesses reduced their corporate tax liability by over $2.9 billion through the use of credits, with $2.4 billion from the research and development tax credit.

This suggests that the $5 million limit on utilizing business incentive tax credits, at minimum, would apply to California R&D credits. The proposed limitation may also apply to other California credits.

Short timeline for California to approve budget bill

The Governor's budget now goes to the California legislature for negotiations, with a constitutional deadline of June 15, 2020, for the legislature to approve a budget bill for California's fiscal year beginning July 1, 2020. Based on California's Proposition 26, laws that increase tax need a two-thirds majority to pass. Currently, California Democrats have a two-thirds majority in both the Assembly and Senate and thus the Governor's budget proposal, after revisions, would be expected to pass.

Implications

With preparations for the 2019 tax filings currently underway, businesses will want to understand the impact of these proposed changes and analyze both their 2019 and 2020 California filing positions.

While the June 15 deadline is approaching, there is still time for changes to be made to the Governor's proposals. EY will continue to provide updates as they become available.

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ENDNOTES

¹ Cal. Laws 2019, ch. 39, §24 (amending Cal. Rev. & Tax Code §24416), enacted July 1, 2019.