SENATE BILL NO. 151 "An Act excepting from the Alaska Net Income Tax Act the federal deduction regarding income attributable to certain domestic production activities; and providing for an effective date." This was the first hearing for this bill in the Senate Finance Committee. Co-Chair Green explained that this legislation would decouple a federal tax deduction from the Alaskan Net Income Tax Act. DAN DICKENSON, Director, Tax Division, Department of Revenue, explained that, beginning in 2005, the Qualified Production Activities Income (QPAI) section of the federal American Jobs Creation Act of 2004, would phase in tax relief to certain tax payers by excluding a specified percentage of their net income earned from extraction, production, and manufacturing activities in the United States. Several handouts, including "The American Jobs Creation Act of 2004", the "Tax Analysis Special Report" dated February 21, 2005, and the "Primer: IRC 199 Qualified Production Activity Income (QPAI)" dated April 4, 2005, [copies on file] were provided to Members to provide additional information. Mr. Dickenson stated that QPAI is "an attempt" by the United States (U.S.) Congress "to advantage these kind of activities" that occur in the nation "relative to those activities occurring abroad". The affected industries in this State would include the construction industry, the fishing and fish processing industry, the mining industry, and the refinery/production and marketing activities of the oil and gas industry. The QPAI would allow a three percent deduction of their QPAI for the specified activities in 2005-2006, a six percent deduction in 2007-2008, and a nine percent deduction thereafter. Mr. Dickenson stressed that the QPAI deduction would not be limited to new activity. Companies would operate "exactly" as they had before; however, under this new tax law, their "taxable income is going to decrease", as a percentage of the specified activities income "would be deducted, or excluded" from the calculation. Alaska typically "adopts the federal tax code by reference" and, as a result, the Alaska tax is based on the business's "worldwide or U.S." taxable income. As of the year 2005, QPAI would lower a business's taxable income by three percent. This would in effect reduce the amount of money Alaska would collect in taxes. Mr. Dickenson informed that the State has the option to decouple from federal law. This has occurred in other areas of State law: for example, Alaska's depreciation deductions differ from those of the federal government. He pointed out that the impact of QPAI would be more severe on Alaska than on any other state due to the fact that "natural resources ? form the base" of the State's taxable income. The State has limited service industry income in its tax base. Mr. Dickenson also observed that it is impossible for the State to mirror the concept of the federal QPAI, which is to encourage business activities in the United States rather than in other countries, as the State is prohibited from passing a law that would, in effect, lower a business's tax on an activity occurring in Alaska rather than in another state. Mr. Dickenson theorized that had the entire nine-percent deduction been in effect in Fiscal Year (FY) 2004, the State would have received approximately $24.7 to $27.4 million less revenue. He reminded that the deduction would gradually increase from three percent in the year 2005 to nine percent beginning in 2009. The projected revenue loss, by year, is depicted on page two of the aforementioned "Primer: IRC 199 Qualified Production Activity Income (QPAI)" in the section titled "Projected State Revenue Loss from QPAI Deduction". As reflected on that chart, the State would lose approximately $100 million in tax revenues over the next decade "as a consequence" of this federal tax. Mr. Dickenson reiterated that this federal tax and its economic policy goals could "not be replicated" by the State. In addition, the income of foreign oil and gas corporations is viewed in terms of corporations' worldwide income rather than their U.S. income. To that point, the State is required to create a deduction table based on those companies' worldwide income. "We believe that we would" be required to allow QPAI-like deductions for activities done in places outside of the United States such as Nigeria. The State would be prohibited "from drawing that line between interior U.S. and exterior U.S." activities in the same manner as allowed the federal government. Mr. Dickenson detailed that when the State audits a large multinational oil company, it relies on the federal government to conduct 95-percent of the work. While the State does not replicate any audit work that the federal government conducts, it does audit any income that might be attributed to Alaska or how a company managed rules exclusive to Alaska. Were the State to accept the QPAI deduction, it must be recognized that the federal government would not be auditing a company's construction activities occurring outside of the U.S.; therefore, the State would be required to either conduct that audit or ignore it. To that point, the fiscal notes accompanying this legislation do not reflect that, absent the adoption of this legislation, more State resources would be required as the State would be required to conduct audits "without the support of the federal Internal Revenue System. This effort would not be required were the legislation adopted. [NOTE Co-Chair Wilken assumed chair of the meeting.] 10:04:50 AM Mr. Dickenson noted that when this issue was discussed with Governor Frank Murkowski, "his quick reaction" was that this was "another unfunded federal mandate. Basically the feds have passed a law, it has desirable policy goals for the federal government". The State could recognize QPAI as being beneficial to taxpayers even though the State would lose revenue. However, unlike most unfunded federal mandates, the State, in this case, has the option to not participate. Mr. Dickenson clarified that were the State to decouple the QPAI for State taxes, that action would "not make any changes to the benefits the taxpayers receive when they file their federal income taxes". The State's action would have no affect on the rules governing a taxpayer and the federal government. Were the State to decouple the QPAI section of the federal revenue code, the affect on a taxpayer would be that the information filed on the taxpayer's federal tax return would be used as the basis for their State filing. This legislation would simply specify that one section of the federal tax code would not apply in this State. Mr. Dickenson qualified that this legislation would require some transitional rules to be developed in order to avert confusion regarding such things as estimated payments. Mr. Dickenson remarked that the backup material in Members' packets is extensive in comparison to "the brevity of the bill". The aforementioned "The American Jobs Creation Act of 2004" handout explains the history of the Act and briefly explains QPAI and the other sections of the Act. Were this legislation adopted, with the exception of the decoupling of the QPAI section, the other sections of the Act would become part of State law. Another handout, titled the "Tax Analysts Special Report" is a 24-page report that provides information to companies about how to deal with the Act. The third piece of material is a brochure notifying the Department's Certified Public Accountants (CPAs), who are required to undergo continuing professional education, about an upcoming conference that would educate CPAs on how "to maximize U.S. tax benefits on domestic production activities". Department participation in the conference might be beneficial, as it would allow the State to review tax codes and issues that could be relevant to the Alaska Tax Code. Mr. Dickenson stated that Chuck Harlamert with the Department's Tax Code Division could address Members' technical questions. 10:09:26 AM Senator Stedman voiced apprehension about whether this legislation is "as simple of an issue as stated". His understanding is that other than decoupling domestic production activities, no other activity would be excepted from the federal Act. To that point, he asked for further clarification regarding whether specific groups of industries, such as the oil and gas industry for instance, have been identified for exclusion. Mr. Dickenson responded that the State has not identified any particular industry: the oil and gas industry would be treated the same as the fishing and construction industries. However, the federal tax exemption's application to the oil and gas industry would have significant impact as that industry "is paying the majority of the dollars" under the State's tax system. Senator Stedman asked for further information about how the State would be affected by the federal nine-percent taxable income reduction. Mr. Dickenson explained that a company would calculate their taxable income based on revenues less taxable expenses. The Act would allow an additional deduction of up to nine percent of the income derived from qualified production activity. This would essentially allow some expenses to be "deducted twice". One limiting factor is that expenses could not exceed 50-percent of the business's W-2 wages. 10:12:02 AM Senator Stedman asked whether this legislation would permit a business to incorporate an appreciation schedule, referred to as an Accelerated Cost Recovery System (ACRS), which would allow appreciation to occur, for instance, over a 15-year period rather than a 30-year period. Such compression would increase deductions. Mr. Dickenson responded no, current appreciation schedules would continue unaffected. The only other change specifically included in this legislation would be an accelerated appreciation schedule in regards to an Alaska gas plant "for federal purposes". Senator Stedman asked, were this legislation to fail and the federal Act to become effective in its entirety, whether a business would be able to incorporate an ACRS instead of the regular depreciation schedule. Mr. Dickenson stated that neither the action of adopting or rejecting this legislation would provide a business "access to that". 10:13:38 AM Senator Olson understood that the theory behind this federal Act was to create jobs. He asked whether that theory would hold true for Alaska, regardless of the outcome of this legislation. Mr. Dickenson agreed that the purpose of the Act was to create jobs in the U.S. There is "no sense" that this would result in jobs in Alaska. The Act would essentially provide a "tax advantage if you create jobs" in the United States. No tax advantage would be provided were an entity to create jobs outside of the United States. Alaska is prohibited "from drawing that same line". There is no doubt that this legislation would provide the economic tools to encourage new jobs in the nation; however, "the point is that it doesn't help Alaska at all". Senator Olson calculated that, absent this legislation, the State would experience a $10,000,000 a year revenue loss for the next ten years. He inquired to the cost associated with the implementation of this legislation. Mr. Dickenson expressed that this legislation would not incur any expenses. To the contrary, costs would be incurred absent this legislation, as the State would be required to conduct deduction auditing on "QPAI-like activities that occur outside of the U.S". Senator Bunde questioned the Department of Revenue indeterminate Fiscal Note #1, dated March 22, 2005, [copy on file], as it does not reflect the cost to the State were the legislation not enacted, as specified in the Note's analysis on page two under the "Revenue Discussion" heading. Mr. Dickenson replied that the Department based its calculations on FY 2004, "which was a very high" taxable income year. Future taxable income level projections, which consider such things as falling oil prices, are lower than FY 2004. Projections indicate a range of losses from five million dollars in the initial years to $16 million dollars in FY 2013. Losses could amount to $25 million were a year similar to FY 2004 to occur. Co-Chair Green commented that the fiscal note is "a little bit misleading in that the information on page two must be brought into consideration. 10:17:12 AM Senator Stedman understood that this legislation would, in effect, opt the State of Alaska out of this federal "economic stimulus concept". To that point, he asked whether that action would affect the accounting practices of such entities as "Sub-chapter "S" corporations. Mr. Dickenson reiterated that the State would be uncoupling from only one section of a large multi-section piece of federal legislation. CHUCK HARLAMERT, Juneau Section Chief, Tax Division, Department of Revenue, expressed that while the QPAI section is "a major piece" of The American Jobs Creation Act of 2004, it does not have any specific affect on "S" Corporations under Alaska law. "Basically the affect of this bill would be to reverse in your Alaska tax return", one line item in the Other Deductions category of your federal tax return. "Only corporations who pay tax now would be affected; S Corps would not". Senator Stedman noted that the State has two options: to uncouple from the QPAI or to incorporate the federal Act in its entirety into State tax code. The question is, "from the corporate standpoint and from the State standpoint" which of these two options would encourage development of refineries and other large capital projects in the State. Mr. Harlamert voiced being unaware of any element in this federal Act that would incentivize construction of a refinery in Alaska; as regardless of the location, be it in Alaska, Texas, or any other state, the company would benefit from the federal tax exemption. This benefit would also be allowed under Alaska tax code were the State to adopt the Act in its entirety. Senator Stedman asked which state would be in a better position to attract development of a refinery: a state that has chosen not to opt out or one that opted out. Mr. Harlamert responded that that would depend on a mix of economic factors including the specific state's taxation. Texas's income tax laws, for example, differ from Alaska's. However, were the tax laws identical and Texas to accept the Act in its entirety and Alaska to uncouple the QPAI, the tax rate for the refiner would be lower in Texas. However, it should be noted that even were the refinery built in Alaska, the refiner would receive the same tax deduction in Texas; the refiner would not receive the tax deduction in Alaska regardless of whether the refinery was built in Texas or Alaska. In conclusion, regardless of where the refinery was built, the refiner would receive the same result under the State tax law. Senator Stedman stressed that the encouragement of economic development in the State is important. The concern is, therefore, that the State not position itself at a disadvantage in that regard. Senator Bunde asked whether any taxpayer would be testifying regarding this legislation. Co-Chair Green replied that none have, of yet, signed up to testify. Senator Bunde stated that that could be an indication of "a lack of concern" as he doubted their being unaware of the issue. Senator Stedman requested that the bill be held in Committee to allow for further discussion. Co-Chair Green agreed. Senator Olson referenced the "Status of QPAI in Other States" section on page three of the Department's "Primer: IRC 199 Qualified Production Activity Income (QPAI)" report, and asked whether the desire is to move the State from the "Conform to Federal QPAI Deduction" column to the "Decoupled from Federal QPAI Deduction" column. Mr. Dickenson responded that would be correct. Senator Olson commented that none of the states in the "Decoupled from Federal QPAI Deduction" column resemble the State of Alaska. Alaska is an oil producing state and has no personal income tax. He inquired to the reason that Alaska should consider decoupling when other oil producing states such as Oklahoma and Louisiana were listed in the "Conform to Federal QPAI Deduction" column. Mr. Harlamert expressed that the information reflected on page three was voluntary, was not all-inclusive, and was not up-to-date. One issue on which the State "stands alone in the nation for applying worldwide combined reporting" is that major industries in the State, specifically oil and gas companies, represent "80- percent of the State's tax base". There is no other state in which the implications of the bill would be "as dramatic as they are in Alaska". Mr. Harlamert continued that there "is a good argument for staying in conformity with federal law ? [it] keeps things simple". Minor timing differences should be avoided, as they would "generate headaches for taxpayers and the State for years to come". However, this legislation addresses "a permanent difference" ? the State "would never be able to recoup the revenue" once its gone. The affect of this Act would be more dramatic for Alaska than for any other state. Most states typically adopt federal standards in a manner similar to how Alaska does as that is the easiest approach: it "takes an effort to come forth and change it". Mr. Dickenson observed that West Virginia, Montana, and North Dakota, which are also considered resource states, have decoupling legislation pending. 10:26:53 AM Co-Chair Green recognized Arkansas, which has already decoupled from the Federal QPAI Deduction, as a resource state. Mr. Dickenson voiced that the Department would be available to work with the Committee to address further concerns. Co-Chair Green ordered the bill HELD in Committee. AT EASE 10:27:37 AM / 10:30:35 AM