REPORT FROM

OFFICE OF THE CITY ADMINISTRATIVE OFFICER

Date: September 18, 2012 CAO File No.

Council File No. 11-0600
Council District: All
To: Antonio R. Villaraigosa, Mayor
Herb J. Wesson, Council President
Eric Garcetti, Chair, Jobs and Development Committee

From: Miguel A. Santana, City Administrative OffiC~ C . J;A-.--

Subject: EXTENSION OF BUSINESS TAX EXEMPTION ORDINANCE FOR NEW

BUSINESSES

SUMMARY

The City of Los Angeles first implemented a new business tax exemption (NBE) for new businesses
in 2001, consisting primarily of an exemption from the minimum tax due for the first year of operation
(C.F. No. 98-2358). Over the years the exemption, also referred to as a tax holiday, has been
modified with goal of attracting new businesses to the City. On August 6, 2010, the City Council
adopted an ordinance to expand the NBE for up to three years for those businesses that
commenced operations between January 1,2010 and December 31,2012 and added an exemption
from other business taxes to the existing minimum tax exemption (C.F. No 09-1858-S1). This three
year extension is set to expire December 31,2012.

On November 16, 2011, City Council directed the City Attorney to prepare an ordinance extending
the NBE through December 31,2015 (C.F. No. 09-1914-S9). Additionally, the City Council adopted a
motion directing the Office of Finance to respond to questions concerning the efficacy ofthe tax
holiday, specifically: the number of new businesses that registered and took advantage of the tax
holiday during the first three years; the amount of business taxes waived during the first three years;
and whether the new businesses generated other fees or taxes. Also, the Offices of the City
Administrative Officer and Finance were instructed to prepare a financial analysis of the first three
years and to determine if there was a net gain to the City.

In summary, from tax periods 2010 through 2012, approximately 11,100 new businesses have
claimed the NBE and $30.1 million in business tax receipts have been waived for all NBE claimants.
Offsetting revenues have been identified, but whether the revenue resulted in a net gain to the City
cannot be determined. The data and findings are provided in greater detail in the discussion below.

The City Attorney has submitted its March 20, 2012 report and ordinance relative to amending
Subsection (a) of Section 21.30 of the Los Angeles Municipal Code to extend the new business
exemption from business taxes by another three years (C.F. No. 12-0402). While conclusive data
demonstrating a net gain is currently unavailable, based on the City's economic development and job
growth priorities, this Office supports this proposal and tax relief measures that are specifically
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targeted to those industries that will generate economic and revenue growth, as opposed to the
wholesale elimination of the business tax.

FINDINGS

Number of New Businesses

The expanded three-year business tax exemption became effective for the 2010 tax period. The
existing ordinance already provided an exemption from two years of business taxes for firms with
gross receipts less than $500,000. The 2011 tax period is the first period where firms reporting gross
receipts greater than $500,000 claimed the exemption. The 2012 tax period is the first where all firms
could claim the third year exemption. To date, approximately 15,600 firms have claimed the NBE
from 2010 through 2012.

The impact of these changes may be seen on Chart 1 where the total number of firms claiming the
exemption increases by 911 to 4,171 firms (27 percent) in 2011 tax period and nearly doubles to
8,189 firms in the 2012 tax period. The chart illustrates the number of all firms claiming the NBE
within the previously established gross receipts threshold of $500,000 and those firms now claiming
the NBE with gross receipts in excess of $500,000 in tax periods 2011 and 2012, and it distinguishes
additional third year of the exemption.

Chart 1. Total firms claiming the New Business Exemption (NBE).

9,000
8,189
8,000
7,000
6,000
5,000 ill $500k + Yr 3

4,000 < $500k Yr 3

3,000 I!I $500k + Yr 1&2

2,000 '" < $500k Yr 1&2
1,000
o
2009 2010 2011 2012
Tax Period

Chart 2 provides a breakdown of those firms claiming the new (first), second or third year business
exemption, illustrating that the majority of the growth in NBE claimants in 2012 is attributed to the
third year of the credit. (Note that the total does not equate to all businesses claiming the NBE in
Chart 1 above.)
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0116-00001-0000 3

Chart 2. Total firms claiming the NBE in first, second or third year.

9,000

8,000

7,000
6,000

5,000
Third Year
4,000
I!l Second Year
3,000
Ell First Year
2,000

1,000

0
2009 2010 2011 2012
Tax Period

With regards to the number of new firms claiming the exemption (Le., first year business exemption),
the figure cannot be easily determined by the data collected by the Office of Finance, as a tax filer
may claim an exemption from the gross receipts tax under different mechanisms. For example, a firm
may opt for the small business exemption rather than the NBE, or the firm may not file for the first
year exemption and instead submit a late filing in the second year of operation. While a business
may not have claimed the new (first) year exemption, it may have claimed the exemption in a
subsequent tax period, categorized as "additional tax exemption" by the Office of Finance. Chart 3
provides a breakdown of firms that claimed the new business exemption or the additional exemption
to provide a better picture of first year firms claiming the exemption. To date, approximately 11,100
new businesses have since claimed the NBE from 2010 through 2012. Note that firms represented
under the additional exemption were likely first established in the previous tax period.

While there is an increase in the number of firms claiming either exemption in the tax periods after
the enactment of the ordinance (2011 and 2012), some of this increase may be attributable to the
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0116-00001-0000 4

expanded eligibility for the exemption, rather than to an increase in the number offirms establishing
themselves within the City. For example, in the 2012 tax period approximately 17 percent (600 firms)
of the new firms claimed the NBE under the higher exemption for gross receipts in excess of
$500,000, leaving the number of new firms with gross receipts less than $500,000 relatively
unchanged from the 2009 tax period, before the expanded NBE was approved.

Business Tax Waived

By extending the exemption to firms with gross receipts in excess of $500,000, the City realized
$6.25 million in less business tax revenue in 2011 and $15.03 million less in 2012. Alternatively, by
extending the exemption to a third year, the City realized $9.02 million in less business tax revenue
in 2012. The combined impact of forfeited receipts between the two exemptions is approximately
$16.8 million annually. For tax periods 2010 through 2012 approximately $30.1 million in business
tax receipts have been waived for al/ NBE claimants. Chart 4 illustrates the impact of extending the
exemption to additional firms and tax periods.

Chart 4. Exempted business taxes by firms' gross receipts and year of exemption (millions)

19.14
20.00 '.--- ------ ...~--.

15.00
L1!! $500k + Yr 3

< $500k Yr 3
10.00 --.---. - -_ .
iii $500k + Yr 1&2

5.00 lliil < $500k Yr 1&2

0.00
2009 2010 2011 2012
Tax Period

Offsetting Revenue
The availability and confidentiality of data preclude drawing substantial conclusions about the
generation of additional revenue from taxes or fees. The Office of Finance is only able to determine
offsetting revenue that is tracked in the LATAX system (e.g., parking occupancy tax). Table 1 below
is a breakdown of other tax revenue generated by 48 firms that received the NBE credit in tax period
2012 as reported in the LATAX system. Note that the amount of offsetting revenue is dependent on
the mix of businesses that are formed.
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Table 1. Offsetting revenues generated by firms claiming the NBE in 2012

Parking Occupancy Tax $554,586
Transient Occupancy Tax $8,232,548
Fire Permits $3,276
Police Permits $4,292
Communication Users Tax $10,573
Tobacco Permits $300
Total: $8,805,575
Other revenues collected by other governmental or private entities (e.g., sales and use taxes) and
fees for City services where tax identifying information is not collected cannot be connected to NBE
firms. Based on an analysis ofthe North American Industry Classification System codes designated
by new business tax filers, it is roughly projected that less than 20 percent offirms claiming the NBE
fall within categories that have a clear nexus with sales or other use tax revenue (e.g. restaurants,
retail sales, gasoline stations). The remaining 80 percent fall into service categories (e.g., legal
services, property management, physician offices) where there less direct correlation with tax
revenue; although non-business tax revenue would be realized from business activities.

Net Gain Analvsis

The 2012 tax period was the first year where the overlapping impact ofthe eliminated gross receipts
threshold and the third year of exemption were in effect ($15 million and $9 million in forfeited
receipts, respectively, and $16.8 million combined). With full implementation of the NBE now in
effect, further significant increases in forfeited receipts are not projected. The amount forfeited
receipts will likely increase (or decrease) in conjunction with the change of net business tax receipts.

This Office is unable to determine whether there has been or will be any net gain to the City as a
result of the extended NBE, due to the complexity of the economic analysis required to quantify
offsetting revenue increases. Previous analysis of various proposals to eliminate the business tax
reported that reduced business taxes would increase economic output and employment; however,
whether the increased activity would generate enough non-business tax revenue was uncertain (C.F.
No.09-1914-S8).

As the City's projected revenue growth is outpaced by the projected increases in expenditures for the
next four years, the City must be judicious in implementing business tax relief. Measures should be
targeted to those firms that produce the most economic gain or revenue growth. Alternatively broad
measures without offsetting revenue elsewhere should be temporary to avoid the permanent loss of
general fund revenue. The reinstatement of eliminated taxes is prohibited under Proposition 218
without a vote from the public.

As a sunset clause is included in the proposed ordinance to extend the NBE, adoption of this tax
relief measure will not result in a permanent loss of revenue.
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RECOMMENDATIONS

It is recommended that the City Council, subject to the approval of the Mayor, adopt the ordinance to
extend the New Business Exemption from December 31,2012 to December 31,2015 as submitted
by the Office of the City Attorney on March 20, 2012 (C.F. No. 12-0402).

FISCAL IMPACT

Extending the New Business Exemption to 2015 may result in the City continuing to forgo at least
$16.8 million in General Fund revenue from the business tax through the 2017 tax period. Offsetting
tax revenues are expected to be realized as a result of new business formation, including sales,
parking occupancy, transient occupancy and utility users taxes.

MASRPC:BCIMCK: 01130034