Elimination of Water’s-Edge Election
California proposed a bill (Senate Bill 567) in February 2017 which includes a provision to remove its Water’s-Edge Election. Many corporate taxpayers with multinational operations through subsidiaries and affiliates have been minimizing California tax liability and compliance complexities by utilizing the water’s-edge election. The bill will remove this election for taxable years beginning on or after January 1, 2017, if enacted. Generally, the election is good for 84 months, therefore corporate taxpayers with the election in place already would be able to report its income to California on the water’s-edge base until December 31, 2022.
California is one of the few states requiring worldwide combined unitary reporting. When a group of corporations conducts a unitary business, members of the commonly controlled group are generally required to file a combined report if the unitary activities are carried on within and without California.
In California, a group of corporations are deemed to be conducting a unitary business if the group meets any of the judicially developed and accepted three tests (the three unities, contribution or dependency, and flow of value tests). We omitted the discussion of the above-mentioned three tests as they are beyond the scope of our discussion. And, in general term, a commonly controlled group is a group of corporations connected through 50% or more of stock ownership or 50% or more of voting power, directly or constructively.
The unitary or combined approach ignores legal entities and geographical boundaries and focuses on the economic unit. In other words, under the California tax system (so called the “worldwide unitary combined reporting method”), the state applies its apportionment formula to the combined income of all corporations in a unitary group, including foreign corporate entities.
In 1986, legislation was enacted in California to permit a water’s-edge election to be made by certain taxpayers. The water’s-edge legislation was intended primarily to restrict California’s application of the worldwide combined reporting method of determining income from California sources. By electing water’s-edge, a taxpayer elects into a system of taxation, under which the scope of combined reporting is limited to certain corporations whose income is subjected to tax by the United States government (including domestic corporations, foreign corporations with ECI, or foreign corporations meeting the 80/20 rule). In other words, certain foreign group members would be excluded from the combined California report.
However, Senate Bill 567, if enacted, would eliminate the ability to make the water’s-edge election and the state’s boundaries for taxation would be extended to worldwide for corporate taxpayers with multinational operations through affiliates and subsidiaries.
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