California Assembly Bill 1790 (“AB 1790”), introduced earlier this year, proposes significant changes to California’s corporate income tax regime by phasing out the current water’s-edge election and moving toward broader worldwide combined reporting for multinational groups.

Under the current water’s-edge election system, many multinational businesses are generally permitted to exclude most foreign affiliates from the California combined reporting group. If the proposed legislation were enacted, certain multinational groups could instead be required to include foreign affiliates in a worldwide combined report, potentially increasing the amount of income considered in the California tax calculation. As a result, the proposal has generated concerns among multinational businesses regarding expanded filing complexity, additional disclosures, and potential increases in California taxable income.

However, there are several important considerations that taxpayers should keep in mind before concluding that the proposal would necessarily create significant California tax exposure.

First, the proposed legislation is still in the early stages of the legislative process and is far from becoming law. The bill must still proceed through multiple levels of committee review, legislative approval by both chambers, and ultimately gubernatorial approval before enactment. In addition, legislation of this nature is likely to face substantial scrutiny and opposition from multinational businesses, industry groups, and other stakeholders due to the potentially significant expansion of California’s taxing reach. As with many tax proposals, the final version of any enacted legislation could differ materially from the current draft.

Second, even if the proposal is ultimately enacted, worldwide combined reporting generally applies only where a “unitary business” relationship exists among related entities. The existence of foreign affiliates alone does not automatically subject a taxpayer to worldwide combined filing requirements.

California’s unitary business analysis is highly fact-specific and generally focuses on factors such as common ownership or control, centralized management, operational integration, intercompany dependency, and functional interrelationship among the entities. Accordingly, a separate legal and factual analysis would still be required to determine whether a particular multinational group is considered unitary for California tax purposes.

Lastly, and perhaps most importantly, California does not tax worldwide income in its entirety. Rather, California generally taxes only the portion of income apportioned to California under its apportionment rules. California currently utilizes a single-sales-factor apportionment methodology for many taxpayers. As a result, even in a worldwide combined reporting environment, taxpayers with little or no California sales may ultimately have minimal California taxable income.

Accordingly, the existence of worldwide combined reporting does not necessarily translate into significant California tax exposure, particularly where a taxpayer’s California sales factor is limited or nonexistent.

At this stage, we believe the proposal should be monitored carefully, but multinational businesses should avoid prematurely assuming that the proposal will automatically result in substantial California tax liabilities. As the legislative process evolves and additional guidance becomes available, taxpayers should evaluate their organizational structure, intercompany operations, and California sales footprint to assess any potential future implications.

We will continue monitoring developments relating to AB 1790 and provide updates as additional information becomes available.