By Anthony Diosdi
Many California corporations also have foreign subsidiaries. This often leads to complex tax situations, including the issue of determining income for the unitary group of corporations (typically consisting of a U.S. parent corporation and one or more foreign subsidiary corporations). There are two approaches to dealing with unitary group members that are incorporated in a foreign country or conduct most of their business abroad. One approach is a worldwide combination, under which the combined report includes all members of the unitary business group, regardless of the country in which the group member is incorporated or the country in which the group member conducts business. The alternative approach is a water’s-edge combination, under which the combined report excludes group members that are incorporated in a foreign country or conduct most of their business abroad.
Overview of State Corporate Income Taxes
Most states that impose a corporate income tax use either federal taxable income before the net operating loss and special deductions (federal Form 1120, line 28) or federal taxable income (federal Form 1120, line 30) as the starting place for computing state taxable income. The use of the federal tax base as the starting point greatly eases the administrative burden of computing state taxable income. The use of the federal tax base as the starting point greatly eases the administrative burden of computing state taxable income. However, most states require numerous addition and subtraction modifications to arrive at state taxable income. Examples of common addition modifications include interest income received on state and municipal debt obligations, state income taxes, royalties and interest expenses paid to related parties. Examples of common subtraction modifications include interest income received on federal debt obligations, state net operating loss deductions, state dividends-received deductions, and federal global intangible low-taxed income or GILTI, Subpart F, and Internal Revenue Code Section 78 gross-up income.
States employ a wide variety of consolidation rules for a group of commonly controlled corporations. California typically requires members of a unitary business group to compute their taxable income on a combined basis. Roughly speaking, a unitary business group consists of two or more commonly controlled corporations that are engaged in the same trade or business, as exhibited by such factors as function and centralized management. See Practical Guide to U.S. Taxation of International Transactions, Sixth Edition, CCH (2007), Robert J. Misery, Jr and Michael S. Schadewald. To prevent double taxation on worldwide income, California permits unitary business groups to make a water’s-edge election.
Worldwide Versus Water’s-Edge Combined Reporting
Requiring a multinational corporation to compute its state taxable income on a worldwide combined reporting basis is controversial for a number of reasons, including: 1) the difficulty of converting books and records maintained under foreign accounting principles and in a foreign currency into a form that is acceptable to the state; 2) the inability of the state to audit books and records located in foreign countries; and 3) distortions in the property and payroll factors caused by significantly lower wage rates and property values in developing countries. Despite these practical difficulties, the constitutionality of requiring a multinational corporation to compute its state taxable income on a worldwide combined basis is firmly established. In Container Corp. of America v. Franchise Tax Board, 463 U.S. 159 (1983), the United States Supreme Court ruled that California’s worldwide combined reporting method was constitutional with respect to a U.S.-based parent corporation and its foreign subsidiaries. In Barclays bank plc v. Franchise Tax Board, 512 U.S. 298 (1994), the United States Supreme Court held that California’s worldwide combined reporting method was also constitutional with respect to a foreign-based parent corporation and its U.S. subsidiaries.
In spite of these legal victories, the international business community took a dim view of combined unitary reporting and, in particular, the practice of requiring a worldwide combination. This ultimately resulted in California repealing a mandatory worldwide combined reporting requirement and allowed for a unitary group to make a water-edge election. A water-edge election is made for an initial period of 84 months and remains in effect thereafter, year by year, until terminated by the taxpayer. For California tax purposes, a water’s-edge group includes the following members of the unitary group: 1) corporations whose average property, payroll, and sales factor in the United States is 20 percent or more; 2) corporations organized in the United States that have more than 50 percent of their stock controlled by the same interests; 3) foreign sales corporations and domestic international sales corporations; 4) controlled foreign corporations or “CFCs”, which are included based on the ratio of their current year income to current year E&P; and 5) any other corporations with U.S. located business income, which are included to the extent of their U.S. located income and factors. See Calif. Reg. Section 25110. If a water’s-edge election is not made, the group members that are taxable in California compute their income on a worldwide combined basis.
The effect of a water’s-edge election is to make the determination of state tax more predictable. Whether or not it is beneficial for a taxpayer to make a water’s-edge election typically depends on the facts and circumstances of the case. A major advantage of making a water’s-edge election is that it avoids the compliance burden of a worldwide combination, which can be substantial, particularly if the unitary business group includes numerous foreign members. On the other hand, a water’s edge election could increase the taxpayer’s California tax, particularly if the unitary group’s state operations are more profitable than its foreign operations.
The water’s-edge analysis dramatically changes when a foreign corporation that is a member of a unitary group conducts business (even without physical presence) in California.The economic nexus rules under Cal. Rev. and Tax Code Section 23101 can result in the foreign corporation having a filing requirement in California without any physical presence. For foreign corporations of a unitary group that generates revenue from intangible assets, these nexus rules can be extremely unfavorable. A foreign corporation that has an economic nexus with California will have a state filing requirement and be subject to California income tax. However, if the foreign corporation has established an economic nexus in California without any physical presence in the state, the foreign corporation can make a water’s-edge election to avoid including its income in a combined report. Some or all of the foreign corporation’s income will not be excluded from the combined report, however, if the foreign corporation has effectively connected income (“ECI”) or a 20 percent or higher U.S. apportionment factor will result in an income inclusion. When a foreign corporation engages in a trade or business in the United States, it likely has received income that is ECI.
A foreign corporation is considered to be conducting business in California and engaging in a trade or business if it actively engages in any transaction for the purpose of financial or pecuniary gain or profit. A foreign corporation also conducts business in California if it has a minimum amount of property, payroll, or sales in California. Can a foreign corporation that is engaged in a trade or business in California make a water’s edge election to avoid reporting foreign source income on a California income tax return? The general rule is that if a foreign corporation makes a water’s-edge election it can exclude its income from a water’s edge return; that is, unless it has either ECI or a 20 percent or higher U.S. apportionment factor. Thus, if the foreign corporation has ECI, then it will be included in the combined report to the extent of its ECI. If a foreign corporation does not have any ECI, it may still be included in the water’s-edge combined report if its U.S. apportionment percentage is 20 percent or more. California Revenue and Tax Code Section 25110(a)(1)(B) states that any corporation (other than a bank) will be fully included in the water’s-edge combined report regardless of where it is incorporated if the average of its property, payroll, and sales factors within the United States is 20 percent or more. See The Tax Advisor, Water’s-Edge Election: Effectively Connected Income and the 20% Rule in California, Chris Berkness, Estrilla A. McKinley, and John Yoak (May 1, 2016).
California allows corporations to elect to compute income attributable to California sources on a water’s-edge combined report (Form 100W). This election results in the exclusion of affiliated foreign corporations from the combined California report. This results in the U.S. corporation only being required to pay California tax on California sourced income. The election is made on Form 100-WE and must be attached to a timely filed original Form 100W. Given the 84 month election length, it is important to consider the following before making a Water’s-edge election:
1. Do the corporation foreign subsidiaries generate a loss and if so, is this loss expected to continue. If the losses from foreign subsidiaries are expected to continue in the future, these losses could be utilized to reduce state of California income tax liabilities.
2. Do the corporate foreign subsidiaries generate income? If so, this foreign source income could increase taxable income apportioned to California.
3. Does the corporation’s foreign subsidiaries generate revenue from intangible assets? In these cases, failing to make a water’s-edge election can result in an unfavorable result.
There are a number of complexities and nuances to consider before making the California water’s-edge election. For this reason, a California international tax attorney must model the potential implications of making the election.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.