California: New Law Clarifies Water's-Edge Election for Certain Unitary Foreign Affiliates

A bill (Assembly Bill No. 3372 (A.B. 3372)) signed by the California governor on September 29, 2020 contains provisions that prevent the unintended cancellation of certain water’s-edge elections due to a change in California’s definition of “doing business.” The new law provides that an otherwise valid water’s-edge election will not be terminated if a unitary foreign affiliate becomes subject to California income or franchise tax solely because it meets the definition of doing business in the state. A.B. 3372 essentially codifies administrative guidance issued by the California Franchise Tax Board (FTB).
 
The new law applies to water’s-edge elections made for tax years beginning on or after January 1, 2021.

 

Details

History of California’s Water’s-Edge Election

For over 30 years, California has permitted a unitary group of corporations to make a statutory election as to whether their income for franchise tax purposes is determined on a worldwide basis or a water’s-edge basis. A unitary combined reporting group can make a water’s-edge election only if each member of the group that is subject to tax in California makes the election at the same time. Therefore, a member that chooses not to make the water’s-edge election but that subsequently becomes subject to California nexus could terminate the election for the group, with the result that the group would revert back to worldwide reporting.
 
In 2011, California expanded the definition of doing business under Rev. & Tax Code Section 23101 to include sub-Section (b), which creates a “factor presence” nexus standard. This subsection provides that an entity is considered to be “doing business” in California if its total sales in the state exceed $500,000. The sales (and property and payroll) threshold is inflation-adjusted and is currently set at $601,067 for the 2019 tax year. As a result, some foreign affiliate corporations that were not subject to California taxation at the time the group made the water’s-edge election became subject to tax in the state because they exceeded the new factor presence nexus standard.
 
To temporarily address this issue, the FTB issued several notices (FTB Notice 2016-02, FTB Notice 2017-04 and FTB Notice 2019-02) indicating that a water’s-edge election will not be terminated when a unitary foreign affiliate becomes taxable in California only because of the expanded doing business statute. However, unless legislation was enacted, taxpayers would have had to rely on periodic administrative guidance without any certainty that the FTB would continue to allow this treatment in future tax years.

 

New Legislation Updates the Water’s-Edge Election

A.B. 3372 addresses this water’s-edge election issue. For taxable years beginning after December 31, 2020, foreign affiliates that were members of a unitary combined group at the time a valid water’s-edge election was made, but that were not subject to California tax at that time will not terminate the group’s water’s-edge election if they subsequently become "taxpayer-members" in California under Section 23101(b) simply because they are doing business in the state. The foreign affiliate corporation will be deemed to have elected with the other members of the unitary combined reporting group.