California's water's-edge taxation of international businesses: 2003 Update.

Practitioners and taxpayers who are familiar with state tax issues are well aware of California's historically aggressive position regarding taxation of international businesses. Indeed, California's victories in the Supreme Court of the United States in both Container Corporation of America v. Franchise Tax Board, 463 U.S. 159 (1983), and Barclays Bank PLC v. Franchise Tax Board, 512 U.S. 298 (1994), validated California's use of the so-called worldwide unitary method of taxation with respect to California corporate taxpayers with international operations. To date, California's ambitions to tax international businesses have only been tempered by the "water's-edge" election provisions, which were first passed by the California legislature in 1986 and subsequently amended on several occasions.

California's current fiscal straits arguably make international businesses with a taxable presence in the State a potentially attractive target for tax administrators and the legislature. Accordingly, it is important for those companies, as well as those considering entry into California, to understand how breaking developments may affect their tax liability. This article explores a number of current issues involving the California water's-edge election.

The Water's-Edge Election

As a general rule, California utilizes the worldwide method of unitary taxation, under which all the worldwide activities (i.e., payroll, property, sales and business income) of all the members of a California taxpayer's "unitary business" are taken into account in determining the corporate income/franchise tax for that California taxpayer. In 1986, the California legislature enacted a "water's-edge" election, under which certain foreign operations of a taxpayer's worldwide unitary business were excluded from the tax base. Since 1986, the California legislature has made numerous changes to the election, with the largest and most significant changes being made in 1993 under the shadow of the then-pending litigation in the Barclays Bank case. (1)

The basic provisions of the current water's-edge election are, as follows. There are six classifications of entities included in the water's-edge group under an election. Four are wholly included, and two are partially included: The four wholly included types of entities are:

* Domestic international sales corporations (DISCs) and foreign sales corporations (FSCs);

* Corporations, other than banks, with 20 percent or more average apportionment factors within the United States, regardless of where incorporated;

* Corporations incorporated in the United States, more then 50 percent of whose stock is owned or controlled directly or indirectly by the same interests, except for corporations making an election under section 936 of the Internal Revenue Code; and

* Export trade corporations.

The two partially included types of entities are:

* Controlled foreign corporations (CFCs), as defined in section 957 of the Internal Revenue Code, that have Subpart F income. Generally, the income and apportionment factor denominator amounts of such an entity are included based on the ratio of the total Subpart F income of the entity for the year to its current year earnings and profits; and

* Foreign incorporated banks and corporations not meeting any of the four tests above for full inclusion, are included to the extent they have (1) income that is effectively connected income (ECI) with a U.S. trade or business; or (2) U.S.-source income that is "business income" under California law, regardless of whether or not it is considered ECI for federal purposes.

The election is currently made by entering into a contract with the California Franchise Tax Board (FTB). For the election to be effective, all affiliated California taxpayers engaged in a unitary business must file on a water's-edge basis. The contract is for an initial period of seven years, and must be entered into by all unitary taxpayers at the time the original return is filed for the first taxable year the contract is to be effective. Once the contract period starts, it will automatically renew on the anniversary date of the contract, until a Notice of Nonrenewal is filed. In other words, unless a Notice of Nonrenewal is filed, an additional year is added each year to the initial seven-year contract period upon the anniversary of the election, thereby making the election perpetual.

936 Possessions Corporation Issues

Consistent with the fact they are excluded from a federal consolidated return, section 936 possessions corporations are generally excluded from the water's-edge group. (Cal. Rev. & Tax. Code [sections] 25110(a)(3).) A 936 possessions corporation with a 20 percent or more average U.S. factor, however, is 100 percent included in the water's-edge group. (Cal. Rev. & Tax. Code [sections] 25110(a)(2); 18 Cal. Code of Regs. [sections] 25110(d)(1).) A 936 possessions corporation also will be included in the water's-edge group to the extent of any income derived from or attributable to sources within the United States or any factors (i.e., payroll, property or sales) assignable to a U.S. location. (Cal. Rev. & Tax. Code [section] 25110(a)(4).)

A common California issue involving the treatment of 936 possessions corporations that have been excluded under a water's-edge election involves the application of the section 936(h) profit-split method. This allows, for federal tax purposes, a 50-50 split between the possessions corporation and its U.S. affiliates of the profits from manufacturing intangibles employed in Puerto Rico. Thus, 50 percent of the profit is reported on the federal tax return of the U.S. affiliates and is therefore not eligible for the federal Possessions Tax Credit. In FTB Legal Ruling 2003-2 (dated May 6, 2003), the California FTB recently announced California has not conformed to the federal "profit-split" method of allocating income and deductions of a possessions corporation under section 936(h)(5)(C)(ii)(I) of the U.S. tax code. Thus, a California water's-edge taxpayer does not have a right to use the federal profit-split method to allocate income and deductions involving a 936 possessions corporation that was excluded from the unitary group under the election. FTB staff views Legal Ruling 2003-02 as a formalization of a position taken informally by FTB for a number of years.

Because California has no counterpart to section 936(h), an excluded 936 possessions corporation that used the federal profit split on its federal return has audit exposure for California state tax purposes under California's version of section 482 of the Internal Revenue Code. (Cal. Rev. and Tax. Code [sections] 25114.) California's version of section 482 gives the FTB authority to adjust transactions between members within and without the water's-edge group in order to prevent evasion of taxes or to clearly reflect the income of any of the members. Accordingly, a taxpayer who makes the water's-edge election and has an (excluded) 936 possessions corporation that uses the profit-split method for federal tax purposes may be subject to a California 482-type audit by the FTB. As a practical matter, however, if the taxpayer's use of the profit-split method clearly reflects the income of the 936 possessions corporation and the water's-edge group, audit exposure should be minimal, even though the taxpayer has no "right" to use the profit-split method for California purposes.

Subpart F Income Issues

A federal controlled foreign corporation (CFC) is generally defined as an entity that is organized in a foreign country and is owned greater than 50 percent by U.S. shareholders. The treatment of Subpart F income in the water's-edge group is significantly different from its treatment for federal tax purposes. As previously mentioned, Subpart F income is partially included in the water's-edge group. (Cal. Rev. & Tax. Code [sections] 25110(a)(6).) In general, the amount of Subpart F income to be included is calculated by a fraction, the numerator of which is the Subpart F income for the year and denominator of which is the earnings and profits for the year.

A recent trial court decision illustrates the complexity of this calculation. In Amdahl Corporation v. Franchise Tax Board,(2) a California court in San Francisco considered how to compute the fraction in the case of a CFC that receives dividends from an affiliate which is also a CFC. The issue is complicated by another California statutory provision providing that dividends paid out of unitary income of a subsidiary are to be eliminated from the income of the recipient. (Cal. Rev. & Tax. Code [sections] 25106.) The court concluded that based upon that elimination provision, dividends paid out of unitary income of a lower-tier subsidiary should be excluded from the computation of the amount of Subpart F income included in the water's-edge group. Thus, such inter-CFC dividends must be excluded from the numerator (Subpart F income) and denominator (earnings and profits), and the amount of the income of the CFC to which the inclusion ratio is to be applied.

A second Subpart F-related issue in Amdahl concerns the deemed source of dividends. When a CFC pays a dividend to its parent corporation, a portion of that dividend may be paid out of the income of the unitary group (and therefore eliminated under Cal. Rev. & Tax. Code [sections] 25106) and a portion may be paid out of other income. The court addressed the issue of how to source the dividends between income of the unitary group and other income. The FTB takes the position that when a lower-tier subsidiary whose income and apportionment factors are fully included in the water's-edge group pays a dividend to a CFC, which, in turn, distributes the amount received as a dividend to its shareholder, then the latter dividend should be deemed to be paid only partially (i.e., pro rata) out of the income of the unitary group (i.e., to the extent of the inclusion ratio of the CFC) and partially out of non-unitary income (i.e., to the extent of the remainder). The court rejected FTB's approach, concluding instead that section 25106 should be applied to dividends from CFCs that are partially included in the water's-edge group in a manner that deemed dividends are to be distributed first from income that has already been included in the unitary group, to the extent thereof, and then from non-unitary income.

A third CFC issue in Amdahl concerns whether and how section 959(b) applies to a water's-edge group, and specifically whether its provisions to exclude from income previously taxed earnings and profits apply in California. The court concluded that the FTB adopted the federal definition of Subpart F income in section 952, but did not adopt section 959. Hence, section 959(b) has no application to the CFC water's-edge calculations.

The FTB and Amdahl have both appealed from the Amdahl trial court decision, and the case is currently awaiting decision in a California court of appeal.(3)

Water's-Edge Inventory Issues

The treatment of intercompany gains on certain inventory sales under a California water's-edge election continues to present issues for transactions occurring before January 1, 2001.(4) The principal questions involved are whether and to what extent a California taxpayer must recognize (upon the sale of inventory outside the unitary group) intercompany inventory gains realized by a foreign-based member of the taxpayer's worldwide combined reporting group following the taxpayer's water's-edge election and the subsequent disaffiliation of the foreign-based member of the worldwide combined reporting group. For instance, this situation can arise when a foreign parent corporation sells inventory to its subsidiary in the United States (e.g., the U.S. distributor) that is a California taxpayer and both corporations are part of a worldwide unitary business, but then the California taxpayer makes a water's-edge election so that the foreign parent is no longer a member of the water's-edge group. The problem arises where the California taxpayer subsidiary claims a "cost" basis in the inventory it purchased from the foreign parent (the consequence being the intercompany gain goes untaxed by California).

In 2000, the California State Board of Equalization (BOE) decided two cases on this issue in the taxpayer's position that the gain goes untaxed: Appeal of Yamaha Motor Corp., U.S.A. and Appeal of Pentel of America Ltd.(5) The BOE, however, reheard the cases in November 2001, and substantially reversed its earlier decisions.(6) The BOE held on rehearing, in non-precedential decisions, that taxpayers must utilize the method contained in California Franchise Tax Board Notice 89-601, and previously unrecognized intercompany gains must be apportioned to California using the apportionment factors for the year prior to the water's-edge election and included in income over a five year period beginning with the year of the water's-edge election.

The BOE recently decided two more cases on this same water's-edge inventory issue: Appeal of Canon USA, Inc., and Appeal of Alps Electric, USA, Inc., Nos. 55001 & 55446 (Jan. 8, 2003). On January 8, 2003, the Board voted to apply the FTB's proposed "elimination and basis transfer" approach to intercompany inventory sales and purchases where a water's-edge election had been made and the transferring entity has been excluded from the water's-edge group. As in Yamaha and Pentel, the taxpayers here had argued for a deferral approach that would involve stepping up the tax basis of the transferred inventory items. FTB argued the profit from the intercompany sale and the step-up in basis from the intercompany purchase should be eliminated. As with its earlier decisions in 2001 in Yamaha and Pentel, the Board of Equalization did not issue decisions in Canon and Alps that can be cited as precedent by either taxpayers or the FTB. Thus, the issue continues to linger for some taxpayers, until perhaps resolved by the courts.

Inverted Corporation Issues

As a result of certain federal tax advantages, some U.S.-based multinational corporations with foreign-earned income have chosen to reincorporate and relocate their domiciles outside the United States. This transformation is typically accomplished by reincorporating in a foreign location, often by having a firm's subsidiary exchange its shares for those of the U.S. parent company. This process is known as corporate "inversion." Extensive hearings on corporate inversions were held last year in Congress on whether an American company should be allowed to take advantage of federal tax benefits when it reincorporates in a foreign jurisdiction where the corporate tax rates are lower.

That momentum has now swept into California. Senate Bill 1067, which is currently pending in the California legislature,(7) would provide that the income and apportionment factors of an "inverted domestic corporation," as defined, must be included in the water's-edge unitary group for California tax purposes. Under a prior version of the bill before it was amended in June 2003, an inverted domestic corporation would have been prohibited from making a water's-edge election if the inversion was completed on or after January 1, 2003.

A companion bill, Senate Bill 640, generally would prohibit the State of California from entering into any contract with a publicly traded foreign incorporated entity or its subsidiary if that entity meets certain conditions that would make it an expatriate company (i.e., a domestic corporation or partnership that incorporated in a foreign jurisdiction in name only).(8)

Water's-Edge Election Procedural Issues

Another bill pending in the California legislature that would affect taxpayers making, or considering making, the water's-edge election is Senate Bill 1061. This bill would substantially reform the water's-edge election procedures to resolve problems that arise with elections made under the current contract rules. The key point of this bill is that water's-edge elections would be made by statutory election, instead of by contract as under the current rules.

When the water's-edge election procedures were first enacted by the California legislature in 1986, they required the election to be made by entering into a contract with the FTB. According to the FTB, the reason the 1986 legislation required a contract was because it was felt that a contract was necessary to justify the imposition on electing taxpayers of (1) the filing requirement of a domestic disclosure spreadsheet (DDS); and (2) the payment of the water's-edge election fee. As part of the changes to the water's-edge election brought about by the then-pending Barclays Bank case, however, the California legislature in 1994 repealed the requirements for the DDS and the election fee. Accordingly, the FTB has concluded there is no longer any justification for requiring the water's-edge election to be made by contract, so this bill would replace the contract with a statutory election.

Senate Bill 1061(9) would make other significant changes to the water's-edge procedures. First, the bill attempts to make it easier for taxpayers to perfect the election when they have inadvertently failed to make the water's-edge election because they have failed to satisfy a procedural aspect of the election. Two prior statutory amendments in 1994 and 1995, and one California FTB regulation change in 1998, have already attempted to address this problem. Issues continue to arise, however, because taxpayers continue to fail to properly make the election. This bill would generally codify the "substantial performance" concept currently in the California FTB regulations to allow taxpayers the election even where they have inadvertently failed to satisfy all procedural requirements.

Second, Senate Bill 1061 addresses a serious problem involving the water's-edge election and corporate acquisitions. Current law provides that with only two exceptions, if a corporation acquires a water's-edge taxpayer, then the water's-edge election will carry over and be binding upon the acquired corporation. The two exceptions are that (1) a taxpayer can always request permission from the California FTB to terminate the election, which the FTB can either grant or deny in its absolute discretion; and (2) a taxpayer has a right to timely elect to terminate the election if it is acquired, directly or indirectly, by a non-electing entity that alone or together with its affiliates included in the taxpayer's unitary group is larger, in terms of equity capital, than the taxpayer.

This provision in the current law has been the downfall of many a (non-water's-edge electing) unsuspecting corporation which makes an acquisition, and later finds itself to then be subject to the water's-edge election simply because the corporation it acquired had made a water's-edge election. Senate Bill 1061 would remedy this problem by amending the current law to provide that a water's-edge taxpayer would no longer automatically taint any non-electing affiliates with which it becomes unitary. Instead, when two or more taxpayers become unitary under these circumstances, the election status of the larger taxpayer, based on the value of total business assets, will prevail. According to the FTB, this result is more likely to coincide with a taxpayer's expectations, and would prevent a large unitary group from being unintentionally bound by a water's-edge election when it acquires a smaller water's-edge electing taxpayer.

Finally, Senate Bill 1061 would change the provisions regarding automatic renewal of the election. Current law provides that a water's-edge election is for an initial term of seven years, but that the election is automatically renewed each year thereafter for an additional one-year period unless the taxpayer gives written notice of nonrenewal at least 90 days prior to the anniversary date. Thus, the "rolling" election will continue indefinitely if a taxpayer elects water's-edge treatment and does not file a notice of nonrenewal. Under the current law, a taxpayer wishing to limit the election to the minimum seven year period must file a notice of nonrenewal soon after it first makes the election--which acts to terminate the election seven years in the future.

This bill would allow a taxpayer who makes the election to receive permission, as specified, from the FTB to terminate the election within the first seven taxable years. Senate Bill 1061, however, includes provisions to limit a taxpayer's ability to jump back-and-forth from year-to-year between making the election and filing on a worldwide unitary basis.

Tax Shelter and Tax Avoidance Issues

Another bill of interest is Senate Bill 614. (10) This bill would create a regime of penalties and reporting requirements for investors, promoters, tax advisers, and tax preparers involved in abusive tax shelter transactions. The bill is intended, in the words of the California FTB, "to mitigate the attractiveness of these shelters," and its provisions were initially fashioned after the tax shelter provisions which the U.S. Senate recently passed in Senator Grassley's CARE Act of 2003 (S. 476) by a 95-5 vote in March 2003. As originally drafted, Senate Bill 614 would have expanded the California FTB's ability to issue a subpoena; extend the statute of limitations for taxpayers involved in abusive tax shelter transactions from four to eight years; conform California law to federal law regarding a number of penalties, including penalties for failure to disclose reportable transactions; and codify the economic substance doctrine.

Amendments to the bill in September 2003 addressed a number of concerns raised regarding earlier versions of the bill. (11) For example, the final version of the bill no longer codifies the economic substance doctrine, but does contain a definition of a "noneconomic substance transaction." (12) Although not directed at water's-edge taxpayers, the bill should be of considerable interest to all practitioners as well as international businesses with a California presence.

Conclusion

As can be seen, changes involving the calculations for making the California water's-edge election inevitably will continue. While change itself can be challenging and even disconcerting, with each legislative change the procedural aspects of the election continue to ease. Senate Bill 1061 is another positive step in that process.

(1) See Eric J. Coffill, "A Kinder, Gentler, 'Waters-Edge' Election: California Wards Off Threats of U.K. Retaliation as Part of Comprehensive Business Incentive Package," Tax Notes, Oct. 25, 1993, at page 477.

(2) San Francisco County Superior Court, Case No. 321296.

(3) Amdahl Corporation v. Franchise Tax Board, California Court of Appeal, First Appellate District, Case No. A101101--appeal by FTB; Case No. A101203 appeal by Amdahl. Similar issues were considered by the California State Board of Equalization in Appeal of Baxter Healthcare Corporation, Case No. 150881, decided October 5, 1994, and in which the SBE denied rehearing on December 19, 2002. There is, however, no written decision in Baxter, and the case may not be cited as precedent.

(4) For intercompany transactions occurring on or after January 1, 2001, FTB enacted a regulation that generally adopts the deferral approach utilized in the federal consolidated return regulations to intercompany sales and purchases. (Cal. Code of Regs., tit. 18, [section] 25106.5-1, subd. (2).)

(5) Appeal of Pentel of America Ltd., California State Board of Equalization, Case No. 89002464880, decision adopted November 2, 2000, Not to Be Cited As Precedent; Appeal of Yamaha Motor Corp., U.S.A., Case No. 89002467500, Not to Be Cited As Precedent.

(6) The Board decided the cases, on rehearing, on November 28, 2001. No precedential written decisions were issued.

(7) As of October 1, 2003, SB 1067 was pending in the Senate. It was refused passage on Third Reading, but reconsideration was granted.

(8) As of October 1, 2003, SB 640 has passed the Legislature and been sent to the Governor for his signature or veto.

(9) As of October 1, 2003, SB 1061 has passed the Legislature and been sent to the Governor (for his signature or veto. (10) As of October 1, 2003, SB 614 has passed the Legislature and been sent to the Governor for his signature or veto.

(11) Among the comments received was an August 29, 2003, letter from Tax Executives Institute, highlighting the Institute's concerns with respect to the proposed codification of the economic substance doctrine and extreme penalties. (A copy of the letter is available at http://www.tei.org.)

(12) Chapter 9.5 of the bill provides in part: "A 'noneconomic substance transaction' includes the disallowance of any loss, deduction or credit, or addition to income attributable to a determination that the disallowance or addition is attributable to a transaction or arrangement in which an entity is disregarded as lacking economic substance. A transaction shall be as lacking economic substance if the taxpayer does not have a valid nontax California business purposes for entering into the transaction." (Emphasis added.)

Author's Addendum 

On October 2, 2003, California's Governor signed two of the bills discussed in this article. First, the Governor signed SB 640 (Cal. Stats. 2003, Ch. 657), which prohibits California from contracting with a U.S. corporation or partnership that has re-incorporated in a foreign jurisdiction in name only. The Governor's Press Release stated this is "first-in-the-nation legislation" that will prohibit California from contracting with expatriate off-shore companies "that headquarter their business overseas only to avoid paying California taxes.... the people of California are sending a clear message to the tax avoiders on the beaches of Bermuda and Barbados: pay your taxes or we will avoid doing business with you." Second, the Governor signed SB 614 (Cal. Stats. 2003, Ch. 656), which addressed tax shelters. The Governor stated in the accompanying Press Release, "Once again, California is ahead of the pack. In fact, we are taking action before the federal government to curtail the use of abusive tax shelters."

The Governor had previously signed a third bill discussed in this article. On September 30, 2003 the Governor signed SB 1061 (Cal. Stats. 2003, Ch. 633), which made significant changes to the water's-edge election procedures.

ERIC J. COFFILL is a partner in the Sacramento office of Morrison & Foerster LLP, where he practices with the State and Local Tax Practice Group. He is a regular contributor to The Tax Executive.