Tax Law

Water's-Edge Election: Look Before You Leap and Calculate Before You Elect

By J. Pat Powers - Baker & McKenzie LLP (®)

General Editor - Charles J. Moll III - winston & Strawn LLP



Taxpayers considering making a water's-edge election should review all current and planned transactions between (i) on the one hand, companies that will be outside the water's-edge group following the election and, (ii) on the other hand, companies that will remain in the water's-edge combined group. Because the treatment of transactions within the combined group differs so completely from the treatment of transactions with companies not members of the group, taxpayers may achieve significant tax savings by deciding when to undertake such transactions in relation to the effective date of a water's-edge election. Taxpayers should consider all types of intercorporate transactions, including sales of inventory, payments of dividends, payments of intragroup interest and royalties, transfers of fixed assets, as well as any corporate restructurings such as reorganizations or liquidations. By the same token, a taxpayer contemplating termination of a water's-edge election should examine whether intercompany transactions should be accelerated or deferred to take place before or after the termination of the water's-edge election.


The reasons for making a water's-edge election are numerous, as are the practical and fiscal implications.

Both foreign-based and domestic groups should thoughtfully analyze the consequences of making a water's-edge election before such an election is made. If the taxpayer makes the water's-edge election, it will have to report on a water's-edge basis for the next seven years, even if worldwide reporting would be more advantageous, for example, for four years. In addition to trying to forecast the advantages or disadvantages of a water's-edge election years into the future, the taxpayer should consider if there are any transactions it should complete or accelerate prior to the foreign affiliates leaving the group.

In some cases, simpler reporting or motivations other than tax minimization cause taxpayers to make the water's-edge election. Some foreign-based groups prefer to make the water's-edge election even if no tax savings result because they do not believe that their foreign operations and activities are proper subjects of inquiry and examination by state tax authorities.

As taxpayers and planners have become more familiar with the water's-edge election, more companies, U.S and foreign-based alike, have made the election.

After decades of imposing unitary taxation on a worldwide basis (and winning court cases raising a variety of substantial constitutional challenges to the method), in the face of mounting international pressure, and with the threat of federal legislation looming, California finally, in 1988, allowed taxpayers an election to calculate their income subject to taxation in California on the so-called "water's-edge" basis. Although tremendous unhappiness with worldwide combined reporting (sometimes referred to as WWCR) and great political pressure led to the original enactment of Cal. Rev. & Tax. Code § 25110 authorizing the election, comparatively few taxpayers originally took advantage of it, and reportedly most of those that did elect were foreign-based companies. Over the next 20 years, the election statute was amended some nine times, with most of the amendments making the election more user-friendly. Partly as a result of changes in the election, and partly through more sophisticated planning as taxpayers and their advisors became more familiar with the election and analyzed how to reduce the tax burden using it, many U.S. and foreign-based groups have made the election.

Generally, once the water's-edge election has been made, domestic corporations with more than 50 percent of their stock owned or controlled by the same interests, directly or indirectly, are in the water's-edge group, as are domestic international sales corporations, foreign sales corporations, export trade corporations, and any corporation where more than 20 percent of the average of its property, payroll, and sales factors is in the United States.

The term "water's-edge" is something of a misnomer, though it perhaps is as good as any other term to describe the mixed group of companies that are included. First, domestic corporations with more than 50 percent of their stock owned or controlled by the same interests, directly or indirectly, are in the water's-edge group, unless they elected to be treated as Possessions Corporations for federal tax purposes (an option that has now expired). Domestic international sales corporation (which of course are by definition also domestic corporations), foreign sales corporations and Export Trade Corporations are included, as is any corporation if more than 20 percent of the average of its property, payroll, and sales factors is in the United States. For this purpose the three factors are equally weighted. Affiliated controlled foreign corporations (CFCs) as defined in IRC § 957 are included in proportion to the ratio of their annual subpart F income (as defined in IRC § 957) over their earnings and profits for the year. Finally, any corporation is included to the extent of its income derived from, or attributable to, sources within the United States, and its factors assignable to a location within the United States with respect to its activities conducted within the United States (The awkward terminology used to describe this group reflects the general lack of familiarity with, and proper usage of, federal tax terms and concepts in drafting the water's-edge provisions.) Originally the Franchise Tax Board (FTB) did not try to include foreign affiliates just because they received U.S. source fixed or determinable annual or periodic (FDAP) income, for example royalties or interest from their U.S. subsidiaries. However, in the early 1990's the FTB changed its position and asserted that a foreign corporation was includible in the water's-edge group to the extent of such FDAP even though the income was not effectively connected with the conduct of a U.S. trade or business. When the FTB tried to include foreign affiliates (primarily foreign parents or foreign affiliates of a foreign-based multinational group) based on interest or royalties paid by members of the water's-edge group, numerous groups strongly protested this change in interpretation. Ultimately, the political pressure was sufficient to make the FTB back down from its reinterpretation and return to the original position.

The water's-edge election must be made on a timely filed return for the year in which it is to be effective and will be in effect for seven years.

The election has always been required to be made on the original return for the year for which the election is to be effective. At one point, taxpayers and the FTB disputed whether the election could be made on a tardy (but original) return. The statute has subsequently been amended to specify that the election must be made on a timely filed original return.

For elections for years beginning prior to January 1, 2003, the election was made by contract and was "evergreen" in that the term continued until seven years after the taxpayer gave notice of its intention to revoke it. The original election term was a five-year period, but it had a similar "evergreen" characteristic. In response, taxpayers devised the tactic of making the election and then giving notice of revocation to start the clock running on the time to revoke. If at the end of that seven-year period the taxpayer wanted to continue on a water's-edge basis, it would make a new election (and file notice to revoke seven years later).

For elections made for years beginning after January 1, 2003, such tactics are not necessary as the election can be revoked after seven years.

Practitioners should consider encouraging their clients to clean out the earnings of foreign affiliates before making a water's-edge election because dividends between members of a combined group are eliminated.

Pursuant to Cal. Rev. & Tax. Code § 24411, a water's-edge group receiving dividends from an affiliated controlled foreign corporation outside the water's-edge group is entitled to a 75 percent dividends received deduction (DRD) to the extent the dividends are not otherwise deductible or eliminated from income. Dividends from one member of a combined group to another are eliminated, as set forth under Cal. Rev. & Tax. Code § 25106. Controversy continues on how to apply this Cal. Rev. & Tax. Code § 25106 elimination when a controlled foreign corporation is partly included as a result of a subpart F inclusion. In Fujitsu IT Holdings v. Franchise Tax Board, 2004 Cal. LEXIS 9881, the court held taxpayer was first entitled to exclude the dividend to the extent of previously taxed income (PTI) just as it would be able to exclude PTI for federal tax purposes under IRC § 959. The FTB sought to avoid this result by amending regulations and issuing announcements, and the controversy continues. See In the Matter of Apple Computer Inc., 2006-SBE-002, 2006 Cal. Tax LEXIS 431; aff'd by Apple Inc. v. Franchise Tax Board, No. CGC 08-471129 (Cal. Sup. Ct., Jan. 26, 2010).

Since dividends between members of a combined group are eliminated, it can be particularly important for a U.S.-based group considering a water's-edge election to "clean out" the earnings of foreign affiliates before making the election.

Practice Tip:    Practitioners should be aware that beginning with the 2009 tax year, the FTB may deny the elimination of intercompany dividends provided under Cal. Rev. & Tax. Code § 25106 if the FTB determines that the transaction has been entered into, or structured with, a principal purpose of evading California corporation franchise or income taxes.

Crucial to savvy pre-election planning is understanding that the federal rules for treatment of deferred intercompany transactions differ in form and impact from those followed by California.

Except for intercompany transfers of capital assets, California does not follow the federal rules for deferred intercompany transaction (DIT) between group members. For transfers of inventory and other intercompany transfers (excluding capital assets), California follows an elimination and basis transfer approach. The following example illustrates this approach and contrasts it to federal treatment.

Example:    FP is a foreign parent that makes video happiness machines. DS is its domestic subsidiary that buys the machines from FP and distributes them throughout the U.S. FP and DS report on a worldwide basis. In 2006 FP sells its newest model "Ultimate Joy" to DS for $100,000. FP's cost of production was $50,000, but its $50,000 profit is not recognized on the intragroup sale. In 2007 DS sells the Ultimate Joy for $200,000 and the group has $150,000 income to be apportioned by the group that year. If, instead, DS made a water's-edge election effective for 2007, there would still be $150,000 income to be apportioned in 2007, but it would be apportioned over the water's-edge group (i.e. DS) rather than over the worldwide group including FP.

On the other hand if the water's-edge election had been effective for 2006, then DS would have a basis of $100,000 in the Ultimate Joy and would only have $100,000 income from this sale to apportion in 2007.

This California approach can be contrasted with the approach taken by the federal consolidated return rules. If FP were the domestic parent of the FP-DS consolidated group, the 2006 sale to DS would be a deferred intercompany transaction (DIT), and the group would have $150,000 of income to report in 2007 when DS sold the machine. However, $50,000 of that income would be FP income and $100,000 would be DS income. Interestingly, if at the end of 2006, FP sold DS to end the consolidated group then FP would recognize the $50,000 of deferred gain for federal purposes. This different treatment reflects the essential difference between federal deferred intercompany rules and California's elimination and basis transfer for intragroup transactions. Recognition of this difference in California's approach is essential in planning prior to a change in water's-edge status.

In 2009, the FTB adopted a new regulation governing water's-edge elections made by unitary group members filing combined reports.

In 2009, the FTB adopted a new regulation governing water's-edge elections. See 18 CCR § 25113 (effective May 6, 2009 and applicable to taxable years beginning on or after January 1, 2008). The new regulation addresses the 2003 legislative changes that revised the water's-edge procedure from a contractual process to a statutory election. The regulation defines key terms and provides examples regarding how an election is made, terminated, and re-elected. See 18 CCR § 25113(b)-(e).

In addition to making a water's-edge election by filing Form 100W (California Corporation Franchise or Income Tax Return for Water's-Edge Filers), and attaching a Form 100-WE (Water's-Edge Election), the FTB may consider other objective evidence of the taxpayer making a water's-edge election, such as a statement attached to the timely-filed, original return indicating a water's-edge election is being made or the inclusion of a substantially completed form associated with water's-edge combined reporting with the taxpayer's timely-filed, original return. 18 CCR § 25113(c)(3)(C).

Requests to terminate a water's-edge election for good cause prior to the end of the initial seven-year period must be filed with the FTB no later than the 120th day prior to the due date of the return for which the termination would be effective, including extensions. 18 CCR § 25113(d)(2). If the FTB takes no action or requests no additional information within 90 days of the filing of the requires to terminate the election, the request is deemed to be disallowed. The FTB will send a notification of the termination if the request is granted. The FTB may also take into consideration objective factors similar to those for determining whether a valid election was made in determining whether a taxpayer has terminated its water's-edge election. 18 CCR §  25113(d)(3).

Requests to re-elect water's-edge reporting prior to the end of the initial seven-year period following a water's-edge termination must be filed with the FTB no later than the 90th day prior to the due date of the return for which the re-election would be effective, including extensions. 18 CCR § 25113(e)(2). If the FTB takes no action or requests no additional information within 60 days of the filing of the request to re-elect water's-edge reporting, the request is deemed to be disallowed. A taxpayer may withdraw its request at any time prior to the FTB's granting permission. The FTB may not grant consent for a re-election of water's-edge reporting on a retroactive basis. 18 CCR § 25113(e)(2).

These materials are published solely as reference materials for use by attorneys and other tax professionals.  They do not constitute an opinion or written advice concerning federal or state tax issues and are not written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or other applicable tax laws.


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