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

• Author: Coffill, Eric J.

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...