Water's-edge election: effectively connected income and the 20% rule in California.

• Author: Berkness, Chris

For years beginning on or after Jan. 1, 2011, the threshold for doing business in California changed significantly. The economic nexus rules under Cal. Rev. &Tax. Code Section 23101 can now result in a business entity having a filing requirement in California without any physical presence. For companies that generate revenue from intangible assets, the results can be unfavorable.

A foreign corporation that has established economic nexus without any physical presence in California could make a water's-edge election to avoid including its income and factors in the 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% or higher U.S. apportionment factor. (When a foreign person engages in a trade or business within the United States, it may have income that is considered ECI.)

The sourcing rules for determining economic nexus can be much different from the sourcing rules for determining ECI or the 20% full inclusion rule. This item discusses how foreign corporations that generate income from intangible assets are affected by the economic nexus rules as well as the water's-edge rules.

Economic Nexus

A business entity is considered to be doing business in California for tax years beginning on or after Jan. 1, 2011, if it actively engages in any transaction for the purpose of financial or pecuniary gain or profit. In addition, if a business entity has a minimum amount of property, payroll, or sales in California, then it will be considered to have economic nexus in California.

In determining California sales for economic nexus purposes, the market-based-sourcing rules under Cal. Rev. & Tax. Code Section 25136(b) apply for sales other than the sale of tangible personal property.

Water's-Edge Application

If a foreign corporation has established economic nexus in California, then it will have a fifing requirement and be subject to California's franchise tax. Can a foreign corporation simply make a water's-edge election to avoid having to include all its foreign income and factors on a California return? The general rule is that all foreign corporations are excluded from the water's-edge combined report if the election is in effect. Therefore, if the foreign corporation makes a water's-edge election, it can exclude its income and factors from the water's-edge return unless it has either ECI or a 20% or higher...