Summary
Beginning in 2011, California enacted its factor presence statute under which an out-of-state corporation, including a non-U.S. corporation, with more than $500,000 of gross receipts (indexed for inflation) sourced to California is subject to the state’s corporation income/franchise tax and becomes a California taxpayer. However, since such “new” taxpayer never consented to the water’s-edge election, the election could be terminated for that electing group. In FTB Notice 2016-02 (Sept. 9, 2016), the California Franchise Tax Board (“FTB”) addresses the treatments the FTB will apply in situations where a unitary foreign affiliate of a water’s-edge combined reporting group becomes subject to income/franchise tax after the enactment of the “factor presence nexus” statute beginning January 1, 2011.
Details
Background
A multinational unitary group of affiliated corporations, one or more of whose members are subject to California corporation income/franchise tax, may make a water’s-edge election to allocate and apportion income of the unitary group’s business. Under Cal. Rev. & Tax. Code § 25111(a), a water’s-edge election is effective for an initial term of 84 months (seven years), unless terminated earlier under Cal. Rev. & Tax. Code § 25113. The water’s-edge election automatically continues after the seven year anniversary date, unless a worldwide combined reporting election is made.
In general, when a water’s-edge election is made, the income (or loss) and apportionment factors of a unitary foreign affiliate of the group are excluded from the California water’s-edge combined report under Cal. Rev. & Tax. Code § 25110, as long as the unitary foreign affiliate does not have effectively connected income with a U.S. trade or business, or at least 20% of its apportionment factors assigned to U.S. locations (collectively, “United States Income”).
Pursuant to Cal. Rev. & Tax. Code § 25113, a water’s-edge election is effective only if every member of the water’s-edge group with nexus in California (a “taxpayer member”) makes or consents to the election. If a unitary foreign affiliate did not have a physical presence with California for taxable years prior to January 1, 2011, it could not have made or consented to the water’s-edge election. During those years, the unitary foreign affiliate was not a taxpayer.
For taxable years beginning on or after January 1, 2011, Cal. Rev. & Tax. Code § 23101(b) was added. Section 23101(b) established a “factor presence economic presence” standard for an out-of-state corporation, including a unitary foreign affiliate, to be considered “doing business” in California. Among other factor-presence criteria, an out-of-state corporation with more than $500,000 of gross receipts sourced to California under California’s sales factor sourcing rules was now deemed “doing business” in California and subject to income/franchise tax. When applied to a unitary foreign affiliate with no physical presence but more than $500,000 of California sales after January 1, 2011, the affiliate becomes a California taxpayer. Since the unitary foreign affiliate never made nor consented to the making of the water’s-edge election, the election could be terminated for the entire group under Section 25113, an issue that the FTB has raised in audit examinations.
Under Cal. Rev. & Tax. Code § 25113(b)(4), if a member of the water’s-edge group subsequently becomes subject to California corporation income/franchise tax and becomes a taxpayer member of the water’s-edge group, the deemed election provisions apply and the new taxpayer member is deemed to have made or consented to the water’s-edge election. As a result, if an out-of-state unitary affiliate, including a non-U.S. unitary affiliate with United States Income, later becomes a taxpayer member of the water’s-edge group because of the “factor presence economic nexus” statute, the water’s-edge election does not terminate. Prior to 2011, both types of entities were already “members” of the California water’s-edge group.
Nonetheless, the deemed election provisions of Section 25113(b)(4) are silent as to the treatment when a non-member unitary foreign affiliate becomes a California taxpayer.
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This article originally appeared in BDO USA, LLP’s State and Local Tax Alert – September 2016. Copyright © 2016 BDO USA, LLP. All rights reserved. www.bdo.com.