What is the California Waters Edge Election and how does that affect taxation for certain taxpayers with offshore business income and assets? The California water’s edge election was established in 1986 and was designed to restrict California’s “application of the worldwide combined reporting method of determining income from California sources.” Instead of eliminating worldwide combined reporting, the California water’s-edge election gives taxpayers another choice in how taxation is applied to income. If the taxpayer would owe more taxes based upon the “worldwide method” they can opt to pay less tax by making a “water’s-edge” election. For some business clients, the water’s-edge basis requires much less documentation and record keeping.
The water’s-edge legislation has been modified many times since 1986. As of January 1, 2011 a business or commercial entity including a foreign corporation can be considered to be conducting business in California even if it doesn’t have a physical presence here. The corporate entity is taxable if “it actively actively engages in any transaction for the purpose of financial or pecuniary gain or profit.” Once an established minimum is exceed in California payroll, sales or property, the business will be considered to have “economic nexus” (connections) in California.
A foreign corporation with established business or nexus but no physical presence in California may make a water’s-edge election to avoid including its income and factors in the combined report. When a foreign individual or entity conducts business or trade within the US there may be income that is considered to be “Effectively Connected Income or ECI. The challenge in these decisions is that a portion or all of the foreign corporation’s income will not be excluded from the combined report, if the foreign corporation is determined to have ECI or a 20% or higher U.S. apportionment factor. For state corporate income tax purposes, “apportionment” is the process of assigning to California (or any other state) that portion of a multi-state or international corporation’s income that the state may tax. It is important to note the sourcing rules used to determine ECI are much different from the sourcing rules used in determinations based upon the 20% rule.
The California waters edge election impacts many foreign corporate decisions. Business taxpayers must give extensive consideration to all inter-company transactions, including but not limited to:
- Sale of Inventory
- Transfers for Fixed Assets or Services
- Payments of Intra-Company Interest and Royalties
- Payments of Dividends
- Corporate Restructurings, Reorganizations or Liquidations
The opposite perspective also applies, as a corporate taxpayer who is considering the termination of their water’s-edge election should examine whether inter-company transactions should be accelerated or postponed to take place before or after the water’s-edge election is terminated.
California tax laws relating to business nexus and market-based-sourcing rules may require a foreign corporation with no physical presence in California to declare income and file appropriate tax returns with the FTB. The California waters edge election may or may not prevent the foreign corporation from being forced to include part or all of its income and factors in the combined report.
In summary, since California now applies the economic nexus and market-based-sourcing rules, a foreign corporation with no physical presence in California may actually have a filing requirement and taxable income in the state. A water’s-edge election will not necessarily prevent the foreign corporation from having to partially or fully include its income and factors in the combined report.
Keep in mind that you don’t have to have a physical presence in California to trigger California state tax obligations. Allen Barron is uniquely positioned to advise international corporations, foreign corporations, and interstate businesses who conduct business in the State of California. Our unique blend of international tax, legal, and accounting expertise in a single-source firm allows us to provide a much more informed insight into any business issue or tax conversation. We invite you to contact us for a free consultation at 866-631-3470.