California Eyes Tax Reporting Rules for Multinationals

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By Laura Mahoney

A California senator wants to end a corporate income tax law put in place 30 years ago to avert a tax war with foreign trading partners that now costs the state more than $2 billion a year.

Sen. Ricardo Lara (D) has introduced a bill to end the water’s-edge election, which allows multinational companies to exclude their affiliates that are beyond the “water’s edge” of the U.S. from the reported income base upon which California may levy the corporation tax.

The bill, S.B. 567, also targets tax exemptions on corporate executives’ pay and charitable trusts, and a tax benefit on inherited property. Lara told Bloomberg BNA March 15 he intends to get the Millionaire Tax Accountability Act to the desk of Gov. Jerry Brown (D) by the end of this year’s session in September.

Lara said the 2016 national election indicated to him that tax breaks favoring the wealthy and corporations will continue at the federal level. At the same time, working Californians have shown they are willing to tax themselves to pay for parks, schools and public services through recent state and local ballot measures, Lara said.

“It’s time for millionaires and companies with offshore subsidiaries to do the same,” he said.

S.B. 567 has been referred to the Senate Governance and Finance Committee, where it can be heard after March 23. It was introduced Feb. 17.

15,000 Corporate Claims

The water’s-edge election is California’s most expensive corporate income tax expenditure and will cost $2.3 billion in the current fiscal year, according to the California Department of Finance. About 15,000 corporate returns used the water’s-edge method in 2013, the most recent year for which return data is available.

The water’s-edge method is the required or default method in 25 of 29 states that require combined corporate income reporting, according to Bloomberg BNA data. (For more information on state regimes, see chart below.)

The California bill would phase out the water’s-edge method as the seven-year election expires for corporations using it. Those corporations would shift to the worldwide combined reporting method, which is what corporations that don’t elect to use the water’s-edge method now use.

Lara could see opposition from foreign governments and corporations that pressured the Legislature to adopt the water’s-edge election in 1986. The Franchise Tax Board had begun requiring corporations to place their foreign affiliates into a worldwide combined group and apportion income to California based on property, payroll and sales in the state compared to those factors elsewhere.

Opponents argued the FTB’s worldwide method was an administrative burden that could result in tax on more than 100 percent of a multinational companies’ income because other countries have a different method of assigning income. They also argued that with an apportionment formula based on property, payroll and sales, worldwide reporting discouraged investment in California.

Possible Trade War

Removing the water’s-edge election could start a trade war with countries that dislike California and the U.S., Joseph Henchman, vice president of legal and state projects for the Washington-based Tax Foundation, told Bloomberg BNA in a March 13 email.

“Yes, it would punish the Cayman Islands Holding Corporation, but it would also negatively impact the vast majority of compliant companies,” Henchman said.

California’s shift in 2013 from an income apportionment formula based on sales, property and payroll to only sales adds a new wrinkle to the debate.

Foreign subsidiaries with economic nexus and sales but no presence in California could face a new filing or payment obligation under the single-sales factor formula, Henchman said. Other countries may view those obligations as an intrusion of California tax authorities beyond the state’s boundaries.

California Market

The importance of the California market and the lack of property and payroll factors gives foreign companies without a state presence less leverage in the debate, said Prentiss Willson, a California tax attorney who recently retired from Eversheds Sutherland LLP.

“No one is not going to sell into California,” said Willson, a member of Bloomberg BNA’s State Tax Advisory Board.

Lara said he doesn’t intend to single out specific countries or companies, but he wants to launch a conversation with California lawmakers about the items in the bill that he calls loopholes.

“Shielding profits in another country is wrong,” he said.

Step-Up Basis

Two other California tax provisions Lara wants to eliminate with the bill help wealthy individuals avoid taxation for themselves or their heirs. If adopted, they would create different tax policies for California and the federal government.

Lara is proposing to eliminate a provision that allows people who inherit California property to set the basis in the property at the fair market value at the time of a decedent’s death. The step-up basis provision, which is currently in federal and state law, allows those inheriting property to avoid tax on the gain in the inherited property’s value in the time since a decedent purchased it.

The end to step-up basis would apply to taxpayers with annual incomes of more than $1 million. It costs the state $2.5 billion a year in forgone revenue, according to the Department of Finance.

“Wealthy Californians shouldn’t be allowed to turn their family home into a tax shelter,” Lara said.

Charitable Remainders

Lara’s bill also would increase to 40 percent, from 10 percent, the amount of assets that must remain in a charitable remainder trust to qualify for tax exemption. Those creating such trusts could still receive income from them for specified periods, or until death, but ultimately would need to transfer 40 percent of the initial asset value to a charitable purpose to be tax-exempt.

In addition, Lara would eliminate the ability of corporations to deduct executive compensation of more than $1 million, which would also make California inconsistent with federal law.

The Franchise Tax Board and the Department of Finance told Bloomberg BNA they don’t have revenue estimates for the executive pay deduction and charitable remainder trust provisions. The FTB will provide estimates to lawmakers as the bill moves through the Legislature.

Henchman said the end of step-up basis is the most defensible of the four changes Lara is proposing. The executive compensation and charitable remainder provisions are arbitrary changes to punish corporations, executives and those who use charitable remainder trusts, he said.

To contact the reporter on this story: Laura Mahoney in Sacramento, Calif. at

To contact the editor responsible for this story: Ryan C. Tuck at

For More Information

Text of S.B. 567 is at

Worldwide Income vs. Water's-Edge Reporting
Alabama Combined reporting not allowed.
Alaska Both. Water's-edge is default method, but taxpayers engaged in oil or gas production or transportation by regulated pipeline, or those included in a group with those taxpayers, must use worldwide net income reporting method.
Arizona Water's-edge.
Arkansas Combined reporting not allowed.
California Both. Worldwide combined reporting is default method, but qualified taxpayers may make water's-edge election.
Colorado Water's-edge.
Connecticut Both. Water's-edge is default method, but combined groups may elect to use the worldwide reporting method.
Delaware Combined reporting not allowed.
District of Columbia Both. In the District, a unitary business group must file a combined report on a water's-edge basis, but may make a worldwide reporting election.
Florida Combined reporting not allowed.
Georgia Combined reporting not allowed.
Hawaii Water's-edge.
Idaho Both. Worldwide combined reporting is default method, but a taxpayer may elect to use the water's-edge reporting method.
Illinois Water's-edge.
Indiana Both. Water's-edge is default method, but taxpayers may petition to use worldwide reporting method.
Iowa Combined reporting not allowed.
Kansas Water's-edge.
Kentucky Combined reporting not allowed.
Louisiana Combined reporting not allowed, unless specifically required by the Secretary of Revenue.
Maine Water's-edge.
Maryland Combined reporting not allowed.
Massachusetts Both. Water's-edge is default method, but can make worldwide combined reporting election
Michigan Water's-edge.
Minnesota Water's-edge.
Mississippi Combined reporting not allowed.
Missouri Combined reporting not allowed.
Montana Both. Worldwide is default method, but corporations may elect to use the water's-edge reporting method.
Nebraska Water's-edge.
Nevada N/A. No corporate income tax.
New Hampshire Water's-edge.
New Jersey Combined reporting not allowed.
New Mexico Combined reporting not allowed.
New York Water's-edge.
New York City Water's-edge.
North Carolina Water's-edge.
North Dakota Both. Worldwide is default method, but can make water's-edge election.
Ohio Combined reporting not allowed.
Oklahoma Combined reporting not allowed.
Oregon Combined reporting not allowed.
Pennsylvania Combined reporting not allowed.
Rhode Island Water's-edge.
South Carolina Water's-edge.
South Dakota N/A. No corporate income tax.
Tennessee Water's-edge.
Texas Water's-edge.
Utah Both. Water's-edge is default method, but can make worldwide combined reporting election.
Vermont Water's-edge.
Virginia Water's-edge.
Washington N/A. No corporate income tax.
West Virginia Both Water's-edge is default method, unless worldwide combined reporting election is made.
Wisconsin Water's-edge.
Wyoming N/A. No corporate income tax.

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