Insight: Moving into Worldwide Waters? States Reaching Beyond the Water’s-Edge

Daily Tax Report: State provides authoritative coverage of state and local tax developments across the 50 U.S. states and the District of Columbia, tracking legislative and regulatory updates,...

Many states require or permit affiliated businesses to report their income to the state in a combined group return. In this article, Eversheds Sutherland (US) LLP’s Maria Todorova, Justin Brown, and Samantha Trencs discuss some of the complexities of combined reporting related to the inclusion of foreign entities in a combined group, including trends among states intended to expand the combined group to include additional foreign affiliates.

Maria M. Todorova Justin T. Brown Samantha K. Trencs

By Maria M. Todorova, Justin T. Brown, and Samantha K. Trencs

Maria Todorova is a Partner in Eversheds Sutherland’s State and Local Tax (SALT) practice, located in Atlanta, Georgia. She helps national and international Fortune 100 companies and other large corporations navigate through all aspects of complex tax disputes.

Justin Brown is an Associate in Eversheds Sutherland’s State and Local Tax practice, located in Atlanta, Georgia, and assists clients on a variety of SALT matters, including tax planning, compliance and audit defense.

Samantha Trencs is an Associate in Eversheds Sutherland’s State and Local Tax practice, located in Washington DC, and counsels clients on multistate tax planning, policy and controversy matters.

No one would disagree that economic globalization is an irreversible trend. The last two decades have witnessed the unprecedented mobility of commodities, services and capital, leading to a continuing expansion and consolidation of subnational and international market frontiers. Citing tax base erosion resulting from economic globalization, many states require mandatory combined reporting to determine the amount of income of a unitary multistate or multinational enterprise attributable to operations within a taxing state. A combined reporting regime generally treats a group of entities under common ownership and engaged in a unitary business as one single taxpayer.

While combined reporting is perceived to neutralize tax base erosion techniques, it can create complexities related to the determination of a taxpayer’s combined reporting group. To that end, the treatment of foreign affiliates and the extent to which those affiliates are included in a combined filing group has always been an important issue for both states and companies with overseas operations. Given the rapid pace of economic globalization, combined with the recent cases and state legislative action discussed below, the treatment of foreign entities for combined reporting purposes will likely receive increased attention and scrutiny from states in the months and years to come.

Determining the Combined Group: Water’s-Edge vs. Worldwide

States generally follow one of two approaches for including foreign subsidiaries that are incorporated and/or that conduct substantial business activities outside the US in a combined report: water’s-edge combined reporting or worldwide combined reporting.

As the name implies, worldwide combined reporting requires inclusion of the income and apportionment factors of all members of a unitary business group, regardless of their place of incorporation or level of US business activity. Under this approach, a taxpayer’s unitary group for state tax purposes could include additional entities relative to the taxpayer’s federal filing group. Water’s-edge combined reporting, on the other hand, generally allows the group to include, with certain exceptions, only US affiliates. Although the worldwide method was validated by the US Supreme Court 35 years ago (in Container Corp. v. Franchise Tax Bd., 463 U.S. 159 (1983)), it has been unpopular partly due to political pressure from the international business community and foreign governments. Today, only one state, Alaska, requires worldwide combined reporting without a water’s-edge election and only for certain oil and gas producers and pipelines. Alaska Stat. §. 43.20.031(a); Alaska Admin. Code § 20.330(a), (c). The majority of the states requiring combined returns either: (a) follow the water’s-edge method (e.g., Colorado, Illinois and Wisconsin), (b) require worldwide combination but allow taxpayers to elect the water’s-edge method (e.g., California, Idaho and Montana), or (c) require water’s-edge as the default method but allow an election for the worldwide method (e.g., Massachusetts, Utah and West Virginia).

Living on the Water’s Edge? 80/20 Companies

Putting worldwide combined reporting aside, water’s-edge combined reporting does not entirely exclude foreign income or business activity of foreign affiliates. While water’s-edge combination generally requires combined reporting for affiliated, unitary domestic companies, some states add or exclude so-called 80/20 companies from the water’s-edge group. These 80/20 companies are typically foreign companies with at least 20% of their business (measured by payroll, property and/or sales) conducted in the US or domestic companies with at least 80% of their business conducted abroad. However, determining whether an entity is an 80/20 company could be daunting due to the complexity and wide variation of state laws. Two recent cases illustrate the divergence among states in wrestling with the treatment of 80/20 companies for combined reporting purposes.

In Agilent Technologies Inc. v. Colorado Dep’t of Revenue, No. 16CA0849 (Colo. App. Nov. 2, 2017), the Colorado Court of Appeals considered whether a domestic corporation formed as a holding company to own certain foreign affiliates of the taxpayer constituted an 80/20 company that must be included in the taxpayer’s Colorado water’s-edge return. Colorado defines an 80/20 company by a two-factor metric – property and payroll. Only C corporations with more than 20% of factors assigned to locations inside the US are included in the combined report (i.e., an “includable C corporation”). Colo. Rev. Stat. §39-22-303 (8), (12)(c).

The holding company owned and derived all of its income from investments in foreign entities conducting business entirely outside the US. It did not own or rent any property or have any payroll of its own. The taxpayer took the position, and the appellate court agreed that, though the holding company was part of the taxpayer’s unitary business, it was not an “includable C corporation” because it did not have at least 20% of its property and payroll assigned to locations in the US. Thus, according to the court, the Department could not forcibly combine the taxpayer and its affiliated holding company. The court also concluded that the Department could not rely on Colorado’s anti-abuse statute or economic substance doctrine to adjust the members of the combined group.

Interestingly, the taxpayer made an alternative argument that because the holding company and its foreign subsidiaries elected to be treated as a single C corporation for federal tax purposes – under the federal check-the-box regulations – they should also be treated as a single C corporation for purposes of determining whether the holding company (as an entity including the foreign subsidiaries) was an includable C Corporation under Colorado law. Under this approach, the property and payroll of the foreign subsidiaries entirely outside of the US would be viewed as property and payroll of the holding company. Since all of the holding company’s payroll and property (via its foreign subsidiaries) were outside the US, the holding company failed the definition of an includable C corporation and thus could not be combined with the taxpayer. In rejecting the taxpayer’s argument, the court held “[a] federal check-the-box election does not determine whether a corporation is considered domestic or foreign ….” Although Colorado appears to follow check-the-box generally, the court reasoned that allowing an entity’s election regarding its consolidation for federal tax purposes to determine its treatment under Colorado’s combined reporting regime would render the statutory 80/20 rules meaningless.

Unlike Colorado, Minnesota will respect a federal check-the-box election in determining the composition of a combined reporting group, according to the State’s Supreme Court. See Ashland Inc. v. Comm’r of Revenue, No. A16-1257 (Minn. S. Ct. Aug. 2, 2017). Prior to 2013, a Minnesota combined report excluded all “foreign corporations or foreign entities,” regardless of whether they were a part of a unitary business. Minn. Stat. § 290.17, subd. 4(f) (2012). In Ashland, the taxpayer’s foreign affiliate elected to be treated as a disregarded entity for federal tax purposes. The Ashland court held that the taxpayer’s foreign affiliate was also disregarded for Minnesota combined reporting purposes. As a result, the foreign affiliate did not constitute a “foreign corporation or foreign entity” and its income/losses were thus properly included in the taxpayer’s water’s-edge report.

Agilent and Ashland demonstrate that an important step in determining the treatment of foreign entities for water’s-edge reporting purposes is understanding how the foreign entity would be classified for state income tax purposes. A taxpayer filing a water’s-edge report could get caught by surprise – and end up with a larger water’s-edge group and potentially more taxable income in the state – if its foreign affiliate elects to be treated as a regarded entity for federal tax purposes yet that entity’s check-the-box classification is not respected for state income tax purposes. Further, taxpayers should beware that a state could generally conform to federal check-the-box rules and still disregard a taxpayer’s check-the-box election for combined reporting purposes, as Colorado did in Agilent.

Is Water’s-Edge Losing Its Edge?

Water’s-edge reporting is not a recent phenomenon at the state level and continues to be a viable option for states seeking to neutralize perceived corporate tax abuse and to tap new revenue sources. Connecticut and Rhode Island are the latest states to adopt combined reporting regimes – Connecticut for tax years beginning on or after January 1, 2016, Conn. Gen. Stat. § 12-222(g), and Rhode Island for tax years beginning on or after January 1, 2015, R.I. Gen. Laws § 44-11-4.1(a). However, with the perceived loss of state tax revenues at stake, states appear to have turned their focus to expanding the water’s-edge. Many states are considering or have adopted various measures that have the effect of enlarging the traditional contours of the water’s-edge to include foreign entities and foreign-source income. In addition to the 80/20 rules and entity-classification considerations discussed above, taxpayers should pay close attention to trends including tax-haven legislation, anti-abuse statutes and expanding nexus provisions.

Tax Haven Legislation

A leading trend among state legislatures is enacting “tax haven” laws, which require a water’s-edge group to include affiliates organized or doing business in a “tax haven,” regardless of the amount of activity conducted in the US. Tax haven laws typically provide a list of jurisdictions considered to be tax havens (i.e., “blacklist”) or specify criteria for determining whether a jurisdiction constitutes a tax haven (e.g., lack of transparency, low tax rates, etc.). Most recently, Connecticut adopted a tax haven law requiring that the water’s-edge group include any member incorporated “in a jurisdiction that is deemed by the commissioner to be a tax haven” unless it is proven that such incorporation is for a legitimate business reason. Conn. Gen. Stat. § 12-218f(b)(3). Likewise, Rhode Island recently enacted a tax haven law that requires inclusion of certain attributes of non-US members of a combined group in a combined return if the tax administrator determines that the non-US member is organized in a tax haven – defined as a jurisdiction that meets a number of criteria – unless the taxpayer can show that (1) the transactions between the tax haven corporation and the group are at arm’s length and not with the principal purpose of avoiding tax; or (2) the inclusion of the income for purposes of Rhode Island would be unreasonable. R.I. Gen. Laws § 44-11-4.1(d).

States’ tax haven laws vary significantly and can be vague, resulting in uncertainty and lack of predictability for taxpayers. The criteria approach adopted by states such as Rhode Island gives state tax administrators particularly broad discretion. The ambiguous language and far-reaching effect of tax haven laws raise Due Process and Commerce Clause concerns beyond the scope of this article.

While there has not been an indication that states are ready to give up on tax haven laws altogether, the tax haven trend might shift in some states because of the Federal Tax Cuts and Jobs Act’s provisions related to inclusion of certain low-taxed intangible income. I.R.C. § 951A (GILTI). At least one state, Oregon, has already introduced legislation that would repeal its tax haven laws and conform to the federal GILTI provisions (the Bill has passed the Oregon legislature and was awaiting Governor Kate Brown’s signature at the time of this writing). S.B. 1529, 79th Leg. Assemb., Reg. Sess. (Or. 2018). Although questions remain regarding the constitutionality of states’ inclusion of GILTI in the state tax base, more states may follow Oregon’s lead on this issue.

Anti-Abuse Statutes

Another trend among revenue agencies seeking to stretch the confines of a water’s-edge group is reliance on “anti-abuse” or “income-shifting” laws. These provisions give states authority to make adjustments of income and expenses among related entities to reflect income. Thus, a state might attempt to rely on these provisions to attribute US income or apportionment factors to a foreign entity that might otherwise have no US operations. Such an attempt was correctly rejected by the Agilent court, which held that Colorado’s anti-abuse statute could not be used by the Department to modify the members of the water’s-edge group and only gave it authority to allocate income among the members of the combined group.

Economic Presence

Foreign entities with no physical presence in the US do not have nexus for state income tax purposes – false! Many states’ income tax standards focus on an entity’s economic – and not physical – presence in a state. A growing trend among states is enacting bright-line nexus laws (i.e., “factor-presence” standards) that could create traps for, and require the water’s-edge inclusion of, foreign entities with no physical presence in the US. Many states’ factor-presence provisions provide that a foreign entity is deemed to have nexus with a state if it has certain levels of activity (e.g., $50,000 of property or payroll or $500,000 of sales). Although the validity of these factor-presence nexus standards remains questionable, they appear to provide states with more opportunities to include foreign entities in a water’s-edge group, even when the only connection of such entities to the US is sales to US customers.


As the water’s-edge reporting landscape continues to evolve – whether through the states’ varying interpretations of 80/20 rules, tax haven laws, anti-abuse statutes or expansion of economic nexus standards – the state income tax treatment of foreign entities for combined reporting purposes is likely to become more of a focus of the states. Companies with foreign affiliates or foreign operations should consider how these developments and trends may impact their filings and business operations so they don’t find themselves in hot water in case of an audit.

Copyright © 2018 Tax Management Inc. All Rights Reserved.

Request Daily Tax Report: State