August 2017

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California Addresses the Impact on Water's-Edge Elections When A Foreign Affiliate Becomes Subject to California Tax

In September 2016 the FTB released Notice 2016-02 which addresses the impact on a taxpayer’s water’s-edge election when, due to an expansion in California’s definition of “doing business", a taxpayer’s foreign affiliate that previously was not subject to California income or franchise tax, now becomes subject to the tax.

Background and Issue

Beginning with the 2011 tax year California expanded the list of factors that determine whether an out-of state business is “doing business” in California. Companies “doing business” in the state are considered California taxpayers and are subject to state income or franchise tax.

Besides property and payroll thresholds, a corporation is considered “doing business” if its California sales exceed the lesser of $500,000 (adjusted for inflation) or 25% of the corporation’s total sales. (For 2016 the inflation adjusted sales amount is $547,711.) Such criteria are referred to as an “economic nexus standard”. Consequently, a corporation that was not considered a California taxpayer prior to 2011 could now be considered a taxpayer due to meeting this new standard.

For California tax purposes a taxpayer may elect to determine its income under a water’s-edge election. In order to be valid the election needs to be made by every California taxpayer that is a unitary member of the reporting group. Absent this election a taxpayer may have to compute its California tax based on worldwide income, which means including the income of all its unitary foreign affiliates (including the foreign parent) in the California return.

The water's-edge election allows a taxpayer to limit or eliminate the income of these foreign affiliates from being included in the return. Therefore, there was concern whether a water's-edge election terminates if a foreign affiliate that was not included in the original water's-edge group making the election (because it previously was not considered a California taxpayer) suddenly became a California taxpayer due to meeting the economic nexus standard mentioned above. Prior to the issuance of Notice 2016-02 the FTB did not provide any guidance for such a situation. Notice 2016-02 now provides some input on the FTB's position.

Notice 2016-02

In Notice 2016-02 the FTB addressed how it will treat an existing water’s-edge election when, after the initial election, a unitary foreign affiliate of the water’s-edge combined reporting group becomes a California taxpayer due to meeting the economic nexus standard.

The Notice indicates the FTB will not terminate the existing water’s-edge election in certain situations. It generally provides that a unitary foreign affiliate is considered to have made a water’s-edge election either along with other members of the combined reporting group, or in the year it becomes a California taxpayer, if specific conditions are met.


A case-by-case review should be done to determine if each unitary foreign affiliate has economic nexus in California and, if so, whether or not Notice 2016-02 applies under the circumstances. Also to be considered is what California taxes will be owed by the foreign affiliate.


Please note that the information provided is of a general nature and based on authorities that are subject to change. If you have any questions or would like further information regarding this matter, please contact the office of Kakimoto & Nagashima LLP at (310) 320-2700.

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