California currently taxes the foreign income of a “unitary group” through worldwide combined reporting with a single sales factor for apportionment. Under this method, U.S. businesses and their foreign affiliates engaged in a single trade or business are treated as a “unitary group,” and the business income of the “unitary group” is apportioned and reported in a single “combined report,” which treats a group as one single taxpayer. The combined report is used to determine how the income of a unitary business is attributable to operations within the state.
California generally uses a single sales factor to apportion the unitary group’s income attributable to activities in California. California also allows corporations to elect to apportion income on a “water’s edge” basis, which restricts the combined reporting method to include only income sourced in the United States. A combined group that makes a water's-edge election can deduct 75% of qualifying dividends received from its foreign affiliates, and the election is made for at least 84 months. The water’s edge election, however, can provide an incentive to shift income abroad to avoid state taxation.[1]
Unitary business principle
The first element of the combined report, the “unitary group,” is rooted in the “unitary business principle” first articulated in property tax cases involving transcontinental railroad companies during the 19th century.[2] The Due Process Clause of the Fourteenth Amendment limits a state’s income taxing authority to income generated within the state, but states faced the challenges of taxing the income of multi-state businesses.[3] The “unitary business principle” recognized that a business’s value derives from the combination of all its activities and permits a state to tax a unitary business even if the value or income of the business is earned in different states.[4] The “unitary business principle” was first based on physical unity, and the concept was extended to corporate income tax based on the idea of operational unity.[5] The U.S. Supreme Court noted in a 1980 decision that the unitary business principle was the “linchpin of apportionability in the field of state income taxation.”[6]
California uses both the “three unities test” and the “dependency test” separately to determine whether a business is a “unitary business.”[7] Under the “three unities test,” a unitary business must have unity of ownership and management, unity of operation, and unity of use.[8] Under the “contribution or dependency test,” parts of a business are unitary if “the operation of the portion of the business done within the state is dependent upon or contributes to the operation of the business without the state.”[9]
Worldwide combined reporting
Multi-state or multinational unitary groups are taxed as a unitary business in a combined report. In the 1970s, California required multinational corporations to file a combined reporting on a worldwide basis.[10] Companies soon challenged the use of worldwide combined reporting as a violation of the Foreign Commerce Clause.[11]
In 1983, in Container Corporation of America v. Franchise Tax Board,[12] the U.S. Supreme Court held that California’s worldwide combined reporting under the “unitary business” principle did not prevent the United States from “speaking with one voice” in regulating foreign trade and therefore did not violate the Commerce Clause.[13]Container Corporation prompted concern from foreign multinational companies and foreign trading partners about California’s use of worldwide combined reporting.[14] U.S. trading partners protested the use of mandatory worldwide combination by the states, and the U.S. government pressured the states not to use mandatory worldwide combined reporting.[15] The United Kingdom threatened to impose reciprocal taxes on U.S.-based international groups.[16]
The Reagan administration convened a Worldwide Unitary Taxation Working Group, which included California Governor George Deukmejian, to review the issue of worldwide reporting.[17] In 1984, the Working Group recommended that states limit the combined reporting of U.S. and foreign multinationals to the U.S. water’s edge.[18] The states did not follow the recommendations.[19] In 1985, the U.S. Treasury proposed legislation to restrict worldwide combined reporting.[20] Many states then repealed their worldwide combined reporting statutes or passed legislation to allow a water’s edge election.[21]
Water’s edge election
In 1986, California became the first state to introduce a “water’s edge election” when it enacted Senate Bill 85 to permit a “water’s edge election” to restrict California’s “application of the worldwide combined reportingmethod of determining income from California sources.”[22] This option allows a taxpayer that would pay more tax under the worldwide method to choose to pay less by making a water's-edge election.[23] The bill was effective for tax years beginning on or after January 1, 1988.[24] The new law included an “80-20 rule,” which requires the water’s-edge group to the income of a foreign affiliate (other than a bank) that has more than 20 percent of their property, payroll, and sales factors within the United States.[25]
California’s worldwide combined reporting requirement was controversial, and in 1994, the California subsidiary of Barclays challenged California’s worldwide combined reporting, arguing that the cost to provide worldwide financial data unduly burdened foreign corporations and violated the anti-discrimination of the Commerce Clause. The U.S. Supreme Court held in Barclay's Bank, PLC v. Franchise Tax Bd. of California,[26] that worldwide combined reporting “did not result inevitably in multiple taxation.”
California taxes international income using the “80/20 rule,” under which a corporation’s a water's-edge combined report includes all income and apportionment factors if 20% or more of the average of a foreign corporation's property, payroll, and sales are within the U.S. California also taxes subpart F income, which is earned by foreign subsidiaries, by including it in the corporate income tax base through its “inclusion ratio.”[27] This “inclusion ratio” is a controlled foreign corporation’s net income multiplied by a fraction with subpart F income of the CFC as the numerator and the earnings and profits of the CFC for that tax year as the denominator.[28]
[1] Shanske, White Paper, p. 2. [2] Catherine A. Battin, Decoding Combination: What Is a Unitary Business, The National Law Review. [3] Shanske, White Paper, p. 1. [4] Darien Shanske, White Paper on Eliminating the Water’s Edge Election and Moving to Mandatory Worldwide Combined Reporting, p. 3. [5] Shanske, White Paper, p. 3; Catherine A. Battin, Decoding Combination: What Is a Unitary Business, The National Law Review. [6]Mobil Oil Corp. v. Comm'n of Taxes of Vermont, 445 U.S. 425, 439 (1980). [7] See Oil Corp. v. Franchise Tax Bd., 386 P.2d 40, 43-45 (Cal. 1963); Tax Bd., 386 P.2d 33, 38 (Cal. 1963); Edison Cal. Stores v. 1947); Butler Bros. v. McColgan, 1 1 1 P.2d 334, 341 (Cal. 5Cal. Code Regs. tit. 18, § 25110(d)(l)(B) (2008). [8] 17 Cal. 2d 644 (1941), affd., 315 U.S. 501, 508 (1942). [9] 30 Cal. 2d 472 (1947). [10] Shanske, White Paper, p. 2. [11] Chapter 1, p. 4. [12] 463 U.S. 159 (1983). [13] 463 U.S. 159, 205 (1983). [14] Sutton, Jones, Hodges, and Yesnowitz, California Water's-Edge Election, p. 1113. [15] Shanske, White Paper, p. 2. [16] Sutton, Jones, Hodges, and Yesnowitz, California Water's-Edge Election, p. 1113; Darien Shanske, White Paper on Eliminating the Water’s Edge Election and Moving to Mandatory Worldwide Combined Reporting, p. 4. [17] Sutton, Jones, Hodges, and Yesnowitz, California Water's-Edge Election, p. 1113; Chapter 1, p. 5. [18] Sutton, Jones, Hodges, and Yesnowitz, California Water's-Edge Election, p. 1113. [19] Sutton, Jones, Hodges, and Yesnowitz, California Water's-Edge Election, p. 1113. [20] Sutton, Jones, Hodges, and Yesnowitz, California Water's-Edge Election, p. 1113-14. [21] Sutton, Jones, Hodges, and Yesnowitz, California Water's-Edge Election, p. 1114. [22] Shanske, White Paper, p. 4; Chapter 1, p. 2, 5. [23] Chapter 1, p. 2. [24] Sutton, Jones, Hodges, and Yesnowitz, California Water's-Edge Election, p. 1114. [25] Donovan, Frieden, Hogroian, and Wood, States Tax Notes, October 22, 2018, p. 30. [26] 512 US 298 (1994). [27] Donovan, Frieden, Hogroian, and Wood, States Tax Notes, October 22, 2018, p. 30. [28] Jéanne Rauch-Zender, Should States Embrace GILTI?, State Tax Notes, March 18, 2019, p. 937.