Time to Revisit

August 23, 2022

The Unitary Business Rules & Water’s-edge Election

By Ming P. Fang, CPA

Affiliated corporations doing business in California are required to evaluate the unitary business rules. Under the California unitary business rules, unitary businesses are taxed as a single unit where each corporation is considered a division of the same corporation and all the activities are combined. The determination of unitary business is based on three unity tests (unity of ownership, unity of operations, and unity of use of centralized executive force and system of operations) or the dependency of business operations test.

The U.S. Supreme Court has ruled that business functions integration and centralization of management to achieve economies of scale create a unitary business. With the moving workforce and remote work environment during the pandemic, smaller multi-national corporations have seen opportunities to centralize management and business functions. The current economic landscape with many companies tightening budgets to weather a potential recession may further increase the centralization of these functions. The effect of the centralization of management and business functions may mean affiliated corporations that were previously non-unitary businesses are now unitary businesses.

When corporations are determined to be part of a unitary business, the reporting requirements are more complex and extensive. It also requires the determination of lines of businesses within each corporation. Only the line of business attributable to the unitary business must be combined. The combined reporting pursuant to R&TC Sec. 25101.15 apportions income to California based on the apportionment factors of the unitary line of business. 

The unitary business rules are further complicated when the unitary group includes foreign corporations. California has always been and continues to be a state where foreign corporations establish operations through a U.S. subsidiary to enter the U.S. market. Executives and key employees of the foreign parent corporations often move to California to establish the U.S. operations. The continued prevalence of remote work allows some of these executives and employees to move back to their home country to be closer to family during the pandemic. This movement tends to increase the centralization of management and business functions creating a unitary business with foreign parent and affiliated corporations as well as potentially creating nexus for the foreign corporations in California.

California requires worldwide reporting of business operations for the unitary group, including the worldwide operations of the foreign corporations. This reporting is substantially different to the federal requirements where foreign corporations are only required to report the operations of the U.S. branch. In many cases, it also results in higher California taxes.

Fortunately, California enacted R&TC Sec. 25110 to limit California’s worldwide combined reporting. Pursuant to R&TC Sec. 25110, corporations can make a Water’s-edge election which generally limits the taxation to income taxed in the U.S. for federal income tax purposes. This includes all income from U.S. corporations and effectively connected income from foreign corporations. The Water’s-edge election allows corporations to be taxed similarly to the federal U.S. branch reporting rules.

Making the Water’s-edge election does not override the unitary business rules. It simply limits the entities and income subject to tax and apportionment factors in California. One of the most significant provisions is the limitation of income and apportionment factors attributable solely to sources within the U.S. for foreign corporations with average of sales, property and wages factors of less than 20 percent within the U.S.

Another significant benefit from the Water’s-edge election is the allowance of dividend deduction for U.S. corporations receiving dividends from foreign subsidiaries. The dividend is fully or partially excluded if it is attributable to the foreign subsidiaries’ earnings and profits previously fully or partially, respectively, included in a combined unitary report. Otherwise, there is generally a 75 percent dividend deduction when certain conditions are met.

Once the Water’s-edge election is made, it’s effective for seven years with very limited exception for termination. There are also extensive record keeping and documentation requirements. 

Despite the additional tax implications associated with unitary businesses, there may be tax benefits as well. A potential tax benefit is presented when the unitary group includes corporations with business losses and corporations with business income from a unitary business. Since the unitary business rules tax the unitary group as a single unit, the unitary business income and losses from all members of the unitary group are aggregated to compute the combined unitary business income. This essentially allows for the losses of one corporation to be deducted from the income of another corporation, similarly to the federal controlled group consolidated income tax rules.

The aggregation of the income and losses from all members of the unitary group also may result in income being allocated to a member that had a loss. This may allow certain tax attributes carryover, such as net operating losses, from that member to be utilized that would otherwise been disallowed.

With all this in mind, it may be time to revisit the unitary business rules.  
Ming P. Fang, CPA is a partner at Spott, Lucey & Wall CPAs.

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