Water’s-Edge Election: Effectively Connected Income and the 20% Rule in California

Editor: Kevin D. Anderson, CPA, J.D.

For years beginning on or after Jan. 1, 2011, the threshold for doing business in California changed significantly. The economic nexus rules under Cal. Rev. & Tax. Code Section 23101 can now result in a business entity having a filing requirement in California without any physical presence. For companies that generate revenue from intangible assets, the results can be unfavorable.

A foreign corporation that has established economic nexus without any physical presence in California could make a water’s-edge election to avoid including its income and factors in the combined report. Some or all of the foreign corporation’s income will not be excluded from the combined report, however, if the foreign corporation has effectively connected income (ECI) or a 20% or higher U.S. apportionment factor. (When a foreign person engages in a trade or business within the United States, it may have income that is considered ECI.)

The sourcing rules for determining economic nexus can be much different from the sourcing rules for determining ECI or the 20% full inclusion rule. This item discusses how foreign corporations that generate income from intangible assets are affected by the economic nexus rules as well as the water’s-edge rules.

Economic Nexus

A business entity is considered to be doing business in California for tax years beginning on or after Jan. 1, 2011, if it actively engages in any transaction for the purpose of financial or pecuniary gain or profit. In addition, if a business entity has a minimum amount of property, payroll, or sales in California, then it will be considered to have economic nexus in California.

In determining California sales for economic nexus purposes, the market-based-sourcing rules under Cal. Rev. & Tax. Code Section 25136(b) apply for sales other than the sale of tangible personal property.

Water’s-Edge Application

If a foreign corporation has established economic nexus in California, then it will have a filing requirement and be subject to California’s franchise tax. Can a foreign corporation simply make a water’s-edge election to avoid having to include all its foreign income and factors on a California return? The general rule is that all foreign corporations are excluded from the water’s-edge combined report if the election is in effect. Therefore, if the foreign corporation makes a water’s-edge election, it can exclude its income and factors from the water’s-edge return unless it has either ECI or a 20% or higher U.S. apportionment factor.

If the foreign corporation has ECI, then it will be included in the combined report to the extent of its ECI. In addition, it is entitled to factor relief, so its effectively connected sales will be included in the sales factor. If the foreign corporation has a 20% or higher U.S. apportionment factor, then it will be fully included in the water’s-edge combined report.

Fixed or determinable annual or periodical (FDAP) income typically consists of interest, dividends, rents, royalties, annuities, and wages. Other items of FDAP income are listed in Sec. 871. In the past, California required FDAP income to be included in the combined report less expenses. However, California no longer includes FDAP income in the water’s-edge combined report unless it is considered ECI under either the asset-use test or business-activities test.

If FDAP payments are made between members of the water’s-edge combined report, the group may be subject to withholding. Cal. Rev. & Tax. Code Sections 18662 and 18666 require certain taxpayers to withhold income or franchise taxes from payments and distributions made to foreign corporations or partnerships. This requirement can apply to U.S. corporations included in the water’s-edge combined report for payments made to excluded foreign corporations and partnerships.

Payments made to a foreign corporation that has a permanent place of business in California or is qualified through the secretary of State will not be subject to withholding. If withholding is required for payments made to an excluded foreign (non-U.S.) corporation, then the withholding rate is 8.84% rather than the normal 7% withholding rate. Keep in mind that the sourcing rules used to determine the withholding requirements are not the same as the market-based-sourcing rules.

20% U.S. Apportionment Factor

If a foreign corporation does not have any ECI, it may still be included in the water’s-edge combined report if its U.S. apportionment percentage is 20% or more (Cal. Code Regs. tit. 18, §25110(d)(2)(B)). Cal. Rev. & Tax. Code Section 25110(a)(1)(B) states that any corporation (other than a bank) will be fully included in the water’s-edge combined report regardless of where it is incorporated if the average of its property, payroll, and sales factors within the United States is 20% or more. The general rule requires the use of a three-factor formula.

If a foreign corporation does business in a state that does not impose a tax on income or assigns income on the basis of an apportionment formula that does not have each of the three factors, the rules for California should be applied for any factor that the state does not use (Cal. Code Regs., tit. 18, §25110(d)(2)(B)(3)(b)). Therefore, if a state uses a single sales factor formula, then, according to the regulations, the rules set forth in Article 2 of Chapter 17 of the Revenue and Taxation Code should be followed in determining the property and payroll factor. However, California now uses a single sales factor formula. Although a single sales factor formula is required for years beginning on or after Jan. 1, 2013, the regulations still provide rules for determining the property and payroll factor (Cal. Code Regs., tit. 18, §§25129 and 25132).

Should these rules apply in determining the property and payroll factors, or should the single sales factor apply to the 20% rule? When California changed to a double-weighted sales factor for years beginning on or after Jan. 1, 1993, the Franchise Tax Board issued Legal Ruling 95-5 to address questions raised by taxpayers regarding the calculation of the 20% U.S. apportionment factor rule. The question was whether to apply the double-weighted sales factor to the calculation or continue to apply the traditional three-factor formula. The legal ruling concluded that the three-factor formula should continue to apply for purposes of the 20% rule even though the apportionment factor rules changed to a double-weighted sales factor. Based on the analysis in Legal Ruling 95-5, it would appear that California will continue to apply the three-factor formula.

In determining the sales factor for the 20% rule, should the cost-of-performance rules apply or the market-based-sourcing rules? The market-based-sourcing rules apply to the single sales factor formula whereas the cost-of-performance rules typically apply to the three-factor formula. If California is going to require a three-factor formula in determining the 20% rule, then one would assume that the cost-of-performance rules would apply. However, the cost-of-performance rules are no longer in Cal. Rev. & Tax. Code Section 25136. Instead, the market-based sourcing rules are now in this section. Because the cost-of-performance rules were repealed, it would seem that California will require the market-based-sourcing rules in calculating the 20% rule for years beginning on or after Jan. 1, 2013. However, an argument could be made that, since Cal. Code of Regs. Section 25136 still provides cost-of-performance rules, those rules should apply if the standard three-factor formula is still used to calculate the 20% rule. The Franchise Tax Board has not provided guidance on this issue.

A sale made by a foreign corporation to an affiliate that is a member of the water’s-edge combined report is not taken into account in computing the numerator or denominator of the sales factor (Cal. Code Regs., tit. 18, §25110(d)(2)(B)(3)(d)). This rule can have a substantial effect on the apportionment calculation since the majority of the foreign corporation’s sales into the United States may be to its U.S. subsidiary.

In summary, since California now applies the economic nexus and market-based-sourcing rules, a foreign corporation with no physical presence in California may actually have a filing requirement and taxable income in the state. A water’s-edge election will not necessarily prevent the foreign corporation from having to partially or fully include its income and factors in the combined report. Keep in mind that the sourcing rules used to determine ECI are much different from the sourcing rules used in determining the 20% rule.

EditorNotes

Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Washington.

For additional information about these items, contact Mr. Anderson at 202-644-5413 or kdanderson@bdo.com.

Unless otherwise noted, contributors are members of or associated with BDO USA LLP.