Worldwide combined reporting: An underutilized opportunity

By Daniel Sieburg, CPA, and Jon Cesaretti, J.D., LL.M., Chicago

Editor: Howard Wagner, CPA

A common refrain after the passage of the law known as the Tax Cuts and Jobs Act of 2017 (TCJA), P.L. 115-97, was that the United States had finally moved from a worldwide tax regime to a territorial tax regime consistent with its trading partners. While that characterization overstated the change, it could be said that the U.S. federal income tax is now at least a hybrid or quasi-territorial regime. However, worldwide taxation has always been alive and well in a number of states even if it never resembled the federal "worldwide" reporting regime. Of the states that impose an income tax, over half require combined reporting. About half of the combined-reporting states allow or "require" worldwide reporting. This discussion focuses on how state worldwide reporting works and what taxpayers should consider in determining whether to elect it or avoid it.

Differences between US federal and state 'worldwide' reporting

Under the pre-TCJA Code, U.S. corporations were taxable on their worldwide income regardless of where it was earned. Foreign earnings were subject to tax when the income was repatriated. This is known as "deferral" because the income tax owed was deferred until a later date when the income was repatriated. Under this regime, the United States did tax some foreign earnings immediately. Under the TCJA, there is generally no taxation of repatriated dividends received by domestic C corporations. However, the Code still contains Subpart F rules, as well as the newly introduced concept of global intangible low-taxed income (GILTI).U.S. consolidated returns include only U.S. corporations. The international tax provisions, both pre- and post-TCJA, tax income accrued by foreign affiliates by attributing it to domestic entities.

GILTI is imposed on U.S. shareholders of a controlled foreign corporation (CFC) on their share of any income earned by the CFC exceeding a 10% return on investment. If a CFC has passive income known as Subpart F income, then those U.S. shareholders must include in their income their share of the Subpart F income even though no dividend is paid to them (see Secs. 951-965). (Further discussion of GILTI is beyond the scope of this item.)

Unitary business principle

Worldwide combined reporting at the state level involves a different system from the federal "worldwide" filing. The first difference is a concept unique to state reporting — the unitary business principle. A U.S. consolidated federal income tax return is made by taxpayer election and requires 80% ownership of vote and value, and the Sec. 1504 affiliated group includes only U.S. corporations. There is no analysis of the relationship among the entities in the group.

Conversely, states that have combined reporting require taxpayers to file under this method. It is precisely because of the mandatory nature of combined reporting that courts have restricted states' use of it by requiring the presence of a unitary relationship. Courts have consistently held that if a state is going to tax a group of entities as a single economic enterprise, the U.S. Constitution requires that members of the group of commonly controlled corporations constitute a unitary business. Unlike a federal affiliated group, which is determined solely on a quantitative analysis, a unitary determination is based on a quantitative ownership test and a qualitative test for unity.

The determination of unity requires an analysis of the relationships between the affiliates, which has taken the form of a number of tests or factors: common ownership and control (usually defined as 50% as opposed to 80%), flow of value, economic interdependence, intercompany transactions, and horizontal or vertical integration. A portion of the unitary business's income is then attributed to a state using an apportionment formula — traditionally a ratio of in-state sales, property, and payroll as it bears to sales, property, and payroll everywhere. But the state apportionment formula now more commonly uses the sales factor only.

Under the worldwide combination method, a state imposes its tax on income apportioned to that state by the corporate taxpayer and all of its affiliates, domestic or foreign, that engage in a unitary business. When a state employs a water's-edge combined reporting method, the group excludes foreign affiliates and even U.S. corporations if they conduct most of their business outside the United States.

'Mandatory' or elective

While some states default to a worldwide filing, those states typically allow an election to file on a water's-edge basis. However, this election is a trap for the unwary, as the election typically must be made on an originally filed return (e.g., California) or within a certain number of days of the beginning of the year for which the election is to be effective (e.g., Montana). The window during which the election must be made can sometimes be closed by the time the tax preparer is even aware of activities taking place in these states. It is critical to frequently review the activities and state nexus of the group's members and determine the filing methodologies and options in the states with the new activity. Given the elective nature of worldwide filing, taxpayers should analyze which filing method — water's-edge or worldwide — is more beneficial.

General requirements

Like other unitary combined filings, there are requirements for an entity to be included in a worldwide filing. In general, these requirements are the same as for the U.S. entities. These requirements are that the entities need to have a common ownership entity or parent entity (again usually 50%), are not included in another group filing in the state, and are part of a unitary business group.

As with general combined group filings, worldwide combined groups need to combine all unitary entities in the combined group. All income and losses from those entities are included in the return to arrive at state taxable income. Foreign entities need to convert income to dollars for this calculation. If these entities file a Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, with their group's federal consolidated return, the income presented on the form may be used to analyze the relative benefit or detriment of a worldwide combined filing.

In a worldwide combined filing, the apportionment rules apply in the same manner to the foreign affiliates that are included in the group. The foreign affiliates' sales, property, and payroll are included in the denominators of the factors and are included in the numerators if they have activity within the state. Transactions between members of the worldwide group are generally eliminated from both the tax base and the sales factor.

Considerations for the election

The first thing to consider when analyzing a worldwide versus a water's-edge election is (1) which method is the default and (2) the length of the election when opting out of the default filing method. For example, California defaults to a worldwide filing. California's water's-edge election, if made, runs for 84 months. Conversely, Connecticut's default filing method is water's-edge, but the state allows a worldwide election. The Connecticut worldwide election runs for 10 years. Foresight is required when making the election — while it might be beneficial for the first or second year, it could be detrimental in a later year.

Generally, the greatest consideration is the relative profitability of domestic versus foreign operations. In a worldwide filing, a taxpayer is including the income (or loss) and apportionment of the unitary foreign affiliates. The additional income brought into the state filing by including the foreign affiliates may be mitigated by the dilution of the apportionment factor (presuming the foreign affiliates' property, payroll, and sales would add to the denominator of the apportionment ratios, thereby reducing the amount of income assigned to the state).

Not only does a worldwide combined filing affect the income or loss included in the group's return, it may also impact state tax adjustments. States begin their income tax computations with federal taxable income and then make adjustments or modifications to arrive at state taxable income. There may be beneficial effects of electing to file on a worldwide combined group's state modifications. One example of this is foreign dividends. Most states have a general dividend deduction for any foreign dividends included in income. However, the deduction is not always 100% of the dividends reported. By electing to be taxed as a worldwide group, these dividends may be eliminated, as they are received from an entity included in the combined group.

Another category that needs to be analyzed is intercompany transactions. In a water's-edge filing, transactions between domestic and foreign entities (that are presumably not included in the combined group) are not eliminated. However, under a worldwide combined election, the transactions may be eliminated as transactions between members of the combined group. Eliminating intercompany transactions can potentially impact both the state tax base and apportionment. The elimination of intercompany transactions may affect how much or whether the sales factor is diluted by the inclusion of foreign affiliates. In the case of an integrated supply chain that crosses the U.S. border, the sales of a foreign affiliate may be mostly to a U.S. company, so including the entity would not increase the sales factor denominator, as the sales would be eliminated.

The elimination of intercompany transactions may also affect the state related-party addback provisions. State addback rules are often thought of in the context of separate-company reporting states, where deductions of certain intercompany expenses (e.g., royalties or interest) are required to be added back in arriving at state taxable income. However, some combined reporting states also have addback rules that may apply to transactions between a water's-edge group and foreign affiliates excluded from the group. A taxpayer that is concerned about meeting the exceptions for the addback requirement may find it is advantageous to elect a worldwide filing and avoid the addback.

Below is an example and analysis of a potential worldwide combined election to determine whether it would be beneficial. The clearest example is where including a foreign affiliate can create a loss for state tax purposes.

Example 1: An affiliated group, ABC, includes three entities: Corp. A, Corp. B, and Corp. C. A and B file a federal consolidated return. C is a foreign affiliate excluded from the federal consolidated return and state water's-edge filings. A has taxable income of $1 million, and B has a loss of $500,000. C has a pro forma loss of $750,000. Assume state taxable income equals federal taxable income. On a water's-edge filing comprising A and B, there would be taxable income of $500,000. By electing worldwide combined filing, the group would have an overall loss of $250,000. The election would be beneficial regardless of the impact on apportionment.

A more complicated example involves profitable foreign affiliates. Here the analysis involves weighing the additional income included in a worldwide combined group with the effect the foreign affiliates have on apportionment.

Example 2: The same group from Example 1 is filing a state return with a single-factor sales apportionment and a 5% tax rate. In this example, C has $250,000 of income. The U.S. entities have $3 million of in-state sales and total sales of $10 million. The foreign affiliate has $8 million of total sales, all of which are in its local jurisdiction. Under a water's-edge return, the combined group has income of $500,000 and an apportionment factor of 30%, resulting in state income of $150,000. Under a worldwide combined filing, the group's income increases to $750,000, but the apportionment factor is reduced to 16.67%, resulting in state taxable income of $125,000. In this scenario, the additional income included in the worldwide return is offset by the dilution of the apportionment factor.

Conversely, using the same example, assume C has only $2 million in total sales, again entirely in its local jurisdiction. Here the worldwide election would be detrimental. The worldwide group's income remains $750,000. However, the apportionment factor increases to 25%, resulting in state taxable income of $187,500.

The potential benefit of a worldwide filing should depend on the relative profitability of a business's operations in the United States versus the relative profitability of its operations outside the United States. Those businesses that are marginally more profitable inside the United States than outside the United States should consider the benefit of filing on a worldwide basis, as they would presumably be able to dilute their state taxable income with marginally less profitable apportionment factors (typically sales factors). Those businesses that are marginally more profitable outside the United States than inside the United States should consider the benefit of filing on a water's-edge basis. Any analysis of the impact of filing on a worldwide or water's-edge basis should include an assessment of likely future profitability between U.S. and non-U.S. operations, the impact of the elimination of intercompany transactions, dividends from foreign entities and whether they are included in the state tax base under either scenario, and the potential impact of state addback rules.


Howard Wagner, CPA, is a partner with Crowe LLP in Louisville, Ky.

For additional information about these items, contact Mr. Wagner at 502-420-4567 or

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

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