I've done some more research and came across a very good article. Basically, California requires taxpayers to file their returns on a worldwide basis, meaning that all income from the parent company and all of its subsidiaries throughout the world are included in California taxable income. However, California allows companies to make a “Water’s-Edge” Election, whereby only income from subsidiaries within the US is included in California taxable income. For instance, let’s say a Parent company has US losses of $1M and a foreign subsidiary with income of $2.5M. Generally, California taxable income would be $1.5M. If a water’s-edge election is made, the $2M of foreign subsidiary income could be excluded from California taxable income, and the company would have a CA taxable loss of $1M.
Of course, there are a few catches.
1. The election is binding for 7 years. So, if your profitable foreign entity begins to lose money and generates significant losses beginning in year 3, the corporation cannot begin filing on a worldwide basis to include those losses in CA taxable income.
2. In the year the election is made, the company must restate all of the company’s prior year loss carryforwards as if the company had previously made a water’s-edge election. I believe that this would require the unitary concept as well, as the California water's edge deduction is for all companies in the US only. So, if the company has significant NOLs from prior year foreign losses, the company may lose significant NOL carryovers by making the election. This could also be a very time consuming and expensive exercise.
3. If the income from the foreign subsidiaries is excluded from the taxable income, then the apportionment factors must also be excluded. So, if the company has a very low CA apportionment percentage due to significant foreign sales, property, and payroll, the company may not benefit from a water’s-edge election. This would mean that ALL companies in the unitary group WOULD be included! However, there is a dividend deduction of 75% that is allowed to eliminate the dividend income between the parents and subs.
I am continuing to research this, as my wife is at chemo tonight. If I run across anything more on point, I will post it;.
So, not all companies will benefit from a water’s-edge election, but companies with the right fact pattern could significantly benefit. You need to look at your facts. I would think that the profitability of the Mexican CFC would be the key factor.