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We have 5 subsidiaries within the US Federal consolidated group,

with 1 Mexican CFC. One...
We have 5 subsidiaries within the US Federal consolidated group, with 1 Mexican CFC. One of the subsidiaries has nexus in California and has been filing separately in CA since 2008.
Questions: (1) Should we be concerned with CA coming after us to file worldwide unitary? Will We have never been audited by CA. All subsidiaries do almost similar businesses. (2) We can file water's edge election. What are the advantages and disadvantages of filing water's edge? (3) Will CA penalize us for filing incorrectly since 2008?
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7/26/2013
taxmanrog
taxmanrog, Certified Public Accountant (CPA)
Category: Tax
Satisfied Customers: 869
Experience: Licensed CPA, MA, MST with 31 years' experience. Teach Accounting and Tax courses at Masters level.
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Welcome to Just Answers! Thank you for the opportunity to answer your question! I will do my best!

First, a question for you. Is the sub with the California nexus the owner of the CFC? I ask because it will make a difference. I am familiar with this situation, as I used to be responsible for the US filing of a company with 32 US corporations and 116 foreign subs.

Once I know, I can give you a better answer.

Thanks!
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Customer reply replied 4 years ago


Yes, this company having the CA nexus is the owner of the Mexican CFC.

OK. First of all, if you file consolidated for Federal, the State of California can force you to file worldwide unitary. A state may impose a unitary tax only on a corporation whose operations constitute a unitary business. No universal definition of "unitary business" exists. Instead, the definition varies among the states. At a minimum however, the definition requires some common bonds of ownership and control. There has to be a solid relationship between the in-state and the activities of the unitary companies.

The United States Supreme Court has approved a three part test. In order to be unitary, there must be 1) unity of ownership, 2) unity of use, and 3) unity of operation. unity of ownership means over 50% of the voting stock. For unity of use means that the companies have common management control and general operating systems. For unity of operations, the affiliated companies are assumed unititary when the entities all use the same accounting, advertising, or management.

California uses unitary, but on a worldwide combined reporting basis. So if California feels that your five US subsidiaries plus your Mexican CFC are considered unitary, they can force you to file unitary and apportion your income based on their apportionment formula. They subject worldwide income to their formula.

In 1986, California modified its state corporation tax provisions to include a water's-edge election for international corporations. Barclays Bank PLC V Franchise Tax Board in 1994 changed the method of apportionment, but it affirmed the State's right to tax international corporations. By making a Water's Edge election, the company "carves out" corporations that meet the water's edge inclusion test. These corporations are combined in the "water's edge" unitary group, and are the only ones included in the combined reporting group. A water's edge election is in effect for 7 years.

If you made a "water's-edge" election for your corporation with California nexes, it and it's Mexican CFC would be subject to apportionment and taxation in California, but the rest of the corporations in your consolidated return would not be subject to California tax. So you need to see what will give you a better answer - apportioning your worldwide income to California for your consolidated group, vs making a "water's-edge" election and using just the company with California nexus and the Mexican CFC for tax purposes.

I hope this answers your question! If you have any more, please let me know. If you have found my answer helpful, please rate me highly! I would appreciate it!

Again, thanks! Have a great weekend!





The United States Supreme Court has approved a

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Customer reply replied 4 years ago

Thank you for your answers.


1. If we make the water's edge election in our 2012 tax return, what is the impact on our previously-filed separate return 2008 to 2011? Will CA force us to amend those returns and pay the additional taxes due (if any)? In other words, will CA penalize us for filing incorrectly since 2008?


2. Can you provide me with the supporting CA code section on your comment below:


If you made a "water's-edge" election for your corporation with California nexes, it and it's Mexican CFC would be subject to apportionment and taxation in California, but the rest of the corporations in your consolidated return would not be subject to California tax.


I am still confused with your statement above. What if the other 4 entities meet the unitary tests of the supreme court? Will these 4 entities need to be included in the water's edge reporting? In other words, these 4 entities do not have nexus in CA but they meet the unitary tests, will these 4 entities be required to file water's edge?


Thanks.

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;.

 

Thanks!

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.

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Customer reply replied 4 years ago

Thank you for your further clarifications on the filing requirement in CA and the impacts of water's edge election. We will analyze our facts closely before making any changes.


Could you please answer my first question above? We just want to make sure we are not penalized if we change our method of filing because from what I heard CA is the hardest state in chasing after non-compliant taxpayers.

I have not been able to find anything concrete about them forcing you to go back and amend when you make the water's edge election. However, you have been "flying under their radar" so far. If they see you are unitary, even if you don't make the election, they can make you amend your returns as you are not compliant. They can make you go back as far as they want, until you are no longer unitary.

I know that Illinois has done this for unitary businesses, I don't think California would be any less aggressive.

I hope that answers your questions! If I find out anything else, I will post it. If you have found my answer helpful, please rate me positively. I would appreciate it.

Again, many thanks!
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Customer reply replied 4 years ago

Thank you. You have been very helpful. If I have other tax questions, how do I make sure those questions reach to you directly? You seem to have the experience and knowledge that match what I was looking for.

Thank you for your complement! I like to be as correct as possible. I guess that is the academic in me!

ll you have to do is request me, either Taxmanrog or Roger. You do that by stating in the first line something like "This question is for Taxmanrog" or "I would like Roger to answer this question". Most of the experts follow the professional courtesy and will allow the expert you ask for to answer the question.

Again, if this was helpful, please remember to rate me, that is how the question is closed, and how my performance is rated.

Thanks!

Have a great weekend! It is a beautiful day here in the SW burbs of Chicago!
taxmanrog
taxmanrog, Certified Public Accountant (CPA)
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Satisfied Customers: 869
Experience: Licensed CPA, MA, MST with 31 years' experience. Teach Accounting and Tax courses at Masters level.
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