Water’s-Edge Elections

California Revenue and Taxation Code Division 2, Part 11, Chapter 17, Article 1.5 deals with the water’s-edge election under the Corporation Tax Law.

Section 25110 provides that a qualified taxpayer that is subject to the tax imposed under this part may elect to determine its income derived from or attributable to sources within this state pursuant to a water’s-edge election in accordance with the provisions of this part, as modified by this article. A taxpayer that makes a water’s-edge election is required to take into account that portion of its own income and apportionment factors and the income and apportionment factors  The terms “Subpart F income,” “earnings and profits,” “affiliated corporation,” and “qualified taxpayer” are defined.

Sales are considered to be made to a state only if the corporation making the sale may otherwise be subject to a tax on, or measured by, net income under the Constitution or laws of the United States, and do not include sales made to a corporation whose income and apportionment factors are taken into account  in determining the amount of income of the taxpayer derived from or attributable to sources within this state.

Section 25112 states that, if a taxpayer electing to file under Section 25110 fails to supply any information described, then the taxpayer is required to pay a penalty of $1,000 for each taxable year with respect to which the failure occurs. A taxpayer electing to file pursuant to Section 25110 must do all of the eight specified actions.

If the failure continues for more than 90 days after the date on which the FTB mails notice of that failure to the taxpayer, the taxpayer is required to pay an additional penalty $1,000 for each 30-day period (or fraction thereof) during which the failure continues after the expiration of the 90-day period. The increase in any penalty under this subdivision cannot exceed $24,000.

If the taxpayer fails to comply substantially with any formal document request arising out of the examination of the tax treatment of any item before the 90th day after the date of the mailing of the request, any court having jurisdiction of a civil proceeding in which the tax treatment of the examined item is an issue may, upon motion by the FTB, prohibit the introduction by the taxpayer of documentation covered by that request.

Section 25113 specifies that the election provided for in Section 25110 is on an original, timely filed return for the year of the election. The election will be considered valid if both of the specified conditions are satisfied. Except as otherwise provided, a water’s-edge election is effective only if made by every member of the self-assessed combined reporting group that is subject to taxation under this part.

Section 25114 requires the FTB to examine all returns filed by taxpayers subject to these provisions. In any case of two or more organizations, trades, or businesses, whether or not organized in the United States and whether or not affiliated, owned or controlled directly or indirectly by the same interests, the FTB may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among these organizations, trades, or businesses, if the FTB determines that the distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of these organizations, trades, or businesses. In the case of any transfer, or license, of intangible property, within the meaning of Section 936(h)(3)(B) of the Internal Revenue Code, the income with respect to that transfer or license is commensurate with the income attributable to the intangible property.