United States: California FTB Issues Guidance On Effect Of Economic Nexus On Water's-Edge Combined Reporting Groups

The California Franchise Tax Board (FTB) has recently issued guidance to clarify the rules for water's-edge filers with foreign affiliates who were impacted by California's adoption of a bright-line or economic nexus standard to determine whether a company is doing business in the state.1 Specifically, the FTB explains how it treats a water's-edge election when a unitary foreign affiliate of the water's-edge combined reporting group becomes a taxpayer in the state under the economic nexus standard. The FTB has created several exceptions that will allow taxpayers to include these foreign affiliates in their water's-edge combined reporting group.

Adoption of Economic Nexus Standard

California law defines "doing business" in the state as "actively engaging in any transaction for the purpose of financial or pecuniary gain or profit."2 For taxable years beginning on or after January 1, 2011, California expanded the definition of doing business in the state by adopting an economic nexus standard with sales, property and payroll thresholds that subject entities with otherwise limited connections to California to franchise (corporate income) tax reporting requirements.3 Due to this change, a corporation that previously was not doing business in California could suddenly become subject to tax under the economic nexus standard.

Foreign Affiliate of a Unitary Group

Under California law, a qualified taxpayer may elect to determine its income derived from or attributable to sources within the state under a water's-edge election.4 However, a water's-edge election is only effective if every member of the combined reporting group that is subject to tax makes the election.5 For tax years beginning before January 1, 2011, a unitary foreign affiliate of a water's-edge combined reporting group that was not doing business under the original nexus standard was unable to make a water's-edge election because it was not a taxpayer in California. For tax years beginning on or after January 1, 2011, however, the foreign affiliate could become a taxpayer in California if it is doing business in the state under the new economic nexus standard. The FTB's guidance addresses the problematic situation in which, as an operation of law, these foreign affiliates suddenly became subject to California franchise tax, and yet were not qualified under their U.S. group's valid water's-edge election.

The guidance explains that a water's-edge statute and the corresponding regulation address the effect on water's-edge elections resulting from changes in the composition of a reporting group due to corporate events such as acquisitions and mergers between electing and non-electing affiliates that occur after the election is made.6 However, the statute and regulation do not cover the effect on an election due entirely to a change of law causing a change of status of a non-electing unitary foreign affiliate from a non-taxpayer to a taxpayer.

Deemed Water's-Edge Elections

The FTB has identified three situations in which taxpayers that became subject to California franchise tax as a result of the economic nexus standard may still claim a water's-edge election:

  1. A unitary foreign affiliate with U.S. income7 at any time is deemed to have made a water's-edge election if the affiliate becomes a taxpayer in the state solely on the basis of the economic nexus statute.
  2. A unitary foreign affiliate with no U.S. income that becomes subject to franchise tax under the economic nexus statute would generally not be includable in its unitary group's water's-edge election. However, the FTB is allowing such a foreign affiliate to be included in the water's-edge combined reporting group for "administrative convenience." The deemed water's-edge election adopts the commencement date of the electing taxpayers of the existing water's-edge combined reporting group.
  3. A unitary foreign affiliate that had no U.S. income before becoming a California taxpayer as a result of the economic nexus statute, but then has U.S. income after that date, is deemed to have made a water's-edge election that mirrors the election date of the other taxpayers of the water's-edge reporting group.

Each of these deemed election scenarios is predicated on the existence of all of the following facts:

  • A valid water's-edge election was made before the FTB notice date (September 9, 2016).
  • When the water's-edge election was made, the foreign affiliate was not eligible to be included in the water's-edge group because it was not subject to California tax.
  • Since the valid water's-edge election, the excluded foreign affiliate and the U.S. members have remained in a continuous unitary relationship.
  • The unitary foreign affiliate became a taxpayer in a tax year ending on or before December 31, 2016 due solely to the addition of the economic nexus provision, such that, had the foreign affiliate been a taxpayer member of the group when the election was made, the foreign affiliate would have been required to make a water's-edge election in order for the election to have been valid.

If these conditions are met, the FTB will not seek to terminate the water's-edge election of the water's-edge combined reporting group that is unitary with the foreign affiliate that is now a taxpayer under the economic nexus standard. The deemed election provisions discussed above only apply to tax years beginning within 84 months of the date of the notice (September 9, 2016).


As discussed in the notice, California law does not address the effect on a water's-edge election when a non-electing unitary foreign affiliate became subject to tax solely because California enacted the economic nexus standard. The issuance of this notice clarifies several reporting requirement questions for those unitary filers whose foreign affiliates suddenly became California taxpayers in 2011 or in later years due to the change in law. This notice reflects the fact that the adoption of economic nexus thresholds complicates the water's-edge election in ways which were not necessarily envisioned when California expanded its "doing business" standard. If certain requirements are met, the FTB will deem that the proper water's-edge election had been made.

This is the second published document that the FTB has issued relating to the relatively new economic nexus standard. In July 2016, the FTB issued a Chief Counsel Ruling that examined the relationship of the economic nexus standard with the throwback rule and Public Law 86-272.8


1 FTB Notice 2016-02, California Franchise Tax Board, Sep. 9, 2016.

2 CAL. REV. & TAX. CODE § 23101(a).

3 CAL. REV. & TAX. CODE § 23101(b). Under this standard, a corporation is doing business in California if: (i) its sales in the state exceed the lesser of $500,000 or 25 percent of the taxpayer's total sales; (ii) its property in the state exceeds the lesser of $50,000 or 25 percent of the taxpayer's total property; or (iii) its payroll in the state exceeds the lesser of $50,000 or 25 percent of the taxpayer's total payroll. Note that the dollar thresholds have increased since their original enactment because they are annually indexed for inflation.

4 CAL. REV. & TAX. CODE § 25110.

5 CAL. REV. & TAX. CODE § 25113(b).

6 CAL. REV. & TAX. CODE § 25113(c); CAL. CODE REGS. tit. 18, § 25113.

7 CAL. REV. & TAX. CODE § 25110(a)(2)(A)(i).

8 Chief Counsel Ruling 2016-03, California Franchise Tax Board, July 5, 2016. For a discussion of this ruling, see GT SALT Alert: California FTB Chief Counsel Ruling Considers Economic Nexus Standard and Throwback.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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