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Water's-Edge White Paper

SUMMARY

For income years beginning on or after January 1, 1988, apportioning bank and corporation taxpayers had, for the first time and after much controversy, the option to elect to limit the entities included in their combined reports to the water's-edge. Generally, the water's-edge election allows California taxpayers to exclude the income and apportionment factors of certain foreign corporations from a combined report filing. The election was made available in response to perceived compliance and foreign policy concerns associated with worldwide combined reporting. The complexity of the statutory provisions allowing for the election reflects the legislative negotiation and compromise through which the water's-edge provisions initially were enacted. Many of the original provisions, the dividend deduction, the foreign investment interest offset and various information reporting requirements, for example, have since been amended or repealed in order to simplify compliance.

The statutes prescribing the time and manner of making the election are similarly complex and may trip the unwary. The requirements are stringent, leave no margin for error and do not grant FTB authority to allow invalid elections to be "perfected." Because the election is made by contract between the taxpayer and the FTB, the considerable and not always compatible body of contract law is engrafted onto tax law and principles. In addition, the interaction of the so-called "deemed election" rule with the other statutory requirements for making the election has been subject to dispute as to whether it can be used to save an invalid election. The deemed election rule itself is inflexible and can give rise to unintended results as can the provisions for renewal and nonrenewal of the election term and the rules on subsequent affiliation and disaffiliation.

Legislation was enacted in 1994 to provide taxpayers a narrow window period for perfecting invalid elections resulting from unintentional noncompliance with the election provisions. Revenue and Taxation Code (RTC) §18405, Stats. 1994, ch. 1243. However this legislation provided relief only for the 1988 income year and only to those taxpayers which requested perfection under its provisions during the window period. Invalid elections for the 1988 income year are still being identified as audits progress, however relief is no longer available under §18405. Because §18405 did not address the underlying complexities of the water's-edge provisions, the unintended noncompliance it was designed to mitigate continues. In every year since 1994, taxpayer-specific legislation has been introduced to cure invalid elections.

Staff recommends amendment of the statutory provisions to make the rules less complex and more administrable. Specifically staff recommends that the election not be made by contract but by a statutory tax election and that the manner of making the election follow the mechanics which were developed for Assembly Bill 601 (1997) (AB 601), the elective combined reporting bill. AB 601 was drafted to provide for a group election by a top tier parent. This manner of making the election addresses the problems taxpayers and staff have encountered in the water's-edge context and reflects a solution that has been responsive to the comments and concerns of taxpayers, practitioners and staff. The top tier parent election, developed with water's-edge hindsight, should be adopted for water's-edge purposes. It would simplify the election process by eliminating the contract issues, overriding inconsistent filings by water's-edge group members and obviating the need for the deemed election provisions.

Staff also recommends that the FTB be given the authority to allow perfection of elections whose invalidity resulted from unintentional noncompliance with the current statutory rules. As a matter of taxpayer equity, similarly situated taxpayers should be treated similarly, and there are currently a number of taxpayers which would have been granted relief under RTC §18405 were it not limited as to income year and date of request for relief. FTB discretionary authority to allow perfection would stem the introduction of taxpayer-specific legislative bills and ensure that all taxpayers which clearly intended to elect but inadvertently failed to meet all of the election requirements were treated similarly.

If the mechanics of making the election were simplified to reduce compliance errors, staff recommends that it retain ongoing authority to allow perfection of elections. However, this authority should be exercised only in limited situations in response to unusual circumstances and unforeseeable events; perfection should be not be available where there is no reasonable cause for not complying with the statutory requirements.

Staff's recommendations, which address the difficulties and problems encountered by taxpayers and staff alike, are threefold. To streamline the manner of making the election, staff recommends legislation providing for a top tier parent election. To address problems encountered to date, staff recommends that FTB be given broad authority to allow perfection of invalid elections in cases where it is clear that an election was intended but there was inadvertent noncompliance with the election requirements. If staff's recommendations as to the top tier parent water's-edge election were enacted, staff recommends that it retain the authority to perfect, but that its exercise be more limited in scope.

CURRENT WATER'S-EDGE ELECTION PROVISIONS AFFECTING THE TIME AND MANNER OF MAKING THE ELECTION

In general, members of an affiliated group doing business in California can elect to exclude the income and apportionment factors of certain corporations, principally foreign incorporated entities that do not do business in the United States, from their combined report. Currently the election is made by contract on the original return and must be joined by all taxpayer members of the water's-edge group. In addition to the ability to limit the combined report to the water's-edge, taxpayers also receive a substantial deduction for dividends received from more than fifty percent owned foreign subsidiaries. While the election was originally conditioned upon payment of a fee and the filing of a Domestic Disclosure Spreadsheet, those requirements were repealed in 1994.

The time and manner of making a water's-edge election is prescribed in RTC §25111(a) which provides in pertinent portion:

The making of a water's-edge election as provided for in Section 25110 shall be made by contract with the Franchise Tax Board in the original return for a year and shall be effective only if every taxpayer which is a member of the water's-edge group and which is subject to tax under this part makes the election...An affiliated bank or corporation which is a member of the water's-edge group and subsequently becomes subject to tax under this part or is a nonelecting taxpayer which is subsequently proved to be a member of the water's-edge group pursuant to Franchise Tax Board audit determination, as evidenced by a notice of deficiency proposed to be assessed or a notice of tax change shall be deemed to have elected. (emphasis added).

California Code of Regulations (CCR) §25111-1(d)(1) requires that the "contract, to be effective, must be entered into by all banks or corporations required to file under this part which are part of the water's-edge group".

CCR §25111-1(b)(1) defines water's-edge group as:

...all banks, corporations or other entities whose income and apportionment factors are considered pursuant to Section 25110 of the Revenue and Taxation Code in computing the income of the individual taxpayer for the current income year which is derived from or attributable to sources within this state. (emphasis added),

while CCR §25111-1(e) provides that:

The contract must be entered into at the time the original return for the year is filed and must be signed by an officer of the electing corporation...The contract may not be entered into through an amended return. (emphasis added).

Provision is also made in CCR §25111-1(c) for an election on behalf of a controlled group by its parent whether or not the parent is a California taxpayer.

DISCUSSION OF ISSUES ARISING UNDER THE CURRENT STATUTORY RULES FOR ELECTING TIME AND MANNER

The first sentence of RTC §25111(a) sets forth three requirements for making a valid water's-edge election.

  1. The election must be made on the original return, and
  2. Every taxpayer member of the combined report group must make the election, and
  3. The election must be made by contract.

Under the current language, it is critical that all taxpayer members of the water's-edge group satisfy all three of these requirements for the election to be valid. A failure to meet any of the requirements by one taxpayer member of the water's-edge combined report group invalidates the election of the entire group. Once the original return is filed, an amended return cannot be filed to cure an invalid election. If the election is not valid the taxpayer will be required to file on a worldwide basis until such time as a valid election is made. This may be several years after the purported election if the invalidity is discovered at audit rather than at the time the return is filed.

Invalid elections have commonly resulted from failure to include the contract electing water's-edge with the original return and failure of all taxpayer members of the water's-edge combined report group to elect on their original returns. Both large and small taxpayers have made these errors in all income years since 1988 when the water's-edge legislation became operative.

The Contract Requirement

Failure to include the contract generally occurs through oversight or misunderstanding of the contract requirement and was so prevalent for the 1988 income year at the inception of the water's-edge option that the Legislature responded by enacting RTC §18405. Laws 1994, Ch.1243. Section 18405 provided a window period during which taxpayers, whose return clearly indicated their intention to elect, could perfect elections which were invalid due to unintentional noncompliance (generally failure to include the contract).

The requirement that the election be made by contract between the taxpayer and the FTB necessitates an analysis under both tax law and contract law (including offer and acceptance and substantial compliance) to determine the validity of the election. The two bodies of law, tax which generally requires strict statutory adherence, and contract, with its more generous admission of inferences drawn from facts and circumstances, are neither compatible nor complimentary. The result of this is that taxpayers which neglect to include a contract in their return argue that the contract law doctrine of substantial compliance should cure the tax law requirement of a mandatory filing. The requirement that the election be made by contract also raises the possibility of disputes over nontax issues such as breach of contract or contract clause questions.

The original premise was that a contract was necessary to justify imposition of the water's-edge election fee (the consideration). Because RTC §25115, which imposed the fee, was repealed effective January 1, 1994, there no longer appear to be any policy reasons for retaining the contract requirement. If the water's-edge election were simply considered a tax election like any other, e.g., S corporation and installment sales, only tax law would be considered in determining the validity of the election and the mechanics of the election would be simplified.

Staff recommends legislation to replace the current requirement of an election by contract with a statutory election.

The Requirement that Every Taxpayer Member of the Water's-Edge Group Elect

Because it is logically inconsistent to permit members of the same unitary business to file on both a water's-edge and worldwide combination basis, the requirement that all taxpayer members of the water's-edge group elect is a reasonable one. However, it can lead to some harsh results when combined with the requirement that the election be made on the original return. In some cases the deemed election can rescue the election, however that provision raises its own problems. (See Deemed Election Issues, infra.)

Staff has dealt with the situation on many occasions where taxpayers A, B, C and D are engaged in a single unitary business and A, B, and C file their California returns on a combined report basis electing water's-edge and including the income and factors of A, B, C and D. However, D files its California return on a separate company basis and does not elect water's-edge. Because D is included in the A, B and C combined report and did not elect on its original return, A, B and C's election is not valid. Taxpayers have argued that the deemed election provisions of RTC §25111-1(a) (see Deemed Election Issues, infra.) should save the election but staff interprets that provision to be applicable only when a nonelecting taxpayer has not been included in an electing group's combined report.

Invalidation of the election is the only way to give meaning to the requirements that the election be made on the original return and that all taxpayer members of the water's-edge group elect. The statutory requirements place the burden on the taxpayer group both to determine the taxpayer members of the group and to ensure that each taxpayer member makes a proper election. Because, in the above example A, B and C determined they were unitary with D and included D in their combined report and because D did not elect on its original return and cannot elect on an amended return, the election is not valid.

This situation leads to various anomalies. First, if at audit it were determined that D were not in fact unitary with A, B and C their election would be valid. This could lead to the situation where a taxpayer was notified of an invalid election based on the position taken in the returns, properly filed amended returns based on a worldwide combination only to find, potentially several years later, that its election was valid after all.

In addition and more serious from a tax policy perspective, this requirement poses a dilemma for taxpayers. If A, B and C knew D's original filing position, despite their determination that D was a taxpayer member of their unitary business, they could file omitting D from their combined report in order to save their election. If at audit FTB subsequently finds D to be a taxpayer member of the unitary group the deemed election provisions will apply, and D will be included as a member of the water's-edge group. The requirement that the election be made by all taxpayer members of the group on the original return interacts with the deemed election provision in such a way as to force taxpayers to choose between filing an inaccurate return and losing their election.

The requirement that all taxpayer members elect could be addressed by providing for the top tier parent to elect for its subsidiaries. This is the approach taken in AB 601, the elective combination bill, which was drafted with an eye to the problems taxpayers have experienced with the water's-edge election provisions.

Under the elective combination bill, taxpayers are permitted to treat all members of their commonly controlled group as if they were members of a unitary group and include all of their income and factors in a single combined report. The purpose for the proposed combined reporting election is to avoid the complexities associated with identifying the members of a unitary group under current law. The election must be made by the top tier corporation(s) in the group on behalf of all members of the group. Generally, top tier corporations are parent corporations or brother/sister parent corporations. The electing corporations need not be California taxpayers.

The term of that election is ten years, subject to an automatic ten year renewal at the end of the term unless one or more of the top tier corporations takes affirmative action not to renew. The taxpayer may have unlimited successive ten year periods of election. Generally an acquired entity or group assumes the electing or nonelecting status of its new top tier parent.

If the elective combined reporting model were adopted for water's-edge electors, all lower tier corporations, including later acquired entities, would automatically be included in the scope of the group's water's-edge election. This would avoid the deemed election problems of the current water's-edge election (see Deemed Election Issues, infra) and would limit the potential for inconsistent original return filings within the same commonly controlled group.

The current water's-edge regulations, for reasons of administrative ease, allow a common parent to file a single contract on behalf of its subsidiaries; however, the regulation cannot be used to correct inconsistent original filings. Because a regulation interprets and must be read in harmony with the statute under which it is promulgated, the common parent election cannot be read as overriding the statutory requirement that all elections be made in the original return for the year. Therefore a common parent election is not valid if a subsidiary files its return but doesn't elect. A statutory common parent election would prevail over any inconsistent filing by a subsidiary.

The common parent election, however, does not address those situations where there is not a single top tier corporation. Although each top tier brother/sister corporation could be required to make the election on behalf of its subsidiaries, a failure by one or more of the brother/sisters to elect properly raises the same problems discussed above. The approach taken in AB 601 is to provide that as a general rule the election would be invalid if a brother/sister failed to elect but to allow the department discretion to permit perfection in such cases.

It should be noted that RTC §25111 originally provided that consent by the common parent of an affiliated group would constitute consent by all members of the group. Section 25111 also originally required that all affiliates elect whether or not they were members of the same unitary business. This requirement and the common parent consent language were dropped when §25111 was amended to allow taxpayers to elect along unitary business lines. A taxpayer or a group of taxpayers engaged in more than one unitary business may make a water's-edge election for one or more of its businesses, but need not elect for all lines. Thus, currently a taxpayer may file on a water's-edge basis for one of its unitary businesses and on a worldwide combination for the other.

Section 25111 was amended to allow taxpayers to elect along business lines because of the perceived unfairness of requiring nonunitary affiliates that had no foreign activities to pay the election fee for an election they did not need and from which they derived no benefit. The election fee was repealed, effective for income years beginning on or after January 1, 1994. Thus, the only remaining reason for allowing the election along business lines is that some taxpayers (fewer than 50 of the 4,200 electors) are currently benefiting from doing so. The water's-edge election was originally enacted in response to taxpayer complaints that compliance with worldwide combined reporting was difficult, cumbersome and intrusive. Affiliates which elect to file water's-edge for one line of business and worldwide for another manifestly do not have problems complying with worldwide reporting requirements.

Another reason exists for eliminating the ability to elect along lines of business. Under the current rules there would be no need for a nonunitary brother/sister corporation to make a water's-edge election if neither it nor any of its subsidiaries are members of an electing water's-edge group. If the brother/sister groups are deemed unitary at audit, what should the rule be? A deemed election or an invalid one? If all top tier parents in the commonly controlled group were required to elect, this problem would be eliminated.

Staff believes that there is no longer any policy justification for allowing the election along business lines. Once the top tier parent elected, all subsidiaries, no matter which unitary line of business they were engaged in, would file a water's-edge combined report for that line of business. Taxpayers would no longer be concerned with the possibility that the FTB's audit determination of the entities included in the water's-edge group would differ from their original filing. A common parent election would also effectively address the problem described in the above example of Corporations A, B, C and D (example at supra) by eliminating the possibility of inadvertent inconsistent filing. Preservation of the election along lines of business causes problems for taxpayers because they must determine, and in some cases identify the taxpayer members of the controlled group which are also members of the water's-edge group and thus required to elect on the original return. This requirement to coordinate the election only with unitary affiliates occasions the need for the deemed election provisions which are intended to provide safe harbor elections when the determination of the members of the water's-edge group is modified at audit. (See Deemed Election Issues, infra) The number of taxpayers taking advantage of the ability to elect along business lines is a very small subset of the universe of electors. The majority of taxpayers whose elections were invalid for reasons other than the failure to include the contract with the original return or which find themselves with unwanted elections have been ensnared by provisions required by, or meant to provide safe harbors for, those few taxpayers.

Staff recommends adoption of the AB 601 elective combined reporting model and specifically that the water's-edge election be made by the top tier parent(s) of an affiliated group for all entities in the group regardless of how many lines of business there may be. This would address the problems of inconsistent filing identified in this section as well as the contract and deemed election issues discussed in The Requirement that Every Taxpayer Member of the Water's-Edge Group Elect and Deemed Election Issues respectively.

Time of Making the Election

Currently there is no requirement that the election be made on a timely filed original return. As a general rule elections required to be made on an original return are also required to be made on a timely filed return. Allowing an election to be made on a delinquent original return is inconsistent with the general prohibition on retroactive elections and if used in conjunction with the deemed election provision (see Deemed Election Issues, infra) could provide an unintended opportunity for aggressive corporate filers to try to obtain a retroactive election.

For example, assume Taxpayer A filed its original 1990 return on a separate company basis and did not elect water's-edge. In 1994, after the U.S. Supreme Court decision in Barclay's, A realizes that it has worldwide combination audit exposure. A has an affiliate, Corporation B, that has never filed a California return. Even though B's nexus with California is questionable, A causes B to file a delinquent 1990 original return making a water's-edge election and paying minimum tax. If A and B are subsequently determined at audit to be engaged in a worldwide unitary business, A will assert it has a deemed water's-edge election as a result of the election made by B. Although the question of whether the delinquent elector is really a taxpayer presents a stumbling block to this type of planning (because under the statute only taxpayers are permitted to make the election), FTB audit resources would be expended on what could be a time consuming nexus audit that would not otherwise have been pursued. The possibility for this sort of manipulation should not exist.

Consistent with staff's recommendation, supra, that the election be treated like any tax election and that the AB 601 model be followed, the top tier parent election should be filed on a date certain. Staff also recommends that FTB be given the authority to allow an election on a delinquent return to taxpayers which are filing for the first time in California because it has been determined at audit they have nexus. (See FTB Authority to Allow Perfection if the Proposed Legislation Were Enacted, infra)

DEEMED ELECTION ISSUES

The last sentence of RTC §25111(a) provides that if a nonelecting affiliate is subsequently proved at audit to be a unitary member of the electing water's-edge group, the nonelector is deemed to have made a water's-edge election effective as of the date of the election of the other members of the water's-edge group. The deemed election rule was added to §25111 in 1989 to address situations where the electing group made a good faith determination, before filing, of the composition of the unitary group. If not for the deemed election rule, a subsequent audit determination that a nonelecting affiliate was unitary would automatically invalidate the group's election because that affiliate would not have met the statutory requirement to elect on its original return. The need for a deemed election is directly attributable to the ability to elect along lines of business. This provision was added in response to FTB Public Notice 89-197, April 24, 1989, which held that under the water's-edge statute in existence at that time, if a nonelecting affiliate was determined at audit to be a member of the unitary electing group, the election was void because not every member had complied with the requirement to elect on its original return. The business community believed that this result was unfair because of the uncertainty surrounding the unitary determination and was successful in amending §25111 to provide for the deemed election rule.

The rule is automatic, there are no exceptions. It applies even if the group as a whole is disadvantaged by the election. For example, because the deemed election is mandatory, a deemed election will result even if the electing taxpayer does not control the nonelector or is significantly smaller than the nonelector. Thus a nonelecting parent corporation will be bound by the election of a subsidiary it considered to be nonunitary if the subsidiary is determined at audit to be unitary. The regulations allow the election to be terminated prospectively in such cases but the group is bound by the election for the income years prior to the year in which the notice of assessment is received. CCR §§25111(i)(4), and 25111-1(i)(3).

The deemed election rule could also be used by aggressive taxpayers to force an unwilling affiliate into a water's-edge election. For example, assume taxpayers A and B are engaged in a single unitary business. A wants to file on a water's-edge basis but cannot convince B to elect. A therefore excludes B from its combined report and makes a water's-edge election with its original return, deliberately not complying with RTC §25101's requirement to file a combined report, for the sole purpose of circumventing the "all members must elect" requirement of RTC §25111. If and when A and B are combined at audit, B will be subject to the deemed election provision even though B specifically did not want to make the election. The opportunity for this kind of manipulation should not exist.

While the validity of the deemed election rule has not yet been challenged, there is some risk that it might be attacked on the grounds that a taxpayer cannot be forced to file on a water's-edge basis unless there is evidence that it consented to be bound by the actions of its affiliate.  This problem could be addressed by providing that the deemed election rule would apply only if, at the time of the election, the electing corporations obtained the consent of nonelecting affiliates to be bound by the election if they were subsequently determined at audit to be unitary. However, for the following reason this solution would be only partial. According to testimony before the legislature while the amendment of §25111 to provide for the deemed election rule was being considered, one of the situations this provision was designed to address was the existence of a large electing group whose election would be invalidated because it was unaware of the existence of a unitary affiliate which did not elect. Obviously, consent to be bound by an election cannot be obtained in advance from an unknown entity. This testimony does however, support the proposition that the legislative intent was clearly not that the minnow should swallow the whale but that the whale should not be beached by the minnow. Yet, because the deemed election rule is automatic, that is exactly the result that may occur.

The interaction of the deemed election rule with the statutory requirements as to time and manner of election has been the subject of some controversy. While the statute requires that each taxpayer member of the water's-edge group elect on the original return it further provides that a nonelecting taxpayer found unitary at audit will be deemed to have elected. Taxpayers have argued in situations where a nonelector is included in its electing affiliates' combined report that the nonelector should nonetheless be deemed to have elected under this provision. FTB staff has taken the position that a deemed election is available only to a nonelector which is not included in its affiliates' water's-edge combined report. As discussed above, the deemed election rule was enacted to address the limited situation where a good faith determination of the unitary group was made (and all water's-edge group affiliates elected on their original returns) and FTB subsequently determined at audit that a nonelecting entity should have been included in the water's-edge group.

Substantially all of the deemed election problems, the minnow and the whale, the incentive for filing inaccurate returns, the automatic and possibly unintended results which can and do occur, would cease to exist if a statutory common parent election were adopted which bound all affiliates, whatever their line of business. Staff recommends adoption of legislation to provide for a top tier parent election.

AUTOMATIC RENEWAL/NOTICE OF NONRENEWAL

RTC §§25111(a) and (d) provide that each water's-edge contract shall be for an initial term of 84 months, but that an additional year is automatically added to the contract term each year on the anniversary date of the contract unless the taxpayer files a written notice of nonrenewal at least 90 days before the anniversary date. If a taxpayer elects water's-edge and does not file a notice of nonrenewal, the election will continue indefinitely. If the taxpayer files a notice of nonrenewal, the election remains in effect for the balance of the period remaining on the original election or the last renewal of the election, as the case may be. All taxpayers must enter into, or consent to, the nonrenewal for it to be effective. Unlike the election the statute provides that a common parent may file a notice of nonrenewal binding on its controlled group. RTC §25111 (h)(2)(A).

Apart from the obvious administrative burdens for both the taxpayer and the FTB associated with whether and when a notice of nonrenewal has been filed, the nonrenewal provisions can have unintended consequences. Most taxpayers file notices of nonrenewal during the first year of the election period in order to have a window period at the end of the seven years during which they can decide whether or not to reelect. A taxpayer that has filed a notice of nonrenewal must reelect by filing a new contract at the expiration of the 84 -month contract term if it wishes to continue filing on a water's-edge basis. Unfortunately, considering the length of the contract term, it has proven to be easy for taxpayers to overlook the fact that a notice of nonrenewal has been filed and that a new contract is required. Because the election must be made on the original return, taxpayers cannot rectify their omission and find themselves unexpectedly required to file a worldwide combined report until they make a new valid election.

The requirement that all taxpayer members of the group enter into the notice of nonrenewal potentially presents the same problems as the requirement that all group members elect (example at supra) if a common parent notice of nonrenewal is not filed. Depending upon when an invalid notice of nonrenewal was identified, taxpayers might find themselves, at what they thought was the end of their election term, with several years to go because the automatic rollover had extended the term.

Instead of the rolling election and the notice of nonrenewal, staff recommends that the statutory election provide for an 84-month election term followed by automatic renewal of the election for an additional 84-month period unless the taxpayer elects out before the end of the election term. The FTB should have the discretionary authority to permit termination of the election in limited circumstances. In the case of either an election out or a permissive termination, reelection should generally not be permitted for five years thereafter. This follows the proposal in AB 601, which in turn is based upon the federal consolidated return rules.

AFFILIATION AND DISAFFILIATION ISSUES

In instances where two or more taxpayers subject to an election become disaffiliated, or where two or more taxpayers become affiliated and one or more of them has made a water's-edge election, issues arise as to the effect the disaffiliation or affiliation will have on the election. The law and the regulations provide that taxpayers generally will be bound by any contract they enter into or by any contract entered into by a new unitary affiliate, regardless of changes in their affiliations since the time the election was made. Under certain circumstances, taxpayers adversely affected by this rule may terminate the election on a prospective basis. Requests to terminate an election are required to be filed no later than the due date of the return for the year immediately succeeding the year of acquisition or disaffiliation. RTC §25111(b); CCR §§25111-1 (d) and (i).

The carryover effect of an election after affiliation or disaffiliation can have serious consequences for new affiliates. The purchaser of an electing corporation must timely file a request to terminate if it does not want the election. Once the due date of the termination request has passed, the corporation cannot qualify for termination with respect to that acquisition. If a purchaser is unaware that its newly acquired, and very likely not yet unitary, subsidiary has a water's-edge election in effect, it may fail to file the request to terminate timely. If the subsidiary subsequently becomes unitary with the purchasers' group, the group will become subject to an election it did not intend to make.

Assume that A has 25 subsidiaries in its unitary business and files on a worldwide basis. A purchases B, a California water's-edge taxpayer with substantially fewer net assets than A. Both A and B have a calendar year end. A purchased B on October 31, 1995. B would typically have a short year filing requirement covering January through October 1995 and, assuming unity, would file with A for the November through December 1995 period. B must file its request to terminate its water's-edge election by October 15, 1996, the extended due date of the return for the income year immediately succeeding the acquisition year. If, as is more likely, A and B are not instantly unitary, it may only come to A's attention that B has a water's-edge election in effect when they become unitary and B must be included in A's combined report, at which time it will be too late to request termination. If the request is not filed by October 15, 1996, A and its unitary group will be required to file on a water's-edge basis for B's remaining contract term no matter how disadvantageous and unintended that result may be.

Under RTC §25111(b), a taxpayer may terminate its water's-edge election prior to the expiration of the original 84-month term if the taxpayer is acquired by an unaffiliated, non-electing entity which is larger with respect to equity capital or, with the FTB's permission, under other circumstances, such as a substantial and unforeseeable change in the composition of the group or its factors. AB 601, the elective combination bill, provides for FTB discretion to allow early termination and for the automatic election or termination of an election, depending on affiliation or disaffiliation, coupled with anti-abuse provisions. In general a taxpayer's election would terminate if it were acquired by a nonelecting group and it would join in the election of its acquirer if one had been made. This approach would eliminate the need to request termination timely and would simplify the rules in the water's-edge setting.

Staff recommends legislation to provide for FTB discretion to allow early termination for good cause and automatic termination upon disaffiliation as discussed above.

TRANSITION ISSUES

If a new statutory election procedure were to be enacted, the question of the treatment of existing elections arises. While the Legislature could provide for rescission of all existing elections as it did for the 1994 income year, staff recommends that because the proposed statutory scheme generally amends the mechanics, rather than the substantive law governing water's-edge filing, that existing elections be left in place. Statutory provisions should be adopted that stop the yearly rollover and allow current elections to run for the term remaining on the contract as of the end of the income year. This would allow those groups which are affected by the only substantive proposed change, those currently filing on both a water's-edge and a worldwide basis for different lines of business, the benefit of their existing contracts. At the end of the election term taxpayers would reelect under the new provisions or return to filing on a worldwide basis. The elections of taxpayers with existing contracts would be automatically terminated if they are acquired by another group which has elected under the new provisions. In that case they should be subject to the new rules on affiliation and disaffiliation . Otherwise, the current rules on affiliation and disaffiliation would apply until the contract term expired. In addition, taxpayers should be given the opportunity to elect under the new rules before the expiration of their contract term.

Staff recommends that existing elections be allowed to run their current term following the existing rules. However, if a taxpayer with an existing election is acquired by an entity which has made a water's-edge election under the proposed legislation it should follow the proposed rules for acquisition and disposition under that section.

FTB AUTHORITY TO ALLOW PERFECTION OF ELECTIONS

Because so many would-be electors inadvertently failed to comply with the statutory requirements for electing, the Legislature, in 1994, enacted RTC §18405, Laws 1994, Ch.1243, which provided a window period for perfection of elections which were invalid owing to unintentional noncompliance with RTC §25111. This relief was limited to the 1988 income year and to taxpayers which requested relief under §18405's provisions before December 31, 1994. Perfection was allowed under §18405 to those taxpayers which timely filed returns, paid the tax and other amounts consistent with the water's-edge election, filed one or more water's-edge forms, but failed to include a contract. This problem and variants thereof, have also occurred after 1988. Taxpayers continue to file elections which are invalid because they fail to attach a contract for all taxpayer members of the water's-edge group on the original return. Also, some taxpayers elected water's-edge, intended to continue filing on a water's-edge basis, but forgot they had filed a notice of nonrenewal, and failed to reelect timely. In addition, for the 1994 income year all existing contracts were rescinded under RTC §25111.1 and all taxpayers wishing to continue to file water's-edge were required to reelect. Many did not do so, or made invalid attempts to do so.

In 1995, RTC §18405 was amended to address the situation described in The Requirement that Every Taxpayer Member of the Water's-Edge Group Elect, supra, where all but one member of the water's-edge group elected and the nonelecting member was included in the electors' water's-edge combined report. Laws 1995, Ch. 490. In 1996, and again this Legislative Session, further taxpayer-specific amendments to §18405 were introduced to allow perfection of elections attempted for the 1988 income year. Because the inherent complexity of the interaction of the procedures for making a water's-edge election has not been addressed, these piecemeal efforts to allow perfection of elections are likely to continue. Section 18405 relief has so far been limited to the 1988 income year although not all invalid elections for that year have been perfected pursuant to its provisions. Also, as audits continue to uncover invalid elections, perfection of purported elections made in later years will undoubtedly be sought.

Staff recommends that the FTB's statutory authority to allow perfection be made permanent, however if the staff recommended legislation modelled on AB 601 were to be enacted, the scope of that authority should be limited for the years after the legislation is operative and the election process has been simplified.

FTB Authority to Allow Perfection for Years Prior to Effective Date of Amendments

Staff recommends that the Franchise Tax Board have the delegable authority to allow perfection of elections which are clearly intended by the would-be electors and are invalid owing to unintentional noncompliance with the requirements of §25111. This authority would encompass such ministerial errors as failure to attach a contract as well as failure of all members of the water's-edge group to elect, so long as it is clear that the failure is a result of honest miscommunication or lack of communication among the electing and nonelecting members of the group. There may be other situations where an election was clearly intended but the execution was imperfect. Therefore, the statute should be broad enough to provide the FTB discretion to allow perfection in circumstances where the noncompliance was unintentional, an election was clearly intended at the time it was attempted and there is manifestly no taxpayer attempt to gain a retroactive election with benefit of hindsight. Taxpayers which have already been allowed perfection under RTC §18405 should not be permitted to request different or additional relief for the 1988 income year under any new FTB authority to allow perfection.

Although staff has recommended that it be given retrospective authority to allow perfection of elections for all open income years, as has already been done for the 1988 income year under RTC §18405, it should be noted that there may be a California Constitutional problem with respect to the prohibition of gifts of public funds. Cal. Const., art. XVI, sec. 6.

The liability of taxpayers which made invalid elections is now fixed by their failure to comply with the law for all closed tax years, those years for which the due date for payment of the tax has passed. If the legislature grants the department authority to provide relief for those years it effectively allows a retroactive change in the taxpayer's lawfully determined liability. Arguably, unless done for a public purpose, the retroactive grant of relief is a forgiveness of a lawfully imposed tax and is therefore a gift of public funds.

FTB Authority to Allow Perfection if the Proposed Legislation Were Enacted

If the recommended legislation modelled on AB 601 were enacted, for income years beginning on or after it became operative, staff recommends that FTB retain the discretion to allow elections to be perfected. However, because the mechanics of electing would have been greatly simplified, this authority should be limited in scope. If the water's-edge election becomes just another tax election, a failure to elect properly should be treated similarly to a failure to "elect out" of installment sale reporting or to elect S corporation status. Neither federal nor state law permits perfection or amendment of returns if those elections are not made, or are not properly made.

The FTB should, however, retain the discretion to permit perfection in certain limited situations. For example, in cases of questionable nexus, if a corporation which has never filed in California is determined to have had nexus and a filing requirement by the FTB at audit, its ability to make a water's-edge election on a delinquent return should be subject to FTB discretion. While such a situation should not be used as a planning device, neither should a good faith determination on the part of the taxpayer that it did not have nexus preclude the election. Another example might be where, perhaps because of a complicated ownership structure, one top tier brother/sister corporation properly elected and the other did not. Although staff proposes that in general the election would be invalid if all brother/sister parent corporations did not elect, there should be some latitude for the unusual case. There may be other fact patterns where the FTB's exercise of discretion would be appropriate. Therefore staff recommends that FTB retain the authority to allow perfection in unusual cases where invalidation of an election might result from circumstances other than a simple failure to comply with the statutory requirements of the election.

REVENUE EFFECT OF STAFF PROPOSALS

Attached is the Department's revenue estimate of the effect of the proposed statutory election, the effect of allowing perfection of existing invalid elections for the 1988 income year through the present and the effect of allowing limited authority to perfect an election under the proposed top tier parent election.

Also attached is suggested language to accomplish staff's recommendations.