California lawmakers are considering mandating worldwide combined reporting, bringing back a policy the state abandoned in the 1980s due to strong pushback from international trading partners and the federal government. The policy failed to work as intended then, even beyond the international controversy it created. It doesn’t make any better sense now.
The US Apportionment System Is Unique
The US state system of corporate income taxation differs from the international approach. States use what is called formulary apportionment, where net income is apportioned to states for taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. purposes based on factor representation—the share of property, payroll, or sales in the state. These days, most states, including California, use single sales factor apportionment.
Few large businesses consist of a single entity, but rather a collection of subsidiaries and affiliated entities. Many states, including California, adopt what is called combined reporting, which means that affiliated entities are considered a unitary group for tax purposes. These groups, however, stop at the “water’s edge.” States do not typically tax companies based abroad if they do not have their own direct contacts with (for instance, sales into) a state. Some California lawmakers would like to change that, making California the only state with mandatory worldwide combined reporting.
Formulary apportionment is unique to US states. In the rest of the world, countries use separate accounting, where each corporation is taxed on its in-country profits and losses. When a company operates in multiple countries and pays taxes to both, it receives credits for taxes paid to other jurisdictions. At the federal level, the US currently uses something similar to this “territorial” model of corporate taxation.
States’ unique approach to corporate taxation creates complications when the formulary apportionment system is extended to international activity, interacting with foreign systems of taxation. Worldwide combined reporting does more than just extend the unitary group; it overlays two different systems of taxation, one that apportions activity based on factors (chiefly sales) and another that allocates it to where income is earned. Notably, states do not offer credits for taxes paid to other countries, so tax liability abroad doesn’t reduce state tax liability.
Mandatory Worldwide Combined Reporting Is Based on Faulty Premises
Proponents of mandatory worldwide combined reporting like to present worldwide combination as a presumptive default from which all states have somehow diverged. But states use water’s edge combined reporting for a reason. It is not an accident or an omission, but a deliberate policy choice that respects international treaty obligations, acknowledges the extraordinary complexity of mandatory worldwide combined reporting for many businesses, and understands the crucial differences in approach to taxation in US states compared to foreign countries.
Many of the arguments for mandatory worldwide combined reporting rest on the faulty theory that affiliated companies with foreign income must be doing something nefarious to avoid US tax. This represents a surprisingly blinkered view of the world, where the primary reason that companies might make money in countries other than the US is profit shiftingProfit shifting is when multinational companies reduce their tax burden by moving the location of their profits from high-tax countries to low-tax jurisdictions and tax havens. from the US, as if companies don’t also have actual operations—with profits and losses—abroad. There’s often further insinuation that any related-party transactions are illegitimate, even though companies must make payments to affiliates in the ordinary course of business.
In layman’s terms, proponents of worldwide combined reporting speak as if the income of foreign companies that share a parent with a US company is mostly “hiding” US profits abroad to reduce tax burdens, when in fact, the vast majority is simply the proceeds of doing business in other countries. Existing rules on transfer pricing also address profit-shifting, and most large multinational enterprises are under automatic in-house IRS auditA tax audit is when the Internal Revenue Service (IRS) or a state or local revenue agency conducts a formal investigation of financial information to verify an individual or corporation has accurately reported and paid their taxes. Selection can be at random, or due to unusual deductions or income reported on a tax return..
In recent years, moreover, international tax changes—like the adoption of a 15 percent minimum tax in most formerly low-tax countries and the implementation of new international tax provisions (like NCTI and BEAT) in the US, which take away much of the potential benefit of profit-shifting activity—make the problem worldwide combined reporting is intended to solve increasingly marginal. It takes a sledgehammer to a thumbtack.
Currently, California has worldwide combined reporting, but permits corporations to make a water’s edge election. That only a small percentage of businesses make the election has led to a misapprehension that worldwide combination is simple and straightforward. Actually, this is just a consequence of the fact that the overwhelming majority of C corporations are small companies that have no overseas operations or affiliates. A company that only does business in a few US states, with no international affiliates, won’t bother jumping through all the hoops necessary to elect water’s edge, since there’s no worldwide income to take into account. This tells us precisely nothing about the complexity of worldwide combined reporting for multinational businesses to which it is pertinent.
Mandating Worldwide Combined Reporting Introduces Extraordinary Complexity
Worldwide combined reporting requires determining if every foreign affiliate is unitary with the California business, a subjective determination that invites litigation. It also requires a unitary analysis of each member of the affiliated group, which involves understanding foreign governance and entity formation rules. Companies would have to submit documentation upon which the state’s revenue agency, the California Franchise Tax Board (FTB), could make determinations on flow of value, functional integration, centralized management, and economies of scale. This sort of documentation may not be kept by some foreign affiliates, and even if maintained, may not be in English.
Adding to the complexity, foreign affiliates often maintain books based on local accounting rules, not on a US GAAP basis. Converting foreign accounting standards (IRFS or local GAAP) to US standards, and accounting for exchange rate fluctuations, differing depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and disco and deferral rules, and other foreign distinctions for tens or hundreds of affiliates is a herculean task, and one likely to yield arbitrary taxation. Foreign entities, of course, do not compute US federal taxable income, but would have to do so if mandatory worldwide combined reporting were adopted. In some cases, trade secrets and privacy laws—particularly where government contracts or government ownership interests are concerned—may hinder sharing of necessary data with the related US company.
Worldwide combined reporting is workable for some companies and incredibly complex for others. US-based parents may be in a better position to comply than foreign parent corporations, as they are already obligated to maintain more records in a form comprehensible to US tax administrators. Conversely, complexity for a foreign multinational with a US subsidiary can be extraordinary.
If California required worldwide combination, the FTB would have to audit fully foreign companies. The IRS does not do this. It’s not just that, with worldwide combined reporting, the FTB would undermine its ability to piggyback on IRS calculations and audits, though that’s certainly true. It would also pick up the obligation to do something that even the IRS doesn’t do.
(Proponents have pointed to IRS Form 5471, arguing that it could be a basis for taxation. This form relates to foreign subsidiaries of US companies and contains some financial information, but it is not calculated based on US taxable income, and it is not applicable to foreign-headquartered companies.)
Mandatory worldwide combined reporting has been tried before. It didn’t work. Companies had to routinely fall back on “reasonable approximations” because neither they nor the state tax authority could actually calculate their appropriate liability. Proponents argue that “reasonable approximations” are a solution to the compliance and administrative challenges, but they are, rather, an admission of its failure—one that leads to endless tax controversy and litigation, since the state is always free to reject a company’s approximation, even if there’s no way to get to a truly “right” answer.
Mandatory worldwide combined reporting would make California a global outlier. Ending water’s edge election would import foreign tax complexity, invite litigation, and even implicate US treaty obligations. And for all that, its revenue implications are uncertain. The tax imports losses and lower profits as well as gains.
Worldwide Combined Reporting Imports Losses as Well as Gains
When a foreign company with fully foreign activity is added to the unitary group for a business with operations in California, the share of group sales in California declines. Imagine a simple example of a company with domestic sales of $1 billion, $100 million of which are in California. The company has profits of 8 percent ($80 million). In this case, California taxes 10 percent of the company’s profits ($8 million), since 10 percent of the company’s sales are in California.
If worldwide combined reporting brings in another $1 billion worth of activity of foreign affiliates, with the same rate of profit and no sales in California, then instead of apportioning 10 percent of $8 million in profits, California apportions 5 percent of $16 million—which yields the identical tax bill. If the foreign affiliates are more profitable, California collects more. If they are less profitable, California collects less.
Proponents assume that the only reason companies currently elect water’s edge is because they’d pay more tax under worldwide combined reporting. That will be true for some companies, but certainly not all. For many, the extraordinary complexity is the true deterrent to worldwide combined reporting.
To the extent that ending water’s edge election does increase tax revenues, it acts as a tariffTariffs are taxes imposed by one country on goods imported from another country. Tariffs are trade barriers that raise prices, reduce available quantities of goods and services for US businesses and consumers, and create an economic burden on foreign exporters. on foreign companies investing in California. Creating nexus in California drags the entire global parent and all affiliates into California, which is worth avoiding if possible.
For retail sellers, avoiding the California market may be practically impossible. But for other businesses, it’s a possibility, to California’s economic detriment. And where the additional tax does apply, it will have a tendency to increase California consumer prices. What is designed as a tax on large multinational businesses could end up hurting them primarily through the incredible complexity, with much of the actual economic incidence of the tax burden itself falling on California consumers.
California’s unusual system, where worldwide combined reporting is treated as a default and water’s edge (the national standard) is an election, can give the impression that water’s edge is a tax preference. It is not. It is the tax code operating as intended. California’s prior experiment with mandatory worldwide combined reporting should remain in the past.
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