Client Alert

FTB Issues Guidance on Implementing the New California Water's-edge Election Statute



On September 30, 2003, the Governor signed Senate Bill (SB) 1061 (Cal. Stats. 2003, Ch. 633), which made significant changes to the California water's-edge election procedures. SB 1061 (the "new legislation") became effective immediately upon enactment, and is operative for taxable years beginning on or after January 1, 2003. On May 3, 2004, the FTB issued FTB Notice 2004-2 (the "Notice"), in which FTB staff explains the implementation of the new legislation. The history, and the basics, of the California water's-edge election are beyond the scope of this article. [fn1] Instead, this article reviews the highlights of the new legislation as implemented by the Notice.

SB 1061 applies to elections made for taxable years beginning on or after January 1, 2003. However, taxpayers who are currently filing under a water's-edge election in prior years do not have to make a new election under SB 1061. For taxpayers who would have been required to file on a water's-edge basis in their first taxable year beginning on or after January 1, 2003, pursuant to a water's-edge election made in a prior year, the election shall be deemed to have been made under the new provisions. The commencement date of the election made in a prior year continues to be treated as the commencement date under the new procedures. [fn2]

Making the Election

The water's-edge election is now a statutory election, instead of an election by contract as under the prior law. Since the time the water's-edge election procedures were first enacted by the California Legislature in 1986, they had required the election to be made by entering into a contract with the FTB. The FTB's bill analyses of SB 1061 explains the 1986 legislation used a contract because it was necessary to justify imposition of the filing requirement of the Domestic Disclosure Spreadsheet ("DDS") and the payment of the water's-edge election fee. However, the repeal of the DDS filing requirement and the fee in 1994 eliminated this original justification for the contract. Accordingly, FTB has now concluded there is no longer any justification for requiring the water's-edge election to be made by contract. For taxable years beginning on or after January 1, 2003, the new legislation provides the election will now be made on the original, timely filed return for the year of the election, and "a written notification of election is filed with the return on a form prescribed by the Franchise Tax Board." [fn3] An election will be considered valid under the new legislation if (1) the tax is computed in a manner consistent with a water's-edge election; and (2) the written notification is filed.

Interpreting the new legislation, the FTB Notice states that in order to make a water's-edge election, a corporation must do each of the following:

  • Compute its income on a water's-edge basis.
  • Use Form 100W, California Corporation Franchise or Income Tax Return-Water's-Edge Filers; and
  • Attach the Form 100-WE, Water's-Edge Election, to the timely filed original return (Form 100W) for the year of the election.

The Notice confirms that the election is for an initial term of 84 months and remains in effect, year by year, until terminated by the taxpayer. Corporations which have a valid election for taxable years beginning before January 1, 2003 will continue to file on a water's-edge basis and will be deemed to have elected under the new statute for taxable years beginning on or after January 2, 2003. The original commencement date remains in effect.

Interestingly enough, the FTB's Notice does not directly address the "substantial performance" concept previously found only in the FTB regulations, but which was codified in SB 1061. [fn4] FTB Regulation 25111-1 provides that the election contract shall be considered valid "so long as there has been substantial performance of the requirements for entering into the contract," with "substantial performance" being defined as "'objective evidence' to support the conclusion that an election was intended." [fn5]5 This regulation then goes on to provide a non-exclusive list of what constitutes "objective evidence." SB 1061 incorporated this "objective evidence" regulatory principle into the California Revenue and Taxation Code, and provides that pursuant to regulations promulgated by the FTB, the FTB "may accept the filing of other objective evidence that supports the conclusion that a water's-edge election was intended in lieu of notification on the designated form." [fn6] It remains to be seen whether FTB begins a regulation project on the "objective evidence" standard, and no such project is underway at this time.

Effect of Different Fiscal Years When Making the Election

The Notice sets forth rules for making the election when taxpayers that are members of the water's-edge group have different fiscal years. In general, the Notice states that each member of the water's-edge group must make the election on its timely filed original return for the taxable year for which the election is being made, and the election becomes effective as of the beginning of the taxable year of the last member of the water's-edge group to file its return and election. The 84-month election period for each member starts from the date that the election becomes effective. Each taxpayer in the electing group must compute its tax on a water's-edge basis for the portion of the taxable year for which the election is effective.

Nonrenewal and Terminating the Election

The new legislation significantly changed the provisions regarding automatic renewal and termination of the election. The prior law provided that a water's-edge election is for an initial term of 84 months, but that the election is automatically renewed each year thereafter for an additional one-year period unless the taxpayer gives written notice of nonrenewal at least 90 days prior to the anniversary date. Thus, the "rolling" election continued indefinitely if a taxpayer elected water's-edge treatment and did not file a notice of nonrenewal. Under the prior law, a taxpayer wishing to limit the election to the minimum seven-year period had to file a notice of nonrenewal soon after it first made the election -- which acted to terminate the election seven years in the future.

SB 1061 changed these renewal and termination provisions, and provides new rules for how the election may be terminated with or without the consent of the FTB. The Notice states that Form 1116, Notice of Nonrenewal of Water's-Edge Contract, is now obsolete, and as of January 1, 2003, there is no need to file a Notice of Nonrenewal.

Termination Without the FTB's Consent

SB 1061 provides that a water's-edge election may be terminated without the consent of the FTB after it has been in effect for at least 84 months. The termination must be made on an original, timely filed return (on a non-water's-edge basis) for the first year in which the water's-edge election is to be terminated. To be effective, the termination shall be made by every taxpayer that is a member of the water's-edge group. [fn7] The Notice states that the effective termination date would be the last day of the taxable year immediately preceding the non-water's-edge filing. However, SB 1061 also includes a provision intended to limit a taxpayer's ability to jump back and forth from year to year between making the election and filing on a worldwide unitary basis. Although the FTB may make exceptions for good cause, [fn8] the new legislation and the Notice provide that if the taxpayer terminates its water's-edge election, it is required to file on a worldwide basis (i.e., non-water's-edge basis) for at least 84 months before making another water's-edge election (absent the FTB's consent).

The Notice states that "questions have arisen" regarding the issue of when a taxpayer may terminate the election with the FTB's consent, and the Notice sets forth four specific examples of situations where consent will or will not be required because of the interaction between California Revenue and Taxation Code Sections 25111 and 15113. For instance, in Example 1, a taxpayer had filed a Notice of Nonrenewal and did not file a new contract for year ended 12/31/02, but continued to file on a water's-edge basis "on an original return that contained other objective evidence of an intended water's-edge election." The Notice states this "substantial performance of the requirements for entering into a water's-edge contract" meant a new contract had started as of 1/1/01, so that the taxpayer cannot now terminate the election without the FTB's consent, because the election has not been in effect for seven years. The Notice concludes the taxpayer in this example must obtain the FTB's consent if it wishes to terminate the election at this time.

Termination with the FTB's Consent

The new legislation also provides that an election may be terminated prior to its normal expiration date with the consent of the FTB, and provides such a request for termination shall be made at the time and in the manner specified by the FTB. The request may be granted for good cause. For this purpose, "good cause" has the same meaning as specified in Treasury Regulation Section 1.1502-75(c). [fn9]

The Notice elaborates upon these statutory provisions, and provides that "in general," the request for consent to terminate will be granted "only" if the taxpayer demonstrates that it meets the good cause requirements as provided under Treasury Regulation Section 1.1502-75(c). The Notice also states that consent given by the FTB will not be retroactive. If consent is given, the taxpayer will be required to file on a worldwide basis (i.e., non-water's-edge basis) for at least 84 months before making another water's-edge election (absent consent from the FTB).

The Notice states the request to terminate for good cause must be in writing and must clearly state the reason for the request. A taxpayer must file FTB Form 1117, Request to Terminate Water's-Edge Election, with the FTB no later than the 90th day prior to the due date, including extensions of the return for which the termination would be effective. A taxpayer may withdraw its request at any time before the FTB takes action.

The New Deemed Election Provisions and Changes in Affiliation

SB 1061 addressed what had been a very serious problem, and a trap for the unwary, under the prior water's-edge election law involving corporate acquisitions. Prior to the new legislation, there were only two methods by which a taxpayer could terminate a water's-edge election prior to the end of the 84-month period. First, a taxpayer could request permission, at any time, from the California FTB to terminate the election, which the FTB could either grant or deny in its discretion, and could impose conditions upon the termination. Second, a taxpayer had a right to timely elect to terminate the election if it was acquired, directly or indirectly, by a non-electing entity that alone or together with its affiliates included in the taxpayer's unitary group was larger, in terms of equity capital, than the taxpayer.

This latter provision frequently gave rise to problems where a nonelecting corporation acquired a corporation which had made the water's-edge election, and both were unitary. Unless the acquiring corporation timely terminated the (acquired) election, the acquired company's water's-edge election was automatically binding on the acquiring company for the remaining term of the contract. This provision in the prior law had been the downfall of many a (non-water's-edge electing) unsuspecting corporation which made an acquisition, and then found itself subject to a California water's-edge election for no reason other than the fact a corporation it acquired had made a water's-edge election.

SB 1061 addressed this problem by providing that the acquisition of a water's-edge taxpayer no longer automatically "taints" any non-electing affiliates with which it is engaged in a unitary business. Instead, when two or more taxpayers become unitary under these circumstances, the new legislation provides that the (election or nonelection) status of the larger taxpayer, based on the value of the total "business assets" [fn10] of the taxpayer and its "component unitary group," [fn11] will prevail. [fn12] According to the FTB, this result is more likely to coincide with a taxpayer's expectations, and would prevent a large unitary group from being unintentionally bound by a water's-edge election when it acquires a smaller water's-edge electing taxpayer.

The Notice summarizes this significant change, and summarizes other current rules regarding changes of affiliation, as follows:

  • If one or more electing taxpayer members of a combined reporting group for any reason leave the group, the water's-edge election remains in effect as to the departing taxpayer members and any remaining taxpayer members. [fn13]
  • If electing taxpayers with different election start dates become members of a new group, the election start date of the new group shall be the start date of the taxpayer (and affiliates, if any) whose total business assets are the largest. [fn14]
  • If an electing taxpayer and a non-electing taxpayer become members of a new unitary group, the nonelecting taxpayer shall be deemed to have elected if the value of the total business assets of the electing taxpayer (and affiliates, if any) is greater than that of the non-electing taxpayer (and affiliates, if any). Otherwise, the election shall automatically be terminated at the time the electing members become part of the combined report. [fn15]
  • If two non-electing taxpayers with different termination dates become members of a new group, the termination date, together with any associated restrictions on re-election, of the taxpayer (and affiliates, if any) whose total business assets are the largest shall be the termination date of the new group. [fn16]

The Notice then proceeds to give four examples of the application of these rules.


The process of analyzing whether or not to make a California water's-edge election has never been an easy one, and the election provisions of the new legislation and the Notice will not measurably ease that process. However, the mechanics of the election and the termination processes will certainly be easier. SB 1061 was an FTB-sponsored bill, and to FTB's credit, it has taken another major step toward easing the mechanics of the water's-edge election. While it is inevitable that future glitches will occur in the election and termination process, the new legislation, and Notice 2004-2, provide useful guidance on the new rules.


1: For an overview of the history and basics of the California water's-edge election, see Coffill, "California's New Water's Edge Election Provisions," State Tax Notes, Dec. 8, 2003, p. 845. For a more complete history of the original election dating back to 1986, see Coffill, "A Kinder, Gentler 'Water's Edge' Election: California Wards Off Threats of U.K. Retaliation as Part of Comprehensive Business Incentive Tax Package," State Tax Notes, Oct. 25, 1993, p. 965.

2: Cal. Rev. & Tax. Code §§ 23111, subd. (f); 25113, subd. (f).

3: Cal. Rev. & Tax. Code § 25113.

4: It is, however, at least indirectly addressed in one example in the Notice, which is discussed below.

5: Tit. 18, Cal. Code of Regs., § 25111-1, subd. (a)(2).

6: Cal. Rev. & Tax. Code § 25113(a)(2).

7: Cal. Rev. & Tax. Code § 23113, subd. (c)(10).

8: Cal. Rev. & Tax. Code § 23113, subd. (c)(11).

9: Cal. Rev. & Tax. Code § 23113, subd. (c)(10).

10: "'Business assets' are assets, including intangible assets, other than stock of a member of the unitary affiliate group, which are used in the conduct of the business of the unitary affiliate group or would produce business income to the unitary affiliate group, if an election were not in place, if the assets were sold. Business assets shall be valued at net book value." Cal. Rev. & Tax. Code § 25113, subd. (c)(6)(A).

11: "The phrase 'component unitary group' means that portion of a group of corporations that have become members of a new unitary affiliate group that were members of their own respective unitary affiliate group prior to entering the new unitary affiliate group, disregarding any corporations that did not become part of the new unitary group." Cal. Rev. & Tax. Code § 23113, subd. (c)(6)(D).

12: Cal. Rev. & Tax. Code § 23113, subd. (c)(2).

13: Cal. Rev. & Tax. Code § 23113, subd. (c)(1).

14: Cal. Rev. & Tax. Code § 23113, subd. (c)(3).

15: Cal. Rev. & Tax. Code § 23113, subd. (c)(2).

16: Cal. Rev. & Tax. Code § 23113, subd. (c)(4).




Unsolicited e-mails and information sent to Morrison & Foerster will not be considered confidential, may be disclosed to others pursuant to our Privacy Policy, may not receive a response, and do not create an attorney-client relationship with Morrison & Foerster. If you are not already a client of Morrison & Foerster, do not include any confidential information in this message. Also, please note that our attorneys do not seek to practice law in any jurisdiction in which they are not properly authorized to do so.