California Ruling Demonstrates Complexity of Combined Group Filing Rules Following an Acquisition
When a combined group filing on a worldwide basis acquired a combined group filing on a water’s edge basis, California stated that the value of business assets would determine how to file going forward.
A recent California Franchise Tax Board Chief Counsel Ruling addressed the details of how two unitary combined groups of corporations that join to become one newly-combined group of corporations operating as a single unitary enterprise must file when each of the combined groups had different combined filing methodologies in effect prior to the transaction. 
When a group of commonly-controlled business entities are engaged in a unitary business with one another, over half of the states either permit or require the taxable members of the group (i.e., those with nexus in the taxing state) to determine their corporate income tax liability by filing a combined report, which takes into account the income and apportionment factors of all unitary group members (regardless of nexus with the taxing state) in computing the state tax liability. 
The composition of a combined group varies by state. In general, states mandate either a worldwide group, which includes all unitary entities conducting business both within and without the United States, or a water’s edge group, which only takes into account group members who are incorporated within the United States, have income effectively connected with the United States and/or have a certain level of factor presence in the United States. 
California presumes that a taxpayer (or taxpayers) and a group of corporate entities are unitary when there is evidence indicating that the different entities are integrated with, dependent upon or contribute to one another and the taxpayer’s operation as a whole. California requires a unitary group of C-corporations under common control to file a single combined report. 
Further, California defaults to worldwide combined group filing, although a combined group may make a binding seven-year election to instead file using a water’s edge group.  The fact that this election is binding for such a long period of time requires taxpayers to consider the long-term consequences carefully, as the exclusion of foreign group members could either increase or decrease the group’s overall franchise tax liability.
In the example in this Chief Counsel Ruling, a combined group of corporations filing in California on a worldwide basis acquired a second combined group that had an active water’s edge election, forming a new unitary group. California rules provide that when a taxpayer filing on a worldwide basis and a taxpayer filing on a water’s edge basis form a new unitary group, California law deems the new group to have made a water’s edge election when the net book value of the total business assets of the electing group is greater than the value of the business assets of the non-electing group.  Otherwise, the existing water’s edge election is terminated, and a new election must be made in order for the newly combined group to file on a water’s edge basis.
The taxpayer in this ruling sought clarification on what comprises “total business assets” for the purposes of this test. Financial accounting rules resulted in the target company’s assets being recorded at their fair market value at the time of the transaction, with goodwill making up the balance of the purchase price. The issue was whether this newly-recorded goodwill was part of the total business assets of the acquired group for purposes of determining if the new group was deemed to have made a water’s edge election.
California ruled that the goodwill recorded as a result of the acquisition is indeed considered part of “total business assets” of the acquired/target group and should be taken into account for purposes of determining whether the new group was deemed to have made a water’s edge election. Since the inclusion of the goodwill resulted in the acquired/target group (which had an existing water’s edge election) having a higher value of total business assets than the acquiring group, California concluded the newly-formed combined group was deemed to have an existing water’s edge election as of the date of the transaction. 
This ruling demonstrates the complexity of combined reporting rules for groups of entities operating a unitary business in states such as California. In order to file properly, a group of businesses must identify whether it comprises a unitary business under each states’ laws, and if so, whether or not it is obligated to file a combined report in the states where it conducts business. Further, there could be significant tax planning opportunities when states permit elective combined group filing or allow taxpayers to elect to file on a worldwide or water’s edge basis. In addition, taxpayers planning a transaction should be aware of the impact such transaction may have on future combined filing methodologies so that they can plan accordingly.
Aprio’s SALT group has experience in navigating the complex state combined filing rules and can advise on tax planning opportunities for states where elections can be made with regard to combined filing and combined group participation. We constantly monitor these and other important state tax issues in order to assist you with your specific tax situation, and we will include any significant developments in future issues of the Aprio SALT Newsletter.
This article was featured in the October 2017 SALT Newsletter.
 California Franchise Tax Board Chief Counsel Ruling 2017-02 (Sept. 8, 2017).
 The multi-state tax commission defines a “unitary business” as “a single economic enterprise that is made up either of separate parts of a single entity or of a commonly controlled group of entities that are sufficiently interdependent, integrated and interrelated through their activities so as to provide a synergy and mutual benefit that produces a sharing or exchange of value among them and a significant flow of value to the separate parts.” Reg. IV.1.(b)., MTC’s Model General Allocation and Apportionment Regulations as of Feb. 24, 2017. Many states have adopted similar definitions.
 Note that the definitions of what comprises a “worldwide” group and “water’s edge” group are not the same among the states that authorize combined reporting.
 See Cal. Code Regs. 25120(b); Cal. Rev. & Tax Code § 25105(a).
 Cal. Code Regs. 25113(c).
 Cal. Rev. & Tax Code § 25113(c)(2).
 While not addressed in the ruling, the start date for the deemed election was the commencement date of the acquired/target group’s election. See Cal. Rev. & Tax Code § 25113(c)(2); Cal. Code Regs. 25113(f)(2), example two.
Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.