The initial principle of “Water’s Edge” combined reporting was to require combined reporting for affiliated domestic companies that are engaged in a unitary business. Some states have added foreign companies to the Water’s Edge group. These are companies that have a limited United States presence (20% or more) as long as they are part of the affiliated group and engaged in a unitary business.
An even more recent trend is states pushing to include companies in Water’s Edge reporting whose affiliates are doing business in overseas “tax havens” – regardless of the amount of U.S. activity they have conduct. Over time, states have been pushing the envelope to make water’s edge less and less water’s edge.
Companies that are part of a Water’s Edge combined group all include their income and apportionment factors when calculating the particular combined state tax liability. In general, these combined groups have consisted of:
- U.S. corporations included in a federal consolidated tax return
- Corporations incorporated in the U.S.
- Foreign corporations with a certain threshold of U.S. business activities (80/20 corporations)
- U.S. corporations that have more than 50% of their voting stock owned or controlled by another U.S. corporation.
Lately, states like Washington DC, Florida, and Maine – just to name a few – have been adding affiliates engaged in a unitary business that are located in overseas “tax haven” countries to the Water’s Edge mix.
Tax havens can be defined as
- countries that have tax rates lower than that of the U.S. by a certain threshold percentage
- tax regimes that lack transparency, or are favorable for tax avoidance
As an alternative, a state’s laws may have a “blacklist” of countries that are considered tax havens. The countries in the states’ blacklists may overlap, to a certain degree, but are not exactly identical. The number of blacklisted countries/territories is in the dozens for most states, with the US Virgin Islands being among them. The intent of expanding water’s edge combined reporting appears to be to prevent multinational corporations from shifting U.S. earned income to these tax havens.
Opponents of these “expanded” groups argue that the states’ definitions of tax haven countries are too vague and violate the due process clause. They also argue that this practice taxes foreign source income that is statutorily excluded from U.S. state taxation. In addition, they argue that including these companies located in tax havens creates a substantial risk of multiple international taxation, which violates the Commerce Clause.
What can’t be argued is that more and more states including companies located in tax havens in their combined returns. As unfair as it may seem, tax practitioners need to be aware that it is happening.