California’s Business Asset Test for a Deemed Water’s-Edge Election Includes Goodwill

On September 8, 2017, the Franchise Tax Board (FTB) issued Chief Counsel Ruling 2017-02 (Ruling), which provides that the business-asset test for a deemed water’s-edge election includes goodwill when determining whether a combination of electing and non-electing affiliates may be included in a water’s-edge return.

California Water’s-Edge Election – In General

By default California requires members of a unitary group to file on a worldwide basis (include both domestic and foreign members) unless a water’s-edge election is made, which generally excludes foreign members from the combined report. The election is effective for 84 months and must be made by every member doing business in California.

Certain transactional events such as a merger or acquisition that creates a new unitary group may require a reevaluation of the water’s-edge election. In order to determine the proper filing methodology after such a transactional event, California provides a business-asset test. Under that test, if the water’s-edge group’s business assets are larger than the business assets of the non-electing group, then the non-electing group is deemed to have made a water’s-edge election at the time of the original election. If the business assets of the non-electing group are larger than the business assets of the water’s-edge group, then the water’s-edge election is terminated and the post-transaction group must file on a worldwide basis.

The Ruling

The Ruling provides that goodwill is considered a business asset and therefore must be included under the water’s-edge business-asset test because goodwill is inseparable from the operations of a business. Goodwill is an intangible asset that is calculated as the excess of the purchase price over the book value, as determined under United States Generally Accepted Accounting Principles (US GAAP), of the assets and liabilities.

The Takeaway

Prior to the Ruling there was some uncertainty among California taxpayers whether goodwill may be included in the definition of business asset for purposes of the water’s-edge business-asset test. California water’s-edge taxpayers should review prior transactional events and determine whether goodwill was included when applying the business-assets test. Furthermore, California taxpayers should be aware that an acquisition may impact a previous water’s-edge election and the post-acquisition unitary group may be required to file on a worldwide combined basis if it fails the business-asset test because the target company’s business assets exceed the business assets of the acquirer due to the inclusion of goodwill.