News and Insights

California Ruling on Deemed Water’s Edge Election

Tax Development Oct 09, 2017

In a recent Chief Counsel Ruling, the California Franchise Tax Board (FTB) determined that a deemed water’s edge election was made when an acquisition caused a revaluation of the Target’s assets that resulted in a larger value than the Acquirer.1 California requires unitary groups to file on a worldwide combined basis, unless an election is made to file a water’s edge combined report. Such an election is binding for 84 months. In the event of an acquisition involving an electing member and a non-electing member, the non-electing member shall be deemed to have elected if the value of the total business assets of the electing member and its component unitary group is larger than the value of the total business assets of the non-electing member and its component unitary group.

Prior to the acquisition, the Acquirer filed on a worldwide basis, and the Target filed on a water’s edge basis. Under financial accounting rules, an acquired company’s assets must be revalued to fair market value. The company’s consolidated financial statements did not attribute the goodwill obtained in the acquisition, to any specific entity, but rather listed goodwill as a separate item on the balance sheet.

“Business assets” as defined under R&TC Section 2511 3(c)(6)(A) is broadly defined to include intangible assets used in the conduct of the business of the unitary affiliate group, with the exception of the stock of a member of the unitary affiliate group. As there is no exception for goodwill, it should be included in the calculation of the business asset test for purposes of the deemed election. 

The courts have recognized goodwill as inseparable from a business’s ongoing operations. California case law also indicates that goodwill attaches to the acquired entity. In Appeal of Borden,2 the Board of Equalization cited a federal decision,3 which stated that goodwill is so essential to the viable conduct of a business that is held to be inseparable from the business as a whole. 

Based on this approach, the value of the Target’s goodwill was integral to the Target’s business operations and, therefore, attributable to the value of total business assets. As a result of including goodwill in the value of the business assets, the Target’s total business assets exceeded the value of the Acquirer’s total business assets. The Acquirer was therefore deemed to have made a water’s edge election. 

1 (Chief Counsel Ruling 2017-02) (Release Date: September 08, 2017) (Doc 2017-72016).

2 Appeal of Borden, 77-SBE-007 (February 3, 1977).

3 Grace Brothers v. Commissioner, 173 F 2d 170, 175-176 (9th Cir. 1949).


Mary Bernard