History
California imposes a corporate franchise (similar to an income) tax on corporations deriving income from sources within the state. Two or more corporations that operate as a “unitary” business are required to file a “combined report” with the state to report their combined incomes as apportioned to it. By default, foreign affiliates operating in the unitary group must be a part of the combined filing. However, a “water’s edge” election can be made, and by doing so, the business income of their foreign affiliates is not included in the combined group’s income and is not subject to California tax. Once made, a water’s edge election lasts for seven years.
Assembly Bill 1790’s Repeal of Water’s Edge Elections
California Assembly Bill (AB) 1790, introduced on Feb. 10, 2026, proposes a shift to worldwide combined reporting by phasing out the water’s edge election. If enacted, AB 1790 will significantly impact multinational taxpayers that file California corporate tax returns. The bill proposes three significant changes to how multinational taxpayers who operate in a unitary environment file California corporate income tax returns:
- For tax years beginning on or after Jan. 1, 2026, a water’s edge group includes all corporations, except banks, that have a U.S. sales factor of 20% or more (replacing the current three-factor average).
- For tax years beginning on or after Jan. 1, 2026, and before Jan. 1, 2028, current water’s edge filers may terminate the water’s edge election without the consent of the Franchise Tax Board (FTB, California’s version of the IRS).
- For tax years beginning on or after Jan. 1, 2028, all water’s edge elections will be terminated. All foreign and domestic corporations operating in a unitary business environment would be required to file a combined report with the FTB.
Because it is a tax levying measure, AB 1790 requires a legislative supermajority vote (two-thirds of each chamber of the legislature) before it can be presented to Gov. Newsom. Currently, California Democrats control both the Assembly and the Senate (holding 60 of 80 assembly seats and 30 of 40 senate seats, respectively). Based on recent tax-levying measures (e.g., SB 132), the California Legislature tends to vote heavily along party lines, and there appears to be strong support for AB 1790 among Democratic legislators.
The California water’s edge election (Rev. Tax Code §25110) was first introduced in 1986 and underwent significant legislative reform for tax years beginning in 1994. Over the last several decades, there have also been judicial decisions upholding California’s mandatory worldwide filing methodology (e.g., Barclays Bank PLC v. Franchise Tax Board of California (512 US 298 (1994)).
What Eliminating Water’s Edge Election’s May Mean for CA’s Economy
Eliminating the water’s edge election’s availability in today’s digital economy will expand California’s reach far greater than it did decades ago, given California’s factor presence nexus standard and market-based sourcing rules. Additionally, California stands out as a state that holds that Public Law 86-272 does not apply to foreign commerce. Analysts estimate that AB 1790 will raise $3 billion in additional tax revenue for California.
While the California Legislature anticipates AB 1790 to be a revenue raising bill, certain taxpayers may also benefit from worldwide filing, though many taxpayers historically opt out of worldwide filing simply due to its complexity. Furthermore, many states (including Connecticut, Massachusetts, and New Jersey) allow elective worldwide filing. Taxpayers who benefit from the California worldwide filing methodology may elect worldwide filing in other states if they must go through the exercise of calculating taxable income on a worldwide basis. Should this occur, it would be unsurprising if other states eventually followed California’s lead and mandated worldwide filing.
To learn more about worldwide versus water’s edge filing methodologies, please reach out to CBIZ SALT team member.
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