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Federal law provides income reporting rules for U.S. shareholders of a CFC. This provision provides that if a foreign corporation is a CFC at any time during the taxable year, each U.S. shareholder that owns stock in such corporation on any day during the CFC taxable year, is required to include in the U.S. shareholder’s gross income its pro rata share of the corporation’s subpart F income for the CFC’s taxable year as determined by the portion of such income that is attributable to the stock of such corporation owned by the shareholder and any period of the CFC year during which the shareholder owned the stock, such shareholder was a U.S. shareholder, and such corporation was a CFC. Each U.S. shareholder that owns stock in such corporation on the last day of the CFC taxable year, is required to include in the U.S. shareholder’s gross income its pro rata share of any amount as determined under IRC section 956 with respect to investment of earnings in U.S. property.
This provision also provides that any amount required to be included in gross income by a U.S. shareholder shall be included in gross income for the U.S. shareholder’s taxable year that includes the last day on which the shareholder owns (within the meaning of IRC section 958(a)) stock in the CFC during such CFC taxable year.
California does not conform to the changes to IRC sections 951, 951A, or 956.
Worldwide Unitary Method
California corporate taxpayers doing business both within and without California are required to compute their California franchise or income tax using the worldwide unitary method. Under this method, a corporate taxpayer's business income from both domestic and foreign unitary operations is considered in the calculation of the taxpayer's tax base, and a share of that business income is then “apportioned” to California using a formula. Income apportioned to California is subject to California franchise or income tax. The formula measures relative levels of business activity in the state by using the amount of the taxpayer’s sales in California divided by the taxpayer's sales everywhere. This measure of activities is commonly called the “single sales-factor formula.” The amount of sales from both domestic and foreign activities are included in the calculation of the apportionment formula. Generally, dividends paid from one member to another within the unitary group from unitary earnings are eliminated from tax computations under Revenue and Taxation Code (RTC) section 25106.
California Water's-Edge Election
As an alternative to the worldwide unitary method, California law allows corporations to elect to determine the business income of their combined reporting group on a “water's-edge” basis. In general, the water’s-edge method excludes foreign corporations from the calculation of business income. An exception to this general rule is a CFC with subpart F income. The income and factors of the CFC are included in a water's-edge combined report based on the CFC's inclusion ratio. This ratio is equal to the CFC’s current year subpart F income divided by the CFC’s current year earnings and profits. While California does not conform to the subpart F scheme of the IRC, for purposes of computing the CFC's inclusion ratio under water's-edge, California incorporates the federal definitions of "subpart F income" and "earnings and profits" as applicable for federal income tax purposes for the same taxable year.
Generally, rather than computing a dividends-received deduction using federal dividends received deduction (DRD) provisions, dividends paid to the water's-edge combined reporting group from foreign affiliates are income on the water's-edge combined report and California taxpayers electing water's-edge treatment are generally entitled to a 75 percent DRD on such dividends under RTC section 24411.
In addition, California does not conform to IRC section 956 with respect to investment of earnings in U.S. property.
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