TEI Roundtable No. 43: Separate, Combined, and Worldwide Unitary State Filings
Some practical advice for making these key decisions

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One of the most talked-about education sessions at this year’s Midyear Conference in March was the session titled “Separate, Combined, and Worldwide Unitary State Filings—What’s New?” We thought this very important state and local tax topic deserved more discussion, so we convened a roundtable in May to take a deeper dive, with these participants: Jessica Brown, senior manager of the national controversy team at Ernst & Young; Matt Hunsaker, partner and national SALT team lead at BakerHostetler; and Rob Ozmun, SALT partner at PwC’s national tax services office in Washington, D.C. Michael Levin-Epstein, senior editor of Tax Executive, moderated the panel.

Michael Levin-Epstein: Jessica, how would you define “separate,” “combination,” and “worldwide” filings?

Jessica Brown: I think the key thing is for each state, you might be filing with a different group of related entities or on a standalone basis. Some states are separate entity filing states, so that each entity in your group will file their own return for that state. So, you could have multiple returns. Another way that you could be filing is a “water’s-edge filing.” That would be all the members of your group would file one unified return up to the boundaries of the water—the United States, essentially. A worldwide combined return would include all entities, including international entities, on one return for that state. So, it’s really who’s filing on your return with you. Is it a separate entity, your US group, or your worldwide group?

Levin-Epstein: What are some things that companies should consider when making a water’s-edge versus a worldwide election?

Brown: What you’re deciding when you’re making this election is who’s going to be in your group. One of the things you want to think about is, obviously you want to minimize your overall tax liability and filing burdens. When it’s an election, you get to decide. Some of the things you could think about are the relative profitability of your domestic versus foreign operations. Is the additional income that’s going to be brought into this state by including the foreign affiliates going to be mitigated by the apportionment factor effects? If you’re marginally more profitable in the US than outside, you could consider the benefit of filing on a worldwide basis, because it could dilute your taxable income with the less profitable foreign businesses. Another thing that you can think about is intercompany transactions. In a water’s-edge filing, transactions between domestic and foreign entities are not eliminated, but in a worldwide return they would be eliminated. What are those transactions? How can those eliminations benefit or hurt the overall tax return? And then you also want to think about timing: How long are you electing for, and are there going to be changes to your business operations that you think could affect the profitability or the likelihood of paying more taxes in the long run?

Federal Intervention?

Levin-Epstein: Matt, if states were to begin enacting mandatory worldwide combination, do you think we would see federal intervention?

Matt Hunsaker: We have seen this before. When the US Supreme Court upheld the constitutionality of California’s worldwide mandatory combination regime in 1983 (the Container case), the federal government acted swiftly. They were under enormous pressure by our trading partners, both in Europe and Asia. In 1984, President Ronald Reagan convened the Worldwide Unitary Taxation Working Group to study the issue. Treasury Secretary Donald Regan, who led the group, concluded that state tax policy should require water’s-edge unitary combination. When states didn’t respond to this conclusion with sufficient vigor, two federal bills were introduced that would have preempted states from using worldwide mandatory combination. Faced with the prospect of losing sovereignty through federal preemption, states acted swiftly to adopt water’s-edge reporting or elections. Would we see this again? Recent history has shown a declining interest by the federal government in addressing vexing state tax issues. Bills relating to sales tax collection nexus and taxation of the mobile workforce have languished. This issue also has to be considered in the context of the OECD Pillar One and Pillar Two proposals, which do not appear to support worldwide combined filing. Even the federal government, with the enacting of the [Tax Cuts and Jobs Act] in 2017, has drifted towards a quasi-territorial tax system. If states begin enacting worldwide combination en masse and it causes friction with the OECD partners, I suspect that there will be pressure again for the federal government to use its Commerce Clause powers to address the situation. Whether they do is anyone’s guess.

State Actions

Levin-Epstein: Speaking of adopting worldwide combination en masse, what states are considering mandatory worldwide combination right now?

Hunsaker: That list is relatively small—at least those who have publicly stated interest in a legislative change. Since 2021, New Hampshire has had a study commission evaluating worldwide unitary combination. Its findings are due November 1, 2023. But this session, bills have been introduced that would adopt worldwide combination before the study is even complete! Hawaii and Minnesota have also been considering legislation to adopt mandatory worldwide combination, but I believe the Minnesota legislation is dead for the year after the Senate withdrew its support. Although nothing has passed and only a few states have dipped their toes into proposing legislation, we know how states watch what other states do, and the tide can change pretty quickly. Especially if legislators buy the argument that it is a panacea against all profit shifting.

Meaning of “Water’s Edge”

Levin-Epstein: Jessica, you were talking earlier about water’s-edge returns. I think our members would like to know some of the ways that foreign entities can be included in water’s-edge returns.

Brown: We have this term “water’s edge,” but it doesn’t always mean water’s edge, because states can pull in foreign entities in certain circumstances. One of the standard rules that most states have, or a lot of states have, are 80–20 rules. When a foreign entity has twenty percent more US apportionment—could be sales, property, and/or payroll—they can be pulled into the water’s-edge group, even though they’re an international company. Another key issue I think that a lot of states are grappling with, as are companies, are tax haven rules. If you are a foreign entity that’s operating in a quote-unquote “tax haven,” they can get pulled into the water’s-edge group.

The real rubber-meets-the-road [moment] is in defining a tax haven. Some states have lists; some states have subjective factors they run through. Knowing which states have which rules, how that affects your business operations, I think, ultimately, can be a challenge. Also, for instance, controlled foreign corporations can be included in a water’s-edge return based on their subpart F income. I think about DISCs [domestic international sales corporations] and selling US property, but I would say the 80–20s, the tax havens, and the CFCs are the big ways you can get pulled in.

Mergers & Acquisitions

Levin-Epstein: Rob, now that we’ve covered an overview of unitary filing methods and which entities may or may not be included in a unitary group, when should companies look at whether or not they are unitary when there is a merger or acquisition by one group with another?

Rob Ozmun: That is a really good question. The answer is that taxpayers should really start to look at the unitary relationship as soon as possible. The question of whether or not an entity or group of entities is unitary is a facts-and-circumstances analysis. While some states have a rebuttable presumption of instant unitary in the first year (for example, Texas), others have a rebuttable presumption of not being unitary in the first year (for example, Massachusetts), and still others are silent on it (for example, Minnesota), the answer really is [that] it depends on each entity’s/group’s specific facts at the time of acquisition and throughout that first year. In my experience, when organizations announce a merger or acquisition and up and through the first year after it is completed, the company will have outlined if and how they plan to integrate or if they will operate it as a separate unit; the synergies they expect to achieve and how they plan to achieve them; and/or if and how they will realign existing business operations, distribution centers, etc. These types of facts and others are what will help support the organization’s unitary position, and it is way easier to document these facts while they are being developed and/or are in process than trying to document the facts three or four years later when [the company is] under a state tax audit.

Levin-Epstein: That’s interesting, but as we wrap up the discussion, are there any other unitary combined return issues to think about when completing a merger/acquisition?

Ozmun: There is probably much more that we could discuss, but the one item I’d remind people to consider when completing a merger/acquisition is to consider which election may survive the acquisition. For example, if the acquiring entity files on a water’s-edge basis in California, it is not a given that the acquiring entity’s election is the election that survives. California will use an asset test to determine which group is larger, and that test will determine which election will effectively survive. Depending on when the surviving election was made, the new combined group may not be able to immediately switch the surviving election. While California is just one example, there are other state filing elections like nexus consolidated filings or full consolidated filings that may or may not be impacted by the transaction. So, the punchline is simply that taxpayers and state tax practitioners need to gather the facts for each group, identify the position and elections that have been made, and then do the analysis to determine how the merger/acquisition will impact those positions and what options are available as of day one.

Who Makes the Decision?

Levin-Epstein: Jessica, the final question goes to you. It would seem that there are a number of players at every company, any taxpayer, who would be affected by these kinds of decisions. My question to you is, How far ahead of time before making an election should you start the process, and is there a best practice in terms of how decisions are made at companies?

Brown: I think it’s a good question. When you’re electing, oftentimes you’re electing for five to ten years. So, you’re going to want to take a long view. I do think that having time to do some modeling in advance of making that decision is important, and depending on the business operations, that can be more or less complicated and take more or less time. If you’re a tax director at one of these companies, you’re going to have to be talking to your business operations teams to make these decisions. What are the business decisions that are upcoming that could affect this? And, importantly, can you realistically get the information necessary to file a return on a worldwide basis? It’s about communication outside of your tax department.

Levin-Epstein: Thank you all.

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