Mary Bernard
Variations on a Combined Theme

Exactly half of the 46 states imposing corporate income taxes now generally require combined-reporting under certain circumstances. The differences among the definitions and methodologies far outweigh the similarities from one state to another.

September 23, 2010
by Mary Bernard, CPA

As of September 2010, there are four states with no corporate income tax, seven separate return states and the remaining states either require, allow or are proposing combined-reporting for unitary businesses or related entities. The last six years saw the increase of the trend towards combined-reporting when Vermont became the first new state to adopt combined-reporting in more than 20 years. Before that time, the same dozen or so states had imposed a combined-reporting requirement on unitary businesses since that concept began in 1980 when California started the trend.

In general, combined-reporting attempts to prevent a multistate corporation from diverting income through related entity transactions to states with low or no corporate income tax. This is done by requiring addbacks of intercompany transactions such as management fees or payments for use of intangibles such as trademarks and patents. The corporation’s taxable income is calculated by combining the income of the entire related group, eliminating intercompany transactions and apportioning that income by the combined apportionment percentage. The numerator of the apportionment factors usually includes the in-state values for all entities with nexus in the state and the denominator includes the total everywhere of the entire group. This calculation attempts to treat the entire related group as one business entity to more fairly present the business activity within a state.

The factors addressed in the combined-reporting regulations generally include the following:

  1. Unitary business,
  2. Common ownership and
  3. Water’s edge reporting.

The definitions imposed in the largest states vary greatly and account for the complexity involved in combined-reporting for multistate corporations. The accumulation and reporting of data for filing in combined-reporting states greatly complicates the income-tax compliance process.

An attempt at uniformity was made by the Multistate Tax Commission (MTC) in 2006 with the adoption of the Proposed Model Statute for Combined Reporting. Under this model, a corporation engaged in a unitary business with one or more corporations must file a combined return. The following discussion addresses the variations among some of the basic combined-reporting rules of the MTC and the four largest combined-reporting states are California, Illinois, New York and Texas.

Unitary Business

The MTC defines a unitary business as “a single economic enterprise that is made up of either separate parts of a single business entity or of a commonly controlled group of business entities that are sufficiently interdependent, integrated and interrelated through their activities so as to provide a synergy and mutual benefit that produces a sharing or exchange of value among them and a significant flow of value to the separate parts.” Texas basically follows this model definition but California does not have a statutory definition, relying instead on regulations, stating that there is a strong presumption of a unitary relationship if any one of the following factors exists:

  1. Same type of business, as in a chain of retail shoe stores;
  2. Steps in a vertical process, such as exploration, mining and refining; or
  3. Strong centralized management.

Case law that mirrored the “three unities test” was established in Butler Brothers v. McColgan to further describe a unitary business existence through:

  1. Unity of ownership;
  2. Unity of operation; and
  3. Unity of use of centralized executive force and system of operations.

In the Edison California Stores v. McColgan case, the California Supreme Court held that a unitary business exists if “the operation of the portion of the business done within the state is dependent upon or contributes to the operation of the business without the state”, the “contribution or dependency test.” Satisfying either the three unities or the contribution or dependency test will determine the existence of a unitary business in California.

In Illinois, the term unitary business group means “a group of persons related through common ownership whose business activities are integrated with, dependent upon or contribute to each other.” The following conditions would satisfy this definition:

  1. The members are in the same general line of business or in a vertically structured enterprise; and
  2. The members are functionally integrated through the exercise of strong centralized management.

Substantial Inter-corporate Transactions

A unitary business is not specifically required to determine the applicability of combined-reporting in New York. The existence of “substantial intercorporate transactions among related corporations” will necessitate the filing of a combined return. Facts and circumstances are examined to determine the extent of transactions involved in a related group. The types of typical activities examined in this process include:

  1. Manufacturing, acquiring goods or property or performing services for related parties;
  2. Selling goods acquired from related parties;
  3. Financing sales of related parties;
  4. Performing related customer services using common facilities and personnel for related corporations;
  5. Incurring expenses that benefit, directly or indirectly, one or more related corporations; and
  6. Transferring assets, including intangibles, from one or more related corporations.

The existence of substantial intercorporate transactions may still dictate a combined return, even if the transactions occur based on an arm’s length transfer price. “Substantial” transactions may be determined to exist where 50 percent or more of the corporation’s annual receipts or expenditures involve related corporations. Multiyear tests may be used if the range of transactions is between 45 percent and 55 percent. The threshold may be met if the aggregate receipts or expenditures over a two-year period equal or exceed 50 percent.

Common Ownership

The concept of common ownership varies among the states in terms of required control and relationship. Under the MTC model, more than 50 percent of the voting power is required for filing a combined return, with constructive ownership rules applied. California, Illinois and Texas follow this definition, but New York requires “substantially all,” meaning more than 80 percent, voting control to be included in a combined return. The New York standard follows the federal requirement for filing a consolidated return under Internal Revenue Code section 1504.

Water’s Edge Reporting

The MTC model combined-reporting statute does not include a mandatory water’s edge reporting clause. If no election is made, all entities — domestic and foreign — would be included in the combined group. With a water’s edge election, along with the corporations incorporated in the US, the following entities could be included:

  1. Non-U.S. corporations with 20 percent or more property, payroll or sales within the US;
  2. Domestic sales corporations (DSC or DISC), foreign sales corporations (FSC) or export trade corporations; and
  3. Other non-US corporations under certain conditions.

California’s statute most closely resembles the MTC model except that a water’s edge election is binding for seven years rather than the 10 years required in the MTC model. Illinois, Texas and New York require water’s edge filing, which generally includes all taxable entities except those conducting more than 80 percent of its business outside the U.S. or assigns more than 80 percent of its property, payroll or sales to locations outside the U.S.


This comparison only included the four largest combined-reporting states. For large multistate corporations filing in all of the 23 combined-reporting states, the variations in requirements can amount to a staggering burden of paperwork. In addition to the issues discussed here, other complexities arise in the area of includible entities, differing fiscal year-end rules and Joyce v. Finnigan apportionment methods. As this trend towards combined-reporting continues with several states still considering adoption, compliance simplification is not likely to be on the horizon.

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Mary F. Bernard, CPA, is director -- income/franchise tax, at the Dallas, Texas-headquartered tax services firm of Ryan. Bernard formerly worked as principal, director of State & Local Tax Services, at Providence, RI-basedKahn, Litwin, Renza & Co., Ltd.