What Is Worldwide Combined Reporting for State Taxes?

Worldwide combined reporting is a method certain states use to calculate the corporate income tax for multinational businesses. This approach treats a parent company and its subsidiaries, including those located in foreign countries, as a single economic entity for tax purposes. The goal is to accurately determine the portion of a multinational corporation’s total profit earned within a specific state’s borders. This prevents companies from artificially moving profits to subsidiaries in countries with lower tax rates to reduce their state tax liability.

This method is an extension of “water’s edge” reporting, which only combines the income of U.S.-based entities. Worldwide combined reporting expands this concept to include foreign affiliates, allowing a state to tax a proportional share of the entire group’s combined profit.

The Unitary Business Principle

Before a state can require a group of corporations to file a worldwide combined report, it must establish that they form a “unitary business group.” This principle is the legal foundation for treating legally separate corporations as a single entity for tax purposes. Affiliated corporations are considered unitary if they are integrated in a way that contributes to each other’s value and operational success.

To determine if a group of companies constitutes a unitary business, states rely on two key tests: the “Three Unities Test” and the “Dependency or Contribution Test.” The Three Unities Test examines the relationship between the entities across three dimensions. The first is Unity of Ownership, which is met when a parent company directly or indirectly owns more than 50 percent of its subsidiaries’ voting stock.

The second element, Unity of Operation, looks for centralized business functions and shared services among the affiliated corporations. Evidence of this unity includes having a centralized executive team, shared legal or accounting departments, and combined purchasing or advertising efforts. The existence of intercompany financing, such as loans from the parent to a subsidiary, also points toward an integrated operational relationship.

The third element is Unity of Use, which focuses on the integration of management and operational systems. This is demonstrated when a parent company and its subsidiaries have a shared system of governance and control. This can include having interlocking boards of directors, the frequent transfer of key employees between entities, and a unified system for training.

Some jurisdictions use the Dependency or Contribution Test as an alternative or supplement to the Three Unities Test. Under this framework, a unitary business exists if the in-state operations of a company are dependent upon, or contribute to, the out-of-state or foreign operations of its affiliates. For instance, if a foreign subsidiary manufactures a component for a product assembled by a U.S. parent, a dependency is clear. Similarly, if a U.S. research center creates intellectual property used by foreign subsidiaries, it demonstrates a contribution to the enterprise.

Determining the Combined Tax Base

Once a group is identified as a unitary business, the next step is to calculate the total income of the group, which becomes the combined tax base. This process involves aggregating the net income of every member of the worldwide unitary group. The goal is to create a single, consolidated income figure representing the entire enterprise’s profitability.

A part of this calculation is the elimination of intercompany transactions. When a parent company and its subsidiaries are treated as one entity, transactions between them must be removed to prevent income from being counted more than once. For example, if a foreign subsidiary pays dividends to its U.S. parent, that dividend income is eliminated. Similarly, sales between subsidiaries and interest payments on intercompany loans are also disregarded.

Further adjustments are necessary to ensure consistency across financial data from different entities. Foreign subsidiaries may prepare their financial statements using different accounting standards, such as International Financial Reporting Standards (IFRS). For U.S. tax purposes, these figures must be converted to align with U.S. Generally Accepted Accounting Principles (U.S. GAAP).

Another adjustment involves foreign currency translation. The financial results of foreign subsidiaries are recorded in their local currency and must be translated into U.S. dollars for a combined report. Tax regulations provide specific rules for this process, often requiring an average exchange rate for the year for income statement items and the year-end exchange rate for balance sheet items.

Apportioning Income to a Jurisdiction

After calculating the total combined income of the unitary business group, the next step is to determine what portion of that income is subject to tax in a specific state. This is done through formulary apportionment. Instead of tracking specific profits from in-state transactions, the state uses a formula to assign a share of the worldwide income based on the company’s business activity there.

The traditional method is the three-factor apportionment formula, which uses property, payroll, and sales. The formula calculates the share of income attributable to the state by averaging the ratios of the company’s in-state property, payroll, and sales to its total property, payroll, and sales everywhere. This provides a standardized way to divide the tax base.

The property factor is the ratio of the average value of the company’s real and tangible personal property in the state to the average value of all its property worldwide. This includes assets like land, buildings, machinery, and inventory. The property is valued at its original cost, not its depreciated value. The average value is determined by adding the value at the beginning and end of the year and dividing by two.

The payroll factor represents a company’s workforce in the state. This factor is the ratio of the total compensation paid to employees working in the state to the total compensation paid everywhere. Compensation includes wages, salaries, and commissions. For employees who work in multiple states, specific rules assign their compensation to a single state, usually where their base of operations is located.

The sales factor measures the company’s market presence within a state. It is the ratio of the company’s total sales derived from the state to its total sales everywhere. Most states have shifted to “market-based sourcing,” where sales are sourced to the location of the customer or where the benefit of a service is received. Many states have also modified the traditional formula, placing a greater or exclusive weight on the sales factor.

Required Information and Filings

Complying with worldwide combined reporting requirements demands extensive data collection and record-keeping from a multinational corporation. The company must gather the following:

• A complete organizational chart and a detailed analysis supporting the unitary determination based on the state’s specific tests, such as the Three Unities or Dependency or Contribution tests.
• The complete financial statements for every member of the unitary group, both domestic and foreign. If foreign subsidiaries use accounting standards other than U.S. GAAP, a full reconciliation must be prepared to convert their financial data.
• Detailed data to accurately calculate the apportionment factors. This includes schedules listing the original cost and location of all property, payroll records broken down by state, and sales data that can be sourced according to state rules.
• A comprehensive record of all intercompany transactions, including details on sales, loans, and dividend payments. These must be tracked so they can be eliminated from the combined income calculation.
• All gathered financial data and the results of the apportionment factor calculations must be transferred onto the specific state tax forms or schedules required for a combined report.