Five state lawmakers introduced legislation February 10 to raise taxes on corporations by repealing the water’s-edge election (AB 1790, Connolly), even as a Newsom administration official said during a budget hearing that the governor “is not interested in entertaining or pursuing additional revenue increases.”
AB 1790 would repeal the water’s-edge election for the first taxable year beginning on or after January 1, 2028. Until mandatory worldwide combined reporting is required in 2028, taxpayers that file on a water’s-edge basis would be penalized by a requirement that they include 40 percent of net controlled foreign corporation (CFC) tested income in business income – effectively taxing water’s-edge filers more than those filing on a worldwide basis, unless that taxpayer opts to terminate its water’s-edge election.
“The bipartisan water’s-edge policy was carefully crafted to reform the state’s old tax structure that subjected taxpayers to double-taxation and made California an international outcast,” California Taxpayers Association President Robert Gutierrez noted. “Given the need to improve trade relations and grow our state’s economy, it is surprising that anyone would want to go back to the system that prompted other countries to launch retaliatory tax policies against California companies.”
Assembly Member Damon Connolly, a Democrat from San Rafael, said in a press release that his bill would “end the corporate tax loophole known as Water’s Edge.”
The large tax increase proposed by Connolly runs counter to Governor Gavin Newsom’s pledge to not include tax increases in the 2026-27 state budget.
The governor’s position was reiterated February 11 during a Senate Budget and Fiscal Review Committee hearing. Laura Ayala, of the governor’s Department of Finance, testified: “The governor has stated that he is not interested in entertaining or pursuing any additional revenue increases. So, if the Legislature would like to propose something, we’re happy to hear any ideas, but the governor has stated multiple times that he’s not interested in pursuing any new taxes or revenue proposals.”
Ayala added: “I think the one thing that, from the administration’s standpoint, that we’d like to flag is that the revenues have been increasing. … The Department of Finance specifically updates revenues on a monthly basis, and monthly revenues are up even compared to the time of the [January 2026] governor’s budget. The Department of Finance does not see it as a revenue problem, because we have been getting increased revenues. It’s a structurally imbalanced budget that we have to address, and we see it as an expenditure problem. So that is the administration’s perspective.”
During a press conference and a February 11 joint hearing of the Assembly Revenue and Taxation Committee and Senate Revenue and Taxation Committee, proponents of the legislation repeatedly referred to the water’s-edge policy as a “loophole.”
Marilyn Wethekam, a tax law expert from the Council on State Taxation, clarified that the water’s-edge election is not a loophole in any sense.
“A loophole means an exploitation of some unintended ambiguity in the statute or a gap in a statute,” Wethekam said. “Water’s-edge election is anything but a gap in the California statute. It’s been in place for 40 years. … It certainly was done with a conscious effort on a tax policy decision by this state. So, it doesn’t fall into the definition of a loophole by any stretch of the imagination.”
Chris Micheli, an attorney and legislative advocate with Snodgrass & Micheli LLC, raised the same point in a February 10 column for the California Globe: “There are a number of complexities and nuances to consider before making the California water’s-edge election for a multinational corporation …. Much consideration must go into making this determination that is clearly allowed under California’s Revenue and Taxation Code, as well as the forms and ‘Water’s-Edge Manual’ (over several hundred pages) from the Franchise Tax Board. Hardly is this election a ‘loophole’ in the state’s tax law. And, nearly all states with combined reporting regimes include a water’s-edge method.”
During the hearing, Wethekam also responded to proponents’ apparent belief that companies can abuse the water’s-edge election by annually choosing the methodology that results in the lowest tax liability.
“If you look at … the statutory election, that election is made for 84 months – that’s seven years,” she testified. “I don’t know if anyone here has ever had to estimate corporate income of a multinational, but it is extremely difficult to hit the mark for seven years. So, when we talk about ‘would you elect this because you’re going to save taxes,’ you may in one year, you may not in the next. You’re doing this for seven years.”
Wethekam additionally noted that those who elect to report under the water’s-edge method must agree to provide documentation to the Franchise Tax Board, agree to present officers to the FTB to explain transactions, and more.
Wethekam also warned legislators that repealing the water’s-edge election would create more volatility in corporation tax revenue.
California Tax Foundation Visiting Fellow Jared Walczak discussed the issues of double-taxation and compliance burdens, testifying: “If you have companies abroad that have no business with California, in fact, probably have no business with anyone in the United States, but they simply are part of the same foreign parent that also has subsidiaries here, combining their income, combining their profits and losses, bringing that into California, from a fairness perspective, there’s a question of why are we doing that? That activity is fully separate from California. … It may bring revenue to California, may lose revenue for California, depending on how profitable those other entities are. But also from the fairness perspective, the compliance costs can be extraordinary. And if a company is prevented by laws abroad or finds it incredibly difficult from an accounting standpoint to provide this information, or if some of those individual companies just refuse to do it because they’re not connected to California, but the California entity would essentially obligate them to, then it falls back on potentially very rough estimates that I don’t think accurately reflect the actual tax position.”
Darien Shanske, a law professor at the University of California at Davis and the Legislature’s go-to academic for testimony in support of tax increases on businesses, alleged that corporations are engaging in “aggressive corporate tax shifting” as a tax-avoidance strategy, and repealing the water’s-edge election would be “a pretty straightforward possible reform that would advance tax policy along basically every dimension.”
Walczak noted that a study cited by Shanske indicates that if California becomes much more aggressive in taxing multinational businesses that are selling products in California, “one of the channels that that additional tax burden will flow … into is higher prices for Californians on those products.”
Dan Kostenbauder, vice president for tax policy and general counsel for the Silicon Valley Leadership Group, briefed the lawmakers on the retaliation by foreign countries against U.S.-based firms that prompted California to adopt water’s-edge reporting.
“Repealing the water’s-edge election could put us right back to where we were in the early 1980s,” Kostenbauder said. “Foreign governments would put great pressure on the U.S. government to impose water’s-edge treatment through federal legislation, and there would be a lot of businesses in the U.S., as well, that would be interested in avoiding the prospects of retaliation.”
The hearing was led by Senator Jerry McNerney, chair of the Senate tax policy committee, and Assembly Member Mike Gipson, chair of the Assembly committee. Neither expressed support or opposition to the concept of repealing the water’s-edge election. At points during the forum, McNerney expressed concern that doing so would increase the state’s revenue volatility, and Gipson asked witnesses about the likelihood of “pushback from our allies.”
On the latter issue, Rowan Isaaks, representing the Legislative Analyst’s Office, said: “I think it is plausible that there would be a similar reaction as to, you know, back in the 1980s. I think that foreign governments would be concerned about the competitiveness of corporations domiciled in their countries and they would be concerned about unfair taxation on corporations located in their countries. … I don’t see any reason why it would be any different.”
Walczak noted that compliance problems are a factor in the foreign opposition.
“One of the reasons why there was so much foreign pushback on this is that many foreign countries and their companies felt, I think legitimately, that they were not able to submit the information that California required,” Walczak said. “And therefore, California substituted estimates that may not have particularly accurately reflected their actual tax situation.”
Terry Brennand, representing the Service Employees International Union, said the hearing presented “quite possibly [the] most informative conversation I’ve ever heard about this subject in my many years here – I actually learned some things, not all of them good.”
Kayla Kitson, with the union-affiliated California Budget and Policy Center, said the water’s-edge election “deprives the state of billions of dollars in revenues each year that could be used to improve the lives of everyday Californians.”
During the public comment period, numerous union members and pro-tax activists repeated the “loophole” claim and focused their arguments on the idea that the state needs more revenue to sustain spending.
The California Tax Foundation is hosting a webinar on the water’s-edge election February 17 at 9 a.m., featuring Karl Frieden, vice president of the Council on State Taxation, and Alan Pasetsky, owner of Tax Policy LLC. Click here for registration information.