California bill targeting “water’s-edge” tax rule sparks debate
A proposal moving through the California Legislature is drawing sharp opposition from business groups, who warn it could raise costs for consumers, strain international trade relationships, and make the state a global outlier in corporate taxation.
At the same time, proponents say that closing the largest corporate tax loophole in the state is just common sense.
At the center of the debate is AB 1790 (Connolly, D-San Rafael), a bill that would effectively eliminate the long-standing “water’s-edge” election for multinational corporations, who can choose to calculate its state taxes based only on income earned within the borders of the state rather than its total worldwide profits.
“For the last 40 years, California has allowed the biggest corporations to choose a tax scheme that ensures they pay as little in taxes as possible,” said Assemblymember Damon Connolly, who described the water’s edge election as “the largest corporate tax break in California,” one that cost the state $4.1 billion in 2024-2025.
Under current law, companies can choose to pay California taxes only on income tied to their U.S. operations, allowing them to establish subsidiaries offshore to avoid paying taxes on their profits. The proposed change would require broader reporting of worldwide income, potentially increasing tax liabilities for companies with significant overseas business.
Proponents argue that mandatory worldwide combined reporting will generate substantial revenue—Connolly said between $3 and $4 billion annually—but critics like the California Chamber of Commerce say that’s far from certain.
According to Alexis Rodriguez, policy advocate for CalChamber, “We strongly believe AB 1790 would actually make California’s tax revenues more volatile and could end up costing the state money.”
In a letter to lawmakers, Rodriguez said the shift would make doing business in California more expensive, that companies facing higher taxes are likely to pass those costs on to consumers, particularly in industries where demand is relatively inelastic. That could mean higher prices for everyday goods such as electronics, vehicles, and machinery, many of which are produced abroad and sold competitively in California markets.
With affordability already a major concern for Californians, an added tax burden could further strain household budgets, said Rodriguez.
Beyond domestic impacts, opponents say the proposal risks reopening old tensions with key international partners. Before the water’s-edge system was adopted in 1986, countries such as the United Kingdom, Japan, and Canada objected strongly to California’s method of taxing multinational corporations. The dispute prompted threats of retaliatory measures and was ultimately resolved with bipartisan legislation—SB 85, authored by Senator Al Alquist—that created the current system.
The water’s-edge election has since been viewed as a compromise, allowing California to tax income connected to the state while avoiding what foreign governments consider overreach. Eliminating that option, critics argue, could revive concerns about double taxation, where the same income is taxed both abroad and in California.
Rodriguez warned that foreign governments may interpret the proposed changes as inconsistent with international tax agreements involving the United States. Such a perception could discourage foreign investment and complicate future economic partnerships.
“California cannot effectively pursue international partnerships while adopting policies that global partners see as hostile to their domestic employers,” Rodriguez stated.
Another point of contention is California’s potential status as a global outlier. Opponents note that no other U.S. state—and no national government—requires mandatory worldwide combined reporting in the way AB 1790 proposes. If enacted, they argue, the policy could place California at a competitive disadvantage compared to other jurisdictions.
Supporters of the current system also push back on the characterization of the water’s-edge election as a loophole. Companies that choose the method must commit to “a binding seven-year contract with the Franchise Tax Board,” said Rodriguez, thus limiting their ability to switch tax strategies based on short-term advantages. In some cases, businesses may even pay more over that period than they would under a worldwide system.
“In fact, it is entirely possible businesses will pay higher taxes during portions of the seven-year period because of their election to file on a water’s-edge basis,” Rodriguez said.
AB 1790 is scheduled to be heard by the Assembly Revenue and Taxation Committee later this month, setting up a closely watched debate over tax policy, economic competitiveness, and California’s role in the global economy.
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Photo by Elena Mozhvilo on Unsplash
