How does California treat IRC 367(d) deemed royalties in worldwide and water's edge years?
Edvin Givargis Published 7 minute read
The short answer
It depends on whether the transferor and the foreign transferee are in the same California combined report, and the answer can change year by year. When a United States corporation transfers intangible property to a foreign affiliate in an exchange described in IRC section 351 or 361, section 367(d) treats the transferor as receiving annual payments contingent on the property's productivity or use, over the property's useful life and capped at twenty years. California conforms to section 367 through the Subchapter C conformity statute (Rev. and Tax. Code section 24451). In a year when both corporations are members of a worldwide combined report, the deemed royalty is an intercompany transaction, deferred under the combined reporting intercompany regulation (Cal. Code Regs., tit. 18, section 25106.5-1) rather than taxed. In a year when a water's edge election excludes the foreign transferee from the group, the deferral ends: the annual deemed royalty enters the California tax base of the transferor and is apportioned, and it is apportioned using the factors of the year in which the income is restored, not the year of the original transfer. A group that made an outbound intangible transfer while worldwide and later elects water's edge has therefore not avoided the royalty stream; it has changed when and how California taxes it.
The federal mechanism California inherits
Section 367 polices nonrecognition transfers to foreign corporations, and its subsection (d) is the intangibles rule: instead of gain at the moment of transfer, the transferor takes into account a stream of deemed royalty payments, ordinary income, commensurate with the income attributable to the intangible, for the property's useful life up to twenty years, sourced as if actual royalties were paid. California does not have its own version of this machinery; it conforms to Subchapter C, section 367 included, through Revenue and Taxation Code section 24451, and the Franchise Tax Board's water's edge manual walks through the conformity expressly. The starting point for the California computation is therefore the same deemed royalty the federal return reports. What California layers on top is combined reporting, and that layer is where the analysis actually lives.
Worldwide years: an intercompany transaction, deferred
While the transferor and the foreign transferee file in the same worldwide combined report, the deemed royalty runs between two members of the group, and the intercompany transaction regulation treats it the way combined reporting treats intercompany income generally: deferred, on the model of the federal consolidated return rules in Treasury Regulation section 1.1502-13, which California adopts with modifications for combined reporting. The economic logic is that a unitary group cannot generate income by paying itself, so the deemed royalty, like an actual royalty between members, is held out of the measure of tax as long as the group relationship holds. The deferral is not forgiveness. Deferred intercompany income waits for a restoration event, and the regulation's principal triggers are exactly the ones that matter here: the property leaving the group by disposition to a nonmember, or the buyer and seller ceasing to be members of the same combined reporting group.
The water's edge election as a restoration event
A water's edge election is the second trigger in action. When the group elects water's edge and the foreign transferee is excluded from the combined report, the transferor and transferee are no longer members of the same group, and the deferral machinery releases. From the first water's edge year forward, each annual deemed royalty is included in the transferor's California tax base and apportioned. The apportionment vintage is the point practitioners miss: the Franchise Tax Board's manual states that income from a deferred intercompany transaction required to be restored is apportioned using the apportionment percentages of the group's members for the taxable year in which the income is restored. The transfer-year factors are irrelevant. A group whose California apportionment percentage has fallen since the transfer restores the royalty stream into a smaller California factor; a group whose percentage has risen does the opposite; and because section 367(d) runs for up to twenty years, the stream will ride the group's factor wherever it goes for as long as the inclusion lasts, including through the single sales factor sourcing rules that now determine that factor.
There is also an election hiding in the mechanics, and a trap beside it. The intercompany regulation permits a taxpayer to elect to report income from an intercompany transaction currently rather than deferring it (Cal. Code Regs., tit. 18, section 25106.5-1(e)(2)(B), (C)). Whether current reporting beats deferral is a modeling question: current recognition uses today's apportionment factors and rates and starts the clock inside worldwide combination, while deferral pushes the income into the water's edge era with whatever factors those years bring. The trap is that the election can be made by accident. The federal return includes the section 367(d) royalty in income; the California combined report is supposed to make an adjustment deferring it; and a return that simply follows the federal income without making the California deferral adjustment has, in the Franchise Tax Board's view, effectively elected current reporting and cannot later claim the deferral. A group that intended to defer and discovers years in that its compliance software never made the adjustment has an election it never meant to make.
The conformity date layer
Because California's version of section 367 is whatever the conformity date captures, the 2025 conformity legislation matters here. The Tax Cuts and Jobs Act rewrote parts of section 367 for federal purposes beginning in 2018: it repealed the active trade or business exception for outbound asset transfers and expanded the intangibles definition for section 367(d) to reach goodwill, going concern value, and workforce in place. California's conformity date sat at January 1, 2015 through taxable year 2024, which left the state, for those years, arguably conformed to the pre-TCJA version of the section while the federal computation ran on the amended one, a divergence with real consequences for which transfers produced deemed royalties at all and how large the royalty base was. SB 711 moved the conformity date to January 1, 2025 for taxable years beginning on or after that date, aligning California with the current federal text going forward. Transfers made during the divergence years deserve a careful look at which version of the statute governed the California inclusion for each open year, and the related article on federal entity classification conformity covers the general mechanics of how the conformity date propagates through provisions like this one.
Practice notes
The recurring failures in this area are bookkeeping failures with twenty-year tails. First, the deferred royalty must actually be tracked: a schedule of the section 367(d) stream, the deferral adjustments made each worldwide year, and the balance waiting for restoration, maintained across preparer changes, because the restoration event may arrive a decade after the transfer and the audit will ask for the history. Second, the water's edge election decision should price the restoration in: the election analysis usually focuses on excluding foreign earnings, and a group with a large deferred intercompany balance can find that the election's first-year cost includes turning a dormant royalty stream back on, apportioned at current factors. The related articles on the water's edge election and reorganizations and on which foreign corporations a water's edge group excludes carry the election mechanics. Third, check the deferral adjustment every year it is claimed; the effective-election trap means one year of silent federal-conformity reporting can end the deferral permanently. And for any transfer touched by the 2018 through 2024 divergence era, the federal and California royalty computations should be reconciled rather than assumed equal, both for the open-year returns and for the restoration balances those years produced.
This article states the law as of September 15, 2026
Statutes, rates, thresholds, and agency practice change, and a different set of facts can change the answer. Before acting on anything discussed above, contact G&G State Tax Group to confirm what has changed since this was written and how the rules apply to a specific situation.
G&G State Tax Group, LLC is a state and local tax advisory firm. The firm provides state and local tax consulting and representation in state and local tax controversies. G&G does not prepare or file tax returns, perform attest services, or provide bookkeeping, and is not a CPA firm.