How does California treat IRC 367(d) deemed royalties in worldwide and water's edge years?

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, commensurate with the income attributable to the intangible, for the property's useful life. The amounts are ordinary income and, for purposes of the foreign tax credit limitation, are treated as a royalty (IRC section 367(d)(2)(C)); the transferee's earnings and profits are reduced by them (IRC section 367(d)(2)(B)). For transfers before September 14, 2015, the regulations capped the period at twenty years; for later transfers, useful life is the entire period during which exploitation of the property is reasonably anticipated to affect taxable income, with no cap, unless the transferor elects the twenty-year inclusion period (Treas. Reg. section 1.367(d)-1(c)(3)).

The inclusions can also end before the useful life does. If the transferee disposes of the property to an unrelated person, the transferor recognizes gain and no further deemed payments are taken into account (Treas. Reg. section 1.367(d)-1T(f)). For dispositions on or after October 10, 2024, a disposition to a qualified domestic person, such as the original transferor or a related United States corporation, ends section 367(d) treatment once gain is recognized and the regulation's reporting conditions are met (Treas. Reg. section 1.367(d)-1(f)(4), (j)(2)). No authority addresses the California combined report consequences of such a repatriation.

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 Water's-Edge Manual walks through the conformity expressly. California applies final and temporary Treasury regulations to the extent they do not conflict with its own statutes (Revenue and Taxation Code section 23051.5(d)), which is how the section 367(d) regulations reach the California computation. Where the federal and California versions of section 367 are the same, the California computation starts from the deemed royalty the federal return reports; the conformity section below covers transfers where they differ. What California layers on top is combined reporting, and that layer is where the analysis lives.

Worldwide years: deferral as a general position, not a settled rule

While the transferor and the foreign transferee file in the same worldwide combined report, the deemed royalty runs between two members of the group. California's intercompany transaction regulation, modeled with modifications on the federal consolidated return rules in Treasury Regulation section 1.1502-13, defers intercompany income until a restoration event, chiefly the property leaving the group by disposition to a nonmember, or the seller and buyer ceasing to be members of the same combined reporting group (Cal. Code Regs., tit. 18, section 25106.5-1(d)). The Water's-Edge Manual states that section 367 income "may nevertheless be deferred for California purposes as an intercompany transaction" (section 17.2(a)(1)), and its discussion is framed around section 367 gain (section 17.2(a)(6)). No regulation, Franchise Tax Board ruling, or State Board of Equalization or Office of Tax Appeals decision addresses how the regulation applies to the annual deemed payments of section 367(d) in a combined report.

The open question is whether a deferred balance builds up at all. The regulation does not hold every intercompany item in suspense; under its matching rule, a seller takes its intercompany income into account in the year the buyer takes the corresponding item into account. Licensing technology to a member is an intercompany transaction (Cal. Code Regs., tit. 18, section 25106.5-1(b)(1)(A)), and the regulation's rental example has the lessor take its $100 of rental income into account in the same year the lessee deducts $100 (section 25106.5-1(c)(2), Example 6). An actual royalty between members therefore nets out each year and leaves nothing to restore. Whether a section 367(d) deemed royalty behaves the same way depends on whether the transferee has a corresponding item. Federally, the transferee's earnings and profits are reduced, and the current final regulation treats the deemed payment as an allowable deduction of the transferee, "whether or not that amount is paid," allocated among classes of gross income (Treas. Reg. section 1.367(d)-1(c)(2)(ii)). Whether the Franchise Tax Board treats that as a corresponding item, so that the deemed royalty matches annually rather than defers, has not been addressed in published guidance. A group that has been deferring the stream is relying on the manual's general statement about section 367 income, not on a rule written for section 367(d).

The water's edge election as an acceleration event

When the group elects water's edge and the foreign transferee is excluded from the combined report while the transferor remains in it, the two are no longer members of the same group, and the regulation's acceleration rule applies. Acceleration happens immediately before the event that causes it. The regulation's example takes the deferred amount into account "immediately before S becomes a nonmember" (Cal. Code Regs., tit. 18, section 25106.5-1(d)(3), Example 1), and the Water's-Edge Manual applies that timing to the election: "the deferred income is taken into account in the taxable year immediately before the year affected by the water's-edge election" (chapter 14, section e). Restored income is apportioned using the apportionment percentages for the taxable year in which it is restored (Water's-Edge Manual, section 17.2(a)(5)(A); Cal. Code Regs., tit. 18, section 25106.5-1(a)(5)). That year is the last worldwide year, so any accumulated section 367(d) balance is apportioned with a factor that still includes the foreign affiliates.

The deemed royalties for the water's edge years themselves are not deferred. A transaction between a member of the water's edge group and a corporation outside it "will be taxed currently as if the transaction had occurred between unrelated entities" (Water's-Edge Manual, chapter 14, section e; section 17.2(a)(4)). From the first water's edge year forward, each annual deemed royalty enters the transferor's income in the year it arises and is apportioned with that year's water's edge factor, including the single sales factor sourcing rules that now determine it, for as long as the inclusions last.

The transfer-year factors are generally not used. Restoration-year apportionment is the regulation's general rule, but the same regulation applies the year-of-sale apportionment percentage to installment-sale income under section 25137 (Cal. Code Regs., tit. 18, section 25106.5-1(c)(2), Examples 3 and 4), and section 367(d) recasts the transfer as a sale in exchange for payments that are contingent on the property's use (IRC section 367(d)(2)(A)(i)). No authority says which of the two rules governs a section 367(d) stream.

The timing creates a reporting problem that the authorities do not resolve. The water's edge election is made on the original, timely filed return for the election year (Revenue and Taxation Code section 25113(a)), so by the time the election is made, the return for the preceding year, the year that must carry the accelerated amount, may already be on file. No published guidance addresses how the Franchise Tax Board expects the accelerated amount to be reported in that case, whether by amended return or otherwise; the Water's-Edge Manual's chapter on intercompany transactions is silent on the point.

A transferee that is only partly excluded

The analysis above assumes the foreign transferee drops out of the water's edge group entirely. An intangible-holding transferee that is a controlled foreign corporation with Subpart F income is instead partially included: its income and factors enter the water's edge combined report in the ratio of its Subpart F income to its earnings and profits, capped at one (Revenue and Taxation Code section 25110(a)(2)(A)(ii)). A transaction with a partially included corporation is an intercompany transaction only to the extent of that corporation's partial inclusion ratio. Acceleration then follows the regulation's own tests: it occurs immediately before the first year in which the ratio is 50 percent or less of the ratio for the year of the transaction, or whenever the ratio falls below 10 percent, and the regulation offers an elective proportionate acceleration (Cal. Code Regs., tit. 18, section 25106.5-1(j)(3)(B); Water's-Edge Manual, chapter 14, sections e.2 and f). A foreign corporation included only for its United States source income triggers acceleration in a year when it has no includable income (Cal. Code Regs., tit. 18, section 25106.5-1(j)(3)(A)). The regulation still cites the former paragraphs (a)(4) and (a)(6) of section 25110; the current provisions are section 25110(a)(2)(A)(i) and (ii).

Section 367(d) also interacts with the ratio itself. The reduction of the transferee's earnings and profits for the deemed payments (IRC section 367(d)(2)(B)) shrinks the denominator of the inclusion ratio (Revenue and Taxation Code section 25110(a)(2)(B)), which can raise the share of the transferee that the water's edge report includes, and with it the share of any transaction with that transferee that remains intercompany.

Elective current reporting, and the effective-election trap

The intercompany regulation permits a group to elect to report its intercompany transactions on a separate-entity basis, recognizing the income currently rather than deferring it. The election is made on a timely original return, is treated as an accounting method, and applies "for all intercompany transactions occurring in the year to which the election is first applied, and for each year thereafter" (Cal. Code Regs., tit. 18, section 25106.5-1(e)(2)(B), (C)). For a section 367(d) stream, the choice is narrower than it first appears. Deferral does not carry the worldwide-year royalties into the water's edge years: on an election, the deferred balance is accelerated into the last worldwide year and apportioned at that year's factors. The difference between current reporting and deferral is mostly one of timing within the worldwide period, and of exposure to factor changes between the year each royalty arises and the year the balance is accelerated or otherwise restored.

The trap is that the election can be made by accident. The Water's-Edge Manual states that a taxpayer that reports section 367 income as the federal return does and makes no California deferral adjustment "has effectively elected to report income from the transaction in the same year," and examiners are not to defer it (section 17.2(a)(6)). Because the regulation keys the election to transactions occurring in the year it is first applied, the year of the transfer is the year that matters most. Neither source states how a missed adjustment in a later year affects deemed payments from a transfer made in an earlier year, and neither addresses revocation.

The conformity date layer

Because California's version of section 367 is whatever the conformity date captures, the conformity statutes matter 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 transfers of property (Pub. L. 115-97, section 14102(e)). It added goodwill, going concern value, and workforce in place to the intangibles definition now in section 367(d)(4), and it added a valuation rule calling for valuation on an aggregate basis or on the basis of realistic alternatives (IRC section 367(d)(2)(D)), both for transfers in taxable years beginning after December 31, 2017 (Pub. L. 115-97, section 14221). For taxable years beginning in 2015 through 2024, California's statutes fixed the Internal Revenue Code as of January 1, 2015 (Revenue and Taxation Code sections 17024.5(a)(1)(P) and 23051.5(a)(1)), so for those years California applied the pre-TCJA version of section 367 while the federal computation ran on the amended one. That divergence can change which transfers produced deemed royalties at all and how large the royalty base was, so for transfers made in those years the federal deemed royalty is not automatically the California starting point. The divergence is narrower for goodwill than it first appears, because the 2016 final regulations (T.D. 9803) had already removed the foreign goodwill exception for transfers on or after September 14, 2015. The Franchise Tax Board's Water's-Edge Manual chapter on section 367, as posted in October 2026, still describes the temporary regulations and the foreign goodwill exclusion, and so predates that change.

SB 711 (Stats. 2025, ch. 231) moved the general conformity date to January 1, 2025 for taxable years beginning on or after that date (Revenue and Taxation Code sections 17024.5(a)(1)(Q) and 23051.5(a)(1)), but the same act added Revenue and Taxation Code section 24454.1, under which the Tax Cuts and Jobs Act amendments to section 367(a) repealing the exception for property used in the active conduct of a trade or business "shall not apply" (the personal income tax counterpart is section 17321.1). The active trade or business divergence therefore did not end in 2025. Section 24454.1 reaches only that section 367(a) amendment. 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.

Limitations, federal changes, and appeal

When the Internal Revenue Service adjusts a section 367(d) inclusion, the change carries into California. A taxpayer must report a final federal change to the Franchise Tax Board within six months (Revenue and Taxation Code section 18622(a)). If the change is not reported, the FTB may assess "at any time" (section 19060(a)); if it is reported late, the FTB may assess within four years of the date it receives notice (section 19060(b)). Otherwise, the general assessment period is four years from the date the return was filed (section 19057(a)). A notice of proposed assessment can be protested within 60 days (section 19041), and the FTB's notice of action on the protest can be appealed to the Office of Tax Appeals within 30 days (section 19045). A claim for refund, for example where an accelerated balance or a deemed royalty was overstated, must be filed within four years from the date a timely return was filed, four years from the last day prescribed for filing the return without regard to extensions, or one year from the date of the overpayment, whichever period expires later (section 19306(a)). Because the stream and any deferred balance span many years, an error in the transfer year or a deferral year can carry into later open years, and each year's period runs separately.

Practice notes

Because the deemed royalty stream can run for the life of the intangible, errors in this area have long tails. First, the sound practice is to keep a schedule of the section 367(d) stream, the deferral adjustments made each worldwide year, and any balance waiting for restoration, maintained across preparer changes, because a restoration event may arrive a decade after the transfer and an examination will ask for the history. Second, a water's edge election analysis for a group that has been deferring a section 367(d) stream prices in two costs: the acceleration of any deferred balance into the last worldwide year at that year's worldwide factors, and the current inclusion of each later deemed royalty at water's edge factors. Because the return for the acceleration year may already be on file when the election is made, the reporting question is best worked through before the election return is filed. 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, a group that intends to defer reviews the deferral adjustment each year it is claimed, and above all in the transfer year, since the Franchise Tax Board treats federal-conformity reporting without the adjustment as an effective election. Fourth, for any transfer touched by the 2018 through 2024 divergence years, and for any outbound transfer affected by the continuing active trade or business divergence, the federal and California computations should be reconciled rather than assumed equal, both for the open-year returns and for any restoration balances those years produced. Finally, a group's deferral position rests on the manual's general statement about section 367 income rather than a rule written for section 367(d) deemed payments, and its records and return positions are stronger when they acknowledge that. G&G State Tax Group provides water's edge election analysis and California combined reporting support alongside its state and local tax practice.