On February 10, 2026, the California legislature introduced a bill, AB 1790, that would repeal the water's-edge election allowed under the state's mandatory combined reporting regime in 2028, subsequently requiring a unitary business group to use the worldwide combined reporting method. The proposed bill also would include captive insurance subsidiaries in the combined return, and for tax years 2026 and 2027, would modify provisions regarding the income and apportionment factors that a taxpayer making a water's-edge election must consider.

Water's-edge election

California's default filing methodology is worldwide combined reporting. However, the unitary business group may elect to file the combined report using the water's-edge method. A water's-edge election is binding on the combined group for 84-months but may be terminated with the consent of the Franchise Tax Board (FTB) before the end of that period. The election can be terminated without FTB consent after the 84-month period.

For tax years beginning on or after January 1, 2026, and before January 1, 2028, a combined group that made a water's-edge election would be allowed to terminate the election without the FTB's consent.

For tax years beginning on or after January 1, 2028, taxpayers would no longer be able to make a water's-edge election, and every water's-edge election would be terminated.¹

Transition rules

Under current law, a foreign-incorporated business must be included in a water's-edge combined report if its US apportionment factor (the average of its property, payroll and sales factors) is 20% or more (the 20% test). For tax years 2026 and 2027, the proposed bill would modify the 20% test so that the entire income and apportionment factors of any corporation, other than a bank, would be included in the water's edge combined report if its sales factor within the United States is 20% or more. In addition, the entire income and apportionment factors of any corporation that is a member of the water's-edge group incorporated in the United States or formed under the laws of a state or US territory or possession would be included.

For tax years 2026 and 2027, water's-edge filers also would be required to include 40% of net controlled foreign corporation (CFC) tested income (NCTI)² as business income. However, the apportionment factors of a CFC³ would not be included as a result of including the NCTI income.

Legislative findings

In regard to the combined reporting method, the Legislative findings provision of AB 1790 includes the following sweeping proposed language:

• All persons that are part of a unitary business would be included in the combined report.
• The determination of a unitary business would be governed by the unitary business principle.
• The combined return would include captive insurance subsidiaries.
• All income and apportionment factors of a combined group would be combined even if the state has a special apportionment regime for a particular entity, unless the FTB consents to the use of special apportionment.
• The tax liability of a unitary business group member that is subject to a net income tax or tax measured by net income under another California law would be a credit against the unitary group's corporate tax liability.

Recent Informational Joint Hearing

The Senate Revenue and Taxation Committee and Assembly Revenue and Taxation Committee on February 11, 2026, held a joint informational hearing "Peering Over the Water's Edge: State Taxation of Foreign Subsidiary Income." Testimony was presented both in favor for and against the repeal of the water's-edge election. Those in favor of repealing the water's-edge election reasoned that the repeal would reduce profit shifting out of the United States. The Committee also asked panelists if there is a concern that California would face pressure from foreign governments if the state moved away from water's-edge combined reporting and whether eliminating the water's-edge election would increase the risk of double taxation. The Legislative Analyst's Office Economist and FTB's Chief Economist also noted the uncertainty and unpredictability associated with estimating the amount of additional revenue that would be raised by eliminating the water's-edge election. The Committee and panelists did not reference the proposed language in AB 1790.

Information on the hearing, including a background paper, is available here. A replay of the hearing is available here.

Implications

The sweeping language included in the Legislative findings provision of AB 1790 may indicate that the authors expect the bill to be revised. During the months leading up to the Governor's revisions to the budget proposal in May, numerous proposed bills are heavily revised or do not become law. However, the joint informational hearing to educate the leaders of the Revenue and Taxations Committees signals that proposals to eliminate the water's edge election may be gaining traction.

A required shift from a water's-edge election to mandatory worldwide combined reporting would be a significant change to California's tax regime that has allowed filing on a water's-edge basis for the past 40 years. Taxpayers filing on either a water's-edge or a worldwide basis in California should review the proposed bill and consider modeling its potential impact. Some of the proposed changes in AB 1790 would start impacting taxpayers as early as the 2026 tax year.

The Legislative findings section in AB 1790 would also provide for the inclusion of captive insurers in the combined return. This change is separate from the elimination of the water's edge election and would be a carve out from insurance companies that are generally exempt under the California Constitution (Article 13, section 28) from the franchise tax imposed on corporations by California.

Because AB 1790 would result in an increase in tax, it requires approval by two-thirds of each house of the legislature.

The bill's language will likely be amended as it makes its way through the legislative process and as members of the legislature consider the testimony, public comments and background information provided during the hearing, as well as information interested parties submit after the hearing.