State & Local Tax Bulletin
(Volume 1, Number 2,
California's Position: Money Damage
Not Refund Claim, Required to
Water's Edge Election Fee
By Richard E.
Nielsen, of counsel, and Jeffrey M. Vesely, tax partner, both in the San Francisco
office of Pillsbury Winthrop
Shaw Pittman LLP.
Reprinted from the March 28, 1994 issue of State Tax Notes
This information is only of a general nature, intended simply as background
material, omits many details and special rules and cannot be regarded as legal or tax
Are California taxpayers who seek to challenge the payment of water's edge election fees while
awaiting the outcome of the Barclays/Colgate Supreme Court cases required to file
money damage claims with the Board of Control or refund claims with the Franchise Tax Board
Apparently the FTB's answer is that a taxpayer must file a damage claim and not a refund claim
even though California Revenue and Taxation Code ("Rev.& Tax.Code") section 25115(h),
which was effective during the period when water's edge election fees were required, specifically
provided that election fees were to be "collected and refunded in the same manner as the taxes
imposed by this part...."
In recent court litigation in which a taxpayer has filed an action to contest the constitutionality of
the payment of water's edge election fees, the FTB, through the Attorney General's Office, has
for the first time asserted this position through affirmative defenses in its answer to the complaint.
This allegation is being asserted directly in the face of the contrary position taken by the FTB at
the administrative appeal before the State Board of Equalization ("SBE") that the appropriate relief
for the taxpayer was a "suit for refund."
The taxpayer for the income year ending December 31, 1988, filed FTB Form 1115
(Water's-Edge Contract), therein agreeing to determine the amount of income derived from or
attributable to California sources, pursuant to Rev.& Tax.Code § 25110 et seq. The
taxpayer agreed by filing Form 1115 to pay and did pay the FTB the election fee provided for in
Rev.& Tax.Code § 25115. Subsequently the taxpayer filed a claim for refund. The
FTB denied the claim for refund, and the SBE denied its appeal. The refund suit followed.
Statutory and Regulatory Provisions
A corporate taxpayer or group of affiliated taxpayers otherwise subject to worldwide combined
reporting can make an election to be taxed under the water's-edge method. A taxpayer wishing to
make the water's-edge election enters into a contract. Rev.& Tax.Code § 25111.
Prior to January 1, 1994, the contract was conditioned on the taxpayer agreeing to pay a
fee. Rev.& Tax.Code § 25115(b).
By statute and regulation, the election fee is to be collected and refunded in the same manner as
taxes under the bank and corporation tax law. Rev.& Tax.Code § 25115(h); 18
Cal.Admin.Code § 25115(b)(1). If the worldwide unitary method is held per se
unconstitutional in a final appellate decision, a taxpayer would be allowed to change its election
for past income years that are open, if a timely request is made. 18 Cal.Admin.Code
In the present case, the taxpayer filed its refund claim on the basis that the water's-edge election
fee is in violation of various provisions of the U.S. Constitution and/or the Constitution of the
State of California and that, as a consequence, the State of California has no right to charge and
collect the fee. The FTB at the administrative level contended that this argument was addressed to
the wrong forum essentially because both the FTB and the SBE are prohibited by law from
declaring a statute unconstitutional and that the taxpayer should address its claim to a court by
way of a suit for refund.
FTB's Affirmative Defenses
In its answer to the taxpayer's refund complaint filed in superior court, the FTB has asserted
numerous questionable affirmative defenses, including failure to file a damage claim and various
contract law arguments. The affirmative defenses which have been asserted are worth
- Failure to exhaust administrative remedies: The FTB alleges that notwithstanding
the filing of the claim for refund and the denial thereof, plaintiff has failed to exhaust available
administrative remedies prior to the filing of this action. Plaintiff's income year 1988 is open for
audit and proposed deficiency assessments, including adjustments to the water's-edge election fee
amount in issue. Therefore, the FTB contends that the amount of the water's-edge fee in dispute,
or other franchise tax amount owing for the year in issue, will not be fixed and final until
completion of both the FTB audit process, and any subsequent administrative protest and
- Failure to present a claim: The FTB also alleges plaintiff has not complied with
statutory (non tax) requirements by failing to present to the appropriate state administrative body
its claim for money damages against the State as this action arises out of an express contract.
- Judicial economy dictates one-cause for all issues: The FTB also raises as an
affirmative defense the maxim that California law favors one trial of all tax issues arising from the
same income year for a taxpayer in order to conserve judicial resources and promote judicial
economy. The FTB contends that all issues arising from the 1988 income year relating to the
water's-edge fee calculation, including its constitutionality, and any dispute concerning the
amount of franchise tax owing should be tried in court in one action upon completion of the
administrative process. The FTB asks the Court to dismiss the instant action pending conclusion
of the administrative process.
- Offset - unjust enrichment: The FTB separately alleges that the actions of the
plaintiff will result in damage to the FTB which entitles the FTB to an offset for such damages.
The FTB contends that these damages would be any greater amount of franchise tax that would
be owing under the worldwide method of tax accounting. Offset is claimed on the grounds of
unjust enrichment and failure of consideration. The FTB alleges that the water's-edge statutory
scheme should be voided if the election fee is declared unconstitutional.
- Indemnification: The FTB also alleges that it is entitled to indemnification from the
plaintiff upon rescission of the water's edge contract.
- Plaintiff lacks standing: The FTB raises standing as a defense and specifically
alleges plaintiff lacks standing to assert the unconstitutionality of the worldwide method because
it did not employ it for the tax year in issue.
- Failure to state a claim: The FTB raises without further elaboration the common
defense the complaint does not allege facts sufficient to constitute a cause of action.
- Statute of limitations: The FTB alleges, notwithstanding plaintiff's compliance with
the statute of limitations under old Rev.& Tax.Code §§ 26073 and 26103
(now Rev.& Tax.Code §§ 19306, 19384), that the action is barred by the
provisions of either or both section 313 or 337(1), of the Code of Civil Procedure--both non-tax
- Legally binding contract: The FTB also alleges that the action is barred because
plaintiff was capable of contracting to enter the water's-edge election contract; did enter into the
contract voluntarily with informed consent to be bound by the contract terms and conditions; and
contracted for a lawful object with sufficient cause or consideration in the form of a water's-edge
- Contract performed: The FTB also contends the action is barred because the FTB,
being bound by the water's-edge contract provisions, performed all duties required of it under the
- No contract disavowal: Continuing with its contractual allegations, the FTB alleges
that plaintiff, having performed under the contract in issue, has ratified by its performance the
terms of the water's-edge contract should not be allowed to deny the nature and terms of said
contract after performance.
- Restitution/unjust enrichment: Finally, the FTB alleges plaintiff is seeking
rescission without just cause and without tendering an offer of restitution that would take the
form of plaintiff's amended franchise tax return for the income year 1988 employing the
worldwide method of accounting, the absence of which otherwise would result in unjust
enrichment to the plaintiff.
It is apparent that someone either at the FTB or the Attorney General's Office has spent
considerable time and effort to concoct as many defenses as possible, irrespective of whether they
have any merit or directly contradict statutory refund provisions and/or positions taken by the
FTB at the administrative level. Again, this appears to be another example of a state taxing
agency playing by different rules. It is doubtful these defenses will be sustained if the matter is
ever fully litigated. But a taxpayer attempting to preserve its rights while
Barclays/Colgate is pending should be aware of the obstacles to be strewn in its path by
the gatekeeper of the tax (fee) dollar.
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