Two California tax proposals could be devastating for credit funds and their investors
California is facing a budget deficit of about $12 billion in fiscal year 2026. Gov. Gavin Newsom’s (D) 2025-26 May Revision budget summary includes new spending cuts but does not include new tax proposals compared to the January version. Recall that the January budget proposal included a shift to single-sales-factor apportionment for financial institutions, with is projected to result in tax revenue of approximately $330 million in 2026.
Additionally, in a June 5th statement to Tax Notes which is described in this article entitled California Lawmakers Float Corporate Tax Increase Proposals, Assembly Member Alex Lee (D) has floated the idea of repealing the California water’s edge election, which is projected to result in tax revenue of approximately $3 - $4 billion annually.
Both proposals, if enacted into law, could be devastating for certain private credit funds and their investors. The potential adverse impact and planning opportunities are summarized below.
Proposed change to single-sales-factor apportionment formula for Financial Institutions
Adverse impact:
Credit funds that file as financial institutions in California and perform loan origination activities outside of the state may see their California apportionment percentage and tax liability double as a result of the state’s change to a single-sales-factor apportionment formula.
Planning opportunities:
There may be an opportunity to revisit the sales factor sourcing under the Financial Institution apportionment rules, if all that a credit fund is left with is a single sales factor to apportion its income to California.
Asset-based and infrastructure lenders which plan to make multiple collateralized loans to the same borrower may want to consider combining / cross-collateralizing the loans into a single loan / collateral agreement, so that less than 50% of the fair market value (FMV) of cross-collateral is located in California. In that case the interest income on the loan would be sourced to the commercial domicile of the borrower (potentially outside of California) and not pro-rata based on the FMV of collateral in California under the state’s Financial Institution apportionment rules.
Potential repeal of the California water’s edge election for corporations
Adverse impact:
Stand-alone corporations or unitary groups of corporations with nexus in the state which were previously taxed on income that is effectively connected with a U.S. trade or business (ECI) only from state sources could also become subject to tax upon fixed, determinable, annual, or periodical (FDAP) income from state sources, if the water’s edge election is repealed.
Planning opportunities:
There may be an opportunity to revisit the activities that generate ECI (e.g., direct lending), activities that generate FDAP income (e.g., secondary market purchase), as well as which entities are engaged in these activities. Ideally, the FDAP income-generating activities should be isolated in a separate entity which may be eligible for the state’s ‘purchased loan exemption’ which is afforded to certain foreign lending institutions pursuant to Cal. Corp. Code § 191(d). Note, this exemption is an entity-level exemption rather than an activity-level exemption, meaning that an entity which comingles exempt and taxable activities would not qualify for this exemption.
The management and execution of direct lending and secondary market purchases may need to be separated into different teams at the management company or external asset manager, so that commonly controlled entities engaged in either strategy would not be considered to be ‘unitary’ and combinable, which could subject the FDAP income from secondary market purchases to California corporate income taxation on a combined reporting basis.
