Foreign entities not engaged in a U.S. trade or business, not deemed to have a permanent establishment, or that have claimed a federal treaty exemption may still be subject to state and local income taxes. The term "U.S. trade or business" is not defined in the Code or Treasury regulations. The standard for determining whether a foreign entity is engaged in a U.S. trade or business is subjective and is generally satisfied if the foreign entity is engaged in a sustained activity in the United States for a substantial portion of the tax year.
It should be noted that the IRS has historically taken a very restrictive view of the amount of activities that may be carried on without creating a U.S. trade or business. Specifically, any activities beyond the mere receipt of income from property and the payment of organization and administration expenses incidental to the receipt and distribution thereof will constitute the conduct of a U.S. trade or business by a foreign corporation. A foreign entity that is entitled to treaty benefits and maintains a U.S. permanent establishment is subject to U.S. tax only on business profits that are attributable to the permanent establishment.
A state's ability to impose an income, franchise, or gross receipts tax on a foreign entity is not dictated by any federal limitations unless a state voluntarily enacts implementing legislation adopting similar limitations. Each state may implement its own set of rules, resulting in complexity for foreign entities operating in multiple states.
If a state has not adopted any tax limitations similar to those the foreign entity relies upon from a federal perspective, the foreign entity is generally taxable if nexus has been established with the state. Historically, a physical presence was required to establish nexus resulting in a requirement to file income, franchise, or gross receipts tax returns. Further, under most U.S. tax treaties, a U.S. corporation or a foreign corporation is treated as having a permanent establishment in the other contracting state only if (1) it maintains a fixed place of business in the United States or (2) the activities of another person who maintains such a fixed place of business are imputed to the foreign corporation. However, over time, states have become increasingly creative in establishing nexus with theories such as economic nexus and factor presence.
The economic nexus theory targets companies without a physical presence but that are considered to benefit or profit from a state's commerce. Factor presence nexus is established by the amount of property, payroll, or sales an entity has within a state. For example, Ohio's factor presence test requires a commercial activity tax (gross receipts tax) filing when any of the following thresholds are met or exceeded: $50,000 of property; $50,000 of payroll; $500,000 of gross receipts; or 25% of total property, total payroll, or gross receipts (Ohio Rev. Code §5751.01(H)(3)).
P.L. 86-272 (the Interstate Income Act of 1959), enacted by the federal government to protect companies from having to file net income tax returns if they engaged in certain activities, could offer protection to foreign entities from having to file net income tax returns. P.L. 86-272 states:
No State . . . shall have power to impose . . . a net income tax on the income derived within such State by any person from interstate commerce if the only business activities within such State by or on behalf of such person during such taxable year are . . . (1) the solicitation of orders by such person, or his representative, in such State for sales of tangible personal property, which orders are sent outside the State for approval or rejection. [P.L. 86-272, Title I, §101]
However, California (Franchise Tax Board Informational Publication 1050 (revised June 1, 2011)) and the Multistate Tax Commission (Statement of Information Concerning Practices of Multistate Tax Commission and Signatory States Under Public Law 86-272 (third rev. July 27, 2001)) have affirmatively indicated that P.L. 86-272 applies only to interstate commerce and not international commerce. Because other states may take the same position, prior to seeking statutory protection, a foreign entity should thoroughly examine the applicability of P.L. 86-272 in the states in which the foreign entity feels it might have nexus. Finally, foreign entities claiming P.L. 86-272 protection should be aware that they would not be protected from the filing of tax returns based on net worth, capital stock, gross receipts, or other types of returns not considered net income tax returns.
A foreign entity that is part of a larger group of related entities should be aware that states vary in their method by which taxpayers are permitted or required to file an income tax return. The general methods are separate return, nexus-combination, unitary combined, and consolidated reporting. Certain states will deem the foreign entity as the taxpayer, requiring the foreign entity to report only the income of the taxable entity, while other states will require the foreign entity and some or all of its affiliates to file a consolidated or combined income tax return. A group could consist only of U.S. corporations (water's-edge filing) or could include all global entities (worldwide filing).
Additionally, the composition of the group may vary among states. Some states exclude 80/20 companies (companies that conduct 80% or more of their business outside the United States), while other states may require certain taxpayers to be excluded from a reporting group based on their business. For example, insurance companies and financial organizations are excluded from a reporting group where a state apportions insurance companies' and financial organizations' state taxable income differently from that of other members of the reporting group, or insurance companies and financial organizations are subject to a different tax base.
Calculation of Income
A taxable foreign entity will need to determine the starting point for calculating its state taxable income. In general, states may choose whether to conform to the Internal Revenue Code. Some states opt for "fixed" conformity, essentially adopting the Code as of a certain date, while others elect to automatically and continually update their reference to the Code. This can cause discrepancies between the federal and state treatment of certain items. Related-party expenses such as royalties and dividends may be deductible for federal income tax purposes, but if paid to a foreign or domestic related party, those expenses might have to be added back for state income tax purposes. For example, in lieu of the federal dividends-received deduction, Massachusetts permits a deduction of 95% of dividends received, other than (1) dividends from a corporate trust carrying on business in Massachusetts; (2) dividends from a domestic international sales corporation that is not wholly owned; (3) dividends from any class of stock, if the corporation owns less than 15% of the voting stock of the corporation paying the dividend; or (4) dividends received directly or indirectly from a regulated investment company (Mass. Gen. Laws ch. 63, §38(a)).
Once state taxable income is calculated, a percentage of that income is taxed by the states with which the foreign entity has a filing requirement. The percentage is measured by the relative in-state property, payroll, or sales, or a combination of the three. Approximately 19 states have migrated to a 100% sales factor apportionment methodology (2015 tax year). Other states continue to use the traditional three-factor (property, payroll, and sales) weighted methodology. Sales of tangible personal property typically are sourced to their delivery destination. One exception applies to the extent a state has a throwback rule. Under throwback, sales are sourced to the state of origination if the taxpayer does not have nexus in the state of destination. Service revenues are sourced either to the state in which the services are consumed or where the plurality of the costs to create them have been incurred.
Sales and use taxes and commercial rent tax are examples of indirect taxes. These taxes typically require a foreign entity to have physical presence nexus before the foreign entity is required to collect and remit such taxes. However, as indicated above, states are becoming more creative and in some cases require sellers without a physical presence to provide sales data about their in-state customers. State tax authorities continue to place heightened scrutiny on foreign entities and are expected to exchange more information between their sales and use tax auditors and income tax auditors, which may lead to additional risk.
States such as California, Kentucky, Michigan, New York, and Ohio have local taxing jurisdictions that could subject foreign entities to an additional filing requirement. Foreign entities doing business in Kentucky or Ohio could find themselves subject to several city business returns as well as local-level sales and use taxes. Often, these taxes are administered by the state, but not always.
Foreign entities may not be accustomed to dealing with local sovereign taxing jurisdictions and find that the concepts are difficult to comprehend. They can be surprised by the state tax compliance and liabilities that arise from U.S. activity. Foreign entities should proactively evaluate all of the aforementioned state and local tax consequences of their prospective activities within the United States even if they do not plan to engage in a U.S. trade or business, have a permanent establishment, or claim a federal treaty exemption.
Mark Heroux is a principal with the Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.