State income tax considerations for non-US corporations

Editor: Jeffrey N. Bilsky, CPA

With more than $15 trillion in annual household spending, per the World Bank, the United States is an attractive market for non-U.S. corporations. Globalization, technological advancements, and multinational trade agreements have facilitated non-U.S. corporations’ doing business in the United States.

Non-U.S. corporations have increased investment in U.S. employees and capital. According to the U.S. Bureau of Economic Analysis, U.S. affiliates of foreign multinational enterprises employed nearly 8 million U.S. workers in 2021, accounting for over 6% of total private-industry employment. E-commerce allows multinational corporations to capture a U.S. customer base with minimal employees or capital.

For organizations operating in the United States, direct state and local taxes on net income typically make up the bulk of those companies’ overall tax burdens. State income tax rules are extremely complex, and inbound companies could unknowingly incur tax liabilities, leading to penalties for noncompliance. Some exposures are created through false assumptions, for instance, that U.S. states are not able to impose taxes under multinational treaties, that the business lacks activities that rise to the creation of a U.S. permanent establishment, or that income is not effectively connected with U.S. operations.

This item highlights key considerations non-U.S. corporations should take into account in connection with state income taxes, including nexus, filing methods, determining state taxable income, structuring, and reporting. While not part of this item, non-U.S. companies doing business in the United States should also consider the application of other taxes, including gross receipts taxes, franchise taxes, sales and use taxes, real and personal property taxes, payroll taxes, and excise taxes, as well as unclaimed property obligations.

State tax nexus versus federal income tax permanent establishment

Misunderstandings may occur regarding U.S. states’ ability to impose taxes on non-U.S. corporations. For a state to tax a corporation, nexus must exist. Generally, having property or payroll in a state is sufficient to create nexus. That applies to employees who travel to a state for work-related tasks and remote employees working from home. Since the end of the COVID-19 pandemic, states have become more aggressive in asserting nexus against taxpayers with limited in-state presence caused by remote employees.

States also assert that physical presence is not necessary to create nexus. Since the 1990s, states have claimed that the presence of intangible property (e.g., licensing trademarks or copyrights, issuing loans or credit cards) is enough to establish income tax nexus. They increasingly assert nexus when receipts sourced from within their borders exceed a threshold in a tax year (e.g., $500,000). The threshold for a state to impose nexus might be low and might not require physical presence.

For federal income tax purposes, the taxability threshold can be much higher. Foreign corporations engaged in a trade or business within the United States are generally required to file a return (see Sec. 864). However, tax treaties between the United States and a foreign nation may protect the non-U.S. corporation from federal taxation when the corporation’s U.S. activities do not create a permanent establishment. Most treaties generally define that concept to mean a fixed place of business in the United States through which the foreign enterprise carries on its business. Examples include a place of management, an office, a factory, or a workshop.

Treaties may also exclude specific activities from creating a permanent establishment, including using a facility solely to store, display, or deliver goods; maintaining a stock of goods solely to store, display, or deliver goods; maintaining a stock of goods solely for processing by another enterprise; maintaining a fixed place of business solely for purchasing goods; or maintaining a fixed place of business for any activity of a preparatory or auxiliary nature. In comparison, the state tax nexus standards described above are far easier to surpass.

Non-U.S. corporations may be protected from state income taxation by federal law if specific facts exist. Under the Interstate Income Act of 1959, better known as P.L. 86-272, states cannot impose a net income tax on a taxpayer whose in-state activities are limited to the solicitation of sales of tangible personal property (with the approval and shipment of the order occurring outside the state). However, P.L. 86-272 applies only to sellers of tangible personal property, not to service providers or sellers of intangible property.

Further, states interpret the term “solicitation” very narrowly, a problem that was compounded when the Multistate Tax Commission issued a limited interpretation of P.L. 86-272 in August 2021. An increasing number of states are adopting the MTC statement to further reduce the application of P.L. 86-272. States also may take the position that the statute does not protect non-U.S. corporations engaged in international commerce because it addresses only interstate commerce (see California Franchise Tax Board, FTB Publication No. 1050, Application and Interpretation of Public Law 86-272 (May 2022)).

While this item focuses on state income tax, other state taxes are worth mentioning. P.L. 86-272 applies only to net-income-based taxes and does not protect taxpayers from nonincome- based state taxes. Non-U.S. corporations that qualify under P.L. 86-272 still need to consider other non-income-based state obligations, such as sales and use taxes, real and personal property taxes, and abandoned/ unclaimed property rules.

Determining state taxable income

Once a non-U.S. corporation has state income tax nexus and a return filing obligation, it must find the starting point for determining its state taxable income; generally, states use federal taxable income for this purpose. However, federal income tax laws and treaties might reduce or eliminate federal taxable income for non-U.S. corporations. The Internal Revenue Code imposes federal income tax only on a foreign corporation’s taxable income that is effectively connected with the conduct of a U.S. trade or business, generally referred to as “effectively connected income,” or ECI. Further, tax treaties between the U.S. and foreign nations might reduce or eliminate federal taxable income (especially if no permanent establishment is created).

That said, U.S. states are not parties to tax treaties. Some states, including Illinois, provide that income that would otherwise be treaty-protected is not subject to state taxation (see 35 Ill. Comp. Stat. 5/203(b)(2)(J)). Other states, such as Georgia, do not directly address treaty protection or limiting taxable income to ECI, thus indirectly providing the same protections as federal income tax law (see Ga. Code §§48-7-21(a) and (b)). However, some states specifically provide that income otherwise protected by a multinational treaty is subject to state taxation (see Cal. Code Regs. tit. 18, §§25110(d)(2) (F)1.a and b; 72 Pa. Stat. §10003.11). While some states may still limit taxation to a corporation’s ECI despite denying treaty protection (see Cal. Code Regs. tit. 18, §§25110(d)(2)(F)1.a and b), they might also assert that state taxable income is not limited to ECI, making corporations subject to tax on their worldwide income in those states (see Or. Rev. Stat. §317.625).

Filing methods

Once a non-U.S. corporation has established state income tax nexus in a jurisdiction, it must examine whether it should file a separate-company return or file as part of a unitary combined group. Unique complications can arise if the corporation is doing business in a unitary-combined-reporting state, such as whether the corporation is included in a unitary combined group. Most unitarycombined- reporting states will require reporting on a water’s-edge basis, and some non-U.S. corporations may be required to join a water’s-edge unitary combined group in those jurisdictions.

Many water’s-edge unitary-combinedreporting states pull “80/20 companies” into the combined group. Even though corporations may be formed in a non- U.S. jurisdiction, they may be pulled into a water’s-edge combined group if at least 20% of some business activity metric occurs in the United States.

How states define an includible 80/20 company is not uniform. For instance, Connecticut includes in a unitary combined group any corporation wherever incorporated or formed if at least 20% of both its property and payroll during the income year are in the United States, the District of Columbia, or any U.S. territory or possession (see Conn. Gen. Stat. §12-218f(b)(2)). In Illinois, a unitary combined group “will not include those members whose business activity outside the United States is 80% or more of any such member’s total business activity” (see 35 Ill. Comp. Stat. 5/1501(a)(27)(A)). To determine total business activity, most taxpayers will use a property and payroll factor (see Ill. Admin. Code tit. 86, §100.9700(c)). Wisconsin includes in a water’s-edge combined report an 80/20 corporation, defined as having “80 percent or more of its worldwide gross income during the testing period [be] ‘active foreign business income’ as defined in subchapter N of the Internal Revenue Code” (see Wis. Admin. Code Tax §2.61(4)(b)1.). Companies with intercompany transactions must be cautious when calculating these metrics because some states provide that intercompany transactions are not included (see Ill. Admin. Code tit. 86, §100.9700(c)).

Further, states may include non-U.S. corporations formed or domiciled in a tax haven jurisdiction in a water’s-edge combined group, and what constitutes a tax haven jurisdiction varies by state. Connecticut, for example, includes in a unitary combined group a corporation in a tax haven, which it defines as a jurisdiction that meets criteria such as having “a tax regime which lacks transparency” and being “favorable for tax avoidance” (see Conn. Gen. Stat. §§12-218f(b)(3) and (4)). As of the date of this item, the Pennsylvania Legislature was considering a combined-reporting bill under which a reporting group would include any corporation that operated in one of 39 enumerated tax haven jurisdictions (see S.B. 161, 2023–2024 session).

While most combined reporting jurisdictions use a water’s-edge combined reporting method, many jurisdictions permit or require worldwide combined reporting, which generally includes all unitary affiliated corporations no matter where formed or domiciled. A small minority of jurisdictions (e.g., California and Montana) require worldwide combined reporting unless a specific water’sedge election is made. In many states where the default method is water’s-edge combined reporting (e.g., Massachusetts and New Jersey), an election can be made for worldwide combined reporting, which could benefit taxpayers by (1) pulling in losses of non-U.S. corporations and/or (2) watering down the overall state apportionment percentages. Before making such elections, taxpayers are advised to model the effects not only for the current year but also for future years, because many of those elections are binding for a set period.

If a non-U.S. corporation cannot be pulled into a unitary combined return under the above rules and if that corporation has nexus in the combined-reporting state, it will file a return on a separatecompany basis. If doing business in a default separate-company-reporting state (e.g., Delaware, Florida, Georgia, Maryland, Pennsylvania, or South Carolina), a non-U.S. corporation doing business in the state files its own separate-entity report. Many of those states also have combined reporting elections for taxpayer use (e.g., Georgia and South Carolina). Taxpayers with multiple affiliates doing business in-state, including non-U.S. corporations, should evaluate eligibility and the benefits of making such elections.

Non-U.S. corporations should also consider local tax filing obligations. Many cities (Los Angeles, New York City, Philadelphia, and San Francisco) impose their own taxes.

Takeaways

Non-U.S. corporations are advised to evaluate the topics discussed before entering the U.S. market. Some planning could mitigate the state income tax impact of doing business in the United States. If an organization has not taken these items into consideration, prospective planning may still be of benefit (e.g., making specific filing elections or evaluating the organizational structure). If exposure exists in a jurisdiction, corporations should seek voluntary disclosure agreements, which could mitigate assessments of taxes and penalties.

Editor notes

Jeffrey N. Bilsky, CPA, is managing principal, National Tax Office, with BDO USA LLP in Atlanta. Contributors are members of or associated with BDO USA LLP. For additional information about these items, contact Bilsky at jbilsky@bdo.com.