Foreign companies with activity in the United States often are surprised that such activity may trigger both federal and state-level taxes. Even more surprising, there are no uniform rules among the states as to whether state tax liability attaches; in some cases, significant state tax liabilities may be imposed even if little or no US federal tax obligations exist.
Foreign companies may not have experience dealing with taxing authorities within a country that have such broad taxing powers.
A state’s power to impose a tax is derived from the US Constitution and may be limited by the Commerce Clause of the Constitution; the Due Process Clause of the Constitution; federal statutes, such as Public Law (P.L.) 86-272; and state laws, such as ‘doing business’ statutes.
US treaties generally do not apply to state taxation, unless specifically mentioned in the treaty or if a state voluntarily follows treaty provisions. A foreign entity should understand the various bases for state taxation that may subject its activities to state taxation.
A state generally may impose its tax on an entity to the extent a sufficient ‘nexus,’ or taxable connection, exists between the entity and the state. While US federal taxation generally requires a threshold level of activity of being ‘engaged in a trade or business’ or having a ‘permanent establishment,’ mere physical presence in a state, such as having employees or property in the state, generally may be sufficient for nexus to exist for state taxation purposes. Thus, a foreign company may not have a permanent establishment in a particular state, but it may have sufficient nexus with that state to become subject to that state's taxes.
States also may assert that a foreign corporation has nexus through the in-state activities of an agent or affiliate. Some states also have applied ‘economic’ nexus or ‘factor presence’ principles.
Economic nexus could be deemed to exist between a state and a company based on the presence of intangible property in a state. For example, the license of trademarks to a company located in a state could be deemed to create nexus for the out-of-state licensor on the basis that the intangibles are ‘present’ in the state. A factor-presence standard establishes nexus based on a certain level of sales activity into a state even in the absence of physical presence in the state. California, Ohio, Washington, and certain other states have enacted factor-presence standards for certain taxes. For example, California’s factor-presence statute provides that an entity is doing business with the state if the entity’s California sales exceed $500,000 (adjusted annually for inflation). Alabama and Tennessee enacted factor-presence nexus standards in 2015. In November 2016, the Ohio Supreme Court ruled that the state’s commercial activity tax economic threshold for nexus was constitutional.
A federal statute that may protect inbound companies is P.L. 86-272, under which a state is prohibited from imposing an income tax if the only business activity in the state is the solicitation of sales of tangible personal property, provided that the orders are approved and shipped or delivered from outside the state. As the language of the provision indicates, the protection applies only to income tax and the sale of tangible personal property. Service activities and other non-tangible property sales are not protected. Because non-income-based taxes, such as net worth and gross receipts taxes, are not protected, many states actively assert nexus on foreign entities for such taxes.
With broad nexus concepts, state tax jurisdictions may appear to have a greater reach than US federal tax provisions with respect to taxing non-US entities. However, there is one US federal tax requirement that does not apply to state taxation. A non-US entity that is neither engaged in a trade or business within the United States nor has a permanent establishment in the United States still may be subject to withholding tax on US-source income that is ‘fixed or determinable, annual, or periodical income,’ such as interest, dividends, or royalties. From a state tax perspective, the receipt of interest or dividends by itself generally should not be deemed to create nexus. The receipt of royalties also generally should not be deemed to create nexus for state taxation, unless such royalties are derived from in-state intangible property that is deemed to create ‘presence’ in a state that has adopted an economic nexus rule. However, with more states asserting an ‘economic nexus’ standard, the receipt of interest, dividends, or royalties becomes increasingly susceptible to claims of nexus from those states where such income streams derive.
Non-US entities may be familiar with the US federal tax concept of effectively connected income — that is, being taxed on income that is derived from a US business. However, for state tax purposes, a percentage of the entire net income of an entity (or group of entities, as discussed below) may be subject to tax by a state. That percentage generally relates to the proportionate level of activity the entity has within the state as compared with its activity outside the state.
Activity may be measured by the relative in-state sales, property, payroll, or any combination of the three. Some states weight sales activity greater than property and payroll. A current trend among states is a move to a single-sales weighted apportionment factor. Using a single-sales factor results in the state increasing its taxable reach among out-of-state taxpayers because the absence of in-state property and payroll does not serve to dilute the apportionment percentage assigned to the state, as would be the case for a state that incorporates a property or payroll factor.
Complexities arise when states do not uniformly apportion income. For example, the assignment of service income to a particular state may be treated in various ways. Some states source service income to the location where the provider incurs the greater cost in performing the service. Other states employ a marketplace approach, sourcing to where the customer receives the benefit of the service.
Sales of tangible personal property generally are sourced to the state of destination. One exception applies to the extent a state has a ‘throwback’ rule. Under throwback, sales are sourced to the state of origin if the taxpayer does not have nexus with the destination state or country.
States vary in their treatment of reporting income among affiliates. ‘Separate company’ states require a taxpayer to report only the income of the taxable entity. ‘Unitary combined’ states may require a unitary group of corporations — which may be different from a US consolidated group, and which may include different members from state to state — to file as a combined group regardless of whether a particular entity has nexus with the state. This unitary group could consist only of US corporations (a ‘water’s-edge’ filing) or could include all global entities (a ‘worldwide’ filing).
Generally, states that give taxpayers an option between water’s-edge and worldwide provide worldwide filing as the default, as does California; taxpayers must elect to file water’s-edge returns. In California, a water’s-edge election, which must be made on a timely filed original return, is an 84-month commitment. Note that some state elections have different filing and approval requirements. For example, Montana requires that a water’s-edge election must be filed within 90 days of the start of the tax year and must be approved by the state Department of Revenue.
A California water’s-edge combined report generally will include a foreign corporation to the extent of its effectively connected income (income derived from or attributable to sources within the United States). Note that California does not recognize provisions of US treaties. Thus, to the extent treaties limit the application of effectively connected income provisions of the Internal Revenue Code, California does not follow the limitations. Any CFC (to the extent of its Subpart F income over its E&P) is included in the California water's-edge combined report as well. Wisconsin has a similar rule regarding effectively connected income; a non-US corporation includes only US-source income (effectively connected income as defined by the Code) and related apportionment factors in determining Wisconsin taxable income.
Some water’s-edge states, like Illinois and California, include foreign entities in the group if more than 20% of their activity is in the United States.
As noted above, composition of the group may vary among states. Some states may exclude ‘80/20’ companies and may define such companies in various ways (generally, companies with 80% or more activity outside the United States). Other states may require certain taxpayers to be excluded from a reporting group based on their business. For example, a financial institution may be excluded from a reporting group because it either apportions its state taxable income in a fashion different from its other related affiliates or it is subject to tax on a different tax base such as gross receipts.
A development that has gained importance in recent years involves states including ‘tax haven’ entities within a reporting group. States that would otherwise impose (or allow as a taxpayer election) a water’s-edge return limited to US companies have been expanding their reach to include non-US entities incorporated or doing business in certain foreign jurisdictions.
Alaska, Connecticut, the District of Columbia, Montana, Oregon, and West Virginia include such entities to varying degrees. Rhode Island has its own unique tax haven law. The Multistate Tax Commission has approved a model tax haven statute that other states could adopt. At the time of this publication, at least eight states, including Pennsylvania and Massachusetts, are proposing establishing or expanding tax haven laws. Inbound companies doing business in these states should be aware that non-US entities could be included in unitary state returns by virtue of their incorporation or activity in identified ‘tax haven’ jurisdictions.
The starting point for determining US state taxable income generally is an entity’s federal taxable income. If an entity has no federal taxable income, this does not mean that it has no state taxable income. Some states may require an addback of a foreign corporation’s income that is exempt from federal tax by treaty. Other states may require federal taxable income to be calculated on a pro forma basis as if a treaty did not apply.
States also may expand their reach beyond taxing a foreign entity’s effectively connected income. For example, in one case, the Alaska Supreme Court ruled that the state did not expressly adopt Section 882 provisions that limit foreign corporate dividend income to US effectively connected income. Alaska’s 80% foreign dividend-received deduction (DRD) serves as an exception to the state’s general adoption of the section. As a result, an Alaska taxpayer was required to apply the state’s 80% DRD to its foreign dividends rather than exclude them entirely under Section 882.
Another discrepancy between US federal and US state taxable income arises due to related-party expenses. Certain expenses, such as royalties and interest, may be deductible for US federal tax purposes, but if such expenses are paid to a foreign or domestic related party, those expenses may have to be added back to taxable income for US state purposes. While most states have a foreign treaty exception to the addback, the particular treaty must be analyzed because states may consider a US treaty that calls only for a lower tax rate to be different from a US treaty that exempts all the income from tax.
For example, a Washington tax review officer ruled in 2016 that a German pharmaceutical company had economic nexus in the state due to its receipt of royalties paid when its products were sold in Washington, even though the business had no physical presence in the state. The officer also determined that a tax treaty between the United States and Germany implicitly permits states to tax royalties. Although the treaty would protect against discrimination created by the state business and occupation tax, the officer found no prohibited discrimination occurred here.
While the treatment of foreign-source income technically is an issue for US domestic entities, the complexities of how such income is treated may be important to non-US entities with federal and state tax reporting obligations.
US shareholders of CFCs may be required to include a portion of the foreign entity’s undistributed earnings in their federal taxable income. This deemed income is commonly referred to as Subpart F income. For state tax purposes, if the state starts with federal taxable income, the ‘deemed’ dividend will be included in the state tax base. States differ regarding the extent to which the Subpart F deemed dividend and the Section 78 dividend gross-up are subject to a DRD.
California employs unique rules with regard to foreign-source income. California requires that a water’s-edge filer include a portion of certain CFC income and apportionment factors. The portion to be included is computed using a ratio of the CFC’s Subpart F income to its total E&P (its ‘inclusion ratio’). Dividends paid between unitary group members are eliminated to the extent the dividends are paid from previously taxed income. There also is a 75% deduction for certain dividends not eliminated (i.e., paid from excluded income).
There also are many issues regarding the state tax treatment of GILTI and the corresponding Section 250 deduction, such as whether the state conforms to the relevant Code changes; whether the state includes GILTI income in its taxable base; whether the state adopts the Section 250 deduction; whether the state has a dividend received deduction or other modification that will apply to the included GILTI income; how included GILTI income is reflected in the state’s apportionment factor; and, if all or a portion of the GILTI income is not taxable, whether the state requires expenses associated with such income be added back. Complications also arise due to states that may not conform to federal consolidated return regulations. Because proposed regulations provide that certain GILTI and Section 250 calculations are performed pursuant to the federal consolidated return regulations, there could be significant differences between federal and state calculations in states that do not follow such regulations.
Many states have Code Section 482-type powers to adjust the income or apportionment factors of taxpayers (known generally as UDITPA section 18 powers). (Section 482 contains the Code’s transfer-pricing provisions.) States may force combined reporting on certain taxpayers regardless of whether intercompany transactions are at arm’s length. Further, states may disallow interest expense to a foreign affiliate under their Section 482-type powers, even if the IRS has not adjusted that same payment. These are concerns for domestic and foreign companies alike, but it may come as a surprise to non-US companies that US states have broad income adjustment powers that mirror federal powers.
Many states have statutory modifications that can result in disallowance of certain intercompany expenses, different treatment of certain types of income, and other adjustments to the tax base.
Several states, including Alabama, Arkansas, Georgia, and New Jersey, require that certain intercompany expenses (interest, royalties, intangibles) that were deductible for federal income tax purposes are disallowed when computing taxable income, unless they qualify for certain exceptions.
Two common exceptions to a state’s addback rule are: (1) when the related member is located in a foreign country with a US income tax treaty and (2) when the amount is subject to tax in another state or foreign jurisdiction. Complexities arise, and not every state with an addback rule provides either or both exceptions; some states require the existence of a US income tax treaty and that the amount was subject to tax.
State ‘indirect taxation’ generally refers to any state tax that is not based on income. The most common indirect tax is a state's sales and use tax; other indirect taxes include franchise taxes, real estate transfer taxes, telecommunications taxes, commercial rent taxes, and hotel occupancy taxes. The indirect taxes that apply depend on the nature of the company's business activities. A non-US company might be surprised at the number of indirect taxes that it has to consider.
On June 21, 2018, the US Supreme Court in South Dakota v. Wayfair ruled that physical presence no longer was required for state sales taxation. The Court concluded that nexus was ‘clearly sufficient’ when South Dakota imposed a sales tax collection and remittance requirement on a seller where, on an annual basis, the seller (1) delivered more than $100,000 of goods or services into the state or (2) engaged in 200 or more separate transactions for the delivery of goods or services into the state.
Non-US companies often sell directly to US customers without engaging in any other activities in the United States. The act of selling into the United States, by itself, typically may not create a federal tax liability or federal tax filing obligation. However, these same sales now could create a sales tax registration, compliance, and possibly collection responsibility under state law.
In certain states, a recent trend is the establishment of nexus due to the use of affiliate marketers for out-of-state sellers. Affiliate marketing is an internet-based marketing practice under which an in-state third party promotes the products or services of an out-of-state seller by providing a link on its website to those products or services and the out-of-state seller compensates the in-state third party for such promotion. Recently, some states have enacted legislation that creates a rebuttable presumption that an out-of-state seller engaging in affiliate marketing with an in-state third party has nexus and therefore is required to collect sales tax.
Affiliate nexus and remote seller provisions allowed states to impose a sales tax collection responsibility on sellers in the absence of a physical presence. With Wayfair abolishing the physical presence requirement, many of these affiliate nexus and remote seller provisions may be moot as the remote seller may have economic nexus with the state.
As discussed above, one of the nexus protections for state income and franchise taxes is P.L. 86-272, but that statute does not apply to non-income taxes. Accordingly, an entity with employees engaged only in the solicitation of sales of tangible personal property within a state, which otherwise is protected from income tax nexus under P.L. 86-272, still may be subject to a state’s sales and use tax and other non-income tax based taxes (e.g., franchise taxes based on net worth).
Once a company has nexus to a state with respect to sales and use taxes, that company must register with the state's tax department, file sales tax returns, and pay its sales tax liabilities. Depending on the volume of sales, the company may be required to file returns on an annual, quarterly, or monthly basis. Sales tax generally is imposed on retail sales, leases, rentals, barters, or exchanges of tangible personal property and certain enumerated services unless specifically exempted or excluded from tax.
Sales tax generally is imposed in the jurisdiction in which the ‘sale’ occurs. The definition of ‘sale’ differs from jurisdiction to jurisdiction; however, the definition generally includes both (1) consideration and (2) transfer of title, right to use, or control (possession) in the case of tangible property and completion of the service act in the case of a service.
Issues arise regarding the taxation of software. States vary in their treatment depending on whether the software is custom-made or off-the-shelf. The method of delivery may control whether tax applies — for example, physical delivery on a CD or flash drive, an electronic download from a website, access to a hosted cloud environment, and application accessed through a browser. States have taken substantially different positions on whether these unique types of software and cloud technologies are taxable, and, if so, where these sales are deemed to occur (that is, where the sales would be taxable.)
All retail sales of tangible personal property are presumed to be taxable sales unless the contrary is established. When tangible personal property is sold, and the purchaser intends to resell the property, the sale is not a retail sale; rather, it is a sale for resale. A resale exemption is allowed because the intermediate sale does not represent the ultimate sale or final consumption sale of the tangible personal property. The burden of proving that a sale is not a sale at retail is on the seller unless an exemption applies. For example, the collection of a resale certification from purchasers generally supports the position that the sale is an exempt sale for resale.
In 2016, a US appellate court upheld a unique state sales/use tax reporting rule enacted by Colorado that requires retailers that sell products to Colorado customers, but do not collect and remit Colorado use tax, to report certain information about such purchases to the customers and to the Colorado Department of Revenue. The law generally requires non-collecting retailers to (1) notify Colorado purchasers that sales or use tax is due on certain purchases, (2) provide an annual report to certain Colorado purchasers of their purchases for the year, and (3) provide an annual statement to the Colorado Department of Revenue listing their Colorado customers and the total amount paid for Colorado purchases in the prior calendar year. A petition for rehearing at the US appellate court was denied April 1, 2016, and a petition for certiorari at the US Supreme Court was denied December 12, 2016. As a result, the US appellate court’s decision stands and retailers selling into Colorado will be subject to this notice and reporting requirement. Other states, such as Louisiana and Vermont, have enacted similar notice and reporting requirements.
Cities that impose their own income tax modeled after their respective state’s combined unitary reporting methodology include New York City; Portland, Oregon; and Detroit, Michigan. A non-US entity doing business in Kentucky or Ohio may be subject to dozens of individual city returns, as many cities in those states impose separate income tax filing obligations. Compliance complexities multiply because US taxation geographies are further divided within states and some US cities have significant taxing powers. Further, these local income taxes often are imposed on pass-through entities, such as partnerships, in addition to corporations.
In addition, cities may impose local-level sales and use taxes. Administratively, the sales taxes usually are collected by and remitted to the state, and then allocated to the localities. Generally, the rules for the localities are modeled after the rules for the states, but this is not always the case. The rules can vary from jurisdiction to jurisdiction. Overall, there are thousands of indirect taxing jurisdictions in the United States. Any non-US company doing business in the United States should be aware of all the various indirect taxes that may be imposed.
From a US state and local tax perspective, there are two main methods for incentivizing business: statutory credits and discretionary incentives.
Statutory credits typically are offered to all qualifying companies within a jurisdiction and can, in certain circumstances, be claimed retroactively. Discretionary incentives, on the other hand, typically must be negotiated between the taxpayer and the state and local governing bodies or economic development groups prior to commencement of the project.
State and local governments have become more competitive in offering tax credits to attract and retain growing companies for the purpose of promoting economic development. Today there are hundreds of statutory tax credits available as a result of this competition.
A number of these credits mimic the federal credits discussed above, but usually apply to activities performed only in a given state or local jurisdiction. Such credits may include:
State and local governments continue to add to the increasing complex array of economic incentives to encourage private-sector investment.
The types of incentives offered vary significantly depending on jurisdiction and industry. The majority of incentives are based, at least partially, on increases in workforce and capital investment in property. A number of other factors such as the location of the project, wages of employees, amount and types of benefits offered to employees, and type of investments, also may be considered.
Incentives can take many forms, such as:
An area unique to doing business in the United States is state legislation surrounding abandoned and unclaimed property (AUP). All 50 states, as well as the US jurisdictions of the District of Columbia, Puerto Rico, the US Virgin Islands, and Guam, have specific laws as to the treatment of AUP.
AUP is amounts held by a business that is due to another entity (i.e., a business, individual, or government agency). State laws require businesses to turn these amounts over to the state administrators after a specified period known as the dormancy period. Commonly, businesses are required to review uncashed disbursements (such as payroll, vendor payables, and customer refunds), unutilized receivable credits, unredeemed gift certificates and merchandise credits, customer deposits, unidentified remittances, and as any other unresolved liabilities on the books and records of the company. Each industry has specific areas of potential property types that should be examined for compliance with state AUP laws.
Any amounts of AUP are paid in full to the state on an annual basis, and the state retains the records and funds for the payee or owner to come forward and claim the amounts directly from the state. This creates a dollar-for-dollar liability for businesses with aged unresolved liabilities or uncashed checks.
If AUP is identified, the amounts are payable to the states based on sourcing rules, as opposed to a nexus standard. The sourcing rules were developed through a series of Supreme Court cases and are reaffirmed directly in many state laws. The sourcing rules indicate that property is to be remitted to the state of the last known address on the books and records of the business.
If that information is not available, not collected, or associated with the specific property, the amounts would be due to the state of incorporation or state of domicile of the business. For any past-due property that is remitted, depending on the state, interest and penalties may be assessed. Therefore, businesses can easily have a large potential AUP exposure. The states also require that their specific state regulations be followed for any amounts potentially due to the state, meaning businesses need to consider multiple state rules related to AUP.
For any states where a business is not compliant, the business is at risk of receiving an audit notice from that state. Audits are conducted either by the state directly, or more commonly, by a third-party audit firm. Third-party audit firms often are paid on a contingency basis and hence may be aggressive in pursuing large settlement offers. They also may seek to expand the audit to multiple states. Generally speaking, an audit is a lengthy process and leads to an internal drain in resources.
As AUP is not a tax, some states view AUP as an additional non-tax source of revenue. The concept of statute of limitations as applied to AUP audits also is less relevant. States utilize a ‘lookback period’ during audits to determine unremitted properties. The lookback period varies by state, but generally covers 10 reporting years (or 11 to 15 calendar years, depending on the property type and dormancy period). If a business does not have records for the entire lookback period, the state may calculate estimates to cover these periods. All amounts derived from calculations are due to the state of incorporation or state of domicile as ‘owner unknown’ property.
A proactive self-initiated program to quantify AUP liabilities affords businesses the ability to manage the process through ‘self-audits’ and ‘voluntary disclosure programs’ offered by the states. These options still require a comprehensive review of all divisions and property types; however, rather than the review being controlled/managed by a third-party auditor, it is done by the business itself and/or consultant engaged. Interest and penalties on past-due property often are waived by the state, and the review itself is not as lengthy as an audit.
When selling a business, the first state-level issue a seller should examine is whether state gain is different than federal gain. Under certain circumstances, when the seller’s tax basis in the assets sold is different for state purposes than it is for federal purposes, the amount of state gain or loss could be different.
In particular, when a corporate subsidiary is being sold from a consolidated group, a difference in basis may exist in those states that do not conform to the federal consolidated return rules – in particular, the investment adjustment rules under Reg. sec. 1.1502-32. Generally, in addition to adjusting the basis of the stock of a subsidiary for contributions to capital and return of capital, the investment adjustment rules provide that the basis of the stock of a subsidiary may be adjusted for items of income, gain, deduction, and loss taken into account by the subsidiary while a member of the consolidated group.
State basis differences in the context of a sale of business assets also may result in a difference between federal and state gain. For states that apply different depreciation methodologies than federal (e.g., California), the state basis of the depreciated assets may be higher or lower depending on whether the state depreciation methodology is applied at an accelerated or decelerated rate.
Several states have enacted legislation along the lines of the Uniform Division of Income for Tax Purposes Act (UDITPA). These rules classify income as either business or nonbusiness. Business income is apportioned among the states in which a corporation does business. In contrast, nonbusiness income typically is allocated to a particular state (e.g., commercial domicile for the sale of an intangible, physical location for real and tangible personal property). Upon the sale of assets or stock of a business, the fundamental inquiry in UDITPA states will be whether the income or gains constitute business income.
A state’s apportionment factors are intended to fairly apportion income resulting from business operations. Arguably, however, ordinary apportionment does not fairly reflect the results of unusual business transactions, such as the isolated sale of a business. Not every state provides clear guidance as to whether the receipts from the sale of a business should be included in the sales factor. As a result, determining how to source receipts from the sale of a business may be exceedingly complex.
Generally, receipts from the sale of tangible and real property of a business are sourced to the state location of such assets. However, sourcing receipts derived from the sale of intangible property, such as stock of a corporation or equity interest in a pass-through entity, is more complicated because intangibles, by their nature, do not have a fixed geographical location. Certain states provide more guidance than others with respect to determining how to source the sale of an intangible.
Business acquisitions also can create significant state and local transfer tax liabilities depending on the structure of the transaction and the nature of the assets being conveyed. The sale of business assets, particularly tangible assets, can give rise to sales tax, unless an exemption applies.
In addition, the sale of owned or leased real property may be subject to real estate transfer tax in several jurisdictions. Real estate transfer taxes often are required to be paid at the time of recording the deed. A minority of states impose an indirect real estate transfer tax upon the direct or indirect transfer of an entity based on ownership interests and certain leasehold interests (e.g., long-term leases, below-market leases, and leasehold improvements) in real property.
The Act brings with it considerable state tax complexities. It still is unclear how the states will react to particular federal changes made by the Act.
States vary in how they follow federal law. Some states automatically adopt federal changes; these states will have to determine proactively whether to decouple from tax reform provisions. Some states that use a fixed conformity date may not adopt tax reform changes automatically; these states may decouple from specific tax reform provisions when they update their federal conformity dates. Other states adopt specific Code provisions, based on a current or fixed date, thereby introducing additional complexity. It remains uncertain whether states will adopt all, some, or none of the federal tax reform provisions enacted by Congress.
US inbound companies will find it difficult to estimate accurately their state income tax liabilities due to the different methods of federal conformity and the possibility that states may pass legislation to adopt or decouple from certain provisions of the Act. These companies should follow the legislatures of the states in which they do business to determine how their state tax liabilities will be affected.
With the federal tax rate reduction, the significance of the state income tax component of a company’s overall effective tax rate will increase substantially. State taxes may be even more significant if states choose to adopt the base broadening measures included in the Act without a corresponding state rate cut.