Occasionally, a non-US corporation’s expansion of its business into the United States has unforeseen or unintended state income tax consequences. While federal income taxation is generally a matter of primary concern when a non-US corporation starts conducting business in the United States, the conclusions reached on federal income taxation do not necessarily carry over for state income tax purposes. For example, many companies are surprised to learn that a lack of federal income tax jurisdiction does not necessarily equate to a lack of state tax jurisdiction and that a lack of federal taxable income does not necessarily equate to a lack of state taxable income. In this article, we discuss some of the main differences between the federal income taxation and state income taxation of non-US corporations.
Who is subject to tax?
As a threshold matter, under fundamental principles of US federal constitutional law, a state may not impose a tax unless the imposition satisfies the requirements of both the Due Process and Commerce Clauses of the US Constitution.
The Due Process Clause requires some “minimum connection” between the state and the person it seeks to tax, and is concerned with the fairness of the governmental activity. A Due Process Clause analysis focuses on “notice” and “fair warning,” and the Due Process nexus requirement will be satisfied if an out-of-state company has purposefully directed its activities at the taxing state.
The Commerce Clause, on the other hand, requires a “substantial nexus” between the state and the person, property, or transaction being taxed or required to collect tax. Importantly, the substantial nexus standard is not equivalent to the jurisdictional standard that applies for federal income tax purposes. Additionally, states are not bound by federal tax laws or by income tax treaties. Thus, when a non-US corporation has “substantial nexus” with a taxing state, that state may impose a corporate income tax (or other business activity tax) on that corporation regardless of whether that same corporation is subject to federal income tax. Accordingly, it is critical to analyze the issue of whether a corporation has substantial nexus with a state independently from whether the corporation is subject to federal income tax.
A corporation will generally have substantial nexus with a state if that corporation has more than a de minimis physical presence in the state. A physical presence may be established through the presence of a corporation’s own employees or property (real or tangible personal property) in the state or through the presence of a third party (including an independent agent) that conducts market-enhancement activities in the state. This physical presence standard generally aligns with the standard for having a US trade or business under federal income tax principles, but is less stringent than the standard that generally applies under income tax treaties, pursuant to which a corporation may not be subject to federal net income tax unless its presence in the US rises to the level of a “permanent establishment” (which generally requires a fixed place of business in the US through which its business is conducted either directly or through a dependent agent).
However, where things really differ between federal and state income tax jurisdiction is in those states that have adopted a so-called “economic nexus” standard. States that have adopted an economic nexus standard generally subject a corporation to income tax (and consider a corporation to have substantial nexus with the state for income tax purposes) if that corporation has a sufficient economic connection with the state. Examples of activities that can create economic nexus with a state include licensing a trademark for use in the state or earning a certain threshold amount of receipts (typically, ranging from $250,000 to $1,000,000) from customers located in the state (also known as “factor presence nexus”). Corporations that may otherwise be subject to state taxation as a result of economic nexus standards should consider whether they qualify for protection from such taxation under a US federal statute known as Public Law 86-272. Public Law 86-272 exempts certain sellers of tangible personal property from state income taxation if the only activities conducted in the state are sales solicitation activities (i.e., direct sales activities or those activities ancillary thereto).
While the validity of economic nexus has never been addressed by the Supreme Court of the United States (indeed, the Supreme Court has repeatedly declined to hear cases on economic nexus), the validity of economic nexus has been litigated and upheld by many state courts. Thus, a non-US corporation that is merely earning receipts from customers in a state may be subject to that state’s corporate income tax. Accordingly, careful attention should be paid to both the quantitative and qualitative aspects of activities conducted in the US by non-US corporations.
How is the tax computed?
If a state has jurisdiction to impose an income tax on a non-US corporation, the next question involves how that tax is computed. A corporation’s state tax base may vary from its federal income tax base (which, in some cases, could be zero).
Generally, states use federal taxable income as the starting point for computing state taxable income, with certain addition or subtraction modifications, and then allocate or apportion that tax base to the state using an apportionment formula consisting of one or more factors (typically, the percentage of the corporation’s gross receipts, payroll and/or property within the state).
Because states generally use federal taxable income as the starting point for computing state taxable income, a corporation that has no federal taxable income may consequently have no state taxable income. However, several states explicitly require corporations to include in their state tax base income that is not otherwise included in their federal income tax base. For example, a non-US corporation that does not have a permanent establishment under an applicable treaty may be required to include in its state tax base all of its worldwide income, or income that it would have been required to include in its federal tax base if it were not treaty protected.
Likewise, a non-US corporation that does have federal taxable income may be required to include in its state income tax base other items of worldwide income that may have been excluded from its federal income tax base. For federal income tax purposes, a non-US corporation is only subject to net income tax on income that is “effectively connected” to the corporation’s US trade or business, meaning that the non-US corporation must separately account for its items of income and deductions connected to its US trade or business. States, on the other hand, have generally rejected such a separate accounting method in favor of formulary apportionment. Thus, a non-US corporation may be subject to state income tax on an apportioned share of its worldwide income, even though the corporation may only be subject to federal income tax on its “effectively connected” income.
Additionally, states may require corporations to file returns on a combined basis, namely a “unitary” combined basis, with other related corporations. As a result, a corporation with substantial nexus in a state may be required to compute its income or business activity tax liability based on the combined incomes (after intercompany eliminations) and combined apportionment factors of all of its “unitary” affiliates. This requirement applies regardless of corporate formalities and regardless of whether those affiliates have substantial nexus with the state. A “unitary” business determination is a factual inquiry, but the common hallmarks of a unitary business include business activities that experience a flow of value as evidenced by functional integration, centralized management and economies of scale. Moreover, while some states limit the entities included in the combined report to entities located in the US (known as a “water’s-edge” combination), others require the inclusion of all worldwide affiliates as a default (although a water’s-edge election may be available), while still others require the inclusion of certain income from “foreign” corporations even in a so-called water’s-edge combination. There has also been a recent trend of expanding the entities in a water’s-edge report to include entities domiciled or operating in so-called “tax havens” (which are determined through either a specific list of jurisdictions or after application of a test that examines various factors, include the lack of transparency in a jurisdiction).
Because of the significant differences between state and federal income taxation of non-US corporations, expanding business operations into the US may have unintended state tax consequences. Non-US businesses should carefully consider the potential state income tax consequences of any US business operations.
Contact the authors: Maria Eberle, Lindsay LaCava
This article was originally published in the February 2016 edition of Tax News and Developments (Volume XIV, Issue 1) and is available under insights at www.bakermckenize.com.
