Foreign companies may not be used to dealing with tax authorities within a country that have such broad taxing powers. For example, states are not restricted in their taxing powers by federal limitations such as engaging in a trade or business, having a permanent establishment (PE), or treaty restrictions. States are also not bound by uniform tax laws; each state may implement unique tax rules, making compliance difficult for foreign companies.
There are several aspects of state taxation that are critical for owners of non-US companies to understand, including a state's power to tax, income apportionment, state filing methodologies, tax starting point issues, treatment of foreign source income, transfer pricing adjustment considerations, registration requirements, and indirect taxes.
Activities that could subject a foreign entity to state tax
A state's power to impose a tax is derived from the US Constitution and may be limited by: (1) the Commerce Clause of the Constitution; (2) the Due Process Clause of the Constitution; (3) federal statutes, such as Public Law (P.L.) 86-272; and (4) state law, 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 state theories that may apply to its activities that could subject it to state taxation.
A state may generally impose its tax on an entity to the extent a nexus, or taxable connection, exists between the entity and the state. Having a physical presence in a state will typically create such a nexus. While US federal taxation generally requires a threshold level of activity of being "engaged in a trade or business" or having a PE, a physical presence in a state is generally all that is needed for nexus to exist for state taxation purposes. Having employees or property in a state may be enough of a presence in a state to establish nexus. Thus, a foreign company may not have a PE, but it may have nexus and be subject to that state's taxes.
In addition to creating nexus through its physical presence within a state (for example, property or payroll), states may assert that a foreign corporation may have nexus through the in-state activities of an agent or affiliate. Additionally, some states have applied "economic nexus" or "factor presence" principles. Economic nexus could 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 in a state could create nexus for an 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. States such as California, Ohio, and Washington have enacted factor presence standards for certain taxes. California's factor presence statute, for example, provides that an entity is doing business with the state if the entity has more than $500,000 of California sales.
While economic nexus and factor presence concepts may be constitutionally suspect, until successfully challenged, they remain methods a state may use to bring foreign entities within its taxing jurisdiction.
One provision 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 the orders are approved and shipped or delivered from outside the state. As the definition suggests, the protection only applies to income tax and the sale of tangible personal property. Service activities and other non-tangible property sales are not protected.
With broad nexus considerations, state nexus concepts appear to have a greater reach than US federal tax provisions when it comes 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 US, nor has a PE, may still be subject to withholding tax on US sourced income that is "fixed or determinable annual or periodical income" such as interest, dividends, or royalties. From a multistate tax perspective, the receipt of interest or dividends by themselves will generally not create nexus. The receipt of royalties will also generally not create nexus, 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.
Joel Walters, based in Washington, DC, is PwC's US Inbound tax leader. Maureen Pechacek, based in Minneapolis, and Todd Roberts, based in Denver, are partners in the firm's State and Local Tax practice. The authors give special thanks to Michael Santoro.
Thsi is the first in a series of articles looking at multistate US tax issues facing inbound companies. Look out for Part II next week.
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