“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 filing and worldwide filing provide worldwide filing as the default (for example, California) and taxpayers must elect to file water’s-edge returns. In California, a water’s-edge election must be made on a timely-filed original return and is an 84-month commitment. A California water’s-edge combined report will generally include a foreign corporation to the extent of its effectively connected income (income derived from or attributable to sources within the US). Note that California does not recognise provisions of US treaties. As such, to the extent they limit the application of effectively connected provisions of the Internal Revenue Code, California does not follow the limitations. Any controlled foreign corporation (CFC) – to the extent of its Subpart F income over its earnings and profits – is included in the California water's-edge combined report as well. Wisconsin has a similar rule regarding effectively connected income. Accordingly, the risk exists that a single entity’s presence in a US state could bring the income of a global group of affiliated entities within the taxing power of the US state.
Additionally, composition of the group may vary among states. Some states may exclude 80/20 companies (generally, companies with 80% or more activity outside the US), and may define such companies in various ways. 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.
Adjustments to federal taxable income starting point
The starting point for determining US state taxable income is generally an entity’s federal taxable income. If an entity has no federal taxable income, this does not necessarily mean it has no state taxable income, though. Some states may require an addback of a foreign corporation’s income 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.
Another discrepancy between US federal and US state taxable income arises from 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, one must analyse the actual treaty as states may consider a US treaty that only calls for a lower tax rate as different from a US treaty that exempts all the income from tax.
Treatment of foreign source income
While the treatment of foreign source income is technically an issue for US domestic entities, the complexities of how such income is treated should be of importance to non-US entities with federal and state tax reporting obligations.
For US federal tax purposes, domestic corporations receiving dividends from foreign affiliates are not allowed a dividends received deduction (DRD) as they would from a domestic subsidiary. Rather, the foreign dividends are included in taxable income and the taxpayer may receive a credit for foreign taxes paid. Some states may allow all or a portion of a deduction for dividends received from a foreign entity.
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 on 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 for 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 earnings and profits (its inclusion ratio). Additionally, dividends paid between unitary group members are eliminated to the extent the dividends are paid from previously taxed income. Finally, there is a 75% deduction for certain dividends not eliminated (that is, paid from excluded income).
New York City, New York; Portland, Oregon; and Detroit, Michigan are examples of cities that impose their own income tax modelled after their respective state’s combined unitary reporting methodology. A non-US entity doing business in Kentucky or Ohio could find itself 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.
In addition, these and other cities impose local level sales and use taxes. Administratively, the sales taxes are usually collected and remitted to the state and then allocated to the localities. Generally, the rules for the localities are modelled after the rules for the states; however, this is not always the case. The rules can vary from jurisdiction to jurisdiction. Overall, there are thousands of indirect taxing jurisdictions in the US. Any non-US company doing business in the US should be aware of all the various indirect taxes that may be imposed.
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.
This is the third in a series of articles looking at multistate US tax issues facing inbound companies. Part I looked at instances and activities that could subject a foreign entity to state tax. Part II explored the issues surrounding multistate apportionment.
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