Foreign companies operating in the United States may be surprised to learn they have a taxable presence for state income tax or sales tax purposes even though they may not pay any federal income tax.
No PE, No Problem
If the U.S. has a tax treaty with the foreign company’s country and the foreign company doesn’t have a “permanent establishment” in the U.S., then the foreign company may assume it doesn’t have any tax obligations in the U.S.
A “permanent establishment” is generally defined as a “fixed place of business through which the business of an enterprise is wholly or partly carried on.”
However, states are generally not parties to U.S. tax treaties and have their own “nexus” laws (laws that determine whether a company has a taxable presence in a state). Consequently, state tax obligations can grow for years if the foreign company remains unaware.
State Income Tax Nexus
For state income tax purposes, the term “nexus” is used to indicate that the connection between the taxpayer and a state is sufficient to subject the taxpayer to taxes imposed by the taxing jurisdiction. The amount of activity or connection necessary to create nexus is defined by state statutes and regulations or case law and may vary among the states.
In general, businesses can create nexus by either having a physical presence or an economic presence.
Physical presence nexus can be created in numerous ways such as having employees or independent contractors living and working in a state on the company’s behalf, entering a state to solicit sales, perform services, or conduct a variety of other activities. Physical presence can also be created by having any type of property in a state, either real or tangible personal property, or inventory. The inventory may be at a third-party location or even on consignment and create nexus for the business. Additionally, some states require corporate tax filings for entities that are simply registered with the secretary of state and have a certificate of authority to do business in the state.
Economic presence nexus, or “economic nexus,” is often defined broadly as “any activity of a business that enjoys the benefits and protection of the government and laws of the jurisdiction,” or simply as “deriving income from sources within the jurisdiction.” Most states assert that having “economic nexus” is enough to subject a taxpayer to income tax, franchise tax or gross receipts tax. Some states have even enacted “factor-based nexus standards” or thresholds for determining economic nexus. These factor-based nexus standards generally hold that if a business has more than $50,000 in payroll, $50,000 in property, or $500,000 in sales in a state, then the business is subject to income tax, franchise tax or gross receipts tax. Some states don’t have a payroll or property standard and simply use a sales standard or threshold such as $500,000 of sales, $350,000 of sales, or even as low as $100,000 of sales.
If it is determined a company has a physical presence nexus or economic presence nexus, a company could still escape income taxation if the company’s activities in a jurisdiction are within the protection of P.L 86-272. P.L. 86-272 is a federal law enacted in 1959 that prohibits a state from imposing an income tax on a business if the only activities within the state conducted by or on behalf of the business consist of the solicitation of orders for sales of tangible personal property. State statutes and regulations provide examples of protected and unprotected activities, and a separate analysis is often required to confirm the protection.
Caution: Since P.L. 86-272 applies to interstate commerce and not explicitly to foreign commerce, states have adopted their own view as to whether P.L. 86-272 applies.
Key concepts regarding P.L.86-272:
- It only applies to the sale of tangible personal property.
- It only provides protection from income taxes or a tax based on income. It does not protect a company from franchise tax, gross receipts tax or sales tax.
Additionally, the Multistate Tax Commission (MTC) recently revised its Statement of Information on P.L. 86-272 attempting to restrict the protections of P.L. 86-272 to activities companies conduct via their websites. As a result, most companies may lose P.L. 86-272 protection unless their websites are very “static” and do not provide any type of customer “interaction” on their website.
Note: The MTC is an intergovernmental state tax agency working on behalf of states and taxpayers to facilitate the equitable and efficient administration of state tax laws that apply to multistate and multinational enterprises. The MTC is not a governmental entity and does not make law. It does, however, set standards that states may adopt or enact. In regards to the MTC’s Statement on P.L. 86-272, California is currently the only state that has adopted these standards. More states are expected to do so.
State Income Tax Nexus, But Minimal Liability?
It is possible for foreign companies to have state income tax nexus but have minimal income tax liability. Generally, companies without a permanent establishment in the U.S. may still file a federal tax return without reporting any federal taxable income. Consequently, since most states’ starting point for computing state taxable income is federal taxable income as defined by the Internal Revenue Code, a foreign company may not have any state taxable income.
Sales Tax Nexus and Exposure – the LARGER Problem
Similar to income tax nexus, sales tax nexus can be created by physical presence or economic presence. Unlike income tax, P.L. 86-272 doesn’t apply and every state that imposes a sales tax has a “factor-presence” standard or sales threshold that if exceeded, creates economic nexus. Most states hold that companies with more than $100,000 of sales to customers in their state creates nexus. A few states have a threshold of $250,000 or $500,000 of sales. Consequently, sales tax is likely the biggest exposure area foreign companies operating in the U.S. face.
It is vital for foreign companies who sell into the U.S. to clearly understand that state tax law is different than federal income tax law and take proactive action to mitigate any exposure.