State Tax Snapshot: Non-U.S. Based Entities Must Navigate Varying Income Tax Treatment Among States

Conducting business across international borders is a commonplace occurrence in today's economy as a result of the expansion of global markets, the Internet, and other recent technological developments. But the state tax treatment of non-U.S. based entities doing business within the United States can be difficult to ascertain and unpredictable. The Bloomberg BNA 2013 Survey of State Tax Departments, which will be published on April 26, asked state department officials several questions aimed at eliciting further insights on this issue.

At the federal level, non-U.S. entities can rely on treaty provisions to offer guidance on the tax consequences of most types of transactions. Under the bilateral tax treaties, a non-U.S. company generally is not subject to U.S. tax on business income derived in the U.S. unless the income is attributable to a permanent establishment in the U.S. The definition of "permanent establishment" varies by treaty, but it is generally defined as a place of management, an office, a construction site, or an agent of the non-U.S. company with authority to enter into contracts.

At the state level, whether a non-U.S. entity is subject to tax depends on the entity having nexus with the particular state. Most states adhere to an economic nexus rationale for income taxes, which does not require a physical presence. As a result, a non-U.S. company can achieve nexus with a state even if it lacked a permanent establishment.

Another question is whether a state extends the protection afforded under Pub. L. No. 86-272 to non-U.S. entities. Public. L. No. 86-272 prohibits the imposition of state income-based taxes against businesses engaged in the sale of tangible personal property whose activities in the taxing state are limited to the solicitation of orders. This protection applies "interstate commerce," but not to foreign commerce. States have the option, however, to extend the protection to foreign commerce.

If nexus with a state is established, the non-U.S. entity's actual tax liability would depend on the state's starting point for computing its income tax. The starting point in "water's-edge" states is taxable income within the U.S. Under this method, if a state starts its computation with federal taxable income, assuming that the state does not require an addition of treaty-exempt income, then the company's tax liability would be zero.

But not all non-U.S. entities qualify for this treatment because of the so-called "80/20 rule," which is the main method that the states use to determine if a non-U.S. corporation should be included in a combined group for water's-edge purposes. Under this rule, a state that requires or permits the filing of a water's-edge combined return will exclude from the combined return a non-U.S. entity whose income apportionment percentage outside of the U.S. is 80 percent or more. But there are variances in the method used by the states to determine if a non-U.S. based company has met this standard.

In a state that begins its computation with world-wide income, a non-U.S. entity could have state tax liability even if it had no federal income tax liability. Because nearly every state uses federal income as the starting point for computing taxable income within their jurisdiction, non-U.S. based entities must begin the state computation process by completing a "pro forma" federal tax return.

 Bloomberg BNA asked each state specify if it:

  • determines the state taxable income of a non-U.S. entity by permitting federal income tax treaty exemptions or other limits to control liability for state income taxation (i.e., the non-U.S. entity will only have state taxable income if it has a "permanent establishment" in the U.S. and reports income on Federal Form 1120-F);
  •  requires a non-U.S. entity that is not subject to federal income tax, but subject to the state's income-based tax, to compute the state's tax by first completing a "pro forma" federal tax return or computation of federal income;
  •  requires a non-U.S. entity not subject to federal tax, but subject to state income-based tax, to use a starting point in determining state taxable income other than federal taxable income (i.e., $0);
  •  imposes tax on a non-U.S. entity's apportioned worldwide taxable income;
  •  determines the source of income for purposes of taxing nonbusiness income by using the federal source rules;
  •  uses federal source rules to determine the non-US income of an 80-20 corporation for water's edge or other purposes;
  •  imposes tax only on the income of the U.S. branch of a non-U.S. entity;
  •  imposes income tax on a non-U.S. entity that is not subject to federal income taxation and only files federal Form 1120F;
  •  denies deductions of a foreign business that does not file a federal return within a specified period of time after its due date; or
  •  imposes franchise tax or other non-income based tax on a non-U.S. entity that is not subject to federal income taxation and only files federal Form 1120F.

By Steven Roll

Follow us on Twitter at: @BBNATax
Join BNA's State Tax Group on LinkedIn here.