Tax Reform Friday: Should Foreign Entities Be Wary of SALT Minefields?

Because of the dual character of our union, foreign entities risk incurring unexpected tax liability in a host of state and local U.S. jurisdictions unless they have a plan for navigating state tax law in addition to federal and international law.

“Foreign business with little or no actual (i.e., physical) presence in the United States are faced with two major challenges,” Art Rosen, a partner at McDermott Will & Emery, told Bloomberg Tax on Sept. 14, 2018.

“First and foremost is their common lack of knowledge of potential state and local tax obligations. Over my career, I have encountered numerous foreign businesses that are shocked to learn that they may have such obligations when they are not subject to the federal income tax. With many other countries today focusing on digital economy VAT issues, some such businesses have become a little more sensitive to sales tax issues but the general state of ignorance continues to exist. However, in connection with state income taxes (and other business activity taxes), the state of ignorance and resultant shock continues to be omnipresent.”

“Second, the complexities that state and local tax variations are truly foreign - literally and figuratively - to foreign businesses. That there can be thousands of localities that exercise their independence with abandon makes full compliance virtually impossible.”

U.S. Tax Treaties Do Not Always Shield Foreign Entities From State Taxation

Foreign entities may hope that they will escape the grasp of state tax by relying on U.S. tax treaties, but it’s often not so simple because states are prohibited from directly entering into treaties in accordance with Article I, sec. 10, cl. 1 of the U.S. Constitution. While federal law is the supreme law of the land and supersedes any contrary state law, U.S. tax treaties do not expressly apply to states, leaving a grey area.

Under IRS guidance, the states individually determine whether to honor tax treaties the U.S. has with various countries, so it’s possible that a taxpayer could be exempt from federal income taxes based on a tax treaty but still be liable for state income taxes.

As part of the annual Bloomberg Tax Survey of State Tax Departments, state tax departments are asked whether they conform to the federal treatment of permanent establishment and tax treaties under I.R.C. § 894. An analysis of the responses from state tax departments reveals that although 28 states and the District of Columbia conform, nine states do not conform. Meanwhile nine other states offer no guidance on the issue.

In the Aftermath of Wayfair, Foreign Entities May Need to Be Especially Cautious of State Taxes

States are no longer bound by the bright-line physical presence standard for sales tax nexus, making some tax experts wonder whether remote foreign businesses should be worried about increased exposure to state taxation where they may not have been before.

Bloomberg Tax’s Bruce Chang wrote in July about the potential for the Wayfair decision to impact the ways states determine corporate income tax nexus. During the House Judiciary Committee’s hearing on the impact of Wayfair, the committee received testimony ranging from optimistic projections of business as usual to speculations that states will become emboldened by the decision and aggressively pursue extraterritorial taxation.

In a recent Tax Management Memorandum article, the authors argue that because of Wayfair, “foreign sellers should be especially concerned.” They explain that South Dakota’s sales tax statute, which took center stage in Wayfair, is similar to the OECD’s base erosion and profit shifting initiative (BEPS) in that under both regimes an online business becomes subject to tax in a jurisdiction once an economic threshold is reached regardless of the physical presence that business has in that tax jurisdiction. While the U.S. does not currently support the BEPS initiative, the authors ponder if it’s only a matter of time before the U.S. changes its policy.

Other Experts Argue That Foreign Exposure to State Taxation is Limited

Just as there was a diversity of opinions seen in the House Wayfair hearing, tax experts are not universally concerned about what the future holds for foreign entities doing business in the United States.

Law professor Richard Pomp comments in the Bloomberg Tax Daily Tax Report that foreign businesses are probably safe. “There’s currently no treaty between any foreign country and the U.S. to collect sales tax based on a state judgement … [s]o really our country would have to put pressure on a foreign country to collect the tax—and good luck with that.”

As the story’s author, Ryan Prete, writes, although Wayfair didn’t directly address the application of sales tax to a seller outside the U.S., there is case precedent to suggest that the burden becomes harder to meet when states attempt to go after businesses abroad.

In the Supreme Court’s 1979 decision in Japan Line, Ltd. v. County of Los Angeles, the court outlined a six-part test which determines whether a state can validly tax a foreign party. The test is met if: 

  1. the tax applies to an activity with a substantial nexus with the taxing state, 
  2. is fairly apportioned, 
  3. does not discriminate against interstate commerce, 
  4. is fairly related to the services the state provides, 
  5. the regime does not result in a substantial risk of multiple taxation, and 
  6. the tax wouldn’t prevent the U.S. from speaking with one voice when regulating commercial relations with foreign governments. 

The first of the four factors are derived from the court’s opinion in Complete Auto Transit, Inc. v. Brady, and apply to U.S. based companies. The final two factors only come into play when a state seeks to tax a foreign entity.

Unless the U.S. Supreme Court breaks precedent, states may find it harder to overcome commerce clause challenges to their taxing authority on foreign entities with limited connection to their state.

Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn. How serious is the risk that states will go after foreign entities? Has Wayfair changed the likelihood that foreign entities doing business in the United States can avoid state taxation?

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