State Taxation Will Impact Foreign Entities who Sell in the U.S.
Merrill Barter, Managing Director, and Anna Mikhaylina, Intern, Tax Practice
States in the U.S. have been described as “laboratories of democracy.” This is exemplified by the way that states, which are not limited by the tax treaties to which the federal government is a party, have been paying extra attention recently to potential tax liabilities of the foreign entities that generate sales in their respective jurisdictions. State taxable presence can be established in multiple ways, sometimes quite unexpected, with each of the 50 states crafting its own laws, regulations and policies.
Whether your foreign (non-U.S.) company is planning to enter the U.S. marketplace, or is growing its U.S. sales, three primary state tax concepts are increasingly relevant in your understanding of state taxation. The concepts are (1) nexus, (2) PL 86-272, and (3) sales tax. They are described below to help you successfully navigate your business objectives and overall U.S. tax strategy.
The first concept is income tax nexus - the connection that must exist between the business and the state for the activity to be taxable. Note that it is plausible and perfectly legal that a foreign company that is not required to file a U.S. federal tax return might have nexus with a state, and thus be required to file a state return and pay tax to that state.
For federal tax purposes, a fixed place of business is generally required to create nexus (see the discussion on “permanent establishments” in our November 2014 article). However, state income tax nexus is potentially triggered by the existence of either physical or economic presence, or some combination of the two, of a foreign company in the state. Thus, the foreign business without any physical presence in the state but with sales in that state could face income tax liability and filing requirements.
Generally, the nexus analysis concentrates on whether the entity’s activities as a whole constitute an established market in the state. These are examples of activities that are likely sufficient to establish nexus:
- selling licenses or franchises to the residents of the state,
- licensing software,
- selling or licensing a patent or a copyright to related and unrelated entities with locations within the state,
- owning shipping containers in ports,
- owning tangible personal property located in the state, including inventory,
- assisting wholesale customers with product marketing,
- hiring employees, or hiring contractors to perform warranty services,
- consigning goods, and
- leasing real estate, or equipment.
Interestingly, according to a 2016 BNA State Tax Survey, twenty states indicated that employees of an out of state corporation flying into the state on a commercial airline for business, one to four times a year, would be sufficient by itself to create nexus (unless the state’s recognition of PL 86-272 prevented it).
Thus, whether your company is selling services or products, you should assess the potential consequences of taxable presence within the U.S. states. Proactive determination could help your business navigate state-specific market entrance techniques, and affect pricing choices.
Another concept is Public Law 86-272. Although PL 86-272 is not legally binding on the states in international commerce context, according to 2016 BNA State Tax Survey, more than half of the states apply PL 86-272 to foreign businesses selling in the U.S. For instance, Maine, Michigan and Virginia extend protections of PL 86-272 to foreign entities, while California does not.
The focus of PL 86-272 is to minimize the ability of states to tax business activities as long as the entity:
- restricts its activities to solicitation of orders for tangible property;
- sends its orders out of the state for approval; and
- makes deliveries from outside of the state via common carrier.
While the model sounds plausible, for the purposes of PL 86-272 “solicitation” is a rather narrow concept. Given the current marketing research trends and developments, the protections of PL 86-272 are rather thin, but could be useful.
PL 86-272 focuses on the types of activities carried out by the foreign corporation selling tangible personal property. With emphasis on solicitation of sales, if the activity explicitly or implicitly invites an order it is most likely protected. However, if the activity has an independent business function, it will not be protected. For example, in states that apply PL 86-272 to foreign businesses, carrying samples and promotional materials only for display or distribution without charge, or soliciting sales by advertising will constitute protected activities under PL 86-272.
At the same time, activities such as replacing old products, collecting information about competitive products or investigating customer credit-worthiness fall outside of the PL 86-272 protection. Although, all these activities are marketing-oriented, only some qualify for the limited safeguards of PL 86-272.
States that currently choose to follow PL 86-272 administer it differently. In Virginia, for example, the protections of PL 86-272 apply to not only tangible property, but intangible property as well. In Massachusetts, protections of PL 86-272 apply, but the entity is still required to file a non-income measure excise tax return, and possibly pay a minimum tax. A number of other states require a tax return to be filed even if the corporation’s activities are protected by PL 86-272.
Thus, in a marketing context, it pays to figure out which activities are protected in certain states, and which are not, and implement the strategy accordingly.
The third concept is sales tax. International treaties cannot address the applicability of sales tax nexus to non-U.S. entities, thus there is no treaty protection from it. Foreign entities doing business in the U.S. have the same sales tax collection responsibilities as the U.S. businesses.
Out of the three, sales tax might seem to be the tamest concept, but a foreign entity should closely monitor the sales tax developments in the states where it sells. If a business is not properly collecting sales taxes from its customers and remitting it to the correct jurisdictions, then it could be responsible to bear the burden of covering those taxes from its own funds, which could result in significantly narrowing profit margins. More likely than not, a company that should have been remitting sales tax but failed to do so will be liable not just for the tax, but also penalties and interest.
The importance of understanding sales and use tax laws cannot be overestimated. Currently, 45 states and the District of Columbia impose a sales tax, and within some states, local jurisdictions impose an additional layer of their own. The vast majority of the states also impose use tax for items purchased outside the state but used in the state. The rates and rules vary widely, creating what can be an extreme level of complexity for businesses operating in multiple states. The sales tax liability for a business with a high sales volume can grow exponentially in a short period of time.
It is critical to understand that sales tax treatment may vary for your particular products. For example, many states classify software as tangible personal property, without regard to the method of delivery. Thus, while your company might perceive itself as selling services, it may not be so for the purpose of state sales taxes. Be sure to become familiar with sales and use tax exemptions, and properly collect supporting documentation from your customers if exemptions apply.
A variety of other taxes (not labeled as income or sales tax) may apply that are not covered separately in this article. Like the concepts described above, one must be familiar with each state’s unique requirements. Examples include the Business and Occupation Tax (a gross receipts tax) in Washington, and the Margin Tax in Texas. The formulas, thresholds, and filing requirements for additional taxes like these vary widely.
Compliance with state tax laws adds an entirely new level of jurisdictions that you must become familiar with when operating a foreign business in the U.S. While failure to do so may unfavorably impact the long-term success of your business, proactive understanding of state tax laws will not only help you avoid unexpected surprises, but enable you to take advantage of tax planning opportunities.
If you have any questions about state taxation of foreign entities, please contact Merrill Barter or your BNN tax advisor at 1-800-244-7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.