State Tax Issues Facing Foreign Businesses
Many foreign (non-U.S.) businesses are selling to customers within the U.S. These companies conduct various activities within the states, and one often overlooked (or ignored) topic is state taxes.
A little background on U.S. taxation of corporations is in order. The U.S. taxes U.S.-based corporations on all of their worldwide income, potentially reduced by a credit for taxes paid to other countries. By contrast, the U.S. taxes non-U.S. corporations only on income “effectively connected” with the conduct of a trade or business within the U.S. Also, the U.S. has entered into numerous treaties whereby it has agreed not to tax businesses of the treaty country unless that business has a “permanent establishment” within the U.S (and vice versa).
The background above, however, explains only federal law. A common misconception is that federal tax treaties entered into between the U.S. and many foreign countries apply to all state taxes. Unfortunately, this is not the case. The states are not a party to these treaties, and therefore the tax protections afforded under these agreements may not apply in the states. This is especially true for sales taxes.
For a business entity from a country with which the U.S. has a tax treaty in place to be subject to federal income tax, it must have a permanent establishment (“PE”). A PE is defined as a “fixed place of business” through which a foreign entity’s U.S. business is wholly or partially carried on. Some examples include an office, factory, a construction site, and in certain conditions, the home office of an employee who works at home. There are numerous “acceptable” activities that a foreign entity can conduct that will NOT create a PE, including:
- Renting or leasing a facility solely for storing, displaying or delivering the entity’s inventory;
- Maintaining the entity’s inventory for the purpose of storage, display or delivery;
- Maintaining the foreign entity’s inventory solely for the purpose of processing by another enterprise;
- Maintaining a fixed place of business solely for the purpose of purchasing goods or collecting information for the taxpayer;
- Carrying on business through a broker, general commission agent, or any other independent agent, provided the person is acting in the ordinary course of their business as an independent agent.
It is important to understand that while the above activities will not create a PE, and will therefore not create a federal income tax issue, the same is not true in the states that do not follow the federal treaty exemption. If a foreign entity conducted any of these activities in Connecticut, New Jersey or Pennsylvania, for example, they could be subject to the state’s income and franchise taxes. This is true despite the fact that they may not have a federal tax filing requirement. And importantly, the protections offered by P.L. 86-272 which apply to sellers of tangible personal property do not apply to non-U.S. entities (i.e. U.S. branch operations of foreign entities). This means that if a foreign entity’s employees are merely soliciting sales within a state that doesn’t follow the federal PE treaty exemption – an activity that would not create a federal income tax filing requirement if conducted by a U.S. entity – the foreign entity could be subject to that state’s income tax.
As confusing and onerous as states’ income tax laws can be for foreign entities, state sales taxes are worse. Federal income tax treaty exemptions do not apply to state sales taxes. Therefore, if a foreign company is making sales in the U.S., it must be aware of the states’ sales tax laws and filing requirements. Currently, 45 states and the District of Columbia have a sales tax, and within some states, local jurisdictions also impose a sales tax. The states’ rates and rules regarding what is and is not taxable, and who is and is not subject to tax, vary widely, creating what can be an extreme level of complexity for businesses operating in multiple states. A foreign entity engaging in any of the “protected” activities under P.L. 86-272 within a state that has a sales tax would have a filing requirement. Some other activities that can create nexus, and therefore a filing requirement for sales tax purposes are:
- Using independent agents to solicit sales, conduct installations or perform warranty repair services.
- Maintaining an in-state sales office.
- Use of 3rd party fulfillment services.
- Internet sales resulting from referral agreements with in-state residents (Amazon laws – “click-through” nexus).
And what would be the implications to foreign entities if the Marketplace Fairness Act becomes law? (If passed, the law would require internet retailers meeting certain requirements to collect states’ sales/use taxes, even if they didn’t have a physical presence in the states. As of November 14, the legislation is stalled in the House of Representatives.)
A critical point to remember with regard to sales taxes is that the tax is ultimately the buyer’s responsibility. However, the states look to the sellers who are required to collect tax to do so, and it is the seller who upon audit will be burdened with the liability (plus interest, and possibly penalties). It is most often very difficult, if not impossible, to recover sales tax from a customer several years after the sale was made. Therefore, it is very important for foreign businesses to be aware of states’ sales tax laws in order to properly comply, or at least be able to assess the potential liabilities and associated risks.
State taxes are complex, and can be an area of significant financial exposure for foreign entities doing business in the U.S. It is important for foreign business entities currently operating in the states, or planning to do so, to be aware of the states’ laws to ensure compliance and avoid unpleasant surprises.
If you would like to discuss further, please call Merrill Barter or Stuart Lyons 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, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.