Do your foreign affiliates earn income from sources within the United States but otherwise do not have a presence in the U.S.? Do you think you are not subject to state income tax? Then this article is a must read for you.
Unlike U.S. federal and international tax law, the concepts of “U.S. trade or business” and “permanent establishment” generally do not apply when determining if a state has jurisdiction to tax a foreign entity. In addition, not all states follow the federal rules for treaty-based return positions. Rather, a state may use its own rules (limited only by the U.S. Constitution) for determining if it has jurisdiction either to subject a foreign entity to tax or to include a foreign entity’s activity within the state’s tax base. Therefore, it is not uncommon for foreign entities to suddenly find themselves subject to a particular state’s taxing jurisdiction, even though they may not have a U.S. federal corporate income tax filing requirement.
As the United States continues to deal with a downturned economy, many states are facing significant shortfalls in their budgets, and their fiscal problems are expected to continue over the next few years. With state tax receipts dwindling and budget gaps increasing, states are looking for ways to increase tax collections. One method for doing so is to increase the state tax base by either subjecting more activity to tax or subjecting additional persons or entities to tax. Two tax concepts that states may employ to increase their tax revenue and that trap unwary foreign entities are (1) unitary combined reporting and (2) economic nexus.
Unitary Combined Reporting
Unitary combined reporting is a methodology for apportioning the business income of a corporation that is a member of a unitary business group. Although the term “unitary business group” varies by state, it generally means a group of corporations related through common ownership whose business activities are integrated with, dependent upon and contribute to each other. Common ownership is generally defined as the direct or indirect ownership or control of more than 50 percent of the outstanding voting stock.
Under the unitary combined reporting methodology, an entity that does not otherwise have nexus with a particular state may nonetheless be required to be included within a particular state’s combined reporting group. Similarly, foreign entities that have no physical presence in the U.S. and no obligations to pay federal corporate income taxes can find themselves being included within certain unitary reporting groups. For example, a foreign entity that does not have a physical presence in the U.S. but that owns a wholly owned subsidiary that conducts business in the U.S. may have to be included within the combined reporting group.
Before 2006, about 16 states required mandatory unitary combined reporting. However, recent trends in state taxation have seen more and more states implementing the combined reporting methodology. Most recently, the District of Columbia implemented mandatory unitary combined reporting beginning after December 31, 2010. Currently, about 23 states have implemented mandatory combined reporting, and many foreign entities are suddenly finding themselves subject to these state tax regimes.
Worldwide vs. Water’s-Edge Combined Reporting
States have followed two general approaches to deal with unitary members that are incorporated outside the U.S. and/or conduct most of their business activities abroad. The first method, the worldwide combination approach, requires all members of the unitary business group to be included regardless of the country in which the member is incorporated or the country in which the member conducts business. Therefore, all activities of all foreign affiliates will be brought into the unitary group. Certain states, such as California, Idaho and Montana, recognize the concept of worldwide combination. However, these states also provide the option of electing to exclude certain foreign entities from the unitary group via the filing of a “water’s-edge election.”
While the concept of unity is always applied on a worldwide basis, the water’s-edge combination method generally excludes from the group those members that conduct most of their business activities outside the United States, whether they are foreign or domestic members. These entities are commonly referred to as “80/20 entities.” These are entities whose business activities outside the United States constitute 80 percent or more of their total business activity. The business activities used in determining whether or not a company is an 80/20 entity vary by state. Therefore, a foreign entity that has some physical presence in the United States can find itself subject to a state’s taxing regime.
Tax Haven Countries
Another issue that has become a hot topic as of late is the state taxation of entities that are incorporated in certain “tax haven” countries. For instance, West Virginia enacted provisions for unitary combined reporting to include members doing business in a tax haven. Similarly, Alaska provides that a unitary combined report should include certain corporations that are incorporated in or are conducting business in a country that does not impose an income tax or that imposes an income tax at a rate of lower than 90 percent of the U.S. income tax rate on the income tax base.
Continuing this recent trend, many states have proposed legislation that requires income derived from activities performed in tax haven countries to be included in the water’s-edge combined group. For instance, California, Minnesota, Rhode Island and Virginia have proposed legislation in recent years that requires income derived from activities performed in tax haven countries to be included in the water’s-edge combined group. Although most of the legislation has failed to be enacted, more and more states appear to be proposing bills that mandate the inclusion of the activities from entities doing business in tax haven countries as a way to increase their tax base.
States have historically relied on the concepts of minimal contact and physical presence to assert jurisdiction over a corporation for income tax purposes. However, in the early 1990s, a new concept, “economic nexus,” began to evolve from state tax case law. The concept is catching on: certain states have recently enacted economic nexus provisions via legislative amendments.
Economic nexus generally refers to the assertion of a state’s taxing jurisdiction based on something other than a physical presence in the taxing state. A company that derives income from sources within a particular state, or that has a substantial economic presence within a state, but no physical presence, can still be subject to state corporate income taxation. For example, California recently passed a statute that revised its “doing business” standard for tax years beginning on or after January 1, 2011 to include entities that have California sales in excess of $500,000. Similarly, Colorado provides that a business entity organized outside Colorado is considered to be doing business if its sales attributable to Colorado exceed $500,000 or 25 percent of the total sales. Under this economic nexus standard, certain foreign entities that were not otherwise subject to tax under the minimal contact and physical presence standards may now find themselves subject to tax.
The following example provides some insight into the application of some of the provisions discussed above.
A foreign corporation (“Foreign Parent”) that does not have a physical presence in the United States directly owns two subsidiary corporations. One of the subsidiaries is a U.S. corporation that conducts 100 percent of its business activity in State Y. The other subsidiary, “Foreign Corporation A,” is a foreign corporation with $1 million of sales sourced to State X. Foreign Corporation A, in turn, wholly owns a foreign corporation, “Foreign Corporation B,” which conducts 30 percent of its business activities in State Y. Foreign Parent is unitary with Foreign Corporation A and U.S. Corporation. Foreign Corporation A is unitary with Foreign Corporation B, but not with U.S. Corporation.
State X is a mandatory unitary combined state that has adopted a worldwide combination, but that permits unitary groups to file on a water’s-edge basis. Assuming State X has implemented economic nexus provisions, Foreign Corporation A will be deemed to be doing business in State X.
If Foreign Corporation A does not make a water’s-edge election, all four entities should be included in State X’s combined group. However, if Foreign Corporation A elects to file on a water’s-edge basis, the following entities should be included as part of the combined group:
- Foreign Corporation A because it is deemed to be doing business in State X;
- Foreign Corporation B because its activities preclude it from being an “80/20 corporation” and it is unitary with Foreign Corporation A; and
- U.S. Corporation because it is unitary with Foreign Parent, which is unitary with Foreign Corporation A.
Although Foreign Parent meets the unitary tests, it will not be included in the water’s-edge combined group. However, Foreign Parent still plays a role in determining which corporations are included in the unitary group.
Alvarez & Marsal Taxand Says:
The application of state corporate income tax rules to foreign entities is a daunting task, as the U.S. federal tax concepts often do not apply. Although a foreign entity may not have a filing requirement for U.S. federal income tax purposes, it may nonetheless have a requirement for state income tax purposes. Before your foreign affiliate starts conducting any business in the U.S., with physical presence or not, it is imperative that you become aware of these state tax rules to avoid falling into any pitfalls along the way.
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The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
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