Federal Taxation Basics for Non-US Entities
Under IRC Section 882, the United States government imposes federal income tax on non-U.S. entities that have income effectively connected with the conduct of a U.S. trade or business (ECI). This provision is important because the rules for determining ECI differ from those used to allocate profits to a Permanent Establishment (PE), a concept rooted in tax treaties.
A U.S. trade or business can include activities such as performing services within the U.S., manufacturing goods in the U.S., or selling goods in the U.S. through employees or agents on a regular basis. Conversely, certain activities do not qualify as a U.S. trade or business, including purchasing goods for resale outside the U.S., trading securities for personal account, selling goods or services from abroad, exercising general supervision from an office in the U.S., or using another person’s fixed place of business in the U.S. These distinctions are essential for determining the U.S. tax obligations of non-U.S. entities engaged in various cross-border activities.
IRC § 881 imposes a tax on fixed or determinable annual or periodic income (FDAP), which typically includes items such as interest, dividends, rents, and royalties. In the absence of a tax treaty, FDAP income is generally subject to a 30% withholding tax rate. However, many tax treaties between the U.S. and foreign countries serve to either eliminate or reduce this withholding rate, providing tax relief to foreign individuals or entities earning such income from U.S. sources. This provision ensures that foreign recipients of U.S.-sourced income are taxed appropriately while also taking into account the benefits of international agreements designed to avoid double taxation.
Income tax treaties between the U.S. and other countries are primarily designed to avoid double taxation, ensuring that businesses and individuals are not taxed on the same income in both countries. Under these treaties, the U.S. generally only taxes a foreign business if it has a permanent physical establishment, or Permanent Establishment (PE), in the U.S. and generates income that is effectively connected with the conduct of a U.S. trade or business. However, it is important to note that these treaties do not extend to individual U.S. states, as states are not parties to federal income tax treaties. As a result, the tax obligations of a non-US business may differ at the state level, potentially subjecting it to state taxes regardless of the protections offered by federal tax treaties.
State Taxation Basics for Non-US Businesses
When addressing the issue of subjecting non-U.S. entities to state income tax, several important considerations must be kept in mind. State legislatures typically design income tax rules with domestic (U.S.) corporations in mind, meaning the rules of state income taxation do not always translate effectively when applied to non-U.S. businesses. As a result, there is often confusion in the interpretation of how state income tax rules should be applied to foreign businesses.
For example, one common misunderstanding arises in research and commentary about state conformity to specific sections of the Internal Revenue Code, such as IRC Section 863. Many commentaries incorrectly claim that a state’s lack of conformity to this section means it does not follow the federal rules regarding income sourcing. However, IRC Section 863, while a federal income tax sourcing rule that distinguishes between U.S. and foreign-source income, also plays a critical role in determining what constitutes U.S. Federal Taxable Income (FTI).
Although states have their own apportionment and sourcing rules, most states begin their calculations with the federal starting point of the federal taxable income, making the federal sourcing provisions relevant in many state tax calculations. Therefore, it is essential to carefully analyze state tax rules, especially when dealing with non-U.S. entities, to avoid misunderstandings about the application of federal sourcing guidelines at the state level.
State Income Tax Nexus Principle
A critical mistake that foreign companies often make regarding U.S. state taxation is assuming they are not subject to state and local taxes simply because they
- do not have effectively connected income (ECI) from a U.S. trade or business, or
- are protected by a federal tax treaty, lack a Permanent Establishment (PE), and therefore believe they are exempt from federal income tax.
However, these assumptions do not account for state tax nexus principles, which can create tax obligations independent of federal rules.
Nexus refers to the minimum connection between a taxpayer and a state that allows the state to impose tax filing and payment obligations. While the specific thresholds for establishing a nexus can vary by state, it is generally triggered by physical presence within the state. This includes, but is not limited to, owning in-state property, having employees, agents, affiliates, or independent contractors in the state. More importantly, the state standard for nexus is typically broader than the federal requirement for a PE, which focuses on a “fixed place of business.”
In addition to physical presence, nexus can also be established through economic presence. For example, some states impose tax obligations if a company’s annual sales exceed a specific threshold or if it has any sales or economic presence in the state. These “bright-line” sales thresholds differ from state to state, and some states may apply a broad “doing business” standard that captures a wide range of business activities. Thus, even if a foreign company meets the criteria for exemption from federal income tax, it may still be subject to state and local taxes if it meets a state’s nexus requirements.
Can Public Law 86-272 Help?
Public Law (PL) 86-272, also known as the Interstate Income Act of 1959, provides an important limitation on state income tax authority by generally prohibiting states and their political subdivisions from imposing income taxes on businesses operating within their borders under certain conditions. Specifically, the law bars income taxation if a business’s activities within a state are limited to soliciting orders for tangible personal property, and those orders are subsequently approved and shipped from outside the state.
This provision is designed to prevent states from taxing businesses that engage only in minimal activity, such as order solicitation, without establishing a more substantial presence or nexus within the state. As a result, businesses that meet these criteria are generally exempt from state income taxes, even if they have a physical presence or conduct other activities within the state, as long as those activities are restricted to the solicitation of orders for goods to be shipped from outside the state.
Sounds promising for non-US businesses, doesn’t it? Not really. Because Public Law 86-272, prohibits a state from imposing a net income tax on a business. However, this law does not shield businesses from other types of state taxes. Specifically, states may still impose franchise taxes, gross receipts taxes, or sales and use taxes on businesses even if they meet the requirements of PL 86-272.
Non-protected activities under Public Law 86-272 are those that go beyond the mere solicitation of sales. As the scope of business activities evolves, an increasing number of states have taken the position that certain online activities disqualify a business from P.L. 86-272 protection. States such as California, New Jersey, and New York have adopted this interpretation, expanding the definition of taxable activities beyond traditional in-state sales solicitation.
Examples of activities that can trigger tax liability in these states, even if the business otherwise limits its activities to solicitation, include hiring, training, or supervising personnel, other than personnel involved only in solicitation even if through a website, investigating the creditworthiness of potential customers, repossessing property or providing technical assistance. These activities are considered to create a more substantial in-state presence or business activity than the simple solicitation of orders, thus subjecting the business to state income or other taxes despite the protections of P.L. 86-272.
The Multistate Tax Council has issued a statement indicating that Public Law 86-272 should apply to foreign commerce (Multistate Tax Commission, 2023), meaning that businesses engaged in soliciting sales of tangible personal property from outside the United States should also be afforded the protections of PL 86-272, provided their activities are limited to solicitation and their orders are filled and shipped from outside the state. However, not all states extend these protections to non-U.S. entities. For example, California, as outlined in its Tax Publication 1050, does not provide PL 86-272 protection to foreign businesses. Similarly, Oklahoma’s Rule 710:50-17-4(b)(3) and Wisconsin’s Administrative Code Tax 2.82(3)(b)(2)(c) also exclude non-U.S. entities from benefiting from PL 86-272, meaning these states may impose income taxes on foreign businesses that engage in solicitation activities within their borders, even if those activities fall under the protections of federal law in other jurisdictions.
Even if a foreign corporation‘s activities in a state create sufficient nexus to trigger state tax obligations, it is important for the corporation to carefully consider each state’s “doing business” definition, as these rules may exclude certain activities or provide exemptions that prevent the company from being subject to tax. For example, New York provides several exclusions for foreign corporations under 20 NYCRR section 1-3.3(b), which reflect provisions of IRC Section 864. Notably, New York excludes from its definition of “doing business” the maintenance of an office in the state by one or more officers or directors who are not employees of the corporation, as long as the corporation does not otherwise engage in business or employ capital in the state, nor own or lease property there. Additionally, New York also excludes the use of fulfillment services provided by a third party in the state, as long as the foreign corporation does not own or lease property stored at the third party’s premises in connection with those services. Similarly, Tennessee has issued a revenue ruling, Tenn. Dep’t of Rev., Rev. Rul. 20-08 (Oct. 9, 2020), stating that a non-U.S. corporation that did not have effectively connected income (ECI) was not subject to the state’s franchise tax, even though it was engaged in activities that could be considered “doing business” in the state. In this case, the state determined that the foreign corporation did not have a substantial nexus with Tennessee, and thus, it was not liable for the franchise tax.
These examples highlight the importance for foreign corporations to carefully evaluate the specific criteria for “doing business” and nexus in each state, as certain activities may not result in tax obligations depending on the state’s laws and exemptions.
Computing State Taxable Income of Non-U.S. Corporations
When a foreign company determines that it has a nexus for state income tax purposes, the next critical step is to determine its tax base, or state taxable income. In most states, the process begins with federal taxable income as the starting point. This means that a foreign company will typically start with the income it reports on its federal tax return and then make adjustments as required by state-specific tax laws. Federal income tax laws and treaties may reduce or eliminate federal income for non-U.S. entities and therefore leave no taxable income on form 1120F. However, as mentioned above, the treatment of treaty-protected income complicates this process, as U.S. states are not bound by federal tax treaties and take varying positions on whether treaty protections extend to state taxation.
Some states, such as Florida, explicitly provide treaty protection, ensuring that income exempt from federal taxation under a treaty is similarly exempt from state taxes. Other states, like Georgia and North Carolina, do not directly address treaty protections but, by limiting taxable income to effectively connected income (ECI), effectively offer similar protection as federal law. In contrast, states such as California, New York, and Pennsylvania specifically state that income protected by a tax treaty is still subject to state taxation, meaning treaty benefits do not apply at the state level. Finally, some states, such as Oregon, assert that state taxable income is not limited to ECI, meaning foreign corporations could be subject to tax on their worldwide income, regardless of treaty protections. As a result, foreign companies must carefully review each state’s tax laws and understand how treaty-protected income is treated to ensure accurate compliance with state income tax requirements.
Even if a non-U.S. corporation files a federal Form 1120-F, it may not report income on Line 29 (taxable income before net operating loss and special deductions) or Line 31 (taxable income or loss after NOL and special deductions) if the corporation lacks a Permanent Establishment (PE), has no profits attributable to a PE, or is exempt from U.S. tax under a treaty. In such cases, the corporation may not have any taxable income to report on these lines, as the treaty exemption or absence of a PE removes the income from U.S. tax liability.
However, certain states, including California, Massachusetts, and Pennsylvania, take a different approach. These states require non-U.S. corporations that are exempt from federal tax due to a treaty to report income as if the treaty exemption did not apply. Essentially, these states may require the corporation to file a pro forma federal return, which replicates the federal tax calculation as if the income were subject to tax, in order to determine its Federal Taxable Income (FTI) for state tax purposes. This pro forma return helps establish a starting point for calculating state taxes, even if the corporation’s federal taxable income is zero due to treaty protections or lack of a PE. Non-U.S. corporations must, therefore, be aware that while they may be exempt from federal tax under a treaty, they may still face state tax filing obligations and may need to provide additional documentation, such as a pro forma return, to comply with state tax requirements.
The issues we discussed here are only a portion of what foreign corporations need to consider when operating in the United States regarding state taxation. The complicated nature of state and federal taxation differences make this very difficult to navigate. When some local governments try to tax businesses based on their own nexus criteria, now you have a 4 player game and 3 different sets of rules to navigate.
n conclusion, the issues discussed here represent only a fraction of the complexities that foreign corporations must navigate when it comes to state taxation in the United States. The intricate differences between state and federal tax systems make it challenging for businesses to comply with the relevant rules and regulations. The situation becomes even more complicated when local governments apply their own nexus criteria, creating a scenario where businesses must contend with a “four-player game” involving three sets of rules: federal, state, and local. This multi-layered framework adds considerable complexity to tax compliance for foreign corporations, underscoring the importance of careful planning and a comprehensive understanding of both state and federal tax requirements.
