In order for a state to legally impose its taxes upon an out-of-state entity, nexus – a connection between the income producing company and the state – must exist. Nexus laws, which may vary from state to state, can be particularly troublesome for foreign companies who often overlook these complex tax obligations – resulting in substantial tax assessments and penalties.
What is Nexus?
Nexus is a particular threshold by which an entity’s in-state business activity is so great that the state can enforce its tax rules on the business. The U.S. Constitution, through its Due Process and Commerce Clauses, limits a state’s ability to establish nexus. The Due Process Clause requires a minimal connection between an out-of-state taxpayer and the taxing state, while the Commerce Clause requires a substantial nexus between the taxing state and the activity being taxed.
In recent years, state nexus boundaries have seemingly been stretched to their Constitutional limit. Many states have started imposing economic presence nexus standards and adopting factor-based bright-line tests. For example, in Colorado an out-of-state company will have established income tax nexus if during the course of a tax year they meet any of the following criteria:
• at least $50,000 of in-state property or payroll;
• at least $500,000 of in-state sales; or
• 25% of the company’s total property, payroll or sales are within the state.
Similar standards have also started to be applied in the sales and use tax arena whereby economic nexus regulations target out-of-state retailers with substantial sales into the state. Alabama, the pioneer of sales tax economic nexus, imposes a sales tax collection and reporting obligation on out-of-state retailers, lacking an in-state physical presence, if they make retail sales of tangible personal property into the state exceeding $250,000. In order to maintain compliance, the law of each state in which a company is doing business must be consulted.
Federal vs. State Obligations
For foreign companies, these complicated state nexus laws can be exceptionally challenging. Foreign corporations are only required to file federal income tax returns when engaging in a trade or business within the U.S., and federal taxes are typically only applicable to effectively connected income. However, most foreign corporations operating in the U.S. originate from a tax treaty country. Under a bilateral tax treaty, federal tax obligations are largely based on the foreign corporation’s establishment of a fixed place of business within the U.S. where the activities of the business are carried on. Accordingly, the U.S. tax focus of most foreign companies is on the determination of whether or not they have a fixed place of business in the U.S. What foreign companies often overlook is the fact that an entity can establish tax nexus with a state and thus be liable for state taxes, and yet not be required to file a federal tax return.
By way of example, some Federal tax treaties contain a permanent establishment exemption for maintaining a purchasing facility within the U.S. For state tax purposes, the storing of inventory in an in-state warehouse is sufficient to create nexus in virtually all states. Housing inventory within a state establishes a physical presence in the jurisdiction. The difficulty for many foreign corporations is to recognize that while some activities are protected for federal tax purposes by tax treaties they are not necessarily protected for state tax purposes.
Worldwide Filing Obligations for State Tax
Foreign companies, when establishing nexus with a state, should be aware that states can take an aggressive approach to imposing their tax obligations. States are increasingly moving to requiring unitary and combined filings. This necessitates the inclusion of all commonly owned affiliates. When a foreign organization files such a return, it can potentially be exposed to mandatory worldwide filing obligations. Some states mitigate this exposure through the proper filing of a water’s-edge election, which limits the scope of combined reporting to specific entities subject to U.S. taxation. However, a foreign corporation will only know to file the election if informed that it has established state nexus.
With the aforementioned in mind, foreign companies are cautioned to take stock of their U.S. business activities through the state nexus prism. Foreign corporations often discover they have had years of state tax nexus resulting in devastating tax assessments and penalties, particularly if tax elections are missed.
If you have any questions regarding your foreign corporation’s state and local tax obligations, please contact Alan Goldenberg, Senior Manager of State and Local Taxation and Tax Controversy, at firstname.lastname@example.org or 212-897-6421, or your Friedman LLP tax professional.