For many foreign companies expanding their business operations into the United States, the focus of their tax planning usually centers on the federal income tax laws. While doing business in the U.S. can be a substantial boon, many of these companies express concern about the current 35% federal corporate tax rate, one of the highest business tax rates in the world. Accordingly, non-U.S. companies seek to limit their U.S. tax exposure by avoiding having a taxable presence within the U.S., and by applying bilateral tax treaties which cap the federal government’s ability to impose taxes on foreign entities. However, a common misconception of foreign businesses is that federal tax treaties between the U.S. and foreign countries apply to state taxes as well. Yet, this is not the case and state taxes can lead to significant financial exposure for foreign companies doing business in the U.S.
By way of background, the U.S. taxes U.S.-based corporations on all of their worldwide income. In contrast, the U.S. only taxes non-U.S. corporations on income effectively connected with the conduct of a trade or business within the U.S. Effectively connected income is earned by businesses that maintain a physical place of business in the U.S. or have employees working within the country. The U.S. has also entered into over 60 bilateral tax treaties agreeing to limit its ability to tax businesses of the treaty country.
For example, assume a German company manufactures eye glasses and sells them to U.S. customers through independent distributors. The company uses a third-party fulfillment center in the U.S. to fill customer orders and does not have employees involved in selling activities. The German company also sells vitamins in the U.S. through U.S.-based sales associates. Seemingly, both the income from the eye glasses and the vitamins would be subject to federal income tax. However, a treaty-country company is only subject to U.S. taxation on income that is directly generated from business operations created by a U.S. taxable presence. Assuming the German company qualifies for the benefits under the U.S.-Germany treaty, only the income from the sale of vitamins in the U.S., which is performed by its sales associates, would be subject to federal income tax.
The above example, however, only addresses federal tax laws. States are not parties to these treaties and, consequently, are not bound by their terms. Accordingly, a non-U.S. company under the protection of a federal tax treaty may be at risk of noncompliance with its state income tax obligations, should it incorrectly assume that the treaty benefits encompass state and local taxes too. Many foreign companies have difficulty grasping the complexities of the U.S. federal, state and local multitier tax structure, as most countries do not employ a federalist tax system.
How states impose their tax regimes upon foreign corporations is determined on a state-by-state basis. For example, Oregon requires non-U.S. companies to compute their corporate taxes on their federal taxable income as if no tax treaty is in effect. In other states, the existence of a tax treaty may, by default, provide protection against a state tax levy. Georgia and North Carolina, for instance, use federal taxable income as the starting point for calculating their state taxes. Since their regulations do not provide for an addback of the income protected by a federal tax treaty, the income is effectively shielded from state income tax. Other states like California, New York and Pennsylvania take a moderate approach and tax only income that is effectively connected with a U.S. trade or business.
In Massachusetts, the rules are much more confusing. If a combined return is filed with a water’s-edge election, the non-U.S. company’s income that is exempt from federal taxation by virtue of a tax treaty is excluded from the water’s-edge unitary combined return. However, Massachusetts only considers such income exempt from tax if the treaty excludes all the income from tax. Merely reducing the applicable tax rate in accordance with the provisions of a tax treaty does not render the income fully exempt from Federal taxation, and thus such income remains subject to Massachusetts tax.
As perplexing as state corporate tax laws can be for foreign companies, sales and use taxes can be even more challenging. Federal tax treaties do not apply to sales and use taxes at all. Therefore, if a foreign company is making sales, particularly of tangible personal property, in the U.S., it must be aware of the local sales tax laws and filing requirements. Currently, 45 states and the District of Columbia levy a sales tax, and many localities impose their own supplementary sales taxes. What the applicable rates are and the 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 non-U.S. companies.
With this in mind, foreign companies should conduct a careful analysis of the interplay between any applicable federal tax treaty that they are structuring their business operations around, and their state tax obligations – not only for corporate tax purposes but for sales and use taxes as well. If you are a foreign company operating within the U.S., consult an experienced state tax professional to assist you in complying with your state tax obligations. If you have any questions regarding the effect of a federal tax treaty on your state and local taxes, 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.