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Warning: Non-US Corporations May Find Themselves Subject to State and Local Taxation in the United States
Is your company earning income from sources within the United States, but otherwise does not have a presence in the US? Is your company affiliated with other companies that are conducting business within the US? Does your company think that it is not subject to state taxation in the US? Then this article is a must read for you. Taxand US identify what non-US businesses should look out for when carrying out any business in the US to avoid paying penalties further down the line.
Unlike US federal and international tax law, the concepts of "US trade or business" and "permanent establishment" generally do not apply when determining if a state has jurisdiction to tax a non-US entity. In addition, not all states follow the federal rules for treaty-based return positions. Rather, a state may employ its own rules for determining if it has jurisdiction to either subject a non-US entity to tax or to include a non-US entity's activity within the state's tax base. Therefore, it is not uncommon for non-US corporations to suddenly find themselves subject to a particular state's taxing authority, even though they may not have a US federal corporate income tax filing requirement.
As the United States continues to deal with a downturn 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 constantly 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 to tax. Two tax concepts that states may employ to increase their tax revenue and which trap unwary non-US entities are (1) unitary combined reporting and (2) economic nexus.
What is Unitary Combined Reporting?
Unitary combined reporting is a methodology for apportioning the business income of a corporation that is 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, non-US corporations that have no physical presence in the US and no obligations to pay federal corporate income taxes can find themselves being included within certain unitary reporting groups. For example, a non-US corporation that does not have a physical presence in the US but which owns a wholly-owned subsidiary that conducts business in the US may have to be included within the combined reporting group.
Before 2006, approximately sixteen states required mandatory unitary combined reporting. However, recent trends in state taxation have seen more and more states implementing the combined reporting methodology. Currently, there are approximately twenty-three states that have implemented mandatory combined reporting, and many non-US corporations are suddenly finding themselves subject to these state tax regimes.
Worldwide vs. Water's-Edge Combined Reporting
There are two general approaches that states have implemented in order to deal with unitary members that are incorporated outside the US 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 non-U.S affiliates will be brought into the unitary group. Certain states such as California, Idaho and Montana recognise the concept of worldwide combination. However, these states also provide the option of electing to exclude certain non-US corporations 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 incorporated outside the US or domestic members. This entities are commonly referred to as "80/20 corporations." "80/20 corporations" are entities whose business activities outside the United States constitute 80-percent or more of the corporation's total business activity. The business activities that are used in determining whether or not an entity is an "80/20 corporation" vary by state. Therefore, a non-US corporation 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 taxation of entities that are incorporated in certain "tax haven countries." For instance, California and Minnesota have recently proposed legislation that requires income derived from activities performed in tax haven countries to be included in the water's-edge combined group. In addition, Rhode Island and Virginia have also proposed bills that mandate combined reporting on a water's-edge basis and which would require the inclusion of activities from tax haven countries.
States have historically relied upon the concepts of minimal contact and physical presence in order 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 as certain states have recently enacted economic nexus provisions via legislative amendments.
"Economic nexus" generally refers to the assertion of 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 corporations that have California sales in excess of $500,000. Under this economic nexus standard, certain non-US corporations that were not otherwise subject to tax under the minimal contact and physical presence standards may find themselves subject to tax via this new economic nexus standard.
The application of state and local corporate income tax rules to non-US entities is a daunting task as US federal tax concepts often do not apply. The idea that there are multiple levels of taxation in the US - at the federal and individual state levels - is unfamiliar to most non-US corporations. Although a non-US corporation may not have a filing requirement for US federal income tax purposes, it may nonetheless have a requirement for state income tax purposes. Before conducting any business in the US, with physical presence or not, it is imperative that non-US corporations become aware of these state tax rules in order to avoid falling into any pitfalls along the way.
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