State Income Tax Considerations Applicable to Foreign Investment in the United States
Author: Bryan Neuendorf
The U.S. state income tax reporting requirements and methods can vary between the states and District of Columbia for a foreign company with investments and/or activities within the United States. Foreign companies making a U.S. investment can create a number of state income tax issues.
Below are some examples of state income tax considerations applicable to foreign companies with investment in the United States.
State Tax Nexus
While the federal nexus standards of engaging in trade or business within the U.S. is based on whether the company has income effectively connected with a U.S. trade or business, or a permanent establishment where an income tax treaty applies, state income tax nexus standards generally only require a physical presence within the jurisdiction. A common misconception is that U.S. income tax treaties and treaty permanent establishment provisions apply to state nexus standards. These provisions aren’t binding for state nexus purposes, and as a consequence, it’s possible for a foreign corporation to have nexus for state but not federal income tax purposes.
A common trend in many states is the adoption of an economic nexus standard based on the amount of income or sales derived from in-state sources. State income tax may apply to any company deriving income from sources within the state and with substantial economic presence in a state based on frequency, quantity and the systematic nature of a company’s economic state contacts—without regard to physical presence and to the extent permitted by U.S. Constitution. In addition, it’s important to note that federal Public Law 86-272 doesn’t explicitly apply to foreign commerce.
Inclusion in a Combined Unitary Reporting
For federal income tax purposes, an affiliated group of corporations may elect to file a consolidated income tax return. A federal affiliated group is defined as one or more chains of includible corporations connected through stock ownership. For federal income tax purposes, a foreign company is not an includible corporation. Some states may require the inclusion of a foreign entity in a combined unitary reporting or require a water’s edge election to exclude the foreign corporation from the filing.
Market-Based Sourcing Apportionment
Companies taxable in more than one state have a U.S. constitutional right for fair income apportionment among the taxing jurisdictions. A taxpayer apportions its income by computing the percentage of its taxable business income in each nexus state using the state-provided formulas.The Uniform Division of Income for Tax Purposes Act provides for the use of an equally weighted three-factor formula that includes sales, property and payroll. However, many states have the ability to choose an alternative apportionment formula, and many have increased the weighting of the sales factor or enacted 100 percent sales factor apportionment methods.
With the continuing trend of increased weighting of the sales factor, a growing number of states also are adopting market-based sourcing rules for services and income from intangibles. A foreign entity will need to consider the impact of these changes should it have economic nexus or be includible in a combined unitary reporting.
Related-Party Expense Add-Back Provisions
Many states require the add-back of related-party expenses, including payments to a foreign related party, e.g., interest, intangible fees and management fees. Statutory exceptions to the add-back requirement may exist and vary by state, including, but not limited to, payments made to a foreign country related party. A related party may be required to be located in a country with a comprehensive income tax treaty with the U.S., or, more restrictive, requiring the payment to be subject to tax exception.
These items just scratch the surface of potential state income tax issues affecting a foreign company investment in the United States.
If you have any questions regarding your particular situation, please contact your BKD advisor or Bryan Neuendorf.