Multinational businesses face a variety of state tax issues. Many non-U.S. corporations1 conduct business in the United States using various business structures such as branches or subsidiaries. Additionally, when U.S. corporations have operations abroad, changes in such foreign operations may have effects on the state taxation of the business.
In this article, we compare the United States federal income tax laws regarding subjectivity to tax with state corporate net income tax laws regarding subjectivity and nexus. We highlight instances in which a non-U.S. corporation may be subject to a state corporate tax but not to the federal income tax. We then address tax base computational issues, including whether the worldwide income of a multinational business is subject to tax for state corporate tax purposes. Finally, we analyze business structures that may limit the state tax exposure of a multinational business.
Subjectivity and Tax Base
Federal Subjectivity – Permanent Establishment
The business profits of a non-U.S. corporation that is a resident of a foreign country that has a bilateral income tax treaty with the United States are subject to the federal income tax only if the corporation has a permanent establishment in the United States.2
A non-U.S. corporation may have a permanent establishment in the United States if it has some types of physical presence in this country. Under the United States model tax treaty (the “Model Treaty”), a “permanent establishment” is “a fixed place of business through which the business of an enterprise is wholly or partly carried on . . .” and includes: “(1) a place of management; (2) a branch; (3) an office; (4) a factory; (5) a workshop; and (6) a mine, an oil or gas well, a quarry, or any other place of extraction of natural resources.”3
Although a permanent establishment exists if a corporation has a certain type and level of physical presence (i.e., employees or property) in the United States, not all types of physical presence create a permanent establishment. The Model Treaty provides a list of activities that will not create a permanent establishment. These include:
- The use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise;
- The maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery;
- The maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise;
- The maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or of collecting information, for the enterprise;
- The maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character; and
- Any combination of the above provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character.4
State Subjectivity and Nexus – Taxability With and Without Physical Presence Significantly, the Model Treaty specifically provides that it only applies to federal taxes.5 Thus, state law controls whether a corporation is subject to tax (limited, of course, by the U.S. Constitution and U.S. statutes).
Most states impose corporate taxes on a corporation that has a physical presence in the state – such as owning or renting property in, maintaining an office in, or having employees located in or working in the state.6 Additionally, some states impose tax on corporations that do not have property or employees (i.e., physical presence) in the state. Some of the fact patterns under which states impose tax absent a physical presence include:
- The licensing of intangibles to a third party that operates in the state;7
- Soliciting and conducting of a credit card business or providing consumer lending to customers located within a state;8 and
- Making sales that are sourced to a state in excess of a certain threshold (e.g., $500,000).9
Most state statutes do not distinguish between U.S. corporations and non‑U.S. corporations on their face when imposing the state’s tax.10 However, the Connecticut “economic nexus” statute distinguishes between U.S. corporations and non-U.S. corporations with respect to economic nexus (i.e., subjectivity to tax) and does not assert economic nexus on certain non‑U.S. corporations. Connecticut General Statute Section 12‑216a provides:
Any company that derives income from sources within this state and that has a substantial economic presence within this state, evidenced by a purposeful direction of business toward this state, examined in light of the frequency, quantity and systematic nature of a company’s economic contacts with this state, without regard to physical presence, and to the extent permitted by the Constitution of the United States, shall be liable for the [Connecticut corporation business tax].
. . .
The [above-cited provisions] shall not apply to any company that is treated as a foreign [i.e., non-U.S.] corporation under the Internal Revenue Code and has no income effectively connected with a United States trade or business.
Therefore, certain non-U.S. corporations would not be subject to tax in Connecticut even if they conducted the same activities with respect to the state that a U.S. corporation conducted.
Non-U.S. Corporations with No Permanent Establishment May Still Be Subject to State Corporate Taxes
Because the Model Treaty does not apply to state taxes, a non-U.S. corporation may be subject to a state tax on its business profits even though its business profits are not subject to the federal income tax because the corporation does not have a permanent establishment. Moreover, a non-U.S. corporation with no physical presence in a state may nevertheless be subject to a corporate tax as the result of some other contact with the state. Consider the following examples:
Physical Presence That Does Not Constitute a Permanent Establishment – A non-U.S. corporation maintains a stock of goods or merchandise in New York that belongs to the corporation solely for the purpose of storage, display or delivery. The company’s activities do not create a permanent establishment.11 However, the corporation is subject to tax in New York because it owns property in New York.12
No Physical Presence in a State – A non-U.S. corporation with no permanent establishment in New Jersey derives income from the licensing of intangibles to an entity that operates in New Jersey. The Division of Taxation would likely assert that the corporation is subject to tax in New Jersey.13
Furthermore, a taxpayer may have a permanent establishment in one state, but may be subject to tax in several other states as a result of activities in those states that are insufficient to constitute a permanent establishment. Consider the following example:
Permanent Establishment in One State With Physical Presence in Surrounding States – A non-U.S. corporation maintains an office and has a permanent establishment only in New York. The corporation’s employees regularly perform work functions in Massachusetts, New Jersey and Pennsylvania that exceed solicitation as described in P.L. 86-272. The corporation is subject to tax in New York. The corporation is also subject to tax in Massachusetts, New Jersey and Pennsylvania.14
Computation of the Tax Base
Various issues exist with respect to a multinational business’ computation of state taxable income. For instance, must a corporation report more than its federal taxable income to a state, e.g., must it report foreign source income that it does not include in federal taxable income? Additionally, how does a non-U.S. corporation that is not subject to federal income tax determine its state taxable income if state taxable income is tied to federal taxable income? The states’ laws vary in whether and how such issues are addressed. We review below the federal income tax laws regarding the tax base of non-U.S. corporations with a permanent establishment in the United States and then analyze a few states’ laws regarding the tax base of multinational businesses below.
Federal Income Tax – Tax Base Limited to Business Profits
Operating through a permanent establishment in the United States does not cause the worldwide income of a multinational business to be subject to federal income tax in the United States. Instead, the federal income tax base of a corporation that is a resident of a foreign country and that has a permanent establishment includes “only so much of [the profits of the corporation] as are attributable to that permanent establishment.”15 The Model Treaty further provides that “[e]ven when a [non-U.S.] corporation conducts business in the United States” the profits to “be attributed to that permanent establishment [are] the profits that it might be expected to make if it were a distinct and independent enterprise engaged in the same or similar activities under the same or similar conditions.”16
State Tax Base – Worldwide Income of a Multinational Corporation
Whether a state requires a corporation to include in the state tax base income in addition to its federal taxable income is a state-specific question. However, the U.S. Supreme Court has held that a state may tax the worldwide income of both U.S. and non-U.S. corporations as long as the income is derived from the taxpayer’s unitary business.17 The following highlights a few states’ laws regarding computation of the tax base.
Under current New York tax law, a corporation includes income in addition to its federal taxable income in the New York tax base.18 In 2007, a non‑U.S. corporation argued that under New York tax law only the income that it reported to the U.S. could be included in entire net income (i.e., the New York tax base).19 The applicable statute provides:
The term “entire net income” means total net income from all sources, which shall be presumably the same as the entire taxable income . . . which the taxpayer is required to report to the United States treasury department [i.e., federal taxable income]. . . . Entire net income shall include income within and without the United States.20
In interpreting the above statute, the New York State Tax Appeals Tribunal explained that “[t]he statute’s use of the word ‘presumably’ appears to indicate that the starting place for the calculation of entire net income is not always Federal taxable income.”21 The Tax Appeals Tribunal held that the foreign source income of a non-U.S. corporation that is not included in federal taxable income is nevertheless included in the New York tax base.22
In contrast to New York, Maine only taxes a corporation’s federal taxable income (with certain additions and subtractions).23 The Maine statutes impose tax on “income,” which is defined as “the corporation’s net income.”24 “Net income,” in turn, means “the taxable income of that taxpayer for that taxable year under the laws of the United States” with statutory modifications.25 The Supreme Judicial Court of Maine has interpreted these statutes to mean that a taxpayer’s income “begin[s] with figures derived from corporations’ federal taxable income, which is limited to income derived from United States business.”26
A recent New Jersey case, Crestron, Inc. v. Director, Division of Taxation, indicates that, like Maine, the New Jersey tax base does not include worldwide income that is not included in federal taxable income.27 Crestron involved the tax computation of a U.S. corporation and the question before the court was whether extraterritorial income, as defined by the Internal Revenue Code, should be included in New Jersey’s definition of “entire net income.”28 The applicable New Jersey statute provided:
“Entire net income” shall mean total net income from all sources, whether within or without the United States, and shall include the gain derived from the employment of capital or labor, or from both combined, as well as profit gained through a sale or conversion of capital assets.
. . .
For the purpose of this act, the amount of a taxpayer’s entire net income shall be deemed prima facie to be equal in amount to the taxable income, before net operating loss deduction and special deductions, which the taxpayer is required to report . . . to the United States Treasury Department for the purpose of computing its federal income tax . . . .29
The New Jersey statutes also listed explicit additions and subtractions to federal taxable income to arrive at entire net income, none of which addressed extraterritorial income for the tax years at issue.30
The New Jersey Tax Court held that extraterritorial income was not included in the definition of “entire net income” because the Corporation Business Tax (“CBT”) ties directly to federal taxable income except with respect to certain explicit statutory modifications and none of these modifications addressed extraterritorial income. The court explained that the “statute couples entire net income [for New Jersey tax purposes] to line 28 of the federal income tax return which is entitled ‘Taxable income before net operating loss deduction and special deductions.’”31 The court continued that “[a]fter linking entire net income for CBT purposes to line 28 of the federal return, the statute provides that ‘[e]ntire net income shall be determined without the exclusion, deduction of credit of’ and lists more than a dozen exceptions – both additions and subtractions – to federal tax statutes that define federal taxable income.”32
The court’s interpretation in Crestron of the New Jersey statutes may affect whether a multinational business must include foreign source income in the New Jersey tax base. Based on Crestron, foreign source income that is not included in federal taxable income is likely not includable in the New Jersey tax base unless the New Jersey statutes explicitly add such income to federal taxable income to compute entire net income.
Computation of Income When a Taxpayer Is Not Subject to the Federal Income Tax
Where a state uses federal taxable income as the starting point for computing the state’s taxable income and the non-U.S. corporation is not subject to federal tax, the question arises as to whether the corporation has any state taxable income, even where some or all of that income is United States source income and would be included in federal taxable income if the non-U.S. corporation had a permanent establishment in the United States.
The Montana statutes specifically address such a scenario, providing that:
The term ‘gross income’ means all income recognized in determining the corporation’s gross income for federal income tax purposes. . . . Any corporation not subject to or liable for federal income tax but not exempt from the corporation license tax . . . shall compute gross income for corporation license tax purposes in the same manner as a corporation that is subject to or liable for federal income tax according to the provisions for determining gross income in the federal Internal Revenue Code.33
Unlike Montana, the Maine and New Jersey statutes discussed above do not directly address how a non-U.S. corporation that is not subject to federal income tax computes its state tax base. Under Crestron and Irving Pulp & Paper, Ltd. v. State Tax Assessor, the respective state tax bases of a corporation are directly tied to federal taxable income (as statutorily modified). Accordingly, these two cases support the position that in Maine and New Jersey a non- U.S. corporation that is not subject to the federal income tax does not have entire net income except to the extent that one of the statutory modifications apply.34 Consequently, a non‑U.S. corporation with no permanent establishment could be subject to tax in Maine or New Jersey but have little or no entire net income in its tax base, even if it derived United States source income.35
Limiting Exposure to State Taxes
Some business structures may limit the state tax exposure of a multinational business even when the corporation is subject to tax in a state. For example, conducting business in the United States as a separate legal entity rather than a division may limit a multinational corporation’s tax base in some states, including combined reporting states.
Operating as a Division or a Separate Entity
Operating as a separate legal entity in a state may limit the amount of a multinational corporation’s income that is subject to tax. For example, in Reuters Ltd. v. Tax Appeals Tribunal, the New York Court of Appeals addressed whether New York could subject to apportionment “the worldwide net income of a single multijurisdictional business enterprise” that operated through a branch office in New York.36 The Court of Appeals upheld the lower court’s ruling that the worldwide income of a non-U.S. corporation could be subject to apportionment without violating the Foreign Commerce Clause.37 The court also stressed that the unitary business principle allows taxation of an entity’s worldwide income if the income is derived from the taxpayer’s unitary business.38
Presumably, a company like the taxpayer in Reuters could limit its exposure to New York tax by operating as a separate legal entity in New York rather than as a branch or division. Under current New York tax law, a multinational business that conducts its United States operations in a separate legal entity would be taxable on only that entity’s income, in this case, the income from its United States operations. Furthermore, New York’s mandatory forced combination law would not apply to the worldwide income of affiliates formed outside of the United States because New York combined groups do not include “corporations that are formed under the laws of another country.”39
Division or Separate Entity Considerations In Unitary Combined Reporting States
A multinational business’ decision to segregate its United States operations into a separate entity rather than a branch or division may limit the business’ liability in unitary combined reporting states primarily because of water’s-edge combined reporting. Most, if not all, states that require combined reporting either require or permit a combined group of corporations to report income on a water’s-edge basis. To the extent that a multinational business conducts its worldwide activities in entities that are not part of the water’s-edge group, the taxpayer may limit its state tax exposure.
The mechanics of a water’s-edge filing vary state to state. The states’ definitions of a water’s-edge group vary and some states include in a water’sedge group more than just the income of entities that are organized under the laws of the United States. For example, a Massachusetts water’s-edge combined group includes unitary entities that are “incorporated in the United States or formed under U.S. laws, any state, the District of Columbia, or any U.S. territory or possession.”40 In some circumstances, the Massachusetts water’s-edge group also includes the income and apportionment factors of the following entities (assuming that the entities are unitary):
- Other entities regardless of the country of organization if the average of the entity’s property, payroll, and sales factors within the U.S. is 20% or more; and
- Any entity “that earns more than 20 per cent of its income, directly or indirectly, from intangible property or service-related activities” that are provided to other members of the combined group, “but only to the extent of that income and the apportionment factors related thereto.”41
Other states include the income of entities organized under the laws of “tax haven” countries in the water’s-edge combined group.42
Multinational businesses face unique state tax issues. In particular, differences in the laws regarding subjectivity to the federal income tax and subjectivity and nexus for state corporate tax purposes may result in a non-U.S. corporation being subject to a state corporate tax but not subject to the federal income tax. Whether a multinational corporation’s worldwide income is included in the tax base for state corporate tax purposes is a state-specific question. Furthermore, various business structures exist that may limit a multinational business’ exposure to state taxes.