First published in the Spring 2017 edition of Partnering Perspectives.

Foreign corporations should keep a watchful eye on the attempts of states, largely through legislative action, to expand their so-called “water’s-edge” tax base. Traditionally, mandatory worldwide combined reporting was the state corporate tax issue of most concern to entities engaged in international business. Under worldwide combined reporting, a substantial amount (perhaps all) of the activities of non-US corporations were drawn into a state’s tax computational compliance scheme. Indeed, decades ago, the Supreme Court of the United States in Container1 and Barclays2 upheld the ability of states to require worldwide combined reporting, potentially forcing a taxpayer to include the income and activities of all of its “unitary” companies throughout the world in its state tax return.

Worldwide political pressure, however, subsequently resulted in states moving toward a water’s-edge unitary combination method for both US and foreign-based companies. As a consequence, with a limited exception found in one state (Alaska), no state currently forces a taxpayer to use a worldwide combined reporting method. Except for Montana, there have been no recent legislative efforts to return to mandatory worldwide combined reporting.

Instead, foreign corporations should now keep a watchful eye on the attempts of states, largely through legislative action, to expand their so-called “water’s-edge” tax base through various means. This article discusses four such trends.

Expanding Nexus

Income tax treaties between nations typically limit taxation to those jurisdictions in which a company maintains a “permanent establishment.” However, in general, no current income tax treaty to which the US is a party applies to subnational taxes, i.e., to state corporate income taxes. Accordingly, the permanent establishment analysis typically does not apply to a state’s jurisdiction to tax a non-US corporation.

The jurisdiction to tax at the state level involves a two-part analysis. First, one must look at the law of a particular state to discern its nexus standard under its state statutory and administrative law. If a corporation cannot be taxed under a state’s own law, the inquiry is over. The second and overriding analysis is whether a state claiming jurisdiction to tax has the ability to tax a corporation under the Due Process and Commerce Clauses of the United States Constitution. 

Both of those clauses pose separate limits on a state’s ability to tax, with the Commerce Clause requiring substantial nexus with a state in order to tax. Twice the Supreme Court of the United States has held that, in the context of a use tax, physical presence is required to satisfy this substantial nexus requirement. With respect to corporate income taxes, a split exists in state court decisions between those courts that hold that federal Constitutional standards (specifically the Commerce Clause) require a physical presence to create nexus for corporation income tax purposes and those courts that hold only an economic (non-physical) presence is required.

Against a background of inactivity by the Supreme Court, the growing trend has been to adopt by state legislation a “factor presence” standard for nexus under which physical presence is not required in order for a state to tax a foreign corporation. More than 20 years ago, in 1992, the Multistate Tax Commission (MTC) approved a model Factor Presence Nexus Standard for Business Activity Taxes. Under the MTC model, substantial nexus for a business activity tax enacted by a state is established if any of the following thresholds for activity within a state is exceeded during the tax period: (a) a dollar amount of $50,000 of property; (b) a dollar amount of $50,000 of payroll; (c) a dollar amount of $500,000 of sales; or (d) 25% of total property, total payroll or total sales.

While not all states that adopted a factor presence standard use the precise MTC model, the MTC model certainly appears to have been the impetus for a large number of states to move in the same general direction. Examples of the current law in two major states—California and New York—illustrate this trend.

In 2011, California expanded its statutory definition of “doing business” to provide that nexus exists if a taxpayer’s sales in California exceed the lesser of $500,000 or 25% of the taxpayer’s total sales, regardless of physical presence. In 2015, New York expanded the nexus standard for the New York franchise tax so that corporations with sales of $1 million or more to New York customers during the taxable year are subject to the New York franchise tax, regardless of physical presence.

The concern here is obvious with respect to expanded nexus. A foreign corporation with no physical presence in a state, that is selling into the state, generating licensing or royalty income from the state, or performing services in the state (or even performing services outside of the state where the benefit from those services is received in the state) may find it has a state filing requirement and potential tax liability, regardless of federal treaty protection. This potential is magnified when the trend toward a factor presence test is combined with the trend toward using market sourcing of intangibles.

Approximately two dozen states have adopted market sourcing rules for sales of “other” than tangible personal property, with many of those legislative changes taking place within the past several years. For example, under such rules, receipts from the licensing of intangibles are typically assigned to the state in which the intangible is used, with the use determination typically based on the location of the customer. Thus, under a typical state factor presence standard, a non-US corporation with more than $500,000 of licensing revenue from a customer in a particular state would be taxable in that state, even with no physical presence.

Expanding Transfer Pricing

A number of states have enacted statutory provisions comparable to Internal Revenue Code section 482, giving the state the broad discretionary authority to distribute, apportion, or allocate income, deductions, credits, etc., between businesses, typically in order to “prevent tax evasion” or to “clearly reflect income.” Federal transfer pricing under section 482 is governed by extensive Internal Revenue Service regulations, and states that have statutorily adopted transfer pricing authority, either by enacting their own statute or by adopting section 482, typically piggyback onto those federal regulations.

While transfer pricing statutes per se are not a recent development at the state level, the trend to watch here is the potential growth of transfer pricing activity by states as a result of the MTC’s proposed multistate transfer pricing audit program, also referred to as the Arm’s-Length Adjustment Service (ALAS) Advisory Group. In February 2015, the MTC invited states to join together “in a new cooperative effort to reduce corporate income tax avoidance” through participation in the program. The MTC sought to have states jointly design an Arm’s-Length Adjustment Service in order to pool their resources to “more effectively, efficiently and equitably” address this challenge.

In October 2015, the ALAS Advisory Group met with representatives of a number of economic analysis firms in anticipation of using such firms to assist the participating states with economic analysis, training and even audit selection. To date, only five states (i.e., less than the minimum threshold of seven) have agreed to participate: Alabama, Iowa, New Jersey, North Carolina, and Pennsylvania.

The concern here is that states increasingly will attempt to make adjustments with respect to transactions across the water’s-edge. Where expanding nexus adds “taxpayers” to the water’s-edge group, transfer pricing adjustments no longer respect the geographical limits of the water’s-edge group and instead recast transactions. While federal transfer pricing adjustments are, to some extent, constrained by treaty terms and processes such as Competent Authority, such constraints do not apply to the states.

To further complicate the issue, there is no consensus among states regarding whether the results of a transfer pricing audit by the Internal Revenue Service under section 482 will be honored by a state. For example, California law provides that even a detailed audit by the Internal Revenue Service creates only a presumption that those results will be applied for California corporate tax purposes in water’s-edge audits.

Tax Haven Legislation

Another significant trend among the states is the adoption of so-called tax haven legislation as a means of taxing additional foreign source income by including it in the tax base of even a water’s-edge group. Recent legislative activity on this subject has occurred in states such as Colorado, Connecticut, Maine, Massachusetts, Minnesota, New Hampshire, Oregon, and Rhode Island. Such legislation expands the scope of the state corporate tax base to include income earned by a foreign corporation in a country that the state, by legislative action, has defined as a tax haven jurisdiction.

While the term “tax haven” often had been legislatively defined by the states to incorporate the definition used by the Organisation for Economic Co-operation and Development (OECD), the current trend seems to be away from such a blacklist approach in favor of a criteria/factor-based approach.

The obvious concern here is a creeping legislative expansion of the water’s-edge group. Obviously, a water’s-edge group that is redefined to include more and more foreign operations becomes less and less water’s-edge and more akin to mandatory worldwide combined reporting with its panoply of inherent problems. Developments such as the recent release of the so-called Panama Papers may result in increased concerns at the state level regarding operations in foreign jurisdictions and may create more tax policy-driven impetus for this type of legislation. On the other hand, “[t]he legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted.”3

Frequently, these legislative attempts to expand the water’s-edge group involve foreign countries with major economies that are major trading partners with the United States. For example, Ireland, the Netherlands, Switzerland, and Hong Kong have been under consideration at times by various states as potential additions to the water’s-edge group under tax haven legislation.

Expansive Taxation of Foreign Income

Whether and to what extent foreign income is included in a state’s corporation income tax base is often largely a function of what companies and operations are included in that particular state’s water’s-edge group. However, a number of special situations may arise.

While tax treaties generally do not apply to subnational taxes, there are situations in which income exempt from federal income tax by treaty is not taxable by a state. As a general proposition, the starting point for a state’s taxation is the corporation’s federal taxable income. Subject to treaty protection, a foreign corporation is generally taxed on all income that is effectively connected with the conduct of a trade or business in the United States. Internal Revenue Code section 894 and its related regulations, however, provide that income is not included in gross income to the extent required by any income tax convention to which the United States is a party.

If a state’s starting point is federal taxable income, and what otherwise would be a foreign corporation’s federal taxable income is reduced or eliminated by treaty protection through section 894 (or the corporation has no effectively connected income), then the excluded income will not be taxable at the state level.

Other states have statutory add-back provisions. For example, California law provides that any income satisfying the Internal Revenue Code’s definition of effectively connected income that is excluded from federal taxable income due to a tax treaty is included, i.e., added back, for California purposes. As another example, New York requires all corporate taxpayers to include all income, including effectively connected income, from sources outside of the United States that was not included in computing federal taxable income without regard to treaty protections.

Foreign dividend income also presents unique issues. Many states allow a subtraction or deduction for foreign dividends that match the dividends received deduction the state would allow for dividends received from domestic companies. This position is largely the result of the decision of the Supreme Court of the United States in Kraft, 4 which held that Iowa’s tax scheme violated the Commerce Clause by discriminating against foreign commerce by allowing a dividends received deduction for dividends paid from domestic, but not from foreign, subsidiaries. Some states that generally do not follow the federal dividends received deduction rules do not allow such a deduction for foreign dividends. To the extent that foreign dividends are taxed, there is also the issue of whether some factor representation is required.

To the extent the dividends are received from a company, even a foreign-based one, whose income is included in the tax base for state tax purposes, there is typically a full (intercompany) dividend elimination.


While the battles over the states’ use of mandatory worldwide combined reporting appear to be over, disputes over how socalled water’s-edge systems are applied inevitably will continue. Continuing issues include the definition of the water’s-edge group (including factual unity issues); composition of the group (i.e., tax havens); defining who is a taxpayer in the group (i.e., nexus); cross-border transactions (i.e., transfer pricing); and the includible foreign income base.