state tax notes™ Considering a Tax Inversion? Beware of State Tax Issues by Mike Goral and Tatyana Lirtsman Mike Goral is partner-in-charge and Tatyana Lirtsman is a senior associate II in the state and local tax practice at Weaver.
Mike Goral
In the first part of a two-part series that addresses issues non-U.S. foreign corporations face when dealing with state taxing authorities, the authors discuss states’ authority to impose state income or franchise taxes on foreign corporations. In the second part, they will address income tax compliance matters such as sourcing of income to the taxing state, how income should be apportioned, and other compliance matters.
Tatyana Lirtsman
Many non-U.S. companies conduct limited business activities in the United States and may be protected from federal income tax liabilities because of a foreign tax treaty. However, contrary to conventional wisdom, many states do not adhere to those treaties. As a result, some foreign companies have enough nexus with a state to allow the state to impose their taxing jurisdiction over foreign corporations and require the foreign company to file state income tax returns. This is particularly important because of the significant media attention to U.S. companies’ implementation of ‘‘tax inversion’’ strategies. As a result of those tax inversions, the federal tax savings could be mitigated in those types of transactions by unintended state tax liabilities. Further, states that have paid little attention to that area of tax law may step up enforcement, modify their taxing methods, or take other action if tax inversions start to make significant changes to their coffers. As Fortune 500 companies — which constitute a significant percentage of the state and local tax base — implement tax inversion plans, one can’t help thinking that states will not just take this lightly without a fight. Many states may further decouple from federal tax policies to preserve revenue from their largest taxpayers.
State Tax Notes, October 6, 2014
I. International and Federal Tax Limitations The tax must not create an unconstitutional risk of international multiple taxations and the tax must not impede the U.S. government’s ability to ‘‘Speak with One Voice’’ when regulating commercial relations with other nations.1 The U.S. Internal Revenue Service uses a two-prong system to tax the income of a foreign corporation. Under Internal Revenue Code section 882(a)(1), a foreign corporation is subject to U.S. federal tax if it is engaged in a U.S. trade or business and it generates income effectively connected within the United States. Once those two provisions are met, the IRS can technically assert its taxing authority on a foreign corporation and a U.S. federal tax return is required to be completed. However, the devil is in the details. Although case law suggests that a foreign corporation is engaged in a U.S. trade or business if its employees are engaged in considerable, continuous, and regular business activities within the United States, neither the IRC nor regulations provide a precise definition of a trade or business.2 Also, it is possible in some cases that dividends, interest, royalties, and other passive income paid by a foreign corporation will be treated as U.S.-source income — which may subject its foreign shareholders to federal income tax.3 If the United States has a tax treaty with the foreign corporation’s home country, the corporation must also meet the definition of a permanent establishment in the United States before the IRS can assert its taxing powers against the foreign corporation. The PE provisions in those treaties typically act as both a threshold of taxation of business profits in the taxing jurisdiction and a limitation on source of income that a country can tax a foreign corporation. In general, tax treaties that the United States enters into with foreign governments define a
1
Japan Line Ltd. v. County of Los Angeles, 441 U.S. 434 (1979). IRC section 864(b). 3 IRC section 861(a)(2)(B). 2
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