“Considering a Tax Inversion? Beware of State Tax Issues, Part I”

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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II. U.S. Constitutional Limitations Differences between state and national rules for taxing multinational corporations have always been a potential source of conflict in the federal system. However, in recent years, the problems that can result when each state and the national government apply different rules for taxing income arising from international commerce have been accorded increasing prominence due to court decisions, state legislative actions, deliberations on international tax treaties, and proposed national legislation.5 The national interest in state and local taxation of interstate and foreign commerce has historically been limited to four essential U.S. constitutional clauses6: • the supremacy clause — to ensure that there is no conflict between state and federal law; • the commerce clause — to ensure that excessive state taxation does not impede the free flow of commerce among the states;7 • the due process clause of the 14th Amendment — to ensure a guarantee of fair procedure;8 and • the foreign commerce clause — to ensure that states do not infringe upon the authority of the nation to regulate commerce with foreign nations.9

III. Supremacy Clause While the U.S. federal system grants extensive rights to states’ taxing authority, those rights have limitations. A serious conflict can exist if a foreign company cannot simultaneously comply with U.S. federal and state law. The supremacy clause10 provides that the Constitution, federal laws, and U.S. tax treaties negotiated with the United States are superior to all state laws. As a result, when state and federal law conflict, federal law will prevail in almost all cases.

In Missouri v. Holland, 252 U.S. 416 (1920), the U.S. Supreme Court ruled that the federal government’s power to enforce treaties overrode the states’ authority to voice concerns regarding the violation of their rights as prescribed to them from the 10th Amendment. A duly executed treaty is the supreme law of the land, and state and local laws must yield to its provisions.11 Treaties are binding upon the States under the Supremacy Clause of the Constitution. The federal government, however, is responsible for ensuring treaty compliance. If each of the fifty states reinterpreted our diplomatic treaty obligations, the goal of treaty compliance would be elusive. Each of the States would then be conducting its own foreign policy and as a result, at odds with the Constitution, and potentially chaotic.

The federal government is also responsible for treaty interpretation. The United States Supreme Court has recognized that ‘‘although not conclusive, the meaning attributed to treaty provisions by the Government agencies charged with their negotiation and enforcement is entitled to great weight.’’ Sumitomo Shop, Inc. v. Avagliano, (457 US 176, 184-85 (1982)).12 IV. Commerce and Foreign Commerce Clauses In application, many states do not adhere to tax treaties that are negotiated and upheld by the federal government.

The only real criteria that a state taxation system must obey are any tax-related laws passed by Congress — and even then the laws must be consistent with the Constitution.

Although Congress has not exercised its power to a large extent under the dormant commerce clause, the Supreme Court has often done so in determining whether specific state taxing systems violate or infringe the clause. The commerce clause remains the most important and controversial federal limitation on state and local taxation.13 In the

4

See, e.g., U.S. Model Treaty (2006), Art. 5, ‘‘Permanent Establishment’’; U.S. Technical Explanation Accompanying the U.S. Model Income Tax Convention of Nov. 15, 2006.

5 Advisory Commission on Intergovernmental Relations, ‘‘State Taxation of Multinational Corporations,’’ Tax Notes, Mar. 21, 1983, p.

995.

6 Id. 7 Id. 8 Id. 9 Id.

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10

The supremacy clause may be found in Art. VI, section 2 of the U.S. Constitution.

11 Mark Johnson, U.S. Department of State, ‘‘Diplomatic and Consular Tax Exemption Under the Vienna Conventions on Diplomatic and Consular Relations’’ (2001).

12 Id. 13 William Joel Kolarik II, ‘‘Untangling Substantial Nexus,’’ 64 Tax Law. 851 (2011).

State Tax Notes, October 6, 2014

(C) Tax Analysts 2014. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

PE using a two-prong test. Many tax treaties use the PE standards used in the OECD model, which provides two PE thresholds4: • the foreign corporation maintains a fixed place of business through which the business of an enterprise is wholly or partly carried on its business activity; or • the activities of a designated person who maintains a fixed place of business are imputed to the foreign corporation.

The application of those standards provides for a higher threshold of contact or nexus before the IRS can tax a foreign corporation doing business in the United States.

Similar to the manner that U.S. P.L. 86-272 acts as a safe harbor against state income tax nexus, the PE standards act as a higher threshold that must be met by foreign corporations that do business in the United States and offer a safe harbor from U.S. federal taxation.

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V. Due Process In Quill,18 the Court — for the first time — distinguished between ‘‘economic presence’’ nexus for due process clause purposes and ‘‘substantial physical presence’’ nexus for the commerce clause nexus.19 The distinction is important because the Court stated that the due process clause

requires ‘‘some definite link,’’ some ‘‘minimum contact’’ between the state and the object of taxation.20 Therefore, the nexus requirement under a due process clause standard can be satisfied even when the corporation has no physical presence in the taxing state as long as the corporation purposefully avails itself to the state’s economic market and, as a result, had fair warning that its activity may subject the company to the state’s taxing jurisdiction.21 VI. P.L. 86-272 To provide multistate corporations with a limited safe harbor from the imposition of state income taxes, Congress enacted P.L. 86-272 on September 14, 1959.22 The law prohibits a state from imposing a net income tax on a foreign corporation if the corporation’s only state activity is the solicitation of orders for tangible personal property, if the orders are approved and filled outside the state. As a result, it provides no protection against the imposition of sales tax collection obligations, gross receipts taxes, or state franchise taxes imposed on a tax base other than income.

Interestingly enough, that law is silent about foreign corporations organized under the law of foreign nations.

VII. Economic Presence Nexus Recent state income tax cases have held that an economic presence nexus standard could be established and would be sufficient to create income tax nexus based on the presence of intangible property in a state. Licensing intangible property for use in a state is sufficient exploitation of the state’s market to satisfy the substantial nexus requirements of Complete Auto Transit.

As a continuing progression of state income tax nexus standards, some states have started to implement a brightline rule of physical presence. The bright-line factorpresence nexus was first recommended by the Multistate Tax Commission on October 17, 2002, and was intended to represent a simple, certain, and equitable standard for the collection of state business activity taxes.23 Under the model statute, a taxpayer has substantial nexus and will be subject to corporate income taxes with a state if any of the following thresholds are exceeded during the tax year: $500,000 of sales, $50,000 of payroll, or 25 percent of total property, payroll, or sales. Commercial domicile is also required in some states.24

14

Philip M. Zinn, ‘‘The Requirements of ‘Substantial Nexus’ and ‘Fairly Related’ Under the Commerce Clause,’’ St. & Loc. Tax Law. 59 (2007).

15 Id. 16 Christina R. Edson, ‘‘Quill’s Constitutional Jurisprudence and Tax Nexus Standards in an Age of Electronic Commerce,’’ 49 Tax Law. 893 (1996).

17 Supra note 13.

18 Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

19 ‘‘Report of the Task Force on Business Activity Taxes and Nexus of the ABA Section of Taxation State and Local Taxes Committee,’’ 62 Tax Law. 935 (Summer 2009).

State Tax Notes, October 6, 2014

20

International Shoe Co. v. Washington, 326 U.S. 310 (1945).

Id. at 308.

22 P.L. 86-272 (1959), codified at 15 U.S.C. sections 381-384.

23 MTC, ‘‘Factor Presence Nexus Standard for Business Activity Taxes,’’ 1 (approved Oct. 17, 2002), reprinted in Policy Statement 02-02: ‘‘Ensuring the Equity, Integrity and Viability of State Income Tax Systems,’’ (amended Oct. 17, 2002).

24 See, e.g., Cal. Rev. & Tax. Code section 23101; Mich. Comp.

Laws section 206.621(1); Ohio Rev. Code Ann. section 5751.01; Wash. Rev. Code Ann. section 82.04.067.

21

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state and local tax field, no other clause of — or silence within — the Constitution has as much significance as the commerce clause.14 It yields the fundamental limitations on state taxing power with which tax professionals grapple with daily such as nexus, discrimination, and fair apportionment — to name a few.15 To collect or impose taxes on out-of-state businesses, the state first must show a nexus between the business activities and the state. A corporation’s nexus with a state determines whether the due process and interstate commerce concerns are satisfied.16 Complete Auto Transit Inc. v. Brady provided a four-prong test to determine whether a state and local tax regime creates an undue burden on interstate commerce.17 To withstand commerce clause scrutiny and pass constitutional muster for a domestic commerce clause, a state tax must: • apply to an activity with a substantial nexus within the taxing state; • be fairly apportioned; • not discriminate against commerce; and • be fairly related to the services provided by the state.

Also, the Supreme Court in Japan Line Ltd. v. County of Los Angeles applied an additional two-part foreign commerce clause requirement that must also be met when a tax is imposed on international commerce: • the tax may not create a risk of multiple taxation; and • the tax may not prevent the federal government from speaking with one voice when regulating commercial relations with foreign governments.

Note that none of the above criteria puts a limitation on any state from imposing a state income tax on a non-U.S. foreign corporation if the tests in Complete Auto Transit and Japan Line Ltd. are met. In essence, corporations, whether they are from another state or a foreign country, can be taxed similarly as long as the criteria above have been met by the state.

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25 Ada Ko, ‘‘A National Sales Tax After Quill? A Proposal for State and Local Taxation of the Sales of Goods and Services on the Internet,’’ State Tax Notes, July 5, 1999, p. 53.

26 See supra note 19.

27 Id. at 192.

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nexus exists sufficient for a state to impose its income or franchise tax on any foreign corporation even in the absence of any other presence in the state. Thus, many out-of-state companies may be surprised to find that they are subject to tax under a strict bright-line nexus standard.

VIII. Conclusion Any international company planning to do business in the United States should consider the state tax consequences of any business enterprise operating in the country. State income tax rules are complex for domestic companies but can be particularly difficult for foreign companies to comprehend.

Many foreign companies rely on international treaties, believing that a duly executed treaty is the supreme law of the land. However, states have more power to impose a state tax on a foreign corporation than one would initially think is possible. As demonstrated through an analysis progressing through international, federal, U.S. constitutional, and state cases and principles, foreign companies doing limited business in the United States are at risk of state taxation. Ironically, it seems possible that a state can impose a state-level tax on a foreign non-U.S. corporation in some situations when the U.S. federal government cannot. ✰

State Tax Notes, October 6, 2014

(C) Tax Analysts 2014. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

Also, the Internet has eliminated the geographic limitations that once played a significant role in commerce.25 The Internet Tax Freedom Act (ITFA) was signed on October 21, 1998. ITFA was designed to establish a national policy against state and local interference with interstate commerce over the Internet or interactive computer services. Section 1101(a) of ITFA imposed a three-year state and local tax moratorium that was extended in 2001, 2004, and finally in 2007 until November 1, 2014. ITFA stated that the Internet should be free of foreign tariffs, trade barriers, and other restrictions, and any new federal taxes.26 The act, however, does not protect a remote vendor from an assertion of economic nexus standard for tax payment obligation — such as for business activity taxes — even if the sellers’ or service providers’ only contact with the state is the accessibility of its website from within the taxing state.27 The danger with a bright-line physical presence nexus standard is that once a given financial threshold is reached,