ARTICLE | November 17, 2025

Why California Plays by Its Own Rules: Understanding How State Income Taxation Differs from Federal Law for Foreign Businesses

Foreign companies entering the U.S. market often assume federal tax treaties and sourcing rules apply uniformly across states. In California, they don’t. The state operates under its own tax code, doesn’t recognize most federal treaties, and applies distinct rules for determining income sourced to California that run counter to federal tax rules for sourcing of income. For multinational enterprises, this can mean unexpected filing obligations, double taxation risks, and compliance challenges even if federal nexus thresholds aren’t met.

The California Conundrum: Federal vs. State Tax Systems

Foreign businesses expanding into the U.S. typically structure their tax exposure around federal law and international treaties. These set expectations around permanent establishment, transfer pricing, and income sourcing. However, the California tax system often disregards those federal norms.

California’s tax system is independent from the federal government. It conforms to parts of the Internal Revenue Code but deviates in key areas that matter to international taxpayers. These deviations affect:

• When a foreign company is considered to be “doing business” in California (nexus)
• Whether treaty protections apply (they generally do not)
• Determination of California basis taxable income or loss
• How income is sourced and apportioned for state tax purposes

Nexus: California’s Expansive Definition of “Doing Business”

At the federal level, a foreign entity is taxed only if it has a permanent establishment (PE) in the U.S. under a tax treaty. California, however, has no such limitation.

Under California Revenue & Taxation Code Section 23101, a company is considered “doing business” in the state if it:

• Is actively engaging in any transaction for financial gain in California, or
• Exceeds certain economic thresholds: roughly $711,000 in California sales, $71,000 in property, or $71,000 in payroll (2024 figures, indexed annually)

This means a foreign business can have California nexus even without a U.S. office, employees, or physical assets—if, for example, it sells or provides services (even remotely) into California markets or licenses intangibles used in the state.

Case example: A Canadian architectural services corporation doing computer aided design solely in Canada provides architectural services remotely to California customers. Even if it lacks a U.S. subsidiary or presence, it may meet the economic nexus threshold and be required to file a California return – even if there is absolutely no need to file a US federal income tax return.

No Treaty Recognition: Where California Breaks from Federal Norms

One of the most significant differences between California and the federal government is that California does not recognize U.S. income tax treaties. This includes treaties designed to prevent double taxation of income.

At the federal level, treaties can exempt foreign entities from U.S. tax if they lack a “permanent establishment” (an office, place of management, or other place where physical conduct of business occurs) in the US. California, however, ignores those treaties entirely. In practice, this means:

• Foreign companies protected federally may still owe California income tax.
• Treaty-based positions taken on federal returns have no effect at the state level.
• Foreign tax credits or exemptions available federally may not reduce California liability.

Example:
A Canadian manufacturing firm has extensive sales to US customers including California state customers, but the manufacturer has no PE under the U.S.–Canada tax treaty and is able to avoid US federal tax income tax imposition. Yet if the manufacturer’s California sales exceed economic thresholds, the FTB may assert California nexus and impose tax regardless of the presence of any federal treaty.

Foreign taxpayers with US activities should always evaluate state income tax exposure independent of US federal income tax exposure.  Additionally, if a foreign parent corporation and a US subsidiary share mind and management and the foreign parent corporation itself has significant economic presence in the US, California may consider both companies “unitary” and require a combined state income tax filing for both.

California State Nonconformity to Federal Rules in Determining Net Income Subject to Tax

California does not conform to several key federal tax provisions that feed into the computation of net income that is subject to tax at the state level.  This can mean, for example, that a Canadian corporation (or a US subsidiary of a Canadian corporation) with nexus in California can have a California state net taxable income that is significantly different than federal taxable income.  Significant differences can be found in depreciation methods, interest expense deductibility, and research and experimentation cost deductibility, for example.  California also does not permit foreign tax credits for taxes imposed by foreign countries. To make matters worse, certain large cities in California might even have their own separate local income tax structures for businesses operating there.

Looking Ahead: Policy Trends and Global Context

California’s stance on foreign taxation reflects a broader trend toward state-level independence in U.S. tax policy. As states seek to capture revenue from the digital economy, economic nexus and market-based sourcing are becoming the norm nationwide.

However, this trend also complicates global tax coordination. Foreign businesses accustomed to treaty-based protection face a fragmented U.S. system where each state acts as its own taxing authority.  This approach to taxation makes the US (and its individual states) unique in relation to other economically developed countries.

Final Takeaway

California’s tax rules for foreign businesses are not an afterthought—they’re a separate system entirely. Foreign companies expanding into the U.S. must analyze state exposure independently of federal law. The key is understanding how nexus, treaty non-recognition, computation of taxable income, and sourcing rules interact to create obligations that are often invisible at first glance.

For companies expanding into the US or trying to establish a market in the US, California serves as a case study in why state-level tax analysis is essential to international strategy.