ARTICLE | February 21, 2024

A common oversight made by foreign businesses expanding their sales or operations into the USA is the failure to consider the various state taxes that might apply.

Every state is like its own country regarding tax rules; a foreign business should never assume that one state is similar to another, and even though a foreign business may be exempt from federal income tax, it can still be subject to various taxes at the state level.

Several key state tax considerations for foreign corporations that want to do business in the US include the following:

Foreign corporations may be subject to state income taxes, franchise taxes, gross receipts taxes, net worth taxes, sales and use taxes, and other state and local taxes, depending on their activities and presence in each state.

Most states have both an income tax and a sales tax, but certain states have only one or the other. Most states do not impose sales taxes on services, but certain states do. Sales taxes generally give the highest tax exposure to the foreign business if the rules aren’t complied with, due to the following:

1. The tax is based on gross sales revenue, with no (or limited) deductions to offset the tax liability
2. The tax was supposed to be collected from the buyer at time of sale, and if it wasn’t, it can become the liability of the seller
3. Unlike state income tax, there is no dilution for apportionment of net income (see below) in determining the net income the state could tax

Foreign corporations may have to determine their state tax “nexus,” which is the level of connection or activity that triggers a state tax obligation.

Nexus rules vary by state and by type of tax, and may be based on physical presence, economic presence, “bright-line” tests of revenue/payroll/property in the state, or other factors. Certain states (WA and NJ, for example), have low revenue thresholds that, once exceeded from customers or clients in these states, can wrap the foreign business into state tax filing and payment obligations. Note that these nexus tests typically determine what states the company will file and have tax obligations in (rather than the sole consideration of the state of incorporation if the foreign business installs a subsidiary in the US).

Foreign corporations may have to apportion their income among the states where they have nexus, using different formulas and factors depending on the state and the type of tax.

Some states may even require the inclusion of foreign affiliates in a particular state’s computation of state taxable income and revenue apportionment. Apportionment generally determines how much of a company’s net income a state has a right to tax, primarily relating substantially to the sourcing of revenue by state. Even the rules relating to sourcing of income to a particular state can vary amongst the states, depending on whether the business renders services or ships products, and can be far different than federal tax sourcing of income treatment.

Foreign corporations may be eligible for certain tax credits, deductions or exemptions that reduce their state tax liability, depending on the state and the type of tax.

However, some states may not conform to the federal tax treatment of certain deduction items, causing a different state profit on which tax is based compared to taxable profit computed under the federal tax rules.

There is a long-standing federal law regarding interstate commerce that generally prevents a state from imposing a net income-based tax on out-of-state corporations that are selling tangible products into the state and the only connection the corporation has with or within the state is mere solicitation of sales.

However, several states (including California) do not extend this protection to foreign, non-US corporations, and some states are starting to impose further limitations on this protection based on the types of interaction a website allows the company to engage with in-state customers.

Certain states may allow a foreign corporation to take advantage of a federal income tax treaty to exempt state taxable income from state net income taxes, but many states (including California) do not allow recognition of federal tax treaties.

It is also important to consider whether the foreign country will permit foreign tax credits on the residence country income tax return for any US state income taxes imposed.

These are just some aspects of state taxation that foreign corporations in the US should consider prior to expansion into the US. If the company has already been doing business in the US and has missed state tax obligations, it may be possible to become compliant based on state voluntary disclosure/catchup programs with mitigation of penalties. Disregard of state tax rules can cause serious trouble down the road if a state makes an inquiry of the business (typically with a nexus questionnaire) prior to the business becoming compliant first, in which case penalty relief may be off the table. During a future sale of the business, the due-diligence process undertaken by a buyer may also uncover deficiencies in state tax compliance, which could cause issues with the purchase-sale transaction.

In summary, each state has its own tax laws and regulations, which may change frequently and differ from the federal tax rules. The specific tax implications for a foreign corporation will depend on its unique activities, structure, and locations within the US. Consulting with a qualified tax professional specializing in state and international tax matters is highly recommended to ensure compliance and optimize your tax position, before engaging in business activities in the US.