Unexpected State Tax IssuesInternational Companies Must Consider

by Mike Goral and Tatyana Lirtsman

Once a state has asserted that nexus is present and re-quires a state income tax filing, a taxpayer must then deter-mine how to compute the income tax owed to the state. Formost states, the starting point would be to determine howmuch revenue should be sourced to the taxing state.

I. Sourcing of IncomeSourcing rules are the foundation of both international

and domestic tax systems. The principle used to formulatesource rules is that income should be sourced in the countrythat provides governmental services and protections used toderive the income.1 Based on an economic nexus betweenthe income and a particular country, that policy is usuallycarried out by associating income with a geographic source.2

In the international arena, tax treaties require a perma-nent establishment threshold before the source country canimpose a tax. However, foreign companies conducting busi-ness in the United States without forming a PE may be

surprised to learn that income can be included in a state’sunitary combined income tax return, regardless of the pro-tections supported by a U.S. tax treaty.3 As a result, thesourcing rules are a product of balancing complex sets ofconflicting principles, concerns, and claims as they apply toparticular income types.4

No U.S. state tries to measure intrastate profits of multi-state enterprises by requiring separate accounting.5 Instead,states use some variety of a formula to distribute U.S. profitsto the state. Historically, the formula is based on the fractionof U.S. assets, sales, and payroll that is located or carried outwithin the state. No country applies a similar formula tocalculate taxes or formulate the profits of a multinationalenterprise that is based on a domestic-source formula.6Instead, all other countries use variations of a method basedon separate accounting and review practices between relatedcorporations.7

In 2002 the European Commission recommended thataffiliated countries use formula apportionment techniquesto tax multinational companies.8 That deviation from stan-dard separate accounting methods to a transfer pricingapproach was an attempt to reduce the costs and biasesassociated with auditing transfer prices.9 However, switch-ing to a formula apportionment system affects the after-taxprofits of multinationals and the tax revenue paid by domes-tic and foreign firms.10 As a result, most countries useseparate accounting methods to source income to theirjurisdictions.

1Fred B. Brown, ‘‘An Equity-Based, Multilateral Approach forSourcing Income Among Nations,’’ 11 Fla. Tax Rev. 565, 574 (2011).

2Id.

3Scott D. Smith, ‘‘Spotlight on SALT: The Global Reach of StateUnitary Tax Regimes,’’ Lorman.com newsletter (2010).

4Brown, supra note 1.5Douglas Shackelford and Joel Slemrod, ‘‘The Revenue Conse-

quences of Using Formula Apportionment to Calculate U.S. andForeign-Source Income: A Firm-Level Analysis,’’ Int’l Tax and Pub.Fin. 41-59 (1998).

6Id.7Id.8Thomas A. Gresik, ‘‘Formula Apportionment vs. Separate Ac-

counting: A Private Information Perspective,’’ 54 Eur. Econ. Rev.133-149 (Jan. 2010).

9Id.10Id.

Tatyana Lirtsman

Mike Goral

Mike Goral is partner-in-charge ofWeaver LLP’s state and local tax ser-vices, while Tatyana Lirtsman is a se-nior associate II in the SALT practiceat Weaver.

The second installment of a two-part series that discusses issues non-U.S. foreign corporations face whendealing with state taxing authorities,this article addresses income tax com-pliance matters such as sourcing in-come to the taxing state and how in-come should be apportioned. Part oneaddressed states’ authority to imposestate income or franchise taxes on for-eign corporations.

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II. Apportionment of Income

The Uniform Division of Income for Tax Purposes Act,approved in July 1957 and adopted by more than 20 states,was designed to promote uniformity among states.11 Itincorporated what was essentially the existing practice in1957 in numerous states: an equally weighted, three-factorformula of property, payroll, and sales. UDITPA also dis-tinguished income as either business income, which is ap-portioned using the formula, or nonbusiness income, whichis allocated in total to a particular state.

In 1967 the Multistate Tax Compact was created byincorporating UDITPA as its centerpiece. Established toimprove the fairness, efficiency, and effectiveness of state taxsystems, the compact applied to interstate and internationalcommerce. It also played an important role in preservingstate tax sovereignty.

Based on the UDITPA and compact principles, somestates follow an equally weighted, three-factor apportion-ment formula to calculate the percentage of a corporation’stotal taxable income to be allocated to the taxing state.Other states give greater weight to sales activity than prop-erty and payroll. Today, single-sales-factor apportionment isthe trend among states.

For multinational companies, that lack of uniformityamong states increases the difficulty and related administra-tive expense of complying with state tax laws. That can alsoexpose corporate organizations to a wide range of tax liabili-ties and result in an effective tax greater than 100 percent oftheir net income at one level, to net income that completelyescapes state-level taxation at the other level. The potentialcombination of a state asserting a tax return filing require-ment based merely on a foreign corporation having a spe-cific level of sales in a state — along with single-sales-factorapportionment and U.S. treaties not binding the state —could result in substantial state income tax liability for someforeign companies.

III. Reporting

Formula apportionment is used by most states to taxforeign companies, but the states use substantially diversefactors to calculate apportionment. Common factors in-clude property, payroll, and sales, but those are not uni-formly defined by the states. Some states start with federaltaxable income and then make adjustments to determinethe apportionable tax base, but other state formulas begin

with gross income. That lack of starting point consistencyfurther complicates administering state tax returns.12

There are significant differences in how states determinethe tax base. Most states use federal taxable income as thestarting point to determine state income tax liability. Withso much attention being paid to companies moving theirheadquarters to a foreign country in a tax inversion plan, itis possible that many states will decouple from the federaltaxable income figure as a starting point. Similar to howstates decoupled from the federal treatment of bonus depre-ciation, some states will find that if the federal tax liability isreduced through a tax inversion, they may be forced tochange their starting point to something other than federaltaxable income.

Some states require an addback of a foreign corporation’sincome that is otherwise exempt from federal tax, whereasother states may require federal taxable income to be calcu-lated on a pro forma basis as if a treaty did not apply.

However, a pro forma return may not resolve state issues.Alabama, for example, is among the few states that permit adeduction for federal taxes paid. If only a pro forma federalreturn is prepared, would a taxpayer still get that deductioneven if no federal return is actually filed?

In contrast, New Jersey requires an addback of most taxesimposed on corporations, including federal taxes paid oraccrued. Again, if a federal tax return is not actually filed,would New Jersey still require a foreign taxpayer to add backfederal taxes imputed on a pro forma federal tax return?13

Other states use different methods to impose other busi-ness taxes in lieu of a corporate income tax.14 Washingtonimposes the business and occupancy tax15 and Ohio im-poses the commercial activities tax,16 both of which aremeasured on gross receipts. Texas imposes a margin tax17

measured by gross receipts less one of three deductions, anduntil December 31, 2007, Michigan imposed the singlebusiness tax,18 which has been described as a VA T.19 Finally,

11As of August 1, the following states had adopted UDITPA:Alabama, Alaska, Arizona, Arkansas, California, Colorado, District ofColumbia, Hawaii, Idaho, Kansas, Kentucky, Maine, Michigan, Min-nesota, Missouri, Montana, New Mexico, North Dakota, Oregon,Pennsylvania, South Dakota, Texas, Utah, and Washington.

12See Committee on Interstate Commerce of the New York StateBar Association, ‘‘Congress and the Taxation of MultijurisdictionalCorporations,’’ Tax Notes, Nov. 7, 1983, p. 451.

13See Ross Fogg Fuel Oil Co. v. Dir. Div. of Taxation, 22 N.J. Tax 372(2005).

14Supra note 12 (almost every state other than Nevada, NorthDakota, and Wyoming imposes a tax on corporations).

15See Wash. Rev. Code section 82.04.010 et seq.16See Ohio Rev. Code Ann. section 5751.01 et seq.17See generally Texas Tax Code section 171.0001 et seq.; see also

Texas Tax Code sections 171.0001, 171.1014; Texas Admin. Codesection 3.587.

18Reynolds Metal Co. LLC v. Dep’t of Treasury, No. 300001 (Mich.Ct. App. Mar. 20, 2012) (unpublished opinion not precedentiallybinding).

19See generally, Michigan Treasury Department, ‘‘What Is theSingle Business Tax?’’available at http://www.michigan.gov/taxes/0,1607,7-238-43533-154440--.00.html.

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states such as Louisiana20 and North Carolina21 imposenet-worth-based franchise taxes in addition to their corpo-rate income taxes.

IV. Reporting MethodsAnother complication for foreign corporations is that

states do not uniformly define how a company or group ofcompanies should be included on the state tax return. Statestraditionally have used one of three reporting methods:separate company, unitary combined, and consolidated.

1. Separate Company MethodEach taxable entity is treated as a stand-alone taxpayer

and files its own tax as a separate taxpayer. Each corpora-tion’s tie with a particular state is determined based on itsactivities independent of other related companies’ activities.The corporation’s income is separately computed and thenreported to the state based on the proportion of the corpo-ration’s in-state activities. Separate company filing methodstates include Delaware and Pennsylvania.

In general, consolidated or combined filing is not al-lowed in a state that uses the separate company method.However, as with many state tax issues, a rule may change.Some traditionally separate company filing states — includ-ing Massachusetts, Michigan, New York,22 Texas, Vermont,and West Virginia — have moved away from it and noweither require combined filing or allow a combined taxreturn filing.

2. Unitary Combined MethodCompanies with a similar ownership structure, central-

ized management, functional integration, economies ofscale, and common departments providing services to theother members of a commonly owned group are oftenconsidered to be members of a unitary group. Under aunitary combined reporting method, there is a disregard forseparate legal entities. In general, under combined report-ing, the taxpayer multiplies the total group’s income by anapportionment percentage that is based on factors (usuallyproperty, payroll, and sales — or sometimes just sales) as afraction, with the numerator including in-state factors andthe denominator including those factors everywhere. Thatraises another issue when determining what the total de-nominator should include: total U.S. factors or total world-wide factors?

3. Unitary Combined Water’s-Edge ElectionThat question has led some states to allow taxpayers to

make a water’s-edge election. Under that filing method, all

members of the unitary group that are incorporated outsidethe United States and conduct most of their business outsidethe United States are excluded from the unitary combinedreturn.

In California, qualified taxpayers can make a water’s-edge election on a timely filed original return, but thatelection is an 84-month commitment that cannot bechanged during that period.23 Historically, a Californiawater’s-edge election was essentially a contractual arrange-ment between the taxpayer and the state. For tax yearsbeginning on or after January 1, 2003, the contract form hasbeen converted into a statutory election.24

What will surprise many foreign taxpayers is that accord-ing to California law, a water’s-edge combined report in-cludes a foreign corporation’s income to the extent of itseffectively connected income, as defined by IRC section971, simply because California does not recognize provi-sions of U.S. tax treaties. California includes any incomefrom a controlled foreign corporation to the extent itssubpart F income exceeds its earnings and profits in theCalifornia water’s-edge combined income tax return.25 Therisk exists that a single entity’s presence or a single salesfactor in a U.S. state such as California could bring theincome of a global group of affiliated entities within thetaxing power of a U.S. state.26 Federal authorities haveacknowledged that risk. As far back as the Carter adminis-tration, the U.S. Treasury Department has said that theconflict between states’ worldwide combination and appor-tionment practices — along with rules applied by the U.S.and international practices — could have serious implica-tions.27

The debates continue between corporate officials and thestates. Corporations generally oppose worldwide combinedreporting, arguing that it is an unconstitutional impositionof state taxes on foreign-source income, it undermines for-eign commerce, it increases the risk of international doubletaxation, and it creates substantial administrative burdens.28

However, states maintain that worldwide combined report-ing does not constitute taxation of foreign-source income,

20See La. Rev. Stat. Ann. section 47:601 et seq.21N.C. Gen. Stat. section 105-114 et seq.22See, e.g., Matter of Infosys Technologies Ltd., DTA No. 820669,

N.Y. Div. of Tax Appeals, ALJ Unit (Feb. 15, 2007); N.Y. Tax Lawsection 208.9; N.Y.C.R.R., Tit. 20, section 3-2.3(a)(9); New YorkState Dept. of Tax and Finance, ‘‘Combined Reporting for GeneralBusiness Corporations,’’ TSB-M-07(6)C (June 25, 2007).

23See, e.g., RTC section 25110(a)(2), RTC section 25110(a)(1)(B),CCR section 25110(d)(2)(B)(1).

24See Franchise Tax Board Notice 2004-2, ‘‘Implementation ofNew Water’s-Edge Election Statute’’ (May 3, 2004).

25Joel Walters et al., ‘‘Multistate US Tax Issues for Inbound Com-panies: Part I,’’ Intl. Tax Rev. (Aug. 7, 2013). See also California FTB,‘‘Water’s-Edge Combined Report’’ (2006).

26Walters et al., supra note 25.27See Advisory Commission on Intergovernmental Relations,

‘‘State Taxation of Multinational Corporations,’’ Tax Notes, Mar. 21,1983, p. 995 (discussing how water’s-edge rules conflict with proce-dures used in states that adopt a unitary apportionment approach).

28Comptroller General, Report to the Chairman, House Commit-tee on Ways and Means, ‘‘Key Issues Affecting State Taxation ofMultijurisdictional Corporate Income Need Resolving,’’ ii, iii, 31(1982).

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but simply calculates an individual state’s share of a multi-national corporation’s total income using the factors thatcontributed most of the earned income.29

4. Consolidated MethodSome states permit or require a consolidated return fil-

ing. Although rules differ, most states allow a consolidatedfiling if the parent corporation owns 80 percent of the totalstock value and 80 percent of the total voting power in atleast one of the affiliated companies. Unlike the unitarycombined method, most states base their requirements tofile a consolidated return on an ownership test rather thanthe unitary factors required under a unitary filing. Othercompanies in the combined group can be owned by eitherthe parent or a subsidiary as long as the ownership totalobtains the 80 percent threshold. Consolidated filing mayalso be allowed or required when separate filing doesn’t fullyreflect a company’s income or activities. Moreover, a statemay require a consolidated return when members of theconsolidated group all have nexus with the state.

States that use consolidated return filings include Okla-homa, Kansas, and Florida.30 In general, when a taxpayerfiles a consolidated return, each corporation must calculateits state taxable income separately on its own factors and

then combine the separate taxable income figures for onetotal income on which the tax will be computed. If anelection is made, it is usually irrevocable for all future taxyears unless the group cannot file a consolidated federal taxreturn or the state taxing authority releases the affiliatedgroup of corporations from the election.

Finally, some states require a federal consolidated returnfiling in order to file a consolidated state return. If a federalreturn is not actually filed because a pro forma return isprepared, could a non-U.S. corporate taxpayer file a stateconsolidated return?

V. ConclusionState tax systems’ lack of uniformity can be confusing,

disruptive, and expensive. Non-U.S. companies that con-duct limited business activities in the United States may beprotected from federal income tax liability because of for-eign tax treaties. Those companies, however, may haveenough nexus to allow states to impose their taxing jurisdic-tion over them and require them to file state income taxreturns. Any international company planning to do businessin the United States should consider the state tax conse-quences. State income tax rules are complex for domesticcompanies, but they can be particularly difficult for foreigncompanies to comprehend. Therefore, caution is advised forforeign corporations conducting any business in the UnitedStates. That especially holds true for U.S. companies con-templating the use of a tax inversion to reduce federal taxliabilities, which may result in an unintended increase instate tax liabilities. ✰

29Id. at 33-36.30See, e.g., Okla. Stat. 68 section 2367 et seq.; Okla. Admin. Code

710:50-17-31; Kan. Stat. Ann. section 79-32,142(a); Kan. Admin.Reg. section 92-12-52; Fla. Stat. section 220.131; Fla. Admin. CodeAnn. section 12C-1.0131.

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