The U.S. consumer marketplace is the largest and the richest in the world.
Therefore, most foreign businesses desire to take advantage of the U.S. consumer market. But before doing so they should understand the unique U.S. tax system. Every State in the U.S. and the Federal Government, have the authority to subject any business (domestic or foreign) to State taxation. This authority supersedes U.S. income tax treaties and can be enforced without the business having an actual presence in a particular State.
The mere fact of selling goods or taxable services, even if solely by way of the internet can subject a foreign business to State and Local taxation.
For more information, contact us to speak with a skilled international, state and local tax expert, subscribe to our newsletter, and check our blog regularly for informative articles from IWTA’s Founder, Jack Brister.
State and Local Taxation Overview
The most significant tax implications to doing business in the U.S. as a foreign business is the potential State and Local taxes imposed under each State law, not Federal taxes. State and Local tax liabilities for doing business (selling goods or services) in the U.S. can be significant if not properly planned and structured. In order to sell goods or services in a State, a business (domestic or foreign), must register with each State’s taxing authority and potentially with each State’s Department of State / Division of Corporations to ensure they have the State’s authorization.
Without a State’s authorization to do business in their state there can be significant penalties and potential personal liability of the business owners for certain taxes.
Generally, there are two types of State taxes: income (individual and corporate) and excise taxes. Excise taxes are generally broken down into the broad categories of sales tax, hospitality taxes and other excise taxes. It should be noted that excise taxes usually carry personal liability of the owners. This means, regardless of the structure created to do business in the U.S., the ultimate beneficial owners (domestic or foreign) of the business structure can be held personally liable for uncollected excise taxes.
Excise taxes also include consumption taxes such as sales tax. A State sales tax is similar to a foreign VAT (Value Added Tax) or GST (Goods & Services Tax). There are 46 States that impose a sales tax and of those states the sales tax is anywhere from 22 to 64 percent of a State’s total revenue. That is a large budget item! On the other hand, State corporate Income taxes are a very small budget item. Most state’s total revenue is less than 10 percent from corporate income tax (generally known as Franchise Tax).
State and Local Sales Tax
Sales tax, like foreign VAT or GST tax, is imposed on the consumer (purchaser of the goods or taxable services) but the business selling the goods or services must collect the tax on behalf of the State and Local governments. As mentioned before, excise or consumption taxes such as Sales Tax carries personal liability. If a business (foreign or domestic) does not collect the appropriate Sales Tax, the business and the owners of the business are responsible to pay the tax.
You ask, how is it that a State can impose such liability on a business, especially a foreign business with no presence in a State? The explanation is simple: There was a recent (June 2018) U.S. Supreme Court ruling, (the supreme law of the land) Case of South Dakota v. Wayfair that allows each State to require collection and remittance of Sales Tax for the mere selling of taxable goods and services that exceed a small threshold. This is called Economic Nexus (an economic connection). In other words, the U.S. Supreme Court stated that so long as a business (domestic or foreign) has derived a certain level of revenue by way of selling the goods or taxable services to consumers within a State, the State has the right to impose the collection and remittance of Sales Tax on the business selling goods or taxable services within their State.
Almost all states have enacted a law which states that “sufficient economic connection” is when a business (foreign or domestic) has made 100 sales within their state or $100,000 of sales within their state regardless of the number of sales. A handful of states have a lower threshold, and a few has a higher threshold.
If you think about it, the threshold is very low. It does not take much for a business (domestic or foreign) to be subject to the collection and remittance of a State’s sale tax.
How is State sales tax to be reported and submitted to a State? Each state will require their own sales tax return for reporting and submission of the tax, and depending on the level of sales within a State, a return may be required monthly. Yes, this means multiple monthly sales tax returns may be required – depending on the level of sales and which States you are deemed to be doing business.
State and Local Corporate Income Tax
As mentioned before, a State also has the ability under the U.S. Constitution to impose an income tax on businesses doing business in their state. Unlike sales tax, business income tax is imposed on the business, not the business’ customers. The nexus requirements are different from the sales tax requirements. Pursuant to Public Law 86-272, most states require a presence within the state to impose a corporate income tax, also known as a Franchise tax. The exception to the presence rule is the sale of services. It should also be noted that there are a few states that impose a type of income tax which is based on the gross revenue instead of net revenue.
The States that generally impose a tax on gross revenue are Delaware, Nevada, Ohio, Texas and Washington; and there are no minimum presence requirements to be required for a business to be subject to paying this tax. It should be further noted that the states of Oregon, Louisiana, Oklahoma and West Virginia have proposed legislation to enact a gross revenue tax.
Because of the above noted case Wayfair case, which allows states to consider a business’s Economic Connection rather than their physical presence in a State (employees, office, inventory, etc.), and the fact that gross revenue taxes are not subject to the U.S. Constitution, some other states have discussed a gross revenue tax.
U.S. Federal Income Tax and the Branch Profits Tax
The U.S. Federal government by way of the U.S. Internal Revenue Service does impose and collect an income tax. Federal income tax is separate, and in addition to the State Corporate Income / Franchise Tax on the net revenue of a domestic and foreign entity doing business in the U.S. The Federal Tax law does not have a bright line test like many states, but a substance-over-form approach (i.e., facts and circumstances) as to what constitutes doing business. However, it can be said that if a business is treated as doing business in a State, they will be deemed to be doing business in the U.S. for federal income tax purposes.
To ensure that foreign corporations do not have an advantage over domestic businesses by way of reduced taxes, a foreign business operating in the U.S. without a U.S. corporate entity will be subject to the federal Branch Profits Tax. The Branch Profits Tax imposes a system of double taxation for both domestic and foreign corporations. First, corporations’ profits are subject to a corporate level income tax and secondly, the individual shareholder level are taxed upon receipt of corporate profits in the form of a dividend. Note: what constitutes a dividend under U.S. rules is very different that what is a dividend under most foreign jurisdiction’s rules.
Additionally, at the Federal and State tax level businesses are subject to complex transfer pricing rules. This means that without proper justification, a foreign business cannot do business in the U.S. and simply shift profits to a lower tax jurisdiction by way of a management fee or other arrangement which treats the payment or distribution of funds to the parent company as an expense.
Generally, a foreign business must be able to prove by way of a transfer pricing study or other means that inter-company transactions by the U.S. branch and the foreign branch are like transactions between unrelated parties.
Single Member U.S. Limited Liability Companies
Under U.S. tax law, single member limited liability companies (SMLLC) are disregarded for tax purposes though they maintain their legal protective aspects. Because SMLLCs are disregarded for U.S. tax purposes the owners (called members) of the business will be subject to U.S. tax if the owner is doing business in the U.S.
It should also be noted that even if the foreign owner is not doing business in the U.S. there are generally filing reporting requirements for a SMLLC owned by a foreign person or entity even though there is no U.S. source income.
U.S. Estate and Gift Tax and Inheritance Tax for Non-U.S. Citizens
You may ask: “What does Doing Business in the U.S. have to do with the U.S. Estate tax rules”? If a foreign person does business in the U.S. by method of a U.S. business structure, (which is generally the preferred method of doing business in the U.S.) and they die while having an ownership interest in a U.S. business, they will be subject to U.S. estate tax on the fair value of the business interest. But if that same person gives away an interest in said business as an estate tax planning mechanism, the gift is not subject to gift tax and may not be subject to estate tax if gifted to person or to a Trust. Whom to give it to, person or Trust, will depend on many factors. Strategies should be discussed with appropriate U.S. tax counsel before making the gift to determine which method will be the most tax efficient.
As you can see, the U.S. tax system is very complex and almost all taxes interact with each other. Hence, planning for the right structure to do business in the U.S. is paramount! For a more in-depth analysis and strategy on doing business in the U.S., book a consultation with IWTA Founder Jack Brister.
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