1/ PERMANENT ESTABLISHMENT
The contrasting of Permanent Establishment versus Nexus Standard is a very important subject of US International Tax to understand because, it will not only determine if a corporation is subject US Federal and/or State tax, but also how to manage expansion of a foreign corporation to the United States.
The United States use a bilateral structure to tax the income of a ‘Foreign Corporation’ that is, in this case, a corporation which is formed in accordance with the laws of a country foreign to the US. (Internal Revenue Code Sec. 7701(a)) If the foreign corporation has Permanent Establishment in the United States, the resulting net income effectively connected with that U.S.trade or business is taxed at the customary graduated rates. (Internal Revenue Code Sec. 882) Also, the gross amount of a foreign corporation’s U.S.-Source income such as dividend, interest, royalty and other investment-type income commonly referred to as Fixed Determinable Annual and Periodic Income is subject to a flat-rate of 30%(IRS Pub. 515 Table 1).
In this introduction, many technical words were referred to and turn out to be paramount in understanding one’s tax exposure in America. So let’s clarify one of them and talk about Permanent Establishment.
The words PERMANENT ESTABLISHMENT are supremely important in the world of inbound US international taxation and that is because, in effect, a foreign corporation’s business profits are subject to U.S.taxation if the foreign corporation is ‘engaged in trade or business within the United States’.
But here is the problem; neither the Code nor the Regulations provide a comprehensive definition of the term trade or business. Sec. 864(b) of the Internal Revenue Code of the United States, the most authoritative Tax document in US Tax Law, presents that a U.S. trade or business includes ‘the performance of personal services within the United States’ but does not include the trading of stocks, securities, or commodities, if such trades are either made through an independent agent, or made for the taxpayer’s own account (unless the taxpayer is a dealer such as Goldman Sachs for example). In fact, these exceptions do not apply if the foreign corporation has an office in the United States through which the trades are made.
Many Case laws propose that a foreign corporation is engaged in a U.S. trade or business if its employees are engaged in considerable, continuous, and regular business activity within the United States. Also, if a partnership, estate, or trust is engaged in a U.S.trade or business, then each partner or beneficiary is measured to be engaged in a U.S.trade or business. (Code Sec 875)
Now that we’ve discussed what were the implications of Permanent Establishment at the US FEDERAL level, can we assume that the rules are the same at the US STATE level?
The answer’s is most generally NO.
Treaty permanent establishment provisions are not biding for state nexus purposes, because income tax treaties generally apply only to selected types of federal taxes. As a consequence, it is often true for a foreign corporation to have nexus for state tax purposes but not for federal income tax purposes.
2/ STATE NEXUS STANDARDS
In contrast to the FEDERAL nexus standards of engaging in trade or business within the United States, STATE income tax nexus standards generally require only a physical presence within the state of a type that is not protected by Public Law 86-272 (more on Public Law 86-272 insoon to be published blog) in addition to physical presence, since states have adopted the theory of either type of nexus:
- economic nexus
- agency nexus, and
- affiliate nexus.
For example, under the theory of economic nexus, an in-state physical presence is not an absolute precondition for income tax nexus. Instead, a significant economic presence, such as licensing intangibles or making substantial sales in the state, is sufficient to create state income tax nexus.
So should a foreign corporation leases a warehouse space in a state solely for the purpose of storing and delivering its merchandise to U.S. customers so the physical presence of company-owned inventory would generally create STATE income tax nexus, but not necessarily federal income tax nexus, because the mere storage of inventory does not constitute a permanent establishment..
States generally attempt to impose their taxes on out-of-state corporations to the fullest extent permissible under federal tax law. A state has jurisdiction to tax a corporation organized in another state only if the out-of-state corporation’s contacts with the state are sufficient to create nexus. Historically, states have asserted that virtually any type of in-state business activity creates nexus for an out-of-state corporation. This approach reflects the reality that, it is politically more attractive to collect taxes from out-of-state corporations than to raise taxes on in-state business interests.
The desire of state lawmakers and tax officials to, in effect, export the local tax weight is counterbalanced by the Due Process Clause and Commerce Clause of the US Constitution. They both limit a state’s ability to impose a tax obligation on an out-of-state corporation.
3/ Audio Blog
One of the most noteworthy source of International Tax exposure occurs when carrying on business outside of an entity’s country of residence through permanent establishment and Nexus.
The audio blog below covers U.S. Tax exposure by Permanent Establishment and Nexus by describing federal nexus basics of a permanent establishment, clarifying the physical presence test for state tax nexus, and identifying protection from state income tax nexus afforded by Public Law 86-272.
Please do not hesitate in emailing should you have any question on the subject.
Best regards,
Chaz.
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