Doing business across state lines or diving into the United States market from overseas can be a fruitful growth opportunity for many businesses. But navigating state tax regulations can mean wading through nexus rules (the ability to tax) that differ state to state. Many factors go into choosing which state to expand into. But selling a product in one state could mean significantly less state tax exposure than a neighboring state. So how do you decode the code? Knowing these four general rules that govern state nexus application is a good place to start.
Background: federal and state government tax structure
The United States is comprised of an overarching federal government and underlying state and local governments. These governments have overlapping tax systems. The federal government imposes nationwide federal income taxes, but there is no nationwide federal sales tax or value-added tax. Overlaid on these federal taxes are a myriad of state and local income and sales and use taxes. This means that the rules for state taxes, implemented by a state’s taxing agency, change from state to state, even though the federal government’s taxes, implemented by the Internal Revenue Service, follow the same rules across the country.
How should a company manage overlapping state taxes?
First, it is possible that many, if not all of these state taxes do not apply to you even if you are required to file a U.S. tax return such as Form 1120F. A business must have substantial nexus within a state to be subject to income, franchise, or gross receipts taxes in that state, or for the state to have the authority to compel the business to collect its sales taxes or pay its use taxes.
When does a company have nexus?
This is where things get interesting. As you might imagine, with more than 50 different state tax codes there is great variety in the standards of activity required before a state may legally tax a company. It is common for an activity to create nexus in one state but, because of a different state’s laws, not create nexus in another state for the same activity.
However, there are some general types of activities that create nexus in a state or local taxing jurisdiction.
Physical presence in a state will likely create nexus for income, franchise, gross receipts, sales, and use taxes. For example, the type of physical presence that creates nexus for income, franchise, gross receipts, sales and/or use tax purposes occurs when you have property in a state, employees permanently or temporarily visiting the state, or independent contractors permanently or temporarily in the state when they are acting on the company’s behalf.
Nexus for income, franchise, and gross receipts
In addition to physical presences, nexus for income, franchise, and gross receipts tax purposes may be created through economic presence (i.e., sales to in-state purchasers). States have defined this in many ways from whatever they can tax under the constitution to a threshold amount of property, payroll, or sales.
Some states are trying to assert that a substantial economic presence is sufficient enough for them to impose a sales tax collection responsibility over a company, but no court has yet upheld this position.
Permanent establishment and nexus
It is important to distinguish the concept of permanent establishment and nexus. Permanent establishment is a concept found in many income tax treaties and most European Union value-added tax systems. If a business has a permanent establishment in a treaty jurisdiction, this will often lead to income tax or value-added tax liability in that jurisdiction (“trade or business” is the analogous concept in nontreaty jurisdictions). Nexus has some similarities to the “trade or business” and “permanent establishment” concepts, but these concepts are not interchangeable.
Many companies doing business in the United States would like to use permanent establishment as a nexus defense. While there is overlap between permanent establishment and nexus, a lack of permanent establishment is not an effective defense to the nexus arguments raised by U.S. states. For example, since 1998, Pennsylvania law has asserted that its income tax regime does not respect U.S. tax treaties with foreign nations, on the grounds that those treaties are between the foreign nation and the U.S. federal government rather than with the state’s government.1
With that foundation in mind, here are four ways, but by no means all the ways, that states impose tax on companies with no physical presence in their states.
1. Economic nexus can subject a company to tax — even with no physical presence
Some states have adopted rules mandating that nexus is created (for taxes other than sales and use taxes) by having a sufficient economic presence in the state. This “economic nexus” concept has not been adopted by all states, and its parameters vary widely even among states that do adopt it.
For example, in 2015, if a non-U.S. company sells $536,446 (indexed) of product to customers in California, that company will have nexus in California for purpose of the state’s income and franchise tax even if the company has no physical connection to the state of California.2
In addition, for international transactions, the federal protections companies can rely on for domestic transactions, do not apply in California. 3
Sales made in a state that has adopted this type of standard would create nexus for the seller in that state even though it lacks a physical presence there.
Some states with economic nexus rules have not specified a bright-line threshold amount of property, payroll, or sales that must be exceeded to create nexus. Instead, these states broadly assert that any entity that is “doing business” in these states has nexus.
In practice, nexus is less certain in these states if the amount of sales is less than the bright-line amounts adopted by other states. Even where sales to these states may exceed the amount commonly used by states with a bright-line standard (such as $500,000), the impact must be carefully evaluated.
2. “Click-through” nexus can subject a company with no physical presence to sales tax collection obligations
The legal concept that allows states to enact “click-through” and other similar nexus rules is called affiliate nexus. Broadly, this is the idea that even though a company may not have a physical presence of its own in a state (such as having employees or maintaining inventory or other property in a state), the company should be subject to tax because of the in-state actions of the “affiliate” of the company.
More or less, states are arguing that it is fair to tax companies that sell in a state and benefit from the state’s legal system, while attempting to avoid taxation simply by using an affiliate to physically conduct its in-state business. Note that for these purposes, the term “affiliate” does not necessarily require companies to be commonly owned; merely working together in specified ways is sufficient, according to the state.
“Click-through” nexus is a tangible example of affiliate nexus. The classic example has three items: first, an online influencer (e.g., an individual) residing in a given state; second, a company that hires the influencer to pitch the company’s product through his or her internet audience. This could include activities such as blogging about the product, taking pictures of it and distributing them through social media, and posting links to a website where customers can purchase the product. The third item is a contract between the company and the influencer. Contracts can be written or unwritten, but a contract, in which money exchanges hands, gives an auditor excellent evidence to build a case for nexus.
These online influencers can simply be thought of as the modern-day version of independent sales representatives — their effectiveness in generating sales for out-of-state businesses is just as strong — even though they operate on a website instead of going door-to-door.
For example, if a company has agreements with Georgia residents that refer potential customers through the internet and the cumulative gross receipts from sales by the company to customers in Georgia referred by the Georgia resident exceed $50,000, then the company has nexus.4
These laws are often known as “Amazon Laws” by virtue of being created in response to well-publicized efforts of states to make the online giant Amazon collect state sales taxes. As a result, click-through nexus is generally a response to the rise of internet retailers that sell into states without maintaining a physical presence in the state. Using click-through nexus laws, international and domestic companies with no physical connection to the taxing state must collect sales tax if they have an affiliate in the taxing state (whether or not commonly owned with that company) that refers potential customers via an internet link. By the close of 2016, approximately 20 states have enacted click-through nexus standards.
3. Contract sales reps can create nexus for sales tax and income tax
Another tangible example of affiliate nexus is how states have written their laws in such a way that contract sales reps can create nexus for sales tax and even income tax. Essentially, some states’ laws will subject a company to sales tax with no physical presence of their own in a state, if the company has an affiliate operating on its behalf in a state and the relationship between the affiliate and the company creates an agency relationship.
For example, if an independent contractor makes sales inside Florida, and has only one company that he or she works for, this relationship creates nexus in Florida. The company that has contracted with the independent contractor is “doing business” in Florida and subject to income and sales tax nexus.5
4. Independent contractors can subject a company to tax even with no physical presence
The actions of third party (independent) contractors can also create nexus for international companies who hire them. For example, in Texas, hiring a contractor to provide warranty work, repair, or installation creates nexus in the state for the company that paid the contractor.6 One or multiple activities in this list create nexus in some states:
- Collecting delinquent accounts
- Contracting for fulfillment services
- Using a third party to investigate credit worthiness
- Installing, providing warranty repairs, and repossessing property
Unfortunately, the nexus-creating effect of each of these activities varies from state to state. Each state must be individually addressed in the context of a company’s business operations to evaluate the nexus-creating potential of this type of activity.
How we can help
Because each state has a great deal of flexibility in writing its own tax laws, state tax laws vary broadly across the country. Moreover, each company’s specific facts could provide exemptions from taxes, and that creates tax planning opportunities. We can help your business enter the U.S. market, answer your nexus questions for state and local taxes, address uncertain tax exposure, or assist in interacting with state taxing authorities.
- 1 See, e.g., 72 Pa. Cons. Stat. § 10003.11
- 2 Cal. Rev. & Tax. Cd. § 23101(b)(2)
- 3Appeal of Dresser Industries, Cal. St. Bd. Of Equalization (June 28, 1982) and FTB Chief Counsel Ruling 2012-03 (Aug. 28, 2012).
- 4 Ga. Code Ann. § 48-8-2(8)(H); Ga. Code Ann. § 48-8-2(8)(M); Ga. Code Ann. § 48-8-30(b)(1)
- 5 Fla. Admin. Code Ann. § 12C-1.011(1)(k)
- 6 Tex. Admin. Code 34 § 3.586(c)(5); Tex. Admin. Code 34 § 3.586(c)(16)