Mary Bernard
Mary Bernard
Foreign Corporations and Nexus Issues

Could a foreign corporation have no nexus for federal purposes but have state tax nexus?

February 26, 2009
by Mary Bernard, CPA/MST

The United States has income tax treaties with over 60 countries. These treaties normally include provisions for determining nexus for federal income tax purposes. Most treaties require the foreign corporation to maintain a "permanent establishment" in the United States before their business profits would be subject to federal income tax.

Federal Nexus Standard

A "permanent establishment" is generally a fixed place of business, like a sales office or the presence of employees who regularly exercise an authority to conclude contracts within the United States that are binding on the foreign corporation. Certain activities, however, are specifically excluded from the definition of a permanent establishment, such as: (1) using facilities solely for storing, displaying or delivering inventory belonging to the taxpayer; (2) maintaining inventory belonging to the taxpayer for the purpose of storage, display or delivery or processing by another enterprise; and (3) maintaining a fixed place of business for the purpose of purchasing goods or collecting information for the taxpayer or any other activity of an auxiliary nature. These activities are not construed to comprise a permanent establishment in the US for purposes of federal income tax.

The concept of a permanent establishment, however, has been evolving into a more complex nature. The concept is currently being expanded to include computer server locations. When the Internal Revenue Service addressed the issue of Web sites in a Treasury Technical Explanation in 2005, the determination was made that a Web site did not constitute tangible property and was therefore not considered a place of business. On the other hand, a server on which the site is stored is a piece of equipment having a physical location and may constitute a "fixed place of business" of the enterprise that operates the server.

State Income Tax Nexus

Generally, state income tax nexus is established when an out-of-state entity, including an entity organized in another country, purposefully directs its activities at the state and has some type of nontrivial physical presence within the state that is not protected by Public Law 86-272. (This federal law generally prevents a state from taxing an out-of-state entity whose only activity in the state is the solicitation of sales of tangible personal property, with orders to be approved and shipped from outside the state.) The permanent establishment provisions of most treaties are not binding for state nexus purposes because income tax treaties do not apply to state taxes. Once the permanent establishment provision of tax treaties is eliminated from the nexus requirement, foreign entities are much more likely to establish nexus for state tax purposes, while avoiding nexus for federal purposes.

When you consider the specific exclusions in the definition of a permanent establishment, any of those activities may likely constitute nexus for state income tax purposes. Owning property in a public warehouse is sufficient physical presence to constitute nexus in almost every state that has an income tax. If you include the states that have corporate taxes based on non-income measures, states like Ohio, Michigan, Washington and Texas, the bar is even lower to establish nexus. The mere solicitation of sales could create nexus in these states due to the fact that Public Law 86-272 protection only applies to taxes based on income. Likewise, foreign entities could become exposed to franchise, business privilege and capital stock tax liabilities in several states, even though they are not subject to federal income taxes in this country.

With the current trend towards expanding nexus to encompass any economic gain derived from activities within a state, nexus can be triggered even without any physical presence within the state lines. This approach used currently in more than a few states can create a significant challenge to a foreign entity operating within the U.S. Deriving "substantial economic gain from the Massachusetts market through a sophisticated marketing campaign that targeted Massachusetts customers" was substantial nexus for Massachusetts excise tax. (Capital One Bank and Capital One F.S.B. v. Commissioner of Revenue [Nos. C262391, C262598 (Mass. App. Tax Bd., June 22, 2007)]. New Jersey and West Virginia previously concluded that a "significant economic presence" was sufficient to establish nexus for income tax purposes.


It is becoming more of a challenge for a foreign entity to conduct business in the U.S. without a thorough review of the nuances of all 50 states. With the imposition of income taxes, gross receipts taxes, franchise taxes, business privilege taxes, capital stock taxes and margin taxes, it is impossible to find any two states operating under identical rules. Once foreign entities are exposed to tax in unitary or combined states, the problems multiply exponentially.

As this country has over 8,800 taxing jurisdictions, when you include state and local taxing authorities, the task of compliance can be monumental, once sales taxes are thrown into the mix.

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Mary F. Bernard, CPA, MST is a Tax Principal and Director of State and Local TaxServices at Kahn, Litwin, Renza & Co., Ltd. in Providence, RI.