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Tax Law

State Taxation of Foreign Source Income

by Robert Desiderio *

States undertake a myriad of approaches to tax foreign source income, primarily due to the diverse operations of the taxpayers. Non-U.S. corporations may own U.S. entities as separate subsidiary corporations or as branches of the foreign parent. A U.S. corporation may operate multi-nationally through locally incorporated subsidiaries located abroad. The domestic corporation's subsidiaries' earnings may be taxed when repatriated to the U.S. parent through a dividend distribution.

Although tax treaties entered into between the U.S. and foreign countries play a significant part in federal taxation, they generally do not play a large role in overriding state tax laws. U.S. constitutional principles do control the limits of a state's ability to tax foreign source income. The multistate taxation of the international operations of business entities has created an abundance of issues relating to the state taxation of foreign source income. The following Emerging Issues Analysis explores some of the elements that substantially impact the state taxation of domestic and foreign corporations with foreign source income.

Constitutional Provisions. When looking at limitations on state taxation, one of the foremost considerations is the Due Process Clause of the U.S. Constitution. The Due Process clause requires that, in order for a state tax to be sustainable with respect to foreign corporations, a definite link, or minimal connection, must exist between the state and the person, property, or transaction that the state seeks to tax. [U.S. Const. Amend. XIV, § 1 "... .nor shall any State deprive any person of life, liberty, or property, without due process of law ... ." See also, Quill Corp. v. North Dakota, 504 U.S. 298 (1992). 

Due Process prohibits a state from taxing income generated in interstate commerce, unless there is: (1) "a 'minimal connection' between the interstate activities and the taxing State," and (2) "a rational relationship between the income attributed to the state and the intrastate values of the enterprise."Exxon Corp. v. Dept. of Rev. of Wisconsin, 447 U.S. 207, 219-220 (1980); quoting Mobil Oil Corp. v. Comm. of Taxes, 445 U.S. 425,436-37 (1980).

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Treaty Considerations. The minimum standard for the imposition of a federal tax on foreign entities domiciled in countries with which an income tax treaty is in effect with the U.S. is higher than the requirements of the states, i.e., "engaging in trade or business" within the state. The federal counterpart requires the maintenance of a "permanent establishment" within the U.S. Where statutory provisions and the terms of a treaty conflict, the treaty controls. 11 A foreign entity may be engaged in U.S. business operations without maintaining a permanent establishment. [1996 U.S. Model Income Tax Treaty, Article 5.4.]

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Internal Revenue Code Provisions. Foreign corporations are subject to U.S. income tax on certain foreign source income if that income is "effectively connected" with a U.S. trade or business. [IRC §§ 864( c), 871(b), 882(a) & (b). There are exemptions for other foreign source income. See IRC §§ 872(a) & (b).] Jurisdiction to subject the foreign corporation to U.S. Income Tax may also derive from sourcing the corporation's income within the United States. The sourcing rules are the first step in determining whether the gross amount of "fixed or determinable annual or periodical income" paid to foreign persons is subject to U.S. Income Tax  [IRC § 881(a). The sourcing rules are found in IRC §§ 861, 862 & 865.] and are the initial measure to calculate income considered "effectively connected" with the conduct of a trade or business within the U.S. [IRC §§ 864 & 897.]

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Use of Special Entities.

 A dispute between the U.S. and the European Economic Community focused on whether the pre-1985 DISC system constituted an illegal export subsidy that violated the General Agreement on Tariffs and Trade (GATT). This led to the extinguishment of DISCs and the use of foreign sales corporations (FSC). An FSC was required to be organized under the laws of a foreign country or a U.S. possession and conform to certain arm's-length pricing standards mandated by GATT. [IRC §§ 921–927. Effective for transactions occurring after September 30, 2000, the FSC Repeal and Extraterritorial Income Exclusion Act of 2000, Pub. L. No. 106-519, terminated the specific IRC provisions governing the taxation of FSCs but extended transitional relief to existing FSCs.] Once again, this scheme was challenged by the World Trade Organization, which concluded that there was a violation of export subsidies as a result of the lower U.S. parent's effective tax rate on export sales. Effective October 1, 2000, the U.S. Congress responded to the WTO's conclusions by replacing the FSC provisions with another tax scheme known as "extraterritorial income exclusion" or ETI. [Extraterritorial Income Exclusion Act of 2000, P.L. 106-519. The WTO has also characterized the ETI to be an illegal export subsidy.] The ETI regime has also been declared by the WTO to be an illegal export subsidy and negotiations continue.

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* ROBERT J. DESIDERIO practices with Sanchez, Mowrer and Desiderio, P.C., Albuquerque, New Mexico, in the areas of tax law, tax-exempt organizations, and business and commercial transactions. He was dean of the University of New Mexico School of Law from 1979 to 1985 and from 1997 to 2003, and served as a professor of law for the school over several decades. He is currently Professor Emeritus at UNM, teaching State and Local Taxation, Tax-Exempt Organizations and Remedies.

Information referenced herein is provided for educational purposes only. For legal advice applicable to the facts of your particular situation, you should obtain the services of a qualified attorney licensed to practice law in your state.

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