Winter 2016 | Partnering Perspectives
Both of those clauses pose separate limits on a state’s ability to
tax, with the Commerce Clause requiring substantial nexus with
a state in order to tax. Twice the Supreme Court of the United
States has held that, in the context of a use tax, physical
presence is required to satisfy this substantial nexus requirement.
With respect to corporate income taxes, a split exists in state
court decisions between those courts that hold that federal
Constitutional standards (specifically the Commerce Clause)
require a physical presence to create nexus for corporation
income tax purposes and those courts that hold only an
economic (non-physical) presence is required.
Against a background of inactivity by the Supreme Court, the
growing trend has been to adopt by state legislation a “factor
presence” standard for nexus under which physical presence
is not required in order for a state to tax a foreign corporation.
More than 20 years ago, in 1992, the Multistate Tax Commission
(MTC) approved a model Factor Presence Nexus Standard for
Business Activity Taxes. Under the MTC model, substantial nexus
for a business activity tax enacted by a state is established if any
of the following thresholds for activity within a state is exceeded
during the tax period: (a) a dollar amount of $50,000 of
property; (b) a dollar amount of $50,000 of payroll; (c) a dollar
amount of $500,000 of sales; or (d) 25% of total property, total
payroll or total sales.
While not all states that adopted a factor presence standard use
the precise MTC model, the MTC model certainly appears to
have been the impetus for a large number of states to move in
the same general direction. Examples of the current law in two
major states—California and New York—illustrate this trend.
In 2011, California expanded its statutory definition of “doing
business” to provide that nexus exists if a taxpayer’s sales in
California exceed the lesser of $500,000 or 25% of the taxpayer’s
total sales, regardless of physical presence. In 2015, New York
expanded the nexus standard for the New York franchise tax so
that corporations with sales of $1 million or more to New York
customers during the taxable year are subject to the New York
franchise tax, regardless of physical presence.
The concern here is obvious with respect to expanded nexus.
A foreign corporation with no physical presence in a state, that
is selling into the state, generating licensing or royalty income
from the state, or performing services in the state (or even
performing services outside of the state where the benefit from
those services is received in the state) may find it has a state
filing requirement and potential tax liability, regardless of federal
treaty protection. This potential is magnified when the trend
toward a factor presence test is combined with the trend
toward using market sourcing of intangibles.
Approximately two dozen states have adopted market sourcing
rules for sales of “other” than tangible personal property, with
many of those legislative changes taking place within the past
several years. For example, under such rules, receipts from the
licensing of intangibles are typically assigned to the state in
which the intangible is used, with the use determination
typically based on the location of the customer. Thus, under a
typical state factor presence standard, a non-US corporation
with more than $500,000 of licensing revenue from a customer
in a particular state would be taxable in that state, even with no
Expanding Transfer Pricing
A number of states have enacted statutory provisions comparable
to Internal Revenue Code section 482, giving the state the broad
discretionary authority to distribute, apportion, or allocate
income, deductions, credits, etc., between businesses, typically
in order to “prevent tax evasion” or to “clearly reflect income.”
Federal transfer pricing under section 482 is governed by
extensive Internal Revenue Service regulations, and states that
have statutorily adopted transfer pricing authority, either by
enacting their own statute or by adopting section 482,
typically piggyback onto those federal regulations.
While transfer pricing statutes per se are not a recent
development at the state level, the trend to watch here is the
potential growth of transfer pricing activity by states as a result
of the MTC’s proposed multistate transfer pricing audit program,
also referred to as the Arm’s-Length Adjustment Service (ALAS)
Advisory Group. In February 2015, the MTC invited states to join
together “in a new cooperative effort to reduce corporate
income tax avoidance” through participation in the program.
The MTC sought to have states jointly design an Arm’s-Length
Adjustment Service in order to pool their resources to “more
effectively, efficiently and equitably” address this challenge.
In October 2015, the ALAS Advisory Group met with
representatives of a number of economic analysis firms in
“Worldwide political pressure, however,
subsequently resulted in states moving
toward a water’s-edge unitary
combination method for both US
and foreign-based companies.”