Winter 2016 | Partnering Perspectives
Expansive Taxation of Foreign
Whether and to what extent foreign income is included in a
state’s corporation income tax base is often largely a function
of what companies and operations are included in that
particular state’s water’s-edge group. However, a number
of special situations may arise.
While tax treaties generally do not apply to subnational taxes,
there are situations in which income exempt from federal
income tax by treaty is not taxable by a state. As a general
proposition, the starting point for a state’s taxation is the
corporation’s federal taxable income. Subject to treaty
protection, a foreign corporation is generally taxed on all
income that is effectively connected with the conduct of a
trade or business in the United States. Internal Revenue Code
section 894 and its related regulations, however, provide that
income is not included in gross income to the extent required
by any income tax convention to which the United States is a
If a state’s starting point is federal taxable income, and what
otherwise would be a foreign corporation’s federal taxable
income is reduced or eliminated by treaty protection through
section 894 (or the corporation has no effectively connected
income), then the excluded income will not be taxable at the
Other states have statutory add-back provisions. For example,
California law provides that any income satisfying the Internal
Revenue Code’s definition of effectively connected income
that is excluded from federal taxable income due to a tax treaty
is included, i.e., added back, for California purposes. As another
example, New York requires all corporate taxpayers to include
all income, including effectively connected income, from
sources outside of the United States that was not included
in computing federal taxable income without regard to
Foreign dividend income also presents unique issues. Many
states allow a subtraction or deduction for foreign dividends
that match the dividends received deduction the state would
allow for dividends received from domestic companies. This
position is largely the result of the decision of the Supreme
Court of the United States in Kraft, 4 which held that Iowa’s tax
scheme violated the Commerce Clause by discriminating
against foreign commerce by allowing a dividends received
deduction for dividends paid from domestic, but not from
foreign, subsidiaries. Some states that generally do not follow
4 Kraft General Foods, Inc. v. Iowa Dept. of Revenue & Finance, 505 US 71 (1992).
the federal dividends received deduction rules do not allow
such a deduction for foreign dividends.
To the extent that foreign dividends are taxed, there is also
the issue of whether some factor representation is required.
To the extent the dividends are received from a company,
even a foreign-based one, whose income is included in the
tax base for state tax purposes, there is typically a full
(intercompany) dividend elimination.
While the battles over the states’ use of mandatory worldwide
combined reporting appear to be over, disputes over how so-called water’s-edge systems are applied inevitably will continue.
Continuing issues include the definition of the water’s-edge
group (including factual unity issues); composition of the group
(i.e., tax havens); defining who is a taxpayer in the group (i.e.,
nexus); cross-border transactions (i.e., transfer pricing); and
the includible foreign income base.
About the Author: A widely respected thought leader on state
and local tax issues, Eric Coffill brings more than 30 years of
experience counseling clients on multistate tax controversy and
litigation matters at the administrative, trial and appellate levels,
particularly before the California Franchise Tax Board (FTB) and
State Board of Equalization (SBE). Eric advises manufacturers,
government contractors, technology service providers and other
industry-leading companies on all aspects of state and local taxes,
including transactional, income, nexus and apportionment issues.
He can be reached at email@example.com.
“As a general proposition, the starting
point for a state’s taxation is the
corporation’s federal taxable income.”