Clearing federal hurdles doesn’t stop state tax auditors; foreign groups learn this only after a surprise assessment. When multinational businesses enter the U.S. market, they often begin by evaluating federal tax rules: whether the foreign entity is engaged in a U.S. trade-or-business, whether treaty protections apply, and how income is characterized for U.S. purposes. These considerations shape decisions around structure, reporting, and overall tax exposure.
But that’s only part of the picture. State tax regimes operate independently of federal rules, and many impose their own filing obligations based on economic activity, often without regard to treaty protections or federal determinations. A structure that limits federal tax liability may still trigger state-level nexus, withholding exposure, or combined reporting requirements.
Effectively navigating inbound U.S. tax issues means addressing both federal and state considerations in tandem. From determining whether a foreign entity has a U.S. trade-or-business or permanent establishment, to understanding how state economic nexus and unitary reporting rules apply, each layer of the U.S. system carries its own risks, plus planning opportunities.
Before diving into state-specific risks, foreign companies should first understand when and how they become subject to U.S. federal taxation. Under U.S. federal tax law, a foreign corporation becomes taxable on its effectively connected income (ECI) if it is engaged in a U.S. trade-or-business (USTB). This determination is based on a facts-and-circumstances test, with key indicators including the regularity, continuity, and extent of commercial activity within the U.S.
In practice, this threshold is relatively easy to meet, particularly in cases involving service provision, sales solicitation, or licensing. The activity must be active and business-related (e.g., marketing, negotiating, delivering), and not passive (e.g., collecting dividends or royalties). If the IRS determines that a USTB exists, the foreign entity is subject to tax on its effectively connected income (ECI), generally at the standard U.S. corporate rate of 21%, although there are some carveouts. A foreign entity may also be subject to a 30% withholding tax on U.S.-source fixed or determinable annual or periodic income (“FDAP” income, generally dividends, interest, royalties, rents, and similar payments) unless a treaty reduces the rate.
An applicable income-tax treaty usually raises that bar by requiring a U.S. permanent establishment (PE) before federal tax liability arises. While the specific PE standard varies by treaty, it typically requires some form of fixed place of business or dependent agent acting with authority to conclude contracts on behalf of the foreign entity. This can include offices, factories, or warehousing facilities, and often excludes purely preparatory or auxiliary functions.
Recent treaties include anti-abuse clauses, so relying on minimal presence is risky. Moreover, treaties apply specifically to federal income tax. State taxes, which largely operate under their own frameworks and enforcement mechanisms, only incorporate treaty considerations such as permanent establishment or tax-exempt income if they specifically conform to federal treatment or mechanically follow federal taxable income.
State income taxation of foreign entities hinges on the concept of nexus: a jurisdictional threshold that determines whether a taxpayer has sufficient connection to a state to justify taxation. Unlike the federal USTB or PE standards, state nexus rules do not rely on physical presence or distinguish between U.S. and foreign entities. Nor are they constrained by federal income tax treaties, with some exceptions.
The table below shows the top 10 U.S. states by Gross State Product (GSP), outlining which recognize federal treaty exemptions and which do not.
| State | Follows Federal Treaty-Exempt Income Treatment? | Notes |
|---|---|---|
| California | No | Ignores treaties; taxes based on state nexus regardless of PE status. |
| Texas | N/A (no corporate income tax) | Franchise (Margin) Tax starts with gross receipts; treaties are ignored. |
| New York | Partial | New York starts with federal taxable income but adds back treaty-exempt ECI; foreign corporations also face economic-nexus thresholds (see $1 million/$1.283 million rule below) |
| Florida | Yes | Treaty-exempt income is generally excluded because Florida starts with federal taxable income, but nexus can still arise. |
| Illinois | Yes | Starts with federal taxable income; some independent adjustments. |
| Pennsylvania | No | Treaty-exempt income is fully taxable with narrow exceptions such as interest or intangible expenses paid to affiliate entities. |
| Ohio | N/A (no income tax) | Commercial Activity Tax (CAT) – gross receipts tax; treaties irrelevant. |
| Georgia | Yes | Follows federal income but makes its own adjustments. |
| North Carolina | Yes | Conforms to federal taxable income but may decouple in some areas. |
| Washington | N/A (no income tax) | Business & Occupation (B&O) gross-receipts tax applies; treaties are irrelevant. |
In fact, many states impose tax based on economic nexus, under which an entity becomes taxable if it has a “substantial” presence in the state based on economic factors, including having sales in the state above a certain threshold (either in absolute terms or as a percentage of total sales, payroll, or property).
For example, California taxes an out-of-state corporation once in-state sales exceed $735,019, in-state property or payroll exceed $73,502, or any of these in-state amounts exceed 25% of total company sales/property/payroll (2024 factors; updated annually). New York applies a similar bright-line, taxing foreign corporations once receipts sourced to the state exceed $1 million (indexed annually; $1.283 million for 2025) in a taxable year. Beyond those bright-line tests, some states also apply “doing business” tests that look at a wide range of indicators, including drop-shipping arrangements, affiliate relationships, or licensing intangibles to in-state customers.
The result: a foreign entity that is not federally taxable may still be subject to state income tax filings and liabilities, often across multiple states. Adding to the complexity, state tax administrators are not bound by federal determinations or audit findings, although they do receive notifications from the IRS regarding federal activity. These communications may result in them starting their own audits or adjusting state tax liabilities based on federal determinations. Whether that income is exempt at the state level depends on the specific state’s conformity rules; some mechanically follow federal calculations, while others make independent determinations about permanent establishment and taxability.
To reduce risk and gain control over their U.S. activities, most foreign businesses entering the U.S. do so through a domestic entity; typically a U.S. corporation. This structure delivers several benefits from a tax planning perspective.
First, it limits the foreign parent’s exposure to U.S. trade-or-business status by moving income-generating activities into a separate taxpayer. This containment approach helps avoid inadvertently creating ECI or establishing a PE for the foreign corporation, though the subsidiary itself will, of course, have U.S. taxable presence.
Second, a corporate subsidiary facilitates control over intercompany flows, including financing and repatriation of earnings. U.S. corporations are subject to a 30% withholding tax on U.S. FDAP income paid to a foreign parent. Treaties may reduce this rate. States generally do not impose withholding on outbound payments made by corporations, so repatriation planning is typically driven by federal tax considerations.
From a structural perspective, a corporation offers administrative clarity. Certain inbound groups instead hold their U.S. activities in an LLC that is disregarded for tax purposes. Because the IRS treats a disregarded LLC as a branch of its foreign owner, any cash or asset distribution from the LLC is a deemed dividend. That payout can trigger the branch-profits tax at 30% (lower under a treaty) whenever it shrinks the parent’s U.S. investment. Auditors often scrutinize the calculation because it compares the dip in that U.S. investment with the parent’s global equity, which is hard to carve out from consolidated accounts.
At the state level, a U.S. subsidiary creates nexus through its direct activities, triggering income tax obligations in states where it operates. Additionally, some states use worldwide combined reporting, potentially pulling the foreign parent into the state tax base. Absent (or pending) a water’s-edge election, the parent’s income may be included in the combined group. Intercompany agreements between the subsidiary and foreign parent, such as for services or royalties, can also raise transfer pricing and apportionment issues.
Federal tax compliance requirements differ significantly based on whether a foreign entity has a U.S. trade or business and whether it operates through a U.S. subsidiary.
When a foreign corporation engages in U.S. trade or business activity, especially through a branch, it must comply with reporting obligations tied to effectively connected income. Even in cases where it is not clear if there is a USTB, it may be prudent to file preemptively to preserve key tax positions, such as the ability to claim deductions.
If the business operates through a U.S. subsidiary, the focus shifts to cross-border transparency. Intercompany transactions with the foreign parent trigger extensive disclosure requirements, and failure to report properly can result in significant penalties. State tax compliance also comes into play, as both direct activity and intercompany arrangements may establish nexus or affect apportionment.
At the state level, reporting obligations are broader and less nuanced. States do not distinguish between domestic and foreign entities in the same way federal rules do. If a foreign entity has nexus in a state, it may be required to file either on a standalone basis or as part of a combined return under the unitary business principle.
States that mandate combined reporting may do so on a worldwide or water’s-edge basis. Worldwide combined reporting includes all unitary affiliates regardless of location unless specific exclusions apply. Water’s-edge regimes limit inclusion to U.S. entities and certain foreign entities with significant U.S. activity, often using a 20% apportionment factor threshold or the presence of effectively connected income. Taxpayers should model their group’s profitability and state tax footprint to determine which approach yields a more favorable result.
Foreign multinationals face several state-specific risks that purely domestic groups are less likely to encounter.
State tax risk is often underestimated by multinational groups, but it can have meaningful consequences. While federal tax planning focuses on trade-or-business and treaty thresholds, state exposure arises through separate nexus standards. Left unaddressed, these rules can generate compliance obligations, penalties, or unexpected tax bills that compromise broader international planning.
Navigating these challenges effectively requires attention to both layers. Federal considerations—such as U.S. trade-or-business status and permanent establishment—form the foundation of any inbound tax strategy. But without accounting for how those choices interact with state rules, even well-planned structures can fall short.
Sapowith Tax Advisory specializes in navigating these complex intersections between international and state taxation. With extensive experience restructuring multinational operations to optimize both domestic and international tax positions, we help our clients identify exposure before it becomes a liability and resolve existing issues in a tax-efficient manner.
Contact Sapowith Tax Advisory for a tailored strategy that aligns international structure with state-level compliance.
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