State Nexus Policies Focus of Bloomberg BNA Survey

Apr 30th 2013
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By Jason Bramwell

Many states say they would find nexus as a result of owning a web server in their jurisdiction, telecommuting employees, and making transactions that involve non-US entities, according to the thirteenth annual Survey of State Tax Departments by Bloomberg BNA.

The goal of the survey was to clarify each state's position on the gray areas of corporate income and sales and use tax administration, with an emphasis on nexus policies. For state tax purposes, nexus means "the threshold of contact that must exist between a taxpayer and a state before the state has jurisdiction to tax the taxpayer", the survey states. 

"As emerging technologies, such as Cloud computing, continue to proliferate, a growing portion of the US economy is operating independently of state, local, and international borders. This shift has increased the number and complexity of cross-border transactions", the survey states. 

Technology has also allowed companies to reduce the number of locations in which they own a property or have employees. The virtual tax base that has emerged has spurred states to aggressively pursue revenues from business activities with a connection to their borders. 

"Trailing nexus certainly has become a more visible issue within the state tax community during the last few years, both among taxpayers and states", Thomas Shimkin, director of the nexus program for the Multistate Tax Commission, says in the report. "Formal issuance of state guidance has increased over the past several years, but the number of states with specific guidance is low." 

Nexus from a Web Server

According to thirty-six states and the District of Columbia, income tax nexus results from owning a web server in their jurisdiction. Several of these jurisdictions say they would find nexus even if the corporation did not make sales into the state. Twenty-six states add that they would find nexus for an out-of-state corporation that leased space on a third party's Internet server located within their borders. 

"Having data on an in-state leased server would trigger nexus in twenty-four jurisdictions, regardless of whether the data was stored on the server for more or less than six months", the report states. 

From the perspective of the Cloud provider, the states' responses that a company would have an income and/or sales and use tax-collection obligation by virtue of owning a server in the state is not surprising, Kendall Houghton, a partner with the law firm Alston & Bird LLP in Washington, DC, says in the report. 

A key constitutional question that remains undecided by the US Supreme Court is whether the states making corporate income tax nexus determinations must use the physical presence test established by the high court in Quill Corp. v. North Dakota for sales taxes. 

"The key issue is whether ownership of the server – and/or licensing of software – creates taxable nexus", Houghton says. "Many states have taken this position in formal rulings on the basis that [a] server is tangible property, the presence of which is more than de minimis, and thus satisfies Quill." 

From the Cloud computing purchaser's perspective, the issues become even more challenging and nuanced, Matthew Hedstrom, a senior associate at the New York City office of Alston & Bird, says in the report.

"[Because] most Cloud computing services involve software and hosting of such software on servers, the question becomes whether purchasing Cloud-based services results in taxable presence", he explains. "Under Quill, the issue would be whether the purchaser would be deemed to own or lease tangible personal property. The states' positions may not withstand challenge by taxpayers when you consider that any nexus inquiry is highly fact-intensive." 

States still appear to be grappling over their positions on the nexus consequences of activities related to Cloud computing. Providing access to software via the Internet to in-state customers and hiring independent contractors to perform setup or configuration services within their jurisdiction are sufficient to create nexus, thirty-two states report – up from thirty states in 2012. 

Cloud-based service providers would also trigger nexus by allowing employees to solicit services within their jurisdiction, according to thirty-two states – up from twenty-nine states last year. 

Sixteen jurisdictions say that nexus would also result for Cloud-based service providers that lacked a physical presence within the jurisdiction, but had a substantial number of customers with billing addresses in the state or earned a substantial amount of revenue from customers in the state. 

The report also says that in twenty-seven states, a company that offers services via the Cloud would achieve nexus by renting space on a server located in the jurisdiction. 


Thirty-six states, plus the District of Columbia and New York City, say income tax nexus would result for an out-of-state corporation with employees who telecommute from homes within their jurisdiction. 

The survey states",As in prior years, most states say nexus would result from telecommuting employees even if the corporation had made no sales in the state or the employees telecommuted for only part of their total work time." 

Thirty-three jurisdictions report nexus would arise from a single telecommuter who performed back-office administrative business functions, such as payroll, as opposed to direct customer service or other activities directly related to the employer's commercial business activities. Thirty-four jurisdictions say nexus would be triggered by a single telecommuting employee who performs product development functions, such as computer coding. 

Treatment of Non-US Entities

One of the new topics the survey addresses in 2013 is the state tax treatment of non-US entities. 

"When a foreign company enters the US market, its US sales volume is small, its state tax liability insignificant, and its knowledge of US subnational  taxes essentially nonexistent", David Fruchtman, who is of counsel with Chicago-based law firm Horwood Marcus & Berk, says in the report. "At this point, a foreign company's failure to comply with state tax obligations often will go undetected by state tax agencies." 

Fruchtman adds that even after generating meaningful amounts of US sales and state tax liabilities, foreign businesses often remain unaware of their state tax obligations. "As a result, these companies may have significant multistate tax exposures before they are genuinely aware of their liability for these taxes", he says. 

At the federal level, a non-US company generally is not subject to US tax on business income derived in the United States unless the income is attributable to a permanent establishment in the United States. The definition of "permanent establishment" varies by treaty, but it is generally defined as "a place of management, an office, a construction site, or an agent of the non-US company with authority to enter into contracts", according to the report. "At the state level, taxation of a non-US entity depends on if the entity has nexus with the particular state."

"Most states adhere to an economic nexus rationale for income taxes, which does not require a physical presence", the report states. "As a result, a non-US company can achieve nexus with a state even if it lacked a permanent establishment. Only eighteen jurisdictions say they rely on 'permanent establishment' criteria for purposes of making income tax nexus determinations."

The survey also asked whether a state extends the protection afforded under Public Law (Pub. L.) No. 86-272 to non-US entities. "Pub. L. No. 86-272 prohibits the imposition of state income-based taxes against businesses engaged in the sale of tangible personal property whose activities in the taxing state are limited to the solicitation of orders, according to the report. Twenty-four states say they extend the protection to foreign commerce under Pub. L. No. 86-272 to non-US entities", the survey states. 

Also, thirteen states report that a franchise tax or other non-income-based tax would apply to a non-US entity that is not subject to federal income tax and only files federal Form 1120-F, US Income Tax Return of a Foreign Corporation

"The survey demonstrates the state income tax hazards confronting foreign-based businesses, too many of which are neither complying with nor planning for state income taxes", Fruchtman concludes. "The states have long sought to shift the burden of their income taxes to out-of-state businesses. Now, as borders of all kinds become less significant to both commerce and taxation, the states' interest in taxing foreign businesses is continually increasing." 

About the survey:

Bloomberg BNA sent a questionnaire to senior state tax officials in every state, the District of Columbia, and New York City. Every state participated in the survey this year; however, some states declined to answer certain questions. The states were asked to provide their positions as of December 31, 2012. 

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