Foreign companies have penetrated the large and diversified U.S. market with their goods and services. And many successful foreign businesses sell to U.S. customers online without any physical location in the United States.
Most U.S. income tax treaties with other countries provide federal tax exemption for a foreign company’s U.S. profits if the company does not have a U.S. permanent establishment (i.e., a U.S. taxable presence). But states where their customers are located may not follow the federal income tax rules.
Discover important U.S. federal and state tax rules that apply to inbound online sales of goods and services in the United States.
U.S. Permanent Establishment Rules
Simply put, a U.S. permanent establishment (PE) refers to a fixed place from which a foreign entity conducts business in the U.S. What matters most is that the U.S. business location is permanent and the foreign entity has full control over it. Other aspects, such as ownership or location type, are not always relevant.
Treaty Permanent Establishment Rules for State Income Tax and State Sales Tax
Some U.S. states may honor the provisions of tax treaties and preclude foreign entities from income tax when they do not have a permanent establishment in the U.S. However, these protections do not extend to other tax measures. A business only needs a sufficient connection ("nexus") with a state or local jurisdiction to be subject to sales and use tax and often other state-imposed taxes.
For foreign and domestic businesses, sales tax nexus was historically triggered if a business established a physical presence in a state. Examples of physical presence include offices, inventory, salespeople, or employees. The U.S. Supreme Court abolished this decades-long requirement in its 2018 decision, South Dakota v. Wayfair, Inc. As a result, states can impose sales and use tax on remote sellers based solely on their economic presence, prompting states with a sales tax regime to enact thresholds based on total sales or number of transactions.
The thresholds vary by state, but the most widely adopted is $100,000 in sales or 200 separate transactions within a 12-month period. Foreign companies near or above these limits should be aware of potential requirements to register, collect, and remit sales and use taxes.
State Tax Implications for Foreign Companies with U.S. Servers or Other Computer Equipment
A server is typically used to host websites. A foreign entity may have its own website through which it sells goods or services in the U.S. By itself, a website is not considered tangible property and usually does not result in a PE.
In many cases, the foreign entity may rent its website server — located in the U.S. — from a third-party internet service provider. Usually, such a server may not constitute PE because it is not considered to be at the disposal of the foreign entity. On the other hand, a server owned or rented by the foreign entity exclusively to host its website may constitute a U.S. PE.
Taxpayers also need to consider other aspects for determining if there is a U.S. PE through a server, including:
- Permanency of the server at the location (i.e., the duration of time for which that server is in the U.S. to be considered a fixed-place U.S. PE)
- Whether the taxpayer does its main U.S. business activities through that server (PE) or only uses it only for ancillary business (not a PE)
State Tax Implications for Foreign Businesses with a U.S. Agent or Warehouse
Foreign entities making online sales in the U.S. often have a U.S.-based warehouse to ship the actual goods to the customers. These entities may also have agents in the U.S. to support their business operations.
Generally, a warehouse used only to store and display goods does not constitute a U.S. PE. Agents who have authority to sign contracts or who lead deals to contract signing could qualify as a U.S. PE. For foreign entities selling online directly to customers, agents, if used, might not constitute a U.S. PE.
However, when it comes to sales tax, the results may be very different. Maintaining inventory with a third-party logistics provider can create nexus — and therefore collection and remittance responsibilities — long before the economic thresholds are met. Some of these services (e.g., Fulfilled by Amazon) can create these requirements in multiple states as property is moved and stored across the country.
Other Sales and Use Tax Considerations
Drop shipping can pose unique burdens on foreign businesses making online sales into the U.S. The transaction between a wholesaler and distributor should qualify under the resale exemption; however, sales are only exempt if the proper documentation is presented.
If a retailer isn't registered in the ship-to state, they may not be able to issue a valid resale certificate and will be subject to sales tax themselves. Retailers generally can't pass along the tax charged by the supplier unless they are registered to collect that state's tax.
Digital Products and Related Services
Digital products, such as cloud-based software and streaming video, music, and gaming services, were created long after states established sales tax frameworks. Some states consider digital products tangible property since they are “perceptible to the senses” and tax them like their tangible counterparts (e.g., software delivered via CD or a physical book).
Meanwhile, some states have enacted separate laws to address the taxability of digital products, defining them as a distinct sales tax category or enumerating them as a taxable service. Subscription-based software-as-a-service and media streaming services have been enumerated as taxable services in about half of states.
Also, since software is rarely licensed as a standalone product, related services (e.g., implementation, training, etc.) can be taxable if performed by the same person who sold the computer program.
Digital Services Taxes
The lack of taxing rights around online businesses has prompted several countries to introduce taxes on digital services and/or goods. These taxes are commonly referred to as Digital Services Taxes (DSTs). Each country may have its defined set of online activities on which a DST is levied.
While the U.S. does not have any federal DSTs, about a dozen states have proposed legislation for digital advertising taxes either by expanding their sales tax base or by creating new tax regimes. Only two states have enacted such a tax: Maryland and Washington.
However, the former has met legal challenges claiming the tax violates the Internet Tax Freedom Act — for taxing digital advertising but not non-digital — and the U.S. Constitution’s Commerce Clause. Recently, U.S. officials spoke out against France’s digital service tax. For Maryland to enact a similar tax is counterproductive. The U.S. Supreme Court ruled in 1979 that state taxes that prevent the United States from “speaking with one voice” when regulating foreign commercial relations violate the Foreign Commerce Clause.
Inbound Businesses Must Proactively Evaluate Their Tax Obligations
Foreign companies with no U.S. presence may consider themselves beyond the legal jurisdiction of state and local taxing authorities. However, they may be subject to sales and use taxes, and failure to register, collect, and remit sales tax can have long-term consequences.
The liability for sales and use taxes can transfer to a successor entity or individual, which may limit the desirability of the business, especially to U.S.-based investors. Therefore, inbound businesses should proactively evaluate their state and local sales and use tax obligations.
Mowery & Schoenfeld’s dedicated state and local tax (SALT) and international tax experts can provide customized and comprehensive assessments and efficient solutions for your businesses. Reach out to our team today to discuss how we can support your U.S. federal and state compliance.