Foreign entities receiving royalties in Washington create nexus in the state, according to a determination by the Administrative Review and Hearings Division (ARHD). The position comes from Washington Tax Determination (WTD) No. 15-0251, 35 WTD 230 (2016), which was released by the Department of Revenue’s ARHD on May 31, 2016.
The key takeaway: Tax treaties don’t preclude the state of Washington from imposing tax on foreign companies, even if those companies don’t pay US tax at the federal level. We give some background and details on the determination in this Insight.
The United States has negotiated income tax treaties with 66 countries. These aim to eliminate or at least limit the potential for double taxation of taxpayers, and they’re most often applied to investment income (dividends, royalties, and interest) and personal services income. These treaties also define a taxable presence in the state, and refer to businesses that meet the threshold as permanent establishments (PEs).
In the Treasury Department’s Model US Income Tax Treaty, a PE is generally defined as a “fixed place of business through which the business of an enterprise is wholly or partly carried on.” It goes on to expressly list several examples of PEs:
Additionally, a person that habitually exercises the ability to conclude binding contracts may create a PE.
Based on this definition, foreign entities that have neither a physical presence in the United States nor agents concluding contracts within US borders generally won’t be subject to federal tax.
US income tax treaties are all based on either the model published by the Organisation for Economic Co-operation and Development or the US Treasury model, but they may differ in specifics. The federal government of the United States and the foreign jurisdiction may also negotiate special terms.
It’s important to note that these treaties are negotiated on behalf of the federal government and that states don’t have a seat at the table. As such, states have taken the position that they aren’t obligated to respect all of the terms of a federally negotiated income tax treaty.
The Washington determination concerned a German company that had no physical presence or business registration in Washington. The company received royalties based on where its products were sold. The ARHD analyzed whether the foreign company was subject to Washington business and occupation (B&O) tax and whether the treaty between the United States and Germany preempted Washington’s imposition of B&O tax on royalty income.
The ARHD rejected multiple arguments from the taxpayer, concluding that the foreign company was subject to B&O tax because it had substantial nexus and that the tax treaty between Germany and the United States didn’t preempt the imposition of Washington B&O tax.
The ARHD’s reasoning included:
Foreign companies that lack physical presence in Washington but receive royalties from Washington sources may potentially be subject to Washington B&O tax. It’s important to understand that a treaty position that exempts a foreign corporation from US federal taxes doesn’t extend to US states. As such, foreign corporations need to understand the nexus rules that apply to states in determining whether they’re subject to tax in those states.
If you have any questions about how the Washington determination may affect your business, or for guidance on next steps for your organization, contact your Moss Adams professional.