US state taxes: Be aware or be liable
It is an open secret that many foreign businesses (including Israeli businesses) fail to comply with US state and local (subnational) tax requirements. The taxes primarily involved are state income taxes, sales taxes and use taxes.
Regarding businesses based in Israel, we have previously reported on possible US state tax implications of Israel’s efforts to reduce the significance of international borders and of activities shining an unwanted light on Israeli businesses. These include the Israel Tax Authority’s 2016 issuance of a circular asserting jurisdiction over remote businesses directing digital commerce into Israel – an echo of the states’ position regarding remote businesses – and the 2016 conviction of an Israeli businessman who illegally employed other Israelis to work in shopping mall kiosks and paid them “off the books.”
Shipments to the US
Below, we review relevant developments since our last state tax article, beginning with the “Wayfair” case currently being considered by the US Supreme Court. At issue is whether states may require e-commerce and other businesses lacking an in-state physical presence to collect a remote state’s sales taxes. Significantly, Supreme Court justices, tax practitioners and government officials are concerned that a ruling in the state’s favor will expose remote businesses based anywhere in the world to liability for years of uncollected taxes. A decision in the case is expected in June, after which we hope to address its significance to Israeli businesses.
Of further sales tax interest to Israeli businesses is a recent confirmation that federal customs officials provide information to states regarding shipments of goods originating outside the United States. The confirmation comes from a May 2018 decision of the Arkansas Tax Appeals Tribunal, holding a taxpayer liable for unremitted taxes on the entire cost of an item purchased and shipped from abroad. This federal information assists states in their efforts to enforce collections of the states’ sales and use taxes.
Transfer pricing
For income tax purposes, three jurisdictions recently provided guidance bearing on transfer pricing between related domestic and foreign entities. This is important, as Israeli businesses often add random mark-ups to the cost of goods sold to affiliates reselling in the United States. It is doubtful that such random mark-ups will withstand state audits.
The most important transfer pricing development is in Washington DC, where three oil companies unsuccessfully challenged government transfer pricing analyses determining that the businesses owed $3.8 billion in city taxes. The case settled for an undisclosed amount that presumably was much less than the amount assessed but, also presumably, was more than the businesses believed reasonable.
Second, a case now at the Utah Supreme Court involves a question of whether arm’s length pricing is sufficient to prevent the state from redetermining a domestic affiliate’s cost of goods in a manner that increases its Utah income tax liability. Third, Mississippi issued a 10-page request for proposal for expert transfer pricing assistance, explaining that fees will be paid on a contingency fee basis as a percentage of taxes, interest and penalties collected due to the transfer pricing adjustment. (Taxpayer advocates object to contingency fee arrangements as they provide the state’s expert with an incentive to inflate the taxes assessed.) It is also reported that Connecticut is seeking transfer pricing assistance.
Israeli businesses selling to affiliates operating in the US therefore are cautioned to the need to have a sound transfer pricing analysis in hand.
To-dos
First, be aware that states guard their revenue sources and are assisted by federal agencies.
Second, understand that states will collect a business’s unpaid taxes from its management, as occurred in April when an Illinois court held a company president personally liable for $1.8 million in unremitted withholding taxes.
Third, Israeli companies must protect themselves by ignoring “easy-fix” advice from anyone lacking American state and local tax expertise. For example, despite assurances from an Israeli adviser, incorporating in Delaware or Nevada provides no protection against multi-state taxation.
Rather, Israeli businesses should obtain expert state tax counsel to estimate the likelihood that the business is liable for prior periods’ unpaid taxes, and then quantify any exposures. The businesses then need expert advice on the methods for eliminating or at least reducing their state tax exposure. This last point bears emphasizing, as the traditional “yihiye b’seder” philosophy has kept Israeli businesses from doing actual, legitimate subnational tax planning.
As always, consult experienced tax advisers in each country at an early stage in specific cases.
David.fruchtman@post.harvard.edu
David A. Fruchtman is the chairman of Rimon P.C.’s state and local tax practice. He is the author of a treatise on the unitary business concept central to state income taxation and a recent brief to the US Supreme Court.