Washington Rules that a German Company Had Nexus and Was Not Protected by U.S./German Tax Treaty

Non-U.S. entities and their affiliates should not simply assume that they are protected from state and local tax by a treaty.

By Jess Johannesen, SALT manager

Dealing with state tax and nexus issues can be complicated and frustrating for U.S. businesses, given that they have to understand each state’s tax system and varying rules. For non-U.S. businesses, that task is even more difficult due to the fact that (i) in many countries, there is nothing similar to our state tax system and (ii) many foreign countries have tax treaties with the U.S., creating confusion as to the impact, if any, those treaties have on state taxes.

On May 31, 2016, the Washington Department of Revenue Appeals Division released a Tax Determination regarding the imposition of the state’s business & occupation (“B&O”) tax upon a German pharmaceutical company (the “taxpayer”). [1] The taxpayer had no physical presence in Washington and received royalties based upon where its pharmaceutical products were sold. Under audit, the taxpayer was assessed B&O tax, penalties and interest based upon the royalty income related to the sales of pharmaceuticals to Washington customers. The taxpayer argued that (1) it lacked nexus with Washington and (2) it was protected by the U.S./Germany tax treaty (the “treaty”). [2]

With regard to nexus for its B&O tax, Washington has adopted factor presence nexus standards for certain activity classifications, including apportionable activities, which are defined to include receipt of royalties. [3] Factor presence nexus provisions establish nexus in a state when property, payroll and/or sales exceed the state’s statutory threshold. In the case of sales, therefore, it is possible to establish nexus in a state without having a physical presence. Even though the taxpayer had no payroll or property in Washington, it was undisputed that royalties paid to the taxpayer based on total Washington sales “far exceeded” the statutory factor presence nexus thresholds. Accordingly, it was held that the taxpayer had B&O tax nexus with Washington.

The taxpayer also argued that the nondiscrimination provision of Article 24 of the treaty protected it from Washington’s tax on royalties. The nondiscrimination provision prohibits German individuals/entities from being subject to more burdensome taxes in the U.S. compared to U.S. individuals/entities, and vice versa. Even though the treaty provisions generally are limited to specifically cover certain U.S. federal taxes, the nondiscrimination provision applies more broadly to “taxes of every kind and description imposed by [the United States] or a political subdivision or local authority thereof.”

Essentially, the taxpayer argued that Washington was a “political subdivision or local authority” of the U.S., and, therefore, the treaty protection applied to Washington’s B&O tax on royalties. Ultimately, the ALJ ruled that Washington’s B&O tax on royalties did not violate the treaty’s nondiscrimination policy because German companies and U.S. companies were both subject to the tax on equal terms.

This ruling is a reminder that non-U.S. entities and their affiliates should be mindful of state and local tax developments and not simply assume that they are protected by a treaty, because often they are not. For example, a non-U.S. business can easily establish nexus in a state even though, under a tax treaty between its home country and the U.S., it has not created a permanent establishment in the U.S. Aprio’s SALT team has experience working with non-U.S. companies to help them understand their state tax obligations as well as advising them on potential structures to minimize state tax and compliance burdens.

Contact Jess Johannesen, SALT manager, at jess.johannesen@aprio.com or Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the July 2016 SALT Newsletter. To view the newsletter, click here.

[1] Washington Determination No. 15-0251, 35 WTD 230 (09/11/2015).

[2] Convention between the United States of America and the Federal Republic of Germany for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital and to Certain Other Taxes, U.S.-Ger., Aug. 29, 1989, 1708 U.N.T.S. 3.

[3] Wash. Rev. Code §82.04.460(4)(vii); Wash. Rev. Code §82.04.2907.

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.