Impact of State Corporate Income Tax on Site Selection
Companies entering the U.S. market find state Corporate Income Tax (“CIT”) enticing when considering where to establish their new entity. Many have heard about the Delaware “tax haven” or Wyoming’s absence of taxation. But when it comes to where to form a U.S. company, businesses should consider additional factors when deciding on the best location for their company. Businesses may overvalue state CIT, and its pertinence to where the company should be established, but where a company is established does matter and can have lasting implications. TABS helps companies weigh all considerations when determining where to form companies in the United States.
Impact of State Corporate Income Tax on Site Selection
By: Henry Rogers and Jacob Willemsen
State CIT (Corporate income tax) is often overvalued when deciding where to form an entity in the United States. Its value is often rendered moot by the mere fact that companies expanding to the United States will typically operate in several different states and seldom operate where they are initially established or incorporated. Business practices created by the new Covid landscape are influencing businesses to spread out. This is causing them to have to pay taxes in more states. Some of these can be navigated with creative solutions or by selecting a tax-friendly site. Thus, a company has less and less incentive to choose a state based on its CIT. This is especially true for foreign companies whose net taxable profits are typically modest or adjusted downward due to transfer pricing.
Understanding the different levels of government in the United States is important for foreign-owned businesses operating in the United States. Companies are required to follow federal, state, and local (county, city, etc.) laws. Though a bit more complicated (something that we don’t have time to get into in this article) as a simplification, federal laws sit at the top of the pyramid and are supreme to state laws, and state laws are supreme to local laws. The laws may take precedence over each other, but taxes compound. This means that taxes affect corporations on all three levels simultaneously. For example, a corporation’s profits are subject to a federal tax of 21%, a varying state corporate income tax amount of 5% (Fictional for this example), and a varying local amount of 1.5%(Fictional). This means that the corporation’s overall CIT is 27.5%. That is vertical compounding. Horizontal compounding deals with the state and local levels. If a company works in multiple states, each has a different state CIT; for example, a company operating in Colorado, Utah, and Idaho: with respective CITs of 6.55%, 4.95%, and 6.5% does not mean that this corporation pays a state CIT of 20.29%. Revenues, expenses, and profits are allocated to the various states and are taxed on where they are generated, not in a catch-all.
Incorporation and where you do business
Many incoming European companies often want to incorporate somewhere like Wyoming or South Dakota because they’ve heard about low or no company taxes. These companies do not realize they will pay taxes in every state where they do business. These two states lack a solid consumer base for most goods and services. This culminates in challenging operations for a company based out of Europe.
Delaware is often chosen for incorporation, but it’s often the right choice for the wrong reasons. The Delaware “tax haven” is a myth and is not why over two-thirds of fortune 500 companies are incorporated there. The reason is a combination of privacy considerations, a favorable and well-established precedent in a dedicated Court of Chancery, and exceptionally favorable case law protecting limitation of liability for officers, directors, and shareholders. These are far superior reasons for businesses to incorporate in Delaware.
Many often overlook the logistical challenges that come from doing business in a country the size of the U.S. The country is divided into Four time zones: Eastern, Central, Mountain, and Pacific. So, the eight-plus-hour business day in much of the US does not line up well with business hours in Europe. For example, when businesses are starting their day on the west coast of the United States (9:00 a.m. PT) it is already 18:00 CET. So, it would be more valuable to pick a state in a time zone where communication would be more efficient, rather than prioritizing CIT.
Covid the new corporate landscape and how it relates to tax
As Covid has swept the globe, it has rocked the corporate world. The remote workforce has surged, and it appears to be here to stay. This new reality allows companies to hire quality workers without paying for relocation. However, this does not come without additional considerations. As the pandemic recedes, state and local governments are getting wise to this dispersion of labor. Location of operations used to identify an employee for tax purposes because, pre-pandemic, everyone worked from a dedicated office. Now governments are noticing dedicated remote workers entering the market and seeing a new source of tax income. This new revenue stream for state and local governments means corporations are not necessarily paying more taxes, but they are paying their taxes across more states.
Companies still find it key to have a team in the United States. Before the federal CIT was cut from 35% to 21%, and American immigration laws were strengthened, companies would attempt to have as small a team in the U.S. as possible. Now European companies are building out their American-based team. Incoming companies consistently struggle with hiring an American-based team. This is a field that TABS is well versed in and ready to help with; While it may be easier to import talent, Dutch ventures in the U.S., a study conducted by TABS, shows that recruiting U.S. talent rather than importing European talent creates a far more successful and efficient office.
Other taxes are more prevalent and avoidable
When multiple other taxes exist, this waters down the influence of CIT. Some of these taxes are easily minimized, while others are not. The taxes that almost every corporation must tackle are:
Unlike its European equivalent VAT, sales tax is levied when a product is sold to the end user. This can be an adjustment for incoming European companies. Corporations must be mindful of state-by-state fluctuations in sales tax, which should be factored into site selection. For additional information regarding sales tax, we suggest reading the following: Sales Tax in The United States
In the recent Supreme Court case: South Dakota v. Wayfair, Inc., the Court ruled in favor of the state, creating a new precedent. This ruling opens the floodgates for states to levy sales tax on online businesses, even if they lack a physical presence within the boundaries of the state. The new model that states can follow heavily impacts sales tax on online businesses. This forces online businesses to register in the state for the reason of sales tax, but since they are registered, this means that they now must pay state CIT.
The federal government currently taxes Corporations 21% of their net profits.
A tax on owned property such as warehouses, office space, server farms, and any property the corporation possesses. (Depending on the state, this can apply to just land, or so much more, even office furniture.)
Employment or Payroll Tax
A dual tax system pulling from the employer and the employee. Corporations must pay taxes on each employee to keep up their half of this model. State-level employment taxes vary and will impact corporate site choice. States will often advertise payroll incentives. While those are helpful, they don’t tell the whole story. Federal-level employment taxes will take their toll regardless of the corporation’s location.
Gross Receipts Tax
A tax on a company’s overall revenues, not on just its profits. For an incoming business with low profits, picking a state that has a gross receipts tax could be far more expensive than a state with CIT.
States with Gross Receipts Tax
Delaware • Nevada • Ohio • Oregon • Tennessee • Texas • Washington
States that Allow Gross Receipts Tax Only at the Local Level (a city or a county, but not the whole state would follow gross receipts)
Pennsylvania • South Carolina • Virginia • West Virginia
Personal Income Tax
A company may not be a person, but it is made up of them. That is why personal income tax, something commonly overlooked in corporate expansion, is important. A site that a company selects is only as good as its employees. The better the pay, the better the employees. Locations with lower personal income tax rates allow employees to keep more of their paychecks.
The point of highlighting these is to reinforce the minute effect of state CIT on site selection. For example, Wyoming has no state CIT but many other taxes. If a company is incorporated in Wyoming and only does business within the state, you would still have to pay sales tax, pay employee taxes, and property taxes. All of these would be on the federal, state, and local levels, except for sales tax. These taxes far outweigh any savings from the state’s CIT.
Low-profit margins and transfer pricing solutions
Two further reasons make CIT savings irrelevant: low-profit margins and transfer pricing. When expanding to the U.S., the subsidiary or the new branch will have slim profit margins. Thus, taxes on profits will be negligible. But if the company has large profit margins, there is the counterweight of transfer pricing, which allocates a corporation’s profits to the locations where the most added value and risk are apparent.
Companies will lower their U.S. profits by arguing via transfer pricing studies that the majority of their risk and added values reside in Europe, allowing them to allocate where they are taxed.
Transfer pricing does have its limitations. The U.S. government has combatted the effectiveness of the practice by setting restrictions on it. These restrictions are referred to as an arm’s length between companies and their subsidiaries. This means a company cannot sell its goods at a discounted or increased price to its subsidiary; in comparison to what it would charge a third party. Thus, companies use transfer pricing studies to justify their prices.
What TABS can do for you
As laid out above, many factors play into site selection, from time zones to transfer pricing. Thus, state corporate income tax should only be one factor in a company’s decision. Site selection is not the only issue incoming corporations need help with, and TABS is here to help. All the tax issues addressed in this article are surmountable. There are many other strategies, in addition, to transfer pricing when utilizing all the tools available within U.S. tax policy. With a dedicated tax support service, TABS has worked with certified public accountants and tax planners to help hundreds of incoming U.S. companies with taxes and much more.
Contact us to book a consultation today.
Links for sources
2022 State Business Tax Climate Index
2021 State Business Tax Climate Index
Tax Foundation Gross receipts Tax
Pay, Tax, and Work Laws for Remote Employees
6 Differences between vat and U.S. sales tax