Israeli businesses exporting goods into the United States must plan for a variety of taxes. However, many Israeli businesses do not know that the income tax treaty between Israel and the United States does not cover the taxes imposed by the 50 states, Washington D.C. or any of the thousands of municipalities across the United States. As a result, the businesses are unnecessarily exposing themselves to tax liabilities or are unnecessarily increasing the cost of their goods to their customers.
There is no doubt that Israeli businesses can do much more to plan for state and local taxes and to increase the affordability of their products and their overall profitability.
American State and Local Taxes
The states impose income taxes, gross receipts taxes, franchise taxes, sales taxes, use taxes, payroll taxes and many other taxes. These taxes can create liabilities for companies in circumstances where there would be no federal income tax liability. For example, some states impose income taxes on single member limited liability companies and partnerships – entities that are disregarded or treated as flow-through entities for federal income tax purposes.
In addition, shareholders, officers, directors, partners and non-executive “responsible persons” can be held liable for a business’s unpaid state and local sales, use, payroll and other taxes. The states frequently publish decisions holding such responsible persons liable for their business’s taxes. For example, in April, 2006, New York State issued two responsible person decisions, one holding a business owner liable for $450,000 of tax, interest and penalties owed by his business. In the other case, a 50% partner was held responsible for 100% of his partnership’s unpaid payroll taxes.
Numerous other examples can be provided demonstrating the importance of state and local tax awareness and planning. United States businesses know the importance of state and local tax planning and their Israeli competitors must be equally well informed to keep pace.
Transfer Pricing Agreements Do Not Reduce Most Tax Liabilities
There can be a misimpression that all material United States tax issues can be resolved through the use of a transfer pricing agreement between an Israeli parent and its United States affiliate. However, such arrangements generally do not reduce non-income taxes. The states know this, and they are enacting new taxes that result in liabilities even where a valid transfer pricing agreement reduces or eliminates income tax liabilities.
For example, Texas enacted a gross receipts tax in May, 2006. Also, Ohio’s gross receipts tax became effective in 2006, Kentucky’s gross receipts tax became effective in 2005, and New Jersey’s gross receipts tax became effective in 2002. Because these taxes are imposed on a business’s receipts instead of its net income, they generally are determined without deducting the costs of goods sold or any other expenses paid to their parents or other affiliates. Also, transfer pricing agreements do not affect the sales and use taxes that are imposed by literally thousands of jurisdictions across the United States.
State Enforcement Mechanisms
Sometimes, taxpayers that do not have a permanent location in a state question whether they really need to pay tax to the state. Such out-of-state taxpayers question whether the state can audit them and, if an audit is conducted, whether the state can collect the tax alleged to be owed.
It is clear beyond any doubt that businesses can be liable for state taxes even without having a permanent location in the state and even if they lack a permanent establishment anywhere in the United States. This is important, as many foreign businesses are surprised to learn that they can be subject to state taxation even if they are not taxable for federal income tax purposes.
Every state has a department of revenue that is prepared to audit out of state businesses. These departments have the power to assess tax against absent businesses. In addition, every state has an attorney general’s office that is prepared to sue businesses in the state’s courts and in any other state’s courts to enforce the department of revenue’s assessments. Therefore, a business that intends to continue to operate in the United States cannot ignore its state tax obligations
State and local tax liabilities can be reduced by planning. In some cases, it is possible to avoid creating tax presence in a state, so that no tax is owed to that state. Or, where tax presence exists for several years but the tax liability has not been paid, it may be possible for the taxpayer’s outside counsel to negotiate an agreement with the state under which the taxpayer will pay only part of its tax liability.
In other circumstances, it is possible to reduce the income or gross receipts that are taxable in the state, and in still other circumstances it is possible to treat a sale as nontaxable for sales and use tax purposes. All of these approaches raise issues and opportunities different from issues raised by United States federal taxes and Israeli taxes.
As Israeli businesses attempt to increase their penetration into the American market, they must increase their planning for American state and local taxes. Doing so will put Israelis on equal footing with their competition in the United States, and in many cases will allow the businesses to increase their after tax profitability and reduce the total cost to their customers.