Foreign State Taxation of Intellectual Property Income

Foreign State Taxation of Intellectual Property Income

Paying income taxes to the federal and Virginia state governments is unpleasant enough for most businesses, but an unexpected tax bill from a state in which your business has no employees, no real or tangible personal property and no sales can be especially distressing.

If your business involves the licensing of intellectual property such as copyrights, trademarks, service marks or patents, your chances of encountering this situation increase. Under pressure to make ends meet while easing the tax burden on residents, several states are testing the limits of their power to tax nonresident businesses.

In a familiar scenario, Company A licenses its intellectual property to Company B in return for a royalty of a certain percentage of Company B’s sales using Company A’s intellectual property. The less familiar scenario occurs when Company B takes this license and conducts business in a distant state that subsequently asserts that, not only Company B, but also Company A owes state income tax on income derived from the use of its intellectual property in that state. South Carolina, for example, has taken the position that licensing intangibles for use in South Carolina and deriving income from their use in South Carolina requires the payment of South Carolina corporate income tax. This includes situations where the licensor has never “”set foot”” in South Carolina.

Attempts by the states to tax such royalty income are subject to the limits imposed by the Commerce Clause of the United States Constitution and the Due Process Clause of the Fourteenth Amendment. In order for a state to justly tax a nonresident business, the Due Process Clause requires (1) some definite link, some minimum connection, between the taxing state and the person, property or transaction it seeks to tax and that (2) the income attributed to the state for tax purposes must be rationally related to values connected with the taxing state. In essence, it must be fair for the state to tax the nonresident business. Meanwhile, the Commerce Clause requires that (1) the tax is applied to an activity with a substantial nexus with the taxing state, (2) is fairly apportioned, (3) does not discriminate against interstate commerce, and (4) is fairly related to the services provided by the state. In other words, the imposition of the tax on a nonresident business cannot place an undue burden on interstate commerce.

As is often the case in legal questions involving the United States Constitution, the tests are easily stated, but the application of such tests to specific facts is often challenging. A Virginia business facing demands for the payment of income tax from states in which the Virginia business’ licensees have commercial activity must determine whether the Constitution offers protection from such demands. Careful review of the facts and circumstances may reveal that the tax man has reached too far.