September 26, 2005

Paying for “Civilized Society” in the Global Marketplace: H.R. 1956’s Physical Presence Rule Accurately Matches Taxes Paid and Benefits Received

Fiscal Fact No. 31

Imagine you are the proprietor of a small software company, selling your products to customers all over the United States. Your offices are based in your home in South Carolina. You are the only employee of the company. You make occasional sales trips to other states, but generally only sell through advertising your products in magazines and on your website.

You recently made a sale to a customer in New Jersey. The customer is a casino and is using your software to help manage its activities. One day, you receive a letter from the state of New Jersey. They demand taxes from you for the privilege of doing business in New Jersey, and they want you to register to do business in the state. The total cost of the registration fee plus the minimum taxes due exceeds the revenue received from the software sold to your New Jersey customer.1

Is it right for New Jersey to levy taxes on your small software company? Oliver Wendell Holmes once said that taxes are what we pay for civilized society. But is it right for a small business with no offices, employees, or other physical presence in New Jersey to pay taxes for government services offered in the Garden State?

H.R. 1956, the Business Activity Tax Simplification Act of 2005, would require a corporation to have employees or real property physically present in a state before it could be required to pay state business activity taxes (e.g., income, franchise, or gross receipts taxes). Physical presence—as opposed to the most popular alternative, economic presence—is the correct standard for our 21st century international economy. Under physical presence, your small software company would not have to pay tax in New Jersey or anywhere else in the world where you merely sell products to customers.

Physical vs. Economic Presence
The physical presence rule would require a business to pay state business activity taxes only where it has offices, factories, warehouses, inventory, employees, or other property (see Table 1). H.R. 1956 defines physical presence as being individually present in a state, leasing or owning property, or using the services of another to establish and maintain a market for sales.2 In the previous example, the small South Carolina software company was never physically present in New Jersey and thus would not be required to pay New Jersey tax under the physical presence standard.

Table 1: More Activities Generate Economic Presence than Physical Presence

Physical Presence

Economic Presence







Leasing or owning tangible property

Leasing or owning tangible property

Independent contractors

Independent contractors


Deriving income


In contrast, economic presence would require a business to pay tax not only to those states where it has physical presence, but also to those states where it makes sales or derives income from customers (see Table 1). In the previous example, the small South Carolina software company had economic presence in New Jersey since it derived income from the sale of software to the New Jersey casino.

Physical Presence More Accurately Tracks Benefits
If, as Justice Holmes said, “Taxes are what we pay for civilized society,” then it seems reasonable that those receiving the benefits of civilization pay the costs of maintaining it. In the context of state taxes on corporations (e.g., income, gross receipts, franchise), the physical presence standard more accurately tracks the benefits received by corporations from state governments for which they can be expected to pay taxes.

Supporters of economic presence claim that corporations are benefiting from education, transportation, and a viable economic market in those places in which they have customers, and thus should be expected to pay taxes in those states as well.3 Supporters of physical presence, however, maintain that the physical presence rule gauges benefits better because it ties taxes paid to the states and communities in which the corporation is actually employing labor and capital and thus actually benefiting from public services such as education, transportation, and public safety (i.e., police and fire fighters).4

Who is correct? It is important to understand, at the outset, that merely giving a benefit (however small or remote) to a corporation is not sufficient to impose taxes. If that were the case, states would be able to tax many firms with trivial or practically non-existent business dealings in their state.

For instance, if New Jersey can extract taxes from the South Carolina software company merely because the state provides a marketplace for goods and services, then surely each state through which those goods and services travel can also claim they are providing the benefits of highways and roads. A truck carrying its product from South Carolina to New Jersey passes through at least four states if it travels directly (see Table 2). If a package is shipped via FedEx it may be routed through Memphis, where Tennessee might claim the right to tax because it provided an orderly marketplace for the FedEx hub. Also, if a sales contract contains a choice of law clause detailing, for example, that the law of Delaware controls any dispute on the contract, Delaware might claim a right to tax for providing its legal structures.

Table 2: Possible States that Could Demand Tax from a South Carolina Software Firm that Makes a Sale in New Jersey


Benefit Given

South Carolina

State and local services

New Jersey

Orderly marketplace for goods and services

North Carolina

Roads (if shipped directly)


Roads (if shipped directly)


Roads (if shipped directly)


Roads (if shipped directly)


Choice of law clause in sales contract


Transportation hub (If shipped by FedEx)

New York

Accounting services for sales


Software used to develop the product

Furthermore, the South Carolina software company in the previous example also benefits from the inputs of production and the government services in those states in which those inputs were produced. If it bought software from Washington State to help develop its own software products, and purchased accounting services from New York, those states might demand taxes in exchange for the orderly market in which its business inputs were produced and shipped or delivered to it.

It is also unclear why producers should be liable to pay tax in the customer’s state while customers are free from paying tax in the producer’s state. If the producer is receiving benefits from the customer’s state, then the customer is also receiving benefits from the producer’s state. Why should the corporation who produces and ships the product be the only one required to pay taxes to support the market in the destination state?5 For that matter, the customer could also be expected, under a real economic presence standard, to remit tax to every state from which he, like the producer, receives a benefit (see Table 2).

It is easy to see how quickly the number of states in which we have to pay tax multiplies if we are expected to pay tax for any benefit—no matter how small—received from any state. Thus, it becomes necessary for the law to make qualitative judgments about which states have given benefits sufficient to expect a payment of tax in return. In making those qualitative judgments, it is clear that the economic presence rule would subject corporations to taxation that is too widespread and expansive to support an integrated, national economy.

The physical presence rule matches benefits received with taxes paid without wading into the complicated questions above. The producer pays for the benefits in the state where the product is shipped from, and the customer pays for the benefits received in the state to which the product is shipped. Physical presence provides a legal rule that is equitable, easy to enforce, and simple for companies to comply with. Economic presence, on the other hand, rewards states (via taxes from out of state companies) for merely doing what they ought to do in our free-market, open-economy federalist society, i.e., providing an organized marketplace for their goods and services.

Physical Presence Works Better in a Global Marketplace
The United States generally adheres to the Model Tax Convention of the Organisation for Economic Cooperation and Development (OECD). The OECD’s model tax language forms the basis for many tax treaties that the United States maintains with foreign countries, such as Australia.6 Part of this model language is the permanent establishment rule, which says that neither the U.S. nor its treaty partner will seek to tax the income of a multinational corporation unless it has a “fixed place of business through which the business of an enterprise is wholly or partly carried on.”

Making sales or deriving income in a country is not sufficient, in the international context, to require the payment of taxes. The OECD’s model language thus thoroughly rejects the idea of economic presence, and the U.S. has committed itself to not taxing the income of many foreign-based corporations unless they have a physical presence in the United States, no matter how much they advertise and sell here.

Table 3 shows how state economic presence standards disadvantage U.S.-based corporations selling in the United States compared with an Australian corporation selling in the United States. Though U.S. tax treaties do not apply to sub-national taxes (e.g., state taxes), as a practical matter it is more difficult to enforce tax collection judgments against foreign-based corporations. Furthermore, since many states conform to the Internal Revenue Code and use federal income as a starting point for state income, many if not most foreign-based multinationals without a permanent establishment in a state will rightly claim zero income on their state returns.

Table 3: Economic Presence Leads to Tax Inequity between U.S.-Based and Foreign-Based Multinationals

Australia-Based Corporation

California-Based Corporation

Activities in Maine

Selling goods and services

Selling goods and services

Federal Taxes Due?




U.S.-Australia tax treaty requires permanent establishment

Treaty does not apply to U.S.- based company; sales enough to trigger taxation under economic presence

Maine State Taxes Due?




State law (economic presence)

State law (economic presence)

Likelihood of Maine Collecting Tax from Corporation

Unlikely (due to administrative difficulties of enforcing judgments and the reliance on federal income tax base)

More likely

The result of a widespread economic presence standard would thus clearly disadvantage U.S.-based firms compared with their foreign-based competitors. In the expanding global marketplace, this is hardly the right policy choice to promote U.S. competitiveness.

U.S. corporations should only pay business activity taxes in those states in which they are physically present. The physical presence rule is fair to businesses since it requires tax in exchange for government-provided benefits in every state where companies employ labor and capital. Physical presence is also more consistent with the language in U.S. tax treaties and thus creates more equity between U.S.-based and foreign-based corporations doing business in the U.S. The physical presence standard also has other benefits, including the promotion of a robust interstate market,7 maintenance of state tax competition and the reduction in the number of states in which corporations have to pay tax.8 For these reasons, Congress should consider moving ahead with the adoption of a physical presence standard for state business activity taxes.

(For more information, please contact Chris Atkins at (202) 464-6200.)

1. This factual situation is based on actual events. See Business Activity Tax Simplification Act of 2003: Hearings before the Subcommittee on Commercial and Administrative Law of the House Judiciary Committee, 108 th Cong., 2d Sess (2004) (letter of Bo Horne).

2. Business Activity Tax Simplification Act of 2005, H.R. 1956, 109 th Cong. § 3(b)(1)-(3) (2005). H.R. 1956 does create some exemptions from the general physical presence requirement, such as the gathering of news activities.

3. See Walter Hellerstein and Charles McLure, Jr., Congressional Intervention in State Taxation: A Normative Analysis of Three Proposals, 2004 STT 40-3 (March 1, 2004) (“Corporate income should be subject to tax in the state where it is earned, at rates chosen by the state.”).

4. See 108 th Cong., 2d Sess 12 (2004), supra note 1, (statement of Arthur Rosen) (“…states and localities that provide benefits and protections to a business, like education, roads, fire and police protection, water, sewer, etc., should be the ones who receive the benefit of that business’ taxes, rather than a remote state that provides no services to the business.”).

5. The producer’s state could easily extract taxes from the consumer in exchange for benefits by charging a sales tax at the point of origin which the customer would pay to the producer.

6. See, e.g., Convention for the Avoidance of Double Taxation, Aug. 6, 1982, U.S.-Aus., art. V and VII, available at

7. See 108 th Cong., 2d Sess. 35 (2004) (letter of Bo Horne) (“We have become so concerned about the risk of our continued participation in Interstate Commerce that we have begun to ask ourselves ‘Why bother? Can we afford this risk? Should we terminate the business before it gets worse?’”).

8. See Chris Atkins, “A Twentieth Century Tax in the Twenty-First Century: Understanding Multistate Corporate Tax Systems,” Tax Foundation Background Paper No. 49 (September, 2005).

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