Canadian Corporations Doing Business In The U.S - Responsibilities and Expectations - Part 2
Leading Tax Advice
Call Nicholas Kilpatrick
604-612-8620
Growing Canadian businesses searching for new markets are conducting business on a multinational level. The United States, being Canada's largest trading partner is the country many businesses are seeking first to expand to.
Since more businesses are expanding into the United States, Revenue Canada and the I.R.S. have increased audit activity of cross-border transactions. In order to ensure that companies are taxed on their cross-border activity there has been a vast increase in the cross-border tax compliance requirements for businesses, and large penalties to ensure compliance with the new and existing rules. It is imperative that businesses are aware of these rules in order to minimize tax costs as well as to maximize profits and cash flows. There are a significant number of new rules that require information disclosure only. This is however, not to be taken lightly, because the penalties attached to non-filing of this information can be as much or more than the tax bills that many companies pay.
The second part of this series on doing business in the U.S goes through various methods to undertake business operations in the U.S
Canadian Structural Considerations
This section of the paper assumes that the U.S. business will be operated as either a branch or a separate legal entity will be formed. Having understood what is meant by expanding to the U.S. the next step is to consider the structure of that legal entity. In considering how to structure the expansion to the U.S. from a Canadian tax perspective, a number of issues should be considered: (i) management and strategic direction; (ii) status of Company as a small business corporation; (iii) the ability to restructure on a tax-deferred basis and (iv) investments by Canco in real estate situated in the U.S. Each of these factors will be addressed in turn.
- Management and Strategic Direction
Our fact situation indicates that Canco has a sole director and officer. As such, that person both manages and strategically controls Canco. It will be important for your client to consider who will be managing and controlling the strategic direction of the U.S. business and from where that is to take place. The issue of central management and control can affect where the income of the entity/USco will be subject to tax.
If the director of USco is a resident of Canada, for example, the risk is that the U.S. entity will be considered to be resident in Canada. Canco will have to take steps to ensure that USco will not be a resident of Canada. One option is to have a resident of the U.S. manage and control the U.S. entity. Another option would have a number of directors with the majority of the directors present in the U.S. when decisions are made. A further option would be have a Canadian director ensure that those strategic decisions take place in the U.S. Where the manager/director travels to the U.S. to make the strategic decisions there, there would need to be documentation to support the assertion that that is what happened. In addition to travel records, this would include board minutes, resolutions, and proof of execution of contracts and key agreements in the U.S. This would be an additional administrative task that Canco might not be used to undertaking. That being said, provided USco is a “C” Corporation, even if it is found to be both a resident of Canada and a resident of the U.S., the tie-breaker rules in the Treaty should result in USco being a resident of the U.S. on the basis of its place of incorporation.
Mind and management and therefore residency in Canada from a common law perspective can result in adverse consequences under the exempt surplus regime. In order to have business income added to exempt surplus, the foreign affiliate, in this case, USCo, must be resident in a treaty country under Canada’s common law test. 41 The concern is that by having mind and management in Canada, USco’s business income will be added to taxable surplus rather than exempt surplus with the possible additional tax payable on the repatriation of a dividend.
2. Small Business Corporation
In considering how Canco will expand to the U.S., consideration should be given to whether Canco will be a “small business corporation.”
What is a small business corporation? First, Canco must be a Canadian-controlled private corporation. Second, all or substantially all of the fair market value of Canco’s assets must be attributable to assets that are (i) used principally in an active business carried on primarily in Canada by the particular corporation or by a corporation related to it; (ii) shares of the capital stock or indebtedness of one or more small business corporations that were at that time connected with the particular corporation or (ii) assets described in (i) and (ii). For this purpose, (i) principally is generally considered to mean more than 50% and is applied on a property-by-property basis; (ii) all or substantially all is considered by the CRA to mean 90% or more; and (iii) primarily is more than 50%. In considering how to structure the expansion of the business to the U.S. it will be important to think about the prospect for growth in the U.S. and the relative value of those assets to Canco’s assets.
Canco’s status as a small business corporation is essential if Canco’s shareholder wishes to access the lifetime capital gains exemption (LCGE) in respect of “qualified small business corporation shares” at the time of the disposition or deemed disposition of the Canco shares. If a shareholder or a debtholder realizes a loss and Canco is a small business corporation, the shareholders may be able to treat the loss as an allowable business investment loss with the result that one-half of the loss may be used to offset any source of income. The so-called corporate attribution rules will not apply if Canco is a small business corporation from the time of the loan or transfer of property. A 10-year reserve is available in respect of the transfer of shares of a small business corporation to a child. Depending on the context, Canco must be a small business corporation throughout a period of time or at a particular time.
Act Now To Get Our Value Pricing Adjustment on Audit and Review Engagements For Your Business
In the case of the LCGE, Canco must be a small business corporation at the time the shares are disposed of. In addition to the point in time test, the corporation must have derived more than 50% of the value of its assets from an active Canadian business for the 24-months prior to the disposition.
If Canco operates a branch in the U.S., the assets of the branch, including goodwill, will not meet the definition in (i) and thus will not be an eligible asset. If the value of those assets (together with Canco’s other ineligible assets, such as surplus cash) exceeds 10% of the fair market value of all of Canco’s assets, Canco will not meet the test of small business corporation and the LCGE will not be available.
If instead of operating a branch, Canco proposes to form an entity in the U.S., that entity will not meet the definition in either (i) or (ii) with the result that the value of any equity or debt would not be an eligible asset. If the value of that equity or debt (together with Canco’s other ineligible assets, such as surplus cash) exceeds 10% of the fair market value of Canco’s assets, Canco will not meet the test of small business corporation and the LCGE will not be available.
Because the small business corporation status is tested at the time the shares are disposed of, if the ineligible assets comprise more than 10% of Canco’s assets, steps will need to be taken to remove those assets from Canco or “purify it.” There may be questions as to whether it is even possible to do so. The Canadian tax implications of removing the U.S. assets from Canco will have to be considered. There may be legal and U.S. tax implications and/or impediments to moving the U.S. operations in a separate company.
For these reasons, it may be preferable to establish the U.S. business in a Canadian entity that is separate from the Canco. Ideally the U.S. business would not be owned by an individual as there may be U.S. Estate Tax implications. The incorporation of another Canadian company to own the business will result in additional set-up and maintenance costs and compliance. There will also be concerns about allocating costs from Canco to that entity.
3. Ability to Restructure on a Tax-Deferred Basis
There may be reasons why consideration should be given to having the U.S. business structured as a branch. For example, the prospect for success in the U.S. is not certain with the result that there is a reluctance to invest the time and money to establish a separate legal entity. It could also be because the branch will initially generate losses which may be used to offset the income of the Canco. If it is determined that it would be beneficial to incorporate the branch, consideration will have to be given to whether this can be effected on a tax-deferred basis from a U.S. or a Canadian tax perspective.
From a Canadian tax perspective, there is no ability to effect the transfer of the branch’s assets to USco on a tax-deferred basis because a condition of subsection 85(1) is that the company must be a taxable Canadian corporation. Accordingly, any appreciation in the branch’s assets will be subject to tax in Canada. If there are losses, the losses will be deemed to be nil as a result of the application of the so called stop loss rules.
For U.S. federal tax purposes, Canco should be able to rollover its branch assets to USco in exchange for shares of USco if it acquires at least 80% control of the vote and value of USco. However, if the assets transferred include U.S. situs real estate, nonrecognition may not be available. One should also consider the Canadian tax implications of having disparate tax basis for assets rolled over to USco where a disposition occurs for Canadian but not U.S. federal tax purposes.
For this reason, it is important that consideration be given to the form of the U.S. business and the ownership structure at the outset.
4. Canco Invests in U.S. Real Estate
Canco that expands to the U.S. via purchase and exploitation of U.S. real estate will be subject to U.S. federal income tax on both the rents and gains when the property is disposed. Rents are either taxed as Fixed, Determinable, Annual, Periodical (FDAP) or income effectively connected (“ECI”) to a U.S. trade or business. Rents which are FDAP are subject to a 30% U.S. federal withholding tax on gross amounts paid. If rents are effectively connected to a U.S. trade or business, they are taxed on a net basis and at graduated rates. Gains from dispositions of real estate situated in the U.S. are automatically treated as effectively connected to a U.S. trade or business.
The Treaty does not alter the taxation of U.S. real estate as it defers to the source country for the first right to tax the income which is consistent with U.S. domestic tax law. The Treaty can expand on the definition of real property beyond what U.S. domestic law would otherwise provide.
5. Income for U.S. Purposes is Not the Same as Income for Canadian Tax Purposes
As one might expect, there are differences between U.S. and Canadian tax laws that will affect how U.S. taxable income is translated in Canada. Perhaps the biggest difference between the two jurisdictions is accelerated depreciation available in the U.S. which would allow 100% expensing for qualified investments in new or uses tangible property. If bonus depreciation is used in the U.S., Canco needs to be mindful of the disparity this might create between U.S. and Canadian calculations of taxable income. Other disparities between the two jurisdictions that should be considered are IRC section 1031 exchanges, outside basis adjustment for partnership liabilities and tax-deferred IRC section 351 rollovers.
6. Timing of Income Inclusion
We are assuming that USco will be a wholly-owned subsidiary of the Canco with the result that it will be a controlled foreign affiliate of the Canco.
Where the business is carried on by USco, consideration will have to be given to whether Canco will not be subject to tax those earnings before the funds are repatriated to Canada. Depending on the source of income, it is possible that there will be no additional Canadian tax payable. For example, if USco carries on an active business, its profit from that business as well as investment income that is incidental to that business as well as gains on the disposition of assets used in the business will be subject to tax in the U.S. and not in Canada. The profit will be included in exempt surplus with the result that it will not be subject to tax in Canada when it is repatriated to Canada in the form of a dividend. If, however, USco earns passive income, foreign accrual property income or FAPI, that income will be included in Canco’s income on a current basis. A deduction would generally be available for foreign accrual tax.
Should loans be denominated in Canadian dollars or U.S. dollars? If Canco loans USco in U.S. dollars, it will be susceptible to foreign exchange gain or loss in Canada on repayment of principal. Conversely, if Canco makes a loan to USco in Canadian dollars, USco will be subject to foreign exchange gain or loss in the U.S. Given the reduction in U.S. federal corporate tax rates and depending on the applicable corporate tax rate in Canada, Canco may be indifferent to where it recognizes foreign exchange gain.
Conclusion
There are a myriad of Canadian and US tax compliance issues for Canadian businesses expanding into the US A review of at least the items identified in this paper will assist businesses to identify the requirements and to make a calendar of important filing dates. Planning ahead will ensure that proper business structures have been considered, and that all required compliance filings are made to avoid unnecessary and expensive penalties. It will also help to plan for tax compliance issues for Canadian employees spending time or transferring to the US.
Nicholas Kilpatrick is a partner with the accounting firm of Burgess Kilpatrick and specializes in tax structuring and business development for his small and medium business sized clients. Please visit our website at www.burgesskilpatrick.com or on Facebook at www.facebook.com/Burgess Kilpatrick for more information on our firm.
