Canadians Expanding Business To The U.S – Issues To Attend To.
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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.
When businesses expand into the US they often start up with very minimal presence in the US, and, as they expand and grow, this activity increases.
There are no US tax or compliance requirements if there is no US formal business presence or business structure. Under US tax law, Canadian companies are subject to US tax on any US source income which is "effectively connected with the conduct of a trade or business within the U.S". This term is not defined in the US Internal Revenue Code ("I.R.C."). However, the US courts have tended to define "the conduct of a trade or business in the United States" as some type of on-going activity. The Internal Revenue Service ("I.R.S.") has defined trade or business to be any activity beyond the mere receipt of income and payment of expenses. Therefore in order to avoid US compliance requirements, there must be no US business activity such as sales representatives or agents in the US, inventory in the US, marketing activity in the US, or regular customer visits in the US
US Trade or Business but no US Source Income
While foreign taxpayers are subject to US tax if they have a US trade or business, this income must be US sourced income to be subject to tax in the US For example, there is a US trade or business if salesmen travel to the US and conclude sales but the income is Canadian sourced if title to the goods sold passes to the purchaser in Canada. US tax or compliance filings are not required if there is a US trade or business but there is no US source income. The I.R.C. defines various sourcing rules. For example, generally, the income from retail sales is sourced where the rights and title pass to the buyer. Service income is sourced based upon where the service is performed. Sales of manufactured inventory is allocated based on the location of manufacturing and sales activity. |
Doing Business in the US - US Business Activity Without Permanent Establishment
US domestic law requires Canadian companies to pay tax in the US if they have US source income "effectively connected with the conduct of a trade or business within the United States". The Canada-United States Income Tax Convention, 1980 ("the Treaty") overrides the US domestic law such that the Canadian company is taxable on US income only if it has a permanent establishment in the US It is imperative to understand the concept of permanent establishment because permanent establishment defines when tax is levied in the US Even though a Canadian corporation may have a trade or business in the US and is liable for tax pursuant to the I.R.C., the Treaty overrides the obligation of the I.R.C. Recently the US introduced new rules that require many Canadian-based corporations to file US tax returns disclosing the nature and extent of their activities in the US and explain why they
are exempt from US tax on business profits in the US The need to file arises in situations where the corporation would be subject to tax under US domestic law but is exempt, or taxable at a reduced rate, under the Treaty.
Historically speaking, most Canadian businesses have a tacit aversion to filing US returns unless they have to. The new compliance provisions must be carefully studied because the US imposes a penalty of up to $10,000 per item of income plus the disallowance of business deductions if the corporation is subsequently determined by the I.R.S. to be engaged in a US business and has not timely filed its US return. Timely means within 18 months of the date the return is due.
Canadian companies can undertake certain US business activities without the imposition of US tax, however, Treaty disclosure may be required. For example, US activity including participation at trade shows, US direct mail or phone advertising, salesmen visiting customers in the U.S but without having contracting authority in the US, final sales orders that are negotiated in Canada, inventory that is maintained only in Canada and ownership of tangible property sales transfers in Canada, allows a Canadian company to do business in the US with no US federal tax liability. Also the Canadian company can use franchises or non-exclusive distributorships on a commission basis if they do not function as dependent agents with contracting authority on behalf of the Canadian company. Inventory can be in the US with no federal tax liability. However, although there may be no US tax liability some of these circumstances may require treaty-based disclosure. In addition, there may be state tax issues.
One of the most difficult problems is determining when a treaty-based return is necessary. Most Canadian businesses do not know whether they would be taxable in the US were it not for the Treaty. For small and medium sized businesses, the following questions should be asked to determine whether treaty-based filing is required. This is not all inclusive but it covers some of the more common situations.
Does the corporation:
- Have sales representatives based in the US, whether they are dependent or independent?
- Have Canadian-based sales representatives or officers who travel in the US?
- Have exclusive sales agents in the US?
- Provide technical maintenance or similar services to US customers?
- Have inventory in the US in a public warehouse, showroom, etc.?
- Attend trade shows in the US?
- Maintain a purchasing office in the US? |
- Have any joint ventures in the US?
- Provide management, accounting or other administrative services to a US affiliate?
If the answer to any of these questions is "yes" a US treaty-based return may need to be filed. This is because US domestic law would, without the Treaty, subject the Canadian business to U.S federal tax. While many Canadian companies seem reluctant to become embroiled in these new US compliance requirements, the risk of penalties for not doing so is now extremely onerous.
 Canadian and U.S Tax Compliance Issues For Doing Business In The U.S, Canadian Tax Foundation, Brenda J. Lowey.
A US "treaty-based" return is required if the Canadian company has US source income effectively connected to a US trade or business but no US permanent establishment. The following must be filed with the I.R.S. Philadelphia, P.A. 19255.
- Form 1120F US, Income Tax Return of a Foreign Corporation - complete only the information section including T.I.N.(taxpayer identification number) and sign
- Form SS-4 is used to apply for T.I.N.
- Attach Form 8833, "Treaty-Based Return Disclosure Under Section 6114 or 7701(b)" to 1120F. Form 8833 requires an explanation of the treaty-based return position taken, including a brief summary of the facts on which it is based. Also, include the nature and amount or estimate of gross receipts, and each separate gross payment for which the Treaty benefit is claimed. For example, the statement to indicate that there is no US permanent establishment would include that there are gross receipts from sales in the US, the amount of these receipts, and a description of the facts that support that there is no US permanent establishment. An example would be the fact that sales are made by an independent agent.
Protective "Treaty-Based" Return
An example of when a "Protective "Treaty-Based" Return" might be filed is if, after reviewing the Treaty, the Canadian company is uncertain whether its US activities constitute a US permanent establishment. As indicated, the US does impose tax | if there is a permanent establishment. The protective treaty-based return would be prepared as follows:
- Form 1120F and Form 8833 are filed; a statement is made that it is a protective filing stating that the corporation does not have a US permanent establishment and therefore is not subject to US tax, but is filing the protective statement to ensure entitlement to deductions and credits attributable to US source income if the income were taxable in the US
- This protective filing starts the statute of limitations for that taxation year. There is no statute of limitations on an I.R.S. assessment if no income tax return is filed. Once filed, the federal statute of limitations is 3 years.
- This filing also ensures entitlement to US deductions because if a timely return is not filed in the US, there is no entitlement to deductions or credits. "Timely filed" means within 18 months of the original due date not including extensions.
The timing for filing treaty-based returns for Canadian corporations is the 15th day of the sixth month after the taxation year end. Therefore, for a December year end, the filing deadline is June 15th. A return is considered filed when postmarked by the US postal service.
Late filings should be done to meet compliance requirements, even if filed more than 18 months late.
Penalties for Non-Filing of Treaty-Based Information
Businesses receiving payments or income items from US sources during the taxable year that do not exceed US $10,000 are exempt from filing a treaty-based return. Businesses over that limit may face steep fines for failure to file such a return of up to US $10,000 for each payment or each item of income from US sources.
State Income Tax Requirements
- Most US states impose income tax. State taxation is imposed if there is any nexus with the state. Nexus can be a much lower threshold than permanent establishment, which is the threshold that is required to establish tax liabilities for US federal purposes. Therefore, each state's code must be carefully studied.
- Most states base their tax on US federal adjusted gross income or federal taxable income. If there is a nexus with the state then the state tax calculation generally begins with federal taxable income.
- Some states such as California and New York do not use federal taxable income as a tax base. These states impose state tax on the amount of the company's worldwide income allocatable to the state. The allocation is based on the amount of gross sales, payroll and assets which are attributable to or located in the state. Therefore, even though there may be no US source income from sales in that state, there may be a requirement to file state tax returns. This allocation on world-wide income is referred to as a "unitary tax." This requires the allocation of worldwide income of the Canadian corporation within and without the state based on sales, payroll and assets, as opposed to apportioning US income only. This can result in the state imposing tax on the Canadian corporation even in years when the US operations have a loss. There have been court cases in the US that have challenged the constitutionality of the unitary tax. There is in most cases prescribed relief to elect to be taxed only on state activity.
- Some states that do not have income tax have a franchise tax, which is like an income tax for companies doing business in the state. For example, Texas has a franchise tax. Some states have income taxes and franchise taxes as well as capital taxes.
- Filing deadlines, extensions, and payment dates for states need to be individually researched for each state in which the company is doing business. They do not automatically follow federal law. |
Canadian Tax Requirements
- If there is no US permanent establishment, then tax is computed in Canada. The provincial abatement applies to taxable income of the Canadian company if there is no US permanent establishment. The taxable income allocated to a province is eligible for a 10% tax reduction federally. This same income amount is then subject to provincial tax.
- The Canadian company may allocate some income to the US if US state tax is imposed. The income allocated to the US in this circumstance would not be eligible for the provincial abatement. Also the Canadian provinces would not likely impose tax on such income. The allocation of income to a province is determined by the Regulations in Part IV of the Income Tax Act (the Act). These Regulations define permanent establishment and then allocate income among the permanent establishments by a formula dependent upon sales and wages. Usually there is not a conflict when there is a permanent establishment under the Treaty, but there may be times when there may be a permanent establishment according to provincial allocation regulations but not under the Treaty.
Canadian foreign tax credits may be used to reduce Canadian federal tax payable if US state tax is imposed.
- US business income is included in the provincial base for tax calculation if there is no US permanent establishment.
- The Canadian company's taxable income is allocated to provinces based on gross sales and payroll attributable to that province. Retail and wholesale sales revenue is allocated based on the location of the individuals negotiating the sales. Sales of manufactured goods are allocated to the province performing the sales activities and manufacturing activities.
- If both a Canadian province and a US state tax a sale, there are no Canadian provincial foreign tax credits for US state tax paid. |
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.