Canadian Corporations Doing Business In The U.S - Responsibilities and Expectations - Part 1
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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.
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
Doing Business in the US - Through Permanent Establishment - US Branch
US domestic law provides that foreign companies will be subject to tax in the US on income effectively connected with a US trade or business. The Treaty however, in the case of US companies, restricts the imposition of US tax to situations where the Canadian company has a permanent establishment located in the US Therefore, since US federal tax can be exempted if the Canadian company does not have a permanent establishment in the US, it is important to understand what constitutes a permanent establishment and what does not.
Taxation in Two Jurisdictions
As a result of expanding its operations to the U.S., Canco will need to consider the fact that it may have a tax liability and/or a compliance obligation in two jurisdictions. There are 2 ways that Canco can expand into the U.S:
- Branch
- Separate Legal Entity
[1](i) Branch
Canco is subject to tax on its worldwide income. Thus, if Canco carries on business in the U.S. through a branch, the income of the branch will be included in the income of the Canadian company for Canadian tax purposes. Any losses may be applied to reduce the income of the Canadian company for Canadian tax purposes. Canco should be entitled to a credit for U.S. federal and state taxes that have been paid; however, Canco will not be entitled to a tax credit in computing its income for B.C. tax purposes.
(ii) Separate Legal Entity
If the U.S. business is operated by a separate legal entity that is subject to tax in the U.S. (that is, USco), the income will be subject to U.S. federal and potential state income tax. The U.S. federal corporate tax rate is 21% and considering state income tax the combined rate is approximately 26%. Generally speaking, USco’s income will not be subject to Canadian tax provided that its income is active business income. This will be discussed further below. Profits that are distributed by USco to Canco may be subject to U.S. withholding tax. The tax treatment of such distribution to Canco will depend, among other things, on the nature of the payment and the surplus account from which it is paid.
Unless structured properly, there is a risk that the income earned in the U.S. business could be subject to tax in both Canada and the U.S. Suffice it to say that planning the expansion of the business to the U.S. the right way will ensure that there will be no double taxation.
(iii) Tax Rates
The following table compares the tax consequences of Canco carrying on the U.S. business as a branch or through USco.
[1] Expanding to the U.S the Right Way – Know Before You Go, Canadian Tax Foundation, Catherine A. Brayley, Sidartha Rao
Act Now To Get Our Value Pricing Adjustment on Audit and Review Engagements For Your Business
Similar results between a U.S. Branch and U.S. subsidiary are to be expected. By implementing a U.S. Branch Profits Tax, the U.S. is attempting to put a U.S. branch of a Canadian corporation on equal footing with a U.S. subsidiary of a Canadian corporation.
There are a couple of points to keep in mind. If Canco is otherwise eligible for the small business deduction or the manufacturing the processing tax credit, the profits from the U.S. branch will not be eligible for either with the result that the income will be subject to tax at the highest marginal rate.
In addition, not all taxes paid in the U.S. may be eligible for a foreign tax credit. For example, if Canco is carrying on business in Canada and does not have a permanent establishment in the U.S., it may still be subject to state income tax because its sales exceed certain nexus thresholds but may not be eligible to claim foreign tax credits for those state income taxes. Moreover, as will be discussed later, if Canco fails to charge state sales tax and is ultimately liable for the tax it should have collected, it may not be able to deduct that tax for Canadian income tax purposes.
- Treaty
As noted, upon expanding the business to the U.S., Canco will have to deal with the U.S. tax implications of the arrangement in addition to the Canadian tax consequences.
The Treaty can provide some relief to Canco from being subject to tax in the U.S. To benefit from the Treaty, an entity must be fully liable to tax. As will be discussed if the entity is a “C” Corporation, its income will be subject to tax in the U.S. In the case of a “C” Corporation, the Treaty provides that where a company is considered to be a resident of Canada and a resident of the U.S., it is treated as a resident of the U.S. based on its place of incorporation. In the case of a Limited Liability Corporation, as will be discussed, the LLC is fiscally transparent and its members are subject to tax on the profits of the LLC for U.S. tax purposes. Thus, if the LLC is resident in Canada because its central management and control is exercised in Canada, there is a potential for double taxation. In this situation, it would be critical that the central management and control of that entity be exercised in the U.S.
Under the Treaty, a resident of Canada will be subject to tax in the U.S. on business profits only if a business is carried on in the U.S. through a “permanent establishment.” If Canco is found to have a permanent establishment in the U.S., the U.S. will have the right to tax the business profits that are attributable to that permanent establishment.As only the profits that are attributable to that permanent establishment will be subject to tax in the U.S., it will be important to determine the amount of the profits that are attributable to the permanent establishment. The methodology for determining the profits should be documented.
What is a permanent establishment? The Treaty defines permanent establishment to mean a fixed place of business through which the business of a resident of one country is wholly or partly carried on. 24 It is also defined to include a place of management, a branch, an office, a factory, a workshop and a mine, oil or gas well, a quarry or any other place of extraction of natural resources.
Having a fixed place of business is somewhat obvious. The Treaty addresses more than that. A permanent establishment can arise where there is an ability to conclude contracts in its name. The conclusion of contracts and the provision of services by persons in the U.S. could also result in a permanent establishment.
If Canco would not otherwise have a permanent establishment but provides services in the U.S., Canco could be deemed to have a permanent establishment if the services are performed by an individual who is present in the state for a period or periods exceeding 183 days or more in any 12-month period, and, during that period, more than 50% of the gross active business revenues consist of income derived from services performed by that individual. A permanent establishment can also be deemed to arise if the services are provided for 183 days or more in any 12-month period for the same or connected project for customers who are either residents or have a permanent establishment in that state.
It will be very important for Canco to determine the number of days that it will be required to have someone present in the U.S. and the percentage of the U.S.-source revenues to all of its revenues. Canco will also have to maintain records, together with support, confirming the number of days spent in the U.S. by each individual. The requirement is not on an annual basis but rather a 12-month basis.
On the other hand, the use of facilities for the purpose of the storage, display or delivery of goods will not constitute a permanent establishment. Nor will the maintenance of a stock of goods for the purpose of storage, display, delivery or processing or the purchase goods or the collection of information. Finally, advertising, the supply of information, scientific research or similar activities that have a preparatory or auxiliary charter for the resident will also not result in a permanent establishment.
It will be important for Canco to consider carefully how it will have to execute on its desire to expand to the U.S. to determine if it has a permanent establishment or not. If Canco determines that it will not have a permanent establishment, it will still have to consider whether there is a U.S. compliance obligation. If Canco lacks a permanent establishment but has income effectively connected to a U.S. trade or business or is otherwise engaged in a U.S. trade or business, it must affirmatively file what is known as a “Treaty-Protective tax return.” This tax return declares to the Internal Revenue Service that the corporation is engaged in business activity in the U.S. but includes a treaty position declaration that it is protected from U.S. federal income tax pursuant to the terms of the Treaty.
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.
