For Canadian Parent Corporations Considering U.S Business Investment – Analysis and Methodology – Part 1

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When a Canadian corporation (Canco) considers expansion into the U.S, careful consideration of key factors is necessary  from a Canadian and U.S. federal and state tax perspective so that Canco expands to the U.S. in the right way. An important goal is to structure the expansion so as to minimize the overall tax costs, achieve tax deferral to the extent possible and manage tax compliance obligations. In addition, it will be important to ensure that Canco recognizes the complexities resulting from carrying on business in two jurisdictions.[1]

Key Factors When Considering U.S Expansion

1. Residency
2. US sourced-based income
3. US Trade or Business
4. Effectively Connected Income (ECI)
5. Permanent Establishments
6. Distributions
7. US State Tax Obligations

This article will discuss issues 1 and 2 above, while part 2 will discuss issues 3 to 7.

1. Residency

A very common issue with respect to Owner Managed Business's (OMB's) that expand abroad is maintaining the residency of the FAs in the country in which the foreign affiliate (FA) is carrying on its activities. Residency must be considered under 1) the common law test for Canadian purposes, 2) the domestic law of the foreign jurisdiction, and 3) a relevant tax treaty, if any.[2]

Under the common law test, a foreign incorporated company will be considered to be a tax resident of Canada where its central management and control is exercised in Canada. In very general terms, central management and control is considered to reside where strategic decisions are made, as distinct from day-to-day management decisions. The strategic decisions of a corporation are typically made by the board of directors and, therefore, central management and control of a corporation is generally considered to be where the directors reside and meet to make strategic decisions in respect of the business.

[1] Expanding to the U.S The Right Way – Know Before You Go, Canadian Tax Foundation, Catherine A. Brayley, Sidhartha Rao.

[2] Andrew Morreale and Andrew Somerville, "Structuring Outbound Foreign Expansion for Owner Managed Businesses," in 2017 Ontario Tax Conference (Toronto: Canadian Tax Foundation, 2017) 10:1-37.

It is often best practice for a majority of the board of directors to be residents of the country in which the FA conducts its business so that it is considered a resident there under the common law test.

Common Criteria of Residency

There is no bright-line test for establishing where central management and control of a corporation is exercised. All relevant facts and circumstances have to be considered over the entire time period of the corporation's existence such as:

1) Where do the majority of the directors reside? While not determinative, it will likely be factually easier to evidence central management and control in being exercised the country the directors live. Should the board have Canadian resident directors, they should physically attend board meetings in the foreign country, and not remotely via phone or video conference.

2) Is there documentation to support board meetings? Board meetings should be documented, and during such meetings, the board of directors, should exercise its control and make decisions relating to the company's operations and general policies such as investment, financing and dividend payments.

Being able to form a functioning board in the country where the FA carries on business can be very challenging for Owner-Managed Businesses (OMBs), especially those that may be in the early stages of expanding and do not have the financial resources nor the need to engage foreign directors. Further, most entrepreneurs and business owners are very heavily involved in the strategic management of their businesses and consider the decision to expand abroad to be significant and are often hesitant to give up any control of their foreign operations (to either employees in the local jurisdiction or independent directors who reside there).

As a result, consideration must be given to whether or not residency of the FA can be properly maintained outside of Canada, as this will impact the appropriate structure. For example, if there is concern that the US subsidiary will be considered to be a resident of Canada under the common law test (because the sole director is the Canadian resident owner-manager who makes most of the strategic decisions in respect of the US corporation while in Canada), consideration should be given to forming a US C-corporation (or regarded LLC) so that the corporate tie-breaker rule in the Treaty can be invoked. The Treaty tie-breaker rule provides that where a company is considered a resident of Canada and also a resident of the US, it is treated as resident only of the US based upon its place of incorporation.

It is important to note that not all of Canada's tax treaties contain a place of incorporation "treaty-tie breaker rule." One such example is Canada's tax treaty with the UK, where the CRA could take the position that a UK subsidiary that is incorporated under the laws of the UK and operates solely in the UK is a resident of Canada because its central management and control is exercised in Canada. Absent Competent Authority resolution concluding on UK residency only, the UK subsidiary could be subject to Canadian income tax on its worldwide income together with the requisite Canadian income tax filing and reporting obligations.

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Mind and management[3]

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.   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.  US Sourced-based income

Unlike the taxation of non-business items, the United States seeks to tax business income on a net basis. The United States calculates this tax on a foreign corporation's net taxable income that is "effectively connected" with the "conduct of a trade or business" in the United States (both terms are analysed below). Therefore, two things are needed in order to be taxable in the United States on business income: (1) a US trade or business and (2) the income must be effectively connected with the conduct of that US trade or business. In most cases, it is easier to determine whether the income a person earns is from US sources than it is to determine whether the US source income is from a trade or business.[4]

The following are general income sourcing rules set out in the US Internal Revenue Code (the Code):

1. Interest. The United States generally sources interest to the residence of the debtor. Interest paid by residents of the United States constitutes US source income, while interest paid by foreign residents or foreign corporations is foreign source income.
2. Dividends. In the case of dividends, the United States generally says the source is to the place of incorporation of the payor. Distributions paid by US corporations generally constitute US source income and distributions paid by foreign corporations is foreign source income.
3. Personal Services. The United States sources income from personal services to the place where the taxpayer performs those services. Generally, where a person performs services wholly in the United States, those services are US source income.
4. Rentals and royalties. The location, or place of use of the leased or licensed property should determine the source of rents for US federal income tax purposes. Rents or royalties generated from property located in the United States, or from any interest in such property, is US source income.
5. Sale of real property. The location of real property on which a taxpayer realizes gains, profits, or other income will dictate the source of that gain, profit, or other income. Therefore, gains, profits, and income generated from an interest in real property located in the United States is US source income.

[3] Expanding to the U.S The Right Way – Know Before You Go, Canadian Tax Foundation, Catherine A. Brayley, Sidhartha Rao.

[4] US Tax Treatment of a Canadian Company’s Cross-Border Business – Whitestorm Drains Case Study, Canadian Tax Foundation, Kevin Duxbury.

6. Sale or exchange of inventory property. Generally, the United States sources gains, profits, and income from the purchase and sale of inventory propertyentirely from the country where the taxpayer sells the property. The sale of inventory property generally occurs at the place where the seller transfers its rights, title and interest in the property to the buyer.

Conclusion

There are many considerations relevant in the process of considering whether or not to expand to the U.S, and if so, how to structure that expansion.  The above discussion is not exhaustive, and care should be taken to ensure that the expansion is done in such a way as to facilitate the tax, operational compliance needs of the Canadian parent corporation.

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.