For Canadian Parent Corporations Considering U.S Business Investment – Analysis and Methodology – Part 2
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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
- Residency
- US sourced-based income
- US Trade or Business
- Effectively Connected Income (ECI)
- Permanent Establishments
- Distributions
- US State Tax Obligations
Part 2 of this article will discuss issues 3 to 7 above.
3. US Trade or Business
The next question after considering the source of the income is to consider whether the sales are part of a US trade or business. There is no comprehensive definition of a US trade or business in the Code. However, the Code does state that a US trade or business includes the performance of personal services within the United States at any time within the taxable year. The Code excludes the performance of personal services for foreign corporations not engaged in a US trade or business by a non-resident individual temporarily present in the United States for a period not exceeding ninety days and receiving compensation not exceeding $3,000. The Code also excludes trading in securities or commodities through a resident broker, commission agent, custodian, or other independent agent. Apart from these brief rules, whether a foreign corporation is engaged in a US trade or business depends on the applicable facts and circumstances. As such, the determination of whether a foreign corporation is engaged in a US trade or
[1] Expanding to the U.S The Right Way – Know Before You Go, Canadian Tax Foundation, Catherine A. Brayley, Sidhartha Rao.
business has been left to the courts. This determination is generally based on the nature and extent of the foreign corporation's economic activities in the United States.
4. Effectively Connected Income (ECI)
Along with a US trade or business, the second thing needed to be taxable in the United States on business income is income that is effectively connected with the conduct of that US trade or business. The United States calculates income 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.
Deductions from ECI
Ordinary corporation income tax is imposed on a foreign corporation's taxable income, net of applicable deductions, that is effectively connected with the conduct of a US trade of business. The Code permits non-US corporations to take deductions only to extent they are related to or connected with gross income that is ECI. To determine what portion of the deductions relate to US ECI, Treasury Regulations prescribe that taxpayers should categorize gross income into "buckets" (e.g., service fees, income from a business, income from selling property, interest, rents, etc.) and that deductions be apportioned to these buckets according to their relationship with each item of gross income. Interest deductions are subject to a special regime that seeks to apportion deductions to categories of gross income.
5. Permanent Establishments
The Canada-US Tax Treaty overrides certain areas of US and Canadian domestic tax law to reduce instances of double taxation. Generally, the Treaty limits the ability of the United States to tax a Canadian corporation's business profits to those business profits that are attributable to a US permanent establishment (PE).
The Treaty provides that a PE is a fixed place of business through which the business of the foreign corporation is wholly or partially carried on. A PE includes a place of management, branch, office, factory, workshop and mine, oil or gas well, quarry or any other place of extraction of natural resources. The Treaty specifically excludes from the definition of a PE the maintenance of a stock of goods or merchandise belonging to the foreign corporation for the purpose of storage, display or delivery.
In order to be eligible for Treaty benefits under the Canada-US Tax Treaty, a person must be a resident of Canada or the United States under Article IV. As analyzed above, under that article, a corporation is generally resident in the country where it is formed. Even if a person is a resident of Canada or the United States, that person must also meet the tests set out in the Treaty's limitation of benefits provision (LOB). The LOB extends treaty benefits only to "qualifying persons" of Canada or the United States. A corporation can be considered a qualifying resident if its principal class of shares is primarily and regularly traded on one or more recognized stock exchanges.
A corporation can also be a qualifying person if it meets an ownership test and a "base erosion" test. A corporation resident in Canada or the United States will satisfy the ownership test if 50 percent or more of the vote and value of its shares is not owned, directly or indirectly, by persons other than qualifying persons. The "base erosion" test requires that less than 50 percent of expenses that are paid or payable by the corporation to persons that are not qualifying persons, and that are deductible from gross
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income, be less than 50 percent of the gross income of the corporation. For these purposes, a qualifying person is a resident of Canada or the United States.
A Canadian parent corporation may operate its US retail store as a US branch or through a US subsidiary. Under US income tax law and under the Treaty, there should be no particular tax advantage to operating in branch form compared to operating through a subsidiary. The branch profits tax (BPT) is supposed to act like a dividend withholding tax for US branches, with the intention of equalizing the US withholding tax burden of foreign corporations operating in the United States through a branch and through a subsidiary. BPT applies to a US branch's earnings and profits (E&P) repatriated to the Canadian corporation and not reinvested in the US trade or business. E&P is, in a way, like a tax version of retained earnings. The amount of repatriated E&P is determined by formula. Generally BPT applies at 30 percent of repatriated E&P unless it is reduced by treaty. The Canada-US Tax Treaty can reduce BPT to 5 percent.
If a Canadian parent corporation (Canco) decides to operate the retail store through a US subsidiary, Canco can expect to pay a withholding tax on amounts distributed from the US subsidiary back to Whitestorm Canada. For US federal income tax purposes, a dividend is a distribution of cash or property by a corporation to its shareholders with respect to its stock, from its accumulated or current E&P. Distributions made out of a corporation's current or accumulated E&P are treated as taxable dividends, and should be subject to 30 percent US withholding tax. The Treaty reduces withholding tax on dividend payments to 15 percent in general and 5 percent if the corporation receiving the dividend owns at least 10 percent of the voting stock of the paying corporation. Distributions made in excess of E&P are treated first as a return of capital to the extent of a shareholder's basis in the stock, then as a capital gain for all distributions in excess of E&P and all available basis.
6. Distributions
For Canadian income tax purposes, the character of distributions from a foreign affiliate to the Canadian corporate shareholder depend on the activities of the foreign affiliate. A US corporate subsidiary is a foreign affiliate of a Canadian corporation if the Canadian corporation directly owns at least 1 percent in the US corporation and the Canadian corporation and its related persons together own at least 10 percent in the US corporation. A controlled foreign affiliate is generally a foreign affiliate that is controlled by the Canadian corporation or some combination of the Canadian corporation and other non-arm's length persons. A Canadian corporation's ownership is determined by taking into consideration its direct and indirect ownership in the US corporation.
The income a foreign affiliate earns can fall into one of several categories. For the purposes of this discussion, the most relevant categories are income from an active business and foreign accrual property income (FAPI). These 2 income types are dealt with in another article and will not be analyzed here.
7. US State Tax Obligations
The thresholds which make a foreign corporation taxable in any state differ from the federal thresholds and also differ between states. Many states also take the position they are not a party to federal tax
treaties, including the Canada-US Tax Treaty. Generally, states require a minimum connection or "nexus" between the activities of a taxpayer and the taxing state. Each state imposes its own nexus thresholds.
It is common for Canadian companies to conclude that since they do not have permanent establishments in the U.S. and are therefore not subject to U.S. federal income tax, their only tax obligations are in Canada. Unfortunately, these conclusions would be very premature.
The various states in the U.S. are not signatories to the Treaty. Accordingly, states are not bound to concepts of “permanent establishments” that may otherwise limit their ability to impose an income tax on an out-of-state taxpayer. States are restricted, by the U.S. Constitution and legislation passed by the U.S. Congress, from imposing an income tax on an out-of-state taxpayer that lacks “substantial nexus” with a specific state.
Substantial nexus is the minimum contact with a state that allows the state to impose an income tax on an out-of-state taxpayer. The activity or presence that triggers substantial nexus has changed over time and in general has shifted towards the ability for states to impose a tax burden. This rationale by U.S states has opened the door to what is now referred to as “economic nexus” for state income tax purposes. Economic nexus is the notion that deriving income from sources within a state is enough to create substantial nexus. Substantial nexus in the context of state income tax was at one time believed to also require physical presence in a state. Physical presence would include leasing or owning property within the state or having employees or agents enter the state.
However, In Quill Corp. v. North Dakota(Quill), the U.S. Supreme Court ultimately ruled that physical presence was not required to adhere to Due Process requirements in the context of requiring an out-of-state taxpayer to collect state use tax.
After Quill, states began adopting legislation that would require out-of-state taxpayers to file income tax returns in a particular state if they derived income from sources within the state even if they lacked physical presence. Since Quill only dealt with state sales and use taxes and the physical presence needed for Commerce Clause purposes, states took advantage of this ambiguity in the decision and implemented economic nexus doctrine to supplant physical presence requirements for purposes of state income taxation.
Today, almost all states with an income tax have adopted some form of economic nexus for purposes of establishing substantial nexus. Many of the larger states like California and New York have adopted bright-line nexus amounts which establish thresholds for sales, property and payroll in the state that will trigger nexus.
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.
