U.S Business Structures for Canadian Parent Corporations Doing Cross-Border Business – Part 2

 

 

 

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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.

This third article in our series on Canadian Outbound investment into the U.S analyzes the various structures that can be utilized within the corporate structure, as well as repatriation issues when bringing income back into Canada from the U.S.  Another article will analyze the tax implications of these various structures.

 

1. Repatriating Profits from the U.S.

 

In this part of the paper we will consider the means by which profits can be repatriated from USco to Canco: (i) dividends, (ii) interest, (iii) royalties, and (iv) management fees. In each case, it is assumed that USco will be eligible to use the Treaty.

If USco is ineligible to use the Treaty, the rate of withholding tax will be 30%.

i.  Dividends

If the profits of USco are distributed as a dividend, the dividend will be subject to U.S. withholding tax at the rate of 30% subject to reduction under the Treaty.   If USco is subject to the Treaty, the rate of withholding tax on dividends will be either 15% or 5% depending on the ownership of the USco’s shares by Canco. Because in our situation USco is a wholly-owned subsidiary of Canco, the rate of withholding tax will be 5%.

It is important to note that unlike the situation in Canada, it is not possible for a U.S. company with either current or accumulated earnings and profits to return capital without giving rise to withholding tax. For U.S. tax purposes, a distribution will be treated as a dividend subject to withholding if there are current or accumulated earnings and profits and to the extent the distribution exceeds these amounts, the distribution will be treated as a return of capital which will reduce Canco’s basis in shares of USco.   Lastly, if the distribution exceeds Canco’s basis in USco’s shares, the distribution will result in a gain from the exchange of property for U.S. federal tax purposes.

The Canadian tax treatment of the dividend will depend upon the surplus account from which the dividend is paid. Where the business is an active business that is conducted in the U.S. by USco the dividends will likely be considered to be paid out of the exempt surplus account. In this case, the Canadian shareholder will be entitled to a deduction in computing income.  Where the dividend is paid out of exempt surplus, there will be no tax relief for the withholding tax that was paid.   Where the dividend would be paid out of exempt surplus, the incidence of Canadian tax can be deferred by deferring the payment of dividends.

 

 

ii.Interest

Similar to dividends, the default U.S. federal withholding tax is 30% on Interest paid by USco to Canco.   However, if Canco provides USco with a completed IRS Form W-8BEN-E, Certificate of Status of Beneficial Owner for U.S. Tax Withholding and Reporting (Entities) the rate of withholding tax can be reduced to zero.

iii. Royalties

If USco uses tangible or intangible property owned by Canco, chances are that the use of this property in the U.S. will result in royalties being paid by USco to Canco. Like interest and dividends, the default withholding tax rate is 30% but can be reduced to 10% of the gross amount of the royalties if IRS Form W-8BEN-E is provided to USco by Canco.   Certain types of royalty payments for the license of computer software to USco may be eligible for 0% withholding tax.

iv.  Management and Other Fees

If Canco provides management and support to USco, a management fee paid to Canco would be appropriate to consider. For a long time, it was common to see management fees to Canco that happened to leave US$50,000 or less of taxable income in USco. Oddly, this US$50,000 taxable income amount coincided in a reduced 15% U.S. federal tax rate prior to 2018. Given the relative parity between the U.S. and Canada with respect to corporate tax rates, the incentive to strip earnings in the U.S. via management fees has diminished significantly.

 

Management fees are not subject to U.S. federal withholding tax because they are considered payments for services. Services are sourced to where those services are rendered and under the presumption that Canco’s management fees relate to services rendered in Canada, the management fees are sourced to Canada.  The exception to this would be where Canco provides its services through a permanent establishment in the U.S.  

Employees of Canco Working in the U.S.

 

1. Compliance obligations

When Canco expands to the U.S., it may require key Canadian resident-employees to travel and work in the U.S. to assist with business expansion. It is common to neglect to consider the payroll and personal tax considerations for Canco and its employees that work in the U.S.  

The remuneration paid to Canco’s employee for services rendered in the U.S. is sourced to the U.S. under U.S. domestic tax law.   Therefore, the wages paid to Canadian-resident employees are subject to U.S. federal payroll withholdings.   Under U.S. domestic tax law, wage withholdings are not required where:

• The non-U.S. employee is present in the U.S. for less than 90 days in the tax year;
• Total wages are less than US$3,000; and
• The services are rendered for a non-U.S. corporation that is not engaged in a U.S. trade or business.

As is evident from the conditions above, this is a very narrow exception. In almost every instance that Canco sends an employee to the U.S., it will be engaged in a U.S. trade or business.

 

 

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While the U.S. domestic tax law exception is quite narrow, the Treaty provides additional relief if either of the following conditions are met:

• US source remuneration is less than US$10,000; or
• The employee is present in the U.S. for less than 183 days in any 12-month period and the remuneration is not borne by a permanent establishment in the U.S. nor a resident of the U.S.

If the Treaty exception applies, the employee must complete and provide Canco with IRS Form 8233, Exemption From Withholding on Compensation for Independent (and Certain Dependent) Personal Services of a Nonresident Alien Individual.  Canco will then need to file this form with the IRS.   If instead USco or Canco’s U.S. Branch bears the cost associated with the remuneration, the Treaty exception will likely not apply and employee’s wages will be subject to U.S. payroll withholding tax.

Notwithstanding the potential U.S. federal income tax associated with employee’s wages sourced to the U.S., Canada should allow a foreign tax credit for the final U.S. federal tax liability from employee’s IRS Form 1040NR, U.S. Nonresident Alien Income Tax Return.

2.  Personal Tax Considerations for the Employees

If Canco’s employee’s wages are subject to US federal income tax because those wages are borne by USco or by Canco’s U.S. branch, he or she will be required to file IRS Form 1040NR, U.S. Nonresident Alien Income Tax Return to report and pay U.S. federal income tax on those wages.

Things become more complicated where Canco’s employee spends more than 121 days on average in the U.S. for any purpose for the current year and the 2 preceding years.   If this happens, then the individual will be considered a U.S. resident for U.S. federal tax purposes subject to U.S. federal tax on his or her worldwide income. However, he or she can nevertheless be considered a non-resident if the following conditions are met:

• The individual is present in the U.S. for fewer than 183 days in the U.S. in the current year;
• The individual maintains a tax home in a foreign country during the current year; and
• The individual has a closer connection to a single foreign country in which a tax home is maintained than to the U.S.

More complicated still is where the employee spends more than 182 days in the U.S. in the current tax year as the employee will be ineligible to file the Closer Connection Exception Statement. Instead, the only exception from U.S. worldwide taxation is relief under the Treaty. The Treaty contains tie-breaker provisions in case an individual meets the residency requirements in both Canada and the U.S. under each jurisdiction’s domestic law. Assuming the individual remains a Canadian resident for tax purposes under Canadian domestic tax law, the following test from the Treaty is applied:

1) The individual will be a resident of the country in which he or she has a permanent home available to them;

2) If a permanent home is available in both countries, the individual be considered a resident where his or her centre of vital interests are;

3) If the former test is not dispositive, then the individual will be a resident in the country where his or her habitual abode is; and

4) If the individual has a habitual abode in both countries, where he or she is a citizen.

The employee would need to file an IRS Form 1040NR and would be subject to most of the international informational disclosures that would apply to a U.S. person.

 

Compliance in the U.S.

 

Often Canadian companies are surprised at the complexity associated with U.S. compliance burdens for relatively straightforward business activity. Not only are there requirements to file U.S. federal income tax returns and related disclosures but there can be state and local tax returns that require filing as well. Failure to timely file certain information disclosures can result in significant penalties being assessed in excess of $10,000 per return.

Canco’s US Branch

Assuming Canco is operating in the U.S. through a branch in California, the following tax returns and disclosures may apply:

• IRS Form 1120-F, U.S. Income Tax Return of a Foreign Corporation – Due 3.5 months after year-end;
• IRS Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business – Attached to IRS Form 1120-F;
• IRS Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b) – Attached to IRS Form 1120-F;
• IRS Form 1099-MISC, Miscellaneous Income – Due February 28th following the calendar year for which a return applies;
• California Form 100, California Corporation Franchise or Income Tax Return – Due 3.5 months after year-end.

USco’s Filing Obligations

If instead of a branch, Canco has formed USco which has nexus in California, the following tax returns and disclosures may apply:

• IRS Form 1120, U.S. Corporate Income Tax Return – Due 3.5 months after year-end;
• IRS Form 5472 – Attached to IRS Form 1120;
• FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR)– Due April 15th and filed electronically;
• IRS Form 1099-MISC – Due February 28th following the calendar year for which a return applies;
• IRS Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding – Due March 15th;
• California Form 100 – Due 3.5 months after year-end.

 

U.S. State Tax Considerations

 

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.

 

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.