Tax Considerations for Canadian companies expanding to the United States

U.S. Federal Income Tax

US trade or business

The starting point for determining the federal income tax obligations of foreign entities, including Canadian corporations is to analyze if the company’s activities in the US create a “U.S. trade or business”.  The term US trade or business generally refers to the activities conducted within the United States that are considerable, continuous, and regular. The US tax law does not clearly define this concept, so it involves a facts and circumstances test, focusing on the nature and extension of the activities conducted by foreign corporations within the United States. It is important to note that the threshold for what can be considered a US trade or business is rather low and a Canadian company can find itself meeting this status just by sometimes making sales into the US market (eg. when the company sells goods, and the title passes to U.S. customers).

Permanent Establishment

Once it is determined that the Canadian company is engaged in a US trade or business, the next step is to analyze if the company has a permanent establishment (“PE”) in the United States. A PE is generally defined as a fixed place of business and can include an office, branch or even the presence of dependent agents who habitually exercise authority to conclude contracts on behalf of the company.

Under the Canada-U.S. tax treaty, a Canadian company is subject to U.S. federal income tax only on its business profits attributable to the PE. Thus, even if a Canadian company is engaged in a U.S. trade or business, its business profits will not be taxable in the U.S. assuming it does not operate from a PE in the U.S.

Treaty-Based Tax Return

Claiming a treaty-protected position is not an automatic process. A Canadian company will need to file a U.S. federal income tax return annually (Form 1120-F, U.S. Income Tax Return of a Foreign Corporation) and disclose the treaty position (Form 8833 Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b)) that it is relying upon.

Although the treaty-based return is a nil tax return, it is crucial to comply with this process as there are substantial implications for not filing which include:

• Penalty of US$10,000 for treaty position not disclosed on a timely filed return
• No protection from statute of limitations meaning that the IRS can go back as many years as they wish to assess taxes.
• IRS assesses tax on 30% of gross revenue without allowing any deductions relating to the revenue.

State Income Tax

Nexus

While the Canada-US tax treaty provide protections against U.S. federal income tax for Canadian companies, these provisions do not automatically extend to state income taxes. There are 50 states, and each state has its own standard “nexus” for imposing taxes. State nexus refers to the connection or link between a business and a state that justifies the state imposing tax on the businesses. Nexus is generally established when a business has a sufficient physical or economic presence in a state. A Canadian company should carefully review their level of activities in each state including the allocated sales amounts to ensure that they are compliant with state taxing jurisdictions.

Other Considerations

Following is an additional list of considerations that is beyond the scope of this article, but which should not be overlooked by Canadian businesses when it carries on business in the United States.   

• Choice of business entity (eg. branch vs subsidiary).
• Transfer Pricing issues related to intercompany transactions.
• Payroll taxes both at the Federal and State levels.
• Sales taxes in the States.
• Withholding taxes and applicable certificates for exemptions.

Takeaway:

It is not a simple task to navigate through US tax rules, especially in a cross-border context. The volume of U.S. tax laws and regulations seems endless, and we are all aware that they are constantly being updated over time. The good news is that with holistic advanced planning and sound professional advice from the experts that are aligned with the business objectives of the company Canadian business owners and executives can experience a much smoother expansion into the U.S. market.