Doing Business in the U.S.
By Steve Sherman, LL.B, CPA
In the search for sales growth for many Canadian businesses, the U.S. market provides great potential. When considering U.S. expansion, it's important to consider the tax consequences of venturing south of the 49th parallel. Some planning before heading south can save $ and let you focus on business, not tax compliance.
Let's assume Canco, a Canadian manufacturer, wants to test the U.S. market by sending down one of their sales representatives. We'll assume the rep has the appropriate visa. The tax issues for Canco are as follows:
When is Canco subject to federal U.S. tax?
The Internal Revenue Code ("IRC") imposes general corporate income tax on a foreign corporation which is "engaged in trade or business" within the U.S. Trade or business generally requires a series of repetitive business transactions. Thus, in our example, when the Canco rep starts to generate sales, Canco may well be engaged in a U.S. trade or business and subject to U.S. tax. Before Canco writes a check to the IRS, we need to look at the Canada-U.S. Income tax Convention, i.e. the Treaty.
The Treaty regularly overrides certain domestic U.S. and Canadian tax law and provides rules to resolve certain conflicts between each countries respective domestic law. In our situation, Article VII deals with business profits and indicates that a resident of Canada will taxable in the U.S. only if the Canadian carries on a business in the U.S. through a "permanent establishment" ("PE") situated in the U.S. If a PE exists, the business profits attributable to the PE and derived only from it's assets and activities.
The definition of a PE is thus critical for determining whether Canco is subject to U.S. tax. Article V of the Treaty includes a place of management, a branch, an office a factory, or workshop. Most important to Canco is that employees who are acting on behalf and have the authority to conclude the contract are deemed to be a PE. To avoid the problem, make sure any orders generated by the rep are approved in the Canadian office.
Also, you will have a PE in the US if services are provided by your business in the US for 183 days or more in any 12 month period with respect to the same or connected project for customers who are resident in the US or who maintain a PE and in the US and the services are performed in respect of the PE.
The treaty specifically exempts facilities used for storage, display or delivery from the PE definition. The Treaty also makes a distinction between the U.S. marketing done by an employee of Canco and independent contractor. The independent contractor may conclude contracts "provided that such persons are acting in the ordinary course of their business". In sum, Canco's U.S. tax exposure is lessened by using a U.S. resident manufacturing rep than marketing through his employee.
Assuming Canco's activity does not create a U.S. PE, a treaty disclosure form should be filed with the IRS. Under U.S. domestic law, Canco is engaged in U.S. business and taxable. Only under the Treaty rules is Canco not taxable. Reliance on the Treaty must be reported and nondisclosure is subject to a potential US$10,000 penalty.
If Canco does have a U.S. PE, it files Form 1120F and is subject to tax at graduated rates.
When is Canco subject to state tax?
U.S. states are not bound by the Treaty. (New York and California, for example, do not follow the Treaty) The threshold for determining whether state tax applies is called "nexus". Generally, nexus is some minimum contacts that Canco has with the state. The presence of a Canco employee, assets (owned or leased), inventory and even attendance at trade shows are some of the factors state use to determine whether nexus applies. Unfortunately, each state has its own nexus standards. The nexus determination should be made for each state in which Canco plans to do business. The result: even though Canco may not be subject to federal tax, state taxes may apply.
Note that states are beginning to aggressively go after foreign companies. One client was contacted by a state revenue department after officials reviewed the invoices of a public warehouse where the client leased space. State governments also use audits of U.S. companies to identify foreign suppliers and/or customers potentially subject to state tax.
There are also different types of state taxes including capital/franchise tax, sales and use tax, and excise taxes. Whether Canco is subject to these taxes depends on it's activity in the state.
Does the Canco representative have any tax exposure?
The general rule under the Treaty provides that wages derived by a Canadian with respect to his employment is taxable only in Canada unless he is working in the U.S. In that case, the U.S. can tax the employment income.
There are two exceptions to this rule. First, no U.S. tax is due if the amount received by the Canco employee does not exceed US$10,000. the second exception applies if the Canco representative is not present in the U.S. for over 183 days in any calendar year and the Canco rep's salary is not an expense of a Canadian company with a PE in the U.S.
Wages are generally allocated to the U.S. based on the number of days the rep is present divided by 240. This fraction is multiplied by the rep's salary for the year. If the rep is in the U.S. 30 days in 1997 and earns a yearly salary of C$75,000, the amount allocated to the U.S. is 30/240 x $75,000= C$9,375. In this example, even if Canco has a PE in the U.S., the $10,000 Treaty exception means the $9,375 is not subject to U.S. tax.
Should Canco decide to operate in the U.S. it must choose a business structure. Generally, the choice is whether to operate as a U.S. subsidiary or through a branch.
Operating through a U.S. subsidiary, i.e. a separate U.S. corporation, is fairly simple. It offers the advantage of relatively low corporate tax rates, with the highest marginal rate of 35%. State taxes can add up to an additional 10%. It is also important to structure the repatriation to Canada of the US subsidiary's funds to insure they are deductible and subject to a minimum withholding. Payments of reasonable management fees to the Canadian shareholder normally are deductible by the U.S. subsidiary and not subject to withholding taxes. No withholding tax applies as long as the recipient does not maintain a PE in the United States. Royalties or profits on goods sold are other means of transferring funds to Canada. Royalties are generally subject to a 10% withholding tax. The US has laws to insure the reasonableness of the these payments, with substantial penalties for violations.
Alternatively, Canco may operate as a branch in the United States i.e. without using a US corporation. Basically, the branch is subject to two taxes. First, the normal tax on its US "effectively connected earnings". In addition, a "branch profits tax"("BPT") is imposed. The BPT is designed to place the US subsidiary and branch on a level playing field. The BPT imposes a withholding tax on the "dividend equivalent amount"("DEA") which is basically US profits not reinvested in the US either in asset purchases or reductions of liabilities. The branch has an advantage over the subsidiary as the first $500,000 of DEA is exempt under the treaty. In addition, the branch structure allows startup losses to be used against profits of the Canadian parent.
A substantial disadvantage to the branch structure may be state taxation. As discussed above, the state taxation may apply even where federal taxation does not due to the state nexus rules. Also, the state may require worldwide reporting, followed by an allocation formula, to determine the state tax liability. This can result in additional tax and/or increased tax return preparation costs.
State Sales Taxes
Under a 2018 Supreme Court case, the court decided that states may collect sales tax from out of state and foreign retailers that operate solely remotely online, even if the seller does not have physical presence in the taxing state. The court leaves to the individual state sales tax laws the decisions about who should pay state sales taxes and how they should be collected.
Other issues that may arise include financing the operations and the tax consequences of disposing or unwinding of the business. The key is to review the issues before marketing to the U.S. and before the IRS or a state revenue department send their greetings.
Incorporating in the US
Crossborder tax services provides US incorporations for Canadian businesses wishing to incorporate in the US. The primary reason most Canadian companies incorporate in the US is to increase their US presence and have their US customers feel they are doing business with a US company.
The decision on where to incorpoate generally depends on where to corporation does business. If the company is primarily doing business in one state, it is generally recommended that the incorporation should be done in that state. If the company is doing business in serveral states, it is generally recommended to incorporate in Delaware and file to qualify to do business in the other states the company conducts business. The company only pays tax in Delaware if it actually is doing business there (there is an nominal annual fee paid to Delaware). The company files tax returns in each state it is doing business generally using the allocation method in which profit is allocated to an individual state based on property, payroll and sales factors
For companies with no presence in any state, the Delaware corporation in recommended.
Crossborder can also obtain the corporate US identification number (called an employer identification number or EIN)required by the IRS. Just complete the form SS-4 and fax it to our office.