Top 5 Tax Issues: Canadians Doing Business in the U.S.
This article considers the top 5 tax issues for Canadians doing business in the U.S. Conducting business in the U.S. can be a complex and challenging proposition because of the differences from conducting business in Canada. Significant tax issues can arise. This commentary is intended to highlight relevant U.S. tax issues and does not constitute tax advice. For simplicity, this commentary assumes that a Canadian business would be eligible for benefits under the Canada-U.S. income tax treaty (“Treaty”). Please contact Andersen LLP to discuss your facts and circumstances.
Topics:
- U.S. Federal Income Tax
- State Corporate Income Tax
- State Sales Tax
- Use of Contractors in the U.S.
- Structuring Ownership of U.S. Business
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1. U.S. Federal Income Tax
The issue?
The U.S. has the authority to tax Canadian businesses that have business activity in the U.S.
Why does it matter?
A Canadian business with U.S. business activities is only taxable in the U.S. when it has a “permanent establishment” in the U.S. as defined by the Treaty. If a Canadian business does have a U.S. permanent establishment, it is required to pay U.S. federal corporate income tax and comply with U.S. federal tax reporting requirements.
Scenario 1: Online Business
A Canadian business sells goods to U.S. customers through its website, which takes orders and processes payments. It will occasionally send salespersons to the U.S. for trade shows and meet with customers.
Scenario 2: U.S. Office and U.S.-Based Employees
Canadian business hires salespersons based in the U.S. and leases office space for them. The Canadian business is doing business in the U.S. and appears to have a U.S. permanent establishment too.
What is the Solution?
A Canadian business with U.S. business activities can minimize its U.S. tax compliance and complexity where it does not have a permanent establishment in the U.S. A Canadian business will generally not have a U.S. permanent establishment where it does not:
- Have an office, workshop, or place of business in the U.S.
- Habitually conclude contracts within the U.S.
- Provide services within the U.S. for 183 days or more in any twelve-month period.
Other factors could also result in a permanent establishment where they relate to natural resource extraction, construction and installation activities.
Where a Canadian business has U.S. business activities, but does not have a permanent establishment there, it will not be subject to US federal income tax. However, it will still be required to file a U.S. federal income tax return disclosing its gross revenues from the U.S. and identify its claim under the Canada-U.S. tax treaty that it does not have a permanent establishment. Failure to file a U.S. tax return is subject to penalties and could have other adverse U.S. tax results.
Some businesses may not be effective in their U.S. business activities without having a permanent establishment there. In those cases, they will be subject to U.S. federal income tax on their net taxable income in the U.S. and may claim their U.S. income tax as a foreign tax credit to offset the Canadian tax otherwise payable on such income. Alternative strategies may be used to minimize the overall U.S. and Canadian income tax as discussed below.
2. State Corporate Income Tax
The Issue?
Canadian businesses that have “nexus” in a state will be subject to its corporate income tax. Nexus is the minimum connection to a state that allows the state to assert its taxing authority. Several states do not have an income tax.
Why Does it Matter?
The lack of uniformity makes state corporate income tax the most bewildering aspect of U.S. taxation for Canadian businesses. It can also result in high tax compliance costs relative to the tax payable to each state.
Scenario 1: Online Retail Business
If the Canadian online business has no physical presence in the U.S., it may be exempt from U.S. federal income tax but it may still be subject to state income tax.
Scenario 2: Service Business with U.S.-Based Salespersons
The presence of personnel, including independent contractors, in a state will generally create nexus and subject the business to the state’s corporate income tax.
What is the Solution?
The solution for dealing with state income taxes is the same as any other costs of the business, estimate the tax exposure and create a strategy to comply. The larger the estimated tax the more attention should be directed to strategies to minimize it and comply with its requirements. All businesses with U.S. customers should track their sales, property (including rents), and payroll by state.
3. State Sales Tax
The Issue?
Canadian businesses with sales to the U.S. may be required to collect and remit sales tax. For states with a sales tax, it only applies to the sale of tangible personal property and certain services if the seller has nexus. Nexus for sales tax is broader than what is applicable for state income taxes.
Why Does it Matter?
State sales tax can be significant because they are based on the gross selling price, not net income. A Canadian business that does not collect and remit required sales tax will be held jointly liable for their payment, plus interest and penalties. The failure to comply with state sales taxes may adversely affect a sale of the business. The recent Supreme Court decision Wayfair has expanded states’ ability enforce sales tax obligations on out-of-state sellers.
Scenario 1: Online Retail Business
A Canadian business that has $1 million USD of California sales would generally be required to collect and remit sales tax. If it failed to collect and remit the required tax, it could have a $90,000+/- tax liability depending on where in California its products were shipped to.
Scenario 2: Canadian Manufacturer with U.S. Installers
A Canadian business manufactures its products in Canada which it ships to states in the U.S. The buyer’s contract to purchase the products includes their installation by an independent installer. Because the contract to purchase is connected to the installation, the Canadian business is required to collect and remit sales tax in states that have a sales tax.
Scenario 3: Canadian Wholesaler Sells to U.S. Retailer
Canadian wholesaler has offices located in multiple U.S. states to facilitate shipping, delivery and storage of its products. All U.S. sales are to U.S. retailers who re-sell their products to unrelated consumers. The Canadian wholesaler is jointly liable with the U.S. retailers for the collection and remittance of state sales tax.
What is the Solution?
All sales should be tracked by state. In addition, Canadian businesses should know in what states their employees and independent contractors conduct business and where its inventory and assets are located, including temporary storage and rents.
To avoid collecting state sales tax on products delivered to a state for installation by an unrelated contractor, the buyer would have to sign two contracts, one to purchase the product and a second unrelated contract for the installation of the products. For the installation of products that become real property (doors, windows, cabinets, etc.) it may be to the advantage of the wholesaler, especially where it is the manufacturer and its customer for the former to be required to collect and remit sales tax. In these situations, the sales tax assessed will only be on the direct costs of materials, not the other manufacturing costs.
A resale certificate should be obtained on all sales to resellers. The certificate exempts the seller (not the reseller) from the obligation to collect and remit sales tax and avoids joint liability with the reseller.
4. Use of Contractors in the U.S.
The Issue?
A Canadian business that conducts activities in the U.S. through contractors may have a U.S. permanent establishment regardless of how the business classifies the contractor.
Why Does it Matter?
Even if a Canadian business classifies a contractor as an independent agent and issues IRS Form 1099, U.S. tax law will look at the substantive underlying relationship between the contractor and the business to determine if the contractor is considered an employee of the company.
Scenario 1: Online Retail Business
A Canadian business uses a U.S. based contractor to conduct sales activities on its behalf in the U.S. If the salesperson is deemed to be both be a dependent agent (e.g., employee) of the Canadian business and to conclude contracts in the name of the Canadian business, it would have a U.S. permanent establishment for U.S. federal income tax purposes.
What is the Solution?
To avoid having a permanent establishment in the U.S. the Canadian business could:
- Restructure the activities conducted by the contractor or the degree of control the business has over the activities conducted by the contractor;
- Proactively deem the contractor an employee and file its U.S. tax returns accordingly; or
- Restructure its legal entity organization chart to include a U.S. subsidiary to employ the contractor.
5. Ownership of U.S. Business Operations
The Issue?
How should the U.S. business activity be owned and what is the most tax efficient structure? Generally, this issue becomes relevant when the Canadian business has a permanent establishment in the U.S. and will be subject to U.S. federal income tax.
Why Does it Matter?
Simplicity of the ownership structure is good until its costs exceed its benefits. Choice of the ownership structure may affect both U.S. and Canadian tax results. The use of a Canadian corporation to conduct business in the U.S. will subject it to its Branch Profits Tax in addition to U.S. corporate income tax. It may also adversely affect choices as the U.S. business grows and the ability of its Canadian owners to claim Canada’s Lifetime Capital Gains Exemption on the sale of its business.
Scenario 1: Online Retailer
An online retailer that does not need employees or contractors in the U.S., would generally be best off selling directly to its U.S. customers from a Canadian corporation. Its U.S. federal tax obligations would be limited. However, using a Canadian corporation would not generally exempt it from state income, sales and other tax obligations.
Scenario 2: Hospitality
Hospitality businesses in the U.S. like food service and accommodations will generally result in a permanent establishment in the U.S. subjecting the business to U.S. federal and state income and sales tax. Generally, these activities should be conducted through a U.S. entity, typically a corporation.
Scenario 3: Real Property Investment and Development
Real property has some unique characteristics associated with it such as the fact that in certain circumstances it can be eligible for preferential capital gains taxation and in other cases it will be taxed as ordinary income.
What is the Solution?
A Canadian business should consult with a tax advisor who understands both the U.S. and Canadian tax implications of the business’ life cycle and can determine the optimal ownership structure for it.
The Key Takeaway
With any business activity in the U.S., it is critical to consider all aspects of the activity to determine whether they attract U.S. federal income tax and state income, sales and other taxes. Do not ignore issues like permanent establishment and nexus. They carry significant liability if they are not handled correctly. Similarly, even where the facts indicate a business does not have a permanent establishment or nexus, there may be reporting and filing requirements necessary to avoid U.S. tax penalties, loss of deductions and other adverse tax implications in both the U.S. and Canada. There are plenty of pitfalls, but there are also opportunities to structure your activities to optimize your tax position.
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Further information
If you want more information on any of the above issues or others, please contact any the following:
Warren Dueck, Partner T: 604-242-1401 or 587-390-1610
E: warren.dueck@ca.Andersen.com
Steven Flynn, Partner T: 604-242-1416
E: steven.flynn@ca.Andersen.com
Krista Rabidoux, Partner T: 587-390-6568
E: krista.rabidoux@ca.Andersen.com
Emily Yu, Principal T: 604-242-1405
E: emily.yu@ca.Andersen.com
Catherine Shen-Weafer, Senior Manager T: 604-242-1407
E: catherine.shen-weafer@ca.Andersen.com
Darren Bastarache, Senior Manager T: 587-390-1616
E: darren.bastarache@ca.Andersen.com
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Other “Top 5” Subjects
- Americans Moving to Canada
- Canadian Investment in U.S. Rental Property
- Canadians Buying U.S. Vacation Property
- Americans Doing Business in Canada
- Americans Investing in Canadian Real Property
- Americans Buying Canadian Vacation Property
- U.S. Estate and Gift Tax for Canadians
