Federal tax responsibilities in the U.S. are designated by the Internal Revenue Service (IRS). One of the most important factors determining cross-border tax responsibilities, is the United States-Canada Income Tax Treaty.
Most Canadian companies with a presence in the U.S. are trying to sell a product or service to the American public without creating what is known as a “taxable presence.” Under the treaty, this is described as a permanent establishment. For instance, a simple way to establish a permanent establishment would be to open up an office across the border. This is also easy to avoid, by operating your organization directly from Canada.
The trickier stitch comes when your organization has employees or contractors (referred to by the treaty as a dependant agent), who enter into contracts in the U.S., which will create a taxable presence. At this point, your footprint would be too large and you would be subject to U.S. federal tax.
To avoid this taxable presence, for a traditional Canadian company creating Canadian products and services to sell to the American public and businesses, the ideal approach is to conduct your operations from Canada. With no contracts, no stored goods and no office in the United States, you are reducing the risk of having to pay U.S. federal tax to the IRS.
With that being said, as your business grows in the U.S., the more likely you are to increase your cross-border presence and taxable presence. Then there are all of the nuances and ambiguities in the world of taxation. While your financial advisors might not view your cross-border footprint as a taxable presence, the IRS may not always agree. For instance, the IRS might dispute at what point exactly a contract was legally entered into. In short, you will not always definitively know if you are subject to tax at the federal level or not.
The most important thing for a Canadian company with U.S. customers is to file a treaty-based return, which is based on the technical requirement to file a tax return if you have a U.S. trade or business.
What’s intriguing about the treaty-based return is that there is no concrete definition of what is or isn’t a U.S. trade or business. For this reason, I recommend most companies with U.S. customers simply assume there is a high probability you have a U.S. trade or business. And while you can work to minimize your taxable presence, it’s still important to always file your U.S. federal tax returns on a timely basis or face avoidable penalties.
One of the key reasons to file your treaty-based return is to avoid the Expense Disallowance Rule which states that if a Canadian company does not file a federal income tax return on a timely basis, the IRS has the legal ability to disallow all other deductions when they discover the lack of filing. For this reason, it’s important to file a tax return to protect your deductions on the chance that something went offside or you inadvertently entered into a contract, creating a taxable presence.
Naturally, as your company grows, there is a progression of how proactive you want to be at a federal level, which could look something like the following:
- Try to avoid taxable presence.
- At some point (hopefully), business will be so good you cross over the taxable line. When you are going to have a taxable presence, it’s best to shift your structure to something more adaptive that allows you to minimize tax in the U.S.
- If you wish to establish more substantial operations in the U.S., creation of a U.S. corporate entity may be the appropriate vehicle. While taxable income of a U.S. company would be subject to U.S. federal and state taxes, U.S. business income may not be taxable in Canada, allowing for more flexibility from a tax perspective. This structure may also afford more tax planning opportunities and reduces risk to the Canadian assets.
- While staying within transfer pricing rules, you can minimize the income held in a U.S. corporation, with the overall goal of keeping as much income in Canada as possible.
Federal taxation is far from the end of the cross-border tax story for Canadian companies. State and local taxation (SALT) can significantly impact a company’s cash flow, effective tax rate and risk profile. Every state can have its own income tax and then on top of that, almost any local level of government can also have its own tax. For example, it’s very common for cities or municipalities to have their own taxes.
The intriguing part of state taxation is that it’s completely different than from a federal level. For one, individual states are not required to follow or abide by the United States-Canada Income Tax Treaty. As mentioned earlier, at the federal level the determining factor is whether or not you have an established presence. At the state level, there is a concept called “nexus” as a benchmark for determining whether the state corporate tax revenue department is permitted to assess tax on an out-of-state taxpayer. At its very base, nexus is determined by whether or not you have a sufficient minimum connection to the state to make it fair for the state to tax you. Nexus in its classic form, really comes down to whether or not you have “boots on the ground.” For instance, if you have property, an employee or a contract in said state, that could create nexus.
Nexus, however, has been put into an evolving concept called ‘economic nexus,’ which basically measures whether you have economic activity in the state. For instance, having $500,000 in sales in one particular state could establish economic nexus. It’s important to also know that depending on rules and regulations from state to state, there is a possibility of creating economic nexus without having ever gone to the state. Having a clear understanding of whether you have nexus or not depends on being able to recognize that each state’s rules are different and having an in-depth understanding of what those are will be key.
At the federal and state income levels, it’s easier to create strategies and practical solutions which allow you to remain compliant to tax legislation, while also capitalizing on opportunities that better position you for growth and prosperity.
The difficulty with sales tax is that the burdens are so great at times, it’s difficult to have good practical advice. It’s important to understand how sales tax works and the risk involved. Similar to how state income taxes have nexus thresholds, so, too, is there a sales tax nexus threshold. For instance, under the general rule if you have had a “boot on the ground” in a state, you have created sales tax nexus. One of the key considerations is if you have a taxable sale, you will want to minimize your footprint at a sales tax level or you could find yourself with obligations to collect or remit sales tax.
The good news is not every organization has a taxable sale of product. For example, if you sell to documented resellers, you are not responsible for charging sales tax as the sale is not direct to consumer. If, however, you do sell to an end consumer or sell to both resellers and end consumers, you may be expected to charge, collect and remit sales tax.
Given the fact that every county, city or state can have a sales tax, there are over 10,000 sales tax jurisdictions in the U.S., making it quite difficult to stay at the forefront of multi-jurisdictional tax responsibilities and compliance requirements. Many organizations may not even realize they have incurred liabilities, which can lead to hefty penalties and interest payments, especially when left over time.
Whether your business is already operating in the U.S. or you are looking to start doing business in the U.S., it’s important to understand all the tax implications so you can strategically plan and manage your tax liability as cross-border tax requirements and legislation are becoming increasingly complex. To ensure you pay the least amount of tax possible, it’s important to work with experienced professionals who understand the complexity of local, state and federal regulations. That’s where MNP’s International Tax Services team can help.
For more information, contact Mike Shumate, CPA, JD, LL.M., Director, U.S. Corporate Tax at 416.596.1711 or firstname.lastname@example.org.
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