A patchwork of generous treaties and international agreements have encouraged Canadian businesses to sell goods and services in the US, and vice versa. Cross border ventures can be a source of trepidation because one must comply with a completely new set of federal and local laws. However, with advance knowledge of the relevant rules, a business can make the process both manageable and profitable. This article covers several key considerations of a Canadian business that decides to conduct operations in the US.
1. STRUCTURE OF US PRESENCE
1.1 General Considerations. At least initially, most Canadian companies will attempt to engage in US activities without sufficient presence (e.g., local office) to attract US tax, which is covered in more detail below. Neither a subsidiary nor a branch office is suitable when pursuing a “no tax presence.” Instead, the Canadian company is relegated to making occasional business visits.
As business activity increases, a Canadian company will probably desire a more substantial presence. Customers may insist on the continuity and personal attention available from dealing with employees in a local office, rather than doing business with a voice on the telephone. US immigration laws allow easier movement of Canadian employees to the US if there is a US subsidiary or branch office. A local office will increase visibility. It will be helpful in ensuring access to US courts, which might be necessary to collect debts, protect intellectual property or settle disputes. Banking may be simplified. This list of advantages is by no means complete.
If a Canadian company desires a US office, the structure of its US activities should be carefully planned. For example, the US activities might be conducted through a wholly-owned US limited liability company (LLC) or a corporation. Another alternative is to operate the US business as a branch office of the Canadian company. Each alternative has advantages and disadvantages.
1.2 US Branch Office. One option is to open an informal branch office in the US. An advantage is the simplicity of not having to create and maintain a separate US business entity. But there are a number of disadvantages, including the following:
● The Canadian parent is directly liable for all debts and taxes of the US branch.
● The Canadian parent must file a US income tax return to report the income attributable to the USoffice. The business profits taxable by the US are those which the branch “might be expected to make if it were a distinct and separate person engaged in the same or similar activities * * * and dealing wholly independently with the [parent].” See Article VII.2 of US-Canada tax treaty. Although the treaty expressly allows deductions for executive and administrative expenses, substantiating the allocations between the parent and branch may necessitate disclosing the parent’s worldwide activities to the IRS. Deductions for interest on loans from the parent to the branch may be limited.
● State and local tax authorities are not bound by the treaty, and may impose income taxes on a share of the parent’s worldwide profits based on the ratio that the branch’s revenues in that state bear to worldwide revenues. Thus, a parent that is profitable outside the US may end up owing local US income taxes even though the local branch operates at a loss. It may also be necessary to disclose the parent’s worldwide books and records to the local taxing authority.
● A US branch profits tax of 5% is imposed on profits of the branch that are not reinvested in fixed assets or used to pay taxes, but only to the extent that the cumulative profits exceed $500,000 CAD. While a subsidiary is not liable for branch profits taxes, a 5% tax is imposed on dividends paid by the subsidiary to the parent, which effectively evens the playing field on this issue. See Article X.2 and X.6 of US-Canada tax treaty.
1.3 US Subsidiary. A key nontax benefit to using a US subsidiary is shielding the Canadian parent from liabilities of its US business operations. If the US business fails or incurs substantial debts, creditors are normally relegated to securing payment from the subsidiary’s assets. In other words, use of a subsidiary may deprive US courts of jurisdiction over the Canadian parent, leaving the US court with no power to enter a judgment against the parent.
● Limited Liability Company. For US income tax purposes, an LLC is a pass-through (or fiscally transparent) entity; its income is taxed exclusively to the owners, not the LLC. Thus, a Canadian parent doing business through a US LLC will be directly liable for all US taxes attributable to LLC’s operations. (Non-tax debts, however, are payable only from the LLC.) Even so, the LLC is a separate entity with its own accounting records, which may limit or remove the parent’s books and records from the scope of an IRS audit examination.
● Corporation. A corporation is fundamentally different than an LLC inasmuch as it is not fiscally transparent and is directly liable for its taxes. Thus, if a Canadian parent conducts US business through a wholly-owned US corporation, it will have no liability for US federal or state taxes imposed on the corporation. Along the same lines, the parent will not have to file a US income tax return (assuming it has noUS presence). Nor will the parent be responsible for the US corporation’s non-tax liabilities. A 5% tax will be imposed on dividends paid (or “repatriated”) by the US corporation to the Canadian parent, but this is no worse than the 5% branch profits tax imposed if the US operations are conducted through a branch.
1.4 Organizing Under State Law. AUS subsidiary will be organized under the laws of a state in the US. The state of organization should usually be the state where most business activities will occur. State income taxes range from roughly 5% to 10%; if choice of location is arbitrary, consideration should be given to selecting a low tax state. Having said that, comparing one state to another is complicated because of the different types of taxes imposed by each state. For example,Oregon imposes a corporate income tax of roughly 6.6%, whereas Washington has no income tax. However,Washington imposes a gross receipts tax of varying percentages (depending on the type of business), and requires businesses to collect and remit sales tax from Washington residents. There may also be differences in property taxes and local taxes imposed by cities and counties.
2. US INCOME TAXES
For Canadian business visitors, the US tax issues are minimal. The activities usually do not rise to the level of “doing business” in the US, and the visitor usually does not have to file US income tax returns or pay US tax. And since business visitors are compensated by their Canadian employers, there are usually no US withholding tax issues.
In general, “doing business” in the US requires physical presence in the US. The focus then shifts to the frequency and nature of the US activities. For example, are there only occasional business meetings or trade shows in the US, or are compensated services being performed in the US? If income is being earned from the activities performed in the US, the Canadian company is probably doing business in the US. However, even if a Canadian company is doing business in the US, it may still escape US tax if its activities are sheltered by the US-Canada tax treaty.
2.1 US-Canada Treaty and Permanent Establishment Threshold. Canadians doing business in the US enjoy the generous benefits of the US-Canada tax treaty, which effectively “trumps” the tax laws found in the Internal Revenue Code. Under Article V of the treaty, liability for US tax hinges on whether the Canadian company has a “permanent establishment” in the US. A thorough analysis of the activities constituting a “permanent establishment” is beyond the scope of this article, but frequent examples include the following:
2.1.1 Fixed Place of Business. A Canadian company has a US permanent establishment if it has a fixed place of business, such as an office, place of management, factory, workshop or construction site (if it lasts more than 12 months). See Article V.2 of the US‑Canada tax treaty.
2.1.2 If No Fixed Place of Business. Even if a Canadian company has no fixed place of business in the US, it may nonetheless have a US permanent establishment if any of the following apply:
● During at least 183 days during any 12-month period, services are performed in the US by one or more employees or agents of the Canadian company, and more than 50% of the revenues of the Canadian company are derived from services performed in the US. See Article V.9(a) of US-Canada tax treaty. Thus, US tax attaches only if the US activities account for a very substantial portion of the Canadian company’s worldwide revenue.
● During at least 183 days during any 12-month period, services are performed in the US by one or more employees or agents of the Canadian company, and such services are performed for the same or a connected project for customers who are US residents or have a permanent place of business in theUS. See Article V.9(b) of US-Canada tax treaty. Thus, a large project requiring on-site US presence for more than 183 days is sufficient to attract US tax.
● An employee or agent of the Canadian company habitually concludes contracts in the US. See Article V.5 of US-Canada tax treaty. There is no bright line test to determine when one “habitually concludes contracts.” The treaty is not supplemented by detailed examples and there are no reported court cases. Unofficial commentary suggests that Article V.5 is aimed at those who make frequent sales of goods in the US, rather than service providers, who are governed by the more specific provisions of Article V.9. However, nothing in the treaty says that Article V.5 does not apply to service providers. Query: Is a Canadian service provider liable for US tax merely because it negotiates and signs five engagement letters each year in the US? It is uncertain whether physically signing contracts in Canada (if the negotiations are concluded in the US) will be sufficient to escape US taxation. For example, home office approval is meaningless if a company is wholly-owned by one individual.
2.2 US Tax Risk of Approaching Permanent Establishment Threshold.
2.2.1 General Rules. At least initially, many Canadian companies structure or limit their US activities in a manner intended to stay below the thresholds described in Article V of the treaty. Article V.9 is relatively mechanical, and a Canadian company should be able to ensure that in any 12-month period: (i) its employees and agents are in the US less than 183 days, (ii) its US revenues are less than 50% of its worldwide revenues, or (iii) no projects last more than 183 days. But due to its vagueness, there will nearly always be some risk of flunking the “habitually concludes contracts” test of Article V.5.
2.2.2 US Tax Exposure and Compliance. The monetary exposure of operating just below the permanent establishment threshold is that the IRS will take the position that US business activities “cross the line” and are subject to US taxes, or worse yet, US taxes for many prior years. The delinquent taxes (and related penalties and interest) may lead to the company’s demise.
● Foreign Tax Credit. In some instances, the ultimate cost of being subject to US income tax may be modest. So as to avoid double tax,Canada allows a credit against Canadian tax on income already taxed by the US. This “foreign tax credit” may soften or eliminate any additional tax burden by reason of being subject to US tax.
● US Tax Returns. Even if a Canadian company is not liable for any US income tax, it must nonetheless file US tax returns – if it is “doing business” in the US. The income will be reported to the IRS, and the return will include a statement identifying the treaty provisions that shield the Canadian company from US tax.
2.3 Withholding US Income Tax From Compensation Paid to Canadians. We mention the rules for withholding US taxes because of the harsh penalties for failure to withhold. In general, the usual penalty for an employer’s failure to withhold is a liability to the IRS in the amount that should have been withheld, along with penalties and interest.
2.3.1 Canadian Employees Working in US. If a Canadian individual performs services in the US as an employee of a Canadian parent, it may or may not be necessary to withhold US income taxes from the wages paid to the individual. In general, withholding is not required if the treaty shields the employee from US income tax. Under the treaty, the Canadian employee will owe no US tax on the wages if (i) his or her annual wages (during each calendar year) for US services do not exceed $10,000 in Canadian dollars, or (ii) the employee is present in the US for less than 183 days during any 12‑month period and the wages are paid by the Canadian company and not deducted on the US tax return of a US branch office. Mechanically, the employee must provide his employer a completed IRS Form 8233 (that explains the treaty exemption), and the employer must submit the Form 8233 to the IRS for its approval. If the individual is paid by the Canadian parent, this is easier said than done. In order to complete the Form 8233, the Canadian employee will have to obtain an individual tax identification number (ITIN) from the IRS, which can be a burdensome process. If an employee does not qualify for an exemption under the treaty, the wages are subject to slightly higher withholding rates than those applicable to US citizens.
2.3.2 Canadian Independent Contractors Working in US. With a couple of exceptions, the withholding rules applicable to Canadian independent contractors are similar to those for Canadians working in the US as employees. If the treaty shields the independent contractor from US tax, no withholding is required (provided the Form 8233 procedure is followed). Having said that, treaty based tax exemptions for independent contractors are different from for employees. Instead of the tests described at (i) and (ii) of the preceding paragraph, the treaty exemption is based on the permanent establishment test at paragraph 2.1 above. If the Canadian independent contractor has a US permanent establishment, payments to him or her are subject to the default 30% withholding rate.
2.3.3 Social Security and Medicare. By reason of the US-Canada totalization agreement, the employees of a Canadian company working in the US (perhaps on L-1 status) are not subject to US Social Security or Medicare withholding on their US wages so long as they are sent to work in the US for five years or less. If the wages are paid by a US entity (which is usually reimbursed by the Canadian company), the Canadian individual must provide a certificate of coverage from Canada that verifies he or she will be covered under the Canadian system while in the US.
Business ventures into the US raise various business, tax and immigration issues. They are complicated — primarily because they are different from the Canadian equivalents — but very manageable, as corroborated by the strength of the US economy. We welcome the opportunity to assist you in bringing your goods and services to markets in the US.