Canadian companies looking to sell goods into the Unites States have several choices of structure for their U.S. operations. These choices can have substantial impact on the amount of taxes paid (corporate and state tax) as well as the complexity and number of the U.S. filings required.
The Canada-United States Income Tax Convention (1980), commonly referred to as the Treaty, lays out in some detail the interaction of the tax systems in both countries for individuals and companies working across the border.
In the United States, each state has differing business tax laws that apply to foreign companies. These different taxes, coupled with the fact that the individual States are not bound by the provisions of the Canada-U.S. Income Tax treaty creates complication for Canadian companies looking to enter U.S. markets.
Most, but not all, states impose a corporate income tax. Some states also impose franchise taxes on the value of the company’s equity in addition to the corporate income tax, while other states have tax bases other than income and equity. The type of corporate structure chosen can have an effect on how each of these taxes may apply to Canadian companies expanding into the U.S.
A number of Canadian companies wonder if they need to go to the trouble of setting up subsidiaries or other entities to do business in the various states in the U.S. Two common misconceptions are;
- since they will only operate from a Canadian location, there isn’t any risk; and
- a Canadian company will never be caught.
Both of these ideas usually lead down the road to disaster. If you set up your business correctly right from the beginning, you can generally reduce the amount of tax paid and reduce the amount of risk you face.
How are the tax authorities going to find me?
This is one of the most common questions asked by companies beginning their journey across the border and it is a valid question. One way that foreign companies are found out by the various tax authorities in the U.S. is by audit of your U.S. customer. When your customer is audited, the revenue agent will want to look at a sampling of supplier invoices and your invoice may likely be in the sample group. Suppliers in the sample group are compared to the list of currently filing taxpayers and if you aren’t on the list of taxpayers, you will likely get a questionnaire asking what you are doing in the U.S. or in the state.
The IRS in the United States has been increasing its focus on reporting from non-resident institutions and companies in the past few years. One need only to look at the Swiss bank
There are a few states where the Departments of Revenue have asked the federal government for all customs documentation pertaining to goods imported into the US where the final destination is in their particular state. A state revenue agent then cross references the shipper to the tax rolls and in the case where a shipper isn’t a taxpayer, the shipper gets a questionnaire asking what they are doing in the state.
Watch out for tax traps
Keep in mind that these questionnaires are intended to determine who should be filing, not who shouldn’t be filing and the questions are worded accordingly. To quote an agent from one of the Departments of Revenue of a large and populous eastern state, “our Unit is here to figure out who is taxable, not who is not! If you want someone to determine that you are not taxable, you’ll need to find a different Unit.” A simple misinterpretation of the jargon used on the questionnaire can inadvertently cause a tax presence for a Canadian company that may be difficult to correct.
One of the favorite questions is, “when did you begin selling your products in the state”. For most people, the answer would be when they made their first sale to an in-state customer. Often overlooked is the distinction between a sale in the state and a sale into the state.
If it is determined that you have a U.S. federal or state tax exposure, you will be required to register, file and pay back taxes, including substantial penalties and interest. Once you have been identified and contacted, the ability to ask for relief of those penalties and interest is gone, so you should review your current situation with your U.S. tax advisor.
For a discussion of state tax nexus, please see the Nexus article on our website.
What are the tax penalties?
There are substantial penalties for non-compliance with taxes and tax filings which range in size based on severity of the offence.
Some states require the inclusion of certain federal forms which carry substantial penalties for non-filing or late filing. As an example the Treaty Based Return Disclosure Form (#8833) carries a penalty of USD $10,000 for failure to timely file.
In addition to piggy-backing on federal penalty provisions, states have the opportunity to add additional penalties which can range to over 50% of outstanding amounts. The states can also decide on whether to allow relief for any penalties and interest independent of any determination made at the federal level or in any other state. California requires that a taxpayer include copies of certain federal forms and mirrors the federal penalty for California purposes. Effectively, the penalty for not filing certain forms with your federal and California returns can climb to USD $20,000 per occurrence.
What can be done?
Canadian companies that properly structure their ventures into the U.S. can effectively reduce tax payable, both federally and in the various states. By properly structuring the organizational chart along with ensuring that the duties of employees and agents in the U.S. is controlled, companies can ensure that they do not create a U.S. Permanent Establishment so that they may take advantage of the Treaty to source their income to Canada and reduce their U.S. federal taxable income to zero. Additionally, by using the right structure, Canadian companies are able to take a dollar for dollar credit for U.S. taxes paid instead of a deduction from income.
Many states, while not actively adhering to the treaty, nonetheless do so by default. These states rely on taxable income reported on the federal tax return as filed with the IRS as the starting point for computing state taxable income. If the Treaty is used to reduce federal taxable income to zero, then the computation of state taxable income also begins at zero. There are, however, several states that require a foreign corporation to recompute their U.S. taxable income as if there were no treaty to find the starting point for determining state taxable income.
The use of different subsidiary structures for your U.S. business can reduce or restrict legal liability in addition to tax liabilities. In certain circumstances, a Canadian subsidiary responsible for all sales to the U.S. may provide relief from U.S. federal tax and greatly reduce U.S. state income tax. We remind readers of this article that no single tax plan is suitable for all situations. Making sure that you have the most effective structure possible is highly dependent upon your individual situation and what you want the plan to accomplish.
AG TAX LLP Can Help
If you have any other tax-related queries, and/or need assistance with tax planning/filing please contact AG Tax. Our tax professionals are highly-experienced with U.S. and Canadian tax laws and can provide you the right guidance to handle your tax situation.
Aylett Grant Tax LLP is a full service accounting firm with a dedicated team of experts, who are highly-qualified and experienced in handling situations related to U.S., Canada and other international tax laws.
We can assist with:
- Canadian Personal and corporate tax returns
- Cross Border Taxation and Business Planning
- Personal and Corporate Taxation
- Disclosure of Foreign Assets and other information filings
- Retirement planning
- Estate Planning, Inheritance tax advice
To obtain a quote or to arrange for a consultation to discuss your tax related queries, please contact us at:
- 416-238-5920 (Greater Toronto Area, ON)
- 604-538-8735 (Greater Vancouver Area, BC)
- 780-702-2732 (Greater Edmonton Area, AB)
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