We often get calls to our office asking what the tax implications are if I want to get into a business in a country. We thought it would be useful to help explain taxation in a particular country. One concept that particularly affects the transaction of business between Canada and the United States is Permanent Establishment.
Article VII of the Canada – US Income Tax Convention (1980) (the “Treaty”) provides that the business profits of an individual or corporation resident in one country may only be taxable in the other country to the extent that those business profits are attributable to a Permanent Establishment (“PE”) in that other country. In other words, if you can set up your business in such a manner as to not create a PE in the other country, you don’t have to pay their tax! You should still file a treaty based return to protect your rights, but there isn’t any tax to pay.
Since the rules governing PEs are set out in the Treaty, the requirements of PEs are generally the same in both countries. As a consequence this article should be of interest to residents of both Canada and the United States engaged in cross border trade and commerce or services. For clarity, in this article the country that the company or individual is resident in is described as the foreign country and the country where the PE is located is referred to as the source or other country.
It is important to note that Canadian residents may be subject to US state and local taxes that can vary significantly from state to state since the individual States are not necessarily bound by the Treaty. US companies doing business in Canada should note that the Canadian federal government administers taxes on behalf of all provinces except Quebec and generally applies the Treaty to those Provinces income taxes.
Permanent Establishment defined
Article V of the Treaty defines a PE as, among other things;
- a place of management,
- a branch,
- an office,
- a factory,
- a workshop,
- a mine, oil or gas well, a quarry or other place of extraction of natural resources,
- a building site, construction or installation project that lasts more than 12 months, and
- a dependent agent who has and habitually exercises the authority to conclude contracts in the source country on behalf of the foreign company.
Depending upon the frequency and nature of the activity, things such as directors or management meetings may create a PE; and signing contracts in the other country will almost always create a PE.
Historically, the definition of a PE has emphasized “bricks and mortar” facilities with a relatively narrow definition given to an agent. An agent does not, however, generally create a PE by simply assisting a customer or facilitating contracts by acting as an intermediary between the customer and the foreign management.
Determining Whether You Have a Permanent Establishment
The existence of a PE is a based on a ‘facts and circumstances’ test within the criteria of Article V of the Treaty.
A PE could be any premise or facility used by a foreign individual or corporation to carry on the business of the foreign resident whether or not it is used exclusively by the foreign resident nor does the foreign resident require a formal right to use the premises. A place of business may be determined to be a PE even if it exists for only a short time if that is the nature of the business.
Specifically excluded from the definition of a PE are;
- a facility used to store, display or deliver the goods of the foreign person;
- maintenance of a stock of goods for the purpose of storage, display or delivery;
- maintenance of a stock of goods for the purpose of processing by another person;
- purchase of merchandise, or the collection of information for the foreign person;
- advertising, the supply of information or scientific research or similar activities which have a preparatory or auxiliary character for the foreign person; and
- ownership of a subsidiary in the other country.
Dependent Agent Permanent Establishment
If the foreign business does not meet the criteria for a fixed place of business the source country taxing authority may try to establish the existence of a Dependent Agent PE. If the business of the foreign resident is conducted through a dependent agent that has, and habitually exercises, the authority to conclude contracts on behalf of that foreign person, a PE likely exists. The agent may be either a company or an individual. Furthermore, a dependent agent is not required to be a resident or have a place of business in the source country where the business is carried on.
Independent Agents
Independent agents operating in the normal course of their own business representing the products or services of the foreign resident generally do not create a PE of the foreign resident. Therefore, having your products sold by an unrelated company should not give rise to a PE, however, if that agent undertakes activities on your behalf (e.g. concludes a contract) a PE may be created.
New Rule: Permanent Establishments from Services
The fifth protocol to the Treaty that became effective January 1, 2010 introduced an additional definition for a PE. As a result individuals and companies engaged in providing cross border services will be deemed to have a PE in the other country if either of the following tests are met:
- The Single Individual Test for Individuals.
If an individual resident in one country performs services in the other country and the non-resident individual is present in that other country for a period exceeding 183 days in any twelve-month period and, during the period the individual was present in the other country, more than 50% of gross active revenues of the individual were earned in the other country.
- The Enterprise Test for Corporations.
If a company resident in one country performs services in the other country through one or more individuals present in the other country for a period of more than 183 days in any twelve-month period; or
Provides services for a client or customer in the other country for an aggregate of 183 days or more in any twelve-month period with respect of the same project or a connected project.
If an individual or a corporation resident in one country is deemed to have a PE in the other country they must file tax returns and pay taxes in the second country on profits attributed to the PE.
In any case, individuals and corporations engaged in cross border trade will now need to keep detailed records of the border crossings of their management and staff and accurately distribute payroll and other expenses between the two countries.
What’s the Risk?
If a Canadian corporation fails to file a U.S. tax return because it believes its U.S. activities do not constitute a PE, and is later found to have had a PE, it may be denied deductions against income attributed to its U.S. PE. More likely, however, is the US $10,000 penalty per occurrence arising from failure to file the Treaty Based Position Statement with the U.S. return. US companies operating in Canada are required to report all Canadian-source income to the Canada Revenue Agency whether or not a PE actually exists.
Another position of the IRS is that where a taxpayer has failed to file returns, the statute of limitations has not started and all years of the taxpayer are open for assessment. Accordingly, the U.S. could require a Canadian company to pay income tax for a year that is closed in Canada or is beyond the ability to carry over unused foreign tax credits and double taxation would result.
AG TAX LLP Can Help
Our specialists at Aylett Grant Tax LLP have considerable experience helping clients in many different industries work through the complexities of the B&O tax. We have dealt with multi-state tax questions in several states and can help you to determine how best to navigate the various rules of the B&O to ensure that those taxpayers are neither underpaying nor overpaying the tax.
Additionally, 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)
Disclaimer: The information in this publication is accurate as of the time of its publication. AG Tax assumes no responsibility for changes to tax legislation subsequent to the publication of this document. The information provided is for general information purposes only and should not be acted upon without seeking professional advice. If you would like to engage our services, please contact our staff and obtain authorization to send our firm confidential information. A client relationship is not created by the transmission of information. A client relationship is only formed with our firm when a scope and engagement letter signed by the firm and the potential client detailing the terms of engagement is present.
