Thinking of Expanding Your Business to the United States? Don’t Overlook the US Tax Implications!
Many Canadian businesses that have been successful in the Canadian market naturally turn to the United States to continue the momentum of growth of the company’s revenues. Many unsuspecting Canadian companies do not realize that extending the activities of their Canadian business to the United States can come bundled with a burden of potential tax exposures to the extent the US tax implications are not considered in advance. Tax planning and structuring are critical considerations when expanding to the United States so that you may then focus on building the business as opposed to defending against tax assessments and steep penalties.
Consider the following example. A long–standing Canadian company in the business of plastics manufacturing has grown its business over time starting in Ontario and expanding all over Canada; a deserving result stemming from the reputation of superior products and services coupled with an incredibly successful in-house team of sales reps. The company’s revenues have grown substantially over time and Management would like to test out the US market. This expansion can be done in a number of ways including sending those same Canadian sales reps to the United States to market the products, engaging independent US sales reps , developing relationships with US distributors, or selling the products remotely over the internet (among a host of other possible sales strategies and/or a combination of those listed). Each option comes with pros and cons from a business standpoint but each one also comes with tax considerations, as well.
Perhaps we consider the situation that seems the easiest to execute whereby the Canadian company sends its Canadian sales reps to travel to U.S. trade shows a few times per year.[1]While in attendance at the trade shows, the sales reps establish relationships with new US customers generating interest in the products and igniting the sales process. While the sales reps may negotiate and conclude on sales while in the United States[2], it is more often the case where the sales reps return to Canada and continue to correspond with the prospective clients fostering the new relationships remotely. Deals are eventually struck and products start shipping to customer locations south of the border. While this all seems quite innocent in terms of a US presence, the IRS may very well consider this activity to be a US trade or business which could result in a US Federal corporate income tax filing requirement.
US TRADE OR BUSINESS
According to the IRS, a non-US entity becomes subject to US Federal corporate income tax when it earns income that is effectively connected to a US trade or business. The threshold for this level of activity (and the corresponding US tax filing requirement) is not well defined in the Internal Revenue Code or the corresponding regulations. Rather, the determination is based on the facts and circumstances of each situation relying upon case law and other rulings where a common understanding of what activities constitute a trade or business have been developed over time… that a US trade or business stems from considerable, continuous and regular activity within the United States.
In our example above, the attendance of the sales reps at the various trade shows, the subsequent successful sales and corresponding deliveries to the Unites States could very likely trip over this threshold and subject the Canadian manufacturer to US Federal corporate income tax. If you throw in services associated with the sales (e.g., installation, repairs, maintenance, training, troubleshooting, etc.), the likelihood of the US filing requirement increases.
TREATY PROTECTION
While the Canadian company may need to file a US corporate tax return, the extent of the taxation depends on whether or not the activities being conducted in the United States fall within those protected by the US-Canada Tax Treaty.[3] If that’s the case, the filing requirement is not eliminated but it is certainly simplified and far more limited in that the US corporate tax return is used simply as a means to disclose the Treaty position being relied upon and the revenues attributed to the United States.
PENALTIES AND OTHER IMPLICATIONS IF CHOOSING NOT TO FILE
You might think to yourself, why would I bother with filing such a simple return? Why wouldn’t I just claim the position if the IRS came knocking on my door? The answer lies in the implications and penalties associated with the failure to file the return to claim the Treaty position.
The IRS may assess a $10,000 penalty for each Treaty position that was not disclosed on a timely filed return.
The IRS may deny all deductions associated with the revenue earned resulting in the US federal corporate tax rate being applied against revenue as opposed to the net taxable income.
The statute of limitations never starts running, thus, the IRS would have an unlimited look-back period to assess tax, penalties, and interest, if any applies.
All of these risks and penalties can be mitigated with the simple timely filing of a US “protective” tax return. The cost of engaging a professional services firm is insignificant when compared to the benefits associated with the protection from the Treaty positions being reported to the IRS on an annual basis.
PERMANENT ESTABLISHMENT
There is the possibility, however, that the Canadian company’s activities were closer to the scenario where the US sales reps negotiated and concluded contracts while at the trade show noted earlier. Or perhaps the Canadian sales reps made numerous visits to the United States for negotiations and concluded contracts in the United States on one or more of these visits. If that is the case, it’s likely that the IRS would interpret the situation differently. Not only would there be a US trade or business but the activities in this scenario would extend to that of a “permanent establishment” (also referred to as a “branch”) resulting in US Federal corporate income tax assessed on the business profits attributed to the activities of the permanent establishment. In this circumstance, the Canadian company would again file a US Federal corporate income tax return but it would no longer fall within the limited reporting on a “protective return” described above. Rather, the US corporate income tax return would be completed in its entirety including the reporting of the revenues, cost of good sold, and deductions apportioned to the US business activities in addition to a special tax on branch profits, if applicable. While an explanation of these calculations is beyond the scope of this article, suffice it to say that the IRS would expect its share of the business profits attributable to the business that has been established in the United States.
STATE CORPORATE TAXES
But, that’s not the end of the story…the Canadian company shouldn’t neglect to recognize there are also 50 states eager to sink their teeth into their “fair share” of the pie, too. While 47 of those states administer some sort of corporate tax regime, a startling revelation to most new US corporate taxpayers is that not one of them follows the IRS’ method for determining a trade or business or a permanent establishment. Rather, the States use a determination of “nexus” as a benchmark for determining whether the State corporate tax revenue department is permitted to assess tax on an out-of-state taxpayer. State nexus can be created in a great number of ways but most states follow some form or combination of the following rules:
The company owns or rents tangible personal property or real property in the state including:
Inventory stored in a public warehouse in the state.
Office furniture, computers, and other office equipment in an employee’s or agent’s home office (whether owned or leased).
Leasing office space or reimbursing an employee for the costs attributed to a home office.
The company employs people in the state. This could include:
Sales reps travelling into the state more than one time for the purpose of establishing and/or maintaining a market in the state (i.e., any type of sales call where the rep is visiting the client or potential client).
Engaging with independent sales reps (depending on a number of additional factors).
Engaging with in-state distributors or wholesalers to establish and maintain a market on the Canadian company’s behalf in the state (depending on a number of additional factors).
Engaging in-state service providers to provide services associated with your product (e.g., installation, repair, warranty, training, etc.).
MODERNIZATION OF NEXUS RULES
While the items noted above indicate a physical presence of the company in a state, there are now close to ten states that have introduced new rules which don’t require any physical presence at all. These states have passed new laws which allow for the State Tax Departments to assess tax on any company that reaches a particular threshold of revenue in their state, regardless of whether anyone has ever entered the state on the company’s behalf. For instance, California passed a law that became effective in 2011 that requires an out-of-state taxpayer to file and pay California corporate tax if the taxpayer has $500,000 or more in revenue from California sources; regardless of whether the company has ever set foot in the state for any reason. Eight other states[4] have similar legislation in place!
WE CAN HELP!
Needless to say, the US corporate tax landscape can be complicated and potentially treacherous if Canadian businesses don’t consider the tax implications of their expansion before embarking on a growth strategy that includes the US market. Thoughtful consideration in advance can save time, effort and money in the long term, not to mention the stress avoided by not getting caught on the wrong side of the rules of the intricate web of the US Federal and State Corporate Tax system.
Provided by: Amy Shumate, CPA CA, CPA (Illinois), MSc Tax, MBA
For more information please contact:
Lionel Chen
Director of US Corporate Tax
T: 416-214-7833 x148
F: 416-214-1281
lionel.chen@trowbridge.ca
[1] Please note, all methods of sales solicitation (e.g., “hiring” independent sales reps in the US, using US distributors in the US, selling remotely over the internet to US customers) can lead to the possible creation of a US trade or business.
[2] See the discussion on permanent establishments later as conclusion of contracts in the United States may create more complex US Federal corporate tax filing requirement considerations.
[3] The US-Canada Tax Treaty protects activities from taxation in the United States to the extent they do not rise to the level of a permanent establishment. A permanent establishment can result from a fixed place of business in the United States, a dependent agent habitually concluding contracts in the United States, or the performance of services exceeding 183 days in the United States.
[4] Colorado, Connecticut, Michigan, New York, Ohio, Tennessee, Virginia, and Washington have similar laws (albeit the thresholds differ by state).