Canadian CORPORATIONS doing business in the U.S. – Update January 1, 2018
Canada and the United States of America share the longest unprotected border in the world. As neighbours and close friends, we have also established the largest trading relationship in the world. It is natural that Canadian companies and individuals want to do business in the U.S. After all, the close geographic proximity to the U.S. – the largest market in the world, the free trade agreement between the two countries, and the relatively strong U.S. dollar, all make it enticing to want to do business in the U.S. Add to this the warm climate, large disposable income, friendly and educated population and advanced commerce structure in the U.S., why wouldn’t it make sense for Canadians to do so, right?
This article does not question the rationale for Canadians who are in the process of making or have made the decision to do business in the U.S., but rather examines the corporate income tax implications in the U.S. and Canada, for Canadian corporations doing business in the U.S. selling product, services, and owing rental properties. For more information pertaining to Canadian individuals doing business or a Canadian working in the U.S.A., please refer to the accompanying article on our website.Disclaimer – This article is about the U.S. and Canadian tax consequences of Canadian corporations doing business in the U.S. Readers are cautioned that information in this article is for general purposes only and does not purport to provide specific advice. Individuals should consult with a tax professional. The author bears no responsibility for the use or dissemination of this information.
The Canadian and U.S. income tax rules and regulations are at the same time similar, and vastly different. It is very important for Canadians to understand U.S. tax laws and how they will impact your income tax filings in the U.S. and Canada.
The Internal Revenue Service (IRS) is the administrative arm of the U.S. income tax system and responsible for enforcing U.S. federal tax law, known as the Internal Revenue Code (IRC). Note – this is similar to the arrangement in Canada, whereby the Canada Revenue Agency (CRA) enforces the Canadian Income Tax Act (ITA). It does not end here. Each state within the U.S. has its own income tax regime, administered by that state, and which also must be taken into consideration in regards to income tax planning. The discussion below will focus on U.S. federal law initially, and then follow with an overview of state income tax considerations.
U.S. Taxation of Foreign Corporations
Canadian corporations doing business in the U.S. are viewed by the IRS as ‘Foreign persons’. The U.S. taxes foreign persons on income effectively connected with a U.S. trade or business, and certain U.S.-source income not effectively connected with a U.S. trade or business that being Fixed, Determinable, Annual or Periodic income (FDAP). All of this is explained below, but for now, this means that there might be a U.S. income tax filing and tax obligation for the business that is conducted in the U.S. The key word is ‘might’ because it depends on the details of the situation, the concept of ‘effectively connected income’ and the overarching principles of the Tax Treaty between Canada and the U.S. which allows some U.S. tax exemptions and relief to Canadians doing business in the U.S.
Effectively Connected Income
Under U.S. domestic tax law, a non-resident – whether an individual or corporation – is subject to U.S. federal tax if they have income that is “effectively connected with the conduct of a trade or business within the United States”. This is an ongoing test, which means that if you carry on a trade or business in the U.S. at any time in the year, you will be subject to U.S. tax for that particular taxation year. This is similar to the Canadian domestic law that taxes non-residents of Canada on any income they earn from carrying on a business in Canada.
Effectively Connected Income (ECI) is generally U.S.-source business income attributable to a U.S.-based activity that rises to the level of a trade or business (TOB). The threshold for a U.S. TOB is fairly low, as any profit-seeking activity deemed to be considerable, continuous and regular can suffice. Guidance for determining whether a U.S. TOB exists is largely found in case law. U.S. courts generally have ruled that mere physical presence is not enough to constitute carrying on a business. However, “continuous and regular” may be interpreted to include intermittent presence if such presence occurs on a regular basis. The activities must be in the U.S. and should extend beyond casual or incidental activities. The number of transactions may be relevant, but the amount of income or loss generated from the activities is not of concern in determining whether a TOB exists. ECI includes situations where Canadian individuals and corporations own and operate property rentals in the U.S. Also, capital gains or losses earned on the disposition of U.S. real property, including shares of a U.S. real property holding company, are considered effectively connected to the U.S., even if you are not considered to be engaged in a U.S. trade or business (eg/ sale of personal use real property located in the U.S. by an individual).
FDAP is Fixed, Determinable, Annual or Periodic income. FDAP income applies to foreign persons earning income in the U.S; FDAP includes Interest, Dividends, Rents, and Royalties, but generally do not include capital gains. FDAP-type income may also be considered as ECI if it generated by assets or activities associated with the conduct of a U.S. trade or business. An example would be a property rental which generates rental income, but because of the fixed place of business in the U.S., is considered to be ECI.
U.S. Foreign Corporate Income Tax
For a foreign (non-U.S.) corporation to be subject to U.S. tax, generally it must have U.S. sourced ‘FDAP’ income, or income ‘effectively connected with a U.S. trade or business’ pursuant to IRC Section 882.
U.S. corporate tax on effectively connected income
U.S. corporate tax – for tax years beginning January 1, 2018 and onwards
The Tax Cuts and Jobs Act (H.R. 1) enacted by the U.S. federal government on December 20, 2017 changed the U.S. federal corporate tax rate to a flat 21% of taxable income. The bill makes the new rate permanent. To reiterate – these tax rates pertain to effectively connected income.
The 21% U.S. federal corporate tax rate replaces a graduated tax rate that varied between 15% and 39% depending on taxable income. The previous corporate tax rates are provided below as a point of reference. As can be seen, the new U.S. corporate tax rate of 21% dramatically changes the landscape for corporations doing business, or planning to do business in the U.S. Tax planning, including corporate tax structures must take these changes into consideration. In a nutshell, the U.S. corporate tax rates are now very comparable to Canadian corporate tax rates. There were numerous other changes to U.S. corporate tax regulations that were enacted as part of H.R. 1, and readers are strongly encouraged to review these, along with State corporate taxes, with their Canadian and U.S. tax professionals.
U.S. corporate tax brackets for ECI (prior to 2018 for reference only)
As mentioned previously FDAP is Fixed, Determinable, Annual or Periodic income. FDAP income applies to foreign persons earning income in the U.S; such persons will be subject to 30% withholding tax, or a lower rate if there is a tax treaty between the United States and the country of residency. The U.S. tax on FDAP income is generally a 30% withholding tax at source on the gross amount of the income, unless it constitutes ECI. FDAP-type income may also be considered as ECI if it generated by assets or activities associated with the conduct of a U.S. trade or business. An example would be a property rental which generates rental income, but because of the fixed place of business in the U.S., is considered to be ECI.
U.S. corporate tax brackets for FDAP (as of 2015)
Note that there is withholding taxes typically required to be withheld from foreign corporations by U.S. payers, typically your U.S. customers. Please see below for further discussion regarding withholding taxes.
If a foreign corporation is subject to tax on its ECI, it may also be subject to a branch profits tax (BPT) and/or a branch-level interest tax (BLIT). These taxes are meant to balance the effect of operating through a U.S. branch versus a U.S. subsidiary. The calculation of these taxes are fairly complex and are described here for general purposes only.
A foreign corporation is subject to a 30% BPT on its dividend equivalent amount. Generally, this amount is the after-tax earnings of a foreign corporation’s U.S. trade or business that is not reinvested in that trade or business. The tax can be reduced by the U.S.-Canada tax treaty to 5%. The treaty also provides for a lifetime $500,000 exemption.
Due to the interchangeable nature of money, foreign corporation interest is pushed down to its U.S. branch using a prescribed formula. A 30% U.S. tax is imposed on interest taken as a deduction, which is in excess of U.S. branch interest actually paid as it is treated as U.S.-source income. The applicability of this tax is rendered academic in a Canadian company context due to the 0% tax rate afforded to interest under the Canada-U.S. tax treaty.
Foreign interest in real property tax act (FIRPTA)
Generally, capital gains are sourced to the residence of the seller. Thus, a foreign corporation is generally not subject to U.S. tax on capital gain dispositions. An exception to this rule applies to U.S. real property interest dispositions under the FIRPTA rules. This tax is generally satisfied through a 15% withholding tax imposed on the gross proceeds from disposition. This tax might be recoverable when filing a U.S. Foreign Corporate tax return.
Tax Treaty between Canada and the U.S.
Although a foreign corporation is generally subject to U.S. tax as noted above, the Canada-U.S. tax treaty can provide Canadian corporations with some relief from taxation on ECI if the trade or business activity generating the ECI does not reach the threshold at which it would constitute a permanent establishment (PE). Under the treaty, only business profits attributable to a PE in the U.S are taxable, as opposed to ECI which is not taxable. A PE is generally viewed as a more stable or permanent business connection with the U.S. and can be any of the following:
- Fixed place of business (e.g., a branch, office, place of management, factory or worksite)
- Dependent agent acting on behalf of the Canadian corporation who has, and habitually exercises, an authority to conclude contracts in the name of the Canadian corporation
- Services PE (where the first two criteria are not met).
A services PE exists when services are provided:
- By an individual present in the U.S. for at least 183 days in a 12-month period when during that time more than 50% of the gross active business income of the Canadian corporation is derived from such services,
- For customers in the U.S. for at least a total of 183 days in a 12-month period for the same or connected project.
Activities that do not give rise to a U.S. PE
- Under the treaty, certain fixed places of business are not considered a U.S. PE if used solely for specified activities. Examples of these activities include:
- Use of facilities, for storage, display, or delivery of goods or merchandise,
- Maintenance of a stock of goods or merchandise for storage, display and delivery or for processing by another person,
- Purchase of goods in the U.S.,
- Collection of information in the U.S., and
- Advertising, supplying information or scientific research done in the U.S. that is preparatory or secondary to the business.
Therefore, it is possible for a Canadian corporation to conduct business directly in the U.S. without triggering branch taxation if the activities do not create a PE. Essentially, the tax treaty overrides the U.S. tax code (IRC), and permits a Canadian business with effectively connected income to claim an exemption from owing U.S. tax, provided they do not have a ‘permanent establishment’. However, a treaty-based Form 1120-F must still be filed to report the treaty position(s) relied upon. Note – U.S. income tax filings and forms are discussed below, but for now, Form 1120F is the U.S. Foreign Corporate tax return.
Under the IRC, FDAP income is generally subject to a 30% withholding tax on a gross basis. The treaty often provides reduced rates of withholding tax for those eligible for treaty benefits and the rates were described above.
U.S. income tax filings
Form 1120F – U.S. Foreign Corporate tax return and Form 8833 – Treaty-Based Return Position Disclosure
A corporation that carries on business in the U.S. has a federal filing obligation. Additionally, tax obligations may arise if the business is conducted through a permanent establishment in the U.S. Even if the taxpayer does not have a federal filing obligation, it may still have a state filing obligation.
A foreign corporation carrying on business in the U.S. without a permanent establishment files Form 1120-F, U.S. Income Tax Return of a Foreign Corporation, to report income effectively connected with the U.S. trade or business and reliance on the Canada-U.S. tax treaty. Subject to certain limitations, any taxpayer who relies on a treaty of the U.S. as overruling or otherwise modifying the IRC must disclose such position. This is done on Form 8833, Treaty-Based Return Position Disclosure, which is filed along with the taxpayer’s Form 1120-F. Where a Canadian corporation is claiming no permanent establishment according to the treaty, only the information section of the Form 1120-F is required to be completed. In practice, this type of filing is referred to as a treaty-based return, or ‘short form’. Where a Canadian corporation has a permanent establishment, it must file Form 1120-F by completing all sections of the form including the information section as well financial statement details and other data, or ‘long form’.
U.S. taxpayer identification
Forms 1120-F, and 8833 both require a U.S. taxpayer identification number in order for the IRS to process these tax filings. For corporations, the taxpayer identification number is the Employer Identification Number (EIN). To obtain an EIN, a Canadian corporation must file Form SS-4 with the IRS. Obtaining an EIN can also be done by applying to the IRS on-line, fax, mail or telephone. We recommend Canadian corporations apply for the EIN by telephone, by contacting the IRS at 267-941-1099. If approved, the IRS will provide the EIN on the telephone and it can be used immediately, with hard copy to follow in the mailed at a later date.
U.S. withholding tax
U.S. clients of Canadian corporation are required by the IRS to ascertain its status as a U.S. or a foreign (non-U.S.) person to determine the amount of withholding tax required to be withheld from any payments owed to it. In order to determine its status, the U.S. clients may request the Canadian business to complete Form W-8BEN, W-8ECI, W-8IMY or W-8EXP depending on the situation. In some cases Form W-9 is provided, however, Form W-9 should only be completed by U.S. persons.
U.S. trade or business income is generally not subject to withholding tax, however, a 30% withholding tax may be deducted from your gross income and remitted to the IRS should you choose to ignore a request to complete a W-8 series form by your U.S. client. If the withholding is remitted to the IRS, a U.S. tax return must be filed to obtain a refund of any excess withholding. W-8 series forms are not filed with the IRS, but are kept on file by your U.S. client in the event of an IRS audit. Generally, a U.S. taxpayer identification number is required to complete these forms. U.S. client acts as a ‘withholding agent’ on behalf of the IRS and may be liable for such withholding for failure to determine status.
U.S. Corporate filing deadlines
A Canadian corporation that maintains an office or place of business in the United States must generally file Form 1120-F by the 15th day of the 3rd month after the end of its fiscal tax year. This deadline essentially pertains to Canadian companies with a PE. Canadian corporations with a PE must generally file Form 7004 (Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns), by the 15th day of the 3rd month after the end of its tax year to request a 6-month extension.
A Canadian corporation that does not maintain an office or place of business in the United States must generally file Form 1120-F (and Form 8833 if applicable) by the 15th day of the 6th month after the end of its tax year. File Form 7004 by the 15th day of the 6th month after the end of the tax year to request a 6-month extension of time to file.
U.S. Corporate tax penalties
Interest is charged on taxes paid late even if an extension of time to file is granted. Interest is also charged on penalties imposed for failure to file, negligence, fraud, substantial valuation misstatements, substantial understatements of tax, and reportable transaction understatements from the due date (including extensions) to the date of payment. A corporation that does not pay the tax when due generally may be penalized 1/12th of 1% of the unpaid tax for each month or part of a month the tax is not paid, up to a maximum of 25% of the unpaid tax.
Penalty for late filing of return
A Canadian corporation that does not file its tax return by the due date, including extensions, may be penalized 5% of the unpaid tax for each month or part of a month the return is late, up to a maximum of 25% of the unpaid tax. The minimum penalty for a return that is over 60 days late is the smaller of the tax due or $135. The penalty will not be imposed if the corporation can show that the failure to file on time was due to reasonable cause.
U.S. state income tax
A state has the right to impose any reasonable form of tax and to tax income of a Canadian corporation operating within the state as long as:
- The entity has nexus (defined below).
- Income is apportioned to the state.
Various types of taxes may be imposed on a corporation by each of the states:
Nexus is the minimum threshold of activity at which a state is granted the right to impose a tax. The level of contact required for nexus may differ from state to state. Generally, some physical presence within the state is required. However, the threshold is lower than that considered in assessing whether a permanent establishment exists. A Canadian corporation may still be subject to state taxation even in the absence of a permanent establishment because the Canada-U.S. tax treaty is a contract between the two governments at the federal level and not necessarily at the state level. In other words, not all states adopt the treaty and they are not required to do so. As such, each state must be considered separately when a foreign corporation is relying on the treaty for federal tax purposes.
A Canadian corporation carrying on business in a U.S. state must generally register with the state in which it carries on business. There may be a registration fee or other legal or administrative requirements. It’s also important to remember that each state has its own filing requirements and deadlines that may differ from the U.S. federal requirements and deadlines.
Canadians who own U.S. rental properties are essentially engaging in a trade or business in the U.S. and as such, the rental property is effectively connected income. A common consideration is whether or not to own the property rental as an individual, or set up some other structure such as owing the property within a Canadian corporation. The decision has implications for both U.S. income tax, and U.S. Estate Tax. U.S. Property rentals owned by a Canadian corporation would be taxed as a foreign corporation and file Form 1120F. The U.S. property is deemed to be a permanent establishment, and taxes would be calculated as outlined previously.
The U.S. also has an Estate Tax, and this tax is applicable to foreign persons including individuals. If the U.S. property is owned by an individual, depending on the situation, there might be U.S. Estate tax obligations upon death of the owner. There are numerous tax treaty exemptions to reduce or completely eliminate the tax for the deceased Canadian individual, but the possibility exists nonetheless. If on the other hand the U.S. property is owned by the Canadian corporation, the U.S. Estate tax would not be applicable due to tax treaty provisions which essentially permits a non-resident alien individual to transfer U.S. real property on a tax-free basis to a foreign entity (Canadian corporation), which will be treated as a domestic entity for income tax purposes and as a foreign (non-taxable) entity for U.S. estate tax purposes.
The costs and benefits of a Canadian corporation owning U.S. property should be reviewed by a tax and legal professional.
U.S. Domestic Corporation
Canadian businesses may decide to establish a U.S. corporation to operate their U.S. business. Corporations organized under the laws of the U.S. (domestic corporations) are U.S. persons, and so they are subject to U.S. tax on their worldwide income. This tax is generally imposed on gross income, reduced by deductions, and is applied at a flat rate of 21% effective for tax years beginning January 1, 2018 (per the Tax Cuts and Jobs Act (H.R. 1). Various tax credits are available to offset the tax. Alternative minimum tax for corporations was eliminated as part of H.R. 1. U.S. domestic corporations file a tax return on Form 1120, U.S. Corporation Income Tax Return.
A U.S. corporation is usually established because the Canadian business requires employment of U.S. employees, who in turn require an office (permanent establishment). In this situation, the Canadian business would not be able to be tax treaty exempt from U.S. federal taxes. The focus of the analysis will then be the net benefit and costs, including income taxes, of establishing and operating a U.S. domestic corporation. Considerations include:
- Legal and administrative fees for compliance with all federal and state income tax rules and regulations.
- Employees in the U.S., who will require source deduction for federal and state income tax, FICA, Medicare and year-end tax slips (W-2).
In addition to U.S. domestic corporations (referred to as ‘C’ corporations), Canadian corporations may consider other U.S. entities that might also be considered such as ‘S’ corporations (flow-through), LLCs and ULCs. Tax and legal professionals should be consulted to provide sound guidance and advice. The Tax Cuts and Jobs Act (H.R. 1) provides a reduced tax rate on flow through income, but there are restrictions and limitations that must be considered.
Canadian taxation of U.S. sourced income
Canadian Controlled Private Corporations
Canadian corporations are taxable on their worldwide income, which would include U.S. sourced income. To avoid duplicate taxation, Federal and State taxes paid to the U.S. can be used as a foreign tax credit to reduce taxes owed in Canada.
However, when a Canadian-controlled private corporation (CCPC) carries on business in the U.S. through a PE, any income derived from that PE will not qualify for the small business deduction. Furthermore, where services are rendered in the U.S., income derived from the provision of those services will not normally be eligible for the small business deduction, even if the CCPC does not have a PE in the U.S. As a result, such income could be taxed at a higher corporate tax rate in Canada.
In addition, having U.S. operations in a CCPC can affect the CCPC’s eligibility to be a qualifying small business corporation (QSBC). If the shares of the CCPC are not QSBC shares, the shareholders will not be able to claim the lifetime ~ $800,000 capital gains exemption on the sale of such shares. The QSBC rules are also important to consider if a Canadian business is considering running the U.S. business in a U.S. subsidiary of the CCPC. A CCPC with a U.S. subsidiary may not meet all of the tests required in order to be a QSBC, as the shares of the U.S. subsidiary are a non- qualifying asset. This problem may be avoided by setting up another Canadian corporation to hold the shares of the U.S. company rather than having the U.S. company established as a subsidiary of a Canadian company that would otherwise be a QSBC.
The U.S. is the world’s largest market and geographically located right beside Canada and a logical path for Canadian companies to expand. Canadian companies considering business operations in the U.S., could be liable for a wide array of different taxes. And there are a number of considerations to make in order to determine the appropriate filing requirements. Liability for U.S. federal income taxes depends upon whether the Canadian business is carrying on a trade or business in the U.S. through a U.S. permanent establishment. Even without a liability for U.S. federal income taxes, Canadian companies may still have U.S. filing obligations. Keep in mind state income taxes, which may be determined on a different basis, and filing requirements can vary depending on the state.
We hope you have found this article useful. Please contact our firm to discuss how Edelkoort, Smethurst, Schein CPAs LLP can assist you with your U.S. and Canadian corporation tax planning and filings. We look forward to hearing from you. Thanks for taking the time to read this article, and best wishes.
Gary Schein, CPA, CGA, MBA
IRS registered paid tax preparer and IRS Certified Acceptance Agent
Edelkoort, Smethurst, Schein CPAs LLP
Edelkoort | Smethurst | Schein CPAs LLP is located in Burlington Ontario servicing the Golden Horseshoe and Greater Toronto Area and well beyond. The firm is fully licensed with CPA Ontario to provide assurance, tax and accounting services as well as registered as tax preparers with the Canada Revenue Agency (CRA) & Internal Revenue Service (IRS).
All blogs and articles published on this site are for informational purposes only and do not constitute professional advice. Readers should contact a professional to discuss their individual situation. Neither the author nor the accounting firm shall accept any liability for any reliance placed on the information posted.