ARE YOU DOING BUSINESS IN THE UNITED STATES?

It is possible that your business or your corporation may have U.S. tax filing requirements or even U.S. income tax liabilities if you have U.S. customers. Determining the U.S. tax status of your Canadian business is important in order to avoid penalties and inadvertent tax consequences. We will briefly guide you through some tax considerations for carrying on business in the United States.

The United States taxes non-resident individuals and foreign corporations based on U.S. business profits and U.S. source non-business income (income from interest, dividends, and royalties). We will deal here with U.S. business profits.

Effectively Connected Income
A non-resident individual or a foreign corporation that is engaged in a U.S. trade or business must report and pay tax based on the net amount of U.S. source income effectively connected with the U.S. trade or business.

A trade or business is not clearly defined in the Internal Revenue Code or its regulations. Instead, the courts have relied on regular and continuous activity based on a facts and circumstances analysis. You may have a trade or business in the U.S. under the following circumstances:

• Your are making sales into the U.S. to U.S. customers.
• You are shipping goods to the U.S. with title passing at the customer’s premises after inspection.
• Your employees are regularly travelling to the U.S. on sales calls or are regularly present at U.S. trade shows carrying out demonstrations and marketing activities.
• Your employees are travelling to the U.S. to install and service your products.
• You are performing personal services in the U.S. carrying out consulting activities.

Effectively connected income is subject to tax in the U.S. at graduated rates (the average rate of federal and state tax is a combined 39%).

The Treaty
Fortunately, as a resident of Canada, a corporation is not subject to tax on U.S. effectively connected income unless that income is earned through a U.S. permanent establishment. This relief from U.S. taxation is provided pursuant to the Canada / U.S. Income Tax Convention (“the Treaty”). Examples of situations where a corporation may be considered to have a permanent establishment in the U.S. include where the corporation has:

• an office,
• a factory,
• an employee in the U.S. who has the ability to conclude contracts.

It is in the latter situation where many Canadian corporations are likely open to U.S. taxation. In many small corporate scenarios, the principals, i.e. the president, vice president, key shareholders are the individuals that are travelling to the U.S. to conduct sales meetings and “clinch the deal”. In almost all situations, these individuals have the ability and authority to conclude the contract. Where this is carried out in the U.S., the IRS will view the Canadian corporation to have earned the income through a U.S. permanent establishment. Where a corporation has engaged an independent contractor to conduct its business, it will generally not have a permanent establishment in the U.S. as long as the independent contractor is acting in the ordinary course of their own business. The IRS may scrutinize the relationship, however, to determine whether the independent contractor is in fact an employee of the corporation. They will look at the amount of control exercised over the agent, who bears the risk of loss, and other tests of economic independence.

Note that where a corporation does not have a permanent establishment but it does have income effectively connected with a U.S. trade or business, it will have U.S. filing requirements. The corporation must file a U.S. Income Tax Return of a Foreign Corporation with Treaty disclosure to claim the Treaty exemption. If the corporation does not file these forms, and it is later found that the income was earned though a U.S. permanent establishment, the corporation will be taxed on its gross income (rather than being allowed the related deductions). If the Treaty exemption is claimed after the fact, a $10,000 penalty for non-disclosure of a Treaty position can be assessed for each item of income.

Filing these forms does not get the corporation “off the hook” with respect to U.S. tax. The IRS may still challenge the existence of a U.S. permanent establishment. If the IRS is successful, the Canadian corporation will be subject to the full U.S. tax regime on U.S. business profits. Luckily, a foreign tax credit can be claimed in Canada to the extent that the Canadian corporation paid Canadian tax on those profits. If, however, the U.S. federal and state tax on the income is higher than the Canadian tax on the same income, it will not be possible to obtain a full credit for the U.S. taxes paid. At present, the average combined U.S. and state tax rate exceeds the average combined Canadian federal and provincial tax rate.

There is a myriad of other issues to consider including state income and sales tax implications. Remember there are 50 states out there, each with their own rules! The above comments deal with federal issues only – the states are not bound by the federal guidelines.

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