Corporate Income Tax Considerations for Canadian Companies Expanding to the United States 

Successful Canadian businesses commonly expand into the United States to continue their revenue growth. Many of these Canadian-founded companies do not realize that extending business activities to the United States could potentially expose the company to US tax implications, which are not considered in advance. Tax planning and structuring are critical considerations when expanding across borders so you can focus on your business growth instead of retroactively defending against possible assessments and potentially substantial penalties.  

US basis of taxation 

According to US domestic tax law, a non-US company is subject to US federal corporate income tax when it has income that is effectively connected with a US trade or business. The threshold for having income that is “effectively connected with a US trade or business” is not well defined in the Internal Revenue Code, or the corresponding Regulations, and as such the determination of whether a company is earning effectively connected income is based on the facts and circumstances of each situation. That said, case law and other rulings have established a common understanding that a US trade or business streams form considerable, continuous, and regular activity within the United States.  

This means if you operate a business in Canada and have dealings with US customers, you may be considered to be carrying on a business in the US. The following are a few examples of when your business could be subject to US federal corporation income taxes: 

• If you sell and ship your products to US customers, either directly or through an online retail marketplace, and title passes to your customers in the US, you will likely be considered to have a US trade or business. 
• If you (or your employees and an independent contractor acting on behalf of your company) perform services while physically present in the US, you will likely be considered to carrying on a US trade or business.  
• If your technicians travel to the United States regularly to help US customers with installations, training, or service products, you may have a US trade or business.  

It is important to understand and recognize when your company starts to have business connections with the US. Once those connections rise to the level of operating a US trade or business, your company may be subject to US tax, or at least have US filing requirements.  

The benefits of the Canada-US tax treaty 

While a Canadian company may need to file a US federal corporate income tax return, the extent to which the Canadian company is subject to US federal corporate income taxes depends on whether the activities conducted in the United States fall within the activities protected by the Canada-US Income Tax Treaty1. Even if the company is protected from US federal corporate income taxes because of the Canada-US Income Tax Treaty, the company is not exempt from filing a US federal corporate income tax return. Specifically, the IRS requires all foreign corporations, which are subject to US federal corporate income taxes and are relying on the terms of an Income Tax Treaty with the United States and their home country, to file a federal corporate income tax return and disclose the Treaty position relied upon and the revenues from the US.  

Penalties and other implication if choosing to not file 

Canadian companies which choose to not comply with the IRS’s filing requirement may be subject to substantial implications. Specifically, the following could apply: 

• The IRS may assess a $10,000 penalty for each Treaty position that was not properly disclosed on a timely filed return. 
• The IRS may deny all deductions relating to the revenue earned result in US federal corporate income taxes being assessed on gross US revenues instead of net taxable income. 

• If no return is filed, the statute of limitations never starts meaning the IRS could potentially have an unlimited look-back period to assess tax, penalties, and interest charges.  

All of these potential risks and penalties can be mitigated by filing a protective US federal corporate income tax return. The cost of engaging a professional services firm to assist with this reporting requirement is relatively insignificant when compared to the potentially severe penalties and taxes that could be applied if no action is taken.  

Permanent Establishment 

There are situations when a Canadian company operating in the United States is not protected under the terms of the Canada-US Income Tax Treaty, such as when the Canadian company has a permanent establishment in the United States. If your company has a permanent establishment the United States, the income relating to the permanent establishment is subject to US federal corporate income taxes. In this circumstance, your Canadian company would again file a US federal corporate income tax return to report US revenues and allocate your cost of goods sold and other operating expenses to the US revenues. In addition, your company may be subject to a special branch profits tax. While the explanation of these calculations is beyond the scope of this discussion, the IRS would expect its share of taxes on business profits attributable to the permanent establishment.  

State taxes 

Your Canadian company should also not neglect potential state tax implications. There are 50 states, and each state has its own set of tax rules which do not necessarily align with US federal tax rules. While currently only 47 states administer some sort of corporate tax regime, it is usually a surprise to most new US taxpayers that not one of these states follows the same federal rules for determining a trade or business or permanent establishment. Instead, the States use a determination of a nexus threshold to determine whether businesses set up outside the state are subject to State taxes.  State nexus can be created in several ways, but most states follow some form of a physical presence nexus, economic presence nexus, or a combination of physical and/or economic presence nexus thresholds.  

In addition, State tax rules may apportion revenue in a method that differs from the rules generally used for US federal corporate income tax purposes. One example is that for service revenues, some states apportion revenue based on the location of recipient of those services instead of where those services are performed. We recommend reviewing our upcoming post on the difference between market-based sourcing and cost of performance sourcing to understand how these rules may affect your company’s state reporting requirements.  

Additionally, States are not parties to the United States federal Income Tax Treaties and as such, can choose whether to follow these Treaties. This means if your company has established state nexus, it may be subject to the state’s corporate income tax regime, and thus may be subject to state corporate taxes even if it protected from US federal corporate income taxes under the terms of Treaty.  

Lastly, sales and other state taxes should not be overlooked If your company makes sales into a state, you should determine whether those sales are subject to states sales taxes which would require your company to collect and remit state sales taxes. Like corporate income taxes, state sales taxes could apply if your company has met a sales tax nexus threshold. We recommend reviewing our upcoming post on state sales taxes rules and how they may impact your Canadian business.   

Summary 

If you have business operations in the United States, you could be liable for a number of different taxes, and there are a number of considerations to make to determine the appropriate filing obligations. Thoughtful consideration in advance can save time, effort and money, not to mention potential stress avoided by not getting caught on the wrong side of the US federal and/or state tax rules.  If you have business dealings in the United States, or are thinking about expanding to the United States, contact your RLB advisor or RLB’s US Tax Team to discuss your US tax obligations.