- What are the corporate income tax rates in the U.S.?
- Are you subject to tax laws if you have an active American sales representative?
- When are you subject to state income tax laws?
- And what about sales tax? How does this work?
- How can you maximize your after-tax revenues in an environment where every state has its own rules?
Whether your corporation is already selling in the U.S. or contemplating an expansion south of the border, tax considerations should be a high priority. In fact, as a business owner or manager, you should treat taxation as a crucial part of your organization’s risk strategy. To achieve this, you must understand the complexities of U.S. tax in order to take the appropriate actions to mitigate the risks they pose.
Our firm’s experts Robert Chayer, Partner in U.S. Tax, and Peter Var, Manager in U.S. Tax, explain five key facts to get you started on your strategy.
1. Federal taxes are the real issue
The first thing you should know is that U.S. corporate taxes are currently relatively high when compared to Canadian taxes, typically 13% higher.
It is important to realize that federal income taxes make up the bulk of income tax, with rates up to 35% (and even higher with surtaxes). State income taxes, in comparison, range from 0%–12%. When considering Canadian foreign tax credits, your U.S. tax strategy should focus on structuring your activities in order to minimize taxable income at the federal level.
2. No permanent establishment, no federal income tax
As a general rule, U.S. corporations are subject to federal income tax based on their worldwide income. However, the situation is very different for Canadian corporations.
To be subject to federal income taxes, a Canadian corporation must be engaged in a trade or business in the U.S. and generate effectively connected income with that trade or business. It takes very little to be engaged in a U.S. trade or business. It has been deemed by U.S. tax courts that Canadian corporations that merely solicit sales in the U.S. have effectively connected income. Given that the income is effectively connected with a U.S. trade or business, the Canadian corporation becomes subject to federal income tax under U.S. tax law.
However, Article V of the tax treaty between the U.S. and Canada exempts Canadian corporations from income tax provided they do not have what is called a “permanent establishment”. A “permanent establishment” can take three forms:
- Use of a fixed place of business
If you own, rent or use a space in the U.S. that serves as a place of business for your company, it is very likely to be considered a permanent establishment, and you will be subject to U.S. tax laws. A fixed place of business can take many forms. For instance, renting a hotel suite for a few weeks every year to use as a place of business has been considered a permanent establishment.
However, there are exceptions. Among them, a permanent establishment excludes locations where the sole activity is warehousing or displaying products. In other words, the criterion to determine if a location is a permanent establishment is the nature of the activity taking place at that location. For example a showroom would not qualify as a fixed place of business (a permanent establishment), as long as the only activity consists in showcasing.
- Exercising the authority to contract in the United States
When you habitually exercise authority to contract sales while physically in the U.S., you create a permanent establishment. There are therefore major tax implications when deciding to negotiate and conclude contracts on U.S. soil.
- Presence of employees in the United States for more than 183 days per year when the above two rules do not apply
A Canadian enterprise will be deemed to provide its services in the U.S. through a permanent establishment if one of the following two conditions is met:
The services are performed by an individual who is present in the United States for more than 183 days during any 12-month period and more than 50% of the enterprise’s gross active business revenues are derived from such services;
The services are provided in the United States for more than 183 days during any 12‑month period and the services relate to the same project or a connected project for a customer who is either a resident of the United States or who has a permanent establishment in the U.S. (to which the services can be attributed).
3. You still have to file a federal tax return even if you don’t pay federal income tax
If you are engaged in a trade or business activity in the United States but don’t have a permanent establishment, you will not be subject to federal income tax. Nonetheless, you are still required to file a U.S. tax return.
The permanent establishment exemption comes from the Canada–United States income tax treaty. This means that you must still file a tax return with the Internal Revenue Service (IRS) to notify them that you are taking a tax treaty position. The penalty for failing to do so is hefty: US$10,000 per transaction. This is not a risk you want to take.
4. You may have to pay state income tax even if you are exempt from federal income tax
State income taxes have their own rules. In fact, each state has a separate set of laws that will determine if you are subject to state income tax or not. Here are some of the situations that may subject your company to state income tax.
- Physical presence
Physical presence is broadly defined as having representation or physical space in that state for your business. It is slightly different from the fixed business place concept used for federal tax purposes: in regard to state taxes, a warehouse qualifies as a physical presence. You should therefore choose the location of your warehousing activities carefully, because it could have substantial tax consequences.
- Intangible presence
In certain states, the use of intangible property will cause a corporation to be subject to tax in that state. For instance, income received for the use (in that state) of a licence or trademark could be subject to income tax in that state.
- Economic nexus
Economic nexus is defined differently in every state. The general idea is that a state that has adopted the concept of economic presence will tax you if you economically benefit from that state. To make this determination, one test measures whether you exceed a certain amount of sales to the state (a bright-line test). California for example, will determine economic presence if your sales in the state exceed $500,000 or 25% of your worldwide sales. Moreover, California also measures whether fixed assets, inventory or payroll exceed $50,000 in their state or 25% of your totals elsewhere (these amounts are indexed for inflation). As more states continue to adopt economic nexus, you should investigate whether you are affected and if you exceed any sales thresholds.
- Click-through nexus
This concept is also referred to as the “Amazon.com law”. Some states apply this rule. New York State, for instance, specifies that if the seller pays a third party to direct traffic to their website with click-through ads, and the company delivering the click-through service has a presence in New York State, then the seller may also be considered as having a presence in New York State.
5. You may benefit from an exemption on sales tax
Just like state income taxes, state sales taxes follow their own set of rules. Contrary to the situation in Canada, there is no sales tax at the U.S. federal level, only at the state level. Out of 50 states, 45 (and the District of Columbia) collect a sales tax if you have a physical presence in that state. The tax applies in the following cases:
- Sale of tangible personal property
- Sale of certain services
- Sale of certain intangible property (digital content such as movies, e-books, music, etc.)
Taxation would not be taxation without exemptions. Therefore, a corporation might not be subject to sales tax under certain circumstances. These include:
Only sales to end customers are subject to sales tax. Therefore, if you sell to a retailer or distributor (e.g. Walmart), which then sells the product to customers, you are exempt from collecting the sales tax. However, be aware that you must receive an exemption certificate from every client in every state in order to comply with regulations.
- Integration into other goods
Products sold to be integrated into other goods, which will then be sold, are not subject to sales tax. An example of this would be a company that manufactures steering wheels and sells them to a car manufacturer, which then integrates them into cars before selling the cars to customers. Similar to items held for resale, the recipient of the goods (in the example, the car manufacturer) must provide you with an exemption certificate.
- Exempt goods
Some goods are exempted from sales tax. This means that if you sell property (e.g. medication), you do not have to collect sales tax even though you have a physical presence in the state.
There is no denying it: U.S. tax issues can be complicated. From the location of your warehouse to the presence of your employees and the nature of their activities, the factors affecting your tax situation are numerous and they pose significant risks. In addition to the threat of monetary penalties, failure to comply with tax regulations can have major consequences for your future business plans. When you sell your business, you do not want a buyer or an investor to uncover compliance issues during the due diligence process and retract their offer. The only way to prevent this is to work with true experts that can fully understand U.S. tax issues from a Canadian perspective. Because it’s not just about tax: it’s about the future of your business.
To receive the latest news and insights from our experts, please register for our publications.
About Richter : Founded in Montreal in 1926, Richter is a licensed public accounting firm that provides assurance, tax and wealth management services, as well as financial advisory services in the areas of organizational restructuring and insolvency, business valuation, corporate finance, litigation support, and forensic accounting. Our commitment to excellence, our in-depth understanding of financial issues and our practical problem-solving methods have positioned us as one of the most important independent accounting, organizational advisory and consulting firms in the country. Richter has offices in both Toronto and Montreal. Follow us on LinkedIn, Facebook, and Twitter.