Ask just about any Canadian entrepreneur who does business in the U.S. and they’ll no doubt confirm that cross-border tax issues are a headache, and a complicated one at that. PROFIT asked accountant Michel Oulimar, BDO Canada’s senior manager of U.S. tax, to walk us through the red (white and blue) tape that exporters with operations in America face.
PROFIT: If a Canadian firm is delivering a service to U.S.-based clients, but doesn’t have a U.S. division, how should the firm handle that revenue from a tax perspective?
Oulimar: Generally revenue from services will be taxed in the jurisdiction where the services are performed. If the services are performed in Canada, then the revenue will be considered earned in Canada and taxable in Canada. If the services are performed in the U.S., the Canadian firm will generally be considered to be engaged in a U.S. trade or business and the service income will be taxable in the U.S. unless relief is obtained under the Canada-U.S. Income Tax Treaty. If it is not exempt from U.S. tax under the treaty, it must be reported on a U.S. tax return and U.S. taxes paid. When the Canadian firm files its Canadian tax return, it would report the income in Canada, but would generally be able to claim a foreign tax credit to offset some or all of the U.S. taxes paid.
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Taxes at the state level must also be considered and most states do not provide relief under the CanadaU.S. income tax treaty. Even if the service is not performed in the U.S., some states may try to tax the revenue under certain economic principles. Both U.S. federal and state tax rules must be considered when assessing U.S. tax obligations.
PROFIT: When does U.S. taxes become payable? And what do Canadian SMEs need to consider if they are setting up a tax account with the IRS?
Oulimar: Under U.S. domestic rules, taxes are due if the Canadian company is considered to be carrying on a business in the U.S. The term “carrying on a business” is not clearly defined in the U.S. tax code and is a facts and circumstances test that relies on whether the activities in the U.S. are regular, continuous and substantial. Rulings are not typically issued on this by the IRS, so it really is a judgment call. If it is determined that a business is being carried on in the U.S., taxes will be owed by installments throughout the year and on the 15th day of the third month following the period end. It may be possible to claim exemption from U.S. tax under the CanadaU.S. tax treaty if the U.S. business is not carried on through a permanent establishment located there. That determination should be made with the help of a tax professional.
Canadian SMEs need to understand that establishing a tax account with the IRS is not the event that triggers the filing requirement. Instead, filing requirements and tax liabilities are determined by the activities actually being conducted in the U.S. Once they have a tax account, they will be in the IRS’ system and some form of reporting is likely to be officially requested of them. So, before establishing a tax account with the IRS, it is beneficial to take a look at the company’s U.S. activities, past, present and future, to determine what filing will be required and what taxes will be due. This will help plan for any upcoming taxes and/or penalties. Activities conducted in the past for which filings were missed can be dealt with in various ways to mitigate penalties. Present and future activities can be structured in such a way as to avoid the application of both Canadian and U.S. taxes to the same income, as well as using any strategies available to keep the overall tax rate low. These last few points should be dealt with using the help of a tax professional.
PROFIT: What general advice do you give to firms as they build an export operation?
Oulimar: Generally, Canadian SMEs should not let complex U.S. tax rules stand in the way of business opportunities there. Taxes cannot be completely avoided, but double tax can be prevented and the overall tax rate managed. By being mindful of the tax rates of each country and the tax brackets at which they apply, a corporate structure can be designed to keep overall taxes as low as possible. If exports to the U.S. are expected to become more than just occasional, a tax professional should be consulted to walk you through the U.S tax obligations, the application of the Canada-U.S. tax treaty, the various structures available, such as branches, corporations or flow through entities. Many other issues must be addressed such as the use of foreign tax credits, transfer pricing rules that apply to goods and services, financing the U.S. operation and repatriation of funds, state and local taxation etc. SME’s should also get an idea of the timing and the extent of tax compliance requirements, as well as the cost, so they can prepare accordingly.
PROFIT: What happens if the IRS decides to audit a Canadian company that doesn’t have a U.S. subsidiary/division?
Oulimar: Canada and the U.S. have an income tax treaty in place that governs, among other things, the exchange of information, assistance in the collection of taxes and procedures to reach mutual agreements on tax issues affecting both countries. As well, the U.S. and various countries, including Canada, are now developing joint audit processes. The U.S. is also introducing a set of rules under the Foreign Account Tax Compliance Act (FATCA) to force non-U.S. entities to disclose information to the IRS about U.S. citizens’ holdings outside the U.S.
This means a Canadian company may be directly or indirectly subjected to a U.S. tax audit even if it doesn’t have a U.S. subsidiary or division, as long the actions of either the U.S. or Canada stay within the guidelines set forth by the treaty, or issues being audited deal with U.S. citizen’s holdings outside the U.S.
PROFIT: Can the Canada Revenue Agency ask the IRS to initiate an audit of a Canadian firm if they suspect unreported U.S. income?
Oulimar: Under the guidelines of the CanadaU.S. tax treaty and also under the joint audit processes, Canada Revenue Agency (CRA) and the IRS will cooperate to collect taxes owed and exchange information. This means CRA can request information from the IRS, which in turn may request such information from the U.S. operations of the Canadian corporation. This may or may not constitute an audit, but at the very least, under the treaty, there will be cooperation between CRA and IRS for the collection of taxes. This cooperation can result in Canadian corporations being subjected to IRS requirements as well as U.S. corporations being subjected to CRA requirements.
Related: U.S. Tax-Planning Strategy