U.S. Federal Tax Consequences for Canadian Businesses with US Operations

Posted on December 8th, 2022 in Cross-border Tax

Background

Canadian businesses continue to extend their reach into the U.S. for numerous reasons; some of which include proximity, lower corporate tax rates as a result of the 2017 US tax reform, a stable economy, and a skilled workforce. While these are all great reasons to expand operations into the U.S., companies must consider the U.S. Federal and State tax implications of carrying on a trade or business in the U.S. Note that this article does not cover U.S. state tax issues Canadian businesses may face – please contact us for further guidance on navigating such situations.

What does it mean to “carry on a trade or business in the U.S.”?

Generally, a trade or business is any activity conducted for the purpose of generating income. The threshold for this determination is fairly low in that a Canadian company could be considered to be carrying on a trade or business in the U.S. when it has considerable, regular, and continuous dealings with U.S. customers.

Effectively Connected Income and U.S. Permanent Establishments

Generally, when a Canadian company engages in a U.S. trade or business, all income associated with that trade or business is considered to be Effectively Connected Income (ECI). Note that U.S. source income may still be considered to be ECI even when there is no connection between the income and the U.S. trade or business.

Canadian companies are required to pay U.S. federal income tax on ECI (less expenses incurred to generate ECI) however, companies may seek relief from this tax burden pursuant to the U.S. – Canada income tax convention. Under the tax treaty, Canadian companies are only required to pay U.S. federal income tax if they carry on business through a U.S. permanent establishment.

Generally, a permanent establishment (PE) is defined as a fixed place of business in the U.S. through which a non-resident entity (i.e. a Canadian company) carries on business. This definition continues to evolve given the rise in e-commerce activities. Some traditional examples of a PE include:

• A fixed place of business such as a branch, an office, factory, workshop, etc.
• Agents who habitually exercise the authority to conclude binding contracts in the U.S. on behalf of the Canadian company.
• The provision of services that meet certain specified criteria.

Pursuant to the tax treaty, the following activities generally do not give rise to a U.S. PE:

• The use of facilities for storage, display or delivery of goods.
• The maintenance of a stock of goods for storage, display, and or delivery.
• The purchase of goods in the U.S.
• Advertisement, supply of information or scientific research done in the U.S. that is preparatory or secondary to the business.

U.S. Federal Income Tax Filing Requirements

Canadian companies with income effectively connected to a U.S. trade or business must file U.S. federal income tax returns. A Canadian business with U.S. ECI that is not attributable to a U.S. PE must file U.S. Federal Form 1120-F US Income Tax Return of a Foreign Corporation and Form 8833 Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b) to claim relief from U.S. federal tax pursuant to the U.S.- Canada income tax treaty. Generally, this return must be filed 5 ½ months after the taxpayer’s year-end. For example, a calendar year taxpayer must file the protective return by June 15^th.  

Canadian companies with U.S. ECI attributable to a U.S. PE cannot claim the treaty exemption and must file Form 1120-F to report U.S. source income and expenses. The taxpayer may claim foreign tax credits on its Canadian income tax return for any U.S. income tax paid. Generally, this return must be filed 3 ½ months after the taxpayer’s year-end. For example, a calendar year taxpayer must file the return by April 15^th.

Penalties

If a return is filed late but no tax is payable due to the treaty exemption, interest and penalties may not apply if the return is filed by the second deadline which is 18 months from the original due date. If the return is not filed by the second deadline, the Canadian company may be taxed on its U.S. source gross business income. If a treaty exemption is claimed to eliminate the tax liability, a non-disclosure penalty of $10,000 may be levied for each item of income.

If a return is filed late and there is tax due, interest and penalties will be calculated based on the tax due and exposure can be quite significant

Summary

Canadian companies with activities in the U.S. may have federal income tax filing obligations and in some cases, a federal tax liability when business is conducted through a permanent establishment. Note that U.S. state income tax obligations may also apply based on the different laws of each state.

If you determine your business may have a U.S. income tax filing obligation or are thinking about expanding to the U.S., we can help. Our cross-border taxation advisors have the knowledge and expertise to help you evaluate and determine the implications for your business.