Manufacturing Articles
State Income Taxes on Canadian Companies Doing Business in US in State of Flux
Author: John McCrudden, Lionel Chen
Date: July 2010
Publication: Canadian PLANT
As America’s 50 states strive to pull their way out of budget shortfalls, many are increasingly looking to Canadian companies doing business in the US.
Whereas US corporate earnings previously contributed hefty income tax revenues to state coffers, the recession decimated that revenue flow. In response, many states are becoming more aggressive in building their revenue base: increasing audits, hunting for more tax dollars from more companies with nexus, and sharing corporate tax information to track businesses with potentially taxable revenue in multiple states.
Any Canadian manufacturer doing business in the US therefore needs to be vigilant about shifting state tax laws – regardless of the states in which you do business and the length of time you have been doing so. Here, for example, are some recent developments that could impact your corporate tax situation.
More tax revenue sought through permanent establishments and nexus
At both the US federal and state levels there is now a stronger focus on seeking tax revenue through permanent establishments (PEs) and nexus. Recent changes to the Canada-US Tax Treaty, for example, expand the circumstances in which a Canadian corporation can be deemed to have a US permanent establishment. At the same time, the Internal Revenue Service is increasing audit scrutiny of PEs.
Most Canadian manufacturers have to maintain a permanent establishment in the US in order for their profits to be subject to federal income tax. A PE is generally a fixed place of business such as a branch, factory, office or the presence of an employee or agent who finalizes contracts in the US on behalf of the Canadian company. Since January 1, 2010, however, a Canadian corporation may also be deemed to have a US permanent establishment if it also:
- performs services in the US through an individual present in the US for 183 days or more in any 12-month period, where more than 50% of the corporation’s gross active business income is derived from that individual’s services rendered in the US, or
- provides services in the US for 183 days or more in any 12-month period for one project or a series of connected projects for US customers.
If the US Internal Revenue Service determines that a company has a PE, it could be required to pay both Canadian and US taxes on profits attributed to that PE, although Canada would generally allow a foreign tax credit to offset any Canadian tax payable on such profits. At the same time, having a PE means a Canadian company may also be subject to income tax by the state in which it conducts business – and US states are not bound by the Canada-US Tax Treaty. Some states conform completely with the Treaty (Florida, Illinois), some do in part (Idaho, North Carolina), while others do not at all (New York, California).
State tax requirements are based on “nexus” – a company’s connection to the state – and each state has a different threshold as to what constitutes nexus. Storing inventory; renting office or warehouse space; providing installation, implementation, warranty or repair services; even delivering goods in trucks owned by the Canadian company – any of these may constitute nexus in certain states. The level of activity that constitutes nexus in a state is generally less than the activity needed to constitute a federal PE.
Moreover, these thresholds often change. Last year for example, Michigan signed into law a bill exempting Canadian trans-border trucking companies and auto parts manufacturers that do not have a PE in Michigan from having to pay the Michigan business tax (MBT). Specifically, the act exempts foreign persons from taxation under the MBT so long as the foreign person is domiciled in a subnational jurisdiction (e.g., a Canadian province) that does not impose an income or other business tax on a similarly situated person domiciled in Michigan. Other US states, however, are not so Canadian business-friendly.
Unitary combined reporting of income on the rise
Another popular way for states to raise more revenue is the unitary combined reporting for state income tax system. More US states are adopting this method of tax reporting: Michigan and Texas in 2008, and Massachusetts, West Virginia and Wisconsin last year.
Under the unitary system, a state determines whether a group of corporations under common ownership share a "unitary relationship.” If so, the company must combine income and apportionment factors (property, payroll and sales) to compute state taxable income.
This system does not exist in Canada. Here, if you have a parent company with four subsidiaries, you would file five income tax returns. In US states having the unitary system of reporting, a company would file one return on a combined basis.
Twenty-four states have now employed some type of unitary combined reporting. The rise in such regimes increases the risk of Canadian companies facing state income taxation, especially since the definition of a "unitary business" can vary from one state to another, as can the apportionment rules. California, for example, has a 80/20 rule: when 20 percent or more of the average of a foreign corporation’s property, payroll and sales are in the US, then all of the company’s income and apportionment factors are included in computing the taxable income of the unitary group in California.
Crackdown on non-filers
Along with tougher tax rules for Canadian companies doing business in the US, many states have stepped up audits, increased penalties and are actively identifying Canadian non-filers. As well, there are a growing number of information-sharing agreements among the states and with US Customs and the Internal Revenue Service.
Therefore the best way for Canadian manufacturers doing business in the US to minimize the impact of state income taxes is to carefully strategize your US business activities and the states in which you carry out these activities. Remember – it’s always tax time in the US!
John McCrudden (JMcCrudden@bdo.ca) and Lionel Chen (LChen@bdo.ca) are senior tax managers at BDO Canada LLP (www.bdo.ca) who work with Canadian and US companies on cross-border tax issues. You can reach them in the Mississauga office at (905) 270-7700.
