Harry Chana:
Welcome everyone to the next episode of our Cross-Border Tax Podcast Series. This is your host, Harry Chana, International Tax and Transaction Tax Practice Leader for BDO Canada.
In today's podcast, I have the pleasure of talking about some tax issues involved in outbound transactions. That is when a Canadian company is looking to expand outside of Canada. Specifically, we'll be looking at expanding into the United States. You will see from our podcast today there are several issues to navigate through. Joining me to help uncover these issues, I have Rose Cross, International Tax Partner, and Emily Heinrich, U.S. Tax Partner. Rose, Emily, welcome and thank you for joining me on this podcast.
So Emily, I'm going to start with you. Canadian companies when looking to expand often look to the U.S. given our geographical proximity. Let's say a Canadian company is looking to sell into the U.S. What U.S. tax issues can this create for the Canadian company?
Emily Heinrich:
Thanks, Harry. I agree. The U.S. is a natural marketplace for Canadian businesses to target. So this is a question we have a lot of experience answering.
In the early stages of doing business in the U.S., a Canadian company will typically sell products or services into the U.S. without having any significant presence, no employees or property, just remote sales. As sales increase and business needs evolve, the company is more likely to increase its presence in the U.S. and create what's known as a permanent establishment, or PE for short.
Once a company gets to the point where they expect to create a permanent establishment, they should consider whether to forge ahead and operate through a branch of the Canadian corporation or if it would be more beneficial to set up a new U.S. subsidiary.
Harry Chana:
Thanks, Emily. Can you talk to me a little bit more about what kinds of activities create a permanent establishment?
Emily Heinrich:
Absolutely. The term permanent establishment is defined in the U.S.-Canada Treaty, but it generally means a fixed place of business. It could be an office, a factory, a workshop, or any kind of permanent site where business is conducted.
You can also create a permanent establishment by concluding contracts in the U.S. Once you have a permanent establishment, you're essentially operating a branch and have to pay taxes on your U.S. source income. So you want to be mindful of the rules and be purposeful with your activities in the U.S.
Harry Chana:
Thanks, Emily. Rose, I want to turn to you. What do you usually advise clients when they're looking to expand into the U.S. from a Canadian tax perspective?
Rose Cross:
Thanks, Harry. From a Canadian perspective, the implications of incorporating in the U.S. or operating as a branch are quite different. From an income tax perspective, if a Canadian company carries on business in the U.S. directly without creating a U.S. subsidiary, the Canadian corporation reports its worldwide income on its corporate tax return, including those U.S. activities. In other words, all income is taxed in Canada. To the extent a U.S. branch is created and U.S. income taxes are paid, foreign tax credits are available to provide relief from double taxation for any U.S. taxes paid.
Now losses from the branch can be offset against the other profits of the Canadian corporation. So that is a big reason a company in Canada chooses not to incorporate a U.S. subsidiary. Having said that, it is very common for Canadian companies to expand into the U.S. through a U.S. subsidiary, both to limit commercial liability, but also to take advantage of Canada's relatively favourable system for taxing foreign subsidiaries.
When US operations are conducted through a subsidiary, the act of business income earned by the subsidiary is generally not subject to tax in Canada until profits are omitted to the Canadian shareholders in the form of dividends or until the Canadian corporation disposes of its foreign subsidiary.
I want to caution you on earning income other than active business income in a U.S. subsidiary. Certain forms of passive investment type income will not be deferred until a dividend is received, but rather it will be accrued to the Canadian corporation in the year it is earned and taxed in Canada. This income is commonly referred to as FAPI, Foreign Accrual Property Income. Now these rules are quite complex, so if you're ready to expand to the U.S., it is critical to obtain the necessary advice.
Harry Chana:
Emily, Rose mentioned from a Canadian tax perspective the difference between operating as a branch versus setting up a U.S. subsidiary. Can you talk a little bit more about the U.S. side and what the difference is between the two are?
Emily Heinrich:
Yes. From a U.S. perspective, the filing obligations for a U.S. branch return are different from a U.S. subsidiary. For one, a branch is subject to a branch profits tax. This is imposed at a rate of 5% on the after-tax profits of the U.S. branch. In other words, you pay 5% more for operating your U.S. business through a branch compared to operating through a U.S. entity. Oh, and by the way, the 5% is a reduced rate provided by the U.S.-Canada Treaty. The U.S. statutory rate is 30%. So it's important to make sure you are properly claiming treaty benefits by filing the correct forms in order to take advantage of that lower rate. You wouldn't want to misstep here or that 5% could become 30%.
Harry Chana:
But there are also state taxes to consider, correct?
Emily Heinrich:
Yes. State and local taxes can be the most cumbersome and difficult compliance burden to get your arms around. There are payroll taxes, sales and use taxes, and income and franchise taxes to consider for every state in which you do business.
For companies in the technology and software space, this can be particularly challenging to navigate. The sourcing of revenue and determination regarding taxable presence is more challenging for companies in these industries. From a state income tax perspective, some of the risks and tax exposure are minimized if the company is incurring losses. For example, there will be no state income tax expense if there's no net income being earned. However, it's critical to get your income tax compliance up to date before the company makes a profit.
Harry Chana:
For Canadian businesses operating in the U.S., what should they know about state taxes?
Emily Heinrich:
There are two important things to keep in mind when it comes to U.S. state taxes. First, they are administered on a state level. Each state makes their own rules, and the tax returns and payments must be made directly to each state following the state's administrative procedures. Obviously, if you are operating in 50 states, this is a huge challenge and is very time-consuming. For Canadian businesses entering the U.S. market, this can be an unexpected burden.
Second, states generally don't follow U.S. tax treaties. Even if you aren't taxable for U.S. federal purposes, you may be taxable for state purposes. This can get complicated, and many companies don't realize they have state tax requirements until they are contacted by a state, at which point it is typically too late to avoid interest and penalties.
And if we're talking about sales tax, where the company should have been collecting sales tax from its customers, if they didn't collect and remit sales tax when it was required, they will likely have to pay back the back taxes out of the company's pocket. It's best to understand and plan for the various state and local taxes upfront to avoid unpleasant surprises down the road.
Harry Chana:
Thanks, Emily. Rose, before we move on to the next topic, is there anything else that needs to be considered when a Canadian company is expanding into the US?
Rose Cross:
Yes, Harry. If you're running your business in Canada through a Canadian-Controlled Private Corporation, or CCPC for short, and are looking to expand to the U.S., there are a few things to consider. First of all, when a CCPC carries on business in the U.S. through a permanent establishment, any income derived from that U.S. permanent establishment will not qualify for the small business deduction. In addition, having U.S. operations in a CCPC can impact the CCPC's eligibility to be a Qualifying Small Business Corporation, or a QSBC.
If the shares of the Canadian-Controlled Private Corporation do not qualify as QSBC shares, the shareholders will not be able to claim the lifetime capital gains exemption on the sale of such shares. The lifetime capital gains exemption in 2022 is $913,630 per person. So it is not an insignificant amount, especially if a company is held by multiple Canadian shareholders who have all not used up their lifetime capital gains exemption.
I should also mention that the QSBC rules are also important to consider if you are thinking of running the U.S. business through a U.S. subsidiary of the CCPC. A CCPC with the U.S. subsidiary may not meet all the tests required to be a Qualifying Small Business Corporation, as the shares of the U.S. subsidiary are not a qualifying asset. This problem may be avoided by setting up another Canadian corporation to hold the shares of the U.S. company rather than having it owned by the company that would otherwise qualify for the QSBC treatment.
I cannot stress enough that it is so important to plan your expansion with international tax advisors that understand the impact on both sides of the border.
Harry Chana:
Thanks, Rose. I wanted to change gears a little bit and discuss an important entity structure that's unique to the U.S., limited liability companies, also known as LLCs. Emily, why are LLCs so popular in the U.S.?
Emily Heinrich:
LLCs can be useful entities. They provide limited liability to the members and can be simple to set up. They also offer a lot of flexibility. A single-member LLC is treated as a disregarded entity by default. Multi-member LLCs are treated as partnerships by default. But then there's also the option to check the box and treat your LLC as a corporation. They are very popular in the U.S., partially because they're so versatile.
Harry Chana:
And Rose, how do LLCs work from a Canadian tax perspective?
Rose Cross:
LLCs are popular for U.S. resident individuals, but may not be optimal for Canadians. You see, Canada considers both single and multi-member LLCs to be corporations for Canadian tax purposes. The difference in the treatment of an LLC in Canada and the U.S. can result in more than double taxation to its Canadian members.
A Canadian member of an LLC is taxed in the U.S. on the LLCs profits whether or not they are distributed, and as such will pay U.S. federal and state tax. However, the Canadian member will not generally be taxed on the earnings for Canadian tax purposes unless we're dealing with the FAPI rules that was briefly discussed above.
The lack of congruence between the Canadian and U.S. tax treatments generally results in tax in the U.S. in a different year than there is in tax in Canada. Even if the tax is incurred in both countries in the same year, there may be limitations on the Canadian member's ability to claim a credit for the U.S. tax paid.
Harry Chana:
So Rose, I have to ask, is there a place for LLCs in structuring investments into the U.S. from a Canadian tax perspective?
Rose Cross:
Of course. Many times the Canadian investor is a minority holder or may not be able to dictate what type of entity's set up or purchased in the US. If the type of entity must be an LLC, then there would need to be additional tax planning undertaken to ensure more efficient tax structure is in place rather than holding the LLC directly.
Harry Chana:
Thank you, Rose. I want to take this opportunity to thank both Rose and Emily for their thoughts and comments on structuring matters to consider when Canadian companies are expanding into the U.S. As you can see, there's many tips and traps if not done properly. Luckily, your BDO advisor is here to help you to navigate all of these rules.
Thank you Rose and Emily once again. And thank you everyone for listening to this podcast. This is your host, Harry Chana, signing off. Have a great day.