The U.S. has a vast and dynamic market that offers considerable sales opportunities for Canadian businesses. Yet the complex regulatory environment south of the border makes some businesses wary, sometimes causing them to take on unnecessary risk and liability by attempting to avoid state taxes.
What makes state and local taxes in the United States so daunting is that there is no general set of rules by which all states abide. There are 80,000 state and local jurisdictions, some of which don't even follow federal tax law. As each state operates differently, with its own taxation standards and exemptions, Canadian business owners can easily make mistakes or not understand their responsibilities.
While Canadian business owners should seek professional advice when operating in or selling to the U.S., there are some general guidelines that can help you understand how taxation works at the state level.
If you are doing business in the U.S., your first step should be to determine whether you have nexus with any of the states. Nexus is defined as a business's connection to or presence in a state sufficient to be subject to state taxes. This is generally a minimum threshold. Once this level is passed, the state may be able to tax the business's income and/or require that business to collect and remit state sales tax.
Each state has its own definition of nexus, and thus its own minimum standards of business presence or activity that must be exceeded to trigger taxation. However, there are some general guidelines.
A business's physical presence is still the primary standard used to determine nexus. Depending on the state, this is usually defined as including a physical location (whether permanent or temporary) such as an office, store, or other place of business; inventory or equipment housed within the state; and/or an employee or other representative working within the state, even if not on a full-time basis.
Nexus may also include:
- Agency nexus. If your business works with third-party contractors or other representatives to perform certain activities on your behalf, such as sales solicitation or warranty repairs, your business may have nexus.
- Affiliate nexus. If you are an out-of-state or online retailer who works with an affiliate retailer selling similar products with a similar business name within the state, your business may have nexus.
- Economic nexus. A strong economic presence within a state, such as a high volume of sales to customers within that state, also creates nexus for your company. For example, in Alabama economic nexus is created with sales equal to or greater than $250,000 to in-state customers.
Not only do different states have different nexus standards, but there are also different nexus standards within each state to trigger different kinds of taxation. In general, it is easiest to pass the nexus threshold for state sales and use taxes than it is for income or franchise taxes.
Sales and use taxes
In the U.S., 45 states have some kind of sales tax, with rates varying from 3% to 7.5%. Like the HST in Canada, these taxes are payable by the buyer, but must be collected and remitted by the seller. And, as with HST, failing to collect the tax does not free you from the obligation to pay.
Once you have determined that your business has nexus, you next need to determine whether your business activities are subject to sales tax within that state. Generally, sales tax is applicable on sales of tangible personal property, which is any product that can be seen, weighed, measured, felt, touched, or is otherwise perceptible to the senses; and on taxable services, such as hardware or software consulting, repair services, entertainment, and utilities.
There are some exceptions to these guidelines. Selling products for resale is a notable exemption area; however, if you are working with resellers you should acquire a certificate of exemption from them at the time of sale. Your business may also be subject to use taxes, which is a tax imposed on use of property within the state. Once you have established that your business has nexus, you should register with the state, and if applicable begin to charge and remit sales and/or use taxes. Depending on the volume of sales, you may need to file annually, quarterly, or monthly.
Please note that there is considerable ongoing debate whether sales taxes should apply to internet sales, digital goods, and/or digital services, with different approaches from state to state. If these sales types apply to your business, you would be best served to consult with an advisor.
If your company has nexus, you are obligated to file state income tax returns should your in-state activities involve the sale of services, the lease of tangible personal property, the sale or lease of real property, and/or the sale or license of intangible property.
In some situations, Canadian companies are protected by a federal law (Public Law 86-272) that prevents states from taxing interstate commerce. This law applies to situations where orders are approved, filled, and shipped from outside the state, and the only activity within the state is sales solicitation. However, this law does not apply to the sale of services; any in-state services other than sales solicitation may create nexus. Additionally, in some states this law is deemed only to apply to U.S. persons or residents, making Canadian companies ineligible for relief in these areas.
If a company is obligated to file state income taxes, the taxable income in that state is based on apportionment and allocation. The amount is usually based on a combination of three factors:
- Property (rental property, inventory, fixed assets)
Many states currently use a double-weighted sales factor (i.e. 50% sales, 25% property, and 25% payroll). However, an increasing number of states are moving to adopt a single sales factor (100% sales) method of calculating taxable income as it results in higher revenues for the state.
Canadian businesses that are used to the rules and exemptions allowed in the Canada-U.S. Tax Treaty should also be aware that some states do not follow the federal treaty, either in whole or in part. In these states, nexus rules are deemed to prevail over the treaty, meaning that a company exempt from federal taxes may still owe state taxes.
In order to increase state revenues and circumvent Public Law 86-272, many states now charge a franchise tax. These franchise taxes can be based on gross receipts, asset value, capital, net worth, and more. U.S. franchise taxes that are not based on profits are deductable for Canadian tax purposes.
Approximately 24 states currently charge some kind of franchise tax. Depending on the state, franchise taxes often require that the business register or qualify for the privilege of doing business within the state, and minimum taxes may also apply. This means that your business may be responsible for a set minimum amount of tax for having nexus within the state, regardless of sales volume and even if you are in a loss position.
Because of the complexity of state taxes, some business owners attempt to avoid the issue entirely. This is a big mistake that can have serious long-term consequences, especially as states are becoming more vigilant in tracking down businesses that are not following their rules. In addition to any back taxes, penalties, and interest that may result, violation of state tax laws will be uncovered in a due diligence process if you attempt to sell your business, potentially impacting buyers or lowering the purchase price.
Yet state taxes don't need to be a stumbling block, and should not deter you from pursuing business south of the border. In order to properly understand your obligations and keep your business safe from potential liability, the best plan is to consult a tax advisor who can guide you through the process.
For more information on these and other areas, please contact your BDO advisor.
Senior Manager, Corporate US Tax
403 213 5446