Author: Namir Hallak, CPA, CA, CPA (Kansas), CGMA, Tax Partner, Andersen, Vancouver, BC
Expanding your Canadian business to the United States unveils an exciting growth opportunity that requires a well-planned roadmap. This article aims to identify key tax factors that owner-managers often consider when navigating cross-border business opportunities. Unfortunately, some business owners leave tax issues to the end not recognizing they are foundational to your business and in some cases are difficult to resolve later. In addition, unlike Canada’s relatively uniform federal and provincial taxes, the U.S. has over 13,000 taxing jurisdictions between federal, state, county and other political subdivisions for income, sales and other taxes. Even in an electronic world, U.S. tax law at all these levels may amount to a paper blizzard. This article will focus on the U.S. federal tax consequences.
Expansion Structure
You may initially decide against setting up a U.S. subsidiary and unintentionally create a U.S. 'branch' with unanticipated tax consequences. If your company's U.S. activities exceed the protections provided by the Canada-U.S. tax treaty, it will be subject to U.S. federal income tax. You need to decide whether or when to continue operating in the U.S. through your Canadian entity ('branch') or establish a separate legal entity. Generally, branches are not desirable.
You are also faced with the task of evaluating numerous non-tax considerations. These include determining whether you will have unlimited liability from your U.S. branch. Establishing a subsidiary could be used to restrict its liability solely to investments in it. Additionally, you need to evaluate whether your U.S. business requires separate management, decision-making, brand identity, financial reporting, etc.
Canadian corporations operating in the U.S. may risk your Small Business Corporation status in Canada, particularly as your business’ value expands. You need to protect your Small Business Corporation status by carefully adhering to eligibility criteria. This includes ensuring Canadian control of your company and primarily utilizing its assets for active business operations in Canada, or investing in shares or debt of other qualifying corporations.
Failing to meet these requirements could result in the loss of your SBC status, leading to the forfeiture of important tax benefits including:
lower Canadian corporate tax rates,
lifetime capital gains exemption, and
access to certain Canadian tax incentives.
The more successful your U.S. business activities are, the more at risk your Canadian Small Business Corporation status may be. Solutions may include establishing a distinctive ownership structure for the U.S. business.
There are Canadian and U.S. tax advantages to U.S. subsidiaries that are owned by Canadian corporations, particularly when U.S. earnings are repatriated to Canada.
Whether or not you form a U.S. subsidiary, doing business in the U.S. introduces additional tax variables. Those include:
Transfer pricing on goods and services
Financing the U.S. business
Employees working in the U.S.
Repatriation of U.S. earnings
For example, “Transfer pricing” determines the fair market prices of goods, services, and intellectual property exchanged between related parties. A well-designed transfer pricing practice should allocate profits and costs between your U.S. and Canadian business activities in a manner that achieves the most attractive tax result and is defensible under examination.
Funding the U.S. Business
When establishing a U.S. subsidiary, you will need a strategy to finance its formation, development and growth. The choice between debt and/or equity financing must be evaluated against the relevant tax considerations on both Canada and the U.S.
Debt financing for the U.S. entity offers advantages, including tax-free principal repayment, deductions from U.S. taxable income through actual (not accrued) interest payments, and exemptions from any U.S. federal withholding tax on interest income. The U.S. subsidiary may be subject to limitations on deducting interest expense, especially if the related companies exceeds $27 million USD in adjusted gross receipts in the previous three years. Canadian entities financing a U.S. subsidiary should also consider whether a Canadian interest income amount will be imputed, depending on the nature of the U.S. business.
Equity financing does not provide deductions for payment of dividend from the U.S. earnings. They are subject to U.S. federal withholding tax. Unless the U.S. subsidiary’s asset value is more than 50% from U.S. real property, if the Canadian company sells its shares in the U.S. subsidiary, any capital gain realized would only be subject to Canadian tax.
Canadian businesses should mitigate the risk of scrutiny by the U.S.’ Internal Revenue Service from loans to the U.S. subsidiary, which could result in recharacterization from debt to equity. The IRS examines various market factors to determine the existence of a bona fide loan. If the debt instrument is converted to equity by the IRS, an undesirable cross-border mismatch occurs, with the U.S. denying interest deductions while Canada continues to recognize interest income. Additionally, unexpected U.S. federal withholding taxes may apply to repayments of the debt being treated as distributions of earnings by the IRS.
Canadian Employees Working in the U.S.
Another stop on the road to expanding your business in the U.S., are your Canadian employees’ presence in the U.S. through business travel or extended relocations.
Before sending your Canadian employees across the border, it is important to establish the immigration and tax implications to them and your business. U.S. immigration status can often be achieved at the border, but in other cases may require advance application and advice from U.S. immigration counsel. Employees who cross the border without appropriate status or seek to deceive U.S. border officials may be barred entry to the U.S.
Tax implications of Canadian employees working in the U.S. may affect both the employee and employer. Employees who provide employment services in the U.S. may be taxable in the U.S. and their presence there may subject their Canadian employer to U.S. tax too. Generally, the Canada-U.S. tax treaty helps limit the application of U.S. tax on Canadians working in the U.S., but it does not protect all situations including where an individual is present in the U.S. for more than 183 days in any 12 month period or where the individual is indirectly paid by a U.S. taxpayer.
From a corporate perspective, the employee’s U.S. activities will likely obligate the filing a U.S. federal tax return which may only be to disclose that there is a U.S. business activity. The penalty for failure to disclose is $10,000 USD. If the activity is taxable in the U.S. there could be substantial additional penalties of $25,000 USD for failure to disclose transactions with non-U.S. related parties.
If your Canadian business relocates Canadian employees to the U.S. on a full-time basis, it should develop a secondment agreement. This agreement should clearly define the employees' activities, payroll and if there is a U.S. subsidiary or other entity, its obligations for withholding, etc. It is important to continuously track your employees’ tax residency. Before employees are relocated they should be advised on the tax implications to them including Canada’s “departure tax”, their ability to stay on the much less expensive Canada Pension Plan (U.S. payroll taxes are very high to both the employee and employer), etc.
Transferring U.S. Earnings to Canada
There are various methods available for Canadian entities to transfer earnings from their U.S. subsidiaries back to Canada. The U.S. subsidiary can distribute dividends to its Canadian corporate parent with a 5% U.S. federal withholding tax. That rate jumps to 15% for other Canadian recipients or 30% for non-qualifying recipient. Where the earnings come from an active business in the U.S., the distributed earnings will not be subject to Canadian corporate income tax and distributions to individual shareholders will be eligible dividends and include a dividend tax credit.
Royalty payments from the U.S. subsidiary to the Canadian entity, for the use of property owned by the Canadian entity, are subject to a reduced U.S. withholding rate of either 10% or 0%, depending on its character. Also, the Canadian entity can assess a management fee to the U.S. entity for services performed exclusively in Canada, which is exempt from U.S. federal withholding taxes.
These mechanisms allow Canadian entities to transfer earnings from their U.S. subsidiaries while minimizing U.S. withholding taxes, leveraging the provisions outlined in the Canada-U.S. tax treaty and optimizing financial objectives.
Evaluate, Plan and Optimize
If you've already made the decision to expand your Canadian business to the U.S., it's important to remember the significance of evaluating, planning, and optimizing your cross-border tax approach.
Evaluate the right structure, funding options and potential risks.
Strategize your employee deployment, financing and transfer pricing strategy.
Seek guidance from cross-border tax experts who possess expertise in both U.S. and Canadian tax laws, to take advantage of tax opportunities and avoid tax traps. This comprehensive approach ensures tax efficiency, strategic foresight, and sets the stage for the growth and success of your cross-border business expansion.
For more information, please visit the Andersen LLP website at https://ca.andersen.com/.