Many American enterprises look north to expand their reach. However, a US company doing business in Canada must navigate a unique set of legal and tax regulations. Whether you are selling services or establishing a physical presence, understanding the Canadian legal landscape is vital for success.
It is a challenge to comply with one legal and tax system. Try TWO at the same time. Although costly and more effort, as long as the two laws don’t contradict each other, things should be relatively simple. So, what happens when two different countries, jurisdictions, and treasuries are after the same dollars?
For example, take the following scenario: A US Corporation (“USco”) is a US resident and not a Canadian resident. USCo carries on business in the US with no ties to Canada. This changes when USCo lands a large contract with a Canadian company (“Canco”). USCo provides services to Canco in Canada. Consequently, USCo generates $10 million of revenue from these Canadian services. Which country can tax the income?
The US asserts its jurisdiction to tax USco because USco is a resident of the US. Canada asserts its jurisdiction to tax USCo because it carries on business in Canada. This applies even though USCo is a “non-resident” for Canadian tax purposes. Does this mean that USco has to pay tax to both countries – a double taxation of the income earned? This would obviously be an unfair result and would certainly discourage companies from doing business across the border. Therefore, the Canada-US tax treaty (the “Treaty”) steps in to prevent double taxation. The Treaty ensures that only one of the two countries has the jurisdiction to tax this particular income.
Treaty rules determine which country can tax different types of income. These rules are complex and depend on numerous factors. For example, Article VII covers business profits. It states that the “Source State” (Canada) cannot tax a resident of the other State (the US) unless the business operates through a “permanent establishment” in the Source State. What constitutes a “permanent establishment” is the subject of its own entire Article in the Treaty.
With a Permanent Establishment
Suppose USCo provides services through a Permanent Establishment in Canada. Under the Treaty, Canada can tax the business profits attributable to that location. Since Canada views USCo as a “non-resident,” it applies to 25% federal corporate tax.
Canada also applies to “branch tax” when a non-resident corporation carries on business directly in Canada. This tax mirrors what would happen if a Canadian subsidiary paid dividends to a US parent. While the standard branch tax is 25%, the Treaty limits it to 5%. Additionally, the first $500,000 of cumulative profits remain completely exempt.
Note that from a Canadian tax perspective, there are also withholding tax obligations on the payer of amounts to a non-resident. Payments to a non-resident for services rendered by the non-resident will generally be subject to a 15% withholding tax under Regulation 105 of the Income Tax Act Regulations. Regulation 102 must also be considered.
Remember that USco will continue to be taxed in the US according to all US domestic tax laws. However, USco should, generally speaking, be entitled to a foreign tax credit in the US for Canadian tax paid.
Without a Permanent Establishment
As mentioned, the Treaty provides that Canada would only be able to tax USco if USco carried on business through a Permanent Establishment in Canada. If USco carried on business in Canada but not through a Permanent Establishment, then Canada would not be able to tax USco at all pursuant to the Treaty. However, interestingly, a Canadian payor of amounts to a non-resident in respect of services rendered by the non-resident to the Canadian payor are still subject to Regulation 105 withholding in the absence of obtaining a waiver of this obligation from the Canada Revenue Agency. Technically, USCo may not incur a Canadian tax liability. However, Canadian domestic law still obligates the payor (Canco in our example) to withhold 15% of the total payment. USCo can obtain a refund of this amount later. It must simply provide documentation proving it is entitled to Treaty benefits.
Note that the foregoing example deals with a US corporation that is not an LLC. An LLC is trickier under the Treaty because it is a “hybrid” entity. Canada treats an LLC as a taxable entity. In contrast, the US treats it as a flow-through entity that is not subject to tax itself. When an LLC is in the mix, a different analysis applies entirely.
Conclusion
Depending on the scenario, different structures are available for doing business across the border. In some cases, it may be appropriate to simply utilize a branch office (i.e., USco to carry on business directly in Canada), while in some cases it may be appropriate to set up a subsidiary corporation in the other jurisdiction. The appropriate structure depends on tax, commercial, and practical considerations.
When doing any business across the border, proper planning and compliance are essential. Our team provides expert guidance in Corporate Reorganizations and Corporate/Commercial for any US company doing business in Canada.