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 and has no ties to Canada, until the day that USco lands a large contract with a Canadian company (“Canco”). USco provides services to Canco in Canada and USco generates $10 million of revenue from the services it provides in Canada. 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 on the basis that USco carries on business in Canada (despite being a “non-resident” of Canada 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 and prevents such a result from occurring. The Treaty provides that only one of the two countries will have the jurisdiction to tax the particular income, with the goal of preventing the double taxation of such income.
The rules in the Treaty addressing the question of which country can tax different types of income are complex, and depend on numerous factors. For example, the general rule of the Treaty regarding business profits (in Article VII) is that the business profits of a resident of one Contracting State (the US, in our example) cannot be taxed by the other Contracting State (the “Source State” – Canada, in our example) unless the business is being carried on 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
So let us say that USco was providing services to Canco in Canada through a Permanent Establishment of USco in Canada. According to the Treaty, Canada has the right to tax USco on the business profits attributable to such Permanent Establishment. So the question becomes, how is such income taxed? USco is a “non-resident” of Canada for Canadian tax purposes and is therefore taxed at a federal level at 25% corporate tax. Furthermore, Canada (as well as the US) has a “branch tax”, which is an additional tax that applies where a non-resident corporation carries on business directly in Canada. (This tax is similar to the tax that would apply if USco had earned the income through a Canadian subsidiary, and then distributed the profits up to USco (parent corporation) which would be subject to a withholding tax on dividends.) Generally, the Canadian Branch Tax is 25%. However, the Treaty limits the amount of Branch Tax that Canada can apply to 5%, with the first $500,000 of cumulative profits being 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. What this means is that even though USco should technically not incur a Canadian tax liability, the default domestic law in Canada is that the payor (Canco in our example) is still obligated to withhold 15% of the total payment. USco would be entitled to obtain a refund of this amount once it provides the requisite documentation and proof of it being entitled to Treaty benefits.
Note that the foregoing example deals with a US corporation that is not an LLC. An LLC (that has not elected to be taxed as a Corporation) is trickier under the Treaty because it is a type of entity known as a “hybrid”, which means that it is treated for the purposes of one Treaty country (i.e., Canada) as a taxable entity itself and, for the purposes of the other Treaty country (i.e., the US) as a flow-through entity which is not itself subject to tax. When an LLC is in the mix, a different analysis applies entirely.
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 is essential.