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Tax time in America

As America’s 50 states strive to pull their way out of budget shortfalls, many are taking a closer look at Canadian companies doing business in the US.


December 10, 2010
by John McCrudden and Lionel Chen

Cash-strapped US states want more of your money.

Photo: iStockphoto

As America’s 50 states strive to pull their way out of budget shortfalls, many are taking a closer look at Canadian companies doing business in the US.

Pre-recession, US corporate earnings contributed hefty income tax revenues to state coffers but with the cash flow decimated by the downturn and the subsequent economic hangover, many states are aggressively seeking other tax revenues. They’re doing more audits, hunting for taxes from more companies with nexus – a company’s connection to the state – and sharing corporate tax information to track businesses with potentially lucrative revenue streams in multiple states.

If you’re doing business in the US, be hyper-aware of shifting state tax laws, regardless of where and how long you’ve been doing so. There are recent developments that could impact your corporate tax profile.

For instance, there is greater focus at both the US federal and state levels on seeking tax revenue through permanent establishments (PEs) and nexus. Recent changes to the Canada-US Tax Treaty expand the circumstances under which a Canadian corporation is deemed to have a permanent US establishment, and the Internal Revenue Service (IRS) is increasing its scrutiny of PEs.

Most Canadian manufacturers have to maintain a permanent establishment in the US for their profits to be subject to federal income tax. A PE is generally a fixed place of business such as a branch, factory, office or the presence of an employee or agent who finalizes contracts in the US on behalf of the Canadian company. However, since Jan. 1, a Canadian corporation may also be deemed to have a permanent US establishment if it also performs services in the US through an individual present in the country for 183 days or more in any 12-month period; where more than 50% of the corporation’s gross active business income is derived from that individual’s rendered services; or services are provided in the US for 183 days or more in any 12-month period for one project or a series of connected projects.

If the IRS determines a company has a PE, Canadian and US taxes may have to be paid on profits attributed to it, although Canada would generally allow a foreign tax credit to offset any domestic tax. State income tax may also apply. Incidentally, the Canada-US Tax Treaty doesn’t bind states, although some conform completely (Florida, Illinois), some do in part (Idaho, North Carolina), and others do not (New York, California).

State tax requirements are based on nexus and each state has a different threshold that defines what that is. It may include storing inventory; renting office or warehouse space; providing installation, implementation, warranty or repair services; and even delivering goods in trucks owned by the Canadian company, but the level of activity that constitutes nexus is less than the activity needed to constitute a federal PE.

Moreover, these thresholds often change. Last year Michigan signed into law a bill exempting Canadian transborder trucking companies and auto parts manufacturers that do not have a PE in Michigan from having to pay the Michigan business tax (MBT). Specifically, the act exempts foreign persons from taxation under the MBT so long as they’re domiciled in a subnational jurisdiction (such as a Canadian province) that does not impose an income or other business tax on a similarly situated person domiciled in Michigan. Other US states, however, are not so Canadian business-friendly. More states use unitary combined reporting to raise money, including Michigan and Texas in 2008, and Massachusetts, West Virginia and Wisconsin last year.

Under the unitary system, a state determines whether a group of corporations under common ownership share a “unitary relationship.” If so, the company must combine income and apportionment factors (property, payroll and sales) to compute state taxable income.

This system does not exist in Canada. If you have a parent company with four subsidiaries, you would file five income tax returns. In states that have the unitary system of reporting (and now there are 24 of them), a company files one return on a combined basis.

The rise in such regimes increases the risk of Canadian companies facing state income taxation, especially since the definition of a unitary business and apportionment rules vary from one state to another. California has a 80/20 rule: when 20% or more of the average of a foreign corporation’s property, payroll and sales are in the US, all of the company’s income and apportionment factors are included in computing the taxable income of the unitary group.

Many states have also stepped up audits, increased penalties and are actively identifying Canadian non-filers. There are a growing number of information-sharing agreements among the states, with US Customs and with the IRS, so the best way to minimize the impact of state income taxes is to carefully strategize your US business activities.

Remember, it’s always tax time in the US!

John McCrudden (JMcCrudden@bdo.ca) and Lionel Chen (LChen@bdo.ca) are senior tax managers at BDO Canada LLP (www.bdo.ca) in Mississauga, Ont. who work with Canadian and US companies on cross-border tax issues.