Many American companies today are looking towards Canada as one of the primary destinations for international expansion due to geographical proximity and Canada’s relatively strong and stable economy.
However, there are significant tax issues to take into consideration. If you are a US based corporation and are planning on expanding to and doing business in Canada, then this article is a must read. I will address the tax implications for US companies expanding to Canada
US Companies Carrying on Business in Canada – tax implications
Any person (individual or corporation) that is carrying on business in Canada is required to file a Canadian tax return, under Canada’s laws. “Carrying on Business” is a very broad term and therefore encompasses most activities that US businesses engage in with respect to Canada. In fact, a sale made to a Canadian customer even if the sale was initiated and concluded in the US, could be considered as ‘carrying on business in Canada’ According to the Canadian Income Tax Act, a US company is carrying on business in Canada if that company:
1. Produces, grows, mines, creates, manufactures, fabricates, improves, packs, preserves or constructs anything in Canada; 2. Solicits orders or offers anything for sale there through an agent or servant, whether the contract or transaction is completed inside or outside of Canada; or 3. Disposes of certain resource properties or Canadian real estate.
Thus, the threshold for what constitutes “carrying on business in Canada” is very low. US companies expanding to Canada must examine their activities to determine if they are carrying on business in Canada, and if they are, those companies will be required to file a Canadian income tax return.
If you are an American business you may also need to obtain an extra-provincial license, please see our FAQ’s for more information regarding extra-provincial license.
Liability for Tax in Canada – for US Companies
The potential liability for income tax in Canada is an important tax consequence for US companies expanding to Canada. US companies that expand to Canada are liable for Canadian income tax if they: – Carry on a Business in Canada – Dispose of Taxable Canadian Property (e.g. real estate or shares of private companies) However, the Canada-US Tax Treaty provides relief for some US companies that carry on business in Canada.
According to the Canada-US Tax Treaty, only those US companies that carry on business in Canada through a permanent establishment are required to pay income tax on the business profits earned through that establishment. A permanent establishment includes a fixed place of business (such as an office), or an agent in Canada that has the authority to bind contracts on behalf of the US Company. A permanent establishment also includes a contract in Canada that lasts for six months or longer in any 12 month period. Thus, US businesses should examine their contracts with Canadian customers to see if they are caught by this ‘six month rule’. Once you have determined that a permanent establishment exists, you must calculate the profit attributable to the Canadian permanent establishment.In this calculation, you should include:
- Canadian sales
- Canadian direct expenses
- Overhead from the US office relating to Canada
For more information on permanent establishments please see our article on what is classified as a permanent establishment in Canada.
Regulation 105 Witholding Tax
– American corporations doing business in Canada are subject to a withholding tax. Regulation 105 of the Income Tax Regulations requires businesses to withhold 15% (additional 9% in Quebec) of fees, commissions, and any other amount paid to non-resident contractors for services rendered in Canada. This tax is not a final tax but is meant as a tax installment against a potential tax liability. – There is the potential for what is known as ‘cascading’ payments where a client pays a middleman, which in turn pays your company. Therefore, a withholding tax is applied at each level of transaction. – There is an additional withholding tax equal to 25% known as “Part XIII tax” which is applied on the following payments made to non-residents
- Rentals and royalty payments
- Pension payments
- Old age security pension
- Canada Pension Plan and Quebec Pension Plan benefits
- Retiring allowances
- Registered retirement savings plan payments
- Registered retirement income fund payments
- Annuity payments
- Management fees
As part of the Canada-US Tax Treaty, there is a reduction in the 25% tax rate on dividends, royalties, pensions and annuities. For more information on these reductions please consult this chart.
Canadian Treaty Based Tax Return for US Companies
US firms that are carrying on business in Canada but do not have a permanent establishment in Canada are not liable for Canadian income tax and must file a tax return in Canada. In such a situation, the tax return to be filed is referred to as a “Treaty Based Tax Return”, and is in substance an information-type return that does not compute or levy tax.
Failure to file a Canadian Treaty Based Tax Return could result in penalties of up to $2,500 for each return for each year. It’s also a wise idea for a US corporation that carries on business in Canada to file a Canadian Treaty Based Tax Return, in order to assert its position that it is not taxable in Canada, because it does not have a Canadian permanent establishment. Consider filing this return as a type of “insurance.” Filing this treaty based exemption will also provide a refund of any tax withheld.
Canadian Subsidiary of US Corporation – tax implications
Canadian corporations have a relatively low tax income rate of approximately 28% (combined federal and provincial income tax). Therefore, US companies often opt to create a Canadian corporation for their Canadian operations, rather than operate through a branch.
In addition, repatriation of profits from the Canadian subsidiary corporation to the US parent corporation is an important tax implication of expanding to Canada. One way to repatriate profits to the US is through dividends. Dividends paid by Canadian corporations to their US parent corporation are subject to Canadian withholding tax of only 5%. Interest paid by Canadian corporations to their US parent corporation is no longer subject to withholding tax pursuant to the Canada-US Tax Treaty. It is therefore a good tax planning point to capitalize Canadian corporations with debt. Canadian branch operations of a US company also have significant downside risks:
- The Canadian branch does not have limited liability protection
- Branch tax of 25% is levied by the CRA. Branch tax is calculated as 25% of the decrease in the net assets of the branch. Thus, a Canadian branch that distributes most of its retained earnings to the US head office will pay a significant amount of branch tax.
American corporations that use non-resident employees in Canada are also responsible for withholding tax. This tax is only applicable to the portion of the wages that was earned in Canada. Much like the withholding tax for US Companies, the withholding tax for employees can also be refunded by filing for a regulation 102 waiver. The Regulation 102 waiver can only be received if the US Based Corporation has proven that it does not have a permanent establishment in Canada by first obtaining the Regulation 105 waiver.
American employees working in Canada are still subject to American payroll taxes including social security, Medicare, state disability insurance. The US company will have to continue to pay unemployment insurance premiums even for these American employees based in Canada. Some American employees who are based in Canada may not have to pay for Social Security and Medicare but will be subject to the Canadian equivalent which includes the Canada Pension Plan and Canadian Employment Insurance. The Canada and the United States have arrangements which allow contributions made to the CPP to transfer over to the American Social Security.
The Canadian wages that a Canadian-based American employee earns is also subject to regular Canadian income tax unless:
- The Canadian wages are under $10,000, or
- The employer does not have a permanent establishment in Canada and the employee is physically present for a duration of 183 days or less within any 12-month period.
Different types of corporations are also subject to different tax consequences. S Corporations for instance are at a severe tax disadvantage. For more information on this subject, please consult our article on the tax advantages and disadvantages for S Corporations in Canada
A large number of US companies fail to comply with these requirements as well as forget to completely file their returns. Therefore they are hit with large penalties plus accruing interest. Luckily, the Canada Revenue Agency has a Voluntary Disclosure Program (VDP) which provides penal relief for US companies and individuals as long as all other criteria set out are met. For more information regarding this program, please consult our article on voluntary disclosure program for Canadian taxpayers.
As a US corporation planning to expand to Canada, it’s a wise idea to set-up a subsidiary Canadian corporation because of the tax and legal benefits.
The information provided on this page is intended to provide general information. The information does not take into account your personal situation and is not intended to be used without consultation from accounting and financial professionals. Allan Madan and Madan Chartered Accountant will not be held liable for any problems that arise from the usage of the information provided on this page.