It is not unusual for Canadian businesses to expand into the United States.
U.S. and Canada have two different tax systems and such a decision needs careful planning and consideration.
In this post, we are going to have a quick overview of different structures that can be adopted by Canadian businesses to operate in the United States. This post is meant to be a simplified version for readers and does not discuss many other factors that would be otherwise considered by a professional tax adviser. If you are new to U.S. Taxation, you are recommended to read some technical terms used in this post here.
Business structures that Canadian businesses can use to operate a business in the United States
Canadians looking to expand their businesses into the United States can choose from one of the four business structures:
- U.S. Branch of a Canadian Corporation
- U.S. Subsidiary of a Canadian Corporation
- U.S. Limited Liability Corporation (LLC)
- U.S. Limited Partnership (LP)
Before you proceed further, this is recommended to read our post about U.S. Taxation for Canadian Businesses. You should understand the concepts of PE, ECI, FDAP income, and Canada-U.S. Tax Treaty provisions.
(1) U.S. Branch of a Canadian Corporation
One of the options for Canadian Corporations to do business in the United States is to set up a branch there. As a branch, you will be treated as a foreign corporation for U.S. tax purposes. In order to operate a branch of a Canadian corporation, authorization is needed by each state where the branch operates.
U.S. taxes for the Branch of Canadian Corporation
A U.S. branch of a Canadian corporation creates a permanent establishment (PE) in the U.S. ECI of the branch will be taxed at the graduated rates U.S. Corporate tax rate of 21%. There will be a Branch Profits Tax on the after-tax income. The Canada-U.S. tax treaty reduces BPT to 5% only as compared to 30% for non-treaty countries. The first $500,000 will be exempt from BPT as well. Canadian corporations must file 1120-F annually.
Canadian Taxes for the U.S. branch of a Canadian Corporation
Canadian Corporation (CanCo) reports its worldwide income on T2. The worldwide income is taxed in Canada. Foreign tax credits are available to provide relief from double taxation. Losses from the branch can be offset against the other profits of CanCo.
(2) U.S. Subsidiary of a Canadian Corporation
An alternative to the U.S. branch is to establish a subsidiary in the United States. This is a separate legal entity established under the laws of the United States. US tax classification for such an entity is C-Corporation. Canadian corporation is a foreign shareholder of such corporation. CanCo enjoys liability protection since it’s a separate legal entity.
U.S. taxes for U.S. subsidiary of a Canadian Corporation
Since U.S. Subsidiary is a U.S. corporation, it files its own taxes in the U.S. using 1120. Canadian Corporation does not need to file U.S. income tax returns. U.S. corporation pays income tax on its taxable income in the U.S. Any dividend payments from U.S. subsidiary to a Canadian parent are subject to a 5% withholding tax (15% if the shareholders are individual).
Canadian taxes for U.S. subsidiary of a Canadian Corporation
Canadian corporation reports its worldwide income. Foreign tax credits are available against the taxes paid in the U.S. Losses of the U.S. subsidiary corporation cannot be offset against the income of the Canadian Parent. Some of the important tax considerations are as below:
- Canadian Foreign Affiliate Rules and U.S. Transfer Pricing Rules are applicable.
- Canadian dividend tax rules are applicable
- Canadian Controlled Private Corporations lose Qualified Small Business Corporations (QSBC) status and U.S. source income is not eligible for Small Business Deduction.
- Additional Reporting requirements in both U.S. and Canada for foreign assets
Canadian Controlled Private Corporations (CCPC) with U.S. Source Income
Canadian Controlled Private Corporations (CCPC) have preferential tax treatment as per Canadian Tax Laws. The first $500,000 income is subject to a small business deduction which significantly lowers overall corporate income taxes. When a CCPC has U.S. Sourced income some of the key tax considerations should be taken into account:
- A CCPC having U.S. Branch is not eligible to take the small business deduction on income derived through Permanent establishment in the U.S.
- If CCPC has a services PE in the U.S., such income is also not eligible for a small business deduction.
- If a CCPC has U.S. operations, it can affect its eligibility to be a Qualified Small Business Corporation in Canada (QSBC). Shareholders of CCPC will not be able to take advantage of Lifetime Capital Gain Exemption (LCGE) in Canada. LCGE limit as of 2020 is $883,384 in Canada.
Deciding on U.S. Operations is a very critical decision for any Canadian Corporation. Shareholders do not necessarily have to lose the QSBC status of their otherwise eligible CCPC by having a U.S. Subsidiary. It is recommended to set up another Canadian Corporation for this purpose and incorporate a tiered structure using that corporation.
(3) U.S. Limited Liability Company (LLC)
Limited Liability Company (LLC) is an American creation and a structure used in the United States. There is no LLC structure available in Canada. Canadian businesses expanding to the United States are generally not recommended to operate through American LLCs!
U.S. tax treatment
U.S. LLCs are pass-through entities where the income flows to their members (LLC has members, not shareholders). By default, a single-member LLC is considered a sole proprietorship for income tax purposes whereas more than one member LLC is a partnership. Members of LLC do have the choice to elect as a C-Corporation – an option known as “check the box”. Income derived from the U.S. LLC is taxed in the hands of its members.
CRA Tax Treatment of US LLC
CRA does not consider a U.S. LLC a pass-through entity for income tax purposes and considers them as a Corporation. Distributions from a US LLC to Canadian members are considered dividends. The time lag between earnings and distribution of an LLC creates a mismatch in income taxes in both US and Canada. It causes a double taxation problem and Canada’s U.S. Tax treaty doesn’t provide any relief. Therefore, not a smart choice!
(4) U.S. Limited Partnership (LP)
One of the main reasons U.S. Limited Liability Companies are popular is the protection of liability. Since using LLCs causes a double taxation problem for Canadian members, an alternative is using U.S. Limited Partnership (LP).
U.S. Tax Treatment
Limited Partnerships are taxed on a pass-through basis. Income from U.S. LP is taxed in the hands of its partners and U.S. Income taxes are paid in the U.S.
Canadian Tax Treatment of U.S. Limited Partnerships
Unlike LLCs, Canada Revenue Agency recognizes U.S. LP as a pass-through entity i.e. the income flows to its partners in Canada. U.S. taxes paid on the income in the U.S. provide foreign tax credits in Canada as per the U.S. Canada tax treaty.
U.S. State Taxes for Canadian businesses
The Canada-U.S. tax treaty works at the federal level. Many states follow this tax treaty negotiated at the federal level whereas some do not. At the federal level tax treaty provides relief from taxation on ECI unless the PE threshold is met. States which do not honor federal tax treaty have their own rules to tax ECI if there is some sort of presence in that state.
If a Canadian corporation meets nexus (minimum threshold) it may be subjected to state taxes including state income taxes, franchise taxes or state excise taxes. Nexus varies from state to state. Generally, physical presence is the most common nexus but other forms of nexus are also considered such as Agency nexus, Affiliate nexus, or economic nexus. It’s not only the nexus standard at the state level but there are other nexus standards within each state for different taxations.
States which do not follow Canada’s U.S. tax treaty may cause double taxation for Canadian businesses since foreign tax credits are available under the relief provisions of the treaty only.
If you are a Canadian business and looking to expand to the United States, we can help you with determining the right business structure. We have both U.S. CPA and Canadian CPA available to help you navigate the complex technicalities of U.S. and Canadian taxes.
This post is for information purposes and cannot be considered as advice, hence, the writer or Maroof HS CPA Professional Corporation does not have any liability towards the decisions taken by the readers. Readers must consult a professional tax accountant specializing in U.S.-Canada Cross Border Tax issues.