Business Adviser

Trade with the United States can be taxing

By Larry Evans
Partner, KPMG Enterprise/North York

Canadian private companies doing business in the U.S. need to be wary of the inevitable federal and state tax consequences. Understanding federal and state tax compliance before entering the U.S market can mitigate exposure to unforeseen tax traps and contribute to profitability.

Even if private companies don't have physical facilities in the U.S., they can be subject to one or more federal, state or local taxing regimes. Penalties for non-compliance often exceed 50 percent of the tax due. Even worse, some federal tax penalties for failing to file information returns are $10,000 per occurrence so it is crucial for private companies to ensure they are fully compliant with U.S. tax requirements.

Thanks to the U.S./Canada tax treaty, a company outside the U.S. generally has to have a "permanent establishment" in the country to be subject to U.S. federal income tax. Although this includes bricks-and-mortar places of business such as offices and factories, a sales representative or agent can create a permanent establishment if he or she can conclude contracts in the U.S. Recent changes to the U.S.-Canada tax treaty lower the threshold for projects in the U.S. to create a permanent establishment.

However, just because a company lacks a permanent establishment doesn’t mean there are no U.S. or state filing responsibilities. Activities in the U.S. that do not create a permanent establishment may still obligate a company to file a U.S. federal income tax return. In addition, since not all states follow the treaty, some states may subject a company to state income tax even if it doesn’t have a permanent establishment. Plus, treaty protection does not extend to non-income taxes, such as sales taxes.

States use a concept called "nexus" to determine the minimum contact necessary for the state to impose its various taxes on an out-of-state company. Different state taxes can have differing nexus standards. Recently, many states have followed a trend to lower the nexus bar.

An actual in-state physical presence created with inventory or other property as well as by employees, independent agents, representatives or contractors, has been traditionally required for state sales tax nexus. Today, some states, such as New York, assert that some types of virtual presence through the Internet can be enough to create nexus. Also, many states assert that the presence of intellectual property such as a trademark creates nexus for income tax. Some of the newer state tax regimes, such as those in Ohio and Michigan, even disregard any requirement for in-state presence but instead focus on activities targeted at customers in the state.

State sales-and-use tax compliance can be more difficult and expensive than income taxes given that there are over 8,000 taxing jurisdictions involved. Once an out-of-state company satisfies the nexus standard for sales and use tax, the burden of collecting taxes on purchasers of taxable goods and services begins. If a company fails to collect from its customers, it effectively converts a customer's tax into its own liability. Although Canadian private businesses can generally credit U.S. federal and state income taxes paid against their Canadian corporate income taxes, the same cannot be said for sales, use and other taxes that are not based on income.

Whether Canadian private companies are expanding in the United States with their own business or buying other companies, they should definitely consider U.S. federal and state taxes before proceeding.

Business Adviser is published by KPMG Enterprise™ specifically for owners and executives of private companies. KPMG Enterprise is devoted exclusively to helping business owners and entrepreneurs build thriving enterprises. For further information about how KPMG Enterprise can help private companies, visit www.kpmg.ca/enterprise.