Since Canada contributes a relatively insignificant share of the world's overall economy, increasing numbers of Canadians are diversifying their financial holdings by investing in the United States. Therefore, understanding tax concerns, such as withholding tax and filing a U.S. income tax return, is crucial.
This article will illustrate some of the most widespread categories of U.S. investment income and their general U.S. and Canadian tax implications, considering the Canada-United States Income Tax Convention ("Treaty").
Business Structure
Choosing the appropriate corporate structure depends on the business's and its owner's requirements. It is also an excellent approach for minimizing overall taxes. The tax implications vary based on the selected structure.
However, there are four different types of business structures:
- Sole proprietorship
A sole proprietorship is a company where one person has ultimate decision-making authority within a small personnel group.
- Partnerships
A formal contract outlining the terms and conditions under which two or more parties will work together to run a business.
- Limited liability companies (LLC)
U.S. limited liability companies (LLCs) protect its owners from company debts and obligations.
- Business corporations
A corporation refers to a commercial body possessed by its shareholder(s), who appoint a board of directors to supervise the organization's operations.
State Taxes
The Canada-US Treaty does not include state income taxes in the United States, at least not for the majority of states in the United States. The tax rules of each state are different from one another. While some states comply with the federal treaty exemption, other governments make it a priority to tax income that is exempt under international treaties. Certain states refrain from charging any form of state income tax.
Additionally, a firm operating in many states may need to file multiple tax returns and manage its tax plans to minimize its tax load (Grant, 2019).
Depending on the nature of the service(s) being offered, the Canadian firm may be subject to different levels of state taxation (including income and sales tax). Some states impose taxes on earnings depending on the location of the business's clients, while others do so based on the service provider's site (Grant, 2019).
Employee and payroll taxes
When a Canadian company sends employees to the United States to perform employment duties, this may activate U.S. payroll reporting requirements at the corporate level and U.S. individual tax compliance requirements at the employee level for federal and state tax purposes.
The Canadian company must issue the Form W-2 (the U.S. equivalent of the Canadian T4) to employees at year's end after withholding and remitting payroll source deductions to the U.S. federal and state/local (if applicable) tax authorities on compensation earned by employees while physically present in the United States. Payroll source deductions can be waived through alternate processes for employees whose income is free from U.S. income taxation due to the Canada-U.S. tax treaty (Wang, 2021).
Suppose an employee's income is potentially free from U.S. income taxation under a tax treaty. In that case, that does not relieve them of the obligation to submit a federal and, if appropriate, state and local income tax return for each year they perform employment obligations in the United States (Wang, 2021).
Tax Treaties:
The U.S./Canada tax treaty simplifies tax difficulties for U.S. residents in Canada and Canadians in the U.S. Tax treaties with Canada and the U.S. aim to reduce double taxation. For instance, U.S. taxpayers with Canadian pensions and tax-free retirement accounts faced taxation issues. The U.S./Canada tax treaty addresses such concerns and taxes certain situations and individuals (Block, 2023).
Sales tax Nexus:
The sales tax nexus is the relationship between a business and a state or local government that involves collecting and remittance sales tax. Various factors, such as having a physical presence, economic activity, affiliate relationships, or click-through relationships in a state or jurisdiction, can establish a sales tax nexus (Stripe, June 2023)
Compliance with sales tax nexus laws can be complex and challenging for businesses, particularly those with sales tax obligations in multiple states.
These steps can help businesses comply with sales tax nexus laws:
- Find your sales tax nexus. Apply for sales tax permits
- Sales tax collection and payment
- Keep thorough records
- It is essential to remain informed about the current sales tax nexus rules.
Permanent establishment (P.E.)
When growing your business overseas, it is essential to have a solid grasp of the idea of a permanent establishment (P.E.) and how the P.E. will affect your tax obligations. A permanent establishment (P.E.) is a stationary place of business through which a company conducts its commercial activities in a foreign nation. A P.E. can exist in the form of a physical location, such as an office or factory, or it may be produced due to the actions of dependent agents acting on behalf of the enterprise (Balangitan, 2023).
In the United States, companies are subject to taxation if they are deemed to have a permanent establishment there. You may be entitled for foreign tax credits on your Canadian tax return if you have a U.S. permanent establishment.
Canadians' US-connected income is taxed in both countries, but tax credits offset the double taxation. If your operations are only in Canada, foreign tax credits reduce the extra tax you would have paid to both nations (Plooy, 2022).
Transfer Pricing
To ensure profit reporting in Canada, you and another business in your multinational group must price transactions accurately. Transfer pricing laws necessitate arm's-length transactions.
Arm's Length Principle: The foundation of transfer pricing states that connected parties should be treated as unrelated. This guarantees cross-border fairness and transparency.
Transfer pricing methods: The Comparable Uncontrolled Price (CUP), Resale Price, Cost Plus, Transactional Net Margin (TNMM), and Profit Split transfer pricing methods are available in Canada. The best way depends on the transaction (Agency, 2022).
Withholding taxes
Canadians can benefit from a lower withholding tax rate under the Canada-U.S. Treaty. To qualify for the preferential withholding tax rate, provide required documents. This signed document is often an IRS Form W-8BEN Certificate of Foreign Status of Beneficial Owner for U.S. Tax Withholding. U.S. investment income may be liable to the 30% flat domestic tax rate without proper documentation.
The U.S. domestic tax rate, usually a flat 30% U.S. non-resident withholding tax rate, may apply to income earned from U.S. investments if appropriate documentation is not provided.
Remember that a signed W-8BEN form is only suitable for three years before it needs to be replaced to keep receiving payments.
Key Takeaways
- Canadians are diversifying their financial holdings by investing in the United States
- Understanding tax concerns, such as withholding tax and filing a U.S. income tax return, is crucial
- Different types of business structures include sole proprietorship, partnerships, LLCs, and business corporations
- Permanent establishment (P.E.) is a stationary place of business through which a company conducts its activities in a foreign nation
- Employee and payroll taxes may be activated when Canadian companies send employees to the U.S.
- The U.S./Canada tax treaty simplifies tax difficulties for U.S. residents in Canada and Canadians in the U.S.
- Sales tax nexus is the relationship between a business and a state or local government for collecting and remitting sales tax
- Compliance with sales tax nexus laws can be complex, and businesses should keep thorough records
- Transfer pricing laws require accurate pricing of transactions between connected parties in a multinational group
- Canadians can benefit from a lower withholding tax rate under the Canada-U.S. Treaty
- State income tax rules vary in the United States, and some states may exempt income under international treaties
References:
Balangitan, A. (2023, May 9). Navigating cross-border taxation for Canadian businesses expanding internationally. https://taxaccountantidm.com/navigating-cross-border-taxation-for-canadian-businesses-expanding-internationally/
Plooy, C. du. (2022, March 1). A Canadian perspective on setting up a business entity in the USA. https://www.duplooylaw.com/a-canadian-perspective-on-setting-up-a-business-entity-in-the-usa/
Wang, T. (2021, October 12). Tax considerations for expanding into the U.S. https://learn.marsdd.com/article/tax-considerations-for-expanding-into-the-u-s/
Block, H. (2023, February 16). The U.S./Canada Tax Treaty explained. https://www.hrblock.com/expat-tax-preparation/resource-center/country/canada/the-u-s-canada-tax-treaty-explained/#:~:text=Why%20the%20tax%20treaty%20between,residents%20are%20obligated%20to%20pay.
Grant, A. (2019) Tax considerations for Canadian companies before selling services in the U.S., Tax Considerations for Canadian Companies Before Selling Services in the U.S. Available at: https://agtax.ca/us-tax-issues-canadian-companies-selling-services/
Agency, C.R. (2022) Transfer pricing. Available at: https://www.canada.ca/en/revenue-agency/services/tax/international-non-residents/information-been-moved/transfer-pricing.html