Any Canadian resident (company or individual) that conducts some amount of business activity in the United States needs to analyze whether they have a US federal income tax exposure, a state and local tax exposure, or both.
In general, the Canada-US tax treaty and protocols (the treaty) aim to resolve issues regarding double tax and set out rules governing which jurisdiction has the authority to tax certain types of income. Under the treaty, if a Canadian resident “carries on” a business in the United States, the US-sourced business profits are subject to US tax to the extent that they are attributable to a permanent establishment (PE) in the United States. A PE can arise as a result of a having a physical location in the US (physical PE) or through the activities of the employees, dependent agents, or both in the US (service PE).
A physical PE, defined in article V of the treaty, generally means a fixed place of business, such as a place of management, a branch, an office, a factory, or a workshop. It also includes a building site or construction or installation project if it lasts more than 12 months and a mine, well, or any other place of extraction of natural resources if that use is for more than three months in any 12-month period. A physical PE does not include, however, a fixed place of business for the use of facilities for the purpose of storing, displaying, or the delivery of goods or merchandise; the maintenance of a stock of goods or merchandise for the purpose of storage, display, or delivery; or similar uses. In addition, a Canadian resident would not have a physical PE in the United States merely because it carries on business in the United States through a broker, general commission agent, or any other agent of an independent status.
A service PE may be deemed to exist on the basis of the activities of Canadian employees (or dependent agents) in the United States even if the Canadian resident does not have a physical PE. As in most tax treaties, a service PE may arise under the treaty when employees of the Canadian company located in the United States have, and habitually exercise in the United States, an authority to conclude contracts in the name of the Canadian resident. (If a Canadian resident contracts with a third party in the United States to perform services in the United States, it is essential to analyze the relationship to determine whether the third party is an independent or a dependent agent.)
Additionally, and unique to the treaty, a service PE may also arise if:
- The services are provided in the United States by an individual who is present in the United States for a period or periods aggregating 183 days or more in any 12-month period and, during that period or periods, more than 50 percent of the gross active business revenues of the enterprise consist of income derived from the services performed in the United States by that individual; or
- The services are provided in the United States for an aggregate of 183 days or more in any 12-month period with respect to the same or a connected project for customers who are either residents of the United States or who maintain a PE there, and the services are provided in respect of that PE.
These provisions of the treaty result in a much more expansive set of the circumstances in which a service PE could arise.
If a Canadian resident has a PE in the United States, generally the US-sourced business profits attributed to the PE will be subject to US federal income tax. As a result, the Canadian resident will have an obligation to file an annual US tax return. If the Canadian resident (or beneficial owner of a flow-through entity) is an individual, the taxable income attributable to the PE will be subject to tax at graduated rates ranging from 10 to 37 percent. If the Canadian resident is a corporation, the taxable income attributable to the PE will be subject to tax at 21 percent (and may be subject to the branch profits tax). Also, even if the Canadian resident concludes that it does not have a PE in the United States (and is therefore not subject to US federal income tax on its US-sourced business profits), generally it is prudent to still file a US tax return annually and disclose its treaty-based position.1
Importantly, the 50 US states are not party to the treaty, and therefore, the states do not necessarily follow the treatment set forth in the treaty. In addition, the states may have a sales and use tax or other local taxes that will also have to be addressed. Thus, a Canadian resident doing business in the United States must be mindful of potential state and local tax exposure.
1This disclosure is made on IRS Form 8833, “Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b),” and attached to the US tax return.