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Hi, I'm Dan Lundenberg, and I'm a Tax Partner and leader for BDO Canada's U.S. Tax Service Line. In my position, I get to see Canadian companies, and all types of industries that have U.S. sales or U.S. operations. We have two podcasts dedicated to the unique tax issues facing Canadian companies that expand outside of Canada. Canadian companies that export their products and services will be subject to different Canadian tax rules, and they will be subject to the tax rules in the foreign country they operate.
What you'll hear from our BDO experts, is that what works from a purely Canadian domestic context, does not work when you cross the border. In today's podcast, I have two guests, Jill Birks is a Canadian International Tax Partner, and Jill deals with the Canadian tax side of outbound expansion. Jill will talk to some of the critical issues that Canadian companies face in foreign expansion, including how to structure foreign expansion, how to bring back profits in a tax-efficient way.
After Jill will be Gil Lederhos. Gil is a U.S. Corporate Tax Partner, and he deals with the U.S. tax side of expansion into the U.S. Gil will talk about the tax thresholds Canadian companies face when selling into the U.S., and the quickly evolving nature of U.S. sales tax. I trust you will find this podcast thought-provoking.
Jill, we'll start off with you. What are the first things for Canadian companies to think about when expanding outside of Canada?
Expanding Outside of Canada
Yeah. Thanks Dan. So, corporations that are expanding their business outside of Canada, they often like to first dip their toe into the water, to confirm that the business opportunity that they're expecting in that foreign market truly is there. So perhaps they might consider having some marketing individuals work from their own homes, to provide leads back to the Canadian sales team for the contractual negotiations. The tax rules in each country are a little bit different, and so you need to review each country as it comes up, but it may be possible to operate in this way without attracting an income tax obligation out there. And we often rely on tax treaties to help us with this. As business progresses, though, perhaps the Canadian corporation will hire a local sales team. Maybe they'll establish an office in that foreign country, and this would likely give rise to a taxable presence, or what we call in the tax world, a permanent establishment.
This permanent establishment is still really part of the Canadian corporation. It's not a separate legal entity, and so the Canadian corporation itself would be required to file a Canadian income tax return in that other country and pay income tax out there. And then in Canada, we need to determine whether the Canadian corporation could claim a foreign tax credit in its Canadian income tax return, so that it doesn't pay tax on the same income twice. And what I find is while the premise behind this foreign tax credit rule is pretty straightforward, the rules really are not. And sometimes we end up with some unintended consequences, so we do like to do a bit of planning around this.
Let's say instead though, that a legal corporation has been established in the other country, as a subsidiary of the Canadian corporation. And then through that subsidiary, that's how we carry on the business in that foreign jurisdiction. So, one of the first things that we think about, particularly from a Canadian tax perspective, is that that new corporation really is a tax resident of that other jurisdiction, for income tax purposes, rather than being a Canadian tax resident. To determine this, we look at this concept of mind and management, to see where the mind and management of that new corporation is truly located. This concept comes from case law, so it's quite grey, but there's three things that I really look for first. The first being, where do the majority of the directors of that new subsidiary, where are they resident? Where do they meet to make decisions, and where do they actually make those strategic decisions about the business affairs of the corporation, and making sure that they're making those decisions, rather than being told what to do from the Canadian head office.
So if, after reviewing these factors, we think that there's a risk that the mind and management is located here in Canada, we look to the tax treaty between Canada and that foreign country, to see if that confirms where the new corporation should be tax resident. So that's just a bit of an exercise that we go through, from a Canadian tax perspective.
Let's assume though, that the new corporation should be considered a resident of the other country for income tax purposes. Once we've got that in place, it will be clear that that new corporation is going to be subject to income tax in that foreign country. Now, if it's wholly owned by our Canadian corporation, it will be considered what we call, a controlled foreign affiliate. This brings us into some pretty complex Canadian tax rules that apply to the Canadian corporation in respect of its foreign investment.
So for example, if the controlled foreign affiliate is carrying on more of a passive business, perhaps it receives some interest income, also royalties, the Canadian corporation itself may be subject to tax here in Canada, in respect of that income, that's earned by that controlled foreign affiliate, even if those profits aren't brought back up here to Canada. So there's a lot to watch for here.
Jill, do these rules apply only where a foreign subsidiary is wholly owned?
Well, they don't. It's a little bit complex again around this point. So we're typically looking for control. So does the Canadian corporation control that foreign affiliate, hence the term controlled foreign affiliate. And the funny thing is, it's not just controlled by our Canadian corporation, but if you add up the percentages or the interests of other taxpayers in Canada, whether they're related or not, if we get over that 50% mark, we could still have a Canadian corporation, a controlled foreign affiliate. So it's really pretty complex in this area, and just takes some consideration.
Let's plan for success and assume that the foreign subsidiary is profitable. And it's going to get ready to repatriate these profits back up to Canada in the form of a dividend. So the first thing we think about, is whether or not there is foreign withholding tax obligations on those dividend payments. And if there is, can that rate of withholding be reduced under the applicable tax treaty.
And then the next point that we think about is whether or not that dividend income is subject to income tax in Canada, when it's received. Figuring out the Canadian tax treatment on this dividend really requires some detailed calculations. And I'd say that the upshot is that if the foreign affiliate carries on an active business in a jurisdiction with which Canada has a tax treaty, and let's say it's mind and management, that concept that we talked about earlier, is located there in that foreign country. It may be possible that we could pay that dividend back up to Canada, and when it's received by that Canadian corporation, it may be possible that we wouldn't be subject to additional Canadian income tax when it comes back up here.
So these calculations that we work through, we call them surface calculations, they're detailed, they're complicated, and we have to do them year over year, in respect of that foreign affiliate. And so we do recommend that we do those calculations on an annual basis. It certainly makes it easier when the time comes for paying out the dividends.
So the other thing, depending on the operations of the foreign subsidiary, there may be some payments between it and our Canadian corporation. So perhaps some interest on loans that we passed down to get the business started, or maybe some royalties for the use of IP, perhaps payments for services. And again, when those payments come up from that foreign subsidiary, we need to think carefully about whether or not there's any foreign withholding tax on those payments, and whether or not that rate of withholding tax can be reduced under an applicable tax treaty. And we do need to be thinking about those foreign tax credit rules, again, that I referred to earlier. We need to make sure that we're not paying tax on that income twice, up in the Canadian company's tax return.
A final point to make would be around planning our exit. So we often think as we're setting up a business outside of Canada, we often plan for our exit before we even get there. And so, a Canadian individual that owns shares in a Canadian corporation that carries on its business in Canada, so everything's all in Canada, that individual may be able to claim a lifetime capital gains exemption that reduces the tax on any capital gain that arises on the sale of the shares of that Canadian corporation.
Now there's a whole bunch of tests to walk through here, but a couple of them really focus on whether or not those assets of the Canadian corporation are used in the Canadian active business. And so, not going into a whole bunch of detail, but when the Canadian corporation owns a foreign subsidiary that really becomes highly valuable, we may knock off or come offside on some of those tests. So what we do think about from time to time, is whether or not it's more appropriate to establish a sister Canadian company. So it's got the same shareholders as the Canadian operating company, and then that new Canadian holding company sets up the foreign subsidiary. That just helps to protect that capital gains exemption for the future, if we have a Canadian resident individual. So just an extra thing to think about from a planning perspective.
Hey, Jill, is the structuring to manage access to the lifetime capital gains exemption a common practice?
Yeah, we do see it a fair bit here in Canada. It does, not always, sometimes, so you have to assess whether or not it makes sense in a particular situation. So it does lead to some additional tax compliance costs though, and any disposition of the business and the shares will be a little bit more complex, because you're going to be selling shares of two corporations rather than one. So it's really important to do the analysis upfront, to make sure that it's appropriate for that particular situation. And in any event, it's really important that the shares of the foreign subsidiary are owned by Canadian corporations, whether it's that Canadian OpCo, whether it's a Canadian holding company off to the side, rather than directly from an individual, to better manage the Canadian tax treatment of dividends that are paid up to Canada from that foreign subsidiary. We're just able to use some rules in our Canadian Income Tax Act that are just a little bit easier to get through.
Thanks, Jill. I think we're going to pivot now to Gil, and the U.S. side of Canadian expansion. Gil, what are the pressing U.S. Tax issue issues Canadian companies need to focus on when expanding into the U.S. market?
Pressing U.S. Tax Issues
Thanks Dan. Well, typically, as Jill mentioned, most Canadian companies that are expanding into the U.S., they typically dip their toe first in the U.S. waters, to make sure the market is what they thought it was, and they can get some traction, and move their business in that direction. But first, when you're moving, when the Canadian company is moving into the U.S., their primary concerns from a tax perspective, is are they subject to U.S. Federal tax? Are they subject to state income tax, and in the United States, the sales tax or the indirect tax regime is managed by the state. So we have these three types of taxes that can impact the Canadian company when they're expanding into the U.S. And typically, first when you're doing business in the U.S., the question is, are you taxable under U.S. domestic law?
And that's a very comprehensive analysis, and it's based on case law and guidance put out by the IRS. And the question is, "Are you engaged in the U.S. trader business?" And typically, those Canadian companies that are just selling into the U.S., they have no physical presence, those businesses may be exempt from U.S. tax under U.S. Domestic law. But once that activity becomes more present, then the question is, "Can we be exempt from U.S. tax, because of the U.S. Canada Treaty, again, that Jill mentioned earlier?"
And so under the U.S. Canada Treaty, a Canadian company is only subject to tax in the United States if it's considered to have a permanent establishment in the United States. And generally there's three general areas that would cause a Canadian company to have a permanent establishment.
Number one is, do they have an office or a place of business where that activity is attributable to? And there's obviously a lot of detailed rules around that, but if you have a physical location in the U.S., there's a good chance you have a permanent establishment.
The other scenario is if you have dependent agents that are working on your behalf. It could be people that are down there trying to generate business activity in the United States. If they have the ability to conclude contracts, and they habitually exercise that duty, that can cause a permanent establishment for a Canadian company in the United States.
And finally, if you send employees down to the United States to work on behalf of the company to provide services, if they spend more than 183 days in a 12 month period, that would cause the Canadian company to have a permanent establishment.
And what we're talking about is, if you have a permanent establishment, is the income generated in the United States, that's sourced in the U.S., that's attributable to that PE, or that permanent establishment, would be subject to tax in the United States. And, as Jill mentioned, if you're paying tax in the U.S., you would then figure out if I can get a credit on that on my Canadian tax return, so you're not being double taxed. And that’s sort of part of the regime of a tax treaty is to prevent double taxation.
So, now that you have activity in the United States, you also have to think about whether or not I am subject to tax, from a state tax standpoint. Many States do not follow the U.S. Canada Treaty for state taxation, the threshold of whether or not you are subject tax, is referred to as nexus. And the nexus standard has evolved over the years as business has evolved, and it's a lower threshold, and you can be in a situation where you don't have a PE, but you have nexus for state purposes. So you're maybe not subject to tax from a federal standpoint, but you may be for state tax purposes. So those are all things that we work with our clients to understand and minimize where appropriate.
One of the things that's transpired, and I'm originally from the U.S., but I've been working in Canada, working with Canadian companies, doing business in the United States for the last 20 years. And historically, the U.S. Corporate tax rate was when you combined the federal and the state rate, was significantly higher than the Canadian corporate rate. The federal rate was at one point 35%, plus the effective state tax rate was around five. So you had this tax of 40%, and then it was lower in Canada. And so, a lot of times we worked with our clients to appropriately shift income back to Canada because of the lower tax rate.
Well, back when Trump was president, there was some significant tax reform back in 2017, effective 2018, that brought down the U.S. Corporate rate down from 35% to 21%. And the net effect was that Canada and the U.S. were on par with each other, more or less, and so there was less of the need to shift income, particularly if an expanding Canadian company had business opportunities in the U.S., and they wanted to leave that money down there, they weren't getting penalized from a taxing standpoint.
So Gil, I agree with you. We've certainly seen a shift in the way that we work with clients that are looking at doing business across the border. With Biden coming in, do we really anticipate that those tax rates are going to go up? Is that possible?
I would say, the general theme is that the democratic regime tends to increase taxes. I think when Biden was on the campaign trail, he introduced the idea that the federal corporate rate would go up to 28%. There are some other provisions he discussed, that would in effect increase the effective tax rate. So I think that's what we anticipate. We don't anticipate it immediately, because there's other bigger issues to deal with, but we anticipate that will be coming up.
One of the more significant things that's occurred in recent history in the United States is the sales tax regime in the United States has become more expansive, and more people that used to not be subject to sales tax are subject to sales tax now. There was a landmark case back in 2018, involving the online retailer Wayfair. And that court case went all the way up to the Supreme Court of the United States, which in the U.S., then becomes the law of the land, and every state can adopt it. But essentially what's occurred from a state tax standpoint, is that business has changed over the years.
Historically, you had a connection or nexus in a state if you had a physical presence. But as business has evolved, states lose revenue because people don't necessarily have a brick and mortar or a physical presence in a state. So the state of South Dakota changed their rules for economic nexus. And they came up with a threshold that if you sell more than $100,000 into our state, then we feel you have nexus to our state, and you are subject to sales tax. So again, that went to court when all the way to the Supreme Court, the Supreme Court sided in favor of South Dakota, and what's happened, subsequent to that, is the majority of the states have adopted that principle, that if a company sells more than $100,000 into the state, they are subject to sales tax. So it's caught a lot of remote Canadian sellers off guard. And if you're selling more than that, you need to be thinking whether or not you need to report and collect and remit sales tax.
Thanks, Gil. How do Canadian companies comply with U.S. sales tax remittance and reporting requirements?
Good question. In my experience, what seems to be the best approach, is to automate it, because it's difficult, not only to track potentially 50 different States, but the way the state tax or the sales tax rate is determined in most jurisdictions, it's not only the state, but the county, and the city that the businesses is located in. So it's pretty burdensome to try to manually track. It's better to use an automated system, and we work with companies that have systems that can be introduced or added to an ERP system, and effectively track your sales tax reporting.
Great. Thanks, Jill, and thanks Gil. I know that there are many issues for Canadian companies to consider, and the both of you could've talked for much longer. The key takeaway for business community is to be well-informed. Doing business outside of Canada can be very different from doing business inside of Canada. Being proactive will allow your business to be tax efficient, and this will enhance your business's profitability. Please join me for our next podcast in Outbound Investment. Angeline Chandra, of our Transfer Pricing Group, and Daren Raoux, from our Expatriate Tax Group, will be joining me for a deeper dive into foreign expansion. If you enjoyed this podcast, please subscribe and tune in to the other episodes in this cross-border tax series.
The information in this publication is current as of April 26, 2021.
This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.