Headed south: Tax considerations for doing business in the U.S.

Bruce Fee, CPAPrincipalTax Services

T +1 604 443 2182E Bruce.Fee@ca.gt.com

Agenda

• Business licenses• Canada/U.S. Income Tax Treaty• Structuring operations in the U.S.• Multijurisdictional tax compliance• Informational return filing requirements

Business licensesIncorporation

•Overview of typical process

•Documents filed with the Secretary of State's office– Select state of incorporation– Qualify to do business in other states

• Common tips & traps

• Powers of Attorney

Business licensesFederal payroll tax issues

• Apply for Federal Tax Identification Number (FEIN)– An FEIN = account number with the Internal Revenue Service– Electronic Funds Transfer Payment System (EFTPS) - required– Payroll deposit requirements

• Quarter monthly deposit requirement– File Form 941 quarterly– File Form 940 annually– Employee or independent contractor

Business licensesState payroll tax issues

•Must register directly with each state– Unemployment Insurance– Payroll withholding tax

• Some states require electronic funds transfer

Canada/U.S. Income Tax Treaty

General rule: Taxable if engaged in a trade or business in the U.S.

• Treaty provision- taxable only if business in the U.S. is carried on through a "Permanent Establishment" (PE)

• A PE is:– Place of management– Branch– Office– Factory– Workshop– Employees accepting orders in the U.S.

Canada/U.S. Income Tax Treaty

In order to claim the benefits under the treaty:• File Form 1120-F - U.S. Income Tax Return of a Foreign Corporation

• Attach Form 8833 - Treaty-Based Return Position Disclosure

• Begins the running of the statute of limitations

Canada/U.S. Income Tax Treaty

Employees working in the U.S.• 183 Day Substantial Presence Test

– Days present in current year– 1/3 of days present in first preceding year– 1/6 of days present in second preceding year

• Any portion of any day counts regardless of reason present in the U.S. (including vacation)

– Daily commuting – 60 month rule for payroll taxes

Structuring operations in the U.S.Initial considerations

• Projected income/loss• Consider tax rate differentials between Canada and the US

• Worldwide income tax situation

• Foreign tax credits

• Exit strategy

• Reinvest in U.S. or repatriate profits to Canada

Structuring operations in the U.S.Selection of business entity

• Domestic (U.S.) corporation

• Branch of a Canadian corporation

• Partnership

• Limited Liability Company – (generally bad structure for Canadian investment)

Structuring operations in the U.S.Domestic (U.S.) Corporation

• If operating (physical presence) predominately in one state, generally incorporate in that state

• If operating in multiple states, consider incorporating in Delaware, may need to file qualification to do business in other states– State of incorporation is more a legal than tax matter

• Consider holding company structure for multiple businesses in multiple jurisdictions– Consolidated return filing in the U.S. if at least 80% controlled

• Earnings repatriated (dividends) to Canada subject o 5% withholding tax

Structuring considerations

CanadianParent

Business 1State 1

Business 2State 2

Business 3State 3

Canada

USA

Consolidated US Income tax return

• Separate company state filing• Water's edge unitary group state filing• Worldwide unitary group filing

USAHolding Co

Structuring operations in the U.S.Branch of Canadian corporation

• Canadian corporation files a foreign corporation tax return in the U.S. reporting effectively connected income on that return

• Pays a branch profits tax of 5% on earnings not used to reinvest in the U.S. or pay down debt

– First $500,000 of branch profits not subject to branch profits tax under the Canada/U.S. Income Tax Treaty

Structuring operations in the U.S.Partnership

• Canadian corporation files a foreign corporation tax return in the U.S. reporting effectively connected income on that return

• Pays a branch profits tax of 5% on earnings not used to reinvest in the U.S. or pay down debt

– First $500,00 of branch profits not subject to branch profits tax under the Canada/U.S. income tax treaty

Structuring operations in the U.S.U.S. Corporate Tax Rates

Taxable Income Cumulative

Over Not Over Rate Tax Subtotal

- 50,000 15% 7,500 7,500

50,000 75,000 25% 6,250 13,750

75,000 100,000 34% 8,500 22,250

100,000 335,000 39% 91,650 113,900

335,000 10,000,000 34% 3,286,100 3,400,00

10,000,000 15,000,000 35% 1,750,000 5,150,000

15,000,000 18,333,333 38% 1,266,667 6,416,667

18,333,333 - 35% - -

*No multiple surtax exemption for controlled group

State tax complianceState income taxes

• Nexus– Public Law 86-272 – Federal restriction on state income tax– No treaty protection– Sales tax nexus differs from income tax nexus

• Apportioning income – 3 factor formula• U.S. corporation vs. branch of Canadian company• Income taxes administered separately by each states

– Requires separate filing for each state– Separate return basis of taxation– Unitary basis of taxation– Worldwide or water's edge calculations

State tax complianceSales tax

• Nexus based on very limited activity (no P.L. 86-272 protection)

• Sales tax is imposed on the seller– Sales tax is imposed on the seller of tangible personal property (and

some services), retailer may be reimbursed by the customer

• Collect tax exemption certificate from purchaser– Sale for resale– Exempt customer (government)– Exempt property (component part)– Exempt use (manufacturing, enterprise zone)

State tax complianceSales tax

• Third party drop shipments– A sells to B, a reseller located in California– A ships directly to B's customer C located in NY– A needs a resale certificate from B, but B is not registered to collect

tax in NY

• Registration– Obtain a registration/permit before collecting tax– Security deposit or bond may be required– Seller is collecting the tax as a fiduciary, so expect the state will

require a corporate officer's personal information

State tax complianceSales tax

• Sales tax collection and remittance– Rates are based on state, county, city level taxes– Software integrates with billing system to invoice tax

• Bulk or occasional sales– Purchasing the assets of an existing business, often exempt from

sales/use tax

• Use tax– Complementary to the sales tax, but imposed on the purchaser for

the storage, use or consumption of tangible personal property within the state

Informational return filing requirements

• Canadian owned U.S. subsidiary– Form 5472 – Information Return of a 25% Foreign-Owned U.S.

Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business

– $10,000 penalty for failure to file or maintain records– Form 5472 is the US equivalent to the Canadian T106 Information

return – T106 - $2,500 late-filing penalty, plus transfer pricing penalties if

insufficient documentation

Transfer pricing

• Overriding issue: income reported in jurisdiction consistent with economic activity of the business– Transactions between related parties – profit allocated to each

related taxpayer must be measured by reference to the amount of profit that similarly situated taxpayer would realize in similar transaction with unrelated parties

– Contemporaneous documentation– Audit activity escalating– Since 2003 IRS auditors must request transfer pricing

documentation:• To be issued at IRS/Taxpayer opening conference – "Please provide

within 30 days of this request any principal documentation outlined in Treas. Reg. §1.6662-6(d)(2)(iii)(B) that has been prepared."

Transfer pricing

• Identifying transactions between related parties– Tangible products (inventory)– Tangible capital assets (machinery or equipment)– Services, management and/or administrative– Intangibles – use of patent or copyright– Financing

• Have to watch statute-barring differences between the CRA and IRS – (7 years vs. 3 years)

Transfer pricingFunctional analysis

• Functions– Design, manufacture, financing, logistics, research & development,

logistics, marketing, sales, warranty• Risks

– Credit and collection, operational, market, product• Intangible assets

– Intellectual property development, ownership, benefits and burden of ownership

Transfer pricingEconomical analysis

• Select comparable transactions or companies• Consider quality of data• Review assumptions and comparability factors• Select appropriate economic and statistical methods• Determine profit level indicators• Determine and quantify appropriate adjustments

Transfer pricingValuing intangible assets

• Chief Counsel Advice issued 3/18/2011 (CCA 201111013) calling for a "new valuation approach" where parent corporation transfer "valuable initial services (with embedded intangibles)" to a foreign corporation where the controlled corporation must further develop the intangible property before it can exploit that property

• Controlled corporation now owns the intangible• Chief Counsel concludes fundamental financial principles may be more

appropriate valuation technique as compared to comparable approach• Valuation methods now less certain than in the past and subject to

further controversies

Transfer pricingBest method

• Comparable Uncontrolled Price (§1.482-3(b)) Comparison of related party transactions to uncontrolled transactions

• Resale Price (§1.482-3(c)) Gross profit compared to uncontrolled transactions

• Cost Plus (§1.482-3(d)) Gross profit mark-up compared to uncontrolled transactions

• Unspecified Method (§1.482-3(e)) Must provide information on the profits controlled taxpayer could have realized

• Comparable Profit (§1.482-5) Objective measures of profitability derived from uncontrolled taxpayers engaged in similar business activities under similar circumstances

• Profit Split (§1.482-6) Allocation of combined operating profit

Transfer pricing

• Penalties related to transfer price adjustments– Valuation misstatement penalty for underpayment of tax:

• Substantial misstatement of 200% or more (50% or less) = 20%• Gross misstatement 400% or more (25% or less) = 40%

– Three main reason penalties will apply even when a study is prepared

1. Taxpayer did not select and apply the best method in a reasonable manner

2. The conclusions reached in the study are not supported by the background documents

3. Tested party data being used that is incomplete or inaccurate– Documentation must be in existence when the return is filed

Transfer pricing

• Penalties upheld by the Penalty Oversight Committee

– 2004: 33 tax years submitted, 32 upheld– 2005: 27 submitted, all upheld– 2006: 55 submitted, 54 upheld

Questions?

Thank you!