Canada and the United States are one another’s biggest trade partners. In fact Canada is the biggest trade partner for 37 different American states. With so much trade happening, many Canadian small businesses find themselves exporting goods, rendering services, and even opening branches in the United States. A major issue that quickly arises is taxes. Where and how to pay and charge them when operating in two countries is a big concern. In the United States, there are three essential tax issues to understand: federal taxation, state taxation, and sales and use taxes.
Federal Income Tax
Federal corporate income tax rates are higher in the United States than in Canada, at approximately 35%. The Internal Revenue Code and its regulations are the main laws containing the tax provisions. For foreign businesses, the basic rule is that if you have income effectively connected with a U.S. trade or business, you are subject to tax and you must file a return. This is very broad criteria, and it takes very little connection to the United States to be covered by this provision. The Canada-U.S. Tax Treaty contains an article that provides for a different test. Under the tax treaty, Canadian businesses only pay taxes in the United States if they have a permanent establishment in that country. The concept of “permanent establishment” is defined in the tax treaty and can include a place of management, a branch, an office, a factory, a workshop, and others. Interestingly, it can also be a person if that person is a dependent agent who has and habitually exercises the authority to conclude contracts in the United States. The tax treaty doesn’t apply automatically. If you have U.S. income but no permanent establishment, you must file a treaty-based return with the U.S. Internal Revenue Service to benefit from the treaty exemption.
State Income Taxes
Each individual state has its own rules regarding income taxes. Think of it as doing business in 50 different countries. As a rule, the rates for corporations range from 0 to 9.99%. Some local counties or large cities may also have income taxes, so you need to check the local rules that apply to your particular case. State taxes aren’t covered by the tax treaty, so the permanent establishment rule doesn’t apply to them. Instead, states use nexus to determine if an out-of-state business is liable to pay taxes in the state. Unfortunately, nexus is not defined in the same manner in each state, so you have to work on a case-by-case basis. Generally, any physical presence in a state is considered to be a sufficient connection for the state to tax a business. If you do business in several states, you have to determine if you have nexus in each of them, and you may have to file several tax returns. You need to allocate your income to each state and pay taxes accordingly. This isn’t necessarily an easy process, and you should consider consulting with local professionals early on to avoid accidentally misreporting your state income.
Sales and Use Taxes
There’s no federal sales tax in the United States, but there are state sales taxes (in 45 states). Sales tax rates vary from state to state and often from county to county. Compared to Canadian sales taxes, U.S. sales taxes are relatively low, often in the range of 4 to 5%. These taxes are not value-added taxes like the GST/HST, and there is no input tax credit system. Instead, U.S. taxes are charged on retail sales. In general, the tax needs to be charged to consumers of most goods (called “tangible personal property”) and on services, in some cases. If you’re selling to a wholesaler or someone who will resell the product, there is a sale-for-resale exemption, and you may not have to charge the tax. However, if you sell a product that will be incorporated into something else for example, if you’re selling lumber to build a house you may have to charge the tax. There is no universal rule to determine which transactions are taxable. Generally, the place where possession of title passes to the customer determines which state has the right to tax a sale, but the place where the customer receives a service determines which jurisdiction has the right to tax a service. Here also, the concept of nexus determines if you need to register for and collect local taxes. However, nexus for sales taxes is not the same as nexus for income taxes. In general, nexus for sales taxes is broader-reaching, and any minimal connection to a state may be sufficient to trigger registration obligations. If you don’t have nexus, the buyer may need to self-assess for the tax. The complications of U.S. taxation may seem daunting at first, but once you have established a system to check what is applicable to your particular business, they should not be enough to deprive you of the benefits of cross-border trade.