When a Canadian corporation does business in the United States, they are considered a “Foreign Person” by the IRS. Furthermore, the U.S. taxes such entities on any income that is effectively connected to the U.S. part of the business or trade. Additionally, some US-sourced income that is not connected with the U.S. business or trade may be taxed as well, if such business income is any of the following:
More details are provided later in this article. However, for all intents and purposes, it’s possible to have a U.S. income tax filing and potential obligation to pay taxes for non-resident business conducted in the States. But it does depend on the circumstances, whereas the ‘effectively connected income’ along with the guiding principles of the Tax Treaty between the U.S. and Canada allows for some exemptions for U.S. filers, as well as relief to Canadians who do business in the US.
Effectively Connected Income (ECI)
U.S. tax law mandates that non-residents, be it an individual or a corporation, must be subject to U.S. federal taxes if any of the income they have is:
‘Effectively connected with the conduct of a trade or business within the United States.”
The ECI test is ongoing, meaning that whenever you carry on a business in the U.S. during any time of the taxable year, U.S. tax will be charged. The Canadian domestic laws are similar in this context, whereas non-residents of Canada are taxed for the income they may earn from their business or trade in Canada.
Generally, ECI is US-sourced income related to activity based in the U.S. that is up to the level of a trade or business (TOB). For a U.S. TOB, the threshold is moderately low. Because any activity for profit-seeking that is deemed to be considerable, continuous and regular will be sufficient.
Determining if a U.S. Trade or Business Exists
When determining if a U.S. TOB exists, guidance may be found in U.S. tax law. Generally, U.S. courts rule that physical presence only is not quite enough to be considered ‘carrying on a business’. But, the ‘continuous and regular’ ruling could be interpreted as inclusive of ‘intermittent presence’ if said presence occurs regularly.
In this case, activities have to be in the U.S. and must be beyond just casual or incidental activities. What might be relevant in determining if a TOB exists is the number of transactions, but not necessarily the income amount or loss stemming from these activities.
Effectively connected income also covers when individuals and corporations in Canada have rental properties that they own and operate in the US. Additionally, any capital gains or losses from disposing of U.S. real property (including shares of a real property holding company) are also viewed as effectively connected to the US. This is so even in the case where you’re not considered as engaged in the U.S. TOB, for instance with personal use real property by an individual in the US.
Fixed, Determinable, Annual or Periodic Income (FDAP)
FDAP income is applicable to foreign persons who earn more income in the US. It includes:
- Rental Income
However, capital gains are not generally included. FDAP income can be considered ECI if assets generated or any associated activities are associated with conducting trade or business in the US. As an example, property rental that’s generating rental income would be considered ECI because the fixed place of business is in the US.
U.S. Foreign Corporate Income Tax
If a foreign corporation that is not in the U.S. is to be subject to U.S. taxation, it generally has to have FDAP income that is U.S. sourced, or effectively connected income with a U.S. TOB. This is pursuant to IRC Section 882.
U.S. Corporate Tax on ECI
The U.S. corporate tax on ECI for years beginning January 1, 2018, and forward is a flat rate of 21% on taxable income.
This flat rate has replaced the graduated tax rate that was between 15% and 39% dependent on the amount of taxable income.
U.S. Corporate Tax Brackets for FDAP (as of 2015)
Withholding Tax Rate
Dividends (excepting REIT dividends)
5% or 15% (Article X)
0% (Article XI)
0% or 10% (Article XII)
10% (Article XII)
*Please note that there will be withholding taxes that are required from foreign corporations by U.S. filers (i.e. U.S. customers). Read further for additional information about withholding taxes.
Whenever a foreign corporation faces on ECI, branch profits tax (BPT) may also be applied and/or branch level interest tax (BLIT). What these taxes do is balance any effects that originate from operating through a U.S. branch as opposed to a U.S. subsidiary. While BPT and BLIT taxes are complex, our description below is meant to give a general understanding.
Branch Profit Tax
A 30% branch profit tax on dividend equivalent amounts is levied to foreign corporations. Usually, this means the after-tax earnings of U.S. trade or business that has not been reinvested in that business. A reduction in this tax to 5% is made possible by the US-Canada Tax Treaty. A $500,000 lifetime CAD exemption is also available because of the Treaty.
Branch Level Interest Tax
Branch level interest tax is related to the interchangeability of money. In essence, foreign corporation interest is decreased to that of the U.S. branch. Certain formulas are prescribed to ascertain these taxes. For interest taken on deductions, a 30% U.S. tax is imposed if it’s in excess of U.S. branch interest paid (it’s treated as U.S. source income).
In a Canadian business, applicability for this tax is rendered academic due to a 0% tax rate applied to interest under the Canada-U.S. Tax Treaty.
Foreign Interest in Real Property Tax Act (FIRPTA)
Capital gains usually are sourced to the seller’s residence. This means foreign corporations are not usually subject to U.S. tax on capital gain dispositions. One exception to this rule exists when a 15% withholding tax on gross proceeds disposition is imposed. It’s possible this tax could be recoverable during the U.S. Foreign Corporate tax return filing.
Readers are cautioned that information in this article is for general purposes only and does not purport to provide specific advice. Individuals should consult with a tax professional. The author bears no responsibility for the use or dissemination of this information.