March 30, 2015
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Branch or Subsidiary: Tax Planning for Canadian Companies Expanding Operations to the U.S.
Canadian businesses looking to expand operations into the US have many issues to work through at the planning stage, and one important one is how to structure US operations from a tax perspective. This post discusses some of the considerations to keep in mind when deciding between forming a US subsidiary or operating directly in the US through a branch office. This discussion assumes that the Canadian corporate parent will be conducting active business in the US.
US Taxation of Canadian corporations requires a Permanent Establishment (“PE”)
It makes sense that operating your business in the US will give rise to some taxation by the IRS. However, under the Canada – US Tax Treaty (the “Treaty”), Canadian corporations are only subject to US tax to the extent that they have a PE in the US.
The Treaty excludes some common business activities from the definition of PE. For example, maintaining a warehouse in the US, advertising your products or services in American media, or hiring independent agents to sell your wares should not give rise to US tax on your profits.
However, true expansion to the US likely requires a more substantial presence on US soil. As such, if your business has an American fixed place of business, or an employee habitually working for you in the US, you likely have a PE, and must pay US tax on profits earned by that branch office. This means your Canadian corporation will have to file a US income tax return (Form 1120-F).
Profits earned by a US branch of a Canadian corporation are taxable in the US at graduated tax rates between 15% and 35%. It is usually relatively straightforward to calculate the revenues derived from the US branch. However, accounting can become complicated when trying to figure the business expenses that are properly allocated to the operation in terms of management and administration, especially when many business services are centralized at the Canadian headquarters.
In addition, the US imposes a ‘branch profits tax’ on the after tax US earnings of the branch. This tax is an attempt to make up for the fact that the IRS will not get to collect tax on the dividends paid by the corporation to its shareholders. Fortunately, the Treaty provides some relief by reducing the tax rate from its statutory rate of 30%, down to 5% for Canadian corporations. As well the Treaty exempts the first $500,000 earned by a branch office (this is a cumulative exemption, not annual).
One big advantage of starting out in branch form is that start up losses can be used to offset Canadian source earnings of the corporation. However, it may be difficult to transfer assets of the US branch to a US subsidiary later without realizing a disposition in Canada.
Forming a US Subsidiary to Conduct US Operations
Instead of operating a US branch, a Canadian corporation could form a separate US subsidiary. Depending on the circumstances, this may be a better alternative for expansion.
Under the Treaty, owning a US subsidiary is specifically excluded from the definition of a PE, which means that the Canadian parent corporation will not be required to file US income tax returns. This can be seen as a significant benefit for companies who prefer to limit their interactions with the IRS.
US source income is still taxable in the US, of course. However, reasonable royalty fees, debt service costs and management fees paid to the Canadian parent corporation would be deductible against that income.
Dividends paid to the Canadian parent corporation would still be subject to a 5% withholding tax on repatriation, but management has more control over the timing of that expense by determining if and when to declare such dividends (branch profits taxes are due currently as earned by the Canadian corporation).
Of significant importance to many business owners, the Canadian parent corporation will benefit from creditor protection vis-à-vis any liabilities incurred by the US subsidiary, due to its status as a mere shareholder of the US operation. However, the distinction in legal personality also means that losses cannot flow through to offset earnings of the Canadian parent.
Planning is Key to Achieving Business Objectives
The decision between opening a US branch operation and forming a US subsidiary corporation is one of many important choices for Canadian companies looking for business opportunities south of the border. Making the best choice in any given circumstance requires evaluating available alternatives and corporate objectives. More sophisticated financing strategies are also available to create additional opportunities for tax efficiency.