Cross-border businesses and their owners often find taxation to be one of the most frustrating and complex aspects of doing business especially with the growth and prevalence of internet-based cross-border buying, selling, and remote collaboration in the digital economy.
This new age business model has led to the growth of “mini-multinationals” where, as an example, a Canadian e-commerce business can easily purchase inventory from suppliers from Europe or Asia, lease third party logistics service providers’ (3PL) warehouses in the US, sell to consumers in the US and foreign markets, all while employing a remote team who can collaborate and operate the business virtually from their home offices regardless of where they live. Nowadays, more so than before, cross-border taxation has become an important issue for every business and entrepreneur with a cross-border presence. This is especially the case for Canadian businesses who have expanded (or looking to expand) to the US given its market potential and proximity to Canada.
Here are the top 3 reasons why your Canadian business needs a US and Canada cross-border tax accountant.
Reason 1: Knowledge of multiple tax systems
In the context of a Canadian business making the first step of expanding to the US, it is often that they seek US tax advice from a US tax accountant or lawyer to understand the implications from a US domestic perspective. However, this would only capture the tax considerations from one side of the border (i.e., from a US inbound tax perspective).
What works in the US does not necessarily lead to the best result from a Canadian standpoint. Therefore, it is critical to understand the relevant tax implications of any US or global expansion from a Canadian outbound and treaty perspective since the nature of the US business activity and/or the manner and timing in which profits are repatriated to Canada can trigger unexpected Canadian tax consequences at the head office level.
US-Canada Cross-border tax accountants generally will have the qualifications and licensing requirements to provide tax and accounting advice in both countries. This means that the structuring of a business’ US expansion will be approached in a holistic manner integrating the complex and everchanging tax rules from both sides of the border.
Reason 2: Mitigate risk
There are extensive tax compliance and information reporting requirements specific to cross-border businesses in both Canada and the US. Non-compliance can lead to hefty monetary penalties up to USD $25,000 per instance if certain US foreign reporting forms are not filed. Similarly in Canada, omission of certain foreign reporting forms can lead to penalties of CAD $2,500 per filing.
These penalties can quickly add up and hurt the value of your business from cash flow perspective, not to mention the negative impact it will cause when your business is undergoing due diligence from third party lenders, investors, and potential acquirers.
A qualified cross-border tax accountant will be able to ensure that your tax compliance and international reporting forms both in the US and Canada are considered and filed on a timely basis so that you can avoid the significant costs of non-compliance.
Reason 3: Improve profitability and cash flow
The most effective cross-border tax planning approach is based on your company’s specific circumstances and incorporates structuring opportunities that can improve your business’ profitability and cash flow, while mitigating the global tax cost and managing risks.
How a cross-border tax accountant would approach the solution may involve the following set of steps:
US entity choice
Identifying an appropriate vehicle for the US expansion is key, whether it be establishing a US branch operation for your Canadian company or establishing a US legal entity.
US entities can be in various forms including C-Corporations, limited liability companies (“LLC’s”), S-Corps, limited partnerships, general partnerships, and limited liability partnerships (“LLP’s”), etc.
While certain US entities may yield beneficial tax results in the US in a domestic context, a cross-border tax accountant will ensure that the specific nature US expansion and type of US vehicle involved will also achieve the best tax result (and avoid double taxation on income) from a US and Canadian perspective.
Cross-border funding arrangements
If a US entity is set up to do business, how that US entity will be funded by the related Canadian company will need to be carefully considered. This can involve related party loans (interest bearing or non-interest bearing), contribution to share capital, other types of equity arrangements, transfer of assets (i.e., intangibles, and/or inventory), and/or a mix of these methods.
The impact of the different types of funding mechanism will need to be assessed from a cross-border tax perspective. For example, if Canadian company puts cash in a related US entity in the form of an interest-bearing loan, one may need to consider whether:
- the interest payable by the US entity can be deducted against US taxable income to reduce US tax liability,
- the interest rate is appropriate from a US and Canadian standpoint,
- there will be a US withholding tax cost upon paying the interest to the Canadian company, and
- what the impact will be to the Canadian company when it earns the interest income.
In-country business operations
The nature of business activity and the type of income generated in the US entity can have a current tax impact to the Canadian parent.
For example, certain types of US activity may generate passive income, which may lead to such income being taxable on a current basis to the Canadian parent company, even if profits are not distributed back to Canada.
In other cases, if the US entity is generating income from an active business, there may not be a current tax impact to the Canadian parent company until a distribution is made in the future. There may even be a Canadian tax exemption if a US entity makes a distribution to a Canadian corporate parent out of certain tax balances if structured appropriately.
IP ownership and use
A critical element in planning for the structure and operation of a US business involves the ownership and use of the intangible property (“IP”) of the group (which encompasses patents, trademark, brand, technologies, etc.)
In structuring the ownership and use of the IP of the US business, especially if such IP is owned and developed by a Canadian entity, the potential application of the so-called “transfer pricing” rules become an important tax consideration.
For example, should the Canadian entity sell its IP to the US entity for its exploitation in certain markets, and if so, what is the appropriate price at which the IP can be sold between the related parties?
Furthermore, what will be the capital gains tax to the Canadian entity selling the IP, and what will be the tax depreciation available for the US entity to write-off the IP asset as it is being used in its regular business operations?
In other cases, it may be better for the Canadian entity to license its IP to the US entity for its exploitation in exchange for a licensing fee. In that case, what would an appropriate license fee look like in terms of the amount (taking into consideration the transfer pricing rules), deductibility in the US, and the income inclusion in Canada?
When ownership of intangible assets is properly structured, and when appropriate transfer pricing arrangements are properly documented, payments for intangible property rights can be used to significantly reduce the overall US tax liability of the foreign-owned US business, while mitigating the adverse incremental tax costs from a Canadian tax perspective.
As the US operation generates profits and cash flow, there are various ways of repatriating cash from US to Canada. Some of these may include:
- Repayment of principal and interest
- Dividend distributions
- Return of capital
- Management fees
- Reimbursement of expenses
- Upstream loan
- Royalty payments
Certain types of payments may be subject to the US domestic withholding tax of 30%, but this can be reduced to even 0% in specific circumstances under the Canada-US tax treaty if certain requirements are met.
Each type of repatriation mechanism will have its own tax consequences in the US which will need to be examined in conjunction with the corresponding tax consequences in Canada and the US-Canada tax treaty to determine the overall impact to the company as a whole.
It is also important to determine which type of repatriation mechanism fits with a cross-border businesses’ current needs and future objectives as well as understanding which arrangement can maximize cash flow, while minimizing the tax cost in both the US and in Canada.
Tax-efficient exit and liquidity event
Finally, when you are contemplating an exit from your business, it will be important to design a tax-efficient cross-border exit plan that can maximize the after-tax sale proceeds. Several relevant considerations include:
- Whether the exit will be in the form of a share sale or asset sale.
- If it is a share sale, whether there will be capital gains tax in US and in Canada (or both), and whether potential lifetime capital gains exemptions that can be claimed in Canada.
- If it is an asset sale, whether it will be the US entity selling its assets, or will it also involve the Canadian entity selling its assets, or both. Depending on which entity in which jurisdiction will be making the sale, the tax implications for the selling entity will need to factored in.
- After the sale, relevant entities may have a large cash balance that either can be returned to the shareholder or reinvested. If the sale proceeds are to be repatriated, the relevant repatriation considerations will need to be mapped out to minimize the cross-border tax cost of repatriation.