July 2004

They're watching - Be aware of state tax issues when selling to U.S. customers

In recent years, state taxing authorities have become more aggressive in arriving at ways to increase their tax revenue base in order to overcome decreases in federal funding. To avoid negative public reaction from residents, many states have been actively pursuing foreign corporations doing business in their state for additional tax revenue. These corporations may be subject to state income taxes, sales taxes and/or franchise taxes.

In many cases, companies that are being sought after by state authorities are exempt from U.S. federal taxes since they do not have a permanent establishment in the U.S. based on its tax treaty with Canada. However, states are not bound to follow the treaties entered into by the U.S. federal government. Instead, individual states subject foreign corporations to taxes based on the concept of "nexus", which refers to the minimum connection required for a state to impose tax. Although the nexus threshold varies from state to state, the requirements to establish nexus are significantly lower than what is required for a company to have a permanent establishment under the tax treaty.

Canadian companies can avoid creating a permanent establishment in the U.S. by soliciting customers through independent agents. Where employees are sent to the U.S. to solicit business, actual orders would be sent back to Canada for processing and approval. In contrast, the concept of nexus covers a greater scope of activities that would not otherwise constitute a permanent establishment, such as: company employees visiting U.S. clients, delivering goods to U.S. clients using own trucks, driving through a particular state in the course of business, and employees soliciting orders regardless of where the contract is concluded.

Depending on where a corporation has nexus, it could be required to compute its state taxable income in a variety of different ways. Some states base a foreign corporation’s computation of taxable income on an allocation of its worldwide income. This can increase a Canadian company’s vulnerability to certain Canadian-source profits being subject to U.S. taxation. Even where a foreign corporation does not have any taxable income for state tax purposes, it may be subject to a minimum fixed dollar amount for the privilege of doing business in that state.

The states have become more aware of and are monitoring the activity of foreign corporations doing business in their state. There are approximately 22 information sharing agreements between states and the states gather information from the Internal Revenue Service and the United States Customs Service as well. Once a state is informed of the foreign company’s presence, they will typically send out a “nexus” questionnaire. It is recommended that you do not complete the questionnaire without first contacting your accountant. Once the state has determined that a company’s operation in a state triggers nexus, the state’s department of revenue will write to the foreign corporation demanding payment of current and past-due taxes, plus interest and penalties. The company may potentially be liable for the entire period it has been active in the state.

Most states have voluntary disclosure programs that allow delinquent taxpayers to voluntarily and anonymously come forward and resolve past tax liabilities. Most states will only require repayment of taxes for the previous 3-5 years. In addition, many states will wave penalties, and some may even give a break on interest. Some states also offer a tax amnesty program periodically to allow delinquent taxpayers to come forward and resolve outstanding liabilities. The states tend to offer greater relief from interest and penalties under the amnesty program than they do by way of a voluntary disclosure.

For a Canadian corporation doing business in the U.S., state tax can pose significant risks that may initially go undetected. State and local statutes vary in their application and interpretation, which results in little uniformity between jurisdictions. Canadian corporations should carefully review their U.S. activities to determine whether they have nexus in a particular state – and if so, assess how to minimize the tax exposure.

Rob Steven, C.A., MAcc
Tax Associate, Crawford, Smith & Swallow, LLP

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