With today’s technology, it is becoming increasingly easy to sell products to individuals and companies all around the world. Many Canadian companies have developed great business relationships with U.S. customers, selling a wide variety of goods. 

In recent years, an increasing number of my Canadian entrepreneur clients have been telling me that their long-time U.S. customers are now demanding a signed IRS form, and without this form, the U.S. customer will withhold 30% of the gross payment and remit to the IRS. My now extremely confused clients then cite the following form names: W8-BEN, W8-ECI, W-8IMY, W8-EXP, W8-CE, SS-4, W-7, W-9. They tell me, “I never had to do this before, and not all my U.S. customers are asking me to do this. What is going on?”

Before explaining to my clients the technical aspects of doing business with U.S. persons, I point out the various events that led us to this place. Who can forget the recession of 2008 that morphed into the popping of the housing bubble? (Or was it the popping of the housing bubble that led to the recession?) But as I tell my clients, the why and the how are less important. Just know that it happened.

To compound the situation, the U.S. government uncovered information that allowed it to estimate the potential tax revenue lost due to aggressive tax-evasion strategies promoted by Swiss and Liechtenstein banks. At this point, my clients often stop me to ask, “what does this have to do with my situation?” My response is that the U.S. government is under considerable pressure to gain control over the U.S. National deficit, which is currently $16.8 trillion dollars and growing by $46,000 every second¹. In order to gain control over the deficit, the U.S. government must increase revenue, decrease expenditures, or do both.

There are few political parties that campaign on the idea of increased taxes or decreased government programs. In light of these difficulties, the U.S. government adopted a different approach to increase tax revenue. This approach requires diligent tax compliance and enforcement to ensure the protection of the tax base and reduce tax leakage. It is accomplishing this objective through two means: new legislation (FATCA)² to promote compliance, and enforcement of old legislation.

2008 marked a turning point for the IRS with regard to cracking down on various aspects of U.S. tax enforcement. Douglas Shulman, then Commissioner of Internal Revenue, spoke at the 21^st Annual George Washington University International Tax Conference on December 8, 2008:

Today, the IRS will add withholding taxes to the Tier I list of issues. The tier issue process will provide the needed organizational priority and coordination to ensure taxpayer compliance with the U.S. withholding tax provisions. Our compliance efforts will span efforts to ensure individual, business and corporate taxpayers understand and fulfill their withholding tax filing obligations to addressing transactions that attempt to circumvent withholding taxes or claiming improper tax treaty withholding rates.

It would appear that the mandate for the IRS is quite clear. So, why would our U.S. customers want to become the watchdogs of the U.S. tax system and force Canadian businesses to jump through administrative hoops with IRS forms and documents or face the wrath of an arbitrary 30% withholding tax? The answer is contained in Internal Revenue Code sections 6672(a)³ and 7202⁴. Both these provisions contain penalties for any withholding agent⁵ that fails to withhold and remit taxes to the IRS when taxes were required to be withheld. 

So now we know why we are faced with the task of filling out IRS forms and getting IRS identification numbers. But the next question is, what form do you complete and what do you do with it?

There are many different forms for many different purposes. But let’s focus for now on the more common situations faced by Canadian businesses dealing with U.S. customers (individuals and corporations).

In order to determine which forms are required, we must determine if the recipient of the U.S. income is a U.S. person⁶ or a foreign person with regard to the United States. If the recipient is not a U.S. person, then they are a foreign person by default. As we continue the analysis, we will assume the recipient is a Canadian resident and thus a foreign person.

The U.S. imposes income tax on foreign persons with respect to two principal categories of U.S. sourced income:

• Effectively connected income (ECI) – income effectively connected with the conduct of a trade or business in the United States.
• Fixed, determinable, annual or periodical income (FDAP) – all other types of income that are not classified as ECI (e.g. dividends, interest, pension, rent, royalties).

As a starting point, all income from the U.S. is subject to a 30% withholding tax unless the correct paperwork is completed. The penalty regime imposed by the IRS on the withholding agents helps to ensure that the correct paperwork is filed and the correct withholding tax rate is applied.

If the recipient is a foreign business with ECI (which means it has income connected with a trade or business in the United States), then it would be subject to U.S. taxation on a net basis⁷ and subject to graduated tax rate schedules for both individuals and corporations when it files its U.S. income tax return. In order to avoid withholding taxes on ECI, a foreign person must complete Form W8-ECI⁸ and submit it to the payor (i.e. the U.S. customer). The foreign person then is required to file a U.S. tax return and determine their potential U.S. tax liability.⁹

If the foreign person has FDAP, then the starting point for withholding tax is 30% of the gross payment. The Canada-U.S. Tax Treaty provides limitations on the amount of withholding tax that may be collected by either country for certain forms of income. In order to reduce or eliminate the 30% withholding tax based on some favorable term of the Canada-U.S. tax treaty, Form W8-BEN must be completed and submitted to the payor. There is no automatic requirement to file a U.S. income tax return in such a case. 

In order to properly complete either W8-BEN or W8-ECI, a U.S. taxpayer identification number (TIN) is required¹⁰. A corporation or business would apply for an Employer Identification number (EIN) using Form SS-4. An individual would apply for an Individual taxpayer identification number (ITIN) using W-7. These forms must be submitted to the IRS to obtain a U.S. TIN, which is used for all respective IRS forms and tax returns.

The final question is, do you need to file a tax return or not?

If you filed a W8-ECI, then the answer is “yes,” as you are stating that you have income effectively connected with a business or trade in the U.S. Even if you don’t have a permanent establishment in the U.S., you are still required to file a U.S. tax return if you filed a W8-ECI. If you don’t have a permanent establishment in the U.S., then you may claim a treaty exemption (Form 8833) with your U.S. tax return to absolve yourself of any U.S. tax burden.

If you filed a W8-BEN, then the answer is “maybe.” If the payor did not withhold the required withholdings, then you are required to file a U.S. tax return to reconcile the difference. If the payor withholds the correct tax, which could be no withholdings if you claimed full treaty exemption on the W8-BEN, then you should have no requirement to file. That being said, I have received calls from clients indicating that the IRS is sending them a request to file. It would appear that if you apply for an EIN, the IRS will request that you file regardless of whether there is an actual requirement to do so. Given this scenario, you can either contact the IRS to explain that you are not required to file, or simply file the U.S. tax return and claim a treaty exemption on Form 8833.

Now let’s return to the question of a Canadian business that has a U.S. customer demanding the completion of one of these forms or facing a 30% withholding tax on gross payments. If the Canadian business (that meets the definition of a foreign person) does not have ECI, then it should complete a W8-BEN and claim a treaty exemption stating no permanent establishment in the U.S., and supply this form to the U.S. customer. The U.S. customer should then continue to make payments to the Canadian business with no withholding taxes¹¹.

It is very important to consult with your Collins Barrow Tax Advisor regarding any treaty election claimed. There could be significant undesirable tax consequences if you inadvertently claim a treaty exemption to which you were not entitled. Furthermore, the fact that the IRS is requesting Canadian businesses with EINs to file a U.S. tax return increases the detection risk.

With the IRS committed to enforcing the withholding tax rules, Canadian individuals and businesses will be forced to complete a lot more paperwork than in the past.

John F. Oakey, CA, TEP CC, is a Tax Partner in the Dartmouth office of Collins Barrow.

References:

1. http://www.nabber.org/projects/debtcounter/ 
2. For an in-depth review of FATCA, see “Welcome to America!,” April 19, 2012, by Joseph Sardella, CA, CPA, Collins Barrow (http://www.collinsbarrow.com/en/cbn/publications/welcome-to-america).
3. Sec. 6672(a). General Rule
   Any person required to collect, truthfully account for, and pay over any tax imposed by this title who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof, shall, in addition to other penalties provided by law, be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over.
4. Sec. 7202. Willful Failure To Collect Or Pay Over Tax
   Any person required under this title to collect, account for, and pay over any tax imposed by this title who willfully fails to collect or truthfully account for and pay over such tax shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $10,000, or imprisoned not more than 5 years, or both, together with the costs of prosecution.
5. The term “withholding agent” means any person required to deduct and withhold any tax under the provisions of section 1441, 1442, 1443, or 1461.
6. A U.S. person is defined as:
   • an individual who is a U.S. citizen or U.S. resident alien;
   • a partnership, corporation, company, or association created or organized in the United States or under the laws of the United States;
   • an estate (other than a foreign estate); or
   • a domestic trust (as defined in Regulations section 301.7701-7).
7. The net basis refers to the reduction of the gross amount of ECI by the apportionment of appropriate deductions, thereby resulting in a net taxable income used to calculate U.S. taxes.
8. If the foreign person did not provide a U.S. tax identification number, then withholding taxes might still apply.
9. A foreign person that has ECI may or may not have a permanent establishment, which would determine the ultimate taxability of the foreign person in the U.S. The determination of permanent establishment is beyond the scope of this article.
10. U.S. Tax identification number (TIN) is the generic term referring to the different numbers assigned by the IRS for various categories of filers.  Various TINs are: Employer identification number (EIN); Individual taxpayer identification number (ITIN); Social Security number (SSN); Taxpayer identification number pending U.S. adoptions (ATIN); and Preparer taxpayer identification number (PTIN).
11. The W-8BEN election will remain in effect for a period starting on the date the form is signed and ending on the last day of the third succeeding calendar year, unless a change in circumstances makes any information on the form incorrect.