For a number of years, Canadian businesses have been able to limit their exposure to United States (US) federal income taxes based on the definition of a "permanent establishment" (PE) in the Canada-US Income Tax Treaty. However, with some recent amendments to the Treaty, a number of which came into effect January 1, 2010, that may no longer be the case.
What's New?
The Fifth Protocol, signed September 21, 2007, broadens the definition of a PE by adding two new tests for businesses that provide services in the US but do not otherwise have a PE by virtue of a fixed place of business located there. If a business meets either of the two tests, it will be deemed to provide those services through a PE in the US, thus subjecting the taxpayer to US federal income taxes.
The Tests
Under the first test, there are two requirements. First, services must be performed in the US by an individual physically present there for 183 days or more in any 12-month period. Second, during that 12-month period, more than 50% of the business' gross active business revenues must be income derived from the services performed in the US by that individual. This test determines whether a business has a PE by virtue of the physical presence of a single individual. As such, all days present in the US will count toward the 183 days, whether or not they are spent providing the services in question.
The second test provides that a business will have a PE in the US if services are provided there for an aggregate of 183 days or more in any 12-month period with respect to a project or connected projects for customers who are either residents of the US or who have a PE in the US. This test determines whether a business has a PE by virtue of the services it provides. As such, only days during which services are provided count toward the 183 days. If different employees are in the US working on the same project on different days, each of those days will be counted toward the 183 days. If they work the same day, it will only count as one day.
It is important to note that both tests are based on a rolling 12 months rather than a particular calendar year.
The Impact
Once the 183 days are met and a PE is considered to exist, a business will be taxed in the US on profits attributable to the activities carried on in performing the services that resulted in the creation of the PE. Businesses should also consider the impact of the above changes on their US tax-related filing deadlines as these differ from Canadian tax filing deadlines. The IRS does provide the opportunity to file extension requests.
In addition, employment income earned by the business' employees working in the US will be subject to US income tax if the employment income related to the PE exceeds $10,000. This will cause administrative issues involving US payroll taxes and US tax filings by the employee working in the US.
As a result of these changes, documentation of the number of days employees spend in the US will become crucial in order to determine whether these new rules will result in increased US income tax exposure.
Employers should consider recording their employees' activities in the US effective January 1, 2010 to support any tax filings.
Going Forward
This article provides only a brief summary of the changes made to the definition of a PE and the implications that go along with it. If your business provides services in the US, please consult your Collins Barrow advisor to ensure your tax filings are complete and accurate.
Julianne Favron, CA, CPA, is a member of the Tax Group in the Ottawa office of Collins Barrow.
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