This article deals specifically with U.S. state income and sales taxes.
In an increasingly cross-border business environment, many Canadian companies are looking to expand their operations in the United States. However, this expansion raises complex issues, particularly in terms of income tax – both federal (IRS) and state (U.S.), as well as sales tax.
Here’s a structured overview of the essential elements you need to know about the U.S. states before embarking on business development in the United States.
1. Understanding the tax nexus: the key to tax liability
The nexus represents the sufficient link between your company and a U.S. state, enabling the latter to impose taxes.
This link can be:
- physical: office, warehouse, employees;
- economic: sales threshold reached in the state, even without physical presence.
Each state has its own criteria. Some are based on sales figures, others on the broader notion of “doing business in the state”.
2. Public Law 86-272: limited protection
This federal law restricts the imposition of state income tax when the activity is limited to the solicitation of orders for tangible goods, the orders for which are accepted and shipped from a location outside the state.
Be careful however:
- It does not cover services, software or licenses.
- It applies only to solicitation: all other activities (installation, after-sales service, etc.) are excluded from this protection.
- It does not automatically protect international trade, as the law is aimed at interstate commerce. Some states extend it to international trade, others do not.
3. The Canada-U.S. tax treaty: useful but incomplete
The treaty is designed to avoid double taxation, but it applies exclusively to U.S. federal tax, and not to the states, which may or may not choose to refer to it.
At federal level, income is only taxable if it comes from a permanent establishment, such as:
- an office, branch or factory;
- a dependent agent able to enter into contracts.
Exclusions: ancillary activities, bonded warehouses, independent U.S. subsidiary (unless it acts as a dependent agent and has the power to negotiate and/or conclude contracts in the U.S.).
Please note: some states ignore the convention and still impose nexus if their own criteria are met.
4. Where does income come from, depending on the state?
Each state determines its own income sourcing rules.
For tangible goods:
- Several states use destination-based sourcing: the sale is attributed to the state where the good is delivered or used, regardless of the transfer of title.
- Others rely instead on the place of transfer of title.
For services:
- Market-based sourcing is gaining ground: revenue is attributed to the state where the customer receives the service, even if the service is rendered abroad.
- That said, some states may still not tax if the service is performed outside the United States.
For intangible assets:
- The source of income is generally determined by the place where the right (royalty, copyright, patent) is used or exploited.
5. U.S. sales taxes: thresholds to keep an eye on
Since the Wayfair decision, many states have imposed a sales tax collection obligation as soon as a sales or transaction threshold is crossed on the U.S. market, even without a physical presence.
This concerns:
- B2C sales;
- and sometimes B2B sales.
Canadian companies must therefore check their activity thresholds in each state (generally US$100,000) and register if necessary.
6. Best practices for compliance
Here are a few tips to limit the risks and optimize your compliance:
- State-by-state analysis: each state applies its own rules for tax liability, sourcing and calculation.
- Keep an eye on your sales or transaction thresholds for income tax AND sales tax.
- Check your protections: don’t assume that your tax treaty or PL 86-272 protects you in all cases.
- Document everything: keep detailed records of your activities, income and services in the U.S. to support your position in the event of an audit.
Complex terrain calls for a tailor-made strategy
The tax and sales tax liability of Canadian companies in the various U.S. states is a complex and constantly evolving field. It requires a personalized, rigorous and up-to-date analysis.
Thinking of setting up or expanding in the United States? Talk to your tax advisor at Demers Beaulne. We’re here to help you structure your activities, avoid double taxation and ensure compliance in every state.
Marie-Claude Péthel
