What Canadian Businesses Need to Know About U.S. State Taxes

 

Stephanie Hermanutz, CPA, MPAcc

Navigating the U.S. state tax landscape is a complex yet essential task for Canadian businesses expanding south of the border. 

As experts in cross-border structures and tax planning, we understand the hurdles Canadian businesses encounter in the U.S. market. Rather than a unified system, U.S. state taxation resembles a mosaic of 50+  distinct tax regimes. This variety often surprises those familiar with Canada’s more uniform tax system. 

 

Federal Treaties Do Not Exempt You From State Income Taxes 

Canadian businesses must realize that U.S. federal treaties do not necessarily exempt them from state income taxes. Each states’ tax law determines whether it adheres to the federal treaty, leading to different implications depending on the state. For example, a Canadian business operating in both California and Florida might find itself subject to income tax in California, which does not honor the federal treaty, but exempt from tax in Florida which does honor the treaty. It is also important to note that federal treaties only protect a company from income taxes. They do not provide protection from franchise taxes, gross receipts taxes or sales taxes.  

 

Understanding Nexus 

Understanding ‘nexus’ – the connection between a business and a state, that must exist for a state to impose its tax – is crucial. Nexus is most commonly established through economic or physical presence, although there are others for instance, selling to customers in a state can create economic nexus, subjecting a business to that state’s taxes. Similarly, having employees or inventory in a state generally establishes physical presence nexus. The varying definitions and applications of nexus in different states necessitate a careful, state-by-state evaluation of a business’s tax obligations. This task has become even more challenging since the landmark Wayfair case in 2018 marked a new era in sales tax compliance by abolishing the requirement for physical presence in sales tax nexus and introducing economic nexus laws across states with general sales taxes. As a result, businesses now face more diverse compliance challenges, further emphasizing the need for technology and expert advice in effective tax management. 

• Myth: Your Entire Income is Subject to State Corporate Tax: A common misconception among Canadian businesses is that their entire income falls under a state’s corporate tax. However, the reality is that only the income portion allocated to the state, as per its unique apportionment formula, is taxable. While most states base this on the percentage of sales within their borders, some also factor in payroll and property. This can lead to a lower tax liability than initially thought but adds layers to projecting tax liabilities. Such complexities aren’t limited to income taxes but extend to other state tax types. 

 

Diverse Tax Types: More Than Just Income Taxes 

Different states impose various taxes, including income, sales & use, gross receipts, franchise, and personal property taxes. Notably, sales taxes are a transaction tax and are withheld and remitted by the company on behalf of customer. However, if the company fails to collect the taxes from its customers the company becomes liable for paying the sales tax.    The varying taxes and inconsistent state laws, which continue to evolve, can be a major pain point for Canadian businesses expanding to the U.S.   

 

Key Tools for Compliance 

To manage these complexities, businesses are increasingly relying on technology and outsourcing. Determining the taxability of products or services and the sourcing of sales often requires consulting with U.S. tax advisors. Internal accounting software is essential for tracking sales, tax rates, and taxes collected, especially when filing sales tax returns in multiple jurisdictions. With these tools and knowledge in hand, there are proactive steps every business should take as it enters the U.S. market. 

 

Proactive Steps for Market Entry 

As your business enters the U.S. market, identify states with connections, such as sales, property, or employee locations. Work with a U.S. CPA to understand specific state tax liabilities and ensure proper registration in states where you conduct business. This proactive approach is vital where states can be more aggressive than the IRS in tax collection. 

 Understanding and actively managing your tax obligations is the key to successfully navigating the U.S. state tax system. With careful planning and the right expertise, Canadian businesses can confidently expand into the U.S. market, turning the challenge of state tax compliance into an opportunity for growth and success.