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On November 2, 2017, the US House of Representatives unveiled the Tax Cuts and Jobs Act which contains the most sweeping changes to US tax law in 30 years. While it remains unclear whether, when, or in what form the new bill will become law, but if it passes in its current form Canadian businesses with US operations will want to revisit their cross-border tax and business plans.
Of the many changes proposed by the bill, the most important one would be a permanent reduction of the top US federal corporate tax rate to 20% from the current 35% rate. A large rate cut provides an opportunity to increase the tax efficiency of US operations and may encourage an expansion of those operations.
Currently, there is a significant gap between the Canadian and US corporate tax rates. Under the current law, the top US federal corporate tax rate is 35%. When state corporate tax rates are added, the top possible US corporate tax rate is 39.1%. In contrast, Canadian corporate tax rates are currently lower. For instance, in Ontario, the general combined federal and provincial corporate rate is 26.5%. On the first $500,000 of profits, however, the tax rate is 15%.
Because of this rate differential, for an Ontario based business and across Canada generally, it is advantageous for income to be taxable in Canada rather than the US. Many Canadian businesses operating in the US use a variety of strategies to achieve this result. One common strategy is to avoid US federal tax exposure altogether through not having a fixed place of business in the US. Where this is not possible, a common approach is to set up a subsidiary in the US and charge it a reasonable management fee for services performed by the Canadian parent. For example, the Canadian company may perform the centralized administrative functions of the business, and charge the subsidiary a fee for its share of those services. This is a deductible expense for the US subsidiary and is taxable income to the Canadian company. Through arrangements such as these, taxable income at the higher US corporate tax rate can be minimized and achieve substantial overall tax savings.
A reduction in the US corporate tax rate will dramatically alter this approach. It will incentivize businesses to have profits taxed in the US. It may also incentivize a restructuring of cross-border business operations to take advantage of the new low, US tax rate.
Consider the following example to illustrate these ideas. DoorCo is an Ontario company. It sells an innovative type of screen door to customers all over North America. DoorCo’s Canadian tax rate is 26.5%. It sells its product in the United States through its US subsidiary DoorCoUSA. DoorCOUSA currently makes a pre-tax US profit of USD $500,000. Taxed completely as US taxable income, under the current rules it would pay 34% US federal corporate tax on this profit. To reduce its overall tax liability, the business may be arranged to maximize business functions performed in Canada, for which DoorCo charges DoorCoUSA a reasonable management fee. DoorCoUSA takes this as a deduction to reduce its taxable income in the US. The management fee is taxable to DoorCo in Canada. Because Canadian tax rates are lower than US tax rates, this arrangement makes sense. But under the November 2, 2017 House proposal, the US federal tax rate will fall to 20%. As a result, DoorCo may want to have more of the $500,000 taxed in the US and not Canada and restructure its business operations accordingly. It should consult with its tax advisors to determine the optimal plan.
There is a long way to go before the US tax reform is finalized so a lot remains unclear. But the US is a key market for Canadian companies. If adopted, these widespread proposed changes should cause Canadian businesses to revisit their existing cross-border tax plans.
Max Reed is a cross-border tax lawyer at SKL Tax. He can be reached at firstname.lastname@example.org