When to file a tax return in the US

As a person or entity who is not a US citizen and doesn’t live or work permanently in the US, you may believe that you have no obligation to file American tax reporting forms. However, according to US tax law, if a non-US entity is engaged in a trade or business in the US, it will be taxable on its income which is effectively connected with the conducting a trade or business in the United States.

The US-Canada Tax Treaty changes the burden for paying taxes in the US for Canadian entities and persons. They are only required to pay tax when the entity has a permanent establishment in the US. In order to claim these treaty benefits, a Canadian entity would have to file a protective return.

The definition of permanent establishment varies based on state, and certain states have not adopted the US-Canada Tax Treaty into law. Any time that a Canadian person or entity conducts a trade or business in the US, it is important to look at the specific states in which they are operating to determine if state-level tax obligations exist even when no federal taxes are due.

Effectively connected income

The general rule is that if an entity is engaged in a trade or business in the US, all US source income and gains is treated as effectively connected income (ECI). This does not include investment income, but does still apply to US source income earned by the entity which is not related to the trade or business carried on in the US.

Effectively connected income can be earned in a number of different circumstances. For example, certain non-immigrant visas allow people to work in the US while they are temporarily staying there. F, J M, and Q visas are in this category. The taxable part of a US scholarship or grant received by a non-resident would be considered as income connected with a trade or business in the US.

If an entity is a membership of a partnership that is engaged in a trade or business in the US, or if an entity is performing personal services in the US, this would be considered effectively connected income. If an entity is a business or owns a business that sells products or services within the US, the entity has effectively connected income.

Selling real property or real property interests within the US is considered engaging in a trade or business in the US. Income from the rental of real estate is subject to an election to allow it to be considered ECI.

Permanent establishment

Not all entities carrying on business in the US are required to pay taxes on their effectively connected income. Canadian entities earning business profits in the US have treaty protection against paying US taxes on business profits earned in the US if they did not earn those profits through a “permanent establishment.”

Article V of the Canada-US Tax Treaty defines “permanent establishment” as “a fixed place of business through which the business of a resident of [Canada] is wholly or partly carried on. The Treaty definition is fairly broad and includes a place of management, a branch, an office, a factory, a workshop, and a place of extraction of natural resources.

If a state follows the Canada-US Tax Treaty, failing to have a permanent establishment means that the entity should not have to pay income tax in that state (although franchise and licensing taxes may still apply). If the state does not follow the Canada-US Tax Treaty, state law will have to be considered to determine if the entity has nexus in that state and should therefore file a tax return and pay taxes.

Even if the entity does not have a permanent establishment, it does not automatically receive treaty protection. In order to claim treaty benefits, an entity would have to file a US return (1120-F); this return should include a treaty statement declaring that it is a Canadian entity wishing to claim the benefits of the US-Canada Tax Treaty and stating that they have no permanent establishment in the US and therefore are exempt from taxation on business profits. This is called filing a “Protective return.”

If this return is not filed, the US retains the right to issue a request to file and may claim that the treaty benefits were forfeited for failure to file. Filing this return also protects the right of the company to take deductions and credits against gross income in the event that the IRS does not agree with the entity’s determination that it does not have a permanent establishment in the US.

It is therefore very important to consult with professionals about an entity’s US tax liability, even if it only has limited activity in the US.