Canadian Businesses Should be Wary of Their US Permanent Establishment under the Unusual Services Tax Treaty Rule
Foreign entities and individuals that are “engaged in business in the US” are required to file US income tax returns with respect to those US business activities. US federal and individual state penalties may apply for noncompliance, even if no US tax is payable. However, in the case of Canada and several other countries with which the US has an income tax treaty, there is no US federal tax on that US business activity if the business enterprise does not have a “permanent establishment” in the US.
In the US, the starting point to determine whether a permanent establishment (PE) exists is the tax treaty itself. Thus, Article 5 (Article V in the case of the Canada/US treaty) defines a US PE as a “fixed place of business” through which the business of the foreign entity or individual is “wholly or partly carried on.” The treaty lists some examples of when a PE does, and does not, exist. The US Treasury Regulations carry this further with more descriptions and examples of what constitutes an office or other fixed place of business in the US for US tax purposes. [i]
Unusual PE Rules in the Canada/US Tax Treaty
The income tax treaty between Canada and the US (“the treaty”) adds two relatively unusual circumstances which create a PE. [ii] One would not normally think of these situations as constituting a PE, and thus they could result in an unpleasant surprise for some Canadian enterprises with US customers. They arise, generally, when considerable time is spent in the US, by representatives of an enterprise from Canada. They arise regardless of whether the representatives have the authority to conclude contracts in the US, and regardless of whether the Canadian enterprise has an office or other fixed place of business in the US. [iii]
Treaty Situation 1 - A Canadian Individual Works in the US for 183 Days (Article V(9)(a))
A Canadian enterprise that provides services in the US will be deemed to have a PE in the US if; [iv]
- Those services are performed in the US by an individual who is present in the US for a period or periods aggregating 183 days or more in any 12-month period, and
- During that period or periods, more than 50% of the gross active business revenues of the enterprise consist of income derived from the services performed in the US by that individual.
The facts are examined independently for each individual who is present in the US. The test is based on the number of days the individual is physically present in the US, not on the number of days worked in the US Days are tested cumulatively over each 12-month period, not consecutively. Only the services provided by the individual while physically present in the US are counted as services performed in the US by that individual. If multiple individuals are sent to the US and they collectively spend 183 days or more, the test of days is not met unless at least one of the individuals spends 183 days or more in the US in a 12-month period. [v]
The term “gross active business revenues” means gross revenues attributable to active business activities that the enterprise has charged, or should charge, for its active business activities, regardless of when the actual billing will occur or of domestic law rules concerning when such revenues should be taken into account for tax purposes. [vi]
These provisions do not apply to circumstances where the services are provided in connection with any of the activities listed in Article V(6) of the treaty.[vii]
Example 1
Mr. X, an individual resident in Canada, is one of the two shareholders and employees of Canco, a Canadian company resident in Canada that provides engineering services. During the 12-month period beginning December 20 of Year 1 and ending December 19 of Year 2, Mr. X is present in the US for periods totaling 190 days, and during those periods, 70 percent of all of the gross active business revenues of Canco attributable to business activities are derived from the services that Mr. X performs in the US. Because both of the criteria above are satisfied, Canco will be deemed to have a permanent establishment in the US, as long as the services are not performed in connection with any of the activities listed in Article V(6).
Example 2
Mr. Y, is a US citizen who lives in the US. He is employed as an engineer by Canco, a Canadian company resident in Canada that provides engineering services in Canada and the US. During the 12-month period beginning December 20 of Year 1 and ending December 19, year 2, 70 percent of all of the gross active business revenues of Canco attributable to business activities are derived from the engineering services that Mr. Y performs in the US. Because both of the criteria above are satisfied, Canco will be deemed to have a permanent establishment in the US, as long as the services are not performed in connection with any of the activities listed in Article V(6).
None of the rules above will apply to create a PE if the services are only provided in connection with the activities listed in Article V(6) of the treaty. [viii]
US Income Tax Responsibilities for Mr. X.
In addition to Canco’s 12-month test, Mr. X must determine if personally met the US “substantial presence test” for any calendar year. If that test is met in any year, he is treated as a US resident for US income tax purposes for that year, unless he timely files a valid IRS Form 8840 (Closer Connection Exception Statement). Failure to comply can result in substantial penalties for omission of a US international reporting form, such as FinCEN 114, even if no personal US income tax is payable by Mr. X.
Treaty Situation 2 - Canadian Enterprise Provides Services in the US for 183 days (Article V(9)(b))
A Canadian enterprise that provides services in the US will be deemed to have a PE in the US if the services are provided in the US for an aggregate of 183 days or more in any 12-month period with respect to the same or “connected project” for customers who are either residents of the US or who maintain a PE in the US, and the services are provided in respect of that PE.
In this case, the test is based on the number of days the enterprise provided services in the US, not the number of days an individual was present in the US. If several individuals are sent simultaneously to the US to provide services, their collective presence for one calendar day will count for one day only in the US. [ix]
Definition of “Connected Project”
According to paragraph 2 of the Diplomatic Notes to the 5th Protocol (Annex B) to the treaty, projects will be considered to be “connected” if they constitute a coherent whole, commercially and geographically. The technical explanation of the treaty states:
The determination of whether projects are connected should be determined from the point of view of the enterprise (not that of the customer) and will depend on the facts and circumstances of each case. In determining the existence of commercial coherence, factors that would be relevant include; 1) whether the projects would, in the absence of tax planning considerations, have been concluded pursuant to a single contract; 2) whether the nature of the work involved under different projects is the same; and 3) whether the same individuals are providing the services under the different projects. Whether the work provided is covered by one or multiple contracts may be relevant, but not determinative, in finding that projects are commercially coherent.
The Technical Explanation provides the following examples in connection with commercial and geographic coherence:
Example 3
Assume that a technology consultant has been hired to install a new computer system for a company in the other country. The work will take ten months to complete. However, the consultant purports to divide the work into two five-month projects with the intention of circumventing the rule in subparagraph 9(b). In such case, even if the two projects were considered separate, they will be considered to be commercially coherent. Accordingly, subject to the additional requirement of geographic coherence, the two projects could be considered to be connected, and could therefore be aggregated for purposes of subparagraph 9(b).
Example 4
In contrast to Example 3, assume that the technology consultant is contracted to install a particular computer system for a company, and is also hired by that same company, pursuant to a separate contract, to train its employees on the use of another computer software that is unrelated to the first system. In this example, even though the contracts are both concluded between the same two parties, there is no commercial coherence to the two projects, and the time spent fulfilling the two contracts may not be aggregated for purposes of subparagraph 9(b).
Example 5
Another example of projects that do not have commercial coherence would be the case of a law firm which, as one project provides tax advice to a customer from one portion of its staff, and as another project, provides trade advice from another portion of its staff, both to the same customer.
Example 6
Projects, in order to be considered connected, must also constitute a geographic whole. An example of projects that lack geographic coherence would be a case in which a consultant is hired to execute separate auditing projects at different branches of a bank located in different cities pursuant to a single contract. In such an example, while the consultant's projects are commercially coherent, they are not geographically coherent, and accordingly the services provided in the various branches shall not be aggregated for purposes of applying subparagraph 9(b). The services provided in each branch should be considered separately for purposes of subparagraph 9(b).
It is important to remember that none of the rules above will apply to create a PE if the services are only provided in connection with the activities listed in Article V(6) of the treaty. [x]
How AbitOs Can Help
Navigating US tax obligations as a foreign company or individual can be complex—and the stakes are high. At AbitOs, we specialize in cross-border tax advisory services, helping Canadian businesses determine whether their US activities trigger Permanent Establishment risks or tax filings. Contant us, we’ll help you stay compliant and minimize surprises.
[i] Reg. §1.864-7
[ii] Article V(9)
[iii] Of course, the reciprocal applies if a US enterprise exceeds the tine threshold in Canada
[iv] Article V(9)(a)
[v] Technical Explanation of the tax treaty
[vi] Technical Explanation of the tax treaty
[vii] Article V(6)
[viii] Article V(6)
[ix] Technical Explanation of the tax treaty
[x] Article V(6)
