US State-Tax Strategies To Reduce Double Taxation

US state taxes have long been a thorn in the side of Canadian taxpayers, but an awareness of all available elections, and keeping up to date on legislative developments, can go a long way toward helping taxpayers minimize instances of double taxation and non-compliance. More specifically, the tax laws in both California and New York (two states that have traditionally contributed heavily to the foreign tax liabilities of Canadian companies that operate south of the border) now provide mechanisms that can help Canadian taxpayers claim full foreign tax credits (FTCs) on their Canadian returns.

Many Canadian businesses are not aware that state income taxes may not be fully claimed as a business FTC in Canada. Those who are aware may be reluctant to take advantage of the voluntary disclosure programs offered for unpaid state taxes, for fear that the resulting tax liability will not be fully recoverable as a Canadian business FTC.

A number of states—including California and, until recently, New York—have traditionally taxed foreign corporations on their worldwide income. Both states apply similar apportionment factors (commonly, sales into the state) to determine the final amount of income subject to state tax, and neither state permits a taxpayer to use the Canada-US tax treaty to reduce its taxable income. Discrepancies between these sourcing approaches and the sourcing approach mandated under the Canadian tax system have historically resulted in situations where the maximum available Canadian business FTC was less than the state taxes that were actually paid.

Generally, a corporation's business FTC for a particular jurisdiction is limited to the lesser of the foreign business income tax actually paid for the year and the proportion of Canadian tax otherwise payable that the taxpayer's qualifying income from a business carried on in the foreign jurisdiction is of total income for the year (subsection 126(2.1) of the Act). Further limitations can apply to the business FTC to the extent that a portion of the foreign taxes has been claimed as a non-business income tax.

The CRA's position is that foreign-source business income must be determined in accordance with Canadian rules (Income Tax Folio S5-F2-C1, "Foreign Tax Credit") and is limited to income attributable to activities carried on in the particular foreign country (CRA document no. 2000-0010177, March 7, 2000). This generally means that one uses a sourcing methodology similar to that used for transfer-pricing purposes, attributing income based on functions, assets, and risks. Moreover, the carve-out for "tax-exempt income," as defined in subsection 126(7), means that income attributable to activities performed in states that do respect the treaty cannot be included in the computation.

State tax can arise in situations where a taxpayer's presence in that state is minimal or even non-existent. For example, California imposes tax on the basis of economic nexus, whereby a company is taxed if sales determined to be sourced to California-based customers exceed a dollar threshold. Accordingly, foreign-source business income, as determined for Canadian purposes, may be very low, or a taxpayer may be considered not to have been carrying on business in a foreign jurisdiction at all. In the absence of any relieving mechanisms under state tax law, either outcome would almost certainly result in double taxation.

Fortunately, relief is available, although not widely publicized. In 2015, New York adopted a new approach whereby a foreign corporation calculates its New York taxable income as a percentage of its income effectively connected with a US trade or business (ECI) instead of worldwide income. Treaty protections otherwise limiting ECI are still not considered. A Canadian corporation doing business in both Canada and the United States is therefore taxable in New York only on a portion of the income that it earns in the United States. This ECI figure more closely matches US-source business income as calculated on the basis of Canadian principles. Accordingly, much of the potential for a mismatch between the maximum business FTC and the New York state tax may be eliminated.

Similarly, foreign corporations that file California returns may also limit the taxable income to a percentage of ECI by filing their state tax returns on a water's-edge basis. In general, a foreign corporation that makes the water's-edge election is taxable on its worldwide income only if the average of the proportion of its US property over total property, US payroll over total payroll, and US sales over total sales is 20 percent or more (an 80/20 company). Otherwise, the electing foreign corporation is taxable only on a portion of its ECI. While this water's-edge election may not be suitable for all taxpayers, for those Canadian corporations without a substantial US presence, it should provide relief insofar as such taxpayers should be taxable in California on only a portion of their US-source income. This treatment is not automatic. Failure to file a timely return and make an election will result in reverting to taxation on worldwide income.

The alignment of US-source income for New York state tax, California state tax, and Canadian business FTC purposes permits Canadian corporations to minimize double taxation, and it may help to eliminate disincentives for those taxpayers that have been reluctant to resolve instances of past non-compliance. Conversely, corporations that have incorrectly taken a full credit for their prior-year New York or California taxes may need to consider their related audit risk.

Bud Goff
Deloitte LLP, Winnipeg

Michaella DePalo
Deloitte LLP, Ottawa

Canadian Tax Focus
Volume 7, Number 4, November 2017
©2017, Canadian Tax Foundation