US Taxation of Canadian E-Commerce: Two Different Approaches, Two Different Results
The internet has changed how business is conducted, especially in a cross-border context. The ease and relatively inexpensive access to the internet, the emergence of social media sites such as YouTube, and the proliferation of company websites that operate as virtual storefronts, has created business opportunities where none existed before. Now any Canadian business with a computer and a good idea can sell goods or services to US customers with little or no physical presence in the US.
This leads to a fascinating question: how should governments tax e-commerce? In the US, there are two vastly different approaches to this issue that lead to drastically different results.
How is income from e-commerce taxed at the US federal income tax level?
At the federal income tax level, the presence of “old school” rules requiring a Canadian business to have a physical presence in the US before it is subject to federal income tax results in many Canadian e-commerce businesses avoiding US federal income tax liabilities. If the Canadian business is not deemed to have a US trade or business, then the issue of what profits it might have from US customers becomes irrelevant – those profits will generally not be subject to US federal income tax.
What is a US Trade or Business?
The rules for determining whether a Canadian company has a US trade or business are largely based in US domestic law but are augmented by the Canada-US Income Tax Treaty (the “Treaty”). The Treaty slightly alters some of the language and rules used in the analysis, thus providing slightly more clarity, but otherwise does not fundamentally alter the underlying concept.
Typically, a US trade or business exists if activities of a Canadian business in the US are considerable, continuous, and regular. Furthermore, the activities conducted by a Canadian business within the US must also generally be active (as opposed to passive investment activities), substantial, and closely related to deriving business profit. As such, back office and logistic functions of a business, such as clerical activities, collection-related activities, and the mere storing of inventory in the US will not by themselves result in a Canadian business being engaged in a US trade or business.
In addition to the above requirements that are derived from US domestic tax law, the Treaty generally requires one of two additional requirements to be met before the US will consider a Canadian business to be operating a US trade or business: (1) that the Canadian business have a fixed place of business within the US (such as an office or other place of management); or (2) have a dependent agent in the US who has the power to habitually exercise the right to conclude contracts in the name of the Canadian business with US customers.
As noted above, Canadian based e-commerce businesses generally do not trigger either of these two requirements as: (1) operating a website that is accessible from the US generally will not constitute a fixed place of business within the US; and (2) taking orders through such website from US customers will generally not be considered as concluding contracts within the US.
How is income from e-commerce taxed at the state income tax level?
In direct contrast with the federal income tax rules, at the state income tax level, most states have done away with physical presence-based rules and have adopted rules to tax businesses based on whether such businesses have a substantial “economic nexus” with the state. Economic nexus is a facts and circumstances test and is often based on such factors as the dollar amount and number of transactions conducted by the business with customers located in the state. This focus on the number of sales made to customers within a state for purposes of taxing out of state business has gone a step further in certain states such as California, Colorado, Ohio, and Michigan, as these states now have bright line sales thresholds for determining nexus (e.g., Ohio, California, and Colorado have a $500,000 threshold, Michigan has a $350,000 threshold).
Once a state has determined that an out of state business has economic nexus within the state, the business will typically have to apportion a percentage of its profits to be taxed in the state based on an apportionment formula that varies by state. Many states, although not all, have gone to a “single sales factor” apportionment method whereby the apportionment percentage is based on the total dollar amount of sales to customers in the state divided by the business’ worldwide sales.
For example, if we assume a Canadian e-commerce business has $1,000,000 of sales to California, and that its total worldwide sales are $10,000,000, 10% of the total net income of the business will be subject to the California state income tax.
How is income from e-commerce taxed at the state sales tax level?
Pursuant to the US Supreme Court case, Quill Corp. v. North Dakota (“Quill”), states have historically only been able to tax out of state businesses for sales tax purposes if the out of state business had a physical presence in the state. The rule laid down by Quill had the unintended consequences of heavily favoring e-commerce businesses over local brick and mortar retailers. In the last several years, numerous states have passed legislation adopting economic nexus and even bright line tests in order to subject sales from out of state businesses to state sales taxes. Currently, the State of South Dakota is involved in a case before the US Supreme Court that could likely abolish the need for physical presence-based taxation for sales tax purposes. If the US Supreme Court rules in favor of South Dakota and abolishes the physical presence standard, Canadian e-commerce businesses with significant sales to US customers could be faced with state sales tax exposures in addition to state income tax exposures.
Unbeknownst to many Canadian e-commerce businesses, it is entirely possible that such businesses are subject to US state income taxation even though they are not subject to US federal income taxation. Furthermore, with there being a strong likelihood that Quill will be overturned later this year, Canadian e-commerce businesses will likely also have state sales tax exposures to be concerned with.
If you have any questions or would like to discuss any potential US tax issues that may affect your business, please contact your trusted DMCL advisor.