7.3.1 [a] U.S. Taxation of Income of Foreign Persons
Foreign persons generating income from U.S. sources are potentially subject to one, or both, of two U.S. federal taxation regimes. Under the first regime, if a foreign person or corporation carries on a trade or business in the U.S., federal income tax is imposed on its net income, wherever derived, that is effectively connected with U.S. trade or business.
The tax on effectively connected income is imposed at the same rates that apply to a similarly situated U.S. person. An additional tax, the branch profits tax, may be imposed on the “dividend equivalent amounts” of a foreign corporation engaged in a U.S. trade or business.
After determining that the Canadian person or corporation has U.S. source income, the next step should be to determine under U.S. domestic principles whether the Canadian person or corporation is engaged in a trade or business in the U.S., and, if so, whether under the rules in section 864, that U.S. source income is effectively connected with its U.S. trade or business. If the answer is no, the income will not be subject to tax in the U.S. on a net basis, and hence, Article VII of the Treaty will not apply to that income.
Under the second regime, a flat tax of 30 percent is imposed on a foreign corporation’s gross income from “interest, dividend, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determined annual or periodical gains, profits, and income”, but only to the extent the amount is from sources within the U.S. and is not effectively connected with the conduct of trade or business with the U.S. by such person or corporation.
7.3.1 [b] U.S. Sourcing Rules
Dividends and interest are usually sourced by reference to the location of the payer.
Rentals and royalties are generally sourced to the location of the underlying property.
In the case of services, such income is generally sourced to the location where such services are performed.
In the case of inventory property that is purchased by the taxpayer, such income is sourced based on where title to such property passes.
The sale of inventory property that is produced, as opposed to purchased, by the taxpayer, is dealt with under section 863.
7.3.1 [c] Effectively Connected Income
The performance of personal services in the U.S. is also generally treated as effectively connected income.
The asset-use test generally applies to income that is of a passive nature and where the trade or business activities themselves directly give rise to such income.
The business – activities test applies where the income arises directly from the active conduct of the U.S. trade or business. This test is generally applicable where, for example;
Dividends or interest are derived by a dealer in stocks or securities;
Gain or loss is derived from the sale or exchange of capital assets by an investment company as a part of its active conduct of its trading business;
Royalties are derived in the active conduct of a business consisting of the licensing of patents or similar intangible property; or
Service fees are derived in the active conduct of a servicing business.
As a general rule, foreign source income is not treated as ECI. The types of income that can be considered to be effectively connected are:
Rents or royalties for the use of intangible property derived in the active conduct of the trade or business;
Dividends or interest, either derived in the active conduct of a banking or financing business within the U.S., or derived by a corporation whose principal business activity is trading in stocks and securities for its own account;
Sale of inventory through an office or fixed place of business in the U.S.’ or
Certain insurance related income.
A foreign corporation is generally required to file Form 1120F (U.S Income Tax Return of a Foreign Corporation) if it is engaged in a trade or business in the U.S. at any time during the taxable year, or if it has income that is subject to U.S. taxation.
Form 1120F is generally due on or before the 15th day of the third month following the close of the foreign corporation’s taxable year.
If the foreign corporation does not have an office or fixed place of business with in the U.S., Form 1120F is due on or before the 15th day of the sixth month following the close of the foreign corporation’s taxable year.
According to Section 882[c], a foreign corporation shall receive the benefit of the deductions and credits allowed to it in this subtitle only by filing or causing to be filed with the Secretary a true and accurate return, in the manner prescribed in subtitle F, including therein all the information which the Secretary may deem necessary for the calculation of such deductions and credits.
Advisor’s Guide to Canada – U.S. Tax Treaty
By: Vitaly Timokhov, Raymond Montero, David Kerzner
Published by: Thomson Carswell