Many U.S. software companies are attempting to expand their markets by “going international”. Going international can mean anything from sending one knowledgeable company executive to a foreign country to set up one distributorship, to setting up an entirely separate foreign company and hiring local labor. Although going international allows a U.S. company to exploit new markets, it can also be a headache if one is not adequately prepared to operate in the international arena.
The most common issues U.S. companies face in going outside the U.S. include choosing the type of business entity to organize, international taxation, and foreign labor laws. In order to provide guidance for these common concerns, we are publishing a series of articles on going international in Canada, the Netherlands, Japan and the United Kingdom. This issue will begin the series, focusing on Canada.
Canada is one of the world’s largest trading nations and is a good place to start if this is a company’s first international venture. English is one of the official languages, the government is relatively stable and there is a thriving free-market economy, so Canada is an easy choice. In addition, trade activity between the U.S. and Canada has increased in volume so much that the two countries are each other’s largest trade partners.
One threshold decision a company must face before doing business in Canada is deciding under what form of business entity to operate. We’ve chosen a simple hypothetical to demonstrate the choices and the consequences.
A Hypothetical: Softco USA, Inc. is a U.S. software company with principal offices in Massachusetts. Softco maintains relationships with distributors throughout the U.S. and with one in Canada. Recently, Softco’s Canadian distributor resigned. Softco has been extremely successful in Canada, and projects a 20% increase in Canadian sales over the next 12 months. Softco’s Board of Directors is considering pursuing the Canadian market more aggressively by setting up a Canadian office instead of hiring a new distributor. The new office would handle customer service calls, training, and direct sales and marketing campaigns. Because it is unfamiliar with operating in a foreign country, Softco has contacted its U.S. law firm seeking advice on business and taxation issues regarding the establishment of Softco Canada.
Choice of Business Entity: Branch or Subsidiary? A U.S. corporation wishing to set up a foreign enterprise in Canada has two corporate structures from which to select: it can operate the enterprise as a branch or a subsidiary.
A branch is simple to organize and operate, and therefore is probably the preferable structure. Since it is not necessary to incorporate a branch, Softco USA could set up as a branch simply by establishing an office in Canada and registering in each province where it plans to conduct business. Under this scenario, Softco would be taxed in Canada on income derived from carrying on business in Canada. For Canadian tax purposes, the branch’s start-up losses are deductible from Softco USA’s earnings. In addition, Softco Canada must file tax returns as required by the Canadian federal, provincial and municipal authorities.
One possible disadvantage to Softco USA maintaining a branch rather than a corporate subsidiary is that in addition to the income tax payable on profits earned by the branch, a separate “branch profits tax” is due on the branch’s after-tax profits. The tax applies to the taxable income earned by the Canadian branch, reduced by certain deductions. Due to the U.S.-Canada Income Tax Treaty, the branch profits tax is reduced to 10% from 25%, and the first $500,000 of profits is exempt.
However, if Softco USA expands its operations into many foreign countries and not just Canada, the Canadian government may require a worldwide accounting from all of Softco’s branches in order to determine the correct amount of Canadian income and branch tax to be paid.
Softco may also decide that it is an advantage to be identified as a Canadian company, especially if compliance with Canadian regulatory agencies is required. In this event, Softco Canada could elect to do business as a wholly-owned subsidiary of Softco USA. To accomplish this, Softco would need either to incorporate or purchase a business in Canada. However, a Canadian corporation wholly-owned by a foreign corporation is subject to Canadian tax on its worldwide income and not just the Canadian profits. So if Softco Canada were to carry on business outside Canada, that foreign income would be subject to Canadian taxes.
TLB Comment : The issues raised by our hypothetical represent only one aspect of doing business in Canada. Before venturing across the border one must consider the internal political and economic harmony of the country in question as well as the international trade climate, such as foreign relations, international trade agreements (i.e. the North American Free Trade Agreement (NAFTA) and the General Agreement on Tariffs and Trade (GATT)), customs duties and currency fluctuations. In our next issue we will explore the advantages and disadvantages of going international to another popular location, the Netherlands.