The US tax system is one of the more complicated systems in the world. If you’re looking for a 100% definitive answer on what filings you should be doing, you’re unlikely to find one as each situation is unique and tax rules are constantly changing – particularly when cross border transactions are involved. That being said, there are some factors to consider when deciding what actions you should be taking to protect yourself as you sell your products in the US.
On a high level, US filing obligations arise when you have a US permanent establishment (PE) or nexus – terms that refer to having some sort of presence in the US. For example, if you rent an office and pay employees; if you own property like a warehouse or an office building; if you hold inventory at a rented storage facility, you likely have a US permanent establishment.
In general, when you have a permanent establishment in the US, tax filing obligations apply. You may be required to collect and remit sales tax or file US federal and state tax returns.
Whether or not you have a permanent establishment will be a key factor in determining the scope of any filings.
So what if you use a drop shipping or 3rd party logistic company to handle your inventory – do you have a permanent establishment in the US then?
Before answering that question – let’s consider the implications if you do argue that you have a permanent establishment. Suppose Sally, based in Canada, has a Shopify store and uses a 3PL company to handle her inventory. The 3PL company she uses has warehouses in 30 states and Sally’s inventory could be at any of these warehouses at any given time. If we want to argue that Sally has a permanent establishment in the US, she may need to file a state income tax return in each state that inventory is held. To do that, she’ll need to know the sales that she made within each state so she’ll need some fairly involved accounting records.
As each state has its own set of sales tax rules, she’ll likely need to do a sales tax study for each state, determine if she should be charging tax, then deploy US sales tax software for collecting, remitting and filing sales tax returns in those places. As she’s not based in the US, she’ll probably fill out the additional foreign reporting forms. The cost of all this compliance work could be so high that Sally may determine that it’s not worth selling into the US at all.
On the flip side, if Sally argues she doesn’t have a US presence, she may only need to file a simple treaty based return or nothing at all as all her income will be taxed in Canada.
While each case is unique – what’s clear is that US compliance can be a costly and complex process when multiple jurisdictions are involved – which is the case for many drop shippers and those using 3PL companies. Limiting your US presence and avoiding a US permanent establishment will certainly simplify your accounting and ease your tax and accounting bill on both sides of the border.