General Comments on Structuring the Business
There are a number of business structures available to carry on business in Canada for foreign entities. Amongst these include sole proprietorships, partnerships, joint ventures and corporations (both public and private), as well as agency, distributorship and licensing arrangements. Generally, a non-resident entity that is not seeking to set up physical operations in Canada, in other words, those seeking to simply “do business with Canada”, will tend to operate through an agency, distributorship, franchising or licensing arrangement, while those companies that are seeking to “do business in Canada” will opt for one of two options: a Branch Operation or a Canadian Subsidiary Corporation. Tax considerations will be important in making this choice, but a number of non-tax considerations are also relevant.
Where a Branch Operation is chosen, the foreign entity will be required to extra-provincially register in all Canadian provinces in which it wishes to carry on business. The corporate name cannot be registered if it is the same as or similar to one that is already in use in that province. In addition, in Quebec, the foreign corporation must register a French name.
If a Canadian Subsidiary Corporation is chosen, the cost of incorporating a new Canadian entity and the ongoing expenses of maintaining it must be taken into account. For example, the cost of preparing and filing corporate returns, financial statements and income tax returns in Canada should be considered. It will also need to be determined whether there are individuals resident in Canada who are available to serve as directors as most incorporating jurisdictions federally and provincially have minimum Canadian residency requirements for directors. One exception to this is British Columbia, which makes provincial incorporation in British Columbia, followed by extra-provincial registration in the relevant province(s) attractive to foreign investors. In addition, certain corporate records generally must be maintained in Canada.
A Canadian branch of a foreign company that is carrying on business in Canada though a permanent establishment, while not a separate corporate entity, is treated like a Canadian resident corporation and will be subject to tax under Part I of the Act on income earned in Canada. The general federal corporate tax rate for business income is 15% for 2012. The combined federal and provincial corporate tax rates for business income for 2012 range from 25% to 31%, depending on the province in which the permanent establishment is located.
In addition, a distribution tax or branch tax on branch profits repatriated to the non-resident entity and not reinvested in Canadian assets will apply. Branch tax is levied on the after-tax income of the entity, reduced by an investment allowance reflecting the retention of business assets and retained earnings in Canada. Generally, the branch tax is analogous the withholding tax that would have otherwise been imposed on the repatriation of profits by dividend distribution. If Canada does not have a tax treaty with the foreign entity’s country, then the branch tax rate is 25%. Where Canada has a tax treaty with the foreign entity’s country, the branch tax rate is typically between 5% and 15%. The Income Tax Act R.S.C. 1985, c.1 (5th Supp.), as amended (the “Income Tax Act”) also provides an exemption from branch tax for certain limited businesses, such as certain transportation, mining or communication companies. In addition, some tax treaties provides for a lifetime exemption for the first $500,000 (CDN) of income otherwise subject to the branch tax. This is the case, for example, under both the Canada-US Tax Treaty and the Canada-German Tax Treaty.
Where the Canadian Branch Operation receives passive income such as rents, royalties or interest, the payer will be required to withhold and remit to Canada Revenue Agency (“CRA”) non-resident withholding tax. However, if this income is attributable to the Canadian permanent establishment, it will be exempted from Canadian withholding tax under the Income Tax Regulations, C.R.C. c. 945, as amended (the “Income Tax Regulations”). This is because this income will be subject to Canadian income tax. To preclude withholding, the non-resident must obtain a withholding tax waiver from CRA. The waiver is available where CRA is satisfied that income potentially subject to non-resident withholding tax is reasonably attributable to the business of the Canadian Branch Operation. Additionally, it should be noted that recent amendments to the Canada-US Tax Treaty have eliminated withholding tax on cross-border interest payments.
The sale of the branch business assets will give rise to income, gain and recaptured depreciation generally to the same degree as it would in a subsidiary. The sale of the branch business assets will also generally give rise to Part XIV tax (branch tax) to the extent of previously untaxed surplus once the Canadian business has ceased. A foreign corporation will recognize income, gain or loss on disposal of the assets and claim a direct foreign tax credit with respect to the Canadian taxes paid in respect of the Canadian Branch Operation, and the total of Part I and Part XIV tax will normally result in excess foreign tax credits to the foreign entity. In addition, given that the Canadian Branch Operation is a non-resident of Canada, the procedures contained in section 116 of the Income Tax Act must be complied with. Generally, a section 116 certificate must be obtained or the purchaser is required to withhold a percentage of the purchase price (either 50%, 25% or 0% depending on the type of asset disposed) and remit the same to CRA.
There are two primary advantages of using a Branch Operation. First, any Canadian business losses incurred by the Canadian branch would likely be deductible against income earned in the foreign jurisdiction and thereby reduce the overall tax paid for the non-resident. It may be possible that this result would apply in the foreign jurisdiction in any event under the Canadian Subsidiary Corporation structure, if the foreign jurisdiction allows consolidated tax reporting under which it could include a wholly-owned Canadian subsidiary. Second, using a Branch Operation generally also allows the entity to claim foreign tax credits for any Canadian income taxes paid.
Payments Subject to Regulation 105 Withholding
Where a Branch Operation is being used, the corporation which operated the branch will generally be considered a non-resident for income tax purposes, and, as a result, payments received by the branch for any services rendered in Canada are subject to withholding under Regulation 105 of the Income Tax Regulations. Anyone paying an amount to a foreign entity for providing services in Canada will be required to remit a 15% withholding tax to CRA on or before the 15th day of the month following the month in which payment was made. In addition, a T4A-NR Information Return (T4A-NR Slips and Summary Form) must also be filed by the payer reporting all amounts paid to non-residents for services provided in Canada and must be filed with CRA by the last day of February in the year following the year in which the amounts were paid.
Regulation 105 withholding is on account of any applicable Canadian income tax payable by the non-resident by reason of carrying on business in Canada. If the non-resident resides in a country with which Canada has a tax treaty and the non-resident does not have a permanent establishment in Canada, the non-resident can generally obtain a refund of the tax withheld based on treaty exemption.
In the event that the foreign entity will be providing services (as opposed to goods) to Canadian resident customers, it is usually appropriate for the Canadian Subsidiary Corporation structure to be chosen over the Branch Operation in order to avoid Regulation 105 withholding issues. The Regulation 105 withholding requirement is administratively burdensome for payers dealing with non-residents and carries with it significant penalties that can be assessed against payers without ever becoming statute barred.
A payer who fails to deduct and remit an amount as required under Regulation 105 will be held liable for the whole amount under subsection 227(8.4) of the Income Tax Act, together with any interest and penalties. Interest is exigible under subsection 227(8.3) at the prescribed rate from the 15th of the month following the month in which the amount was required to be deducted or withheld. The prescribed rate fluctuates quarterly and for the first and second quarter of 2012 has been set at 5%. Under subsection 227(8) of the Income Tax Act, the penalty exigible could be 10% of the amount that should have been withheld and remitted or 20% if a previously existing penalty is outstanding and CRA determines that the failure to withhold and remit was made knowingly or under circumstances amounting to gross negligence. To the extent that penalties are applicable, interest at the prescribed rate would be charged on the penalties assessed. Also, subsection 227.1(1) of the Income Tax Act can deem the directors of a corporation to be jointly and severally liable, together with the corporation, for amounts that the Corporation failed to withhold, plus associated interest and penalties in certain circumstances.
Canadian Subsidiary Operations
The second option for a foreign entity seeking to do business in Canada is to establish a Canadian Subsidiary Corporation. Canadian tax liability with respect to corporations is based on residence. Corporations resident in Canada are subject to Canadian income tax on their worldwide income. A corporation is deemed to be a Canadian resident if it was incorporated in Canada after April 26, 1965 or if it was incorporated in Canada prior to that date and at any time after that date it carried on business in Canada. However, a corporation incorporated outside Canada may also be considered resident in Canada if its central management and control is in Canada.
A Canadian Subsidiary Corporation would be subject to tax on its worldwide income at regular corporate rates under Part I of the Income Tax Act. The federal corporate tax rate for 2012 is 15% and the combined federal and provincial corporate tax rates for business income in 2012 range from 25% to 31%, depending on the province in which the Canadian Subsidiary Corporation is resident. A resident corporation is also required to withhold tax on certain payments including dividends, interests and royalties paid to non-residents. The general withholding rate is 25%, but depending on the type of payment can be reduced by the various tax treaties Canadian has with foreign jurisdictions.
Since 2008, withholding tax on arm’s length interest paid to a non-resident in any country has been eliminated except for participating debt interest. However, withholding tax on non-arm’s length interest still applies in Canada under the Income Tax Act unless it is “fully exempt interest”. For interest paid to US residents, withholding tax was phased out and now eliminated as a result of the Fifth Protocol to the Canada-US Tax Treaty. For residents of most other countries, the rate is reduced by the tax treaty.
Dividends paid by the Canadian Subsidiary Corporation to its non-resident shareholders will be subject to non-resident withholding tax. If the shareholder receiving the dividend is in a country with which Canada does not have a tax treaty, the withholding tax rate is 25%. Under most of Canada’s tax treaties, the withholding tax rate for dividends is reduced to 15%. Under some treaties, a shareholder with a large shareholding is entitled to a further reduction to the withholding tax rate. For example, under the Canada-US Tax Treaty, where the shareholder is a US resident corporation that owns at least 10% of the voting stock of the Canadian subsidiary, the withholding tax rate is reduced to 5%. The advantage of the dividend withholding over the branch tax is that the parties can control and defer payment of dividends and therefore the Canadian taxation of a repatriation of profits to the foreign jurisdiction.
An advantage in using a Canadian corporation to acquire and hold a Canadian business is that a sale of the shares of the Canadian corporation by the non-resident may be exempt from tax under an applicable tax treaty if the value of the shares is not attributable principally to real property in Canada. If the treaty exemption is not available, the disposition of capital property will give rise to a capital gain, one-half of which is subject to tax at the Canadian tax rate. However, as a Canadian resident, the corporation will not be required to obtain a clearance certificate under section 116 of the Income Tax Act on the disposition by it of taxable Canadian property or otherwise comply with section 116 procedures. Also, it may be possible to defer withholding tax on the after-tax profits from a sale of assets until such time as the Canadian subsidiary either pays dividends or is liquidated. The deferral opportunity may provide cash flow advantages and may also open up foreign tax credit planning strategies.
It is common for non-resident corporations to charge management and administration fees to their Canadian subsidiaries. The non-resident corporation’s head office will often provide services to the Canadian subsidiary in areas such as accounting, data processing, tax, legal, treasury, human resources, marketing, management, technical systems, etc. It is often more cost efficient for the head office to provide these types of services than for each subsidiary to have separate staff and resources in these areas.
When structured and documented properly, reasonable management and administration charges can be quite tax efficient in relation to the Canadian subsidiary. The charges will generally be deductible to the Canadian subsidiary for Canadian income tax purposes. If the recipient is resident in a country with which Canada has a tax treaty, the payments will generally be free of Canadian withholding tax.
The Income Tax Act contains detailed rules regarding international transfer pricing. Therefore, care must be taken that the basis for management and administration any other charges is properly documented in accordance with the detailed rules in the Income Tax Act, failing which significant transfer pricing penalties could be applicable. To the extent that such charges are unreasonable, the unreasonable element will not be deductible to the Canadian subsidiary and will be treated as a dividend subject to withholding tax.
One advantage of using a Canadian Subsidiary Corporation is that the subsidiary is a separate legal entity and therefore the assets of the parent foreign corporation are not exposed to creditors of the Canadian Subsidiary Corporation. However, the subsidiary would be taxable on its worldwide income and any initial operating losses would not be available to offset the parent’s profits (subject to the ability, if any, to report on a consolidated basis in the foreign jurisdiction). Finally, a foreign tax credit is generally not available to the foreign corporation for Canadian income taxes paid by a Canadian Subsidiary Corporation.
Unlimited Liability Corporation
An unlimited liability corporation (“ULC”), either a Nova Scotia ULC, an Alberta ULC or a British Columbia is one type of corporation that can be used to set up a Canadian Subsidiary Corporation structure for inbound investments. A ULC is considered a corporate entity for Canadian tax purposes but can be considered a flow through entity for other jurisdictions, namely the United States. This type of business entity has become increasingly popular among US corporations seeking to enter Canada since US tax authorities treat the ULC as a partnership for tax purposes thereby allowing a “flow-through” of income, deductions, gains and losses to a US parent corporation.
It should be recognized that, just as its name implies, a ULC has “unlimited” liability for its shareholders. This can be contrasted with a federally or other provincially incorporated corporations where the shareholder(s) have “limited” liability. Because of this “unlimited” liability feature, a US corporation would typically incorporate a wholly-owned US subsidiary which would in turn be the ULC’s sole shareholder in order to shield itself from liability.
Recent changes to the Canada-US Tax Treaty can negatively impact the benefits of structuring investments using ULCs in certain situations. For example, ULCs are no longer eligible for reduced withholding tax rates on distributions made to US residents. As a result, any payments made will be subject to 25% withholding tax on interest, dividends, royalties and other payments. The most obvious impact of these new rules is an increase in Canadian withholding taxes as follows:
- from 5% to 25% on dividends from a ULC to a US-resident corporate shareholder owning at least 10% of the voting stock of the ULC;
- from 0% to 25% on interest paid by the ULC to US-resident persons; and
- from 0% (or 10% in some cases) to 25% on royalties paid by the ULC to certain US-resident persons.
CRA has confirmed, however, that the withholding tax problem relating to dividends can be circumvented in the case where a sole shareholder of a ULC is a US Corporation, such as an S. Corp. In such a case, the 5% withholding rate can be obtained by having the ULC increase its paid-up capital (“PUC”) by capitalizing its retained earnings and then making a cross-border payment in reduction of that capital. The increase in PUC would create a deemed dividend for Canadian tax purposes, but would have no relevance for US tax purposes. As a result, because the treatment of the deemed dividend under the taxation laws of the United Sates would be no different than it would have been if the ULC were not a disregarded entity for US purposes, the deemed dividend triggered on the increase of PUC will be eligible for tax treaty relief. CRA has also indicated that it would not apply the Canadian general anti-avoidance rule in these circumstances to tax this type of transaction for Canadian tax purposes.
Watch for a future blog on this site addressing whether ULCs are still a viable investment structure for US entities wishing to establish business in Canada in light of the Fifth Protocol to the Canada-US Tax Treaty.
Acquisition of an Existing Canadian Business
In the event that a foreign entity is considering the acquisition of an existing Canadian business, additional considerations are involved and in many cases the tax considerations result in the creation of a special purpose Canadian acquisition corporation that will be freshly capitalized (using debt or equity, or some combination) with value equal to the acquisition price. This option will make sense if the purchaser’s investment exceeds the target’s historical PUC (essentially the amount invested into the corporation through share subscriptions or through capital contributions), if the purchaser cannot absorb any resulting Canadian withholding tax cost through foreign tax credit (or otherwise) or if distributions from profits exceeding the target’s historical paid-up capital are expected in the future. Usually the special purpose acquisition corporation will be amalgamated with the existing entity or wound up to form a new entity.
The following are some additional reasons for using a special purposes acquisition corporation:
- Interest expense: The amalgamation or wind up of the special purpose acquisition corporation the target will result in the interest on the debt being deductible against the income generated by the amalgamated corporation.
- Distributions from Canadian target to non-resident shareholder: The non-resident shareholder has capitalized the special purpose acquisition company with debt and equity equal to the purchase price of the target’s shares. As a result, the non-resident shareholder’s adjust cost base (“ACB”) and PUC in the amalgamated corporation’s shares will be equal. The amalgamated corporation can repatriate funds to the non-resident shareholder free of Canadian withholding tax to the extent of the purchase price through debt repayment, share redemption and/or reduction of capital. If the non-resident shareholder acquired shares of target directly and the target’s shares had a historical PUC lower than non-resident shareholder’s ACB in the target shares, the target could only repatriate funds to the non-resident shareholder free of Canadian withholding tax to the extent of the PUC. An amount paid on a redemption of shares or a reduction of capital would be deemed to be a dividend under the Income Tax Act to extent that the proceeds exceed the PUC. This deemed dividend would be subject to Canadian withholding tax.
- Step-up in the ACB of target’s eligible assets: Using a special purpose acquisition corporation may also permit the non-resident shareholder to “bump” the ACB of target’s eligible non-depreciable capital property to its fair market value after the amalgamation (or wind-up). This bump in ACB would allow, for example, the amalgamated corporation to distribute certain assets to the non-resident shareholder, or otherwise dispose of such assets, without triggering a taxable gain in Canada.
Share Purchase or Asset Purchase?
In general, a purchase of assets is almost always preferred by the purchaser for a number of reasons. First, this allows the purchaser to pick and choose the assets or aspects of the vendor they want and do not want. Second, this avoids any latent liabilities of the vendor corporation. And finally, because under an asset purchase, the tax basis or “cost” will be the entire current purchase price allocated to the asset, which would make deductions for depreciation (capital cost allowance or CCA in Canadian terms) possible.
In contrast, a purchase and sale of shares may be generally preferred by a vendor who will have only one level of taxation, can benefit from a capital gains treatment (only ½ of capital gains is taxable in Canada) and can be eligible for a capital gains exemption (for instance by a corporation that qualifies as a “Small Business Corporation”).
In a share purchase, the purchaser assumes the tax liabilities attached to the vendor corporation. Thus, the purchase and sale agreement normally requires the vendor to indemnify any existent and undisclosed tax liabilities or tax liabilities that may subsequently be identified related to a pre-closing period. It is also prudent for the purchaser to request a tax due diligence including a review of the vendor corporation’s historical tax affairs. In a sale of shares, there is not a transfer tax applicable (as opposed to the provincial land transfer taxes, for instance, that may apply in an asset purchase involving land).
The acquisition of a Canadian entity by a non-resident under a share purchase will also involve “change of control” issues. A change of control in the target may have several tax effects under Canadian law. If a Canadian entity is purchased by a non-resident, or by a subsidiary of a non-resident, tax benefits stemming from a “Canadian-Controlled Private Corporation” would no longer apply.
Another important tax consequence when control of a corporation changes is the deemed year end rule. When control of a corporation is acquired, the taxation year is deemed to end immediately before the acquisition of control and a new taxation year is deemed to commence. The purpose of this rule is to prevent losses from being used in the same year as control changes. Also, when control of a corporation is acquired, existing carryovers of net capital losses expire and new losses cannot be carried back. Non-capital losses can be carried forward after the acquisition of control, but only if the corporation continues to carry on the business in which the loss occurred, there is reasonable expectation of making a profit and the loss can only be applied against income generated by the same or a similar line of business.
Among the potential benefits that can be adversely affected by a change of control are:
- the Small Business Credit that is deducted from tax payable by Canadian-Controlled Private Corporations; and
- the credits obtained from Scientific Research and Experimental Development (SR&ED) expenditures, especially because they are greater for Canadian-Controlled Private Corporations (35% opposed to the regular rate of 20%). SR&ED expenditures qualify also for additional favourable tax treatment, as they can be deducted as a current expense and can be carried forward for an unlimited period of time.
Financing of the Acquisition and Ongoing Operations
The nature of financing and the manner in which it is made available to the Canadian operations will have a significant effect on the computation of income and the optimum structure. Establishing the Canadian operations may involve the use of equity, internal debt or external debt, or any combination of the above. If the foreign entity has sufficient surplus funds to finance its Canadian operations, it should consider establishing a Canadian Subsidiary Corporation structure so that it can provide financing by lending to the Canadian subsidiary. If this structure was implemented, the related interest charge could be used to repatriate profits on a pre-tax basis, potentially resulting in significant advantages to the extent that Canadian tax rates exceed foreign tax rates. In the event that foreign tax rates exceed Canadian tax rates, it may be better to use a branch structure as there would be an incentive to increase Canadian taxable income and decrease foreign taxable income. The ability to finance the Canadian operations with debt, however, will be restricted by the thin capitalization rules.
Generally, the Canadian “thin capitalization” rules found in subsections 18(4) through 18(6) of the Income Tax Act serve to limit the deductibility of interest by a Canadian Subsidiary Corporation where the Canadian subsidiary has a high level of debt owing to foreign shareholders (or a related non-resident) relative to the level of equity. The interest deduction is limited when the debt to equity ratio exceeds 2:1 (subject to the 2012 Federal Budget proposed amendments). If the debt exceeds the statutory limit, a corporation’s interest expense deduction is reduced based on the ratio of the excess debt amount over the corporation’s total interest bearing debt owed to specified non-residents.
It should be noted that there were proposed amendments to the thin capitalization rules in the 2012 Federal Budget released on March 29, 2012. The substantive amendments being proposed include: (i) the reduction of the operative debt-to-equity ratio from 2:1 to 1.5:1; (ii) extending the application of the thin capitalization rules to debts of partnerships of which a Canadian-resident corporation is a member; (iii) deeming interest expenses disallowed under the thin capitalization rules to be dividends for non-resident withholding tax purposes; and (iv) enacting certain relieving rules that will prevent double taxation from arising a “controlled foreign affiliate” of the corporation. Watch for a future blog on this site discussing in detail the proposed amendments to thin capitalization rules announced in the 2012 Federal Budget.
Not all interest bearing debt is subject to the thin capitalization rules. These provisions only apply to debt owing to a specified non-resident shareholder or non-resident persons who do not deal at arm’s-length with a specified non-resident shareholder. A specified non-resident shareholder is a non-resident person that, either alone or together with other non-arm’s length persons, owns shares that have 25% or more of the votes that could be cast, or 25% of the value of all the issued and outstanding capital stock of the Canadian debtor. Generally, bank loans, trade payables and non-interest bearing debt are not subject to the thin capitalization restrictions.
In the event a Canadian Subsidiary Corporation is utilized, the amount of debt injected into the Canadian subsidiary should be maximized to the applicable debt to equity ratio allowed by the thin capitalization rules. The interest payments paid by the Canadian subsidiary to the non-resident parent will be made using pre-tax dollars. While these interest payments will be subject to withholding tax, in most cases the rate is reduced to 10% by a Tax Treaty and in respect to US residents, the rate is 0%. To the extent that additional amounts need to be repatriated to the foreign jurisdiction, dividends could be paid which, in most cases, attract a lower withholding tax where reduced by a tax treaty.
It should be noted that we are members of the Law Society of the various provinces of Canada and, as such, we are only qualified to express our views and opinions, and we have confined our views and opinions, with respect to the laws of the various provinces of Canada and the federal laws of Canada applicable therein, and accordingly we have made no investigation of the laws of any other jurisdiction. We specifically note that we have not considered the laws, including tax laws, of any foreign jurisdiction. Accordingly, prior to proceeding with the Canadian operations, we strongly recommend that you obtain foreign legal and tax advice.
If you would like more information on establishing a business in Saskatchewan please contact the author of this posting, Crystal Taylor at (306) 667-5613 or firstname.lastname@example.org.
If you would like specific legal advice based on your particular circumstances, please contact one of the following lawyers at Miller Thomson LLP:
Calgary, National Leader
Joseph W. Yurkovich