The Canadian tax consequences of doing business in Canada are complex given the Canadian tax system and the breadth of laws that govern domestic and foreign enterprises. This summary highlights some of the tax issues to be considered in structuring a Canadian business.
Canadian corporate income taxes are levied by the federal and provincial governments. Federally, the Income Tax Act (Canada) (ITA) provides that every person resident in Canada in a taxation year is taxable on their worldwide income for the year. Subject to relief under an applicable bilateral income tax treaty, a non-resident person who
is employed in Canada;
carries on business in Canada; or
disposes of taxable Canadian property in a taxation year
is subject to tax in Canada on the resulting income.
Non-residents who receive certain forms of passive income (such as dividends, rents, royalties and management fees) from a Canadian resident may be subject to a withholding tax equal to 25 percent of the amount paid. Withholding tax can also apply to payments made between non-residents if the payments relate to a Canadian business or certain types of Canadian property.
Canada has entered into tax treaties with 88 countries which, among other things, restrict Canada’s ability to tax non-residents carrying on business in Canada and reduce or eliminate the rate of withholding tax otherwise applicable.
Carrying on Business
There is no “bright line” test for determining whether a non-resident is carrying on business in Canada. The ITA deems a non-resident to be carrying on business in Canada if the non-resident
produces or otherwise expends labour on anything in Canada;
solicits sales or offers anything for sale in Canada; or
disposes of certain real properties or resources properties situated in Canada.
A non-resident entitled to the benefits of a tax treaty will not be subject to Canadian income tax on its income from carrying on business in Canada unless that business is carried on through a permanent establishment. The definition of permanent establishment varies from treaty to treaty; however, generally it includes a place of business with a certain degree of permanence, such as a place of management, branch, office, factory, workshop or place of extraction of natural resources. A non-resident will also be deemed to have a permanent establishment in Canada if it carries on business through a dependent agent who has, and regularly exercises, the authority to enter into contracts in Canada on its behalf.
A non-resident can carry on business in Canada through a Canadian subsidiary, a fixed branch or a sales agent. The decision on structure is dependent on various considerations, including
the availability of financing;
Canadian and home country tax consequences; and
Non-residents entitled to relief under a tax treaty may wish to commence operations in Canada through an independent agent or a dependent agent with limited authority; this type of arrangement should not give rise to a permanent establishment.
A Canadian subsidiary will be subject to tax on its worldwide income. The after tax profits can be distributed to shareholders as dividends, a return of paid-up capital or a repayment of debt. Dividends will be subject to withholding tax, while paid-up capital can be returned to a non-resident shareholder on a tax-free basis.
Branch income is determined substantially in the same manner as for a subsidiary corporation with certain differences to account for the fact that a branch is not a separate legal entity. A branch’s after tax income will be subject to an annual 25 percent branch tax. Broadly, branch tax is payable on a branch’s profits which are repatriated to the non-resident corporation.
Interest on borrowed money used to earn income from a business is deductible in computing a branch or Canadian subsidiary’s Canadian taxable income. The ITA includes thin capitalization rules which will deny a deduction for interest on debts owing to specified non-resident persons if the subsidiary’s debt-to-equity ratio in relation to the specified non-residents exceeds 2:1. Branches are not subject to the thin capitalization rules.
Interest (other than participating debt interest) paid by a resident of Canada to a non-resident, arm’s-length lender is not subject to Canadian withholding tax. Interest paid by a Canadian resident to a non-arm’s-length resident of the United States is no longer subject to Canadian withholding tax.
A Canadian taxpayer that engages in a transaction with a non-arm’s-length non-resident must comply with the ITA’s transfer pricing rules. These rules follow OECD principles and generally require such transactions to occur at a price and on terms similar to those that would exist if the transaction were between arm’s-length parties. The ITA imposes a contemporaneous documentation obligation to support the transfer price used. Prices can be adjusted, transactions recharacterized and penalties imposed when the transfer price used is determined to be inappropriate.
A corporation that is either resident in Canada or carries on business in Canada is required to file a corporate tax return within six months after the end of its taxation year. In addition, every Canadian resident, or non-resident carrying on business in Canada, is required to annually report transactions with non-arm’s-length non-residents having a value in excess of CDN$1 million.
Non-residents who dispose of most kinds of taxable Canadian property must satisfy reporting obligations at the time of disposition to avoid a source deduction from the purchase proceeds. Such non-residents may also be required to file a Canadian income tax return.
Goods and Services Tax
The goods and services tax (GST) is a five percent value-added tax imposed under the Excise Tax Act (Canada) (ETA) on the supply of virtually all goods and services in Canada. GST paid by a recipient of a supply is collected and remitted by the supplier. Any GST paid in the course of commercial activities is recoverable through input tax credits, which are applied against GST collected.
Under the ETA, a supply of goods or services is subject to GST if it is made in Canada. GST also applies at the time the goods are imported into Canada. A supply of goods to a recipient in Canada who intends to immediately export the goods will not be subject to GST.
A Canadian subsidiary will generally be subject to GST in the ordinary course. A non-resident that is registered under the GST regime, or that makes or is deemed to make a taxable supply in Canada in the course of carrying on business in Canada, will be required to collect and remit GST in respect of its supplies.
Such non-resident suppliers are, as a result, generally required to register under the GST regime. For registration purposes, a non-resident may be required to post security if it does not have a permanent establishment in Canada.
Although the GST regime is relatively straightforward conceptually, it is quite complicated in practice, with various exceptions and subtleties.
Provincial and Harmonized Sales Taxes
In Nova Scotia, Newfoundland, New Brunswick, Ontario and British Columbia, the GST has been harmonized with a provincial sales tax component so that a single value-added harmonized sales tax (HST) is imposed on essentially the same tax base as GST. Québec imposes Québec sales tax at the rate of 7.5 percent on a similar (but not identical) tax base to that on which GST is imposed. Manitoba, Saskatchewan and Prince Edward Island impose sales taxes at varying rates. There is no provincial sales tax in Alberta.
Establishing or investing in a Canadian business can be a complex undertaking. Several federal and provincial tax considerations, including many that are not discussed in this brief overview, are relevant to non-residents.
Bennett Jones’ Tax Law Group
Bennett Jones has provided practical and effective advice to clients who are looking to establish or invest in a Canadian business. Our tax lawyers have acted in many of Canada’s largest and most innovative cross-border transactions. We have extensive experience providing tax advice in respect of commercial maters as well as tax litigation matters.
This summary has been prepared as a general overview of certain Canadian tax matters that may be relevant to establishing or investing in a business in Canada. It does not discuss all relevant Canadian tax considerations and therefore should not be regarded as exhaustive in subject matter or comprehensive in discussion. The law herein is stated as of December 31, 2010.