The Corporate Tax Planning Law Review: Canada
Canada is an attractive jurisdiction in which to carry on business because it has a skilled labour force, a stable economy and political system, and well-developed capital markets. From a taxation perspective, Canada has a comparatively low corporate tax rate, a wide treaty network, a sophisticated tax system, relatively generous provisions relating to financing costs and a partial exemption system relevant to many controlled foreign corporations (foreign affiliates) of Canadian multinationals that earn active business income.
Canada has a 'two-tiered' domestic system of corporate taxation whereby active business income earned by small business corporations is subject to preferential corporate tax rates, while larger corporations are subject to the general combined federal and provincial corporate tax rates. The rates applicable to larger corporations have remained relatively stable in recent years in the range of 26.5 per cent to 30 per cent depending on the provincial allocation of income.2
With respect to foreign affiliate taxation, Canada has a partial exemption system applicable to active business income earned by foreign affiliates that carry on business in countries with which Canada has a treaty or Tax Information Exchange Agreement (TIEA) in force; an accrual system of taxation applies in respect of passive investment income earned by controlled foreign affiliates under Canadian CFC rules.
In recent years, the Organisation for Economic Co-operation and Development (OECD) has become increasingly focused on preventing base erosion and profit shifting (BEPS) opportunities for multinational enterprises. Canada, as a member of the OECD, has participated in these initiatives and has recently ratified the Multilateral Instrument3 (MLI). While Canadian courts have generally been reluctant to deny the availability of treaty benefits under one of Canada's many bilateral tax treaties on the basis that the taxpayer engaged in 'treaty shopping,' it remains to be seen whether the MLI will have a material impact on the availability of treaty benefits under Canada's extensive treaty network.
i Entity selection and business operations
Business may be conducted in Canada through many different types of arrangements, although corporations and partnerships are probably the most common forms of business organisation. Many factors influence the ultimate decision about how to conduct a business, including the nature of the activity, industry practice, regulatory regime and tax treatment. The most common arrangements are described below.
In Canada, businesses of any significant size are conducted most commonly through corporations,4 which can be established under provincial, territorial or federal law. Consistent with the principle that a corporation has a legal personality separate from its shareholders, a corporation may own property, incur obligations and carry on business. Absent an agreement to guarantee the corporation's obligations, the shareholders' obligations are generally limited to the capital they have invested or, in certain circumstances, to the funds they have extracted from the corporation. A corporation must file certain information, including directors' names, on the public record, annually hold a shareholders' meeting and provide copies of its financial statements to the shareholders. Shareholders also have rights to certain additional information from the corporation upon request.
Corporations can be incorporated quickly in Canada, and without significant cost, once certain basic decisions are made, including identifying the terms of shares to be authorised, the directors and the corporate name, with the default being a numbered corporation. Consistent with the principle of limited liability, the name must include 'Limited', 'Incorporated', 'Corporation' or a corresponding abbreviation.
Generally, directors must be individuals. It is possible to appoint a corporation as a director in certain Canadian jurisdictions. While they need not be residents of Canada, some corporate statutes require a minimum percentage of Canadian-resident directors. Directors generally do not have to be shareholders.
Corporations may authorise and issue common shares only or shares in more than one class, with each class conferring on the shareholders different rights (e.g., dividends, votes, redemption, conversion, etc.).5 Corporations generally have no minimum capital requirements subject to any applicable regulatory regime (e.g., for financial institutions). Generally, shares cannot be issued until the subscription price is fully paid in money, property or past services, except in Nova Scotia where non-fully paid shares may be issued.
Corporations may be privately owned or offer their shares and other securities to the public. Securities offerings are regulated by securities commissions in each province (although policies are coordinated to facilitate compliance) and, if the securities are to be listed for trading on a public market, by that market. Both English and French are official languages in Canada, and offering documents delivered to residents of Quebec may have to be translated into French.
Public corporations must provide investors with annual audited financial statements, have an audit committee, and hold annual shareholders' meetings. Prior to the annual shareholders' meetings, these public corporations must send an information circular to their shareholders containing prescribed information, including information about the matters to be considered at the meeting and executive compensation.
The corporate law of three Canadian provinces6 also permit unlimited liability companies (ULCs) to be established. As the name suggests, shareholders of ULCs may be liable for the debts of the ULC. The principal advantage of a ULC is that it may be disregarded or treated as a partnership (i.e., a flow-through entity) under United States check-the-box regulations. However, ULCs are treated as corporations, and thus taxpayers, for Canadian tax purposes. Under the Canada–United States Income Tax Convention (1980), payments made by a ULC to US residents may not be eligible for reduced rates of withholding if the anti-hybrid rules in that treaty apply.7
Although further details are provided below, in general terms, Canadian-resident companies are taxed on worldwide income from all sources and must file returns annually. Generally, any corporation incorporated under Canadian law will be deemed to be a tax resident of Canada, subject to the 'tie-breaker' rules in an applicable tax treaty.
Partnerships are another common form of business arrangement, and are widely used in real estate, private equity and professional businesses. A partnership is generally described as a relationship between persons carrying on business in common with a view to profit. Partnerships may be general partnerships, limited partnerships or limited liability partnerships.
A general partnership is formed by contract, typically governed by the laws of a province, and has no separate legal personality. Each partner is wholly liable for all of the debts of the partnership.
A limited partnership is formed under the laws of a particular province on obtaining a certificate of limited partnership. Each limited partnership must have at least one general partner. General partners are responsible for managing the partnership activities and have unlimited liability for partnership obligations. A limited partner's liability is limited to its capital contribution (including any capital it agreed to contribute), unless a limited partner participates in the control of the partnership business, and, thus, assumes unlimited liability.
Limited liability partnerships share features of a limited partnership and a general partnership, but generally are available only to the business of a profession when permitted by the legislation governing such profession.
Partnerships are contractual relationships and, although not required for general partnerships, are typically governed by written partnership agreements. Accordingly, the members may agree to alter rights and obligations as between themselves. Partners have flexibility in providing for the sharing of profits, for the financing of the partnership activities and how those activities will be managed.
While a partnership is not a taxpayer, its income or loss from each source is generally computed as if it were a separate person, and each partner must include in its income its share of the partnership income or loss for the partnership fiscal year ending in the partner's taxation year. The partnership activities are considered to have been carried out by the partners for the purposes of identifying the source of the income, which may affect the rate of applicable tax.
Under special rules (SIFT rules), certain publicly traded partnerships that carry on business activities or earn certain types of income may be liable for tax on that income on the same basis as a public corporation. Any after-tax income of the partnership is treated as a dividend payable to the partners.
Generally, limited partners are permitted to deduct their share of a partnership loss only to the extent their partnership investment is 'at risk'. Any losses denied may generally be carried forward to future years for deduction when the partner's investment becomes 'at risk'.
Non-resident partners may be obligated to file a Canadian tax return and pay Canadian income tax on their share of the partnership business income. A partnership with non-resident partners will be subject to withholding tax on certain payments it receives (e.g., dividends, royalties), but a resident partner's share of such withholding taxes will be credited against its income tax payable for the year.
Statutory rules generally prevent the deferral of partnership income through selection of partnership fiscal periods ending after the partner's taxation year-end and tiering of partnerships with different fiscal periods.
Business activities are also sometimes carried on through trusts, most commonly in the real estate and resource industries. Trusts are taxable entities, but may reduce their income by distributing it annually to the beneficiaries, who are then taxed on their share of the distributed income. Unlike a partnership, however, a trust cannot flow any losses through to its beneficiaries, and, with limited exceptions, the source of the income to the beneficiary is income from a trust rather than income of the source (character) earned by the trust. The SIFT rules may apply to certain trusts that carry on business or earn certain types of income. However, REITs that meet certain conditions are exempt from the SIFT rules.
Canadian permanent establishment (PE)
A non-resident corporation may carry on business directly in Canada through a branch (PE). A PE is not a separate entity from its foreign 'parent'. A foreign corporation that carries on business in Canada generally must register in each of the provinces in which the business is carried on and must designate an agent for service in that province.
Non-resident corporations that carry on business in Canada are subject to tax (including branch tax) on the income from such business (subject to treaty relief ) and must file Canadian tax returns reporting their income for the year and other amounts.
Pension plans are a significant source of institutional capital in Canada. A pension plan can be established as a trust or a corporation. Canadian pension plans are subject to federal or provincial pension benefits legislation which, among other things, restricts a pension plan from making certain investments.
For example, Canada's federal pension benefits statute prohibits a pension plan from investing its money in the securities of a corporation carrying 30 per cent or more of the votes that may be cast to elect the board of directors of the corporation. This '30 per cent rule' does not apply to 'investment corporations', 'real estate corporations' or 'resource corporations', each of which is defined in the pension benefits legislation and is subject to certain restrictions on its activities and capital structure. In addition, investments by pension plans can be structured to comply with the 30 per cent rule while nonetheless permitting a pension plan to maintain a significant equity interest in a corporation.
Pension plans are generally exempt from Canadian income tax. To qualify for tax-exempt status, a pension plan must qualify as a 'registered pension plan' for Canadian tax purposes, which requires the plan to register with the Canada Revenue Agency (CRA) and meet certain statutory requirements.
A subsidiary of a registered pension plan may also qualify for tax-exempt status, provided that it is a 'pension corporation' for Canadian tax purposes. Generally speaking, a corporation that qualifies as an investment corporation, real estate corporation or resource corporation under the pension benefits legislation should qualify as a pension corporation for income tax purposes. However, there are some subtle nuances between the applicable tests under the pension benefits legislation and the Income Tax Act that should be considered when seeking to obtain tax-exempt status in respect of an investment corporation, real estate corporation or resource corporation.
ii Domestic income tax
Determination of taxable profit
Canadian-resident corporations are taxed on their worldwide income from all sources, including business, property and capital gains. Income from business or property is the profit from such activities calculated in accordance with 'well accepted principles of business (or accounting) practice,' adjusted as permitted or required by the tax legislation. As a practical matter, most corporations start with their accounting profits as determined under generally accepted accounting principles (GAAP), although those principles are not determinative.
The tax legislation mandates certain adjustments. For example, the rates at which assets are depreciated for accounting purposes will generally differ from the rates at which capital cost allowance (tax depreciation) may be deducted in computing income for tax purposes.
Corporations may choose any taxation year-end, but no taxation year can exceed 53 weeks. Moreover, once selected, a corporation's taxation year-end cannot be changed unless the CRA agrees. However, certain events will result in a deemed taxation year-end (e.g., an acquisition of control) following which a different taxation year-end may be selected.
Some of the most common adjustments to accounting profits to compute income for tax purposes are described below.
To be deductible for tax purposes, an expense must be incurred for the purpose of earning income, reasonable, not on account of capital (except to the extent expressly permitted) and not contingent.
Certain expenses that might satisfy those tests nonetheless may be prohibited from being deducted. For example, no deduction is permitted in respect of stock option benefits conferred on employees. Business entertainment expenses are only partially deductible. Costs related to vacant land held for development generally must be capitalised. On the other hand, certain expenses that might be considered capital expenditures are deductible (albeit over time), including costs incurred to issue shares or borrow money.
In addition, in the context of non-arm's-length transactions, an amount deducted in respect of an outlay or expense must be paid by the end of the second taxation year following the taxation year in which the deduction was made. Otherwise, the amount of the expense is added back to the taxpayer's income.
Depreciation (capital cost allowance (CCA))
Depreciation taken in computing accounting profits must be added to income for tax purposes. Canada has a CCA system for depreciating assets such as buildings, machinery and equipment; properties of a similar nature are typically included in the same pool for CCA purposes. With few exceptions, CCA may be claimed in respect of property on a declining balance basis at rates that range from 4 to 100 per cent.
CCA is recaptured in income if a depreciated asset is disposed of for an amount in excess of the balance of the CCA pool to which it belongs. A deductible loss arises if the last asset in the pool is disposed of and an undeducted pool balance remains.
Capital gains and income
Capital gains may arise on the disposition of capital property (including depreciable property, where the proceeds exceed the original cost). Only 50 per cent of a capital gain (a taxable capital gain) is included in income. Capital losses may be realised on the disposition of non-depreciable capital property, and 50 per cent of such a loss (allowable capital loss) is deductible, but only against taxable capital gains.
Private corporations add the untaxed half (net of 50 per cent of any capital losses) to a special account (capital dividend account), the balance of which may be paid to its Canadian-resident shareholders as a tax-free dividend. In addition, taxable capital gains realised by a Canadian-controlled private corporation (CCPC) are included in investment income, which is subject to a special higher rate of tax that is refundable if and when the CCPC pays dividends.
Losses are generally categorised as net capital losses or non-capital losses.8 Net capital losses (being one-half of a capital loss not deducted in the year realised) generally may be carried back for three taxation years and carried forward indefinitely, but are only deductible against taxable capital gains realised in those years.
Non-capital losses generally may be carried back for three taxation years and may be carried forward for up to 20 taxation years. Non-capital losses generally may be deducted against taxable capital gains or income from other sources.
Income tax is imposed by both the federal government and the provinces in which a business has a PE. The combined federal and provincial rate on business income ranges from approximately 26.5 to 31 per cent. A CCPC enjoys a preferential tax rate of approximately 9 to 15 per cent (depending on the relevant province or provinces) on active business income less than a specified threshold (generally C$500,000).9 While CCPCs are also liable for a higher rate of tax on investment income (50.2 to 54.7 per cent), a portion of that tax is refunded if and when dividends are paid by the CCPC.
As previously discussed, a corporation is a separate taxpayer from its shareholders for Canadian tax purposes. However, when a corporation pays a dividend to a Canadian-resident shareholder, the rate of tax payable on such dividend is reduced to account for the tax paid by the corporation. This system of integration seeks to ensure that the combined rate of tax payable at the corporate and shareholder levels is approximately equal to the shareholder's personal marginal tax rate.
Tax returns for corporations
Canada has a self-assessment system of taxation. Although each of the provinces assesses provincial income taxes, the federal government administers the provincial income taxes on behalf of most provinces. A corporation must file an income tax return for each taxation year, and such return is due within six months after the corporation's taxation year-end. Most corporations with gross revenue in excess of C$1 million must file their returns electronically.
The typical taxation year is 12 months, but a corporation is deemed to have a taxation year-end immediately before an amalgamation, an acquisition of control of the corporation, or the corporation ceasing to qualify as, or becoming, a CCPC.
Corporations must pay monthly instalments on account of income taxes (quarterly for small CCPCs), and must pay the balance due by the end of the second month following the taxation year-end (third month for small CCPCs). While not all corporate taxpayers are audited, any taxpayer may be selected for audit. Large corporations rated as high risk by the CRA (based on industry, record, etc.) typically are audited annually.
The normal period for reassessing a corporation is four years (three years for CCPCs) after the initial assessment of taxes, but longer periods are permitted for certain types of income, if misrepresentations are made, for transactions with non-arm's-length non-residents, and to accommodate loss carry-backs and similar adjustments. A corporation that disagrees with an assessment or reassessment may object (generally within 90 days). If the objection is upheld, the taxpayer may take the dispute to the Tax Court of Canada, from which an appeal to the Federal Court of Appeal is available, as of right. Thereafter, the appeal may be heard (with leave) by the Supreme Court of Canada.
The CRA has a number of well-established published administrative practices that generally may be relied on by the public. Taxpayers can seek an advance tax ruling from the CRA addressing the tax consequences of proposed transactions. While these rulings are administrative and do not have the force of law, as a practical matter the CRA considers itself bound by its rulings.
Tax clearance and rulings
Tax clearance certificates are required where a non-resident disposes of taxable Canadian property. In the absence of this certificate, the purchaser is obligated to withhold a portion of the purchase price of the property and remit it on the non-resident's behalf. In general terms, taxable Canadian property is now limited to Canadian-situated real property (including mineral resource properties, oil and gas properties, and timber limits) and shares and partnership or trust interests that, at any time in the 60-month period preceding the disposition, derived more than 50 per cent of their value from such property.
In certain cases, an applicable bilateral income tax treaty may provide relief from taxation. In addition to obtaining a clearance certificate, a non-resident that disposes of taxable Canadian property must file a Canadian income tax return reporting the disposition.
Tax clearance certificates are not generally otherwise required, but may be advisable before assets are distributed to shareholders or trust beneficiaries. Failure to do so may result in those who make the distribution being liable for unpaid taxes to the extent of the value of the assets distributed.
The CRA will provide advance income tax rulings on particular tax issues to named taxpayers who apply for a ruling in advance of the relevant transaction. These rulings are considered binding on the CRA with respect to the taxpayer that makes the application.
iii International tax
A corporation will be deemed resident in Canada if it is incorporated in a Canadian jurisdiction. However, a corporation incorporated outside Canada may be resident in Canada if its central management and control is exercised in Canada. Central management and control is generally exercised where the board of directors has its meetings. Tiebreaker rules in Canada's treaties may determine in which of two jurisdictions a corporation is resident if it is otherwise unclear. For example, under the Canada–United States Income Tax Convention (1980), a corporation otherwise resident in both Canada and the United States will be deemed resident in its jurisdiction of incorporation; otherwise the competent authorities must decide. Under the Canada–United Kingdom Income Tax Convention, the competent authorities must decide in all cases. Other treaties may default to the place of effective management and control of the corporation.
Branch or permanent establishment
Under Canada's tax legislation, a non-resident that carries on business in Canada will be liable to pay Canadian income tax on its taxable income earned in Canada regardless of whether it has a PE in Canada. Certain activities are deemed to constitute carrying on business in Canada (including soliciting orders or offering anything for sale in Canada regardless of where the contract is completed). However, in most of its treaties, Canada has generally agreed not to impose tax on business income except where the non-resident carries on business through a PE in Canada.
As a proxy for dividend withholding tax, Canada imposes a 25 per cent branch profits tax on non-residents that carry on business through a PE to the extent branch profits are not reinvested in the branch business. The rate is generally reduced to 5 per cent under Canada's treaties, and some treaties provide for a partial exemption (e.g., under the Canada–United States Income Tax Convention (1980), the first C$500,000 of branch profits is exempt).
Tax incentives, special regimes and relief that may encourage inbound investment
Both the federal government and provincial governments provide targeted incentives for particular business activities. These may take the form of tax credits, forgivable loans, tax holidays, subsidies or accelerated write-offs for qualifying expenditures (e.g., renewable energy). Corporations in the oil and gas, mining and renewable energy industries are permitted to renounce certain deductible expenses to shareholders who subscribe for 'flow-through shares' to fund corporate expenditures, permitting the shareholders to deduct the expenses rather than the corporation. There are relatively generous incentives for expenditures on 'scientific research and experimental development' in the form of immediate deductions for qualifying expenditures and investment tax credits.
Holding company regimes
Dividends are typically tax-free when paid from one Canadian corporation to another.10 Although dividends paid to non-residents are subject to withholding tax at the statutory rate of 25 per cent, many bilateral tax treaties reduce the rate of withholding to 5 per cent for significant corporate shareholders. Moreover, capital may be returned to shareholders as a legal reduction in capital free of Canadian withholding tax regardless of whether the paying corporation has significant retained earnings (see below).
Dividends received by Canadian corporations from non-resident corporations are included in income, subject to foreign tax credits and certain deductions available for intercorporate dividends under the Canadian foreign affiliate rules.
Although complex, the foreign affiliate rules exempt from Canadian tax dividends paid by a foreign affiliate to a Canadian corporation if the foreign affiliate has earnings from an active business carried on by it in a country with which Canada has a tax treaty or tax information exchange agreement (TIEA). Certain 'passive income' arising from inter-affiliate payments may be deemed active business income for this purpose.
On the other hand, under this regime, Canadian residents are required to include, on an accrual basis, their share of any foreign accrual property income (FAPI) earned by a controlled foreign affiliate (CFA). FAPI includes passive income, but also is deemed to include income from certain businesses that derive income from property (e.g., rents, royalties, interest, dividends and licence fees).
Canada has foreign affiliate dumping (FAD) rules that make it less attractive for foreign multinationals to establish a Canadian holding corporation for non-Canadian foreign affiliates. In general terms, an investment by a Canadian corporation that is controlled by a non-resident corporation, non-resident individual, non-resident trust or non-arm's length group of such taxpayers, in a foreign affiliate (or a Canadian corporation that derives more than 75 per cent of its value from foreign affiliates) may reduce cross-border paid-up capital or trigger a deemed dividend subject to withholding tax, subject to limited exceptions.
While Canada does not have a special IP regime, tax incentives in the form of tax credits or write-offs may be available for development of IP in Canada.
iv Capitalisation requirements and funding structure considerations
Canadian corporations are typically funded by a combination of debt and equity (including common and preferred shares). Preferred share dividends may result in the issuer of these shares being liable to a special tax (partially creditable against ordinary income tax) where the preferred shareholder does not have a significant interest in the dividend payer. This special tax is intended to discourage corporations that are not in a tax-paying position from using preferred share financing in lieu of debt financing.
Canada restricts the deduction of interest on debt held by 'specified non-residents' (i.e., non-resident shareholders, or non-resident persons who do not deal at arm's length with shareholders who, alone or together with non-arm's-length persons, own shares representing at least 25 per cent of the votes or value of the corporation). In general terms, interest on debt held by specified non-residents will not be deductible to the extent that the debt11 exceeds 1.5 times the relevant 'equity factors.'
Equity includes the corporation's non-consolidated retained earnings at the beginning of the taxation year, and its monthly average paid-up capital attributable to shares held by, and its monthly average contributed surplus contributed by, specified non-resident shareholders.12 Because only paid-up capital and contributed surplus attributable to direct shareholders is included in equity, debt is typically advanced by specified non-residents to the first-tier Canadian corporation rather than a corporation further down the corporate chain (see discussion below regarding potential reductions to paid-up capital).
In recent years, Canada has extended the thin capitalisation rules, with modifications, to debt of partnerships, trusts and branches of non-resident corporations.
Any interest that is not deductible because of these rules will generally be treated as a dividend paid to the specified non-resident for withholding tax purposes.
Back-to-back (B2B) loan rules target circumstances in which an intermediary that deals at arm's length with a Canadian borrower is funded (or given security interests in respect of property to support the loan) by a non-resident (ultimate funder) with whom the borrower does not deal at arm's length. These rules are intended to prevent arrangements that are perceived as circumventing the thin capitalisation and withholding tax rules. Where they apply, their general effect is to treat the loan, for withholding tax and thin capitalisation purposes, as if it were made directly to the borrower by the ultimate funder.
Deduction of finance costs
Financing costs are typically considered to be on capital account and, therefore, not deductible except to the extent expressly permitted. Like other expenses, they are also deductible only to the extent they are incurred for the purpose of earning income, reasonable and not contingent.
Financing costs (such as commitment fees, investment banker fees, underwriting fees, placement fees) related to the issuance of shares or debt typically are deductible on a straight-line basis over five taxation years, subject to proration for short taxation years.
Interest is deductible only to the extent it is payable in respect of money borrowed, or in respect of an amount payable for property acquired, for the purpose of earning income. Interest borrowed to acquire common shares typically would meet this test. Where a Canadian corporation borrows money to acquire another Canadian corporation and the two corporations merge, the interest generally will be deductible against the earnings of the merged corporation.
Subject to the thin capitalisation rules, simple interest is deductible on an accrual basis, but compound interest is deductible only when paid. Prepayment penalties related to early retirement of debt are typically treated as interest and are deductible over the remaining term of the debt rather than in the year paid.
Restrictions on payments
Dividends must be declared by directors and generally may be paid only to the extent that the directors are satisfied that the corporation will meet the relevant solvency test in the governing corporate statute. Although there are variations among the corporate statutes, a common solvency test is that the corporation must, after paying the dividend, be able to pay its liabilities as they become due and have assets with a realisable value not less than the sum of its liabilities and the stated capital of its shares.
Return of capital
Corporations may distribute paid-up capital to shareholders as a return of legal stated capital regardless of whether the corporation has undistributed income. A distribution of capital by a private corporation will not be taxable but will reduce the shareholder's tax cost of the shares. A gain will arise only if the tax cost is reduced below zero as a result.
A distribution of capital by a public corporation will be treated as a taxable dividend absent an applicable exception. Exceptions include distributions of capital occurring on a reorganisation of capital or the business, or distributions following, and funded from the proceeds of, a disposition of assets outside the ordinary course of the business.
Distributions of capital usually require shareholder approval and the satisfaction of solvency tests contained in the corporate statute governing the corporation.
v Common ownership: group structures and intercompany transactions
Ownership structure of related parties
Canada does not accommodate consolidated income tax returns, and, thus, each taxpayer must compute its own income (or loss). However, closely connected corporations must share certain tax benefits (e.g., the C$500,000 low-rate income threshold for a CCPC must be shared among associated CCPCs).
Following a study of a formal loss transfer system or consolidated tax reporting regime for corporate groups, the government announced that moving forward with a formal system is not a priority. While loss trading is generally precluded, well-accepted techniques may be used to move losses within an affiliated corporate group. That being said, in certain circumstances, anti-avoidance rules may prevent the transfer of losses from a lower-tier partnership to an upper-tier partnership.
Controlled foreign affiliates
As discussed above, shareholders of a CFA must include in income, on an accrual basis, their share of FAPI earned by the CFA. Otherwise, income earned by a foreign affiliate generally is not taxed in Canada unless repatriated to Canada.
Domestic intercompany transactions
While Canada does not have a comprehensive domestic transfer pricing rule, the consideration paid in respect of a non-arm's-length transfer of property may be adjusted to equal the fair market value of the transferred property. In some circumstances, the adjustments are one-sided such that an expense may be reduced (or receipt may be increased) without an adjustment to the income of the recipient (payer) of the amount. Unlike transactions subject to Canada's transfer pricing rules (see below), contemporaneous documentation is not required for purely domestic transactions.
In addition, certain anti-avoidance rules prevent taxpayers from generating losses in non-arm's-length scenarios. For example, any loss arising on a transfer of capital property between affiliated persons is denied, but is reflected in the cost base of the property to the acquirer such that the denied loss can be realised if and when the property is transferred outside the affiliated group.
International intercompany transactions
Canada's transfer pricing rules apply to transactions between Canadian residents (or non-residents carrying on business in Canada) and non-residents with whom they do not deal at arm's length. The rules generally follow the OECD standards. Their objective is to preserve the Canadian tax base by ensuring that Canadian taxpayers do not inappropriately reduce income (and thus tax liability) through advantageous or disadvantageous pricing with non-arm's-length persons.
These provisions permit the CRA to make adjustments to any amounts relevant to taxation of the Canadian resident where the terms and conditions of the transaction differ from those that would have been agreed to by arm's-length persons. The Canadian resident has contemporaneous documentation obligations, and failure to meet these obligations may result in the imposition of penalties.
Recent legislative amendments provide that Canada's transfer pricing rules take precedence over certain specific anti-avoidance rules, such as the thin capitalisation rules.
Withholding on outbound payments (domestic law)
Canada imposes withholding tax at a statutory rate 25 per cent rate on most types of passive income paid to non-residents, including dividends, management fees, rents, royalties, trust and estate distributions, and payments for restrictive covenants (e.g., non-competition covenants). This rate of withholding may be reduced under an applicable bilateral income tax treaty.
Domestic law exclusions or exemptions from withholding on outbound payments
Canada generally does not impose withholding tax on interest paid to non-residents who deal at arm's length with the Canadian-resident payer unless the interest is 'participating debt interest' (i.e., interest computed with reference to revenue, cash flow, dividends, profits, commodity price or production from property). Interest that is not deductible pursuant to thin capitalisation rules is recharacterised as a dividend for withholding tax purposes. (See above for a general discussion of the back-to-back loan rules and their impact on withholding tax.)
Dividends received from controlled foreign affiliates
Canada's system for taxation of dividends received from foreign affiliates operates largely as an exemption system. In this regard, active business income earned by a foreign affiliate in a country with which Canada has a tax treaty or TIEA may be repatriated to its Canadian corporate shareholders as a dividend without any further Canadian tax.
vi Third-party transactions
Sales of shares or assets for cash
Generally speaking, a sale of shares or assets for cash is a taxable event for Canadian tax purposes, subject to the loss restriction rules discussed above which may apply in respect of non-arm's-length transactions. Accordingly, a capital gain or loss is typically realised in respect of a disposition of shares or assets that are capital property for cash. Moreover, a taxpayer will realise a capital gain in respect of an otherwise tax-deferred transaction described below to the extent that they receive a portion of the proceeds in the form of cash consideration. Thus, a taxpayer may have the flexibility to realise part of an accrued capital gain on an asset or share sale by, for example, electing to receive a portion of the sale proceeds in cash and the remainder in shares.
Assets typically can be moved between Canadian corporations or into Canadian partnerships on a tax-deferred basis if the transferee issues equity to the transferor and a tax-deferral election is made. Similarly, shares of one foreign affiliate may generally be transferred on a tax-deferred basis to another foreign affiliate in exchange for shares of the acquiring affiliate.
Corporations can be 'merged' on a tax-deferred basis in Canada through an amalgamation, provided both are taxable Canadian corporations. Amalgamations generally require the corporations to be governed by the same corporate statute (e.g., the same provincial statute or the federal statute). However, it is not difficult to continue a corporation from one Canadian jurisdiction to another with shareholder approval.
Spin-off transactions can be effected on a taxable or tax-deferred basis, although in the latter case extensive conditions must be satisfied and restrictions may be placed on the corporation that spins off the assets as well as the corporation that is the subject of the spin-off.
It is also possible to carry out a winding-up on a tax-deferred basis, but only in respect of a winding-up of a wholly-owned subsidiary into its parent corporation.
Availability of tax attributes
As a general matter, where an acquirer purchases property pursuant to a tax-deferred transaction, the acquirer obtains the existing tax attributes of the acquired property. However, this general rule is subject to several complex anti-avoidance rules that reduce the tax attributes of acquired property in various circumstances.
Where two corporations 'merge' by way of amalgamation, the tax attributes of the two merging corporations are generally carried over to the merged corporation, subject to there not being an acquisition of control of either merging corporation.13
Where an acquisition of control has occurred, the acquired corporation has a deemed taxation year-end immediately prior to the acquisition of control and accrued losses on most assets are deemed realised in that year. Thereafter, the utilisation of losses is restricted. Net capital losses, as well as any non-capital losses incurred in the course of earning income from property (rather than from a business), will expire unless used in the taxation year ending immediately prior to the acquisition of control. Non-capital losses incurred in the course of carrying on a business may be carried forward for deduction in subsequent taxation years only if the loss business is carried on for profit or with a reasonable expectation of profit throughout the taxation year in which the loss is to be deducted. In such a case, the loss is deductible against income (but not taxable capital gains) from the loss business or certain 'similar' businesses. Similar rules apply to the carry-back of losses from post-acquisition of control taxation years to pre-acquisition of control taxation years.
In the taxation year ending immediately prior to an acquisition of control, a corporation may elect to 'step up' the tax cost of capital property (including depreciable property) it owns to fair market value by deeming a disposition of such property for the amount it designates (not in excess of fair market value), thereby generating income or taxable capital gains against which the pre-acquisition of control losses may be deducted.
There are similar rules relating to trusts – the loss restriction event rules being tied to changes in beneficiaries.
Though only applicable in a non-arm's length context, on a winding-up of a wholly-owned subsidiary into its parent corporation, the parent corporation may be able to 'step-up' the cost base of certain non-depreciable property acquired from the subsidiary on the winding-up.
Acquisitions of Canadian corporations by non-residents
Typically, but not universally, a Canadian corporation will be established to acquire a Canadian target. This approach facilitates the deduction of interest expense associated with the acquisition financing against the target's earnings through a post-acquisition merger of the acquirer and target. Secondly, a non-resident acquirer typically wants to establish cross-border paid-up capital to maximise the opportunity to repatriate funds free of Canadian withholding tax. Finally, in certain circumstances, the acquirer will be able to 'bump' the tax cost of the target's non-depreciable capital property to fair market value. This may facilitate a sale, or a distribution to the foreign parent, of the asset free of Canadian tax.
On the other hand, paid-up capital may be reduced where a Canadian-resident corporation controlled by a non-resident corporation uses capital, retained earnings or borrowed funds to make an investment in a foreign affiliate (or in a Canadian corporation that derives 75 per cent or more of its value from foreign affiliates) under Canada's FAD rules. If the investment in the foreign affiliate exceeds the paid-up capital, the excess may be deemed a dividend paid to the non-resident controller.
Continuing into Canada
Corporations that are established outside Canada and continue into Canada generally will enjoy a 'step up' in the cost of their assets, generally to fair market value, and generally thereafter will be treated as if they had been incorporated in Canada.
Provided that the governing corporate law permits it, corporations may continue from one jurisdiction to another. A Canadian corporation that emigrates to a jurisdiction outside Canada and ceases to be resident in Canada for tax purposes generally will be considered to have disposed of all of its assets for fair market value proceeds, and to have realised any resulting income or losses in the taxation year that is deemed to end immediately before it emigrates. In addition, the corporation will be liable for a special departure tax, analogous to a dividend withholding tax, levied at 25 per cent on the corporation's surplus (subject to reduction to an applicable treaty rate). The tax is applied to the difference between the fair market value of the corporation's assets and the total of the paid-up capital of its shares and its debt or other amounts payable outstanding at that time.
vii Indirect taxes
Taxes on goods and services
Canada has a federal goods and services tax (GST) – a value added tax – levied at a rate of 5 per cent. Although the GST is imposed widely, input tax credits are intended to ensure that intermediaries receive a credit for the GST they pay so that the GST is borne only by the final user in the supply chain. Most provinces have adopted a harmonised sales tax (HST) based on the GST, administered for those provinces (other than Quebec, which has its own tax administration) by the federal government.
Of the non-participating provinces, Alberta does not impose a sales tax, and each of British Columbia, Manitoba and Saskatchewan levy and administer their own retail sales tax.
Property imported into Canada may be subject to customs or excise duties as well as GST and HST, although Canada is party to several free trade agreements.
Many provinces (and some municipalities) levy a separate tax on the transfer of land within the province (or municipality). Municipalities typically levy annual property taxes on owners of real property, based on the assessed value of commercial and residential real property.
Personal income tax and social security contributions
Personal income tax rates imposed by provinces and the federal government are higher than corporate rates. The rates are progressive, increasing as income levels rise, but individuals with very low income may pay little or no income tax. The highest combined personal income tax rates in Canada are approximately 54 per cent.
Employers are required to deduct tax at the source from remuneration paid to employees and remit the tax on behalf of the employee. In addition to federal and provincial income tax, individuals and their employers are required to make contributions to the federal public pension and employment insurance programmes. Employers are subject to provincial payroll and social security levies that vary among the provinces.
International developments and local responses
i OECD-G20 BEPS initiative
In 2019, Canada ratified the MLI. Canada initially chose to adopt the minimum standards in the MLI plus a binding arbitration provision for treaty disputes, stating that Canada has accepted the principal purpose test as an interim measure regarding treaty abuse but will consider limitation of benefits provisions in its treaty negotiations.
Canada announced the adoption of the following additional provisions in 2019: (1) a one-year holding period test for shares to benefit from treaty-reduced rates for dividends; (2) a one-year lookback test in determining whether shares derive their value principally from immovable property; and (3) the use of certain factors by competent authorities to resolving dual residency. As a result, certain provisions of the MLI came into force for covered tax agreements in January 2020.
ii EU proposals on taxation of the digital economy
As a member of the OECD, Canada is involved in the multilateral process to develop international standards for the taxation of digital services. However, the government indicated in its 2019 re-election platform that it plans to introduce a new federal digital services tax. The province of Quebec has already enacted legislation requiring certain non-resident suppliers and digital platforms to collect sales tax on taxable supplies made to Quebec consumers.
iii Tax treaties
Canada's extensive treaty network consists of more than 90 treaties that typically reduce the rate of withholding tax on passive income. Generally speaking, Canada's tax treaties follow the OECD Model Tax Convention on Income and Capital.
Dividend withholding is typically reduced to 15 per cent (5 per cent where the shareholder is a corporation with a significant investment in the dividend payer), and rent (other than from real property), royalty and trust distributions generally enjoy a 15 per cent rate. Some treaties eliminate withholding on particular types of royalties, and most treat management fees as business profits governed by the PE article. Where the domestic exemption from withholding tax does not apply, Canada's treaties typically reduce the rate of withholding on interest to 10 per cent.
Canada continues to expand its network of TIEAs and negotiate changes to its existing treaties and additional treaties.
iv Covid-19 pandemic
In response to the covid-19 pandemic, the Canadian government announced significant fiscal measures in an effort to mitigate the economic impact of the pandemic on Canadian individuals and businesses. The measures targeting Canadian businesses include the provision of interest-free loans and interest-bearing loans with favourable repayment terms by the Business Development Bank of Canada, a Crown corporation whose mandate involves providing capital and advisory services to small and medium-sized Canadian businesses. The Canadian government also announced that it would defer Canadians' tax filing and remittance obligations and provide temporary wage subsidies for businesses.
Under the temporary wage subsidy programme, the Canadian government will provide a subsidy to all Canadian employers (regardless of size) whose gross revenue decreased by 30 per cent or more in March, April or May 2020.14 The wage subsidy will run for a period of 12 weeks and will be equal to 75 per cent of an employee's wages, up to a maximum of C$847 per week.15 CCPCs that meet certain criteria but do not qualify for the 75 per cent wage subsidy will qualify for a 10 per cent wage subsidy, up to a limit of C$1,375 per employee and C$25,000 per employer.
MacDonald v. The Queen16
Under Canadian tax law, the characterisation of a derivative contract is determined based on its purpose. If a derivative is used to 'hedge' a taxpayer's risk exposure with respect to a capital asset, any gains or losses realised in respect of such derivative will generally be on capital account. Conversely, where a derivative is entered into for speculative purposes, the gains and losses from the derivative will generally be realised on income account.
In MacDonald v. The Queen, the Supreme Court of Canada held that the purpose of a derivative contract is to be determined by reference to the 'linkage' between the derivative contract and the hedged asset, liability or transaction. In determining whether sufficient linkage existed on the facts, the Court focused on the economic effect of the purported hedge and placed considerably less weight on the taxpayer's stated intention. As the taxpayer was economically hedged in MacDonald, the Court decided that the purpose of the derivative contract was to hedge notwithstanding the taxpayer's stated intention to speculate. While the notion that a taxpayer's stated intention must be supported by objective manifestations of the intention is uncontroversial as a matter of Canadian tax law, the Supreme Court of Canada's approach in MacDonald is novel in its heavy reliance on the underlying economics of a transaction in making this determination.
i Perceived abuses
The Queen v. Alta Energy Luxembourg SARL17
In Alta Energy, the Federal Court of Appeal was tasked with interpreting Canada's domestic general anti-avoidance rule (GAAR) in the context of a fairly straightforward instance of treaty shopping. Shares in a Canadian-resident operating corporation were initially held by an US LLC, but, pursuant to a reorganisation, these shares were transferred to a Luxembourg SARL (the taxpayer). The shares of the taxpayer were in turn held by a partnership the partners of which were the shareholders of the US LLC. The Canadian-resident operating company was subsequently sold and a large capital gain was realised.
Pursuant to an exemption provided in the bilateral tax treaty between Canada and Luxembourg (the Canada–Luxembourg treaty), Canada was not entitled to tax the capital gain.18 The taxpayer paid variable interest on a loan to the partnership that caused it not to pay any Luxembourg tax in respect of the gain. But for the reorganisation, Canada would have been entitled to tax the gain under the provisions of the Canada–United States Income Tax Convention (1980).
The CRA reassessed the taxpayer on the basis that the GAAR applied to deny the tax benefit achieved by interposing the taxpayer between the Canadian operating company and its US-resident investors. In order for the GAAR to apply in respect of one of Canada's bilateral tax treaties, a transaction or series of transactions must: (1) result in a tax benefit; (2) involve one or more 'avoidance transactions'; and (3) constitute an abuse of the provisions of the treaty. At issue in Alta Energy was whether an abuse of the Canada–Luxembourg treaty occurred.
The Crown advanced three arguments in support of its position that the taxpayer had abused the Canada–Luxembourg treaty. First, the Crown argued that a Luxembourg resident must invest amounts in a Canadian company in order to qualify for the exemption. Second, the Crown argued that the exemption was not intended to benefit entities that do not have the potential to realise income in Luxembourg, such as the taxpayer due to its variable rate loan. Third, the Crown argued that the exemption was not intended to benefit entities that do not have any commercial or economic ties to Luxembourg. The Court rejected each of these arguments on the basis that the Canada–Luxembourg treaty simply states that the exemption is available to a 'resident' of Luxembourg, and there was no basis upon which to conclude that the rationale underlying the definition of 'resident' for purposes of the Canada–Luxembourg treaty should be extended to include any of the additional conditions proposed by the Crown. The Court held that the provisions spoke for themselves, and their rationale could be found in their text.
Although the Alta Energy decision is a welcome affirmation of prior case law that questioned whether the GAAR applied to 'treaty shopping' transactions, the MLI was not relevant to the years of issue. The impact of the MLI on cases with similar facts to Alta Energy is uncertain.
ii Recent successful tax-efficient transactions
Encana, one of the largest Canadian energy companies with Canadian roots going back to the 19th century, announced on 24 January 2020 that it had completed a reorganisation to redomicile in the US. This is the highest profile 'inversion' transaction undertaken by a Canadian corporation to date.
The US domestication was effected by way of a reorganisation carried out under a plan of arrangement. The crux of the reorganisation entailed the following steps. First, Encana distributed to its shareholders a fraction of a share of a newly formed Canadian subsidiary (Ovintiv) in respect of each common share of Encana issued and outstanding. These fractional shares had nominal value. Subsequently, Ovintiv issued shares to Encana's shareholders in exchange for all of the issued and outstanding shares of Encana. Encana then transferred shares in its US subsidiary (Alenco Inc) to Ovintiv, partly as proceeds of a share redemption and partly in consideration for Ovintiv assuming certain debts of Encana. Lastly, Ovintiv contributed the Encana shares to a newly formed Canadian subsidiary, and Ovintiv continued to Delaware.
The reorganisation was carried out on a tax-deferred basis for Encana's Canadian shareholders as a share-for-share exchange. In addition, the reorganisation did not generate material corporate-level Canadian or US tax liabilities. This outcome was driven by a unique set of facts; specifically, the aggregate fair market value of Encana's assets appeared to be less than the aggregate paid-up capital of its common shares. It remains to be seen whether the Encana reorganisation will spark a broader trend in the Canadian capital markets of undertaking similar 'inversions'.
Outlook and conclusions
Canadian corporate tax rates have remained relatively low while income tax rates applicable to individuals have remained high by global standards.
Canada's current federal government has demonstrated that it is motivated by a political desire to prevent high-income individuals from gaining an unfair tax advantage over the 'middle class.' For example, in July 2017, the federal government announced broad changes to the taxation of private corporations in Canada and launched a 75-day consultation period. However, many of the proposals were sharply criticised, and the government received some 21,000 submissions. While the federal government has determined to abandon a number of the proposed changes, it moved forward with changes to prevent income splitting and to discourage the accumulation of significant passive investment portfolios by private corporations. Intergenerational business transfers are also a stated focus of the government. With its re-election in 2019, it is anticipated that the current federal government will continue to target private businesses in pursuing its stated goal of improving 'tax fairness' in Canada. For instance, the 2019 federal budget contained proposals to limit the monetary value of stock option grants by 'mature' businesses that can be eligible for taxation at capital gains rates.
In addition, Canada has introduced a number of legislative changes aimed at preserving the tax base in recent years. These changes include extending loss restriction rules to trusts, extending the thin capitalisation rules to trusts, partnerships and non-residents carrying on business in Canada, introducing the FAD rules targeting foreign-controlled Canadian corporations using corporate surplus or capital to make investments in foreign affiliates, strengthening the FAPI system and broadening the anti-avoidance measures in the thin capitalisation rules. A number of legislative changes were made to deny the benefits of transactions that sought to change the character of amounts recognised for tax purposes from income to capital gains and to further restrict the inter-corporate dividend deduction. The B2B rules were extended to royalty and rental arrangements, and a character conversion element was introduced where the B2B arrangement includes a combination of royalty payments and interest payments. For this purpose, royalty is broadly defined and may include payments for services. In addition to these changes, the recent ratification of the MLI may result in significant changes in the international tax landscape in the coming years.
A federal budget was expected to be released in early spring 2020, but has been deferred indefinitely as a result of the covid-19 pandemic. Part of the federal government's 2019 re-election platform was to limit the amount of interest that certain corporations can deduct and to limit the tax benefits of hybrid debt mismatch arrangements. The federal government has stated that it remains committed to augmenting tax enforcement, both domestically and internationally, and working collaboratively with revenue authorities in other countries to enhance tax administration and transparency.
1 Elie S Roth, Chris Anderson and Ryan Wolfe are members of the tax group at Davies Ward Phillips & Vineberg LLP.
2 KPMG Canadian corporate tax tables 2019 and 2020.
3 The Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting.
4 One exception is real estate businesses, which are sometimes carried on by a commercial unitised trust that qualifies as a real estate investment trust (REIT).
5 Shares of a class may be issued in one or more series.
6 Alberta, British Columbia and Nova Scotia.
7 See Article IV(7) of the Canada-United States Income Tax Convention (1980). When applicable, these anti-hybrid rules deny treaty benefits on any amount received from, or derived through, the hybrid entity.
8 There are also special categories of losses not discussed herein, such as farming losses and allowable business investment losses. A distinction is also drawn between non-capital losses and property losses.
9 This C$500,000 business limit will be reduced where the CCPC's investment income or taxable capital exceed certain amounts.
10 Subject to certain anti-avoidance rules and a special refundable tax payable by private corporations or certain corporations controlled by an individual on certain dividends (generally from portfolio investments), tax is refunded when the private corporation itself pays dividends. Recent tax changes have tightened the scope of the dividend-received deduction between taxable Canadian corporations.
11 Technically, the ratio is based on a monthly average of the greatest amount of such debt outstanding in each month.
12 The average is based on contributed surplus and paid-up capital at the beginning of a calendar month.
13 A corporation formed on an amalgamation is generally considered a new corporation, subject to specific rules that deem it to be a continuation of one or more of the predecessor corporations. Canadian corporate law does not include the concept of a 'survivor' corporation resulting from an amalgamation.
14 Calculated based on the employer's 2019 gross revenue in each of these months.
15 This represents a 75 per cent subsidy in respect of annualised wages not exceeding C$58,700.
16 2020 SCC 6.
17 2020 FCA 43.
18 This exemption applies where a resident of Luxembourg owns 10 per cent or more of any class of shares of a Canadian corporation and disposes of shares of such Canadian corporation the value of which is derived principally from immovable property (other than rental property) in which the business of the corporation is carried on.