The Inward Investment and International Taxation Review: Canada
Canada has a skilled labour force, a stable economy and political system, and well-developed capital markets. Thus, it is an attractive jurisdiction in which to conduct business. General combined federal and provincial corporate tax rates have been 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
Common forms of business organisation and their tax treatment
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,3 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, for corporations other than unlimited liability corporations (discussed below), the shareholders' obligations are generally limited to the capital that they have invested or, in certain circumstances, to the funds that they have extracted from the corporation. A corporation must file certain information, including directors' names, on the public record, must annually hold a shareholders' meeting and must 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 under federal law or provincial law, and without significant cost, once certain basic decisions are made, including determining 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.
Directors must be individuals. 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.).4 Corporations generally have no minimum capital requirements subject to any applicable regulatory regime (e.g., for financial institutions). Shares cannot be issued until the subscription price is fully paid in money, property or past services.
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 companies 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 companies 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 provinces5 also permits 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 US check-the-box regulations. However, ULCs are treated as companies, 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.6
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.
Partnerships are another common form of business arrangement widely used in real estate, private equity and professional businesses. A partnership is generally described as the 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 management of the partnership business and, thus, assumes unlimited liability.
Limited liability partnerships share features of a limited partnership and a general partnership but 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, are typically governed by written partnership agreements. Accordingly, the members may agree to alter rights and obligations as between themselves. Partners generally have flexibility in providing for the sharing of profits, for the financing of the partnership activities and how those activities will be managed. Partnerships formed under foreign law may not necessarily constitute a partnership for Canadian tax purposes.
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 (specified investment flowthrough (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 subject to that tax 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 that their investment in the partnership 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 taxes 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 should be credited against its income tax.
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.
Although less common, business activities are 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 or income from property 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, real estate investment trusts (REITs) that meet certain conditions are exempt from the SIFT rules.
iv Canadian permanent establishment
A non-resident corporation or other person may carry on business directly in Canada through a branch (permanent establishment (PE)). A PE is not a separate entity from its foreign 'parent'. A foreign business 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 who 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 tax returns in Canada reporting their income and other amounts.
Direct taxation of businesses
i Tax on profits
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 income as determined under generally accepted accounting principles, 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, but no taxation year can exceed 53 weeks. Moreover, once selected, the taxation year cannot be changed unless the Canada Revenue Agency (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 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 reasonable, not on account of capital (except to the extent expressly permitted), not contingent and incurred for the purpose of earning income.
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. Interest is generally considered a capital expense and is only deductible in circumstances prescribed by tax legislation. On the other hand, certain expenses that might be considered capital expenditures are deductible (albeit over time), including costs incurred to issue shares or financing expenses.
Depreciation taken in computing accounting profits must be added to income for tax purposes. Canada has a capital cost allowance (CCA) system for depreciating assets such as buildings, machinery, equipment and purchased goodwill; properties of a similar nature are typically included in the same pool for CCA purposes. With few exceptions, property is depreciated for tax purposes on a declining balance basis at rates that range from 4 to 100 per cent.
CCA is recaptured into income if a depreciated asset is disposed of for an amount in excess of the balance of the 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 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 generally refundable when the CCPC pays dividends.
Losses are generally categorised as net capital losses or non-capital losses.7 Net capital losses (being one-half of an allowable 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 net 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.8 Non-capital losses generally may be deducted against taxable capital gains or income from other sources.
Immediately prior to an acquisition of control, a corporation is subject to a deemed taxation year end, 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 with 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 (as defined by tax legislation and judicial decisions). 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 upon an acquisition of control, a corporation may elect to 'step up' the tax cost of capital property (including goodwill and other depreciable property) it owns to fair market value by deeming a disposition of such property to occur at the amount that it designates (not in excess of the fair market value of the property), thereby generating income or taxable capital gains against which the pre-acquisition of control losses may be deducted.
The rules relating to acquisitions of control extend to trusts – the loss restriction event being tied to changes in beneficiaries. However, trusts do not benefit from the elective step-up provisions.
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). 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 when dividends are paid by the CCPC.
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, due within six months after the taxation year end. Most corporations with gross revenue in excess of C$1 million must file 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 industry, record, etc.) typically are audited annually.
The normal limitation 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 required 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. Private letter interpretations by the CRA are also widely available, but do not have the status of administrative practices published by the CRA. Taxpayers can seek an advance tax ruling from the CRA addressing the tax consequences of proposed transactions. While such rulings are administrative and do not have the force of law, as a practical matter the CRA considers itself bound by its rulings.
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 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.
Recently announced measures limiting the deductibility of interest expense based on 30 per cent tax earnings before interest, taxes, depreciation and amortisation (EBITDA) (discussed below) will permit the sharing of interest capacity within a defined group. As at the date of writing, draft legislation setting out the relevant provisions has not been released.
ii Other relevant 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 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 (municipality). Municipalities typically levy annual property taxes on owners of real property, based on the assessed value of commercial and residential real property.
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 no income tax. The highest combined (federal and provincial) personal income tax marginal rates in Canada are approximately 53 per cent.
Employers are required to deduct tax at 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.
Tax residence and fiscal domicile
i Corporate residence
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 mind and management is exercised in Canada. Therefore, directors of such non-Canadian corporations should not hold meetings in Canada. 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 the jurisdiction of incorporation; otherwise, the competent authorities must decide. Under the Canada–United Kingdom Income Tax Convention, the competent authorities must decide. Other treaties may default to place of management.
ii Branch or permanent establishment
Under Canada's tax legislation, a non-resident that carries on business in Canada will be liable to income tax on its taxable income earned in Canada regardless of whether it has a PE in Canada. Certain activities are deemed to be 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 that funds are not reinvested in the branch business. The rate is generally reduced to 5 per cent under many of 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 inward investment
Canada is an attractive jurisdiction in which to carry on business because it has a relatively low corporate tax rate, a wide treaty network, a sophisticated tax system, relatively generous provisions relating to financing costs and a relatively generous regime relevant to controlled foreign corporations (foreign affiliates) of Canadian multinationals.
i Holding company regimes
Dividends may be tax-free when paid from one Canadian corporation to another.9 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 either 5 per cent for significant corporate shareholders or 15 per cent. 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, under current law 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 in a country with which Canada has a tax treaty or tax information exchange agreement (TIEA). Certain 'passive income' arising from intra-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 other income such as that from certain businesses that derive earnings from property (e.g., rents, royalties, interest, dividends, licence fees, etc.).
Canada has foreign affiliate dumping (FAD) rules that make it unattractive for a non-resident of Canada 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 the foregoing, 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 (with limited exceptions).
ii IP regimes
Generally, Canada does not have any special IP regime and instead provides tax incentives in the form of tax credits or generous write-offs may be available for development of IP in Canada. In the province of Quebec, the corporate tax on patent royalties and a percentage of profits from specific streams of IP-related income where R&D activities are undertaken in the province is reduced.
iii State aid
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 that reduce taxes payable, and, in some cases, are refundable.
Withholding and taxation of non-local source income streams
i Withholding on outward-bound payments (domestic law)
Canada imposes withholding tax at a statutory rate of 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). The rate of withholding may be reduced or eliminated under an applicable bilateral income tax treaty.
ii Domestic law exclusions or exemptions from withholding on outward-bound payments
Canada 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' (e.g., interest computed with reference to revenue, cash flow, dividends, profits, commodity price or production from property). However, interest that is not deductible pursuant to thin capitalisation restrictions is recharacterised as a dividend for withholding tax purposes. (See below for a general discussion of the back-to-back rules and their impact on withholding tax.)
iii Double tax treaties
Canada's extensive treaty network consists of more than 90 treaties that typically reduce the rate of withholding tax on passive income. 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.
iv Taxation on receipt
Canada's system for taxation of dividends from foreign affiliates operates largely as an exemption system. 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. Moreover, active business income earned by a foreign affiliate in a country with which Canada has a tax treaty or TIEA10 may be repatriated to its Canadian corporate shareholders as a dividend without any further Canadian tax.
Dividends from foreign corporations that are not foreign affiliates are taxable in Canada subject to a foreign tax credit. Moreover, in some circumstances, Canada taxes residents on passive income earned offshore and not encompassed within the foreign affiliate regime (see below).
Taxation of funding structures
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 such 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 regime is intended to discourage corporations that are not in a tax-paying position from using preferred share financing, because the dividend received deduction may be available in respect of dividends received on preferred shares.
i Thin capitalisation
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 such 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 considered appropriate, 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 loan rules target circumstances in which an intermediary that deals at arm's length with the 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 by the ultimate funder.
ii 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 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 in equal parts over five taxation years, subject to proration for short taxation years.
Under current law, interest is deductible only to the extent that 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 deductible over the remaining term of the debt rather than in the year paid.
The 2021 Federal Budget announced new limits on the deductibility of interest and financing expenses, and certain cross-border payments. Effective 1 January 2023, it is proposed that interest and other financing costs will only be deductible up to 40 per cent of tax EBITDA, and then 30 per cent of tax EBITDA commencing on 1 January 2024. Unused debt capacity may be transferred within a corporate group based on the proposals. Under a proposed hybrid mismatch rule, the deduction of cross-border payments would be limited where the recipient is not taxable on the receipt with effect from 1 July 2022. As at the date of writing, no draft legislation has been released.
iii Restrictions on payments
Dividends must be declared by directors and 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 all shares.
iv Return of capital
Corporations may distribute paid-up capital to shareholders regardless of whether the corporation has undistributed income as a return of legal stated capital. 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 business.
Distributions of capital usually require shareholder approval and the satisfaction of solvency tests contained in the corporate statute governing the corporation.
Acquisition structures, restructuring and exit charges
Typically, but not universally, a Canadian corporation will be established to acquire a Canadian target. This approach may facilitate 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. Second, 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.
Corporations can generally merge on a tax-deferred basis in Canada either through an amalgamation or by the winding-up of a wholly owned subsidiary into its parent corporation, 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. As a general matter, the tax attributes of the two merging corporations are carried over to the merged corporation, subject to there not being an acquisition of control.
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. Generally, shares of one foreign affiliate may be transferred on a tax-deferred basis to another foreign affiliate in exchange for shares of the acquiring affiliate (subject to certain exceptions).
Spin-off transactions can be effected on a taxable or tax-deferred basis, although in the latter case extensive conditions must be satisfied and continuity of ownership 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.
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 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 a 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.
Corporations that are established outside Canada and continue into Canada generally will enjoy a step up in the cost of their assets to fair market value, and generally thereafter will be treated as if they had been incorporated in Canada.
A non-resident of Canada that disposes of shares of a Canadian corporation or partnership interest will not be subject to Canadian tax on exit unless the shares or partnership interest constitutes 'taxable Canadian property'. Generally, shares or a partnership interest will constitute taxable Canadian property if they derive more than 50 per cent of their value from Canadian real property, resource property or timber resource property at any time in the 60-month period preceding the date of disposition. In certain cases, an applicable bilateral income tax convention may provide relief from taxation. A non-resident that disposes of taxable Canadian property is subject to clearance certificate obligations and related back-up withholding (discussed below) and must file a Canadian income tax return reporting the disposition.
Anti-avoidance and other relevant legislation
i General anti-avoidance
Canadian tax legislation contains many specific anti-avoidance rules, but also a general anti-avoidance rule that may be applied to recharacterise a transaction or series of transactions where a tax benefit has been enjoyed, and there has been a misuse or an abuse of tax legislation or treaties. The Department of Finance has announced a consultation process to strengthen and modernise the general anti-avoidance rule.
ii Controlled foreign corporations
As discussed above, passive income (FAPI) earned by a CFA is included in the Canadian shareholder's income on an accrual basis. Moreover, passive income earned in offshore entities other than CFAs, and not repatriated to Canada, may give rise to deemed Canadian income, based on prescribed rates applied to the 'designated cost' of the investment.
iii Transfer pricing
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. 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. Related persons are deemed not to deal at arm's length, but unrelated persons may be considered not to deal at arm's length as a factual matter.
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; failure to meet them may result in the imposition of transfer pricing penalties.
Transactions between non-arm's-length Canadian residents also may be subject to adjustment if not carried out at fair market value, albeit not under the transfer pricing rules. 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. Contemporaneous documentation is not required for purely domestic transactions.
The Department of Finance has announced a consultation process regarding changes to Canada's transfer pricing rules.
iv Tax clearances and rulings
Tax clearance certificates are required where a non-resident disposes of taxable Canadian property. In the absence of such a certificate, the purchaser is obligated to withhold a portion of the purchase price of the property and remit it to the CRA on the non-resident's behalf. In general terms, taxable Canadian property is 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 months preceding the disposition, derived more than 50 per cent of their value from such property.
Tax clearance certificates are not generally otherwise required but may be advisable before assets are distributed to shareholders or trust beneficiaries on winding-up. 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. Such rulings do not have the force of law but as a practical matter are considered binding on the CRA with respect to the taxpayer who makes the application. An advance tax ruling requires the disclosure of all relevant facts, circumstances and purpose of the proposed transactions, and typically takes at least six months but may take significantly longer.
Year in review
Canadian corporate tax rates have remained relatively stable while income tax rates applicable to individuals have remained relatively high by global standards.
The 2021 Federal Budget announced a number of new tax measures including interest deductibility limitations based on earnings, hybrid mismatch rules and consultations regarding transfer pricing and the general anti-avoidance rules, and new proposals regarding reportable transactions and the disclosure of uncertain tax positions, which continues the trend of recent legislative changes aimed at preserving the tax base. Other changes have included: 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 initially 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 gain and to further restrict the inter-corporate dividend deduction. The back-to-back rules were extended to royalty and rental arrangements, and a character conversion element was introduced where the back-to-back arrangement includes a combination of royalty payments and interest payments. For this purpose, royalty is broadly defined and may include payments for services.
Canada has continued to expand its network of TIEAs and negotiate changes to its existing treaties and additional treaties. Canada ratified the Multilateral Instrument13 (MLI) and in addition to the minimum standards in the MLI, Canada announced the adoption of the following additional provisions: (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. Canada and certain provinces have introduced digital services taxes directed at non-resident service providers.
Outlook and conclusions
The 2021 Federal Budget delivered numerous proposed changes to Canadian tax laws that will have fundamental impacts going forward.
In addition, Canada is a member of the Organisation for Economic Co-operation and Development (OECD) and supports its two-pillar framework for global tax reform. Under Pillar One, taxing rights over multinationals will be reallocated to market jurisdictions. Under Pillar Two, a global minimum corporate tax for multinationals was agreed upon, to be calculated on a country-by-country basis. The framework was formally endorsed on 30 October 2021, which OECD members are required to implement effective in 2023.
1 Julie Colden is a tax partner at Davies Ward Phillips & Vineberg LLP.
2 KPMG Canada corporate tax rates for 2020.
3 One exception is real estate businesses, which are sometimes carried on by a commercial unitised trust that qualifies as a real estate investment trust.
4 Shares of a class may be issued in one or more series.
5 Alberta, British Columbia and Nova Scotia.
6 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.
7 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.
8 Non-capital losses realised in taxation years ending before 23 March 2004 had a shorter carry-forward period.
9 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.
10 Tax Information Exchange Agreement.
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 The Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting.