Canada imposes corporate and personal income tax on its residents and on non-residents who carry on business in Canada, are employed in Canada or sell property situated in Canada. Canadian resident individuals and corporations are taxable on their income, including capital gains earned anywhere in the world. Non-residents of Canada are generally only taxable on their income from Canadian activities and investments, including gains on the sale of certain types of Canadian investments.
All of the provinces of Canada also impose income taxes on corporations and individuals residing or carrying on business within the province. Historically most provinces impose a capital tax on corporations. However, in recent years provincial capital tax has been eliminated or curtailed. Currently, Saskatchewan, Manitoba, Quebec, Newfoundland and Labrador, Prince Edward Island and New Brunswick impose a limited capital tax on specific entities including, in some cases, financial institutions, insurance corporations, and provincial commercial Crown corporations. The other provinces impose no capital tax. Canada also imposes a 25 percent withholding tax on non-residents who receive dividends, certain interest payments, rents, royalties or management fees from Canada. The Canadian payor of any such amounts is liable for withholding and remitting this tax on behalf of the non-resident recipient. Canada has entered into tax treaties with numerous countries, in order to prevent double taxation of the same income in two countries. Generally, tax treaties address which country is entitled to tax particular forms of income in a variety of specific situations.
Tax treaties may also eliminate or reduce withholding tax. For example, the Canada-US Tax Convention (the “Canada-US Treaty”) eliminates withholding tax on most interest and reduces the rate on dividends to 15 percent or 5 percent depending on the circumstances.
Recent changes to the Canada-US Treaty have also been made to facilitate treaty relief for hybrid entities (such as partnerships and limited liability companies) while ensuring that hybrid entities do not take undue advantage of the Canada-US Treaty.
Federal tax rates are uniform across the country, with certain reductions and credits intended to encourage the development of business activity and employment in certain industries of the economy, and in economically depressed regions of Canada. Tax incentives are also available to encourage research and development in Canada. The provinces establish their own rates of tax and, in some cases, rules for the computation of taxable income. For 2014, the combined federal and provincial tax rate on general active business income (including surtax) for corporations ranges between 25 percent and 31 percent, depending on the province.
Individuals pay taxes in accordance with a progressive rate structure which imposes higher rates of tax on higher levels of taxable income. For 2014, the maximum combined federal and provincial rate for individuals ranges between 39 percent and 50 percent, depending on the province.
A subsidiary incorporated in Canada will be considered to be a Canadian resident for income tax purposes. It will be subject to Canadian income tax on its income earned anywhere in the world from any source, subject to a credit for foreign taxes paid on non-Canadian income.
The income of the Canadian subsidiary that will be subject to Canadian income tax is generally calculated in accordance with acceptable principles of business (such as accounting standards like GAAP and IFRS). There are, however, certain inclusions and deductions which are specifically required or disallowed. The Canadian tax rules treat capital gains more favorably than ordinary business or trading income. Under the current provisions of the Income Tax Act (Canada), taxable income includes one-half of realized capital gains net of capital losses. A net capital loss of a given year can, subject to certain restrictions, be used to offset the capital gain of another year. Business losses incurred by a subsidiary in a year may, subject to certain restrictions, be used to reduce taxable income in other years.
Where a corporation carries on business through a permanent establishment in a province, the rate
of federal tax imposed on a corporation’s taxable income (including surtax) is 15 percent.
In addition, the subsidiary generally will be subject to provincial income taxes on income earned in each province in which it carries on business through a permanent establishment. The rate of provincial tax varies among the provinces from 10% to 16% (11% in British Columbia, 10% in Alberta, 11.5% in Ontario and 11.9% in Quebec). Certain of the provinces provide lower tax rates for companies which qualify for the federal small business deduction. In general, the taxable income on which provincial tax is imposed resembles the taxable income computed for federal purposes, but special rules in provincial corporate income tax legislation can result in a different measure of taxable income in certain circumstances.
The fact that a foreign business enterprise has a Canadian subsidiary carrying on business in Canada, will generally not subject the foreign entity itself to Canadian income tax. For that reason, a Canadian subsidiary can be useful when a partnership or joint venture is to be entered into with a Canadian participant. See also the discussion below under the subheading “Joint ventures and partnerships”. However, after-tax profits of the Canadian subsidiary distributed to the non-resident parent organization by way of dividend will be subject to Canadian withholding tax. The withholding tax rate is reduced to 10%t or 15% under most of Canada’s tax treaties. In addition, the Canada-US Treaty and other treaties provide that the rate will be further reduced in certain circumstances to 5%.
Particular consideration should be given to loan transactions between the Canadian subsidiary and its foreign parent, and to interest charged in respect of such loans. Under the current “thin capitalization rule”, a portion of any interest which the Canadian subsidiary might pay to its foreign parent on amounts owing by it to the parent, may be disallowed as a deduction in computing the subsidiary’s income. In general terms, if the ratio of the debt (owing to the parent or other non-resident affiliate) to the equity (paid-up capital, surplus and retained earnings) of the Canadian subsidiary does not exceed 1.5-to-1, no amount of interest expense will be disallowed. On the other hand, if the debt to equity ratio exceeds 1.5-to-1, the interest on the excess debt will be disallowed and instead, treated as a dividend to the non-resident (which would be subject to withholding tax at the applicable rate for dividends). The subsidiary could borrow from arm’s length financial institutions without offending the thin capitalization rule; however, in these cases, specific anti-avoidance rules are not in place to prevent back to back loans using an arm’s length intermediary lender. These new rules are worded broadly and can capture many arms’ length lending arrangements for Canadian corporations with specified non-resident shareholders.
Because the profits of a Canadian subsidiary or branch can be affected by the cost at which it buys from or sells to related parties, the Income Tax Act (Canada) provides detailed rules governing the accounting of such transactions for tax purposes. In general, transactions between non- arm’s length persons (such as a parent and its wholly-owned subsidiary) are deemed to take place at fair market value, without regard to what is in fact paid. For instance, if a parent sells goods or provides services to its subsidiary at more than the fair market value of the goods or services, or if the subsidiary sells goods or provides services to its parent at less than fair market value, the subsidiary is deemed to have paid or received fair market value for income tax purposes.
The rules relating to Canada’s transfer pricing regime conform with the OECD’s (Organization for Economic Co-operation and Development) arm’s length principle, which, in general, requires that each transaction between parties that are not dealing at arm’s length be carried out under terms and conditions that one would have expected, had the parties been dealing with each other at arm’s length. Pursuant to this principle, requirements in the Income Tax Act (Canada) obligate taxpayers who are parties to such non-arm’s length transactions, to contemporaneously document their transfer pricing transactions and the steps taken to ensure that the terms and conditions of such transactions satisfy the arm’s length principle. A significant penalty may be imposed for failure to comply with the arm’s length principle.
Recently enacted “foreign affiliate dumping” rules dissuade the use of Canadian corporations in structures where the Canadian resident corporation has both a non-Canadian parent and a non-Canadian subsidiary. In such cases, if the Canadian corporation does not have a sufficient level of Canadian management and is not financed with a sufficient amount of equity, its investment into the non-Canadian subsidiary could result in dividends being deemed to be paid to its non-Canadian parent.
A foreign company that is not resident in Canada is subject to Canadian income tax on income earned from any business carried on in Canada. If a business is carried on in Canada through a branch operation, the income attributable to that branch will be subject to income tax in much the same way as if it had been earned by a subsidiary. The method of calculating income subject to tax and the rates will be as outlined above. However, the majority of Canada’s bilateral tax treaties provide, generally, that the business profits of a foreign enterprise carrying on business in Canada will only be taxable in Canada if they are attributable to a permanent establishment PE situated in Canada. PE is defined to include branches, offices, agencies and other fixed places of business of an enterprise. Under the Canada-US Treaty, the provision of services in Canada may constitute a permanent establishment in Canada commonly referred to as a “services PE”.
An additional tax, commonly referred to as “branch tax”, will also be payable. Branch tax is payable at the rate of 25 percent of the after-tax profits of the branch operations not being reinvested in Canada. Branch tax is roughly equivalent to the withholding tax, which would be payable on dividends paid by a Canadian subsidiary to its foreign parent organization. The rate is reduced under certain tax treaties to 10% or 15%. Under the Canada-US Treaty, the rate has been further reduced in certain circumstances to 5% of after-tax profits. In addition, certain treaties, such as the Canada-US and Canada-UK treaties, provide for an exemption from branch tax. Under the Canada-US Treaty, the exemption is in respect of the first $500,000 of branch profits net of prior years’ losses. Under the Canada-UK Treaty, the exemption is in respect of the first $500,000 or £250,000, whichever is greater, of branch profits net of prior years’ losses.
A foreign entity should determine whether its own jurisdiction will permit a foreign tax credit in respect of Canadian income tax payable, including branch tax.
If business is to be carried on in Canada through a branch operation having a permanent establishment, it will be subject to income tax in much the same way as if it had been earned by a subsidiary, as outlined above. However, it is important to note that, in the case of a resident of a country with which Canada has a tax treaty, generally, that person may carry on business in Canada without attracting Canadian income tax, provided no permanent establishment is maintained in Canada. See also the discussion below under the subheading “Canadian distributors and selling agents”. In addition, whether a non-resident decides to carry on business in Canada through a subsidiary or through a branch, appropriate federal and provincial income tax returns will need to be filed and, in support of these filings, the Canadian operation will be required to keep appropriate books and accounting records in Canada.
On a long term basis, the use of a subsidiary is often found to be preferable, if for no other reason than the existence of a separate legal entity in Canada encourages and facilitates the separate accounting necessary for Canadian purposes, and the determination of acceptable cross-border pricing. On the other hand, the ability of the non-resident to use Canadian source start-up losses may encourage the use of a branch operation, until the Canadian business becomes profitable. Subsequently, branch assets, other than real property, can be transferred to a Canadian subsidiary on a tax-free basis for Canadian purposes, provided the appropriate tax elections are made. Before a foreign corporation transfers assets to a Canadian subsidiary, caution should be taken since it could trigger taxes in the foreign corporation’s country of residence. Whether a business comes to Canada as a branch or subsidiary could impact the valuation of imported goods. For customs purposes, it is generally the transaction value (being the value at which goods are sold to the Canadian importer) that forms the value for duty (i.e. the base upon which customs duties are calculated). However, where goods are transferred to a Canadian branch, a sale has not taken place and, consequently, the transfer price may not form the value for duty and another value, such as the selling price in Canada less certain adjustments, may become the value for duty. Likewise, since the federally imposed Goods and Service Tax (GST), Québec Sales Tax (QST) or Harmonized Sales Tax (HST) is payable on the duty-paid value of imported goods, the tax payable depends on the customs valuation of the goods. For more information regarding these taxes, see the discussion below under the section “Commodity tax considerations”.
In certain circumstances, where the parent corporation is a US corporation, an “unlimited liability company” (“ULC”) is often considered. A ULC is a hybrid entity for US tax purposes and as a result may enable the tax attributes, such as start-up losses, of the ULC to be used for US tax purposes.
A foreign business enterprise may choose to enter into a joint venture with a Canadian to carry on a business or a particular activity in Canada. The structure of such a joint venture may be accomplished in a number of ways and the Canadian tax consequences will depend upon the particular structure chosen.
The Canadian joint venture may take the form of a Canadian corporation, the shares of which are owned by the Canadian and foreign participants in agreed proportions. In such a case, the Canadian corporation will be taxable on its income as a Canadian resident corporation, as outlined above under the heading “Canadian subsidiary corporation”. If the Canadian participants are at least equal partners in the Canadian joint venture corporation, it may qualify for a reduced rate of tax (a combined federal and provincial rate in Alberta of 14 percent, 19 percent in Quebec, 13.5 percent in British Columbia and 16 percent in Ontario). The portion of taxable income eligible for the small business rate is reduced, however, on a straight-line basis for corporations that have more than CA$10 million of taxable capital employed in Canada. No portion of the taxable income of corporations with more than CA$15 million of taxable capital employed in Canada is entitled to the small business rate. Taxable capital is generally the sum of shareholders’ equity and long term or secured debt, less debt and equity investments in other corporations.
Alternatively, the joint venture may take the form of a partnership between the Canadian and foreign participants. Canada taxes the profits of partnerships at the partner level and does not tax the partnership directly. Each of the partners of a partnership carrying on business in Canada is considered, for tax purposes, to be carrying on the business of the partnership in Canada. Accordingly, if the foreign enterprise is a partner and the partnership has an office, factory or other permanent establishment in Canada, the foreign partner will generally be taxable in Canada on its share of the partnership profits, as if it carried on the partnership business directly as a Canadian branch of the foreign enterprise. The tax consequences of a branch operation are set out under the subheading “Canadian branch operation”, above. If, on the other hand, the foreign enterprise has its Canadian subsidiary corporation enter into the partnership, the tax consequences would be as set out above under the subheading “Canadian subsidiary corporation”
Amounts paid by a Canadian to a non-resident as interest, dividends, rents, royalties or most any other form of income from property, are subject to Canadian withholding tax. The rate is 25% but may be reduced under an applicable tax treaty. However, in the case of rents in respect of Canadian real property, the rate may remain at 25%. Canada has eliminated withholding tax on interest payments to non-residents who deal at arm’s length with the payor, to the extent that the interest does not constitute “participating debt interest”, as defined in the Income Tax Act
Amounts paid to a non-resident for services rendered in Canada (other than in the course of regular and continuous employment) are subject to a withholding tax of 15% of the gross payment. The payor must deduct and withhold 15 percent for federal income tax and in some cases, an additional 9% for Quebec income tax.
A non-resident who owns certain types of Canadian real property has the option under the Income Tax Act (Canada) of paying tax on rental income, as if the non-resident were a resident taxpayer. This alternative method of payment may result in a lower tax rate, since the non-resident is thereby allowed to deduct his or her expenses, including permitted depreciation costs connected with earning rental income. The non-resident would not otherwise be allowed to deduct expenses, since withholding tax is payable on gross amounts received as interest, dividends and other income from property, without deductions. This special alternative to payment of withholding tax also applies to tax on royalties paid to the non-resident for the use of timber resource properties.
Withholding taxes will be payable in respect of income earned by a non-resident on its investments in Canadian property, whether the Canadian payor is a subsidiary or is unrelated to the non-resident receiving the payment. The tax is imposed on the non-resident, but is required to be collected by the Canadian payor and remitted by it to the Canadian authorities. Property or investment income which would normally be subject to withholding tax, but which is attributable to a Canadian business carried on by the non-resident directly, is generally included in the branch’s business income and is not subject to withholding tax, although the Canadian payor is required to obtain the consent of Canada Revenue Agency not to withhold.
Payment of withholding tax usually will allow the non-resident to claim a foreign tax credit for its own income tax purposes, although this should be confirmed by a foreign entity’s domestic tax advisors.
If a foreign enterprise finds it necessary to transfer an individual to Canada, the individual’s Canadian tax consequences will depend upon whether or not he/she becomes resident in Canada for tax purposes.
Canadian residents are taxable on their income from all sources earned anywhere in the world. Income includes one-half of realized capital gains net of realized capital losses, subject to an exemption for a capital gain realized on the sale of a principal residence. Employment income includes the value of most employee benefits, including housing, automobiles, low-interest or interest-free loans, stock options, profit sharing plans and insurance benefits. If an individual becomes or ceases to be resident in Canada part way through a year, he or she will only be taxed in Canada on worldwide income earned while resident in Canada in that year. Upon ceasing to be a resident in Canada, the individual may also be taxed on unrealized capital gains arising from an increase in values of certain capital property while the individual was a resident.
A non-resident of Canada, on the other hand, is taxed only if the non-resident was employed in Canada, carried on business in Canada, or disposed of “taxable Canadian property” (in general terms, real estate, resource properties, or in some cases shares of corporation that primarily derive their value from such).If an individual is subject to Canadian tax, he or she will pay income tax at rates which increase with the amount of taxable income. Basic federal income tax rates range from 15 percent to 29 percent. In addition to federal income tax, each province levies its own income tax.Combined federal and provincial income tax rates vary from 39 percent to 50 percent of taxable income, depending on the province. Provincial income taxes are not deductible in computing taxable income for federal purposes.