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In Canada, an income tax is levied by both the federal and provincial/territorial governments, and a variety of other taxes, including federal and provincial value-added and sales taxes, are also imposed.
This chapter focuses on income tax and discusses some of the principal income tax considerations that apply to non-residents of Canada who wish to invest or carry on business in the country. Although a wide variety of business structures are available to non-residents, the following discussion mainly addresses the income tax considerations that apply to Canadian subsidiaries and branch operations. Since Canadian income tax rules are complex and subject to change, the information here is not intended to be comprehensive.
- General tax rules
- General application of Canadian tax to non-residents
- Canadian taxation of a Canadian resident subsidiary
- Canadian taxation of a branch operation
1. General tax rules
a. Residence in Canada
The application of Canadian income tax is based on a taxpayer's residence. Although residence is generally a question of fact, there are a few specific rules. For example, a corporation is deemed to be resident in Canada for purposes of the Income Tax Act (Canada) (the ITA) if it was incorporated in Canada any time after April 26, 1965 or, it was continued into Canada after June 1994.
A corporation incorporated outside of Canada can also be resident in Canada if its "central management and control" is located in Canada. In the absence of evidence to the contrary, the location of a corporation's central management and control - that is, the location of its highest level of corporate control - is generally understood to be the place where the corporation's board of directors meet. However, the courts and tax authorities examine the facts in detail to determine the location where the true management and control are exercised.
b. Sources of income
Canadian resident corporations are taxable on their worldwide income from every source, including business income, property income and gains arising on the disposition of capital property (i.e., capital gains).
Income is usually classified as business income if a certain degree of commercial activity is present. Property income is derived from more passive activities such as the collection of interest, dividends, rents and royalties.
Presently, only 50 per cent of a capital gain is taxable, so the classification of property as capital or otherwise for income tax purposes is important. Property is generally considered to be capital property if it is held as an investment and not as a trading asset. For example, the building in which a business has its offices would normally be considered capital property, as would equipment or machinery that is used by the business in the course of earning income. However, property that is acquired for the purpose of generating a profit on resale will generally be considered inventory rather than capital property.
c. Canadian-controlled private corporations
A Canadian-controlled private corporation (CCPC) receives preferential tax treatment, including reduced tax rates on a specified amount of its active business income. Special planning is required if a non-resident wishes to carry on business in Canada through a CCPC. To qualify as a CCPC, a private corporation must not be controlled directly or indirectly by non-residents, public corporations or any combination of the two.
A "private corporation" is essentially a corporation that:
- Is resident in Canada
- Is not a public corporation
- Is not controlled by one or more public corporations (subject to certain limited exceptions)
Control of a CCPC includes not only holding a sufficient number of shares to elect a majority of the directors, but also the ability to control the corporation in fact. In determining whether there is control by a non-resident or a public corporation, all shares held by non-residents and public corporations are aggregated. Therefore, even if 51 per cent of the voting shares of a corporation were widely spread among a very large number of non-resident persons or public corporations, the corporation would not be considered a CCPC.
Where 50 per cent of the voting shares of a private corporation are held by a Canadian resident and 50 per cent of the voting shares are held by a non-resident, it may be possible for the corporation to qualify as a CCPC - provided that no other facts give the non-resident factual control.
The government announced in the 2022 Federal Budget the introduction of the concept of a Substantive CCPC. Pursuant to the draft legislation, a substantive CCPC is defined as a private corporation (other than a CCPC) that is controlled, directly or indirectly in any manner whatever, by one or more Canadian resident individuals, or would, if all shares held by Canadian resident individuals were owned by a particular individual, be controlled by that particular individual. For example, a corporation that would otherwise be a CCPC, but for the fact that a non-resident person or public corporation has a right to acquire the shares of the corporation, would be considered a substantive CCPC. Under the new rules, to be effective for taxation years that begin on or after April 7, 2022, a substantive CCPC will generally be taxed in the same manner as a CCPC with respect to investment income (i.e., a higher rate of corporate income tax rate will generally apply to the aggregate investment income of the corporation, with a portion refundable once the corporation pays sufficient taxable dividends), thereby eliminating a tax deferral opportunity. Substantive CCPC status will only apply for limited purposes and a corporation will continue to be treated as a non-CCPC for other purposes, including not being entitled to the small business deduction).
d. Withholding tax on passive income of non-residents
The ITA imposes withholding tax at a rate of 25 per cent on the gross amount of certain payments made by a resident of Canada to a non-resident, including management fees, dividends, rents and royalties. This rate may be reduced pursuant to an applicable tax treaty.
Withholding tax is not imposed on arm's-length interest payments unless the interest is "participating debt interest" - being, in general, interest determined by reference to revenue, profit, cash flow, commodity price or other similar criteria. Furthermore, under the Canada-U.S. Tax Convention (1980), commonly referred to as the Canada-U.S. Tax Treaty, "non-participating debt interest" paid to a resident of the United States may be exempt from Canadian withholding tax even if the recipient does not deal at arm's length with the payer.
The 25 per cent withholding tax on dividends may also be reduced under an applicable tax treaty. For example, Article X(2) of the Canada-U.S. Tax Treaty provides for a withholding tax rate of 5 per cent on dividends paid or credited by a Canadian corporation to a corporation resident in the U.S. if the U.S. resident holds 10 per cent or more of the Canadian corporation's voting shares. Otherwise, under the Canada-U.S. Tax Treaty, the withholding tax rate applicable to dividends is generally reduced to 15 per cent. It is important to note that a person claiming benefits under the Canada-U.S. Tax Treaty must satisfy the "limitation on benefits" provisions of the treaty.
In addition, Canada has eliminated the withholding tax on computer software and certain other intellectual property royalty payments under certain treaties, including the Canada-U.S. Tax Treaty. The withholding rate on other royalty payments is reduced to ten per cent under the Canada-U.S. Tax Treaty and most other treaties with Canada.
The Organization for Economic Co-operation and Development's multilateral instrument may be relevant to disallow a reduced withholding tax rate where one of the principal purposes of an arrangement was to obtain a benefit under a treaty in a way that is not in accord with the purpose of the treaty provision.
e. Tax treaties
In addition to reducing or eliminating withholding tax, most tax treaties with Canada generally provide that the business profits earned by non-residents from carrying on business in Canada are not subject to tax under the ITA except to the extent that such profits are attributable to a permanent establishment of the non-resident in Canada. Permanent establishments are discussed further in this section under "Canadian taxation of a branch operation."
f. Transfer pricing in non-arm's-length transactions
The ITA deems related parties to not deal with each other at arm's length. Whether or not unrelated persons deal with each other at arm's length is a question of fact, based in part on the price and terms that would have applied between unrelated parties.
Under the transfer pricing rules in the ITA, Canadian taxpayers and non-arm's length non-residents are required to conduct their transactions on terms similar to those that would have applied had the parties been dealing at arm's length. The transfer pricing rules relate to all types of non-arm's-length inter-company transactions involving property, services, intangibles and any "cost-contribution arrangements", such as research and development cost-sharing or management-fee cost allocations.
If the terms and conditions of a non-arm's-length transaction differ from those that would have been agreed between arm's length persons, the terms and conditions may be adjusted under the transfer pricing rules to those that would have existed if the parties had dealt at arm's length.
Canadian taxpayers that transact with non-arm's-length non-residents are also required to meet certain "contemporaneous documentation" requirements under the ITA. Failure to do so may result in significant penalties if the parties are ultimately held to have transacted on other than arm's-length terms. In addition to contemporaneous documentation requirements on a transaction by transaction basis, in certain limited circumstances a Canadian corporation may be required to provide country-by-country reporting to the Canada Revenue Agency (CRA) for the entire multinational group of companies.
Canadian transfer pricing legislation and administrative guidelines are generally consistent with the Organisation for Economic Co-operation and Development (OECD). Canada is a signatory to the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting, which allows jurisdictions to transpose results from the OECD's Base Erosion and Profit Shifting (BEPS) Project into their existing tax treaties.
The government also announced in the 2021 Federal Budget that it intends to consult on Canada's transfer pricing rules following a recent Federal Court of Appeal transfer pricing decision (leave to appeal to the Supreme Court of Canada denied) that was favourable to the taxpayer. In August 2022, the government confirmed that it intends to release a consultation paper on Canada's transfer pricing rules in the near future.
g. General filing and reporting requirements
In general, every corporation that is taxable in Canada must file a Canadian income tax return within six months of the corporation's taxation year-end - regardless of whether the corporation has realized a profit or whether its income is exempt from Canadian tax pursuant to the terms of a tax treaty. The ITA sets out penalties for failing to file or for providing incorrect or incomplete information on a return.
Currently, the filing of consolidated Canadian income tax returns by related corporations is not permitted. Each corporation must file its own return and may not utilize any losses of related corporations to offset the income, although certain deductions may be transferred among members of qualifying corporate groups in limited circumstances.
Corporations making specified payments, including wages and other remuneration, must submit periodic information returns detailing such payments and must remit withholding tax on such payments. Specified foreign property held by corporations, trusts and partnerships and interests in foreign affiliates must be reported on information returns, and Canadian resident corporations and foreign corporations carrying on business in Canada are also subject to reporting requirements in respect of transactions with non-arm's-length non-residents.
h. Tax dispute resolution
The ITA naturally includes a scheme for resolving Canadian domestic income tax disputes (and there are parallel regimes under other Federal and Provincial tax statutes). Tax disputes typically commence with an audit, potentially resulting in a reassessment of tax, interest and, at times, civil penalties.
Tax reassessments can be initially challenged by way of an administrative dispute resolution process within the CRA. If a matter is not satisfactorily resolved at that level, or if taxpayers opt to forego that CRA review, taxpayers are entitled to appeal reassessments to the Tax Court of Canada (TCC). The TCC is a superior, independent and specialized court, dedicated to resolving disputes between the Federal government and taxpayers, primarily determining whether tax reassessments are correct. A decision of the TCC can be appealed to the Federal Court of Appeal (FCA). In turn, a FCA decision may be appealed to the Supreme Court of Canada (SCC), the highest level court in Canada, but only with leave, or permission, from the SCC.
Resolving tax disputes can encompass a wide variety of procedures that can sometimes be pursued in parallel, including audit management, responding to requirements for information, administrative and court appeals, addressing collections issues, making voluntary disclosures, or filing applications seeking remission, taxpayer relief, rectification and rescission. Determining the optimal procedure is crucial to achieving the earliest and most cost effective resolution. Regardless of the procedure to best resolve a particular tax dispute, careful and stringent adherence to statutory timelines is necessary, to avoid irrevocably prejudicing taxpayers' rights to challenge tax reassessments.
i. General anti-avoidance rule
The ITA includes a general anti-avoidance rule (GAAR), which is a broadly worded provision that can result in the re-characterization of transactions for Canadian tax purposes in order to deny a "tax benefit" resulting from an avoidance transaction.
The ITA broadly defines a "tax benefit" as a reduction, avoidance or deferral of tax or other amount payable, or an increase in a refund of tax or other amounts and, as of the date of this guide, a draft amendment has been advanced that will expand the definition to include accrued tax attributes. An avoidance transaction is a transaction or series of transactions that gives rise to a tax benefit (unless the transaction was carried out primarily for other bona fide non-tax purposes). The GAAR may apply where a tax benefit was achieved through an avoidance transaction, if that transaction results in a misuse or abuse of any provision of the ITA, the Income Tax Regulations, the Income Tax Application Rules, a tax treaty or any other enactment relevant to computing tax, or an abuse having regard to those provisions read as a whole.
When a misuse or abuse occurs through an avoidance transaction that results in a tax benefit, the CRA is allowed to re-determine the tax consequences to the taxpayer, in a manner that is reasonable in the circumstances, in order to deny the tax benefit.
The government announced in the 2021 Federal Budget that it will be taking steps to "strengthen and modernize" the GAAR. In August 2022, the government released a consultation paper seeking comments from the tax community regarding potentially sweeping changes to the GAAR that may substantially reshape the rule and overturn decades of case law. However, as of the date of this guide, the consultation is open-ended and no draft legislation has been proposed.
j. Payroll tax
Employers, including non-resident employers, are required to register for payroll accounts with the CRA. They are also generally required to withhold and remit to the receiver general for Canada withholding tax from salaries, wages and other remuneration paid to employees (whether resident or non-resident) for employment services performed in Canada. Employers must also generally pay and remit other amounts, such as Canada Pension Plan contributions and Employment Insurance Act.
These obligations can arise in respect of a non-resident employer that has staff temporarily in Canada, including where the non-resident employer has no permanent establishment in Canada. Where a payee is both a non-resident individual and is exempt from Canadian tax pursuant to a treaty between Canada and the payee's country of residence, the payee may be able to obtain a waiver from income tax withholding from the CRA. Relief from the obligation to make Canada Pension Plan contributions may be available if social security coverage continues in the individual's country of residence.
Relieving rules, which came into effect in 2016, can relieve a qualifying non-resident employer that has qualifying non-resident employees temporarily working in Canada from payroll withholding requirements. In general, both the employer and the employee must be resident in a country with which Canada has a tax treaty, and the employee must work in Canada for less than 45 days in the calendar year or be present in Canada for less than 90 days in any 12-month period.
Additional withholding in respect of tax may be required for services or work performed in Québec.
k. Regulation 105 withholding
The ITA requires all persons to withhold and remit to the CRA 15 per cent of any fees, commissions or other amounts paid to non-residents for services rendered in Canada (other than salary or wages paid to an officer or employee, or a former officer or employee, which are subject to a payroll tax as described above).
This requirement applies even when the non-resident does not have a permanent establishment in Canada or is entitled to an exemption under a treaty for Canadian tax on income from performing services in Canada. The amount withheld and remitted is not determinative of the tax liability of the non-resident, but is applied on account of the tax liability (if any).
If the person performing the services is eligible for an exemption from Canadian income tax on its Canadian business income under a treaty, the person may recover the tax withheld - commonly referred to as the "Regulation 105 amount" - by filing a Canadian tax return. There is also a process whereby the non-resident can obtain a waiver of the requirement of the payer to withhold the Regulation 105 amount in certain circumstances, but the waiver must be applied for in respect of each contract and prior to any payment.
l. Scientific research and experimental development
The ITA provides generous incentives for expenditures incurred for scientific research and experimental development (SR&ED) related to business carried on in Canada by the taxpayer. Through a system of tax deductions and credits to taxpayers, in conjunction with similar tax incentives provided under various provincial laws, Canada has an attractive tax environment in which to engage in SR&ED. These incentives are significantly enhanced for taxpayers that are CCPCs.
2. General application of Canadian tax to non-residents
Canada imposes income tax under the ITA on a taxpayer's income for each taxation year. While residents of Canada are taxed on their worldwide income, with a few exceptions, non-residents are only subject to Canadian income tax on their Canadian source income.
Non-residents who were employed or carried on business in Canada during the year or disposed of "taxable Canadian property" are liable to pay income tax on their taxable income earned in Canada, which will consist of their income from those three sources.
Non-residents are also subject to withholding tax on passive income such as dividends, rent and royalties from Canadian sources (withholding tax is discussed earlier under "Withholding tax on passive income of non-residents"). A non-resident of Canada who resides in a country that has a tax treaty with Canada may benefit from exemptions or reduced rates of withholding tax in Canada under that treaty.
a. Carrying on business in Canada
In many cases, it will be obvious whether a business is being carried on in Canada. However, there are situations where the location of the business is not as clear for tax purposes. Determining whether a non-resident is carrying on business in Canada for income tax purposes requires an analysis of all of the facts, including establishing the place where contracts are concluded and profit-generating operations are based.
In addition, a non-resident will be deemed to be carrying on business in Canada for purposes of the ITA if the non-resident does any of the following:
- Produces, grows, mines, creates, manufactures, improves, packs, preserves or constructs, in whole or in part, anything in Canada, regardless of whether the non-resident sells it or exports it from Canada without selling it
- Solicits orders or offers anything for sale in Canada through an agent or servant
- Disposes of timber resource property, Canadian real property (other than capital property) or, in certain circumstances, Canadian resource property
If a non-resident individual carries on business in Canada in a taxation year, they may be required to file an annual Canadian income tax return. Generally, a non-resident individual is only required to file a return if tax is payable under the ITA, or if they dispose of certain taxable Canadian property.
By way of contrast, a non-resident corporation that carries on business in Canada in a taxation year must file a return for the year, regardless of whether it has realized a profit in Canada or if its income is exempt from Canadian tax under an applicable income tax treaty. If such an exemption is available, it is claimed when filing the Canadian tax return.
Where a non-resident carries on business in Canada, both Canadian federal and provincial (or territorial) income tax may be imposed.
In addition to income tax, a variety of indirect taxes could be applied to business operations in Canada, as discussed below.
Digital service tax (DST)
The DST was proposed in the 2021 Federal Budget and will apply starting January 1, 2022. The proposed DST is a three per cent tax on revenues earned from digital services that rely on the engagement, data and content contributions from Canadian users, including online marketplaces, social media and online advertising.
The DST will apply to Canadian and non-resident businesses having consolidated annual revenues of €750 million or more and revenues associated with Canadian users of more than CA$20 million.
Value-added taxes (VAT)
In addition to income tax, certain value-added taxes (VAT) could apply to business operations in Canada.
The federal goods and services tax and harmonized sales tax (GST/HST) applies to most supplies of property and services made in Canada, and the GST applies to most importations of goods into Canada. The GST applies at a rate of five per cent and the HST at a rate of 13 or 15 per cent, depending on the province in which a supply is made or deemed to be made. Certain supplies are exempt from GST/HST, including certain supplies of financial services, residential real property, health care and educational services.
The GST/HST is a VAT and, therefore is generally recoverable if the business is registered for GST/HST purposes and makes GST/HST-taxable supplies. Businesses that make exempt supplies may not be permitted to recover GST/HST paid or payable on property and services acquired for related purposes and, therefore, will bear the burden of the tax as a cost of their business activities.
A non-resident that carries on business in Canada may be required to register for GST/HST purposes and be liable to collect and remit the GST/HST. A non-resident that is required to register, but that does not have a permanent establishment in Canada, is required to post a recoverable security with the CRA on registering for GST/HST purposes.
A non-resident that does not carry on business in Canada nonetheless may be required to register under a simplified GST/HST regime, and to collect GST/HST on sales of intangible personal property and services made to non-GST/HST registered recipients in Canada. The obligation to register arises if such sales to non-GST/HST registered recipients is expected to exceed $30,000 per year. There is no security requirement under the simplified regime, nor is any GST/HST recoverable by the non-resident.
In addition to the GST, the province of Québec imposes a VAT in the form of the Québec sales tax (QST) at a rate of 9.975 per cent. A non-resident that carries on business in Québec may be required to register for QST collection and remittance. The QST is administered by a separate tax authority under legislation distinct from the GST/HST, such that a separate registration is required. The tax base, exemptions and recoverability are similar to that of the GST/HST.
A simplified regime also applies to a non-resident that does not carry on business in Québec for sales of intangible personal property and services made to non-QST registered consumers. For businesses based in Canada or non-resident businesses that are GST/HST registered, the simplified regime extends to goods sold to consumers in Québec.
A non-resident that does not carry on business in Québec nonetheless may be required to register for QST under a simplified regime, and to collect QST on sales of intangible personal property and services made to consumers in Québec. The obligation to register arises once such sales to consumers in Québec exceeds $30,000 per year. For businesses based in Canada or non-resident businesses that are GST/HST registered, the simplified regime extends to goods sold to consumers in Québec.
As with the simplified GST/HST regime, the obligation to register arises for a non-resident once such sales to consumers in Québec exceed $30,000 per year. QST is not recoverable by the non-resident under the simplified regime.
Provincial sales taxes (PST)
British Columbia, Saskatchewan and Manitoba each impose their own form of provincial sales or retail sales taxes (PST), which are similar to state sales and use taxes in the U.S. British Columbia and Manitoba each impose their PST at a rate of seven per cent, and Saskatchewan at a rate of six per cent - though rates can vary for certain goods.
Most goods and most computer software are subject to the PST, while real property and most other intangible personal property are not. The PST also apply to a limited range of taxable services that vary from province to province. Each province has a slightly different set of tax exemptions, though each has a general exemption for resale.
The threshold for a non-resident to register to charge and collect the PST varies. Manitoba and Saskatchewan effectively require PST registration on solicitation and delivery of taxable goods into the province, though Manitoba allows sales under $10,000 per year without registration. British Columbia has an expanded statutory carrying on business test and requires PST registration for non-residents with sales of software and telecommunications services over $10,000 (as well as for Canadians that are non-residents of British Columbia with such sales, together with sales of taxable goods, over the same threshold).
Books and records
Persons carrying on business in Canada must maintain books and records regarding their Canadian operations at a Canadian place of business - or otherwise make them available for audit by the CRA. Although the CRA's audit powers are not unlimited, the CRA has the power to make broad and probing requests for documents and information in the context of an audit. Failure to comply with such a request may lead the CRA to seek a compliance order from the Federal Court, and failing to comply with such an order may result in a conviction for contempt of court. As well, failing to supply requested documents and information may result in such documents and information being inadmissible in the defense of an assessment for tax in certain circumstances.
b. Taxable Canadian property
A non-resident is generally taxed in Canada on any capital gain from the disposition of "taxable Canadian property."
For this purpose, "taxable Canadian property" includes:
- Real property or resource property located in Canada.
- Property used or held by the taxpayer in, or described in an inventory of a business carried on in Canada (with some limited exceptions).
- A share of the capital stock of a corporation (other than a mutual fund corporation) that is not listed on a designated stock exchange, or an interest in a partnership or trust (other than a mutual fund trust or an income interest in a trust resident in Canada) at a particular time if, at any time during the previous 60-month period, more than 50 per cent of the fair market value of the share or interest was derived directly or indirectly from certain Canadian properties (e.g., real property situated in Canada, Canadian resource properties, timber resource properties, or options or interests in such properties).
- A share of the capital stock of a corporation listed on a designated stock exchange, a share of a mutual fund corporation or a unit of a mutual fund trust at a particular time if both of the following conditions applied at any time during the previous 60-month period:
- The taxpayer - including persons not dealing at arm's length with the taxpayer - owned 25 per cent or more of the issued shares or units of any class of the capital stock of the corporation, or more than 25 per cent of the issued units of the trust
- More than 50 per cent of the value of the shares or units was derived directly or indirectly from certain Canadian properties (- e.g., real property situated in Canada, Canadian resource properties, timber resource properties)
- Options or interests in the properties described in (i) to (iv).
A non-resident that disposes of taxable Canadian property is generally subject to notification and withholding tax requirements. Subject to certain exceptions, the ITA requires a non-resident who disposes of taxable Canadian property to notify the CRA of the disposition not later than 10 days after it occurred. A non-resident vendor will also be required to remit to the CRA an amount on account of its tax payable or provide appropriate security.
Once the non-resident has given the required notice and paid the required amount, the CRA will issue a certificate of compliance - commonly known as a "Section 116 certificate" - to the non-resident vendor. If a Section 116 certificate is not obtained, the purchaser becomes liable for, and must remit to the CRA, 25 per cent of the gross purchase price within 30 days of the end of the month in which the disposition occurs. The purchaser also has the right to withhold this amount from the purchase price or otherwise recover the amount from the non-resident vendor.
It is usually advantageous for the non-resident to obtain a Section 116 certificate from the CRA, since a certificate will be issued based on a payment of an amount calculated with reference to the gain arising from the disposition. Without the Section 116 certificate, the tax withheld by the purchaser is based on the gross selling price of the property. These withholding obligations and notification requirements apply even if a loss arises on the disposition. However, they generally do not apply to certain dispositions of taxable Canadian property that would otherwise be exempt from Canadian tax under Canada's tax treaties.
3. Canadian taxation of a Canadian resident subsidiary
a. Income tax liability
A subsidiary that has been incorporated anywhere in Canada is considered to be resident in Canada for income tax purposes. It is subject to federal and provincial/territorial taxation in Canada on its worldwide income in the manner indicated previously in the discussion on Canada's general tax rules.
Canada's corporate tax rates have been gradually reduced in recent years and are now relatively low. Combined federal and provincial/territorial rates on general business income of a corporation are currently between 23 and 31 per cent, and range between 23 and 27 per cent for the most populous provinces of Alberta, British Columbia, Ontario and Québec.
b. Business and property income
The ITA provides that a taxpayer's income from a business or property is the profit from that source for the taxation year. "Profit" is to be computed initially using applicable general commercial and accounting norms, but is subject to many specific adjustments under the ITA.
c. Capital gains and losses
Capital gains receive preferential treatment under the ITA since only 50 per cent of a capital gain - also referred to as a "taxable capital gain" - is included in income. A capital gain is the amount by which the proceeds of a disposition of a capital property exceed its adjusted cost base and reasonable costs of disposition.
Fifty per cent of a capital loss - also referred to as an "allowable capital loss" - is deductible but generally only against taxable capital gains. The amount by which taxable capital gains exceed allowable capital losses incurred in a taxation year is included in the corporation's income and is subject to tax at the regular rates. Where allowable capital losses exceed taxable capital gains, the excess, or net capital loss, may be carried back three years and carried forward indefinitely, but may only be used to offset taxable capital gains of those other years.
d. Deductibility of expenses
In general, in order to be deductible, expenses must be incurred in the year for the purpose of gaining or producing income from business or property. Generally, only current expenses are deductible in computing taxable income. Capital expenditures are not generally deductible, although an amount representing depreciation may be deducted pursuant to the capital cost allowance (CCA) regime, which is discussed in more detail later in this section.
The accounting and tax treatment of expenses are not always the same:
- Meals and entertainment expenses
Generally, only 50 per cent of food and entertainment expenses may be deducted under the ITA, even if they were incurred solely for bona fide business purposes.
Generally, interest is deductible only to the extent that it is paid or payable on a debt incurred for the purpose of earning income from business or property. A number of restrictions may apply. For example, the "thin capitalization" rules restrict the interest deduction that a corporation resident in Canada can deduct on a debt owing to a "specified non-resident."
For taxation years beginning after 2012, the permissible amount of debt to specified non-residents is one and a half times the equity. In general, interest on debt in excess of this limit is non-deductible and deemed to be a dividend from which the Canadian payer must withhold tax (see "Withholding tax on passive income of non-residents").
The 2021 Federal Budget proposed a new earnings-stripping rule that would limit the amount of interest that certain businesses can deduct in computing their taxable income. The proposed earnings-stripping rule would limit the amount of net interest expense that a corporation may deduct to no more than a fixed ratio of "tax EBITDA," which is that corporation's taxable income before taking into account interest expense, interest income and income tax, and deductions for depreciation and amortization. The measure of interest expense would exclude interest that is not deductible under the thin capitalization rules or other existing income tax rules. Interest expense and interest income related to debts owing between Canadian members of a corporate group would generally also be excluded. The new rule would be phased in, with a fixed ratio of 40% for taxation years beginning on or after January 1, 2023 but before January 1, 2024 (the transition year), and 30% for taxation years beginning on or after January 1, 2024. Interest denied under the proposed rules could be carried forward for up to 20 years or back for up to three years. Denied interest could be carried back to taxation years that begin prior to the effective date of the rule, to the extent the taxpayer would have had the capacity to deduct these denied expenses had the proposed rule been in effect for those years. Other relieving measures would allow Canadian members of a group to transfer unused capacity to deduct interest to other Canadian members of the group who would otherwise be limited by the proposed rule. A "group ratio" rule would also be introduced to allow a taxpayer to deduct interest in excess of the fixed ratio where it can demonstrate that a higher deduction limit would be appropriate in light of the consolidated group's ratio of net third party interest to book EBITDA.
Trusts, partnerships and Canadian branches of non-resident taxpayers would also be subject to the new earnings-stripping rule. Exemptions would be available for Canadian-controlled private corporations that have taxable capital employed in Canada of less than $15 million and groups of corporations and trusts whose aggregate net interest expense among their Canadian members is $250,000 or less.
Specific rules apply for the purpose of calculating both the amount of debt and equity affected by these restrictions. Canada also has specific withholding tax rules on certain back-to-back loan arrangements involving non-residents.
- Loss carry-overs
Losses realized from business or property are fully deductible in the year that they are incurred. To the extent that all or any portion of these losses remain unused and were incurred in or after 2006, they may be carried back three years and forward 20 years. For losses arising before 2006, the carry-forward period is shorter, ranging from seven to 10 years depending on the circumstances. Capital losses may only be deducted against capital gains and may be carried back three years and forward indefinitely.
The ITA restricts the ability of a corporation to use loss carry-overs after control of the corporation has been acquired. In general terms, losses from property do not survive an acquisition of control, while business losses incurred before the acquisition of control may only be used to offset income after the acquisition of control from the same or a similar business.
e. Capital cost allowance (CCA)
The ITA explicitly disallows the deduction of capital expenditures with limited exceptions. For example, instead of claiming a deduction for depreciation, the ITA permits the deduction of CCA. For this purpose, the Income Tax Regulations (the Regulations) require the grouping of depreciable assets into various classes.
A deduction for CCA may be claimed annually based on the total undepreciated capital cost (UCC) of each asset class at the rate prescribed by the Regulations. CCA is generally computed on a declining-balance basis and, in most cases, only half of the amount that is normally deductible can be claimed in the first year that an asset is acquired.
In addition, CCA may only be claimed on an asset when the asset is "available for use" for the purpose of earning income, as that term is defined in the ITA. Detailed rules specify when a particular property becomes "available for use." CCA is a discretionary deduction, thus the taxpayer is not required to claim it in a particular year.
When a depreciable property is sold, the proceeds of disposition are deducted from the UCC of the class. If that deduction results in a negative balance for the class, the negative balance may be included in income as a recapture of CCA. A resulting positive balance may be deducted from income as a terminal loss if no assets remain in the class. The disposition of depreciable property may also give rise to a capital gain.
f. Repatriation of funds: Dividends
The ITA generally imposes a 25 per cent withholding tax on dividends paid by a Canadian subsidiary to its non-resident shareholder. This rate may be reduced by a treaty. For example, under the Canada-U.S. Tax Treaty, the rate of withholding tax on a dividend paid by a wholly owned subsidiary may be reduced to 5 per cent. The Canadian subsidiary is required to deduct or withhold this tax from the dividend.
g. Repatriation of funds: Paid-up capital
A Canadian subsidiary of a non-resident shareholder may distribute paid-up capital without Canadian withholding tax, even if the subsidiary has undistributed earnings and profits. A number of corporate law and tax requirements must be satisfied in connection with a return of capital.
h. Management, rental and royalty payments
The ITA generally imposes a 25 per cent withholding tax on the payment of management fees, rent and royalties, which is subject to reduction under Canada's tax treaties. Under many of Canada's tax treaties, management fees charged by a non-resident parent to a Canadian subsidiary are not subject to Canadian withholding tax if the non-resident does not have a permanent establishment in Canada.
i. Inter-corporate loans
- Loans from non-resident parent to Canadian subsidiary
The "thin capitalization" rules in the ITA may disallow a deduction for interest payable by a Canadian subsidiary on debts owing to a "specified non-resident person" if such debts exceed certain limits.
Subject to an applicable tax treaty, a Canadian subsidiary must withhold tax on interest paid to non-arm's-length parties or on participating debt interest. A notable exception is available for U.S. residents under the Canada-U.S. Tax Treaty, which eliminates withholding tax on interest paid by a Canadian subsidiary to a U.S. parent, provided that the U.S. parent qualifies for the benefits of that treaty and the interest is not participating debt interest.
- Loans from Canadian subsidiary to non-resident parent
If a Canadian subsidiary lends money to its non-resident parent and the loan is not repaid within one year (from the end of the subsidiary's taxation year during which the loan was made), the entire principal amount of the loan will generally be deemed to be a dividend paid to the parent, and withholding tax will be payable on the amount of the deemed dividend.
Even if the full principal amount of the loan is repaid within the time required, if an appropriate interest rate was not charged, a deemed taxable benefit may arise - which would result in a deemed dividend and Canadian withholding tax.
4. Canadian taxation of a branch operation
A non-resident corporation that carries on business in Canada must pay Canadian income tax on income earned in Canada. Generally, however, Canada's tax treaties provide that a corporation's business profits will only be subject to Canadian income tax to the extent that they are attributable to a Canadian permanent establishment.
a. Permanent establishment
Whether a Canadian permanent establishment exists depends on the facts. Generally, a permanent establishment is a fixed place of business through which the business of the non-resident is wholly or partly carried on. Tax treaties generally provide that a permanent establishment includes a place of management, a branch, an office, a factory or a workshop. Under many of Canada's tax treaties, a building site or construction or installation project also constitutes a permanent establishment, but generally only if it lasts more than 12 months. As such, depending on the nature of its activities, a branch operation in Canada will often have a permanent establishment in Canada.
A permanent establishment can arise in many other circumstances as well. For example, the CRA considers computer equipment - such as a server that connects to the Internet - to be tangible property having a physical location. Such equipment may therefore constitute a non-resident person's place of business if it is at the disposal of the person (in other words, if it is owned or leased and used by the person). On the other hand, the mere use of a computer or server owned by a third party will not generally constitute a fixed place of business of the non-resident if the computer or server is not at the non-resident's disposal.
Agents and employees in Canada may themselves constitute permanent establishments in some circumstances - namely in cases where such a person has, and habitually exercises, authority to conclude contracts in the name of the non-resident. Care is required here, but in the appropriate circumstances a non-resident corporation should not be considered to have a permanent establishment in Canada by reason of having sales representatives in Canada - provided the representatives do not have or habitually exercise authority to conclude contracts in the name of the non-resident.
Under the Canada-U.S. Tax Treaty, if a U.S. enterprise is providing services in Canada and is not otherwise found to have a permanent establishment in Canada, it will nevertheless be deemed to be providing the services in Canada through a permanent establishment if:
- The services are provided by an individual who is present in Canada for an aggregate of 183 days or more in any 12-month period and more than 50 per cent of the gross active business revenue of the enterprise is derived from such services; OR
- The services are provided in Canada for an aggregate of 183 days or more in any 12-month period with respect to the same or a connected project for customers who are either resident in Canada or who maintain a permanent establishment in Canada.
b. Branch tax
In addition to Canadian federal and provincial income tax, a non-resident corporation carrying on business in Canada through a Canadian branch operation is subject to a branch tax. Under Part XIV of the ITA, the branch tax is 25 per cent of after-tax income that is not reinvested in Canada. Where the rate of withholding tax on dividends is reduced by a tax treaty, as is usually the case, the rate of the branch tax is often reduced to the same rate.
The ITA generally provides that branch tax is levied on the after-tax Canadian earnings of the business carried on in Canada, less any amounts that are reinvested in the Canadian business. A tax treaty may modify the method of calculating the earnings for branch tax purposes. In addition, a tax treaty may exempt the first $500,000 of a non-resident corporation's income from branch tax.
The branch tax is intended to approximate the Canadian withholding tax that would have been payable on dividends paid by a Canadian-resident subsidiary to its non-resident parent. In the absence of this branch tax, a Canadian branch could be more tax-efficient than a Canadian subsidiary.
A branch is not a legal entity, and the financial and tax accounting for branches may be more complex than for a Canadian subsidiary. For example, the determination of the branch's proportionate share of the corporation's overall general and administrative expenses can raise difficult questions. Non-resident corporations wishing to carry on business in Canada through a branch face the potentially serious practical problem of preparing financial statements for the branch in a manner that will be acceptable to both the CRA and the tax authorities of its country of residence.
c. Books and records
When a corporation carries on business through a Canadian branch, all of its books and accounting records with respect to its Canadian operations must be kept at its Canadian place of business, or other designated place. They must also be made available for audit by the CRA.
d. Taxation of non-resident employees of a branch
The taxation of employees of a branch depends on whether the employees are, or become, Canadian residents. Residency is generally determined based on the extent of the residential connections with Canada. However, an individual may also be deemed to be a resident of Canada, for example, by sojourning in Canada for 183 days or more in the year.
Where an individual is a resident of Canada and continues to be a resident in another country - in other words, if the individual is a dual resident - Canada's tax treaties contain tiebreaker rules for determining where the individual will be considered a resident for tax purposes. Where an individual is a dual resident, the tiebreaker rule in a particular tax treaty may result in that individual being regarded as non-resident in Canada.
Generally, a treaty tiebreaker rule provides that an individual is resident in the jurisdiction in which they have a permanent home available to them. If the individual has a home in both or neither places, then the next consideration is the individual's centre of vital interests - that is, the state in which their personal and economic ties are closer. If these considerations are not determinative, certain treaties will then consider the individual's habitual abode, followed by their citizenship. Failing this, the respective tax authorities must be called upon to settle the matter.
Employees who move to Canada and become Canadian residents are taxable on their worldwide income. On the other hand, employees who are non-residents of Canada are taxed only on their Canadian source income, which would include remuneration received for employment duties they physically exercise in Canada. However, in some situations, a tax treaty may deny Canada the right to tax such remuneration. For example, under the Canada-U.S. Tax Treaty, Canada will generally not tax a U.S. resident employee of a U.S. employer on their employment income for a particular calendar year if either of the following conditions are met:
- The remuneration does not exceed $10,000 in respect of employment in Canada during the particular calendar year; OR
- The employee is present in Canada for periods that do not exceed 183 days in any 12-month period and the remuneration is not paid by a Canadian resident or borne by a Canadian branch.
Canada's other tax treaties generally apply rules similar to those of the Canada-U.S. Tax Treaty, with the exception of the $10,000 safe-harbour rule. As a result, Canada's tax treaties will often deny Canada the right to tax non-resident employees temporarily working in Canada - provided they are in Canada for less than 184 days and their remuneration is not paid by a Canadian resident or borne by a Canadian branch.
This exemption does not preclude the obligation of the employer, whether resident or non-resident, to withhold income tax from a U.S. resident's remuneration for the services performed in Canada - unless a waiver is obtained from the CRA, or relief is provided by the payroll exemption for qualifying non-resident employers and employees that became effective in 2016. Other payroll source deductions may also apply subject to certain exceptions.
Please refer to the more detailed discussion above regarding payroll source deductions and the exemption for qualifying non-resident employers and employees.
Non-resident corporations with a permanent establishment in Canada are deemed to be resident in Canada for GST/HST purposes, and therefore may be required to register for and collect GST/HST on all taxable supplies of property and services made through the permanent establishment. Special rules may require self-assessment for GST/HST on intangible property and services sourced from outside of Canada.
f. Unlimited liability companies
In some circumstances, it may be advantageous to incorporate a Canadian subsidiary as an unlimited liability company (ULC). These special corporate vehicles are available under the laws of the provinces of Alberta, British Columbia and Nova Scotia.
A ULC may be considered to be a flow-through or fiscally transparent entity for U.S. tax purposes. However, for Canadian purposes, a ULC is not fiscally transparent and is taxed as a Canadian corporation. As well, certain benefits under the Canada-U.S. Tax Treaty are not available to US resident shareholders of ULCs. For general information on ULCs, see the "Business structures" chapter.
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