This posting was authored by Stephen Rukavina an
Associate in the Vancouver Office of Miller Thomson LLP
An unlimited liability company (“ULC”) is a common entity US businesses use as a Canadian subsidiary or to hold Canadian assets. This can seem strange. Normally, a business will incorporate because shareholders do not incur liability for the corporation’s debts and liabilities except in exceptional circumstances. However, the shareholders of a ULC do incur liability for the corporation’s debts and liabilities. Why would anyone want to use a ULC if that is the case? The reason is that ULCs offer several tax advantages to US shareholders. Those tax advantages are discussed below after a brief discussion of the use of a branch or subsidiary to carry on business in Canada.
Branch Verse a Canadian Subsidiary
One of the first things a US business needs to decide upon when expanding into Canada is whether to operate a branch or form a Canadian subsidiary. Operating a branch in Canada simply means the US business starts conducting business directly in Canada.
There are several drawbacks associated with a branch operation. First, the US business will be a non-resident of Canada. As such, it will be subject to a number of withholding tax rules. All services provided in Canada by the US business will be subject to 15% Regulation 105 withholding tax. Also Canadian source passive income, such as interest, rents and royalties, earned by the US business will be subject to Part XIII withholding tax which by default applies at a rate of 25% but may be reduced under the Canada-US Tax Convention. Also any taxable Canadian property, which includes land and buildings, will be subject to Section 116 withholding tax and related rules. Second, a US business carrying on business in Canada will be required to file a Canadian income tax return and generally be exposed to Canadian tax obligations. Third, the US business may also be required to register for and comply with the goods and services tax / harmonized sales tax (“GST/HST”) and, in the case of British Columbia, Saskatchewan and Manitoba, provincial sales tax (“PST”).
US businesses often form a Canadian corporate subsidiary in order to avoid the above consequences. The Canadian corporation will be a resident of Canada, which will prevent the withholding tax rules cited above from applying as such rules apply to non-residents. Another advantage of a Canadian subsidiary is that the subsidiary will bear the Canadian tax obligations rather than the US parent. It will be the Canadian subsidiary that will file a Canadian income tax return and comply with GST and PST requirements.
Unlimited Liability Companies
US businesses have two choices when incorporating a Canadian subsidiary. The subsidiary can either be an ordinary corporation whose shareholders have limited liability or an unlimited liability company. As the name implies, a ULC’s shareholders face liability. The shareholders of a ULC incorporated under British Columbia law will be liable for the ULC’s debts and liabilities if the ULC liquidates or dissolves and cannot pay such debts and liabilities. Former shareholders can also be liable in specific circumstances. Despite the lack of limited liability, US businesses have for years used ULCs as Canadian subsidiaries and to hold Canadian assets. The reason being that ULCs offer favourable tax outcomes.
The following discussion of the favourable tax treatment of ULCs assumes that a US corporation is the sole shareholder of the ULC. In such circumstances, the ULC will be disregarded as an entity separate from its shareholder unless it elects otherwise. The fact the ULC is disregarded enables the consolidation of the ULC’s income with that of its US parent. The consolidation of income generally enables the US parent to claim foreign tax credits in the US to offset Canadian tax paid by the ULC. This structure may enable a US parent with a ULC subsidiary to pay less total tax than if the US parent used an ordinary corporation as a subsidiary.
Another advantage of using a ULC is that retained earnings can be repatriated to the US parent with only 5% withholding tax which may also be offset by a foreign tax credit. However, the repatriation has to be done by way of a two-step distribution which is discussed below.
The following assumes a US corporation is the sole shareholder of a ULC and satisfies the limitation on benefits provision of the Canada-US Tax Convention. If that is the case, retained earnings of the ULC can be repatriated to the US parent with only 5% Part XIII withholding tax applying to the distribution. While the end result is simple to understand, the mechanism by which to implement it can be confusing. To understand the mechanism, you must first understand what happens if a ULC pays an ordinary dividend to its US parent.
Dividends paid by a Canadian corporation to a non-resident are subject to 25% Part XIII withholding tax. However, the rate of withholding tax may be reduced under Canada’s bilateral tax treaties. Based on the assumptions made above, the rate would be reduced to 5% under the Canada-US Tax Convention if not for an anti-avoidance rule contained in Article IV(7)(b) of that treaty.
Article IV(7)(b) is an anti-avoidance rule that applies to entities known as hybrids. A hybrid is an entity that is considered a taxpayer in one state and fiscally transparent in another. Fiscally transparent means that the entity itself does not incur tax obligations in regards to its income. Instead, its owners incur the tax obligations. A ULC is a perfect example of a hybrid. For Canadian tax purposes, a ULC is considered a taxable Canadian corporation. For US tax purposes, it is by default treated as a disregarded entity (if it has one shareholder) or a partnership (if it has more than one shareholder).
The different treatment of hybrids in different countries can be exploited to reduce tax in abusive ways. In order to stop that, Canada and the US added Article IV(7)(b) to the latest version of the Canada-US Tax Convention. In summary, Article IV(7)(b) prevents treaty benefits from applying if (1) the “Source State” (i.e., the country from which amounts are paid) views the payee as receiving the amount from a payer resident in the Source State; (2) the payer is treated as fiscally transparent under the law of the “Residence State” (i.e., the country in which the payee is resident); and (3) because of the payer being treated as fiscally transparent under the law of the Residence State, the treatment of the amount received by the payee is not the same as its treatment would be if the payer were not treated as fiscally transparent under the law of the Residence State.
Dividends paid by a ULC to its US parent fall squarely within the Article IV(7)(b) anti-avoidance rule, preventing a reduction of the 25% Part XIII withholding tax. The reason being is that (1) Canada views the US parent as receiving the dividend from a corporation resident in Canada; (2) the ULC is treated as fiscally transparent in the US; and (3) since the ULC is treated as fiscally transparent, the dividend is disregarded for US tax purposes whereas it would not be disregarded if the ULC were not treated as fiscally transparent.
Article IV(7)(b) is generally understood to be broader than necessary, catching transactions that are not abusive tax avoidance. A ULC distributing retained earnings to its US parent is understood as one of the instances where Article IV(7)(b) catches a transaction that is not abusive. Presumably the Canada Revenue Agency (“CRA”) agrees with that analysis, as it has sanctioned a method to circumvent Article IV(7)(b) and to allow retained earnings of a ULC to be repatriated with only 5% withholding tax applying to the distribution. The method is commonly known as a two-step distribution. Once again, the following discussion is based on the assumptions made at the beginning of this section.
As the name implies, a two-step distribution involves two steps. The first step requires the ULC to increase the paid-up capital (“PUC”) on a class of its shares by capitalizing retained earnings. PUC of a class of shares generally equals the capital, for corporate law purposes, of that class of shares. So, the capitalization of retained earnings under corporate law increases PUC by the amount capitalized. In the case of a British Columbia ULC, retained earnings can be capitalized by a directors’ resolution or an ordinary resolution of the shareholders.
The increase in PUC on a class of shares by capitalizing retained earnings triggers a “deemed dividend” on those shares for purposes of Canadian taxation. The amount of the deemed dividend equals the increase in PUC. The amount of the deemed dividend is subject to Part XIII withholding tax. However, the rate will be reduced to 5% under the Canada-US Tax Convention. You may wonder why the anti-avoidance rule in Article IV(7)(b) does not apply to deny treaty benefits. The reason is that the deemed dividend would be disregarded for US tax purposes regardless of whether the ULC is fiscally transparent or not. Therefore, the third requirement of the Article IV(7)(b) anti-avoidance rule is not satisfied, and the rule is not applicable.
The second step requires the ULC to reduce its newly created capital and distribute that amount to its US parent. In the case of a British Columbia ULC, a reduction of capital is done by way of a special resolution of the shareholder. A reduction of capital on a class of shares does not give rise to Canadian taxation provided the reduction does not exceed the amount of PUC on that class of shares. So, the ULC will be able to return capital to its US parent without triggering further tax provided the amount returned does not exceed the amount of retained earnings capitalized in step one. The return of capital generally does not trigger US taxation.
Limited Liability Companies
Using a ULC can be an effective strategy for US C Corporations, S Corporations or partnerships although the tax implications are somewhat different in each case and should be discussed with a tax advisor. However, a fiscally transparent US LLC should generally not use a ULC as a subsidiary because repatriated earnings of the ULC will be subject to 25% Part XIII withholding tax. An LLC is fiscally transparent unless it has elected to be treated as a corporation for US tax purposes.
The CRA’s position is that a fiscally transparent LLC does not qualify as a US resident for purposes of the Canada-US Tax Convention. The CRA’s reasoning is that a fiscally transparent LLC does not fall within the definition of “resident of a Contracting State” because such an LLC is not itself liable to tax in the US. Based on that reasoning, the CRA denies treaty benefits to a fiscally transparent LLC because only a resident of a Contracting State is entitled to treaty benefits.
Under Article IV(6) of the Canada-US Tax Convention, a fiscally transparent LLC may be able to indirectly access treaty benefits if its members would be eligible for the benefits. However, a condition of Article IV(6) applying is that the members of the LLC are “considered under the taxation law of [the US] to have derived the amount through an entity [i.e., the LLC]”. The CRA’s position is that a member of an LLC cannot be considered to have “derived” an amount under US tax law from the LLC if that amount originated from a ULC. The CRA’s position is based on the fact that amounts distributed from the ULC are disregarded for US tax purposes.
In summary, the CRA’s position is that an LLC is not eligible for treaty benefits either directly or by way of Article IV(6) if the amount in question originated from a ULC. Therefore, 25% Part XIII withholding tax applies on dividends paid or deemed to be paid by a ULC to its LLC shareholder, and the amount of withholding tax cannot be reduced under the Canada-US Tax Convention.
Given the complexities involved, US businesses thinking of expanding into Canada should put serious thought into how to structure their Canadian operations. US businesses should consult with both Canadian and US tax advisors. In particular, US businesses should consult a US tax advisor to confirm that the US tax benefits associated with a ULC discussed above are available in their particular circumstances.
The author of this posting can be contacted at (604) 643-1277 or firstname.lastname@example.org
When a Canadian resident makes a payment to a non-resident, the Canadian payor is required to withhold 25% in certain circumstances. Generally, the requirement arises where the payment is of a passive nature – this includes interest, dividends, rents, and royalties, amongst others. Payments from non-resident to non-resident in relation to property in Canada are also often to subject withholding taxes in relation to passive sources of income.
What income is subject to Withholding Tax?
Section 212 of the Income Tax Act (Canada) (the “Tax Act”) specifically requires a withholding for the following:
- Management fees;
- Estate or trust income;
- Royalties (including those from trademarks, patents, secret formulas, and certain visual media);
- Timber Royalties;
- Payments by cooperatives to members;
- Pension Benefits (including Canada Pension Plan and Old Age Security);
- Non-competition amounts;
- Retirement Compensation Arrangement benefits;
- Retiring Allowances (including termination and severance payments);
- Registered Retirement Savings Plans;
- Deferred Profit Sharing Plans;
- Registered Retirement Income Fund Payments; and
- Several other types of payments
The specific application of the withholding tax to any of the above-mentioned sources of income must be considered alongside the jurisprudence, CRA technical interpretations, and any tax treaties which may affect whether withholding tax is actually exigible. For instance, in the case of management fees, an applicable treaty provision may deem such payments to be business profits and, therefore, not subject to Part XIII tax. As another example, royalty and rent payments are often reduced by treaty. Consultation with a tax professional is essential.
Subsection 212(13) of the Tax Act is a deeming provision. It broadens the application of the Part XIII withholding to capture payments made by non-residents to non-residents in respect of property situated in Canada. In the case where payments are made between non-residents, the rules contained in Part XIII should be carefully reviewed to determine whether withholding tax is exigible.
Who is liable for the tax?
The payor is liable for withholding the tax and remitting it to Canada Revenue Agency (“CRA”). Subsection 215(6) of the Tax Act provides that the payor becomes liable for all amounts that should have been deducted or withheld. This can expose, for example, a tenant or property manager to tax risk, where the landlord is a non-resident.
The payee is also liable, as they have failed to pay the 25% tax in accordance with subsection 212(1) of the Tax Act. CRA can seek to enforce payment against the recipient payee, but success in this endeavour is predicated, in part, upon the willingness of one country’s revenue authority to enforce another’s taxes (for example, see Article XXVI A of The Canada-US Income Tax Treaty).
In the Solomon decision (2007 TCC 654), the issue was whether the taxpayer (who became a resident of Switzerland) was properly assessed on Canada pension and social security income he received. Importantly, the judge explained that subsection 215(6) of the Tax Act does not shift that tax burden to the payor, because, in part, subsection 227(8.1) of the Tax Act creates joint liability for the payor and payee. The Solomon case is also of interest as an example of the possible benefits of a tax treaty: the tax treaty in question had the effect of reducing the withholding rate to 15%. Indeed, it is critical to determine (a) whether a tax treaty exists and (b) whether that treaty provides for a reduced withholding.
There are also filing obligations on the payor which are canvassed in NR4 - Non-Resident Tax Withholding, Remitting, and Reporting – 2013 (http://www.cra-arc.gc.ca/E/pub/tg/t4061/t4061-e.html or bit.ly/VEK7B0). The NR4 information return provides information to CRA on amounts paid to the non-resident. This tax does not generally, subject to the below commentary, require a filing on the part of the non-resident recipient.
Special Exception for Rental Income
Section 216 allows rental income to be taxed on a net rather than gross basis. Thus, a taxpayer is provided with the option of either paying withholding tax on gross rental income or electing to pay Part I tax on a net basis. If rental income is tax on a gross basis, it would ignore the fact that many non-resident landlords face mortgage interest payments, maintenance, and other expenditures. Without section 216 of the Tax Act, if the withholding exceeded the net income on a given property, the tax would be highly punitive.
Although not canvassed in this posting, section 216 also provides for payments on net for timber royalties.
The Canada-US Income Tax Treaty
Many countries have entered into tax treaties with Canada. The Canada-US Income Tax Treaty is used in this article for illustrative purposes. Importantly, applicable withhold rates vary between treaties.
Indeed, certain withholding obligations are reduced by operation of The Canada-US Income Tax Treaty. These withholding obligations have changed over time, and it is important to be cognizant of any Protocols to the Treaty, which may further alter withholding rates.
In the case of dividends, the withholding is limited by Article X to 5-15% of the gross amount of the dividend, depending upon the percentage of the company owned by the non-resident. In the case of interest, the withholding is limited to 0% by Article XI. In the case of royalties, the withholding is limited by Article XII to 10%, but may not be subject to any withholding, depending upon the nature of the royalty. In the case of pension income, the withholding is limited to 15% by article XVIII. In the case of estate or trust income, the withholding tax is limited by article XXII to 15%.
In transactions involving, for example, payments of dividends, interest, rents, and royalties to non-residents, careful consideration must be given to Part XIII tax. As the withholding obligation rests with the payor, payors should be vigilant in determining whether such payments are taxable and whether there is relief from the 25% pursuant to the applicable tax treaty, if any.
The author of this posting may be contacted at (306) 347-8338 or email@example.com
This posting was authored by Stephen Rukavina an
Associate in the Vancouver Office of Miller Thomson LLP
The goods and services tax (“GST”) is a value-added tax charged on most supplies made in Canada of goods, services, real property and intangible property. The GST is charged at a rate of 5% on the value of the consideration for a taxable supply. The harmonized sales tax (“HST”) is basically the GST charged at a higher rate. It applies to taxable supplies made in participating provinces. The participating provinces use the HST in lieu of implementing their own provincial sales tax schemes. The HST ranges from 13% to 15% depending on the participating province.
Property sold through the asset sale of a business will generally be subject to GST/HST because personal property used in a commercial activity is deemed to be a taxable supply when sold or leased. Commercial real property is also a taxable supply when sold or leased.
However, the Excise Tax Act (“ETA”) contains many relieving provisions that can prevent GST/HST from applying to an asset sale. This article will discuss one of those relieving provisions: The section 167 election. It can apply regardless of whether a vendor or a purchaser is a resident of Canada. Therefore, it can even be used when a non-resident is purchasing a Canadian business by way of asset sale, provided the conditions discussed below are met.
Conditions for a Section 167 Election to Apply
The conditions that must be satisfied before a section 167 election can apply are as follows:
- If the vendor is a registrant, the purchaser must also be a registrant;
- The vendor is supplying a business or part of a business;
- The vendor established, carried on, or acquired the business or part of a business;
- Under an agreement, the purchaser is acquiring all or substantially all of the property that is reasonably necessary for the purchaser to carry on the business or part of a business; and
- A joint election is made by the vendor and purchaser.
The joint election is made using Form GST44: Election Concerning the Acquisition of a Business or Part of a Business (the “GST44”). The GST44 only has to be filed if the purchaser is a registrant. If required to be filed, the GST44 must be filed for the purchaser’s first reporting period in which the tax would, but for the section 167 election, have become payable in respect of the supply. The CRA has a discretionary power to extend the filing deadline.
There are several traps associated with the GST44. First, the GST44 must be filed if the purchaser is a “registrant”. A registrant includes a person who is required to register for GST/HST purposes but has not. Therefore, there is a risk in not filing the GST44 because the purchaser may have been required to have been registered at the time of the asset sale but did not realize. This could cause the GST44 to not be filed on time which, in turn, would cause the asset sale to be taxable. Second, purchasers sometimes do not file the GST44 even when required. In fact, the few court cases concerning the section 167 election involve, amongst other things, GST44s that were not filed or not filed on time.
Note, goodwill is not subject to GST/HST if bullet points 2, 3 and 4 above are satisfied and part of the consideration for the supply can reasonably be attributed to goodwill of the business or the part of the business. No election is required, and it is irrelevant whether the vendor and purchaser are registrants.
Business or Part of a Business
The Canada Revenue Agency (“CRA”) takes a restrictive approach to what constitutes a business or part of a business. The CRA position is important because there are few court cases on the subject to provide guidance. Also, the ETA does not define the term “part of a business”. For those reasons, practitioners generally adhere to the CRA’s position.
The CRA’s position on what constitutes a business is set out in GST/HST Memorandum 14.4, “Sale of a Business or Part of a Business” (“GST/HST, Memo 14.4”).
The assets of a business generally include real property, equipment, inventory, and intangibles such as goodwill. In general, the supply of one or more individual assets will not be considered a supply of a business. The nature of a business will generally determine the package of assets that would constitute the supply of a business or part of a business. Generally, there is no one type of property, regardless of its value, that alone would determine that there is a supply of a business.
The CRA’s position on what constitutes part of a business is also set out in GST/HST Memo 14.4.
In general, a “part of a business” is an activity that may be a functionally and physically discrete operating unit, or it may be an activity that supports or is related to the broader business, but is organized as a separate activity that is capable of operating on its own. The guidelines that apply when determining if there is a supply and acquisition of a business also apply when determining if there has been a supply and acquisition of “part of a business”.
In other words, the CRA’s administrative position is that part of a business means a franchise or branch of a business that can function as a business on its own and has its own assets, location and goodwill.
Note, there is no statutory requirement that the business or part of a business be a going concern, but there is some CRA commentary to the opposite effect. There is also no requirement that the purchaser ever operate the business or part of a business. A purchaser is free to combine the business or part of a business with the purchaser’s existing business.
All or Substantially All of the Property Required to Carry on the Business
It can be surprisingly difficult to answer the question of whether “the recipient is acquiring ownership, possession or use of all or substantially all of the property that can reasonably be regarded as being necessary for the recipient to be capable of carrying on the business or part as a business”.
The phrase “all or substantially all” is used throughout the ETA and Income Tax Act. The CRA’s longstanding position is that the phrase means 90% or more. However, courts have interpreted that phrase differently, finding that less than 90%, in some cases as low as 80%, qualifies as substantially all. The CRA’s position is that the determination of whether the all or substantially all requirement is satisfied does not take into account property already owned by the purchaser.
The ETA simply states that the purchaser must take “ownership, possession or use” of the required amount of property. There is no requirement that the purchaser buy the property. The all or substantially all requirement can be satisfied if, under the agreement, the purchaser leases some of the property rather than simply purchasing all of the property. Note, GST/HST will apply to the lease because a section 167 election does not prevent GST/HST from applying to leases. This is discussed in greater detail below.
The all or substantially all test can be difficult to apply when real property necessary for the purchaser to carry on the business is not purchased or leased from the vendor. Also anomalous results can occur. Normally, the all or substantially all test will not be satisfied if real property is purchased separately from the other business assets. Real property is so expensive that it will be unusual for its purchase price to not constitute more than 10% of the value of the property necessary to carry on a business. However, the all or substantially all test would appear to be satisfied if the real property was leased for market rents instead of purchased. Such a lease arguably has a value of $0 and would not constitute more than 10% of the value of the property necessary to carry on a business. The CRA has not provided clear guidance on this subject.
When a section 167 election applies to an agreement, GST/HST generally will not apply to the supplies made under that agreement. However, GST/HST will apply to the following supplies even if made under an agreement subject to a valid section 167 election:
- a taxable supply of a service that is to be rendered by the vendor;
- a taxable supply of property by way of lease, licence or similar arrangement; and
- where the purchaser is not a registrant, a taxable supply by way of sale of real property.
Furthermore, when a section 167 election applies, the vendor is deemed to have made a separate supply of each property and service that is supplied under the agreement for consideration equal to that part of the consideration for the supply of the business or part of a business that can reasonably be attributed to that property or service. This causes a reasonable portion of the purchase price to be attributable to any property or service that falls within one of the three above noted exceptions, and GST/HST will apply to any such portion of the purchase price.
The above exceptions cause problems for franchises. Often a franchise is purchased for a lump sum. The franchise will include tangible assets, licenses for intangible personal property (e.g., trade-marks) and vendor training. The tangible assets will not be subject to GST/HST if a valid section 167 election is made. However, the licenses and services will be subject to GST/HST. So, part of the purchase price needs to be allocated to the licenses and services and GST/HST charged on that amount.
Another problem area is restrictive covenants given by vendors selling their businesses. The CRA considers the supply of a restrictive covenant to be a supply of a service, and it is likely correct. The Manrell v. Canada decision held that a restrictive covenant is not property within the ordinary meaning of that word. That appears to make a restrictive covenant a service for purposes of the ETA because of how the term service is defined. The ETA defines service as anything other than property, money and anything supplied by an employee to an employer in the course of the employment relationship. Since a restrictive covenant is a service, a section 167 election will not prevent GST/HST from applying to a reasonable portion of the purchase price attributable to the restrictive covenant.
Use of a Section 167 Election Where Not Applicable
There are several consequences if a section 167 election is used in circumstances where it is not applicable. First, a vendor will be liable for the uncollected GST/HST on all the assets other than real property sold to a purchaser registered for GST/HST purposes. However, a vendor should normally be able to recover such GST/HST from a purchaser after the vendor is reassessed by the CRA. A purchaser may be able to claim input tax credits (“ITCs”) to offset the GST/HST paid. A vendor will be assessed interest on the amount of GST/HST it failed to collect. The rate of interest is currently 5% and compounds daily. The CRA has a policy to reduce the amount of interest to 4% in certain circumstances called a wash transaction where the purchaser would be entitled to ITCs.
Second, a purchaser registered for GST/HST purposes has to self-assess GST on the purchase of real property. A purchaser will be liable for GST/HST it fails to self-assess, but such GST/HST may be offset by ITCs. A purchaser can be assessed interest on the amount of GST/HST it failed to self-assess. The CRA may waive interest owing if offsetting ITCs are available.
Many people assume the section 167 election is relatively simple and straightforward in its application. However, determining whether the election applies can be challenging as shown above. Furthermore, this article has not even addressed the provisions that sync the section 167 election with the ETA’s change-in-use rules. Amongst other things, those provisions can cause GST/HST to apply to assets subject to a section 167 election that are subsequently used in non-commercial activities.
The author of this posting may be contacted at (604) 643-1277 or firstname.lastname@example.org
This posting was authored by Stephen Rukavina an
Associate in the Vancouver Office of Miller Thomson LLP
In Canada v. GlaxoSmithKline Inc. (“GlaxoSmithKline”), Justice Rothstein of the Supreme Court of Canada succinctly summarized transfer pricing and the tax concerns surrounding it.
Aggressive transfer pricing practices erode the Canadian tax base, reducing government revenues. Unsurprisingly, the Canadian government has, therefore, enacted income tax provisions to prevent such practices. This article provides an overview of those provisions, which are primarily found in section 247 of the Income Tax Act.
Transfer Pricing Adjustment
The transactions potentially subject to being adjusted under the transfer pricing provisions are those between a taxpayer and a non-resident person with whom the taxpayer does not deal at arm’s length. A taxpayer is basically any person within Canada’s jurisdiction to tax, regardless of whether the person is a resident or non-resident. Non-arm’s length transactions involving partnerships can also potentially be adjusted. The non-arm’s length transactions described above can be subject to two types of adjustment.
The first type of adjustment applies if the terms or conditions of a transaction differ from those that would have been made between person’s dealing at arm’s length. Where that is the case, there is an adjustment of any amounts that would be determined for income tax purposes in respect of the taxpayer to the amounts that would have been determined if the terms and conditions had been those that would have been made between persons dealing at arm’s length.
The second type of adjustment applies if a transaction would not have been entered into between persons dealing at arm’s length and can reasonably be considered not to have been entered into primarily for bona fide purposes other than to obtain a tax benefit. Where that is the case, there is an adjustment of any amounts that would be determined for income tax purposes in respect of the taxpayer to the amounts that would have been determined if the transaction entered into between the participants had been the transaction that would have been entered into between persons dealing at arm’s length, under terms and conditions that would have been made between persons dealing at arm’s length. In Information Circular 87-2R: International Transfer Pricing (“IC87-2R”), the CRA has stated that it will only use this power of recharacterization in limited circumstances.
The above provisions are geared toward stopping aggressive transfer pricing by making “Upward Adjustments”. Upward adjustments are adjustments that increase a taxpayer’s income, reduce its losses or reduce its capital expenditures. These types of adjustments generally increase the amount of Canadian tax owed.
“Downward Adjustments” are adjustments that decrease a taxpayer’s income, increase its losses or increase its capital expenditures. These type of adjustments can reduce Canadian tax owed. Downward Adjustments are not automatically made. The Minister of National Revenue (“Minister”) does, however, have the power to make such Downward Adjustments if, in her opinion, the circumstances are such that it would be appropriate that the adjustment be made.
Transfer Pricing Penalty
A transfer pricing penalty may apply in addition to any increase in taxes from Upward Adjustments. The penalty applies where the net amount as calculated below exceeds the lesser of $5,000,000 and 10% of the taxpayer’s gross revenue for the tax year. The relevant calculation is as follows.
- the total amount of Upward Adjustments,
- the total amount of Upward Adjustments for which the taxpayer made reasonable efforts to determine an accurate transfer price or allocation, and
- the total amount of Downward Adjustments for which the taxpayer made reasonable efforts to determine an accurate transfer price or allocation.
When the penalty is applicable, the amount of the penalty is 10% of the net amount as calculated above.
Notice that the penalty may not apply even when there has been Upward Adjustments. This is because reasonable efforts to determine the transfer price or allocation are taken into account in the calculation to determine whether the penalty applies and its amount. In effect, reasonable efforts to determine an accurate transfer price or allocation can negate the application of the penalty.
Reasonable Efforts and Contemporaneous Documentation
In general, the determination of whether a taxpayer has made reasonable efforts is a question of fact. However, a taxpayer is deemed not to have made reasonable efforts if the taxpayer does not obtain contemporaneous documentation in respect of the transaction and also satisfies the following. The documentation must be obtained on or before the taxpayer’s documentation-due date, which is generally the taxpayer’s tax return filing due date. If the transaction spans multiple years, material changes must also be documented by the documentation-due date of the year of the material change. The documentation must also be provided to the CRA within three months of a written request.
Contemporaneous documentation consists of records and documents that provide a complete and accurate description of the following:
- the property or services to which the transaction relates,
- the terms and conditions of the transaction and their relationship, if any, to the terms and conditions of each other transaction entered into between the participants in the transaction,
- the identity of the participants in the transaction and their relationship to each other at the time the transaction was entered into,
- the functions performed, the property used or contributed and the risks assumed, in respect of the transaction, by the participants in the transaction,
- the data and methods considered and the analysis performed to determine the transfer prices or the allocations of profits or losses or contributions to costs, as the case may be, in respect of the transaction, and
- the assumptions, strategies and policies, if any, that influenced the determination of the transfer prices or the allocations of profits or losses or contributions to costs, as the case may be, in respect of the transaction.
The recent Tax Court of Canada case of McKesson Canada Corporation v. The Queen (“McKesson”) may encourage the CRA to dismiss contemporaneous documentation as inadequate. That could lead to a transfer pricing penalty applying as discussed above. In McKesson, it was clear that the study used to justify the transfer price (a discount) was not relied upon by the taxpayer and was simply an after the fact justification. Nonetheless, the CRA accepted the taxpayer’s contemporaneous documentation and did not apply a transfer pricing penalty, which led Justice Boyle to state the following:
Given that the TDSI Reports were the only contemporaneous documentation, and given my observations, comments and conclusions on those opinions and the role of TDSI, it appears to me that CRA may need to review its threshold criteria with respect to subsection 247(4). I would not have expected last minute, rushed, not fully informed, paid advocacy that was not made available to the Canadian taxpayer and not read by its parent, could easily satisfy the contemporaneous documentation requirement.
Residents of Canada and non-residents carrying on business in Canada are required to file T106 documentation (a Summary and Slips) if such persons undertake certain transactions relating to a business carried on in Canada. The transactions must be with non-arm’s length non-residents and be for amounts in excess of $1,000,000. The T106 requirement relates to contemporaneous documentation because the T106 Slip asks whether such documentation for the tax year has been prepared or obtained. A false statement or omission on T106 documentation is punishable with a penalty of $24,000, and there are also late filing penalties.
In simplified terms, a corporation resident in Canada that is subject to Upward Adjustments under the transfer pricing rules may be deemed to pay a dividend to the non-resident with which the corporation was transacting. The amount of the dividend is equal to the Upward Adjustments associated with the transactions with the particular non-resident minus any Downward Adjustments also associated with such transactions. The CRA provides the following example in IC87-2R: “if a taxpayer purchased property from its foreign parent at a price in excess of what arm’s length parties would have paid, the price would be reduced ... . The excess amounts paid to the parent ... are deemed to be a dividend to the foreign parent.”
The deemed dividend is subject to 25% withholding tax. The amount of withholding tax may be reduced under one of the bilateral tax treaties Canada has entered into. The Minister is also granted the discretion to reduce the amount of the deemed dividend and any interest on it if the non-resident pays to the corporation resident in Canada an amount agreed to by the Minister.
Determining the Transfer Price
The focus of the transfer pricing provisions is the determination of an arm’s length transfer price or allocation. Yet, the Income Tax Act is silent on how to go about doing that. The CRA has relied on the methods set out in the Organization for Economic Co-operation and Development, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (“OECD Guidelines”). The methods set out in the OECD Guidelines generally involve finding comparable arm’s length transactions and using those transactions to determine the correct transfer price or allocation. The OECD Guidelines set out the following methods which have been endorsed by the CRA:
- Comparable uncontrolled price (“CUP”) method;
- Resale price method;
- Cost plus method;
- Profit split method; and
- Transactional net margin method.
In IC87-2R, the CRA states that the methods form a hierarchy with the CUP method being more reliable than the resale price method and cost plus method, and those three methods being more reliable than the bottom two. Nonetheless, the CRA concedes in IC87-2R that “[t]he most appropriate method in a given set of circumstances will be the one that provides the highest degree of comparability between transactions.” Courts have placed less emphasis on the OECD Guidelines.
The exact position of the courts on transfer pricing has been somewhat uncertain because the leading case, GlaxoSmithKline, involved an older version of the transfer pricing rules. However, in McKesson, Justice Boyle found that the principles set out in GlaxoSmithKlien apply to the current transfer pricing provisions. Justice Boyle summarized those principles as follows:
- A judge is to take into account all transactions, characteristics and circumstances that are relevant (including economically relevant) in determining whether the terms and conditions of the transactions or series in question differ from the terms and conditions to which arm’s length parties would have agreed.
- The transfer pricing provisions of the Act govern and are determinative, not any particular methodology or commentary from the OECD Guidelines, or any source other than the Act.
I would add the observation that OECD Commentaries and Guidelines are written not only by persons who are not legislators, but in fact are the tax collection authorities of the world. Their thoughts should be considered accordingly. For tax administrators, it may make sense to identify transactions to be detected for further audit by the use of economists and their models, formulae and algorithms. But none of that is ultimately determinative in an appeal to the Courts. The legal provisions of the Act govern and they do not mandate any such tests or approaches. The issue is to be determined through a fact finding and evaluation mission by the Court, as it is in any factually based issue on appeal, having regard to all of the evidence relating to the relevant facts and circumstances.
- Arm’s length prices are established having regards to the independent interests of each party to the transaction. In this appeal, this means that the RSA transactions must be looked at from both the perspectives of McKesson Canada and of MIH.
- Other arm’s length transactions can be relied upon as comparables in a transfer pricing analysis only if either there are no material differences that would affect pricing, or if reasonably accurate adjustments can be made to eliminate the effects of such differences.
- Quoting from GlaxoSmithKline:
61 As long as a transfer price is within what the court determines is a reasonable range, the requirements of the section should be satisfied. If it is not, the court might select the point within a range it considers reasonable in the circumstances based on an average, median, mode, or other appropriate statistical measure, having regards to the evidence that the court found to be relevant. I repeat for emphasis that it is highly unlikely that any comparisons will yield identical circumstances and the Tax Court judge will be required to exercise his best informed judgment in establishing a satisfactory arm’s length price.
Taxpayers, especially multinational corporations, are motivated to use transfer pricing to shift profits to low tax jurisdictions in order to reduce the amount of tax they pay. At the same time, governments in the developed world are becoming increasingly concerned about the tax base erosion caused by profit shifting. This means that transfer pricing will be the subject of legislative change and litigation for years to come.
The author of this posting may be contacted at (604) 643-1277 or email@example.com
This posting was authored by Crystal Taylor
a Partner in the Saskatoon Office
and Graham Purse
an associate in the Regina Office of
Miller Thomson LLP
As a non-resident engaging in activities in Canada, it is important to understand whether your activities will result in income tax being levied in Canada. As general rule, a non-resident is liable to pay Canadian income tax on business income earned in Canada if the non-resident carries on business in Canada. The threshold question to determine liability for Canadian income tax, therefore, is whether activities will constitute “carrying on business” in Canada.
Carrying on Business in Canada
There is no exclusive definition of the meaning of carrying on business in Canada under the Income Tax Act (Canada). Therefore, its meaning is derived from the case law. [See discussion below.]
Section 253 of the Income Tax Act (Canada) provides for a non-exclusive extended meaning of carrying on business in Canada. Under that provision, a non-resident person will be deemed to be carrying on business in Canada if the non-resident person:
(a) produces, grows, mines, creates, manufactures, fabricates, improves, packs, preserves or constructs, in whole or in part, anything in Canada whether or not the person exports that thing without selling it before exportation,
(b) solicits orders or offers anything for sale in Canada through an agent or servant, whether the contract or transaction is to be completed inside or outside Canada or partly in and partly outside Canada, or
(c) disposes of
(i) Canadian resource property, except where an amount in respect of the disposition is included under paragraph 66.2(1)(a) or 66.4(1)(a),
(ii) property (other than depreciable property) that is a timber resource property, an option in respect of a timber resource property or an interest in, or for civil law a right in, a timber resource property, or
(iii) property (other than capital property) that is real or immovable property situated in Canada, including an option in respect of such property or an interest in, or for civil law a real right in, such property, whether or not the property is in existence,
the person shall be deemed, in respect of the activity or disposition, to have been carrying on business in Canada in the year.
If the non-resident person is not carrying on business in Canada either because it does not meet the common law meaning of carrying on business as developed by the case law or the legislated extended meaning under section 253, then the non-resident person will not (aside from Part XIII withholding on Canadian source income, the disposition of taxable Canadian property or the earning of employment income in Canada) be liable for tax in Canada.
Although the case law threshold for carrying on business in Canada is relatively low, many of Canada’s tax treaties with other countries provide relief where a business is not carried on through a “permanent establishment” in Canada. Generally speaking, Canada’s various tax treaties provide that tax will be exigible in Canada only to the extent the profits can be attributed to a permanent establishment in Canada. For instance, this is the case in the Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital (the “Canada-U.S. Tax Treaty”). For U.S. entities carrying on business in Canada, the question is whether the activities are carried on through a “permanent establishment”. If there is no “permanent establishment” in Canada, then the U.S entity will not be taxable in Canada. Conversely, where a Canadian permanent establishment exists, the U.S. entity will be taxed in Canada on the business profits attributable to that permanent establishment. The permanent establishment rules can be found in Article V of the Canada-U.S. Tax Treaty.
The following is a general discussion of the relevant case law that has considered the meaning of “carrying on business” in Canada and the meaning of “permanent establishment”.
Maya Forestales S.A. v. The Queen, 2005 TCC 66
The taxpayer was a Costa Rica corporation (“Maya”) which, between 1994 and 1998, offered Canadian investors the opportunity to invest in a teak-tree plantation in Costa Rica. As a result, more than eighty Canadian investors purchased land on the plantation. The Minister assessed on the basis that Maya carried on business in Canada. Maya took the position that the contracts related to the sale of Costa Rican property and that services relating thereto were performed in Costa Rica.
The Court considered the application of paragraph 253(b) of the Income Tax Act (Canada), which gives an extended meaning to carrying on business, and includes instances where a non-resident “solicits or offers anything for sale in Canada through an agent or servant, whether the contract or transaction is to be completed inside or outside Canada or partly in and partly outside Canada.” The taxpayer argued that the reasonable allocation provisions of paragraph 4(1)(b) of the Income Tax Act (Canada) should have led to an allocation of most of the income to Costa Rica. However, the Court noted that there is no way for the tax authorities to do a reasonable allocation when the taxpayer refuses to provide the necessary information. The Court concluded that Maya carried on business in Canada on the basis that it offered investments for sale in Canada. In the Court’s view, the argument that the contract was to be completed outside of Canada was not persuasive. The Court noted on this point that paragraph 253(b) overturns the common law rule, and that paragraph 253(b) specifically captures situations in which a contract is to be completed partly or entirely outside Canada.
Knights of Columbus v. The Queen, 2008 TCC 307
The appellant, Knights of Columbus (“Knights”), was a US corporation. Relying upon Canadian agents, it provided life insurance to its members in Canada. In the period in question, the Knights raised approximately 25% of its funds from its insurance activities. While not directly relevant to the Canadian income tax issues being considered, the Court noted that Knights was not subject to income tax on its insurance activities in the United States. At issue was whether income tax was exigible in Canada on profits arising from the insurance business. The key question before the Court was whether Knights had a permanent establishment in Canada. Knights operated in Canada with several different types of agents, including 220 field agents, 22 general agents, a field director, and a chief agent. The Court found that Knights did not have a permanent establishment in Canada, notwithstanding the significant number of agents it engaged in Canada.
The analysis focussed on the Canada-U.S. Tax Treaty, which states that a permanent establishment in Canada can arise from: (a) carrying on business through a fixed place of business in Canada (the “fixed place of business test”); or (b) using agents – other than independent agents – who habitually exercise in Canada authority to conclude contracts in the name of the corporation.
The Court held that a permanent establishment did not exist pursuant to the fixed place of business test. Because the field agents were independent contractors, the organizing and recordkeeping they conducted in their own homes could not be on account of anything other than their own businesses. Further, the Court noted that the agents’ homes had no Knights signage, the agents’ homes were not under the control of Knights, Knights made no operational decisions at the agents’ homes, and Knights had not regular access to the premises.
The Court also held that a permanent establishment did not exist pursuant to the agency test. The Court concluded that the general agents and chief agent were of independent status and acting in the ordinary course of their business. The Court also found that the field agents did not have authority to conclude contracts. As such, none of the agents were caught by the agency test.
CRA Technical Interpretations
The following is a general discussion of the relevant technical interpretations from Canada Revenue Agency (“CRA”) that have considered the meaning of “permanent establishment”.
In 2010-0381951E5, CRA was asked whether a US corporation’s activities in Canada constituted a permanent establishment based on a number of different scenarios. CRA explained that the determination of the existence of a permanent establishment is a question of fact and stated that Article 5 of the OECD Model Tax Convention provides the appropriate framework for the determination of whether a permanent establishment exists. Specifically: (a) there must be a place of business; (b) the place of business must be fixed; and (c) the non-resident must be carrying on its business wholly or partly through this fixed place of business.
In 2010-0383661R3, CRA was asked to consider a situation in which a Canadian subsidiary provided services to a non-resident parent corporation. The Canadian subsidiary was a taxable Canadian corporation that carried on business in Canada and used its own employees. The question was whether the parent corporation would be carrying on business in Canada. On the facts as presented, CRA took the position that accounting and financial services, the supply of a chief compliance officer, the provision of anti-money laundering services, knowledge management services, and marketing services by the Canadian subsidiary would in themselves not cause the parent corporation to be carrying on business in Canada.
In 2011-0426551R3, CRA considered whether the amendment of a services agreement to provide additional services by a Canadian corporation to a non-resident corporation would result in the non-resident corporation carrying on business in Canada. The Canadian subsidiary carried on its own business and used its own employees to provide computer and support services. The services agreement in question was drafted to ensure that the Canadian subsidiary was prohibited from engaging in any types of activities that would be caught by the permanent establishment rules. CRA concluded that the amendments would not cause the parent to be carrying on business in Canada. Those amendments included risk assessment, development and implementation of an audit plan, maintenance of an audit function, evaluation of changing services and process, issuing reports, among other things.
If you want more information about this topic please contact Crystal Taylor, Partner, at 306.667.5613 or firstname.lastname@example.org or Graham Purse, Associate, at 306.347.8338 or email@example.com.
 C. Kyres, “Carrying On Business in Canada”, Canadian Tax Journal (1995), Vol. 45, No. 5 / no 5 p 1631
In December 2013, the Canadian federal government announced firm dates for Canada’s anti-spam legislation (commonly referred to as CASL) to come into force, some three years after Bill C-28 (the operative bill) received Royal Assent in December 2010.
To assist individuals and organizations, the Canadian government has decided to implement CASL in the following stages:
(i) CASL’s anti-spam provisions will come into force on July 1, 2014;
(ii) CASL’s provisions pertaining to the installation of computer programs will come into force on January 15, 2015; and
(iii) CASL’s provisions pertaining to the private right of action will come into force on July 1, 2017.
Activities captured under CASL
CASL regulates a broad range of activities, including:
(i) the sending of commercial electronic messages;
(ii) the altering of transmission data in an electronic message;
(iii) unsolicited installation of computer programs;
(iv) engaging in fraudulent or misleading practices through electronic messages or websites;
(v) the use of spyware, malware, botnets, and phishing;
(vi) automated collection of electronic addresses (email harvesting); and
(vii) unlawful use of computers to collect personal information
How does CASL apply to non-residents?
The sending of commercial electronic messages
CASL’s provisions applicable to the sending of commercial electronic messages apply where a computer system located in Canada is used to send or access such messages. Therefore, if a non-resident located outside of Canada sends a message to an individual or organization located in Canada, CASL will apply to the non-resident. If the non-resident is located in Canada, CASL will also apply.
The altering of transmission data in an electronic message
CASL’s provisions applicable to the altering of transmission data in an electronic message apply where a computer system located in Canada is used to send, route or access the electronic message. Therefore, like the example above, if a Canadian accesses a message that was altered by a non-resident located outside of Canada, CASL will apply to the non-resident. If the non-resident is located in Canada, CASL will also apply.
The unsolicited installation of computer programs
Certain CASL provisions apply where an unsolicited computer program is installed on a computer system located in Canada at the relevant time or if the person who installed the computer program is either in Canada at the relevant time or is acting under the direction of a person who is in Canada at the time when they gave the directions.
In addition, CASL prohibits individuals and organizations from aiding, inducing, procuring or causing to be procured the doing of any of the CASL restrictions pertaining to sending of commercial electronic messages, the altering of transmission data in an electronic message, and the unsolicited installation of computer programs.
How is the Canadian government able to enforce CASL against non-residents?
CASL permits the Government of Canada, the Canadian Radio-television and Telecommunications Commission (CRTC), the Canadian Commissioner of Competition or the Canadian Privacy Commissioner to enter into a written agreement or arrangement with the government of a foreign state, an international organization of states or an international organization established by the governments of states, or any institution of any such government or organization.
The purpose of the agreement or arrangement would be to share information between signatories that pertains to:
(i) information that a foreign state, organization or institution has that may be relevant to one or more of the prohibitions in CASL; or
(ii) information that Canada has that may be relevant to an investigation or proceeding in respect of a contravention of the laws of a foreign state that addresses conduct that is substantially similar to conduct that is prohibited under CASL.
CASL only permits an agreement or arrangement to be entered into if the sharing of information will be done on a reciprocal basis.
The prohibitions in CASL are types of activities that governments around the world are trying to crack down on. As a result, there is an increased desire by foreign states to co-operate with each other and to help each other root out individuals and organizations who may be located in one jurisdiction but who are unlawfully targeting, intentionally or unintentionally, individuals and organizations located in another jurisdiction.
Other CASL Details
The CRTC and Industry Canada both have regulatory making authority under CASL, and the CRTC, the Canadian Commissioner of Competition and the Canadian Privacy Commissioner all have CASL enforcement powers.
Should CASL really be a concern for non-residents who carry on business in Canada?
While a non-resident may not alter transmission data in an electronic message or install unsolicited computer programs onto a computer system, and thus not run the risk of being off-side with those prohibitions in CASL, a non-resident who carries on business in Canada will most certainly need to be concerned about CASL’s prohibitions regarding the sending of commercial electronic messages.
CASL’s Commercial Electronic Messages (CEMs)
The anti-spam provisions of CASL, as they are commonly referred to as, prohibit a sender from transmitting a commercial electronic message (“CEM”) to an electronic address, unless: (i) the intended recipient has consented; and (ii) the message includes certain prescribed information.
Under CASL, “Electronic messages” mean a message sent by any means of telecommunication, and includes text, sound, voice, and image messages. “Electronic address” means an address used in connection with the transmission of an electronic message, and includes email, text messaging/SMS, instant messaging, social networks (Facebook®, LinkedIn®, etc.), other online services (e.g., web forums, portals), telephone accounts, and “any similar account”.
“Commercial” refers to anything that “encourages participation in commercial activity”, including: (i) an offer to purchase, sell or lease products, goods or service; (ii) an offer to provide a business, sell or lease investment or gaming opportunity; or (iii) advertising or promotion of these and other activities or of a person carrying out or intending to carry out these and other activities.
Factors that would affect the determination of whether a message encourages participation in commercial activity include: (i) content of the message; (ii) hyperlinks in the message to content on a website or other database; and (iii) contact information contained in the message. For these purposes, a “commercial activity” is “any particular transaction, act or conduct or any regular course of conduct that is of a commercial character, whether or not the person who carries it out does so in the expectation of profit…” [Emphasis Added]
CEMs may be sent only with a recipient’s express or implied consent. Under CASL, the onus of proving sufficient consent rests with the sender of a CEM, and the recipient of a CEM does not have to prove that he or she did not provide consent. Also, an electronic message that requests consent to send a CEM is, under CASL, deemed to be a CEM.
CASL contains a number of requirements around how consents may be obtained, and what information must be included in commercial electronic message. In additional, CASL prescribes that a certain type of unsubscribe mechanism must be made available to message recipients.
CASL also contains a number of available exemptions from its anti-spam provisions as well as a number of exemptions from its consent requirements but not its information and unsubscribe mechanism requirements.
There are a number of things that non-residents can do to prepare for CASL. These include:
(i) conducting an audit/gap analysis of their current electronic communication practices;
(iii) following completion of an audit/gap analysis, considering CASL’s requirements and assessing what changes might be required to their current policies, procedures, processes, practices, and/or computer systems and networks in order to ensure CASL compliance.
If you would like to obtain a sample CASL electronic communications survey, a CASL compliance preparedness checklist, or additional information about CASL, please contact your Miller Thomson LLP advisor or the author.
J. Andrew Sprague is an information technology and business lawyer in Miller Thomson’s Toronto office. You can follow him on Twitter® @canadaantispam.
 See Government of Canada press release entitled “Harper Government Delivers on Commitment to Protect Canadian Consumers from Spam”, available at http://news.gc.ca/web/article-en.do?nid=798829.
 See http://www.parl.gc.ca/LegisInfo/BillDetails.aspx?Language=E&Mode=1&billId=4543582.
 See Order 81000-2-1795 (SI/TR), available at http://fightspam.gc.ca/eic/site/030.nsf/eng/00272.html.
The blog sets out a variety of materials relating to the law to be used for educational and non-commercial purposes only; the author(s) of the blog do not intend the blog to be a source of legal advice. Please retain and seek the advice of a lawyer and use your own good judgement before choosing to act on any information included in the blog. If you choose to rely on the materials, you do so entirely at your own risk.