Carrying on Business in Canada For Non-Residents Blog

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Why Would Anyone Want an Unlimited Liability Company?

October 31, 2014
Stephen Rukavina

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.

Two-Step Distribution

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.

Conclusion

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 srukavina@millerthomson.com

Part XIII Tax: Withholding Tax on Canadian-Source Income

September 16, 2014

Introduction

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:

  • Dividends;
  • Management fees;
  • Interest;
  • Estate or trust income;
  • Rents;
  • 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%.

Conclusion

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 gpurse@millerthomson.com

GST/HST & Asset Sales: The Section 167 Election

July 14, 2014
Stephen Rukavina

This posting was authored by Stephen Rukavina an
Associate in the Vancouver Office of Miller Thomson LLP

Introduction

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.

Specific Exclusions

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.

Conclusion

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 srukavina@millerthomson.com

An Overview of Transfer Pricing In Canada

April 25, 2014

This posting was authored by Stephen Rukavina an
Associate in the Vancouver Office of Miller Thomson LLP

Introduction

In Canada v. GlaxoSmithKline Inc. (“GlaxoSmithKline”), Justice Rothstein of the Supreme Court of Canada succinctly summarized transfer pricing and the tax concerns surrounding it.

Transfer pricing issues arise when entities of multinational corporations resident in different jurisdictions transfer property or provide services to one another.  These entities do not deal at arm’s length and, thus, transactions   between these entities may not be subject to ordinary market forces.  Their absence may result in prices being set so as to divert profits from the appropriate tax jurisdiction.  Since 1939, the Income Tax Act has included provisions under which a Canadian taxpayer may be reassessed to include, in Canadian profits, the difference between the prices for property paid to a non-resident with which it does not deal at arm’s length and what those prices would have been had they been dealing at arm’s length.

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,

minus,

  • 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.

Withholding Tax

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:

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. 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.

Conclusion

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 srukavina@millerthomson.com

Meaning of Carrying On Business in Canada

March 31, 2014
Crystal Taylor

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.

Permanent Establishment

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.[1] 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.

Case Law

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 cltaylor@millerthomson.com or Graham Purse, Associate, at 306.347.8338 or gpurse@millerthomson.com.



[1] C. Kyres, “Carrying On Business in Canada”, Canadian Tax Journal (1995), Vol. 45, No. 5 / no 5 p 1631

Canada’s anti-spam legislation (CASL) will affect non-residents who carry on business in Canada

February 26, 2014

In December 2013, the Canadian federal government announced[1] 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.[2]

Implementation Dates

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.[3]

 

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;

(ii)    reviewing and updating their privacy policies, including website privacy policy (where applicable), and the terms of use/terms of service for their website(s) (where applicable); and

(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.



[1] 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.

[2] See http://www.parl.gc.ca/LegisInfo/BillDetails.aspx?Language=E&Mode=1&billId=4543582.

[3] See Order 81000-2-1795 (SI/TR), available at http://fightspam.gc.ca/eic/site/030.nsf/eng/00272.html.

A Non-Resident Disposing of Taxable Canadian Property

December 31, 2013

A Non-Resident Disposing of Taxable Canadian Property

This posting was authored by 
Cheryl Teron a Partner in the Vancouver Office of Miller Thomson LLP and
Stephen Rukavina an Associate in the Vancouver Office of Miller Thomson LLP

A non-resident of Canada may have to pay Canadian income tax on taxable capital gains earned on dispositions of taxable Canadian property.  A taxable capital gain is one-half of the capital gain on a capital property.  A capital gain is the amount the proceeds of disposition of the capital property exceed its adjusted cost base and reasonable selling expenses.

A non-resident of Canada who sells taxable Canadian property may also be subject to special procedures imposed on dispositions of such property under section 116 of the Income Tax Act.

This article will discuss what constitutes taxable Canadian property, tax treaty relief from Canadian taxation of gains, and the special procedures imposed on dispositions of certain taxable Canadian property by non-residents.

Taxable Canadian Property

The following are the most common examples of “taxable Canadian property”.  Note, taxable Canadian property also includes an option, interest or right in any of the below examples.

            Real Property

Real or immovable property situated in Canada is taxable Canadian property.  For example, residential housing and commercial properties located in Canada are taxable Canadian property.

            Business Assets

The assets of a business carried on in Canada are taxable Canadian property.  For example, the equipment of a business carried on in Canada is taxable Canadian property.

            Shares

Taxable Canadian property includes a share of a corporation (other than a mutual fund corporation) that is not listed on a designated stock exchange if, at any time during the last 60 months, more than 50% of the fair market value of the share was derived directly or indirectly from any combination of (1) real or immovable property situated in Canada; (2) certain Canadian resource properties; and (3) an option, interest or right in (1) or (2).  This definition is geared toward catching shares of private corporations.  Note, the shares of a resident or non-resident corporation can fall within this definition. 

Taxable Canadian property also includes a share of a corporation that is listed on a designated stock exchange and a share of a mutual fund corporation if, at any time during the last 60 months, two conditions are satisfied.  First, 25% or more of any class of shares of the corporation were owned by any combination of the taxpayer who owns the share and parties that do not deal at arm’s length with the taxpayer.  Second, the more than 50% of fair market value test described in the paragraph directly above is satisfied.  This definition can catch shares of public corporations listed on exchanges such as the Toronto Stock Exchange, TSX Venture Exchange, New York Stock Exchange, and London Stock Exchange.

Note, a share can also be deemed to be taxable Canadian property for 60 months in certain situations such as if the share was acquired on a tax deferred transaction involving the transfer of taxable Canadian property.

            Interests in Partnerships and Trusts

Taxable Canadian property includes an interest in a partnership or an interest in a trust (other than a mutual fund trust or an income interest in a trust resident in Canada) if at any time during the last 60 months more than 50% of the fair market value of the interest was derived directly or indirectly from any combination of (1) real or immovable property situated in Canada; (2) certain Canadian resource properties; and (3) an option, interest or right in (1) or (2).  A unit of a mutual fund trust will be taxable Canadian property if it satisfies the conditions, discussed above, for public company shares to be considered taxable Canadian property.

Note, a partnership interest can also be deemed to be taxable Canadian property for 60 months if the interest was acquired on a tax deferred transaction involving the transfer of taxable Canadian property.

Treaty Protected Property

A non-resident who disposes of taxable Canadian property will not necessarily have to pay tax on any taxable capital gains earned on the disposition.  A non-resident’s taxable capital gains on treated-protected property are excluded from Canadian taxation.  “Treaty-protected property” means property any income or gain from the disposition of which by the taxpayer would be exempt from tax under Part I of the Income Tax Act because of a tax treaty with another country.

Under the Canada - United States Income Tax Convention, assuming the limitation on benefits provision has been satisfied, a United States resident’s gain from the disposition of property is only taxable in the United States unless the property disposed of was one of the following:

  • real property situated in Canada including any option or similar right in respect thereof and with the term real property including rights to explore for or to exploit mineral deposits, sources and other natural resources and rights to amounts computed by reference to the amount or value of production from such resources;
  • a share of a corporation resident in Canada if the value of the corporation’s shares is more than 50% derived from real property situated in Canada;
  • an interest in a partnership, trust or estate the value of which is more than 50% derived from real property situated in Canada; and
  • personal property forming part of the business property of a permanent establishment which the United States resident has or had (within the 12 month period preceding the date of alienation) in Canada.

Special Procedures Imposed on Sales of Certain Taxable Canadian Property

Non-residents disposing of certain taxable Canadian property must notify the Canada Revenue Agency (“CRA”) about the disposition either before it happens or not later than 10 days after the disposition.  Generally, a Form T2062:  Request by a Non-Resident of Canada for a Certificate of Compliance Related to the Disposition of Taxable Canadian Property is used.  A non-resident’s failure to comply with the notice requirement may result in a penalty plus any applicable interest. 

More importantly, the CRA will only issue a certificate of compliance after being notified and the non-resident paying an amount to cover the tax on any gain realized on the disposition or providing adequate security for such tax.  If a certificate of compliance is not issued, the purchaser is liable to pay up to 25% (and in some cases 50%) of the purchase price as tax on behalf of the non-resident vendor.  If a certificate of compliance has been issued prior to the disposition, the purchaser will still face liability should the certificate limit set out on the certificate be less than the amount paid by the purchaser.  The purchaser is given the right to withhold from any amount paid or credited to the non-resident or otherwise recover from the non-resident any amount paid by the purchaser as such a tax.  The rules set out in this paragraph apply regardless of whether the purchaser is a resident or non-resident of Canada.

If the disposition is between non-arm’s length parties and the consideration paid is less than fair market value, the proceeds received by the non-resident and the amount paid by the purchaser are generally deemed to be fair market value for the purposes of the above rules.

Property that falls within the definition of excluded property is exempt from the procedures mentioned above.  The following are the most common examples of “excluded property”:

  • a property (other than real or immovable property situated in Canada and certain Canadian resource properties) that is described in an inventory of a business carried on in Canada;
  • a share of a corporation that is listed on a recognized stock exchange;
  • a unit of a mutual fund trust;
  • a bond, debenture, bill, note, mortgage, hypothecary claim or similar obligation;
  •  an option, interest or right in any of the above properties; and
  • a property that is, at the time of its disposition, a treaty-exempt property.

A “treaty-exempt property” is a treaty-protected property as discussed above.  However, where the purchaser and the non-resident vendor are related, the purchaser must provide a notice to the CRA in respect of the disposition in order for the property to qualify as treaty-exempt property.  The notice must be given within 30 days after the date of the acquisition of the property.  A Form T2062C:  Notification of an Acquisition of Treaty-Protected Property from a Non-Resident Vendor may be used to give such notice.

The authors of this posting may be contacted as follows:

Cheryl Teron, Partner: (604) 643-1286 or cteron@millerthomson.com

Stephen Rukavina, Associate: (604) 643-1277 or srukavina@millerthomson.com

The Restrictive Covenant Taxation Scheme: Killing a Fly with a Sledgehammer

November 28, 2013
Stephen Rukavina

This posting was authored by Stephen Rukavina
an Associate in the Vancouver Office of Miller Thomson LLP

The Federal Court of Appeal’s decisions in Canada v. Fortino and Manrell v. Canada held that payments for a non-competition agreement were not taxable.  After those decisions, one could expect that taxpayers would allocate greater and greater amounts of the purchase price from sales to related non-competition and similar agreements in the hopes of avoiding any taxation on such amounts.  For obvious reasons, the federal government wanted to close this loophole. 

Unfortunately, the federal government has decided to kill a fly with a sledgehammer.  The Fortino and Manrell decisions created a problem that could have been solved with some simple legislative amendments.  Instead, the federal government has enacted an entire restrictive covenant taxation scheme.  The new scheme is complex, confusing, and overly broad.  From now on, taxpayers and their legal counsel will need to carefully consider the tax implications of non-competition and similar agreements that relate to the acquisition or provision of property or services. 

Restrictive Covenants

The new scheme applies to a “restrictive covenant” which is defined, in part, as follows:

… an agreement entered into, an undertaking made, or a waiver of an advantage or right by the taxpayer, whether legally enforceable or not, that affects, or is intended to affect, in any way whatever, the acquisition or provision of property or services by the taxpayer or by another taxpayer that does not deal at arm’s length with the taxpayer … .

This definition is very broad.  It could apply to a non-competition agreement, non-solicitation agreement, confidentiality agreement, services agreement, and many other types of agreements.  The restrictive covenant does not even have to be given by the person acquiring or providing the property or services, as long as it is given by a non-arm’s length taxpayer:  e.g., an owner-manager giving a non-competition agreement that relates to his or her corporation’s sale of assets.

Excluded from the definition of restrictive covenant is an agreement or undertaking “that disposes of the taxpayer’s property”.  The most reasonable interpretation of this exclusion is that it applies to a specific provision to dispose of property rather than an entire share purchase agreement or asset purchase agreement.

Default Rule:  Income Inclusion

The following applies to a taxpayer who grants a restrictive covenant (“Grantor”).  The Grantor must include in the Grantor’s income for a taxation year all amounts in respect of the restrictive covenant that are received or receivable in the taxation year by the Grantor or by another non-arm’s length taxpayer (“Default Rule”). 

There is potential for double taxation of the same amount since the Grantor may be deemed to receive amounts that are actually received by non-arm’s length taxpayers.  Fortunately, there is a relieving provision that deems the non-arm’s length taxpayers to have not received the amounts included in the Grantor’s income.

Exceptions to the Default Rule

The Grantor will not have an income inclusion under the Default Rule if one of the following three exceptions apply.

            Employment Income Exception

In order for the Employment Income Exception to apply, the Grantor must grant the restrictive covenant to an arm’s length taxpayer, and the amounts paid must be included in the Grantor’s income as employment income.  The Grantor will have to pay tax on the amounts as employment income and will be able claim any available employment deductions.  The person paying the amounts must withhold and remit payroll taxes.

            Eligible Capital Exception

The Eligible Capital Exception may apply when amounts received for a restrictive covenant are on account of eligible capital (e.g., goodwill).  For example, the restrictive covenant may be necessary to ensure long-term customers continue to contract with the business purchased or that the business purchased maintains its positive reputation.  The amounts received are taxed as eligible capital when this exception applies.

The following three requirements must be satisfied in order for the Eligible Capital Exception to apply.  First, the Grantor must grant the restrictive covenant to an arm’s length person.  Second, the amounts paid must be on account of eligible capital in respect of the business carried on or formerly carried on by the Grantor and to which the restrictive covenant relates.  Third, an election in prescribed form and a copy of the restrictive covenant must be filed.

This exception is targeted at a sole proprietor or corporation making an asset sale, and the sole proprietor or corporation gives a restrictive covenant.  The exception will not apply when an owner-manager shareholder gives a restrictive covenant that relates to his or her corporation’s asset sale because, in those circumstances, the second requirement noted above is not satisfied.

            Share / Partnership Interest Exception

The Share / Partnership Interest Exception may apply in the context of a sale of shares or a partnership interest.  However, the requirements that must be satisfied in order for the exception to apply severely narrow its scope.  When the exception applies, amounts received are taxed as proceeds of disposition, i.e., on capital account.

The following requirements must be satisfied in order for the Share / Partnership Interest Exception to apply:

  • The Grantor must grant the restrictive covenant to an arm’s length person;
  • The amount paid must directly relate  to the Grantor’s disposition of a capital property that is
    • a share of a corporation that carries on business to which the restrictive covenant relates,
    • a share of a corporation 90% or more of the fair market value of which is attributable to one other corporation which carries on business to which the restrictive covenant relates, or
    • a partnership interest in a partnership that carriers on business to which the restrictive covenant relates;
  • The disposition is to the person to whom the restrictive covenant is granted (“Grantee”) or to a person related to that person;
  • The amount paid is consideration for an undertaking by the Grantor not to provide, directly or indirectly, property or services in competition with the property or services provided or to be provided by the Grantee or by a person related to the Grantee (i.e., a non-competition agreement);
  • The restrictive covenant may reasonably be considered to have been granted to maintain or preserve the value of the interest disposed of by the Grantor;
  • Subsection 84(3) of the Income Tax Act does not apply to the disposition (i.e., a corporation does not redeem, acquire, or cancel its shares);
  • The amount is taxed as a non-eligible capital receipt of the Grantor; and
  • An election in prescribed form and a copy of the restrictive covenant must be filed.

Note, there is an anti-avoidance rule that prevents this section from applying if the amount would otherwise be included in the Grantor’s income as business or property income or office or employment income.

Reallocation Rule

A taxpayer might wish to allocate no value to a restrictive covenant or only a nominal value in hopes of not having to deal with the Default Rule and the complex exceptions.  Unfortunately, the restrictive covenant taxation scheme does not allow for such a simple solution. 

Under the scheme, the following rule applies if an amount received or receivable from a person can reasonably be regarded as being in part the consideration for a restrictive covenant granted by a taxpayer.  The part of the amount that can reasonably be regarded as being consideration for the restrictive covenant is deemed to be an amount received or receivable by the taxpayer in respect of the restrictive covenant, and that part is deemed to be an amount paid or payable to the taxpayer by the person to whom the restrictive covenant was granted (“Reallocation Rule”).  In other words, the portion of a purchase price that can reasonably be regarded as paid for a restrictive covenant is deemed to be received by the Grantor of the restrictive covenant regardless of who actually received the amount or paid the amount.

The portion deemed to be paid to the Grantor is subject to the Default Rule and will be treated as income of the Grantor unless one of the above noted exceptions applies.

Exceptions to the Reallocation Rule

There are several exceptions to the Reallocation Rule.  If an exception applies, the Canada Revenue Agency cannot use the Reallocation Rule to reallocate a portion of the purchase price to the restrictive covenant.

            Employee Exception

The Employee Exception basically applies to arm’s length employees who receive no compensation for a non-competition agreement.  In order for the Employee Exception to apply, the following requirements must be satisfied:

  • An individual grants a restrictive covenant to an arm’s length person (for the purposes of this exception the “Purchaser”);
  • The restrictive covenant directly relates to the acquisition from one or more other persons (“Vendors”) by the Purchaser of an interest in the individual’s employer, in a corporation related to that employer, or in a business carried on by that employer;
  • The individual deals at arm’s length with the employer and the Vendors;
  • The restrictive covenant is an undertaking by the individual not to provide, directly or indirectly, property or services in competition with the property or services provided by the Purchaser or by a person related to the Purchaser in the course of carrying on the business to which the restrictive covenant relates (i.e., a non-competition agreement);
  • No proceeds are received or receivable by the individual for granting the restrictive covenant; and
  • The amount that can reasonably be regarded to be consideration for the restrictive covenant is received or receivable only by the Vendors.

The amount mentioned directly above is to be added in computing the amount received or receivable by the Vendors as consideration for the disposition of the interest in the individual’s employer.

            Goodwill Exception

The Goodwill Exception basically applies to asset sales that include goodwill and where no proceeds are allocated to a non-competition agreement granted by a sole proprietor selling his or her assets, a corporation selling its assets, or a shareholder of a corporation that is selling its assets.  In order for the Goodwill Exception to apply, the following requirements must be satisfied:

  • The restrictive covenant is granted by a taxpayer (for the purposes of this exception the “Vendor”) to a person with whom the Vendor deals with at arm’s length at the time the restrictive covenant is granted (for the purposes of this exception the “Purchaser”);
  • The restrictive covenant is an undertaking of the Vendor not to provide, directly or indirectly, property or services in competition with the property or services provided by the Purchaser or by a person related to the Purchaser in the course of carrying out the business to which the restrictive covenant relates (i.e., a non-competition agreement);
  • The amount that can reasonably be regarded as being consideration for the restrictive covenant is
    • included by the Vendor in computing a goodwill amount of the Vendor (e.g., where the Vendor is a sole proprietor selling his or her business), or
    • received or receivable by a corporation that was an “Eligible Corporation” (defined below) of the Vendor when the restrictive covenant was granted and included by the corporation in computing a goodwill amount of the corporation in respect of the business to which the restrictive covenant relates (e.g., where the Vendor is the owner-manager of a corporation that is selling its assets);
  • No proceeds are received or receivable by the Vendor for granting the restrictive covenant;
  • The restrictive covenant can reasonably be regarded to have been granted to maintain or preserve the fair market value of the benefit of the expenditure derived from the goodwill amount; and
  • An election in prescribed form and a copy of the restrictive covenant are filed.

An “Eligible Corporation” of a taxpayer is a taxable Canadian corporation of which the taxpayer holds, directly or indirectly, shares of the capital stock.

The Goodwill Exception may also apply if the Vendor grants the restrictive covenant to an individual related to the Vendor and who is at least 18 years old (“Eligible Individual”).  In other words, the exception can still apply in some instances when the arm’s length requirement is not met.  However, two additional requirements must be satisfied.  First, the Vendor must be a resident of Canada at the time of the grant of the restrictive covenant.  Second, the Vendor cannot, at any time after the grant of the restrictive covenant, have an interest in the Eligible Corporation of the Eligible Individual.

Note, there is an anti-avoidance rule that prevents this exception from applying if one of the results of not applying the Reallocation Rule would be that the Employment Income Exception would not apply to consideration that would, if the restrictive covenant regime did not apply, be included in computing a taxpayer’s income from a source that is an office or employment or a business or property.  This anti-avoidance rule also applies to the two other exceptions discussed below.

            Share Sale Exception

The Share Sale Exception basically applies to a share sale where the vendor of the shares receives no compensation for a non-competition agreement.  In order for the Share Sale Exception to apply, the following requirements must be satisfied:

  • The restrictive covenant is granted by a taxpayer (for the purposes of this exception the “Vendor”) to a person with whom the Vendor deals with at arm’s length at the time the restrictive covenant is granted (for the purposes of this exception the “Purchaser”);
  • The restrictive covenant is an undertaking of the Vendor not to provide, directly or indirectly, property or services in competition with the property or services provided by the Purchaser or by a person related to the Purchaser in the course of carrying out the business to which the restrictive covenant relates (i.e., a non-competition agreement);
  • It is reasonable to conclude that the restrictive covenant is integral to an agreement in writing under which shares of the capital stock of a corporation (“Target Corporation”) are disposed of to the Purchaser  or to another person that is related to the Purchaser and with whom the Vendor deals at arm’s length;
  • No proceeds are received or receivable by the Vendor for granting the restrictive covenant;
  • Subsection 84(3) of the Income Tax Act does not apply to the disposition (i.e., the Target Corporation does not redeem, acquire, or cancel its shares); and
  • The restrictive covenant can reasonably be regarded to have been granted to maintain or preserve the fair market value of the shares disposed of.

The Share Sale Exception can apply even if the Vendor grants the restrictive covenant to an Eligible Individual, i.e., certain non-arm’s length individuals.  However, two additional requirements must be satisfied.  First, the Vendor must be a resident of Canada at the time of the grant of the restrictive covenant and the disposition of the shares.  Second, the Vendor cannot, at any time after the grant of the restrictive covenant, have any interest in the Target Corporation or the Eligible Corporation of the Eligible Individual.

The amount that can reasonably be regarded as being in part consideration received or receivable for a restrictive covenant is to be added in computing the consideration that is received or receivable by each taxpayer who disposes of shares of the Target Corporation to the extent of the portion of the consideration that is received or receivable by that taxpayer.

            Property Other Than Goodwill or Shares Exception

This exception basically applies to asset sales that do not include goodwill and where no proceeds are allocated to a non-competition agreement granted by a sole proprietor selling his or her assets, a corporation selling its assets, or a shareholder of a corporation that is selling its assets.  In order for the Property Other Than Goodwill or Shares Exception to apply, the following requirements must be satisfied:

  • The restrictive covenant is granted by a taxpayer (for the purposes of this exception the “Vendor”) to a person with whom the Vendor deals with at arm’s length at the time the restrictive covenant is granted (for the purposes of this exception the “Purchaser”);
  • The restrictive covenant is an undertaking of the Vendor not to provide, directly or indirectly, property or services in competition with the property or services provided by the Purchaser or by a person related to the Purchaser in the course of carrying out the business to which the restrictive covenant relates (i.e., a non-competition agreement);
  • It is reasonable to conclude that the restrictive covenant is integral to an agreement in writing under which the Vendor or the Vendor’s Eligible Corporation disposes of property other than shares to the Purchaser, or the Purchaser’s Eligible Corporation, for consideration that is received or receivable by the Vendor, or the Vendor’s Eligible Corporation;
  • No proceeds are received or receivable by the Vendor for granting the restrictive covenant;
  • The restrictive covenant can reasonably be regarded to have been granted to maintain or preserve the fair market value of the property disposed of;
  • The consideration that can reasonably be regarded as being in part the consideration for the restrictive covenant is received or receivable by the Vendor or the Vendor’s Eligible Corporation  as consideration for the disposition of the property; and
  • The consideration cannot reasonably be regarded as being for a goodwill amount.

This exception can apply even if the Vendor grants the restrictive covenant to an Eligible Individual, i.e., certain non-arm’s length individuals.  However, two additional requirements must be satisfied.  First, the Vendor must be a resident of Canada at the time of the grant of the restrictive covenant and the disposition of the property.  Second, the Vendor cannot, at any time after the grant of the restrictive covenant, have an interest in the Eligible Corporation of the Eligible Individual.        

Non-Residents

Amounts that would, if a non-resident Grantor had been resident in Canada throughout the taxation year in which the amount was received or receivable, be required to be included in computing the non-resident Grantor’s income under the Default Rule are subject to a 25% withholding tax.  Withholding tax also applies to amounts received on a restrictive covenant related debt that has been written off as bad debt.  Canada’s tax treaties may provide a reduction in the amount of withholding tax.

Think Twice Before Using an LLC in Canada

October 31, 2013
Stephen Rukavina

This posting was authored by Cheryl Teron a Partner in the Vancouver Office of Miller Thomson LLP and
Stephen Rukavina an Associate in the Vancouver Office of Miller Thomson LLP

Introduction

A limited liability company (“LLC”) is a common type of business entity used in the United States of America (“US”).  However, Americans planning to expand their businesses into Canada need to think twice before involving an LLC in such activities.  This posting provides an overview of the Canadian tax issues that arise when LLCs earn income from carrying on business in Canada directly or through a subsidiary.

Tax Consequences of Carrying on Business in Canada

There are two basic ways a non-resident can carry on business in Canada:  through a branch or a subsidiary.  A branch operation involves expanding an existing business into Canada without incorporating a subsidiary.  For example, a US company could simply start carrying on its business in Canada by leasing a Canadian office and hiring Canadian employees.  Alternatively, a US company could use a subsidiary for its Canadian business operation. 

The default Canadian tax consequences (not considering tax treaty relief) of using a branch operation are as follows.  The general active business income attributable to the non-resident’s Canadian branch is subject to income tax.  Corporate income tax rates range from 25% to 31% depending on the province or territory in which a permanent establishment is located, if any.  A non-resident company will also be subject to branch tax, which is an additional 25% tax on after-tax income not reinvested in Canada.

The default Canadian tax consequences (not considering tax treaty relief) of using a subsidiary are as follows.  The worldwide income of the subsidiary is subject to income tax at the rates noted above.  As well, dividends paid by the subsidiary to its non-resident parent are subject to 25% withholding tax.  If the subsidiary is capitalized in part through debt, the interest payments to the non-resident parent will also be subject to 25% withholding tax.

The Canada-US Income Tax Convention (“Treaty”) significantly reduces Canada’s jurisdiction to tax.  Under it, Canada cannot tax the business profits of a branch of a US resident unless the US resident has a permanent establishment in Canada and business profits are attributable to the permanent establishment.  Furthermore, a US resident company does not have to pay branch tax unless it has a permanent establishment in Canada.  Even if it does have a permanent establishment, Canada cannot apply branch tax to the first CDN $500,000 of the branch earnings derived by a US resident company or an associated company in the same or similar business.

The Treaty also provides benefits to a subsidiary operation.  Under the Treaty, dividends paid by a Canadian subsidiary to a US parent company entitled to Treaty benefits will have withholding tax reduced to 5%.  There will generally be no withholding tax on interest paid by the Canadian subsidiary to a US parent company entitled to Treaty benefits.

The Treaty provides significant tax reductions for US residents that carry on business in Canada, whether through a branch or subsidiary.  Unfortunately, an LLC often does not qualify for Treaty benefits.  There can also be issues even if an LLC can access Treaty benefits.  Treaty benefits can apply in unexpected ways when an LLC is involved. 

For example, consider an LLC that has not elected to be treated as a corporation for US tax purposes.  The LLC is carrying on a branch operation in Canada through a permanent establishment, and its earnings have exceeded the CDN $500,000 exemption from branch tax.  One might expect that the LLC’s earnings should be subject to the 5% reduced rate of branch tax provided that all of its members are US residents eligible for Treaty benefits.  However, the Canada Revenues Agency’s (“CRA”) position is that earnings of the LLC are only eligible for the reduced rate of branch tax to the extent that the members of the LLC are US resident companies eligible for Treaty benefits.  Therefore, an LLC with two members – a US resident individual and a US resident company eligible for Treaty benefits – will have 50% of its earnings subject to 25% branch tax and the other 50% subject to 5% branch tax for a combined rate of 15%.

The CRA’s Position on LLCs

The CRA’s long standing position is that an LLC is a corporation for the purposes of the Canada Income Tax Act, and the LLC must, therefore, pay Canadian taxes like any other corporation.  The members of the LLC will not pay Canadian income tax on the LLC’s income even if the members are considered to earn the income under US tax law.

The first step in determining entitlement to Treaty benefits is to consider whether the person seeking the benefits is a resident of Canada or the US (i.e., a Contracting State) as only such residents are eligible for Treaty benefits.  The Treaty provides that a person is a resident of a Contracting State if the person is liable to tax in that Contracting State because of that person’s domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of a similar nature.

An LLC is not subject to tax in the US unless it makes an election using Form 8832 “Entity Classification Election” to be treated as a corporation for US tax purposes.  In the absence of such an election, an LLC is treated for US tax purposes as either a disregarded entity if it has only one member or a partnership if it has more than one member.

The CRA’s position is that an LLC does not qualify as a US resident for purposes of the Treaty unless it elects to be treated as a corporation for US tax purposes.  The CRA’s reasoning is that an LLC treated as a disregarded entity or a partnership for US tax purposes 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 LLCs that have not elected to be treated as a corporation for US tax purposes because only a resident of a Contracting State is entitled to Treaty benefits. 

Under recent amendments to the Treaty, an LLC that has not elected to be treated as a corporation for US tax purposes can indirectly access Treaty benefits if its members satisfy the look-through and limitation on benefits rules of the Treaty discussed below.

An LLC Indirectly Accessing Treaty Benefits

            Look-Through Rule

Subject to the limitation on benefits rule discussed below, the look-through rule requires Canada to extend Treaty benefits to a US resident where the following conditions are met.  First, the US resident must be considered under US tax law to have derived Canadian-source income, profit, or gain through an entity, such as an LLC, that is not resident in Canada.  Second, the US tax treatment of such amount is the same as if it had been derived directly by the US resident instead of through a fiscally-transparent entity.

The look-through rule is meant to enable US resident members of a fiscally-transparent entity, such as an LLC, to access Treaty benefits for the amount of Canadian-source income, profit, or gain derived by the entity and proportionally allocated to the US resident members.

An LLC may have both US and non-US resident members.  In such circumstances, the proportion of the LLC’s Canadian-source income, profit, or gain that is allocable to non-US resident members will not be eligible for Treaty benefits.  For example, consider an LLC with two members.  One member is a US resident individual, and he has a 45% interest in the LLC.  The other member is a non-US resident individual, and she has a 55% interest in the LLC.  In these circumstances, only 45% of the LLC’s Canadian-source income, profit, or gain will be eligible for Treaty benefits.  In a corporate structure where there are one or more tiers of LLCs, the tiers of LLCs are looked through to determine the proportion of the Canadian-source income, profit, or gain allocable to non-US resident members and thus not eligible for Treaty benefits.  For example, if Holdco LLC is a member of Subco LLC, the proportion of Holdco LLC’s members that are non-US residents affects the amount of Subco LLC’s Canadian-source income, profit, or gain that is eligible for Treaty benefits.

            Limitation on Benefits Rule

Under the limitation on benefits rule, a person cannot access Treaty benefits unless the person is a “qualifying person” or meets certain other criteria described below.

                        Qualifying Person

The basic rule is that only a qualifying person is entitled to all Treaty benefits.  In the context of an LLC, it is the members of the LLC that must be qualifying persons.  A qualifying person is a resident of Canada or the US that falls within one of the following categories:

  • natural persons;
  • certain Canadian and US government entities;
  • certain publicly traded companies and trusts as well as their subsidiaries;
  • certain companies and trusts that satisfy the ownership and base erosion tests;
  • estates; and
  • certain not-for-profit organizations and other types of tax-exempt organizations.

Under the above rule, a US resident company[1] that is a member of an LLC will be a qualifying person if it falls within the category of publicly traded company and their subsidiaries or if it satisfies the ownership and base erosion tests.

The ownership and base erosion tests are as follows.  The ownership test requires that 50% or more of the aggregate vote and value of the shares of the company and each disproportionate class of shares of the company (in neither case including debt substitute shares) not be owned directly or indirectly by persons other than qualifying persons.  The base erosion test requires that expenses deductible from gross income that are paid or payable by the company in its preceding fiscal period (or, in the case of its first fiscal period, that period) directly or indirectly to persons that are not qualifying persons are less than 50% of the company’s gross income for that period.

                        Active Trade or Business

If the qualifying person requirement cannot be satisfied, the Treaty provides that a resident of one Contracting State is entitled to Treaty benefits with respect to income derived from the other Contracting State if three requirements are satisfied.  First, the Canadian or US resident, or a person related thereto, must be engaged in an active trade or business in the state of residence.[2]  Second, the income derived from the other Contracting State must be in connection with or incidental to the active trade or business carried on in the state of residence.  Third, the active trade or business carried on in the state of residence must be substantial in relation to the activity carried on in the other Contracting State giving rise to the income for which Treaty benefits are being claimed.

The CRA does not consider a member of an LLC to carry on the business of the LLC.  This means that the active trade or business test will be difficult to meet.  However, the test will be met by reference to the business activities of the LLC where a member of an LLC is related to that LLC, and the LLC’s business satisfies the above test.

                        Derivative Benefits

A US company that is not a qualifying person and that does not meet the active trade or business test may still obtain Treaty benefits for dividends, interest, and royalties if a derivative benefits test is satisfied.  Basically, derivative benefits enable a company resident in a Contracting State to access certain Treaty benefits if shareholders owning substantially all of its stock[3] are either qualifying persons under the Treaty or would have been entitled to equally favourable tax treaty benefits from the other Contracting State had the amounts in question been earned directly by those shareholders.  The actual test is similar to the ownership and base erosion tests described above.

An LLC that has not elected to be treated as a corporation for US tax purposes cannot access derivative benefits under the Treaty.  However, a company that is a member of the LLC that meets the tests noted above will be entitled to limited Treaty benefits under the derivative benefits test.  Note, Canadian withholding tax on interest is reduced to 0% when Treaty benefits apply to such interest.  As a result, a member of an LLC that is not a qualifying person can never receive reduced withholding on interest through derivative benefits because no other Canadian tax treaty offers equally favourable treatment of interest.

                        Relief Provisions

A person resident in a Contracting State who does not otherwise satisfy the limitation on benefits rules may request relief from a competent authority.  The person must make the request to the competent authority of the state from which Treaty benefits are sought.  The competent authority in Canada is the Minister of National Revenue or her authorized representative which is the CRA.  An LLC that has not elected to be treated as a corporation for US tax purposes cannot apply to the competent authority for relief.  However, this type of relief is theoretically available to the members of an LLC.[4]

The LLC is the Only Visible Taxpayer

Canada does not grant Treaty benefits directly to the members of an LLC despite the fact that it is the members who must satisfy the look-through and limitation on benefits rules.  Instead, the LLC is treated as the only visible taxpayer, and it must comply with all filing requirements related to Canadian-source income and pay Canadian tax on that income. This means Canada will not require the members of an LLC to file Canadian tax returns for Canadian-source income earned by the LLC.  Instead, the LLC must file a Canadian tax return in which the LLC itself claims the Treaty benefits on behalf of its members.

Anyone using an LLC should be aware that they may be required to fill out and file a Form NR303 “Declaration of Eligibility for Benefits Under a Tax Treaty for a Hybrid Entity”.  An LLC filing a Canadian income tax return and claiming Treaty benefits must submit a Form NR303 along with its tax return.  An LLC seeking a refund or waiver of various Canadian withholding taxes must also fill out and file a Form NR303.

Conclusion

Determining the tax consequences of using an LLC for a business carried on directly or indirectly through a subsidiary in Canada can be complex.  This posting has not even touched on the adverse tax consequences that may arise if an LLC incorporates a Canadian subsidiary that is an unlimited liability company.  Furthermore, any Canadian resident thinking of taking a membership interest in an LLC needs to be cautious because double taxation and other adverse results may arise.  The bottom line is that before using an LLC in Canada think twice and consult a Canadian tax expert.

The authors of this posting may be contacted as follows:

Cheryl Teron, Partner: (604) 643-1286 or cteron@millerthomson.com

Stephen Rukavina, Associate: (604) 643-1277 or srukavina@millerthomson.com



[1] The term “company” is used here because that is the term used in the Treaty.  The Treaty defines company to mean “any body corporate or any entity which is treated as a body corporate for tax purposes”.  However, the Treaty’s use of the term company can cause confusion because an LLC is a company, but it does not itself qualify for Treaty benefits unless it elects to be treated as a corporation for US tax purposes.  The look-through rule described above also applies to any LLC that is a member of another LLC provided both LLCs have not elected to be treated as a corporation for US tax purposes.

[2] Other than the business of making or managing investments, unless those activities are carried on with customers in the ordinary course of business by a bank, an insurance company, a registered securities dealer or a deposit-taking financial institution.

[3] Shares that represent more than 90% of the aggregate vote and value of all shares and at least 50% of the vote and value of any disproportionate class of shares (in neither case including debt substitute shares).

[4] See the CRA’s Guidelines for Taxpayers Requesting Treaty Benefits Pursuant to Paragraph 6 of Article XXIX A of the Canada-U.S. Tax Convention which states the following:

Article XXIX A contains provisions designed to prevent residents of third countries from securing benefits of the Convention through structures and arrangements that are considered to give rise to "treaty shopping". Third country residents may seek to secure benefits because the third country does not have a tax treaty with Canada, or to circumvent a less favourable tax treaty that Canada has with the third country.
...
This provision contemplates the grant of treaty benefits where the creation and existence of the U.S. resident person did not have as a principal purpose the obtaining of benefits under the Convention or factors suggest that it would not be appropriate to deny the benefits of the treaty to the U.S. resident person. Competent Authority shall determine whether either condition is satisfied on the basis of factors that include the history, structure, ownership and operations of the person.

It is expected that U.S. resident individuals and virtually all other U.S. residents will not need to make a Request since they will meet one of the objective tests found in Article XXIX A.

Goods and Services Tax: An Overview for Non-Residents

September 27, 2013
Stephen Rukavina

This posting was authored by Cheryl Teron a Partner in the Vancouver Office of Miller Thomson LLP and
Stephen Rukavina an Associate in the Vancouver Office of Miller Thomson LLP

The Basics

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.

There are currently 5 participating provinces.  In New Brunswick, Newfoundland and Labrador, and Ontario, the HST is charged at a rate of 13%.  In Prince Edward Island, the HST is charged at a rate of 14%.  In Nova Scotia, the HST is charged at a rate of 15%.

Certain supplies are zero-rated.  Zero-rated supplies have a 0% rate of GST/HST charged on them.  In other words, no GST/HST is payable on zero-rates supplies.  Businesses that make zero-rated supplies can still claim input tax credits (explained below) even though they do not collect GST/HST on their zero-rated supplies.  Zero-rated supplies generally include prescription drugs and biologicals, medical and assistive devices, basic groceries, agriculture and fishing products, exports, and transportation services.

There are also certain supplies that are exempt from GST/HST.  No GST/HST is payable on these exempt supplies.  Businesses that make exempt supplies are not able to claim input tax credits on purchases made in order to make exempt supplies.  Exempt supplies generally include supplies of used residential property and residential rental housing, health care services, educational services, supplies by charities and public sector bodies, and financial services.

As mentioned above, the GST/HST is a value-added tax.  Under a value-added tax, the tax is charged at every stage of production, but the goal is to only charge the final consumer.  For example, a mechanic pays GST on his commercial rent and equipment.  The mechanic also charges GST on the services he provides to the automobiles his customers use for their personal use.  The mechanic is allowed to claim back the GST he paid on his commercial rent and equipment.  The customers cannot claim back the GST paid on the services, and they bear the GST. 

The mechanism through which a business claims back GST/HST paid on its inputs is called an input tax credit.  In order to claim input tax credits, a business must be registered for GST/HST purposes, and the GST/HST claimed back must have been paid on expenses that relate to the business’s commercial activities (explained below).  A business should be registered before it starts purchasing inputs in order to avoid problems claiming input tax credits.  As mentioned above, a business cannot claim input tax credits for GST/HST paid in order to make an exempt supply. 

Basically, a commercial activity is any business carried on by a person, and any adventure or concern in the nature of trade carried on by a person.  The supply of real property and connected services can also be commercial activities.  Making exempt supplies is not a commercial activity.

Required Registration

GST/HST registration is important because a non-resident who is registered and who makes taxable supplies in Canada must charge GST/HST and remit GST/HST net of input tax credits claimed.  Also, a business cannot claim input tax credits unless registered.

A non-resident that makes taxable supplies in Canada in the course of commercial activity in Canada must register for the GST/HST, unless:

  • the only commercial activity of the non-resident is the making of supplies of real property by way of sale otherwise than in the course of a business;
  • the non-resident is a small supplier (explained below); or
  • the non-resident does not carry on business in Canada (explained below).

Note, special rules affect the registration requirement for non-residents who supply certain admissions, solicit orders for printed publications and related audio recordings, and exhibit at or are a sponsor of a convention.

            Small Supplier

A small supplier is a small business with low revenue.  In order for a person to be a small supplier, the total worldwide revenue from taxable supplies made by that person and all associated persons must be CDN $30,000 or less in the last four consecutive calendar quarters or in any single calendar quarter.

            Carrying on Business in Canada

The Canada Revenue Agency (CRA) states in GST/HST Policy Statement P-051R2, "Carrying on business in Canada" that "[t]he mere fact that a non-resident person undertakes an activity that falls within the definition of a "business" does not mean that the business is being carried on in Canada".  The CRA also states the following:  "In general, a non-resident person must have a significant presence in Canada to be considered to be carrying on business in Canada.  Generally, isolated transactions carried on in Canada as part of a business that is carried on by a non-resident person outside Canada may not result in the person being considered to be carrying on business in Canada, given that the [relevant] factors will usually not be met to a sufficient degree".

The common law applies in determining whether a business is being carried on in Canada for GST/HST purposes.  Under the common law, the determination of whether a person is carrying on business in Canada is a question of fact and is based on a number of tests and factors. 

Under the place where the contracts are made test, the place where sales, or contracts of sale, are effected is of substantial importance in determining whether a business is carried on in Canada.   It is profit-making contracts that are important.  Entering into contracts in Canada to buy goods or materials to be traded or used outside of Canada will not by itself be considered carrying on business in Canada.

The place where the contacts are made test may not be a decisive factor in determining where a business is carried on for GST/HST purposes.   For example, a business will not necessarily be carried on in Canada if profit-making contracts are entered into in Canada but all other business activities (e.g., design, manufacturing, marketing, day-to-day running of the business) are carried on outside of Canada.  In such circumstances, entering into profit-making contracts may be ancillary because all the other factors point to the business being carried on outside of Canada.

If the place where the contracts are made test is not determinative, courts also apply the place where profits arise test, which involves weighing multiple factors to determine the place where business operations take place from which profits arise.  The CRA will assess the following factors to determine whether a business is carried on in Canada:

  • the place where agents or employees of the non-resident are located;
  • the place of delivery;
  • the place of payment;
  • the place where purchases are made or assets are acquired;
  • the place from which transactions are solicited;
  • the location of assets or an inventory of goods;
  • the place where the business contracts are made;
  • the location of a bank account;
  • the place where the non-resident’s name and business are listed in a directory;
  • the location of a branch or office;
  • the place where the service is performed; and
  • the place of manufacture or production.

The above factors are weighed and balanced against each other, and the importance of any one factor depends on the facts of a specific case.  The fact specific nature of the inquiry and the lack of precise rules can make it difficult to determine whether a non-resident is carrying on business in Canada when the facts are not clear-cut.

Note, the test for carrying on business in Canada is also important for determining whether a non-resident makes a supply in Canada.  A supply of personal property or a service made in Canada by a non-resident is deemed to be made outside of Canada unless: 

  • the supply is made in the course of a business carried on in Canada;
  • the person is a GST/HST registrant at the time the supply is made; or
  • the supply is the supply of an admission in respect of an amusement, a seminar, an activity or an event where the non-resident person did not acquire the admission from another person.

Voluntary Registration

A non-resident that does not have to register for GST/HST purposes can still voluntarily register in certain circumstances.  Voluntary registration may enable a non-resident to claim input tax credits.  A non-resident can voluntarily register if the non-resident:

  • is engaged in a commercial activity in Canada;
  • in the ordinary course of carrying on business outside of Canada, regularly solicits orders for the supply by the non-resident of goods for export to, or delivery in, Canada;
  • in the ordinary course of carrying on business outside Canada, has entered into an agreement for the supply by the non-resident of services to be performed in Canada; or
  • in the ordinary course of carrying on business outside Canada, has entered into an agreement for the supply by the non-resident of intangible personal property (e.g., a trade-mark, copyright, or patent) to be used in Canada or that relates to real property situated in Canada, goods  ordinarily situated in Canada, or services to be performed in Canada.

Security Deposit

A non-resident that is required to register or voluntarily registers must maintain a security deposit with the CRA.  However, a non-resident is not required to maintain a security deposit if it has a fixed place of business in Canada through which it makes supplies.  A fixed place of business includes a place of management, a branch, an office, a factory, or a workshop.  It also includes a mine, an oil or gas well, a quarry, timberland, or any other place of extraction of natural resources.

The amount of the security deposit is determined by CRA policy.  The CRA states in GST/HST Memorandum 2.6, "Security Requirements for Non-Residents" that generally the minimum amount of security is CDN $5,000 and the maximum is CDN $1 million. The security deposit initially is 50% of the estimated net tax (GST/HST collected minus input tax credits claimed) of the non-resident for the 12 month period following registration, whether the estimated net tax is a positive or negative amount.  After the initial 12 month period, the security deposit amount will be 50% of the non-resident’s actual net tax during the previous 12 month period, whether the estimated net tax is a positive or negative amount. This means that a security deposit is required even where the input tax credits that can be claimed exceed the GST/HST that must be collected.

The CRA does not require a non-resident to make a security deposit if the non-resident’s taxable supplies in Canada do not exceed CDN $100,000 annually, and the non-resident’s annual net tax is between CDN $3,000 remittable and CDN $3,000 refundable.

Permanent Establishments

There are special rules for non-residents with a permanent establishment in Canada.  Many of these rules have serious tax consequences.

A non-resident has a permanent establishment in Canada if it has a fixed place of business in Canada through which it makes supplies.  A fixed place of business includes a place of management, a branch, an office, a factory, or a workshop.  It also includes a mine, an oil or gas well, a quarry, timberland, or any other place of extraction of natural resources.  A non-resident also has a permanent establishment in Canada if there is a fixed place of business in Canada of another person (other than a broker, general commission agent or other independent agent acting in the ordinary course of business) who is acting in Canada on behalf of the non-resident and through whom the non-resident makes supplies in the ordinary course of business.

A non-resident with a permanent establishment in Canada is deemed to be resident in Canada in respect of, but only in respect of, the non-resident’s activities carried on through the permanent establishment.  The consequences of that deeming rule are as follows:

  • The non-resident is required to register for GST/HST purposes if it makes taxable supplies through the permanent establishment, unless the non-resident is a small supplier;
  • The non-resident’s supplies made in Canada through the permanent establishment will not be subject to the special non-resident place of supply rule which would otherwise deem the supplies to be made outside of Canada;
  • GST/HST may be payable on supplies acquired by the non-resident through the permanent establishment as the supplies may not be considered zero-rated exports;
  • The non-resident may have to self-assess GST/HST on property and services imported for consumption, use or supply through the permanent establishment; and
  • The non-resident may be required to pay GST/HST on transfers of personal property and rendering of services between its Canadian permanent establishment and its permanent establishments in other countries.

Conclusion

Non-residents who have dealings in Canada should consider whether they are required to register for the GST/HST and whether it would be beneficial to voluntarily register for the GST/HST where not required to do so.  Non-residents also need to consider whether they must comply with provincial sales tax, which applies in provinces that do not participate in the HST.

The authors of this posting may be contacted as follows:

Cheryl Teron, Partner: (604) 643-1286 or cteron@millerthomson.com

Stephen Rukavina, Associate: (604) 643-1277 or srukavina@millerthomson.com



 

 
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