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By Patrick Westaway – 2016/10/06

Original published on LinkedIn

This week’s announcement that Ottawa is closing a loophole which allows non-residents of Canada to claim the principal residence exemption must have the country scratching its collective head. Surely if people who have never lived in Canada qualify for an exemption intended for Canadian residents then black is white, up is down and the whole sorry tax system is done for. Hopefully so. But does the problem lie with a devious cabal of tax professionals or elsewhere?

Not enough is said about the fact that tax laws are too complex to be understood other than by a small minority of lawyers and accountants. Given the most basic of legal tenets that a law must be knowable, anyone without access to those few lawyers and accountants must surely be tax exempt: imagine living in a country where the criminal laws were so little understood and were, as tax laws are, imposed retroactively. So let us look at the “loophole” cited on Monday by our Finance Minister, the Honourable Bill Morneau.

As written by the Minister’s own department, property can be designated as a principal residence if it is “ordinarily inhabited” in the year. So what does “ordinarily inhabited” mean? How many days in the year constitute ordinary habitation? The legislation is silent on this point and the choice of wording intentionally vague. Referring to an Income Tax Folio published by the Canada Revenue Agency, one is told that the answer depends on the facts. Only from a tax specialist is one likely to learn that property will usually be considered to be “ordinarily inhabited” no matter how short the habitation so long as the property does not generate rental income.

Having reasonable grounds for believing that the property qualifies for the principal residence exemption, what of the taxpayer? Must one be a Canadian resident to claim the principal residence exemption? On a casual reading, the answer to this question is ‘yes’ since the years for which the deduction is available are described (within factor ‘B’ of a mathematical formula) as “one plus the number of taxation years that end after the acquisition date for which the property was the taxpayer’s principal residence and during which the taxpayer was resident in Canada”. Upon a closer reading, however, it appears that the Canadian residence requirement qualifies only “the number of taxation years that end after the acquisition date”, leaving non-residents with the benefit of the “one plus”. If, now, the Department of Finance says this reading does not reflect the legislative intent, why is the residence requirement buried within a formula? If the exemption is intended only for Canadian residents, the drafting alternative is simple and obvious.

As a result of this wording, non-residents have been entitled to deduct from their taxable income that portion of the capital gain that “one” is of the total number of years in which the non-resident owned the property. If the non-resident bought and sold the property in the same year then the full amount of the gain was exempt. If the non-resident held the property for ten years then only one-tenth of the gain was exempt. In the case, then, of a 10% gain on a Toronto condo purchased for $2,500,000.00 the year before it was sold, the principal residence designation was worth approximately $33,000.00—assuming combined Federal and Ontario top marginal rates. More commonly, a 15% gain on a Toronto condo purchased while under construction for $800,000.00 and re-sold post completion within the year for a 15% gain is worth slightly less than $32,000.00.

If the Department of Finance remains true to form, the revisions announced this week will serve only to further complicate the provision in question. Thankfully, we will have the text of this week’s announcement with which to interpret those revisions.

By Patrick Westaway – 2016/03/30

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The next time you travel to the US and a customs official asks whether your purpose is business or pleasure, consider the consequences. Outside the U.S., we are accustomed to rely upon income tax treaties to avoid foreign tax in the absence of a material foreign presence. And, we assume that foreign tax applies only to foreign source income. Certainly, we expect that when Americans come to Canada on business, they avoid personal Canadian income tax so long as they remain for less than 183 days. The corollary, however, does not hold true. The rules do not apply equally. And, if Canadians—individuals as well as the companies that employ them—are to sidestep the U.S. tax traps, we must first know they exist.

Both Canada and the U.S., together with most jurisdictions in this world, tax non-residents on business income, employment income and property income sourced from the particular jurisdiction. That is a matter of domestic law. Such laws are then modified by treaties designed to promote international trade and investment and to allocate the tax base among nations rationally and with some degree of uniformity. Typically, those treaties provide a six-month grace period for employees and, in the absence of a permanent establishment, wholly exempt the business income of their employers. The difficulty for Canadians and other foreigners entering the U.S. is that when the U.S. government signs a treaty, the state governments are not bound.

On the employee side, forty-one out of the fifty states tax out-of-state employees. Of these, twenty-four levy tax from the date on which that employee sets foot in the jurisdiction. The other seventeen have varying de minimis thresholds. Fly to Philadelphia for a conference and owe Pennsylvania tax on day one. Visit clients in New York City and enjoy a two-week grace period. It does not matter that your salary is paid by your Canadian employer and that neither you nor your employer have any income sourced in the state. The theory is that if you exercise your employment in that state then you should be taxed in that state: total annual employment income would likely—but not necessarily—be prorated by the number of days (or part days) spent in that state.

The employer then has a corresponding obligation to track the time spent by each employee in each state and apply: (i) a different method of quantifying the time spent in each state; (ii) a different method of quantifying the tax base for each state—that is, for determining the amount of income on which the employee is taxed; and, (iii) a different tax rate for each state. The employer must then file different paperwork for each state. This requires administration, which entails a not-insignificant cost.

Third, the employer has its own tax liability to consider since, by definition, it carries on business in each state to which it sends its employees. One might object that if the employer has no revenue source in a given State then there is no income to tax. Unfortunately, this is the point at which the U.S. throws something at us called the “Unitary Business Principle”. This principle traces its origins back to the 19th century when states won the right to levy property tax based on a railway company’s value instead of the value of the tracks which crisscross its territory. Today, this principle enables states to apply income tax to a portion of worldwide profits based on the nebulous notion of “value flow”, underpinned by such cryptic concepts as “functional integration”, “centralization of management” and “economies of scale”.

Accepting that there might be foreign tax payable, one might expect to recover the tax cost through foreign tax credits. This will work for Canadian employees since U.S. personal income tax is generally lower than Canadian personal income tax. Unfortunately for their incorporated employers, however, Canadian corporate tax rates are typically 13% lower than the U.S. equivalent: the effect is to bump up the employer’s tax rate from about 26.5% to 40%.

This situation applies not only to non-residents of the U.S. but to Americans themselves. The problem is, in fact, greatest for U.S. businesses and Congress has responded by introducing the Mobile Workforce State Income Tax Simplification Act (known as the Mobile Workforce Act). The purpose of this Act is to reduce compliance costs by introducing uniformity among the states. Unfortunately, this legislation has been introduced, shot down and re-introduced every year for almost a decade. At present, the 2015 iteration remains alive, having passed committee stage last year. One hopes that this bill will finally become law.

In light of the above, what are Canadians to do?

The answer to that question is to think carefully about whether a Skype or conference call is a suitable substitute for a personal visit. If flying down for a conference, consider the tax laws of the state to which you are headed. And, when next flying south, be sure that you can truthfully answer that your purpose is pleasure.

* * This article is intended only to inform and educate. It is not legal advice.  Be sure to contact a lawyer to obtain legal advice on any specific matter.

Patrick Westaway is a corporate/commercial and tax lawyer at SorbaraLaw. He regularly advises in such technology industries as animated feature film production, online gaming and telecommunications with an emphasis upon cross-border enterprise and investment structuring.

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The use of corporations by doctors and lawyers is a relatively recent regulatory concession. Historically, medicine and law were considered more vocational than commercial. Client relationships were sacrosanct and corporations, with their commercial connotations and limited liability, anathema. And so, doctors and lawyers, through their respective self-governing bodies, were denied the benefits of incorporation. This has, however, changed in recent years. Today, doctors and lawyers can incorporate their practices and thereby access certain tax benefits widely available to others. As the tax benefits available to doctors and lawyers differ significantly in favour of doctors, this article focuses exclusively upon the medical profession and the tax planning opportunities available to its members.

To begin, there are three tax benefits of incorporating a medical practice, generally known as a “medicine professional corporation”. These are:

•  maximizing investment capital and paying off debts;
•  income splitting; and
•  accessing and multiplying the lifetime capital gains exemption.

It should be noted at the outset that medicine professional corporations do not limit a doctor’s liability for malpractice. One’s professional responsibility is in no way lessened. Liability is, however, limited in other respects, such as in relation to trade creditors and lenders—provided, of course, that no personal guarantee is given.

Maximizing investment capital and paying off debts

Use of a medicine professional corporation provides greater after-tax profits with which to either pay off the practice’s debts or to invest. The corporate tax rate on income from a medical practice is generally 15.5% whereas the corresponding personal rate is 49.53%. By leaving income in the corporation, the taxpayer therefore has an additional 34.03% to either invest or apply against the corporation’s debts. Earnings on the corporation’s investments would then be taxed at 46.2% while distributions would be taxed in the shareholders’ hands at 40.13%. This higher corporate rate on investment income is intended to offset the tax deferral otherwise achieved by investing through a corporation. That tax is then partially refunded when the income is passed through to the shareholder so that the net tax approximates the tax otherwise payable had the shareholder held the investments directly. Again, then, the primary benefit lies in increasing the corporation’s investment capital by 1/3 or correspondingly increasing the corporation’s ability to pay down its debts.

The above statement of rates includes various assumptions. All rates represent the combined Federal and Ontario rates applicable before any changes to be announced in the February, 2015 federal budget speech—which follows the time of writing. The 15.5% rate applies to active business income earned by Canadian-controlled private corporations on the first $500,000.00 of annual income, which would generally include all professional income earned by medicine professional corporations. Active business income above that threshold is taxed at 26.5%. At the shareholder level, the 49.53% rate is the top marginal rate applicable to individuals on annual income above $220,000.00.

It is important to note that investing must be subordinate to the primary medical purpose of the medicine professional corporation.

Income Splitting

When medicine professional corporations were first introduced, income-splitting was not permitted since only members of the College of Physicians and Surgeons could hold shares. That restriction was soon lifted, however, so that medicine professional corporations may now be used to allocate income among immediate family members. Given the graduated personal tax rates, allocating income among lower-income earners results in lower overall tax. Provided that the income-splitting is handled properly, such tax planning is entirely acceptable, having been ratified by the Canadian courts and the Canada Revenue Agency.

One should, however, be aware of the “kiddie tax”. Individuals below the age of 18 (in tax parlance, individuals who have not attained the age of 17 years “before the year”) are subject to tax on dividends at the top marginal rate applicable to individuals. This tax applies equally to taxable shareholder benefits. One cannot, then, effectively split income with one’s minor children.

Accessing and Multiplying the Lifetime Capital Gains Exemption

The lifetime capital gains exemption refers to an exemption available to individuals (not trusts) from tax on the first $800,000.00 of proceeds realized upon the disposition of “qualified small business corporation shares”. In general, the shares of medicine professional corporations would qualify such that the use of incorporation represents a significant tax savings upon a sale of the practice. Since only 50% of capital gains are taxable, this results in a deduction of up to $400,000.00 against taxable income which, at the top marginal rate, represents a cash savings of up to $198,119.00.

If shares have been issued among family members then the sale proceeds must be allocated accordingly, and the lifetime capital gains exemption is effectively multiplied. If one is married with three children then the above $200,000.00 cash savings becomes $1,000,000.00.

As a practical matter, purchasers may prefer to buy the assets rather than the corporation in order to avoid any “skeletons in the closet” and to be able to depreciate the purchase price. In this circumstance, the benefit of the lifetime capital gains exemption is not lost; rather, it becomes leverage to negotiate a higher sale price in order to compensate for the lost tax savings.

Conclusion

Much remains to be said about the incorporation and use of medicine professional corporations. These corporations are governed not only by the Business Corporations Act (Ontario) by also by the Health Professions Procedural Code and regulations under the Regulated Health Professions Act. And, of course, layered above all is the Income Tax Act (Canada). If, therefore, one is interested in learning more about incorporating a medical practice, it is essential to consult an advisor well-versed in both corporate and tax law as well as the medical profession’s governing legislation and regulations.

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Patrick Westaway. Patrick is a corporate/commercial and tax lawyer at SorbaraLaw. He regularly advises in such technology industries as animated feature film production, online gaming and telecommunications with an emphasis upon cross-border enterprise and investment structuring.

Tax Law – Patrick Westaway

 

View the chart here:

Canadian and Ontario Film and Television Tax Credits (Chart)

 

Patrick is a corporate/commercial and tax lawyer of more than 16 years’ experience. He regularly advises in such technology industries as animated feature film production, online gaming and telecommunications with an emphasis upon cross-border enterprise and investment structuring.

Tax Law - Patrick Westaway

 

View the article here:

Animation Outsourcing and the Ontario Computer Animation and Special Effects Tax Credit

 

Patrick is a corporate/commercial and tax lawyer of more than 16 years’ experience. He regularly advises in such technology industries as animated feature film production, online gaming and telecommunications with an emphasis upon cross-border enterprise and investment structuring.

 

Tax Law – Patrick Westaway

New business remains subject to the old taxes. Believing otherwise is wishful thinking. The latest tax topic in the world of technology is the Bitcoin. For those still using old-fashioned e-transfers and PayPal, the Bitcoin is the new currency. Unaffiliated with any country or bank, the Bitcoin works because the parties agree that it should. Bitcoins are accepted by an increasing number of online (and offline) vendors and service suppliers, and can even be converted into “real” money—provided someone with real money agrees. It’s like a barter system but without the bartering.

You might object that the Bitcoin has nothing to do with bartering since it is fundamentally liquid. It is fungible. A loonie is worth a loonie and a Bitcoin is worth a Bitcoin.  There is no squabbling over how many of my chickens your cow is worth, or which service has the greater value. Fundamentally then, Bitcoins are money, but without the underwriting of a bank or national treasury—which, given the experience of recent years, might not be such a bad thing. At least, that is what you might think. But for practical purposes, you would be wrong—at least where taxes are concerned.

The CRA posted its position on the Bitcoin late last year and the news was grim for those who thought that only national currencies are taxed and that the Bitcoin heralded a return to a pre-war income tax free nirvana-that-never-was. The Bitcoin—or more broadly, “digital currency”—is, we are told, “virtual money”. It can be bought and sold “like a commodity” and the receipt of this virtual-money-that-is-sometimes-a-commodity is taxable in the same way as any other income. This is not to say that every Bitcoin transaction is taxable, only that Bitcoins do not make taxable transactions into non-taxable ones.

This is bad news for the wishful thinkers but validation for the champions of stateless money. The rub for the latter bunch, however, is that the CRA did not bestow the status of “money” on the Bitcoin. That would have been unhelpful and a little meaningless since one cannot go onto the Bank of Canada website to check the Bitcoin’s exchange rate. Instead, the CRA simply said that the Bitcoin is subject to the same rules as barter transactions, meaning that Bitcoins are to be valued according to the goods or services for which they are exchanged. Sadly, then, despite its fungibility, the Bitcoin leaves us still asking after the underlying value at tax filing time.

It must also be recognized that when Bitcoins are bought and sold like a commodity—arbitraged like any other currency—their disposition must give rise to income or capital gains according to whether they are traded on income, or held on capital, account.

The takeaway is this. First, tax has always applied to non-cash receipts, such as are realized upon share exchanges, stock dividends, dividends in kind, shareholder benefits, employee benefits and, yes, even barter transactions—unless carefully structured to access a specific exemption or deferral. Whether you are paid in dollars, Bitcoins or ham sandwiches, there is a value to what you receive and you are taxed on that value. Were it otherwise, tax planning would be simple and tax planners could all retire—comfortably financed by the tax-free accruing Bitcoin. Second, although the Bitcoin and its digital ilk may have the hallmarks of real money, the distinction is academic since, without a State-sanctioned exchange rate, the Bitcoin does not bestow a value upon the goods or services but instead must derive its value from those goods or services, which must then still be valued in old fashioned dollars. And, finally, when investing in Bitcoins, be prepared to recognize income or gains when you cash in.

There is also a more technological concern, which should speak to every early adopter and everyone who has ever lost data. What happens when there is a bug in your Bitcoin, when problems with the software cause your digital bank to suspend operations until further notice? What is the value then? Just ask the clients of Mt. Gox, the Tokyo Based Bitcoin exchange that did exactly that in the days before this article was written.

* * This article is intended only to inform and educate. It is not legal advice.  Be sure to contact a lawyer to obtain legal advice on any specific matter.

 

Patrick Westaway is Tax Counsel to Sorbara, Schumacher, McCann LLP, a full service law firm based in Waterloo, Ontario. Patrick advises on a broad range of Canadian taxation issues such as corporate tax planning, structuring inbound investments, corporate reorganizations, cross-border financings, tax opinions for public disclosure documents, tax assessments, personal tax matters, wealth preservation, and on federal and provincial sales tax matters (HST/GST/PST). Patrick also practices corporate and commercial law with an emphasis on the implementation of matters related to his tax planning practice.

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Tax Law – Patrick Westaway

A non-resident who sells software into Canada may be required to levy Canada’s Goods and Services Tax (“GST”—Canada’s VAT) even though the non-resident does not carry on business in Canada. This depends on whether the software is “off the shelf” or custom, whether it is licensed or sold and whether the non-resident is already a GST registrant. To skip this analysis and register for GST out of an abundance of caution can therefore subject a sale to GST when GST would not otherwise apply.

Off-the-Shelf Software

Off-the-shelf software is pre-packaged, commercially available software that one may pull “off the shelf” in a shop. Such software typically comes with a standardized (“shrink wrap”) licence agreement which binds the customer by reason of the customer having opened the box or loaded the software. This kind of software is considered to be tangible personal property and, as such, is always subject to GST on importation. The key, then, for the supplier is to ensure that delivery is made outside Canada, i.e., Ex Worksbefore importation.

Off-the-Shelf software that is sold online is considered to be intangible property. Unlike tangible personal property, it is not taxed upon importation. Instead, the supply is deemed to have been made in Canada. The supplier is therefore required to levy the GST without the Ex Works alternative available to bricks and mortar suppliers.

Custom Software

Customized software is altogether different. If a client commissions the supplier to (a) write new software which the client will own outright or (b) modify the client’s existing software, the Canada Revenue Agency focuses on the fact that the client owns the software and so considers the supplier to charge for the programming service rather than the program. Since services are only subject to GST if performed in Canada, programming services performed abroad are exempt—unless the supplier is a GST registrant. It is therefore important to understand the GST implications before rushing to become a registrant.

In practice, suppliers of custom software will often send employees to Canada to install the software and provide training. If, in doing so, the supplier is considered to carry on business in Canada then the supplier must become a GST registrant and levy GST.  Thus, not only will the installation and training services become taxable, but so also will the software, for the reasons just described. However, a good Canadian tax advisor can enable the supplier to perform installation and training services in Canada without being considered to carry on business in Canada.

It is therefore essential to consult a Canadian tax advisor prior to entering into any agreement so that the non-resident supplier can avoid those GST registration, withholding and remittance requirements that are so commonly and unnecessarily incurred by the unwary.

* * This article is intended only to inform or educate. It is not legal advice.  Be sure to contact a lawyer to obtain legal advice on any specific matter.

 

Patrick Westaway is Tax Counsel to Sorbara, Schumacher, McCann LLP, a full service law firm based in Waterloo, Ontario. Patrick advises on a broad range of Canadian taxation issues such as corporate tax planning, structuring inbound investments, corporate reorganizations, cross-border financings, tax opinions for public disclosure documents, tax assessments, personal tax matters, wealth preservation, and on federal and provincial sales tax matters (HST/GST/PST). Patrick also practices corporate and commercial law with an emphasis on the implementation of matters related to his tax planning practice.

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Tax Law – Patrick Westaway

It is critical for non-residents to obtain proper Canadian legal advice respecting their long-term tax position before entering the Canadian market. The tax consequences of the various available structures vary significantly and opportunities for tax savings can be considerable.

The tax issues arising upon entering the Canadian market are best understood by recognizing that there are only three basic vehicles. A non-resident corporation may carry on business in Canada directly, through a Canadian corporation or through a partnership involving either or both of the foregoing. Once the consequences of each alternative are understood and compared, more complex, contextual, structures may be tailored from these basic building blocks.

Admittedly, this is a simplistic analysis since only the basic ‘building blocks’ are considered. Furthermore, this analysis is limited to the Canadian side of the equation. In respect of the first limitation, the essential point is that the tax issues remain the same for the most complex as for the simplest structures. The simpler the structure, the more readily understood are the tax issues. As to the second limitation, it is, of course, necessary to always consider the tax issues in the applicable foreign jurisdiction.

I. Permanent Establishments

Focusing, then, upon the Canadian side of the equation, the first scenario is one in which the non-resident corporation would carry on business in Canada directly. From a domestic perspective, subsection 2(3) of the Income Tax Act (Canada) (the “Tax Act”) would subject the non-resident to Canadian income tax on all Canadian-source business income. From a cross-border perspective, however, there may be an opportunity to avoid Canadian taxation by avoiding a Canadian permanent establishment. The first point to consider, then, is the threshold at which the Canada Revenue Agency (the “CRA”) would determine a permanent establishment to arise for the purposes of Canada’s typical tax treaty.

It should be noted at the outset that treaty exemptions for non-residents carrying on business in Canada without a permanent establishment usually apply only to non-residents that are corporations. A similar exemption involving the identical concept of “fixed base” applies to individuals. That the concepts of “permanent establishment” and “fixed base” are identical has been recognized by the recent deletion of the latter concept from the Canada-U.S. Tax Convention (1980) (the “Canada-U.S. Treaty”) and the expansion of the former to benefit individuals. All comments on permanent establishments therefore apply equally to fixed bases.

(a) Permanent Establishment

The definition of a “permanent establishment” is set out with some particularity in the tax treaties. In essence, these definitions provide that a permanent establishment is predicated upon any of: (i) a place; (ii) a person; or, in the case of the U.S. treaty, (iii) time allocation.

(i) Places

A permanent establishment as a place requires a “fixed place of business”; that is, a physical location controlled by, and identifiable by prospective clients with, the non-resident. Aside from the obvious examples of owning or leasing space, a non-resident may simply be permitted to use the office of a Canadian affiliate or client. In such circumstances, we would need to consider whether the non-resident has a key to those premises and access at any hour, whether it uses those premises to service other clients and whether it hangs its own shingle in the lobby or hands out business cards with that address or phone number. Relevant factors are as varied as the circumstances.

(ii) Persons

The second concept is that of a permanent establishment as a person. A person can be a permanent establishment if it has and habitually exercises in Canada the authority to contract on behalf of the non-resident. If circumstances permit, this situation can be avoided simply by denying any person in Canada the authority to execute contracts on the non-resident’s behalf.

If, for example, a non-resident is to have only a sales force in Canada, a permanent establishment could be avoided by requiring head-office approval for all sales contracts. In this scenario, it should be noted that the typical treaty definition of “permanent establishment” specifically excludes the use of facilities for the purpose of storage, display or delivery of merchandise. A Canadian sales and distribution network could, therefore, be organized to avoid Canadian income tax entirely—subject to the new 183-day rule.

(iii) Time Allocation: The New 183-Day Rule

A third branch of the definition of permanent establishment is exclusive to Canada’s tax treaty with the U.S., applicable as of January 1, 2010. This branch applies in either of two sets of circumstances:

(A) services are provided in Canada by an individual who is present in Canada for an aggregate of 183 days or more in any 12-month period and more than 50% of the non-resident’s gross active business revenues derives from those services; or

(B) services are provided in Canada by any number of persons, whether or not individuals, for an aggregate of 183 days or more in any 12-month period and those services are in respect of the same or a connected project—in this case, the customers may be either residents of Canada or merely have permanent establishments in Canada, provided in the latter case that the services are provided in respect of those permanent establishments.

The first scenario, which contemplates only a single individual, applies to any number of projects whereas the second scenario, which contemplates any number of persons, applies only to a single or a connected project. Further, whereas the first scenario applies a revenue test, the second does not. When considering the use of local representatives, it should also be noted that the typical treaty specifically excludes from the definition of “permanent establishment” any agent of an independent status acting in the ordinary course of its business. Thus, distributors and other independent contractors would not usually constitute a permanent establishment.

(b) Pros and Cons

Assuming that the non-resident chooses to carry on business in Canada directly through a permanent establishment, what are the consequences? First, that non-resident would be subject to Canadian income tax on all net Canadian-source income attributable to the permanent establishment. Although a foreign tax credit would presumably be claimed in the non-resident’s home jurisdiction, the non-resident would remain liable to pay the higher of the two tax rates and would be required to file a Canadian income tax return. Second, liabilities incurred in Canada would be incurred by the non-resident—there would be no limitation of liability otherwise afforded by a subsidiary corporation. Third, customers of the permanent establishment would be required to withhold and remit income tax on all payments that they make to the permanent establishment, although non-resident corporations typically obtain waivers for this withholding and remittance requirement.

On the other hand, the principal benefit of carrying on business through a permanent establishment is that any losses incurred in Canada would generally be deductible by the non-resident in its home jurisdiction against its non-Canadian-source income. A permanent establishment may also be preferable if the extent or frequency of business activity in Canada does not warrant the incorporation of a separate company.

(c) Branch Tax

The last issue when considering whether to carry on business in Canada directly is “branch tax”. Just as Part XIII of the Tax Act imposes a non-resident tax of 25% on dividends, so Part XIV imposes a branch tax of 25% on the after-tax profits of the branch that are not reinvested in the Canadian business. And, just as the tax on dividends is subject to reduction by treaty, so also is branch tax. This reflects the policy behind branch tax, which is to render tax neutral the choice between a branch and a subsidiary. Differences arise, however, in that the treaty-reduced rate applicable to dividends under most of Canada’s tax treaties is variously 5% or 10%, as discussed in Part II(b), below, whereas the treaty-reduced rate applicable to branch tax is 5%.

Further differences between branch tax and non-resident tax are as follows. First, there is a timing difference since branch tax is payable annually whereas the non-resident tax applicable to dividends is payable when the dividend is paid or credited. Second, Canada’s tax treaties typically provide a one-time branch tax exemption on the first $500,000 of net income. No such exemption applies to dividends, although an analogous result may be obtained for dividends through the use of an acquisition company, discussed in Part II(c), below.

II. Subsidiaries

Thus far, we have reviewed the possibility of avoiding Canadian income tax by avoiding a Canadian permanent establishment and the tax consequences of carrying on a business in Canada through a permanent establishment. The next likely vehicle through which to carry on business in Canada is a Canadian subsidiary.

(a) Pros and Cons

The pros and cons of a subsidiary are the converse to those of a permanent establishment. As a separate legal entity, any losses generated by a subsidiary cannot be deducted by the parent. On the other hand, the subsidiary’s liabilities are its own and, as a Canadian corporation, its customers are not required to withhold and remit taxes. It should also be noted that a subsidiary’s tax filing obligations are also its own, which is significant if the non-resident does not wish to disclose its financial information to the CRA.

Prior to recent amendments to the Canada-U.S. Treaty, unlimited liability companies (ULCs) were often incorporated under the laws of Nova Scotia, Alberta or British Columbia to provide U.S.-resident investors with the benefits of both a permanent establishment and a subsidiary. However, as a result of those amendments, all dividends, royalties and similar payments made to the U.S.-resident parent are now subject to non-resident tax, discussed below in Part II(b), at the full rate of 25% without the benefit of a treaty reduction or exemption. Nevertheless, ULCs continue to offer benefits for U.S. tax purposes, which must be weighed against the loss of treaty benefits. The continued benefits of these corporations is discussed in a separate article.

Notwithstanding that a subsidiary is an independent legal entity, care must be taken to ensure that the subsidiary cannot be construed to be a mere agent of its non-resident parent. In such a case, the CRA might consider the subsidiary’s premises to constitute a “fixed place of business” through which the non-resident parent carries on business in Canada, i.e., the subsidiary’s premises could be construed to be a permanent establishment. This result may be avoided when drafting inter-corporate services agreements by making it clear that the subsidiary is engaged in its own business, that the relationship between the non-resident and its Canadian subsidiary is one of customer and independent contractor.

(b) Non-Resident Tax and Income Tax

(i) Non-Resident Tax

If we divide the non-resident and the Canadian operation into separate legal entities, we must then consider taxes on all payments flowing between them. Part XIII of the Tax Act imposes a non-resident tax on various passive forms of income, including dividends, interest, rents, royalties and so forth. This 25% rate rarely applies, however, since Canada’s tax treaties generally reduce or eliminate this tax. Unlike the Tax Act, the tax treaties treat the various kinds of income differently such that each income source must be separately considered

Looking at dividends, the treaty-reduced rate under the typical treaty is 5% if the beneficial owner of the dividends is a corporation that owns at least 10% of the voting shares. In all other cases, the treaty-reduced rate for dividends is 15%. Rents on real property situated in Canada enjoy no tax reduction. Any amounts that could be allocated to royalties for software licences would enjoy a complete tax exemption under the Canada-U.S. Treaty while certain other royalties would be taxable at 10%.

Interest payments between arm’s-length parties are not taxable provided that the interest is not ‘participating debt interest’. This concept refers to debt on which interest is contingent upon the use of, or production from, property in Canada or that is computed by reference to revenue, profit, cash flow, commodity price, etc. or by reference to dividends paid or payable on the shares of a corporation (not necessarily the debtor corporation). In other words, participating debt is debt the interest on which could be characterized as disguised dividends. Given this exemption from non-resident tax on arm’s length interest payments, there is no tax disincentive to sourcing project financing abroad. When, however, debtor and creditor do not deal at arm’s length, we must rely upon a tax treaty for a reduction or exemption of the non-resident tax which would otherwise apply at a rate of 25%. Pursuant to recent amendments to the Canada-U.S. Treaty, interest payments between the two countries are wholly exempt from taxation in the source country. Under Canada’s other tax treaties, the typical rate is 10%.

(ii) Income Tax

Whereas Part XIII tax applies to passive forms of income earned in Canada by non-residents, income from carrying on business in Canada is subject to income tax under Part I of the Tax Act. It may be, for example, that the non-resident parent, or, perhaps, another member of the corporate group, will provide services to the Canadian subsidiary. In such a situation, income tax must be withheld by the Canadian subsidiary on all fees for such services at a rate of 15%. (For the application of sales tax to non-residents, see the article, Canada’s Federal Sales Tax—An Overview for Non-Resident Suppliers).

It should be noted that, whereas non-residents are not required to file Canadian tax returns in respect of non-resident tax, they are required to file Canadian tax returns in respect of income tax. As well, whereas a treaty reduction or exemption will reduce or avoid the amount of non-resident tax to be withheld, the same is not true of income tax. Income tax must be withheld at a rate of 15% regardless of the application of any tax treaty—subject only to the non-resident obtaining a waiver from the CRA. The treaty benefit is claimed, and the rebate obtained, when the tax return is filed.

(c) Acquisition Companies

The next point to consider in respect of the use of a subsidiary is the potential benefit of an acquisition company for the purchase of either Canadian assets or shares. In the absence of an acquisition company, the purchase price would simply be paid by the non-resident to the vendor and no tax benefit would be obtained by the purchaser (aside from a step-up in the cost base of the acquired shares or assets). If, however, the non-resident purchaser were to pay the amount of the purchase price to a Canadian subsidiary (which would then pay the vendor) paid-up capital would be created in the subsidiary (and the subsidiary would still obtain a step-up in the cost base of the acquired shares or assets). Thereafter, any distributions made by the subsidiary to the parent could, to the extent of the increased paid-up capital, be characterized as a tax-free distribution of capital rather than a taxable dividend or interest payment. Assuming the treaty-reduced rate under the Canada-U.S. Treaty of 5% on dividends, the tax savings to the non-resident on every $1 million of purchase price paid would be $50,000.

(d) Thin-Capitalization

Given the full tax exemption for interest payments under the Canada-U.S. Treaty, it is tempting to characterize all investment in a Canadian subsidiary by a U.S.-resident parent as debt. Unfortunately, there is already in place a “thin capitalization rule” which denies a deduction to the subsidiary for interest paid to the parent (or any other “specified non-resident”) if the debt owed to the parent (or other “specified non-resident”) exceeds 1.5 times its equity. Briefly, a “specified non-resident” is a non-resident that does not deal at arm’s length with the subsidiary or that, either alone or together with other non-arm’s-length persons, owns 25% or more of the subsidiary’s votes or value. Given the ability of the Canadian subsidiary to deduct interest payments (and not dividends), it is difficult to envision a scenario in which a U.S.-resident parent would not wish to maintain the maximum 1.5:1 debt to equity ratio. Pursuant to recent changes to the thin-cap rule, the amount of any denied interest deduction is re-characterized as a dividend payable to the non-resident. This gives rise to Part XIII withholding obligation, described above, and a tax cost to the Canadian borrower if it fails to withhold and remit that tax. The thin-capitalization rule is discussed in more detail in an article entitled, The New Thin-Cap: Lenders Beware.

(e) Transfer Pricing

Finally, the last issue of which we need to be aware in respect of subsidiaries is the potential application of the transfer pricing rules. Since a subsidiary is not a permanent establishment, the non-resident would not be subject to Canadian income tax on fees for services performed in Canada (although withholding and filing obligations discussed above would still apply). Consequently, a non-resident parent could extract profits from a Canadian subsidiary on a tax-free basis by characterizing such amounts as fees for services. Such payments would then be deductible by the Canadian subsidiary. The same result could be obtained through the sale of goods to a subsidiary. In order to prevent such abuses, the CRA applies transfer pricing rules to amounts charged for goods or services passing between Canadian corporations and non-arm’s-length non-residents. If the amounts charged differ from the amounts that would be charged between arm’s-length parties, as determined by the CRA, subsection 247(2) of the Tax Act authorizes the CRA to adjust the taxable income of the subsidiary accordingly. While the application of these rules is beyond the scope of this paper, taxpayers should be aware that these rules exist and that taxpayers are required to maintain contemporaneous documentation to identify and support all amounts paid to or received from related non-residents as consideration for goods or services.

III. Limited Partnerships

The third and final vehicle to be discussed on the Canadian side of the border is the limited partnership. The fundamental point is that the taxation of partnerships reflects the fact that they are not legal entities. While tax practitioners often speak somewhat loosely of partnerships as though they were independent entities, it is important to remember that they exist only as contractual relationships among the partners. This is true of limited partnerships as well as general partnerships notwithstanding that limited partners enjoy limited liability. Broadly speaking, then, if a non-resident were to organize its Canadian operations as a partnership, we would need to look through the partnership and consider all of the above issues in respect of each partner, which will either be carrying on business through a permanent establishment or Canadian subsidiary. Since a Canadian subsidiary is a Canadian resident, the following references to non-resident partners refer only to those non-residents that hold their partnership interests directly.

For the purposes of calculating income and losses of the partners, income is determined and expenses deducted at the partnership level and the resulting taxable income or losses allocated among the partners in accordance with the terms of the partnership agreement. In most instances, the partnership is then required to file an information return which the CRA can then cross reference with the income tax returns of each partner. This ability of limited partnerships to flow through losses to the partners while limiting liability is the reason such partnerships are often used as investment vehicles.

Partnerships with a non-resident partner are subject to specific rules relating to: (i) non-resident tax on payments to the partnership; and, (ii) income tax applicable to capital gains realized upon the disposition of taxable Canadian property held by the partnership.

(a) Non-Resident Tax

Paragraph 212(13.1)(b) of the Tax Act deems any amount paid or credited by a person resident in Canada to a partnership other than a “Canadian partnership” to be paid to a non-resident person. “Canadian Partnership” is defined in subsection 102(1) of the Tax Act to mean a partnership all of the members of which are resident in Canada. This relieves the CRA of the administrative burden of determining the residence status of each partner and the portion of each payment allocable to any non-resident partners. Instead, if even just one partner is a non-resident, Canadian-resident payors must withhold non-resident tax on dividends, interest, rents, royalties, management fees, and so forth paid or credited to the partnership.

Left on its own, the effect of this rule would be draconian given that non-resident tax is not a withholding tax per se but is a tax in and of itself and is therefore non-refundable. We therefore have a further rule according to which a partnership is to be ignored for the purpose of applying the tax treaties. In conjunction with paragraph 212(13.1)(b), this shifts the burden of determining the residence of each partner and its share of partnership income from the CRA to the taxpayers. If tax treaty benefits are to be claimed, the residence of each partner must be separately determined as of the time of each payment and the tax reduction or exemption under the relevant tax treaty must be separately applied to each partner.

If a U.S.-resident corporation owns shares through a Canadian partnership then, for the purpose of determining whether the lower of two treaty-reduced rates referred to in Part (II)(b), above, is available in respect of dividends, the U.S.-resident partner will be considered to own shares in proportion to its partnership interest. Before recent amendments to the Tax Treaty, the lower rate was never available when a partnership was interposed.

(b) Income Tax

If Canadian operations are to be structured as a partnership, it is important to consider that the permanent establishment of one non-resident partner is considered to be the permanent establishment of every non-resident partner. This rule applies to both general and limited partners. Every non-resident partner will, therefore, be subject to Canadian income tax on its share of the partnership income as though that partner were carrying on business in Canada directly through a permanent establishment.

(c) Tax Clearance Certificates

For the purpose of determining whether a tax clearance certificate is required under section 116 of the Tax Act in respect of the disposition of taxable Canadian property, the partnership is generally ignored. Only non-resident partners are required to obtain tax clearance certificates while Canadian-resident partners may rely upon their own Canadian resident status.

The difficulty arises in that a purchaser of taxable Canadian property is liable to pay tax in an amount equal to 25% of the purchase price unless either: (i) after “reasonable inquiry” it has “no reason to believe” that the vendor is a non-resident; or, (ii) a tax clearance certificate is obtained. When the vendor is a limited partnership with numerous limited partners, the obligation to conduct such due diligence would be problematic, to say the least. It is to be expected, then, that the agreement of purchase and sale would require the partnership—or, more properly, the general partner on behalf of the partnership—to represent and warrant that Canadian-resident partners are so resident and to provide tax clearance certificates for the rest.

The difficulty of obtaining tax clearance certificates from any number of non-resident investors is largely relieved by administrative concession. The CRA’s position as stated in paragraph 10 of Information Circular 72-17R5 is that a single application may be made on behalf of all non-resident partners provided that the application includes a complete listing of the non-resident partners together with their Canadian and foreign addresses, identification numbers, percentage ownership and their portion of the tax payment or security therefor. Separate tax clearance certificates are then issued for each partner and each partner must file its own Canadian income tax return to report the gain or loss.

Recent amendments to the Tax Act relieve the purchaser from the withholding and remittance obligation if: (i) the purchaser concludes after “reasonable inquiry” that the vendor is resident in a given treaty country; (ii) the sale proceeds would be exempt under the particular treaty; and, (iii) the purchaser provides the required notice to the Minister. Previously, then, a purchaser was relieved of its withholding and remittance obligations only if its reasonable inquiry disclosed that the vendor was a resident of Canada. Now, a purchaser is relieved of such obligations if its reasonable inquiry discloses that the vendor is a non-resident but is nevertheless entitled to a treaty exemption.

IV. Conclusion

As stated at the outset, it is critical that non-residents obtain proper Canadian legal advice before entering the Canadian market. The long-term tax consequences of the various available structures vary significantly and opportunities for tax savings can be considerable.

* * This article is intended only to inform or educate. It is not legal advice.  Be sure to contact a lawyer to obtain legal advice on any specific matter.

 

Patrick Westaway is Tax Counsel to Sorbara, Schumacher, McCann LLP, a full service law firm based in Waterloo, Ontario. Patrick advises on a broad range of Canadian taxation issues such as corporate tax planning, structuring inbound investments, corporate reorganizations, cross-border financings, tax opinions for public disclosure documents, tax assessments, personal tax matters, wealth preservation, and on federal and provincial sales tax matters (HST/GST/PST). Patrick also practices corporate and commercial law with an emphasis on the implementation of matters related to his tax planning practice.

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Tax Law – Patrick Westaway 

Those who sell goods or services in Canada have always to consider whether to become a ‘registrant’ under Canada’s federal Excise Tax Act. For residents of Canada, the issue is simple. If revenues from the sale of goods or services in Canada that became due in the four preceding calendar quarters exceed CDN$30,000.00 then registration is required unless, in broad terms, an exemption can be found. Unfortunately, matters are considerably more complicated for non-residents of Canada.

Overview of Canada’s Sales Tax System

By way of an overview, Canada has both federal and provincial levels of sales tax. The federal sales tax is referred to as the Goods and Services Tax (“GST”) whereas sales tax at the provincial level is generally referred to as provincial sales tax (“PST”)—except in Quebec, which refers to its sales tax as QST. In the provinces of Ontario, Nova Scotia, New Brunswick and Newfoundland & Labrador, the administration of GST and PST has been combined and the result referred to as Harmonized Sales Tax (“HST”). British Columbia had adopted the HST but reverted to its old PST system as of April, 2013. For simplicity’s sake, this article refers throughout to GST but such comments apply equally to HST.

GST applies at a rate of 5% of the value of the consideration for the supply, i.e., the sale price. The various PST rates range from 5% to 10% and, in non‐HST provinces, is variously applied to the net or gross sale price (sale price with or without GST). In Ontario, the total HST is 13% (GST of 5% plus PST of 8%). Tax advice should be obtained to determine whether and at what rate sales tax applies in given circumstances.

A key element of this federal system is a set of rules—known as the “place of supply” rules—to determine which province has jurisdiction to tax a given transaction. Simply stated, the province with jurisdiction is generally the one in which the supply occurs. If, for example, the goods supplied are tangible personal property then the relevant province is generally the one in which the goods are delivered or made available to the recipient. If the supply is of real estate then the relevant province is generally the one in which that real estate is located. If the supply is of intangible personal property, jurisdiction will depend on a number of factors, including the place in which the property can be used and the location of the purchaser. Different intangible properties will, however, be subject to different rules. When services are supplied, the relevant province is generally determined according to the home or business address of the purchaser, although, again, specific rules apply for certain types of services. The place of supply rules are extensive and the above examples are general and for illustrative purposes only.

When property and services are brought into an HST province from another province (whether or not such other province is also an HST province) or from outside Canada for consumption, use or supply in that HST province, the supplier is required to self‐assess since no actual purchase and sale occurs.

Significance of being a “registrant” under Canada’s Excise Tax Act

So what is the significance of being a registrant? A registrant is required to withhold and remit GST on supplies made in Canada of goods and services (provided that no exemption is available) and to file periodic GST returns. On the other side of the ledger, a registrant is entitled to claim input tax credits for (deduct) any GST paid or payable by it on taxable supplies (inputs) that are used, consumed or supplied in the course of its commercial activities. The policy behind input tax credits is that GST should only be paid by consumers, not each party in the supply chain. Consequently, to the extent that the registrant’s commercial activities involve the making of “exempt” supplies, (supplies that are not subject to GST) input tax credits are not available. Perhaps inconsistently, “taxable” supplies includes “zero‐rated” supplies (supplies that are taxable at a rate of 0%) and supplies that are made outside Canada (to which GST does not apply). Input tax credits can only be claimed if the taxpayer (including non‐residents) keeps documentation sufficient to determine the amount of GST that it paid on its inputs. This documentation is, to some extent, prescribed by regulation and varies according to the cost of the particular input.

Registration requirement as it applies to nonresidents

To return, then, to the original question, when is a non‐resident required to become a registrant? A non‐resident is generally required to become a registrant under the Excise Tax Act if it carries on business in Canada. In making this determination, the Canada Revenue Agency (the “CRA”) claims a broad discretion unfettered by any clearly articulated rules. Instead, the CRA has published various scenarios, each with a lengthy set of circumstances, and expressed an opinion in each instance. It is left to non‐residents and their tax advisors to discern patterns among these scenarios and findings.

In the context of non‐residents selling goods worldwide, for example, the CRA emphasises the solicitation of orders and delivery of goods in Canada. Yet these factors alone are insufficient to find that the non‐resident carries on business in Canada. Something more is always required. That something more may be the place of contract, which itself can involve subtle legal analysis, or the warehousing of goods in Canada.

Other factors, such as a Canadian bank account will be considered but are less significant.

Interestingly, the CRA has indicated that it does not consider it relevant that a non‐resident who sells machinery into Canada also sends its employees into Canada to install that machinery. Such activity is regarded as being merely ancillary to the sale. One must be careful when relying upon such statements, however, since there may well be situations in which the time required for the installation or the amount of the purchase price allocable to such installation services would draw a different response from the CRA. Each situation must be carefully considered in view of its own circumstances.

In addition to the foregoing considerations, special rules require non‐residents to register for GST in the following circumstances, subject, as always to qualifications and exceptions:

  • a non‐resident sells admissions to a place of amusement, seminar or other activity or event in Canada, including concerts and sporting events;
  • a non‐resident sells books, newspapers or periodicals in Canada;
  • a non‐resident organises a convention in Canada; or
  • a non‐resident exhibitor at a convention in Canada brings into the country goods for sale to delegates.

In general, registration must occur before the thirtieth day following the day on which the taxable supply is first made in Canada. Non‐residents who sell admission to a place of amusement, seminar or other activity or event, however, must register before the taxable supply is made.

Conclusion

In view of the foregoing, non‐residents who intend to sell goods or services in Canada should always consult their Canadian tax advisor in advance and, ideally, before finalizing the services or sales agreement. Registration obligations, whether for tax or other purposes, the effects of such registrations and even applicable tax rates are of sufficient complexity that proper advice is always essential.

* * This article is intended only to inform or educate. It is not legal advice.  Be sure to contact a lawyer to obtain legal advice on any specific matter.

 

Patrick Westaway is Tax Counsel to Sorbara, Schumacher, McCann LLP, a full service law firm based in Waterloo, Ontario. Patrick advises on a broad range of Canadian taxation issues such as corporate tax planning, structuring inbound investments, corporate reorganizations, cross-border financings, tax opinions for public disclosure documents, tax assessments, personal tax matters, wealth preservation, and on federal and provincial sales tax matters (HST/GST/PST). Patrick also practices corporate and commercial law with an emphasis on the implementation of matters related to his tax planning practice.

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