Buying and Funding Canadian Companies: The Foreign Buyer’s Perspective

By Patrick Westaway

As a foreign purchaser of Canadian shares or business assets, simple steps may be taken today to reduce consequent costs tomorrow. Looking ahead pays off and it begins both by leaving room in the purchase agreement for a Canadian acquisition company and by properly characterising the target’s up front operational funding.

Structuring the Acquisition

A Canadian acquisition company is an ordinary Canadian corporation wholly owned by the foreign purchaser. It works by creating Canadian share capital (aka “stated capital” for corporate purposes and “paid-up capital” for tax purposes) when the purchase price flows through from the foreign purchaser. That is to say, the purchaser invests the amount of the purchase price in its new Canadian subsidiary and that subsidiary, as purchaser under the agreement, pays the vendor for the shares or assets. If then, by way of example, the purchase price is one million dollars, the foreign parent will have one million dollars of share capital notwithstanding that the actual cash no longer remains. Future Canadian profits of up to one million dollars can then be distributed as non-taxable distributions of capital rather than as taxable dividends—bearing in mind that, unlike intercorporate dividends paid domestically, dividends paid across the border are taxable. For the sake of simplifying the corporate records and tax compliance, the acquisition company and the target company can be amalgamated after the acquisition without reducing the share capital.

In contrast, if the purchase price were paid by the foreign purchaser directly, that money would simply be gone. No share capital would be created and future distributions would be taxable as dividends, interest, or some form of intercompany fee, as discussed below.

Structuring the Operational Funding

How the target’s funding is characterised going in generally determines how the target’s profits are taxed coming out. This is, therefore, a matter to be considered at the time of the acquisition, not later when the distributions are made.

Canada taxes foreign recipients of passive income (dividends, rents, royalties and interest) at a flat rate of 25%. The tax is withheld at source, failing which the Canadian payor is liable. This 25% rate is, however, generally reduced or eliminated under Canada’s treaty network. It is under these treaties that different kinds of income are differently taxed.

Looking at dividends, the treaty-reduced rate under the typical treaty is 5% if the foreign shareholder is a corporation and owns at least 10% of the voting shares (the typical treaty rate otherwise being 15%). In contrast, interest payments between parent and subsidiary are typically reduced to 10% except under Canada’s treaty with the U.S., which exempts interest payments entirely.

Given the full tax exemption for interest payments under Canada’s tax treaty with the U.S. and the subsidiary’s ability to deduct such payments for its own tax purposes, it is tempting to characterise all funding as debt. Unfortunately, there exists a “thin capitalisation rule” which denies the deduction to the subsidiary and taxes the parent as if it had instead received dividends if the total debt owed to the parent were to exceed 1.5 times the parent’s equity interest. While the thin-cap rules have a slightly broader application and are subject to extensive anti-avoidance rules, it is sufficient for the present purpose to understand that funding should be characterised as debt to the extent of this 1:1.5 debt to equity ratio.

Finally, despite the general proposition that the characterisation of the funding determines the taxation of the profits, some alternatives may arise from inter-corporate services, sales or licensing, which have nothing to do with the original form of investment. So, for example, if the parent were resident in the U.S. and were to licence software to its Canadian subsidiary, the resulting royalties would be wholly exempt under the treaty—a result unique to that particular treaty. A similar exemption applies under that treaty to royalties attributable to patents or to “any information concerning industrial, commercial or scientific experience”. Intercorporate services as a whole would broadly be exempt provided that they are not attributable to the parent’s own Canadian “permanent establishment” (being a subject for another article) while proceeds from the sale of goods would not attract Canadian income or non-resident tax in the first place.

Each of the foregoing scenarios has the very desirable benefit of allowing the Canadian subsidiary to deduct the cost (or at least depreciate the cost in the case of a sale). They are, in this respect, comparable to interest without being subject to the thin-cap rules. Unsurprisingly, however, they are subject to their own analogous limitation in the form of the transfer pricing rules. These rules allow the Canada Revenue Agency to adjust the subsidiary’s income and deductions (and, in general, the tax authority of the parent’s own jurisdiction would be able to do the same to the parent’s income and deductions) if, in the Canada Revenue Agency’s opinion, the amounts charged differ from the amounts that would have been charged between arm’s-length parties. The parent and subsidiary must therefore maintain “contemporaneous documentation” to identify and support the fair market value of all such amounts paid between them in accordance with transfer pricing principles. At the very least, that requires having proper contracts in place at the outset.

Future tax costs are not, therefore, tomorrow’s worry but today’s planning opportunity.