In the current economic context, Canada has, so far, come through the recession relatively unscathed. This may tempt U.S.-based enterprises to consider future expansion in Canada. Before implementing any such expansion plans, they should consider some key Canadian tax implications, to avoid potentially costly missteps.
To Incorporate or Not to Incorporate?
One of the first legal considerations faced by U.S. businesses expanding into Canada is whether to do so through an unincorporated branch or a separate legal entity. While the prospects of allowing the flow-through of initial operating losses to the U.S. business might militate in favor of initially setting up a branch operation, a similar outcome may be achieved through the use of a separate legal entity disregarded for U.S. federal income tax purposes, as noted below. Most set-up and maintenance costs, including sales and payroll tax registrations, annual filings with corporate registries, filing of Canadian income tax returns, and preparation of separate financial statements for the Canadian operations, will be incurred irrespective of whether the Canadian business activities are separately incorporated or operated as a branch.
In practice, to the extent such activities are expected to give rise to a taxable presence in Canada, the vast majority of U.S. businesses choose to carry on business in Canada through a Canadian corporation citing, among others, the following reasons:
- Having a separate legal entity to house the Canadian operations allows the Canadian entity and its U.S. parent to more clearly delineate their respective business functions, as well as the risks each assumes. Having a separate subsidiary affords a U.S. parent the opportunity to have agreements between the U.S. parent and the Canadian subsidiary to provide support for any intended allocation of profits between the Canadian and the U.S. operations (subject to applicable transfer pricing rules);
- Having a Canadian subsidiary isolates Canadian tax filing obligations and can generally reduce the extent of the Canadian tax authorities' future enquiries into the U.S. parent's business operations;
- To the extent that the Canadian corporate entity is not an unlimited liability company, it affords limited liability to the U.S. parent for risks arising from Canadian business activities; and
- Where all or any part of the revenues generated by the Canadian operations arise from services rendered physically in Canada, having a separate Canadian subsidiary will prevent the potential application of withholding at source under Canadian federal and provincial income tax regulations.
Withholding Tax on Services Fees
Canadian federal tax regulations provide that a 15 percent withholding must be applied on amounts paid to a non-resident for services rendered physically in Canada (and a further 9 percent withholding must be applied for services in the province of Quebec) and must be remitted to the Canadian tax authorities. This withholding at source is intended to serve as security on account of the payee's potential Canadian income tax liability and does not represent a final tax. Any excess of the amount withheld over the ultimate Canadian income tax liability of the payee can be refunded after the end of the taxation year of the payee after filing of Canadian income tax returns.
While advance waivers (complete or partial) may be sought and obtained from the Canadian tax authorities prior to payments for services being made to the non-Canadian, a complete waiver of such withholding is generally not available if, among other circumstances, the non-Canadian carries on business in Canada through a permanent establishment, its physical presence in Canada exceeds a specified number of days or the payment is made pursuant to a multi-year contractual arrangement.
U.S. enterprises carrying on business in Canada through an unincorporated branch and providing services in Canada from that branch must consequently resort to seeking partial advance waivers so as to ensure that the withholding effected, which by default would be applied on gross service payments made, will approximate the ultimate tax liability of the recipient. Such partial waivers, also referred to as "income and expense waivers," will allow an offset against the Canadian service income of certain expenses, other than depreciation and amortization, incurred by the U.S. business in relation to such service income. Graduated rates (similar to those used for residents) will be applied on the resulting "net" Canadian service income.
This withholding regime is, typically, an incentive for U.S. businesses deriving significant revenues from services to incorporate a Canadian subsidiary to carry on business in Canada. While advance waivers may be considered in situations where the proposed Canadian operations involve a limited number of clients and all conditions for eligibility are met, the convenience of this solution is questionable if significant numbers of customers are expected or if significant expenses not eligible for purposes of an "income and expense waiver" are likely to be incurred.
Getting your Money Out Withholding Tax Free
Virtually any U.S. business that establishes a Canadian subsidiary or acquires an existing Canadian corporation will want to maximize so-called "paid-up capital." The appeal of paid-up capital is that it can be repatriated withholding tax-free to non-Canadian shareholders. "Paid-up capital" for tax purposes uses, as a starting point, stated capital for Canadian corporate law purposes, subject to certain tax-related adjustments (including to take into account any transfers that may have been effected on a partial or complete rollover basis). Paid-up capital for tax purposes may differ significantly from stated capital for accounting purposes. It is normally expressed in Canadian dollars.
Since paid-up capital is in large part derived from legal stated capital, many U.S. acquirers effect the acquisition of a Canadian corporation through a Canadian acquisition vehicle.
This flows from the fact that legal stated capital is generally created in connection with issuances of shares from treasury and reflects the consideration paid for the issuance of such shares. Therefore, irrespective of an acquirer's tax basis in the shares of a Canadian corporation, the paid-up capital of the acquired shares would, in the absence of the interposition of a Canadian acquisition vehicle, reflect the historical amount initially contributed by previous shareholders to the Canadian corporation for the issuance of its shares. That amount would be the effective limit to what can be withdrawn tax-free by the acquirer.
If, however, a U.S. acquirer sets up a Canadian acquisition vehicle to carry out the acquisition of a Canadian target and subscribes for shares of the acquisition vehicle for a consideration equal to the equity component of the purchase price to be paid, the paid-up capital of the shares of the Canadian vehicle will be equal to that amount, which can in turn be repatriated tax-free. An added benefit of the use of a Canadian acquisition vehicle is the possibility of having all third-party financing required to carry on the acquisition incurred by the Canadian vehicle and, through post-closing amalgamation or winding-up, of having future interest expense on the acquisition debt as a deduction in computing Canadian income.
A mistake to be avoided when contributing additional sums to Canadian subsidiaries is to effect such contributions by way of a capital contribution, without the issuance of additional shares of the Canadian subsidiary. In these circumstances, depending on the Canadian federal or provincial corporate statute relied upon, no legal stated capital, and consequently no paid-up capital, may be created despite any resulting increase in tax basis. While it may be possible in certain circumstances to convert contributed surplus into paid-up capital, this is far from a sure thing, especially where the particular contribution did not result in contributed surplus for accounting purposes.
Capitalizing a Canadian Subsidiary: Debt or Equity?
The choice of capitalizing a Canadian subsidiary with debt and/or equity will have an impact on the return an investor will pocket. Interest payments may reduce the Canadian taxable income and can be free of withholding taxes when paid by a Canadian subsidiary to its U.S. parent to the extent the latter is eligible for the benefits of the Canada-U.S. Treaty (Treaty). On the other hand, dividends are generally subject to a 5 percent withholding tax and are not deductible from the taxable income of a Canadian subsidiary.
U.S. businesses cannot capitalize their Canadian subsidiaries entirely with debt to erode the Canadian tax base. Canada has rules, known as the "thin capitalization rules," that apply to limit the deductibility of interest on debt owed by a Canadian subsidiary to its foreign parent (or any other "specified non-resident shareholder"). Also, transfer pricing rules (similar to those applying in the United States) and other domestic interest deductibility rules, which are both beyond the scope of this article, may limit the interest deduction that can be claimed by the Canadian subsidiary on debt owed to its U.S. parent.
The Canadian thin capitalization rules deny an interest deduction on debt to a specified non-resident shareholder where the debt:equity ratio of the Canadian subsidiary exceeds a certain threshold. A "specified non-resident shareholder" is in essence any non-resident who owns, together with persons with whom it is not dealing at arm's length, 25 percent or more of the votes or value of the shares of the capital stock of the Canadian subsidiary. The current maximum debt:equity ratio is 2:1, but such ratio was recently lowered by the 2012 Canadian federal budget to 1.5:1 for taxation years that begin on January 1, 2013, and thereafter. The debt portion of the ratio is represented by the yearly average of the highest amount of debt outstanding to "specified non-resident shareholders" in each month. The equity portion of the ratio is where taxpayers may miss the mark if caution is not exercised. It is the sum of (1) the retained earnings of the Canadian subsidiary (on a non-consolidated basis) at the beginning of the year; (2) the average contributed surplus contributed by a "specified non-resident shareholder" at the beginning of a calendar month that ends in the year; and (3) the average paid-up capital on shares held by a "specified non-resident shareholder" at the beginning of a calendar month that ends in the year. Given that the equity portion is calculated at specific times, a U.S. business must carefully monitor the timing of capitalizing its Canadian subsidiary to avoid exceeding the debt:equity ratio.
As mentioned above, for taxation years beginning on January 1, 2013, and thereafter, the debt:equity ratio for thin cap rules is reduced to 1.5:1, that is 60 percent debt, 40 percent equity. U.S businesses with intercompany debt into their Canadian subsidiaries must consider whether to capitalize or otherwise reduce the portion of such subsidiaries' "specified non-resident shareholder" debt that is in excess of that ratio.
If the debt:equity ratio is exceeded, in addition to losing the interest deduction on the excess debt, the denied interest will be treated as a deemed dividend subject to a Canadian withholding tax of 5 percent under the Treaty, thereby negatively affecting the after-tax return on their Canadian investment.
Use of Hybrid Entities - Advantageous or Disadvantageous?
Various types of legal entities can be used for investment into Canada by a U.S. person. It is important to identify the proper entity to achieve the desired tax result and to avoid unwanted tax consequences. Canadian unlimited liability corporations (ULCs) and U.S. limited liability companies (LLCs) can be useful because they can be treated as disregarded entities or partnerships for U.S. federal income tax purposes while being taxed as corporations for Canadian income tax purposes. These types of entities, commonly known as hybrid entities, have led to some tax arbitrage and the consequential amendments to the Treaty in 2010 that can trigger burdensome withholding on cross-border payments.
The Treaty now denies a lower withholding rate on certain amounts derived through or received from hybrid entities. Although the stated purposes of these rules was to target certain deductible payments, they could apply in many unforeseen circumstances. For example, dividends paid by a ULC can trigger a 25 percent Canadian withholding tax and business profits generated by a Canadian branch of an LLC can trigger a 25 percent branch tax in Canada. These withholdings can annihilate the tax benefits of having a flow-through structure from a U.S. federal income tax perspective.
The Canadian tax authorities have thus far shown some administrative lenience in interpreting and applying these provisions and Treaty benefits may still be available for hybrid entities. In fact, although caution must be exercised, with proper planning one can mitigate the adverse tax consequences involved with hybrid entities and continue to enjoy some of the benefits they present for U.S. investors into Canada.
Purchasing Assets vs. Shares
Probably one of the first important decisions involved with acquiring a Canadian target is whether the acquisition should be structured as an asset or share deal. Contrary to the United States, Canada has no rule (such as IRC Section 338) that permits a purchaser to treat a stock acquisition as an acquisition of the assets of the target. There is a possible step-up in the tax basis of certain non-depreciable assets up to the fair market value of such assets, but this often has limited value to the purchaser. Thus, except for certain transactions where a Canadian target corporation may have significant net operating losses or other tax attributes to carry-over, the preference for most purchasers of a Canadian business is to buy assets instead of stock, to get a higher tax basis in depreciable assets.
Based on U.S. tax instincts, one might think that a Canadian seller, on the other hand, would invariably prefer to sell stock instead of assets to realize a capital gain treatment (instead of recapture of depreciation) of which only 50 percent is taxable in Canada (versus 100 percent for recapture). However, given the integration system in Canada, this may not necessarily be the case. The aim of the integration system is to ensure that income earned in a Canadian corporation and paid to a Canadian taxable shareholder as a dividend should be subject to similar combined corporate and shareholder taxes than if the income had been earned directly by the shareholder and taxed in its hands only. As a result of integration, where a Canadian corporation sells its assets with most of the gain attributable to goodwill, and then distributes the after-tax proceeds to its Canadian taxable shareholders, the after-tax cash proceeds for the shareholder should not be substantially different from the after-tax cash proceeds such shareholders would have received in a stock transaction, barring a significant discrepancy between inside and outside tax basis, the availability of the lifetime capital gains exemption (for individual shareholders only) or other factors. On the other hand, the purchaser will have the benefit of a step-up in the depreciable assets (including goodwill), in addition to avoiding certain potential legacy liabilities.
Foreign Affiliate Dumping Rules
On October 15, 2012, the Minister of Finance released the final version of the so-called "foreign affiliate dumping" rules initially introduced by the 2012 Canadian Federal budget to curtail certain transactions considered by the Canadian tax authorities to improperly erode the Canadian tax base in favor of foreign jurisdictions. There have already been numerous articles criticizing these rules and their likely application to situations beyond the scope of their intended purpose. The following is a brief overview of these rules and how they may apply to a U.S. business investing in Canada.
In general, the rules apply to an investment in a non-resident corporation made by a corporation resident in Canada where: (1) the non-resident corporation is or becomes, as part of the same series of transactions as the investment, a "foreign affiliate" (very generally, a 10 percent direct or indirect shareholding is required) of the Canadian corporation; and (2) the Canadian corporation is or becomes controlled by a non-resident corporation (the "parent") at the time of investment. The consequence of the application of these rules is that the amount of the investment gives rise to either a 25 percent Canadian withholding taxes on a deemed dividend (subject to potential reduction under the Treaty) or a reduction of paid-up capital on the shares of the Canadian corporation held by the parent, which may result in future Canadian withholding tax issues.
The broad application of the rules results partly from the extensive definition of what constitutes an investment in a foreign affiliate. Without limitation, an acquisition of shares of, a contribution of capital to, an acquisition of a debt obligation of, and even an extension of the term of an existing debt or of the redemption date of a share issued by the foreign affiliate can be considered an investment in it. The acquisition of shares of another Canadian corporation can also be considered an investment in a foreign affiliate if the other Canadian corporation derives more than 75 percent of its value from foreign affiliates. Thus, in a situation where a U.S. business incorporates a Canadian subsidiary to acquire shares of another Canadian corporation with substantial foreign subsidiaries, a deemed dividend or a reduction of paid-up capital and corresponding present or future withholding tax may arise although no direct investment was made in a foreign entity in the process.
If there is cross-border paid-up capital in the shares of the Canadian corporation, in general, the tax consequences could be temporary and manageable. Also, certain limited exceptions to the rules may apply, such as for investments more closely related to the business activities of the Canadian corporation, for internal reorganizations, and for certain loans that trigger an interest income in Canada. Nevertheless, these proposed rules have a far-reaching application and it remains to be seen how they will be interpreted and applied by the tax authorities. In the meantime, U.S.-controlled Canadian corporations should review the rules carefully every time they intend to make a direct or indirect investment in a foreign entity.
Conclusion
Despite the similarities otherwise existing between Canada and the United States, the Canadian tax system differs, at times significantly, from its U.S. counterpart. The above constitutes only a summary of certain of those differences. In this context, relying on U.S. tax instincts when planning a Canadian expansion may result in unintended adverse Canadian tax consequences that could have been easily avoided. Before entering the Canadian market, prudence would dictate obtaining Canadian tax advice.