Doing Business In Canada

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Corporations

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2) Corporations

Residence

A corporation that is resident in Canada is taxed on its world wide income.  A U.K. corporation doing business in Canada would be subject to Canadian tax on its Canadian source income only subject to any Treaty relief.

A Canadian corporation is deemed resident in Canada (subject to a limited exception for Canadian corporations incorporated before April 27, 1965 that never carried on business in Canada).  A foreign corporation may be considered a resident under common law principles.

Common law has generally established that a company is resident in the country in which its central management and control is exercised.  For most U.K. companies, the mind and management issue should not be a factor in determining its residency status in Canada.  It may be an issue, however, for private U.K. companies  where the owner/manager moves to Canada.  As such, it is possible that a corporation may be resident in both countries.  Should such a situation occur, taxpayers must refer to the Treaty to make a determination of a company's residency status for tax purposes.

Article 3(1)(d) of the Treaty defines the term "company" to mean any body corporate or any other entity which is created as a body corporate for tax purposes.

Article 4(3) of the Treaty provides the corporate tie-breaker rules.  The provision states "..the competent authority of the Contracting States shall endeavor to determine by mutual agreement the State of which the person shall be deemed to be resident, having regard to its place of effective management, the place where it is incorporated or otherwise constituted and other relevant factors."  Obtaining a competent authority ruling can take a considerable amount of time and result in significant costs.

U.K. companies expanding into Canada will want to ensure that mind and management has not moved to Canada.

Business Income

Canada taxes the profits of taxpayers carrying on business.  The term business implies a certain level of activity as opposed to a passive investment.  The starting point in determining a corporation's taxable income is its "book" income computed in accordance with generally accepted accounting principles or generally accepted business practices. Book income is then modified by specific rules contained in the Act.

In general, expenditures are deductible in computing income if they have been incurred for the purpose of gaining or producing income and are reasonable in the circumstances.  There are, however, restrictions on the ability to deduct certain expenditures such as capital outlays, accounting reserves, and expenses associated with exempt income.  In addition specific expenditures, for example, those incurred for recreational facilities and club dues, are also denied.

A U.K. company which is doing business in Canada may be exempt from Canadian corporate tax, under the Treaty, on its business income if the company does not have a permanent establishment ("PE") in Canada.  A company could have a PE if it has a fixed place of business, including a place of management, a branch, an office, a factory or a workshop, a mine, quarry or other place of extraction of natural resources, or a building site or construction or assembly project which exists for more than 12 months.  Where the company has a PE in Canada, Canadian tax would only apply with respect to activities associated with that PE.  Where a U.K. company does not have a PE in Canada, the associated Canadian source income would be exempt from Canadian corporate taxation.  The company, however, would still be required to file a Canadian corporate tax return to disclose its reliance on the Treaty.

If a company is carrying on business in more than one province, through a permanent establishment in each province, the business must apportion its business income to each province.  The method of apportioning is based on revenues earned and wages paid in each province.

Property Income

Dividends, interest, rents and royalty income are taxable in Canada when received.  Compound interest securities are subject to accrual requirements, generally on an annual basis.

Canada employs an exemption approach to inter-corporate dividends.  Dividends received from a taxable Canadian corporation will not be subject to a second level of corporate taxation.  Dividends received from a foreign corporation will be excluded if the foreign entity is a foreign affiliate and the dividend is paid out of the foreign corporations "exempt surplus".  In general, exempt surplus refers to the foreign corporation's tax adjusted retained earnings from active business income carried on in a country with which Canada has an international tax treaty or an information exchange agreement.

Income from a trust, royalties and similar income is taxed as received or allocated, depending on the circumstances.

Capital Cost Allowance (CCA)

Though a general deduction on capital expenditures is denied, the Act allows businesses to deduct tax depreciation under a standard set of rules known as capital cost allowance.  Under this system most assets are grouped into particular classes and the entire class is depreciated at a set percentage on a declining balance method.  For example, office furniture is a Class 8 asset, depreciated at the rate of 20% per year on a declining balance method.  Buildings would be Class 1 assets depreciated at a 4% rate.

Some classes of assets, such as leasehold improvements or intangibles with a fixed life, are depreciated on a straight line basis over the life of the assets.

Taxpayers are not obligated to claim CCA.  It is a permissive deduction but a taxpayer may not claim more than the annual computed limit.  Catch up claims are not permitted.  If a property is disposed of in excess of its undepreciated capital cost (UCC) it may result in recapture.  If the proceeds are in excess of the property's original cost, the disposition may result in a capital gain.  A terminal loss may result if there are no assets left in the class at the end of the year but there remains a positive balance in the class.

In order to encourage companies to invest in capital assets, the government has allowed for accelerated deprecation on certain classes of assets.   For example, electronic data processing equipment (i.e. computer hardware) is included in Class 50 and is subject to a 55% CCA rate.  Machinery and equipment, used for the manufacturing and processing in Canada of goods for sale or lease,  is a class 43 asset eligible for a 30% CCA rate.

U.K. companies, that are in capital intensive industries, looking to expand into North America may consider selecting Canada to take advantage of the relatively high CCA rates.

Rates and filings

Corporations must file a corporate tax return known as Form T2, "Corporation Income Tax Return". The filing deadline is 6 months after the fiscal year end.  For all provinces, other than Alberta and Quebec, a joint federal/provincial/territorial return is filed.  The provinces of Alberta, Form AT1, "Alberta Corporate Income Tax Return" and Quebec, Form CO-17, "Corporation Income Tax Return",  require additional separate filings.

Canada does not permit the filing of consolidated tax returns.  Each corporation must file its own tax return.  This requirement for independent filings means that taxpayers must plan the co-ordination of tax liabilities and loss utilization within the corporate group.  A taxable loss in one corporation can not be directly used to reduce the taxable income of another corporation.  Planning opportunities exist, however, to mitigate this.

The general federal corporate tax rate, for 2012, is 15%.  General provincial and territorial rates vary from 10% to 16%.  Provincial and territorial tax will only apply if the corporation is doing business in that province through a permanent establishment.  If not, an additional 10% federal tax applies.

The current U.K. main rate of corporation tax is 24% and is scheduled to decrease to 23% for financial years starting April 1, 2013 . As such, though competitive, the Canadian corporate tax rates are slightly higher than U.K. rates.  U.K. companies doing business in Canada would want to ensure that income, where possible, is taxed in the U.K. and not in Canada.

Thin Capitalization

In a global context, though corporate tax rates have been falling, Canada is still considered a relatively high tax jurisdiction.  Multi-national groups, that invest in Canada, can do so by either lending funds, as debt, or acquiring shares of a Canadian entity.  All things being equal, these organizations would prefer to maximize debt in the Canadian entity.  The interest payments on this debt have the effect of reducing business income taxed at a relatively high rate and attracting only the lower (often treaty-reduced) non-resident withholding rate on interest paid abroad.  This would result in an overall loss of tax revenue to Canada.  To stop this potential abuse, Canada imposes limits on how much deductible interest can be paid to certain non-resident investors.

A non-resident is a "specified" non-resident if he owns alone, or together with other non-arm's length parties, at least 25% of the shares of any class of the capital stock of the corporation.  The interest expense is limited when the debt owing to specified non-residents exceeds a 2 to 1 debt-equity ratio.  The 2012 budget has proposed to: (1) reduce the debt-equity ratio to 1.5 to 1 and (2) recharacterize the disallowed interest expense as dividends, which will then be subject to the dividend non-resident withholding tax.  For U.K. shareholders, the general dividend non-resident withholding tax is 15%.  However, a 5% rate applies where the U.K. shareholder controls directly or indirectly at least 10% of the voting power in the Canadian company paying the dividends.

Transfer Pricing

To prevent taxpayers from artificially shifting income earned in Canada  to lower taxing jurisdictions, Canada requires that taxpayers, within a related group, employ a transfer pricing methodology.

Transfer prices represent the prices at which services, tangible property, and intangible property are traded across international borders between related parties. In general, Canada follows the Organization for Economic Co-operation and Development (OECD) Guidelines set out in its 1995 document, Transfer Pricing for Multinational Enterprises and Tax Administrations.  The transfer prices adopted directly affect the profits to be reported by each party in its respective country.

Canada's transfer pricing legislation embodies the arm's length principle and requires that, for tax purposes, the terms and conditions agreed to between related parties be those that one would have expected had the parties been dealing at arm's length.

Under the arm's length principle, related parties would be treated as if they are separate entities.  The principle requires a comparison of prices or margins between related parties on cross-border transactions with prices or margins on similar transactions between unrelated parties.  It is a factual determination as to whether a taxpayer has adhered to the arm's length principle.

Methodologies such as the comparable uncontrolled price (CUP) method; the resale price method; the cost plus method; the profit split method; and the transactional net margin method (TNMM) are examples of strategies devised to determine an arm's length transfer price.

Where the Canadian tax authorities have determined that the transfer price employed does not reflect the price that would have been charged between arm's length parties, the income for Canadian tax purposes can be adjusted accordingly.  Depending on the amount of the adjustment (percentage and dollars), penalties may be imposed.

A company's transfer pricing methodology is routinely examined by the CRA.  Any U.K. company operating a branch or subsidiary in Canada needs to ensure that is has in place an appropriate transfer pricing methodology and that the company has contemporaneous documentation to support its methodology.   Companies may apply to the CRA for an Advance Pricing Arrangement (APA) to reduce its risk of adjustment.

Scientific Research and Experimental Development Credits (SR&ED)

The SR&ED program is intended to encourage businesses of all sizes, particularly small to medium businesses and start-up firms, to conduct research and development (R&D) that will lead to new, improved, or technologically advanced products, processes, devices, and materials. The SR&ED tax incentive is the Canadian government's largest single support program for R&D.

SR&ED expenditures are deducted as business expenses, and may also qualify for investment tax credits  (ITC) that are received in the form of a reduction in income taxes payable, cash refunds, or both.  Cash refunds, however,  are only available to Canadian Controlled Private Corporations.  In general, UK companies doing SR&ED work in Canada, through a Canadian subsidiary, would only be eligible for a reduction in income taxes payable.  The current general ITC rate is 20% on qualified expenditures.  The 2012 Canadian budget, however, has proposed to reduce the general ITC rate to 15% and to provide for more targeted assistance.

Qualifying expenditures may include wages, materials, equipment leases, overhead that is directly related to R&D, and eligible work by contractors.  Experimental development, i.e., technological advancement, applied research, the advancement of knowledge for a practical purpose and basic research, the advancement of knowledge for its own sake, are activities that would qualify.

Eligible activities include: engineering, design, operations research, mathematical analysis, computer programming, data collection, testing and psychological research.  In order to claim such expenditures, an assessment on scientific or technological eligibility of the claimed activities needs to be performed.

The Canadian SR&ED program is comparable in concept to the U.K. R&D Relief Schemes.  For U.K. Small and Medium-sized Enterprises (SME), since April 1, 2011, an SME can deduct 200% of qualifying costs,  Effective April 1, 2012, an SME can deduct 225% of its qualifying costs.  Under the Large Company Scheme, a company may deduct 130% of qualifying costs.  At a general corporate tax rate of 24%,  the effective credit rate is 7.2% (30% increase in deductions x 24% corporate tax rate).  As the corporate rate drops to 23%, the effective rate drops to 6.9% (30% x 23%).    For SMEs, with profits eligible for the small profits rate, as of April 1, 2012 the effective credit is 25% (125% increase in deductions x 20% corporate tax rate).

For larger corporations, the proposed Canadian SR&ED rate of 15% is greater than the U.K. effective R&D rate of 6.9%.  For smaller companies, however, the proposed Canadian SR&ED rate of 15% will be lower than the U.K. effective rate of 20%.

Larger U.K. companies may consider moving R&D activities to Canada to take advantage of the higher credits.

Withholding considerations when undertaking activities in Canada

Under section 105 of the Canadian Income Tax Regulations, whenever a non-resident of Canada performs services in Canada (other than in the capacity as an employee) the payor is required to withhold and remit, to the CRA, 15% of the payment.  This regulation not only covers Canadian payors but also applies to non-residents paying other non-residents for services performed in Canada.  For example, assume a U.K. general contractor wins a contract in Canada and hires another U.K. company as a subcontractor.   The Canadian payor would be required to withhold and remit 15% of the payment made to the U.K. general contractor.  The U.K. general contractor would also be required to withhold and remit 15% of the payment made to the U.K. subcontractor.

The 15% withholding is not the final tax.  The withholding is a payment on account of the non-resident's potential tax liability in Canada. The non-resident would then file a Canadian income tax return to calculate the tax liability or to get a refund of withholding amounts if no PE exists.  If the non-resident taxpayer can demonstrate that they are exempt from Canadian tax, pursuant to the Treaty, they would receive a refund of the full 15%.  In those cases, the 15% withholding represents a cash flow issue only.

If the facts determine that the non-resident has a PE in Canada, the 15% will be applied against the ultimate tax liability.

If a non-resident can show that the 15% withholding is more than their potential tax liability in Canada, either due to treaty protection or related expenses, they may apply for a waiver to reduce or eliminate the withholdings.  The payor is not allowed to reduce the 15% withholding absent a waiver from the CRA.

Non-residents who want to ask for a waiver or reduction of withholding have to file a waiver application to the tax services office in the area where their services are to be provided.   Waiver applications have to be filed no later than 30 days before the period of service begins, or 30 days before the first payment for the related services.

Payroll Taxes

Canada imposes a number of payroll taxes and withholding requirements on employers who have employees providing services in Canada.  It is not necessary that the employer be located in Canada, nor the employee be a resident of Canada.  Withholding may be required even though a Canadian payroll does not even exist.  It is entirely possible that a U.K. based employee could be subject to Canada taxation on his Canadian source employment income and the U.K. employer be subject to Canadian withholding requirements.

In general, employment income is sourced to the physical location where the services are provided.  Therefore, if the employment is exercised in Canada the income would be considered Canadian source and Canada would have the first right to tax that income, absent any Treaty relief.   The allocation of the employment income should be done on a reasonable basis consistent with the facts.  There is no statutory allocation methodology.  In many cases, an allocation based on work days is reasonable and supportable.

An U.K. resident employee may obtain relief from Canadian taxation , on his Canadian source employment income (and vice versa), pursuant to Article 15(2) of the Treaty if " (a) the recipient is present...for a period or periods not exceeding 183 days in the calendar year concerned, and (b) the remuneration is paid by, or on behalf of, an employer who is not a resident of that other State (Canada), and (c) the remuneration is not borne by a permanent establishment or a fixed base which the employer has in the other State (Canada)."

In general, the provision provides that a non-resident individual has not been in Canada for more than 183 days in the year (not just work days but any days) and his associated payroll costs have not been deducted for Canadian tax purposes, then he would not be subject to Canadian taxation on his Canadian source employment earnings.

If the facts determine that an individual would not be subject to Canadian taxation the employer, however, will still be required to withhold and remit Canadian source deductions unless they obtain a waiver before the employee has been paid.

The Canadian Income Tax Regulations require that employers withhold and remit Canadian source withholdings. There is no exclusion for foreign employers.  Typical federal withholdings include income tax, Canada Pension Plan ("CPP") contributions and Employment Insurance ("EI") premiums.

Individuals employed in Canada are required to contribute to the Canada Pension Plan (CPP),  or the Quebec Pension Plan (QPP) if the individual is resident in Quebec. The maximum annual contribution, for 2012, is Cdn $2,306.70 based on a contribution rate of 4.95% on maximum contributory earnings of Cdn $ 46,600 (Maximum pensionable earnings of Cdn $50,100 less the basic exemption of Cdn $3,500).  In Quebec, the contribution rate is 5.025% for a maximum contribution of $2,341.65.  The employer is required to match the contribution.  The employee contribution is partially creditable against income taxes.  A U.K. employee on temporary assignment in Canada may qualify for exemption from CPP contributions under the Canada-United Kingdom Agreement on Social Security Taxes.

Individual employees must also pay a premium to the Canadian Employment Insurance Fund (EI).  The maximum annual premium, for 2012, is Cdn $839.97 based on a contribution rate of 1.83% on maximum insurable earnings of $45,900. In Quebec the EI rate is 1.47% up to a maximum contribution of $674.73.  Employees in Quebec also, however, have to contribute to the Quebec Parental Insurance Plan (QPIP)  at a rate of .559% of earnings up to $66,000.  The employer is required to pay a premium equal to 1.4 times the employee contribution.  The employee premiums are partially creditable against income taxes.  EI contributions are not eligible for exemption under a social security agreement.

Provinces, in general, levy two additional taxes on the employer.  These are premiums for provincially or territorially run health care systems (Manitoba, Newfoundland and Labrador, Ontario, Quebec, Northwest Territories and Nunavut) and worker's compensation programs (all provinces and territories).  The provinces of Alberta, British Columbia and Ontario, however, impose additional health premiums on individuals.  The tax is collected through payroll withholdings.

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