A frequent question that often arises in discussions with companies who want to expand into Canada is how our country goes about taxing foreign corporations.
The process typically begins with determining whether the particular corporation is considered to be resident in Canada for tax purposes. A corporation may be considered resident in Canada without being a Canadian corporation. A corporation that is resident in Canada for tax purposes is subject to tax in Canada on its worldwide income.
Since residency is not specifically defined in the Income Tax Act (ITA), tax residency is determined using common-law principles and certain deeming rules within the ITA. A corporation may be deemed resident in Canada in certain cases, such as where the corporation was incorporated in Canada. Further, a foreign corporation will be considered resident in Canada if its central management and control is exercised in Canada or if it is legally continued into Canada.
It is possible that a particular corporation will be considered resident in both Canada and another country. Fortunately, Canada has an extensive tax treaty network that will override the ITA where applicable. Where a tax treaty exists between Canada and a particular country, the corporation must first be seen as resident in the other country for purposes of that treaty in order to gain access to its benefits. Generally, a corporation will be seen as resident for purposes of a treaty where the corporation is liable to tax in the particular country.
Contained within the residence article of Canada’s tax treaties is a set of rules (generally referred to as the “Tie Breaker Rules”) that are applied to settle instances of dual residency. The overall objective of the tax treaty is to eliminate the possibility of a corporation being exposed to full income taxation in both countries on the same income. The “Tie Breaker Rules” are intended to ensure that a particular corporation is only considered resident in one country.
The “Tie Breaker Rules” vary to some degree from treaty to treaty. Under the first tiebreaker rule in many of Canada’s treaties, if the particular corporation was created under the laws in force in one country but not under the laws in force of the other country, it will be only be considered resident in the country in which the corporation was created. Otherwise, residency will be determined by the competent authorities (i.e. the country’s taxation authority) of the two countries. Where a corporation is seen as a resident of another country under a tax treaty, it will be deemed to be a non-resident of Canada under the ITA.
It should be noted that not all treaties have the first “Tie Breaker Rule” noted above in which case only the second rule will be applicable. Given the uncertainty involved in having the tax authorities determine the residency status of a corporation under the second rule, it would be ideal to understand what constitutes residency in each country and, where possible through proper planning, avoid the scenario of being seen as a resident of both countries.[1]
Care should be taken especially when using hybrid entities (i.e. an entity that is viewed as one type of entity in one country and another type in the other country) in cross border scenarios such as US LLC’s which are treated as flow through entities in the US but corporations in Canada. The Canada Revenue Agency takes the position that hybrid LLC’s are not eligible for treaty benefits since an LLC is not liable to tax in the US. As a result, if central mind and management of an LLC is exercised in Canada (such as where the LLC is owned by a Canadian resident person or entity and managed from Canada), it may be seen as a resident of Canada for tax purposes and subject to worldwide taxation in Canada.
If it is determined that corporation is not a resident of Canada for tax purposes, it will only be subject to tax in Canada to the extent that it carries on business in Canada or disposes of taxable Canadian property. Carrying on business in Canada is not specifically defined in the ITA. Whether a non-resident corporation carries on business in Canada is a question of fact and is determined based on common-law principles.
A corporation may also be deemed to be carrying on business in Canada under the ITA if it solicits orders or offers anything for sale in Canada though an employee or agent (regardless of where the contract or transaction is completed) or if it produces, grows, mines, creates, manufactures, fabricates, improves, packs, preserves or constructs, in whole or in part, anything in Canada.
However, under most of Canada’s tax treaties, assuming treaty benefits are available, a non-resident corporation will be exempt from income tax on its business profits earned in Canada, provided that it does not carry on business in Canada through a permanent establishment. The term “permanent establishment” is defined in the applicable treaty and may vary somewhat from treaty to treaty. In the absence of tax treaty benefits, a non-resident that is seen to be carrying on business in Canada will be subject to Canadian tax on its business profits earned in Canada.
Further, a branch profits tax of 25% may also apply (subject to reduction under the relevant tax treaty). In simple terms, the branch tax is calculated based on after tax profits that are not reinvested in Canada. The branch tax is intended to replicate the withholding tax that would otherwise be applicable on dividends if the foreign corporation were to instead operate its business through a separate corporation in Canada. To the extent that Canadian tax is payable in Canada, it may be possible to claim a foreign tax credit in the home country to reduce the home country tax on that same income, subject to its domestic taxation rules.
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[1] It should be noted however that some countries, may not allow the treaty to override their domestic residency rules; at the same, in such cases if the company is resident of another country under the treaty rules, they typically could still claim the exemptions from (foreign) taxation that are provided by that treaty.
