Todd Trowbridge, Partner - Corporate Tax, Trowbridge Tax
A frequent question that often arises in our discussions with US companies who want to expand into Canada is how our country goes about taxing foreign corporations.
Residency Status
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 controlis exercised in Canada or if it is legally continued into Canada.
Impact of Tax Treaty on Residency Status
It is possible that a particular corporation will be considered resident in both Canada and the US. Fortunately, Canada has a tax treaty with the US that will override the ITA where applicable. The corporation must first be viewed asresident in the US for purposes of the treaty in order to gain access to its benefits. Generally, a corporation will be seen as resident for purposes of the treaty where the corporation is liable to tax in the US. Further, the corporation must also satisfy the rules contained in the Limitation on Benefits provision contained in Article XXIX A within the treaty in order to be eligible for treaty benefits.
Contained within the residence article of the Canada-US tax treaty 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.
Under the first tiebreaker rule in the Canada-US tax treaty, 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.
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 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) incross 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 generally 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.
Taxation of Non-Resident Corporations in Canada
If it is determined that the 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 in which case it must file a tax return in Canada. 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 US 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 through 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.
Where benefits under the Canada-US tax treaty are available, a US corporation will generally be exempt from Canadian income tax on its business profits earned in Canada, unless it carries on business through a factual or deemed permanent establishment in Canada. The term “permanent establishment” is defined in Article V of the treaty as a fixed place of business through which the business is carried on but also contains specific inclusions, exclusions and deeming provisions that will impact whether a company has a permanent establishment.
In the absence of tax treaty benefits, a corporation that is seen to be carrying on business in Canada will be subject to Canadian tax on its business profits earned in Canada. However, there is a ‘look through’ rule within the residency article of the treaty which grants treaty benefits to an LLC or hybrid entity that carries on business in Canada by looking through the LLC toit’s members. If those members would otherwise qualify for treaty benefits, relief under the treaty may still be available in limited circumstances.
Branch Profits Tax
A branch profits tax of 25% may also apply (subject to possible reduction and exemption under the tax treaty). In simple terms, the branch tax is calculated based onafter 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 US corporation were to instead operate its business through a separate corporation in Canada.
Regulation 105 Withholding on Services Rendered in Canada
A US company rendering services in Canada is subject to a 15% tax withholding on their invoices under Regulation 105 of The Income Tax Act (and an additional 9% under Quebec tax law if services are rendered in Quebec). The Canadian customer isrequired withhold and remit the tax to the Canada Revenue Agency (CRA) as well as file Form T4A-NR to report this tax withholding. The withholding is not a final tax but rather a tax instalment against a potential tax liability in Canada.
Where a US company will not have a PE in Canada in respect of their services, it may be possible to obtain a Regulation 105 waiver (in respect of the 15% tax withholding) in advance of providing their services in Canada in order to eliminate the cash flow impact of this tax withholding. Otherwise, the tax withheld will either be applied against the final Canadian tax balance owing for the year or refunded upon filing a tax return in Canada with a claim for treaty exemption.
US Tax Implications of Paying Tax in Canada
Both the Canada-US Income Tax Convention (i.e., the “Treaty”) and the US foreign tax credit system should help California corporations - or other US based corporations - mitigate the impact of any potential tax paid in Canada as a result of a requirement to report taxable income in Canada. As mentioned previously, the Treaty limits Canada’s ability to subject a US corporation to taxation where the level of activity does not rise above certain thresholds as provided under the “Permanent Establishment” rules. It also provides for reduced tax rates on certain income streams that are subject to withholding tax.
However, even if a US corporation does exceed the thresholds and is subject to Canadian tax, the US federal foreign tax credit system provides that such Canadian tax is generally available as a credit against US tax – subject to the foreign sourced (Canadian) income amount, the category of income and the amount of US tax deemed to be assessed on the income. Effectively, the system provides for a US corporation to effectively pay the “higher” of the two rates (Canadian orUS) on the Canadian sourced income after application of the foreign tax credit. With the recently passed Trump tax reform legislation and the US tax rates sitting at historical lows, in most cases this may result in the Canadian income being subject to the now slightly higher Canadian corporate tax rates. Any excess foreign tax credit is carried forward to be used in future years. Note that California generally does not allow a similar foreign tax credit on its California corporate returns.
As always, proper planning will ensure that a US corporation does not pay unnecessary tax in either country and that interest and penalties are avoided. On that note, working with a tax adviser that is well versed incross border tax issues is highly recommended.
[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.