1. RESIDENTS
A resident of Canada (whether a corporation or an individual) is subject to Canadian tax on their worldwide income. Unlike some other jurisdictions, Canada does not provide a different tax treatment for a resident individual who is not domiciled in Canada.
Residence status for tax purposes is determined under common law and under the specific rules in the Income Tax Act (the “ITA”).
A corporation is resident in Canada if its central management and control is in Canada or if it was incorporated in Canada after April 26, 1965.
An individual is resident in Canada if the centre of his or her life (family, home, work, property) is in Canada. An individual who sojourns in Canada for 183 days or more in a particular calendar year is deemed to be a resident of Canada for that calendar year.
It is more and more common for individuals to have significant personal and business ties with, and to regularly spend significant amounts of time in, more than one country. This may be the case for individuals who spend significant amounts of time in Canada over several years in the course of their work and who also maintain a home, family and personal and business interests in another country. These individuals may be residents of Canada for Canadian income tax purposes and also residents of another country under the income tax law of that other country. Where Canada has a tax treaty with the other country, the treaty will typically contain “tie-breaker” rules to determine which of the two countries the individual is a resident of for tax purposes.
2. NON-RESIDENTS
An individual or a corporation that is not a resident of Canada is only subject to income tax in Canada under the ITA on Canadian source income. This includes income from a business carried on in Canada, income from employment performed in Canada and capital gains from taxable Canadian property (e.g., real property situated in Canada or assets used in a business carried on in Canada).
Canada’s tax treaties generally provide relief from Canadian taxation of a non-resident’s Canadian business income if the non-resident does not have a permanent establishment in Canada to which the income is attributable. Canada’s tax treaties also generally provide relief from Canadian taxation of short-term employment (i.e., less than six months) or de minimis employment income.
If a non-resident disposes of taxable Canadian property, section 116 of the ITA requires the purchaser to withhold and remit a certain percent of the purchase price to the Canada Revenue Agency (the “CRA”), unless the vendor provides a clearance certificate from the CRA. This is a mechanism to ensure that the non-resident vendor notifies the CRA and provides the CRA with payment of or security for the estimated Canadian tax in advance of the sale.
A non-resident is also subject to a withholding tax on certain passive income paid to it by a resident of Canada (discussed in more detail below).
A non-resident providing services in Canada is subject to a different type of withholding under the Income Tax Regulations. This withholding is remitted to the CRA on account of the non-resident’s income tax liability from carrying on business in Canada. The non-resident can generally recover this money from the CRA if they are resident in a country with which Canada has a tax treaty and if the income is not attributable to a Canadian permanent establishment.
3. COMPUTATION OF TAXABLE INCOME
Income subject to tax includes income from business, property, employment and taxable capital gains (net of allowable capital losses).
Employment income includes wages, bonuses and taxable employment benefits. Remuneration paid to directors is income from employment. Allowable expense deductions against employment income are very limited. Employers, including non-resident employers with employees working in Canada, are required, subject to treaty relief, to withhold source deductions from employment income paid to employees. These source deductions are for the employee’s income tax, employment insurance premiums and Canada Pension Plan contributions. The employer is required to remit the source deductions to the tax authorities on the employee’s behalf. If these source deductions are not withheld and remitted, the directors of the corporation can be personally liable.
Income from a business or property for tax purposes is generally determined by reference to profit calculated under accepted accounting and commercial principles. Expenses must be incurred for the purpose of earning income to be deductible. Profit calculated in this way is subject to various adjustments under the ITA. Interest is generally deductible in computing income from business or property if the interest is payable on borrowed money used for the purpose of earning income or on unpaid purchase price for property acquired for the purpose of earning income.
Only a portion of a capital gain is included in income. Capital losses are generally deductible only against capital gains and are not deductible against income from other sources.
Unlike in the U.S., corporations cannot calculate their income for tax purposes and file a tax return on a consolidated basis. Each corporation in a corporate group must file a separate tax return and calculate its income on a stand-alone basis.
4. TAX TREATIES
Canada has almost 100 international tax treaties, most of which are based on the Organization of Economic Co-operation and Development (“OECD”) Model Tax Convention. These tax treaties generally reduce the rate of withholding tax and provide exemptions from taxation on certain income and capital gains. Most of these tax treaties provide that business profits of the non-resident are not subject to tax under the ITA, except where those profits are attributable to a permanent establishment of the non-resident in Canada.
Most of Canada’s tax treaties do not contain anti-treaty shopping provisions. A notable exception is the Canada–U.S. Income Tax Convention which has Limitation on Benefits rules restricting treaty benefits to “qualifying persons”.
On December 1, 2019, the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (the “Multilateral Instrument” or “MLI”) came into force in Canada. The MLI applies to Canada’s tax treaties that are covered by the MLI, and is designed to reduce the opportunities for tax avoidance and to prevent treaty abuse. The MLI will not affect the Canada–U.S. Income Tax Convention.
The CRA has not been successful in challenging alleged treaty shopping arrangements in Tax Court of Canada. The federal government is now considering legislated anti-treaty shopping rules. The Tax Court of Canada has not yet considered the application of the MLI to alleged treaty shopping arrangements.
5. TRANSFER PRICING
The ITA contains transfer pricing rules based on the OECD Transfer Pricing Guidelines. Generally, these rules require transactions between a Canadian resident and a non-arm’s length non-resident to take place on arm’s length terms and for arm’s length consideration. If transactions are not done on this basis, the CRA will determine the Canadian tax consequences as if the transaction were undertaken on an arm’s length basis. CRA transfer pricing adjustments can give rise to significant additional tax and arrears interest. Transfer pricing adjustments can also give rise to significant penalties if the taxpayer does not have contemporaneous documentation to explain and justify the transfer price used.
Canada’s transfer pricing rules apply to cross-border inter-company transactions such as the purchase and sale of goods, licences of intellectual property, management and administration services, interest charges and guarantee fees.
6. CANADIAN SUBSIDIARY
a. Income Subject to Tax
A Canadian subsidiary will be a corporation resident in Canada and therefore subject to tax on its worldwide income.
b. Thin Capitalization Rules
Thin capitalization (“thin cap”) rules protect the domestic tax base against reduction due to related party interest deductions. Thin cap rules effectively require a domestic subsidiary of a foreign parent to have a minimum equity investment. Historically, Canada was largely a capital importing country. Therefore, thin cap rules and withholding tax on interest payments to non-residents have been important tools in protecting the Canadian tax base.
c. Distributions
Dividends from a Canadian subsidiary are subject to withholding tax as described above.
Any amount paid on a redemption or purchase for cancellation of a share or on a distribution of share capital which is in excess of the paid-up capital of the share is deemed to be a dividend and subject to withholding tax as such.
7. CANADIAN BRANCH OF A NON-RESIDENT CORPORATION
a. Income Subject to Tax
Income of a foreign entity from a business carried on in Canada is subject to Canadian tax at the general corporate Canadian tax rate, unless treaty protected (see below). The main advantage of using a branch is that if the foreign investor is expecting to incur losses, the losses may be deducted by the foreign investor in computing its income from other sources (assuming the foreign investor’s domestic tax legislation allows this). To the extent that a foreign investor pays Canadian income tax on the profits generated in Canada, the foreign investor may be able to claim a foreign tax credit in its home jurisdiction.
b. Tax Treaty Protection If No Permanent Establishment
Generally, if a foreign investor’s country has a tax treaty with Canada, the foreign investor will not be subject to tax in Canada if the foreign investor does not have a permanent establishment in Canada (e.g., a fixed place of business in Canada such as an office, factory, warehouse, or an agent with authority to conclude contracts in the name of the foreign entity). If treaty protection is available and the non-resident has a permanent establishment in Canada, only income attributable to the permanent establishment will be taxed in Canada.
c. Branch Tax
In addition to tax at the general corporate rate, a branch is also subject to an annual “branch tax” on after-tax income. The income subject to branch tax is reduced by an investment allowance to reflect the retention of business assets and retained earnings in Canada. The branch tax is payable whether or not any after-tax income is distributed or repatriated to the foreign jurisdiction. With a subsidiary corporation, withholding tax only applies when dividends are declared and paid to the foreign parent.
d. Thin Capitalization Rules
The thin capitalization rules that apply to subsidiaries also apply to branches of foreign parent corporations.
e. Distributions
As branches are not considered to be separate entities, a transfer of funds out of the branch is not a dividend and is not subject to withholding tax. However, the branch tax (discussed above) is a proxy for the withholding tax that applies to dividends from a Canadian subsidiary.
f. Canadian Tax on Sale
A sale of real property or any other property from the business being carried on in Canada as a branch is a sale of taxable Canadian property subject to Canadian income tax.