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I love math. I appreciate the coexistence of precision and ambiguity within math. I enjoy the patterns and randomness that present simultaneously within math. I smirk looking back at the quirky symbols and the superscripts and subscripts I once used studying algebra, trigonometry, and calculus. What I truly love about math is the adrenaline rush of reaching a solution.
Solving for tax minimization means locating arbitrage opportunities within our patchwork quilt of Canadian tax legislation. With the federal government and all thirteen provincial and territorial governments autonomously setting income tax rates, brackets, and tax credit amounts and rates for individuals and corporations, differences in effective tax rates for the same type of income is inevitable. I wrote a paper in 2006 for the Canadian Tax Foundation that I titled “Land of a Thousand Rates” – today I would have to at least double that number as provinces and territories continue to flex their taxing muscles. For this article, I want to point your attention north and west – way north and way west.
Yukon Only Wants 2.5%!
Perhaps the largest arbitrage opportunity within the current Canadian tax landscape is the credit made available by section 10.1 of the Yukon Income Tax Act.[1] The pertinent portion states:
10.1 Manufacturing and processing deduction
(1) There may be deducted in computing a corporation’s tax payable under this Part for a taxation year the total of: …
(b) 9.5 per cent of …
(i) the amount, if any, by which the corporation’s Canadian manufacturing and processing profits earned in the year in Yukon exceed [the small business deduction claimed].
That is a tidy saving. The general corporate income tax rate in Yukon is 12%, making the effective territorial corporate income tax rate on Canadian manufacturing and processing profits earned in the year in Yukon a svelte 2.5%. The list of effective provincial and territorial income tax rates beyond the small business limit on “Canadian manufacturing and processing profits,” as that term is defined in subsection 125.1(3) of the Income Tax Act (Canada) (the “ITA”), for 2024 is:
- Newfoundland and Labrador – 15%
- Prince Edward Island – 16%
- Nova Scotia – 14%
- New Brunswick – 14%
- Québec – 11.5%
- Ontario – 10%
- Manitoba – 12%
- Saskatchewan – 10%
- Alberta – 8%
- British Columbia – 12%
- Nunavut – 12%
- Northwest Territories – 11.5%
- Yukon – 2.5%!!
These rates are in addition to the federal general corporate tax rate of 15% that applies beyond the small business limit to Canadian manufacturing and processing profits and all other types of active business income.
What is “Canadian Manufacturing and Processing”?
The terms manufacturing and processing encompass a broad range of activities related to the creation, transformation or alteration of goods for sale or lease. The first threshold test is whether the corporation is engaged in “qualified activities,” a surprisingly broad definition found in Regulation 5202 to the ITA that includes any of the following activities performed in Canada:
- (i) engineering design of products and production facilities,
- (ii) receiving and storing of raw materials,
- (iii) producing, assembling and handling of goods in process,
- (iv) inspecting and packaging of finished goods,
- (v) line supervision,
- (vi) production support activities including security, cleaning, heating and factory maintenance,
- (vii) quality and production control,
- (viii) repair of production facilities,
- (ix) pollution control,
- (x) all other activities that are performed directly in connection with manufacturing or processing, and
- (xi) scientific research and experimental development.
Specifically excluded activities are:
- (i) storing, shipping, selling and leasing of finished goods,
- (ii) purchasing of raw materials,
- (iii) administration, including clerical and personnel activities,
- (iv) purchase and resale operations,
- (v) data processing, and
- (vi) providing facilities for employees, including cafeterias, clinics and recreational facilities.
The second threshold test is the nature of the manufacturing and processing. Industries specifically excluded from the definition of “manufacturing and processing” are:
- (a) farming or fishing,
- (b) logging,
- (c) construction,
- (d) operating an oil or gas well or extracting petroleum or natural gas from a natural accumulation of petroleum or natural gas,
- (e) extracting minerals from a mineral resource,
- (f) processing
-
- (i) ore (other than iron ore or tar sands ore) from a mineral resource located in Canada to any stage that is not beyond the prime metal stage or its equivalent,
- (ii) iron ore from a mineral resource located in Canada to any stage that is not beyond the pellet stage or its equivalent, or
- (iii) tar sands ore from a mineral resource located in Canada to any stage that is not beyond the crude oil stage or its equivalent,
-
- (g) producing industrial minerals,
- (h) producing or processing electrical energy or steam, for sale,
- (i) processing natural gas as part of the business of selling or distributing gas in the course of operating a public utility,
- (j) processing heavy crude oil recovered from a natural reservoir in Canada to a stage that is not beyond the crude oil stage or its equivalent, and
- (k) Canadian field processing.
The third and final threshold test is that at least 10% of the corporation’s gross revenue from all active businesses carried on in Canada are from the sale or lease of goods manufactured or processed in Canada by the corporation or from the manufacturing and processing in Canada of goods for sale or lease by others.
Calculating “Canadian Manufacturing and Processing Profits”
These three tests passed, we move on to the calculation of Canadian Manufacturing and Processing Profits (“CMPP”). The foundation of calculating CMPP is rooted in a specific formula that aims to ascertain the proportion of a corporation’s adjusted business income (“ABI”) that can be attributed to manufacturing and processing activities. The ABI simply represents the excess of the corporation’s income from an active business carried on in Canada over its losses from such active business. The core of the CMPP calculation is determining the proportion of the corporation’s ABI for the year that the aggregate of its cost of manufacturing and processing capital and its cost of manufacturing and processing labour for the year is of the aggregate of its total cost of capital and its total cost of labour for the year. That proportion is then applied to the corporation’s ABI for the year to determine its CMPP.
Calculating the cost of capital and the cost of labour involves identifying the costs directly associated with the qualified activities described above. The cost of labour encompasses salaries and wages paid to employees for the time they were directly engaged in qualified activities, including payments to third parties for services directly related to these activities. The cost of capital includes 10% of the undepreciated capital cost of depreciable property and all rental costs incurred. Calculating the cost of manufacturing and processing labour and the cost of manufacturing and processing capital involves a gross-up function (up to the total cost of capital or labour as the case may be) that implicitly recognizes that there is an overhead element involved in manufacturing and processing that is not directly related to “qualified activities.”
Examples involve math and (as I noted at the beginning) I love the math! For the purposes of this example, I assume the undepreciated capital cost of depreciable property at the end of the taxation year is $6,000,000. Let’s assume no equipment rental to keep it simple. Of this, $4,500,000 is used directly in qualified activities. I also assume that the total cost of labour for the corporation is $5,000,000 and that $3,000,000 of this is for the portion of their time directly engaged in qualified activities. The Regulation 5200 formula yields in this example that the CMPP of the corporation is 80.9% of ABI, calculated as:
[($4,500,000 x 10% x (100/85)) + ($3,000,000 x (100/75))] / [($6,000,000 x 10%) + $5,000,000]
Territorial Allocation – Income Earned in Yukon
Benefitting from the Yukon arbitrage opportunity first requires the manufacturer / processor to establish a permanent establishment within Yukon. This means setting up a fixed place of business of the corporation, including something as simple as an office or a branch or as complex as a factory or a warehouse. Assuming the corporation has one or more permanent establishments outside Yukon, the allocation rule of taxable income among provinces and territories is half based upon gross revenue reasonably attributable to the permanent establishment as a percentage of total gross revenue and the other half based upon the salaries and wages paid to employees of the permanent establishment as a percentage of all salaries and wages paid in the year by the corporation.
Moving numerous employees to Yukon may prove impractical, despite the spectacular nature vistas there. Moving taxable income far north and west therefore requires a focus on the gross revenue aspect of the provincial and territorial allocation formula. Attribution is normally a dirty word within the vocabulary of tax, but in the context of the provincial and territorial allocation formula we can put attribution to work.
For the purpose of determining the gross revenue for the year reasonably attributable to a permanent establishment in a province or territory, there is a nifty little attribution rule tucked in as Regulation 402(4)(b). For merchandise sold within Canada:
… where the destination of a shipment of merchandise to a customer to whom the merchandise is sold is in a province … in which the taxpayer has no permanent establishment, if the person negotiating the sale may reasonably be regarded as being attached to the permanent establishment in the particular province or country, the gross revenue derived therefrom shall be attributable to that permanent establishment.
This allows for the movement of taxable income to Yukon by moving aspects of sales function to Yukon. I’ll continue our earlier example to demonstrate. Let’s assume that our manufacturing and processing corporation has its only other permanent establishment in Manitoba. Let’s also assume that its gross revenue is derived 10% from sales within Manitoba, 10% from sales to the USA, and 80% from sales to the rest of Canada. Let’s also assume that moving the function of negotiating sales results in 5% of total salaries and wages being attributable to Yukon. If all sales are negotiated from Yukon then the territorial allocation formula results in 42.5% of taxable income being allocated to Yukon, calculated as (50% x 80%) + (50% x 5%).
To complete the example, the CMPP earned in Yukon is 80.9% of the ABI of the corporation allocated to Yukon. The overall saving to our Manitoba based manufacturing and processing corporation is 42.5% x 80.9% x 9.5% = 3.27% of its total active business income.
Conclusion
The example of moving CMPP to Yukon from other Canadian permanent establishments is only one example of the many arbitrage opportunities created by the varying tax policy choices made by the provincial and territorial governments. Individuals and corporations alike can benefit from choosing a lower cost patch on the Canadian tax quilt. Mark Twain once wrote something like ‘there’s [tax] gold in them thar hills.’ You don’t even have to climb Mount Logan to mine it. The math is mathing. If you are interested in exploring how the math for a different patch on the Canadian tax quilt works for your particular situation then please contact a member of the Miller Thomson LLP Corporate Tax Team.
[1] RSY 2002, c. 118.
