Carrying on Business Through a Canadian Subsidiary
This blog post highlights some of the principal tax matters that should be considered in deciding whether to carry on business in Canada through a Canadian subsidiary or as a branch operation.
See Chinese version below [中文版参阅下文].
A corporation incorporated in Canada will be resident in Canada and subject to Canadian federal income tax on its worldwide income. As noted in our previous blog post, income of the subsidiary may also be subject to provincial and/or territorial income tax.
The combined federal and provincial/territorial income tax rate to which the subsidiary is subject will depend on the provinces and territories in which it conducts business, the nature of the business activity carried on and other factors.
The calculation of the subsidiary’s income will be subject to specific rules in the Income Tax Act (Canada) and any applicable provincial or territorial tax legislation. Income includes 50% of capital gains.
Expenses of carrying on business are deductible only to the extent they are reasonable. Neither federal nor provincial/territorial income tax is deductible in computing income subject to the other level of tax. Generally, dividends may be paid between related Canadian corporations on a tax-free basis. Groups of corporations may not, however, file consolidated income tax returns. Accordingly, business losses of the subsidiary will not be directly available, for Canadian tax purposes, to offset income of an affiliated company. However, it may be possible to enter into intra-group income balancing transactions in certain situations.
Transactions between the subsidiary and any person with whom it does not deal at arm’s length, including its parent corporation, will generally need to be effected for tax purposes on a “fair-market-value” basis. Certain contemporaneous documentation may also be required under Canada’s transfer pricing rules.
The debt/equity structure of the subsidiary will be subject to thin-capitalization rules, which operate to deny the deduction of interest payable to specified non-residents by the subsidiary to the extent that the subsidiary is “thinly capitalized.” The subsidiary is considered to be thinly capitalized where the amount of debt owed to the non-resident shareholder is more than 1.5 times the aggregate of the retained earnings of the corporation, the corporation’s contributed surplus that was contributed by the non-resident shareholder and the paid-up capital of the shares owned by the non-resident shareholder. Interest that is not deductible because of the thin-capitalization rules is deemed to have been paid as a dividend and is subject to withholding tax as such.
In some cases, the subsidiary may be established as an unlimited liability company (ULC) under the laws of Alberta, British Columbia or Nova Scotia. This may be done to access the advantages of both a branch and a subsidiary operation for a U.S. parent corporation. The reason is that while a ULC is treated as a corporation for Canadian tax purposes, we understand that it may be treated as a branch or a partnership for U.S. tax purposes. U.S. tax advice should be obtained on this point and certain provisions in the Canada-United States Income Tax Convention (1980) (U.S. Convention) should also be considered, as in certain cases they may eliminate the tax benefits associated with such hybrid entities or give rise to adverse tax consequences without proper tax planning.
The withholding tax regime, briefly described above, will apply to the subsidiary’s payments to non-residents, including interest and dividends. In the case of payments by a subsidiary to a U.S.-resident parent, the U.S. Convention eliminates the withholding tax on interest (other than certain types of interest, such as interest determined with reference to profits or cash flow or to a change in the value of property). The benefits of the U.S. Convention are, subject to some exceptions, available only to certain “qualifying persons,” as defined in the “Limitation on Benefits” provisions of the U.S. Convention.
Canada signed the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI) in June 2017. The federal legislation to ratify the MLI in Canada is contained in Bill C-82, which received Royal Assent on June 21, 2019. The most significant treaty modification to be implemented through the MLI will be the addition of a broad anti-avoidance rule into the applicable tax treaties, referred to as the principal-purpose test. Under the principal-purpose test, a treaty benefit may be denied where it is reasonable to conclude that one of the principal purposes of an arrangement or transaction was to gain such benefit, unless it is established that granting the benefit would be in accordance with the object and purposes of the relevant provisions of the treaty.