When foreign investors decide to conduct business in Canada, the typical question concerning whether to operate a branch or to incorporate a subsidiary is often raised. Throughout this article, we will help you find an answer to such a frequently asked question. But, before going deeply into the subject, we have to shed some light upon a few concepts.
General Tax Considerations
Income Tax
Under the Income Tax Act, every individual residing in Canada must pay income tax.
Residence
According to the Canadian Law, an entity is deemed resident in Canada if its central control, management, or administration is situated in Canada. Regarding individuals, any individual is considered a resident in Canada if their vital interests, including personal property, family, or home, are in Canada.
Tax Treaties
According to the tax treaties Canada has signed with other counties, it’s stated that the profits of a non-resident entity in Canada aren’t subject to tax under the Income Tax Act if they aren’t attributed to a permanent foreign entity establishment in Canada.
Related Parties, Transaction, and Transfer Pricing
Based upon the Income Tax Act, related parties should not deal with each other at arm’s length. According to the transfer pricing rule, non-arm’s length foreign entities and Canadian taxpayers should conduct their transactions in a way analogous to that which could have been applied when the parties deal at arm’s length.
General Anti-Avoidance Rule and Re-characterization of Transaction
In some circumstances, and according to the Income Tax Act, the anti-avoidance rule gives the green light to the transaction re-characterization wherein taxpayers carry out tax motivated transactions resulting in any abuse of any of the Income Tax Act provisions.
The dash between tax planning and tax avoidance is not always clear. That is, taxpayers often find themselves obliged to pay tax according to the Canada Revenue Agency CRA even if they have abided by the law letter.
Income Tax of Corporations
How is Profit Determined?
According to the Income Tax Act, it is stated that a taxpayer’s income in a certain business year is the taxpayer’s business profits for that taxation year; it is usually calculated based upon ordinary commercial principals. The deduction from the income is allowed only when expenses and outlays are incurred to earn income from the business.
Under the thin capitalization rule, the expense of interest is often deduced from the income of a taxpayer if it is incurred to a legal obligation to pay interest on money borrowed to earn income from the business.
Capital Gain, Capital Loss
Half of capital gains and losses are entitled to ordinary income tax according to regular rates under the Income Tax Act.
Taxable Income
Taxable income is usually calculated based upon the taxation year. The income is usually modified by certain provisions of the Income Tax Act by deducing specific amounts, including losses from other taxation years. Losses may be carried back for 3 taxation years or forward for 20 years to subtract taxable income related to these taxation years.
No Consolidation
All related corporations might not file any consolidation returns. The losses witnessed by a corporation might not be utilized to offset any other corporations income. Yet, some allowable corporate organizations might obtain loss consolidation among some related corporations.
Operating a Branch in Canada
A branch is defined as a foreign company conducting its business within the boundaries of Canada. As a result of being established in Canada, a branch is mandatorily subject to tax under Income Tax Act, Part One. It should be noted that the income tax rate imposed on business in Canada ranges from 25% to 31%, depending on the province where the business has been conducted.
Yet, wherein Canada has a tax agreement with the country of the non-resident entity, the tax rate imposed on that branch ranges between 5% to 15%. So, suppose Canada doesn’t have a tax agreement with the country of the non-resident entity, then the rate of the branch tax would be 25%.
Branch Profit Tax
Along with the provincial and federal income taxes that are imposed on businesses in Canada, a foreign corporation conducting business in Canada is entitled to pay branch profit tax. The branch profit tax approximates the withholding tax that is paid by a Canadian resident subsidiary if the foreign corporation had intended to incorporate a Canadian subsidiary to conduct business in Canada instead of operating a branch. According to Income Tax Act, the branch profit tax rate is 25%; it can be reduced under specific tax agreements.
Branch Accounting
According to the Income Tax Act, it is required of foreign taxpayers conducting business in Canada to calculate loss or income from its Canadian business. Any expenses that incur for the Canadian branch must be deduced when calculating the branch income.
Branch Finance
Since the Thin Capitalization rule does not apply to the foreign corporations conducting business in Canada, these rules don’t restrict the deduction of interest paid by a foreign corporation on money that is borrowed to finance the branch situated in Canada.
Canadian Withholding Tax
The Canadian withholding tax that is paid by a foreign corporation only applies to the payments that are made by the Canadian residents to the non-residents in Canada. Yet, a foreign business person conducting business in Canada through a branch operation might be considered as though they were resident in Canada. In short, some payments that are made by any foreign to another foreign might be entitled to Canadian withholding tax, unless this tax is exempted to be paid by any tax agreement.
Branch Inevitable Expenses
Any Canadian branch is inevitably subject to pay rent, receive royalties, or grow interest. However, the payer is supposed to adhere to the rules of the Canadian Revenue Agency CRA and the foreign entity withholding tax it imposes.
Converting Branch to Subsidiary
According to the Income Tax Act, a branch is incorporated without the need to incur any income tax or any tax liability belonging to a branch.
Operating a Subsidiary in Canada
A non-resident corporation owner wishing to conduct business in Canada has a second choice which is to set up a subsidiary corporation. In respect to corporations, the Canada tax liability is based upon the concept of residence. Further, any corporation residing in Canada is supposed to adhere to the Canadian income tax on its income. It should be noted that any corporation is considered Canadian if it is set up in Canada after the date of April 26, 1965. Also, a corporation residing outside Canada is deemed resident in Canada if its center of management and control is situated in Canada.
Repatriation of Funds
Because Canadian subsidiaries are deemed Canadian corporations, they are not obliged to pay branch profit tax. However, according to fund repatriation by the Canadian subsidiary to the foreign corporations, a withholding tax of 25% is payable, but it is entitled to reduction by a tax agreement.
Thin Capitalization Rule
The purpose of thin capitalization rules is to discourage a foreign entity from capitalizing its Canadian corporation with an odd amount of debt.
The thin capitalization rule may ban the deduction of interest paid by a Canadian subsidiary on debts owing to some foreign persons whenever such debts exceed the equity of a subsidiary by a ratio of 2:1.
Canadian Withholding Tax
Any Canadian subsidiary should withhold tax on many kinds of payments to foreign persons including the interest that is paid to non-arm length parties, dividends, participating interest, royalties, management fees, and administrative rentals.
Capital Taxation of Corporations
Provincial Capital Taxes
A lot of Canadian provinces, including Ontario, have recently announced their intent to reduce their capital taxes. It should be noted that Large Corporations Tax, known as federal capital tax, was reduced on January 1, 2006.
Corporate Minimum Tax
According to the province of Ontario, a corporate minimum tax levied on all corporations is entitled to Ontario tax. It should be noted that a corporation is required to pay corporate minimum tax exceeding corporate income tax.
Income Tax of Individuals
The federal tax imposed on individual taxpayers is set against the Customer Price Index. Further, provincial tax imposed on individual income is calculated on a basis of a percentage of federal tax in all Canadian provinces except Quebec.
Partnership, Joint Ventures Income Tax
The partnership income is calculated as though the partnership were a completely separate entity. However, it is assigned among the entity’s partners according to the partnership agreement terms. If the partnership is intended to have a never-ending establishment in Canada under a tax agreement, every partner is considered to conduct business through that never-ending establishment.
It is worth mentioning that the Income Tax Act restricts the deductions that might be against a restricted ‘at risk’ amount for the partnership. In joint ventures, every joint venture’s profit is calculated separately
