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Mergers and Acquisitions in Canada


This section outlines some of the Canadian income tax implications of carrying on business in Canada through a branch or a subsidiary, including the use of an unlimited liability company (“ULC”).

Canadian Subsidiary

A subsidiary incorporated in Canada is generally considered to be a Canadian resident for income tax purposes. It is subject to Canadian income tax on its income earned anywhere in the world from any source and a credit for foreign taxes paid on non-Canadian income.

The income of the Canadian subsidiary that is subject to Canadian income tax is generally calculated in accordance with generally accepted accounting principles. However, there are numerous inclusions and deductions which are specifically required or not permitted under the Act.

The Canadian tax rules treat capital gains more favourably than ordinary business or trading income. Generally, only one-half of realized capital gains, net of capital losses, are included in income.

In general terms, the Act permits a corporation to carry back for three years and carry forward for twenty years, non-capital losses (also referred to as net operating losses or “NOLs”). Such losses can generally be applied by the corporation against any form of income. Capital losses can be carried back three years and carried forward indefinitely but can only be used to offset capital gains. The direct or indirect acquisition of control of a corporation may limit the carry back and carry forward of both types of losses as well as certain other tax attributes of a corporation.

An efficient means of reducing the Canadian tax liability of the Canadian subsidiary involves having the U.S. parent corporation charge reasonable expenses to the subsidiary that are deductible in computing income of the subsidiary for Canadian income tax purposes. For instance, the U.S. parent corporation might charge the Canadian subsidiary a reasonable management or administration fee.

The parent corporation may also lend funds to the Canadian subsidiary and charge a reasonable rate of interest. Subject to the thin capitalization rules discussed below, the Canadian subsidiary will be able to deduct the interest paid to its parent. However, withholding tax may apply on the interest payment made by the Canadian subsidiary to its parent. As noted above, for U.S. parent corporations which can benefit from the Treaty, recent amendments to the Treaty have eliminated the withholding tax on interest paid to U.S. related parties which is not “participating interest,” as defined in the Treaty.

Branch

A foreign company that is not resident in Canada is subject to Canadian income tax on income earned from any business carried on in Canada. If a business is carried on in Canada through a branch operation, the income attributable to that branch will be subject to income tax in much the same way, as if it had been earned by a subsidiary. However, the majority of Canada’s tax treaties generally provide that the business profits of a foreign enterprise derived from carrying on business in Canada will only be taxable in Canada if they are attributable to a permanent establishment situated in Canada (see the discussion on “Business Profits” above).

A non-Canadian corporation carrying on its business on its business as a branch will be subject to income tax as discussed above, on the income attributable to its Canadian branch. The determination of such net-taxable income will involve determining the gross profit on a reasonable allocation basis from its activities in Canada (this normally involves complex accounting allocations, keeping separate books and records, or segregating the Canadian operations in the corporation’s books). In theory, a certain portion of the gross profit could be allocated to the head office to reflect its contribution to the branch in the form of management and administration services.

A foreign corporation carrying on business in Canada will also be subject to Canadian branch tax as discussed above. For U.S. corporations which benefit from the Treaty, the rate is 5%. However, the first CDN$500,000 of the corporation’s earnings will be exempt from such taxes under the Treaty, and as such, the repatriation of such exempt profits to the head office will not be subject to withholding taxes.

The exemption can result in tax savings of up to CDN$25,000 (i.e. $500,000 x 5%). Therefore, in certain situations, for U.S. companies, it may be efficient to carry on the Canadian operations initially through a branch and then to transfer the Canadian business to a Canadian corporation after the earnings of the branch exceed the CDN$500,000 exemption threshold.

Using An Unlimited Liability Company (“ULC”)

The “check-the-box” rules under the U.S. Treasury Regulations[[(26 C.F.R).]] permit a Canadian corporate entity to elect to be treated as a flow-through entity for U.S. income tax purposes, if the corporate entity does not provide limited liability protection to its shareholders. Nova Scotia, Alberta and British Columbia are the only Canadian provinces that offer the flexibility of creating a ULC under their provincial statutes.

It is important to understand that a ULC is treated as a corporation for Canadian income tax purposes and is subject to the same Canadian income tax consequences as any Canadian corporation. Accordingly, it is liable to pay Canadian income taxes on its worldwide income.

However, amendments to the Treaty which came into effect January 1, 2010, contain a rule that denies certain benefits of the Treaty to U.S. residents that have an interest in a ULC, where the ULC is a disregarded entity for U.S. tax purposes. An amount of income, profit or gain paid by a ULC (including interest or dividends) to a U.S. resident, no longer qualifies for a reduced rate of withholding tax under the Treaty. Rather, the statutory withholding rate of 25% under the Act applies to such amounts. However, the CRA has issued several technical interpretations and advance income tax rulings which permit a ULC to benefit from the withholding tax rate set out in the Treaty on interest and dividends, so long as such interest and dividend payments are structured in the manner set out in such interpretations and rulings. Therefore, existing structures using a ULC should be reviewed.

Choosing Between A Subsidiary and a Branch Operation

If business is carried on in Canada through a branch operation having a permanent establishment, it is subject to income tax in much the same way as if it had been earned by a subsidiary. However, it is important to note that in the case of a U.S. resident who benefits from the Treaty, that person may generally carry on business in Canada without attracting Canadian income tax, provided that no permanent establishment, as defined in the Treaty, is maintained in Canada. In addition, when a non-resident decides to carry on business in Canada (whether or not subject to tax), appropriate federal, as well as provincial or territorial income tax returns, will need to be filed.

On a long-term basis, the use of a subsidiary is often found to be preferable since the existence of a separate legal entity in Canada encourages and facilitates the separate accounting necessary for Canadian purposes and the determination of acceptable cross-border transfer pricing. On the other hand, the ability of the non-resident to use Canadian source start-up losses may encourage the use of a branch operation until the Canadian business becomes profitable. Subsequently, branch assets can generally be transferred to a Canadian subsidiary on a tax-free basis for Canadian purposes, provided that the appropriate tax elections are made. Before a foreign corporation transfers assets to a Canadian subsidiary, caution should be taken since it could trigger taxes in the foreign corporation’s country of residence, and in certain situations, Canadian tax.

Whether a business comes to Canada as a branch or subsidiary can impact the valuation of imported goods. For customs purposes, it is generally the transaction value (the value at which goods are sold to the Canadian importer) that forms the value for duty (i.e. the base upon which customs duties are calculated). However, where goods are transferred to a Canadian branch, a sale may not take place. Consequently, the transfer price may not form the value for duty and another value, such as the selling price in Canada less certain adjustments, may become the value for duty.

Whether a business operates in Canada as a branch or subsidiary can affect whether the provisions of section 105 of the Income Tax Regulations apply. This provision applies to fees paid to a non-resident for services provided in Canada (other than remuneration for employment services) and requires the payor to deduct and withhold 15% of such payment. If the services are rendered in Quebec, a further 9% must be withheld and remitted to Revenue Quebec. This withholding tax is on account of any Canadian or Quebec taxes owed by the non-resident. If the non-resident is not subject to Canadian or Quebec tax (e.g. because it does not have a permanent establishment in Canada and can benefit from the Treaty provisions applicable to business profits), it can apply for a refund of the withholding tax. A waiver of this withholding may be obtained from the CRA and Revenue Quebec in certain circumstances. In contrast, payments received by a Canadian subsidiary in respect of services provided in Canada will not be subject to this provision.

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