How Canada–India corporate groups can navigate critical tax considerations

An Indian subsidiary owned by a Canadian parent company may be classified as a foreign affiliate (FA) or controlled foreign affiliate (CFA) under Canada’s Income Tax Act, depending on the Canadian parent's ownership percentage and level of control.

These classifications determine the Canadian reporting obligations and how a subsidiary’s income is treated in Canada. Canadian corporations with FAs are generally required to file Form T1134 annually, which discloses information about the FA’s operations, financial results and relationship to the Canadian parent.

Since there are significant penalties for late or incomplete filing, businesses should maintain accurate records and track ownership changes throughout the year; even a small change in ownership or control can change a subsidiary’s FA or CFA status and reporting obligations.

FAPI rules are designed to prevent Canadian taxpayers from indefinitely deferring Canadian tax on passive or investment-type income earned through FAs.

If an Indian subsidiary earns certain types of passive income—such as interest, royalties, rent or income from investment businesses—it may be attributed back to the Canadian parent and taxed currently in Canada, regardless of whether it is distributed as a dividend.

By contrast, active business income earned by an Indian subsidiary is generally not subject to FAPI and can typically be repatriated to Canada more tax-efficiently.

Businesses must undertake a detailed factual analysis to determine and document whether income is active or passive for FAPI purposes, especially for hybrid business models.

When an Indian subsidiary eventually pays dividends to its Canadian parent, the Canadian tax treatment depends on the type of surplus pool the dividend is paid from: exempt surplus, taxable surplus or other categories.

Dividends paid out of exempt surplus are generally excluded from Canadian taxable income due to an offsetting deduction. Dividends from taxable surplus may be taxable in Canada—subject to a deduction for underlying foreign tax paid.

Due to the countries’ comprehensive tax treaty, active business income earned by an Indian subsidiary generally qualifies as exempt surplus, which allows for more tax-efficient repatriation to the Canadian parent company. The treatment of surplus pools should still be reviewed carefully to determine the applicable exempt surplus percentage and confirm that it reflects the specific facts of the structure.

Transfer pricing continues to be one of the most significant compliance risks for multinational groups. Any transactions between a Canadian parent company and its Indian subsidiary—including intercompany services, royalties, financing arrangements or the transfer of goods—must be conducted at an arm's length basis under Canada's transfer pricing rules in section 247 of the Income Tax Act. The CRA expects contemporaneous documentation supporting the pricing methodology used.

The transfer pricing penalty is a compliance penalty that can apply to an income adjustment where the taxpayer has not made reasonable efforts to determine and use arm's length prices. Businesses must keep robust documentation to stay protected from the penalty, even if an adjustment is later made by the CRA.

Given the same transaction is documented in both countries, the Canadian parent company typically maintains Canadian documentation while the Indian subsidiary separately prepares its own documentation and accountant's report under India's transfer pricing rules.

India's transfer pricing regime is well-developed and rigorously enforced, so businesses should confirm that the positions taken in both jurisdictions are consistent to avoid double taxation or disputes with either tax authority.

Recent transfer pricing amendments in Canada also placed greater emphasis on economic substance rather than legal form. This means documentation should increasingly demonstrate how the business actually operates in practice, not just that the pricing itself is arm’s length.

Interest, royalties and other payments flowing from an Indian subsidiary to the Canadian parent company may be subject to India’s withholding tax; this is often reduced under the countries’ tax treaty if eligibility requirements are met.

Canadian rules generally allow relief for foreign taxes paid—but the interaction between India’s withholding tax, FAPI inclusions and Canadian FTCs can be complicated.

Businesses should carefully calculate how these amounts interact each year to confirm the FTC fully offsets the related Canadian tax. Any mismatches in timing or character between the FAPI inclusion and the underlying foreign tax paid can result in unrelieved double taxation.

Dividends, interest, royalties or management fees paid by a Canadian subsidiary to its Indian parent company are generally subject to 25 per cent Canadian withholding tax. This rate may be reduced under the countries’ tax treaty, subject to meeting certain requirements.

Businesses should carefully evaluate treaty eligibility and properly document residency status while accessing reduced withholding tax rates.

Where an Indian parent company has personnel, agents or other business activities in Canada beyond the Canadian subsidiary itself, there is a risk the Indian parent could be considered to have a PE in Canada. This is particularly relevant given an increase in mobile employees and remote work arrangements.

If a PE is established, the Indian parent company may become subject to Canadian tax on business profits attributable to that arrangement—separate from the Canadian subsidiary's own tax obligations.

Businesses should structure intercompany arrangements and employee travel carefully to manage this risk.

Thin capitalization rules restrict the amount of interest deductibility available to a Canadian subsidiary on debt owed to certain non-resident shareholders.

When a Canadian subsidiary's debt-to-equity ratio owed to specified non-residents exceeds 1.5:1, the interest expense on the excess debt may be denied as a deduction for Canadian tax purposes and could be recharacterized as a deemed dividend—subject to withholding tax. Accordingly, Indian parent companies should evaluate their financing structure before advancing shareholder loans.

Canadian subsidiaries of Indian parent companies should also consider the excessive interest and financing expenses limitation (EIFEL) regime. This applies more broadly than the thin capitalization rules and generally limits the deductibility of net interest and financing expenses to a fixed percentage of tax EBITDA (currently 30 per cent).

The EIFEL rules can apply to both related-party debt and third-party debt in some cases—independent of the debt-to-equity ratio.

Given the interaction between these two regimes, Indian parent companies financing their Canadian subsidiary through intercompany loans should model both thin capitalization and EIFEL limitations together when structuring debt levels. This can help avoid unexpected denial of interest deductions and the associated withholding tax consequences of any recharacterized amounts.

A Canadian subsidiary is subject to standard Canadian corporate tax filing and compliance obligations. These include federal and provincial corporate income tax returns and Canadian transfer pricing documentation requirements for its transactions with the Indian parent.

Beyond corporate income tax, Canadian subsidiaries should also maintain compliance with indirect tax obligations—including federal GST/HST and applicable provincial sales taxes, particularly on cross-border transactions and intercompany charges with the Indian parent.

Businesses should also take into consideration Canadian tax outcomes for profits repatriation from the Canadian subsidiary and an eventual exit or restructuring—including a sale, wind-up or reorganization.

Canadian rules around surplus stripping and anti-avoidance provisions such as the GAAR should be kept in mind so these transactions are not viewed as primarily tax-motivated without sufficient business purpose.