Tax considerations of operating a branch in Canada
The tax consequences of a multinational corporation’s expansion in Canada should be carefully considered. While nonresident corporations may decide against creating a Canadian subsidiary, certain circumstances may result in the unintended creation of a branch, with unanticipated tax consequences that are similar to those that may be incurred with a subsidiary. In some cases, the costs (both tax and non-tax) associated with a branch in Canada surpass the costs of maintaining a Canadian subsidiary. Understanding the level of presence and business operations which may constitute a branch is therefore critical to developing a nonresident’s tax entry strategy into the Canadian market. What’s more, companies looking to expand into Canada should be aware of Covid-19 implications and recent initiatives to overhaul international tax systems. Changes clearly seem to be on the horizon concerning the basic principles governing taxation in Canada. Multinationals should therefore be mindful of the evolving state of the rules before expanding into Canada in 2020 and beyond.
Carrying on business and permanent establishment in Canada
Under subsection 2(3) of Canada’s Income Tax Act (Act), a nonresident carrying on business in Canada is liable for Canadian corporate income taxes on Canadian-sourced income. The Act provides an extended meaning of carrying on business in Canada, which generally includes the following activities of a nonresident:
- Produces, grows, mines, creates, manufactures, fabricates, improves, packs, preserves or constructs, in whole or in part;
- Solicits orders or offers anything for sale in Canada through an agent or servant whether the contract or transaction is to be completed inside or outside Canada or partly in and partly outside Canada; or
- Disposed of certain Canadian resource property, timber resource (including an interest in or option in respect of such property), or, real or immovable property (including an interest in or option in respect of such property).
In addition, a nonresident must rely on jurisprudence for guidance on the meaning of ‘carrying on business in Canada’. The courts have considered a number of factors in assessing whether an enterprise is carrying on business in Canada, including the place where the contracts are made, and the place where the operations take place from which the profits arise, among many other factors. No single factor is decisive on its own, and all relevant facts must be taken into consideration to conclude whether the nonresident corporation is carrying on business in Canada, which should involve the expertise of a tax advisor.
Before concluding whether a nonresident carrying on business in Canada is liable for Canadian income taxes, the provisions of the income tax treaty, if one exists, between Canada and the nonresident country need to be reviewed. Most of Canada’s tax treaties with major trading partners require a high threshold presence – referred to as a permanent establishment (PE) – in Canada in order for a nonresident to be subject to Canadian Part I tax. Where a nonresident corporation is a resident of a country with which Canada has an existing treaty (such as the United States), the nonresident corporation is normally only subject to Part I Canadian taxes on its business profits attributable to a PE situated in Canada. The specific rules surrounding the determination of a PE are outside the scope of this article. However, generally speaking, a PE in Canada most often results from a physical presence in Canada through a fixed place of business. In the case of the Canada-U.S. Tax Convention, the enterprise is also deemed to have a PE situated in Canada if employees or agents of the enterprise are physically providing services in Canada for 183 days or more in any 12-month period, and either:
- more than 50% of the enterprise’s gross revenues are derived from the Canadian activities, or
- he services are with respect to the same or connected project for customers who are residents of Canada or have a PE in Canada.
Further, nonresidents entering Canada should also be aware that the thresholds for carrying on business in Canada and/or creating a PE for sales tax purposes is different from the thresholds for corporate income tax purposes. As a result, a multinational could be subject to Canadian sales tax obligations (i.e. HST, GST, etc.) even if no Canadian income tax liabilities arise.
Impact of the multilateral instrument
On June 21, 2019, Parliament passed Bill C-82 which entered Canada into The Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting, also known as the Multilateral Instrument or MLI. The MLI is a global initiative developed by over 100 countries to counter tax avoidance strategies (i.e. tax planning strategies that exploit gaps and mismatches in tax rules) which lead to base erosion and profit shifting (BEPS). The MLI is not a stand-alone treaty, but instead, provides an overlay to existing bilateral treaties for any two countries that have both an existing bilateral treaty and have ratified to the MLI. In essence, the MLI allows participating countries to combat BEPS in a synchronized and efficient manner, avoiding the need to re-negotiate treaty agreements individually. Close to 100 countries have signed the MLI thus far, however noticeably absent from the signatory list is Canada’s largest trading partner, the United States.
One of the mandatory minimum standards that Canada will adopt in the MLI is the ‘treaty abuse’ standard, which encompasses measures to eliminate any opportunities for zero and/or reduced taxation not in accordance with the treaty. As such, nonresident enterprises planning to enter Canada should consider the implications of the MLI, as governments could deny treaty benefits if the principal purpose of a business arrangement or transaction in Canada is to directly, or indirectly, obtain a tax benefit. In other words, there needs to be a bona-fide business purpose for a nonresident to have an entity established in Canada, other than simply to reap the benefits of the respective treaty.
BEPS and the digital economy
Another objective of the MLI is to address the concern of technology companies using aggressive practices to reduce their global tax liabilities. Multinational tech companies have been able to exploit outdated international tax rules, which generally require some sort of physical presence in order to create a PE in a foreign jurisdiction. Consequently, companies that engage in significant economic activity through a ‘digital presence’ may be avoiding their fair share of tax in these foreign jurisdictions (as the lack of physical presence has prevented the existence of a PE), resulting in millions of dollars of tax revenue losses to Canada each year. This trend has been exacerbated by the recent growth of the digital economy, which has experienced even further growth because of the COVID-19 pandemic, meaning tax authorities will likely be even more watchful of multinationals’ digital presence in Canada in coming years.
Income taxes of a branch
Where a subsidiary is the vehicle selected by a multinational to operate in Canada, a subsidiary of a nonresident corporation will operate in Canada and have its own tax filings and tax obligations separate from its parent. If a nonresident has decided against opening a subsidiary to carry on business in Canada, the nonresident is said to be ‘operating a branch in Canada’. Consequently, assuming the conditions for carrying on business in Canada and PEs described above have been met, the nonresident earning Canadian source income will be subject to the same Part I corporation tax rate as a Canadian corporation (26.5 per cent combined 2020 enacted rates for Ontario). Provincial and territorial tax rates range from 11.5 per cent to 16 per cent for the year 2020. Effectively, a branch is treated similarly to a Canadian subsidiary corporation for income tax purposes.
In addition to being subject to Canadian Part I tax, a branch will be subject to Part XIV tax (also known as ‘branch tax’) of 25 per cent on any tax profits that are ‘not reinvested in Canada’ and therefore deemed to be repatriated to the nonresident head office. An applicable tax treaty may reduce the Part XIV tax rate to as low as 5 per cent, which mirrors the lowest reduced rate of withholding tax on dividends in certain tax treaties. In other words, the consequence of branch profits not being reinvested in Canada is that those branch profits are treated the same as a Canadian subsidiary paying a dividend to its nonresident parent.
Further, a tax treaty may exempt the first $500,000 of a nonresident corporation’s cumulative income from branch tax, providing some relief at the earlier stages of operations in Canada.
Although Part XIV tax could increase the overall tax in Canada and therefore cause the Canadian subsidiary alternative to be the most attractive from a purely tax standpoint, decision-makers should consider there could be advantages of entering Canada by way of a branch. For example, branches are sometimes preferred because the structure effectively allows for start-up losses to flow out of Canada and be deducted in the home country. Depending on a number of factors – such as the parent’s home country and the type of legal entities involved – a Canadian subsidiary’s start-up losses may be moved out of Canada, however generally speaking such losses are often trapped in the Canadian subsidiary and therefore not as easily utilized until the Canadian operations become profitable.
Allowance for investing in Canada
The concept of profits ‘not reinvested in Canada’ is intended to approximate the funds remitted to the home base of the nonresident (for example, the United States), since the Canadian tax authorities have no means to measure the actual funds repatriated. In determining the amount of funds deemed to be repatriated – resulting in Part XIV branch tax – a Canadian branch may claim what is referred to as an ‘allowance for investments in property in Canada’ which generally represents the cost of property relating to its business carried on in Canada, including cash deposited with a Canadian bank. Using the after-tax profits on which branch tax applies as the starting point, such allowance may be deducted to reduce the amount of branch tax that would otherwise be payable. In other words, branch tax will only apply to profits earned in Canada that are assumed to be repatriated out of the country.
Because a branch is not a separate legal entity, maintaining separate financial records may be challenging. In most instances, a Canadian branch of a foreign enterprise may not have its own set of financial statements or records, requiring its Canadian activities to be bifurcated from the multinational’s consolidated activities for the purpose of filing a Canadian tax return. If possible, separate financial statements and general ledger should be maintained for the branch. Further, overhead costs may need to be allocated to the branch, which could be a tedious task and require internal cost allocation policies.
Quite often one of the factors in deciding against setting up a separate Canadian subsidiary are the additional legal costs of setting up a new corporation and maintaining separate legal records. However, nonresident enterprises should understand that advisory and compliance costs for a branch could be higher than expected. As seen above, determining whether or not a branch exists in the first place can be complex and requires the expert analysis of a tax advisor (compared to a Canadian corporate subsidiary which does not require such analysis). Once the determination has been made, the analysis must often be revisited whenever facts and circumstances change. Such costs could add up quickly and surpass the costs of setting up and maintaining a Canadian subsidiary corporation. Also, both a branch and a Canadian subsidiary may require additional information returns to report transactions with related nonresidents that could result in significant penalties if not filed on time. Transfer pricing rules may also need to be considered, which may require detailed support for any cross-border transactions.
In the event a nonresident is carrying on a business in Canada but is exempt from Canadian income tax as a result of a treaty (i.e. where no PE exists), the foreign enterprise is still required to file a Canadian tax return which is referred to as a treaty-based information return. Frequently, management is unaware of this Canadian filing requirement, which could result in significant penalties ($2,500 per year, plus applicable interest) that can add up quickly if the enterprise is non-compliant for multiple years.
COVID-19 travel restrictions
A nonresident enterprise may employ a Canadian resident individual to work outside of Canada. However due to the travel restrictions posed by COVID-19, some of these individuals may only be able to fulfil their employment duties in Canada, likely at their home. As noted earlier, under the Canada-U.S. Tax Convention, a PE may be triggered when an employee or agent is present in Canada for 183 days or more in any 12-month period. The question is, should a nonresident enterprise be penalized because of the travel restrictions posed by the pandemic? Thankfully, the Canada Revenue Agency (CRA) has recognized that these extraordinary circumstances could inadvertently trigger a PE in Canada for many nonresidents, and as a result, the CRA has stated it will not consider a nonresident entity to have a permanent establishment in Canada solely because its employees perform their employment duties in Canada solely as a result of the travel restrictions being in force. Nonresidents should be prepared to defend their position in obtaining this relief. Unfortunately, the CRA has indicated that there is generally no COVID-19 relief concerning the tax filing requirement, and therefore the nonresident (deemed not to have a PE due to the aforementioned relief) would still need to file a treaty-based information return where applicable.
Once travel restrictions are lifted, nonresidents need to be aware that allowing employees and agents to continue to work in Canada – as many employees are now performing their duties at home – may trigger a PE as the COVID-19 relief will likely no longer apply.
Have a 360° plan
Nonresident corporations may face complex tax and non-tax implications when entering Canada. A nimble and well-rounded tax strategy begins with determining whether or not the company would be deemed a branch and what tax treaty exemptions can be accessed as a result. Recent global developments relating to COVID-19 and the BEPS project should further inform multinationals’ approach for expansion into Canada.