Canadian Tax Issues Arising Upon The Foreign Acquisition of a Canadian Business

March 27, 2008

When structuring the foreign acquisition of a Canadian business, we are concerned not with tax issues arising upon the acquisition but, rather, with those arising after the acquisition has been completed. Our concern is, therefore, for the purchaser and the target rather than the vendor.

While there are many tax issues that may potentially arise on a foreign acquisition of a Canadian business, it may be useful to consider that there are, fundamentally, just three structures available and to organize the various issues under these three heads. Specifically, a foreign acquiror may carry on business in Canada directly through the foreign entity, indirectly through a Canadian corporation or indirectly through a partnership consisting of either or both of the foregoing kinds of entities.

Admittedly, this is a simplistic analysis since these basic building blocks may be rearranged into highly complex structures. Furthermore, this analysis is limited to the Canadian side of the border. In respect of this first limitation, I submit that the tax issues with which this paper are concerned remain the same for the most complex as for these most simple structures. As to the second limitation, it is, of course, essential that the tax issues arising in the foreign jurisdiction of the purchaser be properly considered by a tax advisor qualified in that jurisdiction.

I. Permanent Establishments

Focusing, then, upon the Canadian side of the equation, the first scenario is one in which the foreign acquiror would carry on business in Canada directly. Obviously, this would entail an asset rather than a share purchase. From a strictly domestic perspective, subsection 2(3) of the Income Tax Act (Canada) (the "Tax Act") would subject the purchaser to Canadian income tax on all income earned from the business then carried on in Canada. Given that the purchaser is a non-resident, however, there may be an opportunity to reorganize the Canadian business operation in order to access the exemption contained in most, if not all, of Canada's tax treaties for non-residents that carry on business in Canada without a permanent establishment. The first point to consider, then, is the threshold at which the Canada Revenue Agency (the "CRA") would determine a permanent establishment to exist for the purposes of Canada's typical tax treaty.

It should be noted at the outset that treaty exemptions for non-residents carrying on business in Canada without a permanent establishment usually apply to non-residents that are corporations. A similar exemption involving the identical concept of "fixed base" applies to individuals with respect to services provided in Canada.

A. "Permanent Establishment"

Places

The definition of a "permanent establishment" is set out with some particularity within the tax treaties. In essence, these definitions provide that a permanent establishment is either a "fixed place of business" or a person, other than an agent of independent status, who has and habitually exercises in Canada the authority to contract on behalf of the non-resident. A permanent establishment can, therefore, be either a place or a person.

In respect of "permanent establishment" as a place, the jurisprudence appeared to have been settled as far back as the early 1960s that, at a minimum, a "fixed place of business" requires a place; that is, a physical, geographic, location. In the late 1990s, however, the CRA began to assess on the basis of time spent in Canada. In one typical situation considered by the CRA, a U.S.-resident corporation sent employees up to Canada to perform engineering consulting services at various locations in multiple provinces. No contracts were entered into in Canada, so there was no suggestion that the individual employees could have constituted permanent establishments. Instead, the CRA tallied the number of days an employee was in Canada, in many cases multiplying a given calendar day by the number of employees in Canada on that day, and then applied an apparently arbitrary judgement as to whether the total number of days was such that Canada should claim jurisdiction to tax the Canadian-source income. Forty years of jurisprudence according to which a "fixed place of business" required, at a minimum, a fixed place, appeared to have been flagrantly ignored.

One of the U.S.-residents involved in a scenario similar to that described above and over whom the CRA claimed jurisdiction to tax based solely upon the amount of time spent in Canada was a Mr. Dudney.[1] In fairness to counsel for the CRA, it was argued at trial that a fixed place of business existed by reason of the services having been performed at an identifiable location, albeit one over which the non-resident had no control. Notwithstanding this argument at trial, however, it is clear from the facts of this case and from other cases held in abeyance pending the outcome of this trial that the CRA's decision to tax the non-residents was based solely upon time spent in Canada. Indeed, Sharlow, J.A. observed that the Crown's position would entail that every person who requires little in the way of a fixed place of business by reason of their skills or the nature of the services they provide would necessarily have a fixed place of business wherever services are provided, rendering the concept of a fixed place of business meaningless. The CRA lost before the Tax Court of Canada,[2] lost again at the Federal Court of Appeal and, in 2000, was denied leave to appeal to the Supreme Court of Canada. Then seven years later, on September 21, 2007, Canada and the U.S. signed the Fifth Protocol to the Canada-U.S. Tax Convention (1980) (the "Canada-U.S. Treaty") which introduced into that treaty the concept of permanent establishment which underlay the CRA's position in Dudney. We must be careful, however, with any suggestion that the Fifth Protocol overrides Dudney. In that case, the CRA equated time spent in Canada with a fixed place of business. The Fifth Protocol does not, however, affect permanent establishment as a place but, rather, permanent establishment as a person. What we are left with is actually three concepts.

The first concept remains that elucidated in Dudney and the preceding jurisprudence, that of permanent establishment as a place. The criteria for this concept can be reduced to the basic proposition that a fixed place of business is a place controlled by and identifiable with the non-resident. Aside from the obvious examples of owning or leasing space, a non-resident may simply be permitted to use the office of a Canadian client. In such circumstances, we would need to consider whether the non-resident has a key to those premises and access at any hour, whether it uses those premises to service other clients and whether it hangs its own shingle in the lobby or hands out business cards with that address or phone number. Relevant factors are as varied as the circumstances.

Persons

The second concept is that of a permanent establishment as a person. As stated above, a person can be a permanent establishment if they have and habitually exercise in Canada the authority to contract on behalf of the non-resident. If, therefore, a non-resident is to have only a sales force in Canada, it is worth considering requiring the approval of the home office for all sales contracts. It should also be noted that the typical treaty definition of "permanent establishment" specifically excludes the use of facilities for the purpose of storage, display or delivery of merchandise such that a Canadian sales and distribution network could be organized to avoid Canadian income tax entirely—subject to the third concept introduced by the Fifth Protocol.

The Fifth Protocol

It should be noted that the Fifth Protocol applies only to the Canada-U.S. Treaty and, therefore, to residents of the U.S. alone. Furthermore, the amendment to the definition of "permanent establishment" provided in this protocol will not come into force until January 1, 2010 at the earliest. Subject to the foregoing, the new, third, concept within the definition of permanent establishment applies in either of two sets of circumstances:

(a) if services are provided in Canada by an individual who is present in Canada for an aggregate of 183 days or more in any 12-month period and more than 50% of the non-resident's gross active business revenues derives from those services; and

(b) if services are provided in Canada by any number of persons, whether or not individuals, for an aggregate of 183 days or more in any 12-month period and those services are in respect of the same or a connected project—in this case, the customers may be either residents of Canada or merely have permanent establishments in Canada, provided in the latter case that the services are provided in respect of those permanent establishments.

B. Pros and Cons

Assuming that the non-resident chooses to carry on business in Canada directly through a permanent establishment, what are the consequences? First, a non-resident that carries on business in Canada through a permanent establishment would be subject to Canadian income tax on all net Canadian-source income attributable to that permanent establishment. Although a foreign tax credit would presumably be claimed in the non-resident's home jurisdiction, the non-resident would remain liable to pay the higher of the two tax rates and would be required to file a Canadian income tax return. Second, liabilities incurred in Canada would be incurred by the non-resident—there would be no limitation of liability otherwise afforded by a subsidiary corporation. Third, customers of the permanent establishment would be required to withhold and remit income tax on all payments that they make to the permanent establishment, although foreign corporations typically obtain waivers for this withholding and remittance requirement.

On the other hand, the principal benefit of carrying on business through a permanent establishment is that any losses incurred in Canada would generally be deductible by the non-resident in its home jurisdiction against its non-Canadian-source income. A permanent establishment may also be preferable if the extent or frequency of business activity in Canada does not warrant the incorporation of a separate company.

C. Branch Tax

Finally, the last issue to be addressed in respect of permanent establishments is branch tax. Branch tax mirrors Part XIII tax, or non-resident tax, otherwise applicable to dividends that would have been paid or credited by a subsidiary.[3] Branch tax is also subject to the same treaty-reduced rates as dividends. As a result, the tax cost of withdrawing profits from Canada via a permanent establishment or a subsidiary is, in theory, tax neutral.

However, there are two distinctions to consider between branch tax and non-resident tax. First, there is a timing difference since branch tax is payable annually whereas the non-resident tax applicable to dividends is payable at the time each dividend is paid or credited.

Second, the Canada-U.S. Treaty exempts from branch tax the first $500,000 of net income. The benefit of this exemption must be weighed against the benefit afforded by an acquisition company, discussed in section II(C), below.

II. Subsidiaries

Thus far, we have reviewed the possibility of avoiding Canadian income tax by avoiding a Canadian permanent establishment and the tax consequences of carrying on a business in Canada directly through a permanent establishment. The next likely vehicle through which to carry on business in Canada is a Canadian subsidiary.

A. Pros and Cons

The pros and cons of a subsidiary are exactly the converse to those of a permanent establishment. As a separate legal entity, any losses generated by a subsidiary cannot be deducted by the parent. On the other hand, the subsidiary's liabilities are its own and, as a Canadian corporation, its customers are not required to withhold and remit taxes. It should also be noted that a subsidiary's tax filing obligations are also its own, which is significant if the non-resident does not wish to file its financial statements with the CRA.

While it should be recognized that unlimited liability companies, which are available under the laws of Nova Scotia, Alberta and, more recently, British Columbia, have often been used to obtain the benefits of both a permanent establishment and a subsidiary, such structures will be negatively affected by the Fifth Protocol. As the benefits of these vehicles are strictly for U.S. tax purposes, their use and their potential restructuring to accommodate the Fifth Protocol are reviewed in a paper to be delivered by my U.S. colleague.

B. Non-Resident Tax and Income Tax

Non-Resident Tax

Once we divide the non-resident and the Canadian operation into separate legal entities, we must then consider taxes on all payments flowing between them. This paper refers above to Part XIII tax, also known as non-resident tax. This is a flat tax of 25% imposed on various passive forms of income, including dividends, interest, rents, royalties and so forth. This 25% rate rarely applies, however, since Canada's tax treaties generally reduce or eliminate this tax. Unlike the Tax Act, however, the tax treaties treat the various kinds of income differently such that each income source must be separately considered.

Looking at dividends, the treaty-reduced rate under the typical treaty is 5% if the beneficial owner of the dividends is a corporation that owns at least 10% of the voting stock. In all other cases, the treaty-reduced rate for dividends is 15%. Rents on real property situated in Canada enjoy no tax reduction. Any amounts that could be allocated to royalties for software licences would enjoy a complete tax exemption under the Canada-U.S. Treaty while certain other royalties would be taxable at 10%.

Of greatest note since the Fifth Protocol was signed is the taxation of interest. The Fifth Protocol provides that interest payments between arm's-length persons will be wholly exempt as of the second month after the protocol enters into force. As we are still waiting for the U.S. to ratify the protocol, we do not yet know when that will be. The point to note, however, is that, rather than waiting, Canada has amended the Tax Act such that interest payments between non-arm's length persons are exempt from non-resident tax as of January 1, 2008. Moreover, because this is an amendment to the Tax Act, the exemption applies regardless of the recipient's country of residence.

Since this amendment to the Tax Act does not affect payments between non-arm's length parties, we must continue to rely upon the appropriate treaty for tax rate reductions in these situations. In this case, the Fifth Protocol is again of interest as it will reduce the non-resident tax rate to 7% in 2008, to 4% in 2009, and, finally, to 0% in 2010. The treaty-reduced rate on interest is otherwise typically 10%.

Income Tax

Non-Resident tax, discussed above, is applied under Part XIII of the Tax Act to passive forms of income earned in Canada by non-residents. Income from carrying on business in Canada is, however, subject to income tax under Part I of the Tax Act. It may be, for example, that the non-resident parent, or, perhaps, another member of the corporate group, will provide services to the Canadian subsidiary. In such a situation, income tax must be withheld by the Canadian subsidiary on all fees for such services at a rate of 15%.

It should be noted that, whereas non-residents are not required to file Canadian tax returns in respect of non-resident tax, they are required to file Canadian tax returns in respect of income tax. As well, whereas a treaty reduction or exemption will reduce or avoid the amount of non-resident tax to be withheld, the same is not true of income tax. Income tax must be withheld at a rate of 15% regardless of the application of any tax treaty—subject only to the non-resident obtaining a waiver from the CRA.

C. Acquisition Companies

The next point to consider in respect of the use of a subsidiary is the potential benefit of an acquisition company. In the absence of an acquisition company, the purchase price would simply be paid by the non-resident to the vendor and no tax benefit would be obtained by the purchaser (aside from a step-up in the cost base of the acquired shares or assets, as the case may be). If, however, the non-resident were to pay the amount of the purchase price to a Canadian subsidiary (which would then pay the vendor) paid-up capital would be created in the subsidiary (and the subsidiary would still obtain a step-up in the cost base of the acquired shares or assets). Thereafter, any distributions made by the subsidiary to the parent could, to the extent of the increased paid-up capital, be characterized as a tax-free distribution of capital rather than a taxable dividend or interest payment. Assuming the treaty-reduced rates under the Canada-U.S. Treaty of 5% on dividends and 7% on interest, the tax savings to the non-resident on every $1 million of purchase price paid would be $50,000 on dividends and $70,000 on interest.

D. Thin-Capitalization

Once a full tax exemption becomes available in 2010 for interest payments between non-arm's length parties, it will be tempting to characterize all investment in a subsidiary by a U.S.-resident parent as debt. Unfortunately, there is already in place a "thin capitalization rule"[4] which denies a deduction to the subsidiary for interest paid to the parent (or any other "specified non-resident") if the debt owed to parent (or other "specified non-resident") exceeds twice its equity.[5] Briefly, a "specified non-resident" is a non-resident that does not deal at arm's length with the subsidiary or that, either alone or together with other non-arm's-length persons, owns 25% or more of the subsidiary's votes or value. Given the ability of the Canadian subsidiary to deduct interest payments (and not dividends) and the availability to the non-resident parent of a full non-resident tax exemption for such payments, it is difficult to envision a scenario in which a U.S.-resident parent would not wish to maintain the maximum 2:1 debt to equity ratio.

E. Transfer Pricing

Finally, the last issue of which we need to be aware in respect of subsidiaries is the potential application of the transfer pricing rules. Since a subsidiary is not a permanent establishment, the non-resident would not be subject to Canadian income tax on fees for services performed in Canada (although withholding and filing obligations discussed above would still apply). Consequently, a non-resident parent could extract profits from a Canadian subsidiary on a tax-free basis by characterizing such amounts as fees for services. The same result could be obtained through the sale of goods to a subsidiary. In order to prevent such abuses, the CRA applies transfer pricing rules to amounts charged for goods or services passing between Canadian corporations and non-arm's-length non-residents. If the amounts charged differ from the amounts that would be charged between arm's-length parties, as determined by the CRA, subsection 247(2) of the Tax Act authorizes the CRA to adjust the taxable income of the subsidiary accordingly. While the application of these rules is beyond the scope of this paper and is more properly the domain of economists, lawyers should be aware that these rules exist and that their clients are required to maintain contemporaneous documentation that identifies and supports amounts paid to or received from related non-residents as consideration for goods or services.

III. Limited Partnerships

The third and final structure to be discussed on the Canadian side of the border is the limited partnership. The fundamental point is that the taxation of partnerships reflects the fact that they are not legal entities. While tax practitioners often speak somewhat loosely of partnerships as though they were independent entities, it is important to remember that they exist only as contractual relationships among the partners. This is true of limited partnerships as well as general partnerships, notwithstanding that Ontario's Limited Partnerships Act purports to "form" a limited partnership rather than to simply confer limited liability upon an existing partnership.[6] Broadly speaking, then, if a non-resident were to organize its Canadian operations as a partnership, we would need to look through the partnership and consider all of the foregoing issues in respect of each partner. However, since such a system poses administrative difficulties, the Tax Act does contain certain rules of which we should be aware in respect of: (i) non-resident tax on payments to a partnership; and, (ii) income tax applicable to capital gains realized upon the disposition of taxable Canadian property held by a partnership.

A. Non-Resident Tax

Paragraph 212(13.1)(b) of the Tax Act deems any amount paid or credited by a person resident in Canada to a partnership other than a "Canadian partnership" to be paid to a non-resident person. "Canadian Partnership" is defined in subsection 102(1) of the Tax Act to mean a partnership all of the members of which are resident in Canada. This relieves the CRA of the administrative burden of determining the residence status of each partner and the portion of each payment allocable to any non-resident partners. Instead, if even just one partner is a non-resident, Canadian resident payors must withhold non-resident tax on dividends, interest, rents, royalties, management fees, and so forth paid or credited to the partnership.

Left on its own, the effect of this rule would be draconian given that non-resident tax is not a withholding tax per se but is a tax in and of itself and is therefore non-refundable. We therefore have a further rule according to which a partnership is to be ignored for the purpose of applying the tax treaties. In conjunction with paragraph 212(13.1)(b), this shifts the burden of determining the residence of each partner and its share of partnership income from the CRA to the taxpayers. If tax treaty benefits are to be claimed, the residence of each partner must be separately determined as of the time of each payment and the tax reduction or exemption under the relevant tax treaty must be separately applied to each partner. Canadian-resident partners are then entitled to claim a credit for the amount of such tax attributable to them.[7]

The situation is further complicated by the CRA's current administrative position that a given partner does not own a particular percentage of the partnership's assets and, consequently, that the treaty-reduced rate of 15% applicable to dividends may be available to partners but never the lower rate of 5% otherwise available to corporations that own 10% or more of the voting stock. Fortunately, this situation will be rectified as of January 1, 2010 in respect of U.S. residents at which time the Fifth Protocol provides that a U.S.-resident corporation will be considered to own shares in proportion to its partnership interest such that the lower rate may be available.

B. Income Tax

If Canadian operations are to be structured as a partnership, it is important to consider that the permanent establishment of one partner is considered to be the permanent establishment of every partner. This rule applies to both general and limited partners. Every partner will, therefore, be subject to Canadian income tax on its share of the partnership income as though that partner were carrying on business in Canada directly through a permanent establishment.

C. Tax Clearance Certificates

For the purpose of determining whether a tax clearance certificate is required under section 116 of the Tax Act in respect of the disposition of taxable Canadian property, the partnership is generally ignored. Only non-resident partners are required to obtain tax clearance certificates while Canadian-resident partners may rely upon their own Canadian-resident status.

The difficulty arises in that a purchaser of taxable Canadian property is liable to pay tax in an amount equal to 25% of the purchase price if a tax clearance certificate is not obtained in accordance with section 116. If, therefore, even just one limited partner were a non-resident of Canada and the limited partnership were to sell taxable Canadian property, the purchaser would be liable to pay tax in an amount equal to 25% of the non-resident partner's interest in the purchase price. It is to be expected, then, that the agreement of purchase and sale would require the partnership—or, more properly, the general partner on behalf of the partnership—to either represent and warrant that all partners are Canadian residents or to provide tax clearance certificates for all non-resident partners.

The difficulty of obtaining tax clearance certificates from any number of non-resident investors is largely relieved by administrative concession. The CRA's position as stated in paragraph 10 of Information Circular 72-17R5 is that a single application may be made on behalf of all non-resident partners provided that the application includes a complete listing of the non-resident partners together with their Canadian and foreign addresses, identification numbers, percentage ownership and their portion of the tax payment or security therefor.[8] Separate tax clearance certificates are then issued for each partner and each partner must file its own Canadian income tax return to report the gain or loss.

Although the 2008 Federal Budget purports to relieve taxpayers of the administrative burden of obtaining these tax clearance certificates, arguably, such changes provide little relief. Under the current draft of the proposed amendments to the Tax Act, a purchaser is only relieved from its withholding obligation if, inter alia, (i) it concludes after "reasonable inquiry" that the vendor is resident in a given treaty country and (ii) the property in question would be protected under the particular treaty. In view of these obligations upon the purchaser, it appears likely that arm's-length purchasers will continue to require vendors to provide tax clearance certificates. This subject is discussed at greater length by my colleagues.

In summary, then, the use of a partnership can be overly cumbersome from a tax perspective. Moreover, there is no Canadian tax benefit to using one such that its use must be motivated by other business considerations.

IV. Conclusion

In view of the foregoing tax considerations, it is critical when advising a non-resident regarding the acquisition of a Canadian business that legal counsel consider the long-term tax position, both in Canada and abroad, of the target business, the non-resident acquiror and the larger corporate group as a whole. The tax consequences of the various available structures will undoubtedly vary significantly.

Patrick Westaway is an associate in the Tax Group at Lang Michener LLP