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In Canada, income tax is levied by both the federal and provincial governments. The combined rate of corporate income tax levied on business income ranges from 17.5% to 31% depending upon the province in which the business is carried on.
Canadian resident corporations are taxable on their worldwide income from every source. Foreign corporations doing business in Canada (a “branch”) are subject to Canadian income tax on the income derived from Canada.
A Canadian-controlled private corporation (CCPC) may receive preferential tax treatment, including reduced tax rates on a specified amount of its active business income. Special tax planning is required if a non-resident wishes to carry on business in Canada through a CCPC.
Carrying on business in Canada will be considered to occur at even relatively low levels of activity. Soliciting offers for sale of goods or services in Canada whether or not the contract is completed in Canada will be considered carrying on business in Canada.
Notwithstanding the fact that a Japanese entity is carrying on business in Canada it will not, by virtue of the Canada-Japan Tax Treaty (the “Treaty”), be subject to Canadian income tax unless it is carrying on the business through a permanent establishment (“PE”) located in Canada. Article 5 of the Treaty addresses what should and should not be considered a PE. It is vitally important that a Japanese entity understands these provisions as small changes to the way it operates in Canada may determine whether or not it is subject to Canadian income tax on any profits attributable to its Canadian operations.
A number of issues should be analyzed in choosing whether to carry on business through a branch or a subsidiary. If the Canadian operation is expected to incur significant losses in its early years of operation, the Japanese entity may wish to carry on business in Canada directly through a branch, in order for the Japanese company to deduct these losses for Japanese tax purposes. However, because a branch office is not a legally distinct entity from the Japanese head office, the Japanese company will be exposed to the debts, liabilities and obligations of the Canadian operations. For this reason, many foreign businesses prefer to carry on business in Canada through a Canadian subsidiary. The use of a Canadian subsidiary is also more convenient for administrative purposes.
In addition to corporate income taxes, a non-resident corporation carrying on business in Canada through a Canadian branch operation is also subject to a branch tax (to replace dividend withholding taxes that would be paid by a subsidiary on repatriation of earnings).
The Income Tax Act of Canada (”ITA”) generally provides that branch tax is levied on the after-tax Canadian earnings of the business carried on in Canada less any amounts that are reinvested in the Canadian business.
The Treaty exempts the first $500,000 of branch profits and sets the branch tax at 5%.
Care must be taken to ensure proper capitalization of a Canadian subsidiary to avoid the tax effect of Canada’s thin-capitalization rules. As well, attention must be paid to ensure the international corporate structure does not offend other tax legislation designed to avoid erosion of the Canadian tax base. Issues such as share structure, intercompany debt, transfer pricing and foreign reporting obligations must also be considered.
In addition, the ITA imposes a 25% withholding tax on the gross amount of certain payments made by a Canadian corporation to a non-resident, including management fees, related party interest, dividends, rents and royalties. The withholding tax rate can be reduced under the Treaty for certain payments; e.g. Interest 10%, dividends 5% or 15% depending on shareholdings, royalties 10%.
Payments made to non-residents for services provided in Canada may also be subject to Canadian withholding taxes. The responsibility to withhold applies to both resident or non-resident payors. Therefore, it will not matter whether a Japanese company carries on business through a Canadian subsidiary or branch; if payments are made to non-residents for work done in Canada it has a withholding responsibility. Failure to comply may result in the payor being liable for the taxes and penalties.
The Canada - Japan Tax Treaty (the “Treaty”) provides for significantly lower rates of withholding and exemptions for many types of payments.
Whether operating through a branch or a subsidiary, the business is required to maintain books and records in Canada or otherwise be made available to the case of audit by the Canada Revenue Agency. Corporate tax returns must be filed within six months of the fiscal year end to avoid late-filing penalties. The balance of tax, if any, is due to be paid within 2 months after the fiscal year end. The corporate tax rate is the same for a branch as for a foreign-controlled corporation. The combined federal and provincial tax rate will depend on the province in which the company carries on business, but as an example, is 26% in BC.
Finally, even if its branch operation is exempt from tax in Canada, under the treaty, a Japanese company must file a corporate tax return claiming the treaty exemption within six months of their year-end, or will be subject to penalties.
Manning Elliott has significant experience dealing with Japanese companies investing in BC and we would be pleased to assist and advise regarding such investments.
For further information about this post, please contact Don Nishio, CPA, CA, leader of Manning Elliott's Japanese Business Specialty Group or Norm MacKay, CPA, CA member of the Manning Elliott Tax Team, at 604-714-3600.
The above content is believed to be accurate as of the date of posting. Canadian Tax laws are complex and are subject to frequent changes. Professional tax advice should be sought before implementing any tax planning. Manning Elliott LLP cannot accept any liability for the tax consequences that may result from acting based on the information contained therein.