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Income tax issues for doing business in Canada
In Canada, income tax is levied by provincial governments as well as the federal government. The combined rate of corporate income tax imposed on business income ranges from 17.5 per cent to 31 per cent, depending on the province.
Canada-based corporations are subject to taxation on their worldwide income from all sources. Meanwhile, foreign companies with a branch carrying on business in Canada are subject to local income tax on the income derived in Canada.
Carrying on business in Canada includes relatively low levels of activity. Soliciting offers for the sale of goods or services in Canada — whether or not a contract is there — will be considered to be carrying on business in Canada.
That said, according to the Canada– Japan Tax Treaty, a Japanese entity carrying on business in Canada will not be subject to Canadian income tax unless it is carrying on business through a permanent establishment (PE) located in Canada. Article 5 of the treaty defines a PE.
It is vital that Japanese entities understand the treaty provisions, since small changes in their Canada operations may affect whether they are subject to Canadian income tax on profits from Canadian operations.
A number of issues should be analyzed when choosing whether to carry on business through a branch or a subsidiary. If a 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, to enable the Japanese company to deduct the losses for Japanese tax purposes.
Yet it should be noted that, because a branch office does not exist as a separate legal 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.
In addition to corporate income taxes, a non-resident corporation carrying on business through a Canadian branch operation is subject to branch tax. That replaces dividend withholding taxes, which would be paid by a subsidiary on the repatriation of earnings.
The Income Tax Act of Canada (ITA) generally provides that the branch tax be levied on the after-tax Canadian earnings of business carried on in Canada, minus any amounts reinvested in the Canadian business.
The tax treaty exempts the first C$500,000 of branch profits and sets the branch tax at 5 per cent.
Care must be taken to ensure proper capitalization of a Canadian subsidiary to avoid the tax effect of Canada’s thin capitalization rules. It is also important 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.
The ITA imposes a 25 per cent 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, such as 10 per cent on interest, 5 per cent on dividends or 15 per cent depending on shareholdings, and 10 per cent on royalties.
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 and 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, the subsidiary or branch has a withholding responsibility. Failure to comply may result in the payor being liable for the taxes and penalties.
Whether operating through a branch or a subsidiary, a business is required to maintain books and records in Canada.
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 for payment within two months after the fiscal year ends.
The corporate tax rate is the same for a branch as for a foreign-controlled corporation, while the combined federal and provincial tax rate depends on the province in which the company carries on business.
Finally, even if its branch operation is exempt from tax in Canada under the tax treaty, a Japanese company must file a corporate tax return claiming the treaty exemption within six months of the Canadian fiscal year end, or it will be subject to penalties.
