Canadian Subsidiary Corporation
A subsidiary incorporated in Canada will be considered to be a Canadian resident for income tax purposes. It will be subject to Canadian income tax on its income earned anywhere in the world from any source, subject to a credit for foreign taxes paid on non-Canadian income.
The income of the Canadian subsidiary that will be subject to Canadian income tax is generally calculated in accordance with generally accepted accounting principles. There are, however, certain inclusions and deductions which are specifically required or disallowed. The Canadian tax rules treat capital gains more favourably than ordinary business or trading income. Under the current provisions of the Income Tax Act (Canada), taxable income includes one-half of realized capital gains net of capital losses. A net capital loss of a given year can, subject to certain restrictions, be used to offset the capital gain of another year. Business losses incurred by a subsidiary in a year may, subject to certain restrictions, be used to reduce taxable income in other years.
Where a corporation carries on business through a permanent establishment in a province, the rate of federal tax imposed on a corporation’s taxable income (including surtax) is 18%.
In addition, the subsidiary generally will be subject to provincial income taxes on income earned in each province in which it carries on business through a permanent establishment. The rate of provincial tax varies among the provinces from 10% to 16% (10.5% in British Columbia, 10% in Alberta, 13% in Ontario and 11.9% in Quebec). Certain of the provinces provide lower tax rates for companies which qualify for the federal small business deduction. In general, the taxable income on which provincial tax is imposed resembles the taxable income computed for federal purposes, but special rules in provincial corporate income tax legislation can result in a different measure of taxable income in certain circumstances.
There are reductions and exemptions available to corporations based on total assets and total gross revenue. Taxable paid-up capital generally includes the subsidiary’s paid-up capital for corporate purposes and most forms of surplus, reserves and indebtedness of the subsidiary. It generally excludes over-valued goodwill, and debt and equity investments in other corporations.
Provincial capital tax is also imposed annually on corporations subject to income tax in the provinces of Manitoba, Nova Scotia, Ontario and Quebec. The capital tax is based on the taxable paid-up capital of the corporation. In British Columbia, only banks, trust companies and credit unions are subject to the provincial capital tax. In Quebec, capital tax is levied at the rate of 0.36% of taxable paid-up capital for corporations other than a bank savings and credit union, a loan corporation, a trust corporation or a corporation trading in securities, although certain types of companies are exempt from this tax. This rate will be reduced to 0.24% in 2009, 0.12% in 2010 and 0% in 2011.
In Ontario, as of January 1, 2010, capital tax is levied at the rate of 0.074% of taxable paid-up capital (there is an exemption for a corporation’s first $15,000,000 of net paid-up capital). The Ontario Government has announced that the capital tax rate will be reduced yearly and will be fully eliminated by July 1, 2010. The government also retroactively eliminated the capital tax for Ontario companies primarily engaged in manufacturing and resource activities, effective January 1, 2007. The 2007 capital tax elimination applies to a qualifying corporation or successor corporation whose employees reported to a permanent establishment in Ontario on March 25, 2008.
The fact that a foreign business enterprise has a Canadian subsidiary carrying on business in Canada, will generally not subject the foreign entity itself to Canadian income tax. For that reason, a Canadian subsidiary can be useful when a partnership or joint venture is to be entered into with a Canadian participant. (See also the discussion below under the subheading “Joint Ventures and Partnerships”.) However, after-tax profits of the Canadian subsidiary distributed to the non-resident parent organization by way of dividend will be subject to Canadian withholding tax. The withholding tax rate is reduced to 10% or 15% under most of Canada’s tax treaties. In addition, the Canada-U.S. Treaty, and other treaties, provide that the rate will be further reduced in certain circumstances to 5%.
Particular consideration should be given to loan transactions between the Canadian subsidiary and its foreign parent, and to interest charged in respect of such loans. Under the current “thin capitalization rule”, a portion of any interest which the Canadian subsidiary might pay to its foreign parent on amounts owing by it to the parent, may be disallowed as a deduction in computing the subsidiary’s income. In general terms, if the ratio of the debt (owing to the parent or other non-resident affiliate) to the equity (paid-up capital, surplus and retained earnings) of the Canadian subsidiary does not exceed two-to-one, no amount of interest expense will be disallowed. On the other hand, if the debt to equity ratio exceeds two-to-one, the interest on the excess debt will be disallowed. The subsidiary could borrow from Canadian lending institutions without offending the thin capitalization rule.
Because the profits of a Canadian subsidiary or branch can be affected by the cost at which it buys from or sells to related parties, the Income Tax Act (Canada) provides detailed rules governing the accounting of such transactions for tax purposes. In general, transactions between non- arm’s length persons (such as a parent and its wholly-owned subsidiary) are deemed to take place at fair market value, without regard to what is in fact paid. For instance, if a parent sells goods or provides services to its subsidiary at more than the fair market value of the goods or services, or if the subsidiary sells goods or provides services to its parent at less than fair market value, the subsidiary is deemed to have paid or received fair market value for income tax purposes.
The rules relating to Canada’s transfer pricing regime conform with the OECD’s (Organization for Economic Co-operation and Development) arm’s length principle, which, in general, requires that each transaction between parties that are not dealing at arm’s length be carried out under terms and conditions that one would have expected, had the parties been dealing with each other at arm’s length. Pursuant to this principle, requirements in the Income Tax Act (Canada) obligate taxpayers who are parties to such non-arm’s length transactions, to contemporaneously document their transfer pricing transactions and the steps taken to ensure that the terms and conditions of such transactions satisfy the arm’s length principle. A penalty will be imposed for failure to comply with the arm’s length principle.
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