In the current economic context, Canada has, so far, come through the recession relatively unscathed. This may tempt U.S.-based enterprises to consider future expansion in Canada. Before implementing any such expansion plans, they should consider some key Canadian tax implications, to avoid potentially costly missteps.
To Incorporate or Not to Incorporate?
One of the first legal considerations faced by U.S. businesses expanding into Canada is whether to do so through an unincorporated branch or a separate legal entity. While the prospects of allowing the flow-through of initial operating losses to the U.S. business might militate in favor of initially setting up a branch operation, a similar outcome may be achieved through the use of a separate legal entity disregarded for U.S. federal income tax purposes, as noted below. Most set-up and maintenance costs, including sales and payroll tax registrations, annual filings with corporate registries, filing of Canadian income tax returns, and preparation of separate financial statements for the Canadian operations, will be incurred irrespective of whether the Canadian business activities are separately incorporated or operated as a branch.
In practice, to the extent such activities are expected to give rise to a taxable presence in Canada, the vast majority of U.S. businesses choose to carry on business in Canada through a Canadian corporation citing, among others, the following reasons:
Having a separate legal entity to house the Canadian operations allows the Canadian entity and its U.S. parent to more clearly delineate their respective business functions, as well as the risks each assumes. Having a separate subsidiary affords a U.S. parent the opportunity to have agreements between the U.S. parent and the Canadian subsidiary to provide support for any intended allocation of profits between the Canadian and the U.S. operations (subject to applicable transfer pricing rules);
Having a Canadian subsidiary isolates Canadian tax filing obligations and can generally reduce the extent of the Canadian tax authorities’ future enquiries into the U.S. parent’s business operations;
To the extent that the Canadian corporate entity is not an unlimited liability company, it affords limited liability to the U.S. parent for risks arising from Canadian business activities; and
Where all or any part of the revenues generated by the Canadian operations arise from services rendered physically in Canada, having a separate Canadian subsidiary will prevent the potential application of withholding at source under Canadian federal and provincial income tax regulations.
Withholding Tax on Services Fees
Canadian federal tax regulations provide that a 15 percent withholding must be applied on amounts paid to a non-resident for services rendered physically in Canada (and a further 9 percent withholding must be applied for services in the province of Quebec) and must be remitted to the Canadian tax authorities. This withholding at source is intended to serve as security on account of the payee’s potential Canadian income tax liability and does not represent a final tax. Any excess of the amount withheld over the ultimate Canadian income tax liability of the payee can be refunded after the end of the taxation year of the payee after filing of Canadian income tax returns.
While advance waivers (complete or partial) may be sought and obtained from the Canadian tax authorities prior to payments for services being made to the non-Canadian, a complete waiver of such withholding is generally not available if, among other circumstances, the non-Canadian carries on business in Canada through a permanent establishment, its physical presence in Canada exceeds a specified number of days or the payment is made pursuant to a multi-year contractual arrangement.
U.S. enterprises carrying on business in Canada through an unincorporated branch and providing services in Canada from that branch must consequently resort to seeking partial advance waivers so as to ensure that the withholding effected, which by default would be applied on gross service payments made, will approximate the ultimate tax liability of the recipient. Such partial waivers, also referred to as “income and expense waivers,” will allow an offset against the Canadian service income of certain expenses, other than depreciation and amortization, incurred by the U.S. business in relation to such service income. Graduated rates (similar to those used for residents) will be applied on the resulting “net” Canadian service income.
This withholding regime is, typically, an incentive for U.S. businesses deriving significant revenues from services to incorporate a Canadian subsidiary to carry on business in Canada. While advance waivers may be considered in situations where the p
