The Advisory Panel on Canada's System of International Taxation released its Final Report: Enhancing Canada's International Tax Advantage1 on December 10, 2008. The Panel had been appointed by the Federal Minister of Finance in November 2007 to consider ways to improve the fairness and competitiveness of Canada's system of international taxation, with a particular emphasis on how these rules affect both Canadian businesses investing abroad and foreign businesses investing in Canada.
In the Final Report, the Panel makes seventeen recommendations to improve aspects of Canada's international tax system. In response to the Final Report, the Government in its 2009 Federal Budget announced several positive tax changes in the outbound taxation area. The most notable is the repeal of Section 18.2 of the Income Tax Act (Canada) (Act), which otherwise was to apply after 2011 to limit or deny the deduction of interest and other amounts paid by a Canadian taxpayer where such amounts are incurred in respect of certain 'double-dip' financing structures. Aside from these specific announcements, the Government indicated that it was studying the other recommendations in the Final Report and would provide a response for consultation in due course.
This article provides a summary of the recommendations made by the Panel in the Final Report.
Background to the Establishment of the Panel
On November 23, 2006, the Minister of Finance released Advantage Canada: Building a Strong Economy for Canadians,2 a national long-term economic plan with the goal of making Canada a world economic leader. Advantage Canada seeks to build on Canada's strengths and gain a global competitive advantage in the following five areas:
- Tax Advantage – Reducing taxes for all Canadians and establishing the lowest tax rate on new business investment in the G7.
- Fiscal Advantage – Eliminating Canada's total government net debt in less than a generation.
- Entrepreneurial Advantage – Reducing unnecessary regulation and red tape and increasing competition in the Canadian marketplace.
- Knowledge Advantage – Creating the best-educated, most skilled and most flexible workforce in the world.
- Infrastructure Advantage – Building the modern infrastructure Canada needs.
On the business side, Advantage Canada proposes to "... lower business taxes, reduce regulatory and administrative burdens, enhance competition, ensure our capital markets are globally competitive and encourage free trade and foreign investment."3 More specifically, the Government indicated that the competitiveness of Canada's business tax system could be improved by lowering the income tax rates and making the structure of the tax system simpler and fairer.
The March 19, 2007 Federal Budget implemented major elements of Advantage Canada, including measures to reduce personal and business income taxes. In addition, the 2007 Federal Budget proposed an International Tax Fairness Initiative to update and improve Canada's international income tax system by: (1) eliminating the deductibility of interest paid on debt incurred by corporations to finance foreign affiliates;4 (2) enhancing Canada's ability to collect tax information from other jurisdictions, through revised tax treaties and tax information exchange agreements (TIEAs) with non-treaty countries; (3) extending the current exemption system for foreign-source active business income, which is currently limited to income earned in countries with which Canada has a tax treaty, to also include income earned in a non-treaty jurisdiction that has signed a TIEA with Canada; and (4) providing additional funding for auditing and enforcement by the Canada Revenue Agency (CRA) in relation to foreign income and cross-border transactions.5
As part of the International Tax Fairness Initiative, the 2007 Federal Budget also announced that the Minister of Finance would create an advisory panel of tax experts to undertake further study and consultations, with a view to identifying additional measures to improve the fairness of Canada's system of international taxation. The Panel, chaired by Peter Godsoe, was formed on November 30, 2007 to consider ways to improve the fairness and competitiveness of Canada's system of international taxation.
Overview of the Final Report
The Panel was formed for the purpose of: (1) improving the fairness, economic efficiency and competitiveness of Canada's system of international taxation, as outlined in Advantage Canada; (2) minimizing compliance costs for businesses and facilitating administration and enforcement by the CRA; and (3) developing practical and readily applicable changes, taking into account existing rules and tax treaties as well as fiscal implications.6 The Panel released a Consultation Paper7 on April 25, 2008, and invited interested parties to make submissions.
On December 10, 2008, the Panel released its Final Report, which provides the results of its review of Canada's international tax system. Undertaken with the goal of supporting Advantage Canada, the Panel's review focused on how the international rules affect both Canadian businesses investing in foreign markets and foreign businesses investing in Canada. The Panel set out six guiding principles that it believed should be used in establishing Canada's international tax policy:
- Canada's international tax system for Canadian business investment abroad should be competitive when compared with the tax systems of its major trading partners.
- Canada's international tax system should seek to treat foreign investors much as it treats domestic investors, while ensuring that Canadian-source income is properly measured and taxed.
- Canada's international tax system should include appropriate safeguards to protect the Canadian tax base.
- Canada's international tax rules should be straightforward to understand, comply with, administer and enforce, to the benefit of both taxpayers and the CRA.
- Full consultation should precede any significant change to Canada's international tax system.
- Canada's international tax system should be benchmarked regularly against the tax systems of its major trading partners.
Overall, the Panel is of the view that Canada's international tax system is a "good one," such that rather than seeking to reform it, the Panel makes seventeen recommendations to improve it. The Panel notes that its recommendations were developed with reference to the six guiding principles and that two key directives emerged from applying these principles: (1) the Government should maintain the existing system for the taxation of foreign-source income of Canadian companies and extend the existing exemption system to all active business income earned outside of Canada by foreign affiliates; and (2) the Government should maintain the existing system for the taxation of inbound investment and adopt targeted measures to ensure that Canadian-source income is properly measured and taxed.
The Panel's recommendations are divided into four topics, including the taxation of outbound direct investment, the taxation of inbound direct investment, non-resident withholding taxes and administration, compliance and legislative process. Each topic is discussed in more detail below.
Taxation of Outbound Direct Investment
The Panel is of the view that outbound direct investment can result in significant economic benefits for Canadians and that these benefits underlie the principle that Canada's outbound taxation rules should be competitive when compared to those of Canada's major trading partners. The Panel believes that the competitiveness of Canada's outbound tax system can be improved by broadening the current exemption system and that other changes are required to update the system and to maintain the integrity of the tax base once a broader exemption system is adopted.
One of the most significant recommendations in the Final Report relates to the taxation of dividends received by a Canadian-resident corporation from a foreign affiliate and sourced from active business income. Under current rules, active business income earned by a foreign affiliate is generally not taxable in Canada until such time as the income is repatriated as a dividend,8 and the tax treatment of such dividends depends on the jurisdiction where the affiliate is resident and carries on business. More specifically, if a foreign affiliate is resident and carries on business in a country with which Canada has a tax treaty or a TIEA, active business income gives rise to "exempt surplus," and dividends paid out of exempt surplus to a Canadian corporation are exempt from Canadian tax. If, however, a foreign affiliate is not resident or does not carry on business in a treaty or TIEA country, active business income gives rise to "taxable surplus" and dividends paid out of taxable surplus to a Canadian corporation are taxable in Canada, with relief provided for any underlying foreign income and withholding tax payments related to the income.
The Panel recommends broadening the existing exemption system so that all dividends paid by a foreign affiliate to a Canadian corporation from active business income are exempt from Canadian tax (Recommendation 4.1). The Panel made this recommendation for the following reasons: (1) it would eliminate the need to track foreign active business earnings and compute exempt and taxable surplus balances, thereby reducing the compliance burden for taxpayers and the administrative burden of the CRA; (2) based on evidence gathered by the Panel that dividends are rarely taxed under current rules, it should be revenue neutral to the Government; (3) it could facilitate the repatriation of foreign profits, generating economic benefits for Canadians; (4) taxing active business income only at its source is consistent with the tax policies of most other industrialized nations; and (5) concerns that doing so would result in a migration of jobs or investments from Canada are not well-founded. The Panel is of the view that certain passive income earned by foreign affiliates should continue to be taxed currently under Canada's anti-deferral regimes.
The Panel proposes three other recommendations as a consequence of Recommendation 4.1. The first recommendation relates to the use of TIEAs. Under current rules, and as described above, active business income earned by a foreign affiliate in a TIEA country is fully exempt from Canadian tax; however, if Canada does not enter into a TIEA with a country within five years following the initiation of negotiations for the TIEA, the active business income will be treated as FAPI. Since Recommendation 4.1 has the effect of "de-linking" the exemption system from tax treaties and TIEAs, the Panel also recommends that the Government pursue TIEAs on a government-by-government basis without resort to accrual taxation for foreign active business income if a TIEA is not obtained (Recommendation 4.2). In the Panel's view, it is unfair to preclude businesses from benefiting from the simplicity and other gains of a broader exemption system because a country chooses not to negotiate a TIEA with Canada.
The second recommendation emanating from Recommendation 4.1 relates to the taxation of capital gains on the disposition of shares of a foreign affiliate. Currently, a Canadian resident is subject to tax on 50 per cent of a capital gain realized on the disposition of shares of a foreign affiliate. The tax treatment of a capital gain realized by a foreign affiliate on the disposition of shares of a second affiliate turns on whether these shares constitute "excluded property."9 If the shares are not excluded property, 50 per cent of the capital gain realized by the disposing affiliate will give rise to FAPI. If the shares are excluded property, the capital gain realized by the disposing affiliate is generally not subject to accrual taxation, and 50 per cent of the capital gain will give rise to exempt surplus and 50 per cent of the capital gain will give rise to taxable surplus. Consequently, even if the capital gain relates to active business assets, 50 per cent of such capital gain will be subject to Canadian tax when this income is repatriated to Canada as a taxable surplus dividend, with relief provided for foreign taxes.
In benchmarking research, the Panel found that most countries that exempt active business income earned by a foreign affiliate from domestic tax also exempt capital gains realized on a disposition of the shares of the foreign affiliate. As a result, the Panel recommends extending the exemption system to capital gains and losses realized by both Canadian shareholders and foreign affiliates on the disposition of shares of a foreign affiliate where the shares constitute excluded property (Recommendation 4.3). With respect to gains realized on the disposition of shares of a foreign affiliate that are not excluded property, the Panel is of the view that these gains should remain taxable, but that the Government should consider adopting an approach of taxing only the pro rata share of the gain that relates to non-excluded property.
The third recommendation stemming from Recommendation 4.1 relates to the status of a foreign corporation as a "foreign affiliate," which is currently defined as a non-resident corporation in which the Canadian taxpayer owns, either alone or with related persons, at least a 10 per cent direct or indirect interest in any class of shares. Given that the broader exemption system proposed in Recommendations 4.1 and 4.3. is available only in respect of foreign affiliates, the Panel recommends that the Government review the "foreign affiliate" definition to take into account the Panel's other recommendations on outbound taxation, the approaches adopted by other countries, and the impact of any changes on existing investments (Recommendation 4.4). Revisions to the foreign affiliate definition would impact a corporation's status as a controlled foreign affiliate, as the latter is defined as a foreign affiliate that is controlled by the taxpayer, as determined by reference to shares owned by the taxpayer and certain other persons. If the threshold for foreign affiliate (and thus controlled foreign affiliate) status were tightened, it could give rise to opportunities to inappropriately avoid FAPI imputation, which is required only where such income is earned by a controlled foreign affiliate. The Panel is of the view, however, that current specific and general anti-avoidance rules in the Act should be sufficient to deter these opportunities. As a final point, the Panel recommends that the Government consider extending the foreign affiliate definition to include any form of non-resident entity, and not just corporations.
Recommendations 4.1 to 4.4 focus on foreign active business earned through foreign affiliates. Where a Canadian corporation earns active business income through a foreign branch, this income is subject to Canadian tax on a current basis, with a foreign tax credit available for any foreign tax paid on the income. The Panel is of the view that even though there is no reason to tax foreign-source active business income earned through a branch differently from such income earned through a foreign affiliate, the practical difficulties of doing so outweigh the benefit of uniform treatment largely because this proposal would require new rules to tax FAPI of the branch on an accrual basis.
As described above, the Panel is of the view that while it is appropriate to exempt active business income earned by foreign affiliates from Canadian tax, passive income earned by foreign entities should be taxed currently under Canada's anti-deferral regimes. Canada currently has three anti-deferral regimes: (1) the FAPI regime; (2) the proposed foreign investment entity (FIE) regime; and (3) the proposed non-resident trust (NRT) regime. In the course of consultations, the Panel heard concerns regarding the complexity of the FIE and NRT regimes and the fact that aspects of these regimes overreach or overlap. In addition, the consultations revealed that despite some problems, the FAPI regime is well-understood and -accepted. Consequently, and especially in light of the recommendation to adopt a broader exemption system, the Panel recommends that the Government review and undertake consultations on how to reduce overlap and complexity in the anti-deferral regimes, while ensuring that all passive income is taxed in Canada on a current basis (Recommendation 4.5). The Panel notes that a solution must be found for taxing the FAPI of a non-controlled foreign affiliate, and seems to favour expanding the FAPI regime to accomplish this over doing so under the FIE regime.
The Panel also considered the scope of the FAPI regime, including the base erosion rules and the "investment business" definition. Various submissions were made to the effect that these rules are too broad, they inappropriately subject legitimate business activities to the FAPI regime in certain cases, and they are unnecessary in light of Canada's transfer-pricing rules.10 The Panel is of the view that these rules complement the transfer-pricing rules, but in response to the concerns raised, the Panel recommends that the scope of these rules be reviewed to ensure that they are properly targeted and that they do not impede bone fide business transactions and the competitiveness of Canadian businesses (Recommendation 4.6). In particular, the Panel believes that the base erosion rules targeting income derived from Canadian debt obligations, Canadian leasing activities and the insurance of Canadian risks are appropriate and should be retained. The Panel submits that if the FAPI regime is extended to non-controlled foreign affiliates, the Government should consider the extent to which the base erosion rules and investment business definition would apply differently to non-controlled foreign affiliates.
The Panel canvassed three other aspects of the FAPI regime and urged the Government to consider the following proposals: (1) retain the "inter-affiliate payment exception," which applies to deem passive income received by one foreign affiliate from another affiliate to be active business income if the amount is deductible by the paying affiliate in computing its active business income (among other conditions); (2) exempt passive income from accrual taxation if the income is subject to a certain level of foreign tax or if the income is earned in a particular designated jurisdiction; and (3) increase the current de minimus exception from FAPI imputation, which provides that a Canadian shareholder of a controlled foreign affiliate that earns up to $5,000 of FAPI is not subject to Canadian tax on an accrual basis.
The last topic considered by the Panel in the outbound area is the tax treatment of expenses incurred to earn foreign-source income. Historically, and largely for competitive reasons, Canadian taxpayers have been able to deduct interest on money borrowed to invest or acquire shares in a foreign affiliate, even though dividends received on such shares may be exempt from Canadian tax. Notably, however, for periods that begin after 2011, new Section 18.2 of the Act will apply to limit or deny the deduction of interest and other amounts paid by a Canadian taxpayer where such amounts are incurred in respect of certain 'double-dip' financing structures. Other business expenses incurred by a Canadian shareholder are generally deductible to the extent that they are incurred to earn or maintain income and there are no tracing or allocation rules to determine if these expenses relate to dividends of a foreign affiliate that may be exempt from Canadian tax. For expenses such as 'head office' expenses and other costs related to services provided for the corporate group's benefit, the Canadian payer will typically on-charge the expenses to members of the group that benefitted from the services or enter into cost-sharing arrangements, which, in either case, must comply with Canada's transfer-pricing rules.
In considering interest deductibility, the Panel focused on the treatment adopted in other countries, particularly in the context of outbound financing arrangements. The Panel noted that for the most part, other countries permit the deduction of interest on borrowed money used to finance or acquire foreign affiliates. With respect to outbound financing arrangements, some countries do not have targeted rules to restrict the deductibility of interest and, although both the United States and the United Kingdom have domestic legislation in this area, these structures can nonetheless still be utilized in these jurisdictions in certain cases. As another example, the Panel noted that notwithstanding recent treaty developments (including amendments to the Canada - US Income Tax Convention (Treaty)) aimed at denying the benefits of certain cross-border financing arrangements, these arrangements still remain possible in certain circumstances. In summary, benchmarking research clearly showed that other countries have not eliminated the use of tax-efficient outbound financing arrangements. In light of the current global financing environment and the approach adopted in many other countries, the Panel recommends that no additional rules be imposed to restrict the deductibility of interest expense of Canadian corporations where the borrowed funds are used to invest in foreign affiliates, and further recommends that Section 18.2 of the Act be repealed (Recommendation 4.7). With respect to expenses other than interest, the Panel is of the view that Canada's current treatment of these expenses works reasonably well and sees no need for additional rules.11
The 2009 Federal Budget was delivered by the Minister of Finance on January 27, 2009. Although the Government indicated that it was still studying many aspects of the Final Report, it did respond to three matters raised in the outbound tax area. A welcome announcement in the 2009 Federal Budget was the proposal to repeal Section 18.2 as recommended by the Panel, which has since been incorporated into Bill C-10 Budget Implementation Act, 2009. The 2009 Federal Budget also states that the Government will review the existing FIE and NRT proposals in light of the Panel's recommendations and other submissions before proceeding with measures in this area. The Budget further provides that the Government will consider the Panel's recommendations relating to foreign affiliates before proceeding with the remaining February 2004 proposals, as modified to take into account comments received to date.
Taxation of Inbound Direct Investment
The Panel is of the view that inbound direct investment is important to Canada's prosperity given its traditional status as a net importer of capital. In reviewing Canada's system for taxing foreign inbound investment, the Panel was guided by the principle that foreign investors should be treated much as domestic investors are treated — while at the same time ensuring that foreign companies investing in Canada pay an appropriate amount of Canadian tax on their Canadian-source income.
With regard to the taxation of foreign businesses investing in Canada, the Panel's principal focus was the tax treatment of interest expense incurred by foreign-owned Canadian businesses and, in particular, a review of Canada's existing thin-capitalization rules.
Foreign businesses investing in Canada typically have the flexibility to choose between debt and equity in financing their Canadian subsidiaries. Using related-party debt rather than equity allows a foreign business to reduce its overall tax burden to the extent that the interest paid by the Canadian subsidiary is deductible in Canada at a higher tax rate than the rate at which the interest is taxed in the related lender's home country. In certain cases, through proper structuring, it is possible to defer, or even eliminate, any income inclusion in the related lender's home country. Even when the related lender is liable for Canadian interest withholding tax, the withholding tax is generally lower than the value of the tax deduction for the Canadian subsidiary.
Absent any restrictions, a foreign business could leverage its Canadian subsidiary with debt, thereby significantly reducing the amount of tax the subsidiary would otherwise pay in Canada. To address this issue, the existing "thin-capitalization" rules disallow interest expense paid by foreign-owned Canadian corporations on loans received from certain related non-resident persons12 (related-party debt) to the extent that such loans exceed twice the equity (computed under special rules) of that corporation.
Given that Canada is one of the few developed countries to apply thin-capitalization rules only to related-party debt, the Panel examined whether the existing rules should be broadened to include third-party and guaranteed debt. The Panel notes that there is little empirical evidence that Canada's income tax base is at risk of being eroded by the use of these forms of indebtedness. In addition, the Panel is of the view that restricting the use of these forms of indebtedness would unduly increase the complexity of the current system and the compliance burden of businesses. In short, the Panel concludes that adding restrictions related to interest paid on third-party and guaranteed debt is not advisable at this time.
While the Panel concludes that the current thin-capitalization system should be retained, it also observes that the currently permitted debt-to-equity ratio may be high relative to world standards and, as a result, recommends reducing the maximum debt-to-equity ratio from 2:1 to 1.5:1 (Recommendation 5.1).
In the course of its review, the Panel identified certain technical issues related to the thin-capitalization rules that should be addressed. More specifically, it recommends that the scope of the thin-capitalization rules be extended to partnerships, trusts and Canadian branches of non-resident corporations (Recommendation 5.2). While the existing thin-capitalization rules clearly do not apply to branches, trusts or partnerships that do not have a Canadian-resident corporation as a partner, their potential application to partnerships with Canadian-resident corporate partners is still a matter of debate.
As part of its mandate, the Panel was also asked to review interest deductibility in the context of so-called 'debt-dumping' structures, where a foreign multinational leverages its Canadian operations through intercompany debt without necessarily having a cash need in Canada. In a typical 'debt dumping' or 'debt pushdown' structure, the foreign parent transfers the shares of a non-Canadian subsidiary to its Canadian subsidiary in exchange for shares and interest-bearing debt. The arrangement is structured so that future dividends received on the shares of the non-Canadian subsidiary are paid out of exempt surplus and are therefore exempt from tax in Canada. To avoid any immediate income inclusion on the intercompany debt for foreign tax purposes, these structures generally rely on hybrid instruments, hybrid entities, or a combination of the two. A provision introduced in the Fifth Protocol to the Treaty targets the use of certain debt-dumping structures between Canada and the US where hybrid entities are involved.
The Panel does not believe that all debt-dumping structures raise tax policy issues. For example, consistent with Recommendation 4.7, the Panel does not believe that interest expense should be restricted where a Canadian corporation borrows to make a foreign investment with ordinary business motives. However, the Panel concludes that debt-dumping structures involving the acquisition of preferred shares of a non-Canadian subsidiary where there is no bona fide purpose to the acquisition raise significant tax policy concerns. These kinds of transactions essentially permit a foreign multinational to leverage its existing Canadian operations by simply reorganizing the group's ownership structure. As a result, the Panel recommends curtailing tax-motivated debt-dumping transactions within related corporate groups involving the acquisition, directly or indirectly, by a foreign-controlled Canadian company of an equity interest in a related foreign corporation while ensuring bona fide business transactions are not affected (Recommendation 5.3).
Given that distinguishing preferred shares from common shares is often difficult in practice, the Panel is of the view that any proposed anti-avoidance rule targeting these transactions should cover the acquisition of any equity interest in a non-Canadian subsidiary by a foreign-controlled Canadian corporation.
Non-Resident Withholding Taxes
Canada's tax treaties typically reduce the 25 per cent Canadian domestic withholding tax rate to 10 per cent for interest and most royalties and to five per cent for dividends if certain ownership requirements are met.
Several withholding tax exemptions are also currently available under Canada's domestic law and tax treaties. An important exemption for withholding tax on interest (other than "participating debt interest" as defined in subsection 212(3)) that is paid or credited to arm's-length non-residents including, but not limited to, US residents, took effect on January 1, 2009. In addition, withholding tax on interest paid or credited to related US-resident creditors will be phased out over three years under the Fifth Protocol to the Treaty. Finally, certain copyright royalties are exempted both domestically and under Canada's tax treaties from Canadian royalty withholding taxes.
In this context, the Panel evaluated the case for further reducing Canada's non-resident withholding taxes. The Panel believes that such reduction would benefit Canada economically. It notes that if withholding taxes were eliminated, foreign companies that could not obtain a full credit for them abroad might be encouraged to increase their investments in Canada. In the end, the Panel recommends that the Government continue to reduce or eliminate withholding taxes in future tax treaties. However, in recognition of the significant cost to the Government, and the widely held preference among businesses for lower corporate income taxes over lower withholding taxes, future reductions should be implemented as the Government's fiscal framework permits (Recommendation 6.1).
Administration, Compliance and Legislative Process
An important chapter of the Panel's report is devoted to recommendations for simplifying the current system of international taxation and easing both the compliance burden of taxpayers and the administrative burden of the CRA in a number of areas.
During its consultations, the Panel heard negative comments regarding the current relationship between businesses and the CRA. In the Panel's view, a further deterioration in this relationship could jeopardize the ongoing viability of Canada's self-assessment system. As a result, the Panel recommends that immediate action be taken to enhance the dialogue among taxpayers, tax advisors and the CRA to promote the mutual responsibility and cooperation required to uphold Canada's self-assessment system (Recommendation 7.1).
The Panel also reviewed the administration of Canada's transfer-pricing regime. The Panel formed a subcommittee to provide comments and assistance with this review. In its report, the subcommittee made more than twenty recommendations to improve the process and administration of Canada's transfer-pricing rules, with special emphasis on crafting solutions to current issues that will help both businesses and the CRA. The Panel recommends that the report of the transfer-pricing subcommittee be used as a starting point to improve the administration of the transfer-pricing rules in resolving disputes, centralizing knowledge for better consistency and resolving technical issues (Recommendation 7.2).
The Panel also reviewed the existing withholding tax mechanisms under Sections 102 and 105 of the Income Tax Regulations (Regulations).13 Under Regulation 105, payments to non-residents for services rendered in Canada are subject to withholding tax at a rate of 15 per cent. This withholding is not the final tax; rather, it is a prepayment on account of the non-resident's anticipated tax liability, which is determined when the non-resident prepares and files its Canadian tax return. After the filing, all or part of the amount withheld may be refunded, which would be the case, for example, if the non-resident qualifies for an exemption from Canadian income tax under a tax treaty or if the non-resident's total tax liability is less than the amount withheld. If a foreign service provider can show, prior to commencing to perform the services in Canada, that the amount to be withheld is more than the ultimate Canadian income tax liability, the provider may apply for a waiver of the withholding tax under Regulation 105.
The Panel heard two main concerns regarding Regulation 105. The first was the fact that service providers commonly "gross-up" their fees to offset the withholding tax, which can result in additional costs to Canadian businesses and hamper their ability to engage skilled workers from outside of Canada. The second concern was that the service provider may suffer reduced or delayed revenues and cash flow problems if the service provider has not received a gross-up from the payer.
In this context, the Panel recommends eliminating withholding tax requirements related to services performed and employment functions carried on in Canada where the non-resident certifies the income is exempt from Canadian tax because of a tax treaty (Recommendation 7.3). Under proposed procedures, which would be similar to the current US approach, to claim a reduced or zero rate of withholding, the non-resident could file a short form with the payer certifying the income is exempt. The certification form would capture data about the non-resident so that the CRA could obtain more information if needed. The payer would review the form to assess whether the exemption from withholding is warranted. The payer would reject the form if the payer knew or had reason to know that any of the facts or statements on the form may be false or that the non-resident's exemption from withholding could not be readily determined.
The Panel reviewed the 'Section 116 certificate' process. Under Section 116, a non-resident vendor must generally apply for a certificate confirming that taxes on the disposition of taxable Canadian property have been paid or secured. With respect to property other than depreciable property, if no certificate is provided, the purchaser generally becomes liable to pay to the CRA up to 25 per cent of the purchase price of the taxable Canadian property, and is entitled to withhold this amount from the proceeds otherwise payable to the vendor.
Since January 2009, the Section 116 certificate process has been streamlined. The new rules eliminate the obligation of the purchaser to remit amounts to the CRA (and, as a corollary, eliminate the need to withhold from the purchase price) on an acquisition of taxable Canadian property where three conditions are satisfied: (1) the purchaser concludes, after reasonable inquiry, that the vendor is resident in a tax treaty country; (2) the property would be treaty-protected property of the vendor if the vendor were, under the tax treaty, resident in the particular country; and (3) the purchaser sends a notice containing certain basic information about the transaction to the Minister of National Revenue within thirty days from the date of acquisition.
Unfortunately, these changes do necessarily achieve the desired result of easing the compliance burden of non-resident vendors of taxable Canadian property, especially in the case of high value dispositions between unrelated persons. The new rules put the onus on the purchaser to determine whether the first two conditions are satisfied. While a reasonable inquiry into the residence status of the vendor will protect the purchaser in the case of the first condition, there is no due diligence defence in the case of the second condition. Thus, the purchaser will be liable if it is ultimately determined that the property did not qualify for a treaty exemption. As a result, in the event of any uncertainty, a prudent purchaser will require a certificate from the non-resident vendor or withhold 25 per cent of the purchase price.
During the Panel's consultations, business called for more changes and told the Panel that the these measures do not go far enough to provide purchasers of taxable Canadian property with certainty about their withholding and remittance obligations. Further, the changes offer no relief to members of partnerships and other non-corporate entities that are eligible for treaty benefits on a look-through basis. While it is the policy of the CRA to accept a single Section 116 certificate application on behalf of all the partners of a partnership, evidence must still be submitted to substantiate the residence of each of the non-resident partners for treaty purposes. This generally represents a significant administrative burden for the partnership, especially when it is widely held. Finally, some non-resident investors or their financial intermediaries must still obtain Section 116 certificates when they sell certain Canadian securities, such as units of some business income trusts or limited partnerships.
To simplify and reduce the compliance burden for purchasers of taxable Canadian property, the Panel recommends eliminating withholding tax requirements related to the disposition of taxable Canadian property where the non-resident certifies that the gain is exempt from Canadian tax because of a tax treaty (Recommendation 7.4). It also recommends excluding all publicly traded Canadian securities from the Section 116 certificate process (Recommendation 7.5).
In conducting its work, the Panel indicated that it had had difficulty obtaining certain data needed to evaluate the current international tax system and assess other options. The Panel noted that both the CRA and the Department of Finance also need relevant, reliable and timely information to perform their functions properly and to make appropriate decisions. In this context, the Panel recommends that the Government take steps to streamline and optimize its approach to the collection and use of taxpayer information and improve the existing information management systems to allow for more efficient use of the data currently collected (Recommendation 7.6).
Footnotes
1 Advisory Panel on Canada's System of International Taxation, Final Report: Enhancing Canada's International Tax Advantage (Ottawa: Department of Finance Canada, December 2008).
2 Department of Finance Canada, Advantage Canada: Building a Strong Economy for Canadians (Ottawa: Public Works and Government Services Canada, 2006).
3 Ibid. at page 73.
4 In response to serious concerns raised by the tax and business communities relating to this proposal, the Department of Finance released proposed Section 18.2 on May 14, 2007, which was directed only at interest and other finance expenses incurred with respect to 'double-dip' financing structures. The legislative package that included Section 18.2 received royal assent on December 14, 2007.
5 Department of Finance Canada, The Budget Plan 2007, Annex 5 (Ottawa: Public Works and Government Services Canada, 2007), at pages 419-423.
6 Department of Finance Canada, "Government Establishes Advisory Panel on Canada's System of International Taxation," News Release 2007-092, November 30, 2007.
7 Advisory Panel on Canada's System of International Taxation, Enhancing Canada's International Tax Advantage: A Consultation Paper Issued by the Advisory Panel on Canada's System of International Taxation (Ottawa: Department of Finance Canada, April 2008).
8 A Canadian shareholder will be subject to Canadian income tax on an annual accrual basis on active business income earned by a foreign affiliate that is a controlled foreign affiliate where such income exceeds $5,000 and either: (1) such income is treated as foreign accrual property income (FAPI) under the base erosion rules (such as those contained in Paragraphs 95(2)(a.1) to (a.4) and Paragraph 95(2)(b)) or the definition of "investment business" in subsection 95(1); or (2) for taxation years that begin after 2008, such income is treated as FAPI because it is earned by the affiliate in a country with which Canada does not have a tax treaty or a TIEA and the country has not entered into a TIEA with Canada within five years following the initiation of negotiations for a TIEA.
9 "Excluded property" is defined in subsection 95(1) as property of a foreign affiliate and includes: (1) property used or held by the foreign affiliate principally for the purpose of gaining or producing income from an active business; and (2) shares of another foreign affiliate, where all or substantially all of the fair market value of the property of the other affiliate is attributable to excluded property.
10 Canada introduced new transfer-pricing rules in 1998, after the introduction of the base erosion rules.
11 In Appendix B to the Final Report, the Panel discusses various technical issues from or relating to the recommendations in the Final Report. Notably, in light of Recommendations 4.1 and 4.3, in Paragraph B.4, the Panel recommends that the Government abandon the foreign affiliate proposals released in February 2004 that are aimed at preventing taxpayers from inappropriately creating exempt surplus in certain types of inter-affiliate transactions and that require foreign affiliates in a corporate group to consolidate surplus balances.
12 The existing thin-capitalization rules apply to Canadian corporations that have interest-bearing debts owing to any "specified shareholder" of the corporation that is not resident in Canada or to any non-resident person not dealing at arm's length with a "specified shareholder" of the corporation. A "specified shareholder" of a corporation is defined in subsection 18(5) as a person who, either alone or together with persons with whom the person is not dealing at arm's length, owns 25 per cent or more of the voting shares or shares representing 25 per cent or more of the fair market value of all of the issued and outstanding shares in the corporation.
13 Under Regulation 102, employers have obligations to withhold, remit and report amounts in respect of remuneration paid to an employee who renders services in Canada even if the employee is a not a resident of Canada.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
