Canada: Regulation 105 is the New Section 116

Last Updated: December 16 2010
Article by Pierre G. Alary

Introduction

A Canadian income tax provision is hampering Canadian businesses and prompting U.S. companies to reconsider business opportunities in Canada. Sound familiar? For years, Section 116 of the Income Tax Act1 ("ITA") was a major deterrent to U.S. private equity and venture capital investors looking to acquire Canadian targets. Section 116 stipulated that a non-resident had to obtain a Section 116 certificate from the Canada Revenue Agency ("CRA") when disposing of certain taxable Canadian property. This requirement was especially arduous for limited partnerships given that a Section 116 certificate was required from each partner. To this end, a single partnership could require hundreds of certificates. In its March 2010 budget, following calls for reform, the Canadian federal government amended the definition of "taxable Canadian property", thus removing the red flag from otherwise intriguing Canadian targets. Following the Section 116 amendments, subsection 105 of the Income Tax Regulations2 ("Regulation 105") finds itself at the forefront of income tax provisions in need of amendment. This article will examine the scope of Regulation 105, its onerous characteristics and an alternative approach to the current system it imposes.

Regulation 105 – General Requirements

"Every person paying to a non-resident a fee, commission or other amount in respect of services rendered in Canada, of any nature whatever, shall deduct or withhold 15 per cent3 of such payment." – Regulation 1054

Regulation 105 imposes a withholding tax on non-residents for services rendered in Canada.5 The tax withheld is not a final tax to the non-resident taxpayer. Rather, it is a form of deposit or forced prepayment. It ensures that the non-resident receiving payment for rendering services in Canada fulfills its Canadian income tax obligations. The non-resident's tax liability is only determined following the filing of its income tax return. All or part of the amount withheld may be refunded to the non-resident. Non-residents may reclaim the amounts withheld by applying for a waiver or refund. A refund may be appropriate if the non-resident was not required to pay taxes in Canada, or if its tax liability was less than the withheld amount. The non-resident may also be exempt from paying withholding taxes pursuant to a tax treaty between Canada and its resident country.

Scope of Regulation 105

Broad language

Subsection 105(2) lists the exempt forms of payments, which include remuneration6 to non-residents, payments made to a registered non-resident insurer, and payments made to an authorized foreign bank in respect of its Canadian banking business. However, the broad language of subsection 105(1) casts a wide net over payments which may be subject to withholding. The reference "every person paying a fee" includes individuals, corporations, trusts, partnerships and legal representatives, whether resident or non-resident of Canada. The CRA has taken the position7 that each member of a partnership is responsible for Regulation 105 withholding. Also captured by Regulation 105 are payments made by third parties and tax-exempt parties. The CRA has stated that it broadly interprets the wording "in respect of". The CRA's position is that "a particular payment need not necessarily be paid only for services or, be paid to the person who performed the services in order for Regulation 105 withholding to apply".8

Subcontracting

Non-resident service providers may elect to subcontract a portion of the work in Canada. This may result in the non-resident service provider hiring a resident contractor. The initial payment made to the non-resident is subject to the full withholding, regardless of whether the work is subcontracted to a resident contractor. If the work is subcontracted to a non-resident contractor, the payment from the non-resident service provider to the non-resident contractor must also be withheld.

Canada Revenue Agency Waiver Process

IC 75-6R2 states that Canada does not relinquish its right to Regulation 105 withholding through income tax treaties, rather, it may relinquish this right only through the waiver process9. A non-resident may apply for a waiver10 of the withholding tax if it can show, before performing the services in Canada, that the tax liability is less than the amount to be withheld, either due to a tax treaty exemption or an estimation of its income and expenses. Under most tax treaties, business income earned by a non-resident in Canada is taxable in Canada only if the non-resident carries on the business through a permanent establishment in Canada. Despite the perceived benefits, this waiver process is cumbersome and therefore rarely utilized.

The requirement of a non-resident providing services in Canada to file a Canadian income tax return is not affected by either the granting of a waiver or reduction of withholding on amounts subject to Regulation 105.11 Therefore, non-residents providing a service in Canada must file a Canadian tax return even if the sole purpose is to indicate that they do not have a permanent establishment in Canada.

Main Issues

Costs, penalties and administrative burden

The costs and administrative duties associated with Regulation 105 compliance are significant for any Canadian entity. Regulation 105 imposes a duty on the payer to withhold, remit and report. These requirements frustrate Canadian businesses facing significant administrative responsibilities for another person's tax liability. If a payer fails to deduct and remit the amount in accordance with the ITA and Regulation 105, they will be liable for the entire amount together with interest and penalties. The penalty is equal to 10% of the amount not withheld or 20% if the payer knowingly failed to comply with the requirements.

Gross-up of fees

Non-resident service providers often raise their fees to offset the Canadian withholding tax. Higher fees lead to greater costs for Canadian businesses and hinders their ability to employ foreign skilled workers. Non-resident service providers may be blamed for grossing-up their fees, however, this blame is misplaced as a failure to gross-up fees could result in delayed revenues and cash-flow problems.

Advisory Panel

In December 2008, the Advisory Panel on Canada's System of International Taxation (the "Panel") submitted a report12 to the Minister of Finance James Flaherty. The report contained recommendations to help guide the development of a simpler and more efficient Canadian international tax system. The goal of this report was twofold, to improve the competitiveness of Canadian businesses internationally and attract new foreign investment to Canada.

U.S. approach

The report examined Regulation 105 in Canada as well as the United States approach pertaining to services performed in the United States by non-residents. While United States law13 states the payer must withhold 30 percent of the payment, simplified procedures are in place to facilitate the exemption of payments if the recipient is exempt from tax on that amount by reason of a tax treaty. Once the recipient has filed the appropriate form with the payer requesting exemption, the payer will only withhold the amount if they know facts or statements on the form may be false or cannot be readily determined. The Panel concluded that Canada should "eliminate 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".14

Proposed approach

The Panel proposed an alternative procedure which is summarized as follows: i) the recipient files a form with the payer claiming a reduced or zero rate of withholding tax and certifying the amount is exempt under a tax treaty; ii) the payer reviews the form and assesses whether the exemption is warranted; and iii) the payer files the form and an information return with the CRA describing the transaction.

Advantages of certification system

A certification system would shift the compliance burden at the withholding stage from the Canadian payer to the non-resident recipient. Fewer withholdings and waiver requests would reduce the administrative burden for both the payer and the CRA. Non-resident service providers would no longer need to gross-up their fees to offset the withholding tax, thus resulting in lower costs for Canadian businesses. The Panel also held that replacing the current system for a certification system may cause a decline in amounts collected. However, it would reduce the over-withholding of tax that can occur under the current system and the related costs to Canadian businesses.15

Conclusion

To maximize Canada's access to foreign expertise and relieve Canadian businesses from costly and time consuming procedures, action must be taken to amend Regulation 105 and adopt a certification system. Until such time, businesses will continue to seek alternative ways of circumventing Regulation 105 requirements. For instance, non-residents may consider incorporating a Canadian subsidiary or arranging for the secondment of its employees to avoid withholding. However, these arrangements are not without risk. This is evidenced through cases where the CRA has ruled that a seconded employee was not truly seconded to the receiving employer. As was the case with Section 116, the need for change is clear, the solution is simple and the benefits significantly outweigh the costs. The Section 116 amendments were unanimously praised by Canadians and non-residents alike. A similar response should be expected if revisions are made to Regulation 105.

Footnotes

1 Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.).

2 Income Tax Regulations, C.R.C., c. 945.

3 The withholding tax for services rendered in Quebec is 24% as per the Quebec Taxation Act Regulation 1015R8.

4 Supra note 2, at subsection 105(1).

5 Paragraph 153(1)(g) of the ITA gives legislative authority to Regulation 105.

6 As described in the definition "remuneration" in subsection 100(1) of the Regulation. Includes payments in respect of salary or wages.

7 Canada Revenue Agency, Information Circular 75-6R2, Required Withholding from Amounts Paid to Non-Residents Providing Services in Canada, February 23, 2005.

8 Supra note 7 at para. 6.

9 Supra note 7 at para. 57.

10 The CRA may waive or reduce the withholding pursuant to the Undue Hardship provisions of subsection 153(1.1) of the ITA.

11 Supra note 7 at para. 53.

12 Advisory Panel on Canada's System of International Taxation , Enhancing Canada's International Tax Advantage, December 2008, online at: www.apcsit-gcrcfi.ca
13 Section 1441 of the Internal Revenue Code requires 30 percent federal income tax withholding for independent personal services.

14 Supra note 12 at Recommendation 7.3.

15 Supra note 12 at Recommendation 7.45.

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