Tax advisers to Canadian corporations paying foreign taxes will routinely consider the federal foreign tax credit rules and the deduction under subsection 20(12) of the Income Tax Act (Canada) (the "ITA"). The provincial regime in respect of foreign taxes should not be overlooked as it may not produce effects parallel to those under the ITA. This article will review the Ontario foreign tax credit regime under the Taxation Act, 2007 (Ontario) (the "Ontario Tax Act")hand suggest some practical planning considerations.
A. PRIOR TO HARMONIZATION IN ONTARIO
Prior to harmonization, the Corporation Tax Act (Ontario) (the "CIAO") only provided a foreign tax credit in respect of foreign investment income and not foreign business income.
To qualify for the credit, the corporation had to have a permanent establishment (as defined in the CIAO) in Ontario and had to pay income or profits tax to a jurisdiction outside Canada on foreign investment income. If the corporation did not have a permanent establishment in Ontario, it would not be subject to tax under the CTAO.
Foreign investment income for these purposes consisted of:
- dividends, interest, rent, and royalties received in a year from foreign sources; and
- the amount, if any, by which the aggregate of taxable capital gains for that year from property that may reasonably be considered to be income from a source within a jurisdiction outside Canada exceeded the aggregate of allowable capital losses for the year from dispositions of property that may reasonably be considered to be a loss from a source in the same jurisdiction.
The credit was calculated as the lesser of the following two amounts:
(1) the product obtained by multiplying the amount of the foreign investment income by the "specified base rate" of the corporation for the taxation year, and the corporation's "Ontario allocation factor" (as defined in the CTAO) for the taxation year; and
(2) the product obtained by multiplying the "Ontario allocation factor" for the taxation year by the amount, if any, by which:
(a) the portion of the income or profits tax paid for the taxation year to the foreign jurisdiction in respect of such foreign Investment income that was not deducted under subsection 2 12 of the ITA or the corresponding provision of the CIAO in computing its income for the year
(b) the foreign tax credit allowed for the taxation year in respect of such foreign investment income under subsection 126 of the ITA.
To the extent that income was attributable to a permanent establishment in the foreign jurisdiction, there would be no Ontario corporate tax under the allocation rules. For obvious reasons, Ontario should not provide a tax credit for business income taxes if the relevant business income was not subject to Ontario tax. However, it has not been clear why a foreign tax credit should not be available in respect of such income that was subject to Ontario corporate tax. Moreover, in our view, the manner in which "foreign business income" was excluded from the Ontario tax base was flawed.
B. FEDERAL/ONTARIO CORPORATE INCOME TAX HARMONIZATION
Effective January 1, 2009, pursuant to a Memorandum of Agreement signed by the Canadian federal government and the Ontario provincial government dated October 6, 2006, the Canada Revenue Agency (the "CRA") began to administer corporate taxes on behalf of Ontario (the "Harmonization").
In an October 2006 press release, the Ontario Ministry of Finance set out a number of objectives of the Harmonization, including:
- increasing the harmonization of the tax systems in Canada;
- reducing compliance costs for businesses; and
- reducing administration costs for governments.
The move to a single tax administration required that Ontario's determination of income and taxable income be in accordance with the ITA for taxation years that end after December 31, 2008. As a result, income tax provisions that were peculiar to Ontario (e.g., the partial add-back of management fees paid to related non-residents) were eliminated, and Ontario tax attributes (e.g., balances in loss pools) were replaced by federal tax attributes.
Deductions under subsection 2 12 or 11 1 of the ITA were harmonized because of the determination of income. The question is whether the foreign tax credit rules for taxation years that end after December 31, 2008 have changed in any material way.
C. SECTION 126 OF THE ITA AND SECTION 34 OF THE TAXATION ACT, 2007
Section 126 of the ITA provides a foreign tax credit in respect of foreign business income tax (as defined in the ITA) and foreign nonbusiness- income tax (as defined in the ITA). In general terms, the maximum foreign tax credit that a taxpayer may claim with respect to either foreign non-business-income tax or foreign business-income tax is equal to the lesser of:
1) the applicable foreign income or profits tax paid for the year; and
2) the amount of Canadian tax otherwise payable for the year that pertains to the applicable foreign income.
In addition, the deduction for foreign accrual tax and the deductions under subsection 113 1 of the ITA, both of which are part of the foreign affiliate regulations in the ITA, are designed to avoid double taxation of foreign income.
In contrast to section 126 of the ITA, the CIAO only provides a foreign tax credit in respect of "foreign investment income". Under section 34 of the CIAO, a corporation that has "foreign Investment income" may deduct a foreign tax credit equal to the lesser of:
(1) the product obtained by multiplying the "Ontario domestic factor" (as defined below) by the amount, if any, by which:
(a) the portion of the non-business-income tax paid for the year to the government of a country other than Canada that relates to foreign investment income of the corporation for the year (other than income from a share of the capital stock of a foreign affiliate of the corporation)
(b) the amount deductible by the corporation in respect of the foreign investment income for the year under subsection 126 1 of the ITA, and
(2) the product obtained by multiplying: (i) the portion of foreign Investment income for the taxation year described in (a) above, (ii) the corporation's basic rate of tax for the year (i.e., 11.5%), and (iii) the corporation's "Ontario allocation factor" (as defined below) for the year.
Certain key determinations are now harmonized with the ITA. Subsection 126(6) of the ITA and the definition of "non-business-income tax" in subsection 126 7 of the ITA apply for purposes of section 34 of the CIAO. "Foreign investment income" refers to income from a source in a country other than Canada in respect of which the corporation paid non-business-Income tax to the government of that country.
In summary, provided a corporation's taxable income for the year is a positive amount, the "Ontario domestic factor" for a corporation is the ratio of "A" to "B" where:
- "A" is the corporation's Ontario taxable income for the year; and
- "B" is the corporation's taxable income earned in a province as determined under the Regulations to the ITA.
Provided a corporation's taxable income for the year is a positive amount, the "Ontario allocation factor" for a corporation for a taxation year is the fraction equal to A/B where,
- "A" is the corporation's Ontario taxable income for the year, and
- "B" is the corporation's taxable Income for the taxation year.
Note that CIAO Regulation 302 will no longer be relevant in determining the taxable income earned in a province.
The rule for determining the taxable Income deemed earned in a year in a province is described generally under ITA Regulation 402(3) but is subject to the other specific rules in ITA Regulation 402. There are some differences in the wording between CIAO Regulation 302 and ITA Regulation 402: for example, CIAO Regulation 302 included the following provision that ITA Regulation 402 does not include:
(j) where land which constitutes a permanent establishment in a province under subsection 4(7) of the Act is sold, and the income derived from the sale is included in determining the corporation's income under paragraph 3(a) of the Income Tax Act (Canada) as made applicable by section 9 of the Act, the gross revenue of the corporation derived from the sale for the taxation year shall be attributed to that permanent establishment.
The general rule for determining taxable income earned in the year in the province is as follows:
(3) Except as otherwise provided, where, in a taxation year, a corporation had a permanent establishment in a province and a permanent establishment outside that province, the amount of its taxable income that shall be deemed to have been earned in the year in the province is
(a) in any case other than a case specified in paragraph (b) or (c), 1/2 the aggregate of
(i) that proportion of its taxable income for the year that the gross revenue for the year reasonably attributable to the permanent establishment in the province Is of Its total gross revenue for the year, and
(ii) that proportion of its taxable income for the year that the aggregate of the salaries and wages paid in the year by the corporation to employees of the permanent establishment in the province is of the aggregate of all salaries and wages paid in the year by the corporation;
(b) in any case where the gross revenue for the year of the corporation is nil, that proportion of its taxable income for the year that the aggregate of the salaries and wages paid in the year by the corporation to employees of the permanent establishment in the province is of the aggregate of all salaries and wages paid in the year by the corporation; and
(c) in any case where the aggregate of the salaries and wages paid in the year by the corporation is nil, that proportion of Its taxable income for the year that the gross revenue for the year reasonably attributable to the permanent establ(shment in the province is of its total gross revenue for the year.
The problem of not having an Ontario foreign tax credit in respect of foreign business income that is deemed to have been earned in Ontario remains post-harmonization. In addition, there are numerous problems in respect of Regulation 402 that could result in an inappropriate imposition of Ontario corporate tax.
- It would shift all the taxable income to Ontario if there were foreign-source income subject to a business income tax in the foreign jurisdiction but no permanent establishment in the foreign jurisdiction.
- If there were a permanent establishment in the foreign jurisdiction, the formula would shift income to Ontario where there may be fewer but higher-paid employees in Ontario compared to the number of employees in the foreign jurisdiction, or if there is a high amount of taxable income earned in a particular year attributable to efforts in a prior year.
There are a number of ways to manage the foregoing risks.
It is always a threshold decision whether a Canadian corporation should directly carry on a foreign business through a permanent establishment or a foreign subsidiary. The treatment of foreign business tax for Ontario corporate tax purposes may be an important factor in that decision. As part of the decision-making process, one should Identify whether the foreign tax will be treated as a business income tax or as anon-business income tax. As in the former case, one should determine whether there is a permanent establishment in the foreign jurisdiction and how one expects to allocate taxable income. If there is not a permanent establishment and the tax is a business income tax, double taxation will result, as the income will be allocated to Ontario but without any credit for the foreign tax. Moreover, if there is a permanent establishment, consideration should be given to the potential for double taxation.
In these circumstances, consideration should be given to using a foreign subsidiary to continue the business, rather than carrying on the business directly. That said, using a foreign subsidiary may result in certain disadvantages. In the case of a foreign subsidiary, the deduction under section 11 of the ITA should prevent adverse consequences.
In conclusion, while the harmonization of certain terms in the CTAO with the ITA is welcome, there remains potential traps for corporations subject to Ontario tax on foreign-source income to not get any relief for foreign business income tax.
Originally published in cchonline.
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.