Many household names in US retailing have recently committed to Canada as a destination in which to expand their global market shares. Target, J. Crew, Justice (Tween), Nordstrom, Zumiez, Express, Tanger Outlet Centers, Kohl's and Marshalls, to name a few, have established themselves in Canada or announced they are establishing themselves here, while many others are actively exploring Canadian expansion opportunities.
The interest in Canada is not coming only from the US. Euro-British retailers Topshop, Ted Baker and AllSaints as well as companies from France, Germany and Spain are also entering the Canadian market. This trend should increase its pace once the Comprehensive Economic and Trade Agreement, being negotiated between Canada and the European Union (EU), becomes a reality later this year.
The case for Northern expansion is compelling. Canada weathered the financial crisis far better than most countries, including the US and the EU, and retail spending remains relatively robust. The strong Canadian dollar is also helping to lower the cost of foreign goods in Canada. Moreover, the vast majority of the Canadian population lives within driving distance of the US border, translating into manageable supply chains and brand aware customers, who have shown a penchant for cross-border shopping.
There are a number of key legal issues that must be addressed in connection with Canadian market entry, which are not confined to the obvious ones of store leasing and employment issues. Sound planning for customs, tax, transfer pricing is key to a smooth and successful cross-border business launch and we address these in brief here.
Choice and Financing of the Business Vehicle
The typical choice of business vehicle for Canadian retailers is a Canadian incorporated subsidiary ("Canco"). A Canco can be established quickly and at modest cost either under the federal laws of Canada or the laws of one of its provinces or territories. Canadian corporate law, both federal and provincial, is similar in most respects to US corporate law. In some Canadian jurisdictions, there is a minimum Canadian resident director requirement. In certain situations, US tax advantages may be gained by establishing the Canadian subsidiary as an unlimited liability company (ULC), a corporation for Canadian tax purposes that is fiscally transparent for US tax purposes.
Other business vehicles include a limited partnership or trust but these are less common. Similarly, operating directly through a branch (i.e. without a separate entity) is possible but is usually not recommended because, among other things, it fails to insulate the US company from liability and may increase the base for customs duty purposes. Use of a branch raises allocation issues for income tax purposes, and will generally result in the American company being subject to Canadian tax on its profits attributable to the Canadian permanent establishment.
The Canco can be capitalized with a mix of equity and debt. Reasonable interest expense on debt incurred for an income earning purpose such as store expansion or working capital is deductible for tax purposes. Interest expense on debt owed to a related non-resident is effectively limited by a "thin cap" debt:equity limit of 1.5:1.
Canadian withholding tax is no longer levied on interest payments to arm's length lenders (excluding participating interest). In addition, Canadian withholding tax on non-arm's length, non-participating interest paid to qualifying US treaty residents was recently eliminated. This exemption for non-arm's length interest is unique among Canadian tax treaties and represents a competitive advantage for qualifying US parent companies versus other foreign enterprises seeking to enter the Canadian market.
Dividends paid by a Canco to a US parent would generally qualify for a 5% dividend withholding tax rate. Where the direct shareholder of the Canco is a limited liability company (LLC), care should be taken to avoid any adverse consequences of the anti-hybrid rules in the treaty.
One advantage of Canadian corporate law is that profits can be repatriated by way of return of capital ahead of dividend payments and free of dividend withholding tax. For this reason, it is advantageous to maximize cross-border capital and, if the Canadian expansion involves acquisition of an existing Canadian business, there are opportunities to do so.
Cross-Border Supply Chain Issues
Establishing a Canadian subsidiary retail operation supplied with products purchased or sourced through a foreign parent gives rises to Canadian tax and customs transfer pricing issues. Most multi-national enterprises (MNEs) are familiar with transfer pricing principles and the existence of customs regulations; however, many MNEs fail to co-ordinate the tax/finance and customs/logistics functions, which may have different reporting lines within the organization,with the result that they miss the opportunity for a unified approach to tax and customs transfer pricing that improves compliance and reduces exposure. It is recommended that retailers adopt a sufficiently granular approach to transfer pricing to meet both tax and customs transfer pricing requirements.
Attention should also be paid to documentation of agreements covering the supply of goods, services and/or intellectual property, including the licensing of trademarks, whether the parties are related or not.
Incidental to organization of the international commercial transactions under which goods, services and intellectual property benefits flow into Canada is their sales tax treatment (under the Canadian GST or HST and provincial sales taxes). Management of registration, collection, payment, record keeping and reporting should be addressed in advance of these transactions.
Other customs and regulatory considerations that must be accounted for in supply chain planning are preservation of preferred rates of duty, marking/labeling and product regulation, supply chain security and consumer safety laws, selection of customs brokerage services, maintenance of a tariff data base and other books and records.
In order to help guide companies though the vagaries of getting goods into Canada, the law firm of Bennett Jones LLP developed a Handbook of Canadian Customs Compliance. Intended as a tool to help limit a Canco's exposure to penalties from the Canadian tax and customs authorities it points to the growing need for foreign companies to be compliantly up to speed in order to avoid reassessments, penalties and challenges from the customs authority (http://www.bennettjones.com/Guides/TheBennettJonesHandbookofCanadianCustomsCompliance).
Canada's broadband penetration and web usage are amongst the highest in the world, making e-commerce an attractive opportunity both for retailers physically in Canada who wish to establish web-based sales in parallel to their store-based business and for enterprises testing Canadian demand for their products without taking the plunge of physical expansion. In either case, retailers need establish a seamless, invisible, and cost-competitive cross-border program to deliver goods to the customer's door.
A corollary of broadband penetration and high web usage in Canada is the spread of technology-based payment methods targeting tech-enabled customers, including mobile wallets. A number of initiatives are underway on this front in Canada and they present a combination of legal issues from technology licensing to privacy requirements for customer data, which may be different than home-country regulations, and hence, local advice is strongly recommended.
The Canadian Opportunity
These are exciting times in the Canadian retail trade. After years of welcoming Canadian cross-border shoppers, US retailers are seizing the opportunities to penetrate the Canadian market further by attracting Canadian shoppers on their home turf. European retailers have also recognized the opportunity in Canada, a trend we expect to increase with the advent of a comprehensive economic agreement with the EU.
The Canadian opportunity is rich. With some sound cross-border planning, foreign retailers undertaking or considering a Canadian expansion can smooth their entry and enhance their success.
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.