- Blockers for Investment Funds Coming to Canada
- The Federal Goods And Services Tax: Permanent Establishment In Canada
- Thin Capitalization Rules And Interest Deductibility
Blockers for Investment Funds Coming to CanadaA significant issue for both Canadian tax-exempt investors investing abroad and for foreign tax-exempt investors investing in Canada is that their tax-exempt status in their home jurisdiction generally does not extend to foreign jurisdictions. As a result, foreign tax for a tax-exempt is an absolute cost (unlike taxable entities investing abroad, for which foreign tax credits in their home jurisdiction are generally available to reduce the impact of foreign taxation). Accordingly, structuring investments in order to minimize foreign tax is critically important for tax-exempt investors.
Unlike corporations, partnerships are not separate legal entities for Canadian tax purposes and are treated as "flow-throughs". In other words, although income or loss are computed at the partnership level, that income or loss is "flowed out" to partners in accordance with the governing partnership agreement and reported by the partners in computing their own income or loss for Canadian tax purposes. Because of the flow-through nature of partnerships, they are often the preferred vehicle for structuring investment funds, including private equity funds, particularly if Canadian tax-exempts are expected to participate.
On the other hand, the participation of investors that are non-residents of Canada in a partnership with Canadian activities can give rise to a number of tax liability and compliance issues for such investors and the partnership. For example, if the partnership earns income from a business carried on in Canada, or if the partnership disposes of "taxable Canadian property" (which will include, in general terms, shares of a Canadian corporation that are not listed on a prescribed stock exchange), then the non-resident investor will be directly taxable on the income or gains realized from these sources and will be required to file a tax return reporting such income or gains. This can also give rise to tax concerns in the investor's home jurisdiction (an example would be unrelated business taxable income or "UBTI" concerns for US tax-exempt investors) and to concerns for the partnership itself (for example, if there is even one direct non-resident participant in the partnership, the partnership will not have "Canadian partnership" status for Canadian tax purposes which, among other things, can give rise to issues in respect of tax withholdings on both receipts and payments made by the partnership).
For these reasons, as with structures for investment funds in other jurisdictions, it is typical to use so-called "blocker" entities for investments by non-residents into Canadian investment funds. Such "blockers" can take a number of different forms, depending on the circumstances, particularly the characteristics and home jurisdiction of the investors. In this regard, it is important to note that for Canadian tax purposes, "hybrid" entities generally do not exist. In other words, Canadian tax law does not treat certain partnerships as corporations, or certain corporations as partnerships, as is the case under US tax law. It is also important to note that under its current administrative policy, the Canada Revenue Agency does not extend the benefits of the Canada-US Income Tax Convention to US limited liability corporations that are taxed as partnerships for US tax purposes, on the theory that such corporations are not resident in the US because they are not subject to taxation there. While this policy has been the subject of discussion between Canadian and US tax authorities for some time, this remains the current status of such corporations.
On the other hand, so-called Nova Scotia Unlimited Liability Companies ("NSULCs") can receive "hybrid" treatment for Canadian and US tax purposes. That is, an NSULC can be treated as a corporation for Canadian tax purposes but as a partnership for US tax purposes. It is expected that Alberta unlimited liability corporations (the subject of discussion in prior issues of this publication) will also be able to receive such hybrid treatment. Accordingly, such corporations can act as an effective blocker in appropriate circumstances.
Similarly, a US limited partnership that elects to be taxed as a corporation in the US, but which is treated as a partnership for Canadian tax purposes, can be an effective blocker in appropriate circumstances. This would be the case in particular for US tax exempts with UBTI concerns. It should be noted that this kind of blocker would not address the issue of a potential investee partnership ceasing to be a "Canadian partnership" for tax purposes.
We have employed other blockers for European investors, including Luxembourg corporations and offshore trusts. A Luxembourg corporation can be particularly useful if the facts are such that the benefits of both the Canada-Luxembourg Tax Treaty and the Luxembourg participation exemption are expected to be available to the corporation. An offshore trust may preferable if treaty protection is not expected (for example, this will usually be the case for investments focused on Canadian real estate) but a foreign non-taxed entity is desirable as a blocker.
As mentioned, the appropriate structure of blocker will depend on the particular circumstances. The discussion above is just the tip of the proverbial iceberg with respect to these issues.
The Federal Goods and Services Tax: Permanent Establishment in Canada
The Canada Revenue Agency ("CRA") recently revised its interpretative policy on when a non-resident will be considered to have a "permanent establishment" in Canada for purposes of the Goods and Services Tax ("GST"), which is the federal value-added tax imposed on most supplies of property and services in Canada.
A non-resident with a permanent establishment in Canada is considered resident in Canada in respect of the person's activities carried on through that permanent establishment. As a consequence, a non-resident person that makes taxable supplies through a permanent establishment in Canada is required to register for purposes of the GST and to collect GST on taxable supplies made through the permanent establishment. Furthermore, such a non-resident will lose the ability to acquire most property and services without incurring GST and may be required to self-assess for GST on the value of certain property or services acquired for use or resupply through the Canadian permanent establishment. On the bright side, a non-resident person with a permanent establishment in Canada is not required to supply security to the CRA on registration for GST purposes.
The term "permanent establishment" is defined in the governing legislation as "a fixed place of business … through which the particular person makes supplies". The definition includes the following specific examples: a place of management, a branch, an office, a factory, a workshop, a mine, an oil or gas well, a quarry, timberland or any other place of extraction of natural resources.
CRA's new interpretative policy focuses on the two distinct elements of this definition: (1) that there be a fixed place of business, and (2) that the person make supplies through that place of business.
Following are the key factors in determining whether there is a fixed place of business from the CRA's perspective: (i) is there space at the non-resident person's disposal; (ii) does the space have a certain degree of continuity and permanence; (iii) is there a person who can exercise control with authority to make decisions concerning operations; and (iv) does the non-resident have a constant presence and ordinary routine at the fixed place of business.
It is important to note that the requirements of control and presence through employees or agents may be met in circumstances where only equipment or machinery is located in Canada. As a consequence, a lease of a computer server located in Canada can constitute a permanent establishment of a non-resident, though merely having a web site hosted by a Canadian internet service provider would not ordinarily constitute a permanent establishment.
The second requirement of the definition of "permanent establishment" is that the non-resident person make supplies through the fixed place of business. As a consequence, activities of a preparatory or auxiliary nature in relation to the overall business activity of the person do not constitute supplies through a fixed place of business. These can include storage, display or delivery of merchandise, or the collecting of information.
The definition of "permanent establishment" also provides that a non-resident may have a permanent establishment if a dependent agent with a fixed place of business is acting in Canada on behalf of the non-resident person, and the non-resident makes supplies through that agent in the ordinary course of business. A dependent agent is typically subject to detailed instructions in respect of the manner in which it acts and does not typically act for other principals.
A non-resident having any degree of presence in Canada, including the leasing of equipment located in Canada, should consider the CRA's policy and the implications of having a permanent establishment in Canada.
Thin Capitalization Rules And Interest Deductibility
A tax "trap" that foreign investors can inadvertently fall into when setting up a Canadian subsidiary is not satisfying the thin capitalization rules under the Income Tax Act (Canada). This is particularly the case since these rules were amended approximately five years ago to broaden their application. One of the results of those amendments was to make it significantly more difficult to correct a breach.
The thin capitalization rules exist in principle to prevent what the Department of Finance (Canada) considers an excessive degree of financing of a Canadian corporation by non-resident shareholders with debt, bearing interest which is deductible for the Canadian tax purposes. The interest paid by a Canadian corporation to a "specified non-resident" for a year on outstanding debt may not be fully deductible in the calculation of its taxable income for the year if the "average" amount of the outstanding debt exceeds two times the company's equity for the year. In effect, the thin capitalization rules force a non-resident establishing a Canadian subsidiary to maintain a 2:1 debt to equity ratio.
A "specified non-resident" for the year, in general terms, is a non-resident, who alone or together with non-arm's length persons, owns either 25% or more of the voting shares of the Canadian corporation, or shares having a fair market value of 25% or more of all the issued and outstanding shares of the Canadian corporation.
For purposes of calculating the debt portion of the ratio, the greatest amount of outstanding debt to specified non-residents during each calendar month is used. In calculating equity, the contributed surplus and paid-up capital of a specified non-resident shareholder at the beginning of each calendar month is used. The amendments of five years ago changed the debt to equity computation from being annual to being monthly. This significantly reduced the ability of a corporation to address a situation in which it has excess debt if it is not discovered until late in the year.
Many traps can arise for the unwary under these rules. For example, a direct loan to a second-tier Canadian subsidiary by a foreign indirect parent corporation can be problematic as the full amount of the debt will be included in computing the second-tier subsidiary's debt but none of the equity of the Canadian intermediary will be included.
These rules can be particularly onerous when it is considered that interest that is paid or payable to a non-resident remains subject to Part XIII withholding tax of 25% (or lower if reduced under an applicable treaty) even though the deduction of the interest is denied by the "thin-cap" rules.
In light of the foregoing, it is clear that foreign investors must be careful when capitalizing their Canadian subsidiaries as it may lead to undesired results.
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.