Canadian International Income Tax Rules

General Rules and Principles

Canadian international tax rules adhere to the tax models promoted by the Organisation for Economic Co-operation and Development (OECD). They follow the international norm of giving priority to tax to the country in which taxable income is generated (the source country).

Canadian international tax rules are based on these three broad principles:

  • Worldwide Taxation: Canadian residents are liable for taxes on their income worldwide. A corporation is a resident of Canada for tax purposes if its central management is located in Canada or if it is incorporated in Canada.
  • Double Taxation Elimination: To avoid the double taxation that would occur from having the same income taxed in both the source and residence country, Canadian residents are entitled to relief in the form of a credit or exemption.
  • Permanent Establishment: A foreign entity operating in Canada through a permanent establishment (i.e., an entity not legally separate from its parent corporation) is liable for tax only on income generated in Canada.

Taxation of Foreign Investment in Canada

Subsidiaries

Foreign investors doing business in Canada through a separate legal entity (i.e., a subsidiary) are considered Canadian residents and are taxed as such. Income tax is applied to these investors’ worldwide income, and appropriate relief is provided for taxes paid in foreign jurisdictions if the subsidiary also carries out business abroad.

Canadian residents, including corporations controlled by non-residents, are subject, in addition to income taxes, to withholding taxes on payments made to non-residents. Withholding taxes act as a proxy for the income taxes shareholders would pay if they were residents of Canada. However, invested capital can be repatriated tax-free before any withholding taxes are applied.

The statutory withholding tax rate is 25%; however, the rate is usually reduced through the extensive network of Canadian tax treaties with other countries. The rates can also vary according to the type of payment (e.g., interest, dividends, royalties). The treaty between Canada and the United States with respect to taxes, for example, provides for a withholding tax rate of 10% on interest and royalties and of 5% on dividends paid to non-resident corporations with a significant ownership in the corporation.

Canada is following the worldwide OECD thrust to reduce withholding taxes.

Branches

Non-residents doing business in Canada through a permanent establishment (e.g., a branch) rather than a separate legal entity are liable for income taxes on the income attributable to the business they conduct in Canada. In addition, a branch tax is imposed on non-resident corporations’ after-tax source income that has not been reinvested in Canada. The statutory branch tax rate is 25%, but it can be reduced by tax treaties (the Canada-U.S. tax treaty provides for a branch tax rate of 5%). The branch tax is a proxy for the withholding tax that would have been imposed on dividends if the branch’s business had been carried out through a subsidiary.

Mining-Specific Provisions

Non-resident corporations incorporated as Principal-Business Corporations (PBC) in Canada have access to special tax incentives. PBCs are corporations whose principal business is directly related to one or more mining or oil and gas activities such as exploration, development, extraction, or processing. As PBCs, non-resident investors can:

  • obtain additional domestic financing using the flow-through share mechanism;
  • receive a 100% write-off and indefinite loss carry-over for its exploration and development expenses and a 30% amortization of the cost of acquiring resources properties; and
  • gain access to the accelerated allowance for capital costs on greenfield mines or major expansions.

Note that changes have been made to the above mining-specific provisions by the recent budgets. Detailed information is presented at the Mining-Specific Tax Provisions section.

Taxation of Canadian Investment Abroad

Foreign Resource Expense and Foreign Exploration and Development Expense

Branch Income

When the foreign operations of a Canadian resident are conducted through a branch (a permanent establishment located in a foreign country), the branch's income is included in the resident's taxable income in Canada. However, a tax credit can be claimed for foreign taxes levied on income attributable to the branch. This credit is limited to the tax payable to Canada on the foreign-source income and is computed on a country-by-country basis. Canadian taxes cannot be deferred when a branch structure is elected, but foreign losses are deductible against Canadian source income.

Subsidiary Income

When foreign operations are conducted through a subsidiary, the income earned by the subsidiary is generally not subject to taxation in Canada until profits are remitted to Canadian shareholders in the form of dividends or the Canadian corporation disposes of its foreign subsidiary. The tax treatment of foreign subsidiaries depends on ownership: if Canadian ownership is less than 10% of common shares, then the income is “portfolio income”; if ownership is equal or greater than 10% but less than 50%, the foreign corporation is a “foreign affiliate” (FA); if ownership is greater than 50%, the corporation is a “controlled foreign affiliate” (CFA).

  • Portfolio Income

    Portfolio income (e.g., dividends, interest, rent or royalties) is taxable in the hands of a Canadian resident in the year it is received. Foreign taxes imposed on portfolio income, whether levied by assessment or by withholding, are creditable against Canadian tax payable, subject to the same per-country limitation applicable to foreign branch income. However, the foreign tax credit for individuals, with respect to foreign-source income from property other than real property, is limited to 15%; any foreign taxes imposed in excess of 15% are deductible, rather than creditable, in computing income.
     
  • Foreign Affiliate and Controlled Foreign Affiliate Income

    The taxation of FAs and CFAs depends on whether the income earned is “active business income” or “passive income” and on whether Canada has a tax treaty with the country in which the FA or CFA operates. Active business income refers to income earned from actively conducting business, whereas passive income refers to income passively earned through investment.
    • Active Business Income: The tax treatment of active business income depends on whether or not this income is earned in a country with which Canada has a tax treaty.
      • Treaty Countries: Active business income earned in a treaty country is classified as “exempt surplus.” The exempt surplus of an FA also includes inter-affiliate dividends received out of the exempt surplus of other foreign affiliates, the exempt portion (25%) of all capital gains, and certain taxable capital gains. Dividends paid out of the exempt surplus of an FA can be received free of additional taxes in Canada, since the profits out of which they are paid are considered to have borne a rate of tax in the treaty country comparable to that of Canada.
      • Non-Treaty Countries: Active business income earned in non-treaty countries is “taxable surplus.” The taxable surplus of an FA also includes certain taxable capital gains and dividends paid out of the taxable surplus of another FA. Dividends paid out of taxable surplus are taxable in Canada, subject to a tax credit for non-resident withholding taxes and the underlying income tax paid by the FA in the source country.
         
    • Passive Income - Passive income earned by an FA or CFA in any country is “foreign accrual property income” (FAPI) and is included in the taxable surplus of a taxpayer. CFA FAPI is included in the income of Canadian shareholders on a current basis, subject to a foreign tax credit. The immediate recognition of FAPI in the taxable income of Canadian shareholders, regardless of whether or not the profits were repatriated, is intended to mitigate the tax advantage of earning passive income in low-tax countries.

Foreign Affiliates Dumping Rules

Budget 2012, with the aim of improving the fairness and integrity of the Canadian tax system, proposed to restrict the ability of foreign-based multinational corporations to transfer, or “dump”, foreign affiliates into their Canadian subsidiaries with a view to creating tax-deductible interest or distributing cash free of withholding tax, without providing any economic benefit to Canada.

The following paragraphs are extracted from the Budget 2012:

Foreign affiliate dumping transactions often involve a Canadian subsidiary using borrowed funds to acquire shares of a foreign affiliate from its foreign parent corporation. These transactions are carried out in the expectation that interest paid by the Canadian subsidiary on such borrowed money is deductible in computing income for tax purposes while, at the same time, most dividends received by the Canadian subsidiary on the shares of the foreign affiliate are exempt from taxation, resulting in the erosion of the Canadian corporate tax base. The thin capitalization rules, including the amendments proposed in this Budget, do not provide adequate protection against these transactions.

The Government also has concerns with variations of these transactions, including, for example:

  • acquisitions of shares of a foreign affiliate that are made with internal funds of the Canadian subsidiary – such transactions provide a mechanism for foreign parent corporations to extract earnings from their Canadian subsidiaries free of Canadian dividend withholding tax;
  • acquisitions of newly-issued shares of a foreign affiliate, whether financed with internal or borrowed funds, where previously-issued shares of the foreign affiliate are owned by the foreign parent or another non-resident member of the same corporate group;
  • acquisitions of foreign affiliate shares from a foreign subsidiary of the foreign parent; and
  • acquisitions of foreign affiliate shares from an arm’s length party at the request of the foreign parent.

On October 18, 2012, the Finance minister introduced Bill C-45 in Parliament to implement, among other things, the foreign affiliate dumping rules. Bill C-45 adds a new anti-surplus stripping rule to the Income Tax Act as section 212.3.

To continue its extensive consultation with the stakeholders, on August 16, 2013, the Finance Department released for public comment draft legislative proposals with regards to the foreign affiliate dumping rules in the Income Tax Act.