Table of Contents
Non-residents with significant Canadian business activities most commonly use a corporation (“Canco”) that is created under Canadian corporate law and is thereby resident in Canada for tax purposes to carry on Canadian business operations. Canada’s tax system does not allow group filing or consolidated returns: each Canadian entity within a related group is required to determine its own taxes owing and must file its own tax return, although discussed below under 5., Losses, some degree of self-help is permissible to match income in one Canco with tax shelter available in a related Canco.
1. Creating and Capitalizing a Canadian Subsidiary
- Canadian corporations can be created under federal or provincial corporate law (choice of statute generally does not impact tax liabilities)
- Unlimited liability companies (ULCs) are treated as regular corporations for Canadian tax purposes but may receive advantageous U.S. tax treatment
- Provincial corporate income tax is based on where a corporation has “permanent establishments”
- “Paid-up capital” (PUC), being the tax version of corporate law stated capital and reflecting amounts received by a corporation in exchange for issuing shares, is a very important tax attribute (especially for non-resident investors)
- The ITA differentiates between Canadian-resident corporations that are “public corporations”, “private corporations” and those that are neither public nor private
Creating a Canadian Corporation
Corporations are the primary form of business entity used in Canada, in large part due to the limited liability they offer to their investors (shareholders). Corporations and their principal attributes are discussed here
A corporation can be created federally under the Canada Business Corporations Act (CBCA) Canada’s provinces and territories have similar legislation under which corporations can also be created. The choice of which corporate statute to create a Canadian corporation under depends on various factors, such as where the corporation anticipates doing business and having its principal office, as well as differences that exist amongst various corporate statutes (e.g., a requirement to have a minimum number of Canadian residents as directors). The CBCA offers the advantages of authorizing the corporation to carry on business anywhere in Canada, and without restrictions regarding the province or territory where the head office is located, corporate records are maintained and annual general meetings are held.
The provinces of Nova Scotia, Alberta and British Columbia also have corporate legislation allowing for the creation of “unlimited liability companies” (ULCs), which are similar to regular corporations but which have some important differences in terms of the extent to which shareholders or members of the ULC may be liable for its debts and obligations. For Canadian tax purposes a ULC is treated as a normal corporation. ULCs are often used by U.S. residents for U.S. tax reasons, as they can be disregarded (or treated as a partnership) for U.S. tax purposes. The Canada-U.S. Tax Treaty contains special rules that potentially exclude a U.S. resident from claiming relief from Canadian tax in respect of various payments by or activities of the ULC, as discussed in more detail here.
Corporations generally obtain a “business number” from the CRA, which is used for various CRA program accounts (e.g., income tax, payroll, GST/HST, import/export, etc.). A business number will be assigned automatically if Canco is created under the CBCA or a province other than Quebec or Newfoundland. For more on CRA business numbers see here.
It is relatively quick and easy to create a new corporation in Canada once the following basic decisions have been made:
- who the initial shareholders will be;
- who the directors of the corporation will be;
- whether the corporation will be a normal corporation or a ULC; and
- what the different classes of shares and their respective rights (i.e., voting, dividends and entitlement on liquidation) are.
Provincial Taxation and Permanent Establishments
A “permanent establishment” includes a “fixed place of business” (i.e., an office, etc.), as well as an employee or agent with general authority to contract for the corporation if the corporation carries on business through that person (Regulation 400). The operation of substantial machinery or equipment within a province is also deemed to constitute a permanent establishment. Only if a corporation would otherwise not have a permanent establishment anywhere is it deemed to have a permanent establishment in the place designated in its constating documents as its head office or registered office. The CRA’s views on permanent establishments are found in archived Interpretation Bulletin IT-177R2.
Once the corporation’s permanent establishments (either within or outside of Canada) have been identified, the corporation’s income will then be allocated amongst those permanent establishments, based on a formula using gross revenue attributable to and salaries and wages paid by each permanent establishment. Income thereby allocated to a particular province will be subject to provincial income tax in that province (and be eligible for the 10% federal income tax abatement, which is essentially a reduction in the federal corporate income tax rate designed to “make room” for provincial taxation). Income allocated to a permanent establishment outside of Canada will not be subject to provincial income tax, but will be taxed federally at an extra 10% by virtue of not being eligible for the 10% federal abatement for income earned in a province (s. 124(1)).
When a corporation issues shares of a particular class, it adds the consideration (cash or value of other property) it received for issuing those shares to the stated capital of that class of shares for corporate law purposes. Amounts added to or subtracted from stated capital for corporate law purposes are automatically also added or subtracted to PUC as well. Essentially, PUC corresponds with corporate law stated capital, subject to specific rules in the ITA providing for a different result (usually a reduction) for PUC.
The stated capital (and hence the PUC) of any share of a particular class of shares equals the stated capital (or the PUC, for tax purposes) of the entire class divided by the number of outstanding shares of the class. Thus, the PUC of each share of a class will be the same as the PUC of every other share of the same class, unlike each holder’s cost of the share for tax purposes (which reflects what that particular holder paid for their shares).
Subsequent issuances or redemptions of shares of that class will affect the PUC of each share of the class, but the sale of an already issued-share to another person does not affect PUC. Thus for example:
- if X subscribes for 1,000 shares of Canco for $1,000 and Y later subscribes for another 1,000 Canco shares of the same class for $5,000, the total PUC of $6,000 is apportioned evenly over each share of the class (i.e., $30/share, or $3,000 for X’s 1,000 shares and $3,000 for Y’s 1,000 shares); and
- if Y later sells his 1,000 shares to Z for $10,000, Z’s cost base in those shares will be $10,000 but their PUC will remain unchanged at $3,000, since no new shares were issued or existing shares redeemed.
When a Canadian corporation redeems or repurchases its own shares, it is deemed to have paid a dividend to the selling shareholder equal to the amount by which the redemption price exceeds the PUC of the redeemed or repurchased share. Thus for example, if Z’s 1,000 shares were redeemed for their fair market value of $10,000, Canco would be deemed to have paid a dividend of $7,000 ($10,000 – $3,000 PUC) to Z, even though Z paid $10,000 for those shares and would have realized no dividend or gain had they been sold to a third party (other than Canco) for their $10,000 value. Since a non-resident shareholder of Canco can receive property from Canco as a tax-free return of capital (rather than a dividend) up to the amount of the PUC of the non-resident’s shares, PUC represents a very valuable tax asset: the ability to extract value out of Canada without Canadian dividend withholding tax.
When a non-resident of Canada purchases an existing Canco, Canadian tax counsel typically encourage the non-resident to create and fund a new Canadian corporation as the direct buyer (which is then merged with the Canadian target corporation immediately post-closing), in order that a non-resident purchaser obtains both cost basis and PUC equal to the purchase price paid.2 See Steve Suarez and Kim Maguire, “Tax Issues on Acquiring a Canadian Business,” Tax Notes International, August 31, 2015, p. 775 at 786. For example, a non-resident buyer of a Canadian corporation whose shares are worth $5M but which have only $1M of PUC should not acquire those shares directly. Instead, a new Canadian corporation should be created and capitalized with $5M to make the acquisition, such that the cross-border shares owned by the non-resident have full $5M of PUC.
By maximizing cross-border PUC, a foreign investor facilitates several planning opportunities and optimizes the deduction of interest expense under Canada’s thin capitalization rules for debt owing by Canadian subsidiaries to non-arm’s-length non-residents (see below under 2. Interest Deductibility).
Types of Canadian-Resident Corporations
Public corporations: a “public corporation” as defined in the ITA is a Canadian-resident corporation that either (1) has a class of shares that is listed on a designated stock exchange in Canada, or (2) has elected to be a public corporation at a time when it met certain prescribed conditions relating to the dispersal of its shares amongst holders and has not since that time validly elected not to be a public corporation.3The conditions for be able to elect to be, and to cease to be, a public corporation are set out in Regulation 4800. Thus, it is possible to be a “public corporation” without publicly-traded shares. For the most part “public corporation” status is disadvantageous, as most the favourable tax mechanisms designed to achieve integration for Canadian shareholders are limited to private corporations (discussed below). Also, public corporations are subject to certain limitations on their ability to effect distributions as PUC returns (s. 84(4.1) ITA). One advantage of “public corporation” status is that shares of public corporations are “qualified investments” for holders that are tax-exempts such as registered retirement savings plans (RRSPs, comparable to U.S. 401K plans).
Private corporations: a “private corporation” as defined in the ITA is a Canadian-resident corporation that, (1) is not a “public corporation”, and (2) is not controlled by one or more “public corporations.” Private corporations are generally subject to various favourable aspects of the “integration” provisions in the ITA that seek to make the combined corporate + shareholder levels of tax approximately equal to the tax a Canadian-resident shareholder earning the same income directly would have paid. These include (1) the ability to pay “capital dividends” which are received tax-free by Canadian residents, (2) liability for Part IV tax on investment income it earns, and (3) refunds of refundable dividend tax on hand (RDTOH) on the payment of dividends.
Canadian-controlled private corporations (“CCPCs”) are a subset of private corporations. A CCPC is a Canadian-incorporated corporation (1) that is not controlled (either in fact or in law) by any combination of non-residents and/or public corporations, (2) a voting majority of the shares of which are not owned by any combination of non-residents and/or public corporations, and (3) no class of whose shares is listed on a designated stock exchange. CCPCs enjoy various tax advantages, including:
- a reduced rate of income tax on active business income (up to a specified limit);
- preferential treatment for expenditures on scientific research & experimental development (see below under 8, Scientific Research & Experimental Development); and
- for shareholders, potential eligibility for beneficial treatment of gains on its shares (the qualified small business corporation (QSBC) share lifetime capital gains exemption for Canadian residents)4 QSBC eligibility requires that the corporation also be a “small business corporation.” and stock options to acquire shares.
Neither public nor private corporations (“NPNPs”): Canadian-resident corporations that are neither public nor private corporations (NPNPs) simply are not subject to whatever advantages or disadvantages are unique to the other two categories. The most common example of an NPNP would be a Canadian subsidiary of a “public corporation.”
All three of the foregoing types of Canadian-resident corporations are eligible to be “taxable Canadian corporations,” defined as a Canadian-resident corporation that is not tax-exempt and that is either (1) incorporated in Canada, or (2) resident in Canada continuously from June 18, 1971. Most of the tax-deferred “rollover” provisions in the ITA applicable to corporations are limited to “taxable Canadian corporations,” including:
- s. 85(1) (property-for-share exchanges);
- s. 85.1(1) (share-for-share exchanges);
- s. 87(1) (amalgamations); and
- s. 88(1) (wind-ups).
2. Interest Deductibility
- Interest expense is generally not deductible for income tax purposes unless the underlying debt to which it relates was incurred directly to earn income from a business or property. This makes it important avoid cases where borrowed money can be directly traced to a non-income-earning use.
- Favourable CRA administrative policy allows interest deductibility on money borrowed for certain ineligible uses such as paying dividends or making interest-free loans, within limits.
- A separate interest deductibility limit applies to Cancos that incur debt owing to non-residents who are (or do not deal at arm’s length with) 25%+ shareholders.
- These “thin capitalization” rules limit the extent to which Canco can deduct interest on such debt to $1.50 of such debt for every $1 of “equity” Canco has; interest on excess debt is non-deductible and treated as a dividend for withholding tax purposes.
- The thin capitalization rules are supported by complex “back-to-back loan” anti-avoidance rules.
Interest Deductibility Generally
- borrowed money used for the purpose of earning income from a business or property (other than tax-exempt income); or
- an amount payable for property (i.e., balance of sale price owing) for property acquired for the purpose of earning non-exempt income from a business or property.
Thus, it is important to be able to trace a debt incurred to an income-earning use in order to support interest deductibility. Prima facie, interest on debt incurred to earn capital gains or for non-business reasons will not meet the requirements of s. 20(1)(c). Someone who uses their own capital to invest in a business and borrows money to buy a house for personal use will find their interest expense non-deductible even though they could (and should) have used the borrowed funds to invest in the income-earning business and thereby achieved deductible interest. The onus is on taxpayers to structure their affairs appropriately.
That said, in practice meeting the income-earning purpose test is less onerous than it might otherwise seem as long as one is aware of the issue and plans accordingly. First of all, the courts have held that “income” refers to gross income rather than net income, and that an income-earning purpose need only be one of the purposes (and not necessarily the “dominant” purpose) in incurring the debt in question.7 Ludco Enterprises et al. v. The Queen, 2001 DTC 5505 (SCC). Moreover, the courts have approved re-ordering transactions that “fix” the kind of mis-allocation described in the preceding paragraph, e.g., allowing the taxpayer to withdraw invested capital from the business, use it to pay off the mortgage on the house, and then borrow to invest in the business, to achieve the correct direct tracing.8 Singleton v. The Queen, 99 DTC 5362 (SCC). Such “fill the hole” transactions effectively allow a well-advised taxpayer to “fix” many situations where awareness of the direct tracing principle would have led to the “right” allocation of borrowed and non-borrowed capital.
Moreover, the CRA’s administrative policies in this area are generally favourable, based on the jurisprudence. For example, acknowledging that money is fungible, where borrowed money and other funds are commingled so that direct tracing cannot be used, the taxpayer can choose which uses the borrowed money will be considered to have been applied to. This essentially means that so long as the non-borrowed money can be notionally applied first to non-qualifying uses of property, interest deductibility can be achieved without having to establish direct tracing. The CRA also acknowledges the case law on permissible exceptions to the “direct use” test in exceptional situations where deductibility is permitted on borrowed funds that have been used for an ineligible purpose, because of their indirect effect on the taxpayer’s income-earning capacity. This is reflected in the CRA administrative policy allowing borrowed funds to be used for non-income producing purposes such as paying dividends, returning PUC, redeeming shares or making interest-free loans, up to specified amounts. The CRA’s administrative policies on interest deductibility are set out in CRA Income Tax Folio S3-F6-C1, Interest Deductibility
Note that the ongoing use of the borrowed money or purchased property (not merely the taxpayer’s original use) will dictate continuing deductibility of interest. The ITA also contains special rules applicable to specific situations:
- compound interest is deductible only when actually paid, not merely payable (s. 20(1)(d));
- where new debt is incurred to replace existing debt, the new debt is deemed to be used for the same purpose for which the replaced debt was used (s. 20(3))
- continued interest deducibility is permitted in many so-called “disappearing source” situations, where a taxpayer borrows money to acquire property (other than land or depreciable property) or use in a business and later disposes of the property at a loss or ceases to carry on the business (s. 20.1); and
- restrictions exist on the deductibility of interest on “weak currency” loans, viz, loans in currencies that are expected to depreciate and which therefore bear higher interest rates, to prevent attempts to generate interest expense deductions that are fully deductible from income while realizing capital gains from foreign exchange (s. 20.3).
The key point is to be aware of the importance of linking debt to an ongoing income-earning purpose in order to achieve interest deductibility, and not to assume that all interest expense will necessarily be deductible for tax purposes. Advice should be sought in any case where debt is being incurred and a direct income-earning purpose cannot be established, such as the following:
- funding the payment of dividends
- funding a return to shareholders of share capital;
- funding the repurchasing shares;
- funding an interest-free loan or payment under a guarantee;
- funding a contribution to a corporation’s share capital;
- issuing a promissory note in satisfaction of any of the foregoing; and
- selling property or ceasing a business that was the income-earning use of debt.
While the actual computations are often much more complex, the concept is best explained with a simple example. A Canco that owes $100 million to its foreign parent and has only $50 million of equity for thin capitalization purposes throughout the relevant taxation year can only deduct interest expense relating to $75 million of that debt (see Figure 2). Interest on the remaining $25 million of debt will be non-deductible for Canadian tax purposes and will be recharacterized as a dividend, to which 25% Canadian non-resident dividend withholding tax will apply (subject to reduction under an applicable tax treaty), instead of as interest.
The starting point in the analysis is identifying whether Canco owes money to “specified non-residents.” A specified non-resident as regards Canco is defined as a non-resident person who either (1) owns at least 25% of Canco’s shares (by either votes or value, and including any shares held by non-arm’s-length persons) or (2) does not deal at arm’s length with shareholders holding at least 25% of Canco’s shares. For the purpose of testing whether a particular person is a “specified non-resident,” if they (or someone not dealing at arm’s-length with them) has a right of any kind (absolutely or contingently, presently or in the future) to:
- acquire shares of a corporation;
- control the voting rights of shares of a corporation; or
- cause a corporation to redeem, acquire or cancel shares owned by someone else
such rights are deemed to have been exercised (except if exercisable only on an individual’s death, bankruptcy of disability).
Computing the 1.5-1 debt-to-equity ratio used in the thin capitalization rules can be tricky due to the ongoing nature of the calculation throughout the year and differences in how the components of the formula (Canco’s “outstanding debts to specified non-residents” and “equity”) are defined and measured. Canco’s “outstanding debt to specified non-residents” is calculated by adding the maximum amount of debt9 Only debt the interest on which is otherwise deductible is relevant for this purpose. owed to “specified non-residents” at any time in each calendar month that ends in the relevant tax year, and dividing that amount by the number of those calendar months. This formula makes it disadvantageous to increase debt owed to specified non-residents shortly before month-end, relative to waiting until the start of the next month if possible.
Note that the rules do not permit different amounts owing between Canco and the specified non-resident to be set off against one another, making it important to effect an actual legal set-off of amounts owing to Canco to reduce the amount owing by Canco wherever possible to minimize the amount of “outstanding debt to specified non-residents.”
Canco’s “equity” for a particular year is calculated as the sum of the following three amounts:
- Canco’s unconsolidated retained earnings at the beginning of the year (i.e., an accounting concept);
- Canco’s total of the start-of-month contributed surplus10 “Contributed surplus” is not defined in the ITA. The CRA takes the position that this term should be determined based on applicable accounting principles (see CRA document 2002-0146655, dated October 30, 2002). Contributed surplus typically arises where a corporation receives property from a shareholder without the shareholder receiving equal consideration from the corporation in exchange. received from its specified non-resident shareholders 11 That is, a shareholder holding at least 25 percent of Canco’s shares who is a non-resident. for each calendar month ending in the year, divided by the number of those calendar months; and
- the total of the start-of-month PUC 12 See above under 1. Creating and Capitalizing a Canadian Subsidiary. of Canco shares owned by its specified non-resident shareholders for each calendar month ending in the year, divided by the number of those calendar months.
Canco’s retained earnings for thin capitalization purposes therefore are determined only at the beginning of the tax year, whereas the other equity components are calculated as monthly averages during the year. The various computational nuances make it particularly important for Canco to monitor its debt and equity for thin capitalization purposes throughout the year and to review its retained earnings before each year-end, so that any necessary adjustments can be made to stay within the 1.5-1 debt-to-equity limit for the next year (i.e., reducing debt or increasing equity). Whenever Canco is contemplating an action that would materially reduce its “equity” (e.g., paying dividends, reducing capital, etc.) either immediately or at the start of the following year, the impact on its thin capitalization limits must be considered.
Where an amount of interest accruing in a taxation year has been disallowed as a deduction under the thin capitalization rules, the disallowed interest is deemed to be a dividend for withholding tax purposes. This may result in a different withholding tax rate being applicable than the rate on interest. For withholding tax purposes, such disallowed interest is deemed to have been paid immediately prior to the end of the taxation year in which it accrues (if not actually paid before that time), so as to trigger the withholding tax by no later than year-end (s. 214(17)). The taxpayer is permitted to designate in its tax return for the year which payments (or deemed payments) of interest are allocable to particular amounts of allowed or disallowed interest accruing during the year, such that (for example) payments bearing lower withholding tax are deemed to be those occurring earlier in the year, to the extent permissible on the actual numbers.13 S. 214(16)(b). For a numerical example, see CRA document 2013-0483731C6, dated May 23, 2013. Withholding tax is discussed in greater detail here.
Back-to-Back (B2B) Loan Rules
The thin capitalization (and interest withholding tax) rules are supported by back-to-back (“B2B”) loan anti-avoidance rules, which are directed at attempts to insert an intermediary between Canco and the “real” creditor in order to achieve a better thin capitalization (or interest withholding tax) result. The B2B rules may apply if a connection exists between (1) a debt Canco owes to a ‘‘good’’ creditor (for example, an unrelated bank) from a thin capitalization or interest withholding tax perspective; and (2) specific arrangements between that ‘‘good’’ creditor and a non-resident not dealing at arm’s length with Canco. For example, if Canco’s foreign parent made a loan to a third party bank which in turn made a loan to Canco, the B2B rules would ignore the third party bank and effectively deem the foreign parent to be Canco’s creditor, causing the thin capitalization rules to apply and potentially higher Canadian interest withholding tax (see Figure 3).
To prevent a debtor from claiming interest expense (and other) deductions on an accrual basis while indefinitely deferring withholding tax (which applies upon payment of the expense), s. 78(1) limits how long expenses owed to a non-arm’s-length person can remain unpaid before the Canadian debtor is required to reverse the deduction claimed. An expense incurred by the taxpayer owing to a non-arm’s-length person in one tax year must be paid by the end of the payer’s second following tax year. If it remains unpaid by that time, the amount is added back into the payer’s income in the immediately following tax year, effectively reversing any deduction previously taken (see Figure 5).
As an alternative to increasing the debtor’s income, the parties can file a joint Form T2047 to deem the amount to have been paid and loaned back to the taxpayer, which will avoid the income addback. However, if the non-arm’s length person is a non-resident, the deemed payment of the expense will often trigger Canadian withholding tax. Form T2047 must be filed by the due date of the taxpayer’s income tax return for the following year (i.e., mid-2023 for an expense incurred during 2020).
3. Capital Cost Allowance
- Capital cost allowance (CCA) is the tax version of depreciation.
- Each depreciable property is placed into one of various “classes” of depreciable property, each of which has its own rate of depreciation.
- The cost of a depreciable property is added to the “undepreciated capital cost” (UCC) of the relevant class, and an annual CCA deduction from income is allowed each year as a percentage of the year-end UCC of that class (the UCC balance is reduced by the amount of that year’s CCA deduction claimed).
- Proceeds from the sale of a depreciable property (up to its original cost) are deducted from the UCC of the relevant class; if this results in a “negative” UCC balance, the difference is added back to income as “recaptured” CCA, and the UCC balance set to 0.
- Any excess of a depreciable property’s sale proceeds over its original cost is a capital gain.
- A special rule limits the amount added to the UCC balance of a transferee acquiring depreciable property from a non-arm’s-length transferor.
All depreciable property of a particular type or “class” is grouped together for CCA purposes (subject to certain exceptions). The total cost of all property in the relevant class is added together, and forms the “undepreciated capital cost” (“UCC”) of the class (s. 13(21)). For most types of depreciable property, a special rule known as the “half-year rule” limits the addition to UCC in the year of acquisition to 50% of the cost of the property, the remainder being added to the UCC of the relevant class in the following year (Regulation 1100(2)). In addition, it should be noted that certain rules prohibit a taxpayer from adding the cost of a depreciable property to the UCC of the relevant class until that property is “available for use” to the taxpayer (s. 13(26)). Further, where a taxpayer acquires depreciable property from a non-arm’s-length transferor, the transferee’s capital cost of the acquired property is limited to the transferor’s capital cost plus half of any capital gain realized by the transferor on the sale (s. 13(7)(e)).
Each year the UCC of the class is reduced by the amount of CCA claimed. The taxpayer may claim less than the maximum permissible CCA deduction in any period, leaving more for later years. Since CCA is usually computed as a percentage of the UCC of the particular class, as the UCC gets smaller over time, the amount of the annual CCA deduction will also get smaller. When a property of the class is sold, the proceeds of sale (up to the property’s original cost) are deducted from the UCC of the class. Any excess of sale proceeds over the original cost of the property is a capital gain. Conversely, when new property of the same class is acquired, the cost of the new property is added to the UCC of the class.
Effectively, CCA is meant to reflect a diminution in the value of depreciable property as it gets used up over time in the income-earning process. This means if a taxpayer sells a depreciable property for more than the UCC of its class (which reflects cumulative CCA deducted),16 In fact, individual property does not have a UCC; UCC is computed for the entire class of property, and a disposition of a depreciable property will not give rise to any recapture of CCA until the UCC of the entire class is reduced below zero. In illustrating what ought to occur upon a disposition of depreciable property however, it is nonetheless useful to think of the correct result in terms of an individual property. the property did not actually depreciate in value as fast as the rate used for CCA purposes, and in an economic sense too much CCA was claimed (i.e., the deductions from income allowed on account of the property exceeded its actual decrease in value). For this reason, whenever the UCC of a class of property at the end of the year is reduced below zero (viz., through a combination of asset sales and CCA claims), the “negative” UCC is included in the taxpayer’s income as recaptured CCA claims (or simply “recapture”), and the UCC of the class is reset to zero (s. 13(1)). Recapture reverses the excess CCA deductions taken by including these amounts back into income.
Conversely, to the extent that a taxpayer’s sale proceeds for depreciable property are less than its UCC,17 Once again, UCC is computed for a class of property, not individual property. the amount of CCA claimed was too little compared to the property’s actual diminution in value: the property was depreciating in value faster than its UCC was being reduced through CCA claims. Whenever the taxpayer has no property of the particular class remaining at the end of the year, he is entitled to claim a deduction from income equal to the remaining UCC of the class (s. 20(16)). This deduction (known as a “terminal loss”) gives the taxpayer an immediate deduction for the remaining CCA that is inherent in the UCC balance, and amounts to a “catch-up” of CCA deductions.
How the CCA System Works: Some Examples
The rules dealing with CCA can be quite detailed and complex, and a full discussion of how they work is beyond the scope of this article. However, the following examples illustrate the basic concept of how the CCA system operates in a simplified context of a single depreciable property of a particular class and ignoring the half-year rule that limits the amount added to the UCC of the class in the year that a depreciable property is acquired.
Example 1: In 2017 Mr. X pays $10,000 for a piece of equipment which falls into Class 8 for CCA purposes. The Regulations set out the applicable rate of CCA for Class 8 equipment as 20% per year. In 2020 he sells the equipment for $3,000.
UCC: Start of Year
CCA Deducted During Year
UCC: End of Year
($10,000 x 20%)
($10,000 – $2,000)
($8,000 x 20%)
($8,000 – $1,600)
($6,400 x 20%)
($6,400 – $1,280)
|less||UCC at sale||$5,120|
$2,120 (may be deducted from income)
If the property had been sold for, say, $7,000 in 2020, this would mean that in fact the property had not been diminishing in value as quickly as it was being depreciated for tax purposes. In effect, the taxpayer had been getting deductions from income for depreciation which economically never occurred. This requires the taxpayer to include recapture in his business or property income, being the difference between the sale proceeds (not exceeding the original cost) and the UCC at the time of the sale.
Example 2: assume as above, except that Mr. X’s sale proceeds in 2020 are $7,000.
|less||UCC at sale||$5,120|
$1,880 (must be included in income)
The final possibility is that the taxpayer sells the property for an amount in excess of its original cost. Where this occurs, the property has not in fact depreciated at all, and there should not really have been any deductions taken from income for CCA, since the property was not being “used up” to earn income and was in fact appreciating in value. Accordingly, all CCA previously taken on the property would be “recaptured”, and the excess of the sale proceeds over the original cost of the property (its adjusted cost base or “ACB”) is a capital gain, one-half of which is included in income as a taxable capital gain (as with any other capital property).
Example 3: as above, but assume that Mr. X sells the property in 2020 for $12,500.
|Sale proceeds > cost||$12,500|
$2,500 (1/2 included in income)
|Sale proceeds up to cost||$10,000|
|less||UCC at sale||$5,120|
|equals||Recapture||$4,880 (must be included in income)|
4. Transfer Pricing
- Canada’s transfer pricing rules ensure that Canadians do not pay too much or charge too little on transactions with non-arm’s length non-residents, and are aggressively enforced by the CRA.
- This is accomplished by requiring the Canadian to transact on terms and conditions no less favourable than what arm’s-length parties in the same circumstances would have agreed to.
- Failure to meet this arm’s-length standard exposes the Canadian taxpayer to upward income adjustments and resulting increased taxes (plus interest), and potentially penalties where the Canadian is found not to have made reasonable efforts to determine and use arm’s-length terms and conditions.
- Transfer pricing adjustments also usually result in “secondary adjustments” that amount to a dividend being deemed to have been paid equal to the amount the Canadian taxpayer under-received or was over-charged (triggering Part XIII dividend withholding tax), unless the Canadian is reimbursed.
- Canada’s transfer pricing rules are review in detail in Suarez, “Transfer Pricing in Canada,” Tax Notes International, December 2, 2019, p. 781.
Like most countries, Canada has “transfer pricing” rules in its tax laws that prevent base erosion through transactions between Canadians and non-arm’s-length non-residents (“NALNRs”). Essentially these rules ensure that in such transactions, the Canadian does not pay too much for goods and services received from, or receive too little for goods and services delivered to, such NALNRs. The benchmark used for this purpose is the arm’s-length standard, being what an arm’s-length person would have paid or received for the same goods and services in the same circumstances. What arm’s-length persons in the same circumstances as the actual parties would have agreed is typically a very judgmental exercise, based on a wide range of potential transfer prices and different methodologies for determining them.
Where the Canadian taxpayer’s transfer prices are found to be non-compliant with the arm’s length standard, the CRA is permitted to adjust the taxpayer’s income (i.e., to deny deductions where the Canadian has paid too much, or increase income where the Canadian has received too little), which will increase tax payable (or reduce the taxpayer’s loss) for the year. In addition, the taxpayer may face a “secondary adjustment” to treat the amount of the adjustment as a deemed dividend to which non-resident withholding tax applies, unless that amount is repatriated to the Canadian taxpayer by the NALNR. Furthermore, the taxpayer may be assessed penalties if it is found (or is deemed) not to have made “reasonable efforts” to determine and use arm’s-length terms and conditions in its transactions with NALNRs.
The first step is to identify a particular transaction or series of transactions (the tested transactions) in which both the Canadian taxpayer and an NALNR participate. The arm’s-length standard is then applied to the tested transactions, in the form of one (or both) of the substantive rules in s. 247(2).
The general transfer pricing rule (GTPR) in section 247(2)(a) applies when the terms and conditions of the tested transactions between the actual participants differ from those that would have been made between arm’s-length persons in the same circumstances. If the GTPR applies, the CRA is entitled to revise those terms and conditions (i.e., prices) to those that arm’s-length parties would have agreed to.
s. 247(2)(b) contains a more severe transfer pricing “recharacterization” rule (TPRR). This provision applies when the tested transactions
- would not have been entered into between arm’s-length persons at all (i.e., they are commercially irrational), and
- can reasonably be considered not to have been entered into primarily for bona fide purposes other than to obtain a tax benefit.
The TPRR was recently considered by the courts for the first time in Canada v. Cameco Corporation,18 2020 FCA 112, affirming 2018 TCC 195. The FCA decision is reviewed in Steve Suarez, “Canadian Appeals Court Upholds Taxpayer Win in Cameco”, 2523 Tax Topics (Wolters Kluwer) 1-4 (July 14, 2020) For analysis of the Tax Court decision, see Steve Suarez, “The Cameco Transfer Pricing Decision: A Victory for the Rule of Law and the Canadian Taxpayer,” Tax Notes Int’l, Nov. 26, 2018, p. 877. which clarified that the TPRR applies only where no persons dealing at arm’s-length with each other (as opposed to the actual taxpayer) would have entered into the tested transactions.
The Cameco case highlights the significant variance between how Canadian courts have interpreted and applied Canada’s transfer pricing rules and the OECD’s transfer pricing guidelines. Canada purports to follow the OECD’s transfer pricing guidelines. However, in practice Canadian courts have placed much greater weight on the taxpayer’s commercial law rights and obligations as established under the actual contracts, rather than focusing on perceived economic “substance” as is found in the 2017 OCED Transfer Pricing Guidelines. It is important to be aware of the significant (and growing) divergence between Canadian caselaw and the OECD’s transfer pricing guidelines. The CRA’s cancellation of Information Circular IC87-2R (its primary administrative guidance on transfer pricing) announced in February 202019 See PR 2020/02/26B Rev — Notice to Tax Professionals: International Transfer Pricing Administrative Guidance Archived, dated February 26, 2020. ostensibly on the basis that it no longer reflects the most current OECD transfer pricing guidelines suggests that the CRA is not accurately interpreting the caselaw. Taxpayers should therefore expect increasingly frequent transfer pricing disputes with the CRA.
The CRA long took the position that a natural hierarchy of transfer pricing methods existed, with traditional transaction methods (particularly the comparable uncontrolled price or CUP method) being preferable to transactional profit methods. With the release of the 2010 update to the OECD guidelines, the CRA retreated somewhat from that view:
The 2010 version of the Guidelines essentially suggests that there is no strict hierarchy to be applied to the selection of a transfer pricing method. Rather the focus should be on the quality of the data that is available and, consequently, what will be the most appropriate method. At the same time, the Guidelines continue to suggest that there exists a natural hierarchy to the methods, as referred to in paragraph 2.3. The CRA agrees that the focus of determining the method to use should be the method that will provide the most direct view of arm’s length behaviour and pricing.
Table 1 below summarizes the transfer pricing methodologies applied by Canadian tax courts in various judicial decisions, along with associated CRA commentary (as noted above, the CRA formally withdrew IC 87-2R in February 2020, although it has not yet been replaced with new administrative policy).
|Traditional Transaction Methods||Transactional Profit Methods|
|CUP||Resale Price||Cost Plus||Profit Split||Transactional Net Margin|
Applied in Cameco.
Applied in Marzen.
Applied in Alberta Printed Circuits.
Used by both parties in Glaxo.
|Applied as a secondary check in Cameco.||Rejected in Cameco.||Applied in Ford and Nortel cases (not tax cases).||
Rejected in Cameco.
Rejected in Alberta Printed Circuits.
|CRA commentary (general)||IC 87-2R, paras. 64-69||IC 87-2R, paras. 70-75||IC 87-2R, paras. 76-89||IC 87-2R, paras. 90-105||IC 87-2R, paras. 106-119|
|CRA commentary (specific)||
Provides best evidence of arm’s- length price (64).
Transactions may be comparable if differences can be: (i) reasonably measured and (ii) adjusted for to eliminate effect of differences (66).
|Most appropriate where seller adds little value to goods (74).||
Most relevant where functions performed by tested party are the least complex, and tested party does not contribute valuable or unique intangible assets (89).
Appropriate for intragroup services (162).
Most appropriate when parties’ operations highly integrated and existence of valuable/unique intangibles makes it impossible to establish comparability to a one-sided method (97).
Suitable where intangibles present and no comparables to use a one-sided method (99, 145).
Usually applied to least complex party that does not contribute to valuable or unique IP (108).
Should be applied on a transactional basis and not companywide (118).
Frequently used in MAP settlements (Section IV.B.2).
Transfer pricing penalties may apply to the taxpayer when its net transfer pricing adjustment for the year exceeds the lesser of $5 million or 10% of the taxpayer’s gross revenue for the year. The amount of the penalty is 10% of the net adjustment, excluding adjustments in respect of which the taxpayer made “reasonable efforts” to determine and use arm’s-length prices and allocations. These are relatively onerous penalties, since they are computed as percentages of transfer pricing adjustments rather than any resulting increases in actual taxes owed.
A taxpayer can avoid transfer pricing penalties if it can show it made reasonable efforts to determine and use arm’s-length prices and allocations, this being a question of fact. However, when the taxpayer fails to meet the statutory requirements set out in section 247(4) to prepare and provide the CRA with satisfactory “contemporaneous documentation” outlining the underlying analysis, it is deemed not to have made reasonable efforts. Taxpayers who fail to prepare satisfactory contemporaneous documentation are therefore at significant risk if their transfer prices are found to be deficient (this is the intention of the penalty).
Whether or not penalties apply, an adverse transfer pricing adjustment will also typically result in secondary adjustments to reflect the finding that the Canadian has essentially conferred a benefit on the NALNR (i.e., by paying too much or receiving too little). Unless the CRA allows the NALNR to reimburse the transfer pricing adjustment to Canco, the benefit will be treated as a deemed dividend subject to Canadian dividend withholding tax (25% unless reduced under an applicable tax treaty).
The CRA’s aggressively applies Canada’s transfer pricing rules. Audits in Canada are lengthy, time-consuming and often contentious, often taking many years to complete due to the highly judgmental nature of determining “correct” transfer prices and the large dollar value of transactions between Canadians and non-arm’s-length non-residents. A taxpayer dissatisfied with the result can pursue an administrative review from CRA Appeals and/or litigate the issue before the Tax Court of Canada (and eventually higher appeals courts). A taxpayer whose relevant NALNR is resident in a country with a Canadian tax treaty has the further option of pursuing relief from the Canadian competent authority under the mutual agreement procedure set out in the relevant tax treaty. The dispute resolution options can be quite complex.20 For a visual illustration of the various options see Suarez, “Transfer Pricing in Canada,” Tax Notes International, December 2, 2019, p. 781 at p. 811.
- The two principal types of losses for Canadian income tax purposes are capital losses (usable only against capital gains) and losses from a business or investment (usable against any type of income or gain).
- Excess capital losses from a given year may be carried back and used in the three most recent taxation years or any future years. Excess business/investment losses from a given year may be carried back and used in the three most recent taxation years or the 20 following taxation years.
- Loss recognition is denied or suspended in many transactions between affiliated persons.
- While Canada doesn’t have consolidated returns or a group relief system, the ITA generally allows transactions that achieve a sharing of losses between affiliated Canadian entities, such that losses in one Canco can be used against income/gains in an affiliated Canco.
- Where a corporation undergoes an acquisition of control, (1) any accrued but unrealized losses are deemed realized for tax purposes, (2) pre-acquisition of control capital losses and investment losses become unusable in the post-acquisition of control period (and vice versa), and (3) pre-acquisition of control losses from a business may be used in the post-acquisition of control period only under certain conditions.
Types and Use of Losses
The two primary types of losses for Canadian income tax purposes are (1) capital losses, and (2) losses from a business or investment. A capital loss typically arises on a disposition of a capital property when the sale proceeds are less than the taxpayer’s cost of the property and any expenses of disposition, while a business or investment loss generally arises in a particular year when the expenses associated with the business or investment in the year exceed the income it generates. See here for a discussion of differentiating between transactions on capital account and transactions on income account.
Each business or investment of the taxpayer is treated as a separate source of income with a separate computation of profit or loss. A taxpayer computes its overall income for the taxation year by aggregating the profit (or loss) from each business or investment.21 For Canadian residents, the income or loss from each business or investment is included, while non-residents generally include only income or losses from businesses carried on in Canada that are not excluded from Canadian tax under the terms of a relevant tax treaty. As such, a loss from one business or investment is deductible against income from another within the same year.22Some special types of business or investment losses (losses from some farming activities and “limited partnership losses”) are not freely deductible against other business or investment income; these special types of losses are not discussed here.
Each year, the taxpayer totals 50% of any capital gains realized in the year (taxable capital gains) and subtracts 50% of any capital losses realized in the year (allowable capital losses).23Again, for Canadian residents all capital gains and losses are included. Conversely, non-residents generally include only capital gains and losses from some specified forms of Canadian-situs capital property (“taxable Canadian property”) that are not exempt from Canadian capital gains tax under a tax treaty.
If the net amount is positive, that excess (net taxable capital gains) is added to the taxpayer’s overall income for the year. However, if allowable capital losses exceed taxable capital gains, the excess is not deductible against business or investment income in computing overall income.24 See scenario 2 of Table 2. One particular form of capital loss (an “allowable business investment loss” or ABIL) is deductible against business or investment income. An ABIL arises on some dispositions of shares or debt of Canadian-controlled private corporations all or substantially all of whose assets are used in active businesses carried on in Canada. Instead, it is treated as the taxpayer’s net capital loss for the year, which, subject to some limitations, may be applied against net taxable capital gains of other years as described below.
If the taxpayer’s losses from businesses and investments for the year exceed the sum of the taxpayer’s income from businesses and investments plus net taxable capital gains, that excess is the taxpayer’s noncapital loss for the year. 25See scenario 3 of Table 2.The taxpayer’s noncapital loss for a particular year may be applied against income (or net taxable capital gains) in other years, subject to various restrictions as described below. Hence, the taxpayer’s net capital loss and non-capital loss can be thought of as excess losses for a particular year that can be used in other years. Table 2 contains simplified numerical examples of the operation of those rules.
The distinction between capital losses and business/investment losses is an important one for various reasons:
- only 50% of a capital loss (the allowable capital loss) is recognized by the tax system;
- capital losses are only deductible against capital gains, whereas business/investment losses can be deducted against any income or taxable capital gain;
- excess business/investment losses for a year (i.e., noncapital losses) have different rules for application in other years than excess capital losses for a year (net capital losses); and
- a corporation’s capital losses are treated differently from its business losses on an acquisition of control of the corporation.
A taxpayer’s noncapital loss for the year may be carried back and applied against the taxpayer’s income in any of its three most recent tax years or carried forward and used in any of its 20 immediately subsequent tax years. It expires if not used within that period. A taxpayer’s net capital loss for the year may be used against the taxpayer’s net taxable capital gains (but not business or investment income) in any of the taxpayer’s three most recent tax years or any later year. In both cases, unexpired losses of earlier years must be used before those of later years. 26 The rules dealing with loss carryforwards and carrybacks are largely contained in section 111. ABILs are included in the taxpayer’s noncapital loss. If they remain undeducted at the end of the carryforward period, they are transferred to the taxpayer’s net capital loss (which has no carryforward expiration). As discussed below, a corporation’s ability to use its non-capital losses or net capital losses in another year may be affected by a corporate reorganization or an acquisition of control of the corporation.
Business 1: Income (Loss)
Investment 1: Income (Loss)
|Subtotal: Net Business/Investment Income (Loss)||$40||$70||
Capital Property 1: Capital Gain (Loss)
Taxable Capital Gain (50%)
Capital Property 2: Capital Gain (Loss)
Allowable Capital Loss (50%)
Subtotal: Net Taxable Capital Gains (Losses)
Overall Income (Loss)
Noncapital Loss For the Year
Net Capital Loss For the Year
When are Losses Recognized?
Not all losses are recognized by the tax system. In particular:
- in some cases loss recognition is denied completely – for example:
(1) in some circumstances a loss realized on the disposition of a share is reduced by the amount of particular dividends received on the share27 Sections 112(3)-(7). The basic principle behind the rule is that tax-free dividends that have been received on a share represent a tax-free recovery of cost that should reduce the amount of any loss from a sale of the share. For more on these rules, see Suarez, “The Capital Property Dividend Stop-Loss Rules”, 53(1) Canadian Tax Journal, 269-91 (2005). , and
(2) losses from the disposition of a debt are generally denied unless the debt was acquired by the creditor to gain or produce income or is a balance of sale owing on a disposition of capital property to an arm’s-length person; 28 Subparagraph 40(2)(g)(ii). As a result, interest-free loans can be problematic in that regard. For more on these rules see Suarez, “Tax Topics for Tough Times” and
- in a variety of instances (typically in transactions amongst affiliated parties), a loss that would otherwise be realized is suspended until a later event occurs; and
One principle of the overall scheme of the ITA is that losses on the disposition of property should generally not be recognized when the taxpayer or an affiliate continues to own the property (or an identical substituted property (note: there is no such corresponding rule on the realization of income or gains). The tax policy is that no true economic loss arises until the relevant property ceases to be held within the affiliated group. These rules typically use the status of “affiliated” persons as the relevant degree of relationship for this purpose. In some cases those stop-loss rules delay recognition of the seller’s loss until neither the seller nor a person affiliated with the seller holds the relevant property. In a few instances, the loss is denied to the seller and effectively transferred to the affiliated purchaser as an accrued loss on the acquired property, to be realized on a subsequent disposition.
The concept of “affiliated” persons is somewhat involved, but can be summarized as follows. A natural person is “affiliated with his spouse, but not any other natural person (that is, children, parents, and siblings). A corporation is affiliated with any person (including another corporation) who controls the corporation, any member of a group of affiliated persons that controls the corporation, and the spouse of any of those persons. A corporation is also affiliated with another corporation if:
- each is controlled by the same person;
- each is controlled by a single person and those two persons are affiliated;
- one is controlled by a single person, the other is controlled by a group of persons, and the single person is affiliated with each member of the group of persons; or
- both corporations are controlled by groups of persons and every member of both groups is affiliated with at least one member of the other control group.
For this purpose, “control” refers to de facto control of a corporation, 29 De facto control means effective control of a corporation, such as may occur when (for example) one large shareholder holds less than 50% of a corporation’s shares but the remainder are widely held among the public. rather than the narrower, more typical de jure test of having sufficient shares to elect a majority of the corporation’s board of directors. Analogous rules govern the affiliation status of partnerships and trusts.
While there are separate stop-loss rules dealing with different types of property, they generally operate along similar lines. For example the stop-loss rules applicable to dispositions of non-depreciable capital property by a corporation, partnership, or trust suspend recognition of the taxpayer’s loss if some conditions apply, and (when applicable) go on to prescribe the circumstances in which a suspended loss will be unsuspended and recognized for tax purposes. Thus for example, a loss by a corporation, partnership, or trust (the transferor) from the disposition of non-depreciable capital property (the disposed-of property) is deemed to be nil when:
- the disposition of the disposed-of property is not an excepted disposition; 30 Excepted dispositions include some dispositions deemed to occur by the ITA and a disposition by a corporation that has undergone an acquisition of control in the 30 days following the disposition.
- the transferor or an affiliated person acquires a property (the acquired property) within the 61-day period that begins 30 days before and ends 30 days after the date of the disposition;
- the acquired property is either the disposed-of property itself or property identical to the disposed-of property; and
- at the end of the 61-day period, the transferor or an affiliated person owns the acquired property.
Thus, for example, simply transferring ownership to an affiliated person, or disposing of property and buying it (or an identical property) back within 31 days, will cause the loss to be suspended. The suspended loss will be recognized at the beginning of the first 30-day period following the disposition in which neither the transferor nor an affiliated person owns the acquired property or a property that is identical to the acquired property and was acquired within the 30 days preceding the start of that 30-day period. 31 Some events and dispositions deemed to occur under the ITA (including an acquisition of control of a corporation) will also un-suspend the loss. The rules are contained in subsections 40(3.3)-(3.7) and in some circumstances also deem property to be identical to other property (for example, shares acquired in certain tax-free exchanges) or deem persons to own property. Thus for example, if the acquired property is sold outside the affiliated group or the owner of the acquired property has ceased to be affiliated with the transferor, the loss would be unsuspended.
There are various ways in which losses can be effectively transferred from one party to another, including (1) the sale of the shares of a corporation that has losses, (2) the merger or wind-up of corporations, and (3) transactions designed to effectively allow one entity to use the losses possessed by another. The overall scheme of the ITA is to allow affiliated entities to engage in a substantial degree of “self-help” planning to match income or gains in one Canadian affiliate with available losses in another, but to significantly restrict the sharing of losses amongst unaffiliated persons.
This is best explained by describing the rules applicable when de jure control of a Canco is acquired, viz., an acquisition of control (AOC). 32 Detailed rules in s. 256(7) set out when control of a corporation is deemed to have been acquired (see also s. 256.1, applicable where a person or group of persons acquires more than 75% of the value of a corporation’s equity). Somewhat comparable rules apply to a trust that undergoes a significant change in beneficiaries: see s. 251.2(2). For most ITA purposes, on an AOC Canco is deemed to have a taxation year-end at the first moment of the day on which control is acquired, unless Canco elects for it to occur at the particular moment of that day when de jure control is acquired. Canco must recognize various accrued losses (for example, on capital property, inventory, receivables, and so forth) immediately before that deemed year-end, crystallizing them such that they can either be, (1) used in the tax year ending on the AOC or (2) added to Canco’s net capital loss or noncapital loss for that year.
An AOC impacts unused losses (including those deemed realized as above and not used in the tax year ending on the AOC) in the following manner:
- Capital losses. Canco’s pre-AOC net capital losses cannot be used post-AOC and effectively expire.
- Noncapital business losses. Canco’s unused pre-AOC noncapital losses from a particular business (the loss business) can be carried forward and used in post-AOC tax years (and vice versa) only if (1) throughout the later year in which Canco seeks to use those losses it continues to carry on the loss business with a reasonable expectation of profit; and (2) the post-AOC income that the losses are used against arises from carrying on either the loss business or a business of selling similar properties or rendering similar services as were sold or rendered in the loss business. 33 It is a question of fact whether the loss business continues to be carried on. The CRA has identified several factors it will generally consider, including the location of the business carried on before and after the AOC, the nature and name of the business, the nature of income-producing assets, the existence of a period or periods of dormancy, and whether the original business constituted a substantial portion of the corporation’s activities in terms of time and financial resources. Similar rules apply to scientific research and experimental development deductions, tax credits, and resource sector tax pools.
- Noncapital investment losses. Any Canco pre-AOC operating losses from investments cannot be used in the post-AOC period and effectively expire.
The anti-avoidance rules in subsections 69(11)-(13) are also part of the ITA restrictions on loss utilization between unaffiliated persons. They apply when a disposition of property occurs at below fair market value sale proceeds for tax purposes (that is, a rollover) as part of a series of transactions, and one of the main purposes of the series is to use the deductions or losses of someone unaffiliated with the vendor on a subsequent disposition of the property within three years. When applicable, those rules deem the transferor to have received fair market value sale proceeds on the original disposition for tax purposes, i.e., the rollover is denied.
The existence of these rules provides a legislative basis for the CRA’s conclusion that loss utilization transactions between affiliated persons are acceptable and within the scheme of the ITA. Such planning may take various forms, including:
- the wind-up of one taxable Canadian corporation into another that owns all of its shares;
- the amalgamation of two or more affiliated taxable Canadian corporations; or
- transactions that create income in the Canadian loss entity and deductions in an affiliated entity (i.e., with income or gains to be sheltered).
For a detailed discussion of such planning techniques amongst Canadian corporations, see Suarez, “Using Tax Losses Within a Canadian Group of Companies”, Tax Notes International, April 2, 2012, p. 59
6. Foreign Affiliate Dumping (FAD) Rules
- The foreign affiliate dumping (“FAD”) rules are apply to Cancos that (1) are controlled by a non-resident person (or group of non-resident persons who do not deal at arm’s length with one another), and (2) have an equity interest in one or more non-Canadian corporations.
- They discourage MNEs from putting foreign subsidiaries “under” their Canadian group members, by creating adverse tax results when the Canco acquires equity or debt of a “foreign affiliate”, subject to very limited exceptions.
- Where applicable, the FAD rules either reduce Canco’s PUC or deem Canco to have paid a dividend to a non-resident (triggering Canadian dividend withholding tax).
- In some cases what would otherwise be a deemed dividend can be replaced with a PUC reduction, and in others Canco can elect for a different dividend payer and/or recipient.
- For more on the FAD rules, see Suarez, “An Analysis of Canada’s Latest International Tax Proposals”, Tax Notes International, September 29, 2014, p. 1131.
The foreign affiliate dumping (FAD) rules strongly discourage a Canco from owning significant interests in foreign corporations, if the Canco is itself controlled by a non-resident person or group of non-resident persons who do not deal with one another at arm’s-length (in either case, “Foreign Parent”). These rules start from the premise that except in very limited circumstances, a Canco controlled by a foreign person generally should not have foreign subsidiaries. The impetus for enacting these rules was a concern by the Department of Finance that foreign MNEs were causing their Canadian members to acquire interests in foreign affiliates either,
- to generate interest expense deductions in Canada that reduce Canco’s Canadian corporate income tax (i.e., if Canco issues debt as the purchase price for the foreign affiliate’s shares), or
- as a way of distributing surplus cash out of Canada without paying Canadian dividend withholding tax. 34 For example, by purchasing equity of non-Canadian members of the multinational group for cash.
Since the ITA generally exempts dividends received by a Canco from a foreign affiliate that are attributable to active business income earned by a foreign affiliate, 35 For an excellent overview of Canada’s rules for “foreign affiliates” of Canadians, see Drew Morier and Raj Juneja, “Foreign Affiliates: An Updated Primer,” in Report of Proceedings of the Sixty-Fourth Tax Conference, 2012 Annual Conference Report, Canadian Tax Foundation (2013). such transactions were perceived to be “dumping” under Canada property that gave rise to little or no Canadian tax.
A classic foreign affiliate dump is illustrated in Figure 9. The Canadian member of the MNE group acquires existing shares (often fixed-value preferred shares) of another non-Canadian group member (ForSub, which becomes a foreign affiliate of Canco as a result). Any cash paid by Canco in exchange is viewed as the distribution from Canada of an income-generating asset in exchange for assets (shares of a foreign affiliate) perceived to be unlikely to generate significant taxable income in Canada, 36 Canco remains subject to Canadian income tax on capital gains from a disposition of the ForSub shares, as well as passive income (and certain Canadian-source income) earned by ForSub. without dividend withholding tax arising (i.e., surplus stripping). The same concern exists if Canco pays in shares of itself or with debt instead of with cash. This is because the amount added to the PUC of those shares or the obligation to repay the debt principal on maturity represents an eventual distribution of cash or other valuable property without incurring dividend withholding tax. Payment in debt also allows Canco to deduct the resulting interest expense against its other income (including Canadian-source income), leading to base erosion concerns.
Specifically, the FAD rules apply where a Foreign Parent-controlled Canco makes an “investment” in a corporation (“ForSub”) that is 37 Or becomes as part of the same series of transactions that includes Canco’s investment. a “foreign affiliate” of either Canco or another Canadian corporation not dealing at arm’s length with Canco. Generally, a corporation resident outside Canada will be a foreign affiliate of Canco if:
- Canco owns at least 1% of the foreign corporation’s shares (directly or indirectly); and
- Canco and all persons related to Canco collectively own at least 10% of the foreign corporation’s shares (directly or indirectly).
The following “investments” in ForSub by a Foreign Parent-controlled Canco will cause the FAD rules to apply:
- acquiring shares of ForSub;
- contributing to ForSub’s equity capital;
- extending credit to ForSub, or acquiring existing debt of ForSub;
- extending the date on which any debt owing by ForSub to Canco matures, or on which ForSub shares are due to be redeemed or cancelled; or
- acquiring the shares of another Canco more than 75% of the value of whose assets consist of shares of other foreign affiliates.
Certain investments by Canco that would otherwise trigger the FAD rules are specifically excepted. The first exception to the FAD rules is for specific loans by Canco to ForSub (“pertinent loans or indebtedness” (PLOIs)) in respect of which Canco and Foreign Parent jointly elect for Canco to be deemed to earn at least a minimum prescribed amount of interest income on the loan. The basic principle is that if Canco’s investment is generating enough taxable income in Canada, there is no need for the FAD rules. A separate exception exists for debts arising in the ordinary course of Canco’s business (for example, trade payables) if settled within 180 days (other than as part of a series of loans and repayments).
Another exception to the FAD rules applies to various forms of corporate reorganizations and distributions that technically constitute an investment in the sense that shares or debt of ForSub (or in some cases a Canadian corporation) are being acquired, but without any substantive new transfer of value by Canco to ForSub. An amalgamation of two related Cancos whereby the merged entity technically “acquires” the property of its predecessors is a simple example. This exceptions covers a number of common corporate reorganizations and intra-group transfers, but gaps exist and it is essential to carefully review the terms of the exemption to make sure that a particular transaction comes within its terms to exclude the FAD rules from applying.
A final exception from the FAD rules is intended to allow Canco to make a “strategic acquisition of a business that is more closely connected to its business than to that of any nonresident member of the multinational group.” This “closest business connection” (CBC) exception is based on showing that officers of Canco were sufficiently in control of, and responsible for, Canco’s investment in ForSub, and that for good business reasons Canco (as opposed to some other member of the multination group) was the logical entity to make this investment. As a practical matter, the pre-conditions to the CBC exception are very difficult to satisfy (or to prove they have been satisfied), and as a result it is unlikely to be of use to many taxpayers.
If the charging rule applies and no exception is available, the results are essentially that Canco is deemed to have paid a dividend (triggering dividend withholding tax) and/or suffered a reduction in the PUC of its shares. In some cases, (1) a deemed dividend can be replaced with a PUC reduction, and/or (2) the identity of the dividend payer and recipient can be modified via an election, so as to minimize withholding tax. PUC that has been the subject of an FAD reduction can also be reinstated in certain circumstances.
PUC Reduction and/or Deemed Dividend
The impact of the FAD rules applying depends on whether Canco’s “investment” involves Canco issuing shares and thereby increasing its PUC, or some other form of consideration. If Canco has increased the PUC of its shares for its investment by issuing shares of itself to pay for the ForSub investment (for example, issuing shares to Foreign Parent in exchange for ForSub shares), that PUC increase is reversed. This loss of PUC effectively turns future Canco distributions that could otherwise have been non-dividend PUC returns into dividends that will bear dividend withholding tax. Reduced PUC also reduces Canco’s “equity” for purposes of the thin capitalization rules as discussed above.
If instead Canco has transferred any property other than Canco shares or incurred any obligation (e.g., issued debt) 38 Or received any property as a reduction of any amount owed to it. in connection with its ForSub investment (collectively, “Non-Share Consideration”), the value thereof is treated as a dividend paid by Canco to Foreign Parent. This will generally trigger Canadian dividend withholding tax at a rate of 25% under the ITA, reduced to as little as 5% if the dividend recipient is resident in a country with which Canada has a tax treaty. Note that the FAD rules do not limit the dividend deemed to have been paid to Foreign Parent to Foreign Parent’s proportionate amount of Canco’s equity.
Dividend Substitution and PUC Offset
There are two ways in which these general results may be modified. First of all, Canco can elect to change the dividend payer (and thereby potentially the dividend recipient) in some cases. Specifically, a dividend that would otherwise be deemed to be paid by Canco can instead be deemed to be paid by a related Canadian corporation that meets certain conditions (a “qualifying substitute corporation” or “QSC”). 39 A QSC must have some direct or indirect share ownership in Canco (that is, it must be “above” Canco), and some QSC shares must be owned by Parent or a non-resident corporation that is not dealing at arm’s length with Parent. Making this election (the substitution election) to change the dividend payer to a QSC may allow the parties to reduce the Canadian dividend withholding tax exigible under an applicable tax treaty on the dividend deemed to be paid by the QSC.
Secondly, under the “PUC offset” rule in s. 212.3(7), some or all of a deemed dividend otherwise resulting is automatically replaced with a corresponding PUC reduction of the shares of Canco or a QSC, thereby deferring Canadian dividend withholding tax. In most cases the PUC offset rule requires the PUC reduction to occur so as to produce the greatest total reduction of the PUC in respect of shares owned by Foreign Parent or another non-resident corporation not dealing at arm’s length with Foreign Parent. While the PUC reduction is automatic, a year-end filing is required to avoid Canco nonetheless being deemed to have itself also paid a dividend to Foreign Parent. It is very important to make this filing.
PUC that has been reduced under the FAD rules may in some circumstances later be reinstated to allow Canco (or a QSC) to make non-dividend distributions of property to its shareholders relating to the investment that originally triggered the PUC reduction under the FAD rules.
Figure 10 provides a simplified general overview of the different issues and questions raised in applying the FAD rules. The FAD rules are extremely complicated and invariably require professional advice to deal with.
7. Foreign Exchange Issues
- Unless a Canco is eligible to and has made an election to report its Canadian tax results in another qualifying currency, it is required to compute income, gains and losses in Cdn.$ for Canadian tax purposes.
- This may result in the realization of income, gain or losses due to foreign exchange fluctuations, when Canco has become acquired property (or incurred liabilities) in currencies other than the Cdn.$.
- The principal tax issues are (1) characterizing the relevant amount as being either on income or capital account, and (2) the timing of when gains and losses are recognized for tax purposes.
- For more on F/X issues, see Steve Suarez and Byron Beswick, “Canadian Taxation of Foreign Exchange Gains and Losses”, Tax Notes International, January 12, 2009, p. 157.
If a Canadian-resident corporation maintains its records and books of account for financial statement purposes in Euros, the U.S.$, Australian $, U.K. pounds, it may elect under s. 261 to compute all relevant amounts for Canadian tax purposes in that “qualifying currency.” The CRA’s views on income tax reporting currencies are found in CRA Folio S5-F4-C1
Otherwise, the general rule is that for Canadian tax purposes all relevant amounts must be computed in Cdn.$, meaning that a Canco that engages in transactions expressed in currencies other than the Cd.$ may realize income, gain or loss from foreign exchange fluctuations relative to the Cdn.$.
The two primary foreign exchange (F/X) issues for Canadian tax purposes are:
- Characterization: F/X gains and losses are categorized as, (1) gains and losses on capital account (only 50% of gains included in income; capital losses deductible only against capital gains), and (2) gains and losses on income account (100% included in/deducted from income) and; and
- Recognition: Capital gains and losses are recognized only when realized (i.e., disposition of property or settlement of liability). Conversely, the taxpayer can generally choose to realize F/X gains and losses on income account either an accrual (year-end mark-to-market) basis or when actually settled, so long as the taxpayer is consistent from year to year and the method selected provides an accurate picture of the taxpayer’s profit.
Recognition: Capital gains and losses are recognized only when realized (i.e., disposition of property or settlement of liability). Conversely, the taxpayer can generally choose to realize F/X gains and losses on income account either an accrual (year-end mark-to-market) basis or when actually settled, so long as the taxpayer is consistent from year to year and the method selected provides an accurate picture of the taxpayer’s profit.
As is discussed elsewhere, Canadian income tax law differentiates between transactions on income account and those on capital account. This includes F/X gains and losses.
In many cases a gain or loss relating to F/X (i.e., changes in currency relative to the Cdn.$) will be subsumed within the computation of a taxpayer’s larger gain or loss (i.e., changes in a property’s value generally). For example, if a taxpayer acquires a property for a given amount of US$ and sells the same property for a different amount of $US, the taxpayer’s gain (or loss) is simply the excess (or deficiency) of the US$ sale proceeds (converted to Cdn.$ based on the exchange rate at the time of sale) over the US$ cost of the property (converted to Cdn.$ based on the exchange rate at the time the property was acquired). Hence, the taxpayer’s gain or loss will be the composite of the property’s increase or decrease in value and the F/X movement of the Cdn.$ relative to the currency in which the taxpayer paid for the property and received its sale proceeds. In such cases there is generally no need for tax purposes to compute the F/X gain or loss separately from the overall gain or loss (note: s. 39(2) contains a separate rule for the realization of F/X gains and losses on foreign-denominated liabilities).
In other cases where a change in value relates exclusively to F/X movements, the income/capital character of such change must be determined. The income or capital characterization of an F/X gain or loss is normally determined by reference to the character of the underlying transaction, asset, or liability to which the F/X gain or loss relates. 40 Shell Canada Ltd. v. R.,  4 C.T.C. 313, 99 D.T.C. 5669 (S.C.C.). Thus, an F/X gain arising from the disposition of a capital property will prima facie be a capital gain. An F/X gain or loss is characterized from the perspective of the taxpayer realizing the gain or loss, such that symmetry of tax treatment between both parties to a transaction may, but need not, occur regarding an F/X fluctuation. For example, a creditor’s F/X gain on a loan repayment may be on income account when the creditor is in the business of making loans, whereas the debtor’s F/X loss on repayment of the same loan may be characterized as being on account of capital if the debtor used the loan proceeds to acquire a capital asset.
Hence, examples of F/X gains and losses on income account include those relating to the sale of goods or services in the course of carrying on a taxpayer’s business (e.g., gains or losses on the collection of accounts receivable, on the sale of inventory, or on bank deposits used in the taxpayer’s day-to-day business activities). 41 The same treatment is applied to an isolated transaction that is generally in the nature of a business (for example, a transaction that is undertaken for a profit-making purpose, sometimes referred to as “an adventure in the nature of trade”), even if the transaction is not part of a business regularly carried on by the taxpayer. F/X gains and losses on the sale of capital property will normally be characterized as capital gains and losses.
In the case of liabilities, characterization depends on the underlying liability, which for borrowed money generally depends on the use of the borrowed funds. 42 See however, the Supreme Court of Canada in Gifford v. R.,  2 C.T.C. 1, 2004 D.T.C. 6120, to the effect that the character of a borrowing is determined not by the use of the funds borrowed but by the nature of the funds to the borrower when received. . An F/X gain or loss on debt relating to purchases in the ordinary course of a taxpayer’s business operations (i.e., accounts payable) or a speculative venture is typically characterized as being on income account. Conversely, an F/X gain or loss on debt incurred to acquire a capital asset or make another expenditure on capital account would typically be characterized as being on capital account.
However, if the borrowing forms part of the taxpayer’s fixed working capital, or permanent capital, the F/X gain or loss is characterized as being on capital account regardless of the use of the funds. 43 Shell and Columbia Records of Canada Ltd. v. M.N.R.,  C.T.C. 839, 71 D.T.C. 5486 (F.C.T.D.). See also CRA Document 9427166, Sept. 18, 1995. Whether borrowed funds form part of a taxpayer’s “permanent capital” depends on the circumstances. For example, if the draws and repayments regarding a debt can be linked to the taxpayer’s day-to-day income-earning activities, this may indicate income treatment. Similarly, if the taxpayer would be undercapitalized absent the borrowed funds, this is suggestive of capital treatment. 44 Id. While the term of a borrowing is not necessarily determinative of the issue, there may be a strong presumption that a long-term loan forms part of a taxpayer’s permanent capital even if the direct use of the loan proceeds is the acquisition of current assets. 45 See, e.g., Beauchamp (Inspector of Taxes) v. F.W. Woolworth plc,  B.T.C. 233 (H.L.), cited in Shell, supra.
A frequent F/X dispute between taxpayers and the CRA is hedging and derivatives. An F/X gain or loss from a derivative transaction is generally characterized as being on income account unless the derivative is used to effect a hedge. 46 The CRA may administratively allow certain taxpayers who undertake speculative transactions (often through the use of derivatives) outside the scope of a business and without access to special (insider) information to report F/X gains and losses on the transactions either on income or capital account, provided the same method is used consistently from year to year for all such transactions: Interpretation Bulletin IT-346R, “Commodity Futures and Certain Commodities”(Nov. 20, 1978), para. 15. As the Supreme Court of Canada stated in MacDonald v. The Queen (2020 SCC 6):
 The income tax treatment of gains and losses arising from derivative contracts depends on whether the derivative contract is characterized as a hedge or speculation. Gains and losses arising from hedging derivative contracts take on the character of the underlying asset, liability or transaction being hedged (Shell Canada Ltd. v. Canada,  3 S.C.R. 622, at paras. 68-70). In contrast, speculative derivative contracts are characterized on their own terms, independent of an underlying asset or transaction.
An F/X gain or loss from a derivative transaction used to effect a hedge is therefore characterized as being on income or capital account depending on the income/capital characterization of the underlying property or liability to which the hedge relates. 47 See also CRA Ruling 2007-0255401R3 (2008). For example, an F/X gain or loss on a derivative used to hedge F/X exposure on amounts arising from a taxpayer’s revenue-generating business operations, such as a hedge of a taxpayer’s accounts receivable, is normally characterized as being on income account. An F/X gain or loss on a derivative that is put in place to hedge F/X risk on a capital property (such as shares of a subsidiary held as capital property) is characterized as being on account of capital.
The MacDonald case also clarified that determining whether a hedge exists for tax purposes requires ascertaining its purpose, as determined from the objective evidence:
 As these cases demonstrate, the characterization of a derivative contract as a hedge turns on its purpose. The primary source for ascertaining a derivative contract’s purpose is the extent of the linkage between the derivative contract and an underlying asset, liability, or transaction. The linkage analysis begins with the identification of an underlying asset, liability or transaction which exposes the taxpayer to a particular financial risk, and then requires consideration of the extent to which the derivative contract mitigates or neutralizes the identified risk. The more effective the derivative contract is at mitigating or neutralizing the identified risk and the more closely connected the derivative contract is to the item purportedly hedged, the stronger the inference that the purpose of the derivative contract was to hedge. However, as noted, perfect linkage is not required to conclude that the purpose of a derivative contract was to hedge . . .
The use of hedge accounting for financial statement purposes does not necessarily mean the transaction will be considered a hedge for income tax purposes. For example, in Saskferco Products ULC v. The Queen, 2008 FCA 297, a taxpayer’s U.S.$ borrowing was not considered to be a hedge of its U.S$ dollar revenue, even though the borrowing had that effect, because the actual use of the borrowed funds was to construct a plant that was clearly a capital asset. Thus, F/X losses on the repayment of the debt were characterized as being on account of capital, while F/X gains on the taxpayer’s U.S. dollar sales revenue were characterized as being on income account. A class of similar properties may be treated as one property for hedging purposes, and it is not essential that the hedge provide a complete offset of F/X fluctuations. 48 See for example CRA Document 2002-0160807, dated April 16, 2003, as amended by CRA Document 2003-0019667, dated June 27, 2003.
Gains and Losses on Income Account
The ITA is silent on the timing of recognizing F/X gains and losses that are characterized as being on income account and as relating to current assets or liabilities, such as accounts receivable, accounts payable, and inventory. The courts have not required one particular method of recognition to be followed, generally noting only that a taxpayer must use a method that provides an accurate picture of the taxpayer’s profit for the year. The CRA’s administrative position appears to be that a taxpayer may recognize F/X gains or losses on income account either on an accrual basis (i.e., inherent gains and losses on assets and liabilities not yet sold or settled are recognized and calculated as of the taxpayer’s tax year-end) or on a settlement basis (i.e., gains and losses are recognized and calculated only when the assets and liabilities are sold or settled). 49 IT-95R. See also CRA document 2014-0529961M4, dated June 10, 2014. However, the taxpayer must be consistent from year to year in the method chosen. Accounting principles are relevant but not determinative, and while the CRA will ordinarily look for consistency between accounting and income tax reporting on F/X recognition, it accepts that this may not exist in all cases. 50 In CRA Document 2006-0215491C6, dated December 21, 2006, the CRA stated, in the context of foreign currency deposits held on income account, that a truer picture of a taxpayer’s income would normally be determined by following GAAP (and, in that case, by recognizing accrued F/X gains and losses as of the year-end date). However, the CRA has also acknowledged that GAAP is only one element in determining profit for tax purposes, such that a change in accounting standards would not necessarily result in a change in income tax reporting (CRA Document 2006-0178661E5, dated March 9, 2007. Saskferco, supra, is an example in which accounting and tax treatment of F/X diverged.
Foreign exchange gains and losses on transactions that hedge a current asset or liability are generally recognized in the same manner as the gains and losses on the property or liability hedged. For example, if the taxpayer uses the accrual method to recognize an F/X gain or loss on accounts receivable at year-end, an F/X gain or loss on a hedge specifically related to those accounts receivable should also be recognized at year-end. 51 See CRA Document 2002-0160807, dated April 16, 2003. The CRA also stated in this document that if (a) foreign funds to be purchased under a forward contract are irrevocably committed to payment of a specific debt; and (b) the forward contract can be considered an agreement relating to that specific debt, the CRA would not require the taxpayer to report the related F/X gains or losses.
Gains and Losses on Capital Account
F/X gains and losses characterized as being on account of capital are generally recognized only at the time of disposition of the underlying capital property or settlement of the underlying capital liability. 52 See, e.g., CRA Documents 2007-0234001E5, dated October 22, 2007, and 2001-0083135, dated June 27, 2001. For example, the disposition of a share for proceeds of US $100 (the cost of which is also US $100) will give rise to an F/X gain or loss for Canadian tax purposes if the value of the U.S. dollar relative to the Canadian dollar has changed between the time of acquisition and the time of disposition. It is also not necessary for there to be an actual conversion of foreign currency to Canadian dollars for an F/X gain or loss to be recognized; the disposition of, for example, a share denominated in a foreign currency may give rise to an F/X gain or loss even if the proceeds from that disposition are reinvested in another asset in the same (or another foreign) currency.
A change in the terms of a share (or a debt) may or may not result in a disposition of that share (or a settlement of that debt), depending on the magnitude of the change. The CRA has stated that non-negotiable foreign currency term deposits, guaranteed investment certificates, and other similar deposits on capital account can be moved from one form of deposit to another without giving rise to a disposition as long as the funds continue to be viewed as on deposit and are not converted into another currency or used to purchase a negotiable instrument or some other asset. 53 IT-95R. However, F/X gains and losses on negotiable investments such as notes, bonds, mortgages, and debentures are realized when those investments mature or are otherwise disposed of (whether or not the funds are used to purchase similar securities). 54 Id.
An F/X gain or loss on a capital liability on capital account is generally recognized only at the time of a realization event such as a settlement of the debt. 55 Because a “disposition” is defined (in subsection 248(1) of the ITA) with reference to property rather than liabilities (i.e., creditors rather than debtors), s. 39(2) causes debtors to realize F/X gains or losses on repaying or otherwise settling liabilities. An F/X gain or loss is also recognized, for example, at the time of a conversion of a foreign currency deposit at maturity into another foreign currency, the assumption of a debt by another party as partial consideration for assets purchased, or the conversion of a foreign-currency-denominated debt into common shares. 56 CRA documents 2007-0234001E5, dated October 22, 2007, 2007¬0239291R3 (2007), 2007-0252491R3 (2007), and 2004-0085081E5, dated Sept. 8, 2005. In CRA Document 2001-0083135, dated June 27, 2001, the CRA confirmed its position that an F/X gain or loss can arise before funds are converted into Canadian dollars
F/X losses on debt are deemed to be realized (and offsetting F/X gains on debt may be elected to be recognized) by a corporate debtor if control of the debtor is acquired (s. 111(12)). See above under 5. Losses for the effect of an acquisition of control on losses. Moreover, F/X gains on debts may be deemed to be realized under “debt parking” rules designed to prevent (but are broader than) indefinite gain deferral via the acquisition of a receivable by a related party who will simply leave it outstanding (s. 39(2.01)).
8. Intangible Property (IP)
- Periodic payments in respect of the right to use intangible property (IP) will ordinarily be deductible under general principles, subject to some limitations.
- Outright acquisitions of IP (potentially including an exclusive licence to use IP) will generally be considered to be capital transactions, usually treated as depreciable property.
- Canada does not have a “patent box” regime (although the province of Quebec does). The SR&ED regime is also relevant to the tax treatment of costs incurred on IP.
- Payments in respect of IP often attract Part XIII withholding tax when made to a non-resident of Canada.
- Receipts from the exploitation of IP may be treated as income or capital gains, depending on the circumstances (i.e., mere right to use versus sale or exclusive licence).
Intangible property (IP) often represents a corporation’s most valuable assets. The tax treatment of expenditures on and receipts from such property is therefore quite important.
Acquisition and Development Costs
As with most other elements of the Canadian tax system, the treatment of expenditures on IP starts with segregating capital expenditures from those on income account. The basis on which to make the capital/income distinction is discussed here. In general, expenditures made to create an advantage or benefit of enduring benefit will typically be treated as capital expenditures, while an expenditure substantially all the benefit of which is consumed in that year will typically be on income account.
In this regard, an important distinction exists between the outright acquisition of property (including IP) and the acquisition of a right to use property. Expenditures in the former category will typically be considered to be on capital account, because in most cases the outright ownership of IP creates an enduring benefit that lasts beyond the current period. Conversely, expenditures for a right to use IP (e.g., a lease or licence) where the recipient retains ownership of the property will usually be considered to be on income account.
The most useful analogy that can probably be drawn is rent. Where the taxpayer enters into a lease for real property (e.g., an office or warehouse), it is generally accepted that the rent payable for each month during any particular taxation year is a current expense of that year deductible in full from income. This is because the benefit created by the right to use the space for a period is enjoyed exclusively in that period. Even where the lease is for a number of years (i.e., the lessee has legally obligated itself to pay each year’s rent at the outset of the lease), each year’s rent is treated as a separate expenditure on income account for that year rather than capitalizing the total amount payable over the lease term.
This is not to say that whenever the taxpayer makes a series of expenditures to acquire IP, that series of expenditures is on income account. For example, where the taxpayer acquires ownership of IP and pays the vendor in a series of instalments, the fact that the payment was not made in a lump sum does not make the series of payments deductible – if ownership of the IP creates an enduring benefit, the taxpayer’s total obligation to pay the purchase proceeds (irrespective of when payment occurs) should be treated as a capital expenditure in the year the obligation to pay is incurred.
Conversely, if a taxpayer acquires a right to use property in exchange for a lump sum, the prepayment of that right to use should not make what is otherwise a series of periodic deductible expenditures relating to different taxation years a single capital expenditure. The ITA specifically contemplates prepaid expenses, and requires in a period the deduction from income of the portion of the expenditure that relates to that particular period. 57 S.18(9).
It is important to note that not all “rights to use” result in the associated expenditures being treated as deductible expenditures. For example, an exclusive licence which effectively transfers to the licensee all or substantially all of the benefits of ownership will likely be treated as a de facto sale on capital account. There is no precise line beyond which a right to use becomes a sale, and relatively little judicial guidance exists on this point. The important point however is that where the taxpayer acquires something materially less than outright ownership of (or a portion of) IP, the related expenditures are typically deductible from income rather than capital expenditures.
If IP is developed rather than acquired, the scientific research & experimental development (SR&ED) rules described below in a separate section are often very important in determining the tax treatment of related expenditures. Where the SR&ED rules do not apply, some expenditures in the development of IP (e.g., know-how) may still be on income account to the extent that they arise from the ordinary operation of the business rather than from a distinct attempt to create an advantage of enduring benefit. Moreover, costs of making representations to a government agency (including for the purpose of obtaining a patent, permit, franchise or trademark relating to the taxpayer’s business) are deductible in the year incurred rather than capitalized (s. 20(1)(cc)).
In most cases, Canco will be permitted to deduct the amount of periodic IP licence fees it incurs from its income for tax purposes. Potential exceptions to watch for include the following:
- Capital expenditures: where the rights acquired as a result of any particular IP licence payment are capital in nature (i.e., more in the nature of acquiring ownership in, as opposed to merely a right to use, IP – e.g., purchase price instalments), Canco will not be able to deduct the amount from income in the year incurred;
- Accrued but unpaid amounts owing to non-arm’s-length persons: as noted above, where Canco incurs a deductible expense owing to a non-arm’s-length person in a particular year (e.g., 2020), and at the end of the second following year (i.e., 2022) that amount remains unpaid, the unpaid amount is added back into Canco’s income for tax purposes in the third following taxation year (i.e., 2023);
- Contingent payments: significant limitations exist on the deductibility of contingent obligations (s. 18(1)(e)); and
- Prepaid royalties: to the extent that an amount paid in any particular year relates to a right to use IP in a later year, Canco will typically be required to defer claiming the deduction for tax purposes until that later year (s. 18(9)).
Moreover, as noted at 4. Transfer Pricing above, on transactions between a Canadian and a non-arm’s-length non-resident, Canada’s transfer pricing rules prevent a Canadian from deducting more than what an arm’s-length person would reasonably agree to pay under the same circumstances. The CRA is particularly aggressive in challenging IP transactions with foreign MNE group members. For example, on royalties for the use of know-how, the CRA frequently challenges, (1) whether such know-how in fact exists at all, (2) the extent to which it contributes to the Canadian taxpayer’s profits, and (3) whether it could be otherwise replicated. It is also common for the CRA to assert that the foreign licensor has benefited from the Canadian group member’s marketing activities.
Acquisitions of rights or development expenditures on capital account will not be fully deductible in the year incurred. In most cases they will constitute the cost of depreciable property and entitle Canco to a capital cost allowance (CCA) deduction under the ITA rules dealing with depreciable property. Otherwise they will generally not be deductible from income at all.
The following is a very general summary of expenditures of a capital nature on various common forms of IP:
Patents: Expenditures on a patent (once created) or a right to use patented information for a limited or unlimited period are normally included in Class 44, for which the applicable CCA rate is 25%. Canco may elect not to include such amounts in Class 44, 58 Regulation 1103(2h). in which case they will generally fall into Class 14 (patents, franchises concessions or licenses for a limited period not included in certain other classes). CCA deductions for property in Class 14 are taken over the life of the property (usually but not necessarily evenly each year).
A special rule applies to a patent (whether included in Class 44 or Class 14) the cost of which is wholly or partly determined by reference to the use of the patent. In such circumstances, Canco may choose to deduct as CCA for the year,
- that portion of the cost of the patent determined by reference to that year’s use of the patent; and
- the CCA otherwise claimable (i.e., under Class 44 or Class 14, as applicable) for the year, excluding from the cost of the patent (and hence the UCC of the class) any amount described in (1) for the year or a previous year. 59 Regulations 1100(9) and (9.1).
Thus, for example, a Class 44 patent that cost the holder $100 plus a percentage of revenues generated by the holder in each year would produce CCA in the first year of $25 (25% times the $100 cost) 60 Ignoring the half-year rule in this example, which would otherwise limit the holder to adding only 50% of the $100 cost to the taxpayer’s Class 44 UCC in the year of acquisition. plus the entire amount payable by the taxpayer in respect of Year 1 revenues attributable to the patent. This election reflects the fact that the variable portion of the cost is effectively an expense wholly attributable to the taxation year to which it relates and which should be recognized for tax purposes entirely in that period.
Copyright: while in most cases costs incurred in developing a copyright would be currently deductible, in other cases (or where a copyright has been purchased) the related expenditures could fall into Class 14 as a licence for a limited term. A licence to use computer software is excluded from Class 14. Instead, most software expenditures on capital account fall into Class 50 (55% CCA rate) for systems software (defined in Regulation 1104(2)) or Class 12 (100% CCA rate) for other software.
Trade Marks: Trade mark-related expenditures are usually treated as deductible expenses, either under general principles as expenses incurred in the ongoing operation of the business or as costs of trademark registration (including design, legal and registration costs as well as payments to others to refrain from contesting registration). 61 See CRA Interpretation Bulletin IT-143R3, para. 9. Since trademarks have an unlimited life they will generally not constitute Class 14 property (unless perhaps as part of a franchise or similar agreement that has a limited duration).
Industrial Designs & Integrated Circuit Topography: An industrial design granted protection under the Industrial Design Act has a finite life. As such, related expenditures on capital account are acknowledged fall within the scope of Class 14 property, meaning that capital expenditures to create or acquire such property will be eligible for straight-line amortization over the period of the franchise. 62 Interpretation Bulletin IT-477, ¶18. Topography that falls under the Integrated Circuit Topography Act is similarly granted protection for a finite period, and should also fall within Class 14 to the extent of expenditures thereon that are on capital account. As with other forms of IP, ordinary-course expenditures not incurred to produce an enduring benefit but that happen to assist in the creation of industrial designs or circuit topography should be expensed in the year incurred as expenditures on income account.
Know-How: Know-how has always been a challenge to characterize for tax purposes, due to uncertainty as to what it is exactly. While by no means universally accepted as being correct, the starting point for the analysis of such amounts is arguably that know-how is not “property,” 63 Rapistan Canada Ltd. v. M.N.R., 74 DTC 6426 at 6428 (F.C.A.): “ . . . under no system of law in Canada, does knowledge, skill or experience constitute “property” that can be the subject matter of a gift, grant or assignment … As I understand the law, knowledge or ideas, as such, do not constitute property. . . . To a limited extent, knowledge or ideas can be the subject of a monopoly conferred by a patent for an invention or by registration of an industrial design, and therefore, to that extent, “property” as, I suppose it may be, in a certain sense. As such, how be said, techniques, skills and experience ever, and in the absence of any such statutory monopoly, in my view, “know how, techniques, skills and experience” are not “property” and cannot, therefore, be “property” within Class 14 supra.” such that know-how-related expenditures would not be treated as part of the cost of depreciable property.
Expenditures associated with the creation of know-how will in most cases be currently deductible, to the extent that the know-how arises from experience or information gained as part of the ongoing, day-to-day operations of the business. Moreover, to the extent that know-how is being purchased from another party, it is often possible to characterize the expenditure as being really for a service being provided (i.e., imparting knowledge) rather than for the acquisition of an asset. Generally speaking, expenditures under contracts for services are deductible in the period in which the services are performed. The fact that know-how is generally not subject to the same concept of “ownership” as is, say, a patent or trademark (viz., there is no one owner of information that has been conveyed) makes it difficult to think of the conveyance of know-how as anything other than a service of teaching another, perhaps with a covenant not to compete or convey attached to it. 64 For a more detailed discussion of this issue, see Neal Armstrong, “Exploiting the Unique Features of Intellectual Property,” 1999 Corporate Management Tax Conference (Canadian Tax Foundation) at 9:12-14.
Expenditures in respect of know-how that cannot properly be characterized as services and that are capital in nature and relating to a business will typically be deemed to constitute “goodwill” as defined in s. 13(35) so as to fall within Class 14.1 (5%) for CCA purposes. The CRA has taken the position that where know-how is licensed for a limited period of time or the payer’s use is non-exclusive (viz., something short of “acquisition”), the recipient should treat the payments as income, 65 Interpretation Bulletin IT-386R, ¶2(d). which is consistent with the payer being able to treat the “licence” fee as a current expense. Thus, the same ownership-versus-use issues are generally also relevant here.
Receipts from Exploitation
Where Canco receives amounts in respect of IP licensing, the principal questions are (1) whether the transaction is a sale or a licence of IP by the recipient, (2) whether the transaction is on income or capital account, and (3) the type of property involved. Once the answer to these questions have been determined, the appropriate tax treatment generally follows from that. For example, a sale of a depreciable property will generally result in the sale proceeds of the property (up to its original cost) being deducted from the undepreciated capital cost of the relevant class of depreciable property, with the excess (if any) treated as a capital gain.
Where (as in the vast majority of cases) the taxpayer is carrying on a business, it is essential at the outset to identify just what the “business” of the particular taxpayer is, in order to properly establish the tax treatment of any receipts earned by that taxpayer. In general terms, any revenues earned by the taxpayer from those very activities that are the purpose of the business will be business income, not capital receipts. For example, if the taxpayer’s business is to purchase and resell computer software, income from the sale of that software will be business income. Another taxpayer whose business is the development and licensing of software will treat the income from the licensing of such software as business income. As such, in most cases income from the exploitation of IP will be included in the taxpayer’s business income, since it is the direct result of the very activities that constitute the taxpayer’s business: the taxpayer carries on the business for the purpose of earning those receipts.
In those instances where the receipts of exploitation cannot be characterized as arising from the activities which constitute the purpose of the business, identifying the form of the transaction is a critical step. In very general terms, we start from the proposition that amounts earned in respect of the use of IP will almost always be characterized as being on income account as income from property or income from a business, whereas an outright sale of IP is conceptually a capital transaction unless (as discussed above) the seller is “in the business” of selling that very property. Thus, “sale” versus “use” is a key question.
In this regard, a license that is exclusive and disentitles the licensor from making any other use of the property in question (either in a particular area or for a particular period) has been held to be akin to a sale, since it leaves both parties in essentially the same position as if an outright sale of all or part of the licensor’s property had occurred. The essence of treating an exclusive license as a sale was explained thus: 66 No. 442 v. M.N.R., 57 DTC 435 at 443 and 444 (I.T.A.B.). See also Rustproof Metal Window Co. Ltd. v. C.I.R.., 29 T.C. 243 at 270-71 (C.A.), where on opposite facts the taxpayer was treated as receiving income: “The licence is a non-exclusive licence and the [owner’s] right to exploit the patent by the grant of other licenses is therefore unimpaired.” For a more detailed discussion of this issue, see Neal Armstrong, “Exploiting the Unique Features of Intellectual Property,” 1999 Corporate Management Tax Conference (Canadian Tax Foundation) at 9:37-48.
. . . [W]here a patentee grants an exclusive licence, thereby precluding himself from exploiting his patents in the area covered by the licence, and receives therefore a capital sum, which is estimated in advance and without any relation at all to any user of the patent, that lump sum payment is a capital receipt . . . [In this case] the appellant company precluded itself from any exploitation of the patents in the United States, either by themselves or through other licensees in that country, because of the exclusive nature of the licence.
Hence, in distinguishing a sale of property from the use of property it is important to consider whether the transaction in question leaves the recipient unable to further exploit the subject property, either wholly or as to a particular time or place.
There is an important exception to the principle that outright sales (or exclusive licences) of IP by a taxpayer whose business is not the sale (or exclusive licensing) of IP should be on capital account. As noted, conceptually amounts received for the use of property ought to be treated as income. To the extent that the taxpayer sells property in such a manner that the amount received from the sale depends on the amount earned by the purchaser in using the subject property, these might be thought of as de facto royalties in the guise of sale proceeds, in that the “vendor” effectively continues to have an interest in the exploitation of the property even after the “sale”. To this end, s. 12(1)(g) deems to be included in income any amount received that is dependent on the use or production of property, whether or not as an instalment on the sale price of such property. Such receipts are commonly referred to as “earn-outs.”
Points to note concerning s. 12(1)(g) include the following:
- this provision does not apply where only the timing of the payment is variable, as opposed to the quantum of the payment;
- the precise wording of the sale price is important. For example, the CRA takes the position that an amount dependent on production or use that is stated to have a minimum entitlement is entirely dependent on production or use and hence within s. 12(1)(g), whereas a fixed amount payable plus a variable amount dependent on production or use leaves only the variable portion of the payment subject to s. 12(1)(g);
- where the parties agree on a sale price equal to fair market value and provide for a possible downward adjustment in the event that production or use-related conditions are not met (a “reverse earn-out”), the CRA will not apply s. 12(1)(g) to any portion of the sale price so long as the parties reasonably believe that the production or use-related conditions will be met; and
- the application of s. 12(1)(g) to deem the vendor to receive income does not correspondingly deem the payer to have made an expenditure on income account, viz., s. 12(1)(g) is “one-sided”.
Thus, a taxpayer will typically achieve capital treatment on proceeds from the sale (or exclusive license) of IP only to the extent that those proceeds are not dependent on the use of or production from that property and only if the taxpayer is not “in the business” of acquiring or creating and then reselling (as opposed to using) such IP. The jurisprudence on this issue is not entirely consistent, and there are certainly variations in the way in which different forms of IP are treated as to the income/capital distinction. However, the diagram shown in Figure 11 below serves as a useful summary of these general principles.
9. Scientific Research & Experimental Development
- The ITA provides favourable tax treatment to expenditures incurred for scientific research and experimental development (“SR&ED”) in two respects. Determining whether an expenditure qualifies for SR&ED tax treatment can be quite complex, and the CRA has extensive administrative policies in this area.
- The first tax benefit is enhanced deductibility of qualifying expenses notwithstanding that in many instances they would be considered capital in nature.
- In addition, qualifying SR&ED expenditures entitle the taxpayer to claim an investment tax credit (ITC), which a deduction from tax payable (not merely a deduction from income).
- Most of Canada’s provinces and territories also provide SR&ED incentives.
- For more information on this topic, see the CRA’s SR&ED webpage
A separate regime exists to deal with the tax treatment of expenditures that qualify as being incurred for scientific research and experimental development (“SR&ED”). The SR&ED regime is quite complex (indeed, some tax professionals specialize exclusively in SR&ED work). However, for present purposes it is sufficient to be aware of the kinds of expenditures that will generally qualify and the results of making qualifying SR&ED expenditures. Substantial filing requirements must be met in a timely manner to claim SR&ED tax benefits (see Form T661)
In general terms, the SR&ED system offers tax treatment to SR&ED expenditures more favourable than would otherwise apply. In particular, the SR&ED rules allow some kinds of expenditures, even if they are on capital account and thus otherwise non-deductible, to be deducted from income in full in the year in which they are incurred, if desired. Since many SR&ED expenditures are made with a view to creating advantages of enduring benefit, the opportunity for current deductibility of expenditures is quite beneficial. Moreover, a somewhat smaller range of expenditures entitle the taxpayer to investment tax credits (“ITCs”), which are a direct deduction from tax payable (as opposed to from income).
What Constitutes SR&ED?
“SR&ED” is defined in s. 248(1) as a systematic investigation carried out in a field of science or technology by means of experiment or analysis, being:
- basic research (work undertaken for the advancement of scientific knowledge without a specific practical application in view);
- applied research (work undertaken for the advancement of scientific knowledge with a specific practical application in view);
- experimental development (work undertaken for the purpose of achieving technological advancement for the purpose of creating or improving existing, materials, devices, products or processes); or
- work undertaken by or on behalf of the particular taxpayer with respect to engineering, design, operations research, mathematical analysis, computer programming, data collection, testing or psychological research, to the extent commensurate with and directly in support of the work described in (1) – (3) above undertaken in Canada by or on behalf of that taxpayer.
Activity such as market research or sales promotion, quality control or routine testing, research in the social sciences or humanities, prospecting for natural resources, commercial production of a new or improved material or product, the commercial use of a new or improved process, style changes, and routine data collection are specifically excluded from the definition of SR&ED. 67 S. 248(1); see also the further interpretive rules in s. 37.
The CRA has detailed views on what it considers necessary to constitute SR&ED. In its view, SR&ED exists if all five of the following criteria are met: 68 Discussed in the CRA’s administrative policy on the eligibility of work for SR&ED ITCs, available at https://www.canada.ca/en/revenue-agency/services/scientific-research-experimental-development-tax-incentive-program/eligibility-work-investment-tax-credits.html
- There was a scientific or a technological uncertainty;
- The effort involved formulating hypotheses specifically aimed at reducing or eliminating that uncertainty;
- The overall approach adopted was consistent with a systematic investigation or search, including formulating and testing the hypotheses by means of experiment or analysis;
- The overall approach was undertaken for the purpose of achieving a scientific or technological advancement; and
- A record of the hypotheses tested and the results was kept as the work progressed.
The CRA considers scientific or technological uncertainty to exist if it is not known or determined on the basis of generally-available scientific knowledge or technology whether a given objective can be achieved or how to achieve it. This may occur either because it is uncertain whether the scientific or technological objective can be achieved at all, or because it is not known which of several alternative approaches or technologies will enable the objective to be met. Uncertainties that arise from lack of appropriate expertise, such as the failure to use commonly-available information, lack of scientific knowledge or lack of technical management expertise appropriate to the project are not relevant to SR&ED eligibility. Doubt about the business or commercial success of the material, device, product or process being developed also does not qualify as a scientific or technological uncertainty.
Scientific or technological advancement refers to the generation of information or the discovery of knowledge that advances the understanding of scientific relations or technologies. It is the attempt to achieve a scientific or technological advancement that is important in determining eligibility: a failure can increase scientific or technological knowledge by showing that a particular approach will not succeed. Thus, an unsuccessful SR&ED project can nonetheless meet the “scientific or technological advancement” criterion.
Deduction for Qualifying SR&ED Expenditures
In general terms, qualifying SR&ED expenditures are added to a cumulative pool of such expenditures, and the taxpayer can deduct from income such amount in the pool as it chooses each year. The principal component of the taxpayer’s SR&ED pool is “current” (i.e., non-capital) expenditures on SR&ED carried on in Canada and related to the taxpayer’s business where,
- the SR&ED is directly undertaken by the taxpayer (e.g., salary & wages of employees performing the work; materials used or consumed in the work, etc.);
- the SR&ED is undertaken on behalf of the taxpayer (i.e., contract SR&ED); or
- the payments are made to a Canadian-resident corporation or certain approved recipients (e.g., universities) who will carry on the SR&ED in Canada, and the taxpayer has the right to exploit the results. 69 S. 37(1)(a). Certain amounts relating to government assistance and ITCs earned must be deducted from the taxpayer’s SR&ED pool, as well as (of course) amounts previously claimed as a deduction. Amounts relating to “super-allowance” deductions permitted under provincial tax legislation must also be deducted from the taxpayer’s SR&ED pool.
For this purpose, “current” SR&ED expenditures are defined somewhat more broadly than is typically the case. More particularly, under s. 37(8)(d) expenditures of a current nature made after 2013 include any expenditures made by the claimant other than an expenditure for:
- the acquisition of capital property of the taxpayer, or
- the use of, or the right to use, capital property, that would be capital property of the claimant if the capital property were owned by the taxpayer.
Outright purchases of third-party know-how are not eligible for inclusion in the SR&ED pool. Salaries and wages paid to the taxpayer’s own employees to perform SR&ED carried on outside Canada and related to the taxpayer’s business may be added to the taxpayer’s SR&ED pool only to a limited extent (s. 37(1.5) and (9)):
- the taxpayer must reasonably believe that those employees are not subject to foreign income tax on the salaries and wages paid to them by the taxpayer;
- the SR&ED must be part of the taxpayer’s SR&ED carried on in Canada; and
- the amount is limited to 10% of the total salaries and wages incurred by the taxpayer for SR&ED in Canada.
The following amounts are subtracted from the taxpayer’s SR&ED pool balance:
- SR&ED deductions from the pool balance claimed in prior years;
- any “government assistance” or “non-government assistance” the taxpayer received (or can reasonable be expected to receive) in respect of qualifying SR&ED expenditures that were added to the taxpayer’s SR&ED pool (e.g., provincial tax incentives); and
- ITCs claimed in respect of the taxpayer’s qualifying SR&ED current expenditures.
The taxpayer may deduct as much or as little of its SR&ED pool balance as it wishes in any year. Any undeducted balance may be carried forward and used in future years with no time limit. An acquisition of control of a corporation will force the immediate pre-takeover deduction of its remaining SR&ED pool as of such time.
Separate and apart from the taxpayer’s SR&ED pool, current expenditures on SR&ED performed outside of Canada are also currently deductible (only in the year incurred, not as part of the SR&ED pool), if such SR&ED is either, (1) undertaken directly by or on behalf of the taxpayer or, (2) undertaken by certain authorized recipients (such as universities) in such a manner that the taxpayer has the right to exploit the results. 70 S. 37(2). The range of qualifying expenditures for SR&ED performed outside of Canada is more limited than for SR&ED carried on in Canada. 71 S. 37(8)(a) and Regulation 2900.
SR&ED Investment Tax Credits
SR&ED expenditures that are “qualified expenditures” entitle the taxpayer to ITCs. The amount of the ITC depends primarily on whether the claimant is a “Canadian-controlled private corporation” (CCPC) or not.
CCPCs that are “qualifying corporations” are entitled to the most favourable ITCs. Qualifying corporations are CCPCs whose taxable income for the preceding year (plus the taxable income of any associated corporations) does not exceed a specified limit. That limit is $500,000 for corporations whose taxable capital is less than $10M, and gets progressively reduced for CCPCs with taxable capital between $10M and $50M (i.e., the limit is nil at $50M of taxable capital).
Qualifying corporations are entitled to claim ITCs of 35% on up to $3M of qualified expenditures incurred in the year. Such ITCs are refundable (i.e., the taxpayer is entitled to receive these amounts whether or not tax is owing for the year). Such corporations may also claim a 15% ITC for qualified expenditures above the $3M annual limit, 40% of which is refundable (i.e., the other 60% may only be used to reduce current year taxes owing or be carried forward or back to another year).
CCPCs other than qualifying corporations have the same ITC entitlement as qualifying corporations. However, their entire 15% ITC for qualified expenditures above the $3M annual expenditure limit is not refundable, and can only be used to reduce taxes payable in the current year (or another year to which it is carried back or forward).
Non-CCPCs are entitled to a 15% ITC on qualifying expenditures. No part of this ITC is refundable. Unused ITCs may be carried back and applied in the three preceding taxation years or the 20 following taxation years.
For ITC purposes “qualified expenditures” are defined to include the following (s. 127(9)):
- 100% of an expenditure on current SR&ED carried on in Canada directly by the taxpayer that is included in the taxpayer’s SR&ED pool as described above; 72 Current expenses relating to general, administrative or management activities are typically excluded, as are expenses for the upkeep or maintenance of facilities: Regulation 2902(a).
- 80% of an expenditure on current SR&ED carried on in Canada on behalf of the taxpayer (or a payment made by the taxpayer to a Canadian-resident corporation or certain approved recipients carrying on the SR&ED in Canada) that is included in the taxpayer’s SR&ED pool as described above; 73 The 2012 federal budget reduced the ITC inclusion rate for such expenditures from 100% to 80% for expenditures made after 2012, in order to remove the profit element of SR&ED contract payments from the expenditure base for ITCs. and
- a “prescribed proxy amount” in respect of overhead-related expenditures described in Regulation 2900(4)-(10).
Certain amounts such as “government assistance” or “non-government assistance” and payments for SR&ED to persons not subject to Canadian income tax or not dealing at arm’s-length with the taxpayer are excluded.
10. Mergers and Divisive Reorganizations
- An amalgamation of two or more taxable Canadian corporations to form a merged entity that is the successor of both can be effected on a tax-deferred basis in Canada.
- One taxable Canadian corporation all the shares of which is owned by another can be wound up into the parent on a tax-deferred basis in Canada.
- Divisive reorganizations of a Canadian corporation are possible to achieve on a tax-deferred basis in Canada, but if occurring outside a related group typically involve meeting various constraints as to how the existing Canco’s property is divided and substantial continuity of ownership requirements.
- Spin-outs of property can generally be effected on a taxable basis but without tax payable if (1) the property being spun out has no accrued gain that cannot be absorbed by existing tax shelter, and (2) the value of the spun-out property does not exceed the PUC and cost basis of the shares on which the distribution is being made.
Amalgamations & Windups
Merging two or more Canadian corporations existing under the same corporate statute is relatively simple. 74 It is generally possible for a corporation to “continue” from one Canadian corporate statute to another as a corporate law matter, so as to meet this requirement if necessary. Such a continuance within Canada has no material income tax consequences. Under the relevant Canadian corporate law dealing with amalgamations, the amalgamated entity resulting from the merger (Amalco) automatically acquires all of the property and assumes all of the liabilities of each participating corporation. Unlike the U.S. concept of one participant being the “survivor”, in Canada Amalco is deemed to be a continuation of each of the predecessor entities under corporate law. 75 It is possible to effect a U.S.-style “survivor” amalgamation via a court-supervised corporate law proceeding referred to as a “plan of arrangement.” Where one participating corporation owns all of the shares of the other, a simplified corporate law process applies to effect such a merger (a “vertical amalgamation”).
From an income tax perspective, the amalgamation will be tax-deferred to the participating entities (i.e., no realization of gains and losses, with Amalco acquiring all property at carryover cost basis) so long as:
- all participating corporations are “taxable Canadian corporations”, as discussed above;
- Amalco acquires all property and assumes all liabilities of each participating corporation (except securities of one participant held by another participant); and
- each shareholder of a participating corporation (other than another participating corporation) receives shares of Amalco (s. 87(1)).
The amalgamation will trigger a deemed taxation year-end for the participants, 76 A short taxation year-end has a number of consequences (in addition to accelerating the participants’ tax return filing obligation), such as (1) requiring a re-computation of various tax attributes (e.g., “equity” for thin capitalization purposes), (2) aging tax attributes measured in taxation years (e.g., non-capital loss carryforwards), and (3) reducing the period permitted for paying various amounts (e.g., shareholders loans under s. 15(2) or accrued expenses owing to non-arm’s-length persons under s. 78(1)). and Amalco will be able to choose its first taxation year-end to occur within the subsequent 365 days. While Amalco is deemed to be a new corporation for tax purposes, it is further deemed to effectively inherit most tax attributes of its predecessors and can choose to keep the tax registration number of one of its predecessors. Loss carryforwards of a participating corporation remain available for post-merger use by Amalco. The PUC of Amalco’s shares is generally limited to the PUC of the shares of the participating corporations. 77 Less the PUC of any shares owned by one participant in another (such shares are cancelled without gain or loss). A shareholder of a participating corporation holding such shares as capital property also enjoys rollover treatment so long as no consideration other than Amalco shares are received in exchange.
A wind-up or liquidation of a Canadian corporation is generally a taxable transaction whereby the winding-up corporation realizes all gains and losses on its property and distributes its net assets (to the extent exceeding the PUC of its shares) as a deemed dividend. However, where one taxable Canadian corporation (the parent) owns all the shares of another taxable Canadian corporation (the subsidiary), the subsidiary can be wound up into the parent on a tax-deferred basis, such that the subsidiary’s property is transferred to the parent and the parent’s shares of the subsidiary are disposed of without gain or loss being realized. 78 S. 88(1). To ensure that the parent realizes no gain, the PUC of the subsidiary’s shares should be no higher than their cost basis to the parent. In some cases where the parent’s cost basis in its shares of the subsidiary exceeds the subsidiary’s cost basis of its property (less its debts), the parent is permitted to increase (or “bump”) the cost basis of the subsidiary’s non-depreciable capital property (e.g., land or shares) up to fair value via a “s. 88(1)(d) bump.” This cost basis step-up is a powerful tax planning provision, but contains a number of complex rules primarily designed to prevent its use as a tool to effect tax-deferred divisive reorganizations that include existing shareholders. 79 See Suarez, “Canada’s 88(1)(d) Tax Cost Bump: A Guide for Foreign Purchasers”, Tax Notes International, December 9, 2013, p. 957. The same cost basis bump also applies to vertical amalgamations.
Divisive Reorganizations: “Butterfly” Transactions
Divisive reorganizations are significantly more complicated than mergers and wind-ups. The separation of one Canco into two Cancos occurring outside the constraints of Canada’s limited exceptions for tax-deferred divisive reorganizations will result in significant tax payable, unless Canco either is disposing of assets without significant accrued gains or has sufficient available tax shelter to absorb any gains that will be realized on a taxable disposition.
Canada’s rules for tax-deferred divisive reorganizations are complex. They rely on a few basic concepts:
- property can generally be transferred to a Canadian corporation in exchange for its shares on a tax-deferred basis via a s. 85(1) election; 80 See Steve Suarez and Kim Maguire, “Tax Issues on Acquiring a Canadian Business,” Tax Notes International, August 31, 2015, p. 775 at p. 781.
- one Canadian corporation can generally receive a dividend from another Canadian corporation free of tax (via a 100% dividends-received deduction); and
- on a redemption of Canco shares, the excess of the redemption proceeds over the PUC of the redeemed shares is deemed to be a dividend and reduces any capital gain otherwise realized on a disposition of those shares.
The rules in s. 55 restricting the use of tax-free inter-corporate dividends to reduce gains on shares allow two basic forms of permissible tax-deferred divisive reorganizations:
- s. 55(3)(a), which permits tax-free inter-corporate dividends received in the course of certain related-party divisive reorganizations; and
- s. 55(3)(b), which permits a “butterfly” divisive reorganization where (1) the new Canco receives the same percentage of each “type” of the existing Canco’s property, 81 The CRA’s administrative rules categorize property as being cash/near-cash, business or investment property. Canadian-resident public companies effecting a “butterfly” are exempt from this requirement. (2) each shareholder of the existing Canco receives shares of the new Canco in the same pro rata proportion as their shareholdings in the existing Canco 82 “Split-up” butterflies can also be achieved in certain circumstances. , and (3) certain prohibited transactions do not occur as part of the same series of transactions. 83 The scope of prohibited transactions is broad: they include an acquisition of control of either Canco, dispositions of the shares of either Canco by significant shareholders, pre-reorganization acquisitions of Canco shares, and certain acquisitions of property by either Canco.
Figure 12 illustrates the steps involved in using these rules to effect a divisive “butterfly” reorganization of a Canco:
- Canco’s existing shareholders each transfer an identical pro rata proportion of their Canco shares to a new taxable Canadian corporation (New Canco), which proportion mirrors the value of Canco’s assets that New Canco is intended to own. This transfer occurs on a tax-deferred basis under the elective s. 85(1) property-for-shares rollover;
- Canco transfers to New Canco the assets that are intended to be held in New Canco in exchange for fixed-value New Canco preferred shares with a redemption value equal to the value of the transferred net assets, again on a tax-deferred basis under s. 85(1);
- Canco’s preferred shares of New Canco are redeemed in exchange for a promissory note equal to the redemption value of the preferred shares, producing an inter-corporate deemed dividend equal to the redemption proceeds less the PUC of the redeemed shares. Such deemed dividend reduces Canco’s proceeds of disposition from the New Canco shares and thereby generally eliminates any capital gain Canco otherwise realizes on those shares;
- New Canco’s shares of Canco are similarly redeemed for a promissory note, generating a similar deemed dividend that eliminates the capital gain New Canco would otherwise realize; and
- the two promissory notes are offset against one another and cancelled, leaving no cross-ownership in securities between Canco and New Canco.
It is very easy to inadvertently taint a tax-deferred divisive reorganization, and great care must be taken to ensure that the proposed transactions stay within permissible constraints.
In order to effect a tax-deferred divisive reorganization of a Canco as part of a larger worldwide spinoff undertaken by a widely-owned MNE, the Canadian portion of the spun-out business must represent less than 10% of the value of the top-tier foreign entity to be spun out to the MNE’s shareholders. There are other subtle technical requirements for coming within Canada’s strict rules on tax-deferred “butterfly” divisive reorganizations in such transactions, which require very careful attention.
Divisive Reorganizations: Taxable Spin-outs
Spin-outs can also be achieved outside of a tax-deferred “butterfly” on a taxable basis, which (depending on the facts) may or may not result in actual tax payable. Conceptually, when a Canco wishes to distribute property to its shareholders, there are two potential levels of tax to be concerned with:
- Canco itself will be deemed to have disposed of the distributed property for fair-market value proceeds of disposition. If there are no accrued gains on the distributed property or the corporation has available tax shelter to absorb them (e.g., loss carryforwards), the absence of a corporate-level rollover may not be a practical impediment; and
- Canco’s shareholders will receive property of some kind, which may or may not be a taxable distribution.
A non-butterfly spin-out can be structured on a taxable basis as any of the following:
- a dividend in-kind (which is also a dividend for tax purposes) on the Canco shares;
- a return of capital on the Canco shares (“public corporations” have constraints on their ability to effect capital returns under s. 84(4.1)); or
- property received on a s. 86(1) share-for-share exchange (or potentially a s. 85(1) property-for-shares exchange), whereby each shareholder transfers their Canco shares to Canco in exchange for new Canco shares plus the distributed property, occurring as part of a reorganization of the Canco’s share capital.
On a return of capital or a s. 86(1) share-for-share exchange, the shareholders can receive property from Canco without realizing either a capital gain or a deemed dividend so long as the value of the distributed property does not exceed, (1) the PUC of their shares (any excess of value received over PUC is prima facie treated as a taxable dividend); or (2) their adjusted cost basis in their shares (property received as a return of capital reduces the cost basis of their shares).
Thus, if the tax attributes of Canco and its shares are sufficient relative to the value of the property to be distributed, a taxable spin-out can be achieved without the constraints applicable to a tax-deferred “butterfly” transaction.
For example, under a s. 86(1) reorganization of Canco’s share capital, Canco shareholders exchange their existing Canco common shares for (1) shares of a new class of Canco common shares, and (2) the property being distributed (for example, shares of a subsidiary: Spinco). If the value of the Spinco shares does not exceed the PUC of the existing Canco shares, no dividend arises on the receipt of Spinco shares. Instead, each holder’s adjusted cost base (“ACB”) of its Canco shares is reduced by the value of the Spinco shares received, as is the PUC of Canco’s shares. If such a reduction in the ACB of a shareholder’s Canco shares would result in an ACB of less than zero, the “negative” portion is deemed to be an immediate capital gain.
Consider for example a situation in which each Canco shareholder exchanges each existing Canco common share for one new Canco common share and one Spinco share. If the fair market value of a Spinco share is $3, the PUC of each existing Canco common share is $5, and the shareholder’s ACB of that existing Canco common share was $8, the result would be as follows:
Deemed dividend – nil
Capital gain – nil
ACB of Spinco share – $3
ACB of new Canco common share – $5
PUC of new Canco common share – $2
To the extent that the value of the Spinco share exceeds the PUC of the Canco share, the excess is deemed to be a dividend for tax purposes. 84 For example, if the fair market value of a Spinco shares had been $6, the result would have been a $1 deemed dividend ($6 – $5), with the new Canco common share having only nominal PUC and $2 of ACB to the holder and the shareholder having an ACB of $6 in the Spinco share. To the extent that the value of the Spinco share (less the amount of any deemed dividend described in the preceding sentence) exceeds the particular shareholder’s ACB of the Canco share, the excess is deemed to be a capital gain for tax purposes. 85 For example, if the particular shareholder’s ACB of their Canco shares had been $2 instead of $8, the result would have been a $1 capital gain ($3 of value distributed on a share with only $2 of ACB), with the new Canco common share having only nominal ACB to the holder and the shareholder having an ACB of $3 in the Spinco share.
Spin-outs may also be effected as a distribution of share capital by Canco, with the Spinco shares as the property to be distributed. Canco resolves to reduce the stated capital of its shares by an amount equal to the value of the Spinco shares, and distributes these Spinco shares pro rata to the holders of the Canco shares. To the extent that the value of the Spinco shares does not exceed the PUC of the Canco shares, no dividend should arise for Canadian tax purposes: 86 In order for no dividend to been deemed to arise for tax purposes, a share capital return made by a “public corporation” must also either come within certain limited circumstances described in s. 84(4.1), or must be said to be occurring on the winding-up, discontinuance or reorganization of Canco’s business. The CRA has issued several favourable advance tax rulings on the latter point as to the scope of a “reorganization”, and it is not uncommon for public corporations to seek an advance tax ruling in order to achieve a very high level of comfort. instead, the value of the Spinco shares reduces the PUC of the existing Canco common shares and the shareholders’ ACB of their Canco shares. Using the same example described above (i.e., value of each Spinco share is $3):
- no deemed dividend would occur since the PUC of each Canco share ($5) exceeds the value of the property being distributed ($3);
- the PUC of each Canco share would be reduced from $5 to $2;
- the holder’s ACB of the Canco share would be reduced from $8 to $5; and
- the holder’s ACB of the Spinco share would be its fair market value of $3;
This is essentially the same result as in the s. 86(1) share capital reorganization.
For a detailed discussion of non-butterfly spin-outs, see Steve Suarez and Firoz Ahmed, “Public Company Non-Butterfly Spinouts”, Annual Conference Report, (2003) Canadian Tax Foundation, 32:1.