Table of Contents
1. General Tax Framework
- The principal forms of federal income tax levied under the Income Tax Act (Canada) are Part I income tax on taxable income and Part XIII withholding tax on various payments to non-residents of Canada.
- Canadian income tax starts with the taxpayer’s commercial rights and obligations as they exist under non-tax law, and applies the tax statute to those. Ordering one’s legal rights and obligations in such a manner as to minimize taxes payable is acceptable and legitimate, even if specific transactions are undertaken with a primary tax purpose.
- Canada does not have stamp duties or taxes, but does tax gains realized by non-residents on a sale of shares that are ‘taxable Canadian property’
Canada has three levels of government:
- the Canadian federal government, which relies primarily on income tax, sales tax and customs/import duties, and also collects employer and employee premiums for the Canada Pension Plan (CPP) retirement program and Employment Insurance (EI) program for employees that lose their jobs;
- the governments of Canada’s 10 provinces and three northern territories, which levy income tax, sales tax and taxes on other items such as land transfer taxes and taxes on natural resources extracted from within their borders (e.g., mining, oil & gas, forestry); and
- municipal (i.e., city/township) governments, which rely largely on local property taxes and revenue transfers from higher levels of government.
Canada does not have stamp duties or taxes.
The Income Tax Act (Canada) – Overview
Income tax is levied by the federal government in Canada under the Income Tax Act (Canada) (“ITA”) and by each of Canada’s provinces and territories under legislation that essentially adopts or replicates the rules under the ITA. Federal income tax law is drafted by the Department of Finance (“Finance”), which is responsible for tax policy, and administered and enforced by the Canada Revenue Agency (“CRA”). The province of Quebec (Revenu Quebec) administers its own provincial taxes (including income tax), and the province of Alberta (Alberta Tax and Revenue Administration) administers the Alberta corporate income tax. In all other cases, provincial income tax law is administered by the CRA on behalf of the provinces and territories.
Canadian income tax applies on the basis of both “residence” and “source”: Canadian residents are subject to Canadian income tax on their world-wide incomes, while non-residents of Canada are subject to Canadian income tax on their income from most sources in Canada.
The ITA is subdivided into a number of “parts”, many of which levy distinct taxes, most notably:
- Part I, which imposes basic income tax on (1) non-residents who carry on business in Canada, are employed in Canada or dispose of “taxable Canadian property”, and (2) Canadian residents;
- Part XIII, which levies withholding tax on various payments (interest, dividends, royalties, management fees, etc.) paid to non-residents; and
- Part XIV, which levies a “branch tax” on the taxable income earned in Canada of non-resident corporations, to the extent not reinvested in the assets of its Canadian branch (this tax is roughly equivalent to the Part XIII dividend withholding tax that would apply to a Canadian-resident corporation earning the same income and then paying a dividend to shareholders that are non-residents of Canada).
On this website, references to Canadian “income tax” are to Part I tax (and where relevant its provincial/territorial equivalents), and references to Canadian “withholding tax” are to Part XIII tax.
A number of important general principles apply when interpreting and applying the ITA:
- Legal Substance, not Economic Substance: as a general rule, the ITA applies on top of a taxpayer’s legal and commercial relationships, rather than recharacterizing them as something different “for tax purposes” or ignoring them on the basis of “economic substance.” The ITA does contain some provisions that reflect a conscious policy choice to permit the CRA to ignore or recharacterize a taxpayer’s actual legal rights and obligations in certain limited circumstances, or which reflect a focus on economic results rather than legal rights. However, these express provisions are very much the exception rather than the rule. It is therefore essential to start with the taxpayer’s actual rights and obligations that exist under applicable non-tax (i.e., commercial) law, and apply the ITA to those. The Supreme Court of Canada has stated that “one of the fundamental principles of our tax system [is] that tax consequences flow from the legal relationships or transactions established by taxpayers” (Jean Coutu Group Inc. v. Canada, 2016 SCC 55).
- CRA Policy is Not the Law: the correct result in any case is based on the ITA itself, as interpreted (where necessary) by a court of law. The CRA’s views and administrative policies are not the law, but rather the CRA’s interpretation of the law, and while CRA administrative positions are certainly relevant and important to be aware of, they are frequently challenged by taxpayers in the courts and should not be treated as the final word on any issue.
- Tax Planning is Permissible: Canadian courts have repeatedly made clear that there is nothing per se offensive about taking steps to minimize one’s taxes. The Supreme Court of Canada has stated clearly that
(1) “taxpayers have the right to order their affairs to minimize tax payable” (Jean Coutu Group Inc. v. Canada, 2016 SCC 55); and
(2) “unless the Act provides otherwise, a taxpayer is entitled to be taxed based on what it actually did, not based on what it could have done, and certainly not based on what a less sophisticated taxpayer might have done” (Shell Canada Ltd. v. Canada,  3 SCR 622).
Tax planning within the letter and the spirit of the law is entirely permissible, and no obligation exists to structure ones affairs in a tax-disadvantageous manner. Other than where the text of the relevant ITA provisions explicitly so provides, the fact that a taxpayer may have structured or undertaken a particular transaction to achieve a particular tax result is irrelevant to how that transaction is taxed under the ITA.
- Generally the Cdn.$ Must be Used: Generally a taxpayer’s Canadian tax results must be computed in Cdn.$, although under certain conditions it is permissible to elect to compute Canadian taxes under the taxpayer’s foreign “functional currency.” For more on this topic see here
2. Legal Entities & Relationships
- Corporations (including unlimited liability companies) are legal entities created under specific federal or provincial statutes with the capacity to own property and enter into contracts in their own name. They are tax-paying entities under the ITA.
- Partnerships are also considered separate legal entities under commercial and tax law, but are largely transparent for Part I income tax purposes. A partnership computes its income and loss as if it were a taxpayer, but that income or loss is attributed to the partners of the partnership as if they themselves had earned that income or incurred that loss. As such, partnerships do not themselves pay income tax.
- A trust is a legal relationship amongst a person who owns property (the settlor), a trustee and beneficiaries of the trust. Trusts are taxpayers for Canadian income tax purposes although in some cases they can be made to function much like a flow-through to the extent they allocate their income out to their beneficiaries.
- Joint ventures are not legal entities or recognized for tax purposes.
Corporations are the most common form of business organization in Canada. They have separate legal (and perpetual) existence as persons, and have the capacity to own property, incur liabilities and carry on business generally. A corporation may be created under the laws of Canada (such as the Canada Business Corporations Act) or a province or territory of Canada, or may be created under the laws of another country – see here
Investors in a corporation (“shareholders”) own “shares” of the corporation evidencing their ownership interest in the corporation, and do not have an ownership interest in the property of the corporation. A corporation is also required to have individuals (directors) who are responsible for overseeing the management of the corporation (some corporate statutes including the CBCA require a minimum number of Canadian-resident directors). From time to time the shareholders of the corporation vote to elect the directors, which meets to determine the general strategy of the corporation’s activities and supervise the persons of the corporation administering its day-to-day affairs (the “officers”). These matters are provided for in the constating documents of the corporation (typically its “articles of incorporation” and “bylaws”) as required or provided for in the particular corporate statute under which the corporation was created or exists. In some cases corporations with a relatively small number of shareholders may have a unanimous shareholders agreement (USA) setting out any understandings between them.
A corporation can have different types or “classes” of shares with different rights (subject to any limitations existing in the relevant statute governing the corporation), and the rights of each class of a corporation’s shares are described in its constating documents (i.e., the “articles” of the corporation). The principal attributes of shares of a corporation are its voting rights (if any) at meetings of the corporation’s shareholders, its dividend rights to share in distributions of profits, and its liquidation rights to the property of the corporation on the termination of the corporation’s existence. Investors subscribe for new shares by delivering money or property to the corporation in exchange for the issuance of shares to them, or may instead purchase existing shares from another shareholder. When a corporation issues a new share of any particular class of the corporation’s shares, the relevant corporate law typically requires that the corporation add the amount it received as consideration for issuing the share to the “stated capital” of that class of the corporation’s shares (i.e., each class of shares has its own stated capital amount).
The liability of shareholders in most corporations is limited, such that shareholders are not exposed to legal liability for the activities of the corporation and risk only the value of their shares in the corporation. This “limited liability” is particularly important for activities that present significant potential legal liabilities (e.g., environmental, worker safety, etc.). The Canadian provinces of Alberta, British Columbia and Nova Scotia also have corporate statutes permitting the creation of unlimited liability companies (“ULCs”), where shareholders are exposed to some degree to the company’s liabilities. ULCs are typically used where they receive favourable tax treatment for non-Canadian shareholders under tax laws of another country (such as the United States), since for Canadian income tax purposes they are generally treated as ordinary Canadian corporations (i.e., this is no Canadian tax advantage to using a ULC).
Corporations are taxpayers for Canadian income tax purposes. The type of income they are subject to Canadian tax on and the applicable rate of Canadian tax on such income depends on whether the corporation is a resident of Canada for ITA purposes or not (discussed below). Income tax rates for corporations are different than the rates of tax applicable to other taxpayers.
Corporations pay tax on the income they earn, while shareholders pay tax on distributions of profits (dividends) paid to them by the corporation and on any gains realized when they dispose of their shares. As such, there are two distinct levels of tax and two separate taxpayers when a corporation earns income: the corporation and (on a subsequent distribution or sale) its shareholders.
Partnerships are a different form of legal entity. Under Canadian law, a partnership requires that two or more persons (the partners) carry on business in common with a view to a profit. Canadian law provides for both general partnerships (where all partners have full liability for the activities of the partnership) and limited partnerships. In a limited partnership, the general partner actively manages the business and has full liability for the activities of the partnership, while the limited partners are not actively involved in the business of the partnership and are not legally liable for the partnership’s activities beyond their investment in the partnership. The rights and obligations of the partners are governed largely by contractual agreement amongst them, which is usually set out in a partnership agreement governing matters such as the sharing of profits and liabilities, the management of the partnership and the rights of the parties on the dissolution of the partnership. The partnership law (i.e., statutes and court decisions) of the jurisdiction in which the partnership exists also governs the rights and obligations of the partners. Examples of Canadian partnership statutes include:
- the Partnerships Act (Ontario): https://www.ontario.ca/laws/statute/90p05
- the Limited Partnerships Act (Ontario): https://www.ontario.ca/laws/statute/90l16
In very general terms, for Canadian tax purposes the partnership is treated as owning the property used in and earning the income generated by the partnership’s business (i.e., the partnership is treated as a taxpayer for purposes of computing income for tax purposes), but the partnership itself does not pay tax. Instead, the partnership’s income (net of certain deductions) is attributed to the partners and taxed in their hands, whether or not the partnership actually distributes any property to them. The partners themselves are then able to claim various deductions in computing their respective taxable incomes and are liable to pay income tax on any remaining taxable income. Subject to some limitations, the partners are generally free to allocate the partnership’s income for tax purposes amongst themselves in whatever manner they agree to in the partnership agreement.
Partners are not considered to own the partnership’s property for tax purposes; instead they are considered to own a separate property that is their respective interests in the partnership, and they may realize a gain or loss from that partnership interest. As such, partnerships are often attractive from a tax perspective, because for Canadian tax purposes they are treated as transparent or “flow-through” entities: instead of the partnership being taxed, the income earned by the partnership is treated as having been earned by the partners themselves, and taxed in their hands. Unlike corporations then, partnerships involve one layer of tax (at the partner level), not two.
Partnerships are useful tax vehicles because they are very flexible, being largely governed by whatever contractual agreements the partners choose to put in their partnership agreement. A partnership composed exclusively of Canadian partners (a “Canadian partnership”) is entitled to avail itself of certain “rollover” provisions in the ITA, which allow someone to transfer property to the partnership in exchange for an interest in the partnership or the partnership to be wound up on a tax-deferred basis, i.e., without gains being realized. A “Canadian partnership” can also receive payments free of Part XIII withholding tax that, if made to a partnership with one or more partners who are non-residents of Canada, would be subject to Part XIII withholding tax.
The CRA’s views on partnerships are set out in Income Tax Folio S4-F16-C1, “What is a Partnership?”
A trust is a legal relationship amongst a person who owns property (the settlor), a trustee and beneficiaries of the trust. The settlor transfers property to the trustee, who holds and manages property for the benefit of the beneficiaries based on the terms of the trust. The trustee owes the beneficiaries a fiduciary duty to adhere to the terms of the trust and to act in a prudent and responsible manner with respect to the trust property, and is accountable to them for the trustee’s actions.
A trust is a taxable entity for ITA purposes. Like a natural person or a corporation, the extent of its Canadian tax obligations depends largely on whether it is a Canadian resident or a non-resident. In general terms, a trust is taxed on its income except to the extent that it distributes such income to its beneficiaries (so as to be potentially taxable in their hands). In this way, a trust is not structurally tax-transparent the way a partnership is, but in most cases can be made to function largely as a flow-through by distributing its net income. Trusts are used in a variety of business settings, such as (for example) real estate investment trusts (REITs). A variety of special tax rules apply to trusts.
3. Residence for Canadian Tax Purposes
- Canada taxes Canadian residents on their worldwide income and non-residents on their Canadian-source income.
- Differences in how Canada taxes residents versus non-residents make it very important to establish whether a person is or is not a resident of Canada.
- A corporation will be a Canadian resident if it is incorporated under Canadian law or if its central management and control is located in Canada.
- If both Canada and another country that has a tax treaty with Canada assert that a person is a resident, in many (but not all) cases that treaty will resolve such “dual residence” on the basis that the person is a resident of one or the other but not both countries.
The concept of residence for Canadian tax purposes is critical, since many Canadian tax provisions apply only to Canadian residents or to non-residents of Canada. In many cases determining whether a person is resident in Canada for Canadian tax purposes (herein, a “Canadian resident”) requires applying a general, vaguely-worded test that depends on various facts and circumstances, rather than a simple bright-line test.
Moreover, where the person in question is also considered to be a resident of another country that has a tax treaty with Canada under that country’s tax laws, that tax treaty must be consulted. Many Canadian tax treaties have a “tie-breaker” rule that governs when both Canada and the other country claim the person in question to be a resident, and which (in some cases) deems the person to be a resident of one country but not the other for treaty purposes based on specified criteria (e.g., place of incorporation for corporations). If such a tie-breaker rule deems the person to be a resident of the other country, Canada adopts that result for domestic law tax purposes as well and treats them as a non-resident of Canada for ITA purposes (s. 250((5) ITA).
Both becoming a resident of Canada and ceasing to be a resident of Canada under the ITA have specific Canadian tax consequences. In general terms, a person who ceases to be a Canadian resident is deemed to dispose of their property such that gains (and losses) are realized and subject to tax immediately prior to the severance of Canadian residence. In addition, corporations that cease to be Canadian residents are also subject to an incremental departure tax applied against the corporation’s net surplus (the fair market value of its assets less the sum of its debts and the paid-up capital of its shares). The nominal rate of such corporate departure tax is 25%, but if the corporation is becoming a fiscal resident of a country with which Canada has a tax treaty, that rate of departure tax is typically reduced to the most favourable rate of dividend withholding tax under such tax treaty (ss. 219.1 and 219.3 ITA).
Residence for Canadian Tax Purposes: Natural Persons
- they are “ordinarily resident in Canada” under the criteria established by many decades of court cases;
- they “sojourn” in Canada for 183 days or more in the year (“sojourning” has been held to include vacationers or people travelling to Canada for work and staying overnight, but not people commuting to and from Canada on a daily basis for work); or
- they are part of a narrow class of persons deemed to be Canadian residents (certain government officials or members of the Canadian Armed Forces).
Hence, while being in Canada for more than 182 days will result in being deemed to be a Canadian resident (subject to a treaty tie-breaker providing otherwise), the reverse is not true: being physically present in Canada for less than 183 days does not mean a person with significant ties to Canada is not a Canadian resident.
Determining whether a person is “ordinarily resident in Canada” requires a number of factors to be considered. The courts have stated that “one is ‘ordinarily resident’ in the place where in the settled routine of his life he regularly, normally or customarily lives.” 2 Thomson v. M.N.R.,  SCR 209. The presence of a dwelling and/or spouse or dependent children in Canada is considered strong evidence of ordinary residence in Canada. Other relevant indicia of ties to Canada suggesting Canadian residence include the following:
- the frequency and duration of visits to Canada;
- business interests in and/or financial ties to Canada (e.g., bank accounts, investments, credit cards, etc.);
- keeping personal property in Canada (cars, boats, storage facilities, etc.);
- retention of Canadian social or professional memberships;
- retention of Canadian passports, health cards, drivers’ licences and similar items;
- existence of a Canadian mailing address or telephone listing; and
- the absence of comparable ties established with another country.
The CRA’s views on determining the tax residency of a natural person are set out in CRA Folio S5-F1-C1
Residence for Canadian Tax Purposes: Corporations and Trusts
A corporation may be resident in Canada for tax purposes in either of two ways (subject to any applicable treaty tie-breaker rule described above):
- if it was incorporated under the laws of Canada or Canadian province or territory any time after April 26, 1965;3 For this purpose a corporation that obtains articles of continuance or similar documents causing it to become governed by a Canadian corporate law statute is considered to have been “incorporated” under such law as of that date: s. 250(5.1) ITA. Special rules apply to corporations incorporated prior to April 27, 1965. or
- if its “central management and control” is located in Canada.
The courts have held that “In general, the central management and control of a corporation will be exercised where its board of directors exercises its responsibilities.” 4 St. Michael Trust Corp. v. The Queen, 2012 SCC 14 at para. 9. In this case the Supreme Court of Canada determined that the residence of a trust should also be determined based on the location of its “central management and control,” which on the facts was determined to be where the trust’s main beneficiaries (rather than the trustee) were located. However, if a particular shareholder is in fact making the actual strategic decisions in place of the board, the location where the shareholder is performing such actions will govern. For example, in Landbouwbedrijf Backx B.V. v. The Queen,52019 FCA 310. the Court found that a Dutch corporation’s central management and control resided with its Canadian shareholders who were in fact directing the corporation’s actions, and not with its Dutch director who did not participate in critical decision-making discussions and merely followed the shareholders’ instructions.
The place in which directors’ meetings are held is typically the most important indicia of where a corporation’s “central management and control” (sometime also called its “mind and management”) is located. For this reason, a corporation incorporated outside of Canada that wishes to avoid Canadian resident status will hold its board meetings outside of Canada. A properly-functioning board should hold regular meetings, keep minutes evidencing its decision-making and the process followed, and consist of persons capable of making the type of decisions the board of directors is considering, in order to show that it is indeed exercising the “central management and control” function. Should the CRA assert that a corporation’s central management and control is located in Canada, as a practical matter the onus will be on the corporation to demonstrate otherwise on the evidence. While strictly speaking the fiscal residence of the directors themselves is not directly relevant to where a corporation’s central management and control resides, it is optically helpful to have a majority of directors who are not Canadian residents, and any Canadian-resident directors should travel to the place outside of Canada where the board meetings are held.
The residence of a trust is determined on the same principles as for a corporation, with the trustee prima facie performing the same role as a corporation’s board of directors unless the facts indicate that another person is in fact directing the trust’s affairs. The CRA’s views on a trust’s fiscal residence can be found in CRA Folio S6-F1-C1
4. Income Tax - Overview
- Canadian income tax law makes a critical distinction between income or expenditures on “capital account” and those on “income account”, with those on income account being fully included in (or deductible in computing) income for tax purposes.
- Capital gains are only 50% included in income, and capital expenditures are either deducted from income over a period of years or not deductible from income at all (and in some cases added to the cost of property to which they relate). Capital losses may only be used against capital gains.
- Canadian residents determine tax payable for each taxation year by computing income or loss from each source (e.g., business, investment, etc.), adding any taxable capital gains (net of allowable capital losses), taking any further permissible deductions in computing taxable income (including losses from other years carried forward or back to the current year), and applying the applicable tax rate to determine tax payable.
- Non-residents of Canada are taxable (1) under Part I on business income from Canada computed in largely the same way as Canadian residents (i.e., on a net basis), and (2) on a gross basis (no deductions permitted) under Part XIII on various forms of passive income (e.g., rents, royalties, dividends and non-arm’s length or participating interest). In both cases Canadian tax may be reduced or eliminated under the terms of a tax treaty between Canada and the non-resident’s home country.
Income Tax – Capital Versus Income
Similarly, where a taxpayer makes an expenditure it is necessary to characterize that expenditure as being on income account or capital account. Unless a specific rule provides otherwise, expenditures on income account can be fully deducted from revenues in the year in which they are incurred in computing income from the relevant “source”. Subject to certain specific exceptions, an expenditure on capital account cannot be deducted in computing income when incurred. As such, a taxpayer making an expenditure will typically be motivated to characterize it as being on income account, since recognition (i.e., deduction) of the expenditure in computing income is typically much faster if on income account than if on capital account.
The table below sets out in summary form the treatment of income and capital amounts:
Profit (Loss) on Disposition of Property
profit is fully included in income; loss is fully deductible from income (or net capital gains if desired) in most cases
profit is a capital gain, ½ of which (a “taxable capital gain”) is included in income; loss is a capital loss, ½ of which (an “allowable capital loss”) is deductible only against taxable capital gains
Treatment of Expenditure
generally fully deductible from income
generally non-deductible from income, usually added to the cost of any related property
In the case of an expenditure, probably the most useful rule of thumb is to ask whether the expenditure creates an asset or advantage of enduring benefit to the recipient, as opposed to a benefit substantially all of which will be enjoyed or consumed in the taxation year the expenditure is made. Readers familiar with accounting will recognize that this test is quite similar to the corresponding accounting principle for determining whether an expenditure should be expensed immediately (i.e., deducted from revenue) or “capitalized” by recording it as an asset and deducting it over time (discussed below).6 Note that the GAAP or IFRS treatment of a particular expenditure is usually but by no means always similar to the tax treatment of that amount. In addition to the “enduring benefit” test, the jurisprudence also tends to characterize expenditures of an unusual, “one-time” or “once and for all” nature as being capital in nature, while recurring expenditures are more likely to treated as being on income account.
Because an expenditure of enduring benefit creates an advantage that will be enjoyed in more than one taxation year, it is usually considered inappropriate for the taxpayer to deduct the whole expenditure from income in the year it is incurred. This is because deducting the entire amount in that year when part of the corresponding benefit will be enjoyed in later years typically understates the taxpayer’s income for tax purposes in the year of the expenditure and overstates it in those later years.
On the other hand, an expense on income account is normally considered to be one that is not out of the ordinary, that is made on a recurring basis, and (most importantly) the benefits from which are largely or exclusively enjoyed in the year in which the expenditure is made. For these reasons, deducting such an expenditure from income in the year it is made accurately expresses income for tax purposes for that year by matching the benefit created by the expenditure with the cost of the expenditure in the same period.
Where an expenditure is on income account and relates to the acquisition or creation of property that will be resold (e.g., inventory), it will typically be added to the cost of that property (which under the inventory accounting rules is effectively the same as deducting it from income, subject to timing). 7 This is because the cost of property held on income account is deducted from the sale proceeds in computing sales income. Other expenditures on income account will be fully deductible from income in the year incurred under general principles for the computation of profit, unless a specific rule in the ITA dictates otherwise.
An expenditure on capital account can usually be treated in one of several ways:
- an expenditure on or relating to the acquisition of depreciable property (discussed below) is included in the cost of that property, and the owner will be entitled to claim of a portion of the cost of the property as an annual deduction from income;
- an expenditure on or relating to the acquisition of certain properties relating to natural resources (e.g., a “Canadian resource property”, defined in s. 66(15) ITA) is added to one of various “pools” (e.g., “cumulative Canadian development expense”, defined in s. 66.2(5) ITA), and the owner will be entitled to claim of a portion of the cost of the property as an annual deduction from income in a manner similar to that for depreciable property;
- an expenditure on or relating to the acquisition of capital property other than depreciable property or natural resource properties described above is included in the cost of the property, and typically no deduction from income is available. When the property is disposed of, a capital gain or loss (depending on the proceeds received) will result. Thus, this type of expenditure results in no deduction from income, but reduces the capital gain (or increases the capital loss) ultimately realized upon a disposition of the relevant property;
- a capital expenditure made by a corporation for the purpose of gaining or producing income from its business that is (1) not part of the cost of property, (2) not a debt repayment or a payment to shareholders, and (3) non-deductible solely by virtue of being a capital expenditure (and not some other ITA provision) is included in the corporation’s “goodwill” property and thereby treated as the cost of a depreciable property, referenced above; and
- a capital expenditure not included in any of the categories above generally receives no tax recognition unless a specific rule in the ITA provides otherwise.
These general rules are always subject to specific provisions in the ITA, which may allow a particular capital expenditure to be deducted from income or which may prohibit the deduction from income of a particular expenditure on income account.
A property that is a capital property in the hands of one taxpayer may be a property held on income account in the hands of another, depending on their respective intentions and the manner in which they actually use the property. For example, land could be a capital property to an investor who acquires it for the purpose of constructing an office tower and earning rental income from the property, and inventory to a speculator who buys the land for the purpose of reselling or “flipping” it at a profit. Over the years, the courts have developed various factors that are relevant in determining a taxpayer’s true intentions in acquiring a property. These include:
- the number and frequency of similar transactions in the past by the taxpayer: the more often a person has bought and sold a particular type of property, the more likely she will be considered a trader in such property, i.e., on income account;
- the method of disposition: if the taxpayer actively sought purchasers (as opposed to receiving an unsolicited offer), and disposed of the property in the same way as would a trader in such property, the property is more likely to be considered on income account;
- the relationship between the transaction in question and the taxpayer’s regular business: a person involved in the securities industry may be considered more likely to be a trader or dealer in securities when buying securities for his own account, for example; and
- the nature of the asset: some properties are such that there is no plausible explanation for their purchase by that taxpayer other than to resell at a profit (using one actual case as an example, a large quantity of lead purchased by someone not otherwise able to use it).
Income Tax – Canadian Residents
Under the ITA, Canadian residents are subject to tax on their world-wide income (i.e., whether earned in Canada or elsewhere). Income from each separate “source” (e.g., a business, investment, employment, etc.) is calculated and tax owing is determined as described below. Natural persons (and trusts) pay tax on a graduated or progressive basis, viz., the tax rate on lower amounts of income is less than on higher amounts, and in some cases different rates of tax apply to different forms of income. Corporations generally pay tax at a “flat” rate (i.e., the same rate of tax applies no matter how much income is earned).
See here for current Canadian income tax rates
Income tax is computed with reference to a “taxation year.” For individuals the calendar year is the taxation year. Corporations may choose their first taxation year-end (which must occur within 53 weeks of its creation), and thereafter may not change it without the CRA’s permission. Certain events such as a merger or an acquisition of control of the corporation trigger a deemed year-end.
For each “taxation year”, a Canadian resident computes its Part I income tax payable for the year via the following process:
- for each “source” of income (i.e., a business, investments, employment) inside or outside of Canada, the amount of income (or loss) is determined, based on amounts received or receivable and permissible deductions;
- the taxpayer’s net capital gain (or loss) for the year is determined, by adding the taxable portion (generally 50%) of each capital gain realized by the taxpayer during the year and subtracting the allowable portion (generally 50%) of capital losses realized during the year. Various rules may defer or deny recognition of losses in different circumstances;
- “taxable income” for the year is determined, as the sum of amounts 1 and 2 less any deductions permitted in computing taxable income. For example, a dividend received by and included in the income of one Canadian corporation paid by another Canadian corporation is often fully deductible in computing the taxable income of the recipient, viz., no net inclusion. Similarly, in computing taxable income, losses from other taxation years may be deducted from income or gains from the current taxation year under certain circumstances.
- The applicable rate of tax is applied against the taxpayer’s taxable income, to determine tax payable. If the taxpayer has “tax credits” (for example, “investment tax credits” are offered to encourage certain activities in some regions of Canada), these may be deducted against tax payable.
Note: essentially the same process applies to a non-resident employed in Canada, carrying on business in Canada and/or disposing of taxable Canadian property during the year, to the extent of income from the Canadian employment or business and/or gains and losses from dispositions of taxable Canadian property.
Computing Business Income
Once the taxpayer’s “profit” for the year from the business has been determined, the ITA then imposes a number of specific rules governing what amounts are to be included in income and what amounts are permitted to be deducted, which supersede any accounting principles otherwise used in determining “profit”. For this reason, corporate income tax returns typically start with income or loss for accounting purposes, and then adjust this to reflect items where the ITA mandates a different treatment for tax purposes. For example, since the ITA includes a separate system for depreciation (“capital cost allowance” or “CCA”), accounting depreciation would be added back to income for tax purposes, and the taxpayer then allowed to claim CCA deductions to the extent set out in the ITA.
Expenses that are generally non-deductible for tax purposes include the following:
- expenditures on capital account;
- expenditures of a personal nature or otherwise not made in order to earn income from a business or investment;
- contingent expenses; and
- expenses that are subject to specific limitations or prohibitions in the ITA (e.g., business entertainment expenses, most expenses incurred by employees, stock option benefits, etc.).
As described above, the ITA distinguishes between amounts on income account and amounts on capital account. Items on income account (either revenue or expenses) are fully includable in (or for expenses, deductible from) the taxpayer’s income for tax purpose. Conversely, only 50% of capital gains are included in income and subjected to tax, and expenditures that are capital in nature are generally not deductible in computing income (although in many cases rules exist that permit them to be deducted over a period of years, such as CCA for depreciable property).
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. 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. Hence, the taxpayer’s noncapital loss constitutes excess losses on income account for a particular year that can be used in other years. The taxpayer’s noncapital loss for a particular year may be carried back and used against income in the three most recent prior taxation years or carried forward and used in the 20 immediately subsequent taxation years.
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). 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. Instead, it is treated as the taxpayer’s net capital loss for the year, which (subject to some limitations) may be carried back and used against net taxable gains in the three most recent prior taxation years or carried forward and used against net taxable gains in any future taxation year.
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 (that is, 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 noncapital losses on an acquisition of control of the corporation.
Losses are discussed in greater detail elsewhere
Income Tax – Non-Resident of Canada
Non-residents of Canada are subject to Canadian Part I income tax on (1) income from carrying on business in Canada, (2) income from employment in Canada, or (3) capital gains realized upon disposing of certain forms of Canadian-situs property (“taxable Canadian property”). If they engage in these activities and no applicable tax treaty applies to provide relief, then in general they compute their income from (and pay tax on) these Canadian activities in essentially the same manner as do Canadian residents described above, except that they are only subject to Canadian tax on Canadian-source income or gains, not their world-wide income or gain. “Taxable Canadian properties” include land in Canada (or an interest therein) and shares of a corporation or interests in a partnership that derive more than 50% of their value (directly or indirectly) from land or natural resources in Canada at any time during the immediately preceding 5 years. Shares listed on certain stock exchanges will not be taxable Canadian property unless the foreign shareholder also meets a 25% ownership threshold within the past 5 years.
Non-residents are also subject to Canadian withholding tax (also called Part XIII tax) on payments of passive, investment-type income from Canada (typically where the payer is a Canadian resident). The most prominent examples of income subject to Part XIII tax are dividends, interest (if paid between non-arm’s-length persons or if the interest is participating interest), rents and royalties. The rate of tax is 25% of the gross amount of the payment, with no deductions permitted.
In the case of both Part I income tax and Part XIII withholding tax, the rules in the ITA are subject and subordinate to the terms of any tax treaty Canada has entered into with the country where the particular foreign taxpayer resides. Such a tax treaty may reduce or eliminate Canadian taxes otherwise owing under the ITA, depending on what country the foreign taxpayer is resident in (tax treaties contain rules for determining whether someone is a resident of one country or the other) and what the terms of the particular treaty say. For example, virtually all of Canada’s tax treaties (where applicable):
- prevent Canada from taxing the business profits of a non-resident who carries on a business in Canada, if the business is not carried on through a “permanent establishment” (e.g., a fixed place of business) of the non-resident within Canada; and
- reduce the rate of withholding tax on dividends, interest and royalties.
Tax treaties are typically of great importance to non-residents in terms of minimizing their Canadian taxes, and are discussed in more detail here.
Non-resident corporations that carry on business in Canada are also subject to “branch tax” under Part IVX, which largely replicates the Part XIII dividend withholding tax that would apply if a Canadian subsidiary of the non-resident corporation earned the same income and paid a dividend back to its foreign parent. The rate of branch tax is generally reduced to the most favourable dividend withholding tax rate under the tax treaty (if any) between Canada and the non-resident corporation’s home country. Some tax treaties also exempt the first $500,000 of branch earnings from branch tax.