October 11 2002

Overview (October 2002)

Borden Ladner Gervais LLP | Corporate Tax - Canada

Eva Chan

Introduction
Inbound Transactions: Net Basis Taxation
Inbound Transactions: Withholding Taxation
Outbound Transactions
Taxation of Investments
Taxation of Indirect Loans
Transfer Pricing


Introduction

Income tax is imposed at the federal and provincial levels in Canada. Under the Canadian Constitution, the federal government has unlimited powers of taxation. Provinces have the power to impose direct taxation on income earned in the province and on the worldwide income of persons who are resident in the province. Because the federal government collects both individual and corporate tax on behalf of most provinces, the tax base for the federal and provincial income taxes is, for the most part, the same. Provinces set their own tax rates.

Legislation
There are three main bases from which the rules governing taxation derive in Canada. The most important is the federal Income Tax Act (Canada) and regulations issued thereunder. Another primary influence is tax treaties. Under Canadian law, a tax treaty has the force of law in Canada. If there is any inconsistency between a treaty provision and domestic law, the treaty provision will prevail. To facilitate interpretation of its treaties, Canada has passed the Income Tax Conventions Interpretation Act (RSC 1985, c 1-4, as amended). A third element is Canadian case law. This jurisprudence is important in giving more precise meaning to generally worded provisions in the act. The jurisprudence is expanded by administrative practice and policy of the federal government in the form of interpretation bulletins, information circulars, advance tax rulings, and other interpretation documents issued by the Canada Customs and Revenue Agency (CCRA). However, these do not have the force of law in Canada but generally assist taxpayers and their advisers in establishing the parameters of their tax planning.

Source
For the purposes of Canadian tax law, the concept of income is based on the notion of source. 'Source' has two aspects: the character of income and the geographic origin or location. The character aspect refers to the nature of the activity that generates income. Main sources of income are listed in Section 3 of the act. They include income from office and employment, business and property, and capital gains. The territorial aspect of source means the geographical place in which an item of income is generated.

'Source' is fundamentally important in the Canadian income tax system. If an item is not considered to have a source within the meaning of Section 3, it is generally not taxable. For example, the strike pay that a union pays its members while they are on strike as a replacement of their employment income has been considered not to have a source for tax purposes. Gifts, inheritances, gambling winnings and other forms of windfall are also not considered to have a source and therefore not to be income. Similarly, if an expense is not attributable to a source of income, it is not deductible in computing income. For example, costs of gambling are not tax deductible because gambling winnings are not income.

Income from each source must be calculated separately. The act provides different rules for calculating income from various sources. For example, in computing income from a business or property, any costs and expenses incurred for the purpose of earning income from a business or a property are deductible and are offsets to that income. Once income or loss from each source has been computed, they are aggregated under Section 3 as the taxpayer's income.

Rates
The federal corporate tax rate is 37% minus a 10% abatement to allow for provincial taxation. Provincial corporate tax rates vary, ranging from 9.5% to 16.5%. Preferential rates at both the federal and provincial levels are available for active business income earned in Canada by Canadian-controlled private corporations and for manufacturing and processing profits earned by a corporation in Canada. Large corporations are liable to pay an additional federal tax on capital at the rate of 0.225% of the corporation's taxable capital employed in Canada in excess of C$10 million. Most provinces also levy a capital tax.

The administration of tax collection is based on a system of self-assessment. All taxpayers are required by the act to file an annual tax return reporting their income and expenses, the amount of tax owing or the refund due. The tax returns are verified by the CCRA. If the required information is correct and the computations are mathematically correct, a notice of assessment showing the amount of tax owing is then sent to the taxpayer.

Inbound Transactions: Net Basis Taxation

Compared with countries like the United States, Canada has a strong commitment to source taxation because of its history as a capital importer. The principle of source-based taxation is embodied in Parts 1 and 13 of the act. The general rule is that non-residents of Canada are taxable in Canada only on their Canadian-source income. This rule has several exceptions and is protected by numerous anti-avoidance rules. Treaties also impose some limits on Canada's jurisdiction to tax on the basis of source.

Under Section 2(3) of the act, a non-resident person is taxable where the person "was employed in Canada, carried on a business in Canada, or disposed of a taxable Canadian property, at any time in the year or a previous year". Income from these three sources is generally taxable under rules that are roughly comparable to the rules that would apply if that income was earned by residents. That is, income is taxed on a net basis at the rates applicable to Canadian residents. Non-residents taxable under Part 1 of the act must file a tax return with the CCRA regardless of whether tax is actually payable. They are also required to make self-assessed payments of estimated tax under the rules applicable to resident taxpayers. A reporting and enforcement system is prescribed by Section 116 of the act for all dispositions of non-excluded taxable Canadian property by a non-resident of Canada. This system allows Canada, through the purchaser, to tax non-residents on the disposition of such property.

Business income
Jurisdictional nexus
Non-residents of Canada are subject to Canadian tax on income derived from carrying on business in Canada. The meaning of 'carrying on a business' is generally determined by the common law rules, although in certain circumstances Section 253 extends the meaning to include an economic activity which might not otherwise be thought to come within the ambit of 'carrying on a business'.

At common law, the place at which a business is carried on is a question of fact that must be determined on the basis of all the facts and circumstances of each case. The courts have devised various tests to determine whether a non-resident person is carrying on business in a particular country. The two most important jurisprudential tests, for Canadian tax purposes, are the place where a contract is made and the place of operation from which profits arise. Other tests may be relevant, but the importance attributed to these tests varies with the circumstances of each case.

The first test, the place where a contract is made, is often considered an important factor in determining the situs of a business, especially the trading of goods. English cases (which have been adopted in the Canadian jurisprudence) have held that "if the contracts are concluded in the country, that fact alone will be sufficient to constitute an exercise of trade here". (Crookston Bros v Furtado (1910), 5 TC 602 (Scot Ex Ct)). However, the place where a contract is made is not always conclusive because it is easily manipulated and there are many factors that contribute to the profit-making process. Accordingly, the courts have frequently turned to the second test, which looks at a combination of factors (eg, the location from which materials are purchased, the location of purchases of materials, manufacturing or production of goods, the location of inventory, the solicitation of orders, the terms of delivery and payment) to determine the place of operations from which the profits arise, and hence, the situs of business.

Section 253 extends and overrides these common law principles where they differ. Section 253(a) deems a non-resident person to have been carrying on business in Canada if he or she

    "produces, grows, mines, creates, manufactures, fabricates, improves, packs, preserves or constructs, in whole or in part, anything in Canada whether or not the person exports that thing without selling it before exportation."

The word 'anything' is very broad and includes both tangible and intangible property, as well as services. The enumerated activities have in common the expenditure of labour in relation to property. Therefore, it is thought that some physical presence (eg, personnel and/or assets) would normally be necessary for a non-resident to fall within Section 253(a).

Section 253(b) provides that a non-resident person is deemed to have been carrying on business in Canada if the person

    "solicits orders or offers anything for sale in Canada through an agent or servant, whether the contract or transaction is to be completed inside or outside Canada or partly in and partly outside Canada."

This provision overrides a case law principle according to which mere solicitation of orders or making of offers for sale in a country does not constitute carrying on business in that country.

Canadian courts have provided limited guidance on the application of Section 253(b). In Sudden Valley Inc v The Queen ([1976] CTC 775, at 776, 76 DTC 6448 at 6449 (FCA)) the court held that Section 253(b) did not apply to a mere invitation to treat. The word 'offer' was held to have its ordinary meaning in contract law - an offer which, if properly accepted, creates a binding contract between the offeror and the offeree. It was suggested that the Sudden Valley decision is of exceptional application (because of the nature of the property and the peculiar method by which the property in the United States was offered for sale in Canada). It may not, therefore, have general application to the sale of consumer goods. However, there have been no cases to this effect. It is arguable that the decision has a broader application. If so, it is possible that a non-resident who solicits orders in Canada by mail or advertising on the Internet, subject to acceptance outside Canada, is not carrying on business in Canada.

Section 253(c) deems the disposition of Canadian resource property and real property to be carrying on business in Canada, no matter where the sale takes place. In the absence of this rule, a sale of Canadian real property may be considered an adventure in the nature of trade, which, under the common law, does not constitute carrying on business in Canada. Hence, although the economic source of the gains from a sale of Canadian real property is Canada, the gains would escape Canadian taxation because neither Part 1 nor Part 13 would apply to tax the gains. Section 253(b) preserves Canadian tax jurisdiction by deeming the sale to constitute carrying on business in Canada.

For the purpose of Section 253 and the common law, the business activities of non-residents may be conducted in Canada directly by the non-residents or through an agent. An agency relationship may be constituted in a number of ways. Non-resident partners in a partnership which carries on business in Canada have been held to carry on business in Canada, even if they are never present in Canada, are passive partners and do not play an active role in the partnership by reason of their partnership arrangements. A real estate broker or securities broker, who generally acts in the ordinary course of his/her business, has been found to constitute an agent for a non-resident with respect to the sale of real property or securities in Canada. On the other hand, the mere fact that a non-resident has an agent in Canada does not necessarily mean that the non-resident is carrying on business in Canada. For the activity to constitute carrying on business in Canada, the agent must have the general power to bind the non-resident principal.

Permanent establishment
Canada's tax treaties follow Article 7 of the Organization for Economic Cooperation and Development (OECD) Model Tax Convention and provide, generally, that business profits are taxable in the country of residence of the taxpayer. The source country can tax business income of a taxpayer of the residence country only if the income is reasonably attributable to a permanent establishment in the source country. For income from independent services, the notion 'fixed base' is used as the primary threshold for source taxation.

The concept of permanent establishment in Canada's tax treaties is generally based on Article 5 of the OECD Model Convention. In treaties with developing countries, the concept is expanded to incorporate some elements of Article 5 of the United Nations Model Convention. Canadian courts have held that the word 'permanent' means that "the establishment is a stable one, and not of a temporary or tentative character". For example, the use of another person's office space has been held not to give rise to a permanent establishment if the use was so sporadic as to fail to have the degree of continuity and permanence required to constitute a permanent establishment. The degree of permanence was, however, satisfied where a non-resident trader visited Canada once a year for several years and customarily spent between two and three weeks in Canada per visit in order to sell products from a trailer and a collapsible booth, which he set up at an exhibition place in Canada. A taxpayer who stayed in Canada for a large part of a year (300 days in one case) was found not to have any 'fixed base' in Canada because there was no control of the premises or offices that was made available to the taxpayer by the Canadian customer.

Attribution of profit
Canada does not adhere to the 'force-of-attraction' doctrine. Non-residents are taxable on Canadian-source business income only if the income is attributable to a business carried on in Canada. Canadian-source income that is not attributable to a business carried in Canada is either exempt from Canadian tax or taxable under Part 13. Canadian law is very limited on the attribution of income to a business in Canada. Presumably, if the personnel or assets of a non-resident corporation's business in Canada are instrumental in earning an item of income, the income is attributable to the Canadian business. An example might be a case where the personnel of a Canadian branch of a foreign corporation negotiate a licence agreement between the corporation and a party in a third country. Royalties by the licensee to the foreign corporation should be attributable to the Canadian branch. Similarly, if the licensee is a resident in Canada, the royalties should be attributed to the business and taxable under Part 1, rather than as income from property taxable under Part 13.

In computing net income and taxable income earned in Canada, non-residents are allowed to claim a deduction for costs, expenses, charitable donations (in the case of non-resident corporations), and loss carryovers that are reasonably considered to be applicable to the Canadian-source income. The act contains no specific rules for the allocation of income and expenses to Canadian-source income. Only a reasonable allocation is required by the general rule contained in Section 4. The CCRA seems not to be unduly restrictive in approving reasonably justifiable methods of allocating expenses and other deductions among the various sources of income. For example, head office expenses might be apportioned by the number of transactions, in proportion to revenue. A taxpayer may generally adopt a reasonable allocation based on sales, payroll, plant floor space, units of production, amount of capital employed, so long as the apportionment is applied consistently.

Canada's tax treaties do not contain specific allocation rules, except the provision based on Article 7(2) of the OECD Model Tax Convention. According to this provision, the profits of a permanent establishment shall be determined as if the permanent establishment were dealing wholly independently with its head office and with all other persons. Furthermore, the deduction of expenses incurred for the purposes of the permanent establishment, including executive and general administrative expenses, whether incurred in the state of the permanent establishment or elsewhere, is restricted to those expenses that are deductible under the laws of the contracting state in which the permanent establishment is situated.

The notion that a permanent establishment is treated as a separate entity may be difficult to apply in some cases. One area of difficulty is the treatment of 'notional expenses' between the permanent establishment and its head office. Canadian courts have interpreted the treaty provision based on Article 7(2) of the OECD Model Tax Convention as not authorizing a deduction for notional expenses. For example, in Cudd Pressure Control Inc v The Queen (98 DTC 6630 (FCA)) the Federal Court of Appeal held that a notional payment of rent for equipment by the Canadian permanent establishment was not deductible. In respect of a Canadian branch of a foreign bank, however, legislative provisions have been proposed to apportion the amount of interest expense deductions on the basis of a formula. A foreign bank will be permitted to deduct interest both in respect of money borrowed directly from third parties (direct debt) and on account of money borrowed indirectly through its home office (allocated debt), with an overall limitation of a debt-to-equity ratio of 19:1. This is to be based on the total value of the assets used in connection with the bank's business carried on in Canada. The interest on this allocated debt is to be determined through relevant criteria, such as market rates and the use of funds, and will be prescribed by regulation.

Employment income
Section 2(3) and Section 115(1)(a) provide that non-residents are taxable in Canada if they are "employed in Canada" and their taxable income is attributable to the duties of the office or employment performed by them in Canada.

Whether an individual is employed in Canada is dependent on the place where employment services are performed. This test applies to salaries, wages and employment benefits. For example, the source of income from stock option benefits is the place of performance of the duties for which the stock option was granted. In determining whether an individual performs services in Canada, it is necessary to look at whether the individual is physically present in Canada and performs the services. If a non-resident renders services to a Canadian resident remotely via telephone, the Internet or other means of communications, the services are generally not considered to be rendered in Canada. Where an individual performs services partly in Canada and partly in a foreign country, the income is allocated to both jurisdictions. The employer's residence is generally irrelevant to the determination of the source of employment income.

Canada's tax treaties typically provide that the source of income from services is the place where the services are performed. However, the treaty source rule for employment services and independent services is much narrower than that for domestic law purposes. Under Canada's tax treaties, even when employment services are performed in Canada by a non-resident taxpayer, income from the services in not taxable in Canada if the taxpayer is present in Canada for a period or periods not exceeding in the aggregate 183 days in a calendar year (or any 12-month period); if the remuneration is paid by, or on behalf of, an employer who is a Canadian non-resident, or if the remuneration is not borne by a permanent establishment or a fixed base that the employer has in Canada. With respect to independent personal services, source taxation can be imposed by Canada only if the services are rendered through a fixed base in Canada. However, the 'fixed base' requirement does not apply if the services are rendered by an entertainer or athlete.

Capital gains
Non-residents are liable to Canadian tax only if the gains are derived from the disposition of "taxable Canadian property". Section 248(1) defines 'taxable Canadian property' to include:

  • real property and resource property in Canada;
  • assets used in carrying on a business in Canada;
  • unlisted shares of a corporation resident in Canada;
  • listed shares of a resident corporation if a non-resident shareholder owns 25% or more of the issued shares of any class of the corporation during the five-year period preceding the disposition;
  • unlisted shares of a non-resident company whose underlying assets are mostly Canadian real property or resource property; and
  • listed shares of a non-resident company whose underlying assets are mostly Canadian real property or resources property if a non-resident shareholder owns 25% or more of the issued shares of any class of the corporation during the five-year period preceding the disposition.

Canada's tax treaties generally follow Article 13 of the OECD Model Tax Convention. Article 13 specifies the types of gains which are taxable in the source country, and thus functions as a source rule. In general, gains from the alienation of immovable property or property of a permanent establishment (or fixed base) are taxable in the country where the immovable property or the permanent establishment or fixed base is situated. Some of Canada's treaties provide for a 'place of immovable property' rule for shares of a corporation if the value of shares is derived principally from immovable property. Canada's treaties with some developing countries, such as China, provide that gains from the alienation of shares are taxable in the company's country of residence if the shareholding exceeds a certain threshold (eg, 25%). Gains from an alienation of other types of property, such as personal property and securities, are taxable only in the residence country of the alienator.

Inbound Transactions: Withholding Taxation

Interest, rent, royalty, dividends, management or administration fees, and other specified amounts paid or credited by a Canadian resident to a non-resident person are subject to Part 13 tax at the rate of 25% (which is reduced by tax treaties). Although management or administration fees are not a typical form of investment income, they are taxable under Part 13 of the act. The rationale is presumably to protect the Canadian tax base, as these payments are deductible by the payer in computing its income in Canada. The term 'management or administration fee' does not include any amount paid for services performed by a non-resident person in the person's ordinary course of a business where the non-resident and the payer deal with each other at arm's length. Nor does such fee include a reimbursement for a specific expense incurred by the non-resident for the performance of a service that was for the benefit of the taxpayer, as long as the amount paid is reasonable in the circumstances.

Part 13 tax is levied on gross payments. In computing the amount of tax payable, no deductions are allowed for costs or expenses. The obligation to collect Part 13 tax is imposed on resident payers or paying agents, who must deduct and withhold the tax from their payments to the non-resident payee and remit the tax to the government. The Canadian non-resident withholding tax is actually a tax on the non-resident payee who, in the event withholding has not been made, can be assessed to tax directly. Non-residents are generally not required to file a tax return, unless a Section 216 election is made. In addition to Part 13 tax, fees paid to a non-resident for services rendered in Canada are subject to withholding under Regulation 105.

In cases where both Part 1 and Part 13 potentially apply, Regulations 802 and 805 provide an ordering rule. In effect, where an amount that is otherwise taxable under Part 13 is also taxable under Part 1, the amount is exempt from Part 13 tax. The income is thus taxable only under Part 1. A similar rule is contained in Canada's tax treaties.

Non-resident person
Generally, Canada relies on a factual test to determine residence. However, several rules exist which will deem an entity that would otherwise be considered to be a resident of Canada to be a non-resident for the purposes of Part 13 of the act. In particular, a partnership (other than a 'Canadian partnership' as defined in the act) which receives an amount from a Canadian resident will be deemed to be a non-resident person. Look-through treatment is afforded in certain cases to avoid unduly prejudicing the ultimate partners of the partnership where they would be entitled to treaty benefits.

Other rules deem persons who might not be regarded as residents of Canada to be so resident for purposes of obliging them to withhold tax on payments they make to other non-residents. These rules are found in Section 212(13), (13.1) and (13.2) of the act.

Source rules
Dividend
The act leaves the term 'dividend' undefined. Section 248(1) simply provides that a dividend includes a stock dividend. The ordinary meaning of 'dividend' has been established by the courts. In English cases, which have been generally accepted for Canadian tax purposes, the courts have determined that any pro rata distribution from a corporation to its shareholders is a dividend, unless the distribution is made on the liquidation of the corporation or on an authorized reduction of corporate capital (Hill v Permanent Trustee of New South Wales [1930] AC 720 (PC) and IRC v Burrell [1924] 2 KB 52 (CA)). A dividend also includes a deemed dividend under Section 84 of the act. In addition, for purposes of non-resident withholding tax, dividends include benefits conferred by a corporation on its shareholders, and deemed dividends arising from non-arm's length sales of shares of a Canadian corporation in a surplus-stripping situation. The definition of 'dividend' in Canada's tax treaties does not override the domestic law meaning of the term.

The source of dividends is generally the country of residence of the company paying the dividends. For example, Section 212 imposes a withholding tax on dividends paid or credited by resident corporations to non-resident shareholders. The source of dividends is not determined by the source of business profits out of which the dividends are paid. Therefore, even if a non-resident company derives most of its income from carrying on a business in Canada, dividends paid by the company are not considered to have a Canadian source.

Canada's tax treaties follow Article 10 of the OECD Model Tax Convention. The source of dividends is determined by the payer's residence. These treaties also contain what might be described as a negative source rule, stating that dividends do not have a source in the country in which the profits, out of which the dividends are paid, are derived. This rule appears to prohibit the levy of a branch tax. In order to preserve the right to levy such a tax, Canada's treaties often add a paragraph specifically to allow the imposition of a branch tax.

Interest
In the absence of a statutory definition, the courts have interpreted the term 'interest' to mean the return or compensation for the use or retention by one person of a sum of money belonging to or owed to another. Interest is considered to have three characteristics:

  • It is a return or consideration received by one party for allowing another party to use his/her money;
  • It is computed by reference to a principal amount; and
  • It accrues daily.

Many of the cases dealing with the meaning of 'interest' for income tax purposes have been decided in the context of the deduction for interest under Section 20(1)(c). These cases tend to take a narrow view of the meaning of interest. For example, a discount has been considered not to be interest, although participating interest has been held, in certain cases, to be interest for purposes of Section 20(1)(c). For purposes of Part 13 tax, however, 'interest' has a broader meaning which includes, in addition to payments otherwise considered to be interest:

  • standby charges and guarantee fees;
  • a portion of a combined income and capital payment where it is reasonable to regard part of the combined payment as being in the nature of interest;
  • gains realized by a non-resident from the transfer of certain debt obligations to a resident of Canada;
  • substitute payments under securities lending arrangements made by a borrower to the lender in an amount equivalent to the interest payments that the lender would have received on the security during the term of the loan;
  • fees paid by a borrower to a lender for the use of a security under a securities lending arrangement;
  • certain payments to 'buy down' the interest rate on a debt obligation, or for penalties or bonuses because of early repayment of a debt obligation; and
  • certain dividends received by a specified financial institution on a term preferred share.

The source of interest is generally based on the payer's residence. For the purposes of Canadian non-resident withholding taxes, this general rule is replaced by two tests based on economic substance. The first test is the location of real property that is used as security for the indebtedness. This is consistent with the general rule that income related to real property is sourced to the location of the property on the assumption that the economic value of the property is largely determined by its location. The second test is the place of the business that bears the interest expense or base-erosion. This rule assumes that the source of interest is the country whose tax base is reduced as a result of the interest expense deduction.

Canada's tax treaties adopt the source rule in Article 11(5) of the OECD Model Tax Convention: the residence of the payer, or the location of the permanent establishment (or fixed base) that bears the interest expense.

Rents and royalties - characterization
The act does not provide a comprehensive definition of either 'rent' or 'royalty', but Section 212(1)(d) does include certain payments as rents or royalties for withholding tax purposes. The scope of this provision is extremely broad. By using the words "including, but not so as to restrict", the Canadian tax legislators have been taken to have intended to tax not only payments that had all the strict legal characteristics of 'rent' or 'royalty', but also payments enumerated in the provision that may not ordinarily be considered as such.

Under Section 212(1)(d)(i) of the act, for example, payments for the use of "any property, invention, trade name, patent, trademark, design or model, plan, secret formula, process or other thing whatever" are taxed as royalties. It is not relevant whether the amount of the payments is related to use, production or profit, or whether payments are provided in a lump sum or periodically. The courts have interpreted the meaning of Section 212(1)(d)(i) in several cases. In The Queen v Saint John Shipbuilding & Dry Dock Co Ltd (80 DTC 6272 (FCA)) the taxpayer made a lump-sum payment for the right to use software created by a US company for ship design. The information obtainable by the use of the software was not secret, in that it could have been worked out by competent technical personnel of the Canadian company with expense and time. The right to use the software was perpetual, in that the Canadian taxpayer could use the software for as long and for whatever purposes it chose, but the taxpayer was bound by contract to use the software only for its own purposes. It could not resell the software. The right was non-exclusive and the US company could license other users to use the same software. The court found that the payment could not be regarded as made for the use of secret processes and formulae, but that it could conceivably have been made for the use of "other like property." However, because the payment was not a 'royalty' within the definition of the term in the Canada-US treaty as it then read, it was exempt from Canadian tax.

In The Queen v Farmparts Distributing Ltd (80 DTC 6157 (FCA)) a Canadian company made payments to a US company for:

  • exclusive territorial right to buy 'Wonder Matic' machines used in the replacement of automobile exhaust systems for resale in Canada;
  • the concept or technique of merchandising the systems; and
  • use of the trade name 'Wonder Muffler' and related logos.

The court found that payments for the right to buy machines and resell them in Canada did not fall within Section 212(1)(d)(i), but the other two payments did. The merchandising concept or technique was found by the court to be a 'plan', or perhaps a 'process' or 'property' as those words are used in Section 212(1)(d)(i).

Under Section 212(d)(ii), payments for information concerning industrial, commercial or scientific experience are taxable as royalties where the total amount payable as consideration for such information is dependent, in whole or in part, upon the use to be made of the information or the benefit from it, upon production or sales of goods or services, or upon profits. Section 212(1)(d)(ii) differs from Section 212(1)(d)(i) in that the former catches payments only where there is an element of contingency in the payment related to use or benefit, while the latter applies irrespective of any connection between the payment and use of the property or thing. Also, unlike Section 212(1)(d)(i), Section 212(1)(d)(ii) does not require that the information be used in Canada.

The term 'information' is not defined in the act. Its meaning can be very broad. The information contemplated in Section 212(1)(d)(ii) presumably excludes information that is a property or thing listed in Section 212(1)(d)(i). If the information is a property or thing within the meaning of Section 212(1)(d)(i), payments for such information will be taxed under that provision. For example, a payment made for information used in the fashion business may consist of 'design or models' and other information. Payments for the use of designs or models are subject to Section 212(1)(d)(i), whereas payments for other information are subject to Section 212(1)(d)(ii) and taxable only if they are based on use, production or profits. Similarly, if the information is confidential and can be considered a 'secret process' or 'secret formula', payments for such information are taxed under Section 212(1)(d)(i).

The determination of whether a payment is based on use, production or profits is made on a case-by-case basis. The determination is straightforward in the case of periodic payments based on a percentage of production, sales or profits. A one-off payment in a predetermined amount for information (eg, the right to attend a viewing or an exhibition) is not considered a payment that is dependent in whole or in part upon use, production or profits. Where an initial payment of a fixed sum is coupled with future payments depending upon use, production, or profits, the CCRA will normally regard the initial payments as separate and may consider the future payments as royalties.

Under Section 212(1)(d)(iii), payments for services of industrial, commercial or scientific character are taxable as royalties to the extent that the total amount of the payments is based upon use, production or sale of goods or services, or profits. Payments based on some other criterion are generally not royalties. Where fees are charged for services on a daily or similar basis, it is a question of fact whether the amount depends upon the use to be made or the benefit to be derived from the services. In practice, daily or hourly fees are generally viewed as being outside the scope of Section 212(1)(d)(iii). Section 212(1)(d)(iii) does not apply to management and administrative fees or fees for services performed in connection with the sale of property or the negotiation of a contract.

Service fees should be distinguished from payments for information, as it is not uncommon in practice that information concerning industrial, commercial or scientific experience is obtained as a result of services provided by the person possessing the information. Such a distinction is insignificant for the purposes of Section 212(1)(d)(ii) or (iii), but it is very important when payments are made to residents of treaty countries, because the definition of 'royalty' in Canada's tax treaties generally does not extend to services. Accordingly, a fee for services if it falls within Section 212(1)(d)(iii) is not a royalty for Canadian tax purposes but is not subject to the mitigation provided by treaty. If Canadian non-resident withholding tax is levied it will be at the higher domestic rate. Therefore, most service fees are agreed upon so as not to have Section 212(1)(d)(iii) apply to them. They will then be subject to the business profits provisions of the relevant treaty.

In making the determination of whether an agreement is for information or services, the terms and primary focus of the agreement are important factors to consider. For example, where an agreement is labelled a services agreement, avoids any mention of pre-existing knowledge and focuses, to the extent possible, on the specific tasks to be undertaken by personnel rather than upon the transmission of specific knowledge or information, payments made under the agreement on the basis of use, production or profits are likely to be viewed as service fees.

Similarly, where services rendered constitute the bulk of the contract and the resulting information (eg, drawings, designs or plans) did not exist at the beginning of the contract, payments under the contract will be treated as service fees. On the other hand, where the primary obligation under the contract is to convey specialized technical information in some manner, the payments are more likely to be treated as payments for information. In cases where payments are made for both services and information, an allocation must be made.

In a licence scenario, the licensor may be required to provide related services, such as maintenance, training, technical support, updates, modifications, improvements and additions to trademarks. Payment for such services may be separate from or part of the licence fee. The characterization depends on:

  • the nature of services;
  • whether the acquisition of the services is optional; and
  • whether the amount of service fees is reasonable in relation to the licence fee.

Payments for additions, product updates, enhancement, improvements or modifications to the licensed products are likely to be considered royalties. Where the acquisition of services is optional and the amount is reasonable in relation to the licence fee, the payments will often be treated as service fees. However, if the failure to enter into or renew an agreement or the cancellation of such an agreement would cause the loss of the right to use the licensed products, the payments would likely be treated as a licence fee.

Under Section 212(1)(d)(v), payments that are dependent upon use or production from property in Canada, regardless of whether the payments were instalments on the sale price of property other than agricultural land, are taxed as royalties. This provision makes it irrelevant whether a transaction takes the form of a purchase or a licence or lease of property where payments are contingent on production from or use of the property.

Payments for the use of a copyright in Canada are generally taxed as royalties. The term 'copyright' means "the sole right to produce or reproduce the work or any substantial part thereof". The owner of a copyright may assign the right, either wholly or partially, either generally or subject to territorial limitations, and either for the whole term of the copyright or for any part thereof, and may grant any interest in the right by licence. Any person who produces or reproduces a copyrighted software program must either own the copyright or obtain the right under a licence to produce or reproduce the program. According to the Copyright Act, a person cannot reproduce the program without violating the law, unless either the right to reproduce has been granted by the copyright holder, or the end-user 'owns' the copy of the program. The owner of a copy of the program is permitted by the Copyright Act to make a copy for back-up purposes or for internal use.

Computer software is protected under the Copyright Act. The taxation of software payments depends on the characterization of the payments. Neither the act nor the regulations provide any guidelines for this characterization. The CCRA's administrative characterization seems to be based on the type of software and the extent of rights transferred. Whether or not a software program is shrink-wrap or custom software is a question of fact that can be determined only by reviewing the licensing agreement associated with the right to use the particular program. 'Shrink-wrap software' refers to over-the-counter software that is licensed pursuant to a standard unsigned licence agreement, the terms of which the licensee may or may not have been aware of at the time of purchase. Where software programs are purchased over the Internet, the so-called 'click-wrap' or 'web-wrap' software may also be treated as shrink-wrap software. On the other hand, if a software program is subject to a licence agreement where it is clear that the customer was aware of its terms (usually verified by signing the licence agreement) when acquiring the software, the software is considered to be custom software.

Fees paid for the right to use shrink-wrap software are treated as sale proceeds rather than licence fees or royalties. In other words, where pre-packaged or standard software is 'purchased' by a consumer, although the transaction is formally referred to as a licence, for tax purposes, the transaction is classified as a purchase and sale of a good. In such cases, the customer does not obtain the copyright (ie, the right to reproduce the software). Fees paid for acquiring a copy of custom software are treated as royalties for the right to use a secret formula or process under Section 212(1)(d)(i).

A purchase is distinguished from a licence of copyright. An outright purchase of copyright rights occurs where "there has been an absolute transfer of all intellectual property interests in the software and where the buyer obtains an unrestricted right to sell or lease the software". An outright purchase does not arise where the transferor or any party other than the transferee maintains proprietary rights, or where the transferee has committed itself to restrictions not normally associated with ownership such as restrictions regarding secrecy. Payments for purchasing a copyright are not royalties for Canadian tax purposes, unless the price is dependent on the use of or production from the property. Payments for a licence of a copyright are generally taxed as royalties. However, because computer software is recognized as a 'literary work', payments for the right to produce or reproduce software in Canada fall within the exemption under Section 212(1)(d)(vi).

Treaty definition of 'royalty'
The definition of 'royalties' in Canada's treaties generally follows the definition of the term in Article 12 of the OECD Model Tax Convention. Canada departs from the OECD definition in several respects in order to bring the treaty definition more in line with Section 212(1)(d) of the act. The OECD Model Tax Convention specifies payments for the right to use "copyright of any literary, artistic or scientific work, including cinematography films, any patent, trademark, design or model, plan, secret formula or process". Canada adds to this list of items "or other similar intangible property". Article 12(4) of the Canada-US treaty also extends the definition to:

  • payments "for the use of, or the right to use, tangible personal property";
  • "gains from the alienation of intangible property or rights to the extent that such gains are contingent on the productivity, use or subsequent disposition or such property or rights"; and
  • technical service fees if the fees are periodic and dependent upon productivity or a similar measure.

Rents and royalties - source
There are no specific Canadian domestic statutory source rules for rent or royalties. For the purposes of the Canadian non-resident withholding taxes, the two most important source rules are based on the place where the property is used and the residence of the payer. For tangible property, the place of use is considered to be the place where the property is located. For intangible property, it is generally the country in which the right is used or exploited.

Canada's tax treaties generally permit the source country to impose withholding tax. This practice deviates from the OECD Model Tax Convention, which provides that royalties can be taxed only in the residence country and thus provides no source rules for royalties. Because Canada insists on source taxation of royalties, Canadian treaties need a source rule and normally provide one similar to that used for interest. The source of royalties is based on the residence of the payer or the place of a permanent establishment (or fixed base).

Exemption from withholding tax
Two broad categories of Canadian-source income otherwise taxable under Part 13 are exempt from Canadian non-resident withholding tax under the Canadian domestic rules. The first category is interest. For a variety of reasons, many categories of Canadian-source interest income are exempted from tax under Section 212(1)(b). The principal exemptions include:

  • interest on a debt obligation of, or guaranteed by, the government of Canada, or a debt obligation of a province or a municipality in Canada;
  • interest payable in a foreign currency on foreign currency deposits with Canadian banks and other prescribed financial institutions where the payer and the recipient deal with each other at arm's length;
  • interest on indebtedness in respect of foreign branches of Canadian corporations;
  • interest on Canadian currency deposits with foreign branches of financial institutions where the payer and the recipient deal with each other at arm's length;
  • interest to a prescribed international organization or agency; and
  • interest on an arm's-length corporate debt with a minimum term of five years.

Interest paid or credited to a non-arm's length party is never exempt from Canadian non-resident withholding tax. The test of 'arm's length' for the purposes of the act is both a statutory and a factual one. It is insufficient that market rates are charged. If the payer and the recipient are related as defined in the act, either by statute or factually, no exemption will be afforded.

The other category is income from royalties or rents. A major exemption is provided by Section 212(1)(d)(vi) for payments made in respect of the production or reproduction of any literary, dramatic, musical or artistic work (including computer software), and for rentals for aircraft or aircraft parts.

Tax treaties also provide for additional exemptions from withholding taxes. Examples are:

  • payments in respect of rights to use patented information or information concerning scientific experience;
  • payments made for the use of computer software;
  • interest paid on government debt; and
  • interest on credit sales of equipment, merchandise or services.

Anti-avoidance rules
Previously, non-residents have avoided or reduced Canadian tax:

  • by taking advantage of the differential in tax treatment of a Canadian subsidiary and a branch;
  • through differences in jurisdictional characterization of debt and equity;
  • through the use of hybrid entities in a variety of inbound and outbound transactions; and
  • by removing corporate earnings in a tax-preferred form from Canada.

In certain circumstances, the avoidance is considered offensive to Canadian tax policy and attempts have been made in the Canadian taxing legislation to curtail such planning with anti-avoidance rules.

Branch tax
Section 219 imposes a 'branch tax' on any non-resident corporation carrying on business in Canada. This tax is imposed in addition to Part I tax, and is meant to be a proxy for Canadian non-resident withholding tax on dividends paid by a Canadian subsidiary to its non-resident parent corporation. It equalizes, to the extent feasible, the tax treatment of non-resident corporations carrying on business in Canada through a wholly owned Canadian subsidiary and a Canadian branch. In the absence of the branch tax, a Canadian branch would be tax-preferred to a Canadian subsidiary because income earned through the subsidiary would be subject to both Part 1 tax (on business income) and Part 13 tax (on dividends distributed to the non-resident shareholder), whereas income earned through the branch would be subject to only Part 1 tax on its business income.

The base of the branch tax is, in general, the non-resident's Canadian-source business profits, as adjusted by deducting Part 1 tax and provincial income taxes and an allowance for investment in property in Canada. The tax rate is 25%, which is the same as the rate of Canadian non-resident withholding tax on dividends. The branch tax does not apply to banks or corporations whose principal business is the transportation of persons or goods, communications or mining iron ore in Canada. These corporations generally use branches rather than subsidiaries for business, for tax reduction reasons.

Canada's tax treaties do not prohibit Canada from imposing the branch tax. They generally reduce the branch tax rate to that for dividends (between 5% and 15%). A treaty may also provide relief from the branch tax. For example, the Canada-US treaty provides that the first C$500,000 of after-tax profits is exempt from the branch tax.

Thin capitalization
'Thin capitalization' refers to the capitalization of a corporation with a disproportionate amount of debt; in other words, the corporation's equity capital is insufficient in relation to its debt. The difference in tax treatment of interest and dividends under the Canadian tax rules creates an obvious bias for a non-resident to capitalize a Canadian corporation primarily with debt. Since the Canadian corporation can deduct interest expense incurred for the purpose of earning income, the interest is generally subject to one level of Canadian tax - Canadian non-resident withholding tax, which can often be eliminated or is taxed at the treaty reduced rate (10%). In contrast, dividend payments are not deductible by the payer Canadian corporation, and are subject to Canadian non-resident withholding tax at a treaty reduced rate of between 5% and 15%.

Where the payer and recipient do not deal at arm's length and the Canadian corporation is thinly capitalized, the deduction of interest is considered inappropriate from a tax policy perspective. Specific anti-avoidance rules (Sections 18(4)-(8)) were introduced in 1971 in order to level the playing field for debt and equity.

The thin capitalization rules adopt a fixed ratio approach. Where the debt-to-equity ratio of a Canadian corporation is more than 2:1, the thin capitalization rules deny the deduction of interest paid on the excessive debt. In effect, the thin capitalization rules subject the excessive interest to corporate tax to equate the treatment of interest to that of dividends. The rules do not recharacterize the payment made to the non-resident, however, for purposes of the Canadian non-resident withholding tax.

Surplus stripping
The Canadian tax system permits a Canadian corporation to return capital or earnings at its option at any time to its non-resident shareholder, subject to certain legal requirements which limit the corporation's right to reduce its asset base.

If a Canadian corporation had accumulated surplus, its shareholders in the past were able to 'strip' the surplus through a sale of the shares of the corporation or through a distribution from the capital thereof. Capital can be returned free of Canadian non-resident withholding tax to the extent of corporate capital. Appreciated value, if returned by the corporation to the shareholder, is a dividend to the extent corporate capital is exceeded. If the return is realized on a third-party sale of shares, however, the gains are taxable in Canada only if the share is a 'taxable Canadian property' and the shareholder is not eligible for treaty exemption.

Section 212.1 was designed to prevent conversion of earnings to capital within a corporate group. For example, in RMM Canadian Enterprises Inc ([1988] 1 CTC 2300, 97 DTC 302 (TCC)) Equilease Corporation (EC), a corporation resident in the United Sates, entered into a series of transactions with RMM Canadian Enterprises Inc under which RMM purchased the shares of EC's Canadian subsidiaries. The shareholders of RMM were lawyers of a firm that had a close business relationship with EC. The primary purpose of the transactions was to convert what would otherwise have been a deemed dividend received on a liquidation of EC's subsidiaries into a capital gain from the disposition of the subsidiaries' shares. Under the Canada-US treaty, a dividend would have been subject to Canadian non-resident withholding tax whereas a capital gain on the sale of shares would have been exempt from tax in Canada. The court found that EC and RMM were not at arm's length and Section 212.2 was applicable. In effect, the gain was deemed to be a dividend for Canadian tax purposes.

Absence of dual residency of corporations
In the absence of an anti-avoidance rule, a dual-resident corporation could be used to avoid Canadian non-resident withholding tax. For example, a corporation incorporated in the United States that had its central management and control in Canada would be considered a resident in both Canada and the United States under their respective domestic laws. For treaty purposes, however, the corporation would be deemed to be a US resident. When receiving interest, royalties or dividends from other Canadian corporations, the corporation would not be considered a non-resident for purposes of the act, and thus, the payments would not be subject to Canadian non-resident withholding tax. When making payments to residents in the United States, the corporation could rely on the treaty and claim that it was not a Canadian resident and thus the payments would not be subject to Canadian non-resident withholding tax. Section 250(5) was designed to prevent this result by, in effect, deeming a corporation to be a non-resident of Canada for Canadian tax purposes if it is a non-resident of Canada under a relevant treaty. Thus, the corporation residence determination is consistent for purposes of both the treaty and Canadian domestic law.


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