For Canadian companies making the decision to expand their operations beyond the borders of Canada, there are important income tax matters that need to be carefully considered.
This article will provide an overview of some of the international taxation considerations Canadian companies may face and explore some approaches available to make the income tax rules and regulations work to the advantage of Canadian companies who choose to expand globally.
In particular, a high technology company in Canada may have an opportunity to significantly reduce its global effective tax rate by moving some of its intellectual property outside of Canada. Generally, intellectual property is a legal term used to describe certain unique and valuable intangible assets - these include patents, trademarks, copyrights, "know-how" and other proprietary technology or information.
When making a decision to operate outside of the country, a Canadian company must realize that Canada imposes income tax on a company resident in Canada on its worldwide income. In other words, when a Canadian company earns foreign income, Canadian income tax laws generally require such income be taxed in Canada. To alleviate potential double taxation of the income in both Canada and in the foreign jurisdiction, Canada provides relief by allowing foreign taxes paid on foreign sourced income to be credited against related Canadian income tax payable or deductible in computing income. Generally, a Canadian corporation would compute its Canadian income tax based on its worldwide income and reduce that tax by the amount of related foreign business income tax it paid.
However, Canadian companies may avoid having the foreign income immediately taxable in Canada by operating in foreign jurisdictions through foreign subsidiary corporations. In certain situations, which will be discussed in further detail below, the income of the foreign subsidiary repatriated to Canada in the form of dividends may not be subject to tax in Canada upon receipt by the Canadian parent company.
Minimization of the Canadian company's global effective tax rate
Under Canadian income tax law, income such as royalties earned by a Canadian company from licensing its intellectual property are included in the taxable income of the Canadian licensor and taxed at the normal Canadian income tax rates. A corporation resident in Ontario, for example, would normally pay a combined federal and Ontario income tax rate of approximately 36% on the royalty income. With some technology companies based in tax havens such as Bermuda and the Cayman Islands paying little or no income tax at all, Canadian resident companies are at a competitive disadvantage because of the high level of Canadian income tax.
When a Canadian company has grown to a point at which it has a significant level of sales in one or more high-tax jurisdictions around the world, such as the U.S. and the U.K., the company should examine methods for reducing its overall level of taxation on its worldwide income. However, many companies in this growth stage are usually unable to relocate significant activities and employees from Canada to other lower-tax jurisdictions.
In order to enjoy the benefits of having the income generated from intellectual property taxed in the offshore jurisdiction, the intellectual property will have to be moved out of Canada to that jurisdiction, through either a sale or a licensing arrangement. One method of accomplishing this is to have an offshore subsidiary own the rights to the intellectual property and thereby earn the income generated from the exploitation of that intellectual property. Ideally, the intellectual property should be transferred at the earliest opportunity, before any significant increase in its value occurs. A Canadian tax liability may result on any gain resulting from its disposition.
Generally, when an offshore subsidiary owns the intellectual property of a Canadian parent company, the income earned may be subject to little or no income tax, provided the offshore subsidiary is organized in a low-tax jurisdiction.
Foreign Accrual Property Income
Canadian taxation of the income earned by the offshore subsidiary from exploiting the intellectual property may also be deferred or eliminated, provided that certain Canadian income tax rules, including the Foreign Accrual Property Income ("FAPI") rules, do not apply. The Canadian income tax rules concerning the taxation of FAPI are highly complex, and a detailed discussion of those tax laws is beyond the scope of this article. Generally, if the FAPI rules apply, the royalty income earned by the offshore subsidiary would be included in the Canadian parent company's income on a current basis. However, provided that either the offshore subsidiary carries on an active business utilizing more than five full-time employees, or is deemed to be earning active business income through the global licensing arrangements (which should be the case if the royalty payments are deductible in computing the active business earnings by another foreign subsidiary of the Canadian parent), the FAPI rules should not apply.
Repatriation of foreign income to Canada
Generally, when the offshore subsidiary makes the decision to repatriate the income earned from the exploitation of the intellectual property to the Canadian parent company, they will do so in the form of a dividend. This dividend paid by the offshore subsidiary to the Canadian parent company may not be subject to income tax in Canada provided that certain conditions are met. In particular, the offshore subsidiary must be considered to be earning income from an active business carried on in a 'designated treaty country" - defined as a country with which Canada has entered into a bilateral income tax treaty (Canada has entered into more than 80 such income tax treaties). Countries such as the U.S. and the U.K and many others with which Canada has entered into bilateral tax treaties have tax rates that are comparable to the Canadian rate. However, not every country that has a tax treaty with Canada imposes such a high level of income tax on its resident corporations. A notable example is Barbados where an International Business Company attracts a maximum tax rate of just 2.5%.
Selection of foreign jurisdiction
Having decided that the potential Canadian tax cost of transferring the intellectual property offshore is acceptable, the Canadian corporation would then need to choose a favorable jurisdiction to set up such an offshore subsidiary. Ideally, as mentioned, the offshore subsidiary should be resident in a country with which Canada has entered into a bilateral income tax treaty.
The selection of a particular designated treaty country will depend on the locations of the potential licensees of the intellectual property. For example, if the potential licensees are in France and France imposes a domestic withholding tax on royalty payments to non-residents, it would be desirable to set up the offshore subsidiary in a jurisdiction that has a bilateral tax treaty with France that reduces, or eliminates, the French withholding tax rate.
As the key tax objective is global tax minimization, the income tax rate of the selected treaty country, the network of income tax treaties entered into by that country, the rate of withholding taxes applied by that country on payments of dividends to the Canadian parent company, and any other taxes payable on the royalty income from the licensees must all be considered. In addition, certain non-tax criteria must be taken into account, including the country's political climate and stability, the country's infrastructure, its location in the world, and the company's business plans, objectives and strategies.
Conclusion
This article is intended only to provide an overview of some of the relevant tax issues and challenges of exploiting intellectual property globally. Each issue could in itself warrant a full discussion to properly explain its complexity.
There are numerous international tax issues that need to be considered before a Canadian corporation sets up one or more foreign subsidiaries. The key tax objective is to minimize the worldwide taxation of the Canadian company and its foreign subsidiaries. Proper international tax planning requires an analysis of tax systems around the world and the multitude of bilateral income tax treaties. Given that tax laws around the world constantly change, existing tax treaties may change and new tax treaties may be negotiated, what may appear to be the most preferable offshore structure today may not be so tomorrow. Therefore, any Canadian company with a goal of minimizing its global effective level of taxation must be kept aware of inevitable changes to tax laws in Canada and around the world in order to be prepared to respond appropriately and make any necessary changes to its current structure.
- by Dave Walsh, CA
Senior Manager, International Tax Services
Ernst & Young LLP
100 Queen Street, Suite 1600
Ottawa, ON
K1P 1K1
Tel: 613-598-4331
Fax: 613-232-5324
Email: dave.g.walsh@ca.ey.com
Dave Walsh is a Senior Manager in the International Tax Services group of Ernst & Young. Dave has 10 years of experience in public practice with Ernst & Young, including the Ottawa, Toronto, and New York offices of the firm.
Dave graduated from Queen's University with a Bachelor of Commerce degree in 1994, at which time he joined Ernst & Young. He received his Canadian Chartered Accountant's degree in 1995 and his U.S. Certified Public Accountant's degree in 1998. Dave has participated as a Tutorial Leader at the Canadian Institute of Chartered Accountants' In-depth Tax Course for several years.
As the local leader of the International Tax Services practice, Dave provides international tax consulting services to multinational corporations, with a particular emphasis on Canada-U.S. cross-border transactions. His practice includes clients in the manufacturing, high technology, automotive, retail and entertainment industries.
