Many Canadian high-technology companies are profiting through their sales of products around the world. Conducting international business through structures designed for the domestic environment can impede competitiveness and result in a larger overall tax bill. In addition, early-stage companies doing business with foreign customers could prematurely incur a cash tax liability in foreign jurisdictions. The application of effective planning during a company's early stages will minimize tax and facilitate both global expansion and the founders' eventual sale of their interests.

To be or not to be a CCPC

As is well known, the most effective vehicle in which to conduct research activities in the early stages in Canada is through a Canadian-controlled Private Corporation ("CCPC") that is also a "qualifying small business corporation." The advantages of such a structure include:

• a reduced rate of tax on the first $400,000 of active business profits;

• the ability to earn refundable investment tax credits at the 35-per-cent rate on qualifying research and development expenditures;

• the availability of the $750,000 capital gains exemption on the sale of shares of the corporation; and

• the ability to generate allowable business investment losses on the sale of shares or debt if the investment is unsuccessful.

A company will not qualify as a CCPC if it is controlled by one or more non-residents and/or public corporations. U.S. venture capital investors often encourage the establishment of the Canadian technology company as a subsidiary of a U.S. parent company at the outset, even if such venture capitalists have a minority stake in the company. Further, if the long-term goal is to have the company listed on a U.S. stock exchange, it may be argued that the U.S. parent structure is advantageous to avoid the inherent discount often applied to Canadian companies that go public in the United States.

The U.S. parent structure will usually put the Canadian company offside CCPC status, even if ultimate control is in the hands of Canadians. It is possible, with some rather complex tax planning, to implement structures which preserve CCPC status but still allow the insertion of a U.S. parent corporation. Venture capital investors generally understand the advantages of being a CCPC and are prepared to consider corporate structures designed to preserve that status. However, the most practical advice may be to have the U.S. parent structure avoided unless there are other compelling business reasons.

Recent experience shows that the more typical exit strategy for founders is to sell their shares. In addition, recent amendments to the Income Tax Act (Canada) have facilitated initial public offerings on such non-U.S. exchanges as the Alternative Investment Market ("AIM") of the London Stock Exchange.

Sales to Foreign Markets

Initial sales to foreign markets are often made through independent agents and distributors. If the arrangements are properly structured, the Canadian company should not be considered to have a permanent establishment ("PE") in the relevant foreign jurisdictions, and generally such revenue should not be subject to tax in these jurisdictions. However, as the volume of sales and level of activity in these foreign jurisdictions increases, a decision will have to be made as to whether to incorporate a subsidiary in the foreign jurisdiction or to carry on activities through a branch of the Canadian company. The incorporation of a subsidiary is usually recommended in order to capture the foreign business activities through a separate legal entity. However, this decision will depend on a number of factors, including the costs of such incorporation, the volume of business activities, corporate tax rates and the relevant rates of withholding tax on the distribution of profits.

Sales to the United States

The same considerations apply for U.S. sales. However, there are several additional considerations. First, a corporation engaged in a U.S. trade or business is required to file a U.S. tax return even if it does not have a PE. A corporation that fails to file such a return within a specified time period may lose its rights to claim any deductions in computing its U.S. taxable income. Also, a corporation relying on a tax treaty exemption must report such reliance to the IRS. Therefore, the filing of a protective treaty return is usually recommended.

U.S. states also impose income, business and sales taxes. A state may tax a foreign company, or require it to collect sales tax from its customers, if it has sufficient activities in the state to have a "nexus" there under the U.S. Constitution. In this regard, nexus can be created in a state even if the company does not have an office or PE therein. Dealing with the requirements of various states can be quite onerous and can lead to some unexpected tax implications, for example, when the company fails to collect state imposed sales tax from its customers and becomes liable for the uncollected amounts.

Conclusion

There are many other aspects of globalization to be considered, including the export of technology to low-cost jurisdictions, offshore manufacturing and exit strategies for founders. The application of effective planning during a company's early stages will minimize domestic and foreign taxes and facilitate global expansion. Please contact your Ernst & Young tax adviser.

By Dave Walsh, CA, CPA (Illinois) and Darrell Bontes, CA

To contact Dave Walsh:

Tel: 613-598-4331

Dave.G.Walsh@ca.ey.com

To contact Darrell Bontes:

Tel: 613-598-4364

darrell.bontes@ca.ey.com