Welcome back stranger: a Canadian perspective on the taxation of privately owned business entities and owners

Welcome back stranger: a Canadian perspective on the taxation of privately owned business... Abstract This article contains a summary overview of the income taxation of Canadian resident and non-resident owners of privately owned business entities. It commences with a summary of the following business entities typically utilized in structuring privately owned businesses in Canada, and summarizes the characteristics of each and their domestic tax treatment: corporations, unlimited liability companies, general and limited partnerships and trusts. The article then outlines the general scheme in the Income Tax Act (Canada) (the ‘Act’) for taxation of non-residents in respect of investment in Canadian private business entities, including an overview of the Canadian withholding tax regime, issues related to the determination of whether to invest through a Canadian branch or subsidiary corporation, the taxation of certain hybrid entities and a review of capitalization considerations, including the Canadian thin capitalization and interest imputation rules. The taxation of the disposition of shares or interests in Canadian business entities by non-resident investors is then discussed. The article concludes with a summary of the taxation of non-resident beneficiaries of Canadian resident trusts. Summary of Canadian business entity alternatives and taxation Privately owned businesses in Canada are typically structured in the form of corporations, unlimited liability companies, partnerships or trusts. Certain of the characteristics and tax considerations relevant to the decision of which of these business entities to use in structuring transactions are described in greater detail below. Corporations A corporation is the most frequently used form of business organization in Canada. A corporation has a legal personality distinct from its shareholders and management. As a separate legal entity, a corporation has rights, powers and obligations similar to those of individuals; it can hold property and carry on a business, and can incur legal and contractual obligations. A business corporation can be incorporated either federally, under the Canada Business Corporations Act1 (the ‘CBCA’), or in any of the provinces. In Ontario, the relevant statute is the Business Corporations Act2 (the ‘OBCA’). The main advantages of the corporation as a business entity are the limited liability of the shareholders, the possibility of perpetual existence and the flexibility of the corporate form for financing and estate planning purposes. The disadvantages include the fact that since a corporation is a separate taxpayer, shareholders cannot access directly any tax losses it may generate, in contrast to an unincorporated entity such as a partnership.3 A federal corporation has the right to carry on business under its corporate name in any province of Canada.4 In contrast, a corporation incorporated under provincial law cannot do so as of right in another province. Both federally and provincially incorporated corporations must satisfy the registration requirements of every province in which they intend to carry on business. In most provinces, corporations must file corporate returns annually to keep their registrations up-to-date. Generally, only public corporations, whether federally or provincially incorporated, must file financial statements on the public record. The directors and officers of all corporations must be disclosed on the public record, but not the shareholders.5 The CBCA and OBCA require at least 25% of the directors to be Canadian residents, unless a corporation has less than four directors, in which case the board needs to have at least one Canadian resident director.6 The CBCA and OBCA also allow directors and shareholders to participate and to vote at meetings by electronic means. Both statutes prohibit par value shares and the issuance of shares which are not fully paid up.7 Most provinces in Canada do not provide for hybrid forms of corporate entity with certain partnership-like characteristics. In particular, no Canadian jurisdiction provides for limited liability companies (‘LLCs’). However, Nova Scotia, Alberta and British Columbia permit the formation of unlimited liability companies (‘ULCs’), which are similar to ordinary corporations except that the shareholders of which do not have limited liability. Although a ULC is treated as a corporation for Canadian tax purposes, it is eligible for flow-through treatment for US tax purposes. There are important differences between Nova Scotia, Alberta and British Columbia ULCs. In particular, the shareholders of an Alberta ULC are liable for any liability, act or default of the ULC, whereas in Nova Scotia and British Columbia the shareholders of a ULC have no direct liability to creditors, and their liability arises only when the ULC is wound up and there are insufficient assets to satisfy its obligations. A foreign corporation may carry on business in Canada either through a branch or by setting up a new corporation as a Canadian subsidiary. If an unincorporated branch is chosen as an alternative to a subsidiary, the foreign corporation must register in all provinces in which it wishes to carry on business.8 Taxation of corporations and shareholders Corporations are commonly used in structuring privately owned businesses as a result of the Canadian integration system; the Act is designed to ensure that income earned in a corporation and distributed to a shareholder in the form of a dividend should attract the same amount of net income tax, both corporate and personal, as if the income was earned directly by an individual who is subject to tax at the highest personal marginal rate. As a result, assuming all after-tax earnings are distributed on a current basis, individuals should generally be indifferent from an income tax perspective as to whether to carry on business activities or invest through a corporate structure or personally. In practice, however, the concept of integration is imperfect, and differences in the effective tax rates can create the possibility of tax savings or costs, depending on the province, for earning income in a corporation rather than directly as an individual.9 When investment income such as interest, dividends, rents, royalties or capital gains is earned by a Canadian-controlled private corporation (‘CCPC’), integration is achieved by way of a federal refundable tax mechanism.10 The additional refundable tax paid by a CCPC on its investment income accumulates in a notional tax account, referred to as the corporation’s ‘refundable dividend tax on hand’ (‘RDTOH’). The amount added to the corporation’s RDTOH account is refunded to the corporation when it ultimately pays out taxable dividends to its individual shareholders. Dividends paid by a CCPC may be designated as eligible dividends to the extent of the balance of the corporation’s general rate income pool (‘GRIP’) at the end of its taxation year in which the dividend has been paid. Generally, GRIP represents an accumulation of taxable active business income that did not benefit from preferential tax treatment such as the small business deduction (discussed below) and the RDTOH system that applies to investment income. Eligible dividends received from other corporations also retain their character and form part of the dividend recipient's GRIP balance. Eligible dividends are taxed more favourably to an individual than ineligible dividends.11 Capital gains are subject to an inclusion rate of 50%, such that capital gains are subject to tax at a rate that is equal to one-half of the rate applicable to ordinary income. A corporation’s capital dividend account ensures that the tax-free portion of a capital gain earned by the corporation is preserved so that it can be distributed tax-free to shareholders, subject to filing an election form with the Canada Revenue Agency (‘CRA’) in respect of the distribution.12 With respect to investment income, 30.67% of the aggregate investment income earned by a CCPC is included in its RDTOH account.13 This mechanism is intended to prevent the potential for personal income tax deferral that individuals earning investment income directly could otherwise obtain by earning such income through a corporation. The amount of refundable tax in a corporation’s RDTOH account is refunded at the rate of 38.33% upon payment of taxable dividends by the corporation to its shareholder. The following example illustrates how the refundable tax provisions operate to achieve integration for tax purposes, using as an example $100,000 of interest income and capital gains earned by a CCPC, respectively. View largeDownload slide View largeDownload slide A similar refundable tax is imposed under Part IV of the Act on taxable dividends received by private corporations that are otherwise deductible in computing taxable income.14 Part IV tax is imposed at the rate of 38.33% on dividends received by a corporation. As in the case with the additional refundable tax imposed on the aggregate investment income of a CCPC, the Part IV tax is intended to prevent individuals from deferring personal income tax that they would otherwise pay on taxable dividends on shares held as portfolio investments through a holding company. Part IV tax paid is credited to the corporation’s RDTOH account, and is fully refunded if 2.61 times the RDTOH balance (100/38.33) is paid out to the shareholders by way of taxable dividends.15 Part IV tax is imposed on two types of dividends: (i) portfolio dividends, which are dividends from corporations that are not ‘connected’16 with the recipient corporation, and (ii) dividends that entitle the payer corporation to a dividend refund, which will generally be the case if the payer corporation has a positive balance in its RDTOH account.17 Shareholders benefit from a tax deferral opportunity that exists when active business income of a corporation remains invested in the corporation and is not distributed to its shareholders. The active business income retained in a corporation will not attract personal tax until it is ultimately distributed, either in the form of salary or dividends, to the shareholders of the corporation. In Ontario, for example, the general corporate tax rate on active business income is 26.5 per cent, in contrast to the highest personal marginal tax rate of 53.53 per cent. For income taxed at the small business deduction rate, this deferral advantage is 38.5 per cent in Ontario; for income taxed at the general corporate rate, it is 27 percent. Small business deduction The Act provides for a lower income tax rate applicable to the first $500,000 of active business income of a CCPC, provided that the taxable capital of the corporation and associated corporations does not exceed $10 million.18 This reduced rate of tax, which is referred to as the small business deduction, results in a combined federal and provincial tax rate in Ontario of 15 per cent. For corporations and associated corporations with taxable capital between $10 million and $15 million, the active business income eligible for the small business tax rate is reduced proportionately, and is eliminated entirely once the taxable capital of all of the associated corporations exceeds $15 million. Generally, in order to benefit from the small business deduction, a corporation must be a CCPC and carry on an active business in Canada. Active business income that exceeds the $500,000 small business deduction threshold is taxed at the higher general corporate tax rate. The combined federal and provincial income tax rate on income in excess of the small business deduction threshold ranges from 26 per cent to 31 per cent, depending on the province. As noted above, as a result of recent increases to the highest marginal combined federal and provincial personal tax rate, there is a significant tax deferral opportunity to earning active business income in a corporation where such income is retained and is not distributed to the shareholder on a current basis. Capital gains exemption Individual taxpayers resident in Canada are entitled to claim a lifetime capital gains exemption, which is a deduction in computing taxable income, of up to $835,714 (for 2017) in respect of capital gains realized upon the disposition of ‘qualified small business corporation shares’ (‘QSBC shares’).19 In order to qualify for the capital gains exemption, the shares disposed of must be QSBC shares at the time of the disposition; this requires the corporation to be a CCPC, all or substantially all20 of the fair market value of the assets of which is attributable to (i) property used principally in an active business carried on primarily21 in Canada by the corporation or a related corporation, (ii) shares or indebtedness of one or more small business corporations that are, at the time, connected with the corporation or (iii) any combination thereof. The QSBC shares must not have been owned by any person other than the individual or a related person throughout the 24-month period immediately preceding the time of disposition.22 In addition, throughout that 24-month period, the corporation must have been a CCPC and more than 50 per cent of the fair market value of its assets must have been used principally in an active business carried on primarily in Canada by the corporation or a related corporation, or shares or indebtedness of one or more other corporations connected with it. Capital gains deferral Individuals may also qualify for a deferral of capital gains that are reinvested in an ‘eligible small business corporation’ in the same taxation year or within 120 days of the end of the year.23 Where the deferral is available, the adjusted cost base of the eligible small business corporation in which the proceeds are reinvested is reduced by the capital gain deferred, and is realized only upon a subsequent disposition of the replacement shares. The capital gains deferral is available only to an individual in respect of a gain arising on a disposition of common shares of the capital stock of a corporation that were issued from treasury by an ‘eligible small business corporation’, which is a CCPC all or substantially all of the assets of which are (i) used principally in an active business carried on primarily in Canada, (ii) shares or debt of related eligible small business corporations, or (iii) any combination thereof. The total carrying value of the assets of the corporation and its related corporations must not exceed $50 million. The active business of the corporation must be carried on primarily in Canada at all times in the period that began when the individual last acquired the share and ends at the time of disposition if that period is less than two years; otherwise, the active business must be carried on primarily in Canada for at least two years during the ownership period. The share disposed of must have been owned by the individual throughout the 185-day period ending immediately prior to the disposition. Proposed passive income proposals The Department of Finance released a discussion paper on 18 July 2017, which outlines various proposals currently under consideration by the government that affect tax planning using private corporations. One aspect of the discussion paper addresses the taxation of passive investments held in private corporations. Other legislative changes are intended to restrict transactions that involve the conversion of income taxed at ordinary rates into lower taxed capital gains and that expand the scope of the rules that prevent income splitting among family members through private corporations and trusts. As noted above, individuals who carry on business through a corporation can reinvest business income earned in the corporation by making passive investments, thereby giving rise to a tax deferral advantage. This possibility arises because business income in a corporation is generally taxed at a much lower rate (generally 26.5 per cent in Ontario) than the rate applicable to income earned personally by individuals (up to 53.53 per cent in Ontario). As a result, if the after-tax business income is retained in the corporation, more capital will be available for investment purposes. Investment income (including income earned from the reinvestment of active business earnings) is currently taxed at a rate of just over 50 per cent, of which approximately 30 per cent is refunded when dividends are paid to individual shareholders and subject to tax at personal rates. In addition, capital gains are only half-taxable, with the non-taxable portion of the gain added to the corporation’s capital dividend account, which can be distributed to a Canadian individual shareholder on a tax-free basis. The passive investment proposals under consideration as described in the government’s discussion paper would result in the refundable tax that currently applies to income generated from investments made using after-tax earnings subject to the lower corporate tax rate becoming non-refundable. In addition, they would prevent the non-taxable portion of capital gains derived from such after-tax earnings from being added to the capital dividend account of the corporation. This would result in an increase in the effective tax rate applicable to investment income that is distributed to an individual shareholder from a rate of approximately 27.99–54.57 per cent where such investment income is derived from capital gains, from a rate of approximately 55.98–69.79 percent where it is derived from interest income, and from a rate of approximately 39.34–62.59 percent where it is derived from dividends received from portfolio investments in shares of public companies. As currently formulated in the discussion paper, the proposals under consideration would not appear to affect the tax treatment of dividends received from connected corporations, which could continue to be received without incremental corporate tax payable, or the tax rate applicable to investment income earned before it is distributed to individual shareholders, which is already taxed at a rate in excess of 50 per cent approximating the highest personal marginal tax rate. The additional tax on investment income would be charged when the income is ultimately distributed to the individual shareholders, as the tax rate on dividends paid would increase as a result of the denial of the dividend refund and the inability to access the capital dividend account previously available. The discussion paper suggests that certain corporations focused solely on passive investments may be able to elect to continue to be subject to the current refundable tax system, without becoming subject to the proposed changes; this election would result in an upfront refundable tax being charged on amounts transferred from other corporations (including dividends received or capital contributions made by corporate shareholders) but very little detail has been provided regarding this aspect of the proposals, including the refundable tax rate that would apply. The passive income proposals in the discussion paper are set out for consultation purposes and remain undefined in a number of critical respects; unlike the other proposed changes referred to above, draft legislation has not yet been released and the government is seeking input on the nature and scope of the concepts outlined in the discussion paper before settling on an approach. Among other things, for example, it is unclear how the rules may apply where borrowed funds are used to make passive investments. The discussion paper also does not address how the rules will apply in circumstances where the proceeds of a tax-free intercorporate dividend are used to make passive investments by a holding company, although it appears likely that such investments would be included in the scope of the proposals. Taxation on disposition or deemed disposition of shares No estate or gift tax is imposed in Canada, either federally or provincially. However, the Act contains provisions that deem an individual to have disposed of all capital properties, land inventory and resource property immediately prior to death for proceeds equal to the fair market value of such property and to have reacquired the property at a cost equal to the deemed proceeds of disposition, thereby resulting in the realization of accrued income and gains.24 The realization of accrued gains may be deferred by way of a rollover applicable on the transfer of the property to the taxpayer’s spouse or to a qualifying spouse trust; property so transferred will be subject to the deemed realization upon the death of the surviving spouse. Where a taxpayer disposes of property, including shares of a corporation, to a person with whom the taxpayer was not dealing at arm’s length for no proceeds or for proceeds that are less than the fair market value at the time the taxpayer disposed of the property, or to any person by way of gift, the taxpayer is deemed to have received proceeds of disposition for the property equal to its fair market value at that time.25 An exception applies in respect of property transferred to a taxpayer’s spouse or to certain spousal trusts, which (subject to a contrary election) occurs on a tax-deferred rollover basis.26 Partnerships and joint ventures In Canada, a partnership is not regarded as a legal entity separate from its partners. In a general partnership, all of the partners can participate in management of the business, but are exposed to unlimited liability for partnership obligations. In a limited partnership, limited partners’ liability is limited to their investment in the partnership, but they must remain passive investors and not participate in control of the partnership business.27 In Ontario, the governing statutes are the Partnerships Act28 and the Limited Partnerships Act29 (‘LPA’), which define the rights and obligations of the partners between themselves and in relation to third parties. The provisions of these statutes that address the rights and obligations of partners between themselves can generally be altered by agreement between the partners. Because the relationships between the partners can be determined by agreement, there is great flexibility in providing for such matters as capital contributions or other financings of the partnership, participation in profits and management structure. The statutory provisions permit flexibility in setting terms by agreement among the partners; for example, multiple classes of partnership interests may be created with governance and economic entitlements tailored to the requirements of the investors.30 As discussed in greater detail below, income and losses of a partnership, although computed at the partnership level, are allocated to and subject to tax in the hands of the partners. This tax treatment is often the primary reason for using a partnership rather than a corporation, since each partner may offset its eligible share of the partnership's business tax losses against income from other sources. General partnerships The principal characteristic of a general partnership is the unlimited liability of each partner for the liabilities and obligations incurred by the partnership to third parties. Each partner may bind the others unless there are restrictions in the partnership agreement of which third parties have notice. However, a partner is generally not liable for obligations incurred before it became or after it ceased to be a partner. The primary disadvantages of a general partnership are the unlimited liability of the partners and the ability of each partner to incur partnership obligations that will bind the other partners. In Ontario, all the partners of a general partnership must register the name of the partnership under the Business Names Act (“BNA”), unless the business is carried on under the names of the partners. This registration requires that the partnership business and the names and addresses of the partners be disclosed. In Ontario, although a limited partnership cannot be formed except by the filing of a declaration under the LPA, a general partnership may exist without any registration or filing on the public record.31 If the relationship satisfies the legal criteria for a general partnership, its members will be liable as general partners for obligations relating to the partnership business and will be bound by any such obligations incurred by any of the partners, even to third parties who are not aware of the existence or identity of the other partners.32 Limited partnerships A limited partnership combines the advantages of limited liability and the ability to flow tax losses through to passive investors (subject to the restrictions under the Act described below). This form of business structure is often used for private equity funds, financings and real estate syndications. A limited partnership is made up of one or more general partners, each of whom has the same rights and obligations as a partner in a general partnership, and one or more limited partners, whose powers and liabilities are limited. The general partner or partners manage the partnership. A limited partner may not take part in the management of the partnership without jeopardizing the partner’s limited liability. The authority of limited partners is limited, and in order to preserve liability protection limited partners may not participate in management of the business of the partnership, and cannot bind other partners.33 The primary advantage of a limited partnership over a general partnership is the limited liability of the limited partners, which enables passive investors to participate as partners without risking their personal assets beyond their investment in the partnership. Limited partnerships are typically established by declaration under the applicable provincial law.34 To establish a limited partnership in Ontario, a declaration signed by the general partners must be filed under the LPA.35 Taxation The Act does not define the term ‘partnership’, but sets out the tax consequences that apply where a partnership exists.36 In order to determine whether a particular relationship constitutes a partnership, reference must be made to the provincial partnership statutes, which generally define a partnership as a legal relationship existing between two or more persons who carry on business in common with a view to profit.37 A partnership is not taxed as a separate entity; instead each partner is required to include in income the partner’s share of the income of the partnership for the fiscal period ending in the taxation year of the partner. The Act requires a partnership to determine its income at the partnership level, which must be computed as if the partnership were a separate person resident in Canada. This requires the partnership to compute its income from various sources, as well as any net capital losses and non-capital losses, for each fiscal period.38 While a partnership is required to compute its income for tax purposes, the partnership is not itself liable to tax on that income. Instead, each partner of a partnership is liable to tax on that partner’s share of the partnership’s income from each source for each fiscal period of the partnership. Both the source and the character of income and gain earned by the partnership are generally retained in the hands of the partners for purposes of computing the partners’ liability for tax under the Act. A partner’s adjusted cost base in a partnership interest is generally increased by the partner's share of income of the partnership for each fiscal period, including any gains on the disposition of capital property owned by the partnership, and by the partner's contributions of capital made to the partnership,39 and is reduced by the partner's share of any losses of the partnership for each fiscal period, including losses on the disposition of capital property owned by the partnership, and by distributions made to the partner.40 A partner can generally withdraw an amount from the partnership equal to its adjusted cost base in the partnership interest without incurring tax; the partner's adjusted cost base in the partnership interest effectively represents its net investment in the partnership. Where a partner is a limited partner or a ‘specified member’ of a partnership, the partner is required to realize a capital gain to the extent that its adjusted cost base of the partnership interest is negative at the end of any fiscal period of the partnership.41 A ‘specified member’ of a partnership is a member of the partnership who is not actively engaged in the activities of the partnership business (other than financing), or in carrying on a similar business to that carried on by the partnership, on a regular, continuous and substantial basis throughout the period during which the business of the partnership was carried on and during which the partner was a member. In essence, partners that are limited partners and certain passive partners not actively engaged in the partnership business may not receive tax-deferred distributions to the extent that the adjusted cost base in their partnership interest has been reduced to nil by virtue of the allocation to the partner of deductible losses or distributions. The ‘at-risk’ rules in the Act apply to restrict a limited partner’s entitlement to deduct its share of non-capital losses incurred by the partnership, to the extent that the amount of such losses exceeds the partner’s ‘at-risk amount’ in respect of the partnership at the end of the fiscal period. Losses that are suspended by virtue of the application of the ‘at-risk’ rules may be carried forward indefinitely to offset partnership income from the partnership.42 A partner’s ‘at-risk amount’ is equal to the aggregate of the partner’s adjusted cost base in respect of the partnership interest and the partner’s share of partnership income for the year as computed under the Act, reduced by (i) the outstanding principal amount of debts owed by the partner to the partnership or to a person or partnership not dealing at arm's length with the partnership, and (ii) any amount or benefit that the limited partner or a person that does not deal at arm's length with the limited partner is entitled to receive for the purpose of reducing the impact of any loss that a limited partner may sustain by virtue of being a member of the partnership or by virtue of holding or disposing of an interest in the partnership.43 These provisions are intended to restrict a limited partner from deducting losses in excess of the limited partner's economic investment in the partnership. A ‘Canadian partnership’ is defined in the Act as a partnership all of the partners of which are resident in Canada. Partnerships that meet this definition qualify for beneficial treatment under various rollover provisions in the Act so that tax-deferred reorganization transactions may be undertaken44, and as a Canadian resident for withholding tax purposes. Accordingly, it is common for non-residents investing into Canada through a partnership to do so through a Canadian blocker corporation so that the tax status of the partnership is preserved. Joint ventures A joint venture is an agreement entered into by two or more parties to combine capital and skills for the purpose of carrying out a specific undertaking. It may or may not involve co-ownership by the venturers of the project assets. Because it is essentially a contractual relationship not specifically regulated by statute, participants are able to negotiate and agree on such terms as they may determine. Since a joint venture is not a recognized entity for tax purposes, income and losses for tax purposes are computed separately by each joint venturer rather than at the joint venture level. A joint venture may be difficult to distinguish from a partnership and the parties' characterization of their relationship may not be conclusive.45 The most important legal distinction is that sharing of profits is essential to a partnership, whereas joint venturers generally contribute to expenses and divide revenues of the project, but do not calculate profit at the joint venture level. Equal participation in management of the business is characteristic of a general partnership, but less usual in a joint venture, where one party often operates the project, or management is contracted out. Trusts In Ontario, a trust is primarily governed by the provisions of the declaration establishing the trust and non-statutory principles of equity, although trusts are also subject in certain respects to statutes such as the Trustee Act.46 Unlike shareholders of a corporation, investors in a trust have not historically had the benefit of statutory limited liability, and there has been some concern that in certain circumstances it might be possible for investors to be exposed to liabilities arising from the operations of the trust. Ontario has passed legislation clarifying that investors in a business trust that is governed by Ontario law and is a ‘reporting issuer’ under Ontario securities laws will not incur such liabilities as beneficiaries of the trust.47 Taxation The Act does not contain a general definition of a ‘trust’. It provides that a reference to a trust or estate in the statute shall, unless the context otherwise requires, be read to include a reference to the trustee, executor, administrator, liquidator or a succession, heir or other legal representative having ownership or control of the trust property.48 A bare trust or nominee arrangement is expressly excluded from constituting a ‘trust’ for purposes of the Act.49 A trust is generally required to compute its income as an individual50; however, while a trust is deemed to be an individual for purposes of the Act in respect of the trust property,51 there are a number of provisions that treat trusts differently than natural persons. For example, in general, trusts are not entitled to the graduated rates applicable to individuals, and are instead taxed at a flat rate equal to the highest marginal rate.52 As an exception, this rule does not apply to a ‘graduated rate estate’, which is an estate that arose on and as a consequence of an individual's death if no more than 36 months have passed since the date of death53; a graduated rate estate will therefore enjoy the benefits of graduated tax rates for a period of up to 36 months, and if the estate takes longer than 36 months to administer, it will be subject to taxation at the highest marginal rate in all subsequent taxation years. A trust is also not entitled to the personal deduction or tax credits applicable to natural persons, so as to prevent the multiplication of credits.54 As a trust is treated as a separate taxpayer for most purposes of the Act, it will be taxable on its income earned in a taxation year. However, the trust is generally entitled to deduct an amount not exceeding the portion of its income that was paid or became payable to a beneficiary in the year or that was otherwise included in a beneficiary’s income in a taxation year,55 which will be taxable to the beneficiary.56 Accordingly, a trust is generally taxed only on income accumulated in the hands of the trustee. The underlying principle is that a trust is generally entitled to flow-through income to its beneficiaries so that tax on the income is paid by the beneficiary or the trust, but not both.57 The provisions are intended to ensure integration, so that a Canadian resident beneficiary should be indifferent as to whether to earn income through a trust or instead earn the income directly. Income that is not paid or made payable to a beneficiary will be taxed in the trust; when it is subsequently paid to a beneficiary, it will be distributed on a tax-free basis as a capital distribution. Income that is paid or made payable to a beneficiary of a trust must be included in income as income from property that is an interest in the trust.58 This rule has the effect that income of a trust will generally lose its original source and character when it is distributed to the beneficiaries. However, specific ancillary conduit provisions allow the character of certain income to be retained when included in the beneficiary's income, including taxable dividends, capital dividends and capital gains, to the extent that the distribution is made by the trust to the beneficiary from these sources.59 These provisions preserve the character of these amounts in the hands of the beneficiary, allowing the beneficiary to claim the dividend gross-up and tax credit on dividends received from taxable Canadian corporations, the intercorporate dividend deduction (applicable to dividends allocated to corporate beneficiaries), the one-half inclusion rate for capital gains, the capital gains exemption, and foreign tax credits in respect of foreign-source income received by the trust and made payable to the beneficiary. Losses incurred by a trust cannot be flowed through to its beneficiaries, and may be utilized only at the trust level. The Act deems most personal trusts to dispose of ‘each property of the trust (other than exempt property) that was capital property … or land included in the inventory of a business of the trust’60 at the end of the day which is 21 years after the day on which the trust was created and every 21 years thereafter.61 This is generally referred to as the ‘21-year rule’, the object of which is to prevent an indefinite deferral of gains appreciating within a trust. The 21-year rule is intended to require a realization of accrued income and gains, either on the deemed realization date or, in the event that the trust property is distributed to the beneficiaries prior to the deemed disposition date, upon the death of the beneficiary or the beneficiary's surviving spouse. The Act generally provides for a subsequent deemed disposition every 21 years after the trust’s initial deemed disposition date. Non-resident investment in Canadian private business entities The Act contains two distinct schemes for taxing non-residents. A non-resident who ‘carries on business’ in Canada62 is taxable on Canadian source business income under Part I of the Act; Canadian tax treaties generally limit the source jurisdiction’s right to tax income from carrying on business to businesses carried on through a permanent establishment. A non-resident is also subject to withholding tax under Part XIII on passive Canadian source income earned in Canada, which is imposed at a domestic rate of 25 per cent on a gross basis, and is typically reduced under applicable tax treaties. Withholding Tax A person resident (or deemed resident) in Canada who makes a payment to a non-resident in respect of most types of passive income (including dividends, rent and royalties) is generally required to withhold tax equal to 25 per cent of the gross amount of the payment.63 Under Part XIII of the Act, the non-resident person is subject to a withholding tax of 25 percent on such amounts that a Canadian resident pays or credits (or is deemed to pay or credit) to the non-resident, subject to relief under an applicable tax treaty. Withholding tax is payable on the gross amount of the payment.64 In order to collect the tax, a withholding and remittance obligation is imposed on the payor.65 An income tax return is not required to be filed by the non-resident in respect of the Part XIII tax so withheld and remitted. The domestic withholding rate may be reduced under an applicable tax treaty. For dividends, the typical treaty rate is 15 per cent, except where the shareholder is a corporation that beneficially owns 10 per cent or more of the voting shares of the dividend payer, in which case the rate is generally reduced to 5 per cent. The typical treaty rate on royalties is 10 per cent and may be reduced to 0 per cent on certain royalties. Although withholding tax is imposed on the non-resident recipient, the resident payer is required to deduct the tax and remit it to the CRA on behalf of the non-resident, failing which the resident payer becomes liable for the tax.66 While it is not required by law, the CRA expects Canadian payers to obtain Forms NR301, NR302 or NR303 (depending on the legal status of the non-resident payee) from non-residents in respect of which withholding tax rates are reduced by an applicable tax treaty, certifying their treaty residence and entitlements. A partnership, any member of which is a non-resident, is itself deemed to be a non-resident under the Act.67 Consequently, a payment by a Canadian resident to a partnership with any non-resident members is subject to withholding tax. However, in practice the CRA generally permits the payer to look through the partnership and withhold based on the residence and treaty status of the members of the partnership. Interest that is ‘participating debt interest’ and interest paid or credited by a Canadian resident to a non-arm's length non-resident person is also subject to withholding tax. Conversely, interest that is neither ‘participating debt interest’ nor subject to the thin capitalization rules is exempt from withholding tax when paid to an arm's length non-resident person.68 The Canada–US tax treaty generally eliminates withholding tax for payments of interest to non-arm's length US persons that are entitled to the benefits of the treaty.69 A non-resident carrying on business through a Canadian branch may be deemed to be a resident of Canada for purposes of the withholding tax rules.70 The effect of these rules is to subject certain payments made by the non-resident to another non-resident to Canadian withholding tax. A 15 per cent ‘back-up’ withholding obligation is also imposed on payments made to non-residents in respect of services performed in Canada. The amount so withheld may be refunded or credited to the non-resident when it files a Canadian tax return, together with the information required to support its claim for an exemption from Canadian tax by virtue of an applicable tax treaty or for a refund of tax by virtue of the computation of its income from its Canadian business operations on a net basis.71 Recently enacted anti-avoidance provisions are intended to prevent the avoidance of Canadian withholding tax that would otherwise apply to interest on non-arm's length debt owing by the Canadian borrower to a related non-resident through the insertion of a third party financing conduit or intermediary under a ‘back-to-back’ financing arrangement, or its economic equivalent.72 The back-to-back rules may apply where a Canadian borrower pays interest to an arm's length non-resident lender (an ‘intermediary’) in respect of a particular debt or other obligation to pay an amount to the intermediary (a ‘Canadian debt’), in either of the two following circumstances. First, the rules may apply if the intermediary has an amount outstanding as or on account of a debt or other obligation (the ‘intermediary debt’) to pay an amount to a non-resident person if it is considered that all or a portion of the Canadian debt became owing or was permitted to remain owing because the intermediary debt was entered into or was permitted to remain outstanding. Second, the rules may apply if the intermediary has a ‘specified right’73 in respect of a particular property (a ‘collateral property’) that was granted directly or indirectly by a non-resident person and the specified right is required under the terms and conditions of the Canadian debt, or if it is considered that the Canadian debt became owing or was permitted to remain owing because the specified right was granted. The back-to-back loan rules only apply where the Canadian withholding tax payable on the interest paid to the intermediary is less than the withholding tax that would be payable if the interest had instead been paid directly to the non-resident person, rather than the intermediary.74 If the back-to-back loan rules apply, the Canadian borrower will be deemed to have paid some or all of the interest to the non-resident person, and this deemed payment would be subject to Canadian withholding tax at the domestic rate of 25 per cent, subject to reduction under an applicable treaty. A second consequence of the back-to-back rules applying is that a portion of the Canadian debt would be deemed to be owing to the non-resident person for purposes of the thin capitalization rules under the Act. By deeming a portion of the Canadian debt to be owing to the non-resident person, this debt would be included for purposes of determining whether the thin capitalization limit has been exceeded, and if it is, a portion of the interest paid or payable on the related party debt will not be deductible by the Canadian borrower in computing its income for Canadian tax purposes. Effective January 2017, the back-to-back rules were expanded by (i) extending their application to structures involving multiple intermediaries; (ii) extending their application to rents, royalties and similar payments (ie, where there is no loan to a Canadian entity); and (iii) adding ‘character substitution’ rules, whereby the back-to-back arrangement to the intermediary involves shares or a lease, licence or similar arrangement rather than a loan. They also now capture circumstances in which a Canadian corporation attempts to circumvent the shareholder loan rules in the Act by lending funds to an arm's length person on condition that the person makes a loan to a shareholder of the corporation (or a connected person or partnership). Where they apply, the Canadian corporation will be deemed to have made a loan directly to the shareholder (or connected person or partnership) and the tax consequences associated with such a loan will follow. Canadian branch or subsidiary In general, from a Canadian income tax perspective, there is little difference between carrying on business through a Canadian branch of a non-resident entity and carrying on business through a wholly owned Canadian subsidiary. However, most branch assets are generally ‘taxable Canadian property’, whereas shares of a Canadian subsidiary may not be. Consequently, the sale of a subsidiary is much less likely to be subject to the section 116 certificate requirements discussed below than the sale of a branch. A non-resident branch performing services in Canada is also subject to the ‘back-up’ withholding requirements under Regulation 105 discussed above. A Canadian incorporated subsidiary of a non-resident corporation is a Canadian resident for Canadian income tax purposes and is therefore subject to tax in Canada on its worldwide income. Certain types of payments (including dividends, rent and royalties) made by a subsidiary to its non-resident parent are subject to withholding tax, as discussed above. Similarly, Canadian tax will apply to the profits attributable to an unincorporated branch of a non-resident carrying on business in Canada. The allocation of items of income and expense between head office and the Canadian branch may be unclear and can result in ambiguity in the computation of branch income for purposes of the Act. In addition, Part XIV of the Act imposes a branch profits tax on the profits of the Canadian branch not reinvested in Canada. The branch profits tax is intended to parallel the dividend withholding tax.75 Hybrid entities Nova Scotia, Alberta and British Columbia corporate law permits the establishment of unlimited liability companies or ‘ULCs’. These entities are treated as Canadian resident corporations for Canadian income tax purposes, but in the United States are eligible to be treated as flow-through entities for US tax purposes. This dual or ‘hybrid’ tax characterization can be a useful planning feature. For example, while an unlimited liability company is treated as a taxable Canadian corporation for Canadian income tax purposes, there may be potential US tax advantages arising from the use of a ULC in light of its pass-through treatment, which may facilitate access to foreign tax credits in respect of Canadian tax payable by the ULC, as well as the ability to apply Canadian-source operating losses against taxable income earned by the US parent corporation from other sources. However, the Canada–US tax treaty contains ‘anti-hybrid’ provisions that could result in adverse consequences where ULCs are used in the cross-border context. In particular, Article IV(7) of the treaty provides as follows: 7 An amount of income, profit or gain shall be considered not to be paid to or derived by a person who is a resident of a Contracting State where: (a) the person is considered under the taxation law of the other Contracting State to have derived the amount through an entity that is not a resident of the first-mentioned State, but by reason of the entity not being treated as fiscally transparent under the laws of that State, the treatment of the amount under the taxation law of that State is not the same as its treatment would be if that amount had been derived directly by that person; or (b) the person is considered under the taxation law of the Contracting State to have received the amount from an entity that is a resident of that other State, but by reason of the entity being treated as fiscally transparent under the laws of the first-mentioned State, the treatment of the amount under the taxation law of that State is not the same as its treatment would be if that entity were not treated as fiscally transparent under the laws of that State. As a result of this provision, an amount of income is deemed not to be paid to or derived by a person who is a resident of a contracting state, thereby denying relief under the treaty, in two circumstances. The first is where a hybrid entity is treated as fiscally transparent under the laws of the contracting state of which the amount of income is derived, but not as a fiscally transparent entity under the laws of the state in which the person deriving such amount is resident. If the fact that the entity is not treated as fiscally transparent under the laws of the residence state causes the treatment of the amount to the recipient under the tax law of the residence state to be different than would have been the case had the amount been derived directly, paragraph 7(a) of Article IV will apply, and benefits under the treaty will be denied. The second circumstance in which benefits will be denied under this provision is where the hybrid entity is fiscally transparent under the laws of the state of residence of the person deriving the amount of income but is not fiscally transparent under the laws of the contracting state from which the amount is derived. If the fact of the entity being treated as fiscally transparent under the laws of the residence state results in the tax treatment of the amount under the laws of that state being different than would be the case if the entity were not treated as fiscally transparent under the laws of that state, the amount of income is not considered to be paid to or derived by a person who is a resident of a contracting state, and paragraph 7(b) of Article IV will result in the denial of benefits under the treaty. A common circumstance in which the anti-hybrid rules may apply involves a ULC owned by a US corporation that has not elected to have it treated as a corporation for US tax purposes. In this case, a dividend paid by the ULC to its US shareholder would be denied treaty benefits by virtue of Article IV(7)(b) of the treaty, because under US tax law the fiscally transparent nature of the ULC will result in a dividend being disregarded for US tax purposes, a result that would not apply if the ULC had elected to be taxed as a corporation. Accordingly, as the ULC is resident in Canada and as the treatment of the amount for purposes of US tax law is not the same as would have been the case if the ULC were not treated as fiscally transparent, the dividend will be considered not to have been paid to or derived by a resident of the United States. Accordingly, the domestic withholding tax rate of 25 per cent would be applicable, instead of the 5 per cent rate otherwise available under Article X(2) of the treaty. To avoid this result, instead of the declaration and payment of dividends, retained earnings of the ULC can be capitalized by increasing the stated capital in respect of the common shares of the ULC, which will trigger a deemed dividend for Canadian tax purposes, together with a corresponding increase in the adjusted cost base of the shares owned by the US shareholder.76 As this step triggers a deemed dividend for Canadian tax purposes, withholding tax will apply; however, since the US tax treatment of an increase in paid-up capital of this nature will be the same regardless of whether the ULC is fiscally transparent or not, Article IV(7)(b) will not apply, and the withholding tax rate reduction under the treaty will be available. The ULC would then subsequently reduce its paid-up capital, and distribute funds to the US shareholder. As long as the amount distributed is not greater than the amount of the paid-up capital reduction, this should not be a taxable event for Canadian tax purposes, thereby eliminating the need to rely upon the treaty. The CRA has ruled favourably on this ‘two-step’ approach.77 United States limited liability companies and foreign entity classification While a US LLC is either disregarded if it is owned by a single member or treated as a partnership if it is owned by several members for US income tax purposes, the CRA considers an LLC to be a corporation that is not liable to US tax unless it elects to be taxed in the United States as a corporation.78 However, the Canada–US tax treaty generally treats US LLCs as look-through entities for the purposes of applying the provisions of the treaty. Article IV(6) provides that an amount of income, profit or gain shall be considered to be derived by a taxpayer who is a resident of a contracting state where the person is considered under the taxation law of that state to have derived the amount through an entity (other than an entity that is a resident of the other contracting state), and by reason of the entity being treated as fiscally transparent under the laws of the first-mentioned state, the treatment of the amount under the taxation law of that state is the same as its treatment would be if that amount had been derived directly by that person. Accordingly, the extent to which the benefits of the treaty are available in circumstances where an amount of income, profit or gain is derived by a taxpayer who is a resident of the United States through an entity that is not resident in Canada will, if that entity is fiscally transparent for US tax purposes, depend upon the extent to which the treatment of the amount under US tax law is the same as that treatment would have been had the amount been derived directly by the taxpayer. The entity need not be resident in the United States for this purpose; provided it is not resident in Canada, the look-through treatment provided by the treaty may apply, even if it is resident in a third country. Article IV(6) does not extend the benefits of the treaty directly to the entity (such as to the LLC itself), but rather extends such benefits to any US resident member of the LLC that has derived the amount through the entity. However, it provides relief only for members (or ultimate members) who are resident in the United States and qualify for treaty benefits. Where there are non-US resident members of the LLC, the LLC will only be entitled to claim treaty benefits in respect of its members that are US residents. If, for example, a resident of the United Kingdom invests as a member of the LLC, the LLC will be denied treaty benefits from a Canadian perspective in respect of the proportionate interest owned by the UK resident, and may only claim benefits under the US treaty on a look-through basis pursuant to Article IV(6) to the extent of the interests held by residents of the United States. The CRA’s approach to characterization of an LLC as a corporation for Canadian tax purposes is consistent with the manner in which it generally applies a ‘two-step approach’ in characterizing foreign entities in applying the Act. Because the Act does not contain entity characterization rules or the equivalent of a ‘check-the-box’ regime, the CRA applies a test that (i) determines the characteristics of the foreign entity by reference to any relevant law and the terms of the constating documents in the foreign jurisdiction, and (ii) compares these characteristics to those of entities that exist under Canadian law, in order to classify the entity within the category recognized under Canadian tax principles that it most closely resembles. This approach can give rise to difficulties in the characterization of hybrid entities, in particular, which have legal characteristics that in many cases defy easy classification. For example, the CRA has recently concluded that limited liability partnerships (LLPs) and limited liability limited partnerships (LLLPs) formed under Florida and Delaware law should be treated as corporations for purposes of the Act.79 CRA placed considerable weight in reaching its conclusion on the fact that these types of partnerships have a separate legal personality under state law and that all members of such partnerships are entitled to limited liability protection.80 Capitalization of a Canadian corporation A Canadian corporation may be capitalized with equity or with a combination of debt and equity. The paid-up capital (‘PUC’) of a Canadian private corporation can generally be returned to shareholders free from Canadian tax, including Canadian withholding tax applicable to non-resident shareholders. This is the case even if there are earnings and profits at the corporate level. A distribution to a shareholder in excess of such share capital is deemed to be a dividend for purposes of the Act.81 Deemed dividends to non-resident shareholders are subject to withholding tax in the same manner and at the same rate (including any applicable reduced treaty rate) as regular dividends.82 Repayment of principal loaned to a Canadian corporation by a non-resident shareholder is not subject to withholding tax but, where applicable, tax must be withheld in respect of interest paid or credited on the loan.83 Subject to the thin capitalization rules and the general limitations on interest expense and losses described above, a Canadian subsidiary may deduct interest paid or credited by it to a non-resident in computing its income.84 Thin capitalization and interest imputation The thin capitalization rules are intended to prevent a Canadian resident corporation or trust, as well as a non-resident corporation or trust that carries on business in Canada or earns rental income that is subject to tax on a net basis, or a partnership of which such a corporation or trust is a partner, from excessively reducing its taxable Canadian profits, and thereby its liability for Canadian tax, by maximizing its interest expense to related non-resident creditors. In very general terms, the Canadian business is denied an interest deduction to the extent that its ‘relevant debt’ exceeds 1.5 times its ‘relevant equity’. The relevant equity of a corporation will consist of the aggregate of the corporation's retained earnings at the beginning of the taxation year, the average of the corporation's contributed surplus balance at the beginning of each calendar month (to the extent that the amount was contributed by a specified non-resident shareholder of the corporation), and the monthly average of the corporation's paid-up capital (excluding paid-up capital in respect of shares owned by a person other than a specified non-resident shareholder of the corporation).85 The relevant debt is the total of all amounts outstanding on account of a debt or other obligation to pay an amount to a specified non-resident shareholder or a non-resident person who was not dealing at arm's length with a specified shareholder, on which interest is or would, but for the application of the thin capitalization rules, be deductible.86 A specified non-resident shareholder is a person who, either alone or together with whom that person is not dealing at arm's length, owns shares of the corporation representing 25 per cent or more of the voting power of the corporation or 25 per cent or more of the fair market value of all of the shares of the corporation.87 The thin capitalization rules also include provisions that address attempts to circumvent the application of the provisions by utilizing back-to-back loans in order to indirectly provide debt financing to a corporation or trust in circumstances where the debt would otherwise be included in the calculation of the outstanding debts to specified non-residents of the corporation or trust if the loan had been made directly.88 Where a deduction for interest expense incurred by a corporation is denied pursuant to the thin capitalization rules, the amount is not subject to carry forward and is permanently disallowed from deduction in computing income. Moreover, where the thin capitalization rules apply, an amount paid or credited as interest by a corporation resident in Canada is deemed to have been paid by the corporation as a dividend to a non-resident person, and not as interest, to the extent that an amount in respect of the interest is denied deductibility. Accordingly, the application of the withholding tax rules in Part XIII of the Act to the interest payment will be determined as though the payment in question is a dividend.89 For purposes of the thin capitalization rules, each partner of a partnership is deemed to owe its proportionate share of each debt of a partnership to the creditor in applying the thin capitalization rules to the partners. A partnership debt is attributed to the partners of the partnership on the basis of their ‘specified proportion’, which refers to the members' share of the total income or loss of the partnership for its last fiscal period ending at or before the end of the corporation's current taxation year and at a time when the corporation was a member of the partnership.90 Each corporation or trust that is a member of a partnership is required to include in its income its share of the partnership's deductible interest payments, to the extent that the thin capitalization rules would have precluded the deduction of such interest if it had been incurred directly by the corporation or trust.91 View largeDownload slide View largeDownload slide The application of the thin capitalization provisions in the context of partnerships may give rise to anomalous consequences, as illustrated by the following examples: Conversely, where a Canadian resident corporation has made a loan to a non-resident and it is outstanding for one year or more, and the loan does not bear a reasonable rate of interest, interest income calculated at a prescribed rate on the principal amount outstanding is imputed to the Canadian lender for purposes of the Act.92 Moreover, if the loan is made to a shareholder of the corporation or a person with which such shareholder does not deal at arm's length (other than a foreign affiliate of the corporation), the principal amount of the loan may be deemed to be a dividend for Canadian withholding tax purposes.93 Disposition of shares or interests The disposition (or deemed disposition on death) of property by a non-resident of Canada, other than property used or held by a taxpayer in a business carried on in Canada, is generally not subject to Canadian tax unless it constitutes ‘taxable Canadian property’.94 ‘Taxable Canadian property’ is defined to include property which is considered to have a close nexus to Canada for tax purposes, including real or immovable property situated in Canada, and property used or held by a taxpayer in, and inventory of, a business carried on in Canada. A share of a private corporation (other than a mutual fund corporation), an interest in a partnership and an interest in a trust (other than a unit of a mutual fund trust or an income interest in a trust resident in Canada) are considered to be taxable Canadian property only if, at any particular time during the 60-month period that ends at that time, more than 50 per cent of the fair market value of the share or interest was derived directly or indirectly95 from one or any combination of, (i) real or immovable property situated in Canada, (ii) Canadian resource properties, (iii) timber resource properties and (iv) options in respect of or interests in any such property, whether or not the property exists (the ‘value requirement’). Also included in the definition of taxable Canadian property are shares of publicly listed corporations and mutual fund corporations and units of a mutual fund trust if, at any particular time during the 60-month period that ends at that time, the value requirement is satisfied, and 25 percent or more of the issued shares or units were owned by or belonged to one or any combination of (i) the taxpayer, (ii) persons with whom the taxpayer did not deal at arm's length, and (iii) partnerships in which they hold a membership interest, directly or indirectly through one or more partnerships (the ‘ownership requirement’).96 While the domestic rules thus impose capital gains tax on non-residents disposing of shares or interests in Canadian resident or non-resident private corporations that derive their value directly or indirectly from real property situated in Canada, and apply this test over a five-year look-back period, the imposition of domestic tax on a disposition of ‘taxable Canadian property’ is subject to an exemption available pursuant to the provisions of an applicable tax treaty. Most Canadian tax treaties permit Canada to tax gains realized by non-residents arising from the alienation of interests in real property or from the disposition of shares or partnership interests that derive their value from Canadian real or resource property. However, they generally apply this test only at the time of disposition97 (or limit the relevant look-back period98). Moreover, in many Canadian tax treaties, including those with Germany, the Netherlands, Switzerland and the United States, if the capital gain arises from the alienation of shares, Canada as the source state only retains the right to tax the gain where the corporation the shares of which are disposed of is resident in Canada.99 Furthermore, approximately half of Canada's tax treaties exclude shares that derive their value from Canadian real property where the property owned by the corporation is property, other than a rental property, in which the business of the corporation is carried on. This aspect of the capital gains exemption for property ‘in which the business of the company was carried on’ (often referred to the ‘business property exemption’) has in practice been broadly relied upon for ‘exit planning’ by non-residents investing in shares of Canadian corporations owning Canadian real property or resource property.100 The CRA has confirmed in a number of tax rulings that the business property exemption can apply broadly in a range of circumstances, including to shares where the value is derived from farmland used in a farming business101, to shares where the value is derived from processing plants, buildings, machinery and equipment used in a mining and processing business102, to shares where the value is derived from mineral and timber rights actively exploited by the company103, and to shares where the value is derived actively in exploited oil and gas interests.104 The Canadian Department of Finance has indicated that its current policy is for new tax treaties to contain capital gains articles that parallel or mirror Canadian domestic law with respect to the definition of taxable Canadian property; as a result, treaty relief for share dispositions by non-residents may be expected over time to generally become more closely harmonized with the Canadian taxation and gains as determined under the domestic taxable Canadian property rules in the Act described above. Section 116 notification and clearance certificate requirements In order to ensure the collection of tax owing by non-residents of Canada, section 116 of the Act imposes notification and withholding requirements in circumstances where a non-resident disposes of taxable Canadian property, other than ‘excluded property’ which, as described below, includes property the gain or sale of which would not be subject to Canadian tax by virtue of an applicable treaty exemption. Where a non-resident vendor intends to dispose of property that is taxable Canadian property and is not excluded property, the vendor may submit a notice to the CRA of the proposed disposition in advance of the sale, along with supporting documentation. If the vendor also pays an amount equal to 25 per cent of the estimated capital gain to be realized upon the disposition, or security in lieu of the tax payable, the CRA will generally issue a compliance certificate under section 116 (referred to as a ‘section 116 certificate’).105 If advance notice of the disposition is not provided by the vendor, or if the terms of the actual sale ultimately differ from the notification of the proposed disposition provided to the CRA, the vendor is obligated to notify the CRA of the actual disposition, along with supporting documentation, not later than 10 days after the date of closing of the sale. Upon receipt of the notice, as well as payment of 25 per cent of the amount of the capital gain realized upon the disposition, or security in lieu thereof, the CRA will issue a section 116 certificate to the vendor. The Act imposes withholding and remittance requirements on a purchaser that acquires property that is taxable Canadian property and is not excluded property from a non-resident of Canada unless the vendor provides the purchaser with a section 116 certificate.106 The withholding requirement imposed upon the purchaser is equal to 25 per cent of the cost amount to the purchaser of the acquired property.107 The purchaser is entitled to withhold this amount from the consideration paid or credited to the non-resident vendor and must remit it to the CRA within 30 days after the end of the month in which the transaction closes.108 The obligation imposed on the purchaser to withhold and remit under section 116 does not apply if the disposition is exempt from Canadian tax pursuant to the provisions of a tax treaty, where109: (i) the purchaser concludes after reasonable inquiry110 that the non-resident vendor is, under a tax treaty that Canada has entered into with another country, resident in that country; (ii) the property would be ‘treaty-protected property’ of the non-resident vendor if the non-resident vendor was, under the tax treaty, resident in the particular country, such that any income or gain on the disposition would be exempt from Canadian taxation pursuant to the provisions of the treaty,111 and (iii) the purchaser provides notice to the CRA within 30 days of the closing of the acquisition that the transaction was exempt from tax pursuant to the treaty.112 ‘Excluded property’ is not subject to the notification, withholding and remittance requirements described above.113 Excluded property includes property that is treaty-protected property provided that if the non-resident vendor and the purchaser are related, the purchaser must provide notice of the disposition to the CRA within 30 days of the acquisition.114 If the non-resident vendor and the purchaser are not related and the property is treaty-protected property, no notification or withholding will therefore be required under section 116 of the Act. However, if the property does not in fact qualify as treaty-protected property, such as in a case where the shares derive more than 50 per cent of their value from real property situated in Canada, such that gain from the disposition would not qualify for exemption under the terms of the particular treaty, the Act does not provide for the availability of a due diligence defence to either the vendor or the purchaser and the notification and withholding obligations (and purchaser liability provisions) described above will apply in respect of the disposition. Ontario non-resident speculation tax On 20 April 2017 the Ontario government announced a set of measures, dubbed the Fair Housing Plan, intended to ‘help more people find an affordable place to call home, while bringing stability to the real estate market and protecting the investment of homeowners’. The plan includes a proposed 15 per cent tax on foreign real estate purchasers and an expansion of the current rent control rules. The 15 per cent tax applies, effective 21 April 2017, to the value of the consideration for the transfer (including a beneficial transfer) of a residential property in the ‘Greater Golden Horseshoe’, including Toronto, if any of the transferees is a ‘foreign entity’ or ‘taxable trustee’.115 A foreign entity is a ‘foreign national’ or a ‘foreign corporation’. A foreign national is an individual who is not a Canadian citizen or permanent resident. A foreign corporation includes not only corporations incorporated outside Canada but also certain Canadian corporations. More particularly, a foreign corporation includes a Canadian incorporated corporation the shares of which are not listed on a Canadian stock exchange and that is controlled ‘in whole or in part’ by a foreign national or other foreign corporation. There is no guidance on what it means for a corporation to be controlled in part by a person. A foreign corporation also includes a Canadian incorporated corporation that is ‘controlled’ by a foreign entity within the meaning of section 256 of the Act, which extends control beyond the strict de jure test of more than 50 per cent of the votes.116 A taxable trustee is a Canadian citizen, permanent resident or corporation holding title in trust for foreign entity beneficiaries or a foreign entity holding title in trust for anyone.117 The tax does not apply to a purchase made as trustee for a mutual fund trust, a real estate investment trust or a specified investment flow-through trust. It is unclear whether this exemption is intended to apply to foreign REITs. There are also narrowly cast exemptions for personal use by foreign nationals who receive confirmation under the Ontario Immigrant Nominee Program, for refugees and for foreign nationals who acquire property jointly with a spouse who is a Canadian citizen, permanent resident or other qualifying person. Rebates may also be available for foreign nationals who become Canadian citizens or permanent residents within four years of the acquisition, who are full-time Ontario students for two years following the acquisition or who legally work full-time in Ontario for one full year following the acquisition. Non-resident beneficiaries of Canadian resident trusts Where a Canadian resident trust is used for business or investment purposes by non-residents of Canada, a number of issues under the Act must be considered118, including the following: (i) whether Canadian withholding tax applies in respect of a distribution from the trust to the non-resident beneficiary or on the disposition of an income or capital interest in the trust, (ii) whether income payable to the non-resident beneficiary is deductible by the trust in computing the trust's income for purposes of the Act, (iii) whether the trust is subject to tax under the Act on Canadian-source income earned by it that is paid or made payable to its beneficiaries, and (iv) whether distributions of appreciated property are subject to tax at the trust level. Part XIII withholding tax In order for withholding tax to apply to a payment by a trust to a non-resident beneficiary, the payment must be for an amount that is ‘income of or from a trust’.119 An amount paid or credited by a trust to a non-resident beneficiary is deemed to be income of the trust for withholding tax purposes, regardless of the source from which the income was derived by the trust (eg, capital gains, dividends or interest).120 Conversely, an amount that is deemed to be income of a trust will not be subject to withholding tax if it is not included in computing the income of the non-resident beneficiary. Therefore, a distribution of trust capital is not subject to withholding tax. Distributed taxable capital gains are generally subject to withholding tax to the extent that they are included in computing the beneficiary's income. The non-taxable half of the capital gain may be distributed to the non-resident beneficiary on a tax-free basis, notwithstanding that the entire amount of the distribution is recharacterized as income of the trust.121 Where a trust has elected for any taxable capital gain realized by the trust on the distribution of property to the beneficiaries to be taxed at the trust level122, this gain is not included in the income of the beneficiaries under subsection 104(13) and is therefore not subject to Part XIII withholding tax.123 The amount payable to the non-resident beneficiary that would be required to be included in computing the income of the non-resident beneficiary is deemed to be an amount paid or credited to the beneficiary as income of or from the trust on the earlier of (i) the day on which the amount was paid or credited, and (ii) the day that is 90 days after the end of the taxation year.124 The CRA has stated that where trustees pass a resolution entitling a non-resident beneficiary to the trust's income for the year, but do not pay the amount until the following year, withholding tax need not be remitted until after the amount is paid notwithstanding that the amount was deducted in computing the income of the trust for the year in which the amount became payable.125 Where an amount distributed by a Canadian resident trust to a non-resident beneficiary is subject to Canadian taxation, the tax may be reduced or eliminated pursuant to an applicable income tax treaty, which will generally recharacterize it as income of or from a trust for purposes of the imposition of Canadian withholding tax and the applicable tax treaty. Thus, for example, where a Canadian trust distributes an amount in respect of interest, dividends or capital gains that would in other circumstances be eligible for reduced Canadian tax pursuant to the specific treaty provisions dealing with these items, such provisions will not be applicable to the distribution, which will fall within the scope of the “other income” article (or the article dealing specifically with income from a trust or estate, where applicable) contained in the treaty.126 Part XII.2 tax Where a Canadian resident trust has at least one non-resident beneficiary, the Act imposes a tax (referred to as Part XII.2 tax) at the rate of 40 per cent on any ‘designated income’ of the trust, which is income from a business carried on in Canada, income from real property situated in Canada, and capital gains arising from the disposition of taxable Canadian property.127 Part XII.2 applies to a trust in a year where some or all of its income becomes payable in the year to beneficiaries under the trust. The tax is intended to ensure that Canada retains the right to tax business income, income from real property, and income from the disposition of taxable Canadian property at the general tax rate applicable to Canadian resident taxpayers under Part I of the Act, and not simply at the lower withholding tax rate, as potentially further reduced under the provisions of an applicable income tax treaty. The Part XII.2 tax will not apply where the trust retains its income so that it is taxed at the trust, rather than at the beneficiary, level. A distribution of capital is not subject to tax under these provisions. Tax paid by a trust under Part XII.2 is deducted in computing the income of the trust for purposes of Part I of the Act.128 Part XII.2 tax does not apply to a graduated rate estate.129 Distributions to non-resident beneficiaries Where a distribution of trust property by a personal trust is made to a non-resident beneficiary, the trust is deemed to have disposed of the property (subject to the limited exceptions described below) for proceeds of disposition equal to fair market value and the rollover that is generally applicable to capital distributions made to Canadian resident beneficiaries does not apply. Accordingly, distributions made to non-resident beneficiaries generally result in a taxable disposition of the distributed property by the trust.130 In particular, where property is distributed by a Canadian resident trust to a non-resident beneficiary in satisfaction of all or part of the beneficiary's capital interest in the trust, the deemed disposition rules in subsection 107(2.1) will apply.131 The trust will be deemed to have disposed of the property for proceeds of disposition equal to its fair market value and the beneficiary will be deemed to have acquired the property at a cost equal to its fair market value. A non-resident beneficiary that receives a distribution in these circumstances will not generally realize a gain on the disposition of the capital interest in the trust, although the beneficiary may realize a capital loss if the beneficiary's adjusted cost base of the trust interest exceeds the deemed proceeds of disposition.132 This provision does not apply to distributions of the following types of property made by a personal trust to a non-resident beneficiary, which may occur on a rollover basis: (i) real or immovable property situated in Canada and Canadian resource property; (ii) capital property used in or property described in the inventory of a business carried on by the trust through a permanent establishment in Canada; and (iii) an excluded right or interest of the trust.133 Elie S. Roth is a partner in the taxation and trust law practice groups at Davies Ward Phillips & Vineberg LLP in Toronto. Elie's practice concentrates on all aspects of domestic and international tax planning. He also represents taxpayers in tax audit and litigation matters. As an adjunct professor of law at Osgoode Hall Law School, Elie teaches international tax law and taxation of real estate transactions. Footnotes 1. RSC 1985, c C 44. 2. RSO 1990, c B 16. 3. Shareholders are the owners of a corporation, but they usually do not manage its business or enter into transactions on its behalf. By statute, they are protected from liability for obligations of the corporation. Generally, the authority to manage the corporation rests with the directors, who are elected by the shareholders. However, if the shareholders prefer to retain direct control of the corporation, they can enter into a unanimous shareholder agreement. Such an agreement can effectively transfer responsibility (and liability) for the management of the corporation from the directors to the shareholders. 4. Although it must use a French form of its name in Québec. 5. Except in Québec, where the three largest voting shareholders must be disclosed. In Québec, if all of the powers of the directors have been withdrawn pursuant to a unanimous shareholders' agreement, the names and domiciles of the shareholders or third persons having assumed such powers must be declared on the annual corporate return. 6. The CBCA and OBCA both require, however, that a public corporation have at least three directors, and that a certain number of such directors be independent. British Columbia, Prince Edward Island, New Brunswick, Nova Scotia and the territories do not have residency requirements for directors in their corporate statutes. 7. The corporate statutes of most other provinces in Canada are generally similar to the CBCA and the OBCA. However, there are differences in detail that may provide additional flexibility to certain investors. For example, British Columbia permits a corporation to hold its own shares, whether directly or through a subsidiary (which is restricted under both the CBCA and the OBCA). 8. The corporation cannot register if the name of the foreign corporation is the same as or similar to one already in use in that province. Business names used by a branch should also be registered and should not be the same as or similar to names used in the province. A foreign corporation which establishes a branch in Ontario must obtain a licence under the Extra-Provincial Corporations Act, RSO 1990, c E 27 (or, in the case of an LLC, register its name under the Business Names Act, RSO 1990, c B 17). 9. For example, while combined federal and provincial rates for investment income of a Canadian-controlled private corporation range from 49.7 per cent to 54.7 per cent, depending on an individual's province of residence, there is a 3.4 per cent deferral advantage in respect of investment income retained and reinvested in a corporation in Ontario (or 1.7 per cent for capital gains). 10. A CCPC is defined in para 125(7)(a) of the Act to mean a private Canadian corporation that is not controlled, directly or indirectly, by non-residents, public corporations, or by any combination thereof. It is a negative control test, as it only requires that the corporation not be controlled by non-residents of Canada and public corporations. 11. For example, in 2017 the tax rate in respect of eligible dividends in Ontario is 39.34 per cent, and the rate imposed on non-eligible dividends is 45.30 per cent. 12. Form T2054. 13. This includes a refundable surtax of 10.67 per cent. 14. Intercorporate dividends paid between ‘connected’ corporations (see n 17 below) are generally deductible to the recipient corporation under subsection 112(1) of the Act, subject to the imposition of refundable tax under Part IV. 15. See para 129(1)(a) and sub-s 129(3). 16. A corporation is connected for this purpose if the shareholder corporation controls the payer, or if the shareholder owns more than 10 per cent of the issued share capital of the payer having full voting rights under all circumstances and shares of the capital stock of the payer corporation having a fair market value of more than 10 per cent of the fair market value of all of the issued shares of the capital stock of the payer corporation. 17. See sub-ss 186(1) and (4). 18. For this purpose, an active business carried on by the corporation means any business carried on other than a specified investment business or a personal services business. A ‘specified investment business’ is defined in sub-s 125(7) to mean a business (other than a business of leasing property excluding real property) the principal purpose of which is to derive income from property. However, if the corporation employs more than five full-time employees in the business throughout the year, the business will not be a specified investment business, but rather an active business that may qualify for the small business deduction. A ‘personal services business’, also defined in sub-s 125(7), means a business of providing services where an ‘incorporated employee’ is a specified shareholder of the corporation and that employee would reasonably be regarded as an officer or employee of the entity to whom the services are provided if it were not for the existence of the corporation. A specified shareholder is generally a taxpayer who owns not less than 10 per cent of the issued shares of the corporation or of any other related corporation, at any time in the year (see sub-s 248(1)). A business is not a personal services business if it employs throughout the year more than five full-time employees or its services are performed for an associated corporation. This exclusion is intended to except an ‘incorporated employee’ from qualifying for the reduced rate where the individual employee would otherwise have earned the income directly. 19. Sub-s 110.6(2.1). 20. The CRA generally interprets this condition to mean 90% or more: CRA document number 2013-050661E5, dated 29 April 2014. 21. The CRA generally interprets this to mean 50 per cent or more. 22. Sub-s 110.6(1), ‘qualified small business corporation share’, and sub-s 110.6(14). 23. See sub-s 44.1(2) of the Act. It should be noted that an eligible small business corporation does not include a professional corporation, a specified financial institution, a corporation whose principal business is the leasing, rental, development or sale of real property owned by it, or a corporation more than 50 per cent of the fair market value of the assets of which is attributable to real property. 24. Sub-ss 70(5)–(5.2). 25. See para 69(1)(b). 26. See sub-s 70(6). 27. See, for example, s 9 of the Limited Partnerships Act, RSO 1990, c L16. Ontario and Québec also permit professionals to practise through a special type of general partnership known as a limited liability partnership (LLP), which provides individual partners with a degree of protection against unlimited liability for the negligent acts of other partners. 28. RSO 1990, c P 5. 29. RSO 1990, c L 16. 30. Sub-s 14(2) of the LPA. 31. As noted above, if the partnership uses a firm name or business name other than the name of the partners, that name must be registered under the BNA, but the failure to do so would not affect the existence of the partnership. 32. This reflects the common law principle that an undisclosed principal will be liable in the same manner as a disclosed principal for obligations incurred by its agent. 33. Ss 10 and 13 of the LPA. 34. See, for example, sub-s 2(3) of the LPA. 35. The declaration must be renewed every five years, and when the partnership wishes to cease operations a declaration of dissolution must be filed. The names and capital contributions of the limited partners do not have to be disclosed on the public record, although this information must be disclosed on request by the Registrar appointed under the BNA. 36. Income Tax Folio S4-F16-C1, ‘What is a Partnership?’. s 96 of the Act provides that the income of a member of a partnership is computed as if the partnership were a person resident in Canada. 37. See Continental Bank Leasing Corp. v Canada, [1998] 2 SCR 298; Bachman v Canada [2001] 1 SCR 367, and Spire Freezers Ltd v Canada, [2001] 1 SCR 391. 38. Sub-s 96(1). 39. Para 53(1)(e). 40. Para 53(2)(c). 41. Sub-s 40(3.1) and (3.11). 42. Sub-s 96(2.1) and para 111(1)(e). 43. Sub-s 96(2.2). 44. The ability to wind-up on a tax-deferred basis pursuant to either sub-s 98(3) or 98(5) or to transfer property to a partnership on a rollover basis under sub-s 97(2) require the partnership to be a ‘Canadian partnership’ within the meaning of sub-s 102(1) of the Act. 45. A joint venture will generally be considered to exist where there is (i) a joint property interest in the subject matter of the venture, (ii) a right of mutual control and management of the enterprise, and (iii) a limitation of the objective of the business to a single undertaking or a limited number of undertakings: Woodlin Developments Ltd. v MNR, [1986] 1 CTC 2188 (TCC). 46. RSO 1990, c T23. For further discussion, see Elie Roth, ‘Welcome Stranger: A Global Perspective on the Taxation of Trusts: Canadian Income Taxation of Trusts and Beneficiaries’, Trust & Trustees (2017) 23(1) 88–108. See also Elie S Roth, Tim Youdan, Chris Anderson, and Kim Brown, Canadian Taxation of Trusts (Canadian Tax Foundation 2016). 47. Trust Beneficiaries' Liability Act, 2004, SO 2004, c 29. 48. Sub-s 104(1). 49. Under sub-s 104(1), a ‘trust’ is generally deemed not to include ‘an arrangement under which the trust can reasonably be considered to act as agent for all the beneficiaries under the trust with respect to all dealings with all of the trust's property’. 50. In accordance with the rules in Division B of Part I of the Act. 51. Sub-s 104(2). 52. Sub-s 122(1). 53. Qualified disability trusts are also excepted from the general rule and are taxed at marginal rates. 54. Sub-s 122(1.1). Sub-s 104(2) of the Act prevents the creation of multiple testamentary trusts with the same beneficiaries established in order take advantage of low marginal rates. Prior to 2016, testamentary trusts computed their tax payable based on the marginal rates applicable to individuals. As there was no limit to the number of testamentary trusts that could be created under a will, it was possible, subject to this provision, to ‘multiply’ the benefits of the marginal tax rates by creating multiple testamentary trusts. 55. Para 104(6)(b). 56. Sub-s 104(13). 57. Sub-s 104(6) generally permits a trust to deduct, in computing its income for a taxation year, an amount not exceeding the portion of its income otherwise determined for the year that became payable in the year to a beneficiary under the trust. Sub-s 104(13) operates to include the amount paid or payable to a beneficiary from the income of the trust in a beneficiary's income. In effect, sub-s 104(6) operates to fully integrate income earned by the trust with that of its beneficiaries. 58. Sub-s 108(5) of the Act. 59. Sub-ss 104(19)–104(22.4). Sub-ss 104(27) through 104(28) provide similar rules that deem distributions from graduated rate estates to retain their character as pension income, deferred profit sharing plan income and death benefits to beneficiaries. 60. Depreciable property is dealt with by sub-s 104(5) and resource property by sub-s 104(5.2). 61. Paras 104(4)(b) and (c). 62. Within the broad meaning of s 253. 63. Sub-s 212(1). 64. Sub-s 214(1). 65. Sub-s 215(1). If the payor fails to withhold the tax, it will become liable to pay the withholding tax on the non-resident's behalf, together with interest and penalties: sub-ss 227(8) and (8.1). The payor will be entitled to deduct or withhold such tax from any amount paid or credited to the non-resident, or to otherwise recover from the non-resident the amount of tax paid on such person's behalf: sub-s 215(6). The non-resident is jointly and severally liable for the withholding tax, as well as any interest and penalties thereon: sub-s 227(8.3). 66. Sub-s 215(6). 67. Sub-ss 102(1) and 212(13.1). 68. Para 212(1)(b). 69. art XI(1). 70. Sub-s 212(13.2). 71. Reg 105. 72. Sub-ss 212(3.1), (3.2) and (3.3). 73. For these purposes, the term ‘specified right’ is defined in sub-s 18(5) to mean a right to mortgage, assign, pledge or encumber the property to secure payment of an obligation (other than the particular debt owing to the intermediary), or to use, invest, sell or otherwise dispose of, or in any way alienate, the property unless it is established by the taxpayer that all of the proceeds (net of costs, if any) received, or that would be received, from exercising the right must first be applied to reduce the particular debt. 74. The rules also provide for a safe harbour exception where either of the amount outstanding under the intermediary debt, or the fair market value of the collateral property, depending on which of the two circumstances above is being evaluated, is less than 25 per cent of the total of all amounts owing by the Canadian borrower or by persons not dealing at arm's length with a Canadian borrower (ie, the other borrowers) (collectively, the ‘connected debt’) to the intermediary under the agreement under which the Canadian debt was entered into (or under a connected agreement), provided that (i) the intermediary is granted a security interest in the intermediary debt or the collateral property, as the case may be, and the security interest secures the payment of two or more debts or other obligations that include the Canadian debt and the connected debt, and (ii) each security interest that secures the payment of a debt or other obligation secures the payment of every such debt or other obligation. This is intended to provide possible relief where an intermediary enters into multiple cross-collateralized debts owing to the intermediary by multiple group entities, including the Canadian borrower. 75. S 219 of the Act. Pursuant to s 219.2 of the Act, where a tax treaty provides for a dividend withholding tax rate applicable to a dividend paid by a corporation resident in Canada to a parent corporation in a foreign jurisdiction, the applicable branch tax rate will be levied at this reduced rate. 76. Sub-s 84(1) of the Act. 77. See, for example, CRA document number 2014-0534751R3; and CRA document number 2012-0471921R3. 78. See, for example, CRA document number 2000-0043615, dated 5 April 2001. This position now has statutory support in s 93.2 of the Act and para 5907(11.2)(b) of the Regulations. In contrast, the CRA has adopted the position that an S-corporation should be treated as a corporation for Canadian tax purposes, as it would be liable to US taxation if no election were made to be accorded flow-through status under Subchapter-S of the US Internal Revenue Code. This can result in a timing mismatch and inability to fully utilize foreign tax credits where the shareholder is a Canadian resident and a US citizen, as the S-corporation is fiscally transparent for US income tax purposes. 79. CRA document number 2016-0634951C6, dated 10 June 2016. 80. The CRA has announced that it will provide transitional relief in order to allow such entities formed before 26 April 2017 to be treated as partnerships retroactively from the time of their formation, provided the parties have consistently taken the position that it is treated as a partnership for Canadian tax purposes. 81. Sub-ss 84(1), 84(3) and 84(4). 82. Sub-s 212(2). 83. Para 212(1)(b). 84. Para 20(1)(c). 85. Sub-s 18(5), ‘equity amount’. 86. See sub-s 18(5), ‘outstanding debts to specified non-residents’. Equivalent rules apply to trusts; ‘outstanding debts to specified non-residents’ means debts owing by the trust to a ‘specified non-resident beneficiary’ or to a non-resident who does not deal at arm's length with a ‘specified beneficiary’ on which interest is or would, but for the application of the thin capitalization rules, be deductible by the trust. A ‘specified beneficiary’ of a trust is a person who, alone or together with non-arm's length persons, has a beneficial interest with a fair market value that is not less than 25 per cent of the fair market value of all beneficial interests in the trust. For this purpose, where the person or a non-arm's length person has a discretionary interest in the trust, the 25 per cent fair market value test is determined on the basis of the discretion having been exercised fully in favour of the person or non-arm's length person. A trust's ‘equity amount’ is intended to be equal to the total of the contributions to the trust made by specified non-resident beneficiaries, plus the after-tax earnings retained by the trust. 87. Sub-s 18(5), ‘specified non-resident shareholder’ and ‘specified shareholder’. For the purposes of determining whether a person is a specified shareholder of a corporation, if that particular person (or a person with whom the particular person does not deal at arm's length) has a right under contract, in equity or otherwise, either immediately or in the future and either absolutely or contingently, to acquire shares of the corporation or to control voting rights for the shares of the corporation, or a right to cause the corporation to redeem, acquire or cancel shares, the status of a particular person as a specified shareholder must be considered on the basis that any such right has been exercised. 88. These rules are contained in sub-ss 18(6) and (6.1). 89. Para 214(16)(a). A corporation that is deemed to have paid a dividend in respect of recharacterized interest is entitled to designate in its tax return which amounts paid or credited as interest to the non-resident person in the taxation year are deemed to have been paid as dividends, and thus subject to withholding tax: para 214(16)(b). 90. Sub-s 18(7). 91. Para 12(1)(l.1). A corporation that is a member of a partnership is thus required to include in computing its income its proportionate share of any interest related to the partnership that is rendered non-deductible as a result of the application of the thin capitalization rules. For example, if a specified non-resident beneficiary of a trust makes a loan of $1 million dollars to a partnership in which the trust has a 10 per cent interest, the trust is deemed to owe $100,000 to the specified non-resident beneficiary for the purpose of applying the thin capitalization rules. The partnership itself is not subject to the thin capitalization rules, and the interest is fully deductible by the partnership in computing its income. To the extent that interest is paid by a partnership to a specified non-resident of one of the partners, the partner is required to include its proportionate share of the interest in income if the outstanding debt of the partner owing to specified non-residents (including the proportionate share of the partnership debts) exceeds 1.5 times the partner's equity amount. 92. S 17. 93. Sub-s 214(3). 94. Sub-s 2(3) and para 115(1)(b) of the Act impose Canadian tax on taxable capital gains realized on the disposition by a non-resident of Canada of shares or interests that are taxable Canadian property and are not treaty-protected property. Accordingly, the domestic rules in the Act relating to the taxation of capital gains on shares and interests realized by non-residents are subject to any exemption available under an applicable income tax treaty. See para 150(1)(a) and sub-para 110(1)(f)(i). 95. Otherwise than through a corporation, partnership or trust the shares or interests in which were not themselves taxable Canadian property at the particular time. 96. Sub-s 248(1), ‘taxable Canadian property’. 97. See, for example, art XIII(3)(b) of the Canada–US tax treaty, and CRA document number 2016-0658431E5, dated 1 March 2017. 98. See, for example, the recently concluded treaty with Israel (2016), which has a 12-month look-back period in art 13(4)(a). 99. For example, art XIII(3)(b) of the Canada–US tax treaty only permits Canada to tax gains realized by a resident of the United States where the disposition of share of a corporation that is resident in Canada where the value of such shares is derived principally from real property situated in Canada. 100. An example is art 13(4) of the Canada-Luxembourg tax treaty, which is substantively similar to art 13(5)(a) of the Canada–UK tax treaty. It restricts Canada to taxing gains derived by a resident of Luxembourg from the alienation of shares, other than shares listed on an approved stock exchange in Canada, forming part of a substantial interest in the capital stock of a company, the value of which shares is derived principally from immovable property situated in Canada. For these purposes, immovable property does not include property (other than rental property) in which the business of the company was carried on; and a substantial interest exists when the Luxembourg resident and related persons own 10 per cent or more of the shares of any class of the capital stock of the company. Thus, art 13(4) of the Luxembourg treaty provides a capital gains exemption that carves back Canada's source-country jurisdiction to tax share dispositions in three respects: (i) all shares listed on a Canadian stock exchange are exempt; (ii) all shares representing a minority interest under the 10 per cent substantial interest threshold are exempt; and (iii) even where the shares derive more than 50 per cent of their value from Canadian real property or resource property, the gain can be exempt if there is property in which the business of the company was carried on. 101. CRA document number 2000-0042545, ‘Immovable Property’, dated 9 January 2001. 102. CRA document number 1999-0010583, dated 1 January 2000. 103. CRA document number 9703965, ‘Shares Deriving Value from Immovable Property’, dated 12 June 1997. 104. CRA document number 2000-0015753, ‘Article XIII, Canada-Netherlands Treaty’, dated 1 January 2000. 105. Sub-s 116(1). 106. Sub-s 116(5). 107. The 25 per cent tax (and purchaser liability in respect thereof described below) is increased to 50 per cent in respect of certain property: a life insurance policy in Canada, Canadian real property inventory, depreciable property and certain resource property: sub-ss 116(5.2) and (5.3). 108. If the purchaser fails to withhold or remit an amount as required under this provision, the purchaser assumes personal liability for such amount under the Act and may also be assessed a penalty equal to 10 per cent of the amount required to be remitted: see sub-ss 227(9), (9.3) and (10.1). 109. Para 116(5)(a.1) and sub-s 116(5.01). 110. This requirement may be satisfied by the vendor by having the non-resident vendor certify that it is resident in the particular country for purposes of the tax treaty pursuant to Form T2062C (Part D). 111. Sub-s 248(1), ‘treaty-protected property’. 112. Sub-ss 116(5.02) and 116(6.1). 113. As defined in sub-s 116(6) of the Act. 114. Sub-s 116(5.02). 115. A residential property means a real estate property containing up to six family residences, and includes residential condo units (irrespective of the number purchased). Large residential rental apartment buildings are expressly excluded. 116. For example, a person who exercises de facto control over a corporation or owns shares representing more than 50 per cent of the value of the corporation will be considered to control that corporation for purposes of s 256. 117. The tax applies to a transfer of residential property if any of the transferees is a foreign entity or a taxable trustee. Thus, if a transfer of residential property is made to multiple transferees and only one is a foreign entity or taxable trustee, the tax will be imposed on the full value of the consideration for the property. Each transferee will be jointly and severally liable for the tax payable. 118. See sources at n 47 for further discussion. 119. Para 212(1)(c). Although sub-ss 2(3) and 115(1) of the Act provide that non-resident persons are only liable to pay tax on their ‘taxable income earned in Canada’, para 250.1(b) provides that, for greater certainty and unless the context otherwise requires, a person for whom ‘income’ for a taxation year is determined in accordance with the Act includes a non-resident person. Accordingly, a non-resident beneficiary's ‘income’ for purposes of sub-para 212(1)(c)(i) includes all income of the trust that became payable in the year to the beneficiary and was included under sub-s 104(13), notwithstanding that such income may not be ‘taxable income earned in Canada’. 120. Sub-s 212(11). Where sub-s 212(11) applies to a particular amount, the amount is recharacterized for Part XIII withholding tax purposes as income of or from a trust exclusively. For example, interest income that may be exempt from Part XIII withholding tax by virtue of para 212(1)(b) if paid directly to the non-resident person would be subject to Part XIII withholding tax if it is received by a trust and distributed to a non-resident beneficiary. 121. Pursuant to sub-s 212(11). A capital gain of a trust that is distributed to a non-resident beneficiary will be treated as income for purposes of the application of para 212(1)(c) (although only the taxable half of such gain is subject to Part XIII withholding tax). 122. Under sub-s 107(2.11). 123. See, for example, CRA document number 2001-0115745, dated 27 December 2001. 124. Para 214(3)(f). 125. CRA document number 2003-0009211E5, dated 25 October 2004. Paragraph 214(3)(f) deems the amount to be paid or credited at the earliest of the times currently described in the paragraph and, if the taxation year of the trust ends because the trust ceases to be resident in Canada, the time that is immediately before the end of the taxation year of the trust. 126. See, for example, CRA document number 2009-0327001C6, dated 9 October 2009, and CRA document number 9632715, dated 13 February 1997. 127. The Part XII.2 tax liability is 40 percent of the least of: (i) the trust's ‘designated income’ for the year; (ii) the income of the trust before deducting amounts payable to beneficiaries and Part XII.2 tax (under sub-s 104(30)); and (iii) 100/64th of the amount deducted by the trust as payable to beneficiaries. Where a trust subject to Part XII.2 tax has Canadian resident beneficiaries, a portion of the Part XII.2 tax is deemed to have been paid on account of the Part I income tax liability of the trust's Canadian resident beneficiaries. 128. Sub-s 104(30). 129. Para 210.1(a). 130. Pursuant to sub-s 107(2.1) of the Act. 131. Sub-s 107(5). 132. In the case of a beneficial interest acquired for consideration, the adjusted cost base in the interest is reduced as a consequence of the distribution (under para 53(1)(h)). 133. Sub-s 128.1(10). The definition includes, for example, a right to receive a payment under an annuity contract, an interest in certain trusts and an interest in a life insurance policy in Canada. © The Author (2017). Published by Oxford University Press. All rights reserved. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Trusts & Trustees Oxford University Press

Welcome back stranger: a Canadian perspective on the taxation of privately owned business entities and owners

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Oxford University Press
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© The Author (2017). Published by Oxford University Press. All rights reserved.
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1752-2110
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10.1093/tandt/ttx176
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Abstract

Abstract This article contains a summary overview of the income taxation of Canadian resident and non-resident owners of privately owned business entities. It commences with a summary of the following business entities typically utilized in structuring privately owned businesses in Canada, and summarizes the characteristics of each and their domestic tax treatment: corporations, unlimited liability companies, general and limited partnerships and trusts. The article then outlines the general scheme in the Income Tax Act (Canada) (the ‘Act’) for taxation of non-residents in respect of investment in Canadian private business entities, including an overview of the Canadian withholding tax regime, issues related to the determination of whether to invest through a Canadian branch or subsidiary corporation, the taxation of certain hybrid entities and a review of capitalization considerations, including the Canadian thin capitalization and interest imputation rules. The taxation of the disposition of shares or interests in Canadian business entities by non-resident investors is then discussed. The article concludes with a summary of the taxation of non-resident beneficiaries of Canadian resident trusts. Summary of Canadian business entity alternatives and taxation Privately owned businesses in Canada are typically structured in the form of corporations, unlimited liability companies, partnerships or trusts. Certain of the characteristics and tax considerations relevant to the decision of which of these business entities to use in structuring transactions are described in greater detail below. Corporations A corporation is the most frequently used form of business organization in Canada. A corporation has a legal personality distinct from its shareholders and management. As a separate legal entity, a corporation has rights, powers and obligations similar to those of individuals; it can hold property and carry on a business, and can incur legal and contractual obligations. A business corporation can be incorporated either federally, under the Canada Business Corporations Act1 (the ‘CBCA’), or in any of the provinces. In Ontario, the relevant statute is the Business Corporations Act2 (the ‘OBCA’). The main advantages of the corporation as a business entity are the limited liability of the shareholders, the possibility of perpetual existence and the flexibility of the corporate form for financing and estate planning purposes. The disadvantages include the fact that since a corporation is a separate taxpayer, shareholders cannot access directly any tax losses it may generate, in contrast to an unincorporated entity such as a partnership.3 A federal corporation has the right to carry on business under its corporate name in any province of Canada.4 In contrast, a corporation incorporated under provincial law cannot do so as of right in another province. Both federally and provincially incorporated corporations must satisfy the registration requirements of every province in which they intend to carry on business. In most provinces, corporations must file corporate returns annually to keep their registrations up-to-date. Generally, only public corporations, whether federally or provincially incorporated, must file financial statements on the public record. The directors and officers of all corporations must be disclosed on the public record, but not the shareholders.5 The CBCA and OBCA require at least 25% of the directors to be Canadian residents, unless a corporation has less than four directors, in which case the board needs to have at least one Canadian resident director.6 The CBCA and OBCA also allow directors and shareholders to participate and to vote at meetings by electronic means. Both statutes prohibit par value shares and the issuance of shares which are not fully paid up.7 Most provinces in Canada do not provide for hybrid forms of corporate entity with certain partnership-like characteristics. In particular, no Canadian jurisdiction provides for limited liability companies (‘LLCs’). However, Nova Scotia, Alberta and British Columbia permit the formation of unlimited liability companies (‘ULCs’), which are similar to ordinary corporations except that the shareholders of which do not have limited liability. Although a ULC is treated as a corporation for Canadian tax purposes, it is eligible for flow-through treatment for US tax purposes. There are important differences between Nova Scotia, Alberta and British Columbia ULCs. In particular, the shareholders of an Alberta ULC are liable for any liability, act or default of the ULC, whereas in Nova Scotia and British Columbia the shareholders of a ULC have no direct liability to creditors, and their liability arises only when the ULC is wound up and there are insufficient assets to satisfy its obligations. A foreign corporation may carry on business in Canada either through a branch or by setting up a new corporation as a Canadian subsidiary. If an unincorporated branch is chosen as an alternative to a subsidiary, the foreign corporation must register in all provinces in which it wishes to carry on business.8 Taxation of corporations and shareholders Corporations are commonly used in structuring privately owned businesses as a result of the Canadian integration system; the Act is designed to ensure that income earned in a corporation and distributed to a shareholder in the form of a dividend should attract the same amount of net income tax, both corporate and personal, as if the income was earned directly by an individual who is subject to tax at the highest personal marginal rate. As a result, assuming all after-tax earnings are distributed on a current basis, individuals should generally be indifferent from an income tax perspective as to whether to carry on business activities or invest through a corporate structure or personally. In practice, however, the concept of integration is imperfect, and differences in the effective tax rates can create the possibility of tax savings or costs, depending on the province, for earning income in a corporation rather than directly as an individual.9 When investment income such as interest, dividends, rents, royalties or capital gains is earned by a Canadian-controlled private corporation (‘CCPC’), integration is achieved by way of a federal refundable tax mechanism.10 The additional refundable tax paid by a CCPC on its investment income accumulates in a notional tax account, referred to as the corporation’s ‘refundable dividend tax on hand’ (‘RDTOH’). The amount added to the corporation’s RDTOH account is refunded to the corporation when it ultimately pays out taxable dividends to its individual shareholders. Dividends paid by a CCPC may be designated as eligible dividends to the extent of the balance of the corporation’s general rate income pool (‘GRIP’) at the end of its taxation year in which the dividend has been paid. Generally, GRIP represents an accumulation of taxable active business income that did not benefit from preferential tax treatment such as the small business deduction (discussed below) and the RDTOH system that applies to investment income. Eligible dividends received from other corporations also retain their character and form part of the dividend recipient's GRIP balance. Eligible dividends are taxed more favourably to an individual than ineligible dividends.11 Capital gains are subject to an inclusion rate of 50%, such that capital gains are subject to tax at a rate that is equal to one-half of the rate applicable to ordinary income. A corporation’s capital dividend account ensures that the tax-free portion of a capital gain earned by the corporation is preserved so that it can be distributed tax-free to shareholders, subject to filing an election form with the Canada Revenue Agency (‘CRA’) in respect of the distribution.12 With respect to investment income, 30.67% of the aggregate investment income earned by a CCPC is included in its RDTOH account.13 This mechanism is intended to prevent the potential for personal income tax deferral that individuals earning investment income directly could otherwise obtain by earning such income through a corporation. The amount of refundable tax in a corporation’s RDTOH account is refunded at the rate of 38.33% upon payment of taxable dividends by the corporation to its shareholder. The following example illustrates how the refundable tax provisions operate to achieve integration for tax purposes, using as an example $100,000 of interest income and capital gains earned by a CCPC, respectively. View largeDownload slide View largeDownload slide A similar refundable tax is imposed under Part IV of the Act on taxable dividends received by private corporations that are otherwise deductible in computing taxable income.14 Part IV tax is imposed at the rate of 38.33% on dividends received by a corporation. As in the case with the additional refundable tax imposed on the aggregate investment income of a CCPC, the Part IV tax is intended to prevent individuals from deferring personal income tax that they would otherwise pay on taxable dividends on shares held as portfolio investments through a holding company. Part IV tax paid is credited to the corporation’s RDTOH account, and is fully refunded if 2.61 times the RDTOH balance (100/38.33) is paid out to the shareholders by way of taxable dividends.15 Part IV tax is imposed on two types of dividends: (i) portfolio dividends, which are dividends from corporations that are not ‘connected’16 with the recipient corporation, and (ii) dividends that entitle the payer corporation to a dividend refund, which will generally be the case if the payer corporation has a positive balance in its RDTOH account.17 Shareholders benefit from a tax deferral opportunity that exists when active business income of a corporation remains invested in the corporation and is not distributed to its shareholders. The active business income retained in a corporation will not attract personal tax until it is ultimately distributed, either in the form of salary or dividends, to the shareholders of the corporation. In Ontario, for example, the general corporate tax rate on active business income is 26.5 per cent, in contrast to the highest personal marginal tax rate of 53.53 per cent. For income taxed at the small business deduction rate, this deferral advantage is 38.5 per cent in Ontario; for income taxed at the general corporate rate, it is 27 percent. Small business deduction The Act provides for a lower income tax rate applicable to the first $500,000 of active business income of a CCPC, provided that the taxable capital of the corporation and associated corporations does not exceed $10 million.18 This reduced rate of tax, which is referred to as the small business deduction, results in a combined federal and provincial tax rate in Ontario of 15 per cent. For corporations and associated corporations with taxable capital between $10 million and $15 million, the active business income eligible for the small business tax rate is reduced proportionately, and is eliminated entirely once the taxable capital of all of the associated corporations exceeds $15 million. Generally, in order to benefit from the small business deduction, a corporation must be a CCPC and carry on an active business in Canada. Active business income that exceeds the $500,000 small business deduction threshold is taxed at the higher general corporate tax rate. The combined federal and provincial income tax rate on income in excess of the small business deduction threshold ranges from 26 per cent to 31 per cent, depending on the province. As noted above, as a result of recent increases to the highest marginal combined federal and provincial personal tax rate, there is a significant tax deferral opportunity to earning active business income in a corporation where such income is retained and is not distributed to the shareholder on a current basis. Capital gains exemption Individual taxpayers resident in Canada are entitled to claim a lifetime capital gains exemption, which is a deduction in computing taxable income, of up to $835,714 (for 2017) in respect of capital gains realized upon the disposition of ‘qualified small business corporation shares’ (‘QSBC shares’).19 In order to qualify for the capital gains exemption, the shares disposed of must be QSBC shares at the time of the disposition; this requires the corporation to be a CCPC, all or substantially all20 of the fair market value of the assets of which is attributable to (i) property used principally in an active business carried on primarily21 in Canada by the corporation or a related corporation, (ii) shares or indebtedness of one or more small business corporations that are, at the time, connected with the corporation or (iii) any combination thereof. The QSBC shares must not have been owned by any person other than the individual or a related person throughout the 24-month period immediately preceding the time of disposition.22 In addition, throughout that 24-month period, the corporation must have been a CCPC and more than 50 per cent of the fair market value of its assets must have been used principally in an active business carried on primarily in Canada by the corporation or a related corporation, or shares or indebtedness of one or more other corporations connected with it. Capital gains deferral Individuals may also qualify for a deferral of capital gains that are reinvested in an ‘eligible small business corporation’ in the same taxation year or within 120 days of the end of the year.23 Where the deferral is available, the adjusted cost base of the eligible small business corporation in which the proceeds are reinvested is reduced by the capital gain deferred, and is realized only upon a subsequent disposition of the replacement shares. The capital gains deferral is available only to an individual in respect of a gain arising on a disposition of common shares of the capital stock of a corporation that were issued from treasury by an ‘eligible small business corporation’, which is a CCPC all or substantially all of the assets of which are (i) used principally in an active business carried on primarily in Canada, (ii) shares or debt of related eligible small business corporations, or (iii) any combination thereof. The total carrying value of the assets of the corporation and its related corporations must not exceed $50 million. The active business of the corporation must be carried on primarily in Canada at all times in the period that began when the individual last acquired the share and ends at the time of disposition if that period is less than two years; otherwise, the active business must be carried on primarily in Canada for at least two years during the ownership period. The share disposed of must have been owned by the individual throughout the 185-day period ending immediately prior to the disposition. Proposed passive income proposals The Department of Finance released a discussion paper on 18 July 2017, which outlines various proposals currently under consideration by the government that affect tax planning using private corporations. One aspect of the discussion paper addresses the taxation of passive investments held in private corporations. Other legislative changes are intended to restrict transactions that involve the conversion of income taxed at ordinary rates into lower taxed capital gains and that expand the scope of the rules that prevent income splitting among family members through private corporations and trusts. As noted above, individuals who carry on business through a corporation can reinvest business income earned in the corporation by making passive investments, thereby giving rise to a tax deferral advantage. This possibility arises because business income in a corporation is generally taxed at a much lower rate (generally 26.5 per cent in Ontario) than the rate applicable to income earned personally by individuals (up to 53.53 per cent in Ontario). As a result, if the after-tax business income is retained in the corporation, more capital will be available for investment purposes. Investment income (including income earned from the reinvestment of active business earnings) is currently taxed at a rate of just over 50 per cent, of which approximately 30 per cent is refunded when dividends are paid to individual shareholders and subject to tax at personal rates. In addition, capital gains are only half-taxable, with the non-taxable portion of the gain added to the corporation’s capital dividend account, which can be distributed to a Canadian individual shareholder on a tax-free basis. The passive investment proposals under consideration as described in the government’s discussion paper would result in the refundable tax that currently applies to income generated from investments made using after-tax earnings subject to the lower corporate tax rate becoming non-refundable. In addition, they would prevent the non-taxable portion of capital gains derived from such after-tax earnings from being added to the capital dividend account of the corporation. This would result in an increase in the effective tax rate applicable to investment income that is distributed to an individual shareholder from a rate of approximately 27.99–54.57 per cent where such investment income is derived from capital gains, from a rate of approximately 55.98–69.79 percent where it is derived from interest income, and from a rate of approximately 39.34–62.59 percent where it is derived from dividends received from portfolio investments in shares of public companies. As currently formulated in the discussion paper, the proposals under consideration would not appear to affect the tax treatment of dividends received from connected corporations, which could continue to be received without incremental corporate tax payable, or the tax rate applicable to investment income earned before it is distributed to individual shareholders, which is already taxed at a rate in excess of 50 per cent approximating the highest personal marginal tax rate. The additional tax on investment income would be charged when the income is ultimately distributed to the individual shareholders, as the tax rate on dividends paid would increase as a result of the denial of the dividend refund and the inability to access the capital dividend account previously available. The discussion paper suggests that certain corporations focused solely on passive investments may be able to elect to continue to be subject to the current refundable tax system, without becoming subject to the proposed changes; this election would result in an upfront refundable tax being charged on amounts transferred from other corporations (including dividends received or capital contributions made by corporate shareholders) but very little detail has been provided regarding this aspect of the proposals, including the refundable tax rate that would apply. The passive income proposals in the discussion paper are set out for consultation purposes and remain undefined in a number of critical respects; unlike the other proposed changes referred to above, draft legislation has not yet been released and the government is seeking input on the nature and scope of the concepts outlined in the discussion paper before settling on an approach. Among other things, for example, it is unclear how the rules may apply where borrowed funds are used to make passive investments. The discussion paper also does not address how the rules will apply in circumstances where the proceeds of a tax-free intercorporate dividend are used to make passive investments by a holding company, although it appears likely that such investments would be included in the scope of the proposals. Taxation on disposition or deemed disposition of shares No estate or gift tax is imposed in Canada, either federally or provincially. However, the Act contains provisions that deem an individual to have disposed of all capital properties, land inventory and resource property immediately prior to death for proceeds equal to the fair market value of such property and to have reacquired the property at a cost equal to the deemed proceeds of disposition, thereby resulting in the realization of accrued income and gains.24 The realization of accrued gains may be deferred by way of a rollover applicable on the transfer of the property to the taxpayer’s spouse or to a qualifying spouse trust; property so transferred will be subject to the deemed realization upon the death of the surviving spouse. Where a taxpayer disposes of property, including shares of a corporation, to a person with whom the taxpayer was not dealing at arm’s length for no proceeds or for proceeds that are less than the fair market value at the time the taxpayer disposed of the property, or to any person by way of gift, the taxpayer is deemed to have received proceeds of disposition for the property equal to its fair market value at that time.25 An exception applies in respect of property transferred to a taxpayer’s spouse or to certain spousal trusts, which (subject to a contrary election) occurs on a tax-deferred rollover basis.26 Partnerships and joint ventures In Canada, a partnership is not regarded as a legal entity separate from its partners. In a general partnership, all of the partners can participate in management of the business, but are exposed to unlimited liability for partnership obligations. In a limited partnership, limited partners’ liability is limited to their investment in the partnership, but they must remain passive investors and not participate in control of the partnership business.27 In Ontario, the governing statutes are the Partnerships Act28 and the Limited Partnerships Act29 (‘LPA’), which define the rights and obligations of the partners between themselves and in relation to third parties. The provisions of these statutes that address the rights and obligations of partners between themselves can generally be altered by agreement between the partners. Because the relationships between the partners can be determined by agreement, there is great flexibility in providing for such matters as capital contributions or other financings of the partnership, participation in profits and management structure. The statutory provisions permit flexibility in setting terms by agreement among the partners; for example, multiple classes of partnership interests may be created with governance and economic entitlements tailored to the requirements of the investors.30 As discussed in greater detail below, income and losses of a partnership, although computed at the partnership level, are allocated to and subject to tax in the hands of the partners. This tax treatment is often the primary reason for using a partnership rather than a corporation, since each partner may offset its eligible share of the partnership's business tax losses against income from other sources. General partnerships The principal characteristic of a general partnership is the unlimited liability of each partner for the liabilities and obligations incurred by the partnership to third parties. Each partner may bind the others unless there are restrictions in the partnership agreement of which third parties have notice. However, a partner is generally not liable for obligations incurred before it became or after it ceased to be a partner. The primary disadvantages of a general partnership are the unlimited liability of the partners and the ability of each partner to incur partnership obligations that will bind the other partners. In Ontario, all the partners of a general partnership must register the name of the partnership under the Business Names Act (“BNA”), unless the business is carried on under the names of the partners. This registration requires that the partnership business and the names and addresses of the partners be disclosed. In Ontario, although a limited partnership cannot be formed except by the filing of a declaration under the LPA, a general partnership may exist without any registration or filing on the public record.31 If the relationship satisfies the legal criteria for a general partnership, its members will be liable as general partners for obligations relating to the partnership business and will be bound by any such obligations incurred by any of the partners, even to third parties who are not aware of the existence or identity of the other partners.32 Limited partnerships A limited partnership combines the advantages of limited liability and the ability to flow tax losses through to passive investors (subject to the restrictions under the Act described below). This form of business structure is often used for private equity funds, financings and real estate syndications. A limited partnership is made up of one or more general partners, each of whom has the same rights and obligations as a partner in a general partnership, and one or more limited partners, whose powers and liabilities are limited. The general partner or partners manage the partnership. A limited partner may not take part in the management of the partnership without jeopardizing the partner’s limited liability. The authority of limited partners is limited, and in order to preserve liability protection limited partners may not participate in management of the business of the partnership, and cannot bind other partners.33 The primary advantage of a limited partnership over a general partnership is the limited liability of the limited partners, which enables passive investors to participate as partners without risking their personal assets beyond their investment in the partnership. Limited partnerships are typically established by declaration under the applicable provincial law.34 To establish a limited partnership in Ontario, a declaration signed by the general partners must be filed under the LPA.35 Taxation The Act does not define the term ‘partnership’, but sets out the tax consequences that apply where a partnership exists.36 In order to determine whether a particular relationship constitutes a partnership, reference must be made to the provincial partnership statutes, which generally define a partnership as a legal relationship existing between two or more persons who carry on business in common with a view to profit.37 A partnership is not taxed as a separate entity; instead each partner is required to include in income the partner’s share of the income of the partnership for the fiscal period ending in the taxation year of the partner. The Act requires a partnership to determine its income at the partnership level, which must be computed as if the partnership were a separate person resident in Canada. This requires the partnership to compute its income from various sources, as well as any net capital losses and non-capital losses, for each fiscal period.38 While a partnership is required to compute its income for tax purposes, the partnership is not itself liable to tax on that income. Instead, each partner of a partnership is liable to tax on that partner’s share of the partnership’s income from each source for each fiscal period of the partnership. Both the source and the character of income and gain earned by the partnership are generally retained in the hands of the partners for purposes of computing the partners’ liability for tax under the Act. A partner’s adjusted cost base in a partnership interest is generally increased by the partner's share of income of the partnership for each fiscal period, including any gains on the disposition of capital property owned by the partnership, and by the partner's contributions of capital made to the partnership,39 and is reduced by the partner's share of any losses of the partnership for each fiscal period, including losses on the disposition of capital property owned by the partnership, and by distributions made to the partner.40 A partner can generally withdraw an amount from the partnership equal to its adjusted cost base in the partnership interest without incurring tax; the partner's adjusted cost base in the partnership interest effectively represents its net investment in the partnership. Where a partner is a limited partner or a ‘specified member’ of a partnership, the partner is required to realize a capital gain to the extent that its adjusted cost base of the partnership interest is negative at the end of any fiscal period of the partnership.41 A ‘specified member’ of a partnership is a member of the partnership who is not actively engaged in the activities of the partnership business (other than financing), or in carrying on a similar business to that carried on by the partnership, on a regular, continuous and substantial basis throughout the period during which the business of the partnership was carried on and during which the partner was a member. In essence, partners that are limited partners and certain passive partners not actively engaged in the partnership business may not receive tax-deferred distributions to the extent that the adjusted cost base in their partnership interest has been reduced to nil by virtue of the allocation to the partner of deductible losses or distributions. The ‘at-risk’ rules in the Act apply to restrict a limited partner’s entitlement to deduct its share of non-capital losses incurred by the partnership, to the extent that the amount of such losses exceeds the partner’s ‘at-risk amount’ in respect of the partnership at the end of the fiscal period. Losses that are suspended by virtue of the application of the ‘at-risk’ rules may be carried forward indefinitely to offset partnership income from the partnership.42 A partner’s ‘at-risk amount’ is equal to the aggregate of the partner’s adjusted cost base in respect of the partnership interest and the partner’s share of partnership income for the year as computed under the Act, reduced by (i) the outstanding principal amount of debts owed by the partner to the partnership or to a person or partnership not dealing at arm's length with the partnership, and (ii) any amount or benefit that the limited partner or a person that does not deal at arm's length with the limited partner is entitled to receive for the purpose of reducing the impact of any loss that a limited partner may sustain by virtue of being a member of the partnership or by virtue of holding or disposing of an interest in the partnership.43 These provisions are intended to restrict a limited partner from deducting losses in excess of the limited partner's economic investment in the partnership. A ‘Canadian partnership’ is defined in the Act as a partnership all of the partners of which are resident in Canada. Partnerships that meet this definition qualify for beneficial treatment under various rollover provisions in the Act so that tax-deferred reorganization transactions may be undertaken44, and as a Canadian resident for withholding tax purposes. Accordingly, it is common for non-residents investing into Canada through a partnership to do so through a Canadian blocker corporation so that the tax status of the partnership is preserved. Joint ventures A joint venture is an agreement entered into by two or more parties to combine capital and skills for the purpose of carrying out a specific undertaking. It may or may not involve co-ownership by the venturers of the project assets. Because it is essentially a contractual relationship not specifically regulated by statute, participants are able to negotiate and agree on such terms as they may determine. Since a joint venture is not a recognized entity for tax purposes, income and losses for tax purposes are computed separately by each joint venturer rather than at the joint venture level. A joint venture may be difficult to distinguish from a partnership and the parties' characterization of their relationship may not be conclusive.45 The most important legal distinction is that sharing of profits is essential to a partnership, whereas joint venturers generally contribute to expenses and divide revenues of the project, but do not calculate profit at the joint venture level. Equal participation in management of the business is characteristic of a general partnership, but less usual in a joint venture, where one party often operates the project, or management is contracted out. Trusts In Ontario, a trust is primarily governed by the provisions of the declaration establishing the trust and non-statutory principles of equity, although trusts are also subject in certain respects to statutes such as the Trustee Act.46 Unlike shareholders of a corporation, investors in a trust have not historically had the benefit of statutory limited liability, and there has been some concern that in certain circumstances it might be possible for investors to be exposed to liabilities arising from the operations of the trust. Ontario has passed legislation clarifying that investors in a business trust that is governed by Ontario law and is a ‘reporting issuer’ under Ontario securities laws will not incur such liabilities as beneficiaries of the trust.47 Taxation The Act does not contain a general definition of a ‘trust’. It provides that a reference to a trust or estate in the statute shall, unless the context otherwise requires, be read to include a reference to the trustee, executor, administrator, liquidator or a succession, heir or other legal representative having ownership or control of the trust property.48 A bare trust or nominee arrangement is expressly excluded from constituting a ‘trust’ for purposes of the Act.49 A trust is generally required to compute its income as an individual50; however, while a trust is deemed to be an individual for purposes of the Act in respect of the trust property,51 there are a number of provisions that treat trusts differently than natural persons. For example, in general, trusts are not entitled to the graduated rates applicable to individuals, and are instead taxed at a flat rate equal to the highest marginal rate.52 As an exception, this rule does not apply to a ‘graduated rate estate’, which is an estate that arose on and as a consequence of an individual's death if no more than 36 months have passed since the date of death53; a graduated rate estate will therefore enjoy the benefits of graduated tax rates for a period of up to 36 months, and if the estate takes longer than 36 months to administer, it will be subject to taxation at the highest marginal rate in all subsequent taxation years. A trust is also not entitled to the personal deduction or tax credits applicable to natural persons, so as to prevent the multiplication of credits.54 As a trust is treated as a separate taxpayer for most purposes of the Act, it will be taxable on its income earned in a taxation year. However, the trust is generally entitled to deduct an amount not exceeding the portion of its income that was paid or became payable to a beneficiary in the year or that was otherwise included in a beneficiary’s income in a taxation year,55 which will be taxable to the beneficiary.56 Accordingly, a trust is generally taxed only on income accumulated in the hands of the trustee. The underlying principle is that a trust is generally entitled to flow-through income to its beneficiaries so that tax on the income is paid by the beneficiary or the trust, but not both.57 The provisions are intended to ensure integration, so that a Canadian resident beneficiary should be indifferent as to whether to earn income through a trust or instead earn the income directly. Income that is not paid or made payable to a beneficiary will be taxed in the trust; when it is subsequently paid to a beneficiary, it will be distributed on a tax-free basis as a capital distribution. Income that is paid or made payable to a beneficiary of a trust must be included in income as income from property that is an interest in the trust.58 This rule has the effect that income of a trust will generally lose its original source and character when it is distributed to the beneficiaries. However, specific ancillary conduit provisions allow the character of certain income to be retained when included in the beneficiary's income, including taxable dividends, capital dividends and capital gains, to the extent that the distribution is made by the trust to the beneficiary from these sources.59 These provisions preserve the character of these amounts in the hands of the beneficiary, allowing the beneficiary to claim the dividend gross-up and tax credit on dividends received from taxable Canadian corporations, the intercorporate dividend deduction (applicable to dividends allocated to corporate beneficiaries), the one-half inclusion rate for capital gains, the capital gains exemption, and foreign tax credits in respect of foreign-source income received by the trust and made payable to the beneficiary. Losses incurred by a trust cannot be flowed through to its beneficiaries, and may be utilized only at the trust level. The Act deems most personal trusts to dispose of ‘each property of the trust (other than exempt property) that was capital property … or land included in the inventory of a business of the trust’60 at the end of the day which is 21 years after the day on which the trust was created and every 21 years thereafter.61 This is generally referred to as the ‘21-year rule’, the object of which is to prevent an indefinite deferral of gains appreciating within a trust. The 21-year rule is intended to require a realization of accrued income and gains, either on the deemed realization date or, in the event that the trust property is distributed to the beneficiaries prior to the deemed disposition date, upon the death of the beneficiary or the beneficiary's surviving spouse. The Act generally provides for a subsequent deemed disposition every 21 years after the trust’s initial deemed disposition date. Non-resident investment in Canadian private business entities The Act contains two distinct schemes for taxing non-residents. A non-resident who ‘carries on business’ in Canada62 is taxable on Canadian source business income under Part I of the Act; Canadian tax treaties generally limit the source jurisdiction’s right to tax income from carrying on business to businesses carried on through a permanent establishment. A non-resident is also subject to withholding tax under Part XIII on passive Canadian source income earned in Canada, which is imposed at a domestic rate of 25 per cent on a gross basis, and is typically reduced under applicable tax treaties. Withholding Tax A person resident (or deemed resident) in Canada who makes a payment to a non-resident in respect of most types of passive income (including dividends, rent and royalties) is generally required to withhold tax equal to 25 per cent of the gross amount of the payment.63 Under Part XIII of the Act, the non-resident person is subject to a withholding tax of 25 percent on such amounts that a Canadian resident pays or credits (or is deemed to pay or credit) to the non-resident, subject to relief under an applicable tax treaty. Withholding tax is payable on the gross amount of the payment.64 In order to collect the tax, a withholding and remittance obligation is imposed on the payor.65 An income tax return is not required to be filed by the non-resident in respect of the Part XIII tax so withheld and remitted. The domestic withholding rate may be reduced under an applicable tax treaty. For dividends, the typical treaty rate is 15 per cent, except where the shareholder is a corporation that beneficially owns 10 per cent or more of the voting shares of the dividend payer, in which case the rate is generally reduced to 5 per cent. The typical treaty rate on royalties is 10 per cent and may be reduced to 0 per cent on certain royalties. Although withholding tax is imposed on the non-resident recipient, the resident payer is required to deduct the tax and remit it to the CRA on behalf of the non-resident, failing which the resident payer becomes liable for the tax.66 While it is not required by law, the CRA expects Canadian payers to obtain Forms NR301, NR302 or NR303 (depending on the legal status of the non-resident payee) from non-residents in respect of which withholding tax rates are reduced by an applicable tax treaty, certifying their treaty residence and entitlements. A partnership, any member of which is a non-resident, is itself deemed to be a non-resident under the Act.67 Consequently, a payment by a Canadian resident to a partnership with any non-resident members is subject to withholding tax. However, in practice the CRA generally permits the payer to look through the partnership and withhold based on the residence and treaty status of the members of the partnership. Interest that is ‘participating debt interest’ and interest paid or credited by a Canadian resident to a non-arm's length non-resident person is also subject to withholding tax. Conversely, interest that is neither ‘participating debt interest’ nor subject to the thin capitalization rules is exempt from withholding tax when paid to an arm's length non-resident person.68 The Canada–US tax treaty generally eliminates withholding tax for payments of interest to non-arm's length US persons that are entitled to the benefits of the treaty.69 A non-resident carrying on business through a Canadian branch may be deemed to be a resident of Canada for purposes of the withholding tax rules.70 The effect of these rules is to subject certain payments made by the non-resident to another non-resident to Canadian withholding tax. A 15 per cent ‘back-up’ withholding obligation is also imposed on payments made to non-residents in respect of services performed in Canada. The amount so withheld may be refunded or credited to the non-resident when it files a Canadian tax return, together with the information required to support its claim for an exemption from Canadian tax by virtue of an applicable tax treaty or for a refund of tax by virtue of the computation of its income from its Canadian business operations on a net basis.71 Recently enacted anti-avoidance provisions are intended to prevent the avoidance of Canadian withholding tax that would otherwise apply to interest on non-arm's length debt owing by the Canadian borrower to a related non-resident through the insertion of a third party financing conduit or intermediary under a ‘back-to-back’ financing arrangement, or its economic equivalent.72 The back-to-back rules may apply where a Canadian borrower pays interest to an arm's length non-resident lender (an ‘intermediary’) in respect of a particular debt or other obligation to pay an amount to the intermediary (a ‘Canadian debt’), in either of the two following circumstances. First, the rules may apply if the intermediary has an amount outstanding as or on account of a debt or other obligation (the ‘intermediary debt’) to pay an amount to a non-resident person if it is considered that all or a portion of the Canadian debt became owing or was permitted to remain owing because the intermediary debt was entered into or was permitted to remain outstanding. Second, the rules may apply if the intermediary has a ‘specified right’73 in respect of a particular property (a ‘collateral property’) that was granted directly or indirectly by a non-resident person and the specified right is required under the terms and conditions of the Canadian debt, or if it is considered that the Canadian debt became owing or was permitted to remain owing because the specified right was granted. The back-to-back loan rules only apply where the Canadian withholding tax payable on the interest paid to the intermediary is less than the withholding tax that would be payable if the interest had instead been paid directly to the non-resident person, rather than the intermediary.74 If the back-to-back loan rules apply, the Canadian borrower will be deemed to have paid some or all of the interest to the non-resident person, and this deemed payment would be subject to Canadian withholding tax at the domestic rate of 25 per cent, subject to reduction under an applicable treaty. A second consequence of the back-to-back rules applying is that a portion of the Canadian debt would be deemed to be owing to the non-resident person for purposes of the thin capitalization rules under the Act. By deeming a portion of the Canadian debt to be owing to the non-resident person, this debt would be included for purposes of determining whether the thin capitalization limit has been exceeded, and if it is, a portion of the interest paid or payable on the related party debt will not be deductible by the Canadian borrower in computing its income for Canadian tax purposes. Effective January 2017, the back-to-back rules were expanded by (i) extending their application to structures involving multiple intermediaries; (ii) extending their application to rents, royalties and similar payments (ie, where there is no loan to a Canadian entity); and (iii) adding ‘character substitution’ rules, whereby the back-to-back arrangement to the intermediary involves shares or a lease, licence or similar arrangement rather than a loan. They also now capture circumstances in which a Canadian corporation attempts to circumvent the shareholder loan rules in the Act by lending funds to an arm's length person on condition that the person makes a loan to a shareholder of the corporation (or a connected person or partnership). Where they apply, the Canadian corporation will be deemed to have made a loan directly to the shareholder (or connected person or partnership) and the tax consequences associated with such a loan will follow. Canadian branch or subsidiary In general, from a Canadian income tax perspective, there is little difference between carrying on business through a Canadian branch of a non-resident entity and carrying on business through a wholly owned Canadian subsidiary. However, most branch assets are generally ‘taxable Canadian property’, whereas shares of a Canadian subsidiary may not be. Consequently, the sale of a subsidiary is much less likely to be subject to the section 116 certificate requirements discussed below than the sale of a branch. A non-resident branch performing services in Canada is also subject to the ‘back-up’ withholding requirements under Regulation 105 discussed above. A Canadian incorporated subsidiary of a non-resident corporation is a Canadian resident for Canadian income tax purposes and is therefore subject to tax in Canada on its worldwide income. Certain types of payments (including dividends, rent and royalties) made by a subsidiary to its non-resident parent are subject to withholding tax, as discussed above. Similarly, Canadian tax will apply to the profits attributable to an unincorporated branch of a non-resident carrying on business in Canada. The allocation of items of income and expense between head office and the Canadian branch may be unclear and can result in ambiguity in the computation of branch income for purposes of the Act. In addition, Part XIV of the Act imposes a branch profits tax on the profits of the Canadian branch not reinvested in Canada. The branch profits tax is intended to parallel the dividend withholding tax.75 Hybrid entities Nova Scotia, Alberta and British Columbia corporate law permits the establishment of unlimited liability companies or ‘ULCs’. These entities are treated as Canadian resident corporations for Canadian income tax purposes, but in the United States are eligible to be treated as flow-through entities for US tax purposes. This dual or ‘hybrid’ tax characterization can be a useful planning feature. For example, while an unlimited liability company is treated as a taxable Canadian corporation for Canadian income tax purposes, there may be potential US tax advantages arising from the use of a ULC in light of its pass-through treatment, which may facilitate access to foreign tax credits in respect of Canadian tax payable by the ULC, as well as the ability to apply Canadian-source operating losses against taxable income earned by the US parent corporation from other sources. However, the Canada–US tax treaty contains ‘anti-hybrid’ provisions that could result in adverse consequences where ULCs are used in the cross-border context. In particular, Article IV(7) of the treaty provides as follows: 7 An amount of income, profit or gain shall be considered not to be paid to or derived by a person who is a resident of a Contracting State where: (a) the person is considered under the taxation law of the other Contracting State to have derived the amount through an entity that is not a resident of the first-mentioned State, but by reason of the entity not being treated as fiscally transparent under the laws of that State, the treatment of the amount under the taxation law of that State is not the same as its treatment would be if that amount had been derived directly by that person; or (b) the person is considered under the taxation law of the Contracting State to have received the amount from an entity that is a resident of that other State, but by reason of the entity being treated as fiscally transparent under the laws of the first-mentioned State, the treatment of the amount under the taxation law of that State is not the same as its treatment would be if that entity were not treated as fiscally transparent under the laws of that State. As a result of this provision, an amount of income is deemed not to be paid to or derived by a person who is a resident of a contracting state, thereby denying relief under the treaty, in two circumstances. The first is where a hybrid entity is treated as fiscally transparent under the laws of the contracting state of which the amount of income is derived, but not as a fiscally transparent entity under the laws of the state in which the person deriving such amount is resident. If the fact that the entity is not treated as fiscally transparent under the laws of the residence state causes the treatment of the amount to the recipient under the tax law of the residence state to be different than would have been the case had the amount been derived directly, paragraph 7(a) of Article IV will apply, and benefits under the treaty will be denied. The second circumstance in which benefits will be denied under this provision is where the hybrid entity is fiscally transparent under the laws of the state of residence of the person deriving the amount of income but is not fiscally transparent under the laws of the contracting state from which the amount is derived. If the fact of the entity being treated as fiscally transparent under the laws of the residence state results in the tax treatment of the amount under the laws of that state being different than would be the case if the entity were not treated as fiscally transparent under the laws of that state, the amount of income is not considered to be paid to or derived by a person who is a resident of a contracting state, and paragraph 7(b) of Article IV will result in the denial of benefits under the treaty. A common circumstance in which the anti-hybrid rules may apply involves a ULC owned by a US corporation that has not elected to have it treated as a corporation for US tax purposes. In this case, a dividend paid by the ULC to its US shareholder would be denied treaty benefits by virtue of Article IV(7)(b) of the treaty, because under US tax law the fiscally transparent nature of the ULC will result in a dividend being disregarded for US tax purposes, a result that would not apply if the ULC had elected to be taxed as a corporation. Accordingly, as the ULC is resident in Canada and as the treatment of the amount for purposes of US tax law is not the same as would have been the case if the ULC were not treated as fiscally transparent, the dividend will be considered not to have been paid to or derived by a resident of the United States. Accordingly, the domestic withholding tax rate of 25 per cent would be applicable, instead of the 5 per cent rate otherwise available under Article X(2) of the treaty. To avoid this result, instead of the declaration and payment of dividends, retained earnings of the ULC can be capitalized by increasing the stated capital in respect of the common shares of the ULC, which will trigger a deemed dividend for Canadian tax purposes, together with a corresponding increase in the adjusted cost base of the shares owned by the US shareholder.76 As this step triggers a deemed dividend for Canadian tax purposes, withholding tax will apply; however, since the US tax treatment of an increase in paid-up capital of this nature will be the same regardless of whether the ULC is fiscally transparent or not, Article IV(7)(b) will not apply, and the withholding tax rate reduction under the treaty will be available. The ULC would then subsequently reduce its paid-up capital, and distribute funds to the US shareholder. As long as the amount distributed is not greater than the amount of the paid-up capital reduction, this should not be a taxable event for Canadian tax purposes, thereby eliminating the need to rely upon the treaty. The CRA has ruled favourably on this ‘two-step’ approach.77 United States limited liability companies and foreign entity classification While a US LLC is either disregarded if it is owned by a single member or treated as a partnership if it is owned by several members for US income tax purposes, the CRA considers an LLC to be a corporation that is not liable to US tax unless it elects to be taxed in the United States as a corporation.78 However, the Canada–US tax treaty generally treats US LLCs as look-through entities for the purposes of applying the provisions of the treaty. Article IV(6) provides that an amount of income, profit or gain shall be considered to be derived by a taxpayer who is a resident of a contracting state where the person is considered under the taxation law of that state to have derived the amount through an entity (other than an entity that is a resident of the other contracting state), and by reason of the entity being treated as fiscally transparent under the laws of the first-mentioned state, the treatment of the amount under the taxation law of that state is the same as its treatment would be if that amount had been derived directly by that person. Accordingly, the extent to which the benefits of the treaty are available in circumstances where an amount of income, profit or gain is derived by a taxpayer who is a resident of the United States through an entity that is not resident in Canada will, if that entity is fiscally transparent for US tax purposes, depend upon the extent to which the treatment of the amount under US tax law is the same as that treatment would have been had the amount been derived directly by the taxpayer. The entity need not be resident in the United States for this purpose; provided it is not resident in Canada, the look-through treatment provided by the treaty may apply, even if it is resident in a third country. Article IV(6) does not extend the benefits of the treaty directly to the entity (such as to the LLC itself), but rather extends such benefits to any US resident member of the LLC that has derived the amount through the entity. However, it provides relief only for members (or ultimate members) who are resident in the United States and qualify for treaty benefits. Where there are non-US resident members of the LLC, the LLC will only be entitled to claim treaty benefits in respect of its members that are US residents. If, for example, a resident of the United Kingdom invests as a member of the LLC, the LLC will be denied treaty benefits from a Canadian perspective in respect of the proportionate interest owned by the UK resident, and may only claim benefits under the US treaty on a look-through basis pursuant to Article IV(6) to the extent of the interests held by residents of the United States. The CRA’s approach to characterization of an LLC as a corporation for Canadian tax purposes is consistent with the manner in which it generally applies a ‘two-step approach’ in characterizing foreign entities in applying the Act. Because the Act does not contain entity characterization rules or the equivalent of a ‘check-the-box’ regime, the CRA applies a test that (i) determines the characteristics of the foreign entity by reference to any relevant law and the terms of the constating documents in the foreign jurisdiction, and (ii) compares these characteristics to those of entities that exist under Canadian law, in order to classify the entity within the category recognized under Canadian tax principles that it most closely resembles. This approach can give rise to difficulties in the characterization of hybrid entities, in particular, which have legal characteristics that in many cases defy easy classification. For example, the CRA has recently concluded that limited liability partnerships (LLPs) and limited liability limited partnerships (LLLPs) formed under Florida and Delaware law should be treated as corporations for purposes of the Act.79 CRA placed considerable weight in reaching its conclusion on the fact that these types of partnerships have a separate legal personality under state law and that all members of such partnerships are entitled to limited liability protection.80 Capitalization of a Canadian corporation A Canadian corporation may be capitalized with equity or with a combination of debt and equity. The paid-up capital (‘PUC’) of a Canadian private corporation can generally be returned to shareholders free from Canadian tax, including Canadian withholding tax applicable to non-resident shareholders. This is the case even if there are earnings and profits at the corporate level. A distribution to a shareholder in excess of such share capital is deemed to be a dividend for purposes of the Act.81 Deemed dividends to non-resident shareholders are subject to withholding tax in the same manner and at the same rate (including any applicable reduced treaty rate) as regular dividends.82 Repayment of principal loaned to a Canadian corporation by a non-resident shareholder is not subject to withholding tax but, where applicable, tax must be withheld in respect of interest paid or credited on the loan.83 Subject to the thin capitalization rules and the general limitations on interest expense and losses described above, a Canadian subsidiary may deduct interest paid or credited by it to a non-resident in computing its income.84 Thin capitalization and interest imputation The thin capitalization rules are intended to prevent a Canadian resident corporation or trust, as well as a non-resident corporation or trust that carries on business in Canada or earns rental income that is subject to tax on a net basis, or a partnership of which such a corporation or trust is a partner, from excessively reducing its taxable Canadian profits, and thereby its liability for Canadian tax, by maximizing its interest expense to related non-resident creditors. In very general terms, the Canadian business is denied an interest deduction to the extent that its ‘relevant debt’ exceeds 1.5 times its ‘relevant equity’. The relevant equity of a corporation will consist of the aggregate of the corporation's retained earnings at the beginning of the taxation year, the average of the corporation's contributed surplus balance at the beginning of each calendar month (to the extent that the amount was contributed by a specified non-resident shareholder of the corporation), and the monthly average of the corporation's paid-up capital (excluding paid-up capital in respect of shares owned by a person other than a specified non-resident shareholder of the corporation).85 The relevant debt is the total of all amounts outstanding on account of a debt or other obligation to pay an amount to a specified non-resident shareholder or a non-resident person who was not dealing at arm's length with a specified shareholder, on which interest is or would, but for the application of the thin capitalization rules, be deductible.86 A specified non-resident shareholder is a person who, either alone or together with whom that person is not dealing at arm's length, owns shares of the corporation representing 25 per cent or more of the voting power of the corporation or 25 per cent or more of the fair market value of all of the shares of the corporation.87 The thin capitalization rules also include provisions that address attempts to circumvent the application of the provisions by utilizing back-to-back loans in order to indirectly provide debt financing to a corporation or trust in circumstances where the debt would otherwise be included in the calculation of the outstanding debts to specified non-residents of the corporation or trust if the loan had been made directly.88 Where a deduction for interest expense incurred by a corporation is denied pursuant to the thin capitalization rules, the amount is not subject to carry forward and is permanently disallowed from deduction in computing income. Moreover, where the thin capitalization rules apply, an amount paid or credited as interest by a corporation resident in Canada is deemed to have been paid by the corporation as a dividend to a non-resident person, and not as interest, to the extent that an amount in respect of the interest is denied deductibility. Accordingly, the application of the withholding tax rules in Part XIII of the Act to the interest payment will be determined as though the payment in question is a dividend.89 For purposes of the thin capitalization rules, each partner of a partnership is deemed to owe its proportionate share of each debt of a partnership to the creditor in applying the thin capitalization rules to the partners. A partnership debt is attributed to the partners of the partnership on the basis of their ‘specified proportion’, which refers to the members' share of the total income or loss of the partnership for its last fiscal period ending at or before the end of the corporation's current taxation year and at a time when the corporation was a member of the partnership.90 Each corporation or trust that is a member of a partnership is required to include in its income its share of the partnership's deductible interest payments, to the extent that the thin capitalization rules would have precluded the deduction of such interest if it had been incurred directly by the corporation or trust.91 View largeDownload slide View largeDownload slide The application of the thin capitalization provisions in the context of partnerships may give rise to anomalous consequences, as illustrated by the following examples: Conversely, where a Canadian resident corporation has made a loan to a non-resident and it is outstanding for one year or more, and the loan does not bear a reasonable rate of interest, interest income calculated at a prescribed rate on the principal amount outstanding is imputed to the Canadian lender for purposes of the Act.92 Moreover, if the loan is made to a shareholder of the corporation or a person with which such shareholder does not deal at arm's length (other than a foreign affiliate of the corporation), the principal amount of the loan may be deemed to be a dividend for Canadian withholding tax purposes.93 Disposition of shares or interests The disposition (or deemed disposition on death) of property by a non-resident of Canada, other than property used or held by a taxpayer in a business carried on in Canada, is generally not subject to Canadian tax unless it constitutes ‘taxable Canadian property’.94 ‘Taxable Canadian property’ is defined to include property which is considered to have a close nexus to Canada for tax purposes, including real or immovable property situated in Canada, and property used or held by a taxpayer in, and inventory of, a business carried on in Canada. A share of a private corporation (other than a mutual fund corporation), an interest in a partnership and an interest in a trust (other than a unit of a mutual fund trust or an income interest in a trust resident in Canada) are considered to be taxable Canadian property only if, at any particular time during the 60-month period that ends at that time, more than 50 per cent of the fair market value of the share or interest was derived directly or indirectly95 from one or any combination of, (i) real or immovable property situated in Canada, (ii) Canadian resource properties, (iii) timber resource properties and (iv) options in respect of or interests in any such property, whether or not the property exists (the ‘value requirement’). Also included in the definition of taxable Canadian property are shares of publicly listed corporations and mutual fund corporations and units of a mutual fund trust if, at any particular time during the 60-month period that ends at that time, the value requirement is satisfied, and 25 percent or more of the issued shares or units were owned by or belonged to one or any combination of (i) the taxpayer, (ii) persons with whom the taxpayer did not deal at arm's length, and (iii) partnerships in which they hold a membership interest, directly or indirectly through one or more partnerships (the ‘ownership requirement’).96 While the domestic rules thus impose capital gains tax on non-residents disposing of shares or interests in Canadian resident or non-resident private corporations that derive their value directly or indirectly from real property situated in Canada, and apply this test over a five-year look-back period, the imposition of domestic tax on a disposition of ‘taxable Canadian property’ is subject to an exemption available pursuant to the provisions of an applicable tax treaty. Most Canadian tax treaties permit Canada to tax gains realized by non-residents arising from the alienation of interests in real property or from the disposition of shares or partnership interests that derive their value from Canadian real or resource property. However, they generally apply this test only at the time of disposition97 (or limit the relevant look-back period98). Moreover, in many Canadian tax treaties, including those with Germany, the Netherlands, Switzerland and the United States, if the capital gain arises from the alienation of shares, Canada as the source state only retains the right to tax the gain where the corporation the shares of which are disposed of is resident in Canada.99 Furthermore, approximately half of Canada's tax treaties exclude shares that derive their value from Canadian real property where the property owned by the corporation is property, other than a rental property, in which the business of the corporation is carried on. This aspect of the capital gains exemption for property ‘in which the business of the company was carried on’ (often referred to the ‘business property exemption’) has in practice been broadly relied upon for ‘exit planning’ by non-residents investing in shares of Canadian corporations owning Canadian real property or resource property.100 The CRA has confirmed in a number of tax rulings that the business property exemption can apply broadly in a range of circumstances, including to shares where the value is derived from farmland used in a farming business101, to shares where the value is derived from processing plants, buildings, machinery and equipment used in a mining and processing business102, to shares where the value is derived from mineral and timber rights actively exploited by the company103, and to shares where the value is derived actively in exploited oil and gas interests.104 The Canadian Department of Finance has indicated that its current policy is for new tax treaties to contain capital gains articles that parallel or mirror Canadian domestic law with respect to the definition of taxable Canadian property; as a result, treaty relief for share dispositions by non-residents may be expected over time to generally become more closely harmonized with the Canadian taxation and gains as determined under the domestic taxable Canadian property rules in the Act described above. Section 116 notification and clearance certificate requirements In order to ensure the collection of tax owing by non-residents of Canada, section 116 of the Act imposes notification and withholding requirements in circumstances where a non-resident disposes of taxable Canadian property, other than ‘excluded property’ which, as described below, includes property the gain or sale of which would not be subject to Canadian tax by virtue of an applicable treaty exemption. Where a non-resident vendor intends to dispose of property that is taxable Canadian property and is not excluded property, the vendor may submit a notice to the CRA of the proposed disposition in advance of the sale, along with supporting documentation. If the vendor also pays an amount equal to 25 per cent of the estimated capital gain to be realized upon the disposition, or security in lieu of the tax payable, the CRA will generally issue a compliance certificate under section 116 (referred to as a ‘section 116 certificate’).105 If advance notice of the disposition is not provided by the vendor, or if the terms of the actual sale ultimately differ from the notification of the proposed disposition provided to the CRA, the vendor is obligated to notify the CRA of the actual disposition, along with supporting documentation, not later than 10 days after the date of closing of the sale. Upon receipt of the notice, as well as payment of 25 per cent of the amount of the capital gain realized upon the disposition, or security in lieu thereof, the CRA will issue a section 116 certificate to the vendor. The Act imposes withholding and remittance requirements on a purchaser that acquires property that is taxable Canadian property and is not excluded property from a non-resident of Canada unless the vendor provides the purchaser with a section 116 certificate.106 The withholding requirement imposed upon the purchaser is equal to 25 per cent of the cost amount to the purchaser of the acquired property.107 The purchaser is entitled to withhold this amount from the consideration paid or credited to the non-resident vendor and must remit it to the CRA within 30 days after the end of the month in which the transaction closes.108 The obligation imposed on the purchaser to withhold and remit under section 116 does not apply if the disposition is exempt from Canadian tax pursuant to the provisions of a tax treaty, where109: (i) the purchaser concludes after reasonable inquiry110 that the non-resident vendor is, under a tax treaty that Canada has entered into with another country, resident in that country; (ii) the property would be ‘treaty-protected property’ of the non-resident vendor if the non-resident vendor was, under the tax treaty, resident in the particular country, such that any income or gain on the disposition would be exempt from Canadian taxation pursuant to the provisions of the treaty,111 and (iii) the purchaser provides notice to the CRA within 30 days of the closing of the acquisition that the transaction was exempt from tax pursuant to the treaty.112 ‘Excluded property’ is not subject to the notification, withholding and remittance requirements described above.113 Excluded property includes property that is treaty-protected property provided that if the non-resident vendor and the purchaser are related, the purchaser must provide notice of the disposition to the CRA within 30 days of the acquisition.114 If the non-resident vendor and the purchaser are not related and the property is treaty-protected property, no notification or withholding will therefore be required under section 116 of the Act. However, if the property does not in fact qualify as treaty-protected property, such as in a case where the shares derive more than 50 per cent of their value from real property situated in Canada, such that gain from the disposition would not qualify for exemption under the terms of the particular treaty, the Act does not provide for the availability of a due diligence defence to either the vendor or the purchaser and the notification and withholding obligations (and purchaser liability provisions) described above will apply in respect of the disposition. Ontario non-resident speculation tax On 20 April 2017 the Ontario government announced a set of measures, dubbed the Fair Housing Plan, intended to ‘help more people find an affordable place to call home, while bringing stability to the real estate market and protecting the investment of homeowners’. The plan includes a proposed 15 per cent tax on foreign real estate purchasers and an expansion of the current rent control rules. The 15 per cent tax applies, effective 21 April 2017, to the value of the consideration for the transfer (including a beneficial transfer) of a residential property in the ‘Greater Golden Horseshoe’, including Toronto, if any of the transferees is a ‘foreign entity’ or ‘taxable trustee’.115 A foreign entity is a ‘foreign national’ or a ‘foreign corporation’. A foreign national is an individual who is not a Canadian citizen or permanent resident. A foreign corporation includes not only corporations incorporated outside Canada but also certain Canadian corporations. More particularly, a foreign corporation includes a Canadian incorporated corporation the shares of which are not listed on a Canadian stock exchange and that is controlled ‘in whole or in part’ by a foreign national or other foreign corporation. There is no guidance on what it means for a corporation to be controlled in part by a person. A foreign corporation also includes a Canadian incorporated corporation that is ‘controlled’ by a foreign entity within the meaning of section 256 of the Act, which extends control beyond the strict de jure test of more than 50 per cent of the votes.116 A taxable trustee is a Canadian citizen, permanent resident or corporation holding title in trust for foreign entity beneficiaries or a foreign entity holding title in trust for anyone.117 The tax does not apply to a purchase made as trustee for a mutual fund trust, a real estate investment trust or a specified investment flow-through trust. It is unclear whether this exemption is intended to apply to foreign REITs. There are also narrowly cast exemptions for personal use by foreign nationals who receive confirmation under the Ontario Immigrant Nominee Program, for refugees and for foreign nationals who acquire property jointly with a spouse who is a Canadian citizen, permanent resident or other qualifying person. Rebates may also be available for foreign nationals who become Canadian citizens or permanent residents within four years of the acquisition, who are full-time Ontario students for two years following the acquisition or who legally work full-time in Ontario for one full year following the acquisition. Non-resident beneficiaries of Canadian resident trusts Where a Canadian resident trust is used for business or investment purposes by non-residents of Canada, a number of issues under the Act must be considered118, including the following: (i) whether Canadian withholding tax applies in respect of a distribution from the trust to the non-resident beneficiary or on the disposition of an income or capital interest in the trust, (ii) whether income payable to the non-resident beneficiary is deductible by the trust in computing the trust's income for purposes of the Act, (iii) whether the trust is subject to tax under the Act on Canadian-source income earned by it that is paid or made payable to its beneficiaries, and (iv) whether distributions of appreciated property are subject to tax at the trust level. Part XIII withholding tax In order for withholding tax to apply to a payment by a trust to a non-resident beneficiary, the payment must be for an amount that is ‘income of or from a trust’.119 An amount paid or credited by a trust to a non-resident beneficiary is deemed to be income of the trust for withholding tax purposes, regardless of the source from which the income was derived by the trust (eg, capital gains, dividends or interest).120 Conversely, an amount that is deemed to be income of a trust will not be subject to withholding tax if it is not included in computing the income of the non-resident beneficiary. Therefore, a distribution of trust capital is not subject to withholding tax. Distributed taxable capital gains are generally subject to withholding tax to the extent that they are included in computing the beneficiary's income. The non-taxable half of the capital gain may be distributed to the non-resident beneficiary on a tax-free basis, notwithstanding that the entire amount of the distribution is recharacterized as income of the trust.121 Where a trust has elected for any taxable capital gain realized by the trust on the distribution of property to the beneficiaries to be taxed at the trust level122, this gain is not included in the income of the beneficiaries under subsection 104(13) and is therefore not subject to Part XIII withholding tax.123 The amount payable to the non-resident beneficiary that would be required to be included in computing the income of the non-resident beneficiary is deemed to be an amount paid or credited to the beneficiary as income of or from the trust on the earlier of (i) the day on which the amount was paid or credited, and (ii) the day that is 90 days after the end of the taxation year.124 The CRA has stated that where trustees pass a resolution entitling a non-resident beneficiary to the trust's income for the year, but do not pay the amount until the following year, withholding tax need not be remitted until after the amount is paid notwithstanding that the amount was deducted in computing the income of the trust for the year in which the amount became payable.125 Where an amount distributed by a Canadian resident trust to a non-resident beneficiary is subject to Canadian taxation, the tax may be reduced or eliminated pursuant to an applicable income tax treaty, which will generally recharacterize it as income of or from a trust for purposes of the imposition of Canadian withholding tax and the applicable tax treaty. Thus, for example, where a Canadian trust distributes an amount in respect of interest, dividends or capital gains that would in other circumstances be eligible for reduced Canadian tax pursuant to the specific treaty provisions dealing with these items, such provisions will not be applicable to the distribution, which will fall within the scope of the “other income” article (or the article dealing specifically with income from a trust or estate, where applicable) contained in the treaty.126 Part XII.2 tax Where a Canadian resident trust has at least one non-resident beneficiary, the Act imposes a tax (referred to as Part XII.2 tax) at the rate of 40 per cent on any ‘designated income’ of the trust, which is income from a business carried on in Canada, income from real property situated in Canada, and capital gains arising from the disposition of taxable Canadian property.127 Part XII.2 applies to a trust in a year where some or all of its income becomes payable in the year to beneficiaries under the trust. The tax is intended to ensure that Canada retains the right to tax business income, income from real property, and income from the disposition of taxable Canadian property at the general tax rate applicable to Canadian resident taxpayers under Part I of the Act, and not simply at the lower withholding tax rate, as potentially further reduced under the provisions of an applicable income tax treaty. The Part XII.2 tax will not apply where the trust retains its income so that it is taxed at the trust, rather than at the beneficiary, level. A distribution of capital is not subject to tax under these provisions. Tax paid by a trust under Part XII.2 is deducted in computing the income of the trust for purposes of Part I of the Act.128 Part XII.2 tax does not apply to a graduated rate estate.129 Distributions to non-resident beneficiaries Where a distribution of trust property by a personal trust is made to a non-resident beneficiary, the trust is deemed to have disposed of the property (subject to the limited exceptions described below) for proceeds of disposition equal to fair market value and the rollover that is generally applicable to capital distributions made to Canadian resident beneficiaries does not apply. Accordingly, distributions made to non-resident beneficiaries generally result in a taxable disposition of the distributed property by the trust.130 In particular, where property is distributed by a Canadian resident trust to a non-resident beneficiary in satisfaction of all or part of the beneficiary's capital interest in the trust, the deemed disposition rules in subsection 107(2.1) will apply.131 The trust will be deemed to have disposed of the property for proceeds of disposition equal to its fair market value and the beneficiary will be deemed to have acquired the property at a cost equal to its fair market value. A non-resident beneficiary that receives a distribution in these circumstances will not generally realize a gain on the disposition of the capital interest in the trust, although the beneficiary may realize a capital loss if the beneficiary's adjusted cost base of the trust interest exceeds the deemed proceeds of disposition.132 This provision does not apply to distributions of the following types of property made by a personal trust to a non-resident beneficiary, which may occur on a rollover basis: (i) real or immovable property situated in Canada and Canadian resource property; (ii) capital property used in or property described in the inventory of a business carried on by the trust through a permanent establishment in Canada; and (iii) an excluded right or interest of the trust.133 Elie S. Roth is a partner in the taxation and trust law practice groups at Davies Ward Phillips & Vineberg LLP in Toronto. Elie's practice concentrates on all aspects of domestic and international tax planning. He also represents taxpayers in tax audit and litigation matters. As an adjunct professor of law at Osgoode Hall Law School, Elie teaches international tax law and taxation of real estate transactions. Footnotes 1. RSC 1985, c C 44. 2. RSO 1990, c B 16. 3. Shareholders are the owners of a corporation, but they usually do not manage its business or enter into transactions on its behalf. By statute, they are protected from liability for obligations of the corporation. Generally, the authority to manage the corporation rests with the directors, who are elected by the shareholders. However, if the shareholders prefer to retain direct control of the corporation, they can enter into a unanimous shareholder agreement. Such an agreement can effectively transfer responsibility (and liability) for the management of the corporation from the directors to the shareholders. 4. Although it must use a French form of its name in Québec. 5. Except in Québec, where the three largest voting shareholders must be disclosed. In Québec, if all of the powers of the directors have been withdrawn pursuant to a unanimous shareholders' agreement, the names and domiciles of the shareholders or third persons having assumed such powers must be declared on the annual corporate return. 6. The CBCA and OBCA both require, however, that a public corporation have at least three directors, and that a certain number of such directors be independent. British Columbia, Prince Edward Island, New Brunswick, Nova Scotia and the territories do not have residency requirements for directors in their corporate statutes. 7. The corporate statutes of most other provinces in Canada are generally similar to the CBCA and the OBCA. However, there are differences in detail that may provide additional flexibility to certain investors. For example, British Columbia permits a corporation to hold its own shares, whether directly or through a subsidiary (which is restricted under both the CBCA and the OBCA). 8. The corporation cannot register if the name of the foreign corporation is the same as or similar to one already in use in that province. Business names used by a branch should also be registered and should not be the same as or similar to names used in the province. A foreign corporation which establishes a branch in Ontario must obtain a licence under the Extra-Provincial Corporations Act, RSO 1990, c E 27 (or, in the case of an LLC, register its name under the Business Names Act, RSO 1990, c B 17). 9. For example, while combined federal and provincial rates for investment income of a Canadian-controlled private corporation range from 49.7 per cent to 54.7 per cent, depending on an individual's province of residence, there is a 3.4 per cent deferral advantage in respect of investment income retained and reinvested in a corporation in Ontario (or 1.7 per cent for capital gains). 10. A CCPC is defined in para 125(7)(a) of the Act to mean a private Canadian corporation that is not controlled, directly or indirectly, by non-residents, public corporations, or by any combination thereof. It is a negative control test, as it only requires that the corporation not be controlled by non-residents of Canada and public corporations. 11. For example, in 2017 the tax rate in respect of eligible dividends in Ontario is 39.34 per cent, and the rate imposed on non-eligible dividends is 45.30 per cent. 12. Form T2054. 13. This includes a refundable surtax of 10.67 per cent. 14. Intercorporate dividends paid between ‘connected’ corporations (see n 17 below) are generally deductible to the recipient corporation under subsection 112(1) of the Act, subject to the imposition of refundable tax under Part IV. 15. See para 129(1)(a) and sub-s 129(3). 16. A corporation is connected for this purpose if the shareholder corporation controls the payer, or if the shareholder owns more than 10 per cent of the issued share capital of the payer having full voting rights under all circumstances and shares of the capital stock of the payer corporation having a fair market value of more than 10 per cent of the fair market value of all of the issued shares of the capital stock of the payer corporation. 17. See sub-ss 186(1) and (4). 18. For this purpose, an active business carried on by the corporation means any business carried on other than a specified investment business or a personal services business. A ‘specified investment business’ is defined in sub-s 125(7) to mean a business (other than a business of leasing property excluding real property) the principal purpose of which is to derive income from property. However, if the corporation employs more than five full-time employees in the business throughout the year, the business will not be a specified investment business, but rather an active business that may qualify for the small business deduction. A ‘personal services business’, also defined in sub-s 125(7), means a business of providing services where an ‘incorporated employee’ is a specified shareholder of the corporation and that employee would reasonably be regarded as an officer or employee of the entity to whom the services are provided if it were not for the existence of the corporation. A specified shareholder is generally a taxpayer who owns not less than 10 per cent of the issued shares of the corporation or of any other related corporation, at any time in the year (see sub-s 248(1)). A business is not a personal services business if it employs throughout the year more than five full-time employees or its services are performed for an associated corporation. This exclusion is intended to except an ‘incorporated employee’ from qualifying for the reduced rate where the individual employee would otherwise have earned the income directly. 19. Sub-s 110.6(2.1). 20. The CRA generally interprets this condition to mean 90% or more: CRA document number 2013-050661E5, dated 29 April 2014. 21. The CRA generally interprets this to mean 50 per cent or more. 22. Sub-s 110.6(1), ‘qualified small business corporation share’, and sub-s 110.6(14). 23. See sub-s 44.1(2) of the Act. It should be noted that an eligible small business corporation does not include a professional corporation, a specified financial institution, a corporation whose principal business is the leasing, rental, development or sale of real property owned by it, or a corporation more than 50 per cent of the fair market value of the assets of which is attributable to real property. 24. Sub-ss 70(5)–(5.2). 25. See para 69(1)(b). 26. See sub-s 70(6). 27. See, for example, s 9 of the Limited Partnerships Act, RSO 1990, c L16. Ontario and Québec also permit professionals to practise through a special type of general partnership known as a limited liability partnership (LLP), which provides individual partners with a degree of protection against unlimited liability for the negligent acts of other partners. 28. RSO 1990, c P 5. 29. RSO 1990, c L 16. 30. Sub-s 14(2) of the LPA. 31. As noted above, if the partnership uses a firm name or business name other than the name of the partners, that name must be registered under the BNA, but the failure to do so would not affect the existence of the partnership. 32. This reflects the common law principle that an undisclosed principal will be liable in the same manner as a disclosed principal for obligations incurred by its agent. 33. Ss 10 and 13 of the LPA. 34. See, for example, sub-s 2(3) of the LPA. 35. The declaration must be renewed every five years, and when the partnership wishes to cease operations a declaration of dissolution must be filed. The names and capital contributions of the limited partners do not have to be disclosed on the public record, although this information must be disclosed on request by the Registrar appointed under the BNA. 36. Income Tax Folio S4-F16-C1, ‘What is a Partnership?’. s 96 of the Act provides that the income of a member of a partnership is computed as if the partnership were a person resident in Canada. 37. See Continental Bank Leasing Corp. v Canada, [1998] 2 SCR 298; Bachman v Canada [2001] 1 SCR 367, and Spire Freezers Ltd v Canada, [2001] 1 SCR 391. 38. Sub-s 96(1). 39. Para 53(1)(e). 40. Para 53(2)(c). 41. Sub-s 40(3.1) and (3.11). 42. Sub-s 96(2.1) and para 111(1)(e). 43. Sub-s 96(2.2). 44. The ability to wind-up on a tax-deferred basis pursuant to either sub-s 98(3) or 98(5) or to transfer property to a partnership on a rollover basis under sub-s 97(2) require the partnership to be a ‘Canadian partnership’ within the meaning of sub-s 102(1) of the Act. 45. A joint venture will generally be considered to exist where there is (i) a joint property interest in the subject matter of the venture, (ii) a right of mutual control and management of the enterprise, and (iii) a limitation of the objective of the business to a single undertaking or a limited number of undertakings: Woodlin Developments Ltd. v MNR, [1986] 1 CTC 2188 (TCC). 46. RSO 1990, c T23. For further discussion, see Elie Roth, ‘Welcome Stranger: A Global Perspective on the Taxation of Trusts: Canadian Income Taxation of Trusts and Beneficiaries’, Trust & Trustees (2017) 23(1) 88–108. See also Elie S Roth, Tim Youdan, Chris Anderson, and Kim Brown, Canadian Taxation of Trusts (Canadian Tax Foundation 2016). 47. Trust Beneficiaries' Liability Act, 2004, SO 2004, c 29. 48. Sub-s 104(1). 49. Under sub-s 104(1), a ‘trust’ is generally deemed not to include ‘an arrangement under which the trust can reasonably be considered to act as agent for all the beneficiaries under the trust with respect to all dealings with all of the trust's property’. 50. In accordance with the rules in Division B of Part I of the Act. 51. Sub-s 104(2). 52. Sub-s 122(1). 53. Qualified disability trusts are also excepted from the general rule and are taxed at marginal rates. 54. Sub-s 122(1.1). Sub-s 104(2) of the Act prevents the creation of multiple testamentary trusts with the same beneficiaries established in order take advantage of low marginal rates. Prior to 2016, testamentary trusts computed their tax payable based on the marginal rates applicable to individuals. As there was no limit to the number of testamentary trusts that could be created under a will, it was possible, subject to this provision, to ‘multiply’ the benefits of the marginal tax rates by creating multiple testamentary trusts. 55. Para 104(6)(b). 56. Sub-s 104(13). 57. Sub-s 104(6) generally permits a trust to deduct, in computing its income for a taxation year, an amount not exceeding the portion of its income otherwise determined for the year that became payable in the year to a beneficiary under the trust. Sub-s 104(13) operates to include the amount paid or payable to a beneficiary from the income of the trust in a beneficiary's income. In effect, sub-s 104(6) operates to fully integrate income earned by the trust with that of its beneficiaries. 58. Sub-s 108(5) of the Act. 59. Sub-ss 104(19)–104(22.4). Sub-ss 104(27) through 104(28) provide similar rules that deem distributions from graduated rate estates to retain their character as pension income, deferred profit sharing plan income and death benefits to beneficiaries. 60. Depreciable property is dealt with by sub-s 104(5) and resource property by sub-s 104(5.2). 61. Paras 104(4)(b) and (c). 62. Within the broad meaning of s 253. 63. Sub-s 212(1). 64. Sub-s 214(1). 65. Sub-s 215(1). If the payor fails to withhold the tax, it will become liable to pay the withholding tax on the non-resident's behalf, together with interest and penalties: sub-ss 227(8) and (8.1). The payor will be entitled to deduct or withhold such tax from any amount paid or credited to the non-resident, or to otherwise recover from the non-resident the amount of tax paid on such person's behalf: sub-s 215(6). The non-resident is jointly and severally liable for the withholding tax, as well as any interest and penalties thereon: sub-s 227(8.3). 66. Sub-s 215(6). 67. Sub-ss 102(1) and 212(13.1). 68. Para 212(1)(b). 69. art XI(1). 70. Sub-s 212(13.2). 71. Reg 105. 72. Sub-ss 212(3.1), (3.2) and (3.3). 73. For these purposes, the term ‘specified right’ is defined in sub-s 18(5) to mean a right to mortgage, assign, pledge or encumber the property to secure payment of an obligation (other than the particular debt owing to the intermediary), or to use, invest, sell or otherwise dispose of, or in any way alienate, the property unless it is established by the taxpayer that all of the proceeds (net of costs, if any) received, or that would be received, from exercising the right must first be applied to reduce the particular debt. 74. The rules also provide for a safe harbour exception where either of the amount outstanding under the intermediary debt, or the fair market value of the collateral property, depending on which of the two circumstances above is being evaluated, is less than 25 per cent of the total of all amounts owing by the Canadian borrower or by persons not dealing at arm's length with a Canadian borrower (ie, the other borrowers) (collectively, the ‘connected debt’) to the intermediary under the agreement under which the Canadian debt was entered into (or under a connected agreement), provided that (i) the intermediary is granted a security interest in the intermediary debt or the collateral property, as the case may be, and the security interest secures the payment of two or more debts or other obligations that include the Canadian debt and the connected debt, and (ii) each security interest that secures the payment of a debt or other obligation secures the payment of every such debt or other obligation. This is intended to provide possible relief where an intermediary enters into multiple cross-collateralized debts owing to the intermediary by multiple group entities, including the Canadian borrower. 75. S 219 of the Act. Pursuant to s 219.2 of the Act, where a tax treaty provides for a dividend withholding tax rate applicable to a dividend paid by a corporation resident in Canada to a parent corporation in a foreign jurisdiction, the applicable branch tax rate will be levied at this reduced rate. 76. Sub-s 84(1) of the Act. 77. See, for example, CRA document number 2014-0534751R3; and CRA document number 2012-0471921R3. 78. See, for example, CRA document number 2000-0043615, dated 5 April 2001. This position now has statutory support in s 93.2 of the Act and para 5907(11.2)(b) of the Regulations. In contrast, the CRA has adopted the position that an S-corporation should be treated as a corporation for Canadian tax purposes, as it would be liable to US taxation if no election were made to be accorded flow-through status under Subchapter-S of the US Internal Revenue Code. This can result in a timing mismatch and inability to fully utilize foreign tax credits where the shareholder is a Canadian resident and a US citizen, as the S-corporation is fiscally transparent for US income tax purposes. 79. CRA document number 2016-0634951C6, dated 10 June 2016. 80. The CRA has announced that it will provide transitional relief in order to allow such entities formed before 26 April 2017 to be treated as partnerships retroactively from the time of their formation, provided the parties have consistently taken the position that it is treated as a partnership for Canadian tax purposes. 81. Sub-ss 84(1), 84(3) and 84(4). 82. Sub-s 212(2). 83. Para 212(1)(b). 84. Para 20(1)(c). 85. Sub-s 18(5), ‘equity amount’. 86. See sub-s 18(5), ‘outstanding debts to specified non-residents’. Equivalent rules apply to trusts; ‘outstanding debts to specified non-residents’ means debts owing by the trust to a ‘specified non-resident beneficiary’ or to a non-resident who does not deal at arm's length with a ‘specified beneficiary’ on which interest is or would, but for the application of the thin capitalization rules, be deductible by the trust. A ‘specified beneficiary’ of a trust is a person who, alone or together with non-arm's length persons, has a beneficial interest with a fair market value that is not less than 25 per cent of the fair market value of all beneficial interests in the trust. For this purpose, where the person or a non-arm's length person has a discretionary interest in the trust, the 25 per cent fair market value test is determined on the basis of the discretion having been exercised fully in favour of the person or non-arm's length person. A trust's ‘equity amount’ is intended to be equal to the total of the contributions to the trust made by specified non-resident beneficiaries, plus the after-tax earnings retained by the trust. 87. Sub-s 18(5), ‘specified non-resident shareholder’ and ‘specified shareholder’. For the purposes of determining whether a person is a specified shareholder of a corporation, if that particular person (or a person with whom the particular person does not deal at arm's length) has a right under contract, in equity or otherwise, either immediately or in the future and either absolutely or contingently, to acquire shares of the corporation or to control voting rights for the shares of the corporation, or a right to cause the corporation to redeem, acquire or cancel shares, the status of a particular person as a specified shareholder must be considered on the basis that any such right has been exercised. 88. These rules are contained in sub-ss 18(6) and (6.1). 89. Para 214(16)(a). A corporation that is deemed to have paid a dividend in respect of recharacterized interest is entitled to designate in its tax return which amounts paid or credited as interest to the non-resident person in the taxation year are deemed to have been paid as dividends, and thus subject to withholding tax: para 214(16)(b). 90. Sub-s 18(7). 91. Para 12(1)(l.1). A corporation that is a member of a partnership is thus required to include in computing its income its proportionate share of any interest related to the partnership that is rendered non-deductible as a result of the application of the thin capitalization rules. For example, if a specified non-resident beneficiary of a trust makes a loan of $1 million dollars to a partnership in which the trust has a 10 per cent interest, the trust is deemed to owe $100,000 to the specified non-resident beneficiary for the purpose of applying the thin capitalization rules. The partnership itself is not subject to the thin capitalization rules, and the interest is fully deductible by the partnership in computing its income. To the extent that interest is paid by a partnership to a specified non-resident of one of the partners, the partner is required to include its proportionate share of the interest in income if the outstanding debt of the partner owing to specified non-residents (including the proportionate share of the partnership debts) exceeds 1.5 times the partner's equity amount. 92. S 17. 93. Sub-s 214(3). 94. Sub-s 2(3) and para 115(1)(b) of the Act impose Canadian tax on taxable capital gains realized on the disposition by a non-resident of Canada of shares or interests that are taxable Canadian property and are not treaty-protected property. Accordingly, the domestic rules in the Act relating to the taxation of capital gains on shares and interests realized by non-residents are subject to any exemption available under an applicable income tax treaty. See para 150(1)(a) and sub-para 110(1)(f)(i). 95. Otherwise than through a corporation, partnership or trust the shares or interests in which were not themselves taxable Canadian property at the particular time. 96. Sub-s 248(1), ‘taxable Canadian property’. 97. See, for example, art XIII(3)(b) of the Canada–US tax treaty, and CRA document number 2016-0658431E5, dated 1 March 2017. 98. See, for example, the recently concluded treaty with Israel (2016), which has a 12-month look-back period in art 13(4)(a). 99. For example, art XIII(3)(b) of the Canada–US tax treaty only permits Canada to tax gains realized by a resident of the United States where the disposition of share of a corporation that is resident in Canada where the value of such shares is derived principally from real property situated in Canada. 100. An example is art 13(4) of the Canada-Luxembourg tax treaty, which is substantively similar to art 13(5)(a) of the Canada–UK tax treaty. It restricts Canada to taxing gains derived by a resident of Luxembourg from the alienation of shares, other than shares listed on an approved stock exchange in Canada, forming part of a substantial interest in the capital stock of a company, the value of which shares is derived principally from immovable property situated in Canada. For these purposes, immovable property does not include property (other than rental property) in which the business of the company was carried on; and a substantial interest exists when the Luxembourg resident and related persons own 10 per cent or more of the shares of any class of the capital stock of the company. Thus, art 13(4) of the Luxembourg treaty provides a capital gains exemption that carves back Canada's source-country jurisdiction to tax share dispositions in three respects: (i) all shares listed on a Canadian stock exchange are exempt; (ii) all shares representing a minority interest under the 10 per cent substantial interest threshold are exempt; and (iii) even where the shares derive more than 50 per cent of their value from Canadian real property or resource property, the gain can be exempt if there is property in which the business of the company was carried on. 101. CRA document number 2000-0042545, ‘Immovable Property’, dated 9 January 2001. 102. CRA document number 1999-0010583, dated 1 January 2000. 103. CRA document number 9703965, ‘Shares Deriving Value from Immovable Property’, dated 12 June 1997. 104. CRA document number 2000-0015753, ‘Article XIII, Canada-Netherlands Treaty’, dated 1 January 2000. 105. Sub-s 116(1). 106. Sub-s 116(5). 107. The 25 per cent tax (and purchaser liability in respect thereof described below) is increased to 50 per cent in respect of certain property: a life insurance policy in Canada, Canadian real property inventory, depreciable property and certain resource property: sub-ss 116(5.2) and (5.3). 108. If the purchaser fails to withhold or remit an amount as required under this provision, the purchaser assumes personal liability for such amount under the Act and may also be assessed a penalty equal to 10 per cent of the amount required to be remitted: see sub-ss 227(9), (9.3) and (10.1). 109. Para 116(5)(a.1) and sub-s 116(5.01). 110. This requirement may be satisfied by the vendor by having the non-resident vendor certify that it is resident in the particular country for purposes of the tax treaty pursuant to Form T2062C (Part D). 111. Sub-s 248(1), ‘treaty-protected property’. 112. Sub-ss 116(5.02) and 116(6.1). 113. As defined in sub-s 116(6) of the Act. 114. Sub-s 116(5.02). 115. A residential property means a real estate property containing up to six family residences, and includes residential condo units (irrespective of the number purchased). Large residential rental apartment buildings are expressly excluded. 116. For example, a person who exercises de facto control over a corporation or owns shares representing more than 50 per cent of the value of the corporation will be considered to control that corporation for purposes of s 256. 117. The tax applies to a transfer of residential property if any of the transferees is a foreign entity or a taxable trustee. Thus, if a transfer of residential property is made to multiple transferees and only one is a foreign entity or taxable trustee, the tax will be imposed on the full value of the consideration for the property. Each transferee will be jointly and severally liable for the tax payable. 118. See sources at n 47 for further discussion. 119. Para 212(1)(c). Although sub-ss 2(3) and 115(1) of the Act provide that non-resident persons are only liable to pay tax on their ‘taxable income earned in Canada’, para 250.1(b) provides that, for greater certainty and unless the context otherwise requires, a person for whom ‘income’ for a taxation year is determined in accordance with the Act includes a non-resident person. Accordingly, a non-resident beneficiary's ‘income’ for purposes of sub-para 212(1)(c)(i) includes all income of the trust that became payable in the year to the beneficiary and was included under sub-s 104(13), notwithstanding that such income may not be ‘taxable income earned in Canada’. 120. Sub-s 212(11). Where sub-s 212(11) applies to a particular amount, the amount is recharacterized for Part XIII withholding tax purposes as income of or from a trust exclusively. For example, interest income that may be exempt from Part XIII withholding tax by virtue of para 212(1)(b) if paid directly to the non-resident person would be subject to Part XIII withholding tax if it is received by a trust and distributed to a non-resident beneficiary. 121. Pursuant to sub-s 212(11). A capital gain of a trust that is distributed to a non-resident beneficiary will be treated as income for purposes of the application of para 212(1)(c) (although only the taxable half of such gain is subject to Part XIII withholding tax). 122. Under sub-s 107(2.11). 123. See, for example, CRA document number 2001-0115745, dated 27 December 2001. 124. Para 214(3)(f). 125. CRA document number 2003-0009211E5, dated 25 October 2004. Paragraph 214(3)(f) deems the amount to be paid or credited at the earliest of the times currently described in the paragraph and, if the taxation year of the trust ends because the trust ceases to be resident in Canada, the time that is immediately before the end of the taxation year of the trust. 126. See, for example, CRA document number 2009-0327001C6, dated 9 October 2009, and CRA document number 9632715, dated 13 February 1997. 127. The Part XII.2 tax liability is 40 percent of the least of: (i) the trust's ‘designated income’ for the year; (ii) the income of the trust before deducting amounts payable to beneficiaries and Part XII.2 tax (under sub-s 104(30)); and (iii) 100/64th of the amount deducted by the trust as payable to beneficiaries. Where a trust subject to Part XII.2 tax has Canadian resident beneficiaries, a portion of the Part XII.2 tax is deemed to have been paid on account of the Part I income tax liability of the trust's Canadian resident beneficiaries. 128. Sub-s 104(30). 129. Para 210.1(a). 130. Pursuant to sub-s 107(2.1) of the Act. 131. Sub-s 107(5). 132. In the case of a beneficial interest acquired for consideration, the adjusted cost base in the interest is reduced as a consequence of the distribution (under para 53(1)(h)). 133. Sub-s 128.1(10). The definition includes, for example, a right to receive a payment under an annuity contract, an interest in certain trusts and an interest in a life insurance policy in Canada. © The Author (2017). Published by Oxford University Press. All rights reserved.

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Trusts & TrusteesOxford University Press

Published: Feb 1, 2018

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