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Canada

6. Taxation

a. Introduction

Canada has a comprehensive tax system under which worldwide income of residents is subject to tax. The system has high tax rates, few exemptions and tax incentives, extensive reporting and filings, aggressive enforcement of self-assessment, and copious tax avoidance rules. Quebec has its own income tax regime that is administered by the provincial government. Quebec’s income tax legislation is similar to the federal legislation.

Canadian individuals and corporations have invested extensively outside Canada, leading to legislative changes in the foreign tax area, followed by evolving tax planning structures, which then precipitate further changes. Taxation rules concerning non-resident trusts and foreign investment entities (FIE) are examples. The popularity of certain international plans led to proposed legislative changes, originally announced in February 1999. After many delays and revisions, the legislation was to be effective 1 January 2007 for changes to the non-resident trust rules, and for taxation years ending after 4 March 2010 for changes to the FIE rules. These changes were not yet passed at the time of writing.

b. Tax system

i. General concepts of tax liability

Canada levies tax on worldwide income of residents and on certain Canadian source income of non-residents. Worldwide income includes income from all sources unless the income is exempt.

For individuals, income includes:

  • employment income, including taxable benefits and stock option benefits where, in some cases, a 50 per cent deduction may be available
  • business income, including professional income
  • property income, such as interest, dividends, rents and royalties
  • 50 per cent of capital gains, net of capital losses (for certain Canadian property, such as farms or shares of active Canadian businesses, up to CAD750,000 of capital gains may be exempted), and
  • pension and other retirement income, alimony and other sources of income as stipulated.

Income is computed on an accrual basis for business income, and otherwise generally on a cash or receivable basis. Proceeds of a life insurance policy are exempt if paid as a consequence of death.

The calculation of income for a corporation is similar to that of an individual. Business income is calculated according to generally accepted accounting principles with certain modifications (e.g. depreciation).

Trusts are taxed as individuals with some modifications.

For all taxable entities (individuals, corporations and trusts), a tax rate schedule is applied to taxable income to determine the tax payable. Certain deductions and tax credits may be taken, such as:

  • for individuals, personal exemptions
  • for trusts, deduction for income distributed to a beneficiary
  • for corporations, deduction for certain inter-corporate dividends, and
  • for all taxpayers, credit for foreign taxes paid.

ii. Rates and tax incentives

For individuals, taxes are calculated at graduated tax rates with both a federal component and a provincial component. Rates vary by province. Unlike the US, Canada has no city or local income tax.

Personal graduated tax rates for 2010 (provincial rate assumed at 50 per cent of federal rate) are roughly as follows:

Taxable Income (CAD) Rate

Up to 40,970 22.5%

40,971 – 81,941 33%

81,942 – 127,021 39%

Over 127,021 43.5%

Inter vivos trusts are taxed at the top personal tax rate. Testamentary trusts are taxed at graduated tax rates. Corporations are taxed at a flat federal rate, 28 per cent in 2010, with a federal rate reduction applicable to general active business of 10 per cent, resulting in a net federal rate of 18 per cent. Canadian-controlled private corporations (CCPCs) with under CAD10 million of capital receive a tax reduction of 17 per cent of Canadian active income up to CAD500,000 annually, resulting in net federal rate of 11 per cent. A CCPC earning investment income may receive a refund of 26.66 per cent of that investment income upon payment of a dividend of sufficient size. Provincial rates vary, and reductions are granted to CCPCs generally as per the federal system. Further reduced rates are proposed for 2011 and 2012.

Below are representative corporate tax rates (federal and provincial combined):

General Active Business Income 33%

Small Business Rate for CCPC 16%

Investment Income (before credit) 49%

The tax credit for investment income on payment of a dividend is designed to compensate for the personal tax paid on receipt of a dividend to remove the incidence of double tax.

Canada treats a partnership as a flow-through entity, with the partners being taxable on the partnership’s income. There is no recognition of a limited liability company (LLC) as a flow-through entity. It is taxed as a corporation. However, the US views a Nova Scotia Unlimited Liability Company (NSULC), an Alberta Unlimited Liability Company (ABULC) and a British Columbia Unlimited Liability Company (BCULC) as being in each case a flow-through entity upon election.

Individuals will be considered Canadian residents if they have sufficient ties to Canada, such as a home, a spouse or dependants in Canada, substantial time spent in, and economic or social ties in Canada.

An individual can be resident in more than one country (i.e. a dual resident).

If an individual who does not otherwise have sufficient ties to Canada to be considered resident is present in Canada for 183 days or more in a calendar year, the person is deemed resident for the entire calendar year. A person moving to Canada assumes residency from the date sufficient residential ties are established.

A trust is resident where the majority of the trustees reside but a non-resident trust may be deemed Canadian-resident (see below). Also, a non-resident trust may be considered factually resident if its ‘mind and management’ (the guiding mind) is in Canada.

A Canadian corporation is deemed a resident of Canada (with certain historical exceptions). A non-resident corporation may be held to be Canadian-resident if its central mind and management is exercised from Canada.

If a person (individual, trust or corporation) is resident in another country under an international tax treaty that the country has with Canada, the person is deemed not to be Canadian resident.

iii. Tax evasion and avoidance

Because individuals may not file joint returns, rules apply to prevent income splitting.

Corporations cannot file on a group basis, and rules prevent losses being transferred among taxpayers except within related corporate groups. This matter is now under study.

Extensive anti-avoidance rules prevent undue tax deferrals using financial products (such as insurance or deferred annuities).

In the international area, passive income of a foreign corporation may be deemed income of a Canadian resident shareholder.

A general anti-avoidance rule (GAAR), drafted in 1987, has been litigated numerous times with mixed results. Under legislation, GAAR would override international tax treaties. In two Supreme Court cases on GAAR, the court based its decisions on legislative purpose and drew a distinction between permissible tax avoidance and abusive tax avoidance.

The Supreme Court of Canada refused to accept a doctrine of following economic substance over legal form, and has consistently upheld the notion that a taxpayer may carry out reasonable tax planning.

Canada has enacted transfer-pricing legislation and has the ability to re-price non-arm’s-length transactions.

Tax evasion is a criminal offence (unlike tax avoidance), which, on conviction, may result in a fine and/or imprisonment. In non-criminal cases (e.g. gross negligence), penalties may be applied. Penalties can be assessed against advisors in certain cases.

Assessments may be disputed in an appeal procedure, and then through the Tax Court and appealed further if there are grounds.

iv. Taxable periods and filing requirements

For individuals and inter vivos trusts, the taxation year is the calendar year. Tax returns are generally due on 30 April or 31 March, respectively. Corporations and testamentary trusts may adopt a fiscal year-end of choice, but must then follow that year-end consistently, with tax returns being due six months and 90 days, respectively, after year-end. Special rules require the reporting of foreign assets, transfers to non-resident trusts, distributions from non-resident trusts, and the holding of shares in foreign corporations.

Filings are also required by non-residents in many instances. Related-party transactions with non-residents and the claiming of certain treaty exemptions require special disclosure.

c. International

i. Residents with foreign investments/transactions

Canadian residents are permitted to invest in any legal activity anywhere in the world. There are no foreign currency controls. However, the result of such international investment may be more onerous taxation than that applied to a domestic investment.

Direct investment by Canadians results in direct taxation. If a Canadian resident invests outside Canada so that income is earned by the resident, the income is taxable in accordance with Canadian rules. If the investment is indirect (e.g. via a non-resident corporation), the taxation depends on the nature of the income and the share ownership.

A foreign corporation controlled by six or fewer Canadian-resident persons or by Canadian and non-arm’s-length persons will be a controlled foreign affiliate (CFA). Proposed legislation, if enacted, will broaden the application of when a foreign corporation is considered a CFA. The test of control will aggregate ownership of the Canadian resident persons and persons who deal at non-arm’s-length. If Canadian persons have a minimum shareholding (usually 10 per cent of a share class but sometimes 1 per cent), and the CFA has passive income, the income will be imputed to the Canadian resident shareholder. Passive income includes interest, dividends (except inter-group dividends), most capital gains, rental income, royalty and licensing income, and certain income sources, which are deemed passive. This income is called foreign accrual property income (FAPI). When earning FAPI is compared with earning the same amount of income directly, the overall tax cost is either tax neutral or disadvantageous.

Active income of a CFA is not taxed until repatriated. At that time, the treatment depends on the shareholder (corporation or not) and the location where the income is earned (treaty country or not and, in the future, whether it has entered into a tax information exchange agreement with Canada). The issues are complex and beyond the scope of this discussion.

New rules, which were originally intended to be effective for taxation years ending after 4 March 2010, will tax Canadians who earn passive income via foreign corporations, even where they are not CFAs. These rules are still in draft form.

ii. Expatriates

When Canadian individuals become non-resident, they are no longer subject to Canadian tax, except on Canadian source income. Canadian citizenship is not a basis for taxation. Nonetheless, on leaving, most property is deemed to be sold at fair market value, producing capital gains. The tax may be postponed until the asset is actually sold, if security for the tax is furnished.

Canadians who leave but retain residential ties may be considered continuing residents, unless they move to a treaty country, where the treaty may override.

Frequently, Canadian expatriates retain rental properties and retirement plans in Canada after departure. This income is subject to non-resident withholding tax (generally at 25 per cent), which may sometimes be reduced by treaty or by special elections.

Non-residents who derive income from Canadian sources may be subject to tax depending on the type of income and the existence of an international tax treaty. See the chart below for common types of income and their tax treatment.

Non-residents who earn employment income or business income from Canadian sources, or who realise capital gains from the sale of taxable Canadian property (a defined term) must file an income tax return and, unless exempt by a tax treaty, pay tax according to normal domestic rates. Taxable Canadian property includes:

  • Canadian real estate
  • shares of Canadian private companies with value principally derived from Canadian real estate
  • business assets used in Canada
  • shares of public companies of over 25 per cent of any share class within the past five years (other conditions apply), and
  • any property deemed taxable Canadian property (generally issued on an exchange basis for other taxable Canadian property).

Under Canada’s international tax treaties, capital gains, other than for Canadian real estate, may be exempt.

Non-residents deriving investment income and retirement income from Canadian sources may be subject to non-resident withholding tax, typically at 25 per cent, but subject to reduction by treaty.

At this time, there is controversy as to whether Canada has legislation sufficient to combat so-called ‘treaty shopping’. There are no specific rules in Canadian law or in the majority of Canada’s international tax treaties to prevent ‘treaty shopping’. Nonetheless, the Canadian government seems to take the view that GAAR may be used in certain cases where international tax treaties have been ‘abused’, and has proposed that GAAR be applied to override international tax treaties. Many practitioners believe this approach to be incorrect, a view supported by a recent decision of the Federal Court of Appeal.

iii. Immigrants

Individuals who become Canadian residents are given certain special exemptions.

Upon becoming a Canadian resident, capital property and certain other assets (but not taxable Canadian property) are revalued to fair market value, thus eliminating capital gains on the value accrued to the time of arrival, and allowing for a ‘stepped up’ depreciation basis.

Individuals who have not been resident in Canada for a total of 60 months in their lifetime may establish a non-resident trust, which will be exempt from Canadian tax until they have been resident for 60 months. In this way, new immigrants to Canada may shelter income in such a trust for up to five years.

Since Canada has no estate taxes, succession duties, gift taxes, etc. the combination of capital gains relief and the five-year immigrant trust makes Canada a desirable place to relocate for wealthy individuals, particularly those intending to retire.

iv. Tax treaties

Canada has more than 80 international tax treaties, most of which follow the typical Organisation for Economic Co-operation and Development (OECD) model. By far the most extensive treaty is the Canada-US treaty, which contains very significant custom drafting, making specific reference to the taxation systems in the two countries. Also, unlike Canada’s other treaties, the Canada-US treaty is unique in that it addresses estate duties.

In general, Canada’s treaties do not contain limitation of benefit provisions, unless these have been inserted by the other contracting state. Even so, certain treaties deny treaty benefits to corporations, which are taxed at specially reduced tax rates (e.g. a Barbados international business corporation).

d. Taxation of trusts

i. Types of trusts and tax rates

Trusts, except those exempt from tax, are taxed as individuals at personal tax rates. Personal tax in Canada is composed of both federal and provincial components, with the provincial component dependent on where the trust is resident. If the trust is resident in a territory, then an additional level of federal tax is charged in lieu of provincial tax. Inter vivos trusts are taxed at the top personal tax rate, while testamentary trusts are taxed at graduated rates.

ii. Duration and termination

For income tax purposes, trusts have no set duration. Trusts (other than spousal trusts, alter ego trusts, joint spousal or common law partner trusts) are, however, deemed to dispose of property every 21 years to prevent indefinite tax deferral through the use of trusts. In most cases, transfers to a trust occur at fair market value, so that the transfer of assets with accrued gains to a trust will result in the realisation of those gains. In practice, when a trust distributes assets to a beneficiary, this generally occurs on a tax-free rollover basis. There are various exceptions.

iii. Transfers to a trust

In order to prevent income splitting, when property is transferred to a trust, rules may apply to attribute gains from the sale of the property, and income arising from the property, to the person who contributed the property. There are six major attribution rules, which apply in various circumstances:

Where property is transferred by a spouse to a trust established for the benefit of the other spouse, the property may be transferred at cost, rather than fair market value. Nonetheless, any income or loss from the property, and any capital gains or losses resulting from disposal of the property will, if allocated to the beneficiary spouse, be attributed to the transferor spouse and taxed in that person’s hands. If the income or capital gains are retained in the trust, then no attribution occurs.

Where an individual transfers property to a trust for the benefit of a child who is under 18 years of age, then any income distributed from the trust to that child will be attributed back to the transferor if the transferor and the beneficiary are related (which for this purpose includes nieces and nephews). Capital gains and losses are not subject to attribution.

Where a low interest or interest-free loan is made to a trust, and income (but not capital gains) derived from these funds is distributed to a beneficiary, that income may be attributed back to the person who made the loan if there is a non-arm’s-length relationship between the parties. This can apply to siblings and parents, as well as spouses and children.

Where property is held in trust on the condition that it may revert to the person who transferred the property to the trust, pass to persons to be determined at a later time by that person, or cannot be disposed of without that person’s consent, then any income or loss from the property and capital gain or loss from disposal of the property is attributed to the transferor. This rule applies whether the income is actually distributed by the trust to a beneficiary or not.

Dividend income from private Canadian corporations received by minor children is taxed at the top personal tax rate.

Lastly, a more complicated attribution rule can apply in estate-freeze situations where property is transferred to a corporation that is owned by a trust that includes a spouse of the transferor or children under the age of 18 or held directly by them.

iv. Taxation of income earned in the trust

Trust income is computed in accordance with the normal Canadian rules applicable to individuals, but a trust is not entitled to personal exemptions and certain other deductions. In most cases, a trust may obtain a deduction for income that is distributed to a beneficiary. In such circumstances, the beneficiary is subject to tax on the income (personal income tax if Canadian resident, and non-resident withholding tax if a non-resident).

An additional tax at 36 per cent can apply to certain types of income distributed by a Canadian-resident inter vivos trust to non-resident beneficiaries.

While income may be distributed from a trust to beneficiaries provided it is accompanied by a payment or a promissory note due on demand, losses of the trust may not be allocated to beneficiaries. Instead, these losses may be carried forward or carried back by the trust in accordance with normal Canadian rules.

v. Distributions to beneficiaries

Canadian-resident beneficiaries are taxable on income received from a trust, whether the trust is resident or non-resident. Distributions of capital are not taxable unless a deduction is taken in the trust.

There is no clear agreement as to what constitutes an income distribution as compared with a capital distribution. With a Canadian-resident trust, if a deduction is taken for the distribution, it is considered an income distribution unless there are compelling reasons to the contrary. For non-resident trusts that are not taxable by Canada, this test alone is not sufficient. If a Canadian-resident beneficiary receives distributions from a non-resident trust on a periodic basis (e.g. monthly), tax authorities may attempt to consider them income distributions.

vi. Non-resident trusts

As discussed earlier, the residency of a trust is determined by the place where the majority of the trustees reside (subject to a factual determination of residency based on mind and management). If this is outside Canada, the trust is considered a non-resident trust unless deemed resident. The trust may be deemed to be Canadian-resident if it has a Canadian-resident contributor. For this purpose, a contributor is a person who has contributed property to the trust directly or indirectly. The term ‘contribution’ is broadly defined in the legislation, and includes various indirect arrangements, such as where a Canadian resident arranges for a non-resident trust to acquire property by indirect means. If proposed amendments come into force this deeming will apply effective 1 January 2007, regardless of the residency of the beneficiaries.

The trust is exempted from Canadian tax until the resident contributor has been a Canadian resident for 60 months in total during the contributor’s lifetime.

Prior to 2010, a non-resident trust that is deemed Canadian-resident will generally be taxed similarly to a Canadian-resident trust. There are certain important differences. Starting from 2010, income will be attributed to the resident contributor, proportionate to the amount that person contributed.

For purposes of non-resident withholding tax, a non-resident trust that was deemed Canadian-resident could previously have distributed income to non-resident beneficiaries without Canadian withholding tax. The trust will receive a deduction for the distributions, except that the deduction may be limited or, in some cases denied entirely, where the income is Canadian source income. Proposed legislation (effective 1 January 2007, if enacted in its current form) will, subject to certain grandfathering provisions, provide that withholding tax be applicable to distributions from a deemed Canadian-resident trust.

The trust is considered to have departed from Canada when it ceases to have a resident contributor, at which time it may be subject to departure tax.

Extensive use has been made of non-resident trusts by immigrants to Canada and by non-residents wishing to benefit Canadian residents. These trusts accumulate income and distribute capital to Canadian-resident beneficiaries, all free of Canadian tax.

The exact form of the legislation concerning non-resident trusts is not yet known. It is possible that significant changes can still occur.

e. Taxation of estates

i. Estate and gift taxes

Neither the federal government nor any of the provinces in Canada levy estate or gift taxes or any other kind of succession duty.

ii. Taxation on death

On death, a Canadian individual is deemed to sell all property at fair market value, with certain limited exceptions. This deemed disposition results in capital gains tax where capital property has appreciated in value, and it may also result in business income attributable to previously-claimed depreciation on land inventory and other property. This income is reported on the final tax return of the deceased.

A major exception occurs when property is transferred to a spouse or spousal trust (a trust created under the will whereby the spouse is entitled during their lifetime to all income deriving from the trust and no person other than the spouse may, prior to the death of the spouse, have access to the capital). In this case, assets are transferred at cost, but gains will arise on death of the surviving spouse.

Also, other types of income may be required to be reported in the year of death. For example, unless transferred to a surviving spouse, funds in a registered retirement savings plan (RRSP) are considered income of the deceased.

A number of special elections and designations are available in the year of death, which can provide benefits and reduce the effective tax rate.

Insurance proceeds are not subject to tax on death. They are received as tax-free capital.

A beneficiary receives property of a deceased at tax-cost equal to the proceeds recognised by the deceased.

f. Other taxes

On death, all provinces levy probate fees, which vary significantly by province. Canada does not levy wealth tax, capital tax or stamp duties on individuals. Land transfer tax, however, can be levied on the transfer of real property interests, at a rate of up to 1.5 per cent. There is an exemption in the event of death for assets passed to heirs or estates.

g. Estate-planning issues

Three common estate planning techniques are used in Canada. These estate planning strategies are well established, and are unlikely to be challenged by tax authorities if properly carried out.

In order to limit tax that may occur on death, it is common to carry out an estate freeze. Owners of private companies convert common shares into preferred shares with a frozen value and allow family members from the next generation to subscribe to newly created common shares.

Trusts are used to postpone capital gains tax at death and allow for a measure of control over the assets of an estate. A trust is deemed to sell and reacquire its property every 21 years for tax purposes, creating capital gains and preventing unlimited tax deferral.

Since insurance proceeds are received tax free on death, they may be used in a variety of ways to convert investment income into tax-free proceeds, mitigate double tax problems that can arise from holding assets through corporations, and reduce capital gains that would otherwise arise on death.


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