TRUMP CORPORATE TAX CUTS COULD TRIGGER CANADIAN TAX ON DIVIDENDS FROM U.S. SUBS

Shhhh! There is a dirty little secret that not many people know or talk about. A large percentage of U.S. subsidiaries (“Usco”) of Canadian companies (“Canco”) are actually resident in Canada based on traditional rules for determination corporate residency that are mainly derived from UK tax cases. This is because their “central management and control” or “mind and management” is often in Canada[1]. A majority of the Directors are often Canadians (usually representatives of the parent) or, if not, they are the “just sign here” kind that conveniently do what the parent says[2].

Isn’t that a big deal, from a tax perspective? Well, it turns out that it generally does not matter much. That is because the “tie-breaker” rule in Article IV(3) of the Canada-U.S. Tax Convention conveniently deems Usco to be resident in the U.S., where it is formed, for the purposes of the treaty. Because of that, subsection 250(5) of the Income Tax Act (“the Act”) deems Usco to be a non-resident of Canada for the purposes of the Act.

In part, because of this reality, tax advisors for Canadian corporations with U.S. subsidiaries will not generally advise their clients to exercise the level of care regarding corporate residency issues that they might (or should) in relation to subsidiaries located in tax havens.

So, although this may be interesting, it really does not matter, does it?

Well, it turns out that there is one area where it actually does matter, and that relates to Canada’s complex rules for classifying and taxing dividends received by a Canadian corporation from a “foreign affiliate” (“FA”).

Normally, the active business income of a FA of a Canadian corporation that is resident in a country, such as the U.S., with which Canada has a tax treaty, is included in the “exempt surplus” (“ES”) of that FA relative to the Canadian corporation. This generally means dividends received from that FA would be tax-free because of a deduction allowed under paragraph 113(1)(a) of the Act. The only tax would be the 5% withholding tax that the U.S. levies, and often Canadian corporations are willing to incur that small cost to move the profits upstream.

But what determines residency in a treaty country for this purpose? A superficial reading of the Regulation that are issued under the Act might lead one to conclude that, as long as the FA is resident in that country for the purposes of a tax treaty, that is all that is needed. Paragraph 5907(11.2)(a) of the Regulation states:

“For the purposes of this Part, a foreign affiliate of a corporation is, at any time, deemed not to be resident in a country with which Canada has entered into a comprehensive agreement or convention for the elimination of double taxation on income unless….the affiliate is, at that time, a resident of that country for the purpose of the agreement or convention”

However, although residence for the purposes of a treaty is definitely a requirement as a result of the paragraph quoted above, the FA must also be resident in the treaty country based on traditional tests for corporate residency[3].

This means that, in reality, in many cases, the earnings of Usco are included in “taxable surplus” (“TS”), rather than ES, relative to Canco, since Usco is not actually resident in any treaty jurisdiction.

Now, with high corporate tax rates in the U.S., this distinction has generally been academic[4]. Even if the Usco dividends were derived from TS, Canco would have been allowed a deduction under paragraph 113(1)(b) of the Act with respect to the applicable foreign tax that pertains to the dividend. This tax is generally the average underlying federal and state corporate tax[5] (“underlying foreign tax”-“UFT” as defined in Regulation 5907(1)) that pertains to the surplus out of which the dividend was paid. In recent years, the UFT is multiplied by a factor of 3 to determine the maximum deduction that is allowed. This means that the dividend would be fully sheltered by the 113(1)(b) deduction as long as the average corporate tax rate was at least 25%. At that rate, the remaining surplus would be 75% (i.e. 3x the tax). Hence, normally, given traditionally high U.S. corporate tax rates, even if paid out of TS, the dividend would still be tax-exempt.

However, with a cut in U.S. federal corporate tax rates to 15%, there may no longer be 100% exemption.

Even if we take into account an average state corporate tax rate of about 5% (which would equate to an effective tax rate of 4.25% assuming that state taxes remain deductible for federal purposes) and take into account the additional deduction allowed under paragraph 113(1)(c) for the 5% U.S withholding tax which will generally apply when dividends are paid, there may be some, albeit quite small, amount still taxable.

For example, on $1,000,000 of profits, after allowing for the 19.25% effective corporate tax rate, there would be $807,500 available to pay dividends.

That amount would generate a deduction of $577,500 under paragraph 113(1)(b), leaving $230,000 still taxable

The 5% tax on the $807,500 dividend would $40,375, and that would allow a deduction under paragraph 113(1)(c) (using a factor of 4) of $161,500, leaving $68,500 taxable.

However, many Uscos may operate in states that levy no or little state income taxes. Furthermore, in certain cases, as a result of an election under subsection 93(1) of the Act, there can be situations where a dividend is deemed to be received by Canco from Usco without the 5% U.S. tax applying. This would most commonly apply where Usco is wound-up; it could also apply where the shares of Usco are sold.

If one looks at an extreme case, where the only U.S tax was the 15% corporate tax, there would be $850,000 available to distribute, and only a deduction of $450,000 under paragraph 113(1)(b) available to shelter it-$400,000 would remain taxable.

Of course, for existing situations, it might take many years for the cut in U.S. tax rates to have any effect because there may be substantial amounts of pre-existing TS with high rates of associated UFT. (On the other hand, cuts in U.S. tax rates might cause many Canco’s to take steps to shift profits from Canco to Usco, and this may accelerate the averaging down of the rates of UFT).

In addition, the Regulations allow an election which effectively allows a disproportionate amount of UFT to be used for the purposes of claiming a paragraph 113(1)(b) deduction[6]. This has the effect of deferring taxation of the TS.

However, with the passage of time, ultimately the day will come when Canco will have to “pay the piper”, unless, of course, Usco just stops paying dividends.

It will be interesting to see, if the U.S. corporate tax cuts do actually materialize, whether the CRA will focus on this issue in its audits of Canco-will they just assume that Usco is a U.S. resident and dividends are from ES, or look further? Somehow, I think that the CRA has “bigger fish to fry” in the international tax arena. But, who know? For now, let’s just keep this as our little secret!

[1] See, in particular, DeBeers Consolidated Mines Limited v. Howe, [1906] A.C. 455. Also, see the decision of the UK Chancery Division in Wood v. Holden, [2005] EWHC 547 for an important and more modern UK decision.

[2] You know, the kind of Directors who are just like the trustees in the famous Garron decision, which, although dealing with trust residency, is, by analogy, highly relevant when dealing with corporate residency-See the decision of the Supreme Court of Canada in St. Michael’s Trust Corp. as Trustee of the Fundy Settlement v. The Queen 2012 DTC 5063.

[3] Confirmed by the Canada Revenue Agency (“CRA”), for example, in Document 9810555

[4] Although, in fact, some astute tax advisors have actually used that fact to the taxpayer’s advantage in situations where this TS was pooled with TS arising from FA’s resident in jurisdictions with zero or low tax rates.

[5] Regulation 5900(1)(d)

[6] See additional amount that may be claimed by Canco in paragraph “b” of the UFT definition in Regulation 5907(1). Note that the additional amount must be claimed by Canco in its return for the relevant year-query whether the CRA will allow this claim to be made if Canco had filed on the basis that the dividend was derived from ES, and CRA reassesses on the basis that it was derived from TS.

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Michael Atlas
Michael Atlas
A legendary expert on Canadian-based international tax planning, Michael Atlas is a Toronto-based Chartered Professional Accountant. He practices as an independent consultant on high-level Canadian tax matters. Visit his website at www.TaxCA.com , Michael Atlas can provide direct consultations on a wide-range of high-level Canadian tax issues for accountants and lawyers, as well as private clients with BIG MONEY Canadian tax issues.

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