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Tax implications of doing business in Canada.

This month, Thomas R. Chiavetta, a senior tax manager With Price Waterhouse, Rochester, New york, who has had extensive experience with clients doing business in Canada, reviews some of the tax considerations that companies should evaluate before entering the Canadian market.

The Canadian marketplace provides many opportunities for U. S. companies. Canada and the Untied States share customs and a common language and a further incentive has been provided by the Canada-U.S. Free Trade Accord. However, before venturing into Canada, it is important for a U. S. company to understand the tax implications of such a move. This article reviews some of the important considerations.

PERMANENT ESTABLISHMENT If a U. S. company creates a permanent establishment in Canada, it will have to pay Canadian federal income tax on the Profits connected with it. For a U.S. company, the CanadaU. S. Income Tax Convention of 1980 (the treaty) defines a permanent establishment as a fixed place of business through which the business of a resident of the United States is wholly or partly carried on. Among other things, a permanent establishment includes a place of management, a branch, an office, a factory or a workshop. The treaty also provides that a permanent establishment is created if a person, say a salesperson of a U.S. company, habitually exercises authority in Canada to conclude contracts in the name of the U.S. company. However, a permanent establishment is not created if the contracting authority is limited to storage, display or delivery of merchandise.

The treaty provisions mean that a U. S. company can have a presence in Canada through an agent, such as a salesperson, without Creating a permanent establishment. Additionally, a U. S. company may store inventory in a warehouse in Canada without creating a permanent establishment; a salesperson working for a U. S. cOmPany in Canada may maintain inventory for any of the treaty specified purposes without creating a permanent establishment; a U.S. company may maintain an advertising office in Canada without creating a permanent establishment. As long as the U. S. company does not go beyond treaty exemptions, a permanent establishment is not created and it will not be subject to federal income taxes.


If a U.S. company does business in Canada, say through the use of a salesperson, it should file a Canadian federal income tax return, even if the U.S. company determines that it is not liable for tax on the Canadian sales under the treaty. The Canadian Federal Income Tax Act (the act) provides that a nonresident corporation that carries on business in Canada is subject to income tax on its taxable income earned in Canada. The act provides that a corporation is considered to be carrying on business in Canada if it solicits orders or offers anything for sale in Canada through an agent or employee whether the contract or transaction is to be completed inside or outside of Canada or partly in and partly out of Canada. If a nonresident corporation is considered to be doing business in Canada, it is required to file a Canadian federal income tax return.

However, the act provides a specific exemption for corporations for any amount that is declared exempt from income tax by any other enactment of the Parliament of Canada. The treaty is considered to be such an enactment. Accordingly, if a treaty exemption applies, the relevant income from doing business in Canada is not subject to Canadian federal income tax.


If a U.S. company wants more of a presence in Canada than it would have through a sales force, it could open a Canadian branch.

The taxable income of a Canadian branch is determined on the basis of a separate accounting, as if the branch is a separate person. The U.S. company may charge the branch for expenses that it incurs directly for the benefit of the branch. Such reasonable expenses are deductible for Canadian tax purposes. In addition to the direct expenses, a U. S. company may allocate a reasonable portion of home office expenses to the branch. The branch may also deduct these expenses provided the method of allocation is appropriate under the circumstances. Revenue Canada has indicated that the basis for allocating expenses must be available for its examination.

After determining the taxable income of the branch under the separate accounting, the regular tax is computed in exactly the same manner as it is for any other Canadian corporation. The current Canadian federal tax rate is 28%, after a 10% provincial abatement. A 3% surtax is generally added, increasing the federal rate to 28.84%. On July 1, 1991, the federal rate on manufacturing income will be reduced to an effective 23.84%. Provincial taxes are added to federal taxes. Depending on the province., the combined rate after July 1, 1991, will range from 30. 1% to 40.8% for manufacturing income, and from 35.1% to 45.8% for other corporate income.

A capital tax is levied on large corporations. The tax rate is 0.2% assessed on a corporation's taxable capital employed in Canada in excess of $10 million (Canadian dollars). The tax applies to all taxable Canadian corporations and all other corporations with a permanent establishment in Canada. The tax is not deductible in arriving at taxable income, but it is creditable against the surtax.

The branch is subject to a branch tax in addition to the federal income and capital taxes. The branch tax is assessed in order to equate the tax position of companies carrying on business through a branch with those that are carrying on business through a subsidiary. In a subsidiary, dividends remitted to a U. S. parent company are subject to a withholding tax. The earnings of a branch transferred to the U.S. company are not subject to a withholding tax.

The branch tax rate as specified by the treaty is 10%. Under the act, several industries are exempt from the branch tax. These include companies in the business of banking, transporting goods or persons, communications and mining ore in Canada.

For U.S. tax purposes, income or loss of the Canadian branch is included in the U. S. income tax return. To the extent the branch has income that has been taxed in Canada, the U.S. company will be allowed a foreign tax credit in its U.S. return. Where the branch has a loss, the U. S. company will be able to shelter its operating and other income.


A U.S. company may also set up a Canadian corporation as a subsidiary of the U. S. company. As in the case of a foreign branch, the taxable income of a Canadian corporation is determined on the basis of a separate accounting. The corporation's book income is the starting point. Adjustments to reflect Canadian tax rules are made to book income to arrive at taxable income. Similar to the foreign branch rules, a U.S. company may charge the Canadian subsidiary for reasonable expenses incurred directly and indirectly on behalf of the subsidiary, other than those that are custodial in nature. The Canadian federal tax, the surtax, and the capital tax apply.

Dividends paid by the Canadian subsidiary to its U.S. parent company are subject to a Canadian nonresident withholding tax. Under the treaty, the withholding tax is reduced from the basic rate of 25% to 10%. Interest paid by the Canadian subsidiary to the U. S. parent is also subject to a Canadian withholding tax. The treaty reduced rate is 15%.

For U.S. tax purposes, a U.S. company includes in taxable income the gross amount of dividends received from a Canadian subsidiary. Since the dividends represent earnings that have already been taxed in Canada, the U. S. company is allowed a foreign tax credit in its U. S. income tax return for Canadian dividend withholding taxes and Canadian income taxes paid. For interest paid by the Canadian subsidiary to its U.S. parent, the U. S. company includes in income the gross amount of the interest and is allowed a foreign tax credit for the 15% Canadian nonresident withholding tax.

The Canadian tax rules do not require a minimum amount of equity investment. However, the rules do provide a limit to the amount of interest expense that the Canadian subsidiary may pay to the U.S. parent and deduct for Canadian tax purposes. Generally, a debt to equity ratio of greater than 3 to 1 will result in a disallowance of some of the interest expense for Canadian tax purposes.

OTHER CONSIDERATIONS Canada has replaced a manufacturing sales tax with a value-added scheme known as the goods and services tax (GST). The GST is a value added tax that is imposed on purchasers of goods and services.

For Canadian federal purposes, an employer is required to withhold from employees' wages and remit income tax, Canadian pension plan contributions and unemployment insurance contributions. The Canadian federal rules also require an employer contribution for the pension plan and unemployment insurance. Generally, mandatory provincial healthcare and workers compensation fees are also required. A U.S. company should become familiar with the requirements so that it may comply with the Canadian rules.

Finally, a U.S. company will need to consider the personal tax implications of U.S. individuals who will be working in Canada. If the U. S. person earns more than 10,000 Canadian dollars) while working in Canada, he or she may also be subject to Canadian income tax, and will be required to file a Canadian personal income tax return. The combined Canadian federal and provincial personal income tax rates are higher than the U. S. federal and state rates. Accordingly, there may be an additional cost involved in send citizen to Canada.


The Canadian corporate tax issues highlighted in this article are by no means all-inclusive. There are many other business issues which should be reviewed before a company makes a decision to move beyond the U.S. border, even to a country as close as Canada. FINANCIAL ADVICE FROM A BUSINESS VETERAN

In these difficult economic times, CPAs should take a more active role in guiding a company's financial affairs-especially in capital management. So says John R. Meinert, chairman emeritus of Hartmarx Corp. and Hart Schaffner & Marx. He also draws on over 20 years' experience as chief financial officer. Since retiring last year from Hartmarx, he has launched a new career as a principal in the J.H. Chapman Group, Ltd., an investment banking firm in Rosemont, Illinois.

A WIDER ROLE FOR CPAs Some CPAs see their role in capital management as minimal. Too many limit their job to gathering and reporting historical data-accounting for what happened, not laying out the design for what will happen.

That's unfortunate. CPAs have a unique skill that they can and should bring to bear on financial matters.

At the very least, CPAs should apply their analytical skills and play the devil's advocate, questioning the source of corporate forecasts, ferreting out false premises and observing when emotions are overwhelming better judgment.

To be sure, that's a difficult role to play. But it's worth the candle: It can enhance a business's fortunes and the accountant's professional status. In this way CPAs can add respect for their financial acumen and business judgment and gain more decision making responsibility.

One area in which they can apply their skills is the management of capital. Here is some useful guidance.


Debt has been getting a lot of bad press lately. That's because some companies have been borrowing excessively when they should have been building equity. Now they're paying the price for those errors.

Other, more conservative businesses are being hurt by the spate of negative publicity: Overly cautious lenders deny credit even when it would be used for the right reasons and structured in the light way. In effect, these lenders have been demanding that borrowers demonstrate both a good cash flow and a strong asset base; that's like wearing both a belt and suspenders.

Corporate America's rush to debt was understandable, though imprudent. After all, the least expensive way to raise capital-after accounting for taxes-is with debt. This was a major incentive behind junk bonds.

To better appreciate the lure of corporate debt, assume the following: A debt-free company is in the 40% tax bracket, generating a 12% return on equity. Assume, too, that 80% of its equity is replaced with debt at an interest rate of 15% (9% after taxes). That company's return on equity doubles to 24%! If the company could borrow at 12%, or 72% after taxes, the return on equity would climb to 31.2%. Earnings before interest and taxes (EBIT) are unchanged, so all the gain in both examples is from tax savings, which effectively lowered the cost of capital on the 80% debt segrnent. By using such financing to dictate their actions, many businesses pushed their debt leverage to extremes, even to the point of ending up with negative book values.

What many executives failed to appreciate is that growth at any cost may be too expensive. When debt exceeds a business's ability to carry it, or when related interest consumes the earnings, management probably has exercised poor business judgment. Management's goal should be increasing profit for shareholders, and the only way debt can make financial sense is when its cost, after tax, is lower than the resulting return on equity.

BUY-BACK OR EXPANSION Some publicly held companies with low stock values-say, below book value-buy back their stock to increase per-share earnings and book value with debt that costs them, after taxes, less than their return on equity. While such buy-backs may be attractive investments, management can be faulted for not finding attractive expansion opportunities instead.

Until recently, the risk of growth via debt was concealed by fast appreciation of assets, swelled by inflation and speculation. Some managements, so used to optimistic earnings, did not quickly grasp the impending impact of economic slowdown and tight credit. As a result, they allowed their companies to get mired in debt.

These managers may blame external factors as the sole reason for their debt troubles, but the causes run deeper and include excessive optimism and failure to maximize longterm return on investment. A prime example is carrying huge, slow-turning inventories and hoping for sales growth-a disastrous, unprofitable use of debt. FINANCIAL STRATEGIES At the turn of the century, financial people considered the balance sheet the key statement of a business's condition; back then, the statement of earnings was not always reported. High net worth and low debt were hallmarks of a powerful and prosperous company.

Today, the emphasis is on cash flow. While earning power is the key indicator, smart financial managers are once again balancing the advantages of debt and equity.

The costs of righting the balance can be high, in terms of financial and human costs. The rebalancing may be an act of corporate survival, and it depends on belt-tightening and downsizing, although management would rather use the word rightsizing" to describe its corrective actions. Rightsizing involves retrenchment to the point where a business's cash flow is brought in line with its debt-payment demands.


Many companies suffer from inadequate financial planning, with small and mid-size businesses affected most frequently. Their usual error is to put most of their debt in one basket. Usually that basket is some form of bank borrowing. Financially well run companies segment their capitalization and borrowing into distinct categories. They are n Equity. This is the staying power of a business. It's the cushion for the lean years when downturns leave the business cash short. Equity can be raised by issuing stock, for activities such as acquisitions, employee and executive stock option plans and convertible debt. As its equity builds, a company's capacity to add long-term debt grows apace. The conservative recommended ratio of equity to long-term debt is two to one.

* Long-term debt. If a privately held company is large enough, it can float public bonds as well as make private placements. Smaller companies could turn to insurance companies for long-term money or a mortgage loan, or they could turn to commercial lenders or banks for a secured or asset-based loan. The key is to design the debt-in size and duration-to match the business's needs and cash flow. That takes realistic forecasting and fiscal self-control. Long-term borrowing is especially attractive because interest rates usually are lower than short-term bank loans. Also, long-term planning is easier and payments can be better matched to cash flow. * Seasonal debt. This is the borrowing that's needed to carry a company through a fiscal cycle. When its products are delivered and receivables collected at the end of its natural fiscal year, seasonal loans should be paid in full. If management has to carry that debt over for lack of funds, even when fast growth rather than slow sales causes inventory accumulation, that's a signal of poor financial forecasting.

Unfortunately, banks too often don't see that red flag or simply acquiesce by rolling the debt over, hoping it's temporary.

Both the bank and the business lose when a short-term, seasonal loan is carried over. If allowed to build debt, the business can be overwhelmed by its financial obligations and find itself unable to meet pay-back demands and to get additional credit. BORROWING ADVICE

Before knocking on a banker's door, a financial officer should ask: What kind of borrower is my company? Is our business plan impressive? Are the funds going to be put to the best possible use? What kind of security would a lender demand?

If it's an asset-based borrower, a small company must look at its tangible assets and find the best way to borrow on them. If the company is unable to attract bankers willing to extend working capital loans, it may have to factor receivables, work with vendors to finance inventory or mortgage the fixed assets. Even customers may be a source of funds, either by making advance payments against orders or by covering the cost of materials to be used for production.

If the business is a service company with few tangible assets but with good cash flow, it still may be able to borrow on that cash flow. However, if a business has neither cash flow nor assets, it's in real trouble. Such a company often wisely seeks to be acquired or to develop a joint-venture relationship with another business in order to meet its capital needs.

Financial officers should realize banks like to negotiate loans that the company can repay out of cash flow. If the borrower is a successful and growing company, more funds will be needed and the loan will not self-liquidate; in fact, permanent capital will be needed.

Yet many borrowers make the mistake of trying to squeeze longerterm loans out of bankers rather than use other means; such efforts don't enhance a banker's view of the company's financial management.

Sometimes a bank will agree to extend a loan a bit, but only with the understanding that the business will use the extra time to secure more permanent capital through equity or long-term debt.

It's risky to oversell the bank when presenting cash-flow projections and pay-back plans. If the bank naively accepts those unattainable projections, it may then set default positions on those estimates. The price of not meeting those projections can be quite high-default and possible bankruptcy.

The best way to negotiate with a bank is to present realistic figures, while making it clear that the projections are conservative and there is a good chance the company will exceed them. Make no promises. Bankers are more likely to believe such a presentation and set a realistic pay-back schedule. n
COPYRIGHT 1991 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Author:Chiavetta, Thomas R.
Publication:Journal of Accountancy
Date:Jun 1, 1991
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