Canada: Taxation Law Overview

4. Canada: Taxation Law Overview
Income Tax
- General
Residents of Canada are subject to tax on their worldwide income (including
capital gains) under the Income Tax Act (Canada) (the “ITA”) and the relevant
provincial tax legislation. Non-residents of Canada are generally subject to tax
only on their Canadian source income, including income from a business or
employment carried on or performed in Canada, and taxable capital gains from
the disposition of “taxable Canadian property” (as defined). Although each
province has also enacted provincial income tax legislation, only Alberta and
Quebec administer their own corporate income taxes, and only Quebec
administers its own individual income taxes. Other provinces rely upon the
federal government to collect taxes on their behalf.
- Types of Income
Capital Gains and Capital Losses
One of the most important Canadian income tax incentives is the effective
reduction in the rate of tax on capital gains. Only one-half of any realized capital
gains are included in the calculation of a taxpayer’s taxable income.
Correspondingly, one-half of any capital loss is deducted from any taxable capital
gains of the taxpayer in the year the capital loss arose, and any excess net
capital losses may be carried back to any of the three previous taxation years or
carried forward to any subsequent taxation year.
Generally, dividends received by Canadian resident individuals from
corporation’s resident in Canada are subject to a “gross-up and credit”
mechanism designed to compensate for the fact that the dividend has effectively
already been taxed in the hands of the corporation. The gross-up and tax credit
mechanisms help to provide a rough level of parity between income earned
directly by the individuals (or through a partnership) and income earned through
a corporation (referred to as “integration”). The dividend tax credit for “eligible
dividends” more fully compensates Canadian individual shareholders for the
underlying corporate tax paid. Eligible dividends are, generally, any taxable
dividends designated by the corporation and paid from a pool of income that was

not subject to a reduced or preferential corporate tax rate. The effect of this
gross-up and credit is an effective reduction in the tax rate for dividends. If the
dividend is paid by a non-resident corporation, the gross-up and credit
mechanism is not available.
Generally, dividends received by a corporation resident in Canada from another
corporation resident in Canada are included in, and then fully deductible from,
the recipient’s income provided such dividends were paid from the retained
earnings of the corporate payer. Consequently, dividends paid between two
Canadian resident corporations generally flow tax free. However, private
corporations and certain other corporations must pay a refundable tax of 38 1/3
% of the dividends received, which taxes can be recovered once they will pay
dividends to their shareholders. Dividends received by corporation’s resident in
Canada from corporations not resident in Canada are fully included in the
recipient’s income without a corresponding deduction, unless such dividends are
paid out of the active business income of a non-resident corporation that is a
“foreign affiliate” of the Canadian resident corporation resident in a specified
treaty jurisdiction.
Foreign Source Income
Canadian residents are taxed on their worldwide income, including foreign
source income. Where another country also taxes that foreign source income, an
applicable tax treaty may resolve which country has jurisdiction to tax that foreign
source income. Where tax is imposed by both countries, Canada has a foreign
tax credit system that provides relief, where certain conditions are satisfied, with
respect to such foreign taxes.
Certain types of passive income, defined in the ITA as foreign accrual property
income (FAPI), are included in the income of a Canadian taxpayer when earned
by a “controlled foreign affiliate” (CFA) of the taxpayer. The ITA also contains a
set of rules that deal with investments in offshore investment fund property which
includes interests in non-resident entities (other than CFAs) that are established
for tax deferral / avoidance purposes.
Employment Income
Employment income is subject to deductions at source. All employers that have
employees carrying out their duties of employment in Canada, regardless of their
residency status, are required to register with the CRA and must withhold and
remit tax to the Canadian taxing authority with respect to salaries, wages and
taxable benefits paid to such employees. Employers are also required to pay and
remit certain payroll taxes with respect to the Canada Pension Plan (or Quebec
Pension Plan), Employment Insurance, a workers’ compensation program and, in
certain provinces, health and training taxes.

- Other Income Tax Issues
Non-Capital (or Operating) Losses
Non-capital losses (business losses) are deductible against business income
in the year such losses arise. In addition, excess non-capital losses can be
carried back three years or forward twenty years to reduce taxable income in
those years. There are no consolidated returns in Canada, such that the profits of
one corporation in a related group cannot simply be offset by losses in another,
absent the use of certain loss-utilization transactions.
The ITA and most provincial income tax legislation contain a general anti-
avoidance rule known as the “GAAR”. The GAAR can allow the characterization
of the tax consequences of a particular transaction where (1) a tax benefit
results, directly or indirectly, from the transaction or a series of transactions; (2)
the transaction or series of transactions cannot reasonably be considered to
have been undertaken or arranged primarily for a bona fide purpose other than
obtaining a tax benefit; and (3) the transaction or series of transactions has
resulted in a misuse or abuse of the provisions of the relevant acts, regulations
and treaties, read as a whole. A tax benefit is defined as a reduction, avoidance,
or deferral of tax or other amount payable under the ITA or an increase in a
refund or other amount under the ITA.
Transfer Pricing
Transactions between a corporation resident in Canada and a non-resident
corporation with which it does not deal at arm’s length (essentially, any non-
resident entity within a related group) are subject to Canadian income tax as if
such transactions had taken place between arm’s length persons. In this regard,
Canada generally follows the OECD transfer pricing guidelines. The terms and
conditions of transactions may be adjusted under the ITA so that prices charged
on the transfer of property or provision of services between non-arm’s length
parties reflect the prices that would have been adopted had those parties been
dealing at arm’s length. The ITA provides for certain contemporaneous
documentation reporting requirements with respect to non-arm’s length
transactions. Furthermore, a penalty may be applicable at a rate of 10% of any
net adjustment made by the CRA to the transfer prices of a Canadian affiliate.
This penalty may be avoided if the taxpayer demonstrates that it has made
reasonable efforts to meet the transfer pricing rules in its determination of the
transfer prices.
Governmental Tax Incentives
The Canadian tax system provides for preferential tax treatment in certain
situations based on the nature of the taxpayer and the nature of the income

being earned. In particular, the ITA contains a number of fiscal incentive regimes
designed to encourage investment in particular sectors of the Canadian
economy, including, small business, oil and gas exploration, and certain scientific
and experimental developments.
The Canadian federal government and, in particular, the government of each
of the provinces provide generous tax incentives for the performance of scientific
research and experimental development (SR&ED) in a particular province.
Where a corporation incurs expenditures that qualify as SR&ED for the purposes
of the ITA, such expenditures may generally be deducted in the current year in
computing taxable income. In addition, a federal investment tax credit equal to
15% (or 35% in respect of CCPCs, subject to certain limitations) of qualifying
SR&ED expenditures may be available. The determination of whether certain
activities constitute SR&ED is very technical and fact specific. Most provinces
provide similar tax incentives with respect to expenditures relating to SR&ED.
Goods and Services Tax and Harmonized Sales Tax
The comprehensive federal Goods and Services Tax (GST) generally applies
to the supply of goods and services made in, or imported into, Canada. The rate
of the tax is currently 5%.
The GST applies at each stage of production. However, if the purchaser is
involved in a commercial activity and is a qualified GST registrant, it will generally
be entitled to claim a refund, called an “input tax credit”, for GST paid.
GST on taxable imported goods and services is payable by the importer of
record, while exported goods and services are generally “zero-rated” (GST
technically applies, but at a rate of 0%). A business that provides zero-rated
supplies will generally still be entitled to an input tax credit for the GST expenses
that it has paid, whereas a business that makes exempt supplies will generally
not be entitled to an input tax credit.
Pursuant to the federal Excise Tax Act, a business, whether resident or non-
resident, will normally be required to charge and collect GST from its customers
on taxable goods and services supplied by it in Canada in the course of a
business carried on in Canada. Businesses that make taxable supplies in the
course of a business carried on in Canada must also become GST registrants
unless they are “small suppliers”
(generally very small businesses making less than $30,000 in taxable
supplies in a 12-month period). GST registrants are required to file yearly,
quarterly or monthly returns depending on the registrants’ annual sales.
The provinces of Nova Scotia, New Brunswick, Newfoundland and Labrador,
Ontario and Prince Edward Island have harmonized their provincial sales taxes
with the GST to form a single Harmonized Sales Tax (HST). The HST is also
imposed under the Excise Tax Act, and has essentially the same rules as the

GST. Further, the HST uses the same registration number as the GST (no
separate registration is required), and is reported on the registrant’s GST return.
The HST includes both a provincial component and the federal GST for a
combined rate of 13% in Ontario, and 15% in New Brunswick, Newfoundland,
Nova Scotia, and Prince Edward Island (depending on where the supply is
Although Quebec is not a HST-harmonized province, it levies its own Quebec
Sales Tax (QST), which is a value-added tax applied and administered separate
from, but is legally harmonized with the GST regime (although there are certain
differences). The QST of 9.975% is a tax on the consumption of goods and
services in Quebec. Suppliers require a separate registration number for QST
Provincial Sales Tax
Saskatchewan, British Columbia and Manitoba each impose a provincial sales
tax or retail sales tax (each a PST) on most sales of tangible personal property
and certain specified enumerated services within the particular province. Each
separate PST has distinct but similar rules. The rates for these taxes are 6% in
Saskatchewan, 7% in British Columbia and 8% in Manitoba. These taxes must
generally be collected and remitted by the vendor of the property or services.
However, each province has a number of exemptions for certain goods
(production machinery, inventory for resale, etc.).
As mentioned above, Newfoundland and Labrador, Nova Scotia, New
Brunswick, Prince Edward Island and Ontario have harmonized their provincial
sales taxes with the GST to form the HST. Quebec also levies its own value-
added tax (QST) that is applied and administered separate from the GST and
HST. While British Columbia harmonized its sales tax effective July 1, 2010, it
ceased being a harmonized province and reintroduced its provincial sales tax,
effective March 31, 2013.
Provincial Payroll Tax
Manitoba, Newfoundland, the Northwest Territories, Nunavut and Ontario levy
a payroll tax on employers that is calculated as a percentage of total
remuneration paid in the province, above a certain threshold. In Ontario, for
example, the rate of Employer Health Tax is generally 1.95% of remuneration in
excess of $450,000. Quebec levies similar taxes calculated on the amount of
remuneration paid in Quebec. These taxes take the form of employer
contributions to a provincial health services fund, to a workplace training fund (if
a minimum amount is not spent on training in the company), to a parental
insurance plan and to fund a labour relations commission.
Taxes on Real Property
Property taxes on real property are an important source of revenue in
Canada, particularly for municipalities. Many provinces also levy transfer taxes
on the purchase of land and impose various other taxes on mines, timber
property and similar properties.