Think Canada for Global Projects and Global Expansion: Canadian Corporate and Tax Considerations for Foreign Expansion To and From Canada

Introduction

From its earliest days, Canada has been a nation focused on international trade – a characteristic that continues today. In 2021, Canadian exports of goods and services reached a record high of C$766 billion, much of which related to natural resources, but which also included substantial contributions from a broad range of products, including professional and financial services.^[1][2] This substantial exportation of goods and services is aided by Canada’s broad and growing network of trade-related treaties giving Canadian companies preferred access to diverse markets all over the world.^[3] These commercial trade treaties are supported by tax treaties and similar arrangements with nearly 100 countries.^[4] How can Canadians and non-Canadians leverage this favourable international trade and tax backdrop to use a Canadian corporation to develop their global projects and aid in their global expansion?

In this article, we will outline certain key corporate and tax considerations for Canadian-incorporated entities to consider prior to pursuing their global projects, and to aid in their global expansion plans. Understanding how a potential expansion opportunity may interact with the corporate and tax legal landscape in Canada is key to supporting sound investment decisions.

Jurisdiction of Incorporation

From a corporate perspective, the initial step to consider when structuring a Canadian investment or company is the incorporation of a Canadian entity.

In Canada, corporations can be incorporated under the corporate law of a provincial statute (e.g., the Business Corporations Act (Ontario) (the “OBCA”)) or under the federal corporate statute, the Canada Business Corporations Act (the “CBCA”).^[5] Given the general commonality of the majority of the provincial corporate statutes and the CBCA, one of the key factors to determining where to incorporate is the requirement for a Canadian resident director.^[6]

A corporation incorporated under the OBCA does not require any of their board of directors (“Board”) to be resident in Canada.^[7]

As a result, similar to the Delaware General Corporation Law (the “DGCL”) in the United States, which allows a person or entity to incorporate a corporation “without regard to [their] residence,”^[8] the OBCA is a popular jurisdiction to set up a Canadian entity for international investors considering Canada as a jurisdiction for foreign investment.^[9]

While the CBCA maintains the requirement for 25% of the Board to be composed of resident Canadians, it provides certain other advantages including greater mobility with respect to matters such as the location of a corporation’s registered office, flexibility in the location to hold shareholder meetings and to keep corporate records, and cost advantages at the outset of incorporation.

A corporation incorporated in Canada will generally be treated as a Canadian resident for income tax purposes and subject to tax on its worldwide income.^[10] The corporation will be required to report its income on a tax return and file the return with the Canada Revenue Agency on an annual basis.

Funding, Business Operations and Investments

Following incorporation, an entity will need to consider how to raise capital in Canada to fund future business operations and/or investments. Sources of funding for growth-stage companies are typically through equity investments from shareholders and other investors, or debt financing from shareholders, banks or other financing sources. Businesses may look to other sources of funding for start-up capital, including government grants, venture or private equity financing or other types of loans or funding arrangements.^[11]

The amount of equity contributed to the Canadian corporation for shares of the corporation may be added to the stated capital of the class of shares and form the paid-up capital of the class of shares for Canadian income tax purposes as determined by the Board. Paid-up capital is a valuable tax attribute because, unlike dividends, capital can be returned/distributed to a shareholder free from Canadian withholding tax. Similarly, the principal amount of a loan can be repaid tax-free. Subject to Canadian thin-capitalization rules, transfer pricing rules and other limitations, interest that is not participating debt interest paid by the Canadian corporation to a non-resident that deals at arm’s length with the Canadian corporation is not subject to Canadian withholding tax. However, interest paid by a Canadian corporation to a non-arm’s-length non-resident is subject to withholding tax, unless the non-resident is a resident of the U.S. and a “qualifying person” for purposes of the Canada-U.S. Income Tax Treaty (the “Treaty”), in which case the interest would generally be exempt from Canadian withholding tax under Article XI(1) of the Treaty.

There is technically no limit to the amount of equity and non-interest-bearing debt that can be contributed or advanced, as the case may be, to the Canadian corporation; however, Canadian thin-capitalization rules should be kept top of mind. Canadian thin-capitalization rules would deny a deduction to the Canadian corporation in respect of the proportionate amount of interest payable on debt from a specified non-resident shareholder (generally, a non-resident that alone or together with non-arm’s-length persons holds shares with at least 25% of the votes or value in the Canadian corporation) or a person not dealing at arm’s length with the specified non-resident shareholder if such debt exceeds 1.5 times the equity of the Canadian corporation. Canadian thin-capitalization rules will naturally limit the amount of internal cross-border debt to a 60/40 debt-to-equity ratio. Canadian thin-capitalization rules do not apply to domestic or third-party debt. Importantly, any interest that is non-deductible by virtue of these rules is deemed to be a dividend for withholding tax purposes and subject to applicable withholding under the dividend regime rather than the interest regime. However, Canada is proposing to introduce new excessive interest and financing expense limitation (“EIFEL”) rules which generally apply to domestic, internal and third-party debt. The EIFEL rules will generally limit a corporation’s interest and financing expenses in excess of its interest and financing revenues to 30% of “adjusted taxable income” (generally, earnings before interest, taxes, depreciation and amortization ("EBITDA") computed under the rules in the Income Tax Act (Canada)) for taxation years beginning in 2024.

Once the Canadian corporation has received funding from its investors as described above, those funds can be used for operations and investments within Canada or, as often occurs with many Canadian corporations, those funds can be invested in securities or assets of entities in jurisdictions outside of Canada. This approach of raising capital in Canada and investing in jurisdictions outside of Canada is well known, including in industries such as mining, oil and gas, cannabis and psychedelics, but could be available for other industries as well.^[12]

Approval Thresholds

When contemplating certain key corporate decisions, including the potential entering into of a strategic transaction such as M&A or a financing, shareholder approval thresholds must be considered in order to ensure the corporation can gain the necessary support from shareholders to proceed. These thresholds are contained in the applicable corporate statute under which the corporation exists, but, particularly in the “private company” context, may also be modified by a shareholders’ agreement.

In Canada, “ordinary” shareholder resolutions and “special” shareholder resolutions are the two types of resolutions that may need to be passed by a corporation’s shareholders to undertake certain actions that require approval of shareholders under Canadian corporate laws.

Generally speaking, ordinary resolutions (i.e., 50.1% of votes cast at a formal meeting of shareholders (a “Meeting”) (excluding any votes that were abstained), rather than 50.1% of shares determined on an absolute basis) are used to pass more routine matters, such as the appointment of auditors or the election of directors. Special resolutions (i.e., 66 2/3% of all votes cast at the Meeting, rather than 66 2/3% of shares determined on an absolute basis) which require a higher level of voting support from shareholders are used for more significant matters, including but not limited to the entering into a fundamental strategic transaction, altering a corporation’s articles or amending the corporation’s name. Approval thresholds will vary depending on the jurisdiction of incorporation and whether approval is obtained through a written resolution document, which is often considered instead of a Meeting to reduce unnecessary time and expense if the shareholder base is smaller and the corporation’s stakeholders are engaged with each other to approve certain corporation actions.

Similar to the DGCL, the OBCA has lower shareholder approval thresholds for certain written resolutions when compared to the CBCA. In Ontario, unless contracted out under its articles of incorporation, bylaws or a shareholders’ agreement,^[13] an ordinary written shareholder resolution for a non-offering corporation (i.e., a private company) requires approval from shareholders holding at least 50.1% of the voting shares determined on an absolute basis. Conversely, the CBCA requires approval from shareholders holding 100% of the shares for ordinary written shareholder resolutions. The CBCA does not allow a corporation’s articles, bylaws or shareholders to reduce such thresholds enumerated in the CBCA.

Additional Income Tax Considerations

A Canadian corporation with foreign subsidiaries should be mindful of certain tax issues, particularly the Canadian tax treatment of its foreign income carried on through the subsidiary, as well as the application of troublesome “foreign affiliate dumping” rules.

Canada has a favourable tax regime for foreign affiliates of Canadian entities that earn active business income (as opposed to passive income) in countries with which Canada has a tax treaty or a comprehensive tax information exchange agreement. Canada’s foreign affiliate taxation system effectively exempts qualifying business profits earned in such jurisdictions from Canadian tax. In contrast to active business income, income from passive investments (e.g., rent, royalties, interest, etc.), an investment business (i.e., a business that is deemed not to be an active business) or a non-qualifying business is generally subject to tax in Canada annually on an accrual basis.

Foreign withholding tax may apply when the foreign business profits are repatriated to Canada in the form of dividends. The rate of withholding tax may be reduced pursuant to the terms of an applicable income tax treaty. With respect to business profits sourced from an active business in a designated treaty country, the dividend income would be received tax-free in Canada through a “dividends received deduction.” With respect to income earned in a non-designated treaty country, a deduction is permitted to the Canadian corporation to offset foreign income tax and foreign withholding tax on the income received by the Canadian corporation. If there are non-resident shareholders of the Canadian corporation, the use of a Canadian corporation produces an inherent tax inefficiency due to a double layer of withholding tax in the structure: the first in the source country on the distribution by the foreign subsidiary, and the second in Canada when it pays a dividend to its non-resident shareholders. From a tax perspective, the non-residents would be better suited to hold their interest in the foreign subsidiary directly. In addition, depending on the level of substance in Canada and other factors, consideration must be given to whether the source country will apply favourable treaty withholding rates on payments of interest (and other amounts) to an interposed Canadian holding company.

Foreign investors holding shares in a Canadian corporation with a foreign subsidiary must be mindful of Canadian foreign affiliate dumping rules, which apply when a Canadian corporation is controlled by a non-resident or a non-arm’s-length group of non-residents and the Canadian corporation makes an “investment” in a non-resident corporation. An investment is defined very broadly for purposes of these rules. In these circumstances, a deemed dividend may apply in respect of the amount of the investment by the Canadian corporation in the foreign subsidiary. The dividend would be deemed to be paid to the non-resident(s) and subject to Canadian withholding tax at a rate of 25%, subject to reduction under the terms of an applicable income tax treaty signed between Canada and the country of residence of the non-resident to whom the dividend is deemed to be paid. In certain limited circumstances, the paid-up capital of shares may be reduced instead. The investor group must actively manage its exposure to the foreign affiliate dumping rules if a significant non-resident shareholder or group exists.

Conclusion

Although this article is only intended to be a high-level overview, it introduces key considerations to be contemplated by investors into Canada to ensure compliance with particular Canadian laws, which can often be unique to Canada generally and differ by jurisdiction of incorporation within Canada. While incorporating a Canadian entity may be a relatively non-complex and inexpensive process, many decisions made by a corporation at the outset can have long-term and unexpected consequences on future operations. Furthermore, there are important rules to be considered from a tax structuring perspective as it relates to foreign investment, including how the Canadian corporation will be capitalized, how the income of foreign subsidiaries of the Canadian corporation will be taxed in Canada and potential drawbacks applicable to a significant non-resident investor or group. Experienced Canadian advisers should be consulted to ensure the incorporated entity is efficient from a corporate and tax perspective.

Having an understanding of key corporate and tax legal considerations is important when considering foreign expansion. It is also crucial for investors, incorporators and other stakeholders with a nexus to Canada to engage with experienced Canadian legal counsel with a breadth of expertise and knowledge in these areas to provide advice at the outset.

Once a company or investor has a solid foundation within Canada, they will often begin to consider strategic M&A or investment opportunities. For a fulsome discussion on important legal considerations when contemplating a strategic M&A transaction, please refer to our article from September 2022: Important Canadian Legal Considerations and Market Practices for U.S. and International Purchasers in Cross-Border Private M&A Transactions.

The Capital Markets Group and Tax Group at Aird & Berlis will continue to monitor developments in this area. Please contact Jeffrey Merk, Gary Volman, Francesco Gucciardo (Tax Group), Saam Nainifard (Tax Group) or Ryan Cohen if you have questions or require assistance with any matter related to structuring Canadian companies or investments into or outside of Canada.

[1] State of Trade 2022: The Benefits of Free Trade Agreements (international.gc.ca).