Many Canadian corporations form a foreign subsidiary (“Forco”) in zero or low-tax jurisdictions in order to reduce their tax liabilities.
This is a strategy that can work as long as the following four elements are present:
- Forco is not resident in Canada, having regard to common law concepts of corporate residency (“mind and management”).
- The income of Forco is considered to be income from an “active business”, as opposed to “foreign accrual property income” (“FAPI”).
- Forco’s business is not carried on in Canada, and
- The income of Forco cannot be reallocated, in whole or in part, to its Canadian parent, based on the application of Canada’s transfer pricing rules[1].
Assuming that this strategy has been successfully adopted, what happens when the income of Forco is repatriated to Canada in the form of a dividend to its Canadian parent?
In contrast to the situation with U.S. corporations, Canada allows such profits to be received free of Canadian tax, provided it is derived from “exempt surplus” (“ES”)[2].
In general, the earnings of Forco will be included in ES as long as it is resident in a country with which Canada is party to a tax treaty or a tax information exchange agreement (“TIEA”), and the business is carried on in such a country.
This means that a dividend received by the Canadian parent can be tax-free even if Forco has paid little or no corporate income tax.
Canada has tax treaties with many low-tax jurisdictions, including Barbados. In addition, Canada also has a tax treaty with the United Arab Emirates, which has no income tax at all, meaning that subsidiaries based in Dubai can generate ES.
In addition, Canada has signed TIEAs with such notable tax-havens as Bahamas, Bermuda, Grand Cayman, and the British Virgin Islands.
There is also an added bonus to such planning: not only can the profits of Forco be repatriated to its Canadian parent tax-free (assuming out of ES), but dividends paid by the Canadian parent to Canadian resident individual shareholders can benefit from reduced personal tax rates even if Forco did not pay a penny in corporate tax[3]! Thus, the use of an offshore subsidiary can result in significant tax savings even if the profits are ultimately passed-through to individual shareholders.
[1] Subsection 247(1) of the Income Tax Act (“the Act”). All statutory references are to the Act.
[2] Paragraph 113(1)(a)
[3] Dividends deductible under paragraph 113(1)(a) are included in “general rate income pool” (“GRIP”)-see item “E(b) in formula in definition in subsection 89(1).
