Stock option

Stock option plans are quite often an integral part of an employee’s compensation package to create long term capital use in retirement. Companies implement these plans to attract, reward and retain highly skilled employees.

What is a stock option?

A stock option allows the employee to purchase a certain number of shares at a specified price (‘the option price’) for a specified period of time. Often there is a holding period during which the employee cannot exercise the option. Once this holding period is over, the option is considered ‘vested’ and the employee can exercise the option any time thereafter until the expiry date, if any.

This article will review the different tax rules associated with option plans for Canadian-controlled private corporations (CCPCs) and non-CCPCs i.e. Canadian public corporations.

Taxation of stock options from Canadian public companies

While there are no tax consequences when such stock options are granted, at the time the employee exercises the option they trigger an ‘option benefit’. This benefit is equal to the difference between the market value of the stock and the ‘option price.’ This benefit must be included in the employee’s income from employment in the year in which the option is exercised. The employee can claim a tax deduction equal to one-half of the ‘option benefit’ if the shares are common shares and the exercise price, at the time the options were granted, was equal to the fair market value of the shares.

For example:

  • You have options to acquire 3000 common shares of ABC
    Company at $30 per share (equal to the fair market value of the shares on the date the options were granted).
  • Current market value of ABC’s common shares is $75.
  • All options are vested.
  • If all 3000 shares are exercised, the taxable ‘option benefit’ is $67,500 ($75-$30 = $45 x 3000 shares x 50%).

Taxation of stock options from Canadian controlled private corporations

Employees of CCPCs do not need to include the ‘option benefit’ in income until the year in which the employee disposes the shares. As with non-CCPC shares, the option benefit may be reduced by one-half as long as the exercise price at the time the options were granted was equal to the fair market value of the shares. If it does not meet these criteria, an employee may be able to access another one-half deduction as long as the shares have been held for at least two years at the date of sale.

Deferring the ‘Option Benefit’

The 2000 Federal budget introduced a deferral of the ‘option benefit’ for non-CCPCs until the employee sells the shares, or is deemed to have disposed of the shares on death or on becoming a non-resident of Canada. This deferral applies to options exercised after February 27, 2000, regardless of when the options were issued.

The amount that may be deferred is limited to the benefit arising on $100,000 worth of stock options vested in a particular year. While the $100,000 amount is based on the fair market value of the shares at the time the option is granted, the actual benefit that can be deferred can be much greater.

This can best be illustrated by example:

In January 2000, an employee received 10,000 qualifying shares at an option price of $25 per share equal to the fair market value at the time of grant.

Of the 10,000 options, 5,000 vested in January 2001 and the
remaining 5,000 in January 2002.

On December 1, 2002, all options were exercised. The fair
market value of the shares on that date was $60.

In 2004, the employee sells all 10,000 shares at a fair market value of $65 per share.

2002 Tax Calculation:

Step One – Calculate the number of shares that can be deferred.

The $100,000 maximum deferral is based on the $25 fair market value. Therefore the income benefit that the employee can defer in our example is based on 4,000 shares per vested year ($100,000 / $25).

Step Two – Calculate the income deferral.

(Number of shares * benefit per share)

2001 deferral = $140,0000, (4,000 shares * $35 ($60-$25))

2002 deferral = $140,0000, (4,000 shares * $35 ($60-$25))

Total deferral – $280,000

Step Three – Calculate the income benefit.

2001 income inclusion = $175,000, (5,000 x ($60-$25 = $35))

2002 income inclusion = $175,000, (5,000 x $60-$25=$35))

Total income before deferral – $350,000, less deferral (from Step Two) = $280,000

Total income reported in 2002 = $70,000

Of this $70,000 only 50% is taxable at the employees marginal tax rate.

2004 Tax Calculation

The employee now pays the tax on the $280,000 option benefit that was deferred and the gain on the shares from 2002 to 2004 ($65-$60 x 10,000 shares = $50,000). The total
income reported when the shares are sold is $215,000 ($330,000 x 50%)

Note: If the value of the shares have declined when you eventually sell, you will realize a capital loss but still be liable for the tax on the option benefit.

An employee who receives stock options for a public company and elects to defer the taxable benefit of up to $100,000 per annum (under subsection 7(8) of the Canadian Income Tax Act) until the shares are disposed of must report the taxable benefit (receipt of the stock option) at the time of disposition (on form T1212) and must pay Canadian income tax at that time.

Note: The above article is for information purposes only and should not be construed as offering tax advice. Individuals should consult with their personal tax advisors before taking any action based upon the information in this article.

IFRS Conversion Plan

The Clock is Ticking – Accounting for Taxes in Your IFRS Conversion Plan

International Financial Reporting Standards (IFRS) will replace Canadian generally accepted accounting principles (GAAP) for fiscal years beginning on or after January 1, 2011. Most companies have started their changeover to IFRS. But some companies have delayed their detailed assessment of income taxes in anticipation of a new version of the IFRS for Income Taxes (IAS 12) proposed in the March 31, 2009 exposure draft. 

The March 31, 2009 exposure draft is no longer relevant. After considering comments received in response to the exposure draft, the International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB) jointly agreed that the project should not proceed in its current form.

With the current proposals not proceeding and deadlines looming, Canadian companies can no longer ignore existing IAS 12. This TaxNewsFlash-Canada highlights differences and also some similarities between Canadian GAAP and IAS 12 that you should consider as part of your company’s conversion plan.

Don’t delay

Little time is available before companies first have to report in IFRS. Within 90 days of January 1, 2011 (by March 31, 2011), companies must issue their 2010 annual Canadian GAAP financial statements, and a scant 45 days after that (by May 15, 2011), they must issue their first 2011 interim IFRS financial statements. The Canadian Securities Administrators has proposed a 30-day extension to the deadline for filing the first interim financial report in the year of adopting IFRS. Given the magnitude of work needed to make a successful changeover to IFRS, this extension may offer only minor relief.

Preparing these interim financial statements and the first-time adoption disclosures in the first quarter of 2011 can be an onerous exercise that is quite different from the usual quarterly financial reporting. With timing this tight, companies that do not start working on their conversion well in advance likely will not have enough time to catch up.

Additionally, as IFRS affects reported pre-tax profits, many IFRS standards affect tax reporting as well. The potential effect of IFRS on an enterprise’s income taxes goes well beyond IAS 12. Tax professionals need to understand the impact of all IFRS adjustments — both on adopting IFRS and on an ongoing basis. Your tax group should begin preparing for the impact of IFRS now to avoid the crises that could arise if the project needs to be completed in a rush.

Differences between IAS 12 and Canadian GAAP

Below is a summary of certain items that are treated differently under IAS 12 and existing Canadian GAAP. Other differences may also exist that will affect an entity’s income tax provision calculation.

Investments in subsidiaries, associates and interests in joint ventures

Similar to Canadian GAAP, IAS 12 requires that deferred tax is not recognized for the excess amount for financial reporting over the tax base of an investment in a subsidiary or a corporate joint venture (i.e., outside basis difference), if certain conditions are met.  Unlike Canadian GAAP, however, IAS 12 requires disclosure of the aggregate amount of temporary differences associated with investments in subsidiaries, branches, associates and interests in joint ventures for which deferred tax liabilities have not been recognized.

Foreign non-monetary assets and liabilities

Under IAS 12, a deferred tax asset or liability is recognized for exchange gains and losses related to foreign non-monetary assets and liabilities that are re-measured in the functional currency using historical exchange rates. By contrast, Canadian GAAP provides that a deferred tax asset or liability is not recognized for temporary differences arising from the difference between the historical exchange rate and the current exchange rate translations of the cost of non-monetary assets and liabilities of integrated foreign operations.

The IFRS treatment will affect Canadian companies with a functional currency that is different from their tax reporting currency.

Initial recognition exception

IFRS also has an exemption from recording deferred income taxes on the initial recognition of an asset or liability. There is no equivalent treatment under Canadian GAAP.

Under IAS 12, a deferred tax liability (asset) is not recognized if it arises from the initial recognition of an asset or liability in a transaction that is not a business combination and affects neither accounting profit nor taxable profit at the time of the transaction. For example, such a transaction could occur where assets are transferred under a tax-free rollover or where an entity is acquired through shares in a transaction that does not constitute a business combination. Further, an entity does not recognize later changes in the unrecognized deferred tax asset or liability as the asset is depreciated, requiring companies to track the piece that is essentially a permanent difference.

Canadian GAAP differs from IAS 12 in this respect. When a transaction is not a business combination and affects neither accounting profit nor taxable profit, an entity would recognize the resulting deferred tax asset/liability and adjust the carrying amount of the asset or liability by the same amount (using simultaneous equation).

Inter-company transfers of assets

An inter-company transfer of assets (such as the sale of inventory or depreciable assets) is a taxable event that establishes a new tax base for those assets in the buyer’s tax jurisdiction. The new tax base of those assets is deductible on the buyer’s tax return as those assets are consumed or sold to an unrelated party.

Under IAS 12, a deferred tax asset or liability is recognized for the difference in tax bases between the buyer and seller on an intra-group transfer of assets and so the deferred tax is computed using the buyer’s tax rate. Under Canadian GAAP, a deferred tax liability or asset is not recognized for the difference in the buyer’s and seller’s tax bases on an intra-group transfer of assets, and any current taxes paid or recovered by the seller are deferred based on the seller’s tax rate.

Distributed vs. non-distributed rate

In some jurisdictions, income taxes are payable at a higher or lower rate if part or all of the net profit or retained earnings is paid out as a dividend to shareholders of the entity. In other jurisdictions, income taxes may be refundable or payable if part or all of the net profit or retained earnings is paid out as a dividend to shareholders of the entity. In these circumstances, IAS 12 requires the use of the tax rate applicable to undistributed profits in measuring deferred taxes. The tax consequences of the distribution are only recognized when a liability to make the distribution is recognized.

In Canada, income taxes generally are not payable at a higher or lower rate depending on the payment of dividends, and so Canadian GAAP does not address any such rate differential. However, Canadian GAAP sets out specific guidance for tax-exempt-type entities (such as real estate investment trusts, mutual fund trusts and specified investment flow-through entities (SIFT). This guidance provides an exemption from recognizing deferred taxes if certain conditions are met (see EIC 107). Additional guidance is provided for SIFTs that will become taxable in 2011 (see EIC 167).

Business combinations

In a business combination, temporary differences arise when the carrying amount of identifiable assets and liabilities acquired is revalued at fair value but the tax bases are not affected by the business combination or are affected by a different amount. For example, when the carrying amount of an identifiable asset is increased to fair value but the tax base of the asset remains at cost to the previous owner, a taxable temporary difference arises. Consistent with current Canadian GAAP, IAS 12 requires companies to recognize a deferred tax liability for these temporary differences and make a corresponding adjustment to goodwill.

Further, in a business combination, the deferred tax position of both the acquirer and acquiree at the date of acquisition is assessed from the point of view of the consolidated group. For example, a previously unrecognized deferred tax asset relating to the acquiree’s or acquirer’s tax losses may be recovered by utilizing the consolidated group’s future profit.

While this treatment is consistent with current Canadian GAAP (in accordance with CICA HB 1581), the accounting for the unrecognized amounts may differ under IAS 12. Under IFRS, where previously unrecognized deferred tax assets (e.g., tax loss carryforwards) of the acquirer are recognized, the acquirer recognizes the deferred tax asset in profit or loss. Under current Canadian GAAP, previously unrecognized deferred tax assets of the acquirer that become recoverable due to a business combination are recognized as a reduction of goodwill, rather than in profit or loss. The future recognition of the deferred tax asset is reported in profit or loss under Canadian GAAP only if the acquirer’s deferred tax asset was not recognized as of the acquisition date.

From the acquiree’s perspective, under IAS 12, if deferred tax assets of the acquiree that were not recognized at the date of acquisition are later realized (by realization or reduction of the valuation allowance), the adjustment is applied to reduce the carrying amount of goodwill related to that acquisition provided that the resulting deferred tax asset is recognized within the measurement period and results from new information about facts and circumstances that existed at the date of acquisition.  If the carrying amount of goodwill is zero, any remaining deferred tax benefits are recognized in profit or loss.  All other acquired deferred tax benefits later realized are recognized in profit or loss.

By contrast, current Canadian GAAP requires the later recognition of the acquiree’s deferred tax assets for temporary differences that existed at acquisition to be recognized first against goodwill, then against other intangible assets before any balance is recognized as a tax recovery in profit or loss.

Uncertain tax positions

Like Canadian GAAP, IAS 12 does not contain specific guidance on the recognition and measurement of uncertain tax positions and practice may vary. Canadian companies adopting IFRS may need to re-measure liabilities recorded in respect of uncertain tax positions that remain unsettled at their IFRS transition date.

Compound instruments

Under IFRS, an entity that issues compound financial instruments, such as convertible debentures, classifies the instrument’s liability component as a liability and the equity component as equity. In some jurisdictions, the tax base of the liability component on initial recognition equals the initial carrying amount of the sum of the liability and equity components, and a taxable temporary difference arises. Under IAS 12, the resulting deferred tax liability is recognized, and the deferred tax expense is charged directly to the carrying amount of the equity component. Later changes in the deferred tax liability are recognized in profit or loss.

By contrast, Canadian GAAP provides that if a compound instrument can be settled tax-free, deferred taxes would not be recorded related to the temporary difference (i.e., the tax base of the liability component is considered equal to its carrying amount, and no temporary difference arises).

Allocation of tax to components of profit or loss or equity

IAS 12 requires the tax effects of items credited or charged directly to equity during the current year also be allocated directly to equity.  IAS 12 also requires subsequent changes in those amounts to be allocated to equity (i.e., full backwards tracing).  Such items may arise from either changes in assessments of recovery of deferred tax assets or changes in tax rates, laws, or other measurement attributes.  One must consider where the initial transaction was recorded as they follow through on changes to the deferred tax liabilities and assets in future years.

In contrast, Canadian GAAP is different from IAS 12 in that it generally requires that subsequent changes in those amounts to be allocated to profit or loss.

Balance sheet classification of deferred tax assets and liabilities

IAS 12 does not permit the deferred tax assets and liabilities to be classified as current.  Essentially, they are presumed to be non-current.  In addition, deferred tax liabilities and assets should be presented separately from current tax liabilities and assets.

On the other hand, Canadian GAAP indicates that the classification of future income tax assets and liabilities is based on the classification of the underlying asset or liability.  Where there is no related asset or liability, the classification is based on the date that the temporary difference is expected to reverse.

Similarities to existing Canadian GAAP

Below is a summary of certain items that will be treated under IAS 12 in a way that is more similar to their accounting treatment under existing Canadian GAAP.

Recognizing deferred tax assets

Under IAS 12, deferred tax assets are recognized to the extent that it is probable that the benefits will be realized. “Probable” is not defined in the standard, however, in practice, the “more likely than not” definition is often used (i.e., same as Canadian GAAP).

Measuring deferred tax assets and liabilities

Similar to Canadian GAAP, IAS 12 requires that deferred taxes are measured based on enacted or substantively enacted tax rates as of the balance sheet date.

Similarly, IAS 12 requires an entity to measure deferred tax liabilities and assets using the tax rate that is consistent with the expected manner of recovery or settlement of the asset or liability.  IAS 12 also indicates that the measurement of deferred taxes shall reflect the tax consequences that would follow from the manner in which the entity expects, at the end of the reporting period, to recover or settle the carrying amount of its assets and liabilities.

Goodwill

A deferred tax liability is not recognized if it arises on the initial recognition of goodwill that is not tax-deductible. However, any temporary difference is recognized after the acquisition if the goodwill is tax-deductible.

Due to the general nature of the bulletin, it should not be relied upon as legal or tax advice.

Luxembourg

Luxembourg Foreign Investment

The Luxembourg government actively encourages foreign investment. There are no formalised legal regimes aimed at foreign investment as such (other than the tax-exempt ‘holding’ companies and collective investment funds ) but on an ad hoc basis the government offers a variety of types of assistance including guarantees, cash, tax incentives, subsidised loans, assistance with development and construction projects etc.

Luxembourg has a wide range of customised investment incentives specifically for new ventures to the principality. This includes the offer of land with favourable conditions at one of the country’s municipal business parks or national industrial parks which are equipped with the infrastructure necessary to support a successful business.

In addition, there are incentives for investment available to Luxembourg and foreign investors alike under the laws of 28th July 1923 and 27th July 1972.

 
Luxembourg Tax Treatment of Offshore Operations
.

Offshore companies are taxed as follows :

  • Holding companies formed under the law of 31st July 1929 are exempt from income taxes (the IRC and the Municipal Business Tax on Profits) and from the Fortune Tax. No tax is levied on the transfer of shares, and there are no taxes due on the liquidation of a 1929 Holding Company. No withholding tax is due on dividends payable to a 1929 Holding Company. (NB 1929 holding companies can no longer be formed.)
  • 1929 Holding Companies are subject instead to the capital contribution tax (droit d’apport) of 1% of subscribed capital, either on formation or on a later capital increase, and to the subscription duty (taxe d’abonnement) which amounts to 0.20% of the value of the shares issued by the Holding Company, payable annually in four equal instalments. If shares are quoted, the value is the current market value; if there is no quotation, the paid-in value is used. There are adjustments if dividends are paid out during the year, if profits are written to reserves, or if losses are incurred. Under legislation which came into effect in 2004, in order to satisfy the EU’s ‘harmful tax practices’ initiative:

    A 1929 holding company loses its tax-exempt status if at least 5% of its dividends received relate to foreign participations that are not subject to tax at a rate comparable to the Luxembourg corporate income tax rate. An effective tax rate is considered to be comparable if it is at least 11%, equating to approximately one-half of the current corporate income tax rate that applies to regular resident taxpayers and is in line with the tax rate generally applicable to dividends received from participations that do not qualify for a full exemption.

    Further, the taxable base needs to be determined under a method similar to the methods used in Luxembourg. An auditor or accountant is required to certify annually that the eligibility requirements have been met. A 1929 holding company that loses its tax-exempt status is subject to the normal corporate income tax regime.

    For newly incorporated 1929 holding companies, the amendment applied as from 1 January 2004. For existing 1929 holding companies (i.e. those incorporated under the law applicable before 1 January 2004), the new rules will not apply before they are terminated in 2010.

  • Milliardaire Holding Companies are taxed on the basis of various percentage rates applied to interest paid out and dividends distributed by the company, and on the remuneration and fees paid to directors, auditors and liquidators residing less than six months of the year in Luxembourg. The minimum annual tax liability of a Milliardaire Holding Company is much less than an equivalent 1929 Holding Company would pay. (NB Milliardaire holding companies can no longer be formed.)
  • Financial Holding Companies are taxed on the same basis as 1929 Holding Companies. (NB Financial Holding Companies can no longer be formed.)
  • The replacement for the 1929 holding company, the Family Private Assets Management Company, or SPF is intended to be exempt from corporate income tax, municipal business tax and net-worth tax, and from withholding tax on distributions. These new vehicles are prohibited from commercial activity, and will be limited to private wealth management activity, for example the holding of financial instruments such as shares, bonds and other debt instruments, in addition to cash and other types of bankable asset. If the SPF is used to hold voting rights in other companies, it must ensure that it does not involve itself in the running of those companies, and it is prohibited from providing any kind of service. The SPF’s exemptions can be affected by participation in non-resident, non-listed companies, if those companies are located in a country not subject to a roughly equivalent corporate tax regime.
    A subscription tax at a rate of 0.25% is payable on share capital.
  • SOPARFI companies, which were created under the law of 24th December 1990, are subject to the normal regime of income taxes etc but do receive the benefit of Double Taxation Treaties, and in many circumstances are exempt from taxation on dividends received from or paid to resident and non-resident companies in which they have a significant participation. The EU Parent-Subsidiary Directive also provides some withholding tax exemptions (improved as from 2004), but the SOPARFI benefits are more extensive. The rules are complex; there are conditions; and there are limitations on the deductibility of expenses.
  • The various forms of UCI are all exempt from all Luxembourg taxation, and pay only a small capital duty on start-up, plus an annual tax on net assets which (at the time of writing) varies between 0.01% and 0.06% depending on the type of fund. In June, 2004, the Luxembourg government announced that pension funds would be exempt from the 0.01% ‘subscription’ tax, in order to encourage the transnational pooling of pensions assets.
  • In 2004, Luxembourg introduced the SICAR, which may take one of a number of corporate forms, including that of a limited partnership. A fixed capital duty of Euro 1,250 applies to equity capital injections upon incorporation or thereafter. SICARs that are in corporate form are fully taxable and should in principle, unlike 1929 holding companies, be eligible for benefits under Luxembourg’s tax treaties as well as benefits under EC directives. Investment income and realized gains are not considered taxable income, and realized losses and write-downs are not deductible. All other income and expenses are taxable in the normal way. Distributions are exempt from withholding tax, as are redemptions by nonresident investors, regardless of the amount or holding period. SICARs are exempt from wealth tax, and there is an exemption from VAT for management charges. SICARs are excluded from the benefits of fiscal consolidation. Investors seeking tax transparency will opt for a SICAR in the form of a limited partnership (SeCS). An SeCS is not liable to corporate income tax or net wealth tax, and is exempt from the municipal business tax. Income from the partnership and capital gains realized on units by nonresident partners will not be taxed in Luxembourg.


Luxembourg The EU’s Parent/Subsidiary Directive

Changes to the parent/subsidiary directive in 2004 have reduced the holding requirement to 20% for 2005-06; to 15% for 2007-08; and to 10% for 2009 onward. Under the EU’s Directive on Interest and Royalties, which also came into effect in 2004, both types of payment will be exempt from withholding tax if they are between associated companies (rules as for the participation exemption).

Luxembourg has actually gone even further, meaning that there is no withholding tax on royalties paid to non-resident companies, and Luxembourg holding companies incorporated according to the terms of the law of 1929 are not subject to such withholding tax either. In line with the directive, the laws came into force retrospectively, with effect from January 1st 2004.

Luxembourg Taxation of Foreign and Non-Resident Employees In Luxembourg the taxation of individuals is based entirely on the concept of residence, regardless of nationality.  Generally, individuals are considered to be resident when they maintain a residence in Luxembourg with the intention of remaining other than temporarily. A stay of six months is deemed to be residence. Most types of compensation and benefit paid to employees are taxable; there are no special privileges or exemptions for expatriate workers.Non-residents are liable to pay Luxembourg taxes only on certain types of income arising in Luxembourg or from Luxembourg sources. These types of income are very precisely defined in Luxembourg legislation. Nationals of countries with which Luxembourg has double taxation treaty also need to be aware that the relevant treaty may well affect their tax treatment. The main types of taxable income for non-residents are: 

  1. income from trade or business carried on in Luxembourg or arising there;
  2. income from dependent services (ie employment income) performed or arising in Luxembourg;
  3. pension income resulting from former activity in Luxembourg;
  4. investment income arising or paid from Luxembourg;
  5. income from leasing of goods etc situated in Luxembourg or exploited by a Luxembourg entity;
  6. capital gains on the sale of property or substantial participations in Luxembourg companies.

Each of these categories is further defined in considerable detail in the legislation.

Luxembourg eventually signed up to the compromise on the European Savings Tax Directive reached in January, 2003, and has imposing a withholding tax on non-residents’ investment returns, like Switzerland, as from July, 2005 (initially at a rate of 15%, rising to 20% in 2008, and 35% in 2011).

Due to the general nature of the bulletin, it should not be relied upon as legal or tax advice.

 

US structures

 

US structures

US entities doing business overseas can use a variety of structures. Some of the most important are listed below with notes about their taxation characteristics:

Controlled Foreign Corporation

The foreign subsidiary of a US corporation or a foreign company owned by US shareholders is typically a Controlled Foreign Corporation (CFC).

A CFC means any foreign corporation if on any day during the foreign corporation’s taxable year US shareholders own more than 50% of:

  • The total combined voting power of all voting stock, or
  • The total value of all the stock.

A foreign corporation is any corporation not created or organized in the United States. A US shareholder is a US person that owns 10% or more of the voting power of all classes of stock entitled to vote of the foreign corporation. A US person is a citizen or resident of the United States, a domestic partnership or corporation, or any estate or trust unless its income from sources outside the US (other than income that is effectively connected with a US trade or business) is not includable in gross income under US tax law.

In determining whether a US person is a US shareholder, the US person will be considered to own stock that it owns:

  • Directly;
  • Indirectly through foreign entities; or
  • Constructively under certain rules that attribute stock ownership from one entity to another.

A US shareholder includes actual distributions from a CFC in taxable income, plus under Subpart F of the Tax Code certain types of undistributed income of a CFC, including:

  • Passive investment income;
  • Income from the purchase of goods from, or sale to, certain related entities;
  • Income from the performance of services for or on behalf of certain related entities;
  • Certain types of shipping and oil-related income;
  • Insurance income from insuring risk located outside the CFC’s country of incorporation;
  • Income from bad conduct activities, such as participation in an international boycott, payment of illegal bribes and kickbacks, and income from a foreign country during any period that country is “tainted” under IRC 901(j); and
  • In addition, the US shareholders of a CFC are required to include in income their share of the CFC’s increase in earnings invested in US property.

The Subpart F rules are extremely complex, and professional advice is absolutely necessary in interpreting them.

Foreign Sales Corporation

Under legislation dating from 1984, which was eventually declared unacceptable by the World Trade Organization after a complaint from the European Union, the US Internal Revenue Code authorized the establishment of foreign sales corporations (FSCs), being corporate entities in foreign jurisdictions through which US manufacturing companies could channel exports. 15% of the revenue concerned was exempted from corporation tax, meaning (at 35% tax) that companies kept 5.25% more of their revenue.  

The FSC rules generally replaced the domestic international sales corporation (DISC) rules. IC-DISCs exist, however, for small domestic taxpayers.  

Possessions Corporations

Possessions corporations may operate to obtain the benefits of section 936 in all US possessions including the US Virgin Islands. However, the overwhelming majority of possessions corporations are operating in Puerto Rico.

Possessions corporations must have:

  • Filed a valid Form 5712, Election To Be Treated as a Possessions Corporation Under Section 936 (an election cannot normally be revoked for the first ten years);
  • Derived 80% or more of their gross income from sources in a US possession during the applicable period immediately before the tax year ended, and
  • Derived 75% or more of their gross income from the active conduct of a trade or business in a US possession during the applicable period immediately before the tax year ended. In 1976 the amount was 50%. This amount increased over the years to 75%.

The ‘applicable period’ is generally the shorter of 36 months or the period when the corporation actively conducted a trade or business in the US possession.

A domestic international sales corporation (DISC) or a former DISC, or a corporation that owns stock in a DISC, former DISC, foreign sales corporation (FSC), or a former FSC is ineligible for Section 936 relief.

A possessions corporation is allowed a credit against its US tax liability equal to the portion of its tax that is attributable to:

  • The taxable income from non-US sources from the active conduct of a US trade or business within a US possession, and
  • The qualified possession source investment income.

The credit is not allowed against environmental tax, tax on accumulated earnings, personal holding company tax, additional tax for recovery of foreign expropriation losses, tax increase on early disposition of investment credit property, tax on certain capital gains of S corporations or recapture of low income housing credit.

A possessions corporation may elect either the cost sharing or profit split method of computing taxable income with respect to a certain possession product

Due to the general nature of the bulletin, it should not be relied upon as legal or tax advice.

Tax Forecast

 

Corporate Income Tax Forecast Methodology

 The corporate income tax forecast is produced by:

  • Forecasting total annual corporate tax liability.
  • Forecasting annual liability by payment type – advance payments, final payments, delinquent payments and refunds.
  • Convert the annual tax liability forecast by payment types into a quarterly collections forecast.

Due to the general nature of the bulletin, it should not be relied upon as legal or tax advice.

Corporate Liability Model

The corporate income tax model is similar in nature to the personal models. However, the transition from collections to liability is far more complex. A specific corporate tax year may start any time during the same calendar year. Many corporations use calendar year or fiscal year as their tax year, but not all. As a result, collections and refunds for a given tax year are spread over several years The differing tax years also means that payments are received on multiple tax years simultaneously. For example, an average of 72 percent of advanced payments received during a calendar year belongs to that tax year. The remaining 28 percent belong to the prior tax year.. In essence collections are split by tax year and then shifted back in time to create a liability data set.

This produces a monthly liability variable for each payment type. The monthly data are then converted to annual data prior to forecasting each payment type. The main driver behind the total liability model is corporate profits.

Collections Model

The spreading equations take the annual liability forecasts by payment type and convert them into monthly collections forecasts. The steps involved in this process are laid out below:

  • Annual forecasted liability by payment type is spread equally over the months of the year.
  • The liability series for all payment types except refunds is split into two pieces based on when collections for a given tax year’s liability occur. (The reverse of the process used to convert collections to liability).
  • The forecasts are then shifted forward in time to account for the time between when the liability is incurred and collections occur.
  • Historical seasonally patterns are applied to the forecasts using X-11 determined seasonal factors.
  • Monthly forecasts are summed to get quarterly collections forecasts.

Forecaster Judgement

The raw collections forecasts must be adjusted to account for tax law changes that are not included in the liability models. This includes recent legislation and policy actions such as adding more tax auditors at the Department of Revenue. Kicker credits that have yet to be taken are also reflected in this manner.

In addition, recent collections trends must be taken into consideration. If there is reason to believe that collections patterns will vary from historical patterns, then the forecast can be adjusted accordingly outside of the forecasting models. Both of these items can have significant impacts on the final revenue forecast.

Supplies of health care services

Supplies of health care services

 Under the Excise Tax Act (the Act), exemptions from the GST/HST for supplies of medical and certain other health care services are generally limited to those made by suppliers who are engaged in the practice of a particular profession and who are licensed or certified under the laws of a province to practise the particular profession. These suppliers are defined in the Act.

 For instance, a supply of a consultative, treatment, diagnostic or other health care service rendered to an individual is exempt for GST/HST purposes when a medical practitioner makes the supply. A medical practitioner is defined as a person who is licensed under the laws of a province to practice the profession of medicine or dentistry

 In addition, a supply of an optometric, chiropractic, physiotherapy, chiropodic, podiatric, osteopathic, audiological, speech-language pathology, occupational therapy, or psychological service rendered to an individual is exempt when a practitioner supplies the service. A practitioner is defined in the Act as a person who practises the profession relevant to one of these services and who is licensed or otherwise certified to practise that profession (if required in the province where the service is supplied) or has the qualifications equivalent to those necessary to be so licensed or certified in another province (if not required in the province where the service is supplied). Please note that it is possible for a corporation to qualify as a medical practitioner or practitioner.

 Health care services supplied by corporations that are not medical practitioners or practitioners. The exemptions for supplies of the above-noted health care services do not apply to persons who do not qualify as medical practitioners or practitioners. Thus, the tax status of a health care service can vary depending on the supplier.

 Corporations may supply health care services through their employees or through independent contractors they engage to perform services on their behalf. However, corporations who do not meet the definition of medical practitioner or practitioner should be aware that their supplies may not fall within the exemptions in the Act. Although an employee or subcontractor engaged by a corporation may hold a licence to practise a particular health care profession, this licence does not confer any benefit on the corporation for purposes of the Act. A corporation is a separate legal entity from its owners, directors, subcontractors and employees. The tax status of a corporation’s supplies is evaluated separately from the activities of its owners, directors, subcontractors and employees.

 Corporations and independent contractors

In the health care field, corporations established to provide health care services to individuals often subcontract with independent contractors to provide these services. Because the GST/HST is a multistage tax, each transaction is a supply. This means that when a corporation enters into a contract to obtain the services of an independent contractor, the result is that the contractor has made a supply to the corporation, not to the individual. The provision of the health care service to the individual is made by the corporation.

 It is important to note that if the independent contractor’s supply to the corporation is exempt, this exemption does not flow through to the corporation’s supply. The tax status of the corporation’s supply to its client is determined independently of the contractor’s supply to the corporation because for purposes of the GST/HST, the corporation’s supply to its client is a distinct supply from the independent contractor’s supply to the corporation.

Due to the general nature of the bulletin, it should not be relied upon as legal or tax advice.

Why Incorporate?

Incorporating your practice

Tax Deferral

The tax deferral advantage available to an incorporated person may be substantial. This is because Canadian Controlled Private Corporations (as are most professional corporations) may be able to access the small business deduction under the ITA. More specifically, in an incorporated practice, the first $500,0001 of annual “business related profit” – the amount remaining after deducting all eligible expenses – may be eligible for the small business tax rate of about 13%-18% (depending on the province), which is significantly lower than top marginal personal income tax rates. A person who would otherwise pay tax at the top marginal personal tax rate may be able to defer the payment of tax by leaving money within the professional corporation to be used for investment or corporate debt repayment. This deferral advantage is equivalent to a tax-free loan from the government. Retaining income in the corporation may also create savings for retirement. On retirement, these savings may be distributed, usually by way of dividends to shareholders, during a time when you are in a lower tax bracket.

Income Splitting

Income splitting, which can be achieved in some provinces through the establishment of a family trust or through the payment of dividends to shareholding family members, can be an effective way to reduce the total tax bill paid by your family. Although the “kiddie tax” rules negate the advantage of distributing dividends to minors, you may still be able to reduce your overall family taxes by making distributions to your spouse and/or adult children if they are in a lower marginal tax bracket than yourself.

Timing

All partnerships, sole proprietorships, and professional corporations that are members of partnerships are required to use the calendar year as their fiscal period. Professional corporations that are not members of a partnership can have an off-calendar year-end, which can provide an opportunity for certain tax deferrals at a personal level.

Secondary Advantages

In addition to the primary advantages of tax deferral and income splitting, there are numerous miscellaneous secondary benefits that may be available to incorporated physicians. These include:

  • Individual Pension Plans
  • Capital gains exemption
  • Affordable Benefits
  • Flexibility – Salary vs. Dividend
  • Corporate Owned Universal Life Insurance
  • Cash Flow Maintenance
  • Retiring Allowance and Death Benefits
  • Employee Profit Sharing Plan

Due to the general nature of the bulletin, it should not be relied upon as legal or tax advice.

Nova Scotia Unlimited Liability Company

U.S. Residents Should Consider Using A Nova Scotia Unlimited Liability Company For Canadian Investment (An Update)
Certain jurisdictions allow, under their corporate laws, the incorporation of companies where the shareholders are liable, on liquidation, to the obligations of the companies in excess of their assets. In Canada, the province of Nova Scotia allows for the incorporation of such a company. Section 9 of the Nova Scotia Companies Act permits the formation of unlimited liability companies. The companies are referred to as Nova Scotia Unlimited Liability Companies (NSULC).The shareholders of such a company have unlimited joint and several liability for the obligations of the company. However, unlike the partners of a partnership, the shareholders of an NSULC have no current liability to creditors; their liability only occurs when the company is liquidated with insufficient assets to satisfy its debts. Shareholders of an NSULC should consider interposing some sort of limited liability entity to reduce their exposure.

Formation of an NSULC

An NSULC is incorporated pursuant to the Nova Scotia Companies Act. A memorandum of association, a solicitor’s declaration and a list of officers and directors must be filed with the Registrar of Joint Stock Companies. The memorandum of association records the name of the company, any restrictions on its objects and details regarding share capital. The amount of share capital must be specified. There is no restriction on the number of shareholders. A shareholder must be a legal entity.

The corporation must maintain a registered office in Nova Scotia and have a registered agent for service in Nova Scotia. There is a requirement for an annual corporate statement to be filed and a fee of $85 to be paid. There is no requirement for Canadian directors.

Tax Treatment

In Canada, an NSULC is considered to be a corporation under the Income Tax Act and, therefore, an NSULC is treated like any other Canadian corporation for Canadian tax purposes.

In the U.S., an NSULC is not treated as a corporation under the Internal Revenue Code. Any business entity that is not required to be treated as a corporation is eligible, under the “check the box” rules, to choose its classification for U.S. federal tax purposes. Therefore, an NSULC is eligible to choose a classification that allows for flow-through treatment of corporate income to the shareholders and it would be taxed in their personal hands. Any Canadian taxes paid by an NSULC would be considered to have been paid by its shareholders for U.S. tax purposes and the Canadian taxes would, therefore, be eligible for U.S. foreign tax credit claims. Any losses realized by an NSULC would be considered to have been realized by its shareholders for U.S. federal tax purposes.

An NSULC controlled by non-residents of Canada will not be eligible for the small business deduction or refundable dividend tax on hand and will pay tax at a rate of approximately 44%. An NSULC will be subject to provincial tax in the provinces in which it has a permanent establishment or employees. Canadian corporate taxes will be available to U.S. shareholders as a foreign tax credit, within prescribed limits, against U.S. taxes.

Certain U.S. states still rely on the “four factors” test and this may require the alteration of Standard Memorandum and Articles of Association for an NSULC in order to obtain flow-through treatment for tax purposes in those states.

Under the Canada-U.S. Tax Treaty, an NSULC is a “company” for Canadian purposes of applying the treaty and is a “resident” of Canada under Article IV of the treaty. Therefore, unlike a U.S. limited liability company, an NSULC benefits from the treaty. A subsequent sale of an NSULC by a U.S. shareholder is treaty exempt unless the shares derive their value primarily from Canadian real estate.

A U.S. Corporation owning an NSULC would be able to deduct losses against its U.S. profits (subject to the U.S. dual consolidated-loss rules) without suffering branch tax in Canada. A U.S. corporate shareholder that owns more than 10% of the shares of the NSULC can benefit from the reduced 5% dividend withholding rate under the treaty. A U.S. S Corporation can acquire shares of an NSULC, although it cannot acquire the shares of an ordinary Canadian corporation. Interposing a U.S. S Corporation or limited partnership between U.S. shareholders and an NSULC will protect them from the joint and several liability obligations of NSULC shareholders.

Tax Planning Strategies

Acquisition of a Canadian Rental Property

U.S. residents who wish to purchase Canadian rental property may find that using an NSULC is a tax effective strategy.

An NSULC will be a Canadian resident and, therefore, rent payments made to an NSULC will not be subject to the 25% withholding requirements imposed by the Canadian Income Tax Act. Under the Act, a Canadian resident who pays rent to a non-resident must withhold tax from the rent payment at a rate of 25%. Although it is possible for the withholding to be based on the net rent instead of the gross rent (providing that the non-resident arranges for a Canadian agent to collect the rent and to remit the withholding tax), there would still be Canadian tax filing requirements in respect of the rental activity.

In many cases, taxable income is not expected for several years with a rental property, due to various costs such as interest. U.S. shareholders of an NSULC would benefit from this as they would be able to deduct their proportionate share of the losses in calculating their taxable income in the U.S.

When the NSULC has taxable income, it will be subject to Canadian tax at a rate of approximately 44%. A foreign tax credit will be available to U.S. shareholders of the NSULC.

Purchase of a Canadian Business

U.S. residents or corporations who are interested in buying the assets of a Canadian business from Canadian shareholders, who want to sell their shares in order to access the $500,000 capital gains exemption, should consider using an NSULC.

If the company (Targetco) were an Ontario company, it could be converted into an NSULC and the Canadian shareholder could treat the sale as a sale of shares and the U.S. purchaser could treat the sale as a purchase of assets. The Ontario company would be continued in Nova Scotia as an ordinary Nova Scotia company. This would require the consent of the Ontario Minister of Finance (this takes about a week) and authorization under the Ontario Business Corporations Act, supported by a special shareholders’ resolution (this takes a day or two). An NSULC (Purchaseco) would then be incorporated by the U.S. resident and used to purchase the shares of Targetco. Purchaseco and Targetco would then be amalgamated to continue as an NSULC (Amalgco). The amalgamation would require the approval of a Nova Scotia Supreme Court Judge in Chambers and the approval of major creditors with an affidavit that trade creditors would be paid in the ordinary course of business (this takes about two weeks). The U.S. shareholders of Amalgco would then benefit from flow-through treatment of the income or losses of Amalgco.

Another option would be to use two NSULC’s in order to allow the U.S. purchaser to deduct purchase price interest. First, Targetco would be continued in Nova Scotia as an ordinary Nova Scotia company. Then the owners of Targetco would incorporate an NSULC and Targetco and the NSULC would be amalgamated to continue as an NSULC (Amalgco). The U.S. purchaser would then incorporate an NSULC (Purchaseco) which could be owned by a U.S. S Corporation. Purchaseco would be financed so that the acquisition of Amalgco is structured as 25% equity and 75% interest-bearing debt of Purchaseco to avoid the thin capitalization rules. Purchaseco would then purchase the shares of Amalgco and Purchaseco and Amalgco would then be amalgamated to continue as an NSULC. The interest on the debt could be deducted in calculating the Canadian taxable income of the target business. The purchaser would have a stepped-up basis in the assets for U.S. tax purposes since the target company is treated as a flow-through entity.

Conclusion

An NSULC can be an effective strategy for U.S. residents who desire to hold investments in Canada. In some situations, the use of an NSULC would not be tax effective and may, in fact, be detrimental.

Due to the general nature of the bulletin, it should not be relied upon as legal or tax advice.

Regulation 105

Paragraph 153(1)(g) of the Act makes provision for withholding from a payment of fees paid for services on account of the payee’s potential liability for tax under the Act. 

Section 105 of the Income Tax Regulations gives effect to paragraph 153(1)(g) in the context of payments to non-residents.  The purpose of paragraph 153(1)(g) is to ensure that if the non resident recipient of a payment is liable to pay income tax in Canada, then there will be funds available in the form of a percentage withheld and remitted, to satisfy the obligation. R105 withholding is not the final tax amount. It is only a tax instalment, contrary to Part XIII (Tax on Income from Canada of Non-Resident Persons).

Subsection 164(2) allows for this instalment to be applied against any income tax owed by the taxpayer