Fees for services paid to non-residents of Canada
Canada, like other jurisdictions, is jealous of its tax base. That tax base is reduced when payments, which are deductible for tax purposes in Canada, are made to persons or entities outside of Canada. The concern is that these payments are likely never to be taxed by Canada.
Of course, such is often the proper and final result of many types of legitimate transactions, since the huge benefits to Canada from free trade serve to more than compensate for any “lost” tax revenue. Further, Canada has entered into dozens of income tax treaties with various countries with the express purpose of streamlining international trade, and removing “incidental” incidences of potential tax from situations that might, under a literal and technical reading of Canada’s income tax laws, result in a Canadian tax liability.
Having said all this, the Canada Revenue Agency (CRA) is still concerned with detecting and identifying foreign businesses operating in Canada. They want to be the ultimate arbiters as to whether a particular activity is, in fact, tax exempt in Canada. An important tool in making these discoveries is a provision in the Canadian Income Tax Act (the Act): Regulation 105. This regulation is essentially a “catch-all” provision, designed to detect and identify foreign parties that may be underestimating, for want of a better description, their Canadian filing obligations.
The regulation requires a withholding of 15% of any payment made by a resident of Canada to a non-resident for services rendered in Canada.
As an example, consider a Canadian company that contracts for software to be supplied by an American company. Assume that the contract calls for payments of $10,000 per month, including all related services. Further assume that $2,000 represents the cost of periodic installation, support and training visits rendered by employees of the American company who travel to Canada to perform the service. In such a case, for that month the Canadian company would pay the American company only $9,700.00, with $300.00 ($2,000.00 x 15%) being remitted directly to the CRA as withholding tax.
The Canadian company is also required to disclose the existence of these payments in its annual Canadian income tax return, and to file special reporting forms (T4A-NR) by the end of the following February.
The responsibility for making the withholding is placed upon the Canadian payer. If the Canadian company fails to comply with this regulation, they are required to pay the 15% tax regardless, plus a minimum 10% penalty and interest. At best, the Canadian company would hope to recoup the tax from the American supplier.
It is interesting to note that the 15% withholding tax is not a “tax” per se, but more in the line of a “deposit on account of potential tax”. Essentially, the Canadian government is trying to ensure that non-residents, as they come to Canada to do business, are identified, and their Canadian tax responsibilities, if any, are met.
Many situations involve legitimate free-trade activity in which the payments to the non-resident company are not subject to any form of Canadian tax. If the parties are aware of this regulation in advance, they can apply to the CRA for a waiver (exemption) from withholding tax. Essentially, the waiver process will involve a CRA review of the tax treaty status of the foreign supplier, and the waiver is usually issued, so long as the foreign entity does not have a “permanent establishment” in Canada, from which they perform the services in question.
If a permanent establishment exists, then the foreign entity has a lot more to concern itself with than the 15% withholding - they may, in fact, be exposed to the full impact of the Canadian income tax system, with transfer pricing and “branch tax” implications to consider, among many other factors.
A “permanent establishment” is defined in the particular tax treaty that may apply. For example, in the Canada-U.S. tax treaty, a permanent establishment includes, among other things, a place of management, a branch, an office, a factory, a workshop and a mine, an oil or gas well, a quarry or any other place of extraction of natural resources. Often, much turns on whether a particular apartment, for example, might constitute an “office”. Generally, foreign employees working in Canada are OK if they stay in hotel rooms under typical day-to-day reservations. Long-term contracts that require extended stays definitely run the risk of triggering significant exposure to Canadian income tax.
The usual course of events for foreign companies that have suffered a withholding of tax under Regulation 105 is to file an ordinary Canadian income tax return, but put nothing in it, save and except for a declaration that they consider themselves exempt from Canadian income tax pursuant to a term of a relevant income tax treaty. In many such cases, CRA agrees with the position and, upon assessment, refunds entirely the withheld taxes to the foreign entity.
It is obviously inconvenient to all concerned to go through this process, only to ultimately have the tax fully refunded. Financing costs for the withheld tax could be significant, also.
There is a better way to approach Regulation 105. Here is Lohn Caulder's suggested course of action:
1. Canadian companies should review their operations, and their vendor lists, and take note of any services being supplied by non-residents of Canada.
2. These companies should determine if any portion of these services are to be, or are being, rendered in Canada. If not, there is no cause for concern.
3. If the services are physically being rendered in Canada, the Canadian company should ask the supplier if they obtained a waiver from withholding tax from the CRA specifically with respect to their particular contract, and obtain a copy. If this is done, then no withholding tax need be paid.
4. If there is no waiver, then the Canadian company must withhold 15% and remit to CRA within the required due dates, and report to CRA appropriately, within the time frames noted above.
Lohn Caulder LLP has extensive experience with these sorts of transactions, and can assist both Canadian businesses and foreign entities with the waiver, withholding and filing procedures.