The exempt surplus rule can make Canada an attractive location in which to set up a holding company. Under this rule any dividends paid by a foreign affiliate to its Canadian parent are exempt from tax if the following conditions are met:
- The foreign affiliate is resident in a country listed in the income tax regulations as a designate country with a tax treaty in force with Canada.
- Dividends are paid out of the foreign affiliate's "exempt surplus"
The "Exempt surplus" is defined as:
- Earnings from active business activities carried out from the affiliate's permanent establishment. (Thus interest earned from the deposit of funds in a bank account does not come within the definition of exempt surplus.)
- Dividends received by the foreign affiliate from the exempt surplus of other affiliates.
Thus dividends remitted to a Canadian parent
by an Irish affiliate which manufactures
goods for export to the UK market and which
enjoys a tax holiday under Irish laws will
not be taxed in the hands of the Canadian
corporate entity. (N.B. A characteristic
of double taxation treaties is to define
certain categories of income as exempt surplus
income which qualifies for tax free repatriation).
Budget
2007 had this to say with regard to the
exempt surplus rule:
"Although
its mismatch with interest deductibility
has been a long-standing problem, the 'exempt
surplus' rule in itself is a key competitive
advantage of the Canadian tax system. The
rule allows a Canadian company to earn business
income through a foreign affiliate in any
tax-treaty country, and bring that income
back to Canada, with no Canadian tax. Since
the only tax on this business income will
be that paid to the foreign country in which
it is earned, the system ensures that Canadian
firms are able to operate on a level playing
field with their foreign competitors.
"With
the proposal above to resolve the interest
deductibility problem, it is no longer necessary
to link the exemption to the presence of
a tax treaty. In the current environment,
it is more appropriate to link the exemption
to the presence of a comprehensive exchange
of information agreement."
"Budget
2007 therefore proposes to extend the exemption
to active business income from non-treaty
jurisdictions as well as treaty countries,
provided those jurisdictions agree to exchange
tax information with Canada. This will give
Canadian firms more scope to expand internationally,
especially into new and emerging markets,
without our tax system imposing additional
costs that could reduce their competitiveness,
while also maintaining tax fairness. It
will also encourage non-treaty jurisdictions
to join in the efforts of Canada and our
treaty partners to control international
tax evasion."
In
December 2008, the Advisory Panel on Canada’s
System of International Taxation made the
following recommendations with regards the
taxation of outbound foreign direct investment
from Canada:
-
Broaden the existing exemption system
to cover all foreign active business income
earned by foreign affiliates.
-
Pursue tax information exchange agreements
(TIEAs) on a government-to-government
basis without resort to accrual taxation
for foreign active business income if
a TIEA is not obtained.
-
Extend the exemption system to capital
gains and losses realized on the disposition
of shares of a foreign affiliate where
the shares derive all or substantially
all of their value from active business
assets.
-
Review the “foreign affiliate”
definition, taking into account the Panel’s
other recommendations on outbound taxation,
the approaches of other countries, and
the impact of any changes on existing
investments.
-
In light of the Panel’s recommendations
on outbound taxation, review and undertake
consultation on how to reduce overlap
and complexity in the anti-deferral regimes
while ensuring all foreign passive income
is taxed in Canada on a current basis.
-
Review the scope of the base erosion and
investment business rules to ensure they
are properly targeted and do not impede
bona fide business transactions and the
competitiveness of Canadian businesses.
-
Impose no additional rules to restrict
the deductibility of interest expense
of Canadian companies where the borrowed
funds are used to invest in foreign affiliates
and section 18.2 of the Income Tax Act
should be repealed.
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