January 16, 2013
January 16, 2013
Charles C Gagnon
Reprinted from the 2013 edition of the Bahamas Handbook.
Despite restrictions imposed by Canadian income tax law on the use of tax havens, there are many circumstances in which The Bahamas retains its attractiveness for Canadians. The islands continue to prove a sound and durable base from which to invest in Canada or the outside world or from which to conduct offshore operations for the benefit of Canadians.
In fact, increased investment outside Canada, exports by Canadian firms and the growing number of multinational families have increased the scope for The Bahamas as a centre for international activity.
In Canada, residence remains the foundation of direct taxation for individuals. This benefits Canadians wishing to take advantage of The Bahamas, especially as compared to the US, which taxes on a citizenship basis.
Under the Canadian federal income tax system, individuals resident in Canada are taxed on their worldwide income whereas non-resident individuals are taxed only through the withholding tax regime on certain investment income (discussed later), with respect to income from employment in Canada, a business carried on in Canada and from gains realized on the disposition of taxable Canadian property (also discussed later). They are not taxed with any reference to the fact that they are or are not Canadian citizens. A corporation not resident in Canada is subject to Canadian federal or provincial tax only through the withholding tax regime on certain investment income, on income from its business carried on in Canada and from gains realized on the disposition of taxable Canadian property. Like individuals, resident corporations are taxed on their worldwide income.
Canadian companies incorporated after Apr 26, 1965, are automatically deemed residents of Canada unless they are continued under the laws of another jurisdiction. Corporate continuance is treated as re-incorporation for tax purposes. Consequently, a company’s residence for Canadian income tax purposes may be affected by a change in its corporate status.
The Canadian government has enacted an incentive to lure international shipping companies to Canada. If a company deriving all or substantially all (ie, 90%) of its revenue from an international shipping business is incorporated outside of Canada, (eg in The Bahamas) it can establish its place of central management and control in Canada and yet be deemed a non-resident of Canada. In this way, it avoids Canadian tax on its income.
Canadian withholding tax
The basic Canadian withholding tax is 25%. This applies to investment income, certain pensions, dividends, non-arm’s- length interest, rent, certain types of royalties, income from a trust and certain other forms of revenue paid by Canadian residents to persons abroad. This tax must be withheld from the gross payment by the payer unless the recipient of the income resides in a country with which Canada has a tax treaty. In that event, the withholding tax may be reduced to 15% or less, depending on the terms of the treaty.
Old-age security payments under the Canada or Quebec Pension Plans are subject to withholding tax.
Special withholding tax exemption
Interest paid by a Canadian resident corporation to arm’s-length non-resident creditors is exempt from Canadian withholding tax. The exemption is granted regardless of the currency of the loan or interest. The interest must not be contingent upon the use of, or production from, property in Canada.
Also, interest which depends in whole or in part on revenue, profit, cash flow or other similar criteria, or on dividends paid or payable on shares of a corporation, does not qualify for the exemption. Interestingly, there is no restriction preventing the guarantee of the debt by a non-resident person who is not at arm’s length with the borrower. Thus, Bahamians may lend to Canadians against the security of a guarantee by someone outside of Canada not at arm’s length with the borrower, upon terms which may exempt the interest paid from Canadian withholding tax (the arrangement must, however, remain in law a guarantee and avoid being characterized as an agency between the guarantor and the lender).
Thin capitalization provisions
The “thin capitalization” provisions contained in subsections 18(4), and following, of the Income Tax Act relate to the deductibility of interest paid on money borrowed from abroad by Canadian resident corporations.
Interest payments made to non-residents who hold a substantial interest (ie, 25% of the voting or equity shares) in a Canadian company or which do not deal at arm’s length with such a shareholder, are not always entirely deductible in computing income in Canada. They will be disallowed if the ratio of the company’s equity capital to the debt due to such non-resident shareholders or non-arm’s-length persons is less than 1:2.
Despite the restrictive and wide-ranging nature of the Canadian fiscal law, The Bahamas continues to play an important part in Canadian tax planning. In particular, the use of testamentary trusts and certain inter vivos trusts can yield rewards.
There are not many tax havens that offer benefits comparable to The Bahamas in terms of flexibility of corporate structure, top-quality accounting and legal services, readily available first-class financial and banking services, proximity to major world markets and good docking and harbour facilities.
The modernization and liberalization of the Bahamian company and trust law and the introduction of foundation law now provide a flexibility previously unavailable in The Bahamas. The Bahamas can offer a variety of corporate and settlement structures and procedures that are equal to those in any other jurisdiction. A number of Canadians look to The Bahamas to conduct some of their business. Some achieve this by becoming non-residents of Canada and setting up their homes in The Bahamas. Once they do this, they suffer no income tax in Canada, except on income from employment in Canada, the profits from business done there, gains from taxable Canadian property or the 25% withholding tax on certain kinds of investment income derived from?Canada.
Capital gains tax on non-residents
Non-resident individuals pay income tax to Canada at applicable personal rates on 50% of the capital gains realized by them on the disposition of “taxable Canadian property.”
Taxable Canadian property is defined in subsection 248(1) of the Income Tax Act and includes Canadian real estate, shares in a Canadian private corporation, and shares in a Canadian public corporation if certain threshold ownership requirements are met. Certain other types of property are also considered taxable Canadian property. In particular, the definition of taxable Canadian property includes shares of corporations and interests in trusts not resident in Canada which derive their value principally from Canadian real estate or resource properties.
Liability to Canadian tax could be triggered by the death of an individual who happens to own shares of a non-resident corporation with Canadian assets.
All non-residents must report dispositions of taxable Canadian property to the Canadian fisc, indicate the name of the person to whom the property is sold and pay an amount on account of Canadian tax or furnish acceptable security (this special requirement is not applicable to the disposition of listed shares in a Canadian public corporation).
Upon payment of a tax instalment, a “certificate” is issued to the non-resident which protects a purchaser of the asset from having to pay some of the tax that might not have been paid by the non-resident.
Becoming a non-resident of Canada
In order to become a non-resident of Canada, an individual must generally give up his home and most attachments within Canada such as employment, provincial medicare coverage, clubs, bank accounts, credit cards and the like and acquire a residence in another jurisdiction by purchasing a home or renting an apartment in which he lives as his central family headquarters.
Nevertheless, once a former Canadian resident has become a non-resident, he may return to Canada each year for temporary visits without being taxed.
Thus, because The Bahamas imposes no income tax of any kind, a non-resident Canadian citizen may reside there with the advantage of paying to Canada only 25% on certain kinds of investment income derived from Canadian sources and no withholding tax on certain kinds of interest. Royalties and similar payments on or in respect of a copyright related to the production or reproduction of any literary, dramatic, musical or artistic work are exempt from Canadian withholding tax. The Bahamas is, therefore, appealing to Canadian writers, musicians, singers and artists as a place of residence. The same individual, if he wishes to continue his business activities in Canada, may do so as a non-resident and pay tax at the personal graduated rates in Canada on the profit from the business there.
The exit tax
A problem that faces Canadians who consider taking up residence in The Bahamas is the exit tax imposed by Canada upon capital gains deemed to arise from the notional realization of certain capital property at the time they give up Canadian residence.
Corporations leaving Canada are also subject to exit rules. In particular, a corporation is treated as having disposed of all of its property at fair market value and to have notionally distributed its net equity. This fictitious distribution is assimilated to a liquidating dividend and subjected to a special tax in lieu of withholding tax.
Succession duty and estate tax advantages
There are no estate and gift taxes in Canada. However, individuals are deemed to dispose of their property at fair market value at the time of their death. Thus, a non-resident individual may be liable to tax on capital gains at the time of his death if he holds taxable Canadian property directly.
If he resides in The Bahamas and holds no such property, then he would not suffer any Canadian tax on death.
Corporate uses of The Bahamas by Canadians
Under Canadian tax law, a foreign company is resident where its seat of management and control is found (subject to restrictions on companies incorporated or continued into Canada set out previously). This is usually held to be the place where the directors meet or from which the day-to-day management instructions emanate or are carried out.
In order to prevent a company from being legally resident in Canada and thereby paying tax, management and control must be exercised, bona fide and in fact, outside Canada.
A non-resident company may perform useful functions of an extraterritorial nature such as world advertising, worldwide selling, the financing and organizing of sales abroad, the management and servicing of the facilities needed to maintain the products sold abroad and the operation of ships or certain group insurance activities (except Canadian risk). In each case, it is important to determine whether the income of the Bahamian subsidiary is foreign accrual property income (commonly referred to as FAPI). The FAPI of a “controlled foreign affiliate” of a Canadian resident is attributed to and taxed in the hands of its Canadian resident shareholders on an annual basis.
There have also been cases before the Canadian courts in which attacks made by the Canada Revenue Agency (CRA) on offshore subsidiaries of Canadian corporations have been tested. The income of the subsidiaries has been added, sometimes, to the income of the Canadian parent on the footing that the subsidiary was itself a sham or an instrumentality. Transfer pricing is another line of attack increasingly favoured by CRA. These cases stand on their own facts and need not pose a threat to normal activities carried on bona fide in The Bahamas, provided management and control of the Bahamian corporation are not in Canada.
The foreign affiliate rules affect any foreign corporation in which a Canadian resident has a significant interest. A foreign affiliate is defined to include any non-resident corporation in which a Canadian resident holds at least 10% of the shares of any class. A non-resident corporation will also be considered a foreign affiliate of a Canadian resident who holds 1% of the shares of any class where the equity interest of the Canadian resident together with related persons is at least 10%.
When a foreign corporation qualifies as a foreign affiliate, the dividends that pass upstream to a Canadian corporate shareholder are tax free when paid out of “exempt surplus.” Exempt surplus is income derived by a company resident and carrying on business in a country with which Canada has a tax treaty or tax information exchange agreement (TIEA).
The Bahamas signed a TIEA with Canada on June 17, 2010. Subject to ratification of the TIEA, active business income earned by the Bahamian affiliates of Canadian companies would benefit from exempt surplus treatment.
Passive income is treated quite differently from active business income. The concept of FAPI is meant to tax the passive earnings of foreign affiliates controlled by Canadian taxpayers. In many ways it is not unlike its American counterpart, “Subpart F” of the Internal Revenue Code. FAPI is essentially income from property or from a business other than an active business. Each year an appropriate share of the FAPI of a controlled foreign affiliate (and certain trusts), if it exceeds $5,000, is included in the income of Canadian taxpayers controlling the foreign affiliate in the taxation year in which the foreign affiliate’s taxation year has terminated.
FAPI does not include interaffiliate dividends, active business income, and certain amounts received from other affiliates. It similarly does not include capital gains from the disposition of “excluded property” (property used principally in an active business and shares of foreign affiliates, most of whose property is used in an active business).
A non-resident of Canada who has not resided in Canada during the 60-month period preceding the end of a taxation year can establish, by will or gift, a Bahamian resident discretionary trust (NRT) for the benefit of Canadian resident family members, which will escape the application of the income attribution rules governing offshore discretionary trusts. Distributions of capital (which can include accumulated income) received by Canadian resident beneficiaries from an NRT funded solely by a non-resident should not be taxable.
Before, a Canadian resident could also establish an NRT for beneficiaries who did not reside in Canada. Income of such a trust was not subject to Canadian tax provided a person resident in Canada who is related to the settlor was not “beneficially interested” in the trust. Recent legislative attempts were made to extend the reach of the Canadian fisc in this area by taxing the undistributed income of an NRT to which a Canadian resident has loaned or transferred property irrespective of whether a person related to the settlor is beneficially interested in the trust.
It is still possible for an NRT established by an immigrant or temporary resident to avoid tax for the first five years of residency in Canada. Bahamian trusts are particularly well-suited for this purpose.
Of course it is important that a trust established outside of Canada not be considered resident in Canada under the normal rules regarding the residency of trusts. This requires that the majority of, if not all, trustees having legal and actual control of the trust assets be non-residents of Canada. Expert professional advice in this area is essential, but use of Bahamian trusts can pay substantial dividends.
Current attitudes towards tax planning
The Canadian law contains a number of technical provisions that narrow the field of manoeuvre for the taxpayer. Moreover, Section 245 of the Income Tax Act contains a general anti-avoidance rule (GAAR). The GAAR comes into play whenever a taxpayer engages in a transaction or series of transactions that results directly or indirectly in a “tax benefit” (as broadly defined in that provision) unless the transaction does not result in an abuse or misuse of the provisions of the Income Tax Act. Thus, the uses made by Canadians of Bahamian corporations must be limited to commercially defensible activities and should not be employed merely to hide or artificially minimize truly Canadian income. In this whole field, the area of manoeuvre is narrowing, so a conservative and realistic approach should be taken.
Charles C Gagnon is a tax lawyer at BCF LLP in Montreal. His main areas of expertise include: tax planning for private businesses, structuring of inbound and outbound investments, tax issues relating to immigration and emigration, international tax planning and wills and trusts. In addition to being a guest speaker at tax conferences and author of several reports and publications, Gagnon is a member of the Canadian Tax Foundation, the International Fiscal Association and the Society of Trust and Estate Practitioners (STEP). He was educated at McGill University (BCL, LLB, 1993), Canadian Securities Institute (CIFC, 1991), College Jean-de-Brebeuf (IB, 1989) and Canadian Securities Institute (CSC, 1988). He was admitted to the Bar in Quebec in 1995 and British Columbia in 1994.