Canada, tax, TaxBreaks, April 2006 newsletter

TaxBreaks, April 2006
(06-2)

Are your sights set on China?
Cross-border employees and executives: Do you know your risks?
Did you know that…

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Are your sights set on China?

Answers to five tax questions for companies wanting to do business in China
Is your company interested in taking advantage of China’s opening market opportunities, perhaps to set up a factory to benefit from both the lower cost of labour and the large numbers of qualified workers? Alternatively, given the vast pool of Chinese consumers, do you want to export your products there? In either case, questions regarding the Chinese tax system will arise.

Are corporate tax rates low in China?
At first glance, it appears that the tax rate applied to foreign companies in China is comparable to Canadian tax rates, since Chinese law states that revenues earned by a foreign company are, in principle, taxed at a combined rate of 33% (30% federally and 3% locally). However, the reality is different since most foreign companies, including joint ventures with Chinese partners and Chinese companies owned by non-residents, benefit from tax holidays and other forms of tax relief that considerably reduce their tax burden. According to a recent study by the Chinese Academy of Social Sciences, foreign companies doing business in China pay a real average tax rate closer to 13%.

Can my company benefit from tax incentives?
The Chinese government’s creativity in attracting foreign investors is evident in the proliferation of various forms of tax incentives. For instance:

Companies that set up in special economic zones benefit from a reduced income tax rate that ranges from 15% to 24%.
There are tax holidays ranging from two to five years for foreign companies that invest sufficient capital in particular sectors of the Chinese economy, including manufacturing and high tech.
Once tax holidays or tax reductions have expired, foreign export companies can benefit from a 50% reduction in taxes on the condition that at least 70% of their total production is intended for export. However, the tax rate will never fall below the 10% minimum threshold.
Foreign companies that reinvest profits generated by their Chinese activities can obtain a tax refund ranging from 40% to 100% of the tax paid on the reinvested amount, depending on the type of company.

Are the tax incentives here to stay?
It is important for an entrepreneur attempting to do business in China to know that a major tax reform is expected to take effect on January 1, 2007. Under this reform, foreign companies will be taxed at the same rate as Chinese companies (24% to 28%), tax holidays will be eliminated, and preferential tax rates for companies investing in specific economic zones will be abolished. However, it is likely that a tax system favouring certain industries or regions will be introduced.

Are there taxes to pay when repatriating profits to Canada?
Canadian entrepreneurs will want to invest in China and earn profits if they can eventually recover these amounts without having to pay too much tax. From this point of view, China is a very attractive option because there is no tax on dividends paid to foreign shareholders of a Chinese company owned by non-residents. Therefore, Canadian shareholders can repatriate the net profits earned in China without paying Chinese taxes.

Foreign investors should also be aware that, when selling shares of a Chinese company owned by non-residents, the Chinese government normally levies a 20% tax on the realized profit. However, this tax can be reduced through proper tax planning. There is a broad network of over 75 tax treaties in China that can be used for this purpose.

What other taxes might affect my business in China?
The Chinese tax system has a value added tax applicable to the sale of certain goods. If your company intends to sell a product on the Chinese market, you must charge a tax varying between 6% and 17%, depending on the type of product sold and the size of your business. However, because the tax burden is ultimately borne by the consumer, your company can claim credits for the tax that it paid on its purchases. As a general rule, no tax is applied to the export of goods manufactured in China.

If your company intends to offer services in China, you should be aware that a 3% to 6% business tax must be collected and paid to the Chinese tax authorities.

To Canadian businesses that plan to use China as a low-cost manufacturing centre or to penetrate the Chinese market, we would say: “Remember that tax considerations are a major part of business strategy. Doing business in China requires tax planning!”

Claire Laplante, Montreal
Véronique Jetté, Montreal

Cross-border employees and executives: Do you know your risks?

In today’s global economy, the provision of services across borders is a significant and growing economic activity. Tax authorities around the world recognize this and are responding by increasing both compliance requirements and audits of cross-border services. At the same time, CEOs and CFOs of public companies are under pressure to meet increasing regulatory expectations to ensure that their companies have effective systems in place that identify both tax reporting obligations and tax liabilities, and that ensure compliance with the laws of the countries in which they operate.

The risks
Most companies have expatriate programs to manage the tax issues arising when employees are on long-term assignments in foreign countries. However, many do not have policies to manage the tax issues arising when employees provide services in foreign countries for short periods of time. Often companies mistakenly believe that, so long as the employee is in the foreign country temporarily, there is no tax exposure or the exposure is limited to payroll and reporting obligations. In fact, the potential tax issues are numerous and potentially severe, and extend far beyond payroll withholding and reporting obligations. Failure to manage effectively the tax issues arising from cross-border services can result in significant corporate exposures, such as:

creation of a “permanent establishment,” resulting in a tax liability on the business profits attributable to that permanent establishment;
liability for the 15% withholding tax that should have been withheld by the Canadian company on all fees paid to a non-resident (not an employee) for services performed in Canada;
liability for the employee income tax that should have been withheld on payments made to non-resident employees providing services in Canada, plus penalties and interest;
liability for GST that should have been charged on supplies of cross-border services made in Canada, plus penalties and interest;
transfer pricing adjustments and penalties arising from failure to establish appropriate arm’s length pricing or to maintain detailed contemporaneous documentation; and
adjustments to corporate deductions.

In addition, the individual employee may have a foreign personal tax liability and/or filing obligation as a result of providing services in a foreign country. It is important to note that individuals may incur a Canadian income tax liability even if they are in Canada for less than 183 days.

The following examples illustrate some common situations and their potential tax implications for both the company and the individual employee.

Example 1 – Cross-border services to customers
A U.S. computer company sends employees to Canada on a regular basis to install and test software programs and to provide various computer consulting and other services to its Canadian customers.

Liability to register for and to charge GST if the U.S. company’s presence in Canada constitutes “carrying on business” (with similar provincial sales tax exposure in some provinces)
Possible permanent establishment in Canada resulting in an income tax liability
Transfer pricing issues if there is a permanent establishment
Canadian corporate tax return filing obligations
Different provincial corporate tax rules
Canadian personal income tax withholding and reporting obligations by the U.S. employer
Canadian personal income tax return filing obligations
Reimbursing employees for Canadian taxes paid in excess of foreign tax credit on their U.S. returns

Example 2 – The dual employee
A Canadian company hires, as CEO, the president of its U.S. subsidiary. The CEO remains a resident of the United States and commutes to Canada on a regular basis, spending 50% of his time in each country. However, he often deals with matters relating to the U.S. subsidiary while in Canada and, similarly, matters relating to the Canadian operations while in the United States (e.g., conference calls, emails, etc.).

Potential permanent establishment issues in both countries
Transfer pricing issues if there is a permanent establishment
U.S. and Canadian tax withholding obligations
U.S. and Canadian personal filing obligations
Potential GST issues for the U.S. subsidiary
Corporate deductibility issues and transfer pricing issues – allocating the CEO’s remuneration and overhead costs between the Canadian company and the U.S. subsidiary (activity-based versus location-based)
Pension plan and deferred compensation plan issues

Example 3 - Management/technical services
A U.S. company sends its employees to Canada periodically to assist its Canadian subsidiary with respect to accounting, management, technical and other matters (e.g., the implementation of a new financial accounting system).

Transfer pricing issues in determining the charge or fee for the services and the necessary documentation to support the charge or fee
Canadian tax withholding obligations
Canadian personal filing obligations
Corporate deductibility issues
Possible GST registration and accounting issues for the U.S. company, as well as provincial sales tax for the Canadian subsidiary

To manage the tax issues arising from cross-border services proactively, it is vital to integrate corporate and transfer pricing issues, personal income tax, and the indirect tax implications of cross-border services. Unfortunately, many companies take completely incompatible positions for their corporate tax filings and their employee withholding and reporting obligations. Our team of Deloitte specialists can help companies avoid the pitfalls and establish effective comprehensive solutions.

Marsha Reid, Toronto

Did you know that…

Beware of lotteries and sweepstakes scams. The Canada Revenue Agency (CRA) recently published an alert, warning taxpayers to be on guard against email scams advising them that they have won a large sum of money in a lottery or sweepstakes. The email generally requires the recipient to pay part of the taxes allegedly owing on the prize amount before it can be paid out. The only thing is that there is no tax payable to the CRA or Revenu Québec on lottery winnings in Canada.

Hiring a contractor: reduce your risks. The Canada Revenue Agency (CRA) has also published an alert to taxpayers that they can minimize their risks of lawsuits or financial losses by refusing to hire contractors who don’t issue receipts or provide written contracts. The CRA takes this problem seriously, and has over 1,200 employees involved in identification, audit and enforcement initiatives aimed at addressing the underground economy.

Prescribed interest rates for the second quarter of 2006. The Canada Revenue Agency (CRA) has announced the prescribed interest rates that will apply for income tax purposes for the second quarter of 2006. These rates, in effect from April 1 to June 30, 2006, are: 8% on overdue taxes, Canada Pension Plan contributions and Employment Insurance premiums; 6% on overpayments; 4% on taxable benefits for employees and shareholders from interest-free or low-interest loans. These rates are one percentage point higher than the rates in effect during the first quarter. The rates prescribed by Revenu Québec for the same period remain unchanged from the first quarter, at 8%, 2% and 4% respectively.

What to do when your marital status changes. If your marital status changed in 2005, don’t forget to notify the Canada Revenue Agency in writing as soon as possible, and indicate your current status on your 2005 tax return. Changes in your marital status can affect your eligibility for certain benefits and credits.

Relocation incentive paid to doctors. Medical practitioners may be entitled to receive a relocation incentive as part of a Quebec program to promote the relocation of doctors to designated regions. Generally, the incentives paid to non-salaried medical practitioners as part of this program are taxable as business income, and those paid to doctors working exclusively as employees are taxable as salary or wages.

New tax credits for dividends. The March 23 Quebec budget announced measures to harmonize with federal legislation on dividend taxation announced by the previous federal government. The gross-up of dividend income will be increased from 25% to 45% for eligible dividends (i.e., those principally derived from public companies) and the dividend tax credit for eligible dividends will be increased to 11.9% (from the current 10.83%). In contrast, the dividend tax credit applicable to other dividend income will be reduced to 8%. The net effect of this reduction is to increase the effective tax rate on dividends received by Quebec residents to approximately 3.5%. It is important to note that the current federal government has not yet made its position on this subject known: it will certainly do so in its upcoming budget. The modifications made by the Quebec government will not be passed until the adoption of all federal laws.

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