Canadian Subsidiary of a Foreign Company: Setup and Year One

Canadian subsidiary of a foreign company: what are the setup steps?

A foreign parent opens a Canadian subsidiary by incorporating a Canadian corporation, issuing its shares to the parent, registering it with the Canada Revenue Agency (CRA) and notifying the federal government under the Investment Canada Act, in this order:

Most setup steps are forms. What needs professional judgment is money moving between the subsidiary and the parent. A management fee, licence fee, interest on a parent loan or a dividend can each bring non-resident withholding tax (Part XIII) unless a treaty reduces or removes it. So can cash lent to the parent and not repaid in time. Every price with the parent must match what unrelated companies would agree, backed by records (transfer pricing). Once dealings with the parent pass $1,000,000 in a year, the subsidiary also reports them on Form T106. If the parent funds mostly with a loan, part of the interest can stop being deductible (thin capitalization). A business in a cultural or sensitive sector can face review under the Investment Canada Act.

Gather before you start:

• The parent's certificate of incorporation and a group chart traced up to the individuals who own or control it.
• Each planned director's name, address and residence status.
• The planned funding: how much as share capital and how much as a loan.
• Drafts of any agreements with the parent: services, licences, loans, cost sharing.
• The parent's proof of tax residence in its own country, for treaty claims.
• A Canadian address for the registered office.

Does a foreign company need a Canadian subsidiary, or can it sell into Canada directly?

A foreign company can sell into Canada without a subsidiary, but once it carries on business in Canada it owes Canadian tax on that income (ITA s. 2(3)), subject to any treaty with its home country. A subsidiary instead is a separate taxpayer. A corporation incorporated in Canada is deemed resident in Canada (ITA s. 250(4)) and files its own T2 every year.

If the subsidiary is managed from the parent's country, that country may also treat it as resident; under a treaty tie-breaker it can then be deemed not resident in Canada (ITA s. 250(5)). Where the board meets is then worth settling before it is appointed. For how a branch compares with a subsidiary, including branch tax, see a US business expanding into Canada; a non-US parent applies its own country's treaty instead.

Federal or provincial incorporation when the directors live abroad?

With no director in Canada, the subsidiary cannot incorporate federally but can in Ontario, British Columbia or Alberta, which have no director residency rule. A federal corporation needs resident Canadians as at least 25% of its directors, and at least one when it has fewer than four (CBCA s. 105(3)).

A director must be an individual, so the parent company cannot sit on the board (CBCA s. 105(1); BC Act, s. 124). A federal corporation keeps its registered office in the province named in its articles (CBCA s. 19). Wherever it incorporates, the subsidiary registers in each other province where it carries on business; see federal or provincial incorporation. Who counts as a resident Canadian is covered in incorporating as a newcomer or non-resident.

How are shares issued to the parent, and what goes in the minute book?

The directors pass a resolution issuing shares to the parent, and a share can be issued only once it is fully paid in money, property or past services of equal value (CBCA s. 25). The parent becomes the sole registered shareholder. The articles set the share classes and the number of directors.

A federal corporation keeps its articles, by-laws, shareholder minutes and resolutions, and a securities register at its registered office or another place in Canada; it also keeps director minutes and accounting records. Corporate law lets records sit abroad only if they can be inspected electronically at the registered office or another place in Canada (CBCA s. 20). Tax law is stricter: books and records stay at the subsidiary's place of business in Canada unless the CRA designates another place, including the parent's system abroad (ITA s. 230(1)); see how long to keep business records. It also keeps a register of individuals with significant control and files that information with Corporations Canada. Those are the individuals who own or control, directly or indirectly, 25% or more of the shares, or who control the subsidiary in fact, so the subsidiary traces ownership through the parent to the people at the top. If the parent is listed on a stock exchange designated under the Income Tax Act, or is a reporting issuer under a province's securities law, its wholly-owned subsidiary is excluded (Corporations Canada). An Ontario or British Columbia corporation keeps a similar register under its own act (Ontario Act, s. 140.2; BC Act, Part 4.1). See the minute book for a new corporation.

The parent can fund the subsidiary with share capital, a loan, or both. The choice changes the tax: interest on a loan from the parent or another group company faces Part XIII withholding, and it is deductible only within the 1.5:1 debt-to-equity limit explained below. Decide and document the funding before the money arrives, so the books record it as share capital or as a loan.

Does the subsidiary need an Investment Canada Act notification?

Usually, yes. A non-Canadian that establishes a new Canadian business must notify the government at any time before starting or within 30 days after implementation (ICA ss. 11 and 12). ISED says a notification is due each time a non-Canadian begins a new business activity in Canada that is not reviewable (ISED FAQ).

• What counts: a new Canadian business is one the non-Canadian is not already carrying on in Canada and that is unrelated to its other Canadian business (ICA s. 3). If the parent already runs a related business in Canada, check this definition first.
• How: use ISED's mandatory notification form, "Notification – Establishment of a new business" (ISED forms).
• When it goes further: a new business in a prescribed cultural activity can be ordered for review (ICA s. 15), and the government can review a foreign investment of any size on national security grounds (ISED). Where the investor is state-owned or national security factors may be present, ISED encourages filing at least 45 days before starting (ISED FAQ).

The notification is filed by the non-Canadian making the investment, usually the parent (ICA s. 12). It is separate from every CRA account and return.

How does a subsidiary with no Canadian-resident signer get a business number?

A signer with no SIN, or a SIN starting with 0, uses the CRA's non-resident route: the Non-Resident Business Registration online form, or Form RC1 by mail or fax. That route also applies when the business is incorporated or located outside Canada; the resident online route is only for Canadian residents with a SIN (CRA).

The business number (BN) itself may need no signer. Incorporating federally, or in Alberta, British Columbia, Manitoba, New Brunswick, Nova Scotia, Ontario, Saskatchewan or Prince Edward Island, automatically assigns a BN and a corporation income tax account. In any other province or territory, the corporation registers for both with the CRA (CRA). Other accounts are added to the same BN.

For account details and fixing a wrong registration, see after you incorporate.

The GST/HST small-supplier exemption usually does not help a subsidiary of a larger group. The $30,000 test counts taxable sales made inside or outside Canada by the subsidiary and its associates (ETA s. 148; CRA), and a parent that controls it is an associate (ETA s. 127(1), applying ITA s. 256(1)). Associates count from the start of each calendar quarter. So from the first quarter that begins after the subsidiary is formed, a parent whose taxable sales anywhere in the world pass that figure makes it not a small supplier, and it must apply to register before the day that is 30 days after its first taxable sale in Canada in the course of its business there (ETA s. 240(1) and (2.1)). It can also register earlier by choice (s. 240(3)). See when to register for GST/HST.

Why is the subsidiary not a CCPC, and what does that change?

A corporation controlled, directly or indirectly, by one or more non-residents is excluded from the definition of a Canadian-controlled private corporation (ITA s. 125(7)). A subsidiary controlled by its foreign parent is therefore not a CCPC from day one, even with resident Canadian directors.

Provincial tax is added on top, at the province's higher rate: the lower rate applies only to income eligible for the federal small business deduction (CRA). The other CCPC-only items are listed in CCPC status for a new corporation. An existing company that takes on foreign investors is covered in losing CCPC status to foreign investors.

What does the subsidiary file in its first year?

The first T2 is due six months after the tax year ends, even with no income (T4012). The first tax year starts on the incorporation date and cannot exceed 53 weeks; see the first corporate tax year. The subsidiary picks its year-end, which can match the parent's; a later change needs the CRA's agreement (ITA s. 249.1(7); see choosing or changing a year-end).

A subsidiary with a permanent establishment in Alberta during the year must also file an Alberta return (AT1), unless exempt (Alberta); one with an establishment in Quebec generally files Quebec's CO-17; see filing your corporate return.

What must the subsidiary withhold on money sent to the parent?

Part XIII tax applies when the subsidiary pays or credits the parent a dividend, a management or administration fee, interest, or a royalty (ITA s. 212). The subsidiary withholds it, remits it to the CRA and reports it on NR4 slips.

A treaty between Canada and the parent's country can lower the rate or exempt the payment. The treaty is the one with the country where the parent is resident (Finance Canada list); a Hong Kong parent, for example, uses Canada's agreement with Hong Kong, not the China treaty. Before applying it, the subsidiary gets Form NR301 or the same information from the parent (T4061). If it fails to withhold, the CRA can assess the tax plus a penalty of 10% of the amount not deducted. Fees for work the parent's staff do in Canada can also need a separate withholding; see withholding on services in Canada.

Which related-party reporting starts at once?

Three sets of rules apply from the first year, profit or not: transfer pricing for any transaction with the parent, Form T106 once the year's dealings pass $1,000,000, and thin capitalization once the parent lends.

• Transfer pricing: prices with the parent must match arm's-length terms. To show reasonable efforts, records describing each transaction, the functions of each party and the pricing analysis must exist by the T2 filing due date and go to the CRA within 30 days of a written request (ITA s. 247(4)). Without them, once the year's adjustments not backed by reasonable efforts exceed the lesser of 10% of gross revenue and $10,000,000, a penalty of 10% applies to the whole of those adjustments (ITA s. 247(3)).
• Form T106: required when reportable transactions with all non-arm's-length non-residents total more than $1,000,000 in the year (ITA s. 233.1(4)). A reportable transaction is any transaction or series that relates to the subsidiary's business, so fees, licences, purchases and loans with the parent all count (s. 233.1(1)). Penalties and form details: foreign property and affiliate reporting.
• Thin capitalization: when the subsidiary owes money to a non-resident shareholder holding 25% or more of the votes or value, or to any non-resident that does not deal at arm's length with such a shareholder (a group finance company, a sister company), interest on debt above 1.5:1 times the equity is not deductible (ITA s. 18(4)). Equity here means retained earnings at the start of the year plus the monthly average of the paid-up capital and contributed surplus from the parent. The non-deductible interest is treated as a dividend for Part XIII (ITA s. 214(16)). A second limit, on interest and financing expenses, can also apply once the net amount for the subsidiary and its Canadian group passes $1,000,000 a year (ITA s. 18.2).

Who in Canada must be ready before the first invoice or paycheque?

The subsidiary needs its registered office, directors who meet the residency rule, someone authorized to sign, a Canadian bank account and the CRA accounts it will use. Two items need attention before money moves:

• The bank account: a bank must collect the names of all directors, the names and addresses of everyone who directly or indirectly owns or controls at least 25% of the shares, and the ownership and control structure, then confirm them (FINTRAC). Bring the certificate and articles, the share and significant-control registers and the group chart traced to individuals.
• Remittances: directors are personally liable, together with the corporation, for payroll deductions and Part XIII tax the corporation fails to withhold or remit (ITA s. 227.1), and for GST/HST net tax it fails to remit (ETA s. 323). A director who took the care a reasonably prudent person would have to prevent the failure is not liable, and the CRA must act within two years after the person last ceased to be a director (ITA s. 227.1(3) and (4); ETA s. 323(3) and (5)). Someone must own the remittance calendar before the first payment to an employee or the parent.

For CRA online access and authorizing an accountant, see after you incorporate.

Example

These examples are illustrative; all figures are in Canadian dollars.

A German parent forms a federal subsidiary

A German software company incorporates a federal subsidiary with three directors: two live in Germany and one is a resident Canadian, which meets the one-director rule for a board under four. With most of the board in Germany, the parent decides before the first meeting where the board will meet, since a subsidiary run from Germany could be treated as resident there under the treaty (ITA s. 250(5)). The directors issue common shares to the parent once its C$100,000 arrives. The federal incorporation brings the BN and the corporation income tax account; the other accounts are added through the CRA's non-resident route, since the director handling the registration lives in Germany and has no SIN. The subsidiary opens on March 1, and the parent files its Investment Canada notification by March 31. The parent's worldwide taxable sales are far over C$30,000, so the subsidiary stops being a small supplier from the first calendar quarter after it is formed; it registers for GST/HST before its first Canadian sale.

Year one: a management fee and a software licence

With a December 31 year-end, the same subsidiary pays the parent a C$300,000 management fee and C$900,000 to license its software. Its dealings with the parent total C$1.2 million, over C$1 million, so Form T106 is due with the T2 by June 30. Before the first payment, it reviews Part XIII: at the statutory rate the fee alone would carry C$75,000 of withholding, and the licence fee can be a royalty, unless the Canada–Germany treaty reduces or removes either. It collects the parent's NR301, remits any tax by the 15th of the following month, issues NR4 slips by March 31 and has its transfer pricing records ready by June 30.

A Singapore parent funds mostly with a loan

A Singapore parent pays C$500,000 for shares and lends C$2 million at 5% for the whole year. For round numbers, the shares count as in place at the start of every month; in fact equity is measured at each month's start, so the subsidiary's very first month counts none and slightly more interest is caught.

• Year one: with no retained earnings yet, equity is C$500,000, so debt up to C$750,000 (1.5 times) carries deductible interest. The excess C$1.25 million is 62.5% of the debt, so C$62,500 of the C$100,000 interest is not deductible and is treated as a dividend for Part XIII. The other C$37,500 is interest, subject to Part XIII unless the Canada–Singapore treaty reduces it.
• Year two: the subsidiary kept C$200,000 of year-one profit, so equity is C$700,000 and the limit rises to C$1.05 million. The excess C$950,000 is 47.5% of the debt, so C$47,500 of the interest is not deductible.

Had the parent put in C$1 million of shares and lent C$1.5 million, the limit would have been C$1.5 million and the whole loan would have been within the thin capitalization limit.

Different for you?

• The parent is a US company: see a US business expanding into Canada for branch versus subsidiary, including branch tax.
• The owner is a person abroad, not a company: see incorporating in Canada from abroad, or a Canadian company for a China-resident founder.
• Your directors are newcomers or on work permits: see incorporating as a newcomer or non-resident.
• Foreign investors are joining an existing Canadian corporation: see losing CCPC status to foreign investors.
• The board will meet or the business will be run from the parent's country: the subsidiary's residence can turn on the treaty tie-breaker (ITA s. 250(5)); get corporate tax help before appointing the board.
• The first fee, licence payment, loan or dividend to the parent is coming up: withholding, Form T106, thin capitalization and transfer pricing records can all apply; get corporate tax help before the payment.
• The first T2 as a non-CCPC is due: see filing your corporate return and get corporate tax help.
• The subsidiary has missed T2, GST/HST or NR4 filings: see a non-resident-owned corporation that never filed and get corporate tax help.
• Intercompany balances do not match the parent's books: get bookkeeping help to reconcile them before year-end.