Corporate - Income determinationLast reviewed - 09 December 2022
In most cases, all property included in inventory can be valued at fair market value (FMV), or each item can be valued at its cost or FMV, whichever is lower. Most well-established and reasonable approaches to inventory costing can be used for tax purposes, except for the last in first out (LIFO) method. Conformity between methods used for book and tax reporting is not mandatory, but the method chosen should be used consistently for tax purposes. Inventory must be valued at the commencement of the year at the same amount as at the end of the immediately preceding year.
Half of a capital gain constitutes a taxable capital gain, which is included in the corporation's income and taxed at ordinary rates. Capital losses are deductible, but generally only against capital gains. Any excess of allowable capital losses over taxable capital gains in the current year can be carried back three years and carried forward indefinitely, to be applied against net taxable capital gains from those years, except in the case of an acquisition of control. No holding period is required. Intent is a major factor in determining whether the gain or loss is income or capital in nature.
Non-resident corporations are subject to CIT on taxable capital gains (50% of capital gains less 50% of capital losses) arising on the disposition of taxable Canadian property. Taxable Canadian property of a taxpayer includes, among other things:
- Real estate situated in Canada.
- Both capital and non-capital property used in carrying on a business in Canada.
- In general, shares in a corporation that are listed on a stock exchange if, at any time in the preceding 60 months:
- 25% or more of the shares of the corporation are owned by the taxpayer or persons related to the taxpayer, and
- more than 50% of the FMV of the shares is derived from real property situated in Canada, Canadian resource properties, and timber resource properties.
- In general, shares in a corporation that are not listed on a stock exchange if, at any time in the preceding 60 months, more than 50% of the FMV of the shares is derived, directly or indirectly, from property similar to that described above for shares of a public corporation.
However, in specific situations, the disposition by a non-resident of a share or other interest that is not described above may be subject to Canadian tax (e.g. when a share is deemed to be taxable Canadian property).
The general requirement is that a non-resident vendor of taxable Canadian property must report the disposition to the CRA and obtain a clearance certificate in respect of the disposition. If no certificate is obtained, the purchaser is required to withhold and remit to the CRA 25% of the sales proceeds.
Relief from the reporting and 25% withholding requirements may be available if specified conditions are met (e.g. if the gain from the disposition is not taxable in Canada by virtue of a tax treaty Canada has with another country). However, if the parties to the transaction are related, relief is available only if the CRA is notified.
The CRA can reassess tax after the end of the normal reassessment period (three years after the date of the initial notice of assessment for most taxpayers) on a gain from the disposition of real or immovable property if the taxpayer does not initially report the disposition.
Dividends received by one Canadian corporation from another Canadian corporation generally can be deducted in full when determining taxable income. However, dividends received by a ‘specified financial institution’ on certain preferred shares are an important exception and are taxed at full corporate rates.
Dividends on most preferred shares are subject to a 10% tax in the hands of a corporate recipient, unless the payer elects to pay a 40% tax (instead of a 25% tax) on the dividends paid. The payer can offset the tax against its income tax liability. The tax is not imposed on the first CAD 500,000 of taxable preferred-share dividends paid in a taxation year. Nor does it apply to dividends paid to a shareholder with a 'substantial interest' in the payer (i.e. at least 25% of the votes and value).
Dividends received by private corporations (or public corporations controlled by one or more individuals) from Canadian corporations are subject to a special refundable tax of 38⅓%. The tax is not imposed if the recipient is connected to the payer (i.e. the recipient owns more than a 10% interest in the payer) unless the payer was entitled to a refund of tax in respect of the dividend. When the recipient pays dividends to its shareholders, the tax is refundable at a rate of 38⅓% of taxable dividends paid.
If the payer is resident in Canada, stock dividends are treated for tax purposes in the same manner as cash dividends. The taxable amount of a stock dividend is the increase in the paid-up capital of the payer corporation because of the payment of the dividend. Stock dividends received from a non-resident are exempt from this treatment. Instead, the shares received have a cost base of zero.
Cross-border securities lending arrangements (SLAs)
In general terms, in a security lending and repurchase arrangement, a counterparty transfers or lends a Canadian share to a taxpayer, and the taxpayer agrees to transfer or return an identical share to the counterparty in the future. Over the term of the arrangement, the taxpayer is obligated to pay to the counterparty amounts (dividend compensation payments) as compensation for all dividends received on the transferred or lent Canadian share.
The WHT rules are modified for dividend compensation payments that a Canadian borrower makes to a non-resident lender under an SLA, to address planning undertaken by certain non-residents that attempts to avoid the Canadian dividend WHT.
For compensation payments made after 18 March 2019:
- the rules apply to compensation payments made under both SLAs and 'specified SLAs' (equity-based financial arrangements, which are similar to SLAs)
- all dividend compensation payments made under SLAs and specified SLAs are treated as dividends for WHT purposes, regardless of whether the arrangement is fully collateralised, and
- certain rules apply for purposes of determining the WHT rate available under a tax treaty (the general effect of these rules is to make it more difficult for a lender to access the reduced WHT rates that are available under certain treaties where the dividend recipient owns at least 10% of the shares of the dividend payer [in terms of voting rights and fair market value]).
For securities loans entered into before 19 March 2019, the above measures apply only to compensation payments made after September 2019.
A relieving measure for dividend compensation payments made in respect of non-Canadian shares after 18 March 2019 ensures that such payments will be exempt from WHT if the related SLA is fully collateralised. The scope of an existing exemption for interest compensation payments is also expanded.
Interest that accrued, became receivable by, or was received by a corporation is taxable as income from a business or property.
Rents received by a corporation are taxable as income from a business or property.
Royalties received by a corporation are taxable as income from a business or property.
Derivatives are sophisticated financial instruments whose value is derived from the value of an underlying interest.
Elective use of the mark-to-market method
Taxpayers can elect to mark to market all of their eligible derivatives held on income account. The election remains effective until it is revoked with the consent of the Minister of National Revenue. Without this election, income or losses from derivatives on income account are to be reported on a realised basis. For eligible derivatives that were previously subject to tax on a realisation basis, the recognition of any accrued gain or loss at the beginning of the first election year will be deferred until the derivative is disposed of.
Character conversion transactions
Existing rules, intended to prevent fully taxable ordinary income from being recharacterised into more favourably taxed capital gains under a 'derivative forward agreement', provide an exemption to facilitate certain commercial transactions where the economic return from a purchase or sale agreement is based on the economic performance of the actual property being purchased or sold, rather than an underlying reference property. To prevent potential misuse of this exemption, the definition of derivative forward agreement has been amended to provide that the commercial transaction exemption is unavailable if it can reasonably be considered that one of the main purposes of the agreement to purchase a security in the future is for a taxpayer to convert ordinary income into capital gains. This applies to transactions entered into after 18 March 2019; and also after December 2019 to transactions that were entered into before 19 March 2019, including those that extended or renewed the terms of the agreement after 18 March 2019, subject to certain transitional rules.
Foreign exchange gains and losses
The foreign exchange gains and losses of a Canadian taxpayer that arise from business transactions (i.e. on income account), including the activities of a branch operation, are generally fully includable in income or fully deductible. Any method that is in accordance with generally accepted accounting principles may be used to determine foreign exchange gains or losses on income transactions, provided that the treatment is consistent with previous years and conforms to the accrual method of accounting.
A foreign exchange gain or loss that is on capital account is treated the same as any other capital gain or loss. The accrual method of accounting cannot be used for purposes of reporting gains or losses on capital account. This follows from the CRA's view that a taxpayer has not made a capital gain or sustained a capital loss in a foreign currency until a transaction has taken place. Therefore, paper gains and losses are disregarded.
Debt parking to avoid foreign exchange gains
To avoid realising a foreign exchange gain on the repayment of a foreign currency debt, some taxpayers have entered into debt-parking transactions. As a result, the rules require any accrued foreign exchange gain on foreign currency debt to be realised when the debt becomes a parked obligation. The debtor will be deemed to have a gain, if any, that it otherwise would have if it had paid an amount (expressed in the currency in which the debt is denominated) to satisfy the principal amount of the debt equal to:
- when the debt becomes a parked obligation as a result of it being acquired by the current holder, the amount for which the debt was acquired, and
- in other cases, the FMV of the debt.
A foreign currency debt will become a parked obligation if:
- at that time, the current holder of the debt does not deal at arm’s length with the debtor or, when the debtor is a corporation, has a significant interest (i.e. generally together with non-arm’s length persons, 25% or more of the votes or value) in the corporation, and
- at any previous time, a person who held the debt dealt at arm’s length with the debtor and, when the debtor is a corporation, did not have a significant interest in the corporation.
Exceptions will apply to certain bona fide commercial transactions, and related rules will provide relief to financially distressed debtors.
For Canadian tax purposes, a partnership is treated as a conduit, and the partners are taxed on their share of the partnership income, whether or not distributed. A corporation is not restricted from being a member of a partnership. Income is determined at the partnership level and then allocated among the partners according to the terms of the partnership agreement. However, certain deductions, such as depletion allowances, exploration and development expenses, and donations, will flow through to be deducted by the various partners directly, as will any foreign tax credits, dividend tax credits, or investment tax credits (ITCs). Partners generally may deduct expenses incurred directly, such as interest on borrowings to acquire partnership interests, in computing income from the partnership.
Corporate partners are generally prevented from deferring taxation on partnership income in respect of partnerships in which they (together with related parties) hold an interest greater than 10% (share of income or entitlement to assets); income from these partnerships must be accrued up to the end of the corporation’s taxation year. The accrual is based on the partnership income for the fiscal period ending in the corporation's taxation year (the 'formulaic amount'), unless a lower amount is designated by the partner. Penalties can apply if the designated amount reported is less than both the formulaic amount and the actual prorated income of the subsequent partnership fiscal period. Upon request, permission to change the partnership's fiscal period may be granted. Partnerships in multi-tier structures must adopt the same fiscal period (generally, 31 December).
Joint venture income
An unincorporated joint venture is not recognised as a separate legal entity, and no specific statutory rules govern the taxation of a joint venture in Canada. However, many business arrangements that are set up as joint ventures may be considered partnerships, and treated as such for Canadian tax purposes. Whether a partnership exists in a particular situation is a legal question based on the specific facts and circumstances.
Consistent with the partnership anti-deferral rules (discussed in Partnership income above), corporate participants must report their actual share of joint venture income or loss up to the end of their own year-end.
Non-resident trusts (NRTs) and offshore investment funds
An NRT will generally be deemed to be resident for Canadian tax purposes if (i) it has Canadian resident contributors or (ii) certain former Canadian residents have contributed to an NRT that has Canadian resident beneficiaries. However, an election can be filed to deem the creation of a separate notional trust for tax purposes, referred to as a ‘non-resident portion trust’. Canadian tax will apply only to the income or gains from the properties held by the trust that are not included in the non-resident portion trust. Properties included in the non-resident portion trust are those properties that have not been directly or indirectly contributed by a Canadian resident or certain former Canadian residents (or property substituted for those properties or income derived from those properties). Many direct or indirect transfers or loans of property or services can be deemed to be contributions to an NRT.
An NRT is deemed to be resident in Canada if a Canadian-resident taxpayer transfers or lends property to the trust (regardless of the consideration received) and the property held by the trust may revert to the taxpayer, pass to persons to be determined by the taxpayer, or be disposed of only with the taxpayer’s consent.
The offshore investment fund rules affect Canadian residents that have an interest as a beneficiary in these funds. If the rules apply, the taxpayer will be required to include in its income an amount generally determined as the taxpayer’s cost of the investment multiplied by a prescribed income percentage (i.e. the prescribed rate of interest plus 2%) less any income received from the investment. Also, for certain non-discretionary trust funds in which a Canadian-resident person, and persons that do not deal at arm’s length with the person, have interests in aggregate of 10% or more of the total FMV of the total interests in the trusts, the trust is deemed to be a controlled foreign affiliate of the Canadian beneficiary and is thereby subject to the Canadian FAPI rules (discussed below).
Earnings of specified investment flow-throughs (SIFTs)
Certain earnings of SIFTs (i.e. publicly traded income trusts and partnerships) are subject to a SIFT tax and are deemed to be a dividend when distributed. The rules are intended to discourage corporations from converting to income trusts. The rules do not apply to Real Estate Investment Trusts (REITs) that meet certain conditions.
Canadian resident corporations are subject to Canadian federal income taxes on worldwide income, including income derived directly from carrying on business in a foreign country, as earned. In addition, Canadian resident corporations may be taxable currently on certain passive and active income earned by foreign subsidiaries and other foreign entities. Relief from double taxation is provided through Canada's international tax treaties, as well as foreign tax credits and deductions for foreign income or profits taxes paid on income derived from non-Canadian sources.
Foreign investment income earned directly by Canadian resident corporations, other than dividends, is taxed as earned, with a non-business foreign tax credit and a deduction for foreign income or profits taxes available, subject to certain limitations. Dividends received by Canadian resident private corporations (or public corporations controlled by one or more individuals) from non-connected foreign corporations are subject to the special refundable tax of 38⅓% (see above), to the extent that the dividends are deductible in determining taxable income.
The tax treatment of foreign dividends received by a Canadian resident corporation will depend on whether the payer corporation is a foreign affiliate of the recipient. Dividends received by a Canadian resident corporation from foreign corporations that are not foreign affiliates are taxed when received, with a non-business foreign tax credit and a deduction for foreign income or profits taxes available, subject to certain conditions. Dividends received by a Canadian resident corporation from foreign affiliates may be permitted to flow tax-free, subject to certain limitations pertaining to the nature of the earnings from which the dividends were paid, the foreign income or profits taxes paid, and WHTs paid in respect thereof.
To date, 24 Tax Information Exchange Agreements (TIEAs) have entered into force (one on behalf of five jurisdictions), one has been signed (but not yet in force), and Canada is currently negotiating five other TIEAs. To encourage non-treaty countries to enter into TIEAs:
- an exemption is available for dividends received by a Canadian resident corporation from the active business earnings of its foreign affiliates resident and carrying on their active business operations in non-treaty countries that have entered into a TIEA with Canada, and
- active business income earned by foreign affiliates in non-TIEA, non-treaty countries that have not signed the Convention on Mutual Administrative Assistance in Tax Matters will be treated as FAPI, which is taxable to the relevant Canadian resident corporation on an accrual basis, if a TIEA with Canada is not concluded within a specified period from a written request to commence negotiations or from the commencement of negotiations.
See Controlled foreign affiliates and foreign accrual property income (FAPI) in the Group taxation section for a discussion on foreign affiliates, controlled foreign affiliates, and FAPI.
Shareholder loan rules
Non-resident controlled Canadian corporations are permitted to make certain loans to foreign parent companies or related non-resident companies without being subject to the deemed dividend WHT if appropriate elections are filed. The election may be filed on a loan-by-loan basis, and the Canadian corporation must then include in income interest at a prescribed rate. The legislation also applies to loans made by, or to, certain partnerships.
The shareholder loan rules include those that are similar to the existing back-to-back loan rules, except that the rules apply to debts owing to Canadian-resident corporations rather than debts owing by Canadian-resident taxpayers, for back-to-back shareholder loan arrangements.
A back-to-back shareholder loan arrangement is considered to exist when an ‘intermediary’ that is not connected with the shareholder:
- is owed an amount by the shareholder (the shareholder debt), i.e. the intermediary lends an amount to the shareholder of the Canadian corporation, and
- owes an amount to the Canadian corporation or has a specified right (as defined) relating to a particular property, i.e. the intermediary borrows an amount from the Canadian corporation, and
this obligation or property is linked to the shareholder debt (certain conditions must be met).
If the rules apply to the debt owing by a shareholder of a Canadian-resident corporation, the shareholder will be deemed to be indebted directly to the Canadian corporation.
Cross-border surplus stripping
Section 212.1 of the Income Tax Act contains an ‘anti-surplus-stripping’ rule that applies when a non-resident person (or designated partnership) disposes of its shares in a corporation resident in Canada (the subject corporation) to another corporation resident in Canada (the purchaser corporation) with which the non-resident person does not deal at arm’s length. The rule is intended to prevent the tax-free receipt by the non-resident person of distributions in excess of the paid-up capital of its shares in the subject corporation and an artificial increase in the paid-up capital of such shares. This rule results in a deemed dividend to the non-resident person and a suppression of the paid-up capital of the shares that would otherwise have been increased as a result of the transaction.
An exception to the anti-surplus-stripping rule ensures the rule does not apply when a non-resident corporation is ‘sandwiched’ between two Canadian corporations and the non-resident corporation disposes of the shares of the lower-tier Canadian corporation to the Canadian parent corporation to unwind the structure.
Some non-resident corporations with Canadian subsidiaries have used this exception by reorganising the group into a sandwich structure to qualify for this exception in a manner that increases the paid-up capital of the shares of those Canadian subsidiaries. As a result, this exception has been amended to ensure that the exception does not apply when a non-resident corporation:
- owns, directly or indirectly, shares of the Canadian purchaser corporation, and
- does not deal at arm’s length with the Canadian purchaser corporation.
Comprehensive ‘look-through’ rules for partnerships and trusts ensure that the cross-border surplus stripping rules cannot be avoided inappropriately through situations where a non-resident disposes of an interest in a partnership that owns a Canadian subject corporation to a Canadian purchaser corporation, nor did they deal with similar planning involving trusts. A corresponding corporate immigration rule prevents the use of partnerships and trusts to circumvent the application of the corporate immigration anti-avoidance rule in similar circumstances. These rules allocate the assets, liabilities, and transactions of a partnership or trust to its members or beneficiaries, as the case may be, based on the relative fair market value of their interest.
‘Foreign affiliate dumping’ rules
Transactions described as ‘foreign affiliate dumping’ involve an investment in a foreign affiliate by a corporation resident in Canada (CRIC) that is controlled by a non-resident of Canada. When these rules apply, a dividend will be deemed to have been paid by the CRIC to its foreign parent, to the extent of any non-share consideration given by the CRIC for the ‘investment’ in the foreign affiliate, and any increase in the paid-up capital pertaining to the investment will be denied. The rules define ‘investment’ broadly to include:
- an acquisition of shares in or a contribution of capital to the foreign affiliate
- an indirect acquisition by the CRIC of shares of the foreign affiliate that results from a direct acquisition by the CRIC of the shares of another corporation resident in Canada if the total FMV of all of the shares of foreign affiliates that are held, directly or indirectly, by the other corporation exceeds 75% of the total FMV of all properties owned by the other corporation
- transactions where the foreign affiliate becomes indebted to the CRIC (or a related Canadian company), and
- an acquisition of certain options in shares or debt of the foreign affiliate.
The deemed dividend can be reduced to the extent of available paid-up capital, in accordance with the paid-up capital offset rules, if an election is filed with the Canadian tax authority by the tax return filing due date of the CRIC. Any remaining dividend amount will be subject to Canadian WHT (as reduced by the applicable treaty).
These rules also apply when the CRIC makes an investment in a non-resident corporation that is not a foreign affiliate of the CRIC but is a foreign affiliate of another corporation resident in Canada that does not deal at arm's length with the CRIC.
The scope of the foreign affiliate dumping rules has been extended to include situations where a CRIC is controlled by:
- a non-resident individual
- a non-resident trust, or
- a group of non-resident corporations, non-resident individuals, and/or non-resident trusts, who do not deal with each other at arm's length.
Emissions trading regimes
Under emissions trading regimes, regulated emitters must deliver emissions allowances to the government. These allowances may be purchased by emitters, earned in emissions reduction activities, or provided by the government at a reduced price or no cost. Specific rules clarify the tax treatment of emissions allowances and eliminate the double taxation of certain free allowances. Specifically, emissions allowances will be treated as inventory for all taxpayers; however, the ‘lower of cost and market’ method cannot be used to value the inventory.
If a free allowance is received, there will be no income inclusion on receipt of the allowance. In addition, the deduction for an accrued emissions obligation will be limited to the extent that the obligation exceeds the cost of any emissions allowances that the taxpayer has acquired and that can be used to settle the obligation. If a deduction is claimed in respect of an emissions obligation that accrues in one year (e.g. 2022) and that will be satisfied in a future year (e.g. 2023), the amount of this deduction will be brought back into income in the subsequent year (e.g. 2023), and the taxpayer will be required to evaluate the deductible obligation again each year until it is ultimately satisfied.
If a taxpayer disposes of an emissions allowance otherwise than under the emissions allowance regime, any proceeds received in excess of the taxpayer’s cost, if any, for the allowance will be included in computing income.