- The principal Canadian tax decision a Canadian mining corporation faces when operating outside of Canada is whether to do so directly through a local branch of the Canadian corporation or to set up one or more separate legal entities to conduct operations.
- If the Canadian corporation operates directly in a foreign country, Canada will tax the Canadian corporation on foreign income earned, subject to any relief provided under a tax treaty between Canada and that country. Moreover, Canada will typically offer a “foreign tax credit” for foreign income or profits taxes paid on foreign-source income, reducing Canadian tax owing by the amount of foreign taxes paid on the same foreign income. Most foreign mining expenditures will be treated as “foreign resource expenses”, which the taxpayer may deduct at a rate of 10% per year (more in some circumstances).
- More commonly, Canadian corporations conduct foreign mining operations through separate foreign entities, both to limit commercial liability and to take advantage of Canada’s relatively favourable system for taxing foreign subsidiaries. Where a Canadian corporation conducts activities through a “controlled foreign affiliate”, certain forms of passive, investment-type income will be imputed to the Canadian corporation and taxed in its hands for Canadian purposes, to prevent deferral of tax on such income (active business income is excluded). When a foreign affiliate of a Canadian corporation pays a dividend to the Canadian corporation, that dividend is received free of Canadian tax if it is attributable to either (1) active business income earned by the foreign affiliate in countries with which Canada has a tax treaty or (2) capital gains from most properties used to earn such income. Dividends attributable to other forms of income earned by the foreign affiliate are taxed in Canada, net of deductions permitted for foreign taxes paid by the foreign affiliate.
Where a Canadian resident (such as a Canadian-based mining corporation) carries on mining-related activities outside of Canada, the most immediate decision to be made is whether the Canadian resident should conduct such activities directly through a branch in the relevant foreign country, or instead to create a new legal entity resident outside of Canada (typically a foreign corporation resident in the country in which the mining operations will be carried on) to conduct these activities. The decision to carry on business outside of Canada directly or through a foreign subsidiary is very important, and the Canadian tax consequences of these two alternatives are very different.
A Canadian taxpayer might elect to carry on a foreign venture directly where, for example, losses for tax purposes are expected and these losses could be used by the Canadian taxpayer against income from activities in Canada. However, should it subsequently be desirable to carry on the foreign project through a foreign corporation, the transfer of the venture’s assets to the foreign corporation (even if wholly-owned by the Canadian taxpayer) will cause any accrued gains on those assets to be realized for Canadian (and possibly foreign) tax purposes. Therefore, careful consideration must be given to whether to carry on business directly or through a foreign entity.
A Canadian mining corporation may choose to conduct foreign mining operations through a separate foreign entity (typically a corporation) for a number of reasons:
- a separate corporation usually offers limited liability commercially, and in some cases local law may require the use of a separate local entity;
- a separate entity resident in the jurisdiction in which the foreign mining activity is occurring may obtain more favourable tax treatment under the laws of that country;
- if the local tax rate on income from the project is less than the Canadian rate that would otherwise be applicable if the Canadian resident earned such income directly, there may be either an absolute savings of tax or a deferral of tax created by carrying on the project through a separate foreign entity. In fact, from a Canadian tax perspective, where the foreign venture is carried on through a foreign entity that is a “foreign affiliate” of a Canadian mining company, Canada may effectively forego taxation of income earned in the foreign mining venture, via the exempt surplus system described below;
- a separate local entity allows greater flexibility in terms of repatriation of funds from the foreign project and the timing of how they are taxed; and
- carrying on the foreign venture through a separate entity offers the possibility of selling the foreign venture (or an interest in the foreign venture) at either the project level itself (i.e., the assets located in the foreign country) or at the entity level (interests in the foreign entity).
Most of the tax advantages of using a separate foreign entity depend on that entity not being a resident of Canada for tax purposes, and instead being a resident of another country. In general, for a corporation this requires that the entity be created under the laws of that foreign country (not Canada or a province thereof), and that the “central management and control” of the corporation be located in that foreign country. Typically “central management and control” is considered to be the board of directors of the corporation, although if the directors have no real authority (or habitually do not exercise such authority), it may be determined to lie elsewhere. Where the foreign country has a tax treaty with Canada, that treaty may also include provisions relevant to establishing the residency of an entity for tax purposes.
Part 1: Carrying on Business Outside of Canada Through a Foreign Branch
As noted earlier, Canadian residents are taxable on their income from inside and outside Canada on the basis of being resident in Canada. This means that a Canadian resident will be subject to Canadian income tax on income from foreign mining activities.
While it is relatively unusual for a Canadian mining corporation to conduct foreign activities directly, where this occurs the Canadian mining corporation computes its income (or loss) from those activities under essentially the same rules that apply to Canadian-source activities, with some exceptions:
- most expenditures related to the foreign mining activities will be treated as “foreign resource expenses” (“FRE”), being the foreign equivalent of CEE and CDE under the Canadian income tax regime;
- depending on where the foreign mining activities are located, Canada’s rights to tax may be limited by the terms of a tax treaty between Canada and the relevant foreign country (tax treaties take precedence over Canadian domestic income tax laws); and
- to the extent that income or profit taxes are levied in the foreign jurisdiction where such activities are carried on, the Canadian mining corporation would typically be entitled to a “foreign tax credit” (“FTC”) under Canadian tax rules, which reduces Canadian tax otherwise payable on the same income that the foreign jurisdiction is taxing. While the rules are somewhat more complex than this, essentially a Canadian FTC ensures that the sum of Canadian tax payable on foreign-source income (net of the FTC) plus the foreign income tax paid on that income does not exceed the amount of Canadian tax that would have been payable on that income had it been taxed at normal Canadian rates.
FRE and CFRE
As noted, FRE is best thought of as the foreign mining equivalent of CEE and CDE. It includes the costs of exploring for mineral resources (e.g., prospecting, surveying, etc.,) and the cost of a foreign resource property itself (excluding the cost of any depreciable property). It is computed separately for each country in which the taxpayer operates, such that a Canadian resident with foreign operations in multiple countries will have a separate FRE for each country. Note: expenses incurred in taxation years beginning before 2001 are treated separately under an older set of rules dealing with “foreign exploration and development expenses”.
For each foreign country in which it operates, a Canadian mining corporation will keep track of its FRE on a cumulative basis in a pool (“cumulative foreign resource expense”, or “CFRE”). The taxpayer’s FRE for that country is added to the CFRE pool for that country, while annual CFRE deductions (discussed below) and proceeds from the sale of foreign resource properties in that country are deducted from the CFRE pool. In this way, the CFRE system operates very much like the CCEE and CCDE pools applicable to Canadian mining activities.
The amount of the CFRE deduction that a taxpayer may claim in any given year is somewhat more complicated than the CCDE and CCEE deductions. It can be thought of as consisting of a “regular” deduction plus an additional amount that is determined with reference to its year-end CFRE for all foreign countries in which it operates.
In computing its income for a particular taxation year, the taxpayer is always entitled to claim a deduction of up to 10% of its CFRE for a particular country at the end of the taxation year. As such, this deduction may be taken against income from any source (Canadian or foreign). However, where doing so would produce a bigger deduction, the taxpayer may instead claim a deduction in computing income equal to the least of the following amounts:
- 30% of its year-end CFRE for a particular country;
- the taxpayer’s foreign resource income for the year from that country (i.e., operating mining income and sale proceeds from foreign resource properties); and
- the taxpayer’s foreign resource income for that year from all foreign countries (net of losses for that year from such countries).
The foregoing amounts (either the 10% claim or the larger amount) can be considered the “regular” CFRE deduction for the year in respect of the relevant foreign country. Moreover, the taxpayer may be entitled to a further additional deduction for the year equal to the lesser of:
- the amount of the taxpayer’s year-end CFRE for the particular country, after subtracting the CFRE “regular” deduction for the year taken in respect of that country as described above; and
- the taxpayer’s “global foreign resource limit” for the year, being the lesser of the taxpayer’s foreign resource income for all foreign countries for the year (net of all “regular” CFRE deductions for the year) and 30% of the taxpayer’s year-end CFRE balances for all foreign countries in which it operates (less the “regular” deductions taken for such countries for the year).
Where the taxpayer conducts mining activity in more than one foreign country, the global foreign resource limit must be allocated amongst those countries so that the total claimed in respect of all foreign countries does not exceed the global foreign resource limit.
Other Deductions and Credits
Where the taxpayer acquires depreciable property, it is entitled to claim CCA in respect of that property in the manner described above with reference to Canadian expenditures. CCA claims are not limited on a country-by-country basis the way that FRE deductions are.
Income from the foreign mining activity will be included in the Canadian taxpayer’s income and subject to Canadian tax at the applicable rate of tax. As noted above, Canadian tax payable may be reduced by the amount of an FTC permitted, to avoid double taxation of the same foreign income, the result being that the total foreign/Canadian income tax payable on the foreign mining income should not exceed the higher of the Canadian and the foreign rates of tax:
- where the applicable foreign income tax rate is higher than the applicable Canadian rate of income tax, a Canadian FTC should (at least in theory) eliminate Canadian tax payable; and
- where the applicable foreign income tax rate is lower than the applicable Canadian rate of income tax, a Canadian FTC should reduce Canadian income tax payable to an amount that causes the foreign income tax paid plus the Canadian income tax paid to be equal to the amount of Canadian tax that would have been payable had there been no foreign income tax.
The foreign taxes that entitle the taxpayer to an FTC are limited to income or profit taxes paid to a foreign government. Capital taxes, real property taxes, sales taxes and mining royalties do not generate FTCs, although they are generally deductible in computing income for Canadian tax purposes. While the actual rules governing FTCs are somewhat more complicated than this (in particular where the taxpayer carries on business in more than one foreign country or where the taxpayer has income from some projects and losses from others), the foregoing is a general overview of the FTC rules.
If the foreign mining activity produces a loss for the taxation year, that loss can be applied to reduce the Canadian mining corporation’s income from other sources for the year.
Part 2: Carrying on Business Outside of Canada Through a Foreign Subsidiary
More typically, a Canadian mining corporation will engage in foreign mining activities through a separate foreign entity, typically a corporation. Where this is the case, the primary consideration is the Canadian rules dealing with the taxation of “foreign affiliates” of Canadian corporations.
The “foreign affiliate” (“FA”) rules are the Canadian tax regime dealing with foreign subsidiaries of Canadian taxpayers, where the Canadian taxpayer holds a sufficient interest in the foreign entity for it to be considered an FA of the Canadian taxpayer.
At a very high level, when a resident of one country (i.e., Canada) owns a significant number of shares of a subsidiary resident in another country, the tax system of the shareholder’s country of residence may use three different approaches to the income earned by the shareholder’s foreign subsidiary:
- Accrual taxation: the shareholder’s country of residence may treat income earned by the foreign subsidiary as if it had been earned directly by the resident shareholder, and tax the resident shareholder on its share thereof (with a foreign tax credit (FTC) offered for foreign taxes paid on that income);
- Credit method: the shareholder’s country of residence may tax the resident shareholder on its share of income earned by the foreign subsidiary only when the foreign subsidiary actually makes a distribution to the resident shareholder, i.e., residence country taxation is deferred until a distribution is made. The full amount of any distribution is included in the resident shareholder’s income, (with an FTC given for any foreign income or withholding taxes incurred); or
- Exemption method: the shareholder’s country of residence may choose not to tax income earned by the foreign subsidiary of the resident shareholder or a distribution made by such a subsidiary to the resident shareholder.
Canada’s tax system includes elements of all three methods.
The FA rules in Canada’s Income Tax Act essentially deal with two issues:
- The FAPI System: under certain conditions, income earned by a foreign corporation in which a Canadian resident is a shareholder is treated as if it had been earned by the Canadian taxpayer, whether or not actually distributed to the Canadian resident. Under this anti-deferral regime, the Canadian resident is taxed on income earned by the foreign entity as that income accrues; and
- The Surplus System: Canada has a separate set of rules dealing with how to tax distributions made to a Canadian resident by one of its FAs, so as to provide appropriate recognition for the foreign tax that the FA’s income (from which the distributions are presumed to come) has already borne.
The definition of an FA is important for both purposes. Essentially, a foreign corporation will be an FA of a Canadian resident if the Canadian resident owns at least 1% of any class of the foreign corporation’s shares and the Canadian resident together with all persons related to the Canadian resident owns at least 10% of any class of the foreign corporation’s shares.
Both sets of rules depend on classifying income earned by an FA, depending on the activity that generates the income and where that activity is carried on. In particular, income characterized as income from an active business (“active business income”, or “ABI”) is treated more favourably than income from property or income from a business other than an active business. In general terms, income from an active business will include income from any business other than:
- income deemed to be income other than from an active business. This category of income is generally limited to situations involving an FA earning Canadian-source income;
- income from a non-qualifying business, defined as income from a business carried on in a country that does not have a tax treaty with Canada and which has been asked by Canada to enter into a tax information exchange agreement but has not done so within a certain time period (a “non-qualifying country”); and
- income from an “investment business” (this is deemed to be included in income from property).
Income from an “investment business” is defined to mean a business the principal purpose of which is to derive income from, among other things, property (including royalties and similar returns) and the disposition of “investment property”. Investment property is in turn defined to include:
- most securities;
- commodities and commodities futures (other than commodities manufactured, produced, grown, extracted or processed by the CFA or a person related to the CFA, and commodities futures relating thereto);
- foreign resource properties (and Canadian resource properties); and
- real estate.
Where the activities of what would otherwise be an “investment business” are carried on principally with arm’s-length persons and employs the equivalent of more than five full-time employees, those activities are excepted from being an “investment business”.
In the case of certain inter-affiliate payments, income that would otherwise be considered income from property may be recharacterized as being ABI, where the payer is itself carrying on an active business and the payment is deductible in computing the payer’s own ABI. For example, where one FA of a Canadian taxpayer lends money to another FA of the same Canadian taxpayer and the interest is deductible in computing the ABI of the second FA, the interest received by the lender may be deemed to be ABI. This rule ensures that underlying ABI does not lose its character as such simply because of normal intra-group arrangements that cause ABI to assume the form of passive income.
Capital gains are categorized on a similar basis, with reference to how the property on which the gains arise is used. The key concept is “excluded property”, being property:
- that is used principally to produce ABI;
- substantially all of the income from which is ABI; or
- that is shares of another FA of the Canadian taxpayer (or a partnership interest) substantially all of the fair market value of which is attributable to excluded property.
The FAPI System: Anti-Deferral on Passive Income
The FAPI system is intended to prevent Canadian residents from avoiding or deferring Canadian tax on passive, investment-type income earned by a controlled foreign affiliate (“CFA”) of a Canadian taxpayer.
A foreign corporation that is an FA of a particular Canadian taxpayer will be a CFA of that Canadian taxpayer if the FA is either:
- controlled by the Canadian resident taxpayer; or
- would be controlled by the Canadian resident taxpayer, if the Canadian resident-taxpayer owned all of the shares of the FA that it owns, plus any FA shares owned by persons not dealing at arm’s length with the Canadian-resident taxpayer and any FA shares owned by up to four other Canadian residents.
“Control” for this purpose means ownership of sufficient shares to elect a majority of the FA’s board of directors.
To the extent that a CFA of a Canadian taxpayer earns “foreign accrual property income” (“FAPI”) during a taxation year, a portion of that FAPI (proportionate to the taxpayer’s equity interest in the CFA) is included in the Canadian taxpayer’s income. A deduction is permitted in relation to foreign tax paid by the CFA.
Conceptually, FAPI is intended to encompass passive, investment-type income. More specifically, it includes the following:
(1) income from property (passive income such as interest, dividends, and royalties), other than dividends from other FAs of the Canadian taxpayer or from Canadian corporations;
(2) income from an investment business (strictly speaking, this is included in income from property);
(3) income from a business that is not an active business;
(4) income from a non-qualifying business; and
(5) 50% of certain capital gains realized by the CFA from dispositions of property other than excluded property.
This means that FAPI will not include income from an active business (other than in (4)), dividends received from other foreign affiliates of the Canadian taxpayer, and most capital gains realized by the CFA. A summary of the types of income included in FAPI is included in Table 1, below.
In the context of a mining business, there are a number of FAPI issues that could potentially arise. For example, where the CFA of a Canadian taxpayer holds a royalty in a foreign mining property, it will be necessary to consider whether that royalty would be considered income from property so as to be included in FAPI. In this regard, “income from ‘property” is defined to include income from an “investment business” (see above).
As noted, the “investment business” definition contains an exception for certain businesses that employ more than five employees full time in the active conduct of the business (including some services provided by affiliates). For this purpose, the earning of royalty income from foreign resource properties payable by persons dealing at arm’s-length with the CFA will usually constitute an eligible business. As such, a Canadian resident with a CFA earning royalty income will wish to ensure that such income comes within the relevant exception and is not treated as FAPI by virtue of being treated as income from an investment business.
Generally CFAs of a Canadian mining company engaged in active mining operations will not be troubled by the “investment property” definition in respect of their output, given the exception for commodities extracted, processed, etc. by the CFA or a related person. The inclusion of resource properties within the “investment property” definition is important however, and it is understood that the CRA takes the position that a foreign resource property that is acquired by a CFA of a Canadian taxpayer for the purpose of being re-sold (as opposed to being developed into a producing property) may be considered to be an “investment property.”
A Canadian mining corporation will also generally wish to avoid locating a CFA’s business in a non-qualifying country. Income from an active business that would otherwise not be FAPI could be deemed to be included in FAPI where a CFA carries on a business through a permanent establishment (i.e., a fixed place of business) in a non-qualifying country.
The Surplus System: Canadian Taxation on Distributions from an FA
The second element of the FA regime is the surplus system, which governs the manner in which dividends from an FA of a Canadian taxpayer are treated for Canadian tax purposes. These rules apply to dividends from an FA of a Canadian taxpayer that is a corporation. Essentially, income earned by an FA of a Canadian corporate taxpayer is categorized based on the activity that generates the income, the location of that activity, and where the FA is resident for tax purposes.
While these rules are detailed and complex, they can be summarized in general terms as follows. Income earned by an FA is categorized one of three ways:
- “taxable surplus,” consisting of the FA’s “taxable earnings” and dividends from another FA of the Canadian taxpayer attributable to the “taxable surplus” of the paying FA.
- “exempt surplus,” consisting of the FA’s “exempt earnings” and dividends from another FA of the Canadian taxpayer attributable to the “exempt surplus” of the paying FA.
- “hybrid surplus,” consisting of the FA’s capital gains from the disposition of excluded property that is shares of another foreign affiliate, a partnership interest or certain related F/X hedging contracts.
The importance of this classification is that when an FA of a Canadian corporate taxpayer pays a dividend, that dividend will be considered to come from the exempt surplus of the FA (to the extent of the FA’s exempt surplus), the taxable surplus of the FA (to the extent of the FA’s taxable surplus) or the hybrid surplus of the FA (to the extent of its hybrid surplus). An exempt surplus dividend received by a Canadian corporate taxpayer from one of its FAs is received free of any Canadian tax on the dividend: no net amount is included in the Canadian corporate taxpayer’s income. Conversely, a taxable surplus dividend received by a Canadian corporate taxpayer from one of its FAs is fully included in the Canadian corporate taxpayer’s income and then a deduction is permitted in respect of foreign taxes (income taxes on the income earned by the FA to which the dividend is attributable and withholding taxes on the dividend) related to the dividend. For a hybrid surplus dividend, essentially half the dividend is received free of Canadian tax (like an exempt surplus dividend) and the other half is included in income subject to a deduction for related foreign taxes (like a taxable surplus dividend). An exempt surplus dividend, taxable surplus dividend or hybrid surplus dividend paid by one FA of a Canadian corporate taxpayer to another is subtracted from the exempt surplus, taxable surplus or hybrid surplus (respectively) of the payer and added to the exempt surplus, taxable surplus or hybrid surplus (respectively) of the recipient, i.e., the relevant surplus amount moves “up the chain” on a dividend. To the extent that a dividend is paid by an FA that has no exempt surplus, taxable surplus or hybrid surplus, the dividend simply reduces the recipient’s cost for tax purposes of the FA shares on which the dividend is paid.
This makes it very desirable for an FA to earn income or gains that will be added to its exempt earnings. The basic principle behind exempt earnings is that to the extent a Canadian resident corporation has, through an FA, earned ABI in a country that is not considered a tax haven, Canada will waive its right to tax the Canadian resident corporation on a dividend attributable to that income. This principle is reflected in the classification of income earned by an FA:
- “Exempt earnings” of an FA consists of ABI earned by an FA that is resident in a “designated treaty country” (DTC”), being a country with which Canada has an income tax treaty or a tax information exchange agreement, from a business carried on by it in a DTC or Canada. In the case of an inter-affiliate payment deemed to be ABI, the FA must be a resident of a DTC and the payment must be deductible in computing the exempt earnings of the payer.
- “Taxable earnings” of an FA consists of:
- ABI not included in exempt earnings (e.g., because the FA is not resident in a DTC or the business is not carried on in a DTC);
- FAPI earned by the FA, viz., income from property (including an investment business), income from a non-qualifying business, income deemed to be income other than from an active business and 50% of capital gains from the disposition of property other than excluded property.
Also included in an FA’s taxable earnings is 50% of capital gains accruing after November 1981 realized by the FA on assets used principally to produce ABI in a country that is not a DTC. All other capital gains (except those included in hybrid surplus, as noted above) are included in exempt earnings. Table 1 summarizes the classification of income for surplus purposes.
TABLE 1: INCOME/GAINS CLASSIFICATION
|Income (other than 95(2) deemed ABI) from an active business, which excludes:
- Income from an investment business;
- Income from a non-qualifying business; and
- Income deemed by 95(2) to be income other than from an active business
|Where FA is resident in a “designated treaty country” (“DTC”) and business is carried on in Canada or a DTC
|Income deemed by 95(2) to be income from an active business (i.e., inter-affiliate payments relating to an active business)
||Where FA is resident in a DTC, and amount is deductible in computing payor’s exempt earnings
|Income from property (including income from an investment business), income from a non-qualifying business, and income deemed by 95(2) to be income other than from an active business, other than dividends from another FA of the Canadian taxpayer or s. 112 dividends
|Capital gains from dispositions of property used principally to produce income from an active business carried on other than in a DTC (excluding Canada)
||Taxable portion of gain accruing post-Nov. 1981
|Capital gains from dispositions of property other than “excluded property” (property used principally to produce ABI, property substantially all of the income from which is ABI, and shares of an FA substantially all the FMV of which is attributable to excluded property).
||Taxable portion of gain accruing post-1975
||Taxable portion of post-1975 gain
|Capital gains from excluded property that is either shares of another FA of the taxpayer or a partnership interest
||Entire capital gain now included in hybrid surplus, not 50% exempt/50% taxable
||Entire capital gain now included in hybrid surplus, not 50% exempt/50% taxable
|All other capital gains.
The foreign affiliate rules are extremely detailed and complex, and the foregoing description is only a general outline of the key concepts.
The appropriate structuring of a Canadian corporation’s foreign mining activities is a complex exercise that requires considerable thought as to various matters, such as:
- ensuring exempt surplus treatment to the greatest extent possible;
- financing the investment in the operating FA as tax-efficiently as possible, often through the use of a group finance FA that earns interest income from loans to the operating FA and relies on the intra-group payment recharacterization rule to prevent such interest income from being treated as income from property;
- using holding corporations and operating corporations in different jurisdictions in such a manner as to optimize the use of exempt surplus within the group and take advantage of tax treaties between the various relevant countries; and
- arrange holdings so as to facilitate a sale of an FA tax-efficiently should such prove desirable (for example, by interposing the shares of a holding corporation between the Canadian taxpayer and the operating FA, so as to allow a sale to be made by the holding corporation and avoid a gain being realized by the Canadian taxpayer).