Written by Thomas A. Bauer
On May 7, 2009, the Bermuda Ministry of Finance announced that it has concluded negotiations with Canada to enter into a tax information exchange agreement (TIEA). While the Canadian government has not yet made a similar announcement, it is expected to do so in the near future.
The TIEA will provide for the exchange of information relating to criminal and civil tax matters. Furthermore, the conclusion of a TIEA between Canada and Bermuda means that certain income earned by a Bermudian subsidiary and remitted to its Canadian parent corporation will be eligible for favourable Canadian tax treatment. Since Bermuda presently does not impose any corporate income tax or withholding tax, the pending TIEA with Bermuda means that Canadian corporations may want to consider using a Bermuda subsidiary as part of their overseas structure.
As a general rule, Canadian corporations that earn active business income through a foreign subsidiary are only subject to Canadian tax on that income when it is repatriated to Canada by way of a dividend.
The tax treatment of the dividend in the hands of the Canadian parent depends on whether the dividend is considered to be paid out of the subsidiary's “exempt” earnings or “taxable” earnings. To the extent the dividend is paid out of exempt earnings, it can generally be received by the Canadian parent without any Canadian tax payable.
If, on the other hand, the dividend is paid out of taxable earnings, the Canadian parent is required to include the dividend in income but is entitled to a deduction based on a gross-up of the foreign tax paid by the subsidiary. This deduction may not fully offset the income inclusion to the Canadian parent, especially where the foreign income is earned in a low-tax jurisdiction. It is therefore generally advantageous if the income qualifies as exempt earnings. As a result, most Canadian multinationals tend to structure their overseas operations, including intra-group financing and licensing arrangements, with a view to generating exempt earnings.
Until recently, in order for income to qualify as exempt earnings the foreign subsidiary had to be resident in a country with which Canada has entered into a comprehensive tax treaty and the income had to be active business income earned in a treaty country. While Canada has an extensive treaty network, most treaty countries tend to be countries with relatively high rates of tax (although there are notable exceptions, such as Barbados which imposes a low rate of tax on income earned by certain corporations).
In order to encourage so-called tax havens to enter into TIEAs with Canada, the 2007 federal Budget introduced amendments to the Canadian tax rules which extended the favourable exempt earnings treatment to active business income earned in a TIEA country by a foreign subsidiary resident in a TIEA country. The pending TIEA with Bermuda is the first TIEA to be announced since these new rules were enacted.
At present, Bermuda does not impose any corporate income tax, nor does it impose any withholding tax on dividends. Once the Bermuda TIEA enters into force, it may therefore be possible to earn active business income through a Bermudian subsidiary and repatriate that income to Canada without any Bermudian or Canadian tax. As a result, Bermuda is likely to become a favourable jurisdiction for Canadian corporations looking to set up certain types of off shore operations.