CANADIAN   DOUBLE TAX TREATY AGREEMENTS

Offshore Planning Using Double Tax Treaty Agreements with Low Tax Jurisdictions

Profits earned in a high tax country can sometimes be extracted to tax havens as interest, royalties or management charges. In all these cases the country of source is likely to have rules limiting the effectiveness of the technique. The object here is to arrange for payments to be made which are an allowable deduction against taxable profits in the country of origin, thus reducing the taxable profits there. There may be withholding taxes in the country of origin, and taxes in the country of receipt. Provided that these total less than the tax that would have been levied on the profits against which the payments are charged, there is a net advantage.

Double Taxation Agreements ("DTA') affect the ways in which dividends, interest and royalties extracted from third countries are taxed. For example, if a British company pays dividends to American or Swiss shareholders, withholding tax is limited to 15 per cent. If dividends are paid to a shareholder resident in a country which imposes no tax and is not a party to any double taxation agreement, withholding tax will be at the full standard rate. If a US company pays dividends to a UK shareholder, withholding tax is limited to 15 per cent and there is no withholding tax on interest and royalties.

Payments to a tax haven country suffer 30% in the above cases. Thus an important group of tax haven operations rests on the proper exploitation of double taxation agreements, and more sophisticated operations involve countries which levy some tax but which are parties to double taxation agreements.

Double Taxation Agreements - Switzerland - USA

Another profit extraction technique is to cross-license via Switzerland (i.e. royalties can flow from the United States to Switzerland free of withholding tax under the double taxation agreement, but profits derived from there are then subject to tax in Switzerland). Switzerland, however, imposes no withholding tax on royalties flowing out. Therefore it is possible to transfer patents or copyrights to a Liechtenstein company, which then licensed a Swiss intermediate company, which in turn sub-licensed and received royalties from the United States. No withholding tax would be paid on either of the royalty flows. Although the Swiss company would be liable to Swiss taxes on profits, royalties paid out would be allowable as a deduction, leaving little or nothing to be taxed.

There are very few DTAs between high tax countries and no-tax offshore center and consequently there is likely to be no relief from withholding taxes on payments made from a company situated in a high tax country to one situated in a tax haven. The cost of such withholding taxes may be so high as to nullify any benefits to be obtained from employing the extraction of pre-tax profits technique.

Double Taxation Agreements - Canada - Barbados

The Canada - Barbados tax treaty is a good example to consider. If a Canadian parent company opens a Barbados company to capture the global sales "active income" outside of Canada then the Barbados company would only pay 2.5% taxes there, and could return 97.5% of income to Canada as a dividend tax free. The Canadian company could pay the shareholders dividends, which were taxed in Barbados originally, to the shareholder tax-free. The above does not work for "passive income" derived from investment in property or earned by interest or capital gains.

A Canadian company currently netting $100,000 in income and paying $30,000 in taxes to CCRA, could expect to pay about $3,000 to setup the above, and only $2500 in Barbados tax, which saves about $24,500, and makes paying the shareholders easier. We can help here: Contact us.

Double Taxation Agreements - Netherland Antilles

To illustrate the potential benefit which can be obtained by using DTAs, an offshore company has developed a technological process which it wishes to license to a subsidiary incorporated in the US. If any royalties are paid directly to the tax haven parent, a 30% withholding tax will be levied, since no Double Taxation Agreement exists between the offshore company's domicile and the US. However, to reduce the impact of this withholding tax, the tax haven company sells the technological process to a Netherlands Antilles subsidiary, which grants a license to a subsidiary in the Netherlands, which in turn grants a sub-license to the US subsidiary. These transactions are aimed at:

• sourcing a certain amount of the royalty income in the Netherlands Antilles, which is a favorable location due to its tax haven status
• using the many favorable DTAs entered into by the Netherlands.

The flow of payments would then be as follows:

• Sub-royalty payments would be made from the US to the Netherlands free of any withholding tax.
• The Netherlands tax authorities would impute a 'profit' of approximately 7% of the gross royalties to have been made in the Netherlands. Even if that amount was not retained in the Netherlands, taxation at a rate of 48% would be levied on the imputed profit. It is recommended, therefore, that the various licensing agreements provide that of the total royalty charged by the Netherlands company, 7% be retained as sub-royalty payments in the Netherlands company and 93% be passed back to the Netherlands Antilles company as its royalty payments. The remaining portion can then be remitted to the Netherlands Antilles as a dividend free of withholding tax.
• A corporation tax charge of up to 3% would be levied on the royalty and dividend received in the Netherlands Antilles.
• Profits would then be remitted back to the tax haven in the form of dividends which are not subject to withholding tax.

The importance of arm's length transactions is most relevant when transactions between "related" parties, such as companies in an international group, are undertaken. The transactions between these companies will come under the scrutiny of interested tax authorities, who will ensure that they have been carried out on an "arm's length" basis. The most common test of the "arm's length" nature of a transaction is whether the transaction has been carried out on the same conditions and terms as might have applied between unrelated parties.

The various techniques for extracting pre-tax profits from the foreign branch or subsidiary so as to reduce its taxable profits and move them to another location are here summarized:

• Invariably, the payment extracted will be paid to related companies. Therefore it is important that payments are reasonable.
• The payments discussed will often be subject to a withholding tax at source when paid by the foreign branch or subsidiary. Often this withholding tax may be reduced to nil or a low rate of tax as a result of a DTA between the territories of payment and receipt.Prior planning can ensure that the payment is received in a territory where the tax burden is lowest.
• Techniques for the payment of royalties and interest and the use of an off-shore trading company so as to minimize the foreign branch or subsidiary's taxable profits.
• The rent for occupation of premises (or rent for plant and equipment) may be paid by the foreign branch or subsidiary to a foreign affiliate.
• Last, the foreign branch or subsidiary could make payments for management services where these are provided by affiliates abroad. On similar lines, salary and compensation payments may be made to officers who have provided management services to a foreign entity.

The following common scenario illustrates this profit extracting technique.

When the Enterprise Group XYZ sends executives to work outside the home country, they are employed by the Management Services Company, an offshore subsidiary of the Dutch Holding Company. Over the years the Home Country group has developed various work manuals and methods for both manufacturing and marketing operations, and these are made available to the Foreign Country (FC) group.

The Management Services Company will supply the services of the Home Country group's executives when they work in a foreign country at a fee which will give the Management Services Company a margin of profit between the fee it receives and the salary it pays. In a similar position to patent rights, the Home Country group will assign to the Netherlands Antilles company the territorial rights to the know-how contained in its work manuals. These rights will be sub-licensed to the Dutch company, which will unlicensed them to the various companies in the Foreign Country group that utilize the know-how contained in the manuals. In this way the FC group will be making tax deductible management fee and royalty payments, which will be taxed at a relatively low rate on ultimate receipt by the Management Services and Netherlands Antilles subsidiaries respectively.