Canada: The Red Tape Reduction Trap: Cautions Against Removing Canadian Directors

Cutting red tape has been a mantra of many governments at different levels and in a number of jurisdictions. The zeal with which it is professed to be done and the actual results are not always congruent. That is because blindly cutting what is perceived to be annoying "red tape" can lead to a lot of red ink. That could very well be the case with at least two of the provisions of the Alberta Red Tape Reduction Implementation Act, 2020¹ (the "RTRIA"), which was given royal assent by the Lieutenant Governor General on July 23rd, 2020.

Non-Resident Director

The provisions in question dispense with the need for Alberta companies to have a Canadian director.² Currently, businesses incorporated under the Alberta Business Corporations Act must have 1/4 of their directors be resident Canadians and businesses incorporated under the Companies Act must have 1/2 of their directors be resident Albertans (collectively referred to as an "Alberta Company"). In other words, once these sections are proclaimed, any or all of the directors of an Alberta Company can be either foreigners or foreign resident.

This is generally a positive change and will be very appealing to many, especially to those who have an Alberta Company but might prefer to run it from warmer climes down South; however, the tax consequences to a company of removing its Canadian director(s) could actually be much higher and far more cumbersome than just keeping that resident Canadian director.³ That is due to the direct connection between residency and taxation.

By way of brief background, most major economies base their tax systems on the concept of "tax residency" (also known as the territoriality principle). The one notable exception is the US, whose tax system does not follow that. The US system is instead based on "citizenship" (and indeed, that word features in most of the tax treaties the US signs with other countries). In other words, anyone who is a US person (natural or legal) is subject to US taxes.⁴

Under a territorial/residency system, like that in place in Canada, tax liability is based on substantial connection to a particular territory, with the two strongest connections being residency and place of management. Place of management is in turn very much equated with the residency of a corporation's director(s), and the place where management decisions are made. If that is not readily apparent, then there are a number of factors to help determine that, contained in tax treaties that countries like Canada have entered into with other countries.⁵

International Consequences

By removing residency requirements for directors of Alberta Companies, and assuming there truly is no Canadian resident director, then at an international level, that may be seen as effectively conceding that an Alberta Company is not resident in Alberta for Canadian tax purposes. That potentially exposes the Alberta Company to the tax rules of wherever a director is resident or wherever directors' meetings are held. If directors are scattered across several different jurisdictions where meetings are also held (or held virtually), there could be competing and over-lapping tax jurisdictions. That could prove very cumbersome to deal with.

In other words, not having a Canadian resident director in place of a foreign one who makes decisions for or on behalf of the Alberta Company from abroad risks it being deemed a foreign resident, therefore liable to pay foreign taxes not Canadian ones. Moreover, permanent establishment risks are created that could expose the Alberta Company to very unfair and expensive tax compliance consequences abroad. That could still be the case even if there are Canadian resident directors though fewer in number than those based abroad. That is because having either just one or a minority of Canadian resident directors might not be a sufficient connection to establish Canadian mind and management. Without that, even something that would be straight-forward in Alberta (like preparing financials) would be an expensive burden abroad.

Domestic Consequences

The taxation of corporations in individual provinces depends primarily on where a corporation has a "permanent establishment". For example, in Alberta under the Alberta Corporate Tax Act⁶ (the "Alberta Act"), any corporation that has a permanent establishment within Alberta will be liable for income tax calculated under that Act.

Where the directors happen to reside does not impact the permanent establishment analysis. Accordingly, there may already be Alberta corporations with no Albertan directors, but with directors from other provinces.

However, if an Alberta corporation ceases to be resident in Canada for tax purposes, and instead becomes a non-resident corporation, this will impact the calculation of provincial taxes. Again referring to the Alberta Act, the calculation of taxable income for a corporation not resident in Canada is entirely different than the calculation for a Canadian corporation.

Another issue to consider, especially for a small business, is the small business deduction.⁷ That is available to a Canadian-controlled private corporation ("CCPC") per sub-section 125(7) of the Income Tax Act.⁸ To benefit from that deduction, a CCPC cannot be controlled by a non-resident. In other words, doing away with the requirement for a Canadian resident director places the aforementioned benefit out of reach if there are no other resident directors who can clearly demonstrate they exercise control. The negative impact of that can be very significant. The same rationale would apply to other available tax incentives a Canadian resident corporation might be able to enjoy.

Conclusion

Several other Canadian provinces have already dispensed with Canadian residency requirements for a director (and Ontario may be soon to follow). So, generally, it is a change that is not contentious. However, to avoid the negative tax consequences, many companies may still have Canadian resident directors anyway. If so, that means eliminating the residency requirement may not matter for most Alberta companies. In fact, for the reasons just given, blindly relying on the elimination of the need for a Canadian resident director without proper tax planning can create huge headaches and more red tape for Alberta Companies.

The removal of the requirement for a Canadian director appears at the first glance to be a positive change and a reduction in "red tape"; however, in some situations it may lead to unintentional and deeply problematic tax consequences for Alberta Companies.

For an Alberta Company, this simple director change could have far reaching financial and administrative consequences. It could mean an entirely new taxation jurisdiction for the company along with a potentially costly legal battle determining what that new jurisdiction should be.

Footnotes

1. SA 2020, c 25.

2. Section 1(6) of the Red Tape Reduction Implementation Act repeals section 105(3) of the Business Corporations Act, RSA 2000, c B-9 and section 2(49)(c) repeals section 90(3) of the Companies Act, RSA 2000, c C-21. These sections have not yet been proclaimed into force.

3. Note that US ownership and control of a Canadian unlimited liability corporation still often makes a lot of sense for US tax purposes.

4. A "US Person" includes a born US citizen, a naturalized US citizen, an individual who meets the "green card" or "substantial presence" test, and US "domestic" partnerships and corporations. As an example, an individual that is a US citizen, has dual citizenship, and has never actually set foot in the US would still be considered a US Person for tax purposes.

5. A list of all the countries Canada has entered into tax treaties with can be found at: https://www.canada.ca/en/department-finance/programs/tax-policy/tax-treaties.html.

6. RSA 2000, c A-15.

7. The small business deduction is a reduction in the corporate tax rate on active business income up to a corporation's business limit for the year. The federal limit is currently set at $500,000. It is one of the most beneficial of all income tax reductions available to Canadian corporations.

8. RSC 1985, c 1, 5th Supp.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.