Considering Options for International Business Expansion

May 19, 2017

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International business expansion is a complex process that must be done strategically in order to minimize risk, limit potential tax liabilities, and maximize profits.  Our Doing Business Globally series is designed to give Canadian companies the advice they need to reduce risk and limit exposure as they expand into the global marketplace.  Part 1 of our 4 part series explores important options to consider for international business expansions. 

International expansion is a common component of many Canadian companies’ growth plans. Canada is a small global player and entering the international market is a logical next step for many businesses, whether it be to the United States, Europe, or farther afield.

Yet while cloud computing and other modern technologies make it easier than ever to pursue and manage relationships with clients outside of Canada, companies selling abroad can quickly find themselves in hot water when it comes to taxation. From a tax perspective, international business expansion is not limited to creating a foreign legal entity or having a bricks-and-mortar business presence. Even more routine activities, such as sending Canadian employees to foreign trade shows, having sales people travel to pursue foreign clients, or employing a global workforce can be sufficient to trigger taxation abroad. 

How can a business effectively expand to foreign jurisdictions while minimizing the risk of potential tax and legal issues?

Evaluating Options

Regardless of company size or scope of operations, Canadian companies looking to do business with foreign customers need to approach international expansion with care and foresight.  A strong plan for foreign growth and long-term success must balance business needs with appropriate protection from potential tax, legal, and liability issues.

In general, there are two primary options for structuring an international business expansion: a foreign branch or a foreign affiliate. When considering the appropriate business structure for international expansion, some of the key considerations should include the country of expansion; the tax laws of that nation, whether that country has a tax treaty with Canada, profit repatriation; and the type of business operations. 

Opening a Foreign Branch

A foreign branch is an extension of the Canadian company, which allows a business to operate in another country without establishing a new legal entity. A foreign branch is relatively quick and easy to set up which makes this option advantageous. Also, where the foreign branch is not profitable (which may be the case in the earlier years due to startup costs), any losses incurred can be used against Canadian income.

However, there are also a number of drawbacks to operating through a foreign branch that need to be considered. Key among them is the issue of liability. If the company is sued, all company assets (including the Canadian assets) are exposed, regardless of jurisdiction. This can be especially concerning if the business is looking to operate in a particularly litigious country, such as the United States.

Income from a foreign branch is also subject to immediate tax in Canada with no deferral of profits, and may be subject to local country tax and withholding taxes on payments back to Canada. Foreign exchange rates can also become a concern. A foreign branch limits the business’s options to monitor currency risk or hedge foreign exchange, and currency fluctuations can have a significant impact on profits.

Another issue that has made some companies choose against a branch operation in recent years have been shifts in customer demand. Customers in locations like the U.S., where local taxation rules can make it more difficult and costly to buy from a Canadian firm, prefer to work with or buy from a legal entity registered in their own country.

Long-term planning should also come into play before choosing a foreign branch structure, as converting a foreign branch into a foreign affiliate at a later date is a taxable event in Canada.

Establishing a Foreign Affiliate

The second option is to set up a foreign affiliate such as a foreign corporation, which is the creation of a legal entity in the foreign country to carry on business activities outside of Canada.

From a Canadian point of view, establishing a foreign affiliate is an efficient tax structure that offers several advantages. Canada has a generous tax system with regard to Canadian-owned foreign affiliates, with tax rules designed to minimize double taxation. Income earned through a foreign subsidiary is not taxable until it is repatriated to Canada; and, provided that the affiliate is carrying on an active business, the profit can often be repatriated as a tax-free dividend. A foreign affiliate also provides legal liability protection, creating a ring-fence around foreign operations. These benefits often make establishing a foreign affiliate an optimal choice for many Canadian businesses.

However, care must be taken if the foreign affiliate will be solely or primarily earning passive income, such income from rents, royalties, or interest; or if operations cannot otherwise pass the “active business test.” For example, if a Canadian parent incorporates a foreign affiliate in a low-tax jurisdiction, and that affiliate earns only a passive income stream from royalties, that income may be immediately taxed in Canada.

Regardless of whether the foreign affiliate is earning active or passive income, businesses should be aware that transfer pricing rules apply in all transactions between the affiliate and its Canadian parent.

Watch for Legislative Changes

The tax landscape is always changing, both in Canada and abroad, and such changes can have unexpected impacts on your business activity, profits, and optimal foreign business structure. Canadian tax rules regarding foreign affiliates have changed, and what may have been a tax-efficient strategy a few years ago may not necessarily work today. Advice from an international tax advisor is recommended not only when looking to expand beyond Canada’s borders but also on an ongoing basis to assist in adapting to current realities

Changes to foreign tax laws can also impact your business and its foreign operations. For example, during his presidential campaign, Trump promised aggressive corporate tax reforms. Should these promises become legislative reality, the U.S. could change from a high-tax to a low-tax jurisdiction as compared to Canada. This could have significant impacts on how a Canadian company with U.S.-based affiliate manages its operations and profit repatriation. Similarly, legislative changes following Brexit could impact business operations or sales in Britain and the E.U.

While no significant changes have yet occurred, keeping apprised of such situations is recommended so that your business is ready to respond, and continues to achieve an optimal tax result.

Other Areas to Consider

Any path to foreign business expansion is complex, with multiple impacting factors. Other areas to consider include:

  1. Make business strategy the driving force. While achieving an optimal tax result should be a key factor when considering your foreign expansion options, business strategy should always come first. Ensure that your tax strategy supports your business strategy, not the other way around.
  2. Act with an eye to the future. Choices made now regarding corporate structure and international expansion can limit your options down the road, especially with regard to your exit strategy. Look to protect your options and maintain flexibility down the road.
  3. Maintain your chosen strategy. Without proper implementation and maintenance, any foreign expansion plans can quickly fall apart. Consult with tax, legal and business experts prior to making critical decisions, and follow through on recommendations to avoid costly surprises—especially at tax time.

For personal advice and support on your international business expansion, please contact a member of our International Tax Team or your BDO advisor.

Contributor:

Harry Chana
Partner, International Tax


The information in this publication is current as of May 18, 2017.

This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.