Tuesday, March 13, 2012

(Trying to do) Business in Canada

Over six months since my last post and what is it that gives me the kick in the pants needed to blog again? Not some advance in the field of chip verification; not an epiphany on how to spot future world class programmers from the way they play Plants versus Zombies. No, nothing so valuable. What's got me hitting the keys again is what always gets me hitting keys hard: government and how it can get in the way of Just Doing Business. I annoyed some people a few years back when I lobbed a few barbs at Germany for its anti-business funkiness. Well have a break Germany, cuz it's Canada's turn now, eh?

Enter Canada's Regulation 105. It goes something like this (subject to the usual IANAL caveat)

If a non-Canadian firm delivers a service to a Canadian client, then that client may be required by the Canada Revenue Agency to withhold 15% of their invoice payments, to cover possible Canadian tax. Now it's important to re-stress: the 15% withholding is merely provision for possible tax. In the case of a US firm, it is entirely possible -- likely even -- that if its affairs are in order (specifically, if it is not deemed to have a Permanent Establishment in Canada) it will be paying the relevant taxes back in the US and it simply will not owe any tax to Canada at all. In that case, at the end of the year, the US firm can submit a Canadian tax return and and request a refund of all the withheld money. But even though at the end of the day there may be no actual money owed to the CRA, 105 is still expensive, especially to the smaller company. Here are five reasons why.

First, it creates the intangible cost of risk 

Canadian Reg 105 is currently poorly understood, even by so-called experts. So even the honest and diligent firm has to work hard to obey it. In my investigations so far, I have had three opinions, two contradicting each other, and the third not agreeing entirely with the others. And the two contradictory views came from the same office of the same Big Four accounting firm! Also, I've seen situations, in other US firms I know who are providing a lot more services to Canada than we currently are, where their clients are as confused as we are. My fellow CEO reports of some clients not applying the 15% haircut at all, others applying it across the board, and still others applying it with no apparent consistency. One even began a particular project by applying the 15% to early payments, but then several months in (perhaps their own advisors finally agreed where mine have yet to do so) they stopped. It should be clear, this is not the clients' fault, nor is it my CEO friend's. Reg 105 is just complicated, it seems. In other words, even once a firm has found what appears to be The Truth, it may still carry the nagging doubt that it may, despite its best efforts, have made a mistake and as a result still be doing something wrong or inefficiently. There are enough risks in business without imprecise government rules adding more.

Second, it can hurt cash flow 

Withholding hurts the firm's revenue today, even though it may see that reminded later. And of course that also imposes some cost in the form of lost interest income or increased interest payments.

Third, it costs in the form of more time

Reg 105 means more time is needed for administrative work, thereby hurting the firm's ability to do their actual work; i.e. serving their clients, and in the process building jobs and economies. On its own, each piece of admin overhead like 105 is annoying enough, but it's just another one of a myriad of pieces of such overhead that distract companies from doing the things that result in them making the money in the first place that can then be taxed. Of course Canada is far from alone on this front. The new US 1099 provisions, anyone, or, for very small UK businesses back in the day, the infamous IR35?

Fourth, it costs in the form of money

The regulation may require more money to be paid to advisors. First. the non-Canadian firm may incur costs merely to find out what is going on when they first see a 15% slice coming off their incoming invoice payments. Then, if it is confirmed that Reg 105 is at work, then they may incur costs in deciding whether a waiver application may be in order. If it is, they may incur more costs in getting professional help in applying for one. If a waiver application is not deemed worthwhile, or if it was but it failed nonetheless, they will then begin to incur regular annual costs because they'll have to submit a Canadian tax return to request a refund of the withheld money (i.e. the 15%, which their client will have forwarded on to the CRA). And again, remember, those tax return costs will be incurred even though the non-Canadian firm doesn't actually owe Canada any money. And to understand the significance of these advisory costs, it's important to bear in mind that partly because of 105's of lack of clarity, but also because it has multi-jurisdictional implications, getting advice on this needs advisors who are both good, and have international reach. In practice that means Big Four, and those guys aren't cheap[1]. (And they'll sometimes charge you even when they're learning stuff!). Given that, there is a final particularly nasty risk, the minimization of which would almost certainly require the advice of a big international firm, and which could be non-trivial in cost. And that risk is:

Fifth, ouch!

Consider the following scenario (very simplified to keep us all awake):
  1. A particular non-Canadian firm is, for various reason, not liable for Canadian tax, but is liable to pay the withholding (and then reclaim it)
  2. They don't realize this and fail to pay the withholding (of course neither do they reclaim anything)
  3. Five years later they are audited, and two things are decided. First, the foreign firm is, as they thought all along, not liable for Canadian tax. But second, they were liable to pay withholding.
  4. The CRA demands the unpaid withhold, even though they acknowledge that no tax was ever due. After all, rules are rules and even though everyone knows the foreign firm is going to apply for a full refund, the payment must first be made
  5. So the firm pays the withhold
  6. And then they apply for the refund
  7. Remember, they were not liable for any Canadian tax whatsoever
  8. The CRA refuses the refund. The reason is that there is a statutory limit on the length of time in which certain reclaims may be applied for. And in this case, the limit is three years, and we're now two years past that limit.
The end result is that the CRA gets to keep a portion of tax to which they were never entitled, and that's because they allow themselves more than three years to get it but allow the victim only three years in which to reclaim it. Now if they're lucky, the non-Canadian firm may find a reciprocity treaty allows them to reclaim the money from their own country's tax authorities. But I suspect that is unlikely. Their own tax people would, I'd bet, express sympathy but point out that the firm does indeed owe the tax in the home country (i.e. not in Canada, as confirmed by the audit), and the fact that the CRE has the money is a bug in Canada's reclaim mechanism, and has nothing to do with whether the firm owes their home country tax. OK, that's not all exactly true. I'd be willing to concede it's unlikely that the firm's home country tax people would express any sympathy...

[1] FWIW, the biggest hourly rate I've seen from the Big Four firm we use is over $2,000/hr -- yes, that's two thousand dollars an hour. It was some some kind of Senior Intercontinental Ballistic Executive Partner. She popped into a conference call (for only 15 minutes, thank goodness!) with some of the minions and goblins she'd assigned to work with us. Incidentally, the bill rates I've seen for Big Four Minions and Goblins are in the order of $650/hr and $450/hr respectively. But I'm based in Austin, which is why they're so cheap...

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