5.3.3.2 Formulary allocation in Canada: highlights of the system

In Canada, income tax is levied both at the level of the provinces as well as at the federal government level. Both orders of government have independent tax powers. Despite the decentralization of tax powers, tax policy and tax collection among federal and provincial governments takes place in a coordinated manner. Most of the provinces entered into Tax Collection Agreements with the federal government. As laid down in these agreements, the administration and collection of corporate income taxes is done by the Canada Revenue Agency, while the provincial corporate income tax legislation applies. This leads to a one-stop-shop for taxpayers in these jurisdictions.1 Additionally, the Tax Collection Agreements require tax base harmonization. The provinces should use the same taxable income base as the federal government. This harmonized tax base is also adopted by the provinces that did not sign a Tax Collection Agreement. However, the provinces apply different tax rates and credits.2

Formulary allocation (the Canadian equivalent of formulary apportionment) is applied on a provincial level, for multi-province taxpayers. Similar to a system based on the arm’s length principle, the goal is to resolve problems of overlapping tax jurisdiction.3 In the Canadian system formulary allocation is applied on a separate entity basis: the profits of related entities are not consolidated nor combined. The rules solely apply to determine the amount of income that should be allocated to permanent establishments of an entity in other provinces. If one entity has permanent establishments in different provinces, the income is consolidated and subsequently allocated via a formula.4 If a domestic corporation has a permanent establishment in the province and a second permanent establishment abroad, the income will be allocated between the two permanent establishments. Any income that is allocated to the permanent establishment abroad would not be subject to provincial income tax.5

The formulaic rules also apply to non-resident corporations that have multiple permanent establishments in Canada.6 Non-resident corporations that conduct business in Canada via those permanent establishments are required to file a return and report income earned within Canada, i.e., a water’s edge approach is applied.7

As the Canadian formulary allocation system relies on the presence of a permanent establishment to identify whether or not provinces are entitled to tax a share of the taxable income, a taxpayer can avoid application of formulary allocation by incorporating a separate legal entity in each province in which it conducts business. A company that is established in one province and conducts business via a separate legal entity in a different province does not fall within the scope of the formulary allocation rules.8 In a way, the system can therefore be regarded as elective, which may lead to interprovincial tax planning as well as tax loss shifting across provinces.9

The income is, in general, allocated by the following rule: 50% according to the share of gross revenue (sales) and 50% according to the share of salaries and wages (payroll) associated with a province. If either of the two is nil, the other factor is given a weight of 100%.10 For various sectors specific apportionment formulas exist.11

The Canadian formulary allocation system is stabilized and supported by equalization payments by the federal government to the ‘have-not’ provinces, i.e., the provinces that are less wealthy. Via these payments the possibilities to provide public services for the various provinces are equalized.12 This can decrease tax competition.13