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Would a contract manufacturing structure work as a tax-saving measure for your organization? Here are the implications to consider
Contract manufacturing, in the typical sense, involves one company contracting with a third party to manufacture its product.
If you explore the Internet searching for "contract manufacturing," you will find more lists than the average person would care to read, where people are advertising their contract manufacturing services.
This article will explore the advantages or disadvantages of a contract manufacturing agreement within a related group of companies as a method to reduce the overall worldwide taxation in the corporate group. The article will deal specifically with a Canadian company proposing to become a contract manufacturer for a company in a lowertaxed country with which Canada has an income tax treaty. The purpose of the structure is to shift profits from Canada to a lower-taxed jurisdiction. I will be discussing only the Canadian tax implications. The example shown as Figure 1 will be used to explain the implications.
In the current structure, we have a typical scenario where a foreign parent has successful manufacturing operations in Canada that are highly profitable, and taxable.
The proposed structure is to have the foreign parent incorporate a company in a treaty country ("Treatyco") which would be responsible for every aspect of the Canadian company's operations other than the manufacturing operations. This company would be located in a country which is a lower-taxed jurisdiction than Canada. The structure can be varied by replacing the company in a low-tax jurisdiction with another related corporation that is generating operating losses. The lower the tax rate in the foreign jurisdiction, the more benefit the structure will have. The present Canadian company will become the "contract manufacturer."
In reviewing the proposed structure, there are a number of issues which may arise and defeat the purpose of the overall reorganization. The tax implications are contingent on the Income Tax Treaty between Canada and the country of choice for the Treatyco. For purposes of this article, I have used the Canada-Netherlands Income Tax Convention (1986).
Permanent establishment in Canada
The first issue will be to determine whether Treatyco has a permanent establishment (PE) in Canada. It is important to deal with a treaty country so...