U.S.-Canada Outsourcing: A Canadian Perspective


Canada has become a significant player in the global outsourcing market. Geographic proximity to the United States, political stability and similarities in laws, language and business culture have contributed to Canada 's emergence as a primary nearshore outsourcing destination for U.S. businesses. In addition, Canadian businesses, often subsidiaries of U.S. companies, have been outsourcing their IT systems and business processes to U.S. business partners.

Similarities between Canadian and American laws enhance Canada's desirability as an outsourcing destination for U.S. businesses and make U.S. companies natural partners for Canadian businesses wishing to outsource. While many legal concepts are similar, there are some distinct Canadian legal issues of which U.S. businesses should be aware when contemplating entering into an outsourcing relationship with a Canadian business partner. In this article, a brief overview of some of the key Canadian legal issues in such cross-border outsourcing arrangements is provided.

Procurement Issues

Many outsourcing arrangements will commence with a request for proposals (an "RFP"). There is a well-developed body of procurement law in Canada and these laws apply not only to government tendering processes, but also to the outsourcing of services by and to private enterprises. By issuing an RFP, a company may inadvertently create an offer that is open to acceptance by a service provider, thereby creating a binding agreement, known as "Contract A". Of course, experienced counsel will be able to prepare a privilege clause that is sufficiently broad so as to avoid the creation of an offer and the formation of a binding agreement; however, the outsourcer should consider whether it wishes to create a process that will intentionally avoid the formation of "Contract A".

At first glance, it may appear that it is always advantageous to structure the RFP to provide flexibility and avoid potential obligations to bidders. However, by avoiding the formation of "Contract A", an outsourcer cannot force a bidder to enter into the final agreement, known as "Contract B", on the basis of the bid submitted. Instead, the customer may be required to enter into lengthy negotiations with the service provider in order to secure the favourable terms and conditions set out in the bid documents.

On the other hand, one reason to try to avoid forming "Contract A" is the legal concept known as the "duty of fairness". The duty of fairness is an implied term of the contract, is owed to all bidders and has far-reaching implications. For example, as a result of the duty of fairness (and in the absence of a broad privilege clause), the issuer of an RFP is forbidden from awarding the contract based on undisclosed criteria.

In addition, an outsourcer is not able to accept a non-compliant bid, even if the bid document demonstrates that the bidder is able to deliver the highest level of service at the lowest price. Finally, a disgruntled unsuccessful bidder may rely on the duty of fairness in an attempt to subject the selection process to judicial scrutiny.

Regulatory Issues

There are a number of regulatory requirements that are applicable to cross-border outsourcing transactions. This portion of the paper will focus on the obligations created by the Competition Act, the Investment Canada Act, bulk sales laws, securities laws, and the OSFI Outsourcing Guideline.

Competition Act

Many outsourcing transactions will involve the transfer of assets from the customer to the service provider. Consequently, one must examine the obligations imposed by Canada 's Competition Act. Pursuant to the Competition Act, parties to a proposed transaction are subject to a pre-merger notification obligation if the transaction exceeds certain thresholds. First, the parties to the transaction, together with their affiliates, must collectively have assets in Canada or gross revenues from sales in, from or into Canada that exceed Cdn$400 million. Second, the aggregate value of the assets in Canada which are the subject of the transaction, or the gross revenues from sales in or from Canada generated from those assets, must exceed Cdn$50 million.

For the transaction to be subject to the pre-merger notification obligation, both of these thresholds must be met. In these circumstances, a pre-merger notification must be made; this filing must include the information specified in the Notifiable Transactions Regulations, which includes information relating to the nature of the parties' and their affiliates' businesses, principal suppliers, customers and certain financial information, together with the applicable filing fee (which is currently Cdn$50,000). Where pre-merger notification is required, parties will be able to close the transaction only upon the expiry of prescribed waiting periods.

The parties may wish to request an "advance ruling certificate" (an "ARC") or a "no-action letter". If granted, an ARC precludes the Commissioner from challenging the transaction on the basis of the facts known at the time that the ARC was granted and exempts the transaction from pre-merger notification requirements. In contrast, a no-action letter indicates that the Commissioner of Competition does not currently intend to challenge the transaction, but reserves her right to challenge the transaction during a three-year period following the closing if new facts come to light. Upon the issuance of a no-action letter, the Commissioner also has the discretion to waive the obligation to make a pre-merger notification filing and will usually do so.

Investment Canada Act

The Investment Canada Act ("ICA ") applies to any acquisition of a "Canadian business" by a "non-Canadian". A "Canadian business" is a business carried on in Canada that has:

  1. A place of business in Canada;
  2. An individual or individuals in Canada who are employed or self-employed in connection with the business; and
  3. Assets in Canada used in carrying on the business.

A "non-Canadian" is defined as anyone who is not "Canadian". The determination of whether a corporation is "Canadian" essentially requires a determination of whether ultimate control of the corporation is held by Canadians. If a Canadian business is acquired by a non-Canadian, then the transaction will either be reviewable or notifiable under the ICA.

Where the purchaser is a U.S.-controlled company, an acquisition is subject to review under the ICA only if it is a direct investment and if the value of the assets acquired exceeds Cdn$250 million, subject to certain exceptions.

Where the acquisition of a Canadian business by a non-Canadian is not reviewable, a notification in the prescribed form must be made within 30 days following the closing of the transaction.

Bulk Sales Laws

Where the outsourcing involves the transfer of significant assets, it is likely that the bulk sales laws in various jurisdictions will apply. It is customary in outsourcing transactions to have the purchaser waive compliance with the applicable bulk sales legislation and have the seller provide the purchaser with an indemnity for any such non-compliance.

Securities Laws

Following the accounting scandals of Enron, WorldCom and others, securities regulators in Canada have introduced new regulatory guidelines that seek to better protect investors, primarily through improved corporate governance. For example, Multilateral Instrument 52-109 ("MI 52-109") has introduced a certification requirement for all Canadian public companies (other than investment funds) that is similar to the requirements under the Sarbanes-Oxley Act. Under MI 52-109, both the CEO and CFO of Canadian public companies will be required (subject to certain exceptions) to certify the accuracy of the annual and interim financial statements and related management discussion & analysis.

In addition, CEOs and CFOs will be required to certify that they have designed (or caused to be designed) internal controls and procedures to ensure that they receive adequate and timely information so that financial statements are reliable. Therefore, in the event that a Canadian public company seeks to outsource key corporate functions and processes that could impact the company's financial reporting, the CEO and CFO should ensure that appropriate processes are in place to support their certification of the information derived from the outsourced functions or systems. It should be noted that while MI 52-109 has added an additional layer of compliance, an outsourcing arrangement may in fact assist a public company to implement and document the required controls.

In addition, U.S. businesses that outsource to Canadian service providers should ensure that the outsourcing agreement contains provisions, including appropriate disclosure and reporting mechanisms, to enable the U.S. business to fulfill its Sarbanes-Oxley obligations.

OSFI Outsourcing Guideline

The Office of the Superintendent of Financial Institutions ("OSFI") has issued Guideline B-10 which relates to outsourcing by banks, branches of certain foreign banks operating in Canada, trust companies, insurance companies, and other a federally-regulated financial institutions ("FRFI"). The premise of the Guideline is that FRFIs retain ultimate accountability for all outsourced activities. In addition, the Guideline seeks to ensure that OSFI's supervisory powers with respect to such institutions are not constrained as a result of the outsourcing activity.

The Guideline requires the FRFI to:

  1. Evaluate the risks associated with each outsourcing arrangement;
  2. Develop a process for determining the materiality of arrangements (this process may look at factors such as the impact of the outsourcing arrangement on the finances, reputation and operations of the FRFI, the ability of the FRFI to maintain appropriate internal controls and meet regulatory requirements, the costs of the arrangement and the ability to find an alternative service provider);
  3. Implement a program for managing and monitoring risks, in each case appropriate to the materiality of the arrangement;
  4. Ensure the board of directors or principal officer receive(s) sufficient information to enable them to meet their duties under the Guideline; and
  5. Refrain from outsourcing certain business activities to the FRFI's external auditor.

All new outsourcing arrangements by FRFIs must comply with this Guideline. Any outsourcing arrangement that was entered into prior to December 15, 2004 must fully comply with the Guideline at the first opportunity, such as at the time that the outsourcing agreement is substantially amended, renewed or extended.

A key issue for OSFI is business continuity, so a FRFI must ensure that all of its outsourcing agreements include specific provisions that would enable the FRFI to sustain business operations and meet its statutory obligations in the event that the service provider is unable to provide the service. In addition, FRFIs are required to maintain certain records in Canada; accordingly, the outsourcing agreement must include provisions that restrict the service provider from maintaining these records outside of Canada. Finally, to the extent that the outsourcing relationship involves the processing of certain information or data outside of Canada, the prior approval of the Superintendent of Financial Institutions must be obtained.

Labour and Employment Laws

There are significant differences between Canadian and American employment laws and it is important to understand these differences at the time that the potential outsourcing transaction is structured. In Canada, employment law is generally a matter of provincial authority; consequently, each province and territory in Canada has enacted its own legislation prescribing minimum standards that apply to employment within that jurisdiction, including with respect to notice of termination and severance payments. However, employees that work in certain federally-regulated industries, such as banking, telecommunications, air transportation and inter-provincial trucking and fishing, are governed by federal employment laws.

No At-Will Employment Concept

One of the most significant differences between Canadian and U.S. employment laws is the absence in Canada of the "employment at will" concept. In the U.S., employers in many jurisdictions are free to terminate an employment relationship unilaterally without prior notice to the employee. In Canada, employees are entitled to "reasonable" notice of termination (or pay in lieu of notice), based on, among other factors, the employee's age, years of service and level of responsibility.

Moreover, applicable employment legislation may provide employees with a longer minimum prescribed period of notice in a "mass termination" situation and such notice period will apply to all employees regardless of their length of service. Therefore, where employees are terminated or are transferred to the service provider as part of the outsourcing arrangement, substantial notice of termination, pay in lieu of notice and/or severance payments may be owing.

Accordingly, it is important for the parties to determine who will bear such costs. Furthermore, employees that are transferred to the service provider may be entitled to retain their seniority. Finally, where the employees are governed by a collective agreement, that agreement may follow the transferred employees to the service provider.

Human Resource Key Component

As with any outsourcing, the human resource component can often determine whether a cross-border outsourcing will be successful. Therefore, it is important to develop and implement a clear communication strategy with employees so as to avoid problems such as the loss of key personnel or a drop in morale.

In addition, it is important to develop and implement a comprehensive "transition in" and "transition out" policy that will set the stage for how employees will be dealt with at the commencement, and following the termination, of the outsourcing arrangement. Finally, a potential outsourcer needs to give careful thought to post-outsourcing positions and responsibilities of current employees.

For example, an employee who suspects that the outsourcing arrangement will result in the termination of his or her employment with the customer, whether by severance or transfer to the service provider, may have a conflict of interest which could prevent him or her from negotiating effectively on behalf of the customer. Finally, a customer may have a difficult time administering the service contract and evaluating the performance of the service provider if all of the employees with any knowledge or experience with the subject matter of the outsourcing arrangement are transferred to the service provider.

Pension Issues

An outsourcing arrangement that involves the transfer of Canadian employees who are entitled to receive a pension from their employer may raise complex pension law issues. For example, if, as part of the transaction, a significant number of employees are terminated or a facility is closed, under Canadian law, it may result in a partial wind-up of the customer's defined benefit pension plan. In a recent case, the Supreme Court of Canada held that, upon a partial wind-up of a defined benefit plan, there must be a distribution of any actuarial surplus that is attributable to the affected employees. In addition, under Canadian law, where the parties wish to transfer assets from one registered pension plan to another registered pension plan, approval from the regulator is required.

Privacy Issues

Whether during the diligence phase of the transaction or as part of the on-going services agreement, cross-border outsourcing transactions will generally involve the disclosure, transfer or processing of personal information, thereby raising issues under Canada 's expanding regime of federal and provincial privacy laws.

The Personal Information Protection and Electronic Documents Act ("PIPEDA") applies to all private sector organizations that collect, use or disclose "personal information" in the course of a commercial activity (other than organizations in the provinces of British Columbia, Alberta and Quebec which have enacted substantially similar provincial legislation). "Personal information" is information about an identifiable individual (other than name, title, business address or telephone number of an employee of an organization).

During the due diligence phase, the service provider will likely seek information regarding the outsourcer's in-scope employees (name, years of service, position and salary and benefits), customers (name, contract term, termination and revenues over the past several years) and suppliers (name, contract term, termination and payments over the past several years). One of the key privacy law issues is whether consent is required from the organization's employees, customers and/or suppliers prior to disclosing or transferring their personal information to the service provider.

While the British Columbia 's and Alberta 's privacy laws specifically deal with the disclosure of personal information in the context of a "sale of the business" transaction and allow disclosure without consent under certain circumstances, this issue is not expressly dealt with in PIPEDA.

As part of the services agreement, it is likely that personal information will be collected, disclosed, transferred or processed, once again raising privacy issues. Where the outsourced services involves the transfer of personal information for the purpose of processing, an organization may take the position that such a transfer is not disclosure under PIPEDA and express consent is not required.

Parties to an outsourcing arrangement should ensure that a broad confidentiality agreement is executed prior to the commencement of due diligence. This confidentiality agreement should include limitations on the use of the disclosed personal information and should contemplate the return or destruction of all personal information in the event that the transaction is not completed for any reason. In addition, outsourcing agreements should include

  1. Appropriate privacy protections to ensure that all personal information is protected to the same extent as it would have been if it were in the possession of the outsourcer
  2. Covenants that the service provider will comply with all applicable privacy laws, and
  3. Restrictions on the service provider from using or disclosing any personal information transferred to it for any purpose that is unrelated to the services to be performed.

The introduction of the USA Patriot Act has created an additional level of complexity for cross-border outsourcing transactions. The USA Patriot Act permits the FBI to require a party to produce "any tangible things for an investigation to protect against international terrorism or clandestine intelligence activities;" this legislation may have the effect of compromising Canadian privacy laws.

As a reaction to the USA Patriot Act, the B.C. government has recently amended its privacy legislation to restrict B.C. public bodies from entering into cross-border outsourcings that involve the storage of, or access to, personal information outside Canada, subject to limited exceptions, unless appropriate consents are obtained.

In addition, the federal Privacy Commissioner has suggested that, pending her examination of the USA Patriot Act, a company in Canada that outsources information processing or storage to an organization based in the United States should provide notification that the information may be available to a foreign government or its agencies.

Intellectual Property Issues

One of the key issues in any cross-border outsourcing transaction will be the ownership and use of intellectual property. At the commencement of the arrangement, the parties will need to ensure that the service provider has sufficient rights in the customer's intellectual property to enable to service provider to deliver the outsourced services. In addition, the parties will have to determine who owns any intellectual property that is developed, during the term of the outsourcing arrangement, by one or more of the parties.

In Canada, the concept of "work made for hire" is applicable only to employment relationships. Accordingly, if the customer wishes to own copyright in and to software or other works developed for the customer under the outsourcing arrangement, the customer must ensure that it obtains from the service provider a written assignment of all copyrights in and to such software and works.

Moreover, in Canada, any employee of, or independent contractor to, the service provider that is involved in the development of software or other works for the customer may have "moral rights" in such works. As moral rights are not assignable and can only be waived by the individual author of a work, a customer should ensure that the outsourcing agreement requires the service provider to obtain written moral rights waivers from any person who will be involved in developing software or other works pursuant to the outsourcing arrangement.

Another significant difference between Canadian and U.S. copyright laws relates to joint ownership of works developed by the parties pursuant to the outsourcing arrangement. Under Canadian law, unless otherwise agreed by the parties, works that are jointly owned are held by the joint owners as "tenants in common". As tenants in common of a work, each owner is free to transfer its interest in the work without the other owner's consent; however, a joint owner cannot license the work without obtaining the consent of the other joint owner.

Tax Issues

A cross-border outsourcing transaction is likely to raise a number of tax issues relating to the payment of income, with-holding and commodity taxes. In addition, the Canadian federal government and various provincial governments offer a range of scientific research and development tax credits. Accordingly, tax advice should be sought early in the transaction in order to structure the outsourcing in a tax-efficient manner.

Income Taxes

With respect to the asset sale portion of the outsourcing transaction, where a non-resident of Canada disposes of taxable Canadian property (for example, upon the termination or expiration of the outsourcing relationship), such person will be required to obtain a certificate pursuant to section 116 of the Income Tax Act. In addition, unless there is an applicable treaty exemption, the non-resident will be required to pay Canadian income taxes on any gain resulting from the disposition.

With respect to the on-going services agreement, where payments of service fees are made by a Canadian customer to a non-resident service provider, it is likely that the Canadian customer will be required to withhold income taxes from such fees. A U.S. service provider is well advised to secure appropriate gross up provisions in the outsourcing agreement so that it receives the full amount of the fees that it negotiated, net of withholding taxes.

Commodity Taxes

In Canada, there are three types of commodity taxes that may be applicable to a cross-border outsourcing transaction: federal Goods and Services Tax ("GST"), provincial sales tax ("PST") and in the eastern provinces, harmonized sales tax ("HST"). An outsourcing transaction usually involves the transfer of significant assets, including inventory, equipment, intellectual property, books and records and contracts. GST, PST and HST may be payable on the transfer of many of the foregoing assets. However, at least with respect to GST, in the event that the assets that are subject to the transfer constitute all or substantially all of the assets of a business, the parties may execute an election so that GST does not apply.

With respect to the on-going services, GST may be applicable with respect to the fees charged. However, where services are performed by a U.S. service provide solely outside of Canada and that service provider can provide a representation that it is, and will be during the term of the outsourcing agreement, a resident of the United States of America for the purposes of the Canada-United States Income Tax Convention, GST may not be applicable.

Scientific Research Tax Credits

In order for Canadian businesses to become and remain more competitive and innovative, the Canadian federal government and various provincial governments offer a range of scientific research and development (SR&ED) tax credits. The SR&ED program allows Canadian taxpayers to claim refunds and/or tax credits relating to certain eligible work performed in Canada. The outsourcing agreement should include provisions relating to the allocation of these tax credits, to the extent permissible.

Quebec Issues

While the courts of most provinces and territories in Canada apply principles of common law, Quebec is governed by the Civil Code. Therefore, parties that intend to enter into an outsourcing agreement with an entity that carries on business in, provides services from or to, or has employees in, the Province of Quebec, should obtain legal advice as different legal principles may apply in Quebec.

In particular, Quebec 's Charter of the French Language (the "Charter") makes the use of French compulsory in certain situations. For example, under the Charter, workers have the right to carry on their activities in French. As a result, employers must provide all written communications to its employees in French (another language may also be used, but the French version must be displayed at least as prominently as any other language).

There are additional requirements that apply to organizations that have more than 50 employees in Quebec. In addition, consumers of goods and services have the right to be served in the French language, so service providers must ensure that they have this capacity where they will be providing services to consumers in Quebec. Finally, if either of the parties to the outsourcing agreement conducts business in Quebec, the agreement should contain a clause that states that the parties wish to enter the agreement in the English language.

Summary

Canada is an attractive place to do business for U.S. companies. While there are many similarities between Canada and the United States, there are important differences too. Being aware of the differences will make utilization of Canada as an outsourcing destination a smoother and easier transition.