On July 12, 2013, federal Finance Minister Jim Flaherty released legislative proposals (the Proposals) affecting certain international tax rules in the Income Tax Act (Canada) (the ITA) and the Regulations under the ITA. The government will accept comments on the Proposals until September 13, 2013.
The Proposals will have an impact on a variety of international tax matters, including outbound investments through partnerships, limited liability companies or other non-share capital corporations, foreign mergers, the application of Canada’s anti-deferral “foreign accrual property income” rules, international shipping rules, investments in Australian trusts, functional currency reporting, and use of taxpayer information. The following update summarizes the most significant changes in the Proposals.
Stub Period Foreign Accrual Property Income
A taxpayer’s share of foreign accrual property income (FAPI) earned by a controlled foreign affiliate (a CFA) of the taxpayer is included in the taxpayer’s income in the year in which the CFA's taxation year ends. Where a CFA does not have a taxation year-end in a year (e.g., because it is sold in the year), no FAPI is included in the taxpayer’s income. In addition, the taxpayer’s share of FAPI is determined by reference to its interest in the CFA at the end of the CFA’s year. If there is a reduction in such interest during the year (e.g., because some shares are sold), there is no mechanism to take into account the taxpayer’s greater interest during a portion of the year.
The Proposals address these perceived issues by deeming a CFA to have a taxation year-end for FAPI purposes if, at any point in the CFA’s year, the taxpayer’s “surplus entitlement percentage” (SEP) in the CFA is reduced or eliminated entirely. Where there is a reduction or elimination of SEP, FAPI must be computed immediately before the time of the reduction or elimination, and the taxpayer must include its participating percentage of such FAPI (before the reduction or elimination) in its income for the year. There is an exception where the SEP reduction is matched by a corresponding SEP increase in another taxpayer resident in Canada that is “connected” to the taxpayer. Taxpayers are connected for this purpose if one holds 90% or more of each class of shares of the other, or if another taxpayer holds 90% or more of each class of shares of each of them.
There appear to be technical issues with these Proposals related to, among other things, the manner in which SEP is computed and the narrow definition of “connected.” In addition, it is possible that FAPI will need to be computed multiple times in a year under these rules, which may be difficult (particularly since FAPI is generally computed in Canadian dollars and using Canadian tax rules).
Deemed Active Business Income – Money Borrowed to Acquire Shares of a Foreign Affiliate
Under clause 95(2)(a)(ii)(D), where a foreign affiliate earns interest income on money borrowed by a second affiliate to buy the shares of a third affiliate, the interest income may be recharacterized as active business income (thereby avoiding FAPI inclusion). One of the requirements is that the second affiliate and the third affiliate must be resident in, and subject to income tax in, the same foreign country.
The Proposals eliminate this “same country” requirement. The requirement that each of the second and third affiliate be subject to income tax in a country other than Canada remains, but it no longer must be the same foreign country. This change will allow the favourable treatment provided by clause 95(2)(a)(ii)(D) to apply to an expanded range of transactions. The same change is proposed to be made to the exempt surplus provisions in the regulations corresponding to clause 95(2)(a)(ii)(D).
Foreign Corporations Without Share Capital
New section 93.3 applies where a foreign entity that is characterized as a corporation for the purposes of the ITA does not have capital divided into shares. It deems equity interests in that entity that have identical rights and obligations to be shares of a separate class of capital stock having 100 issued and outstanding shares. A non-resident corporation without share capital may therefore be deemed to have more than one class of shares.
This provision is relevant for certain U.S. limited liability companies and other corporate entities that do not have capital divided into shares and overrides inconsistent administrative positions that the Canada Revenue Agency (CRA) has taken (in some cases refusing to recognize the existence of separate classes of equity interests).
These new rules are proposed to apply retroactively to taxation years of non-resident corporations ending after 1994, subject to the ability to elect for the rules to apply only to such years ending after July 12, 2013.
Foreign Mergers – Avoidance of Subsection 85.1(4)
Subsection 85.1(3) allows a Canadian-resident corporation to transfer the shares of a foreign affiliate to another foreign affiliate on a tax-deferred basis (as a “rollover”). Subsection 85.1(4) disallows the rollover transaction where all or substantially all of the property of the transferred affiliate is excluded property and where the transfer is part of a transaction or event or a series of transactions or events for the purpose of disposing of the shares of the transferred affiliate to an arm’s-length person (other than a qualifying interest foreign affiliate). The reason for the disallowance is that any gain realized on the sale of shares of one foreign affiliate by another foreign affiliate is not currently taxable in Canada (where the sold shares are excluded property), whereas any gain realized on the direct sale of shares by a Canadian shareholder is taxable in Canada. As a result of subsection 85.1(4), subsection 85.1(3) may not be used to defer the gain that would otherwise be realized by the Canadian shareholder on the sale of a foreign affiliate to an arm’s-length person.
Subsections 87(4) and (8) allow a similar rollover in respect of a Canadian shareholder’s shares of a foreign affiliate (the “first affiliate”) involved in a foreign merger, including a foreign merger where the consideration received by the Canadian shareholder for the shares of the first affiliate is shares of the foreign parent corporation that owns the merged corporation following the merger. If such a merger occurred (for example, where the corporation merging with the first affiliate is a “shell” corporation), and the foreign parent corporation then sold the shares of the merged corporation to an arm’s-length person, any gain realized by the foreign parent would not be subject to tax in Canada (assuming the sold shares are excluded property).
The Proposals introduce new subsection 87(8.3), which prevents the foreign merger rollover provisions in subsections 87(4) and (8) from applying where the merged corporation is a foreign affiliate of the taxpayer, shares of the merged corporation are owned by another foreign affiliate immediately after the merger, and the merger is part of a transaction or event or a series of transactions or events that includes the sale of the shares of the merged corporation to an arm’s- length person.
The Proposals contain several measures aimed at ensuring that the foreign affiliate rules operate more consistently in structures containing partnerships, including changes to section 93.1 and the deemed active business income rules. For example, amendments to subparagraph 95(2)(a)(i) ensure that deemed active business income treatment is available where the recharacterized income is earned in a partnership, or where the related active business is carried on by a partnership. Similarly, clause 95(2)(a)(ii)(D) may now apply where the interest paid on money borrowed to acquire the shares of the “third affiliate” is paid by a partnership. However, in order for the relevant interest income to qualify as exempt surplus, the members of the partnership must be foreign affiliates that are resident in the sole country in which the partnership carries on business.
The Proposals contain rules to accommodate investments in certain Australian trusts. Due to Australian commercial and tax advantages, a trust is a common form of business vehicle in Australia. The Proposals apply to treat an Australian trust as a corporation and a CFA, where an interest is held by another CFA of a Canadian taxpayer and certain other conditions are satisfied. Where applicable, the Proposals allow distributions from the Australian trust to the CFA to be treated as dividends (with exempt surplus treatment potentially available for active business earnings in the trust). In addition, the FAPI rules and foreign affiliate reporting requirements will apply in respect of the Australian trust’s activities. It is not clear how these rules will be practically applied where the CFA of the Canadian taxpayer does not have a controlling interest in the Australian trust. For example, in this situation it may be difficult for the Canadian taxpayer to obtain the information required to compute FAPI (especially in light of the new stub year FAPI rules) or to comply with its reporting requirements.
The surplus account Regulations provide for adjustments to surplus accounts and underlying foreign tax accounts to take into account consolidated group reporting under relevant foreign law (such as U.S. law). For example, under these Regulations a compensatory payment made by one foreign affiliate to another to take into account the payment of tax on behalf of the first affiliate or the use of a loss to reduce taxable income of the first affiliate may qualify as underlying foreign tax. These Regulations only apply where each member of the consolidated group is a foreign affiliate of the taxpayer that is resident in the same foreign country under whose laws they are treated as a consolidated group.
The Proposals eliminate the requirement that the affiliates be resident in the same foreign country. In addition, the proposals will deem a member of a consolidated group to be a foreign affiliate of the relevant Canadian corporate taxpayer if such member is a foreign affiliate of a Canadian-resident corporation that is related to the relevant taxpayer.
Foreign Accrual Tax for Fiscally Transparent Entities
Where FAPI is included in a Canadian taxpayer’s income, a deduction is available in respect of foreign taxes paid on the underlying income, referred to as “foreign accrual tax” (FAT).
The Proposals amend the FAT definition to ensure that foreign tax paid by the shareholder of a fiscally transparent foreign affiliate (such as a U.S. LLC) is included in FAT applicable to FAPI earned by the fiscally transparent foreign affilaite. Similar changes are made to the surplus Regulations, to ensure, for example, that such taxes (or compensatory payments made in the consolidated group context) are taken into account in computing surplus of the shareholder and are treated as underlying foreign tax or hybrid underlying tax, if relevant.
Base Erosion Rules
The Proposals make technical changes to the “services” rule in paragraph 95(2)(b). The prevent certain services income from being included in FAPI where the services are performed by a non-resident outside Canada.
Other changes include amendments that apply for the purposes of the “Canadian indebtedness” rule in paragraph 95(2)(a.3), and changes to the rules applicable to foreign affiliates engaged in certain contract manufacturing activities, for the purposes of paragraph 95(2)(a.1).
Section 17 is an interest imputation rule that applies where a Canadian corporation has made a direct or indirect loan to a non-resident of Canada, and the loan is interest free or has a low interest rate. The Proposals clarify certain ambiguities relating to the amount of interest income that is imputed to the Canadian-resident taxpayer, in particular where the interest imputation arises because of an indirect loan made with funds sourced in Canada.
Functional Currency Reporting
A technical issue with the deadline for electing to use a foreign currency to determine Canadian tax results is rectified in the Proposals, allowing the election to be made within the first 60 days of a taxation year rather than at least six months before the end of the year. In addition, the Proposals allow for an amalgamated corporation to be deemed to have an elected functional currency where all of the predecessor corporations have the same elected functional currency, rather than requiring the amalgamated corporation to make a separate election.
Several amendments are made to the rules in the ITA relating to international shipping companies.
Changes to the ITA, and related changes to the Excise Tax Act and the Excise Act, allow government officials to provide taxpayer information to a law enforcement officer or agency (Canadian or foreign) where there are reasonable grounds to believe that the information provides evidence of certain serious criminal offences, such as bribery and the corruption of government officials. According to the Department of Finance, “the administration of these new measures will be closely controlled within the CRA.”
The measures included in the Proposals, and their coming-into-force details, are complex.