This is article is part of a series dealing with draft legislation released for comment by the Department of Finance on July 29th. Read the complete series:
- The evolving taxation of derivatives
- Sales of linked notes
- Taxation of switch fund shares
- Changes coming to country-by-country transfer pricing documentation requirements
- Proposed replacement of eligible capital property rules by new depreciable property class
- Alternative arguments in support of tax assessments
- Foreign exchange gains on debt-parking
- New penalty to support the common reporting standard
Budget 2016 declared that the new Liberal government would ‘protect the integrity of Canada’s international tax system’ by introducing new tax measures to prevent unintended, tax-free cross-border distributions of capital to non-residents by narrowing the application of an existing exception to the cross-border anti-surplus-stripping rule.
Surplus stripping is the practice of extracting profits from a corporation either tax-free or at a lower tax rate, rather than as fully taxable dividends. This practice is restricted by section 84.1 for domestic transactions and section 212.1 for cross-border transactions. The 2016 Legislative Proposals include amendments to section 212.1, which are a mix of structural and substantive changes that will expand both the conditions of application and the consequences of application.
Structural Change – subsections 212.1(1) and 212.1(1.1)
The most readily apparent change in these amendments is the purely structural change to divide subsection 212.1(1) into two: the amended subsection 212.1(1) will contain the conditions for application, and the new subsection 212.1(1.1) will contain the consequences of application. This structural change necessitates several other changes throughout the section and in other sections that previously referred to subsection 212.1(1), updating them to refer to subsection 212.1(1.1) where appropriate. The consequences of application in the new subsection 212.1(1.1) have not been changed in these proposed amendments.
Expansion of the meaning of non-resident – subsections 212.1(1), (3) and (4)
The conditions for application in the amended subsection 212.1(1) have been substantively varied. The reference to non-resident owned investment corporations is removed, as these corporations no longer exist for taxation years ending after 2003. More importantly, the defined term “non-resident person” now refers only to a non-resident person or a designated partnership with regards to subsections (1), (1.1) and (1.2). The Explanatory Notes clarify that “[t]his change is intended to ensure that the references to a non-resident person in subsections 212.1(3) and (4) are not limited to the non-resident transferor referred to in subsections 212.1(1) to (1.2)”.
Subsections 212.1(3) and (4) are also amended to add references to designated partnerships. Due to the limitation of the definition of non-resident person in subsection 212.1(1), references to a non-resident person or a designated partnership in subsections 212.1(3) and (4) are no longer limited to the transferor non-resident person or designated partnership referred to in subsections 212.1(1) to (1.2), but instead refer to any non-resident person or designated partnership.
Deemed consideration – subsection 212.1(1.2)
The proposed amendments also introduce new subsection 212.1(1.2), which creates a deemed consideration rule for subsections 212.1(1) and (1.1). This rule applies in situations where it would otherwise be uncertain whether consideration has been received by the non-resident person from the purchaser corporation in respect of the disposition by the non-resident person of the subject shares. The Explanatory Notes state that this amendment “clarifies” the application of subsections 212.1(1) and (1.1).
The new subsection only applies if no consideration would have been received by the non-resident person from the purchaser corporation for the subject shares. If applicable, the non-resident person is deemed, for the purposes of subsection 212.1(1) and (1.1), to receive consideration other than shares of the purchaser corporation from the purchaser corporation for the subject shares. The FMV of this consideration is deemed to be equal to the amount by which the FMV of the subject shares disposed of by the non-resident person exceeds the amount of any increase in the FMV of the shares of the purchaser corporation because of the disposition. This amendment is important because the FMV of the consideration is used to calculate the consequences of application in subsection 212.1(1.1). This new deeming rule thus expands the scope of subsection 212.1(1.1).
Limitation of the exemption – subsection 212.1(4)
Subsection 212.1(4) determines where, notwithstanding subsection 212.1(1), subsection 212.1(1.1) does not apply. According to the Explanatory Notes, the purpose of this rule is to “permit a Canadian-resident purchaser corporation that acquires shares of a non-resident corporation that itself owns shares of a Canadian corporation to simplify its corporate structure”.
Under the 2016 Legislative Proposals, new paragraph 212.1(4)(a) is the same as the previous subsection 212.1(4) exemption, exempting the taxpayer from the application of subsection 212.1(1.1) if, immediately before the disposition, the purchaser corporation controlled the non-resident corporation. However, new paragraph 212.1(4)(b) introduces a new limitation to the exemption: it must not be the case that, at the time of the disposition, or as part of a series of transactions or events that includes the disposition, a non-resident person or designated partnership (i) owns, directly or indirectly, shares of the purchaser corporation and (ii) does not deal at arm’s length with the purchaser corporation. This limitation reflects the government’s concern that certain corporate groups have manipulated this exemption by reorganizing the group into a cross-border “sandwich” structure and relying on the exemption as part of a series of transactions designed to increase the PUC of the shares of Canadian subsidiaries. The proposal would considerably limit the availability of the exemption, as a non-arm’s length non-resident shareholder of the purchaser corporation will cause the exemption to be unavailable. Further, the introduction of the broad “series” concept into the exemption will add uncertainty as to whether the exemption can be relied on.