On August 14, 2012, the Department of Finance released draft legislation that includes a revised version of the foreign affiliate dumping proposals tabled with the March 29 Federal Budget. The stated objective of the proposals is to curtail the inappropriate erosion of the Canadian tax base but the rules are much broader than that. The revised proposals have potentially adverse income tax consequences where a corporation resident in Canada (CRIC) that is, or becomes, controlled by a non-resident corporation (a parent) makes an investment in a non-resident corporation (a subject corporation) that is, or becomes, a foreign affiliate of the CRIC. Many submissions have been made to the Department of Finance raising concerns with the proposals and a further draft of the legislation is expected. However, it remains to be seen whether these concerns will be fully addressed.
The adverse income tax consequences can include the deemed payment of a dividend by the CRIC to the parent equal to the amount of the investment. The dividend is subject to dividend withholding tax at 25 percent (or such lower rate as is available under an applicable tax treaty). Other possible tax consequences include the reduction of the paid-up capital of the shares in the CRIC which may have an impact on repatriation strategies and meeting thin capitalization debt limits.
This summary is not a technical review of the proposals but an aid in identifying the circumstances in which the proposals might apply. Because of the breadth of the rules, a tax professional should be consulted before a foreign controlled CRIC does anything that might be viewed as an investment in a subject corporation.
Investment in a subject corporation by a CRIC is very broadly defined and can potentially encompass a wide range of transactions or events, including:
an acquisition of shares in a non-resident corporation from treasury or from another person,
a contribution of capital to a non-resident corporation,
the conferral of a benefit on a non-resident corporation such as the provision of services to the non-resident corporation for below market consideration or the forgiveness of an existing debt of the non-resident corporation,
the creation or acquisition of a debt obligation of a non-resident corporation,
the extension of the term of an existing debt owed by, or the extension of the redemption, acquisition or cancellation date of existing shares held in, a non-resident corporation, and
the acquisition of an option, right or interest in any of the forgoing.
Importantly, an investment in a subject corporation can also include an acquisition by a foreign controlled CRIC of shares in another Canadian resident corporation if that other corporation derives more than 50 percent of its value from one or more non-resident corporations that are foreign affiliates.
While there are exceptions and qualifications to the above situations, the rules are tricky and some of the exceptions require a joint election and have their own tax implications, such as the imputation of interest income to the CRIC. The grandfathering is limited and generally only excuses arm’s length transactions completed before 2013 in accordance with a written agreement entered into before March 29, 2012. Taxpayers can elect to have the Budget version of the proposals apply to transactions that occur after March 28, 2012, and before August 14, 2012.