The past year has seen significant developments in Canada's international tax rules affecting both inbound and outbound investment, with the promise of more to come.
Canadians now have greater access to international capital markets. Effective January 1, 2008, Canada repealed its withholding tax on interest paid by Canadian borrowers to arm’s length foreign lenders. The relief is broad covering debt of all maturities and related financing costs. All foreign arm’s length lenders benefit from the exemption regardless of whether their home jurisdictions provide reciprocity to Canadian lenders. However, the exemption does not apply to participating debt interest linked to factors such as revenues, profits, commodity prices or dividends.
On October 31, 2006, the Minister of Finance announced the intention of the Government of Canada to tax existing specified investment flow–through (SIFT) entities, (subject to certain grandfathering requirements) beginning in 2012, at the entity level as if they were corporations. Implementing legislation was enacted in 2007. SIFTs, which included, publicly traded trusts (income trusts) and partnerships had previously not been subject to tax and had been preferred investments for foreign investors.
Despite the tax benefits they offered, at least in the short term, there were also disadvantages to the income trust structure. Many SIFTs, therefore, began to consider conversion to corporations but were hampered by the fact that Canada’s tax rules did not facilitate such conversions. The Canadian government promised to address these uncertainties and on July 14, 2008 released draft amendments to facilitate conversion of SIFT trusts and partnerships into corporations. The draft legislation addresses the different ownership structures used by income trusts and provides tax deferred conversions:
- through an exchange of units of a publicly traded SIFT for shares of a newly created and publicly traded Canadian corporation, followed by a liquidation of the trust (and other subject entities), or
- through a redemption or cancellation of units of a SIFT followed by a distribution of shares of a taxable Canadian corporation.
The principal benefit of the proposals is that, in addition to deferral and some carry-over of attributes, they will minimize the administrative burden attendant on such planning. While the proposals will not directly have application where a foreign investor acquires a SIFT from its unitholders, they will, however, facilitate the process, either pre or post acquisition, of conversion to corporate form.
Against these positive developments, others, among them Canada’s disappointing proposals to amend its reporting rules for foreign arm’s length sellers of Canadian-based investments, its continued adherence to overly complex rules relating to the write-up of inside asset cost for acquirors on non-depreciable capital assets and the absence of any action to redress the rules which leave many Canadian subsidiaries exposed to huge currency gains on repayment of foreign denominated debt with no recognition for offsetting real economic losses on underlying investments, remain ongoing sources of frustration for foreign investors.
Where a Canadian company issues debt convertible into its own shares or exchangeable into shares or other assets to a lender, the recent decision of the Federal Court of Appeal in Tembec Inc. v. The Queen establishes that, in the former case, no deduction will be available to the issuer for the difference between the fair market value of the shares issued on conversion and the issue price of the debt. While this result might well have been expected given the decision of the Supreme Court in Imperial Oil v. The Queen, the decision of the Federal Court of Appeal also casts doubt on the long standing administrative practice of the Canadian tax authorities to permit the issuer a deduction for this difference in the case of commodity-based or exchangeable debt. If this decision was to result in a disallowance of such deductions to issuers, there would be no offset, in future, for the portion of the taxable gain recognized by the issuer on delivery of the shares or commodity into the conversion. Tembec has filed for leave to appeal the decision to the Supreme Court of Canada.
Foreign investors, and in particular those from the U.S. with profitable Canadian subsidiaries that prefer not to repatriate those profits but to redeploy them elsewhere in their corporate group from Canada, have long been the focus of review by Canada’s revenue authorities. In addition, the Canadian and the U.S. tax administrations have had cross-border planning involving hybrid entities, both inbound and outbound, high on their agendas.
In 2007, Canada passed legislation to deny, after 2011, interest deductibility to Canadian corporations in respect of so-called double dip structures. The rules will apply only to outbound double dip financing arrangements (Canadian corporations financing foreign subsidiaries). Two particular types of cross-border financings were targeted in the legislative background material released by the Department of Finance. The first is a structure, which utilizes an intermediary subsidiary located in a low tax jurisdiction. The second is known as a “tower structure”, and takes advantage of hybrid entities, which are treated differently for tax purposes, specifically with reference to Canada and the U.S. Such structures are commonly used by Canadian corporations to finance foreign acquisitions with the tax benefit of allowing, in effect, the same interest deduction to reduce both Canadian and foreign taxes, without an offsetting income inclusion.
The new rules are extremely complex. They are also broadly drafted and will have application beyond the scope of their expressed purpose, that is, where no double interest deduction actually occurs. The rules may apply not only when a Canadian corporation directly incurs interest and financing expenses, but also when it is a member of a partnership that incurs such expenses. In addition, if certain attribution rules apply, an inter-affiliate loan which benefits one corporation in a related group may result in a denied interest deduction to another corporation within the group.
As well, on September 21, 2007, Canada and the US signed the Fifth Protocol to the Canada-US Income Tax Convention that contains both (expected) relieving provisions and (unexpected) changes which eliminate treaty benefits. Treaty benefits will be extended to US members of US LLCs, a withholding tax exemption will apply to both guarantee fees and arm’s length and, over a three-year phase-in, to related party interest payments and “look-through” provisions will permit corporate members of fiscally transparent entities the reduced 5% substantial interest dividend withholding rate.
The Protocol, however, adds highly complex “anti hybrid” rules intended to deny treaty benefits to entities, such as partnerships and companies, that are considered fiscally transparent (that is, not subject to tax at the entity level) in one country but not the other. These rules will have effect from the first day of the third calendar year that ends after the Protocol enters into force. The Protocol has been ratified by Canada and is currently before the U.S. Senate awaiting approval. If the rules apply, cross-border payments (such as interest and dividends) made by or through a fiscally transparent entity will be subject to the full domestic rate of non-resident withholding tax applicable in the country of source of the payment (25% in the case of payments made from Canada). In the Canadian inbound context, U.S. residents routinely use Canadian unlimited liability companies (ULCs), which they can elect to treat as fiscally transparent for U.S. tax purposes, as intermediaries to hold interests in Canadian corporations and to carry on business activities in Canada. Concerns have been raised by many tax professionals that the new rules, which will deny treaty benefits to dividend distributions from ULCs and taxed distributions from other entities should not generally be considered to be tax abusive. The US Treasury Department Technical Explanation of the Protocol released on July 10, 2008, concurrent with the hearing on that date of the US Senate Committee on Foreign Relations on pending income tax treaties with Canada, Iceland and Bulgaria, did not provide the hoped for resolution of these issues.
A significant change in the Protocol is Canada’s buy-in to its first comprehensive “limitation on benefits” provision, intended to curtail tax treaty shopping. Treaty benefits will no longer be available simply because a taxpayer is a resident of the US. Only a US resident that is a “qualifying person” will be entitled to treaty benefits. A US resident that is not a “qualifying person” may obtain benefits for certain income if it meets an “active trade or business” test or a “derivative benefits” test. Any other US resident will not obtain treaty benefits unless Canada grants discretionary relief.
In the commercial sector, the following categories of Canadian and US residents are “qualifying persons”:
- An individual resident in one or other of the contracting states.
- Companies and trusts that satisfy a “publicly traded” test. The company’s or the trust’s principal class of shares or units and any “disproportionate” class must be primarily and regularly traded on one or more recognized stock exchanges. A company’s “principal class” of shares is its ordinary or common shares or such other classes of shares that represent the majority of the votes and value in the company. A disproportionate class is one on which the return tracks the issuer’s income, profit or gain from the other country.
- Subsidiaries of publicly traded companies and trusts of which more that 50% of the votes and value of their shares (and of each disproportionate class of shares) is owned, directly or indirectly, by five or fewer publicly traded qualifying persons.
- Companies and trusts that satisfy an “ownership/base erosion” test. For a company, 50% or more of the votes and value of its shares, (and of each disproportionate class of shares), must not be owned, directly or indirectly, by persons except qualifying persons. A similar ownership requirement applies to a trust. Also, the amount of tax-deductible expenses paid or payable by the company or trust, directly or indirectly, to non-qualifying persons in its preceding fiscal period must be less than 50% of gross income for that period.
A US or Canadian resident that is not a qualifying person may be entitled to treaty benefits for certain income pursuant to an "active trade or business" test or a "derivative benefits" test.
Under the “active trade or business” test, income that a resident earns from the other source country will benefit from treaty relief if the resident (or a related person) is engaged in the active conduct of a trade or business in its country of residence, the source country income is derived in connection with, or is incidental to, that trade or business, and that trade or business is substantial. The Technical Explanation indicates that income will be derived in connection with an active trade or business if the activity in one country is “upstream”, “downstream” or “parallel” to that in the other. For example, the connected US activity of a Canadian manufacturer can consist of selling the manufactured product, providing inputs to the manufacturing process, or manufacturing and selling the same kind of product in the US.
The derivative benefits test permits a US or Canadian resident company that is not a qualifying person to obtain treaty benefits for dividends, interest and royalties. The company must satisfy an ownership base erosion test intended, in essence, to provide benefits if the company is owned by a resident of a third country whose tax treaty with the source country is as favourable in its treatment of the relevant item of income, as that provided for in the Canada-US Income Tax Convention. This will prove difficult in the case of related-party interest paid from Canada, as Canada’s zero rate treaty with the US is unique, among its agreements with its treaty partners.
The limitation on benefits provision will require Canadians paying amounts to the US, to satisfy themselves as to their recipient’s entitlement to treaty reduced withholding tax rates. In most cases entitlement will require factual information not in the public domain. To make the system viable the Canadian tax administration has indicated that it will be issuing guidelines on an appropriate certification system; absent such a system contractual representations and indemnities will be essential. Withholding tax gross-up provisions in contracts with US recipients should be reviewed, as Canadians who have agreed to gross-ups may incur additional costs if the US recipient is no longer entitled to treaty benefits. The limitation on benefits provision has no grandfathering or apportionment relief, so a person who ceases to be entitled to treaty benefits cannot claim relief for previously accrued gains or income. Companies that are not publicly traded will need to monitor the status of their shareholders to determine their eligibility for treaty benefits. A takeover of a publicly traded company or trust by private interests may result in loss of treaty benefits.
Canada’s tax treaties have also been considered in three important Tax Court decisions, all decided in favour of the taxpayers. These cases address two concepts contained in most OECDtype tax treaties, “beneficial ownership” and “permanent establishment” and will be of considerable importance to foreign investors in structuring their investments into and their activities with and in Canada. The Prevost Car decision rejected the government's "conduit" attack on a Dutch holding company through which UK and Swedish shareholders owned their Canadian subsidiary. The Tax Court recognized the Dutch company as the ‘beneficial owner’ of dividends paid from Canada, because it maintained discretion and the right of independent action as to the use of those funds, and applied the reduced rate of withholding tax under the Canada- Netherlands treaty. In the American Income Life Insurance Co. and Knights of Columbus decisions, the Tax Court upheld two US insurers' claims for the "business profits exemption" under the Canada-US Income Tax Convention on the basis that the insurers did not have permanent establishments in Canada. The Prevost case has been appealed.
Canada has created an Advisory Panel to recommend further changes to Canada's international tax system. The Panel will address expansion of the exemption feature of Canada’s CFC system, withholding tax exemptions, changes to Canada’s thin capitalization rules, and measures to counteract treaty shopping and to simplify administration. The Panel is to provide its recommendations by December 1, 2008. Any changes based on the Panel’s recommendations (given its areas of review) will most likely impact future planning for foreign investors in structuring their arrangements into Canada.