On March 19, 2019 (“Budget Day”), Federal Finance Minister Bill Morneau introduced the 2019 Federal Budget (“Budget 2019”). Budget 2019 proposes to extend the “foreign affiliate dumping” rules (“FAD rules”) in the Income Tax Act (Canada) (“Tax Act”) to non-resident individuals and trusts, in a move that would expand the scope of the FAD rules and create significant uncertainty.
The FAD rules were introduced in 2012 to target certain foreign investments made by Canadian subsidiaries of foreign-based multinational groups that were perceived to inappropriately erode the Canadian tax base. The FAD rules have been amended several times since their introduction and have evolved into some of the most complex provisions in the Tax Act.
The FAD rules apply where a corporation resident in Canada (“CRIC”) that is controlled by a non-resident corporation makes certain investments in a foreign affiliate. Where they apply, the FAD rules can reduce the paid-up capital of the shares in the CRIC or deem a dividend (subject to Canadian withholding tax) to be paid by the CRIC to its non-resident parent corporation.
One of the key limiting factors is that the FAD rules currently only apply to a CRIC that is controlled by a non-resident corporation.
In order to “better achieve the policy objectives” of the FAD rules, Budget 2019 proposes to extend the FAD rules to any CRIC that is controlled by any of the following:
- a non-resident individual;
- a non-resident trust; or
- a group of any combination of non-resident individuals, non-resident trusts, and/or non-resident corporations who do not deal with each other at arm’s length.
Proposed rules would create significant uncertainty
In addition to extending the application of the FAD rules to non-resident individuals and trusts, the proposed rules would create significant uncertainty in several respects.
Non-arm’s length group
The proposed rules would apply to any CRIC that is controlled by a group of non-resident individuals, trusts, or corporations who do not deal with each other at arm’s length. The problem is that related persons and unrelated persons can be considered to not deal at arm’s length. While it is straightforward to determine whether two people are related (and therefore do not deal at arm’s length), it is anything but straightforward to determine whether two unrelated people deal at arm’s length – it is a question of fact that depends on all the circumstances.
By extending the FAD rules to CRICs controlled by a group of non-arm’s length persons – as opposed to a group of related persons – the proposed rules would create significant uncertainty.
Special trust rule
The proposed rules contain a special rule for determining whether two persons are related or whether a person is controlled by another person, under which it "shall be assumed" as follows:
- a trust is a corporation with a single class of voting shares;
- each beneficiary holds shares of the assumed corporation based on the proportion of the fair market value of the beneficiary’s interest to the total fair market value of all the beneficiaries’ interests; and
- if the beneficiary’s share of the income or capital depends on the exercise of any discretionary power (i.e. if the beneficiary has a discretionary interest in the trust), the beneficiary is treated as owning all the voting shares of the assumed corporation.
Under this rule, the FAD rules could be engaged where a CRIC is owned by a Canadian-resident discretionary family trust with a non-resident beneficiary, which would represent a significant expansion of the scope of the FAD rules.
But this rule would also create significant uncertainty – for example, would it apply to a non-resident contingent beneficiary? There is a similar rule in the Tax Act that treats a trust as an assumed corporation and a discretionary beneficiary as owning all the shares of the assumed corporation – except this rule specifically does not apply to a contingent beneficiary. By virtue of the “presumption of consistent expression” in statutory interpretation, this difference is presumed to be intentional such that the special trust rule could be interpreted as applying to a contingent beneficiary of a discretionary trust, with the result that the FAD rules could be engaged where a CRIC is owned by a Canadian-resident discretionary family trust with a non-resident contingent beneficiary.
Finally, and perhaps most confusingly, this rule uses the extremely unusual term “shall be assumed” (i.e. it “shall be assumed” that a trust is a corporation with a single class of voting shares). The usual term is “shall be deemed”, which is used over a thousand times in the Tax Act, whereas the term “shall be assumed” is used only twice. Canadian courts have interpreted the term “shall be deemed” as creating a conclusive – as opposed to rebuttable – presumption. By virtue of the presumption of consistent expression mentioned above, does this mean that the legislator, by using the term “shall be assumed” instead of “shall be deemed”, intends this rule to create a rebuttable – as opposed to conclusive – presumption? And if so, under what circumstances would this presumption be rebutted?
In addition to significantly expanding the scope of the FAD rules, the proposed rules would create significant uncertainty in several respects.
Given the complexity of the FAD rules and the significant tax consequences that can result from their application, it is hoped that the government amends the proposed rules to address these issues.
The proposed rules are to apply to transactions on or after Budget Day.