On October 18, 2012, the Canadian Government took a further step toward implementing new “foreign affiliate dumping” rules (the FA dumping rules) that will have a significant impact on foreign-based multinationals with Canadian subsidiaries and on acquisitions by non-resident corporations of Canadian corporations that derive the significant majority of their value from foreign operations.
The March 29, 2012 Federal Budget originally proposed the new FA dumping rules, which were intended to discourage foreign-based multinational corporations from “dumping” foreign affiliates into their Canadian subsidiaries in a manner that erodes the Canadian tax base.1 The Department of Finance released on August 14 a revised version of these proposals with a broader scope than the original version.2 Most notably, the proposed rules could apply where a Canadian corporation that is controlled by a non-resident corporation acquired another Canadian corporation that owned significant share interests in foreign corporations. On October 18, a further revised version of the FA dumping rules received First Reading in Parliament as part of Bill C-45.
As a general matter, the revised FA dumping rules contained in Bill C-45 provide some relief from the rules proposed on August 14. However, the revised rules will continue to have a significant impact on foreign-based multinationals with Canadian subsidiaries and on acquisitions by non-resident corporations of Canadian corporations that derive the significant majority of their value from foreign operations. The rules will generally apply to transactions occurring on or after March 29 (with limited transitional relief for transactions occurring before 2013 pursuant to written agreements in place before March 29 and with an ability to elect to use the original version of the foreign affiliate dumping proposals announced in the Federal Budget for transactions occurring between March 29 and August 14).
Application of FA Dumping Rules – Deemed Dividend or Paid-up Capital Reduction
Subject to three general exceptions discussed below, the revised rules apply where a corporation resident in Canada (CRIC) that is controlled by a non-resident corporation (Parent) makes an investment in a non-resident corporation that is a foreign affiliate (FA) of the CRIC (either immediately after the investment is made or resulting from the series of transactions that includes the investment). As discussed below, in certain circumstances an acquisition of shares of a Canadian corporation by a CRIC is considered to be an investment in such a non-resident corporation. When applicable, the new rules either deem the CRIC or a related Canadian corporation to have paid a dividend to Parent, or reduce the paid-up capital of the CRIC’s shares or of shares of a related Canadian corporation.
A deemed dividend to Parent is subject to Canadian withholding tax at a rate of 25%, subject to potential relief under an applicable income tax treaty. The amount of the deemed dividend is equal to the portion of the fair market value of the investment in FA that is reflected by:
- property (other than shares of the CRIC) transferred by the CRIC;
- obligations assumed by the CRIC; or
- benefits conferred by the CRIC that relate to the investment.
In addition, if the FA investment is contributed to the CRIC for consideration that includes shares of the CRIC, the paid-up capital of such shares is reduced by the amount otherwise added to the paid-up capital on the contribution. Accordingly, contributing an FA investment to a CRIC for shares of the CRIC will generally not result in any net increase to the CRIC’s paid-up capital (which would otherwise reflect an amount that the CRIC could distribute to Parent free of Canadian withholding tax as a return of capital distribution).
The proposed rules in Bill C-45 introduce a new special election that allows the parties to re-designate, for purposes of the FA dumping rules, the payor and/or recipient of a deemed dividend that arises under those rules. Specifically, the proposed rules provide an ability to elect that all or a portion of a dividend otherwise deemed to be paid to Parent by a CRIC to instead be deemed to be paid to Parent or a non-resident corporation that is controlled by Parent on a share of the CRIC or of a qualifying substitute corporation (QSC). A QSC is a Canadian corporation that is controlled by Parent, that has a direct or indirect equity interest in the CRIC and some of the shares of which are owned by Parent or a non-resident person that does not deal at arm’s length with Parent. The election is made jointly by Parent (or Parent and any non-resident corporation controlled by Parent), the CRIC and all QSCs in respect of the CRIC. The main purpose of this rule is to accommodate various holding company structures (such as where a CRIC has a Canadian holding company). Specifically, by allowing the Canadian holding company to make a QSC election a lower treaty withholding rate may apply (such as where a treaty requires direct ownership for reduced withholding on dividends). In addition, a QSC election may allow the deemed dividend to be recharacterized as a reduction of paid-up capital as described below (which treatment would not be available for a dividend deemed to be paid by the lower-tier CRIC).
The August 14 proposals contained a joint election allowing the CRIC and Parent to elect to treat what would otherwise be a deemed dividend as a reduction to the CRIC’s paid-up capital. The Bill C-45 version instead provides for an automatic recharacterization of the dividend deemed to be paid by a CRIC or a QSC (as a reduction of the paid-up capital of the shares of the CRIC or QSC) if certain conditions are satisfied. In certain cases, the paid-up capital reduction can occur on shares of the CRIC or QSC that are owned by persons who deal at arm's length with Parent. This will be useful where there are minority shareholders in the CRIC or QSC.
If the paid-up capital of a class of shares of a CRIC or a QSC has been reduced either because a deemed dividend has been recharacterized as a reduction of paid-up capital or because Parent has contributed shares of an FA to the CRIC for shares of the CRIC (resulting in an automatic reduction to the CRIC’s paid-up capital, as described above), the reduced paid-up capital may be effectively reinstated on certain subsequent distributions as a return of capital by the CRIC or QSC. The application of the paid-up capital reinstatement rule to the second type of paid-up capital reduction is a relieving change contained in Bill C-45. In addition, the paid-up capital reinstatement rule now expressly applies where the relevant FA investment occurred by way of capital contribution to the FA or an acquisition of shares of a Canadian corporation that owned the underlying FA shares. Without this change, a very common acquisition strategy where a non-resident acquires a Canadian corporation that owned shares of FAs and removed the FA shares from Canada on a tax-free basis (through a so-called "bump transaction" and return of capital) would no longer be effective.
More particularly, the paid-up capital of shares of the corporation may be reinstated to the extent that the subsequent distribution is a distribution of:
- the relevant FA shares;
- property substituted for the FA shares;
- subject to a limited exception, proceeds from the disposition of the FA shares or property substituted for the FA shares provided that such proceeds are distributed within 180 days of the disposition (the 180 days provided for in Bill C-45 is an expansion of the previous 30-day limit); or
- proceeds from a dividend or reduction of paid-up capital on the FA shares or shares substituted for the FA shares provided that such proceeds are distributed within 180 days of the receipt of the dividend or return of capital. (The ability to reinstate paid-up capital in respect of distributions made by an FA is another significant expansion of the scope of the paid-up capital reinstatement rule).
One narrowing of the paid-up capital reinstatement rule contained in Bill C-45 is that a paid-up capital reinstatement will not be allowed where proceeds of disposition of the FA shares (or substituted property) are generated in an "in-house" transaction that is not subject to the FA dumping rules by virtue of the corporate reorganizations exemption described below.
Investments Subject to the FA Dumping Rules
For the purposes of the FA dumping proposals, an investment in an FA by a CRIC means any of the following:
- an acquisition of FA shares by a CRIC;
- a contribution to the capital of an FA by a CRIC;
- a transaction where an amount becomes owing by an FA to a CRIC (other than an amount arising in the ordinary course of the CRIC’s business that is repaid within 180 days or an amount that is a “pertinent loan or indebtedness” (a term discussed below));
- an acquisition of an FA debt obligation by a CRIC (other than an acquisition from an arm’s-length person in the ordinary course of the CRIC’s business or a debt obligation that is a pertinent loan or indebtedness);
- an extension of the maturity date of a debt obligation owing by an FA to a CRIC (other than an amount that is a pertinent loan or indebtedness) or of the redemption, acquisition or cancellation date of FA shares owned by the CRIC;
- an indirect acquisition of shares of an FA by a CRIC through the acquisition of shares of another CRIC if the total fair market value of FA shares owned directly or indirectly by the other CRIC exceeds 75% of the total fair market value (determined without reference to debt obligations of any Canadian corporation in which the other CRIC has a direct or indirect interest) of all properties owned by the other CRIC; and
- an acquisition by a CRIC of an option in respect of, or an interest or right in, shares of FA or a debt obligation of FA that is not excluded under the exceptions above in clauses (c) and (d) above.
More detailed rules supplement the indirect acquisition rules above. For example, rules are provided for determining the amount of an indirect FA investment and a rule prevents “stuffing” a CRIC with non-FA investments to avoid the application of the 75% rule relating to indirect investments.
Bill C-45 includes two significant relieving changes to the indirect acquisition rule. First, the threshold has been increased from 50% to 75% for purposes of determining when the acquisition of shares of a Canadian corporation is considered to be an indirect acquisition of FA shares directly or indirectly owned by the Canadian corporation. Second, the indirect acquisition rule effectively deems the underlying FA shares to be acquired by the acquiring CRIC, which allows the paid-up capital reinstatement rule and the corporate reorganization exception to apply as intended.
Exceptions to the FA Dumping Rules
The three general exceptions to the revised rules are for pertinent loans or indebtedness, corporate reorganizations, and strategic business expansions.
Pertinent Loan or Indebtedness
The pertinent loan or indebtedness (PLOI) exception allows an amount owing by an FA to a CRIC to be excluded from the FA dumping rules on an elective basis. The revised rules allow the election to be made on a loan-by-loan basis, rather than in respect of all loans owing by the FA. The result of making the election is that the particular amount owing becomes subject to a new interest imputation regime, rather than the FA dumping rules. This interest imputation regime generally requires the CRIC to include interest income on the amount owing at a rate that is at least equal to the greater of a prescribed rate (in general terms, the Canadian Treasury Bill rate plus 4%) and the rate applicable on any debt obligation incurred by the CRIC to fund the PLOI. The imputed interest is reduced by interest on the PLOI that is otherwise included in income (i.e., because it was received or accrued by the CRIC). If the new interest imputation rules apply the existing interest imputation rules in section 17 of the Income Tax Act (Canada) (the Act) do not apply. The PLOI election applies to amounts that became owing after March 28, 2012 (or to amounts where the maturity date of the debt was extended after March 28, 2012) that were not otherwise excluded from being an FA investment under the ordinary course of business exceptions described below.
A separate new rule also allows a CRIC to make a PLOI election in respect of other loans or indebtedness owing to the CRIC by a foreign corporation (such as a loan by the CRIC to its foreign Parent or to a foreign sister corporation). Although such other indebtedness would not have been subject to the FA dumping rules, it could otherwise have been subject to the current “shareholder loan” rule in subsection 15(2) of the Act – which, subject to certain exceptions, would deem the principal amount of such indebtedness to be a dividend paid by the CRIC that is subject to Canadian dividend withholding tax. Where the new election is made subsection 15(2) does not apply to the particular indebtedness. Similar to the election for amounts owing by an FA, amounts owing by other non-resident corporations in respect of which this election is made will then be subject to the new interest imputation rule. The new election applies to amounts that became owing to a CRIC after March 28, 2012 by Parent or a NAL non-resident corporation.
Bill C-45 includes some additional rules applicable to PLOIs as follows:
- the August 14 proposals provided that the treasury bill rate was to be rounded-up to the nearest percent for purposes of determining the prescribed rate. The rounding-up rule is no longer applicable;
- rules are provided to expand the pertinent loan or indebtedness to debts owing to or by partnerships;
- some transitional relief from the interest imputation regime applicable to a PLOI applies if a debt becomes a PLOI by virtue of an acquisition of control of a CRIC by a non-resident corporation;
- it is now possible to late-file PLOI elections; and
- a debt that otherwise qualifies as a pertinent loan or indebtedness may not so qualify if the imputed interest on the debt is subject to a lower amount of tax under the Act by virtue of a tax treaty.
Exceptions from the FA dumping rules are provided for various types of corporate reorganizations. These exceptions are generally intended to prevent the application of the FA dumping rules where there is no new investment in an FA. These rules apply to certain acquisitions of FA shares by a CRIC:
- on an acquisition from a non-arm’s length CRIC;
- on an amalgamation if all of the amalgamating corporations are related;
- on a conversion of debt into shares or the settlement of debt of the FA by the issuance of shares;
- on the reorganization of capital of the FA;
- on a share for share exchange with another FA;
- a reorganization of capital;
- on a foreign merger; or
- on a liquidation of, share redemption by or dividend or return of capital from, another FA.
Bill C-45 expands the corporate reorganization exemption to provide for analogous exemptions where shares of a Canadian corporation are acquired if the acquisition of such shares would be deemed to be an indirect acquisition of shares of an FA held by such Canadian corporation. In addition, the revised FA dumping rules contain a new relieving rule to ensure that the FA dumping rules do not apply more than once when property is transferred through a chain of Canadian corporations and invested in an FA.
Notwithstanding the above, an investment may nevertheless be considered to have been made on a transaction otherwise eligible for a corporate reorganization exemption where, for example, debt is assumed by the CRIC in respect of a distribution from FA (such as on a liquidation of a top tier FA into the CRIC). In addition, certain of the corporate reorganization exemptions are not available in respect of the acquisition of preferred shares (as discussed in more detail below in the context of the strategic business expansion exemption). Also, an anti-avoidance rule may apply where it may reasonably be considered that one of the main purposes for a transaction or event was to cause persons to be related for the purposes of the reorganization exceptions.
For purposes of the FA dumping rules a corporation formed on an amalgamation of a parent and subsidiary CRIC (under subsection 87(11) of the Act) is deemed to be a continuation of its predecessors and is deemed not to have acquired property from its predecessors. Similarly, where a CRIC is wound-up into another CRIC (under subsection 88(1) of the Act) the parent is deemed to be a continuation of its subsidiary and is deemed not to have acquired property from the subsidiary as a result of the winding-up
Strategic Business Expansion
The explanatory notes accompanying the revised rules provide that the exception for strategic business expansions is intended to recognize that certain foreign affiliate investments made by a CRIC may have been made by the CRIC even if the CRIC were not foreign-controlled. Notwithstanding such intention and some relieving changes in Bill C-45, the exception continues to be very narrowly drafted. The exception applies where the CRIC demonstrates that each of the following conditions are met:
- the business activities of the subject FA and its subsidiaries are, and are expected to remain, on a collective basis more closely connected to the business activities carried on in Canada by the CRIC (or by a NAL CRIC) than the business activities of any non-arm’s length non-resident corporation (other than the subject FA or its subsidiaries or another FA that is controlled by the CRIC);
- officers of the CRIC had, and exercised, the principal decision-making authority in respect of making the investment and a majority of those officers were, at the investment time, resident and working principally, in Canada or in a country in which a FA controlled by the CRIC (a connected affiliate) is resident if the connected affiliate carries on business activities that are at least as closely connected to the business of the subject FA as the business activities carried on in Canada by the CRIC or a NAL CRIC;
at the investment time, it is reasonable to expect that officers of the CRIC,
- will exercise the principal decision-making authority over the subject FA on an on-going basis,
- a majority of those officers will be resident, and will work principally, in Canada or a country in which a connected affiliate is resident, and
- the performance evaluation and compensation of such officers will be based on the results and operations of the relevant FA to a greater extent than will be the performance evaluation and compensation of any officer of a non-arm’s length non-resident corporation (other than the FA or its controlled subsidiaries or a connected affiliate).
For purposes of applying the rules noted above, an officer who is resident of a CRIC and an "upstream" NAL non-resident corporation (e.g. not the subject FA or a connected affiliate) is deemed not to be resident, and not to work principally, in a country in which a connected affiliate is resident.
In determining whether an FA’s business activities are connected with the business activities of the CRIC, the explanatory notes accompanying the draft rules indicate that activities may be connected if they are similar in nature or “parallel” (such as manufacturing and distributing similar products or providing similar services) or if one corporation’s activities are “upstream” or “downstream” to the other’s or if one business uses technology of the other in its operations (such as where one corporation sells the output of, or provides inputs to, the manufacturing process of the other). The explanatory notes also emphasize that mere connectedness is not sufficient. The connection to the CRIC must be closer than the connection to other non-arm’s length non-resident corporations.
In determining whether an officer is working principally in Canada the explanatory notes suggest that they must spend the majority of their working time in Canada, carry out a majority of their important functions in Canada, and make most of their important decisions, with respect to the CRIC in Canada.
The strategic business expansion exception and certain of the corporate reorganization exemptions do not apply in respect of an investment in FA shares that may not reasonably be considered to fully participate in the profits of FA and any appreciation in the value of FA, unless FA is a subsidiary wholly-owned corporation of the CRIC. Accordingly, such exceptions will generally not apply to preferred share FA investments unless the FA is a subsidiary wholly-owned corporation of the CRIC.
An anti-avoidance rule applies where a CRIC uses a “good” FA as a conduit to make an investment in a “bad” FA. For example, the strategic business expansion exemption may be effectively deemed not to apply to an investment in an FA that would otherwise satisfy the exemption if that FA in turn invests in another FA that would not meet that exemption.
Also, a new rule extends the strategic business expansion exception to certain investments in an FA that is established in another foreign jurisdiction where that FA provides financing to an FA that would meet the “closely connected” requirements and uses the funds in an active business carried on in the country in which it is resident.
Other Related Provisions
Additional rules apply for purposes of the FA dumping rules to look though certain investments by partnerships. Very generally, these rules deem each member of a partnership to have entered into any transaction entered into by the partnership itself in proportion to the fair market value of the member’s direct or indirect (through other partnerships) interest in the partnership. Similarly, members of a partnership are deemed to own their proportionate amount of the partnership’s property, and are deemed to owe their proportionate amount of amounts owning by a partnership, for purposes of these rules.
The proposals also include changes to the corporate emigration rules that are intended to deter corporate emigration strategies that could otherwise be used as a substitute for transactions addressed by the FA dumping rules. These rules apply where shares of an emigrating corporation are owned by a CRIC that is controlled by a non-resident Parent and the emigrating corporation is an FA of the CRIC immediately after the emigration. Where applicable, the paid-up capital that the emigrating corporation would otherwise have is deemed to be nil, resulting in a greater departure tax being payable on emigration. Bill C-45 also introduces a paid-up capital re-instatement rule (similar to the one described above) where a corporation that has had its paid-up capital reduced by the FA dumping rules emigrates.
The FA dumping rules are a new complex regime which will have significant implications for foreign-based multinationals with Canadian subsidiaries and on acquisitions of Canadian corporations with significant foreign subsidiaries.