On July 12, 2013, the Minister of Finance released for consultation draft legislative proposals (the July 2013 Proposals) largely dealing with cross-border income tax measures. The government has invited comments by September 13, 2013.
The principal proposed changes affect the taxation of Canadian taxpayers with investments in foreign affiliates (FAs). Other international measures include changes to the rules relating to functional currency reporting and determining the residence of international shipping corporations, and a broadening of the definition of “taxable Canadian property” (TCP). While there are tightening measures, such as amendments to ensure inclusion of stub period foreign accrual property income (FAPI) in a taxpayer’s income, many of the changes are relieving in nature and are consistent with recommendations made in “comfort letters” previously issued by the Department of Finance.
The July 2013 Proposals also contain a measure to allow a government official to confidentially provide taxpayer information to law enforcement officers when the official has reasonable grounds to believe that the information will afford evidence of a listed offence, including bribery, money laundering and terrorism financing.
Stub Period FAPI
A Canadian resident taxpayer’s share of FAPI of a “controlled foreign affiliate” (CFA) of the taxpayer is included in the income of the taxpayer for its taxation year in which the CFA’s taxation year ends. The determination of a taxpayer’s share is based on its “participating percentage” in the CFA at the end of the CFA’s taxation year. If the CFA is sold before the end of its taxation year, then the CFA will not have a taxation year-end in the taxpayer’s year, and the taxpayer will not have a FAPI inclusion for that year. Similarly, if a taxpayer reduces its interest in a CFA during a year, the taxpayer will not have a FAPI pick-up in respect of the portion of its interest in the CFA that was reduced.
The July 2013 Proposals dramatically change these rules by providing that when a taxpayer’s “surplus entitlement percentage” (SEP) in respect of a CFA decreases at a particular time, the CFA is deemed to have a taxation year-end immediately before that time. As a result, the taxpayer’s share of the CFA’s FAPI for the stub period ending upon the decrease in SEP is included in the taxpayer’s income for the year.
This new measure contains a very limited exception for certain transactions within a corporate group where the disposition of shares of a CFA by one group member does not result in a decrease in the overall SEP of the group (because the decrease in SEP is offset by a corresponding increase in the SEP in the CFA by another Canadian-resident taxpayer that is “connected” to the first taxpayer). Taxpayers are considered to be connected if one holds 90% or more of each class of shares of the other taxpayer, or another Canadian-resident taxpayer holds 90% or more of each class of shares of both taxpayers. The exception does not appear to accommodate Canadian-resident taxpayers that are not corporations.
The draft provisions, as currently contemplated, seem to raise a number of significant issues. The requirement to calculate FAPI is triggered every time that there is a reduction in a taxpayer’s ownership interest in a CFA regardless of how small that reduction is. For example, where a CFA has local managers who are compensated in part with equity of the affiliate, the obligation to determine the FAPI of the affiliate could arise multiple times during the year even if the overall reduction in the Canadian taxpayer’s interest in the CFA over the entire year was relatively minor. Furthermore, where a taxpayer’s ownership interest in a CFA both increases and decreases throughout the year, its share of a CFA’s FAPI for the period may be overstated. There would also seem to be a number of technical issues, including how foreign accrual tax (FAT) is to be allocated to these FAPI amounts and how to deal with significant intra-period changes in the CFA’s income or loss.
These changes come into force on July 12, 2013.
Foreign Corporations Without Share Capital
Many of the rules in the Income Tax Act (Canada) (ITA)dealing with a taxpayer’s interest in a corporation, including interests in an FA, look to ownership of shares of a particular class of capital stock of a corporation. This has led to a degree of uncertainty as to how certain provisions of the ITA, including the FA rules, are to be applied to foreign entities that would be treated as corporations for purposes of the ITA but do not have share capital in the conventional sense. A common example of such an entity would be a U.S. limited liability company (LLC) in which owners may hold membership interests rather than shares. The Canada Revenue Agency (CRA) has generally taken administrative positions as to what constitutes a share of a foreign entity characterized as a corporation for purposes of the ITA that have alleviated much of this uncertainty. That being said, there have been inconsistent positions adopted by CRA, including with respect to LLCs, that cast doubt on how the FA rules are to be applied to such entities particularly where there are different classes of interests.
The July 2013 Proposals contain measures to deem non-resident corporations without share capital to have share capital. Generally, the new rules deem equity interests in a foreign corporation without share capital that have identical rights and obligations to be shares of a separate class of the corporation allowing such a foreign corporation to be treated for purposes of the FA rules as if it had different classes of shares. Equity interests are considered to have identical rights and obligations provided that any differences in those rights and obligations are proportionate. Deeming rules allocate notional shares of a class of the foreign corporation among the equity interest holders of that class based on the relative fair market values of the holders’ equity interests of that class. It is not clear how this deeming rule would apply where a member of the foreign entity has a “carried interest,” which may be very difficult to value.
These rules should nonetheless reduce uncertainty with respect to the treatment of some LLCs and other non-share foreign companies, especially in the FA context.
This provision applies retroactively to taxation years of non-resident corporations that end after 1994, but a taxpayer may elect to have the amendment apply prospectively only (i.e., after July 12, 2013).
Partnerships and Foreign Affiliates
A number of years ago, the Department of Finance introduced rules to ensure that the FA rules would apply properly where FAs were owned by, or carried on business through, partnerships. Although simple enough in concept, over the years a number of shortcomings have been discovered and additional technical amendments were required. The July 2013 Proposals continue this trend by introducing additional changes, a number of which were the subject of earlier Department of Finance “comfort” letters.
Where a Canadian-resident corporation owns shares of a foreign corporation through a partnership, subsection 93.1(1) of the ITA provides a look-through rule that deems the Canadian corporation to own a proportionate share of the foreign corporation’s shares, based on the relative fair market value of the Canadian-resident corporation’s interest in the partnership. The July 2013 Proposals will expand the list of ITA provisions to which the look-through rule applies, and the change will generally be effective after July 12, 2013.
Proposed changes will also allow for the proper flow-through of FA dividends received by a taxpayer through tiered partnerships, based on the taxpayer’s proportionate direct or indirect share of the fair market value of all direct interests in the partnership. This change applies to dividends received after November 1999.
The July 2013 Proposals also include rules to deem a partnership to be a corporation and to be a resident of a particular country in certain limited circumstances. Interest earned by an FA on money loaned to a partnership, all of the partners of which were resident in the country in which the partnership carries on business, to finance the partnership’s acquisition of a “third affiliate,” will (assuming the other conditions in the provision are met) be deemed to be active business income under clause 95(2)(a)(ii)(D) of the ITA. This rule applies to taxation years of an FA of a taxpayer that end after July 12, 2013.
Other proposed rules related to partnerships in the FA context include relieving changes related to amounts included in FAPI. These changes deal with the flow-through of dividends and capital gains realized by an FA, an interest in which is owned through one or more partnerships.
Fiscally Transparent Foreign Affiliates
Where FAPI is included in a Canadian taxpayer’s income, a deduction is available in respect of taxes paid or deemed to have been paid (i.e., FAT) in respect of the FAPI. In order to qualify as FAT, the local tax generally must be paid by the relevant FA. This can be problematic where FAPI is earned in a fiscally transparent entity (FTE) such as a U.S. LLC, where the tax liability relating to the LLC’s income is actually imposed on its members/shareholders. The new proposals deal with this issue by allowing FAT to be claimed in certain circumstances in respect of income or profits taxes paid by another FA that is a shareholder of the FTE.
This change applies in respect of taxation years of an FA of a taxpayer that end after 2010.
Changes are also proposed to the regulations relating to the calculation of surplus accounts of FAs to make the necessary adjustments to such accounts where foreign taxes relating to an FA that is an FTE are paid by its shareholder.
Deemed Active Business Income – Interest on Money Borrowed to Acquire Shares of a Foreign Affiliate – “Same Country” Rule
Subparagraph 95(2)(a)(ii) of the ITA is a special rule that allows qualifying inter-affiliate payments to be re-characterized as income from an “active business.” Where an FA earns interest income from a second FA on borrowed money used by the second FA to acquire shares of a third FA that are excluded property, clause 95(2)(a)(ii)(D) will deem such interest to be income from an active business, provided, among other conditions, that the second FA and third FA are resident in, and subject to income tax in, the same foreign country. The July 2013 Proposals will liberalize the inter-affiliate payments rule by removing the “same country” requirement for the second and third FAs.
This change applies to taxation years of an FA that end after July 12, 2013.
Deemed Active Business Income Under Subparagraph 95(2)(a)(i)
Subparagraph 95(2)(a)(i) of the ITA deems income from property of an FA to be “active business income” if certain conditions are met, including that the income could be considered to be directly related to income from an active business earned by another qualifying FA. As suggested in a previously released comfort letter, the scope of this provision is being expanded to encompass situations involving partnerships.
This change is effective for taxation years of an FA beginning after July 12, 2013, unless the taxpayer elects to have it apply retroactively to taxation years of the FA that end after 2007.
Changes to the “Base Erosion” Provisions in the Foreign Affiliate Rules
The July 2013 Proposals contain changes to some of the “base erosion” provisions of the FA rules. These special rules deem income of an FA that would otherwise be income from an active business to be included in FAPI in certain cases where the payment erodes the Canadian tax base. One of these rules that deems income earned by an FA from the provision of certain services is being narrowed to make it clear that it will not apply to fees for services performed by a non-resident outside of Canada. This change is effective for taxation years of an FA beginning after July 12, 2013, unless the taxpayer elects to have it apply retroactively for the taxation years of all of its FAs beginning after February 27, 2004.
As well, a new safe harbour from a base erosion rule dealing with the sale of property by an FA will apply to sales of property manufactured, produced or processed under a qualifying contract manufacturing arrangement. This change applies to taxation years of an FA that end after 2008.
Subsection 85.1(3) of the ITA allows a taxpayer to dispose of the shares of an FA to another FA of the taxpayer on a tax-deferred, or “rollover,” basis. Subsection 85.1(4) is an anti-avoidance rule that denies the rollover treatment in subsection 85.1(3) where all or substantially all of the property of the transferred FA is excluded property and the disposition is part of a “series of transactions” whose purpose is to sell the transferred FA shares to an arm’s length third party.
The Department of Finance is concerned that the “foreign merger” rules could be used to circumvent this anti-avoidance rule and is therefore proposing a new rule, denying rollover relief on a foreign merger where, immediately after the merger, the merged foreign corporation is an FA of the taxpayer, the shares of the new foreign corporation are excluded property of another FA of a taxpayer, and the foreign merger is part of a “series of transactions” whose purpose is to sell the shares of the merged foreign corporation to an arm’s length third party.
This provision applies to foreign mergers that occur after July 12, 2013.
The explanatory notes accompanying the July 2013 Proposals note that Australia has unique tax and commercial law rules that make a commercial trust the preferred entity to carry on certain types of active business activities. Where certain conditions are met, an Australian trust will be deemed, for purposes of the FA and FA dumping rules, not to be a trust and to instead be a non-resident corporation. This helpful new rule will allow distributions from such a trust to a CFA to be treated as (potentially tax-free) inter-affiliate dividends.
This provision comes into force on July 12, 2013, although taxpayers may elect for it to apply retroactively as of January 1, 2006.
Functional Currency Reporting
Section 261 of the ITA allows certain Canadian-resident corporations to determine their Canadian tax results in a functional currency other than Canadian dollars, if certain conditions are met. The July 2013 Proposals will amend the functional currency reporting rules to eliminate certain technical deficiencies, including liberalization of filing requirements and special rules for partnerships.
These amendments generally apply to taxation years that begin after July 12, 2013.
Real Estate/Resource-Rich Public Entities Held Through Partnerships
Subject to treaty relief, non-residents of Canada are taxable on any gain from the disposition of TCP. TCP includes real property situated in Canada, Canadian resource property and timber resource property, as well as certain shares and other equity interests that derive their value principally from such types of property. The existing definition of TCP generally includes a listed share of a public company if, at any time during the 60 months preceding the disposition, the taxpayer together with any persons that do not deal at arm’s length with the taxpayer owned 25% or more of the shares of any class and the share derived more than 50% of its fair market value from real/resource property situated in Canada. Similar rules apply to mutual funds.
Generally, when a partnership disposes of property that is TCP of the partnership, the gain is calculated at the partnership level and allocated to each partner.
Under the July 2013 Proposals, in determining whether the 25% ownership test described above has been met, a taxpayer will have to take into account all shares or units owned by any partnership in which the taxpayer or any non-arm’s length person has any direct or indirect interest.
The purpose of this proposed change appears to be to prevent a non-resident of Canada from avoiding tax on the disposition of real/resource property-rich public company shares through a partnership. However, the rule appears unnecessarily broad, in that it will apply to non-residents on a disposition even if they hold only a de minimis interest in a partnership that holds a 25% or greater interest in a class of public company shares. While such a disposition would be exempt from “section 116” withholding and compliance, the non-resident would still be liable for the tax (and related compliance) on any non-treaty-protected gain. This could be particularly burdensome in the case of dispositions by widely held partnerships such as investment funds or private equity funds where the costs of compliance for each non-resident partner might well exceed the gain.
This change is effective for determining whether property is TCP on and after July 12, 2013.
Special rules in the ITA deem certain foreign corporations principally engaged in international shipping to be non-residents of Canada, even if managed and controlled from Canada, and also exempt the international shipping income of non-residents from Canadian tax. These rules are currently based on the concept of the “operation of ships … in international traffic,” which is largely defined by CRA administrative positions. The amendments codify some of these administrative positions by adding a new definition of “international shipping.” The new definition expands upon the existing concept of the “operation of ships” by specifically identifying a number of items that are or are not included in the definition. In particular, “international shipping” will now specifically include activities incidental to the operation of ships — such as accounting and marketing activities — as well as the use of ships in “pooling arrangements.” On the other hand, leasing activities whereby the lessee obtains complete possession, control and command of a ship are excluded from the definition (other than certain intra-group transactions). The new definition is broadly in line with existing CRA policies and with the similar rules applicable under the Organisation for Economic Co-operation and Development model tax convention. The amendments would also broaden the range of business entities and corporate group structures to which the rules would apply.
These changes apply to taxation years beginning after July 12, 2013.