On August 19, 2011, the Federal Minister of Finance released a significant package of proposed amendments to Canada’s income tax rules applicable to Canadian multinational corporations with foreign affiliates (the Proposals). The Proposals apply to most distributions from, and reorganizations of, foreign subsidiaries of Canadian corporations and contain new rules applicable to certain loans received from foreign subsidiaries that remain outstanding for at least two years, among other significant changes. In addition to certain important new measures, the Proposals replace numerous proposed amendments that were released at various times over the past decade and in many cases will have retroactive effect. The Department of Finance will accept comments on the Proposals until October 19, 2011. This update summarizes the key Proposals.
Summary of Key Proposals
The Proposals contain many detailed and technical changes to the Income Tax Act (Canada) (the Act) and the associated Regulations, including the following key measures (which are discussed in more detail below):
- Upstream Loans: New rules will generally deem a loan from a foreign affiliate to be included in a Canadian shareholder’s income if it remains outstanding for at least two years, subject to certain exceptions (such as for certain loans made in the ordinary course of business).
- Hybrid Surplus: The Proposals introduce a new “hybrid surplus” regime, which tracks capital gains realized by a foreign affiliate from the disposition of shares of another foreign affiliate (or partnership interests), where such gains are not taxed in Canada on an accrual basis as foreign accrual property income (FAPI). This new regime forces the exempt and taxable portions of such gains to be distributed together, replacing the internal gain suspension regime that was introduced in 2004 and is now abandoned.
- Foreign Affiliate Mergers and Liquidations: The Proposals amend the rules applicable to the merger of foreign affiliates, as well as the liquidation and dissolution of one foreign affiliate into another or into a Canadian-resident shareholder.
- Distributions/Returns of Capital: A distribution from a foreign affiliate may be characterized as a dividend or as a return of capital (which often depends on the character of the distribution for foreign legal purposes). The Proposals eliminate this distinction and treat all pro rata distributions on shares of a foreign affiliate as a dividend (unless it arises on the liquidation or dissolution of the affiliate or represents proceeds of disposition from the redemption, acquisition or cancellation of a share). Another new rule allows an election to treat a distribution as a reduction of the tax cost in the distributing foreign affiliate’s shares rather than as a distribution of earnings.
- Foreign Exchange: The Proposals amend the manner in which foreign exchange gains and losses are calculated, and prevent foreign exchange gains and losses from arising in respect of a corporation’s own share capital.
- Anti-Avoidance Measures: The Proposals contain a new rule to recharacterize exempt earnings as taxable earnings where the transaction giving rise to the earnings is an “avoidance transaction” as defined for the purposes of Canada’s general anti-avoidance rule. The Proposals also require that the maximum amount of any discretionary deductions be claimed in computing active business earnings where the Canadian rules are relevant (preventing taxpayers from inflating earnings by not claiming discretionary deductions like depreciation).
- Other Loss Rules: The Proposals prevent the generally-applicable loss-suspension rules in the Act from applying to dispositions of “excluded property,” thereby ensuring that such losses are taken into account in computing surplus. The Proposals also prevent certain rollovers on share-for-share exchanges from applying to shares with an accrued loss, and modify certain loss denial rules to generally allow losses on foreign affiliate shares that relate to foreign currency fluctuations where certain offsetting foreign exchange hedging gains are realized.
- FAPI Capital Losses: Similar to the domestic rules, the Proposals will “stream” capital losses included in FAPI to capital gains included in FAPI, preventing such capital losses from being used to shelter other FAPI amounts.
- Consolidated Groups: Relief from FAPI is generally provided through a grossed-up deduction for applicable foreign taxes. Certain compensation payments made by a foreign affiliate within a foreign consolidated tax group (or payments for the use of another corporation’s losses) may be deemed to be foreign taxes for this purpose. The Proposals prevent such payments from being treated as foreign taxes if they reasonably relate to the use of active business losses. However, such payments may be recognized as foreign taxes if the active business losses may reasonably be considered to shelter other active business income during a five year period.
- Other Measures: The Proposals contain other measures applicable to computing “safe income” for tax-free spin-off transactions, the immigration of foreign affiliates to Canada, the “fresh start” rule applicable on certain changes in the character of a foreign affiliates’ income, the computation of policy reserves in a foreign affiliate’s insurance business, and the computation of surplus entitlement percentage (including to address circular shareholdings).
Overview of the Canadian Foreign Affiliate Rules
There are, generally speaking, two sets of foreign affiliate rules in the Act and the associated Regulations. The first, the “foreign accrual property income” or “FAPI” rules, are broad anti-deferral rules applicable to passive income earned by a controlled foreign affiliate of a Canadian taxpayer. Passive income for this purpose very generally includes income from property (such as rents, royalties, interest, and non-foreign affiliate dividends) and income from certain businesses that either have a link to Canada or do not meet certain minimum employee and other requirements. FAPI generally does not include income from an active business carried on by a foreign affiliate. A Canadian shareholder is generally required to include, in its income for a taxation year, its share of any FAPI earned by a controlled foreign affiliate in such year, regardless of whether or not any amount is distributed by the controlled foreign affiliate to the shareholder.
The second set of rules relates to the treatment of dividends received by Canadian corporate shareholders from foreign affiliates, including dividends paid out of earnings generated through the conduct of an active business. Canada has a combined exemption and credit system for the repatriation of foreign affiliate earnings. Generally speaking, where earnings arise from an active business carried on by a foreign affiliate in a country with which Canada has entered into a tax treaty or tax information exchange agreement, such earnings are added in computing “exempt surplus,” which may generally be distributed as a dividend to Canada free of any additional Canadian corporate tax. Other earnings are included in “taxable surplus”, which is taxable upon distribution as a dividend to Canada, subject to a grossed-up deduction in respect of any underlying foreign tax paid on the earnings that generated such surplus. The Proposals add a third category of “hybrid surplus”.
The Proposals, together with proposals discussed in our Osler Update dated February 2, 2010 appear to mark the end of a major overhaul of the foreign affiliate rules that has taken place over the past decade. Significant proposed amendments were released on December 20, 2002, February 27, 2004 (the 2004 Proposals), and December 18, 2009 (followed by draft legislation on August 27, 2010). Incremental changes were enacted in December 2007 and March 2009. In addition, during this period Finance released a series of “comfort letters” and made other public announcements relating in particular to potential changes to the distribution and reorganization rules in the 2004 Proposals. This period also saw the formation of the International Tax Advisory Panel in November 2007, which released a report in December 2008 recommending various changes to Canada’s foreign affiliate rules.
Overview of the Principal Changes in the Proposals
Canadian shareholders of foreign affiliates with taxable surplus (earnings which although not taxable in Canada when earned are taxable on repatriation) could defer tax liability by having their affiliates simply lend their earnings to Canada rather than paying dividends. Canada currently does not have an equivalent to the U.S. IRC 956 Investment of Earnings in U.S. Property rule.
A proposed new rule will treat such loaned amounts as ordinary income for the Canadian shareholder (proportionately based on the borrower’s interest in the lender) if certain conditions are satisfied.
The new rule is modelled on an existing rule that treats certain loans by a Canadian company to a shareholder as ordinary income and it contains similar exceptions (i.e. the rule is not applicable if the loan is made in the ordinary course of the lender’s business or if it is repaid within two years, other than a repayment that is part of a series of loans and repayments).
In addition, relief is available on a year-by-year basis for amounts which would have been fully exempt from Canadian tax if the loaned amount had been distributed as a dividend to the Canadian taxpayer. Thus, the lender’s exempt surplus and grossed-up taxable surplus (amounts which could have been received tax-free) reduce the income inclusion. No relief will be available for the new hybrid surplus account (repository of certain gains on shares and partnership interests described below) unless the hybrid account underlying tax equals or exceeds the amount needed to fully offset the Canadian tax payable on the taxable half of the distribution.
In short, if a dividend of the loaned amount could have been received tax-free, there is no Canadian tax avoidance and an upstream loan will have no net effect (provided that the relevant surplus accounts remain “available” to shelter a potential dividend while the loan remains outstanding). A deduction is permitted when the loan is repaid (other than as part of a series of loans and repayments).
Under a “re-birth” rule, existing upstream loans will be treated as having been made on August 19, 2011 and thus affected taxpayers will have two years to deal with them. The explanatory notes state explicitly that “back-to-back loans (and similar financial arrangements) with arm’s length parties would be considered a misuse of these new provisions and an abuse of the Act as a whole for the purposes of [Canada’s general anti-avoidance rule].”
The Proposals introduce a new “hybrid surplus” regime, which tracks capital gains realized by a foreign affiliate from the disposition of shares of another foreign affiliate (or partnership interests), where such gains are not included in FAPI. Under current rules, 50% of such gains are added in computing each of exempt surplus and taxable surplus. The current rules allow a foreign affiliate to distribute the exempt surplus half of the gains free of Canadian tax while deferring Canadian tax on the taxable surplus half by leaving such amounts invested offshore (or by loaning such amounts back to Canada). The Proposals force the exempt and taxable portion of such gains to be distributed together (with the new upstream loan rules further limiting the ability to make loans back to Canada that remain outstanding for more than two years). A Canadian shareholder is entitled to deduct half of the amount of any distribution out of hybrid surplus, plus a grossed up amount in respect of foreign taxes applicable to the gains included in hybrid surplus. Very generally, if the foreign taxes on gains included in hybrid surplus are at least equal to the Canadian corporate capital gains tax rate then the resulting hybrid surplus may be distributed free of additional Canadian taxes. The default rules provide that dividends are paid in the following order: exempt surplus, hybrid surplus, and taxable surplus, with any remaining amounts being deemed to be paid out of pre-acquisition surplus. Taxpayers may elect to change the default ordering, by having dividends paid out of taxable surplus or pre-acquisition surplus before hybrid surplus, for example. Some differences arise in the timing and manner in which hybrid surplus is computed relative to that of exempt and taxable surplus (such as hybrid surplus arising at the time of a particular sale rather than at the end of a taxation year).
The hybrid surplus regime replaces the internal gain suspension regime that was introduced in 2004 and is now abandoned. The new hybrid surplus rules apply after August 19, 2011 for sales within a corporate group (to a “designated person or partnership”), and otherwise will not apply until after 2012.
Foreign Affiliate Mergers and Liquidations
Broadly speaking, the Proposals contain three sets of rules relevant to foreign affiliate reorganizations:
- rules relating to a liquidation and dissolution of a foreign affiliate resulting in a distribution of property to (and a disposition of shares by) a Canadian-resident shareholder (new subsections 88(3) to (3.5));
- rules relating to a liquidation and dissolution of a foreign affiliate resulting in a distribution of property to (and a disposition of shares by) another foreign affiliate of a taxpayer (new paragraph 95(2)(e)); and
- rules relating to merger involving a foreign affiliate (new paragraph 95(2)(d.1)).
Liquidations and dissolutions involving a Canadian shareholder
Current subsection 88(3) provides a tax-deferred rollover where shares of a foreign affiliate are distributed to a Canadian shareholder on the liquidation and dissolution of a controlled foreign affiliate. The distributed shares are deemed to be disposed of and acquired for proceeds equal to their adjusted cost base unless the taxpayer elects to receive greater proceeds.
The 2004 Proposals envisaged a significantly expanded role for subsection 88(3), which would have applied to any property distributed to a Canadian shareholder on a liquidation and dissolution, on a redemption of shares, as a payment of a dividend, or otherwise as a distribution of property. The 2004 Proposals created significant uncertainty and complexity, resulted a series of detailed “comfort letters,” and spawned the concept of “foreign paid-up capital” (that has now been abandoned).
In the Proposals, subsection 88(3) is more closely aligned with the current Act, applying solely to a foreign affiliate liquidation and dissolution. However, it has been expanded to apply to all property distributed to the shareholder upon a “qualifying liquidation and dissolution” (QLAD). For other liquidations the rollover rule will only apply to distributed property that is a share of another foreign affiliate that is “excluded property”.
Generally speaking, a QLAD exists where a 90% ownership threshold is met and the taxpayer elects in accordance with the prescribed rules. The 90% ownership threshold is met where the taxpayer owns 90% or more of the shares of each class throughout the liquidation and dissolution, or where the taxpayer is entitled to receive 90% or more of the net fair market value of the property distributed to shareholders upon the liquidation and has 90% or more of the voting shares of the affiliate.
All property of the liquidating affiliate on a QLAD (or solely “excluded property” foreign affiliate shares on other liquidations) is deemed to be disposed of for proceeds of disposition equal to its relevant cost base (RCB) and to be acquired by the shareholder for the same amount. RCB is essentially the amount that gives rise to no gain or loss from the property, subject to the ability for the taxpayer to elect a higher amount if the affiliate is an “eligible controlled foreign affiliate” (being a controlled foreign affiliate in respect of which the taxpayer’s participating percentage is 90% or more). If a higher amount is elected, any gain realized on the property is treated as FAPI, regardless of whether the property is “excluded property”. All other property on a non-QLAD is disposed of (and acquired by the shareholder) for fair market value. FAPI will arise only if such other property is not excluded property.
The taxpayer’s proceeds of disposition of the shares disposed of on a liquidation and dissolution (QLAD and non-QLAD) is equal to the aggregate cost of the properties distributed, net of any amounts owing assumed or cancelled as a result of the distribution.
In the case of a QLAD, a “supression election” is available to prevent any gains that may otherwise be realized by the shareholder on the disposition of the share of the dissolved affiliate, after taking into account any deemed dividend election. The supression election permits the taxpayer to reduce the proceeds of disposition of any capital property distributed by the dissolving affiliate (thereby reducing the shareholder’s proceeds from the disposition of the dissolving affiliate’s shares). The aggregate reduction cannot exceed the capital gain that would otherwise have been realized on the shares. By making a suppression election the taxpayer can defer the capital gain that would otherwise have been realized on the shares of the dissolving affiliate; such gain would continue to be reflected in the capital assets acquired from the affiliate in respect of which reduced proceeds were claimed. The suppression election is ignored for certain purposes, such as the FAPI computation rules (no FAPI loss may be created) and for surplus computation purposes.
An election is also available with respect to shares of a Canadian corporation that are taxable Canadian property to the dissolving affiliate; where there is a QLAD, and the shares are not treaty-protected property, the taxpayer and the affiliate may jointly elect for the shares to have been disposed of for proceeds equal to their adjusted cost base.
The new subsection 88(3) rules apply for liquidations and dissolutions beginning after February 27, 2004. A taxpayer may also elect for the rules to apply in a similar manner to property received on a redemption, acquisition or cancellation of shares of a foreign affiliate, on a payment of a dividend by, or on a reduction of the paid-up capital of a foreign affiliate. This is consistent with the Department of Finance promise that taxpayers who had relied on the 2004 Proposals would not be negatively impacted by subsequent amendments.
Liquidations and dissolutions involving a foreign affiliate shareholder
Current paragraphs 95(2)(e) or (e.1) apply to a liquidation and dissolution of one foreign affiliate into another. Where the Canadian shareholder has an interest in the two foreign affiliates of at least a 90% (specifically a 90% surplus entitlement percentage (SEP)) and no gain or loss is recognized under the local law in respect of property distributed on the liquidation and dissolution (where the dissolving affiliate and the shareholder are resident in the same country), these rules generally provide a full rollover for all capital property, as well as proceeds equal to cost for the shares of the dissolved affiliate. Where the 90% SEP or non-recognition requirements are not satisfied, the rules provide for the disposition of other foreign affiliate shares for proceeds equal to RCB.
Under the Proposals, the current rules would be replaced with new paragraph 95(2)(e). New paragraph 95(2)(e) is very similar to subsection 88(3); where a liquidation and dissolution is a “designated liquidation and dissolution” (DLAD), all property is disposed of at RCB; if it is a non-DLAD, only excluded property shares of other foreign affiliates are disposed of at RCB, all other property is disposed of for fair market value proceeds. A DLAD is very similar to a QLAD, except no election is required. The 90% ownership threshold will be satisfied if the taxpayer has a 90% or greater SEP or if a shareholder that is a foreign affiliate of the taxpayer holds 90% or more of the issued shares of each class of the dissolving affiliate. The 90% net fair market value of distributed property and voting power test, as described above, is also available.
A shareholder’s proceeds from the disposition of the shares of the dissolving affiliate under the new rule are determined based on the following:
- if there is a DLAD and there is an accrued gain in the shares with proceeds determined using the aggregate cost of all property distributed to the shareholder in respect of the shares, the proceeds are equal to ACB;
if there is a DLAD and there is an accrued loss in the shares with proceeds determined using the aggregate cost of the distributed property:
- if the shares are not excluded property, the proceeds are equal to ACB;
- if the shares are excluded property, the proceeds are equal to the aggregate cost of the distributed property;
- if there is not a DLAD, the proceeds are equal to the aggregate cost of the distributed property.
Where there is a DLAD, the shareholder is deemed to be a continuation of and the same corporation as the dissolved affiliate for various purposes relating to loss suspension and FAPI computation rules.
The new liquidation and dissolution rules apply to liquidations and dissolutions beginning after August 19, 2011, subject to the ability to elect for it to apply (with certain modifications) to liquidations and dissolutions beginning after December 20, 2002.
Foreign affiliate mergers
The rules for foreign affiliate mergers are in paragraphs 95(2)(d) and (d.1) of the current Act. Paragraph (d) applies to shares of a merging affiliate held by another foreign affiliate. Current paragraph (d.1) applies to provide a rollover for capital property held by merging affiliates where a 90% SEP threshold is met in respect of each merging affiliate and the merged affiliate and no gains or losses are recognized for relevant foreign tax purposes with respect to capital properties of the merging affiliates.
In the Proposals, new paragraph 95(2)(d.1) will apply where there is a foreign merger of two or more “predecessor foreign corporations” (PFCs) to form a “new foreign corporation” (NFC), where the NFC is a foreign affiliate of a Canadian-resident taxpayer and one or more PFCs was also a foreign affiliate. Where it applies, the new rule provides for a full rollover of all property of a foreign affiliate PFC. The NFC is deemed to be a continuation of and the same corporation as the dissolved affiliate for various purposes relating to loss suspension and FAPI computation rules.
The Proposals also add a rule to clarify that a U.S.-style “absorptive” merger (where one merging corporation ceases to exist and the other remains the “survivor”) qualifies as a foreign merger for purposes of the foreign affiliate merger rules.
New paragraph 95(2)(d.1) applies to mergers occurring after August 19, 2011, subject to the ability to elect to have it apply (with certain modifications) to mergers occurring after December 20, 2002. The new absorptive merger rule applies to mergers or combinations that occur after 1994, subject to the ability to elect to have it apply after August 19, 2011.
Distributions/Returns of Capital
The treatment to a Canadian shareholder of a distribution from a foreign affiliate currently depends in part on whether the distribution is characterized as a dividend or as a return of capital from a foreign corporate law perspective. The Proposals eliminate this distinction and treat any pro-rata distribution on the share of a foreign affiliate as a dividend, except where the dividend is received on the liquidation or dissolution of the affiliate or represents proceeds of disposition from the redemption, acquisition or cancellation of a share. This change removes some uncertainty that had arisen with respect to the Canada Revenue Agency’s treatment of distributions of share premium and other capital amounts. The Proposals also introduce a new election to treat a dividend as being paid out of pre-acquisition surplus prior to distributions of any other surplus. This change is particularly helpful for distributions from countries such as the U.S. which the Canada Revenue Agency generally treated as dividends and not returns of capital. Since pre-acquisition surplus dividends are fully deductible from taxable income and reduce the shareholder’s basis of a foreign affiliate’s share, the Proposals permit a shareholder to recover its basis in a foreign affiliate’s share in a manner similar to a return of paid-up capital under the current rules. As the pre-acquisition surplus election is not limited to the basis of the foreign affiliate’s shares and may potentially result in a capital gain if such basis becomes negative, the Proposals contain an anti-avoidance rule forcing a dividend treatment in respect of any gain that may be recognized as a result of the election where the relevant affiliate group has net surplus available for distribution. These changes apply after August 19, 2011, unless an election is made for them to apply after February 27, 2004.
Share-for-Share Exchange Rollover
Under the current rules, it is generally possible to transfer shares of a foreign affiliate (held by a Canadian taxpayer or by a foreign affiliate) to another foreign affiliate on a tax-deferred basis, whether the transferred shares have an accrued gain or loss. In the case of shares disposed of by a Canadian taxpayer, the rollover is denied if the foreign affiliate shares are excluded property and are subsequently sold by the transferee to an arm’s length person (other than a foreign affiliate) as part of the same series of transactions. The Proposals modify these rules in two important respects in order to curb the perceived opportunities for the transfer and duplication of losses. First, the Proposals add a new exception that prevents the rollover of foreign affiliate shares with an inherent loss. The consequences of this exemption are set out below under “Other Loss Rules.” Second, the existing rule denying the rollover on certain transfers by a Canadian taxpayer is being extended to include dispositions to arm’s length partnerships or other arm’s length persons (other than a foreign affiliate in which the taxpayer has a qualifying interest, which requires ownership of at least 10% of the foreign affiliate’s shares by fair market value and voting power). These changes apply to dispositions after August 19, 2011.
New Anti-Avoidance Rules
The Proposals contain a number of new anti-avoidance rules aimed at preventing foreign affiliates from inflating or duplicating exempt surplus. First, the Proposals replace the draft surplus suspension rules in the 2004 Proposals for certain intra-group asset and share transfers with a surplus reclassification rule. Under the new surplus reclassification rule, earnings that would otherwise be exempt earnings of a foreign affiliate will be reclassified as taxable earnings if the earnings arose as a result of an “avoidance transaction.” For example, if a foreign affiliate deliberately creates exempt surplus on an intra-group transfer, this rule may apply to deem the surplus created to be taxable surplus. For purposes of this rule, an “avoidance transaction” is defined by reference to the general anti-avoidance rule. This rule applies to transactions entered into after August 19, 2011. Second, for purposes of computing the exempt earnings or loss of certain foreign affiliates (i.e., those that compute earnings using Canadian tax rules) for tax years that end after August 19, 2011, those foreign affiliates are deemed to have claimed the maximum amount of all discretionary deductions (such as tax depreciation deductions) so that the exempt surplus accounts of those foreign affiliates are not inflated. Third, when a foreign affiliate disposes of any shares of another foreign affiliate (i.e., not only shares of another foreign affiliate that are excluded property), the Proposals require the disposing foreign affiliate to treat some or all of the gain as a deemed dividend, to the extent of underlying surplus of the foreign affiliate whose shares were disposed of. This rule ensures that new surplus will not be created by the disposing foreign affiliate to the extent that there is underlying surplus in the disposed-of foreign affiliate (although this rule may also be helpful in cases where the disposed-of shares are not excluded property). Changes to these rules apply to dispositions occurring after August 19, 2011, subject to an election to have them apply to dispositions occurring after February 27, 2004. Finally, for dispositions occurring after August 19, 2011, the Proposals amend the rules that prevent surplus from arising on certain intra-group transfers of capital property where rollover treatment is provided under foreign tax law.
Foreign Exchange Gains and Losses
The Proposals amend the current rules that apply where a taxpayer makes a gain or sustains a loss on capital account from foreign exchange fluctuations. Because the existing rules may potentially apply to such a gain or loss, regardless of whether there is an underlying disposition of property, these rules have been interpreted to apply to a redemption by a corporation of its foreign currency denominated shares. The Proposals will restrict these rules to foreign currency gains or losses in respect of “foreign currency debt” owing by a taxpayer. Therefore, as amended, these rules will no longer apply to permit a corporation to recognize currency-related gains or losses in respect of its own shares. In addition, instead of all currency-related gains and losses for a taxation year being pooled and netted together, the Proposals will treat each foreign currency gain or loss in respect of a foreign currency debt as a separate capital gain or loss from the disposition of currency. The latter measure is part of a group of related amendments in the Proposals that are intended to facilitate the carving out of certain income items, other than active business income, that accrued before a foreign corporation became a foreign affiliate of the relevant taxpayer (or certain other persons). These changes apply, in determining a foreign affiliate’s capital gains and losses, in respect of taxation years of the foreign affiliate that end after August 19, 2011, and in any other case, in respect of gains made and losses sustained in taxation years that begin after August 19, 2011.
FAPI Capital Losses
The determination of FAPI currently takes into account passive income (or losses) and other amounts earned on income account, as well as the taxable portion of certain capital gains (and allowable capital losses). An allowable capital loss may therefore be applied to reduce a FAPI income inclusion, and a FAPI loss carryforward can include allowable capital losses that may be used to offset future FAPI income amounts. In an effort to make the FAPI rules more consistent with the rules applicable to Canadian corporations, the Proposals will “stream” FAPI capital losses so that they are deductible only against FAPI capital gains. In particular, this will be achieved by (a) limiting the amount that allowable capital losses can reduce FAPI to the FAPI taxable capital gains for the year, and (b) allowing FAPI capital loss carryforwards to be applied only against current year FAPI taxable capital gains net of current year FAPI allowable capital losses. Although under the domestic rules capital losses may be carried back three years or forward indefinitely, under the Proposals FAPI capital losses (similar to other FAPI losses) may be carried back three years or forward 20 years. These changes generally apply to taxation years of foreign affiliates ending after August 19, 2011.
Other Loss Rules
Various loss suspension rules in the Act apply to certain transfers of property (such as depreciable property, eligible capital property, and certain kinds of capital property) within an affiliated group. Very generally, these rules are intended to prevent taxpayers from recognizing losses on internal transactions that could be used to shelter other income. The Proposals prevent these loss-suspension rules from applying to dispositions by a foreign affiliate of “excluded property,” thereby ensuring that such losses are taken into account in computing surplus accounts. These changes generally apply after August 19, 2011.
The Proposals also restrict the application of share-for-share exchange rules that allow a tax-deferred rollover where a Canadian resident or a foreign affiliate exchanges shares of a foreign affiliate for consideration that includes shares of another foreign affiliate. Under the Proposals such an exchange of foreign affiliate shares with an accrued loss will no longer occur on a rollover basis and may result in a suspended loss to a Canadian transferor, or a reduction to hybrid surplus to a foreign affiliate transferor.
In addition, the Proposals significantly modify the loss denial rules that may apply where a Canadian resident disposes of shares of a foreign affiliate, or where a foreign affiliate disposes of shares of another foreign affiliate that are not “excluded property,” in respect of which “exempt dividends” have previously been paid. The Proposals generally allow recognition of the portion of such a loss that relates to foreign currency fluctuations, but only to the extent of a corresponding foreign currency gain arising from either (a) settlement of arm’s length foreign currency debt incurred in connection with the acquisition of the transferred shares, or (b) certain currency hedging transactions entered into in connection with the acquisition of the transferred shares. In other words, where there is concurrent realization of a loss on a disposition of foreign affiliate shares and a related gain on the acquisition debt or acquisition hedging arrangements, the resulting loss on the foreign affiliate shares will generally not be denied. These changes generally apply after February 27, 2004, unless an election is made for them to apply after 1994 with certain transitional rules.
Very generally, a taxpayer is permitted a deduction in computing income in respect of any “foreign accrual tax” (FAT) that is attributable to an amount of FAPI that is included in computing the taxpayer’s income. In the context of consolidated group taxation rules within a particular foreign jurisdiction, where a particular foreign affiliate makes a compensatory payment in respect of the use of a loss of another corporation within the group, the payment is deemed to be FAT to the extent that it can reasonably be regarded as in respect of an income or profits tax that would otherwise be payable in respect of a FAPI amount for a taxation year of the taxpayer, had the particular affiliate’s income been determined without regard to the use of such loss. FAT may also arise where the compensatory payment relates to a tax payment by another corporation on behalf of the group. The Proposals limit the scope of any such compensatory payments in respect of a loss of another corporation to payments that can reasonably be considered to be in respect of a loss that is a FAPL of a controlled foreign affiliate of a person or partnership that is, at the end of the taxation year, a relevant person or partnership in respect of the taxpayer. Thus a payment for the use of an active business loss may not generate FAT. An amount denied under this new rule can in qualifying circumstances be reinstated as FAT applicable to the FAPI amount in that taxation year of the particular affiliate in which the loss that caused the denial, and all other losses of any consolidated group members in that same taxation year, could otherwise have been applied to reduce income of the group other than FAPI, provided that such year ends within five taxation years of the taxation year of the taxpayer in which the FAPI is realized. Other rules apply to limit the ability to create FAT related to FAPI capital losses that would not otherwise be deductible under the new FAPI capital loss streaming rules. These changes generally apply to foreign affiliate taxation years that end after August 19, 2011.
The Proposals contain various other technical tax changes that will impact on a variety of investments in foreign affiliates. These other changes include:
- New rules to compute the “safe income” of a foreign affiliate, which is relevant in applying the domestic rules for tax-free spinoff transactions. Under the Proposals safe income of a foreign affiliate will generally be equal to the lesser of the amount that the affiliate could distribute as a dividend free of Canadian taxes (its “tax-free surplus balance”), and the fair market value of the shares of the foreign affiliate. Some transitional relief is provided for arm’s length transactions which were agreed to in writing prior to August 19, 2011.
- Significant amendments have been made to the “fresh start” rules that apply where a foreign affiliate carries on business that earns active business income in one year and FAPI in the next. Very generally, these rules apply a deemed disposition of the affiliate’s assets at the end of its active business year – subject to the potential application of the new anti-avoidance rule discussed above for tax-motivated creations of exempt surplus. These changes apply to foreign affiliate taxation years that begin after December 20, 2002, unless an election is made for them to apply to foreign affiliate taxation years that begin after 1994, with certain transition rules.
- Various amendments have been made to the rules that apply where a foreign affiliate immigrates to Canada. These changes apply to taxation years that begin after 2006.
- Other rules apply for computing policy reserves in a foreign affiliate’s insurance business, computing surplus entitlement percentages and FAPI participating percentages for corporate groups that include circular shareholdings.
Abandoned Former Proposals
Excluded from the ambit of the Proposals are certain changes to the foreign affiliate rules that were previously proposed and now abandoned including:
- Proposed rules relating to the computation of “foreign paid-up capital” or “FPUC” (proposed paragraph 88(3)(e), and subsequent comfort letters from the Department of Finance);
- Proposed “gain suspension” or “surplus suspension” rules relating to certain dispositions of excluded property by a foreign affiliate to another affiliated member of the corporate group (proposed paragraphs 95(2)(c.1) to (c.6) and proposed paragraphs 95(2)(f.3) to (f.9));
- Proposed deeming rules in respect of a non-resident corporation that becomes a foreign affiliate of a Canadian taxpayer relating to the determination of the foreign affiliate’s cost of eligible capital property, and its undepreciated capital cost and capital cost of depreciable property (proposed paragraphs 95(2)(f.91) to (f.93));
- Proposed stop-loss rules applicable in respect of a foreign accrual property loss or “FAPL” that would otherwise arise on certain dispositions of non-excluded property by a foreign affiliate to another affiliated member of the corporate group (proposed paragraphs 95(h) to (h.5)); and
- Proposed “fresh start” rules which resulted in a deemed disposition and reacquisition at fair market value by a foreign affiliate of all of its assets when the business of the foreign affiliate changed from an investment business to an active business (proposed paragraphs 95(2)(k.2) and (k.3)).
Navigating Canada’s foreign affiliate rules is often difficult. The myriad of recent changes, both enacted and proposed, makes it more difficult. Many of the Proposals apply to the current taxation year of foreign affiliates, or retroactively (either automatically or on an elective basis); it is therefore key to review current and past transactions in order to determine the impact of the Proposals and the advisability of making any of the elections provided for.