On August 16, 2013, the Minister of Finance released for consultation draft legislative proposals (the August 16 Proposals) to amend the foreign affiliate (FA) dumping rules. The government has invited comments by October 15, 2013. It is expected that the government will then introduce these measures into Parliament in the autumn 2013 session.
Broadly speaking, the FA dumping rules were introduced to prevent foreign multinational corporations from achieving tax advantages by causing their Canadian subsidiaries to hold investments in FAs. The specific tax advantages targeted by the government include not only the deduction of interest on debt incurred to acquire FAs, but also the ability to defer or avoid completely Canadian withholding tax (WHT) applicable to an upstream cross-border dividend or a transaction that results in a similar outcome. FAs are generally defined to mean foreign companies in which the Canadian shareholder has at least a 10% interest in any class of shares. Dividends paid by FAs out of foreign active business income earned in countries with treaties or tax information exchange agreements are generally excluded from taxable income when received by a corporation resident in Canada.
The FA dumping rules were first introduced in the March 2012 Budget and were enacted into law in December 2012. For a detailed discussion of the FA dumping rules as enacted, see our October 2012 Blakes Bulletin. For discussions of prior drafts of the FA dumping rules, see our August 2012 Blakes Bulletin and our Budget 2012 Blakes Bulletin.
Generally, the FA dumping rules apply where a corporation resident in Canada (CRIC) that is controlled by a non-resident corporation (the parent) makes an "investment in a subject corporation". A subject corporation is a corporation that is or becomes an FA of the CRIC as part of the series of transactions that includes the investment. Where non-share consideration is given by the CRIC to acquire the investment, the CRIC will presumptively be deemed to have paid a dividend to its parent (except to the extent such amount reduces the CRIC's paid-up capital (PUC) as discussed below (the PUC offset rule)) at the time of the investment. The deemed dividend is subject to WHT, even though no amount is extracted from Canada. Where the form of consideration consists of shares of the CRIC, the PUC of such shares will be automatically deemed to be nil.
The August 16 Proposals contain changes to the FA dumping rules and the thin capitalization rules, generally of a relieving nature, including:
- Amending the computation of a CRIC's cross-border-related party debt for purposes of the thin capitalization rules to exclude loans that fund PLOIs (as defined below) for purposes of determining the CRIC's debt-to-equity ratio under such rules
- Limiting the application of the FA dumping rules where a CRIC makes an investment in an FA before the CRIC becomes controlled by the parent and aligning the timing of any deemed dividend which an acquisition of control of the CRIC by the parent for purposes of WHT and the PUC offset rule
- Making the application of the PUC offset rule completely automatic and significantly amending the scope of the "dividend substitution" election (the QSC election) that allows other Canadian members of the corporate group (qualifying substitute corporation or QSCs) to be treated as having paid the dividend
- Extending the application of the rule that "reinstates" previously reduced PUC in certain circumstances (the PUC reinstatement rule), including expanding the types of FA investments to which the rule could apply and extending its application to circumstances where the CRIC distributes to its parent amounts it has received as interest on or from the repayment or sale of certain debt obligations owed to the CRIC by an FA
- Broadening the rules which except certain amalgamations of taxable Canadian corporations from the FA dumping rules by ensuring that such an amalgamation will not result in a shareholder of the amalgamated corporation being considered to have made an indirect acquisition in a subject corporation as a result of the amalgamation.
However, the August 16 Proposals also include amendments that narrow the corporate reorganization exception relating to exchanges of FA debt for equity and measures to prevent taxpayers from using certain relieving provisions to avoid the application of the FA dumping rules, for example, by undertaking transactions that take advantage of the PLOI rules and the corporate reorganization exceptions.
While the August 16 Proposals do not significantly simplify the complexity inherent in the FA dumping rules, these Proposals include many welcome changes signalling the government's willingness to narrow the rules to carve out transactions that do not pose a threat to the Canadian tax base and to ease compliance requirements relating to the rules.
The impact of the rules and the proposed changes should be carefully considered by any foreign investor planning an acquisition of, or investment in, any Canadian company with foreign operations including in the context of a public offering of securities.
Exclusion of Loans that Fund PLOIs from Thin Capitalization Calculation
The Canadian thin capitalization rules limit the ability of a CRIC to deduct interest to the extent the corporation's "outstanding debts to specified non-residents" exceeds, generally, 1.5 times the total of the corporation's retained earnings, contributed surplus and PUC. Further, these non-deductible interest payments are deemed to be dividends paid by the CRIC for WHT purposes, resulting in the imposition of a 25% WHT on such non-deductible interest (unless reduced by an applicable tax treaty). A "specified non-resident" is generally a significant shareholder or a person related to a significant shareholder.
The August 16 Proposals amend the definition of "outstanding debts to specified non-residents" by excluding from such definition a debt obligation (made by a specified non-resident to a CRIC) that is entered into as part of a series of transactions or events that includes a loan that is a "pertinent loan or indebtedness" (PLOI) made by the CRIC to a subject corporation of the CRIC where the debt obligation can reasonably be considered to directly or indirectly fund the PLOI. For this purpose, a PLOI is generally an amount owing by a subject corporation to a CRIC provided that the CRIC and its non-resident parent have made a joint election in respect of the amount owing. A PLOI generally results in an amount of interest calculated at a prescribed rate being included in the income of the CRIC. However, where a PLOI made by a CRIC is funded by a debt obligation, the amount included in the income of the CRIC is equal to the greater of such prescribed interest amount and the amount of interest payable by the CRIC (and certain non-arm's length persons) on the debt obligation. The Explanatory Notes to the August 16 Proposals explain that subjecting interest payable on a debt obligation owing to a specified non-resident to the thin capitalization rules where such debt is used to fund a PLOI to a subject corporation is not necessary because the PLOI rules ensure that the interest included in the CRIC's income is at least equal to the interest payable by the CRIC on the debt obligation.
This amendment will apply to taxation years that end after March 28, 2012.
Acquisition of a CRIC After the Investment Time
Under existing law, if a CRIC becomes controlled by a non-resident corporation at any time during a series of transactions that includes an investment in a subject corporation, the FA dumping rules may apply, even if the CRIC is not controlled by the non-resident corporation at the investment time or any time after the investment time. As the term "series of transactions" has been interpreted broadly by Canadian courts, there have been concerns that the FA dumping rules may inadvertently apply to transactions that do not offend the policy of the provisions. The August 16 Proposals contain two relieving measures in this regard.
The August 16 Proposals provide that the FA dumping rules will not apply where a CRIC becomes controlled by a non-resident corporation prior to, and as part of the series of transactions or events that includes, the making of the investment, provided that (1) the CRIC is not controlled by a non-resident corporation at the investment time, and (2) the CRIC does not become controlled by a non-resident corporation after the investment time and as part of the series that includes the making of the investment. Accordingly, pursuant to the August 16 Proposals, the FA dumping rules will not apply in a situation where a CRIC, as part of the series of transactions that includes an investment, is only controlled by a non-resident corporation prior to the investment time.
Under existing law, because of the broad interpretation given to a series of transactions, the FA dumping rules require a non-resident corporation that is considering acquiring a CRIC to consider whether its acquisition would be considered to be part of a series of transactions that includes any investments of the CRIC in a subject corporation made prior to the non-resident corporation's involvement with the CRIC. The August 16 Proposals contain a new "safe harbour" that is intended to reduce impediments in corporate takeover situations. The "safe harbour" provides that where a CRIC is not at the investment time controlled by a non-resident corporation (the parent), but subsequent to the investment time and as part of a series becomes controlled by the parent, the FA dumping rules apply only if one of the three following conditions is met:
- At the investment time, the parent, either alone or together with non-arm's length persons, owns shares of the CRIC that give the holders thereof 25% or more of the votes or value of all the shares of the CRIC. For these purposes, ownership of the CRIC's shares by the parent and each non-arm's length person is to be determined as if all contractual rights to acquire such shares were exercised.
- The investment is an acquisition of FA shares that are in substance preferred shares and the subject corporation is not a "subsidiary wholly-owned corporation" of the CRIC throughout the series of transactions that include the investment.
- Under an arrangement entered into in connection with the investment, a person or partnership, other than the CRIC or a related person, has in any material respect the risk of loss or opportunity for gain or profit with respect to a property that can reasonably be considered to relate to the investment.
The August 16 Proposals also include similar timing rules meant to align the timing of any deemed dividend (and the measurement time for reduction of PUC under the PUC offset rule as discussed below) with the timing of the acquisition of control of a CRIC by a non-resident corporation. As mentioned above, where non-share consideration is given by a CRIC to acquire an investment, the FA dumping rules result in the CRIC being deemed to have paid a dividend to its parent (subject to the PUC offset rule discussed below) at the investment time. The August 16 Proposals provide that the dividend will be deemed to have been paid by the CRIC at the "dividend time", not at the investment time. The dividend time in respect of an investment is:
- If the CRIC is controlled by the parent at the investment time, the investment time, or
- In any other case, the earlier of (1) the first time, after the investment time, at which the CRIC is controlled by the parent, and (2) the day that is 180 days after the day that includes the investment time.
These amendments are relieving in nature in most circumstances. In a situation where the FA dumping rules deem a dividend to be paid by a CRIC prior to its acquisition by a non-resident corporate parent, if the parent acquires control of the CRIC within 180 days of the investment time, the dividend will be deemed to have been paid at the time of the acquisition of control, which would generally allow for the parent to access the lower 5% WHT rate that is generally available under Canada's bilateral tax treaties. It is not entirely clear why the August 16 Proposals limited this beneficial treatment to situations where the CRIC became controlled by the parent within 180 days of the investment time, when there may be circumstances where the 180-day requirement cannot be met due to commercial reasons (for example, regulatory approval requirements). In another context, the Department of Finance has indicated that it typically expects commercial transactions to be completed within 180 days of the signing of an agreement in respect of the transaction and it could be concerned that taxpayers could abuse this relieving provision without an outside limit.
For the purposes of determining whether the CRIC is controlled by a non-resident corporation, the August 16 Proposals contain an anti-avoidance rule that ensures that the FA dumping rules cannot be avoided where the CRIC is held through a related group of non-resident holding companies, no member of which has voting control of the CRIC (the group control anti-avoidance rule).
Except for the group control anti-avoidance rule which applies in respect of transactions and events that occur on or after August 16, 2013, these amendments will apply in respect of transactions and events that occur after March 28, 2012, subject to an election to have them come into force on August 14, 2012.
Dividend Substitution Election and PUC Offset Rule
The QSC election was introduced to address specific problems that arise if the FA investment is made by a lower-tier CRIC, i.e., a CRIC owned by another Canadian holding company rather than owned by the foreign parent directly. Under the current rules, if the investment is made by such a lower-tier CRIC and no QSC election is made, then two problems arise:
- The potentially lower (often 5%) treaty withholding rate on cross-border dividends cannot be accessed under some treaties (including the Canada-U.S. treaty), so the deemed dividend will be taxed at a higher rate (often 15%)
- No PUC offset is available.
The QSC election under the current rules deals with these problems by essentially allowing the group to:
- "Move" all or part of the deemed dividend to one or more other Canadian members of the group the shares of which are owned by the parent or other foreign members of the group
- Treat the deemed dividend to have been paid directly to the parent or to another foreign corporation controlled by the parent.
As a consequence of the proposed changes contained in the August 16 Proposals, the scope of the QSC election is restricted. As discussed below, the PUC offset rule is amended such that it applies automatically in all circumstances, even where the FA investment is made by a lower-tier CRIC. Thus, the QSC election is not necessary in order for the PUC offset rule to apply to an investment made by a lower-tier CRIC. Rather, the QSC election merely allows the corporate group to elect to have the dividend deemed:
- To be paid by either the CRIC or a QSC
- To be paid to the parent or a non-resident corporation that does not deal at arm's length with the parent.
Thus, it appears that the utility of the QSC election under the August 16 Proposals is limited to accessing a lower treaty WHT rate on the portion of the deemed dividend that is not reduced by the PUC offset rule. However, unlike the current rules where all or part of the deemed dividend may be elected to be paid by the CRIC and/or one or more QSCs as agreed to in the election (provided that the total of all agreed amounts is equal to the amount of the dividend), the August 16 Proposals appear to only allow the entire amount of the deemed dividend to be paid by either the CRIC or one QSC.
While the utility of the QSC election under the August 16 Proposals is more limited, the August 16 Proposals expand the definition of QSCs to include certain Canadian-resident corporations that are controlled by a non-resident corporation not dealing at arm' length with the parent (not just those controlled by the parent). The August 16 Proposals also ease the filing requirements for the QSC election by removing the requirement that all QSCs be parties to the election. Only the QSC electing to be the payor of the deemed dividend will be required to be a party to the election.
Under the current rules, where a QSC election is not made, the PUC offset rule applies automatically only to:
- Any cross-border PUC of the CRIC where the CRIC is a top-tier CRIC with only one class of shares, or
- Any cross-border PUC of a top-tier CRIC with more than one class of shares where the PUC is created as a result of funding the CRIC's investment, i.e., the investment can be traced to the PUC.
The August 16 Proposals amend the PUC offset rule to make it apply automatically in all circumstances where there is cross-border PUC in any class of shares of the CRIC and/or one or more QSCs (referred to as a cross-border class), any of which shares are owned at the dividend time by the parent or another non-resident corporation not dealing at arm's length with the parent, regardless of whether the CRIC is a top-tier CRIC, has more than one class of shares and whether the creation of the PUC can be traced to the investment.
Under the new automatic PUC offset rule, where the amount of the deemed dividend is equal to or greater than the total PUC of all cross-border classes immediately before the dividend time, the amount of the dividend is reduced by the total PUC and the PUC of each cross-border class is reduced to nil. Where the amount of the deemed dividend is less than the total PUC of all cross-border classes immediately before the dividend time, the amount of the dividend is reduced to nil and the PUC of the cross-border classes is reduced in total by the amount of the dividend. Similar to the current rules where a QSC election is made, special rules allocate the PUC reduction among the different cross-border classes in a manner that steer the PUC offset as much as possible to cross-border classes owned by the parent or another non-arm's length non-resident corporation.
Where a deemed dividend is reduced by the PUC offset rule, the CRIC is require to file a prescribed form with the Minister on or before the 15th day of the month following the month that includes the dividend time, setting out:
- The PUC of each cross-border class immediately before the dividend time.
- The PUC of the shares of each such cross-border class that are owned by the parent or another non-arm's length non-resident corporation
- The reduction in the PUC of each cross-border class under the PUC offset rule.
The requirement to provide such information in a prescribed form within 15 days following the month of the dividend time may be onerous in certain circumstances, particularly in cases where the filing due-date may occur before the acquisition of control of the CRIC by the parent. Subject to a transitional election for transactions that occur before August 14, 2012, transactions that occurred before August 16, 2013 are not grandfathered from this filing requirement. However, failure to file the prescribed form does not affect the automatic application of the PUC offset rule.
While the completely automatic nature of the new PUC offset rule is helpful in most cases, there may be situations where multinationals might actually prefer deemed dividend treatment, for example, where cross-border PUC is critical under the thin capitalization rules to maintain the deductibility of interest on cross-border-related party debt. Certain strategies that may mitigate unwanted PUC offsets under the current rules, such as not making the QSC election where the CRIC is a lower-tier CRIC, will not be effective under the new PUC offset rule. Multinationals which intend to preserve cross-border PUC will need to consider alternative strategies.
The amendments to the QSC election and the PUC offset rule apply in respect of transactions and events that occur after March 28, 2012, subject to an election to have them come into force on August 14, 2012.
PUC Reinstatement Rule
The PUC reinstatement rule allows a recovery or reinstatement of PUC of the CRIC or a QSC that was reduced under the PUC offset rule, or where share consideration was given by the CRIC for the investment, to allow the CRIC or the QSC to distribute FA shares and certain other property free of WHT in certain circumstances.
Generally, the August 16 Proposals expand the PUC reinstatement rule as follows:
- To apply to all types of investments in a subject corporation, other than certain options or interests in shares of debts of FAs (rather than just to investments that are acquisitions of FA shares, contributions of capital to an FA or indirect acquisitions of an FA under the current rules), thus allowing PUC previously reduced as a result of an investment in debt of the FA to be reinstated when the CRIC or QSC distributes to the parent amounts received as a repayment of, or proceeds from the disposition of, the FA debt, or received as interest on the debt, in each case received no more than 180 days before the distribution
- To apply not only where the CRIC or QSC reduces PUC as part of a return of capital, but also where the PUC is reduced as a result of a redemption, acquisition or cancellation of shares by the CRIC or QSC
- To allow the reinstatement of PUC that may be reduced in respect of the same investment as a result of both the PUC offset rule and share consideration being paid by the CRIC for the investment.
These relieving amendments apply in respect of transactions and events that occur after March 28, 2012, subject to an election to have them come into force on August 14, 2012.
The August 16 Proposals restrict the PUC reinstatement rule in one respect. Where the PUC reinstatement rule does not apply as a result of the distribution by the CRIC or QSC of shares of the FA in which the original investment is made (or substituted shares of an FA of the CRIC or QSC), PUC reinstatement is available only if property traceable to the original investment (either as proceeds of disposition of the FA shares or debt or of repayment of the FA debt or as a dividend or return of capital on the FA shares (or substituted shares) received by the CRIC or QSC is not acquired as part of an investment in a subject corporation to which the FA dumping rules do not apply. Thus, if the CRIC replaces the original FA shares or debt with new shares or other interest in an FA and the investment in the new shares or interest is exempted from the FA dumping rules due to a reorganization exception or the strategic business exception, PUC reinstatement will not be available on the distribution by the CRIC of the new shares or interest or other property, unless the property distributed is new FA shares that are considered to be substituted shares. This new restriction would not apply where the original investment was disposed of for cash since the cash would not be considered to be property acquired as part of an investment in a subject corporation. The new restriction applies in respect of transactions and events that occur on or after August 16, 2013.
The FA dumping rules contain a number of exceptions for corporate reorganizations. The August 16 Proposals make a number of changes to these exceptions, including adding an anti-avoidance rule and limiting an exception relating to exchanges of non-convertible debt, although there are some relieving changes.
The exceptions relating to amalgamations have been broadened in two respects in order to ensure that certain amalgamations of taxable Canadian corporations do not result in any shareholder of a predecessor corporation being considered to have made an indirect investment in a subject corporation, i.e., a "10(f)" investment. These changes fix certain technical issues, including an issue that can arise on the takeover of an FA-rich Canadian public corporation where an amalgamation squeeze-out is necessary to complete the acquisition.
The FA dumping rules do not apply to an exchange of a bond, debenture or note of an FA the terms of which provide for exchange that is held as capital property for no consideration other than shares of the FA; that is, an exchange to which the convertible debt rollover provisions apply (the convertible exception). A separate exception applies to the acquisition of FA shares where such shares are the sole consideration for the exchange of a non-convertible debt obligation owing to the CRIC, whether or not the debt obligation is owing by the FA and whether or not the debt obligation is "a bond, debenture or note" (the non-convertible exception).
Under the current FA dumping rules, subject to the potential application of the general anti-avoidance rule, it may have been possible for a CRIC to utilize a two-step approach to make an investment in a subject corporation that would circumvent the application of the rules. This would be accomplished by the CRIC making a PLOI loan to the subject corporation and subsequently exchanging that loan for shares of the subject corporation. The CRIC would rely on either the convertible exception or the non-convertible exception in order for the subsequent exchange to be excepted from the FA dumping rules.
The August 16 Proposals add a new anti-avoidance rule that provides that the corporate reorganization exceptions (including the convertible exception and the non-convertible exception) do not apply to an investment that is an acquisition of property if the property can reasonably be considered to have been received by the CRIC as repayment in whole or in part, or in settlement, of a PLOI. This amendment applies in respect of transactions and events that occur on or after August 16, 2013, but the Explanatory Notes to the August 16 Proposals include a general anti-avoidance rule warning for any taxpayers that undertook any transactions or events prior to such date that would otherwise be caught by this amendment.
Further, the August 16 Proposals narrow the non-convertible exception from applying to any debt obligations to only applying to a bond, debenture or note of the FA that would qualify for the convertible debt rollover provisions but for the terms of such bond, debenture or note not providing for exchange. Thus, debt obligations that are not evidenced by a bond, debenture or note may no longer qualify for the exception. This amendment applies in respect of transactions and events that occur on or after August 16, 2013.
Strategic Business Expansions
The FA dumping rules contain a business purpose exception that includes a long list of conditions that must be met in order for the exception to apply. While the August 16 Proposals would somewhat broaden this exception, it has not proven to be available in most real world cases and we continue to be skeptical as to its practical utility.