On October 15, 2012, the Minister of Finance (Canada) tabled a Notice of Ways and Means Motion (NWMM) in the House of Commons to implement certain measures from the March 29, 2012 Federal budget (Budget 2012) that were amended in draft legislation released on August 14, 2012 (August Proposals). Bill C-45 received first reading in the House of Commons, as Bill C-45, on October 18, 2012 (Bill C-45). For a full discussion of Budget 2012 and the August Proposals, see previous updates, Harper’s First Majority Government Budget – Tax Changes Include Targeted Measures to Close Perceived Loopholes and Minister of Finance (Canada) Releases Revised Budget Proposals.
Bill C-45 is substantially the same as the August Proposals with respect to the thin capitalization and partnership "bump" proposals, but contains further significant changes to the foreign affiliate (FA) "dumping" and non-resident shareholder loan rules. These changes are generally favourable, reflecting in part submissions that had been made to the Department of Finance by tax organizations and interested parties.
Notwithstanding the relieving nature of many of the changes, the FA dumping and non-resident shareholder loan rules will continue to profoundly alter the way that Canada taxes foreign-controlled corporations resident in Canada (CRIC) in their outbound investments and non residents who acquire Canadian corporations. The following discussion highlights the changes to these rules as contained in Bill C-45.
Changes to FA Dumping Rules
The main operative provisions of the FA dumping rules remain largely unchanged by Bill C-45. However, Bill C-45 contains significant changes that include the introduction of a dividend substitution election for qualifying substitute corporations (QSC), an expansion of the dividend/paid up capital (PUC) set off rule, modifications to the PUC reinstatement rule, an increase in the threshold value for indirect acquisitions, modifications to the pertinent loan or indebtedness (PLOI) rules, changes to the more closely connected business and reorganization exclusions, as well as the introduction of an anti avoidance rule and an indirect funding rule.
- Dividend Substitution Election
New subsection 212.3(3) allows a Canadian resident corporation that is a QSC to be substituted for the CRIC as the payer of the deemed dividend arising under paragraph 212.3(2)(a). Consequently, where a valid election is made, all or a portion of the dividend that would otherwise be deemed to be paid by the CRIC to its non resident controlling corporation (Parent) is instead deemed to be paid by the QSC to either Parent or another non resident corporation (NRC) in the corporate group.
In order to be valid, the election must be filed jointly by the CRIC, all QSCs in respect of the CRIC, including QSCs to which no portion of the deemed dividend is allocated, and Parent, or Parent and the substitute non resident if a portion is allocated to the substitute non resident, by the earliest of the filing due dates for the CRIC and the QSCs for their taxation years that include the time when the CRIC makes the investment. In addition, the election must allocate the full amount of the deemed dividend between shares of some or all of the QSCs and the CRIC, on a class-by-class basis.
Where a valid election is filed, the amount of the deemed dividend paid by the CRIC to the Parent is reduced by the total of all the deemed dividend amounts allocated in the election to classes of shares of QSCs. The remaining portion of the deemed dividend is then deemed to be paid to Parent or the substitute NRC as either a single dividend in respect of a single class of shares of the CRIC or as multiple dividends in respect of multiple classes of shares of the CRIC. In addition, paragraph 212.3(3)(b) provides that each QSC is deemed to pay to either Parent or the substitute NRC a dividend in the amount, in respect of the class of shares, specified in the election.
Subsection 212.3(4) provides that, for the purposes of section 212.3, a QSC, at any time, in respect of a CRIC, means a corporation resident in Canada that is, at that time, controlled by Parent, that has, at that time, an equity percentage (as defined in subsection 95(4)) in the CRIC and shares of the capital stock of which are, at that time, owned by Parent or another NRC with which Parent does not, at that time, deal at arm’s length.
This rule is a welcome change in that it may provide taxpayers with a unique opportunity to shift the deemed dividend to a more favourable treaty jurisdiction in the appropriate circumstances.
- Dividend/PUC Set Off Rules
The QSC definition is not only relevant for the dividend substitution election but, perhaps more importantly, is also applicable for purposes of subsections 212.3(6) and (7), which now contain the dividend/PUC set off rules. In a welcome change, new subsections 212.3(6) and (7) extend the dividend/PUC set off rules to shares of a QSC, effectively allowing a CRIC to access the PUC of a QSC to offset deemed dividends. In particular, subsection 212.3(6) sets out the conditions that must be met for subsection 212.3(7) (the operative rule) to apply.
Paragraph 212.3(6)(a) applies in circumstances where an election has been filed under subsection 212.3(3) and contains two conditions that must be satisfied. The first is that either Parent, or another NRC that does not deal at arm’s length with Parent, must own shares of every class of the CRIC, or a QSC, to which a dividend amount has been allocated in the election. The purpose of this condition is to ensure that there is a reduction of cross border PUC in respect of each class of shares to which the election applies. The second requirement is that the election must result in the greatest possible total amount of hypothetical PUC reduction. To satisfy this condition, the election must allocate the deemed dividend to the class of shares of the CRIC or QSC of which Parent or a non arm’s length NRC owns the greatest proportionate share, followed by the second greatest proportionate share and so on.
Unlike paragraph 212.3(6)(a), paragraph 212.3(6)(b) is non elective and provides that the PUC offset applies automatically in respect of the CRIC shares where specified conditions are satisfied. Where a CRIC has only one class of issued shares and each share that is not owned by Parent is owned by a NRC that does not deal at arm’s length with the CRIC or a person that deals at arm’s length with the CRIC, any dividend will be automatically set off against the CRIC’s PUC calculated immediately before the time of the investment in the subject corporation. Where the CRIC has two or more classes of shares outstanding, there is an additional condition that requires a tracing to the creation of at least some of the PUC in respect of the CRIC shares to a transfer of property to the CRIC, which property was wholly used by the CRIC to make, in whole or in part, an investment in the subject corporation.
Although the automatic PUC offset may be a welcome change for some corporate groups, it could prove to be detrimental for others if they would otherwise be entitled to receive a foreign tax credit for the Canadian withholding tax that would apply to a deemed dividend. In that case, the Canadian withholding tax may not have resulted in an overall increase in Parent’s taxes payable, and the PUC offset reduces a valuable Canadian tax attribute with no net reduction in total tax payable.
- PUC Reinstatement Rule
In keeping with previous iterations of the FA dumping rules, Bill C-45 contains rules that allow a CRIC to reinstate PUC. Bill C-45 expands those rules so that they now apply to a contribution of capital to a subject corporation by the CRIC and an indirect acquisition by the CRIC of shares of a capital stock of a subject corporation where the now 75% threshold is met (discussed below in the context of the indirect acquisition rule). The rule now also applies with respect to distributions that occur within 180 days and that are funded by dispositions of subject shares or dividends and reductions of PUC.
Interestingly, due to the specific wording in the PUC reinstatement rule, it would appear that any reinstatement can only occur in respect of a particular class of shares to which paragraph 212.3(2)(b) or 212.3(7)(b) applied. Consequently, if that particular class of shares no longer exists by virtue of a reorganization of capital or otherwise, it appears that a PUC reinstatement would not be possible.
- Exceptions to the FA Dumping Rules
As noted in our previous update, the August Proposals contain a number of exclusions from the FA dumping rules, including the exclusions for PLOIs, certain indirect investments, more closely connected businesses and certain corporate reorganizations. The significant modifications to those rules are discussed below, as well as a new rule in respect of indirectly funded FAs. The provisions regarding the PLOI or PLI exception to the FA dumping rules have been amended in a way that will make it easier for a CRIC to elect to have a PLOI be subject to the new interest imputation rules set out in section 17.1, and thereby not be subject to the FA "dumping" rules. For details, see below under the heading "Changes to Loans to Non-Residents."
In a welcome change, the definition of investment has been amended in a number of cases but most significantly with respect to the indirect acquisition rule. The indirect acquisition rule is contained in paragraph 212.3(10)(f) and provides that an investment for purposes of section 212.3 includes the indirect acquisition of FA shares by a CRIC by virtue of a CRIC’s direct acquisition of shares of a Canadian resident corporation that meets a certain value threshold.
Under the previous iteration of this rule, an indirect acquisition occurred where a CRIC acquired shares of another Canadian resident target corporation that holds, directly or indirectly, shares of one or more FAs and the total fair market value of all the FA shares held, directly or indirectly, by the Canadian target corporation comprises more than 50% of the total fair market value of all the properties owned by the Canadian target. This rule has been revised in Bill C-45 such that the total fair market value of all the FA’s shares held, directly or indirectly, by the Canadian target corporation must now comprise more than 75% of the total fair market value of all the properties owned by the Canadian target, determined without reference to certain debt obligations.
Bill C-45 expands the closely connected business test in that it now provides that a majority of officers of the CRIC who had exercised principal decision-making authority in respect of the investment may now be resident or in a country in which a particular corporation is resident if the particular corporation is a controlled foreign affiliate (CFA) of the CRIC for the purposes of section 17 and carries on business activities that are, at the investment time, and that are expected to remain, at least as closely connected to those of the subject corporation and the subject subsidiary corporations (corporations in which subject corporations have, at the investment time, an equity percentage) on a collective basis, as the business activities carried on in Canada by the CRIC, or any corporation resident in Canada with which the CRIC does not, at the investment time, deal at arm’s length. Further, the majority of those officers may now be persons resident and working principally or in a country in which a connected affiliate is resident. Under the previous iteration of this rule, the officers had to be residents of Canada and be working principally in Canada. In addition, officers resident in a country in which a connected affiliate is resident will also be considered for the purposes of the performance evaluation and compensation portion of the more closely connected business activities test.
Unfortunately, the foregoing changes also came with a new deeming rule applicable to dual officers. That rule, contained in subsection 212.3(17), provides that any person who is an officer of the CRIC and of a NRC with which the CRIC does not deal at arm’s length at the investment time (other than the subject corporation, the subject subsidiary corporation 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.
The exception for corporation reorganizations has also been expanded to include situations where the indirect acquisition rule is applicable. That exception applies in situations that are similar to direct acquisitions, such as where shares of a subject corporation acquired pursuant to transactions in which subsection 51(1), 86(1), 87(1), and others, apply. In a welcome change, the application of the preferred share rule (now contained in subsection 212.3(19)) has been expanded. That rule now requires the subject corporation to be a subsidiary wholly-owned corporation of the CRIC throughout the series of transactions or events that include the acquisition.
In an unwelcome change, subsection 212.3(21) now contains an anti avoidance rule that provides that if it can reasonably be considered that one of the main purposes of one or more transactions or events is to cause two or more persons to be related to each other so that subsection 212.3(2) would not apply by virtue of the corporate reorganization rules, those persons are deemed not to be related to each other for the purposes of the corporate reorganization rules.
- Indirect Funding Rule
On the relieving side, subsection 212.3(24) now contains what is known as the indirect funding rule. The indirect funding rule is a new exception to paragraph 212.3(2)(a) that applies if the CRIC demonstrates that all of the properties received by the subject corporation from the CRIC as a result of the investment were used at a particular time that is within 30 days after the investment time and at all times after the particular time, by the subject corporation to make a loan to a particular corporation that was, at the time of the loan, a CFA of the CRIC for the purposes of section 17, the particular corporation is, throughout the period that begins at the investment time and during which the series of transactions or events that includes the making of the loan occurs, a corporation in which an investment made by the CRIC would not be deemed to be a dividend because of the more closely connected business test and the particular corporation uses, throughout the term in which the loan is outstanding, the proceeds of the loan in an active business (as defined in subsection 95(1)). The indirect funding rule essentially enables CRICs to fund FAs using subparagraph 95(2)(a)(ii), provided they meet the more closely connected business activities test. CRICs that have investments in subject corporations that do not meet that test will be disadvantaged compared to both Canadian corporations that are not CRICs and CRICs that are financing a closely connected business.
Changes to Loans to Non-Residents
The exception to the FA dumping rules for certain loans that meet the definition of a PLOI made by a CRIC to its FAs and the exception to the existing shareholder debt rules for a PLOI made by a CRIC to a related or connected NRC were not in Budget 2012, but were added in the August Proposals. As noted above, where the definition of a PLOI is met, the amount owing is instead subject to the new interest imputation rules set out in section 17.1. Section 17.1 requires a CRIC to include in its income a deemed amount of interest for each year that the amount is owing.
These exceptions have been made more accessible under Bill C-45.
Firstly, the definition of a PLOI is extended to include not only an amount that became owing after March 28, 2012, but also an existing amount owing where the maturity date is extended after March 28, 2012, if such amount owing would have qualified as a PLOI if it had become owing after March 28, 2012. Absent this change, the extension of the maturity date was deemed to be a new investment that was subject to the FA dumping rules, without the ability to qualify for the exception for a PLOI.
Secondly, the election to treat an amount owing as a PLOI is now made with respect to each amount owing, rather than with respect to all amounts owing by a particular NRC. Although this will require more administrative compliance on the part of the CRIC and the particular NRC, it provides the CRIC a choice as to whether to have the new interest imputation rule in section 17.1 apply to a particular amount owing, particularly in the context of subsection 15(2), as other amounts owing by a particular NRC to the CRIC may qualify for one of the other exceptions to subsection 15(2) (e.g., trade receivables).
Thirdly, the election to treat an amount owing as a PLOI has been extended to include amounts owing by a partnership of which a particular NRC is a member and amounts owing to a "qualifying Canadian partnership" in respect of a CRIC, which is a partnership the members of which are the CRIC and one or more corporations resident in Canada to which the CRIC is related. Special look-through rules are added to deal with multi-tier partnerships. These changes are welcome, as many multinationals operate in Canada through partnership structures.
Fourthly, new continuity rules are added where there has been an amalgamation of two taxable Canadian corporations under subsection 87(1) and a winding-up to which subsection 88(1) applies, so as to ensure that the exceptions continue to apply.
Fifthly, a new rule provides transitional relief from the application of the interest imputation rule in section 17.1 for a period of 180 days, where a NRC acquires control of a CRIC that was not controlled by a NRC immediately before the acquisition of control. This will give the CRIC time to consider whether to make the election to have the amount owing be treated as a PLOI.
Finally, Bill C-45 includes the ability to late file the election to treat an amount owing as a PLOI. The filing of the joint election can be at any time up to three years after the normal filing deadline, subject to a modest penalty of $100 per month. This change would be beneficial in cases where a deemed dividend would otherwise arise under subsection 15(2) on the basis that a loan which was repaid within one year after the end of the year, and thus excluded from the application of subsection 15(2) by virtue of subsection 15(2.6), is subsequently determined to have been part of a series of loans or repayments and thereby not so excluded.
Despite the relieving changes, Bill C-45 does not reflect many of the submissions and comments that were made in respect of the August Proposals. For example, it is still unclear whether any refinancing of a loan so as to qualify the new loan as a PLOI could be considered part of a series of loans and repayments and thereby disqualify the old loan from the exception in subsection 15(2.6).
Submissions were made in respect of the August Proposals that the interest imputed under section 17.1 for a PLOI was too high (the prescribed rate plus 4%), since it would make it difficult for taxpayers to set terms that both comply with the PLOI exception and satisfy the requirements for an arm’s length loan arrangement in the borrower’s jurisdiction and transfer pricing generally. The government refused to reduce the rate, other than to give a minor concession by not requiring that the rounding-up convention be followed.
The reference to transfer pricing concerns may have led to a new change in Bill C-45 that is not likely to be considered relieving. Bill C-45 introduces a new deeming rule that deems an amount owing not to be a PLOI, even if all the conditions for being a PLOI are met. The election is not available if a tax treaty limits the amount included in computing the income of a CRIC in respect of the amount owing. It is understood that this deeming rule was added to address the situation where, as a result of transfer pricing adjustments made under the competent authority provisions of an applicable tax treaty, Canada is required to agree to an amount being included in the income of the CRIC that is lower than that under section 17.1. In such event, since the PLOI election is not available, the amount owing will be subject to the rules in subsection 15(2) or the FA dumping rules, as the case may be.