On March 12, 2009, An Act to implement certain provisions of the budget tabled in Parliament on January 27, 2009 and related fiscal measures (Bill C-10) received royal assent. Bill C-10 includes legislation tabled by the Minister of Finance on November 28, 2008 containing a number of tax initiatives outstanding from the 2008 budget as well as other tax changes, most of which were released on July 14, 2008 in a draft form for consultation. On December 4, 2008, the Minister of Finance released explanatory notes for the provisions included in Bill C-10.
An important set of rules contained in Bill C-10 relates to the computation of income, gains and losses of a foreign affiliate under paragraphs 95(2)(f) to (f.15). Proposed modifications to paragraph 95(2)(f) that were first introduced in 2002 have undergone several revisions throughout the years. The revised provisions in Bill C-10 essentially reproduce the corresponding draft amendments released on July 14, 2008. In turn, the 2008 draft amendments represented the answer of the Department of Finance to the concerns expressed by the tax community with regard to the draft amendments to paragraphs 95(2)(f), (f.1) and (f.2) included in the draft legislation. These had been designed to implement tax measures proposed in Budget 2007 released by the Minister of Finance on October 2, 2007 but were not included in the Budget Implementation Act, 2007 (the 2007 Proposals).
Paragraph 95(2)(f), as it read under the Income Tax Act (Canada) prior to the enactment of Bill C-10, provided rules applicable for computing the taxable capital gain and allowable capital loss of a foreign affiliate of a taxpayer resident in Canada from the disposition of property. These rules were generally referred to as the "main rule," the "currency rule," the "carve-out rule," and the "reading rule." They were relevant for the computation of the surplus and deficit accounts of a foreign affiliate of a taxpayer resident in Canada, and for the computation of the foreign affiliate’s foreign accrual property income (FAPI) or foreign affiliate accrual property loss (FAPL) in respect of the taxpayer. Under these rules, a taxable capital gain and allowable capital loss of a foreign affiliate was computed as though the foreign affiliate is resident in Canada (the "main rule") and in accordance with Part I of the Act, read without reference to Section 26 of the Income Tax Application Rules (the "reading rule"). Paragraph 95(2)(f) also provided that the Canadian dollar was to be used for the computation unless the property disposed of is excluded property, in which case the foreign affiliate’s calculating currency is to be used for the computation (the "currency rule"). In effect, where a taxable capital gain constituted FAPI that was included in the income of a Canadian shareholder, the currency rule specified that it must be computed in Canadian dollars. Paragraph 95(2)(f) also excluded such portion of taxable capital gains from dispositions of property (i) owned by the affiliate at the time it last became a foreign affiliate of the taxpayer; (ii) of any person with whom the taxpayer was not dealing at arm's length; (iii) of any person with whom the taxpayer would not have been dealing at arm's length if the person had been in existence after the taxpayer came into existence; or (iv) of any predecessor corporation (by virtue of a Section 87 amalgamation) of the taxpayer or of a person with whom the taxpayer was not dealing at arm’s length (the "carve-out rule"). In effect, the carve-out rule generally excluded from FAPI any gain accrued prior to the time the foreign affiliate became a foreign affiliate of the taxpayer or of any person described above.
Summary of the New Rules
Subject to transitional rules, the new rules contained in Bill C-10 will apply to those taxation years of a foreign affiliate that begin after October 2, 2007. Transition rules will allow a taxpayer to elect to have the new provisions apply either on December 31, 1994; December 20, 2002; or February 27, 2004.
Paragraph 95(2)(f) sets out the revised "main rule." Under this rule, a foreign affiliate of a taxpayer is deemed to be at all times resident in Canada for the purposes of determining each amount that is its capital gain, capital loss, taxable capital gain or allowable capital loss from a disposition of property, or its income or loss from a property, from a business other than active business or from a non-qualifying business. This represents an extended application of the main rule that was previously limited to the computation of taxable capital gain or allowable capital loss from a disposition of property. The revised main rule contains two exceptions: (i) where a provision of subdivision i of Division B of Part I of the Act specifically provides otherwise (e.g., where the "reading rules" described below apply); and (ii) to the extent the context otherwise requires. The second exception should be applicable where the application of the deeming rule would lead to anomalies.
The revised "carve-out rule" is set out by paragraph 95(2)(f.1). Under this rule, any amount computed pursuant to the main rule should exclude the portion of the amount that can reasonably be considered to have accrued in respect of the property (including any property for which the property was substituted) or the business while the relevant property or business was held or carried on by a "specified person or partnership" in respect of the taxpayer. The amendments to the carve-out rule include the deletion of the unnecessary reference to the time where the relevant property was owned by the affiliate ("property owned by the affiliate at the time it last became a foreign affiliate of the taxpayer"). This reference in the 2007 Proposals could have resulted in the inclusion of gains into FAPI in certain circumstances where it was unintended (e.g., a gain realized by a corporation in the same year but prior to the time it becomes a foreign affiliate of the taxpayer would have been included in the foreign affiliate’s FAPI in respect of the taxpayer). The concept of substituted property is an addition to the former rule. Furthermore and most notably, the revised carve-out rule expands the list of persons whose period of ownership is considered in the determination of the carve-out period. Under the previous legislation, the rule excluded the portion of the gain or loss that could reasonably be considered to have accrued during the period when the affiliate was not a foreign affiliate of: (i) the taxpayer, (ii) any person with whom the taxpayer would not have been dealing at arm’s length if the person had been in existence after the taxpayer came into existence, or (iii) any predecessor corporation (by virtue of a Section 87 amalgamation) of the taxpayer or a person described in either (i) or (ii). As presented in Bill C-10, the rule excludes the portion of an amount that can reasonably be considered to have accrued while no person or partnership that held the property or carried the business was a "specified person or partnership" in respect of the taxpayer. The definitions of "specified predecessor corporation," "designated acquired corporation," and "antecedent acquired corporation" at subsection 95(1), and the deeming rule in subsection 95(2.6) applicable where a person or partnership is not dealing at arm’s length with a particular person at a particular time, are all relevant for the determination of whether a person is a "specified person or partnership." This expansion of persons whose period of ownership is considered in the determination of the carve-out period will generally result in a broader application of the carve-out rule to multinational groups that are reorganizing the ownership of recently acquired foreign subsidiaries.
The revised "reading rules" are set out in paragraph 95(2)(f.11). Under these rules, the Act will, for the computation of the capital gain, capital loss, taxable capital gain or allowable capital loss from a disposition of property, be read without reference to Section 26 of the Income Tax Application Rules. When relevant to the computation of the income or loss from a property, from a business other than active business, or from a non-qualifying business: (i) the Act will be read without reference to subsections 14(1.01) to (1.03), 17(1) and 18(4) and Section 91, except that where the foreign affiliate is a member of a partnership Section 91 is to be applied to determine the income or loss of the partnership, and for that purpose subsection 96(1) is to be applied to determine the foreign affiliate’s share of that income or loss of the partnership; and (ii) if the foreign affiliate has, in the taxation year, disposed of a foreign resource property in respect of a country, it is deemed to have designated, in respect of the disposition and in accordance with subparagraph 59(1)(b)(ii) for the taxation year, the amount, if any, by which the amount determined under paragraph 59(1)(a) in respect of the disposition exceeds the amount determined under subparagraph 59(1)(b)(i) in respect of the disposition.
The revised "calculating currency rules" set out at paragraphs 95(2)(f.12) to (f.15) form an elaborate set of rules applicable to the determination of the currency to be used in the computation of various amounts in respect of a foreign affiliate. This revised set of rules covers a variety of situations not specifically covered in the previous calculating currency rules of paragraph 95(2)(f). The revised rules also include a definition of the expression "calculating currency" added to subsection 95(1), and meaning the currency of the country in which the foreign affiliate is resident at the end of the taxation year, or any currency that the taxpayer demonstrates to be reasonable in the circumstances.
Paragraph 95(2)(f.12) provides that the calculating currency will be used to determine the following amounts with respect to the foreign affiliate: (i) each capital gain, capital loss, taxable capital gain and allowable capital loss from the disposition of a capital property that was an excluded property; (ii) income or loss from each active business carried on by the foreign affiliate in a country; and (iii) the income or loss that is included in computing the foreign affiliate income or loss from an active business because of paragraph 95(2)(a).
Paragraph 95(2)(f.13), applicable where the calculating currency of a foreign affiliate is a currency other than the Canadian currency, provides that the amount included in the computation of a foreign affiliate’s FAPI that is attributable to its capital gain or taxable capital gain from the disposition of an excluded property is the amount of such gain otherwise determined under paragraph 95(2)(f.12), converted in Canadian currency at the rate of exchange quoted by the Bank of Canada at noon on the day of the disposition.
Paragraph 95(2)(f.14) provides that, other than amounts to which paragraph 95(2)(f.12) or (f.13) applies, each amount of the foreign affiliate’s income, loss, capital gain, capital loss, taxable capital gain or allowable capital loss is to be determined using the Canadian currency.
Paragraph 95(2)(f.15) provides that for the purpose of applying subparagraph 95(2)(f.12)(i), the computation of a foreign exchange gain or loss pursuant to subsection 39(2) will reflect the concept of a calculating currency.
Although it does not represent a step towards a simplification of the Act, the new provisions contained in Bill C-10 certainly improve the clarity of the rules applicable to the computation of income, gains and losses of foreign affiliates. These new provisions also resolve several technical issues and anomalies associated with the rules included in the 2007 Proposals.