Anti-Surplus Stripping Rule for Canadian Resident Corporations Controlled by Non-Residents

Bill C-45 adds a new anti-surplus stripping rule to the Income Tax Act (Canada) (the “Act”) as section 212.3. This provision will apply to a corporation that is:

  1. resident in Canada, and
  2. controlled by a non-resident corporation (“NR Parentco”),2

where the Canadian resident corporation engages in certain specified transactions with a non-resident corporation (“NR Subjectco”) that is a foreign affiliate of the Canadian resident corporation.3

A corporation that is resident in Canada and controlled by a non-resident corporation is referred to in Bill C-45 regarding foreign affiliate dumping transactions and in this section as a “CRIC”.

Where new section 212.3 applies, the CRIC is deemed to have paid a dividend to NR Parentco that is subject to Canadian withholding tax and/or the paid-up capital (“PUC”) of the issued shares of the CRIC is reduced. The PUC reduction will probably lead to future Canadian withholding tax because a distribution to a shareholder of a taxable Canadian corporation (other than an actual dividend) in excess of the PUC of the relevant shares is deemed to be a dividend. If the shareholder is a non-resident of Canada, the deemed dividend is subject to Canadian withholding tax.

There are three exceptions:

  1. More closely connected business activities,
  2. Related party transactions and reorganizations, and
  3. Pertinent loan or indebtedness (“PLOI”).

A typical transaction targeted by this new measure is a CRIC acquiring shares of a non-resident corporation in the same corporate group, either by way of subscription or by way of purchase from another corporation in the group, and incurring interest bearing debt to pay the purchase price. The debt results in deductible interest expense for the CRIC which reduces the Canadian tax base, dividends out of the non-resident corporation’s exempt surplus can be received tax-free in Canada and payment of the acquisition price (arguably) removes corporate surplus from Canada. The Department of Finance (Canada) (the “Department of Finance”) considers these results problematic from a tax policy perspective.

Another apparently objectionable transaction is a CRIC acquiring shares of a non-resident corporation in the same corporate group and paying the purchase price by issuing shares of the CRIC with PUC equal to the purchase price. This PUC allows for a future extraction of corporate surplus from Canada by way of a reduction and distribution of PUC (which is not subject to Canadian withholding tax).

The scope of section 212.3 is not, however, limited to transactions between the CRIC and a non-resident corporation in the same corporate group. An acquisition by a CRIC in an arm’s length transaction of shares or debt of a non-resident corporation that is or becomes a foreign affiliate of the CRIC can also trigger the adverse application of section 212.3.

The imposition of current Canadian withholding tax and/or the reduction of PUC (probably leading to future Canadian withholding tax) indicate that the Department of Finance views the transactions subject to section 212.3 as unacceptable surplus strips. One can easily question this view because the CRIC’s assets are generally not reduced in these transactions. The amount that section 212.3 subjects to Canadian withholding tax or a PUC reduction generally represents a new asset owned by the CRIC, not surplus removed from the CRIC.

The broad scope and serious adverse consequences of section 212.3 mean that these new rules must be carefully considered in connection with transactions between a CRIC and its foreign affiliates, reorganizations of a CRIC and any other transaction affecting a CRIC’s interest in an NR Subjectco. Section 212.3 is complicated and creates many traps for the unwary. Unexpected and anomalous consequences can easily result.

What Canadian Resident Corporations Are Subject To Section 212.3?

Section 212.3 applies to a corporation resident in Canada that:

  1. at the time of the relevant investment transaction is controlled by a non-resident corporation, or
  2. becomes controlled by a non-resident corporation as part of a series of transactions or events that includes the relevant investment transaction.

“Controlled” for this purpose means de jure control. This is generally direct or indirect ownership of shares of the Canadian corporation with sufficient votes to elect a majority of the board of directors. De jure control may also exist as a result of a unanimous shareholder agreement. Option or similar contingent rights alone do not result in control for the purposes of section 212.3.

A Canadian resident corporation that is controlled by a non-resident corporation will not be a CRIC subject to section 212.3 if the controlling non-resident corporation is controlled by another Canadian resident corporation that is not controlled by any non-resident.

What Transactions Are Caught?

Section 212.3 applies where a CRIC undertakes an “investment” in a corporation which is a non-resident of Canada and is a foreign affiliate of the CRIC or becomes a foreign affiliate of the CRIC in a series of transactions or events that includes the investment (the “Investment”).

A non-resident corporation will be a foreign affiliate of a CRIC if:

  • the CRIC’s direct or indirect ownership interest in any class of shares of the non-resident corporation is at least 1%, and
  • the total direct or indirect ownership interest in any class of shares of the non-resident corporation of the CRIC and related persons is at least 10%.

An Investment in NR Subjectco is a transaction where:

  • the CRIC acquires shares of NR Subjectco,
  • the CRIC contributes capital to NR Subjectco,
  • the CRIC confers a benefit on NR Subjectco4,
  • an amount becomes owing by NR Subjectco to the CRIC, except in the ordinary course of the CRIC’s business where the indebtedness is repaid within 180 days5 or except PLOI,
  • the CRIC acquires indebtedness of NR Subjectco (except PLOI) from another person, except for an acquisition in the ordinary course of the CRIC’s business from a person with whom the CRIC deals at arm’s length,
  • the maturity date of indebtedness owing by NR Subjectco to the CRIC (other than a debt obligation that is PLOI immediately after the extension time) is extended,
  • the redemption, acquisition or cancellation date of shares of NR Subjectco owned by the CRIC is extended,
  • the CRIC acquires shares of another Canadian resident corporation of which NR Subjectco is a foreign affiliate if the total fair market value of foreign affiliate shares owned by the other Canadian resident corporation is more than 75% of the total fair market value of all of the other Canadian resident corporation’s assets (determined without regard to certain debt) (an “Indirect Acquisition”), or
  • acquires an option in respect of, or an interest in, shares or certain debt of the NR Subjectco.

Section 212.3 contains a look through rule for partnerships so that Investments made by a partnership are, in effect, allocated to the partners pro rata to the fair market value of their partnership interests. Also, if a CRIC’s partnership pro rata allocation increases, then this can result in an Investment for the CRIC that triggers section 212.3.

Indebtedness

There are exceptions from section 212.3 when debt of an NR Subjectco is replaced with shares. (Discussed below in “Related Party Transactions and Reorganization Exception”). But, there is no exception for debt-for-debt exchanges.

Therefore, if NR Subjectco repays existing debt owing to the CRIC by issuing new debt, section 212.3 will be triggered. Caution will be required when amending the terms of a debt owing by NR Subjectco to a CRIC. If the amendments are substantial enough, they could result in a new debt and so a new Investment.

In both intentional and inadvertent debt-for-debt exchanges, grandfathering protection will be lost if the original debt was put in place before March 29, 2012 and section 212.3 would apply based on the fair market value of the new debt. If the original debt was put in place after March 28, 2012 such that Canadian withholding tax has already been paid under section 212.3, Canadian withholding tax would be payable a second time.

Indirect Acquisitions

Where the CRIC acquires shares of another Canadian resident corporation (“CanTargetco”) that is an Indirect Acquisition because the total fair market value of CanTargetco’s foreign affiliate shares exceeds the 75% threshold and the CRIC subsequently transfers property, directly or indirectly, to CanTargetco or another corporation resident in Canada to which the CRIC and CanTargetco are related (“Related Canco”) to be invested in a NR Subjectco, such an indirect transfer will not trigger, in and of itself, any deemed dividend where the indirect transfer occurs within 30 days of the Investment in NR Subjectco by CanTargetco or Related Canco and as part of the same series of transactions or events. In this case, only the Investment in NR Subjectco by CanTargetco or Related Canco will trigger a deemed dividend. The Explanatory Notes confirm that the purpose of this exception is to prevent multiple deemed dividends under the foreign affiliate dumping rules, when property is transferred by a CRIC through tiers of Canadian resident corporations to be invested in a NR Subjectco.

If a CRIC acquires shares of another Canadian resident corporation of which NR Subjectco is a foreign affiliate and the Indirect Acquisition rule is not triggered because the total fair market value of foreign affiliate shares owned by the other Canadian resident corporation is not more than 75% of the total fair market value of all of the Canadian resident corporation’s assets, the acquisition can still be an Investment subject to section 212.3. This will be the case where the other Canadian corporation disposes of sufficient non-foreign affiliate share assets as part of the same series of transactions or events such that it no longer meets the not more than 75% test.

Standard tax planning for structuring a foreign acquisition of a Canadian resident company will be affected where the Indirect Acquisition rule is triggered. A foreign company will often incorporate a wholly-owned Canadian resident subsidiary (“CanAcquisitionco”) to be the purchaser of the shares of a CanTargetco.

If the foreign company were to purchase the shares of CanTargetco directly, it would inherit the historical PUC of CanTargetco’s shares, which will typically be far less than the purchase price paid for the shares of CanTargetco. However, if the foreign company capitalizes CanAcquisitionco to provide it with funds (either equity or a combination of equity and debt) to fund the purchase price paid by CanAquisitionco for the shares of CanTargetco, then the foreign company will be able to repatriate funds from CanAcquisitionco free of Canadian withholding taxes up to the aggregate principal amount of CanAcquisitionco’s debt and the PUC of the CanAcquisitionco shares. The use of a CanAcquisitionco is illustrated below:

Click here to view diagram.

Where more than 75% of the total fair market value of CanTargetco’s assets is attributable to shares of foreign affiliates, CanAcquisitionco’s purchase of the shares of CanTargetco will be an Indirect Acquisition triggering the application of section 212.3. Nevertheless, the common acquisition structure described above should not be adversely affected by section 212.3 if both the PUC reduction and the PUC reinstatement are available as discussed below. The requirements for PUC reduction and PUC reinstatement should be met if the foreign company capitalizes CanAcquisitionco only with equity and CanAcquisitionco has only one class of shares. The PUC reduction and reinstatement rules should be reviewed in detail for any particular transactions.

Canadian Tax Consequences

If section 212.3 applies, there are several possible results:

  1. A deemed dividend from the CRIC and no PUC reduction.
  2. A reduction of the PUC of the CRIC’s shares and no deemed dividend.
  3. A reduction of the PUC of the CRIC’s shares and a deemed dividend.
  4. Deemed dividends from the CRIC and/or certain related Canadian resident corporations.
  5. A reduction of the PUC of the CRIC’s and/or certain related Canadian resident corporations’ shares and no deemed dividend.
  6. A reduction of the PUC of the CRIC’s and/or certain related Canadian resident corporations’ shares and one or more deemed dividends.

In each case, section 212.3 ensures that the amount of the deemed dividend that would otherwise result (the “Deemed Dividend Amount”) is fully accounted for as one or more PUC reductions and/or one or more deemed dividends.

To understand the various possible consequences of section 212.3, it is helpful to start with two base cases.

Deemed Dividend Base Case

In the first base case:

  • The Investment involves the CRIC assuming or incurring a debt or other obligation, conferring a benefit, and/or transferring property (other than the CRIC’s own shares), or a transfer of property to the CRIC which results in a reduction of any amount owing to the CRIC, that can reasonably be considered to relate to the Investment.
  • The requirements for a PUC reduction under subsection 212.3(7) in lieu of all or part of the deemed dividend are not met, and
  • A Dividend Substitution Election (discussed below under “Dividend Substitution Election”) has not been made.

In this case, the Investment results in a deemed dividend paid by the CRIC to NR Parentco. The deemed dividend will be subject to Canadian withholding tax.6

The amount of the deemed dividend is the fair market value of property transferred by the CRIC in the relevant transaction (other than shares of the CRIC), the fair market value of any obligation incurred or assumed or benefit conferred by the CRIC in the relevant transaction and the fair market value of property transferred to the CRIC which reduces an amount owing to the CRIC, that can reasonably be considered to relate to the Investment.

The full amount of the deemed dividend is deemed to have been paid to NR Parentco even if there are other shareholders of the CRIC and even if NR Parentco is not the direct shareholder of the CRIC. This may have an advantageous or disadvantageous impact on the Canadian withholding tax rate, depending on the circumstances. If the applicable tax treaty provides a reduced withholding tax rate based on the level of shareholding (as many tax treaties do) and NR Parentco is a direct shareholder of the CRIC, the result will be the lowest possible withholding tax rate. If NR Parentco is not a direct shareholder of the CRIC, the reduced treaty withholding tax rate based on the level of shareholding would appear to be lost.

Assume that a U.S. NR Parentco subscribes for additional common shares of a CRIC, wholly-owned by the U.S. NR Parentco, for $10,000,000, and the CRIC uses these funds to purchase 10% of the shares of a U.K. NR Subjectco, also wholly-owned by the U.S. NR Parentco, for a purchase price of $5,000,000 and to make a loan of $5,000,000 to the U.K. NR Subjectco (which is not PLOI) and the more closely connected business activities exception does not apply. The resulting corporate structure is illustrated below:

Click here to view diagram.

The broad wording of subsection 212.3(2) suggests that there would be both a deemed dividend of $10,000,000, i.e., the $5,000,000 transferred by the CRIC when paying the purchase price of $5,000,000 for the shares to the U.S. NR Parentco and the $5,000,000 transferred by the CRIC when making the loan to the U.K. NR Subjectco, and a reduction of the $10,000,000 of PUC created by the $10,000,000 share subscription. Fortunately, the explanatory notes released by the Department of Finance in connection with Bill C-45 (the “Explanatory Notes”) confirm that the $5,000,000 share purchase and $5,000,000 loan would be considered to relate to the Investment, but the $10,000,000 share subscription would not be considered to relate to the Investment. Therefore, there would only be a $10,000,000 deemed dividend and PUC would not also be reduced by $10,000,000.

The Explanatory Notes also confirm that similar reasoning would apply where a NR Parentco makes a capital contribution to the CRIC or the CRIC borrows money, in order to fund the purchase price for shares of NR Subjectco or a loan to NR Subjectco with the result that only the payment of the purchase price and the amount of the loan would be considered to relate to the Investment. In these circumstances, the incurring of the debt by the CRIC or any subsequent conversion of such contributed surplus into PUC should not give to a deemed dividend because the incurring of the debt and the contributed surplus would not be considered to relate to the Investment.

If the transaction constituting the Investment is the extension of the maturity date of a debt or the redemption, acquisition or cancellation date of shares, then the CRIC is deemed to have transferred property with a fair market value equal to the amount owing on the debt obligation or the fair market value of the shares, as the case may be.

The Explanatory Notes indicate that the maturity date extension category of Investment is intended to catch indebtedness and shares put in place before March 29, 2012 and extended after that date. Unfortunately, this rule also applies to indebtedness and shares put in place after March 28, 2012. Thus, an extension of post – March 28, 2012 debt or shares could trigger multiple applications of section 212.3 Canadian withholding tax – once when the Investment is initially made and again whenever the maturity date is extended.

PUC Reduction Base Case

The second base case is a transaction where the only property transferred in the Investment is shares of the CRIC and there is no debt or obligation assumed by the CRIC or benefit conferred by the CRIC. Assume similar facts as the example in the “Deemed Dividend Base Case” except that the CRIC acquires 10% of the shares of a U.K. NR Subjectco for $10,000,000 by issuing the CRIC’s own shares to the U.S. NR Parentco in satisfaction of the purchase price and there is no loan from the CRIC to U.K. NR Subjectco. The resulting corporate structure is illustrated below:

Click here to view diagram.

In this case, there will not be a deemed dividend but the PUC of the CRIC shares is reduced automatically by the amount PUC was increased by the Investment, i.e., $10,000,000 in this example. This would typically be the portion of the purchase price satisfied by the issue of the CRIC’s shares (unless the transaction is a domestic tax-neutral rollover).

PUC Reduction under Subsection 212.3(7)

In the August 14, 2012 draft legislation, it was proposed that a CRIC and NR Parentco could elect in certain circumstances to have a reduction of the PUC of the CRIC’s issued shares in lieu of all or a portion of the deemed dividend that would otherwise result under section 212.3.

In Bill C-45, this PUC reduction is automatic under subsection 212.3(7) if certain requirements are met. This is a welcome change because, as long as the requirements for PUC reduction are met, it means the first consequence of section 212.3 is a PUC reduction rather than a deemed dividend and consequential Canadian withholding tax. A PUC reduction has no immediate Canadian tax cost.

The requirements for and consequences of a subsection 212.3(7) PUC reduction differ depending on whether or not a Dividend Substitution Election (discussed below under “Dividend Substitution Election”) has been made.

If a Dividend Substitution Election has not been made, then:

  • If the CRIC has only one class of issued shares, the PUC of those shares is reduced first and the balance if any, of the Deemed Dividend Amount is a deemed dividend from the CRIC to NR Parentco.
  • If the CRIC has more than one class of issued shares, the CRIC must demonstrate that property transferred to the CRIC before the Investment gave rise to a PUC increase for a particular class of shares and was used, in whole or in part, to make the Investment, or where shares of NR Subjectco are acquired in an Indirect Acquisition, was used, in whole or in part, to acquire the CanTargetco shares. In this case, the PUC of that particular class of shares is reduced to the extent that the prior property transferred to the CRIC can be traced to the Investment or the acquisition of the CanTargetco shares. The balance, if any, of the Deemed Dividend Amount is a deemed dividend from the CRIC.
  • The CRIC must in both cases either be wholly-owned by NR Parentco or any shares of the CRIC not owned by NR Parentco must be owned by persons dealing at arm’s length with the CRIC and/or non-resident persons not dealing at arm’s length with the CRIC.

Assume same example as in Deemed Dividend Base Case and that, except for the $10,000,000 of PUC attributable to the additional shares of the CRIC issued to the U.S. NR Parentco, the PUC of the shares of the CRIC is not material. The resulting corporate structure is illustrated below:

Click here to view diagram.

Subsection 212.3(7) automatically reduces the PUC of the CRIC shares by $10,000,000. There is no deemed dividend at the time the CRIC acquires the shares of and makes the loan to the U.K. NR Subjectco. If the CRIC subsequently realized on its Investment in the U.K. NR Subjectco and distributed the proceeds to the U.S. NR Parentco, because the PUC of the CRIC’s shares has been reduced by subsection 212.3(7), the distribution would be a deemed dividend giving rise to Canadian withholding tax at that time (subject to the PUC reinstatement provision and the PLOI exception – both discussed below under “PUC Reinstatement” and “Pertinent Loan or Indebtedness Exception”).

If the CRIC’s Investment in the U.K. NR Sujectco is funded from the CRIC’s retained earnings or by borrowing, the result is different. The Investment would trigger a deemed dividend of $10,000,000 and consequential Canadian withholding tax at the time of the Investment. Subsection 212.3(7) would not be available because no PUC is created in connection with the transaction and we have assumed there is no other PUC. Even if there were $10,000,000 of pre-existing PUC, a subsection 212.3(7) PUC reduction would generally only be available if the CRIC has only one class of shares. If the CRIC subsequently realized on its Investment in the U.K. NR Subjectco and the CRIC distributed the proceeds to the U.S. NR Parentco, then, because we are assuming no material pre-existing PUC, the distribution to the U.S. NR Parentco would be a dividend subject to Canadian withholding tax. Thus, it appears that where a CRIC funds an Investment from retained earnings or a borrowing there is the potential for double Canadian withholding tax, unless the more closely connected business activities exception applies.

Where the CRIC has more than one class of issued shares and a Dividend Substitution Election has not been made, the subsection 212.3(7) PUC reduction is only available if the tracing requirements are met. Tracing of funds received by the CRIC on the issue of shares or on a capital contribution will be possible if the receipt of funds by the CRIC is proximate in time to the Investment and the funds invested can be traced to the funds used to make the Investment. Tracing of funds in this way will probably be impossible for PUC that arose years before the Investment in capitalization transactions unrelated to the Investment. There is no apparent tax policy reason for treating historical PUC less favourably than current PUC traceable to the Investment in relation to this election. Also, tracing of funds will almost certainly be impossible where the transaction triggering section 212.3 does not involve an outgoing payment of funds by the CRIC, e.g., debt forgiveness or debt maturity date extension.

Where a Dividend Substitution Election has been made, there is no tracing requirement. However, a subsection 212.3(7) PUC reduction is only available where a Dividend Substitution Election has been made if:

  • NR Parentco or another non-resident corporation with which NR Parentco does not deal at arm’s length owns shares of each class of the CRIC and each class of a “qualifying substitute corporation” (as discussed below under “Dividend Substitution Election”) to which an amount has been allocated in the Dividend Substitution Election, and
  • the Dividend Substitution Election allocates the Deemed Dividend Amount such that the greatest possible amount of PUC for shares of the CRIC and shares of all qualifying substitute corporations owned by NR Parentco or other non-resident corporations with which NR Parentco does not deal at arm’s length is reduced.

Dividend Substitution Election

A dividend substitution election allows the consequences of section 212.3, whether deemed dividend and/or PUC reduction, to be spread among certain related Canadian resident corporations ("Dividend Substitution Election").

A Dividend Substitution Election can only be made in respect of a qualifying substitute corporation (“QSC”). A QSC is a Canadian resident corporation that is controlled by NR Parentco, has a direct or indirect shareholding in the CRIC and at least one share of which is owned by NR Parentco or another non-resident corporation with which NR Parentco does not deal at arm’s length. Generally, the Dividend Substitution Election is meant to accommodate corporate structures where one or more Canadian resident corporations are interposed between the NR Parentco and the CRIC in a corporate chain.

The election is made on an Investment by Investment basis and will allocate the Deemed Dividend Amount among classes of shares of the QSCs and the CRIC (to the extent not completely allocated to the QSCs).

The election must be made by the CRIC, NR Parentco and all QSCs. Another non-resident corporation controlled by NR Parentco (“NR Otherco”) may also be a party to the election.

The election must be filed with the Canada Revenue Agency (“CRA”) by the earliest income tax return filing-due date of the CRIC and the QSC’s for their taxation years in which the Investment occurs. Late filing of the election is permitted within three years after the filing deadline if a late filing penalty is paid.7

The Dividend Substitution Election allows for some or all of the section 212.3 deemed dividend to be treated as having been paid by one or more QSCs. This allows the CRIC and NR Parentco to use the PUC of the issued shares of the QSCs to reduce the overall deemed dividend where the requirements of subsection 212.3(7) are met.

The Dividend Substitution Election also allows flexibility as to the recipient of the deemed dividend. If one or more NR Othercos are parties to the Dividend Substitution Election, it appears that all or some of the dividend deemed to have been paid by the CRIC and/or one or more QSCs can be treated as having been received by the NR Otherco(s) instead of NR Parentco. This flexibility could be helpful depending on the withholding tax rates that apply to NR Parentco as compared to the NR Othercos and the foreign tax credit rules and circumstances of NR Parentco as compared to the NR Othercos.

Where a Dividend Substitution Election has been made and subsection 212.3(7) applies, subsection 212.3(7) will reduce the PUC of the classes of shares of the CRIC and QSCs to which a portion of the Deemed Dividend Amount has been allocated. The balance, if any, of the Deemed Dividend Amount will be a deemed dividend from the QSCs to which a portion of the Deemed Dividend Amount has been allocated (and the CRIC if not all of the Deemed Dividend Amount has been allocated to the QSCs) to NR Parentco and/or one or more NR Othercos, depending on the election.

PUC Reinstatement

Where the Investment that triggers the application of section 212.3 is an acquisition of shares of NR Subjecto, a contribution of capital to NR Subjectco by the CRIC, conferral of a benefit on NR Subjectco by the CRIC or an Indirect Acquisition and there has been a PUC reduction as described in the PUC Reduction Base case or under subsection 212.3(7) of the shares of the CRIC (and/or one more QSCs where a Dividend Substitution Election has been made), then some or all of the PUC will be reinstated in certain circumstances to allow the CRIC (and/or one or more QSCs if a Dividend Substitution Election has been made) to distribute shares of NR Subjectco or sale proceeds from or amounts received as dividends or PUC distributions on such shares as a reduction and distribution of PUC without Canadian withholding tax.8

The amount of PUC reinstated is the least of:

  • the amount of the PUC reduction at the time of the Investment (to the extent not previously reinstated),
  • where NR Subjectco shares are distributed in specie, the fair market value of those shares at the time of the distribution,
  • the amount, if any, received no more than 180 days before the distribution as a dividend or PUC distribution on or proceeds of disposition from the NR Subjectco shares, and
  • the amount of the PUC distribution otherwise determined.

The relief provided by the subsection 212.3(7) PUC reduction in combination with the PUC reinstatement is extremely important because this completely eliminates both the current and future Canadian withholding tax that would otherwise be payable as a result of section 212.3. However, this relief is only available in limited circumstances. The key constraints of the PUC reinstatement are:

  • The Investment results in a PUC Reduction as in the PUC Reduction Base Case or a subsection 212.3(7) PUC reduction is available.
  • The Investment is an acquisition of NR Subjectco shares, a contribution of capital to or conferral of a benefit on NR Subjectco from the CRIC or an Indirect Acquisition. None of the other transactions constituting an Investment are eligible for PUC reinstatement.
  • If the CRIC (and/or one or more QSCs if a Dividend Substitution Election has been made) is distributing amounts received from a disposition of or a dividend or PUC distribution on NR Subjectco shares, those amounts were received by the CRIC (and/or one or more QSCs if a Dividend Substitution Election has been made), not more than 180 days before the distribution.
  • The distribution is in respect of the same class of shares to which the PUC reduction applied.
  • The sale proceeds are not from a disposition of NR Subjectco shares in respect of a related acquisition to which the related party transactions and reorganization exception applies.

More Closely Connected Business Activities Exception

Subsection 212.3 will not apply if the taxpayer can demonstrate that:

  • the business activities of NR Subjectco and other corporations in which NR Subjectco has a direct or indirect equity interest, are collectively more closely connected9 on an ongoing basis to the Canadian business activities of the CRIC or a Canadian resident corporation that does not deal at arm’s length with the CRIC than to the business activities of any other non-resident corporation with which the CRIC does not deal at arm’s length (other than a controlled foreign affiliates of the CRIC for purposes of section 17 of the Act ( a “section 17 CFA”), NR Subjectco and other corporations in which NR Subjectco has a direct or indirect equity interest),
  • officers of the CRIC, a majority of whom are resident in and work principally in Canada or a country in which a “Connected Affiliate”10 of the CRIC is resident (“Qualifying Officers”), exercised principal decision-making authority with respect to making the Investment, and
  • it is reasonably expected at the time of the Investment that:
    • Qualifying Officers will have and exercise principal decision-making authority with respect to the Investment on an ongoing basis; and
    • the performance evaluation and compensation of the Qualifying Officers will be based on the operational results of NR Subjectco to a greater extent (on a relative basis) than the performance evaluation and compensation of any officer of any non-resident corporation with which the CRIC does not deal at arm’s length (other than NR Subjectco, a corporation controlled by NR Subjectco or a Connected Affiliate).

However, an individual who is an officer of the CRIC and is resident in a country in which a Connected Affiliate is resident is excluded from being a Qualifying Officer if that individual is also an officer of a non-resident corporation with which the CRIC does not deal at arm’s length (other than NR Subjectco, a corporation in which NR Subjectco has a direct or indirect equity interest or a Connected Affiliate of the CRIC).

Also, where the Investment is an acquisition of shares of an NR Subjectco, the NR Subjectco shares must be fully participating shares unless NR Subjectco would be directly or indirectly wholly-owned by the CRIC if the CRIC owned all of the shares of NR Subjectco that are owned by any of the CRIC, a corporation resident in Canada that is wholly-owned by the CRIC and a corporation resident in Canada of which the CRIC is a wholly-owned subsidiary.

When the foreign affiliate dumping proposals were first released in the March 29, 2012 Federal Budget, this exception was described as a “business purpose” exception. It is now described as “more closely connected business activities” exception. This is a more accurate description because it is not per se a business purpose test. A primary, or even exclusive, business purpose will not be enough to bring an Investment within the exception. NR Subjectco’s business must be more closely connected to the CRIC’s business than to the business of any other non-resident corporation in the worldwide group (other than a section 17 CFA, NR Subjectco and other corporations in which NR Subjectco has a direct or indirect equity interest) and the Investment must be managed by the Qualifying Officers.

Because of the principal decision-making authority requirement, the exception will not be available if the decision for the CRIC to make the Investment originates from NR Parentco and the CRIC’s making of the Investment is managed by officers in the corporate group other than the Qualifying Officers. This will be the case even if having the CRIC make the Investment is driven primarily by business, rather than tax, reasons. To stand a chance of coming within this exception, it appears that the Investment should be consistent with the CRIC’s business plan and that the Qualifying Officers should have substantive responsibility for due diligence and negotiations of the terms of the Investment and the decision to make the Investment.

According to the Explanatory Notes, corporate officers outside Canada may have “formal decision-making authority” with respect to the Investment. Perhaps this means that it is acceptable for corporate officers outside Canada to have something akin to final approval after the Qualifying Officers have done the due diligence and negotiation and have concluded that the CRIC should make the Investment, subject to something functionally equivalent to board approval. It is not clear at this point exactly what is required to meet the principal decision-making authority requirement.

If a CRIC makes an Investment in a NR Subjectco that comes within the more closely connected business activities exception and the NR Subjectco subsequently uses the property received from the CRIC in the same series of transactions or events to make an Investment in another non-resident corporation that would have been caught by section 212.3 if made by the CRIC directly, then the more closely connected business activities exception is lost.

The more closely connected business activities exception will also apply where the CRIC funds an Investment in a NR Subjectco indirectly in certain circumstances. This will accommodate a common structure used by Canadian corporations to finance a foreign affiliate carrying on an active business. In the typical financing structure, the Canadian corporation invests equity in one foreign affiliate (“FA1”), which then loans these funds to a second foreign affiliate (“FA2”) on an interest bearing basis. Where FA2 carries on an active business and certain other requirements are met, FA1’s interest income from FA2 will create exempt surplus in FA1. This common structure is illustrated below:

Click here to view diagram.

The requirements for exception from subsection 212.3 in this type of financing structure are:

  • all of the property received by FA1 from the CRIC is used within 30 days to make a loan to a section 17 CFA of the CRIC (i.e., FA2 in the above diagram must be a section 17 CFA of the CRIC),
  • a direct Investment by the CRIC in the section 17 CFA would have been excepted from section 212.3 by the more closely connected business activities exception, and
  • the section 17 CFA uses the proceeds of the loan from FA1 in an active business carried on by it in its country of residence.

It seems likely that it will be very difficult in many cases to come within the more closely connected business activities exception, or at least to know in advance with any certainty if an Investment meets the requirements of this exception. Some of the hurdles are:

  • The onus is expressly on the taxpayer to demonstrate it satisfies the more closely connected and principal decision-making requirements.
  • It is not sufficient that the business activities of NR Subjectco be just as connected to the business activities of the CRIC as to any other non-resident corporation in the group. They must be more connected. This more closely connected test may be difficult to meet in a corporate group with one homogeneous business.
  • The more closely connected business and principal decision-making authority requirements are entirely fact driven. Disagreements with the CRA on audit are inevitable.

Related Party Transactions and Reorganizations Exception

Section 212.3 will not apply to an Investment transaction that is an acquisition of shares of NR Subjectco in certain related party transactions or in certain normally tax-neutral reorganization transactions, including:

  • an acquisition from a related Canadian resident corporation, as long as the transferor did not deal at arm’s length with the CRIC at any time during the relevant series of transactions or events before the Investment,
  • an amalgamation of related Canadian resident corporations to form the CRIC, as long as none of the predecessor corporations dealt at arm’s length with each other at any time during the relevant series of transactions or events and before the Investment,
  • a vertical amalgamation of a taxable Canadian corporation with one or more of its direct or indirect wholly-owned subsidiaries which are also taxable Canadian corporations,
  • the winding-up of a taxable Canadian corporation into another taxable Canadian corporation where the subsidiary being wound up is wholly-owned or the parent owns at least 90% of the shares and all other shares are owned by arm’s length persons,
  • a conversion of shares or convertible debt of a corporation for shares of the same corporation,
  • a share capital reorganization,
  • an exchange by a CRIC of shares of one foreign affiliate for shares of another foreign affiliate,
  • certain foreign merger transactions under which the NR Subjectco was formed,
  • a liquidation or dissolution of a foreign affiliate of the CRIC, except to the extent of any debt assumed by the CRIC in the transaction,
  • the transfer of shares of NR Subjectco to the CRIC from one of its foreign affiliates on a redemption of the foreign affiliate shares, except to the extent of any debt assumed by the CRIC in the transaction, and
  • the transfer of shares of NR Subjectco to the CRIC from one of its foreign affiliates by way of a dividend or reduction and distribution of paid-up capital in respect of the foreign affiliate shares, except to the extent of any debt assumed by the CRIC in the transaction.

Section 212.3 will also not apply to an Indirect Acquisition in certain related party transactions or in certain normally tax-neutral reorganization transactions, including:

  • an acquisition from a related Canadian resident corporation, as long as the transferor did not deal at arm’s length with the CRIC at any time during the relevant series of transactions or events before the Investment,
  • an amalgamation of related Canadian resident corporations to form the CRIC, as long as none of the predecessor corporations dealt at arm’s length with each other at any time during the relevant series of transactions or events and before the Investment,
  • a vertical amalgamation of a taxable Canadian corporation with one or more of its direct or indirect wholly-owned subsidiaries which are also taxable Canadian corporations,
  • the winding-up of a taxable Canadian corporation into another taxable Canadian corporation where the subsidiary being wound up is wholly-owned or the parent owns at least 90% of the shares and all other shares are owned by arm’s length persons,
  • a conversion of shares or debt of a corporation for shares of the same corporation, and
  • a share capital reorganization.

Also, subsection 212.3 does not apply where the CRIC acquires shares of an NR Subjectco or shares of another Canadian resident corporation in an Indirect Acquisition if the sole consideration for such shares is the exchange of a non-convertible debt obligation owing to the CRIC. This is an important exception in relation to dealings with NR Subjectco because it prevents the double taxation that would otherwise occur under section 212.3 where a CRIC first makes an Investment by way of a loan to NR Subjectco and subsequently converts this debt to equity.

Certain of the above transactions are not excepted from section 212.3 if the NR Subjectco shares are not participating shares, unless NR Subjectco would be directly or indirectly wholly-owned by the CRIC if the CRIC owned all of the shares of NR Subjectco that are owned by any of the CRIC, a corporation resident in Canada that is wholly-owned by the CRIC and a corporation resident in Canada of which the CRIC is a wholly-owned subsidiary. The reorganization and related party transaction exception does not apply to options of NR Subjectco or certain debts.

Pertinent Loan or Indebtedness Exception

As noted above, where an NR Subjectco becomes indebted to a CRIC or a CRIC acquires indebtedness of an NR Subjectco, this will not be an Investment triggering the application of section 212.3 if the indebtedness is PLOI.

For the purposes of this exception, PLOI is NR Subjectco indebtedness to a CRIC that:

  • became owing after March 28, 2012,
  • became owing before March 29, 2012 but the maturity date of which is extended after March 28, 2012,
  • did not arise in the ordinary course of the CRIC’s business and was repaid within 180 days,
  • was not acquired in the ordinary course of the CRIC’s business from a person dealing at arm’s length with the CRIC at the time of acquisition, and
  • is covered by an election under paragrpah 212.3(11)(c).

The election under parapgraph 212.3(11)(c) is made by the CRIC and NR Parentco in respect of the particular NR Subjectco. A separate election is required for each indebtedness of NR Subjectco. The election must be filed with the CRA by the income tax return filing-due date of the CRIC for its taxation year in which any amount that could be PLOI first becomes owing, or in which the maturity date is extended if the amount became owing before March 29, 2012. Late filing of the election is permitted within three years after the filing deadline if a late filing penalty is paid.11

Where a CRIC and its NR Parentco elect for indebtedness of a particular NR Subjectco to be PLOI for the purposes of the PLOI exception in section 212.3, the CRIC will have deemed interest income in respect of all such PLOI under new section 17.1 of the Act. Section 17.1 deemed interest income is discussed below in the Pertinent Loan or Indebtedness Regime section.

Application Date

Subsection 212.3 applies to transactions or events that occur after March 28, 2012, subject to grandfathering for certain arms’ length transactions subject to a written agreement entered into before March 29, 2012 if the transaction is completed before 2013.

The CRIC and NR Parentco can elect to have a modified version of section 212.3 apply to transactions or events that occurred before August 14, 2012 if they file the election with the CRA by the later of the CRIC’s income tax return filing-due date for the taxation year in which section 212.3 is enacted into law and one year after the date on which section 212.3 is enacted into law. The modified version of section 212.3 that applies in this case is based on the proposed rules as announced in the Federal Budget on March 29, 2012.

The restriction of grandfathering protection to transactions completed before 2013 seems somewhat harsh. A CRIC may, for example, be party to a pre - March 29, 2012 shareholders’ agreement containing a buy-sell clause with an arm’s length party with respect to one of the CRIC’s foreign affiliates. If the buy-sell is triggered by the other party in 2014 or after such that the CRIC must acquire the other party’s shares of the foreign affiliate, then section 212.3 will apply even though Canadian tax planning has nothing to do with the transaction.