The “foreign affiliate dumping” rules (the FA dumping rules), which came into force in 2012, have had a significant impact on foreign-based multinationals with Canadian subsidiaries and on acquisitions by non-resident corporations of Canadian corporations that derive a significant portion of their value from foreign operations. On August 16, 2013, the Canadian government released proposals to amend various aspects of the FA dumping rules.
The FA dumping rules were originally proposed in the March 29, 2012, Federal Budget to discourage foreign-based multinational corporations from “dumping” foreign affiliates into their Canadian subsidiaries in a manner that erodes the Canadian tax base.1 Generally, the August 16 proposals narrow certain provisions that were previously overly broad; widen the scope of the paid-up capital reinstatement rule and, to a lesser extent, the closer connection exemption (each of which is described below); and ease certain compliance requirements. On the other hand, the proposals also narrow the corporate reorganization exception and add a notification requirement to the paid-up capital reduction rule.
The FA dumping rules apply to transactions occurring on or after March 29, 2012 (with limited transitional relief for transactions occurring before 2013 pursuant to written agreements in place before March 29, 2012. Taxpayers will, however, have an ability to elect to use the original version of the foreign affiliate dumping proposals announced in the Federal Budget for transactions occurring between March 29, 2012, and August 14, 2012). Most of the August 16, 2013 proposals, if enacted, will apply as of March 28, 2012, except for certain provisions that will apply only to transactions or events occurring on or after August 16, 2013.
Application of FA Dumping Rules: Deemed Dividend or Paid-Up Capital Reduction
Subject to three general exceptions discussed below, the revised rules apply when a corporation resident in Canada (CRIC) that is (or becomes) controlled by a non-resident corporation (Parent) makes an investment in a non-resident corporation that is a foreign affiliate (FA) of the CRIC (either immediately after the investment is made or resulting from the series of transactions that includes the investment). As discussed below, in certain circumstances, an acquisition of shares of a Canadian corporation by a CRIC is considered to be an investment in such a non-resident corporation. When applicable, the rules (i) deem the CRIC or a related Canadian corporation to have paid a dividend to the Parent or a non-resident corporation controlled by the Parent, or (ii) reduce the paid-up capital of the CRIC’s shares or of shares of a related Canadian corporation.
A deemed dividend is subject to Canadian withholding tax at a rate of 25%, subject to potential relief under an applicable income tax treaty. The amount of the deemed dividend is equal to the portion of the fair market value of the investment in FA that is reflected by the following:
- property (other than shares of the CRIC) transferred by the CRIC;
- obligations assumed by the CRIC;
- property transferred to the CRIC that results in a reduction of an amount owing to the CRIC; or
- benefits conferred by the CRIC that relate to the investment.
In addition, if the FA investment is contributed to the CRIC for consideration that includes shares of the CRIC, the paid-up capital of such shares is reduced by the amount otherwise added to the paid-up capital of the shares on the contribution. Accordingly, contributing an FA investment to a CRIC for shares of the CRIC will generally not result in any net increase to the CRIC’s paid-up capital (which would otherwise reflect an amount that the CRIC could distribute to the Parent free of Canadian withholding tax as a return of capital distribution).
The FA dumping rules apply if a Parent controls the CRIC at the time the investment is made or if the CRIC becomes controlled by the Parent as part of the series of transactions or events that includes making the investment. The August 16 proposals provide a “safe harbour” rule that limits the application of the FA dumping rules in situations in which the Parent does not control the CRIC at the time the investment is made, in order to reduce impediments on corporate acquisitions arising as a result of the application of the FA dumping rules. In particular, the August 16 proposals clarify that if the CRIC is not controlled by the Parent at the time the investment is made, the rules will apply only if the CRIC becomes controlled by the Parent after the investment time and only if, at the time of the investment,
- the Parent, either alone or together with any persons that do not deal at arm’s length with the Parent, owned 25% or more of the shares of the CRIC, based on either votes or fair market value;
- the investment is an investment in preferred shares of an FA of the CRIC that is not a wholly owned subsidiary of the CRIC; or
- under an arrangement entered into in connection with the investment, a person or partnership that is not related to the CRIC has, in any material respect, the risk of loss or opportunity for gain or profit in respect of a property that can reasonably be considered to relate to the investment.
If the FA dumping rules apply and result in a deemed dividend, there is an ability to elect that all or a portion of a dividend otherwise deemed to be paid to the Parent by a CRIC to instead be deemed to be paid to the Parent or a non-resident corporation that is controlled by the Parent on a share of the CRIC or of a qualifying substitute corporation (QSC). A QSC is a Canadian corporation that is controlled by the Parent; that has a direct or indirect equity interest in the CRIC and some of the shares that are owned by the Parent; or a non-resident person that does not deal at arm’s length with the Parent. The election is made jointly by the Parent (or the Parent and any non-resident corporation controlled by the Parent), the CRIC (or the CRIC and the relevant QSC in respect of the CRIC). The main purpose of this rule is to accommodate various holding company structures (such as where the shares of a CRIC are owned by a Canadian holding company). Specifically, by allowing the Canadian holding company to make a QSC election, a lower treaty withholding rate may apply (such as a treaty requiring direct ownership for reduced withholding on dividends). In addition, a QSC election may allow the deemed dividend to be recharacterized as a reduction of paid-up capital as described below (which treatment would not be available for a dividend deemed to be paid by the lower-tier CRIC).
The rules also provide for an automatic recharacterization of the dividend deemed to be paid by a CRIC or a QSC as a reduction of the paid-up capital of the shares of the CRIC or QSC if certain conditions are satisfied. The August 16 proposals simplify those conditions in a number of respects and add a requirement that a notification of the paid-up capital reduction be sent to the CRA on or before the 15th day of the month following the month in which the investment was made by the CRIC if the CRIC was controlled by the Parent at the time of the investment. If the CRIC was not controlled by the Parent at the time the investment was made, the notification is required to be filed by the earlier of (i) the first time, after the investment time, at which the CRIC is controlled by the Parent, and (ii) 180 days after the day the investment was made. In certain cases, the paid-up capital reduction can occur on shares of the CRIC or QSC that are owned by persons who deal at arm’s length with the Parent. This will be useful if there are minority shareholders in the CRIC or QSC.
If the paid-up capital of a class of shares of a CRIC or a QSC has been reduced, the reduced paid-up capital may, in certain cases, be effectively reinstated on certain subsequent distributions as a return of capital by the CRIC or QSC or on a redemption, acquisition or cancellation of shares of the CRIC or QSC. The paid-up capital reinstatement rule was broadened by the changes included in Bill C-45 and will be further broadened if the August 16 proposals are enacted. Specifically, the August 16 proposals extend the paid-up capital reinstatement rule to distributions that can be traced to proceeds received by the CRIC from the repayment or disposition of certain debts owing to the CRIC.
More particularly, the paid-up capital of shares of the corporation may be reinstated to the extent that the subsequent distribution is a distribution of the following:
- the relevant FA shares;
- property substituted for the FA shares;
subject to a limited exception described below, if any of the following amounts are received by the CRIC no later than 180 days before the distribution:
- proceeds from the disposition of the FA shares or property substituted for the FA shares;
- proceeds from a dividend or reduction of paid-up capital on the FA shares or shares substituted for the FA shares; or
- proceeds from the repayment or disposition of a debt obligation, or other amount owing, in connection with the investment or any interest on such debt obligation or amount owing.
However, a paid-up capital reinstatement will not be allowed if the amount that was received by the CRIC was not acquired as part of an investment in an FA to which the FA dumping rules do not apply. This rule is intended to ensure that the paid-up capital reinstatement rule will not apply if the amount received by the CRIC is in respect of an investment to which certain exceptions to the FA dumping rules (described below) applied.
Investments Subject to the FA Dumping Rules
For the purposes of the FA dumping proposals, an investment in an FA by a CRIC means any of the following:
- an acquisition of FA shares by a CRIC;
- a contribution to the capital of an FA by a CRIC;
- a transaction in which an amount becomes owing by an FA to a CRIC (other than (i) an amount arising in the ordinary course of the CRIC’s business that is repaid within 180 days, (ii) an amount that is a “pertinent loan or indebtedness” (a term discussed below), or (iii) under the August 16 proposals, an amount that becomes owing because a dividend has been declared but not yet paid);
- an acquisition of an FA debt obligation by a CRIC (other than an acquisition from an arm’s-length person in the ordinary course of the CRIC’s business or a debt obligation that is a pertinent loan or indebtedness);
- an extension of the maturity date of a debt obligation owing by an FA to a CRIC (other than an amount that is a pertinent loan or indebtedness) or of the redemption, acquisition or cancellation date of FA shares owned by the CRIC;
- an indirect acquisition of shares of an FA by a CRIC through the acquisition of shares of another CRIC if the total fair market value of FA shares owned directly or indirectly by the other CRIC exceeds 75% of the total fair market value (determined without reference to debt obligations of any Canadian corporation in which the other CRIC has a direct or indirect interest) of all properties owned by the other CRIC; and
- an acquisition by a CRIC of an option in respect of, or an interest or right in, shares of an FA or a debt obligation of an FA that is not excluded under the exceptions in clauses (c) and (d) above.
More detailed rules supplement the indirect acquisition rules above. For example, rules are provided for determining the amount of an indirect FA investment and a rule prevents “stuffing” a CRIC with non-FA investments to avoid the application of the 75% rule relating to indirect investments. Another rule applies where the FA dumping rules have applied to an indirect acquisition that effectively deems the underlying FA shares to be acquired by the acquiring CRIC to allow the paid-up capital reinstatement rule and the corporate reorganization exception to apply as intended in those circumstances.
Exceptions to the FA Dumping Rules
The three general exceptions to the revised rules are for pertinent loans or indebtedness, corporate reorganizations and strategic business expansions.
Pertinent Loan or Indebtedness
The pertinent loan or indebtedness (PLOI) exception allows an amount owing by an FA to a CRIC to be excluded from the FA dumping rules on an elective basis. The result of making the election is that the particular amount owing becomes subject to a new interest imputation regime, rather than the FA dumping rules. This interest imputation regime generally requires the CRIC to include interest income on the amount owing at a rate that is at least equal to the greater of a prescribed rate (in general terms, the Canadian Treasury Bill rate plus 4%) and the rate applicable on any debt obligation incurred by the CRIC to fund the PLOI. The imputed interest is reduced by interest on the PLOI that is otherwise included in income (i.e., because it was received or accrued by the CRIC). If the new interest imputation rules apply, the existing interest imputation rules in section 17 of the Income Tax Act (Canada) (the Act) do not apply. The PLOI election applies to amounts that became owing after March 28, 2012 (or to amounts whose maturity date of the debt was extended after March 28, 2012) that were not otherwise excluded from being an FA investment under the ordinary course of business exceptions described below. The PLOI election may not, however, be available if the imputed interest on the debt is subject to a lower amount of tax under the Act by virtue of a tax treaty.
A separate rule also allows a CRIC to make a PLOI election in respect of other loans or indebtedness owing to the CRIC by a foreign corporation (such as a loan by the CRIC to its foreign Parent or to a foreign sister corporation). Although such other indebtedness would not have been subject to the FA dumping rules, it could otherwise have been subject to the current “shareholder loan” rule in subsection 15(2) of the Act – which, subject to certain exceptions, would deem the principal amount of such indebtedness to be a dividend paid by the CRIC, which is subject to Canadian dividend withholding tax. When the new election is made, subsection 15(2) does not apply to the particular indebtedness. As with the election for amounts owing by an FA, amounts owing by other non-resident corporations in respect of which this election is made will then be subject to the new interest imputation rule. The election applies to amounts that became owing to a CRIC after March 28, 2012, by the Parent or a non-arm’s-length non-resident corporation.
Exceptions from the FA dumping rules are provided for various types of corporate reorganizations. These exceptions are generally intended to prevent the application of the FA dumping rules when there is no new investment in an FA. These rules apply to certain acquisitions of FA shares by a CRIC:
- on an acquisition from a non-arm’s-length CRIC;
- on an amalgamation, if all of the amalgamating corporations are related;
- on a conversion of debt into shares or the settlement of debt of the FA by the issuance of shares;
- on the reorganization of capital of the FA;
- on a share for share exchange with another FA;
- on a reorganization of capital;
- on a foreign merger; or
- on a liquidation of, share redemption by or dividend or return of capital from, another FA.
There are analogous exemptions where shares of a Canadian corporation are acquired if the acquisition of such shares would be deemed to be an indirect acquisition of shares of an FA held by such Canadian corporation. In addition, the revised FA dumping rules contain a relieving rule to ensure that the FA dumping rules do not apply more than once when property is transferred through a chain of Canadian corporations and invested in an FA.
Notwithstanding the above, an investment may be considered to have been made on a transaction otherwise eligible for a corporate reorganization exemption if, for example, debt is assumed by the CRIC in respect of a distribution from FA (such as on a liquidation of a top-tier FA into the CRIC). Certain of the corporate reorganization exemptions are also not available in respect of the acquisition of preferred shares (as discussed in more detail below in the context of the strategic business expansion exemption). In addition, an anti-avoidance rule may apply if it may reasonably be considered that one of the main purposes for a transaction or event was to cause persons to be related for the purposes of the reorganization exceptions. Finally, the August 16 proposals introduce a new anti-avoidance rule that provides that the corporate reorganization exception will not apply to an acquisition of property by the CRIC if such property can reasonably be considered to have been received by the CRIC as a repayment, in whole or in part, or in settlement of, a PLOI. This provision applies only to transactions or events that occur on or after August 16, 2013.
For purposes of the FA dumping rules, a corporation formed on an amalgamation of a parent and subsidiary CRIC (under subsection 87(11) of the Act) is deemed to be a continuation of its predecessors. In addition, the amalgamated corporation and, under the August 16 proposals each shareholder of the amalgamated corporation, is deemed not to have acquired property as a result of the amalgamation. Similarly, if a CRIC is wound up into another CRIC (under subsection 88(1) of the Act), the parent is deemed to be a continuation of its subsidiary and is deemed not to have acquired property from the subsidiary as a result of the winding-up.
Strategic Business Expansion
The explanatory notes that accompanied Bill C-45 provide that the exception for strategic business expansions is intended to recognize that certain foreign affiliate investments made by a CRIC may have been made by the CRIC even if it were not foreign-controlled. Notwithstanding such intention and some relieving changes in Bill C-45 and the August 16 proposals, the exception continues to be very narrowly drafted. The exception applies when the CRIC demonstrates that all of the following conditions are met:
- The business activities of the subject FA and its subsidiaries are, and are expected to remain, on a collective basis more closely connected to the business activities carried on in Canada by the CRIC (or by a non-arm’s-length CRIC) than the business activities of any non-arm’s-length non-resident corporation (other than the subject FA or its subsidiaries or another FA that is controlled by the CRIC).
- Officers of the CRIC (or of a corporation resident in Canada with which the CRIC did not, at the investment time, deal at arm’s length) had, and exercised, the principal decision-making authority in respect of making the investment, and a majority of those officers were, at the investment time, resident and working principally in Canada or in a country in which an FA controlled by the CRIC (a connected affiliate) is resident if the connected affiliate carries on business activities that are at least as closely connected to the business of the subject FA as the business activities carried on in Canada by the CRIC or a non-arm’s-length CRIC.
At the investment time, it is reasonable to expect that officers of the CRIC (or of a non-arm’s-length CRIC)
- will exercise the principal decision-making authority over the subject FA on an ongoing basis;
- a majority of those officers will be resident, and will work principally, in Canada or a country in which a connected affiliate is resident; and
- the performance evaluation and compensation of officers of the CRIC (or of a non-arm’s-length CRIC) will be based on the results and operations of the relevant FA to a greater extent than will be the performance evaluation and compensation of any officer of a non-arm’s-length non-resident corporation (other than the FA or its controlled subsidiaries or a connected affiliate).
For purposes of applying the rules noted above, a person who is an officer of both the CRIC (or of a non-arm’s-length CRIC) and an “upstream” non-arm’s-length non-resident corporation (e.g., not the subject FA 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.
In determining whether an FA’s business activities are connected with the business activities of the CRIC, the explanatory notes accompanying the draft rules indicate that activities may be connected if they are similar in nature or “parallel” (such as manufacturing and distributing similar products or providing similar services) or if one corporation’s activities are upstream or “downstream” to the other’s or if one business uses the technology of the other in its operations (such as one corporation selling the output of, or providing inputs to, the manufacturing process of the other). The explanatory notes also emphasize that mere connectedness is not sufficient. The connection to the CRIC must be closer than the connection to other non-arm’s-length non-resident corporations.
In determining whether an officer is working principally in Canada, the explanatory notes suggest that the officer must spend the majority of his or her working time in Canada, carry out a majority of the important functions in Canada and make the most of the important decisions with respect to the CRIC in Canada.
The strategic business expansion exception and certain of the corporate reorganization exemptions do not apply in respect of an investment in FA shares that may not reasonably be considered to fully participate in the profits of FA and any appreciation in the value of FA, unless FA is a subsidiary wholly owned corporation of the CRIC. Accordingly, such exceptions will generally not apply to preferred share FA investments unless the FA is a subsidiary wholly owned corporation of the CRIC.
An indirect funding rule extends the strategic business expansion exception to certain investments in an FA that is established in another foreign jurisdiction if that FA provides financing to an FA that would meet the “closely connected” requirements and uses, or under the August 16 proposals is considered under certain relieving provisions in the Act to use, the funds in an active business carried on in the country in which it is resident.
However, an anti-avoidance rule applies when a CRIC uses a “good” FA as a conduit to make an investment in a “bad” FA. For example, the strategic business expansion exemption, and under the August 16 proposals, the indirect funding rule described above, may be effectively deemed not to apply to an investment in an FA that would otherwise satisfy the exemption if that FA in turn invests in another FA that would not meet that exemption.
Other Related Provisions
Additional rules apply for purposes of the FA dumping rules to look through certain investments by partnerships. Very generally, these rules deem each member of a partnership to have entered into any transaction entered into by the partnership itself in proportion to the fair market value of the member’s direct or indirect (through other partnerships) interest in the partnership. Similarly, for purposes of these rules, members of a partnership are deemed to own their proportionate amount of the partnership’s property and are deemed to owe their proportionate amount of amounts owing by a partnership.
Bill C-45 and the August 16 proposals also included changes to the corporate emigration rules, which are intended to deter corporate emigration strategies that could otherwise be used as a substitute for transactions addressed by the FA dumping rules. These rules apply when shares of an emigrating corporation are owned by a CRIC that is controlled by a non-resident Parent and the emigrating corporation is an FA of the CRIC immediately after the emigration. Where applicable, the paid-up capital that the emigrating corporation would otherwise have is deemed to be nil, resulting in a greater departure tax being payable on emigration. There is also a paid-up capital reinstatement rule (similar to the one described above) when a corporation that has had its paid-up capital reduced by the FA dumping rules emigrates. The August 16 proposals extend this paid-up capital reinstatement rule to include an increase in paid-up capital equal to the fair market value of a debt obligation, other than a PLOI, of the FA that is owned by the emigrating corporation immediately before it emigrates.
The August 16 proposals included a proposed amendment to the thin capitalization rules in the Act to exclude from the debt portion of a CRIC’s debt-to-equity ratio a debt that can reasonably be considered to have directly or indirectly funded a PLOI. This amendment is intended to ensure that a CRIC that borrows and uses the proceeds from that borrowing to make a loan to an FA that is a PLOI is not prevented from deducting interest on such borrowing under the thin capitalization rules in the Act.
The FA dumping rules are a new and complex regime that has significant implications for foreign-based multinationals with Canadian subsidiaries and for acquisitions of Canadian corporations with significant foreign subsidiaries. If you have any questions or require additional analysis on the FA dumping rules, please contact any member of our National Tax Department.