On August 19 2011 the Department of Finance Canada released for public consultation a package of draft legislative proposals (including explanatory notes) amending the rules in the Income Tax Act (Canada) and the Income Tax Regulations relating to the taxation of Canadian multinational corporations with foreign affiliates. In addition to revising the foreign affiliate reorganisation and distribution rules originally proposed on February 27 2004, the package includes new proposals which replace the regime under the 2004 proposals to suspend the recognition of certain gains from the sale of shares and other assets of foreign affiliates.
Canada's foreign affiliate system combines exemption, credit and foreign accrual property income (FAPI) regimes. Active business income earned by a foreign affiliate resident in a designated treaty country (which includes a country which has entered into a tax information exchange agreement (TIEA) with Canada) from a business carried on in a designated treaty country is included in the foreign affiliate's exempt surplus account. Dividends paid out of exempt surplus by the foreign affiliate to its Canadian parent are not subject to Canadian income tax. Active business income earned by a foreign affiliate where either the foreign affiliate is not resident in a designated treaty country or the foreign affiliate earns the active business outside a designated treaty country is included in the foreign affiliate's taxable surplus account. Dividends paid out of taxable surplus by the foreign affiliate to its Canadian parent are subject to Canadian income tax, subject to a deduction for foreign taxes attributable to such taxable surplus. FAPI (essentially passive income) earned by a controlled foreign affiliate of a Canadian resident is taxable to the Canadian shareholder annually on an accrual basis.
In the news release accompanying the draft legislative proposals, the Department of Finance stated that it remains committed to reviewing and analysing the recommendations made by the Advisory Panel on Canada's System of International Taxation in its December 2008 report, which included:
broadening the existing partial exemption system to cover all foreign active business income earned by foreign affiliates; and
extending the system to capital gains and losses realised on the disposition of shares of a foreign affiliate where those shares derive their value from active business assets.
However, the Department of Finance emphasised that the government's current priority is to encourage countries to enter into TIEAs with Canada. Indeed, it has been active on the TIEA front: three TIEAs are in force, 12 have been signed and 15 are currently under negotiation. According to the Department of Finance, the legislative proposals are aimed at improving the operation of the current foreign affiliate system rather than fundamentally changing it.
A new category, 'hybrid surplus', has been proposed to replace the regime of gain suspension for internal transfers of shares of foreign affiliates proposed in the 2004 draft legislation. Hybrid surplus generally captures all of the gains from the disposition of shares of a foreign affiliate by another foreign affiliate. Half of any distribution from hybrid surplus is exempt and the other half is taxable, subject to a deduction reflecting grossed-up underlying foreign taxes. While this aspect of the hybrid surplus regime is consistent with current rules, the two surplus pools are required to be distributed together. Accordingly, it is no longer possible to defer the repatriation of or to loan the taxable surplus portion of the capital gain to the Canadian taxpayer to avoid Canadian tax. The surplus ordering rule has been revised to deem hybrid surplus to be distributed after exempt surplus, but before taxable surplus, subject to certain elections to change or bypass that default ordering rule.
The new rules apply to internal dispositions of foreign affiliate shares occurring after August 19 2011 and extend to all other dispositions of foreign affiliate shares starting in 2013.
The Department of Finance has proposed a new anti-avoidance rule for upstream loans made by a foreign affiliate of a Canadian resident taxpayer. The rule, modelled on the existing domestic shareholder debt rule in the Income Tax Act, generally provides for an inclusion in the taxpayer's income where a loan is made by a foreign affiliate of the taxpayer to certain specified debtors, including the taxpayer and persons not dealing at arm's length with the taxpayer (other than a controlled foreign affiliate), or where a specifed debtor is indebted to a foreign affiliate and the loan or indebtedness remains outstanding for more than two years. Any amount repaid after the two-year period can be deducted in the year of repayment.
Exceptions from the application of the income inclusion are provided for loans or indebtedness repaid within two years (if it is not part of a series of loans and repayments), and for indebtedness arising in the ordinary course of the creditor's business where, at the time it arose, bona fide arrangements were made for its repayment within a reasonable period of time.
Relief from the income inclusion is provided to the extent that if the amount had instead been a dividend received by the taxpayer, the taxpayer would have been entitled to a full deduction for the dividend (ie, at the time the loan or indebtedness arose, there were sufficient exempt surplus and grossed-up taxable surplus balances to offset the income inclusion). The rationale for relief in that case is that the loan or indebtedness could otherwise have been received by the taxpayer as a tax-free dividend. However, two other conditions must also be met to qualify for the relief:
- No dividends can be paid to the taxpayer (or to another person resident in Canada with which the taxpayer does not deal at arm's length) during the time the loan or indebtedness is outstanding by any foreign affiliate of the taxpayer relevant to the hypothetical dividend determination; and
- no other loan or indebtedness made or incurred while that loan or indebtedness is outstanding can rely on the same surplus balances.
In the explanatory notes accompanying the draft legislation, the Department of Finance states that back-to-back loans and similar financial arrangements with arm's length parties would be considered a misuse of the new rules and an abuse of the Income Tax Act as a whole for the purposes of the general anti-avoidance rule (GAAR).
The rule generally applies after August 19 2011. Outstanding loans or indebtedness are not grandfathered, but they are deemed to arise on August 19 2011 for the purposes of starting the two-year repayment window.
A new anti-avoidance rule reclassifies amounts from exempt surplus to taxable surplus where the amounts arise from transactions that are avoidance transactions for purposes of the GAAR. An avoidance transaction under the GAAR is a transaction (or a part of a series of transactions) that would result in a tax benefit (a reduction, avoidance or deferral of tax), unless the transaction has been undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit. The new rule applies to transactions entered into after August 19 2011.
Return of capital
A new regime intended to replace the 2004 draft legislation and subsequent Department of Finance comfort letters dealing with distributions of capital eliminates the concept of capital of a foreign affiliate and treat distributions in respect of the shares of a foreign affiliate as dividends, unless the distribution is made in the course of a liquidation and dissolution of the affiliate or on a redemption, acquisition or cancellation of shares of the affiliate. In most circumstances, taxpayers will be able to ignore the normal surplus ordering rules and elect to have dividends paid by a foreign affiliate deemed to be paid out of pre-acquisition surplus (ie, essentially any surplus that is not exempt, taxable or hybrid surplus). Dividends paid out of pre-acquisition surplus are fully deductible from taxable income and reduce the adjusted cost base of a foreign affiliate's shares. The intention is to allow taxpayers to access the adjusted cost base of their foreign affiliate shares as a surrogate for the capital of their foreign affiliates. The new regime generally applies after August 19 2011, unless an election is made to have it apply after February 27 2004.
FAPI capital losses
New rules prevent a foreign affiliate from deducting, for taxation years ending after August 19 2011, FAPI capital losses against ordinary FAPI income. To bring the foreign affiliate rules in line with rules applicable to Canadian corporations, a foreign affiliate's FAPI capital losses now need to be tracked separately and are deductible only against the affiliate's FAPI capital gains.
Reorganisations and absorptive mergers
The draft legislation amends the rules relating to liquidations, dissolutions, mergers and combinations of foreign affiliates, and is based in part on the 2004 proposals and on Department of Finance Canada comfort letters issued in respect of the proposals. Amendments have also been made to certain share-for-share exchange provisions involving foreign affiliates in order to prevent the transfer and duplication of losses. The amended rules generally apply after August 19 2011, subject to the ability to elect to have certain rules apply from an earlier date.
A new rule clarifies that certain US-style absorptive mergers will qualify for the foreign affiliate rollover provisions in respect of mergers, provided that specified conditions are met. This rule applies to mergers occurring after 1994, unless a valid election is made to have it apply after August 19 2011.
The draft legislation revises other aspects of the 2004 proposals, including the proposed rules dealing with the foreign affiliate stop-loss rules, foreign affiliates that immigrate to Canada, the FAPI computation of policy reserves of an insurance business and the 'fresh start' FAPI rules. The Department of Finance has confirmed that it has abandoned draft rules contained in the 2004 proposals relating to the concept of a special foreign affiliate paid-up capital, the suspension of gains from the disposition of excluded property, the deemed cost rules for non-resident corporations that become foreign affiliates, the suspension of losses from the disposition of non-excluded property and the 'reverse fresh start' rules.
The draft legislation and explanatory notes are available on the Department of Finance's website and interested parties can submit comments on the draft legislation by October 19 2011.
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