On August 19, 2011, the Department of Finance (Finance) released extensive proposed amendments (2011 Proposals) to the foreign affiliate rules which, in some cases, replace a number of the more controversial amendments that were contained in the proposed amendments released on February 27, 2004 (2004 Proposals) and that may be viewed as a significant shift in tax policy. Many of the less controversial amendments contained in the 2004 Proposals, which replaced earlier proposals released in 2002, have been passed or included in other draft legislation packages. For a discussion of certain of the earlier proposals, see Tax Update dated January 22, 2010.
In the release accompanying the 2011 Proposals, Finance referred to the recommendation of the Advisory Panel on Canada's System of International Taxation (Advisory Panel) in December 2008 that changes be made to Canada’s system of taxation to extend the exemption system to all active business income, regardless of the source country. If the recommendation were adopted, the system would be greatly simplified since there would be no need for the concept of taxable surplus. Finance expressly rejected this recommendation on the basis that access to exempt surplus treatment is being used as an incentive to encourage countries to enter into Tax Information Exchange Agreements (TIEAs) with Canada. TIEAs are a current priority of the Government.
What follows is a brief overview of selected amendments contained in the 2011 Proposals. The topics discussed include the new upstream loan rule, the new hybrid surplus rules, the new anti-avoidance rule with respect to surplus reclassification, the new return of capital regime with respect to foreign affiliates, amendments to the reorganization rules, the tightening of the foreign accrual property income (FAPI) regime with respect to FAPI capital losses, changes to the rules with respect to the calculation of a foreign affiliate's earnings and changes to foreign exchange gains and losses.
Finance is accepting comments on the 2011 Proposals until October 19, 2011. It remains to be seen whether these proposals are the last word on changes to the foreign affiliate rules. Canadian taxpayers who relied on earlier proposals in their tax planning will need to consider whether the 2011 Proposals give rise to adverse or beneficial treatment.
In what can only be viewed as a significant tax policy shift from the provisions of the Income Tax Act (Canada) (Act) and their application by the Canada Revenue Agency in published tax rulings, the 2011 Proposals contain a new upstream loan rule. This rule is modelled on existing subsection 15(2) of the Act (domestic shareholder loan rule). Under the upstream loan rule, Canadian taxpayers will be required to include in their income the amount of loans made by their foreign affiliates to them and to certain non-arm's length persons (other than controlled foreign affiliates of the taxpayers). Like the domestic shareholder loan rule, there are exceptions for indebtedness repaid within two years of the date the indebtedness arose, provided the repayment is not part of a series of loans or other transactions and repayments, and for indebtedness arising in the ordinary course of business of the creditor.
The income inclusion arising under the new upstream loan rule may be offset by any exempt surplus or taxable surplus with sufficient underlying tax on hand. This concession appears to have been made to allow taxpayers to avoid foreign withholding tax that might otherwise arise if the foreign affiliate pays a dividend. Interestingly, no such deduction is available in respect of pre-acquisition surplus.
The upstream loan rule was introduced as an anti-avoidance rule to prevent taxpayers from making synthetic dividend distributions from foreign affiliates in order to avoid what would otherwise be income inclusions that are not fully offset by the deductions referred to above. The explanatory notes state that the rule was needed "to protect the integrity of the existing taxable surplus and the new hybrid surplus regimes." Attempts to get around the rule will be subject to review under the general anti-avoidance rule (GAAR). In particular, back-to-back loans with arm’s length persons would be considered a misuse of the rule and an abuse of the Act as a whole for the purposes of the GAAR.
The upstream loan rule generally applies to taxation years that begin after August 19, 2011. There is no grandfathering in respect of existing indebtedness but indebtedness in existence prior to August 19, 2011, is deemed to have come into existence on August 19, 2011, so that a taxpayer can rely on the two-year repayment window referred to above before being subject to the new rule.
As noted above, the Advisory Panel’s recommendation that Canada extend the current exemption system to all active business income earned by foreign affiliates would have resulted in the repeal of the taxable surplus regime. Instead, the 2011 Proposals create a new surplus account known as hybrid surplus.
"Hybrid surplus" is a hybrid of exempt and taxable surplus in that one-half of any distributions from hybrid surplus will be treated as exempt and the other half will be treated as taxable, with allowance for a deduction reflecting grossed-up underlying foreign taxes. Hybrid surplus will generally include 100 per cent of any gains from the sale of shares of a foreign affiliate by another foreign affiliate, other than FAPI gains. Presently, these gains are divided evenly between exempt and taxable surplus, which allows for the repatriation of exempt surplus in advance of taxable surplus, which can be beneficial where there is no or little underlying foreign tax in respect of the taxable surplus. As noted below, the gains suspension rule previously contained in the 2004 Proposals has been replaced with the surplus reclassification rule.
Hybrid surplus will arise on internal dispositions occurring after August 19, 2011, and with respect to all other dispositions, after 2012.
The 2011 Proposals also contain a new anti-avoidance rule that reclassifies certain amounts from exempt to taxable surplus where the amounts arise from transactions that are avoidance transactions, within the meaning of the GAAR (i.e., a transaction that cannot reasonably be considered to have been undertaken or arranged for bona fide purposes other than to increase the exempt earnings or decrease an exempt loss). This rule replaces the gains suspension regime introduced in the 2004 Proposals, which was intended to apply to internal transfers of property. Interestingly, although the surplus reclassification rule is based on the GAAR, it does not contain an exemption for transactions that do not result in a misuse or an abuse of the Act. Consequently, it would seem that this new anti-avoidance rule will have a much broader application than the GAAR.
This new anti-avoidance rule will apply to transactions entered into after August 19, 2011.
Returns of Capital
In a welcome change, the 2011 Proposals abandoned the foreign affiliate paid-up capital (FPUC) rule introduced in the 2004 Proposals and refined in subsequent comfort letters, in favour of a simplified regime. Instead, all distributions received on shares of a foreign affiliate will generally be considered dividends notwithstanding their legal form as capital or other amount. Recipients of such distributions will be able to treat the "dividends" as having been paid from pre-acquisition surplus and will thus be entitled to a deduction under paragraph 113(1)(d) of the Act. Pre-acquisition surplus dividends reduce the taxpayer's adjusted cost base in its foreign affiliate shares, thus allowing the taxpayer to access its cost base in its shares of a foreign affiliate, as a surrogate for FPUC. Where such an election results in the taxpayer realizing a capital gain because its cost base in the shares of the foreign affiliate is reduced to a negative amount, the taxpayer will be required to treat all or a portion of the capital gain as a dividend paid out of exempt, hybrid or taxable surplus.
These rules generally apply to dividends paid after August 19, 2011. However, a taxpayer may elect to have these rules apply to dividends paid after February 27, 2004, by all foreign affiliates in its corporate group.
Foreign Affiliate Reorganizations
The 2011 Proposals amend various provisions of the Act that deal with liquidations and dissolutions of foreign affiliates, mergers or combinations of foreign affiliates and certain share-for-share exchanges.
With respect to liquidations, the 2011 Proposals contains two sets of rules, one that applies to a liquidation of a foreign affiliate into a Canadian shareholder and one that applies to a liquidation of a foreign affiliate into another foreign affiliate. Both rules have been simplified and are welcome changes. The 2004 Proposals with respect to the liquidation of a top-tier foreign affiliate will now apply to all properties received by the Canadian parent corporation on the liquidation and allow for a rollover of all properties, rather than just shares of another foreign affiliate, where certain conditions are met. Essentially, this rule will now mirror the requirements and results of the tax deferred liquidation rules with respect to Canadian corporations. A second set of rules applies a similar tax-deferred treatment where the requisite ownership requirements are met (at least a 90 per cent surplus entitlement percentage or other conditions are satisfied). If none of the conditions are satisfied, the liquidation will be a taxable event. The first set of rules generally applies to liquidations that begin after February 27, 2004, while the second set of rules generally applies to liquidations that begin after August 19, 2011.
The 2011 Proposals with respect to foreign mergers remove the 90 per cent surplus entitlement percentage requirement and the foreign tax law non-recognition requirement as pre-conditions to the application of the broad rollover rule. Further, the rollover will now apply to all property, not just capital property. The 2011 Proposals contain a so-called "absorptive merger" rule which will extend the beneficial treatment associated with qualifying "foreign mergers" to absorptive style mergers where one of the predecessor corporations is the survivor to the amalgamation (common in U.S. amalgamations). These amendments generally apply to mergers or combinations that occur after August 19, 2011. However, taxpayers may elect to have the amendments apply to mergers or combinations that occur after December 20, 2002.
Lastly, the tax deferred share-for-share rollover rule is being amended so that it will no longer apply where the shares being transferred have an inherent loss. The loss will be suspended and released only in certain circumstances. These amendments apply to dispositions that occur after August 19, 2011.
FAPI Capital Losses
The 2011 Proposals will amend the definition of FAPI so that the allowable portion of capital losses of a foreign affiliate from dispositions of non-excluded property will no longer be deductible against ordinary FAPI income. As in the domestic context, FAPI capital losses will only be deductible against FAPI capital gains with any unapplied FAPI capital losses being carried forward for 20 years and carried back three years.
This amendment will generally be effective for taxation years of foreign affiliates that end after August 19, 2011, with certain of these amendments applying to dispositions that occur after February 27, 2004. Transitional rules also exist with respect to dispositions occurring in taxation years of a foreign affiliate that end on or before August 19, 2011.
In our Tax Update dated March 8, 2011 we commented on a foreign affiliate's calculations of its "earnings" where it is not required to compute its income or profits under the taxation laws of its country of residence or the country in which it carries on its active business. In such circumstances a foreign affiliate is required to compute its earnings under Canadian rules. This provided for a planning opportunity in that a foreign affiliate could choose not to take discretionary deductions such as capital cost allowance in computing its earnings, thus maximizing its exempt surplus.
The 2011 Proposals have put an end to such planning by introducing a rule which requires the maximum amount of any discretionary deductions to be claimed in computing the earnings of a foreign affiliate who is required to compute such earnings under Canadian income tax rules. This new amendment will apply to taxation years of a foreign affiliate that end after August 19, 2011.
Foreign Currency Debts
In addition to various amendments to the rules on the computation of income, gains or losses, the 2011 Proposals amend the rule in subsection 39(2) of the Act, which currently applies where a taxpayer makes a gain or sustains a loss from foreign currency fluctuations, to restrict its application to foreign currency debt owing by a taxpayer. Thus, foreign exchange gains or losses in respect of dispositions of property, including dispositions of foreign currency, will now be determined under subsection 39(1) and there will not be any rule permitting a corporation to recognize foreign exchange gains made, or losses sustained, in respect of its own shares, such as on a redemption of foreign currency denominated shares.
This amendment generally applies to taxation years that begin after August 19, 2011, except that in the case of a foreign affiliate, it applies to taxation years that end after August 19, 2011.