Many U.S. companies engage in business operations in foreign countries, including Canada, through the use of a controlled or wholly owned subsidiary. The reasons for such structures are widely-known and frequently employed. Indeed, there are formation, operational, liability, dividend and permanent establishment issues, which are just a few, that are considered in making an operational choice. Of course, there are other times when foreign tax credit considerations lead a U.S. company to resort to use a hybrid entity organized in Canada as a “company” . Moreover, there are instances where a foreign parent – foreign subsidiary stucture is used with a U.S. parent corporation owning the Canadian holding company where issues under Subpart F merit consideration with a view towards maintaining a tax deferral in the U.S. until such foreign based earnings are repatriated.
While it is always important to understand the potential for legal and regulatory changes in the domestic tax law of a country where a client’s business operations are being conducted, legislators in Canada are now letting it be known that it does not want to be “gamed” by multi-nationals exploiting the Canadian income tax system through certain debt structures or other techniques which have the effect of reducing the income tax base of a Canadian subsidiary.
The warning shot was fired this past Summer by the Canadian Department of Finance in a press release/document that was issued on August 14, 2012. Among the proposals being considered is to limit so-called “debt pushdowns” and “foreign-affiliate dumping” arrangements as well as limiting interest expense deductions claimed by debtor-Canadian subsidiaries to non-Canadian parent companies or affiliates. The proposals generally implement and update elements of the Canadian government's March 2012 Budget. If enacted, the proposals would generally apply to transactions occurring after March 28, 2012.
The Big Debt Pushdown Problem Ok, what’s a “debt pushdown” or “foreign affiliate dumping”? Those are the phrases used by the Canadian Finance Department that are tax strategies used by multinationals operating through Canadian subsidiaries to improperly reduce the impact of Canadian income tax. The reforms being considered attack transactions in which corporations resident in Canada and controlled by non-Canadian residents (CRICs) acquire shares of a non-Canadian affiliate from a related foreign party. The plan involves the issuance of additional debt in Canada, resulting in an interest deduction with respect to the debt and the receipt of tax-free dividends from the non-Canadian affiliate (to the extent that those dividends are deemed paid out of the non-Canadian company’s “exempt surplus” or otherwise result in a outflow of cash without being subject to Canadian withholding taxes.
A shareholder loan proposal is an alternative to one of the original budget proposals regarding debt pushdown transactions. The current shareholder loan rule covers loans by a Canadian corporation to a nonresident shareholder or a person “connected” with that shareholder (other than a non-Canadian affiliate of the Canadian corporation). The August announcement made by the Department of Finance proposes a new elective exception. The 2012 Canadian budget also proposed changes to the thin capitalization rules that limit the ability of Canadian-resident corporations to deduct interest expense. The August proposals would implement those changes. Moreover, the 2012 Canadian budget suggested changes to the law that would allow a taxable Canadian corporation that has acquired control of another taxable Canadian corporation to increase the cost of certain capital assets acquired by the parent in a merger with, or liquidation of, the subsidiary. The changes address the applicability of that increase to a partnership interest (“partnership bump”) owned by the subsidiary under certain circumstances.
Foreign Affiliate Dumping Rules. Another legislative proposal in the 2012 Budget is the “foreign affiliate dumping” rules which are designed to prevent Canadian companies from deducting interest on funds borrowed to acquire shares of stock of foreign affiliates or where foreign corporations access surplus funds of a Canadian subsidiary without a distribution that would otherwise have been subject to Canadian dividend withholding tax (reduction of tax under Part XIII of the Act).
The Proposals, if adopted and enacted into law, will generally 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, and with an ability to elect to use the original version of the foreign affiliate dumping proposals announced in the 2012 Federal Budget for transactions occurring between March 29, 2012 and August 14, 2012). The revised rules provide an exception for certain corporate reorganizations, and relax somewhat the situations in which the rules may result in an immediate deemed dividend as a result of certain foreign affiliate investments. However, the revised rules continue to result in double taxation (such as withholding tax on deemed dividends where property is acquired and a second withholding tax where the same property is distributed as an actual dividend), and may discourage certain non-residents from investing in Canadian corporations.
The foregoing only summarizes the proposals, which are complex and contain several exceptions. There are also withholding and treaty implications.