The FAD Rules
Referred to as the foreign affiliate dumping (“FAD”) rules, section 212.3 was designed to restrict a non-resident corporation (a “parent”) from using a corporation resident in Canada (a “CRIC”) as an intermediary to invest in a foreign affiliate (an “FA”). A CRIC caught by the FAD rules is deemed to have paid a dividend to the parent subject to withholding tax or to have reduced the paid-up capital (“PUC”) of one or more relevant classes of its shares.
Significant changes have been proposed to the FAD rules as a result of Budget 2019 and the legislative proposals released on July 30, 2019. Subject to a comment period that expired on October 7, 2019, these proposals, if passed, would apply to transactions or events occurring on or after March 19, 2019.
The parent trap
Whereas the FAD rules are currently limited to a CRIC controlled by a non-resident corporation, the proposed amendments would extend the rules to a CRIC that is controlled by: (1) a non-resident individual; or (2) a group of non-resident persons not dealing with each other at arm’s length. Thus, a “parent” under the proposed FAD rules can refer to a corporation, a natural person, or a trust. The result is that a variety of currently innocuous circumstances could attract the application of the new FAD rules, such as where an owner-manager who controls a CRIC with an FA decides to emigrate abroad and ceases to be a resident of Canada, or dies and his or her shares are acquired by an estate that is not a resident of Canada.
The conditions under which the new FAD rules could apply would not always be clear to identify. For example, determining whether a group of non-resident persons deals with each other at arm’s length would, absent a deemed non-arm’s length relationship, be a factual determination to which there is an inherent degree of uncertainty. The key takeaway is that because a reference to a ‘parent’ would no longer be limited to a corporation, the proposed amendments to the FAD rules, if enacted, will apply to a much wider range of situations than is currently the case.
New rules for trusts
Consequential on the expanded meaning of a ‘parent’, special rules are proposed to integrate trusts into the new FAD regime.
For the purposes of determining whether a CRIC is controlled by a non-resident person or by a group of non-resident persons not dealing with a each other at arm’s length and thus, whether the FAD rules apply, proposed paragraph 212.3(26)(a) makes certain assumptions. In particular, a trust is: (1) assumed to be a corporation with a single class of voting shares; and (2) each beneficiary is allocated a number of shares equal to their pro rata fair market value interest under the trust. Accordingly, if a non-resident person has a majority interest in a trust which controls a CRIC, that non-resident person would be considered to control the CRIC with the result that the new FAD rules would apply.
For the purposes of determining the number of shares of a corporation that are owned by beneficiaries under a trust, proposed paragraph 212.3(26)(b) deems each beneficiary to own, and the trust not to own, a number of shares of each class of the corporation. The attribution to the beneficiary is again based on the beneficiary’s pro rata fair market value interest under the trust. Note that this proposed rule is not designed to determine who controls a CRIC or whether certain persons deal at arm’s length but rather to integrate the current mechanics of the FAD rules to trusts, such as the PUC offset mechanism discussed below, once it is established there is a CRIC caught by the FAD rules.
In applying both provisions outlined above, a new anti-avoidance rule stipulates that if the trust is a discretionary trust, then each beneficiary would be deemed to own a 100% interest in the trust, unless the trust is resident in Canada and it cannot reasonably be considered that one of the main reasons for the discretionary power is to avoid or limit the application of the FAD rules. Designed to address a “general policy concern regarding the reliance by taxpayers on discretionary or similar interests to avoid certain tax consequences”, this amendment did not originally include a relieving rule. Rather, all beneficiaries of a discretionary trust would have been deemed to own 100% interest in the trust. While it is now possible to avoid this outcome, it is not entirely clear how a taxpayer would satisfy the “one of the main reasons” test, or how to value a beneficiary or beneficiaries’ interest(s) in the context of a discretionary trust.
In addition to contemplating the answer to these questions, practitioners will now have to be on alert for new circumstances where the FAD rules may be engaged in respect of trusts. Take, for example, a discretionary trust resident in Canada which controls a CRIC with an FA. Subject to the relieving rule described above, if a beneficiary of that trust were to become a non-resident (by virtue of attending school abroad, for example), then any investment by the CRIC in the FA would trigger a deemed dividend subject to withholding tax. Certainly these are not the circumstances that give rise to the perceived abuses that the FAD rules are supposed to target. Nevertheless, this example underlines how the connection between the purpose of the FAD rules and their proposed scope of application may no longer be intuitive.
More closely connected business exception
Subsection 212.3(16) of the current FAD rules sets out the “more closely connection business” (“MCCB”) exception. This provision generally operates to stop the FAD rules from applying when the investment by the CRIC in its FA can be shown to relate to the CRIC more so than the parent based on certain enumerated factors. While there are no substantive amendments proposed for the MCCB exception, a discussion of the MCCB exception is relevant in that it may no longer be possible to satisfy in circumstances to which the new FAD rules, as proposed, would apply.
For example, one of the enumerated factors in this provision requires that the officers of the CRIC: (1) had and exercised principal decision-making authority in respect of the investment in the FA; and (2) a majority of those officers were resident and working principally in Canada at the investment time. Circling back to the example of the emigrating owner-manager, it is difficult to conceive of how this factor could ever be satisfied if the owner-manager is the sole decision-maker of the business carried on by the CRIC.
Generally, the FAD rules allow a CRIC to suppress the PUC of its shares, as opposed to paying withholding tax on the amount of the deemed dividend that otherwise arises on the investment in the FA. This PUC offset mechanism is the usual means by which withholding tax on the deemed dividend is avoided. However, in the private company context, where the PUC on voting share classes is usually low, this would not be a viable option. Accordingly, having access to the MCCB exception would be particularly relevant to the owner-manager described above.
Given that the deadline for comments in respect of the revised legislative proposals has passed, it remains to be seen what form the proposed amendments will ultimately take. In the interim, the foregoing is a snapshot of the changes (and uncertainty) brought about by the proposed amendments to the FAD rules.