The recently released Canadian federal budget ("Budget 2018") includes certain international income tax measures that will impact both Canadians investing or carrying on business outside of Canada and foreigners investing or carrying on business in Canada. In this legal update we will summarize these proposals and their significance for key issues including: reporting requirements, reassessments, foreign accrual property income and in the case of foreign investment into Canada, anti-surplus stripping rules.
Measures impacting foreign affiliates of Canadian residents
Canadian taxpayers are required to file an information return with the Canada Revenue Agency with respect to their foreign affiliates in the year. Under current rules, these information returns must be filed 15 months after the end of the taxpayer's taxation year.
Budget 2018, released February 27th, proposes to reduce the due date for foreign affiliate information returns from 15 months to six months, which is the deadline for corporate income tax returns. This measure will apply to taxation years that begin after 2019.
Under current rules, the Canada Revenue Agency generally has three or four years (depending on the status of the taxpayer) after its initial assessment to audit and reassess a taxpayer's tax liability for a particular taxation year. In certain circumstances, this reassessment period is extended by three years to a total of seven. While this extended reassessment period applies to, amongst other things, transactions between a taxpayer and a non-resident with whom the taxpayer does not deal at arm's length, it does not cover all circumstances involving foreign affiliates.
Budget 2018 proposes to apply the additional three year reassessment period to all income arising in connection with a foreign affiliate of a taxpayer. This proposal is intended to address the complexity of foreign affiliate audits and the difficulty that the Canada Revenue Agency has in obtaining information with respect to foreign affiliates. This measure is to apply to taxation years that begin on or after February 27, 2018.
Budget 2018 also proposes a change to the reassessment period in a situation in which a taxpayer has carried back losses to deduct against income for a prior taxation year. Under Canadian rules, losses can be carried back up to three years. Budget 2018 addresses the situation of a reassessment being made with respect to a transaction between a taxpayer and a non-arm's length non-resident within the seven year reassessment period described above. Under current rules, a taxpayer's losses could, for example, be reduced through a transfer pricing reassessment within the seven year reassessment period, but any such losses that have already been carried back and deducted in a prior taxation year could not be reassessed. Budget 2018 proposes to extend the reassessment period in such situations by an additional three years for a total of ten years. This measure is to apply to losses carried back from a taxation year that ends on or after February 27, 2018.
Tracking arrangements and FAPI
Budget 2018 proposes new rules to address so-called "tracking arrangements" which are designed to allow Canadian residents to avoid Canadian tax on their passive investment income through the use of foreign affiliates.
Under Canada's foreign affiliate tax system, the passive investment income of a controlled foreign affiliate is taxable in the hands of its Canadian resident controlling shareholder in the year in which it is earned regardless of whether it has been distributed (with an offsetting deduction for taxes paid by the foreign affiliate). This type of income is known as "foreign accrual property income" or "FAPI". The FAPI regime is intended to prevent a Canadian resident taxpayer from avoiding Canadian income tax on passive investment income by earning it through a controlled foreign affiliate resident in a low tax jurisdiction (although the rules apply to affiliates in any foreign country).
Income from a foreign affiliate's "investment business" (ie, a business the principal purpose of which is to earn income from property) is included in FAPI. However, an "investment business" does not include a business in which the controlled foreign affiliate employs more than five full-time employees in the active conduct of the business. In such case, the business is treated as an active business and income from that business is excluded from FAPI. As such income is treated as active business income, it can be repatriated to Canada as a tax free "exempt surplus" dividend, provided that the foreign affiliate is resident in a country with which Canada has a tax treaty or a tax information exchange agreement (which include many low and no-tax jurisdictions).
Another requirement for FAPI treatment is that the foreign affiliate be a controlled foreign affiliate, meaning that the Canadian resident taxpayer have a controlling interest (generally more than 50% of voting shares) in the foreign affiliate.
The government has identified a concern with "tracking arrangement" structures, through which Canadian resident taxpayers combine their financial assets in a common foreign affiliate with more than five full-time employees. In such a structure, each taxpayer retains control over its contributed assets and any returns from those assets accrue to its benefit. In other words, the investment assets are not truly pooled in the foreign affiliate. According to Budget 2018, "the affiliate is essentially used as a conduit to shift passive investment income offshore and later repatriate that income to Canada tax-free." Such structures could also be used to ensure that no one investor controls the foreign affiliate, such that the FAPI rules do not apply.
Budget 2018 proposes to introduce new rules that would deem each "tracking arrangement" within the foreign affiliate to be a separate business that would itself have to meet the more than five full-time employees test. In addition, Budget 2018 proposes to deem a foreign affiliate of a taxpayer to be a controlled foreign affiliate of the taxpayer if FAPI attributable to activities of the foreign affiliate accrues to the benefit of the taxpayer under a tracking arrangement. These measures will apply to taxation years of a taxpayer's foreign affiliate that begin on or after February 27, 2018.
Measures impacting foreign investment into Canada
Cross-border surplus stripping
Under Canadian tax rules, a Canadian corporation can distribute its profits to non-resident shareholders free of Canadian withholding tax up to the amount of its paid-up capital ("PUC"). PUC represents the amount of equity capital that has been contributed to a corporation by its shareholders. If profits were instead distributed as dividends, a Canadian withholding tax of 5% to 25% would apply (depending on the applicable tax treaty).
The Income Tax Act (Canada) has long contained an anti-surplus stripping provision to prevent non-residents from artificially creating PUC or otherwise extracting surplus profits in excess of PUC free of Canadian tax. Generally speaking, section 212.1 of the Income Tax Act (Canada) applies where a non-resident parent transfers shares of a Canadian subsidiary corporation (the "subject corporation") to another Canadian subsidiary corporation (the "purchaser corporation"). In such a transaction where the purchaser corporation gives non-share consideration (such as cash or a promissory note) in excess of the PUC of the transferred shares, the excess will be treated as a deemed dividend and subject to Canadian withholding tax. Where the purchaser corporation issues shares as consideration for the purchase of the subject corporation shares, the PUC of the consideration shares will be limited to the PUC of the subject corporation shares (less any non-share consideration). Absent section 212.1, such share exchange transactions would allow the foreign parent to extract surplus Canadian profits in an amount up to the fair market value of the subject corporation shares free of Canadian withholding tax through the sale of the subject corporation to the purchaser corporation.
Budget 2018 proposes to extend this anti-surplus stripping rule to transfers to partnerships and trusts, which are generally treated as look-through entities for Canadian tax purposes. Budget 2018 indicates that some taxpayers have attempted to circumvent the existing rule by first transferring subject corporation shares to a partnership in exchange for interests in the partnership. Draft legislation has not yet been published; however, Budget 2018 states as follows:
"To ensure that the underlying purposes of the cross-border anti-surplus stripping rule, and the corresponding corporate immigration rule, cannot be frustrated by transactions involving partnerships or trusts, Budget 2018 proposes to amend these provisions to add comprehensive 'look-through' rules for such entities. These rules will allocate the assets, liabilities and transactions of a partnership or trust to its members or beneficiaries, as the case may be, based on the relative fair market value of their interests."
This measure is to apply to transactions that occur on or after February 27, 2018. In addition, the Budget 2018 paper indicates that transactions prior to that date may be challenged under the general anti-avoidance rule.