Corporate TaxPrepared by:
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Davies Ward Phillips ∓ Vineberg LLP
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CANADA TARGETS FOREIGN INVESTMENT
Recent changes to the Income Tax Act (Canada) introduce new “foreign affiliate dumping” rules and make changes to the thin capitalization rules. Both of these changes target investments into Canada by non-residents. They were originally proposed in the 2012 Federal budget and, with a number of significant amendments, were enacted in December, 2012.
The foreign affiliate dumping rules are intended to deter certain cash surplus stripping transactions and transactions referred to as “debt dumping”. These targeted transactions generally involve an investment in a non-Canadian subsidiary by a Canadian corporation that is controlled by a non-Canadian corporate parent. The legislation is broadly drafted and assumes that any investment by a foreign-controlled Canadian corporation in a non-Canadian subsidiary involves one of the targeted tax-motivated transactions. Consequently, the rules ignore the fact that it is quite common for foreign investors to invest in international operations through Canadian companies for non-tax reasons. This is particularly true in the mining sector. The strong worldwide reputation of Canadian mining companies and markets has led to the widespread use of Canadian corporations to hold foreign mining ventures in order to gain easier access to financing and capital. It remains to be seen to what extent the foreign affiliate dumping rules will deter these sorts of investments. Moreover, these rules will make investments in existing Canadian companies with non-Canadian operations less attractive to non-Canadian investors considering acquiring a controlling interest and will restrict the ability of many existing Canadian companies controlled by non-Canadian investors to make any additional investments in non-Canadian operations.
Changes have also been made to tighten up the Canadian thin capitalization rules affecting the deductibility of interest by Canadian corporations to certain non-residents. These changes may increase the cost to certain non-residents of investing in Canada. However, unlike the foreign affiliate dumping rules, the changes to the Canadian thin capitalization rules are measured and reasonable, and will put the Canadian thin capitalization rules more in line with similar rules in other countries. A further expansion of the capitalization rules to address trusts and non-resident corporations has been prepared in the 2013 budget, but it is not discussed here.
FOREIGN AFFILIATE DUMPING
A 2008 Canadian government sponsored advisory panel on international taxation (the “Advisory Panel”) recommended that the government consider implementing rules to address transactions referred to as “debt dumping”. In the federal budget of March 29, 2012, the Canadian government announced the “foreign affiliate dumping” rules, which have now been enacted.
The foreign affiliate dumping rules address the debt dumping transactions identified by the Advisory Panel, but they go far beyond this to challenge virtually any investment by a foreign-controlled Canadian corporation in a foreign subsidiary, on the basis that the investment should be considered an extraction of earnings from Canada that inappropriately avoids the imposition of Canadian withholding tax. The Canadian budget materials estimated that the foreign affiliate dumping rules would generate $1.3 billion for the federal government over a five-year period.
Both the debt dumping transactions and the surplus extraction transactions that are the target of the foreign affiliate dumping rules rely on Canada's exemption system for the taxation of active business income earned by a “foreign affiliate” of a Canadian corporation. A “foreign affiliate” of a taxpayer resident in Canada is a non-resident corporation in which the taxpayer directly or indirectly holds not less than 1 per cent of the shares of any class of the non-resident corporation (its “equity percentage”), provided the aggregate equity percentage of the taxpayer and related persons is not less than 10 per cent. Under Canada's foreign affiliate tax regime, most active business earnings of a foreign affiliate are not taxed in Canada on an accrual basis. Moreover, dividends received by a Canadian corporation from a foreign affiliate out of such earnings generally are exempt from Canadian taxation.
Debt Dumping Example
Diagram 1 is an example of a typical debt dumping transaction. Assume Canadian Subco has substantial income from its Canadian business and pays Canadian income tax.
A typical debt dumping transaction involves Foreign Parent transferring fixed value preferred shares of Foreign Subco to Canadian Subco for shares and interest-bearing debt of Canadian Subco. Subject to the debt limits in the Canadian thin capitalization rules, the interest on the debt is deductible to Canadian Subco. The rate of Canadian withholding tax on the interest paid to Foreign Parent is reduced to 10 per cent under most of Canada's tax treaties (and to nil under the Canada-US tax treaty).
Foreign Subco likely will be a foreign affiliate of Canadian Subco. In most circumstances, the income of Foreign Subco will constitute exempt earnings and can be paid to Canadian Subco as dividends on the Foreign Subco preferred shares, without Canadian tax. In addition, the preferred shares could at a later time be disposed of by Canadian Subco without Canadian Subco realizing any gain for Canadian tax purposes, except perhaps foreign exchange gain if the shares are not denominated in Canadian dollars. Accordingly, the transactions create deductible interest expense to Canadian Subco that is available to reduce taxable income from its Canadian business, with little other economic effect. Also, the issuance of Canadian Subco shares to Foreign Parent increases the paid-up capital of such shares. Since paid-up capital of a private corporation can generally be distributed to its shareholders without the imposition of withholding tax, the increased paid-up capital of the Canadian Subco shares could be used to extract cash surplus.1
Cash Surplus Extraction Example
Diagram 2 depicts a foreign affiliate investment that can be thought of as a surplus extraction transaction.
Assume that Canadian Subco has excess cash from its Canadian business, which Foreign Parent would like to access to invest in Foreign Subco. Distributing cash from Canadian Subco to Foreign Parent as a dividend will result in Canadian withholding tax, as will an up-stream loan. Accordingly, Canadian Subco invests the excess cash in fixed-value preferred shares of Foreign Subco. As with the debt dumping example above, Foreign Subco likely would become a foreign affiliate of Canadian Subco and it would be intended that any dividends on the Foreign Subco preferred shares would be received without Canadian taxation. Once again, where the preferred shares are denominated in Canadian dollars they could at a later time be disposed of by Canadian Subco without triggering any gain. Accordingly, the transactions result in the excess cash of Canadian Subco being made available as financing to the Foreign Parent Group without any Canadian withholding tax on the redeployment or any Canadian tax on Canadian Subco's return on the preferred shares.
THE FOREIGN AFFILIATE DUMPING RULES
Subject to certain exceptions, the foreign affiliate dumping rules apply where a Canadian resident corporation (“CRIC”) that is controlled by a non-resident corporation (or becomes controlled as part of the series of transactions) makes an “investment” in a foreign corporation that either is a foreign affiliate of the CRIC or becomes one as part of the series of transactions.2 Where this is the case, there are two potential consequences.
Where the CRIC issues its shares as consideration for the investment or acquires the investment as a contribution to its capital, the “paid-up capital” of the CRIC's shares is not increased as a result of the investment.3
In addition, the CRIC is deemed to have paid a dividend to the controlling non-resident shareholder, at the time the CRIC acquires the investment in the foreign affiliate, in an amount equal to the total of all amounts each of which is the fair market value of any consideration (other than its shares) transferred, any obligation assumed or incurred, or any benefit otherwise conferred, by the CRIC that can reasonably be considered to relate to the investment (the “Deemed Dividend Rule”). The deemed dividend is subject to Canadian withholding tax at a rate of 25 per cent, subject to reduction under an applicable income tax treaty. The full amount of the deemed dividend is deemed to be paid to the non-resident controlling shareholder even where the non-resident does not own all of the CRIC's shares.4 In certain circumstances, it is possible to direct that the dividend be deemed to be paid to a different non-resident shareholder to deal with defects in the rule as it applies to a CRIC that is part of a Canadian corporate group or where, for example, preferential withholding tax rates are available.
As described above, the general charging provisions are very broadly drafted. There are four narrowly focussed exceptions to the general charging provisions.
Debt Subject to an Imputed Interest Regime. Where the investment by the CRIC is in debt of a foreign affiliate, the controlling non-resident shareholder and the CRIC can make a joint election so that the investment in the debt is carved out of the foreign affiliate dumping rules. The foreign affiliate debt will instead be subject to an imputed interest regime that will require the CRIC to include in income interest on the debt at a rate that is at least equal to the greater of a prescribed rate for the period during the year the debt is outstanding (which is the Canadian Treasury Bill rate plus 4 per cent) and the interest rate on any debt obligation incurred by the CRIC to fund the investment in the debt.
Corporate Reorganizations. The definition of “investment” under the foreign affiliate dumping rules is broad enough to include many reorganization transactions that involve no actual investment. A carve out is provided for a number of these (e.g., tax-deferred share exchanges, capital reorganizations, amalgamations and wind-ups). However, most of the corporate reorganization exceptions will not apply in respect of an investment in the shares of a foreign affiliate that do not fully participate in the profits of, and any appreciation in the value of, the foreign affiliate, unless the foreign affiliate is a wholly-owned subsidiary of the CRIC (for the purposes of determining whether the foreign affiliate is wholly-owned, the CRIC is deemed to own the shares of the foreign affiliate held by a Canadian parent or a Canadian subsidiary). In addition, there are other significant limitations on some of these exceptions that mean that they will not apply in many unexpected circumstances.
Paid-Up Capital Reduction. Where the Deemed Dividend Rule would otherwise apply as a result of an investment by the CRIC in a foreign affiliate, a paid-up capital reduction rule (the “PUC Reduction Rule”) may apply to permit a reduction in the paid-up capital of the CRIC's shares instead. The PUC Reduction Rule will apply where all the Canadian-resident shareholders of the CRIC deal at arm's length with the controlling non-resident shareholder and, where the CRIC has more than one class of shares outstanding, the CRIC can demonstrate that an amount in respect of the paid-up capital of one or more of its classes of shares arose from contributions of property to the CRIC that was used by the CRIC to make the investment that gave rise to the deemed dividend. Where the investment was the purchase of shares or a contribution to the capital of a foreign affiliate and the CRIC subsequently wishes to distribute those shares , or proceeds from the disposition of such shares or dividends or reductions of capital in respect of such shares, to its shareholders as a reduction of paid-up capital, the paid-up capital that was reduced by virtue of the election will be restored to allow the distribution.
Canadian-Connected Exception. The Canadian-connected exception exempts an investment in a foreign affiliate from the application of the foreign affiliate dumping rules where each of three factual requirements can be satisfied. This exception is not available in respect of an investment in the shares of a foreign affiliate that do not fully participate in the profits of, and any appreciation in the value of, the foreign affiliate, unless the foreign affiliate is a wholly-owned subsidiary of the CRIC (for the purposes of determining whether the foreign affiliate is wholly-owned, the CRIC is deemed to own the shares of the foreign affiliate held by a Canadian parent or a Canadian subsidiary). The three factual requirements that must be satisfied are as follows:
- The business activities of the foreign affiliate (and all other corporations in which the foreign affiliate has an equity percentage) are expected to remain on a collective basis more closely connected to the business activities carried on in Canada by the CRIC than to the business activities carried on by any non-resident corporation with which the CRIC does not deal at arm's length (other than the foreign affiliate, a subsidiary in which the foreign affiliate has an equity percentage or a controlled foreign affiliate of the CRIC).
- Officers of the CRIC had and exercised the principal decision-making authority in respect of the making of the investment and a majority of those officers were resident, and worked principally, in Canada (or, where certain facts can be shown, a country in which a controlled foreign affiliate of the CRIC is resident [a “connected CFA”]) at the investment time.
- It can reasonably be expected that: (i) the officers of the CRIC will have and exercise the ongoing principal decision-making authority in respect of the investment; (ii) a majority of those officers will be resident, and will work principally, in Canada (or a country in which a connected affiliate is resident); and (iii) the performance evaluation and compensation of the officers of the CRIC who are resident, and work principally, in Canada (or a country in which a connected affiliate is resident) will be based on the results of the operations of the foreign affiliate to a greater extent than will be the performance evaluation and compensation of any officer of a non-resident corporation that does not deal at arm's length with the CRIC.
Where the CRIC does not carry on business activities in Canada or where its management is located outside of Canada, it will not generally be possible to satisfy the Canadian connected exception. In addition, even where it does carry on business activities in Canada but the investment is related equally to business activities carried on by both the non-resident parent and the CRIC, it will not be possible for the CRIC to satisfy the Canadian connected exception. In practice, this exception is likely to be so uncertain as to be of little use in most cases. It is unclear how these factual requirements relate to the tax mischief that the foreign affiliate dumping rules are trying to address.
The foreign affiliate dumping rules assume that all investments by non-residents in non-Canadian operations through a Canadian company have a tax avoidance motivation. As such, they will apply in many inappropriate circumstances and will likely deter investments that otherwise would have been made for non-tax reasons. They seem in direct conflict with the Ministry of Finance's broader message that Canada is “open for business”. A few examples may demonstrate the potential application of the rules in circumstances where there is no tax avoidance motive.
Assume that a non-Canadian corporate multinational (Foreign Multinational) acquires the shares of Canco in Diagram 3. Canco is a holding company that does not itself carry on business and, prior to the acquisition, Canco was controlled by a Canadian resident.
The acquisition of the Canco shares by Foreign Multinational will result in Canco becoming a CRIC. As a result, any investment by Canco in Foreign Subco 1 or Foreign Subco 2 will result in a reduction of the paid-up capital of the CRIC shares (to the extent thereof) with any excess being a deemed dividend to Foreign Multinational.5 For instance, assume that Foreign Subco 1 has surplus cash and Foreign Subco 2 requires cash for its operations. Prior to the acquisition of Canco by Foreign Multinational, Foreign Subco 1 could distribute the funds to Canco and Canco could use the cash to invest in shares of Foreign Subco 2. After the acquisition of Canco by Foreign Multinational, the investment by Canco in the shares of Foreign Subco 2 will result in a deemed dividend to Foreign Multinational unless the PUC Reduction Rule applies.6 Indeed, any investment by Canco in a Foreign Subco will have this effect. It is unclear why the acquisition of the Canco shares by Foreign Multinational should restrict Canco's ability to continue to invest in its subsidiaries.
There are a number of Canadian companies listed on the Toronto Stock Exchange that have substantially all their operations outside of Canada and have little or no Canadian management. Many of these companies are mining companies that were formed as a result of reverse merger transactions in order to obtain a listing on the Toronto Stock Exchange and not for tax reasons. Assume that a non-resident corporate shareholder (Foreign Investor) subscribes for 51 per cent of the shares of such a Canadian public company (Canadian Pubco), as shown in Diagram 4.
If the subscription amounts are used by Canadian Pubco to invest in the shares of Foreign Holdco, the amount of the investment will reduce the paid-up capital of the Canadian Pubco's shares. Furthermore, any additional investments (whether through third party borrowing or from retained earnings) will result in a deemed dividend in the full amount of the investment to Foreign Investor except to the extent there is any paid-up capital remaining in the CRIC shares to which the PUC Reduction Rule can apply. Even if the foreign operations have no connection to the investor's business, the Canadian-connected exemption will not be available because Canadian Pubco is a holding company and has its management in the US. The application of the rules in this context is clearly inappropriate.
The Department of Finance is of the view that the paid-up capital election is an appropriate solution to deal with the fact that the rules potentially apply in these types of circumstances but this will not be true in many cases.
As a final example, assume that Canco (controlled by Non-Resident Parent) purchases 10 per cent of the outstanding shares of Canadian Pubco in Diagram 5 and Canadian Pubco has no material assets other than the shares of Foreign Subco.
Since Canco will have a 10 per cent indirect interest in Foreign Subco, Foreign Subco will become a foreign affiliate of Canco. Under the indirect acquisition rule in the definition “investment”, the acquisition of the 10 per cent interest in Canadian Pubco by Canco will be deemed an investment by Canco in Foreign Subco and will result in a deemed dividend in the amount of the investment by Canco to Non-Resident Parent except to the extent that the PUC Reduction Rule applies to reduce the paid-up capital of Canco's shares. It is difficult to understand why the foreign affiliate dumping rules should even be relevant to this acquisition of Canadian Pubco shares by Canco.
Numerous other examples could be provided of the overreaching application of the foreign affiliate dumping rules. And equally importantly, there are serious technical anomalies in the rules that will result in this application in unexpected circumstances and create significant anomalous tax differences between essentially similar transactions that cannot be justified on any tax policy theory. As such, the rules will present many dangerous and unnecessary traps for taxpayers.
THIN CAPITALIZATION AMENDMENTS
The Canadian thin capitalization rules currently apply to deny the deduction of a portion of the amount of otherwise deductible interest paid or payable by a Canadian resident corporation on its debts owed to non-resident persons that are, or do not deal at arm's length with, specified shareholders (“relevant debt”) where the amount of the relevant debt exceeds two times the aggregate of the equity attributable to “specified non-resident shareholders” and the retained earnings of the corporation (“relevant equity”).7A specified shareholder is a shareholder who, either alone or together with persons with whom the shareholder is not dealing at arm's length, owns shares of the Canadian corporation representing 25 per cent or more of its votes or value.
Recommendations of the Advisory Panel
In its report to the Canadian government on international taxation, the Advisory Panel considered the appropriateness of the Canadian thin capitalization rules. While the Advisory Panel concluded that Canada's overall approach to interest expense incurred by foreign-owned Canadian businesses was sound in principle and appropriate in scope, it made a few specific recommendations to the thin capitalization rules in order to protect the Canadian tax base.
With respect to the current 2:1 debt-to-equity limit, the Advisory Panel considered whether the ratio was a good proxy for the amount of related-party debt that a foreign-owned Canadian corporation should be allowed to incur in Canada. Based on the Advisory Panel's benchmarking research, it concluded that the 2:1 debt-to-equity limit was not in line with actual Canadian industry ratios or with the rules in place in other countries, which have been tightening in recent years. As a result, the Advisory Panel recommended reducing the debt-to-equity limit from 2:1 to 1.5:1.
The Advisory Panel also noted that the current thin capitalization rules apply only to foreign-owned Canadian corporations and that foreign companies that carry on business in Canada through partnerships, trusts or branches are not subject to the same limitation, which, in the view of the Advisory Panel, raises issues about the integrity and fairness of the current rules. Accordingly, the Advisory Panel recommended extending the application of the thin capitalization rules to partnerships, trusts and Canadian branches of non-resident corporations.
Lastly, the Advisory Panel noted that interest expense that is not deductible under the thin capitalization rules maintains its character as interest for both domestic and tax treaty purposes, which could allow US investors to inappropriately reduce their Canadian withholding tax liabilities because of the exemption from withholding tax on non-arm's length interest in the Canada-US tax treaty.8 Characterization of this interest as a dividend would avoid this issue, but would reduce withholding taxes payable in many cases by non-US persons subject to the rule. As a result, the Advisory Panel recommended that the Canadian government review the treatment of interest expense not deductible under Canada's thin capitalization rules to ensure non-resident investors are prevented from inappropriately reducing their Canadian withholding tax obligations.
The changes coming out of the 2012 federal budget generally adopted the Advisory Panel's recommendations, other than that of extending the thin capitalization rules to trusts and non-resident resident corporations that carry on business directly through Canadian branches or partnerships. This omission has been corrected in the 2013 federal budget, in proposed changes that are not discussed herein.
The amendments provide that for taxation years that begin after 2012, the thin capitalization debt-to-equity limit is reduced from 2:1 to 1.5:1.
In addition, the amendments provide that for taxation years that begin on or after March 29, 2012, each member of a partnership is deemed to owe a portion (based on its entitlement to partnership income) of the debts owed by the partnership for the purposes of determining whether a Canadian resident corporate partner's outstanding debts owed to specified non-residents exceeds the debt-to-equity limit. Where a Canadian-resident corporate partner's debt-to-equity limit is exceeded by virtue of the allocation of partnership debt to it, the interest deduction is not denied in the computation of partnership income. Rather, the Canadian corporation will have an income inclusion in respect of disallowed interest on its allocated portion of the partnership debt.
Finally, for withholding tax purposes the amendments re-characterize interest paid by a corporation resident in Canada, or by a partnership of which the corporation is a member, to a non-resident person as a dividend paid by the Canadian resident corporation, to the extent that the interest is not deductible or, in the case of the debt of the partnership, an amount is included in computing the income of the corporation, because the thin capitalization limit is exceeded. For the purposes of this dividend withholding re-characterization rule, any interest that is payable after the end of the year is deemed to be paid immediately prior to the end of the year. These re-characterization rules apply for taxation years that begin on or after March 29, 2012.
Both the foreign affiliate dumping rules and the changes to the thin capitalization rules target investments in Canada by non-residents. The thin capitalization amendments are consistent with recommendations of the Advisory Panel and are intended to put the rules more in line with similar rules in place in other countries. They represent incremental changes to existing rules that are consistent with Canada's existing tax framework. On the other hand, in seeking to address surplus stripping as well as debt dumping, the foreign affiliate dumping rules go well beyond the recommendations of the Advisory Panel and in an unexpected direction. They also appear to be broader in scope than is necessary to address either of these issues and apply in many unintended ways. As a result, the foreign affiliate dumping rules will likely deter legitimate foreign investments by Canadian corporations controlled by non-residents — and potentially investments in those Canadian corporations themselves.
- A distribution of paid-up capital by a public corporation is deemed to be a dividend except in certain limited circumstances. The distribution of paid-up capital could affect Canadian Subco's ability to deduct interest on its debt owed to Foreign Parent under Canada's thin capitalization rules which operate by comparing the amount of relevant debt to the amount of relevant equity.
- An “investment” is broadly defined to include: (i) almost any acquisition by the CRIC of shares or options of the foreign affiliate, or debt except when the election described below is made; (ii) a contribution to the capital of the foreign affiliate by the CRIC or the conferral of any benefit by the CRIC on the foreign affiliate; and (iii) an extension of the maturity or redemption date of debt or shares of the foreign affiliate held by the CRIC. An investment in a foreign affiliate also is deemed to occur where the CRIC acquires shares of another Canadian resident corporation if the total fair market value of all the foreign affiliate shares owned directly or indirectly by the other Canadian resident corporation exceeds 75 per cent of the total fair market value of its assets.
- In addition, any contributed surplus otherwise arising on a contribution to the CRIC where the foreign affiliate dumping rules apply is excluded from the computation of the CRIC's debt-to-equity ratio for thin capitalization purposes.
- The wording of the provisions suggests that a contribution of capital by the non-resident controlling shareholder to the CRIC that is invested in a foreign affiliate will potentially result in the application of both rules — i.e., the paid-up capital rule applying to deny the increase in the paid-up capital of the CRIC shares to reflect the contribution to capital and the Deemed Dividend Rule applying to deem a dividend to the non-resident controlling shareholder as a result of the investment in the foreign affiliate. It is understood that this is not what the Department of Finance intended.
- In many cases Foreign Multinational will cause the transfer of Foreign Subco 1 and Foreign Subco 2 out from under Canco so that the two subsidiaries are no longer within the Canadian tax net. In particular, where the Canadian tax bump is available, Foreign Multinational could undertake a set of transactions to utilize the bump to increase the tax cost of the shares of Foreign Subco 1 and Foreign Subco 2 to their fair market value as of the date of the acquisition of control and transfer such shares out from under Canco without triggering any Canadian tax. If the Canadian tax bump is not available and there would be a significant tax cost to transferring such shares out from under Canco or where there are commercial reasons for leaving the foreign subsidiaries under Canco (e.g., third party financing restrictions), Foreign Multinational may, in the absence of the foreign affiliate dumping rules, leave the two foreign subsidiaries under Canco.
- If CRIC shares have sufficient paid-up capital, the PUC Reduction Rule would apply to reduce such paid-up capital instead of the Deemed Dividend Rule applying. This would likely postpone the withholding tax on the deemed dividend, which would arise because there would be less paid-up capital to make tax-free distributions in the future.
- Relevant debt for a particular taxation year of a corporation is computed by totalling the greatest amount of the corporation's outstanding debts to specified non-residents in each month of the year and dividing the total by the number of calendar months ending in that taxation year. Relevant equity for a particular taxation year of a corporation is the sum of: (i) the non-consolidated retained earnings of the corporation at the beginning of the year; (ii) an average paid-up capital amount based on the paid-up capital at the beginning of each calendar month that ends in the taxation year, in respect of shares owned by a specified non-resident shareholder; and (iii) an average contributed surplus amount based on the contributed surplus at the beginning of each calendar month that ends in the taxation year to the extent that it was contributed by a specified non-resident shareholder.
- Under domestic rules, interest paid by a Canadian resident to a non-resident person is only subject to Canadian withholding where: (i) the interest is paid to, or is on debt owed to, a person that does not deal at arm's length with the payer (“non-arm's length interest”); or (ii) the interest constitutes “participating debt interest”. There is an exemption from Canadian withholding tax on non-arm's length interest under the Canada-US tax treaty where such interest is paid to a US resident entitled to the benefits of such treaty withholding tax on non-arm's length interest under the Canada-US tax treaty where such interest is paid to a US resident entitled to the benefits of such treaty.