New foreign affiliate proposals on distributions, reorganizations and other transactions
International Tax Alert August 25, 2011
On August 19, 2011, the Department of Finance (Finance) released the final package of draft legislation (August 19 legislation) related to the February 2004 proposals concerning the taxation of foreign affiliates. Our alert of August 22, 2011 discussed the introduction of the hybrid surplus and upstream loan rules. This alert discusses the remainder of the proposals included in the August 19 legislation.
On February 27, 2004, Finance released an extensive package of amendments to the foreign affiliate rules which replaced another package released on December 20, 2002. Over the years, some of the less controversial amendments were carved out of the 2004 package and passed by Parliament or included in a package of draft legislation released on December 18, 2009 (and re-released in draft on August 27 2010). However, many of the 2004 proposals remained outstanding until the August 19 legislation was released, including most of the proposals relating to distributions and reorganizations.
The August 19 legislation continues the retreat from the 2004 proposals that began with the December 18, 2009 package. Many of the proposals have been abandoned or radically revamped. New proposals that had been anticipated, including the introduction of a concept of “foreign paid-up capital” will not be introduced.
In most respects, the proposals represent a welcome change from the original 2002 and 2004 amendments, and are effective on a prospective basis. In general, most transactions between December 20, 2002 and August 19, 2011 that were analyzed on the basis of “current law”, “draft law” and “expected changes to the draft law” will be taxed in accordance with “current law”, although each situation must be considered carefully. In some cases, a taxpayer may be able to re-file returns that were prepared based on the draft law and obtain a more favourable tax result under current law, or make an election to apply the proposed law on a retroactive basis.
Taxpayers are requested to provide comments on the draft legislation by October 19, 2011.
Dispositions of excluded property
The 2004 proposals to “suspend” surplus arising from the disposition of excluded property of a foreign affiliate (generally, assets or shares relating to an active business) to a “specified purchaser” have thankfully been abandoned, and will never enter into force, even for the period before August 19. The rules were extremely complex and technically deficient in many respects. In particular, the mismatch between surplus balances and other attributes created by the application of the rules made it difficult to enter into subsequent distributions or reorganizations without negative tax implications.
As discussed in our previous alert, gains and losses on dispositions of shares and partnership interests that are excluded property will prospectively be included in “hybrid surplus” and tracked separately. The exempt and taxable portions of a capital gain that qualifies as hybrid surplus must be repatriated together. It will no longer be possible to repatriate to Canada as exempt surplus the exempt portion of a capital gain and pay tax on the taxable portion at capital gains rates rather than the rate applicable to a dividend from taxable surplus. These proposals are effective after August 19, 2011 for non-arm’s-length dispositions and after 2012 for all other dispositions.
For other excluded property assets such as depreciable property, inventory and goodwill, the rules which have historically limited the creation of surplus in respect of certain non-arm’s length transfers to which a local tax rollover applies will not be repealed, as was proposed in the 2002 and 2004 amendments. However, they will be amended for dispositions after August 19, 2011 to apply to transfers to a “designated person or partnership”, as defined in regulation 5907(1) (essentially non-arm’s length persons and partnerships) unlike the current rules which apply to transfers to another foreign affiliate or non-arm’s length person.
There will also be an exception to these surplus denial rules in new regulation 5907(2.01) to allow surplus to be recognized on the transfer of assets to another foreign affiliate if the shares of the affiliate are sold to an arm’s-length purchaser within 90 days. This exception is intended to apply where a transaction that would otherwise be structured as a direct asset sale is structured as a share sale for foreign commercial reasons. This provision also applies prospectively but may be applied retroactively to December 20, 2002 on an elective basis.
Given the reinstatement of the surplus denial rules described above, it is somewhat surprising that a new anti-avoidance rule has been included in draft regulation 5907(2.02), applicable to transactions entered into after August 19, 2011. If an amount that would otherwise increase exempt earnings arises from an “avoidance transaction” (as that term is defined for the purposes of the General Anti-avoidance Rule (GAAR)) the amount will be included in taxable earnings and any related tax will be included in underlying foreign tax. The provision may therefore apply if the transaction cannot reasonably be considered to have been undertaken or arranged primarily for bona fide purposes other than to increase the exempt earnings or decrease the exempt loss of the affiliate. Unlike the GAAR, no exception is provided for transactions that are not abusive. Note that dispositions of shares that are excluded property will not be caught by this rule, since such dispositions will now create “hybrid surplus”.
Dividends, returns of capital and other distributions
The current rules associated with distributions from foreign affiliates can be problematic, particularly where a foreign affiliate distributes capital such as contributed surplus or share premium that does not qualify as legal stated capital under Canadian principles. The Canada Revenue Agency (CRA) has recently reiterated that such distributions may be taxable under section 15 as shareholder benefits. The 2004 legislation addressed this in part in proposed subsection 88(3), but was not complete.
The August 19 legislation contains new subsections 90(2) and 90(3) to address distributions from foreign affiliates, other than distributions made in the course of a liquidation of the foreign affiliate or on a redemption of shares of the affiliate. Any pro rata distribution made on a class of shares of a foreign affiliate will be deemed to be a dividend and not, for example, a return of capital or a shareholder benefit, regardless of the legal classification of the distribution. Because proposed subsection 90(2) applies for the purposes of the Act, it will apply both to distributions from first-tier affiliates as well as distributions between affiliates.
The dividend received by the taxpayer or another foreign affiliate will be subject to the ordering rules for surplus distributions; however, in respect of a dividend paid to a Canadian corporate shareholder, an election is available under new regulation 5901(2)(b) to have the entire dividend deemed to be paid from pre-acquisition surplus and to reduce the adjusted cost base (ACB) of the shares. This effectively provides the ability to access the ACB of the shares and bypass the surplus accounts in circumstances where a dividend from hybrid surplus or taxable surplus would be taxable. Unfortunately, the election is not generally available if any shares of the affiliate are held by a partnership.
If a gain arises under subsection 40(3) because the distribution exceeds the ACB of the shares, the taxpayer is required to reduce the gain by making a deemed dividend election under subsection 93(1.1) and new subsection 93(1.11). This will prevent a taxpayer from choosing to realize a capital gain rather than pay tax on a dividend out of low-taxed taxable surplus.
Notwithstanding the new rules characterizing returns of paid-up capital as dividends, a return of paid-up capital from a foreign affiliate will nevertheless not be treated as a dividend for purposes of the term preferred share rules and guaranteed or collateralized share rules in subsection 258(3) and (5) which apply in certain circumstances to deem dividends to be interest received by a taxpayer.
The proposals are applicable after August 19, 2011 but may be applied on an elective basis retroactive to February 27, 2004. A transitional rule provides that, despite the election, current law will apply to returns of capital which occurred in the transition period.
Safe income of a foreign affiliate
Paying a tax-free intercorporate dividend which reduces a capital gain that would be realized on a disposition of the shares of a Canadian company is generally limited by the amount of “safe income on hand”. Under current rules, safe income of a foreign affiliate is the amount that could be deducted under paragraphs 113(1)(a) and (b) in respect of exempt surplus and underlying foreign tax relating to taxable surplus of the affiliate. Under proposed amendments to paragraph 55(5)(d), safe income of a foreign affiliate will be the lesser of 1) the “tax-free surplus balance” (TFSB) of the affiliate and 2) the fair market value of the affiliate.
TFSB as defined in regulation 5905(5.5) is amended to include an affiliate’s hybrid surplus, provided the effective foreign tax rate on the hybrid surplus is at least 12.5%.The change, in the context of safe income, limits the addition to safe income to those capital gains which were subject to local country income tax at a rate equal to or greater than the Canadian capital gains tax rate and which could therefore be repatriated without additional Canadian tax.
Safe income continues to be measured separately for each foreign affiliate. However, since safe income is now limited to the fair market value of the affiliate, deficits of lower-tier subsidiaries or unrealized losses could reduce a top-tier foreign affiliate’s safe income. This change may be in response to the decision in Brelco which held that deficits of a foreign affiliate do not always reduce safe income.
The proposed rules are effective for dividends received after August 19, 2011, except for dividends received as part of a series of transactions including a sale of shares to an arm’s-length party under a written agreement entered into before August 19, 2011.
Liquidations of foreign affiliates
Top-tier foreign affiliates
Subsection 88(3) currently applies only where there is a liquidation and dissolution of a controlled foreign affiliate of a taxpayer, and only if shares of another foreign affiliate are distributed to the taxpayer on the liquidation. Rollover treatment is provided for shares of other foreign affiliates but not for other properties distributed on the liquidation, which are deemed to be distributed at fair market value by virtue of subsection 69(5).
The August 19 legislation includes significant amendments to subsection 88(3), including some of the changes discussed in various comfort letters issued by Finance following the release of the 2004 proposals. However, the provision has been narrowed from the 2004 proposals, being restricted to liquidations and dissolutions of top-tier foreign affiliates, and not applicable to share redemptions, dividends or other distributions.
Subsection 88(3) will now apply to the liquidation and dissolution of any foreign affiliate (the “disposing affiliate”) and not just controlled foreign affiliates. The proposed rule allows all properties of the disposing affiliate to be distributed on a rollover basis (unless a higher relevant cost base (RCB) is elected), so long as the liquidation and dissolution is a “qualifying liquidation and dissolution” (QLAD) as defined in proposed subsection 88(3.1) and discussed in greater detail below. If the liquidation and dissolution is not a QLAD, only shares of other foreign affiliates that are excluded property are eligible for rollover treatment – other properties are disposed of at fair market value. If the affiliate is an “eligible controlled foreign affiliate” the taxpayer can elect an RCB for the property up to its fair market value under the proposed changes to the definition of RCB in subsection 95(4), however, any resulting income or gain is included in FAPI.
The taxpayer is deemed to have acquired the distributed property from the disposing affiliate at a cost equal to the disposing affiliate’s proceeds of disposition of the property.
The taxpayer is deemed, in general terms, to have disposed of the shares of the disposing affiliate for proceeds of disposition equal to the cost to the taxpayer of all distributed properties received from the disposing affiliate, less any debts assumed by the taxpayer in consideration for those properties. If the liquidation and dissolution is a QLAD, any loss of the taxpayer on the disposition of the shares of the disposing affiliate is deemed to be nil.
In order to be considered a QLAD, the taxpayer must elect QLAD treatment (under proposed regulation 5911) and one of two tests must be met: (i) the taxpayer owns not less than 90% of the issued and outstanding shares of each class of shares of the disposing affiliate; or (ii) the taxpayer receives at least 90% of the net assets of the disposing affiliate and has at least 90% of the voting power in the disposing affiliate’s shares. The 90% threshold is similar to the one required to liquidate a Canadian corporation on a tax-deferred basis under subsection 88(1). There is no rule that would aggregate shareholdings of related Canadian taxpayers for the purpose of applying these thresholds.
Proposed subsections 88(3.3) and (3.4) include a new concept referred to as a “suppression election”. If the liquidation and dissolution is a QLAD and the taxpayer would otherwise realize a capital gain on the disposition of the shares of the disposing affiliate after making a subsection 93(1) deemed dividend election, the taxpayer may elect (under proposed regulation 5911) to reduce the amount at which certain capital properties of the disposing affiliate are deemed to be disposed of (and therefore the amount at which those properties are acquired by the taxpayer) in order to avoid the gain.
Consequential changes are proposed to regulation 5907(9) to clarify the timing of dispositions of property arising on the liquidation and to ignore the suppression election for the purpose of determining the surplus balances of the affiliate in order to avoid a circular calculation.
Finally, if the liquidation and dissolution is a QLAD, the taxpayer and the disposing affiliate may jointly elect (under proposed regulation 5911) for any distributed property that is shares of a Canadian corporation which are non-treaty protected taxable Canadian property (TCP) to be disposed of at ACB rather than RCB. Under proposed amendments included in the August 19 legislation, the definition of RCB is being amended such that it can differ from ACB in certain circumstances.
The proposed rules are effective for liquidations and dissolutions that begin after February 27, 2004. For the period from February 28, 2004 to August 18, 2011, taxpayers may elect the application of a similar version of the provision that applies to property received by a taxpayer on a share redemption, dividend or reduction of paid-up capital in addition to property received on a liquidation and dissolution.
Lower-tier foreign affiliates
Paragraphs 95(2)(e) and (e.1) currently apply where a foreign affiliate of a taxpayer is liquidated and dissolved and property is distributed to a shareholder that is another foreign affiliate of the taxpayer. Paragraph 95(2)(e.1) deals with liquidating affiliates in which the taxpayer’s surplus entitlement percentage is not less than 90%, but only where a non-recognition condition is met (the liquidation must occur on a tax-deferred basis for foreign tax purposes if the shareholder is resident in the same country). Paragraph 95(2)(e) deals with liquidations that do not qualify under paragraph 95(2)(e.1).
Under existing rules, paragraph 95(2)(e) provides a rollover only in respect of shares of another foreign affiliate distributed on the dissolution while paragraph 95(2)(e.1) provides a broader rollover, but only in respect of capital property of the liquidating affiliate.
Under the August 19 legislation, paragraph 95(2)(e.1) is repealed and the rules consolidated in new paragraph 95(2)(e).
Similar to proposed subsection 88(3), the proposed rule will allow all properties to be distributed on a rollover basis, so long as the liquidation and dissolution is a “designated liquidation and dissolution” (DLAD), a new definition in subsection 95(1). There is no longer a foreign rollover requirement. While similar to the QLAD definition used in subsection 88(3), a DLAD is not elective and the test can be met if:
- The taxpayer has at least a 90% surplus entitlement percentage in the liquidating affiliate (as that term is revised in the August 19 legislation);
- One particular foreign affiliate of the taxpayer receives at least 90% of the net assets of the disposing affiliate and has at least 90% of the voting power in the disposing affiliate’s shares; or
- One particular foreign affiliate of the taxpayer owns at least 90% of each class of stock of the liquidating affiliate.
Where the liquidating affiliate is an “eligible controlled foreign affiliate”, as defined in subsection 95(4), the taxpayer can elect to realize some or all of an accrued gain by designating an RCB in excess of ACB (up to fair market value) — however, any gain realized will be FAPI.
If the liquidation is not a DLAD, a rollover is still possible for shares of another foreign affiliate distributed as part of the liquidation and dissolution if those shares are excluded property. Other properties are deemed to be disposed of at fair market value.
The shareholder affiliate is deemed to have a cost in the distributed property equal to the liquidating affiliate’s proceeds of disposition.
The rules that apply in respect of the disposition of the liquidating affiliate’s shares are also being significantly amended. New subparagraph 95(2)(e)(iv) sets out different computational rules that depend on whether there is an inherent gain or loss in the shares, whether the shares are excluded property and whether the liquidation and dissolution is a DLAD. If the liquidation and dissolution is not a DLAD, the proceeds of disposition are based on the cost to the shareholder affiliate of all distributed properties received from the liquidating affiliate, less any debts assumed by the shareholder affiliate in consideration for those properties.
If the liquidation and dissolution is a DLAD and the shareholder affiliate would otherwise realize a gain on the disposition of the liquidating affiliate’s shares, the proceeds are reduced to ACB to avoid gain recognition. If the liquidation is a DLAD and the shareholder affiliate would otherwise realize a loss on the disposition of the liquidating affiliate’s shares, the proceeds are increased to ACB to eliminate the loss if the shares are not excluded property (i.e., the loss would otherwise be a foreign accrual capital loss or FACL). Losses on shares that are excluded property are recognized. Any denied FACL on the disposition of the shares is nevertheless applied to reduce hybrid surplus.
Regulation 5905(7), which currently applies to transfer the surplus balances of the disposing affiliate to the shareholder if paragraph 95(2)(e.1) applies, will similarly be restricted to DLADs. If the DLAD test is not met, a section 93 election can be made to transfer the surplus balances, but only to the extent that there is a gain on the shares as a result of proposed changes to subsection 93(1). Deficits will not be transferred to the shareholder, as under current rules.
If the liquidation and dissolution is a DLAD, the shareholder is deemed to be the same corporation as the disposing affiliate for certain purposes including various stop-loss rules.
Amended paragraph 95(2)(e) and the repeal of paragraph 95(2)(e.1) generally apply in respect of liquidations and dissolutions that begin after August 19, 2011, but the taxpayer may elect to have these rules apply to liquidations and dissolutions that began after December 20, 2002 with some modifications if the taxpayer elects in respect of all foreign affiliates of the taxpayer.
Mergers of foreign affiliates
Paragraph 95(2)(d.1) provides for the rollover of capital property on a “foreign merger” of two or more predecessor foreign corporations, as defined in subsection 87(8.1). Currently, and under the 2004 proposals, the rollover is available only where certain conditions are met:
- The taxpayer’s surplus entitlement percentage in each of the predecessor corporations before the merger and in the new foreign corporation immediate after the merger was not less than 90%; and
- No gain or loss was recognized, under the income tax law of the country in which the predecessor foreign corporations were resident, in respect of capital property of a predecessor foreign corporation that became capital property of the new foreign corporation in the course of the foreign merger.
Paragraph 95(2)(d.1) is amended to drop these two conditions. The provision will now apply where one or more of the predecessor foreign corporations was, immediately before the merger, a foreign affiliate of the taxpayer and the new foreign corporation, immediately after the merger, is a foreign affiliate of the taxpayer.
The rollover currently applies only to capital property but is amended, similar to the 2004 proposals, to apply to all property, with the ability to elect the recognition of income or gain that would be included in FAPI.
These amendments generally apply to mergers or combinations that occur after August 19, 2011. However, a taxpayer may elect to have the amendments (other than certain amendments pertaining to continuity of the stop-loss rules and debt forgiveness rules) apply to mergers or combinations that occur after December 20, 2002 if the taxpayer so elects in respect of all foreign affiliates of the taxpayer.
New subsection 95(4.2) clarifies the circumstances in which certain foreign “absorptive mergers” will qualify as “foreign mergers” as defined in subsection 87(8.1). The Explanatory Notes comment that this rule is mainly designed to ensure that certain common forms of U.S. mergers qualify; e.g., a merger in which one or more predecessor foreign corporations ceases to exist and, immediately after the merger or combination, another predecessor foreign corporation (referred to by the proposed subsection as the “survivor corporation”) owns substantially all of the properties owned by each predecessor foreign corporation immediately before the merger or combination.
This new subsection applies to mergers or combinations that occur after 1994. However, taxpayers may elect to have it apply only to mergers or combinations that occur after August 19, 2011 if the election is made in respect of all foreign affiliates of the taxpayer.
Share-for-share exchange transactions
A rollover is available under subsection 85.1(3) where a taxpayer transfers shares of one foreign affiliate to another foreign affiliate, provided the shares of the transferred affiliate are capital property of the taxpayer and provided the consideration received by the taxpayer includes shares of the acquiring affiliate. However, the rollover is denied under subsection 85.1(4) where the shares of the transferred affiliate are excluded property and the disposition is part of a series of transactions or events for the purpose of disposing of the shares to an arm’s-length person (other than a foreign affiliate of the taxpayer).
The August 19 legislation proposes to amend subsection 85.1(4) in several ways. Under the new rules:
- A rollover will no longer be available if the shares of the transferred affiliate have an inherent loss. Rather, the inherent loss will be recognized by the taxpayer and, in certain cases, as discussed below, suspended under the loss suspension rules in subsections 40(3.3) and (3.4). If suspended, the loss will be released in the future when one of the “triggering events” in subsection 40(3.4) occurs, such as a sale of the shares of the transferred affiliate to a non-affiliated person.
- The denial rule will apply to transfers that are part a single transaction or event, as well as to those that are part of a series of transactions or events.
- The denial rule will apply where there is a disposition of the transferred affiliate’s shares to an arm’s length person or an arm’s length partnership (currently, a disposition to an arm’s length partnership is not caught).
- The exception to the denial rule where the arm’s length purchaser is a foreign affiliate is narrowed such that it is only available where the purchaser is a foreign affiliate in which the taxpayer has a qualifying interest (i.e., 10% votes and value).
Similar to subsection 85.1(4), the rollover provision in paragraph 95(2)(c) for inter-affiliate share-for-share exchanges is being amended so that it no longer applies if the shares of the transferred affiliate have an inherent loss. Instead, the loss will be recognized by the transferring affiliate and, potentially, suspended under subsections 40(3.3) and (3.4).
The amendments to subsection 85.1(4) and paragraph 95(2)(c) are effective for dispositions that occur after August 19, 2011.
Loss on disposition of foreign affiliate shares where exempt dividends received
Subsection 93(2) includes a stop-loss rule that applies where a corporation resident in Canada has a loss from the disposition of shares of a foreign affiliate. The rule also applies where a foreign affiliate of a corporation resident in Canada has a loss on shares of another foreign affiliate that are not excluded property. Specifically, the loss that would otherwise be realized is reduced by any exempt dividends received on the shares of the foreign affiliate (including those received by the corporation resident in Canada, by related corporations, and by foreign affiliates of any of those corporations). Similar rules in subsections 93(2.1) to (2.3) apply where a corporation resident in Canada or a foreign affiliate of a corporation resident in Canada has a loss from the disposition of an interest in a partnership that has a direct interest in a foreign affiliate, or where a partnership has a loss from the disposition of shares of a foreign affiliate or an interest in a partnership that has a direct interest in a foreign affiliate.
The 2004 proposals contained relieving amendments designed to restore, in certain circumstances, the portion of the loss that would otherwise be denied under subsection 93(2) to (2.3) to the extent that a related foreign exchange gain was realized under subsection 39(2), although there were technical defects in the drafting of the proposed amendments. For example, as drafted, it was necessary in certain cases for the related gain to occur in the same year as the loss.
The August 19 legislation contains a number of amendments to address situations where there are corresponding foreign exchange gains, while addressing certain technical defects in the February 2004 proposals. The new amendments are located in proposed subsections 93(2) to (2.32).
The amendments permit, in certain cases, the portion of the loss on the shares that relates to foreign currency fluctuations, to the extent of a corresponding foreign currency gain from certain hedging transactions that arise in connection with the acquisition of the shares, but only if the gain is realized within 30 days of the disposition of the foreign affiliate shares or partnership interest, as the case may be.
However, where the taxpayer or a non-arm’s length person has hedged the hedging transaction, no relief will be available. Thus, if the gain from the hedging transaction is already sheltered by a loss, a loss from the foreign affiliate share disposition or partnership interest disposition will not be entitled to protection under new subsections 93(2.01), (2.11) or (2.21).
The amendments do not address the existing deficiency that arises when exempt dividends are paid through a chain of foreign affiliates, in which case the same economic distribution can be taken into account multiple times in determining the quantum of exempt dividends paid. Further, there is no relief provided in situations where the loss and the corresponding gain are realized in separate but related entities.
The coming-into-force provisions are exceedingly complex. New subsections 93(2) to (2.32) generally apply to dispositions of shares and partnership interests that occur after February 27, 2004. Certain aspects of the 2004 proposals apply to dispositions that occur before August 19, 2012 (i.e., one year after the Announcement Date), unless taxpayers elect out in writing. Taxpayers can elect to have the new rules apply to dispositions that occur after 1994 rather than February 27, 2004, although such an election is subject to a complicated set of transitional rules.
Other stop-loss rules
The proposals contain additional changes to various existing stop-loss rules in order to ensure that they will not apply to dispositions of excluded property by a foreign affiliate. Therefore, losses may be recognized on internal transfers of “active” assets, reducing surplus, and yet denied in similar circumstances in respect of “passive” assets. The more targeted FAPL stop-loss rules of the 2004 legislation have been abandoned.
For example, proposed subsection 40(3.3) provides that the loss deferral otherwise provided under subsection 40(3.4) on a disposition of capital property by a foreign affiliate to an affiliated person does not apply where the property disposed of is excluded property. This amendment is intended to ensure that this provision is not used to defer losses in order to increase exempt or taxable surplus amounts or reduce exempt or taxable deficit amounts. Similar amendments are being made to paragraphs 14(12)(a), 18(13)(a), 40(2)(e.1), (e.2),(g) and 40(3.3)(a) and subsections 13(21.2),40(3.6) and 93(4).
These amendments apply to dispositions, settlements, extinguishments and other transactions (as applicable) that occur after August 19, 2011. In certain circumstances, consequential amendments to subsection 93(4) apply retroactively in the same manner as the amendments to subsection 93(2).
Streaming of FAPI capital losses
New rules will amend the definition of FAPI to prevent the allowable portion of capital losses of a foreign affiliate from dispositions of non-excluded property from being deducted against ordinary FAPI income. The new rules limit the deductibility of the allowable portion of current year FAPI capital losses to the taxable portion of current year FAPI capital gains of the affiliate. Any unapplied FAPI capital losses can be carried forward 20 years or carried back three years and applied against the taxable portion of FAPI capital gains of those years.
The amendments will generally be effective for taxation years of a foreign affiliate that end after August 19, 2011, however certain amendments apply to dispositions that occur after February 27, 2004. Transitional rules are provided for dispositions occurring in taxation years of a foreign affiliate that end on or before August 19, 2011.
Prescribed foreign accrual tax
Regulation 5907(1.3) contains a rule which deems certain compensatory payments for the use of another foreign affiliate’s loss to qualify as foreign accrual tax (FAT). To qualify as FAT, the foreign affiliates must be members of a consolidated tax filing group (or share losses under a group relief regime) and it must be reasonable to view the compensatory payment as being in respect of income or profits tax that would otherwise have been payable in respect of FAPI.
Regulation 5907(1.3) is being amended, and new regulations 5907(1.4) to (1.6) are being added, to restrict the circumstances in which prescribed FAT arises and the timing of its recognition.
Under the new rules, if one foreign affiliate earns FAPI which is offset by a loss of another group company which is not a FAPL (i.e., by an active business loss), the compensatory payment will not give rise to prescribed FAT initially, but may give rise to prescribed FAT in one of the five subsequent years if can be demonstrated that the active business loss of the other affiliate would otherwise have been used to offset active business income of the consolidated group, had there been no FAPI within the consolidated group.
There are further restrictions to incorporate the new FAPI capital loss streaming rules.
These changes generally apply for foreign affiliate taxation years that begin after November 1999, with the exception of the restrictions in relation to the new FAPI capital loss streaming rules, which apply for foreign affiliate taxation years ending after August 19, 2011.
Foreign exchange gains and losses on foreign affiliate debt and shares
Currently, subsection 39(2) applies in any situation where a taxpayer makes a gain or sustains a loss on account of capital from foreign exchange fluctuations. The provision is being amended so that it only applies in respect of “foreign currency debt” owing by a taxpayer (defined in new subsection 111(8) to be a debt obligation denominated in a currency of a country other than Canada). This amendment provides a legislative override to the decision in MacMillan Bloedel where it was held that subsection 39(2) could apply to allow a taxpayer to recognize a loss on the redemption of fixed-value, foreign-denominated preferred shares of the issuer.
The amendments also ensure that foreign currency exchange gains and losses in respect of asset dispositions, including dispositions of foreign currency, will be determined exclusively under existing subsection 39(1). Subsection 39(2) is also being amended to provide that each disposition of foreign currency debt will result in a separate capital gain or loss, rather than being combined into a single capital gain and capital loss for the year, which is the case under current law. Together with amendments to paragraph 95(2)(f.11), this facilitates the application of the so-called “carve-out” rule in paragraph 95(2)(f.1).
Paragraph 95(2)(g), a provision which deems certain foreign exchange gains and losses of a foreign affiliate to be nil, is being amended so it no longer applies to a redemption, acquisition or cancellation of shares by an issuing affiliate. The amendment is consequential to the amendments to subsection 39(2) above. Paragraph 95(2)(g) is also being amended so that it no longer applies to the reduction of capital of a foreign affiliate, a concept that has been eliminated under the August 19 legislation.
Paragraph 95(2)(g.02) is being repealed. This provision, which deems foreign exchange gains and losses to be computed separately for excluded property and for property other than excluded property, is no longer required given the amendments to subsection 39(2) above.
Other consequential and clarifying amendments are proposed to paragraphs 95(2)(f.1) to (f.15).
These amendments are effective for foreign affiliate taxation years ending after August 19, 2011.
Use of Canadian rules in computing exempt earnings
Pursuant to the definition of “earnings” in regulation 5907(1), Canadian principles are used to compute a foreign affiliate’s income from an active business in situations where the affiliate is not required to compute its income or profit under the laws of the country in which it resident or in which the business is carried on. Canadian principles are also used to compute deemed active income of a foreign affiliate under paragraph 95(2)(a). Historically, when computing the income of a foreign affiliate using Canadian principles, taxpayers have often chosen to forgo discretionary deductions such as capital cost allowance in order to maximize exempt surplus.
The CRA recently stated that a single member U.S. limited liability company (LLC) that is disregarded for U.S. tax purposes is nevertheless required to compute its income in accordance with U.S. principles (subject to adjustments in regulation 5907(2), etc.) on the basis that the LLC’s income is required to be included in the member’s income in order to satisfy U.S. income tax law. The CRA acknowledged that this was a controversial provision, but stated that if a taxpayer chose not to follow this position (i.e., use Canadian principles and not claim discretionary deductions), the CRA would consider taking the position that the LLC is not a foreign affiliate.
Presumably in response to this issue, a new rule has been included in proposed regulation 5907(2.03) which specifies that when computing the income of a foreign affiliate under Canadian principles, the computation is to be done on the basis that the maximum amount of all permissible deductions have been claimed and all elections have been made in order to maximize deductions. The Explanatory Notes state that the purpose of the new rule is to prevent taxpayers from “purposely inflating surplus”. This rule should address any concerns the CRA has with using Canadian principles to compute the income of a disregarded LLC. This new provision applies to taxation years of a foreign affiliate that end after August 19, 2011.
Fresh start and reverse fresh start rules
A number of amendments are proposed to the “fresh start rules” in paragraph 95(2)(k). The rules generally apply when an active business ceases to be an active business and begins to generate FAPI, and deem a disposition and reacquisition of the assets of the business at the end of the prior taxation year of the affiliate. The key amendments to the fresh start rules include the following:
- The rules will also apply if the particular business is carried on by a partnership of which a foreign affiliate is a member. The expression “operator” is used to refer to the foreign affiliate (if the foreign affiliate directly carries on the particular business) or to the partnership (if the foreign affiliate carries on the particular business through the partnership);
- The rules no longer apply if the operator begins to carry on the particular business in the specified taxation year; i.e., where it did not carry on the particular business in the preceding taxation year;
- The amendments expand the types of businesses to which these rules apply to include a “non-qualifying business” and businesses to which either paragraph 95(2)(b) or (l) applies ;
- An new exception applies for a “taxable Canadian business” since there is no need for a “fresh start” transition of a business which is already subject to Canadian tax rules; and
- New paragraph 95(2)(k.1) provides (in clause (ii)(B)) a new deeming rule for life insurance businesses. The deeming rule allows certain policy reserves to be claimed by deeming life insurance policies issued in the conduct of the business to be life insurance policies in Canada
New paragraphs 95(2)(k) and (k.1) generally apply to foreign affiliate taxation years that begin after December 20, 2002; however, taxpayers can elect to have them apply to all of their foreign affiliates for foreign affiliate taxation years that begin after 1994.
The 2004 proposals included the so-called “reverse fresh start” rules, which would have applied where a foreign affiliate had been carrying on a business which was not an active business and in a subsequent year the business became an active business. The August 19 legislation indicates that Finance has abandoned the “reverse fresh start” proposals.
Calculation of FAPI from a foreign affiliate’s life insurance business
New paragraphs 95(2)(j.1) and (j.2) are being added to ensure that a foreign affiliate that carries on an insurance business is eligible to claim certain policy reserves in computing its FAPI. These rules have many similarities to the “fresh start” rules; however paragraphs 95(2)(j.1) and (j.2) can apply regardless of whether the insurance business went through a transition from active to passive (for example where the business is considered to be an investment business since it has five or fewer full-time employees).
These new paragraphs generally apply to foreign affiliate taxation years that begin after December 20, 2002; however, taxpayers may elect to have these rules apply to foreign affiliate taxation years that begin after 1994. A specific application rule of these proposals ensures that the “life insurance policies in Canada” deeming rule applies for foreign affiliate taxation years ending after 1999 regardless of whether the taxpayer makes the retroactive election to have all of the paragraph 95(2)(j.1) to (k.1) rules apply for the 1995 and subsequent taxation years.
Participating percentage and surplus entitlement percentage rules
The amendments contain revisions to the rules that apply to determine the “participating percentage” of a taxpayer in a foreign affiliate (relevant for determining the taxpayer’s share of any FAPI of a controlled foreign affiliate) and the “surplus entitlement percentage” of a taxpayer in a foreign affiliate (relevant for many reorganization rules). These amendments are intended to correct an issue with respect to so-called “circular” shareholdings as well as an anomaly that arises in applying these tests where a foreign affiliate has no net surplus. Where this is the case, a new rule will measure net surplus for this purpose based on the greater of the retained earnings of the relevant affiliate and 25% of its total assets.
The amendments to regulation 5904 (participating percentage rules) are applicable to foreign affiliate taxation years that begin after August 19, 2011. The amendments to subsection 5905(11) (surplus entitlement percentage rules) are applicable after August 19, 2011. Surprisingly, there is no election provided to apply the amendments on a retroactive basis.
Immigration of foreign affiliates to Canada
Generally, upon immigration to Canada, a foreign affiliate is deemed to have a FAPI inclusion in the amount by which the foreign affiliate’s taxable surplus exceeds the grossed-up amount of its underlying foreign tax (UFT). This FAPI inclusion may generally be reduced by the notional foreign taxes payable in respect of the gain or income arising on the deemed disposition of the property of the foreign affiliate prior to immigration. Several changes are proposed to these rules including:
- The recognition of the potential decrease to the foreign affiliate’s UFT arising from losses and notional foreign taxes refundable in respect of the deemed disposition of the property of the foreign affiliate prior to immigration;
- Certain limitations on the amounts by which the UFT of the foreign affiliate may be increased or decreased by notional foreign taxes payable or refundable because of the notional application of an income tax convention; and
- The establishment of analogous rules to incorporate in the FAPI inclusion the amount by which the affiliate’s hybrid surplus exceeds the grossed up amount of hybrid underlying foreign tax.
Most of the amendments are effective retroactive to 1993, except for the amendments with respect to hybrid surplus and losses from deemed dispositions which are effective only after August 19, 2011.
Deloitte webcast — The new foreign affiliate proposals: what you need to know
In a live webcast, International Tax leaders from Deloitte will discuss the August 19, legislation, and its broader business implications under a variety of scenarios. Please join us for this one-hour interactive event on September 7, 2011 at 12:00 pm, EDT. Register here.
This publication is produced by Deloitte & Touche LLP as an information service to clients and friends of the firm, and is not intended to substitute for competent professional advice. No action should be initiated without consulting your professional advisors. Your use of this document is at your own risk.