Finance introduces new rules on repatriation from foreign affiliates, including loans of taxable surplus
International Tax alert, August 22, 2011
Finance introduces new rules on repatriation from foreign affiliates, including loans of taxable surplus
The Department of Finance (Finance) has released the final package of draft legislation related to the February 2004 proposals concerning the taxation of foreign affiliates. On August 19, 2011, legislation was released that abandons the “suspended surplus” proposals that taxpayers have been complying with for more than seven years. In their place, Finance proposes to introduce a new surplus account (hybrid surplus) that will track certain gains from the sale of foreign affiliates. Most significantly, the proposals include a rule that will include in income certain loans made by foreign affiliates to Canadian shareholders and certain connected persons.
This International Tax alert discusses the “hybrid surplus” and “upstream loan” proposals. The remainder of the August 19 proposals will be discussed in a subsequent alert to follow shortly.
Canada allows a deduction for dividends received from a foreign affiliate that are paid out of “exempt surplus”. Dividends out of “taxable surplus” are taxable, subject to a deduction in respect of related foreign taxes. Active business income earned by a foreign affiliate in a country that has a tax treaty or tax information exchange agreement (TIEA) with Canada is generally included in exempt surplus. All other active business income is included in taxable surplus. This is intended to provide an incentive for other countries to enter into tax treaties and TIEAs with Canada and facilitate tax compliance.
When a foreign affiliate sells shares of another foreign affiliate that carries on an active business, one-half of the gain is generally included in exempt surplus and one-half of the gain is included in taxable surplus. This is consistent with the general rule that one-half of a capital gain is taxable, even if the taxation of the gain in Canada is deferred until repatriation of the proceeds because the shares derive all or substantially all their value from active business assets (excluded property). If there is little or no tax associated with the gain, there will be additional Canadian tax if the taxable surplus portion of the gain is repatriated to Canada. Therefore, in many cases where the funds are needed in Canada, a dividend is paid out of the exempt surplus portion of the gain and the taxable surplus portion of the gain is loaned back to the shareholder, deferring taxation of the gain indefinitely. The amount of such loans is likely in the billions of dollars, since the Canada Revenue Agency (CRA) has ruled favourably on such transactions for many years.
The February 27, 2004 legislation contained proposed rules to limit the ability of taxpayers to generate surplus through certain internal transfers of the shares of foreign affiliates, and other assets owned by foreign affiliates. The exempt and taxable surplus associated with such transfers was to be “suspended” and released only upon certain events, such as a sale of the property to an unrelated person. These rules are very complex, and taxpayers have been attempting to apply them since 2004.
In December 2008, the Advisory Panel on Canada’s System of International Taxation recommended that Canada move toward a territorial system of taxation by extending the current exemption system to all active business income earned by foreign affiliates and to capital gains realized on the disposition of shares of foreign affiliates that are excluded property. If implemented, those recommendations would eliminate the need for a concept of taxable surplus and would greatly simplify compliance and enforcement.
However, in its August 19, 2011 press release, Finance stated that the priority of the Government is “to encourage countries to enter into (TIEAs) with Canada and to provide exempt surplus treatment as an incentive to those which choose to do so.” In addition to maintaining the current system in order to encourage new TIEAs, it would appear that Finance has chosen to support it by ensuring that the tax applicable to low-taxed taxable surplus cannot be indefinitely deferred through tax planning. However, it is not as clear how the hybrid surplus proposals are necessary to facilitate the stated policy.
The proposals may cause hardship in the case of existing structures, which are eligible for a transitional rule but are not grandfathered, particularly where the funds loaned back to Canada have been invested in illiquid assets. They may also have a broader than expected impact on many common transactions entered into both by Canadian multinationals and Canadian subsidiaries of foreign multinationals. From a policy perspective, it is questionable whether the Government should be discouraging the repatriation of cash for investment in Canada, an issue that is currently garnering significant attention in the U.S. as it concerns similar U.S. tax rules.
Hybrid surplus is a new category of surplus that is required to be computed and tracked by Canadian taxpayers in addition to the traditional exempt and taxable surplus pools. As the name suggests, hybrid surplus is a combination of exempt and taxable surplus in that one-half of any distribution from hybrid surplus is exempt and the other half is taxable with a deduction for grossed-up underlying taxes, if any.
In general, hybrid surplus of a foreign affiliate is defined to include any capital gains (other than capital gains that are relevant in computing Foreign Accrual Property Income or FAPI) that arise on the disposition of foreign affiliate shares, partnership interests and certain financial instruments. Hybrid surplus is reduced by any capital losses (other than capital losses that are relevant in computing FAPI) that arise on the disposition of foreign affiliate shares, partnership interests and certain financial instruments. Hybrid surplus is also reduced by any income or profits taxes that can reasonably be considered to relate to amounts that have been included in hybrid surplus. Adjustments are also provided for any dividends paid by the particular affiliate and for any dividends received by the particular affiliate from another foreign affiliate, to the extent that the dividends are prescribed to be paid from hybrid surplus.
The new hybrid surplus rules maintain the traditional principle that capital gains on the disposition of foreign affiliate shares and partnership interests are allocated equally between exempt and taxable surplus – however, unlike existing rules, hybrid surplus arises at the time of the relevant disposition rather than upon the completion of a foreign affiliate’s taxation year.
Under the new hybrid surplus rules, it is no longer possible for a foreign affiliate to distribute the exempt portion of a capital gain on the disposition of foreign affiliate shares as an exempt dividend, while deferring the distribution of the taxable portion. For this reason, the new rules will impact the ability of Canadian taxpayers to repatriate profits realized by a foreign affiliate on the sale of foreign affiliate shares in situations where there is no foreign level taxation (and thus no hybrid underlying foreign tax).
With the move to hybrid surplus, Finance is no longer concerned with the premature recognition of capital gains on internal dispositions of foreign affiliate shares that are excluded property, and therefore the gain suspension rules that were previously proposed in paragraphs 95(2)(c.1) to (c.6) of the Income Tax Act have been abandoned.
A number of amendments have been introduced to implement the new hybrid surplus rules. The more significant ones are as follows:
- Regulation 5907(1) is amended to include a new definition for “hybrid surplus”, “hybrid deficit”, “hybrid underlying foreign tax” and “hybrid underlying foreign tax applicable”. There is no equivalent to “exempt earnings” or “taxable earnings” – the equivalent provisions are incorporated directly into the “hybrid surplus” and “hybrid deficit” definitions.
- The surplus ordering rules in regulations 5900 and 5901 are amended to provide that a foreign affiliate’s hybrid surplus is deemed to be paid after exempt surplus and before taxable surplus (absent an election under proposed regulation 5901(1.1) to access taxable surplus first).
- Section 113 is amended to include new paragraph 113(1)(a.1) which provides a deduction for foreign affiliate dividends prescribed to have been paid out of hybrid surplus. The deduction is intended to equal the aggregate deduction that would have arisen under existing paragraphs 113(1)(a), (b) and (c) if the dividend had been paid equally from exempt and taxable surplus.
The definition of “hybrid surplus” applies after August 19, 2011 for dispositions to a “designated person or partnership” (essentially, all internal transfers), but only after 2012 for dispositions to other persons or partnerships. Other definitions in regulation 5907(1) apply after August 19, 2011. The amendments to regulations 5900 and 5901 and section 113 apply to dividends paid after August 19, 2011.
Proposed subsections 90(4) to (10) include a new anti-avoidance rule designed to prevent the deferral of Canadian tax in situations where low-taxed taxable surplus (or low-taxed hybrid surplus) of a foreign affiliate is repatriated via what Finance refers to as “a synthetic dividend distribution”. The new rule is explicitly modeled on subsection 15(2) in the domestic context and, similar to subsection 15(2), applies to synthetic distributions in the form of loans and other indebtedness only – equity investments and other traditional forms of financing such as licensing and leasing are not addressed.
The rule operates by including an amount in a Canadian taxpayer’s income if the taxpayer (or any other person that does not deal at arm’s length with the taxpayer, other than a controlled foreign affiliate of the taxpayer as defined in section 17) receives a loan from or becomes indebted to a foreign affiliate of the taxpayer or a partnership in which a foreign affiliate of the taxpayer is a member. There are exceptions for loans and indebtedness that are subject to subsection 15(2) and for loans and indebtedness that are repaid within two years of the day the loan was made or the indebtedness arose, provided the repayment is not part of a series of loans or other transactions and repayments. There are also exceptions for indebtedness arising in the ordinary course of business and for loans made in the ordinary course of a money lending business, provided there are bona fide arrangements for repayment within a reasonable time.
The income inclusion under proposed subsection 90(4) is equal to the “specified amount” of the loan or indebtedness. If the creditor is a foreign affiliate of the taxpayer, the specified amount is defined as the amount of the loan or indebtedness multiplied by the taxpayer’s surplus entitlement percentage in the affiliate at the time the loan is made or the indebtedness arises. If the creditor is a partnership in which a foreign affiliate of the taxpayer is a member, the specified amount is computed in the same manner as above but taking into account the foreign affiliate’s interest in the partnership on a relative fair market value basis.
A reserve mechanism is provided in proposed subsections 90(6) and (7). Specifically, an offsetting deduction is available under proposed subsection 90(6) to the extent that an actual dividend (or series of dividends taking into account lower-tier foreign affiliates) would have given rise to a deduction under paragraphs 113(1)(a) to (b) for the full amount of those dividends. However, a deduction is not available for a particular year if, during the portion of the year during which the loan or indebtedness is outstanding, a dividend is paid to the taxpayer or another person resident in Canada with which the taxpayer does not deal at arm’s length by a relevant foreign affiliate. The amount deducted under proposed subsection 90(6) in one taxation year is included in income under subsection 90(7) in the following taxation year.
If a loan or indebtedness that gave rise to an income inclusion under proposed subsection 90(4) is repaid in a subsequent year (other than a repayment that is part of a series of loans or other transactions and repayments), a deduction is available under proposed subsection 90(9).
From a policy standpoint, it is not clear why the deduction in proposed subsection 90(6) extends to amounts that would be deductible for an actual dividend under paragraphs 113(1)(a) to (b) but not paragraph 113(1)(d). In other words, it is not clear why an upstream loan backed by tax-free surplus of a foreign affiliate is acceptable but an upstream loan backed by outside basis in the foreign affiliate is not.
One of the implications of this inconsistency is that “FAPI is your friend” repatriation strategies may no longer be viable. Under these strategies (which have been sanctioned by the CRA in several Rulings), a Canadian corporation is able to repatriate cash to its non-resident parent company (or another non-resident group company) on a long-term basis without triggering a deemed dividend under subsection 15(2) by capitalizing a foreign affiliate with equity and having the foreign affiliate loan the funds to the non-resident company. However, it appears that the loan from the foreign affiliate to the non-resident company would be caught by the new upstream loan rules, resulting in an income inclusion for the Canadian corporation unless the loan is repaid within two years.
It is also noteworthy that loans to non-residents can be subject to the new upstream loan rules in certain circumstances, particularly where a Canadian taxpayer is a member of a foreign-based multinational group and a foreign affiliate of the taxpayer makes a loan to a group company that the taxpayer does not control. Such a loan may be subject to the upstream loan rules since the borrower would not be dealing at arm’s length with the Canadian taxpayer, but would not qualify for the controlled foreign affiliate carve-out since it would not be a controlled foreign affiliate as defined in section 17.
Subsection 90(4) to (8) and (10) apply after August 19, 2011, and subsection 90(9) applies to taxation years that end after August 19, 2011. There is no grandfathering for existing loans and indebtedness. However, if the loan or indebtedness referred to in subsection 90(4) was in existence before August 19, 2011, it is deemed to have come into existence on August 19, 2011. This effectively provides taxpayers with two years from August 19, 2011 to address existing upstream loans.
Sandra Slaats, Toronto
David Bunn, Toronto
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