On August 29, 2014, the Minister of Finance released for consultation draft legislative proposals (August 29 Proposals) to amend the Income Tax Act (Canada) (Act) which would implement certain measures from the 2014 federal budget as well as certain other measures. The government has invited comments by September 28, 2014. It is expected that the government will then introduce these measures into Parliament in the autumn 2014 session.
Included among the August 29 Proposals are measures revising the "back-to-back loan" rules which partially scale back the overbroad initial proposals. Also included are proposals to amend the foreign affiliate dumping (FAD) rules which, while generally relieving, contain a strong incentive to ensure compliance requirements are met. The press release announcing the August 29 Proposals (Press Release) also addressed the status of the government's treaty shopping proposals. For a discussion of other measures from the 2014 federal budget, including certain proposed changes to the rules dealing with the taxation of foreign affiliates, see our February 2014 Blakes Bulletin: 2014 Federal Budget – Selected Tax Measures.
TREATY SHOPPING PROPOSALS
On August 12, 2013, following a 2013 budget announcement, the Department of Finance released a consultation paper on treaty shopping. Finance indicated its intention to implement measures to restrict what it viewed as the inappropriate use of Canada's tax treaty network. In that paper, Finance posed various questions including whether the approach it takes should be treaty-based or involve a change in the domestic law and whether any rule should be general in nature or set out specific objective conditions.
In the 2014 budget, the government indicated that it prefers to adopt a general domestic rule to address treaty shopping, and released high-level proposals describing the foundation of a sweeping new anti-treaty shopping rule. The new rule was to be added to a Canadian domestic statute, the Income Tax Conventions Interpretation Act, and was to affect benefits claimed under tax treaties. A discussion of these proposals can be found in our 2014 budget bulletin.
The Press Release stated that after engaging in consultations on the proposed anti-treaty shopping measure, the government has instead decided to await further work by the Organisation for Economic Co-operation and Development (OECD) and the Group of 20 (G20) related to their Base Erosion and Profit Shifting (BEPS) initiative.
The OECD is expected to release its recommendations on BEPS regarding the design of domestic and tax treaty measures to prevent abuse of tax treaties (Action 6) in late September 2014, and to continue to work with the G20 on this issue.
BACK-TO-BACK LOAN PROPOSALS
The 2014 budget proposed to introduce specific anti-avoidance rules aimed at preventing the use of back-to-back (BTB) loans to circumvent Canadian tax rules governing the tax treatment of interest payments made by taxpayers to certain non-arm's length non-resident persons. For a discussion of those BTB loan proposals, including the tax consequences to taxpayers if the rules apply, please see our 2014 budget bulletin.
The Canadian government introduced these anti-avoidance rules out of a concern that some Canadian borrowers might interpose a third-party intermediary between themselves and the "ultimate" or "true" lender, in order to circumvent Canadian thin capitalization and/or cross-border interest withholding tax rules.
However, the rules as proposed in the 2014 budget were much broader than was necessary, with the result that they would have affected many existing and future credit facilities where a non-Canadian entity that does not deal at arm's length with the Canadian borrower provides a secured guarantee in respect of the Canadian borrowing.
The August 29 Proposals contain a revised set of BTB loan proposals which narrow the scope of such rules. In effect, the revisions more precisely target the core "mischief" sought to be addressed by the rules – namely financing that is substantially "intra-group" despite the intervention of an intermediary that can be seen not to have a meaningful financial interest in the arrangement.
The new thin capitalization anti-avoidance rules will apply where a corporation or trust has an interest-bearing obligation (the borrower debt) owing to a person or partnership (the intermediary) that is not a Canadian resident with whom the borrower does not deal at arm's length or a specified non-resident, and the intermediary or a person not dealing at arm's length with the intermediary either:
- has an obligation owing to a specified non-resident (the intermediary debt) and one of four conditions are met with respect to such debt; or
- has a "specified right" in respect of a particular property that was granted by a specified non-resident and either the specified right is required under the terms or conditions of the borrower debt or it can reasonably be concluded that without the specified right the amount outstanding under the borrower debt would be less or the terms and conditions of the borrower debt would be different.
Generally, the four conditions referred to in (1) above are that (a) recourse in respect of the intermediary debt is limited in whole or in part to the borrower debt, (b) the intermediary debt is entered into on condition that the borrower debt be entered into or (c) vice versa, or (d) it can reasonably be considered that if the intermediary debt did not exist the amount outstanding under the borrower debt would be less or the terms and conditions of the borrower debt would be different. There is considerable uncertainty in this last condition, especially as there is no materiality qualifier or insight from the explanatory notes accompanying the August 29 Proposals (Explanatory Notes) as to the scope of the condition.
A "specified right," at any time in respect of a property, means a right to, at that time, use, mortgage, hypothecate, assign, pledge or in any way encumber, invest, sell or otherwise dispose of, or in any way alienate, the property.
There is also a 25 per cent de minimis threshold. Generally, the anti-avoidance rules will only apply if the total amount of support for the debt (from non-arm's length non-residents) is at least 25 per cent of the amount of the borrower debt plus all debt of the borrower group owing to the intermediary, provided the intermediary has been granted a related security interest over all of the group's debt owing to it. The inclusion of this broader debt base is intended to provide possible relief where multiple cross-collateralized debts are owing to the intermediary by multiple group entities. The Explanatory Notes contain a helpful example of the application of the threshold in a multinational group borrowing context.
However, the Explanatory Notes also contain an example of a notional cash pooling arrangement that does run afoul of the thin capitalization rule because the Canadian borrower's debt is supported by a significant amount of cash on deposit with the lender that has been deposited by a related non-resident. Given that Finance chose to specifically highlight this example, existing commercial arrangements involving notional cash pooling should be reviewed.
The proposed anti-avoidance rules applicable to withholding tax (WHT) on interest contain very similar conditions of application to the proposed thin capitalization rules.
The revised BTB loan proposals bring some clarity to the application of the anti-avoidance rules, at least in respect of commercial debt transactions where "typical" security interests are provided by non-resident group members in support of a Canadian borrowing. In particular, the introduction of the "specified right" concept appears intended to ensure that the mere provision of a security interest in a property by a non-resident affiliate of a Canadian borrower will not cause the Canadian borrower's obligations to otherwise arm's length lenders to run afoul of the rules (at least prior to a default); although this is only made clear in the Explanatory Notes. It seems that Finance is particularly concerned about property that is pledged or provided as security which may effectively be used by the intermediary to fund the borrower loan (i.e. where the pledgee has the right to sell, encumber or otherwise deal with the pledged property). Existing and future security arrangements may need to be reviewed to confirm that they do not provide a lender with rights that could be considered to be a "specified right."
The proposed thin capitalization BTB loan measures apply to taxation years beginning after 2014, and the WHT BTB loan measures apply to amounts paid or credited after 2014. Aside from the delayed application of these rules, no other transitional relief is available for debt arrangements already in place.
FOREIGN AFFILIATE DUMPING RULES
The FAD rules were introduced to prevent foreign multinational corporations from achieving certain tax advantages by causing their Canadian subsidiaries to hold investments in foreign affiliates (FA). FAs generally mean foreign companies in which the Canadian shareholder has at least a 10 per cent interest in any class of shares. For a detailed discussion of the FAD rules as enacted, see our October 2012 Blakes Bulletin: 2012 Budget Implementation Bill – Foreign Affiliate Dumping and Upstream Shareholder Loan Update.
Generally, the FAD rules apply where a corporation resident in Canada (CRIC) that is controlled by a non-resident corporation (the parent) makes an "investment in a subject corporation." A subject corporation is a corporation that is or becomes an FA of the CRIC as part of the series of transactions that includes the investment. Where non-share consideration is given by the CRIC to acquire the investment, the CRIC will presumptively be deemed to have paid a dividend to its parent (except to the extent such amount reduces the CRIC's paid-up capital (PUC) as discussed below (PUC offset rule)) at the time of the investment. The deemed dividend is subject to WHT, even though no amount is extracted from Canada. Where the form of consideration consists of shares of the CRIC, the PUC of such shares will be automatically deemed to be nil.
On August 16, 2013, Finance released for consultation draft legislative proposals to amend the FAD rules (2013 FAD Proposals). See our August 2013 Blakes Bulletin: August 2013 Legislative Proposals – Foreign Affiliate Dumping Update for a discussion of these proposals.
While the revised amendments to the FAD rules contained in the August 29 Proposals are mostly relieving in response to submissions on the 2013 FAD Proposals, the PUC offset rule will be amended to include new specific anti-avoidance rules and to require timely filing of a prescribed form in order to avoid a deemed dividend. To avoid such a deemed dividend in respect of past transactions, the prescribed form must be filed within 30 days after the August 29 Proposals are enacted into law.
The more significant changes as compared with the 2013 FAD Proposals are summarized below.
PUC Offset Rule
Consistent with the 2013 FAD Proposals, the PUC offset rule will apply automatically in all circumstances where there is cross-border PUC in any class of shares (a cross-border class) of the CRIC and/or other Canadian members of the corporate group (qualifying substitute corporations or QSCs). However, the August 29 Proposals contain the following tightening measures:
Consequences of Failure to File Prescribed Form
Where a deemed dividend is reduced by the PUC offset rule, the CRIC is required to file a prescribed form with the CRA on or before the 15th day of the month following the month in which the deemed dividend would otherwise arise setting out certain information. Unlike the 2013 FAD Proposals under which failure to file the prescribed form does not affect the application of the PUC offset rule, the August 29 Proposals will deem the CRIC to have paid to the parent a dividend equal to the PUC reductions if the form is not filed on time. In other words, the CRIC is treated as if there is no PUC available to offset the deemed dividend otherwise arising under rules. WHT paid on such deemed dividend will be refunded if the CRIC files the form late and makes a written application for a refund within two years after the form is filed. However, there is no specific relief for interest and penalties on any unpaid or late-paid WHT. Although this amendment will apply in respect of transactions and events that occur after March 28, 2012, a transitional rule will deem the prescribed form to be filed on a timely basis if the form is filed within 30 days after the proposed amendments are enacted into law (i.e. receive royal assent).
Readers are encouraged to review their historic transactions to which the FAD rules may apply undertaken after March 28, 2012 to determine if they will have a filing obligation in this regard once the August 29 Proposals receive royal assent.
Under the 2013 FAD Proposals, any class of shares of a CRIC/QSC would qualify as a cross-border class provided at least one share is owned by the parent or another non-resident corporation in the corporate group. Because of this low threshold of foreign ownership, Finance was concerned that certain transactions could be undertaken to create PUC in circumstances where the underlying share class technically qualified as a cross-border class, but in reality the PUC was largely "domestic" as most of the shares were held by another Canadian company in the group. The August 29 Proposals contain two changes to curtail such transactions that occur on or after August 29, 2014:
- In order to qualify as a cross-border class, no more than 30 per cent of the issued and outstanding shares of the class can be owned by Canadian resident person(s) that do not deal at arm's length with the parent.
- An anti-avoidance rule will deem a class of shares of the CRIC/QSC not to be a cross-border class if certain transactions are undertaken to increase the PUC of the class held by a Canadian resident corporation in the corporate group and it can reasonably be considered that one of the main reasons for the relevant transaction was to increase the amount of the PUC offset in respect of such PUC.
The PUC reinstatement rule allows a recovery or reinstatement of PUC of the CRIC/QSC that was previously reduced as a result of an investment, such that the CRIC/QSC can distribute FA shares and certain other property free of WHT under certain circumstances.
The August 29 Proposals provide relief to certain technical concerns with the 2013 FAD Proposals and broaden the circumstances where the reinstatement is available, including where there have been (i) reorganizations of CRIC/QSC shares to which certain rollover provisions of the Act apply or (ii) certain exchanges of FA debt for FA shares.
The August 29 Proposals contain relieving changes to the corporate reorganization exceptions to the FAD rules, including a new exception for transfers of FA debt between Canadian resident corporations in the related group as well as amendments to accommodate transfers of FA shares or debt between Canadian corporate group members following the acquisition of a Canadian corporation.
We wish to acknowledge the contribution of Sabrina Wong to this publication.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.