On August 19, 2011 the Department of Finance released proposed
amendments to the Income Tax Act (Canada) related to the
taxation of foreign affiliates of Canadian taxpayers. These
represent the culmination of a series of proposed changes to the
foreign affiliate rules over the past decade, which have included a
number of false starts and abandoned ideas. There are a number of
welcome changes included in this package, but also some unexpected
and highly restrictive proposals.
Briefly, Canada's foreign affiliate system includes two interrelated sets of rules: (i) the "foreign accrual property income" or "FAPI" rules, and (ii) the surplus rules. The FAPI rules are anti-deferral provisions that tax Canadian taxpayers currently on passive or deemed passive income of their controlled foreign affiliates, regardless of whether such income is repatriated to Canada. The surplus rules track the income of foreign affiliates and determine whether it can be distributed to Canadian shareholders exempt from Canadian tax (in respect of exempt surplus) or with an effective credit for underlying tax (in respect of taxable surplus).
The highlights of the current legislative proposals are as follows:
- Hybrid Surplus: A new category of surplus, called "hybrid surplus", is proposed. It will include all gains from the sale of shares of a foreign affiliate by another foreign affiliate that are not FAPI. At present, these gains are divided evenly between exempt and taxable surplus, allowing the exempt surplus to be returned to Canada tax-free. Hybrid surplus combines the exempt and taxable surplus in a single account, requiring the taxable surplus component to be distributed equally with the tax exempt. This proposal is described as a replacement for a highly complex and unpopular proposal made in 2004 intended to prevent the creation of exempt surplus on internal transfers of shares of foreign affiliates. Clearly the proposal is much more than that, as it is not limited to internal transactions. It fundamentally alters an important aspect of the foreign affiliate rules, and in a manner that is at odds with the direction of most recent discussion and development of Canadian international tax policy. The most obvious effect of this change will be that Canadian foreign affiliate groups will be more restricted in the cash that they can repatriate to Canada for domestic investment.
- Upstream Loans: This package introduces a new "upstream loan" rule to protect the integrity of the existing taxable surplus and the new hybrid surplus regimes. This rule is modelled on the domestic shareholder loan benefit rules. Under it, Canadian taxpayers will be required to include in their income the amount of loans made by their foreign affiliates to the taxpayer and certain non-arm's length persons where the loans remain outstanding for more than two years. The inclusion is offset by any exempt surplus or taxable surplus with sufficient underlying foreign tax on hand. In such cases, the loan does not avoid Canadian tax, but rather may seek to avoid foreign withholding tax that might have arisen had the foreign affiliate paid a dividend rather than made a loan. Strangely, the rules do not seem to provide similar recognition for an affiliate's pre-acquisition surplus, which, like exempt or tax-paid taxable surplus, can generally be repatriated to Canada on a tax-free basis. It is hoped that this is a mere oversight and will be corrected in the final legislation. This change departs from years of consistent policy and practice by the Canadian government, including favorable rulings by the Canada Revenue Agency, of allowing foreign affiliates to "lend up" taxable surplus, thereby providing liquidity to a Canadian parent. While this measure can be understood in the context of the existing taxable and new hybrid surplus regimes, it is unclear what has happened to change such a long-standing policy. Together, the above two proposals create an obstacle to the redeployment of capital of foreign affiliates to Canada, and it is precisely this type of obstacle (if broader) that has traditionally deterred the foreign subsidiaries of U.S. multinationals from redeploying their capital to the United States. In respect of existing upstream loans, the proposals offer some limited grandfathering, effectively providing a two-year period to restructure. For taxpayers without ready liquidity, this may be quite problematic.
- Reorganizations: The rules governing mergers and liquidations and dissolutions of foreign affiliates are revised, mainly in line with "comfort letters" that have been issued on this subject over recent years. The rules relating to liquidations of top-tier foreign affiliates into Canadian parent corporations are being significantly amended. In the case of qualifying liquidations and dissolutions, they will allow rollovers of all properties rather than just shares of another foreign affiliate, and will deny any loss on the shares of the foreign affiliate. As well, the rules governing the carry-over of tax cost of the foreign affiliate's assets to the parent are amended. For other liquidations, any gain on shares of foreign affiliates that are not "excluded property" will now have to be recognized. Amendments are also being made to certain share-for-share exchange provisions involving foreign affiliates in order to prevent the transfer and duplication of losses.
- Return of Capital: Earlier complex and ill-defined proposals dealing with distributions of capital from a foreign affiliate are replaced with a much simpler regime. Distributions in respect of shares of a foreign affiliate will now generally be dividends regardless of their legal form. However, taxpayers will be able to elect, in many circumstances, to treat the dividends as distributions of pre-acquisition surplus. Since pre-acquisition surplus dividends are non-taxable, but reduce the taxpayer's adjusted cost base ("ACB") in its foreign affiliate shares, this new regime allows taxpayers to access this ACB as a surrogate for the capital of their foreign affiliates. This represents a reasonable and welcome solution to a policy issue that threatened to generate untold complexity.
- Surplus Reclassification: A new anti-avoidance rule will reclassify certain exempt surplus as taxable surplus where it arises from tax avoidance transactions.
- Stop-Loss Rules: Rules that restrict losses on the disposition of foreign affiliate shares where exempt dividends have previously been received on the shares are amended to improve on prior proposed amendments and take a more focused approach to the relief granted. Amendments are also being made to various other stop-loss rules to prevent them from applying to dispositions of excluded property by a foreign affiliate and to ensure that suspended losses from non-excluded property dispositions are released at appropriate times.
- FAPI Capital Losses: The FAPI rules are amended so that, like in the domestic context, FAPI capital losses can only be applied against FAPI capital gains. Unfortunately, this measure does not take the next logical step and characterize FAPI capital gains as capital gains when included in the Canadian taxpayer's income, which would permit them to be offset by capital losses of the Canadian taxpayer and generate an increase to the capital dividend account of a private corporation.
- Foreign Exchange Gains and Losses: Although not a change to the foreign affiliate system, the rules relating to foreign exchange gains or losses are revised so that they generally apply only to gains or losses in respect of foreign currency debt. This clarifies that the general capital gain and loss rules apply to gains or losses on assets (rather than liabilities) that are foreign currency denominated and reverses current law that provides that a corporation may have currency-related gains or losses in respect of its own share capital in certain circumstances. How this will affect currency gains or losses on hedge contracts is not immediately clear.
Various other technical changes are included in these
legislative proposals, including clarification in respect of the
calculation of safe income in respect of the surplus of a foreign
affiliate; revisions to certain interpretive rules in respect of
"surplus entitlement percentage"; a new rule to clarify
that certain U.S.-style absorptive mergers will qualify for certain
foreign affiliate rollover provisions in respect of mergers;
revisions to proposals dealing with foreign affiliates that
immigrate to Canada, with the FAPI computation of policy reserves
of an insurance business and with the so-called "fresh
start" FAPI rules. Finally, this package contains revisions to
the rules governing the currency to be used in calculating gains
and losses of a foreign affiliate to deal with gains and losses in
respect of debts owing by a foreign affiliate.
In conclusion, these proposals include many long-awaited and welcome adjustments to the foreign affiliate rules, and offer more workable solutions to some issues than have been proposed in the past, which is commendable. Along with this comes some unexpected but reasonable tightening of certain provisions. However, the proposals also include, whether deliberately or otherwise, changes suggesting a significant tax policy shift in the treatment of proceeds of sales of shares of foreign affiliates. This change is all the more surprising as it runs directly counter to recent developments and expectations, particularly that the concept of taxable surplus would in time be eliminated as Canada's expansive tax treaty and expanding tax information exchange agreement networks erode its relevance.
The legislative proposals and explanatory notes are found at the following Department of Finance web site: http://www.fin.gc.ca/drleg-apl/fa-sea-0811-eng.asp.
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.