Canada: Proposed Foreign Affiliate Amendments Require Review Of Current And Past Transactions

Copyright 2011, Blake, Cassels & Graydon LLP

Originally published in Blakes Bulletin on Tax, August 2011

On Friday, August 19, 2011, the Department of Finance (Finance) released a long-awaited package of proposed amendments to the tax rules governing the taxation of income earned by foreign affiliates of Canadian taxpayers (the Proposals). Those who were expecting that this package would contain only amendments that had been promised in the significant number of "comfort letters" that were released by Finance over the past decade will be surprised, as the Proposals go well beyond that. In addition, the Proposals differ from the approach taken in the comfort letters in certain respects.

The Proposals contain a large number of changes, including the following:

  • a new rule which could give rise to an income inclusion for a Canadian taxpayer where a foreign affiliate has made an "upstream loan"

  • the introduction of a "hybrid surplus" pool which will encompass a foreign affiliate's gains and losses from the disposition of shares of foreign affiliates and certain other property
  • a new approach intended to simplify the characterization of distributions from foreign affiliates
  • revisions to the rules governing acquisitions, dispositions and reorganizations of foreign affiliates including:
  • liquidations of first-tier foreign affiliates
  • liquidations of lower-tier foreign affiliates
  • foreign mergers
  • exchanges of shares of one foreign affiliate for shares of another foreign affiliate
  • a new anti-avoidance rule specifically aimed at recharacterizing exempt surplus into taxable surplus in certain circumstances
  • changes to stop-loss rules including the dividend stop-loss rule applicable on dispositions of foreign affiliate shares
  • the streaming of capital losses in the determination of "foreign accrual property income".

As a consequence of the introduction of some of these proposed amendments, a number of previously announced proposals are being abandoned. These include the surplus suspension rules relating to transfers of certain foreign affiliate shares and other excluded property owned by a foreign affiliate, the proposed rules that were to govern the recognition of gains and losses on certain intra-group transfers of property and the proposal to introduce a "foreign paid-up capital" concept.

Any Canadian taxpayer with an interest in one or more foreign affiliates should take note of these Proposals as they represent the most significant package of amendments affecting these entities since 2004. Since a number of amendments have retroactive application to transactions that occurred prior to August 19, 2011, either on an automatic or elective basis, it is important to review both current and past transactions in order to determine the impact of the Proposals and whether any such elections should be made. Finance has stated that it will accept comments on the Proposals until October 19, 2011.

Upstream Loans from Foreign Affiliates

The Proposals include a new anti-avoidance rule designed to prevent taxpayers from making "upstream loans" from a foreign affiliate instead of distributing cash as a dividend. The relatively common strategy of lending cash from a foreign affiliate to its Canadian parent is described in the explanatory notes that accompanied the Proposals as a "synthetic dividend distribution". Where such cash was sourced from a foreign affiliate's taxable surplus, such strategy enabled the Canadian taxpayer to defer the Canadian tax that would otherwise apply to the receipt of a taxable surplus dividend.

Generally speaking, when a foreign affiliate pays a dividend out of its taxable surplus balance to its Canadian corporate parent, such dividend, net of a deduction relating to underlying foreign taxes, is included in the income for tax purposes of the Canadian corporation. Although subsection 15(2) of the Income Tax Act (Canada) (the Act) deems certain loans to shareholders to be shareholder benefits, a specific exception applies for loans made to a shareholder that is a Canadian-resident corporation. Furthermore, the Canada Revenue Agency (the CRA) confirmed in a ruling that a loan of taxable surplus by a foreign affiliate to its Canadian corporate parent would not be subject to the general anti-avoidance rule. Partially as a consequence of the release of that ruling, many Canadian corporations felt comfortable putting in place such upstream loan arrangements.

Proposed subsections 90(4) to (10) of the Act contain new anti-avoidance rules designed to prevent foreign affiliates from making these types of loans. The proposed regime is modelled on the existing shareholder benefit provision found in subsection 15(2) of the Act and provides for an inclusion of the "specified amount" in a Canadian taxpayer's income where the loan is made to or indebtedness is owed by a "specified debtor". The term "specified amount" is defined as being the amount of the loan or indebtedness, multiplied by the Canadian taxpayer's surplus entitlement percentage (SEP) in the foreign affiliate that made the loan or was owed the debt, determined at such time that the loan was made or the indebtedness arose. A "specified debtor" is defined to include the Canadian taxpayer, as well as certain non-arm's-length persons and certain partnerships. Specifically excepted from being a specified debtor would be a controlled foreign affiliate (utilizing the broader definition of that term in subsection 17(15) of the Act) of the Canadian taxpayer.

The Proposals do include exceptions to the application of this anti-avoidance rule. The first two exceptions are similar to those currently found in the exceptions to the shareholder loan provision in subsection 15(2) of the Act. No income inclusion will result where the loan or indebtedness is repaid within two years from the date on which the loan is made or the indebtedness arose (other than as part of a series of loans and repayments). Additionally, the rule will not apply to a loan or indebtedness that arises in the ordinary course of the creditor's business of lending money and bona fide arrangements are made for repayment in a reasonable time.

A further exception is provided in the form of an offsetting deduction which must be claimed annually in each year that the relevant loan or indebtedness is outstanding. The amount claimed under this deduction by a taxpayer must be brought back into income in the following taxation year; however, the deduction can be claimed in such subsequent year provided that the conditions for claiming the deduction continue to be met. The first condition required for this deduction is that the amount of the loan or indebtedness could have been directly or indirectly distributed to the Canadian taxpayer under circumstances where it would have been entitled to a full deduction under any of paragraphs 113(1)(a) to (b) of the Act. This requires that the foreign affiliate has sufficient exempt surplus or, alternatively, taxable surplus or hybrid surplus, provided that sufficient underlying foreign tax relating to such taxable or hybrid surplus had been paid at the time the loan was made or the indebtedness was incurred. It appears that the time for determining whether there is sufficient surplus (and/or sufficient underlying tax) to satisfy this first condition is at the time the loan was made. Thus, it appears that a subsequent loss affecting the balances of these surplus accounts should not affect the determination of whether the deduction is available for the subsequent year. This seems an appropriate result from a policy perspective since there is arguably no avoidance if the specified amount would not have been taxable to the taxpayer if it was paid as a dividend to the taxpayer at the time the loan was made as that determination would have been made without reference to subsequent events. It is interesting to note that this exception is not extended to dividends that would be paid out of pre-acquisition surplus from which a deduction would have been available under paragraph 113(1)(d) of the Act. Perhaps the thinking of Finance is that a taxpayer should make use of the new election included in the Proposals to have a dividend from a foreign affiliate deemed to have been paid out of pre-acquisition surplus.

The second condition for the deduction requires that, during the period in which the loan or indebtedness is outstanding, no dividend may be paid to the taxpayer or non-arm's-length Canadian resident persons by any of the taxpayer's foreign affiliates that are relevant to the determination under the first condition. This condition will not be met even if the amount of the dividend would not reduce the surplus accounts to such an extent as to cause the taxpayer to fail the first condition. It is not clear why this prohibition on dividends need be absolute.

The final condition for the deduction requires that no other loan or indebtedness made or incurred while the first loan or indebtedness is outstanding has relied on the same surplus balances in applying the exception.

Where there has been an income inclusion under this new rule, a deduction will be available to the extent the debt is repaid in a subsequent year.

This anti-avoidance rule will not only affect loans made or indebtedness created on or after August 19, 2011, but will also affect loans or indebtedness currently outstanding. Loans made or indebtedness outstanding prior to August 19, 2011 will be treated as having been made on that date. Thus, unless one of the exceptions described above is available, Canadian taxpayers with foreign affiliates that have such upstream loan arrangements in place will face an income inclusion unless such loan or indebtedness is repaid by August 19, 2013.

This new rule may apply to second-tier financing structures, a number of which have been the subject of a number of recent favourable rulings from the CRA. These structures generally involve a foreign parent with a Canadian subsidiary. The Canadian subsidiary capitalizes a controlled foreign affiliate which then makes a loan to another non-Canadian corporation in the foreign parent's global corporate group. Loans made by that controlled foreign affiliate to other foreign companies that are not controlled foreign affiliates will now be considered to have been made to "specified debtors". Unless the foreign affiliate would be considered to have made the loan in the ordinary course of its business of lending money, this previously acceptable structure could result in an income inclusion to the extent that such loan remains outstanding for over two years.

Hybrid Surplus

Under existing rules, where a foreign affiliate realizes a capital gain on the disposition of a share of another foreign affiliate that is excluded property, generally one-half of the capital gain is added to the exempt surplus account of the disposing foreign affiliate and the other half is added to its taxable surplus account. Dividends received by a Canadian corporation from a foreign affiliate's exempt surplus account may be received free of Canadian tax while dividends paid out of taxable surplus are included in the Canadian corporate shareholder's income subject to a deduction relating to underlying foreign taxes. The ability to pay dividends out of exempt surplus and taxable surplus separately led to some Canadian taxpayers entering into transactions whereby shares of foreign affiliates were sold within a foreign affiliate group on a non-rollover basis primarily to generate exempt surplus that could be repatriated as a tax-free dividend to Canada, while the taxable surplus created on the sale of the foreign affiliate shares was retained in the disposing foreign affiliate (or prior to the Proposals concerning upstream loans described above, would be loaned to the Canadian taxpayer). These types of surplus-generation transactions led to previously proposed "gain suspension" rules.

The Proposals abandon the "gain suspension" regime and introduce a third category of surplus account referred to as "hybrid surplus". Essentially, this new surplus account will include gains realized by a foreign affiliate from the disposition of foreign affiliate shares, partnership interests and certain financial instruments that are excluded property. The hybrid surplus concept is to be phased in. From August 19, 2011 until the end of 2012, the definition will only apply to dispositions made by a foreign affiliate to a "designated person or partnership" which would include certain non-arm's length persons or partnerships in relation to the relevant taxpayer. Beginning in 2013, hybrid surplus will include capital gains and (capital losses) from all dispositions by a foreign affiliate of shares of a foreign affiliate, partnership interests and certain other properties that are excluded property.

When hybrid surplus is repatriated by way of dividend paid by a foreign affiliate to a Canadian corporate shareholder, one-half of the amount will be entitled to a deduction while the other half will be included in the Canadian corporate shareholder's taxable income subject to a formulaic deduction for underlying foreign taxes. In general terms, where the underlying foreign tax relating to hybrid surplus being repatriated to a Canadian corporation by way of dividend is at least equal to the Canadian capital gains tax rate, no additional Canadian tax should result. The new hybrid surplus concept retains the existing Canadian tax consequences when gains from the disposition of foreign affiliate shares that are excluded property are repatriated to a Canadian corporate shareholder. The new concept, however, makes it impossible to repatriate the exempt surplus while leaving the taxable surplus portion behind in the foreign affiliate. Capital losses realized by a foreign affiliate on the disposition of foreign affiliate shares, partnership interests and certain financial instruments that are excluded property will reduce such foreign affiliate's hybrid surplus account. Foreign taxes that reasonably relate to the amount to be included in hybrid surplus will also reduce this account.

It seems that this new rule may result in a somewhat greater incentive not to repatriate a foreign affiliate's proceeds from the sale of shares of other foreign affiliates to a Canadian parent.

The general rules governing the ordering of payments of dividends from a foreign affiliate's surplus accounts will be amended to contemplate hybrid surplus which will be paid out after exempt surplus and before taxable surplus. The ability to elect to have a dividend paid out of taxable surplus first will continue to be available. Furthermore, as is discussed below, a taxpayer may now generally be able to elect to have a dividend paid by a foreign affiliate be paid out of the foreign affiliate's pre-acquisition surplus accounts.

Treatment of Distributions from a Foreign Affiliate

Under current rules, the Canadian tax treatment of a distribution by a foreign affiliate has been predominantly determined by the characterization of such amounts under the local corporate law governing the foreign affiliate. Particularly where foreign law involves concepts that are different from those found in the Canadian corporate context, the repatriation of amounts such as share premium by a foreign affiliate to a Canadian shareholder has too often been fraught with uncertainty as to the tax character of the receipt to the Canadian shareholder. An example of this uncertainty would be the CRA's recent statements at the conference of the 2011 International Fiscal Association (Canadian Branch) suggesting that a return of share premium by a foreign affiliate could give rise to a shareholder benefit under subsection 15(1) of the Act.

The Proposals should eliminate this uncertainty largely through abandoning the reliance on foreign corporate law and replacing this with two new measures. First, essentially all pro rata distributions in respect of shares of a foreign affiliate will be treated as dividends for Canadian tax purposes unless such amounts are received on liquidation of the foreign affiliate or as a consequence of a redemption or purchase for cancellation of the foreign affiliate share. Second, there is a proposal to allow a taxpayer to elect to forego the general ordering rules governing dividends paid out of foreign affiliates and elect to have such a dividend paid out of pre-acquisition surplus. This has the effect of avoiding a net inclusion in the taxable income of the Canadian corporate taxpayer and instead reduces the adjusted cost base of the foreign affiliate shares held by such taxpayer. Amendments have been made to the automatic deemed dividend election contained in subsection 93(1.1) of the Act and related provisions to ensure that a taxpayer does not use this election to deem a pre-acquisition surplus dividend in an amount which exceeds the adjusted cost base of the foreign affiliate shares to convert taxable or hybrid surplus into a capital gain.

This proposal will generally apply to distributions made after August 19, 2011; however, a taxpayer may elect to have a transitional version of this rule apply after February 27, 2004.

Foreign Affiliate Reorganizations

The Proposals contain revised rules dealing with liquidations and mergers of foreign affiliates, that differ in some respects from the rules contained in the proposed amendments released on February 27, 2004 (the 2004 Proposals) and the subsequent comfort letters issued by Finance. Some of the revised rules have retroactive application either automatically or if the taxpayer so elects. Thus, it is advisable for taxpayers to review past foreign affiliate reorganizations to determine the impact, if any, of the revised rules and whether one or more elections should be made.

Liquidation and Dissolution of First-Tier Foreign Affiliates

The current rules in subsection 88(3) provide a rollover only for shares of foreign affiliates of a Canadian taxpayer that are distributed to the taxpayer on the liquidation and dissolution of a controlled foreign affiliate of the taxpayer, unless the taxpayer elects otherwise. Under the 2004 Proposals, the scope of subsection 88(3) was proposed to be significantly expanded to apply to distributions of property to a Canadian taxpayer whether on a liquidation or dissolution of a foreign affiliate, on a redemption of shares of a foreign affiliate, on the payment of a dividend or other forms of distributions. The 2004 Proposals led to the issuance of a number of comfort letters to clarify the scope of the 2004 Proposals, including the introduction of a "foreign paid-up capital" concept which has now been abandoned as a result of the Proposals.

Unlike the 2004 Proposals, the application of proposed subsection 88(3) under the Proposals is restricted to the distribution of property to the Canadian taxpayer on a liquidation and dissolution of a foreign affiliate of the taxpayer where the distributed property is received in respect of shares of the foreign affiliate that are disposed of on the liquidation and dissolution. On the other hand, proposed subsection 88(3) is broader in scope than the current rules in that it applies to all property (not just shares of another foreign affiliate) distributed to the Canadian taxpayer on a liquidation and dissolution of a foreign affiliate (not necessarily a controlled foreign affiliate) of the taxpayer (referred to as the "disposing foreign affiliate" in the Proposals), although a rollover is available only for property distributed on a "qualifying liquidation and dissolution" (QLAD) or for shares of another foreign affiliate distributed on the liquidation and dissolution that are excluded property.

A liquidation and dissolution qualifies as a QLAD if a 90% ownership test is satisfied and if the taxpayer so elects in accordance with the prescribed rules. The 90% ownership test is satisfied if: (a) the taxpayer owned at least 90% of each class of issued and outstanding shares of the disposing foreign affiliate throughout the liquidation and dissolution, or (b) the taxpayer held, at all times at which property is distributed in the course of the liquidation and dissolution, shares of the disposing foreign affiliate that entitle the taxpayer to at least 90% of the votes that could be cast under all circumstances at an annual shareholders' meeting and received at least 90% of the net fair market value of all distributed property.

Subject to certain exceptions discussed below, all of the disposing foreign affiliate's property distributed on a QLAD and shares of other foreign affiliates that are excluded property distributed on any liquidation or dissolution of the disposing foreign affiliate (whether a QLAD or not) are deemed to have been disposed of by the disposing foreign affiliate for proceeds of disposition and acquired by the taxpayer at a cost equal to the "relevant cost base" of the distributed property. Essentially, "relevant cost base" is the amount that would not give rise to any gain or loss from the disposition of the property, subject to the ability to elect at a higher amount if the disposing foreign affiliate is an "eligible controlled foreign affiliate". An "eligible controlled foreign affiliate" is a controlled foreign affiliate of the taxpayer in respect of which the taxpayer's participating percentage is at least 90%. Any gain realized as a result of such an election would give rise to foreign accrual property income (FAPI) (which is attributed to the taxpayer and taxed on a current basis) even if the property distributed is excluded property.

Properties distributed on a liquidation and dissolution of a foreign affiliate that is not a QLAD and that are not shares of other foreign affiliates that are excluded property will be deemed to have been disposed of by the disposing foreign affiliate for proceeds of disposition and acquired by the taxpayer at a cost equal to the fair market value of the distributed property. In such circumstances, FAPI will arise only if the distributed property is not excluded property.

Subject to the "suppression election" under proposed subsection 88(3.3) available for QLADs discussed below, the taxpayer is deemed to have disposed of the shares of the disposing foreign affiliate for proceeds of disposition equal to the taxpayer's aggregate deemed cost of the properties distributed less the aggregate amounts owing by the disposing affiliate (other than unpaid dividends) or obligations of the disposing affiliate that were assumed and cancelled by the taxpayer in consideration for the distribution of distributed property. Therefore, the taxpayer could realize a gain on the shares of the disposing foreign affiliate where the disposing foreign affiliate's relevant cost base of the distributed property (inside basis) and, thus, the taxpayer's deemed cost of the distributed property exceeds the taxpayer's cost of the shares of the disposing foreign affiliate (outside basis).

The "suppression election" allows the taxpayer to defer such gain, but only in respect of a QLAD. Where the election is made, the taxpayer will be able to reduce the proceeds of disposition of any capital property distributed by the disposing foreign affiliate and, therefore, the cost of such property to the taxpayer and the taxpayer's proceeds of disposition of the shares of the disposing foreign affiliate. The reduction effectively defers the gain as the gain remains inherent in the capital property acquired by the taxpayer from the disposing foreign affiliate. The aggregate reduction cannot exceed the capital gain that would otherwise have been realized on the shares, after taking into account any subsection 93(1) deemed dividend election. Since the "suppression election" is ignored for FAPI purposes, no FAPI losses can be created in the disposing foreign affiliate as a result of the election. The election is also ignored for surplus computation purposes to avoid circularity issues that may otherwise arise on the interaction of the election with a subsection 93(1) deemed dividend election.

Subject to the application of other stop-loss rules, the taxpayer could realize a loss on the shares of the disposing foreign affiliate, except in the case of a QLAD. Proposed paragraph 88(3)(e) deems any loss of the taxpayer on the shares of the disposing foreign affiliate in a QLAD to be nil. Since the QLAD treatment is elective, a loss on the shares of the disposing foreign affiliate that meets the 90% ownership test could still be realized by the taxpayer provided that the QLAD election is not made.

Where the distributed property in the case of a QLAD is shares of a Canadian resident corporation that is taxable Canadian property and non-treaty-protected property (for example, shares of certain real property or resource companies), the taxpayer and the disposing foreign affiliate will be able to jointly elect for the shares to have been disposed of for proceeds equal to their adjusted cost base, such that the disposing foreign affiliate will not realize any gain or loss for purposes of Part I of the Act.

Proposed subsection 88(3) and the accompanying rules apply for liquidations and dissolutions of foreign affiliates that begin after February 27, 2004. Taxpayers may also elect for the rules to apply in a similar manner to property received after February 27, 2004 and before August 19, 2011 on a redemption, acquisition or cancellation of shares of a foreign affiliate, on a payment of a dividend by, or on a reduction of the paid-up capital of a foreign affiliate. However, there is no ability to elect for the current rules, the 2004 Proposals or the proposals described in the comfort letters to apply for liquidations and dissolutions beginning after February 27, 2004 and before August 19, 2011. Thus, taxpayers who may have relied on the current rules or the prior proposals for such liquidations and dissolutions should carefully review the impact of the new rules. It is somewhat unprecedented for rules of this nature to be legislated retroactively with no ability to elect to apply the rules as they were written when previous planning was done.

Liquidation and Dissolution of Lower-Tier Foreign Affiliates

Under the current rules, liquidations and dissolutions of one foreign affiliate into another are governed by two separate rules, depending on the taxpayer's percentage interest in the two foreign affiliates, the local income tax treatment of the liquidation and dissolution and the countries of residence of the two foreign affiliates. Where the taxpayer's SEP in the two foreign affiliates is at least 90% and no gain or loss is recognized in respect of property distributed on the liquidation and dissolution under the income tax law of the country in which both foreign affiliates are resident, current paragraph 95(2)(e.1) provides for a rollover for all capital property distributed on the liquidation and dissolution as well as for shares of the disposing foreign affiliate. Where conditions for current paragraph 95(2)(e.1) are not met, current paragraph 95(2)(e) provides for a rollover for shares of another foreign affiliate distributed on the liquidation and dissolution, unless the taxpayer elects otherwise.

The Proposals replace current paragraphs 95(2)(e) and 95(2)(e.1) with proposed paragraph 95(2)(e). Proposed paragraph 95(2)(e) is very similar to proposed sub-section 88(3), except that proposed paragraph 95(2)(e) relies on the concept of a "designated liquidation and dissolution" (DLAD) rather than a QLAD. Qualifications for a DLAD differ from a QLAD in two respects. First, a DLAD applies automatically (rather than electively as in the case of a QLAD) if the 90% ownership test is met. Second, the 90% ownership test for a DLAD is slightly different from that for a QLAD in that the test for a DLAD may also be met if a 90% SEP test is met.

Consistent with the comfort letters, the requirements for non-recognition treatment under local income tax laws and same country of residence for the disposing foreign affiliate and the shareholder foreign affiliate have been removed.

The tax treatment of the disposition of the distributed property by the disposing foreign affiliate in a DLAD, for distributed property that is excluded property shares of another foreign affiliate and for other property distributed on a non-DLAD is the same as that under proposed subsection 88(3). However, the treatment of the disposition of the shares of the disposing foreign affiliate under proposed paragraph 95(2)(e) is not as flexible as that under proposed subsection 88(3).

Where the liquidation and dissolution is a DLAD, the following rules will apply:

  • if the taxpayer would have an accrued gain in the shares because its deemed proceeds, determined using the aggregate cost of the distributed properties, exceed its adjusted cost base of the shares, the proceeds are deemed to be equal to adjusted cost base;
  • if the taxpayer would have an accrued loss on the shares because its deemed proceeds, determined using the aggregate cost of the distributed property, are less than its adjusted cost base of the shares:
  • if the shares are not excluded property, the proceeds are deemed to be equal to its adjusted cost base; and
  • if the shares are excluded property, the proceeds are deemed to be equal to the aggregate cost of the distributed properties.

Thus, under the Proposals, a liquidation and dissolution of one foreign affiliate into another foreign affiliate that meets the 90% ownership test for a DLAD cannot generate surplus or create a FAPI loss but can create a loss that grinds surplus for the shareholder foreign affiliate. Such treatment is automatic. This result reflects the policy intent to prevent the use of internal transactions to generate surplus or FAPI losses.

For non-DLADs , the shareholder foreign affiliate's proceeds of disposition of the shares of the disposing foreign affiliate will be determined using the aggregate cost of the distributed properties to the shareholder foreign affiliate. Thus, the shareholder foreign affiliate in a non-DLAD could realize a gain or a loss, including a FAPI loss, subject to the stop-loss rules and the FAPI capital loss streaming rules discussed below.

The shareholder foreign affiliate in a DLAD is deemed to be continuation of and the same corporation as the disposing foreign affiliate for various purposes under the loss suspension and FAPI computation rules.
Proposed paragraph 95(2)(e) applies for liquidations and dissolutions that begin after August 19, 2011, but taxpayers may elect to have a modified version apply to liquidations and dissolutions that begin after December 20, 2002.

Foreign Mergers

The current rules governing mergers of foreign affiliates are contained in two separate rules. Where a 90% SEP requirement is satisfied for all merging foreign affiliates and the merged foreign affiliate, and a non-recognition requirement is satisfied under relevant local income tax law, current paragraph 95(2)(d.1) provides a rollover for capital property held by the merging foreign affiliates. Current paragraph 95(2)(d) provides a rollover for shares of a merging foreign affiliate held by another foreign affiliate unless the taxpayer elects otherwise.

Under the Proposals, current paragraph 95(2)(d) is retained and remains essentially unchanged. However, the scope of application of paragraph 95(2)(d.1) is significantly expanded. Consistent with the comfort letters, the 90% SEP requirement and the non-recognition requirement under relevant local income tax law are eliminated. For proposed paragraph 952)(d.1) to apply, only two conditions need to be satisfied:

  • there is a foreign merger (as defined for these purposes) of two or more predecessor foreign corporations to form a new foreign corporation that is, immediately after the merger, a foreign affiliate of the taxpayer; and
  • one or more of the predecessor foreign corporations was, immediately before the merger, a foreign affiliate of the taxpayer (each referred to as a "foreign affiliate predecessor").

Where proposed paragraph 95(2)(d.1) applies, there is a rollover of all property of each foreign affiliate predecessor (not just capital property) at relevant cost base. The new foreign corporation is deemed to be a continuation of, and the same corporation as, each foreign affiliate predecessor for various purposes under the loss suspension rules and FAPI computation rules. In addition, the surplus accounts (including hybrid surplus) of the foreign affiliate predecessors will flow through to the new foreign corporation.

Finally, the Proposals contain a rule to ensure that so-called "absorptive mergers" common in the U.S., where one merging corporation survives and the other ceases to exist, qualify as foreign mergers for purposes of the rules governing mergers of foreign affiliates. This clarifying rule applies to mergers that occur after 1994, but taxpayers may elect to have it apply after August 19, 2011.

Proposed paragraph 95(2)(d.1) applies to mergers that occur after August 19, 2011, but taxpayers may elect to have a modified version apply to mergers that occur after December 20, 2002.

Share-For-Share Exchanges

Current subsection 85.1(3) provides a rollover for transfers of foreign affiliate shares by a Canadian taxpayer to another foreign affiliate in exchange for consideration that includes shares of the acquiring affiliate. Current paragraph 95(2)(c) contains a similar rollover rule for transfers of foreign affiliate shares by one foreign affiliate to another foreign affiliate for consideration that includes shares of the acquiring affiliate.

The Proposals will modify both subsection 85.1(3) and paragraph 95(2)(c) to prevent a rollover at a cost above the fair market value of the transferred shares. In other words, it will no longer be possible to transfer an accrued loss on the shares to the acquiring foreign affiliate. In addition, any resulting loss incurred by the Canadian taxpayer or any FAPI loss incurred by the transferor foreign affiliate may be suspended and any resulting non-FAPI loss will reduce the transferor foreign affiliate's hybrid surplus.

Current subsection 85.1(4) denies a rollover on transfers of foreign affiliate shares that are excluded property by a Canadian taxpayer as part of a series of transactions for the purpose of disposing of the shares to an arm's-length person other than another foreign affiliate of the taxpayer. The proposals will narrow the exception to the rollover denial rule for foreign affiliate purchasers, essentially limiting it to a purchaser that is a foreign affiliate in respect of which the Canadian taxpayer has a "qualifying interest", meaning ownership of at least 10% of votes and fair market value.

These proposed changes will apply to transfers that occur after August 19, 2011.

Dividend Stop-Loss Rule

Where a Canadian-resident corporation realizes a capital loss on the disposition of shares of a foreign affiliate, subsection 93(2) of the Act may operate to reduce the loss to the extent that the Canadian taxpayer has received exempt dividends on such shares as a consequence of the deduction available under paragraphs 113(1)(a) to (c) of the Act. Proposed amendments to subsection 93(2) of the Act, which would reduce the amount of the "stopped loss" in certain circumstances to the extent that the Canadian taxpayer had a corresponding foreign exchange-related gain on debt used to finance the acquisition of the foreign affiliate shares or pursuant to certain other foreign currency hedging arrangements, have been outstanding for some time. The relevant provisions have been significantly reconfigured and include substantive changes to the ability to claim relief from the application of the stop-loss rule. Although some of these changes address technical deficiencies in an earlier version of the proposed exception to the stop-loss rule, other proposed changes may restrict availability to such exception. One such change is a requirement that the acquisition of the foreign affiliate shares and the foreign currency funding/hedging transaction be within 30 days of each other. Similarly, the disposition of the foreign affiliate shares and the settlement of the funding/hedging arrangements must also take place within 30 days of each other. This may prevent taxpayers who have interim funding arrangements from making use of the relief under this provision for subsequent permanent financing arrangements.

These proposed changes will generally apply to dispositions of foreign affiliate shares and partnership interests after February 27, 2004 subject to an election to have them apply after 1994.

Other Stop-Loss Rules

Amendments have also been proposed to the various loss suspension and stop-loss rules contained in the Act. One of the purposes of these amendments is to ensure that these rules are not used to defer losses realized by a foreign affiliate on a disposition of excluded property. Rather, such a loss on excluded property will reduce the foreign affiliate's exempt surplus balance in the taxation year in which the loss is realized rather than being deferred. These changes to the stop-loss rules are generally effective for dispositions occurring after August 19, 2011.

Surplus Reclassification Rule

The Proposals include a new anti-avoidance rule that will allow for the recharacterization of amounts that increase exempt earnings of a foreign affiliate (or reduce exempt loss) in certain circumstances. Proposed subsection 5907(2.02) of the Regulations incorporates the key components of the general anti-avoidance rule which will apply to certain "avoidance transactions" undertaken to increase the foreign affiliate's exempt earnings. Where applicable, such amounts will be deemed to be taxable earnings rather than exempt earnings.

The explanatory notes accompanying the Proposals state that this rule is being introduced to replace the earlier proposed gain suspension regime applicable to certain intra-group transfers of property other than foreign affiliate shares.

This rule is applicable to transactions entered into after August 19, 2011.

FAPI and Capital Losses

Under existing rules, allowable capital losses realized by a foreign affiliate from the disposition of capital property that is not excluded property may be applied to reduce the foreign affiliate's FAPI. This is inconsistent with the approach taken domestically in that allowable capital losses can only be applied against taxable capital gains and not ordinary income. For taxation years of foreign affiliates ending after August 19, 2011, that will no longer be the case. Allowable capital losses relevant to the calculation of FAPI will now only be able to be deducted from taxable capital gains included in the calculation of FAPI of the foreign affiliate for that taxation year. Any unapplied allowable capital losses may be carried back three years or carried forward 20 years and claimed against net taxable capital gains included in FAPI of the foreign affiliate. This 20-year limit on the ability to carry forward such capital losses differs from the capital loss carryforward rule in the domestic context which has no such limitation. The basis for including such a limitation is presumably that there is no rule eliminating such capital losses on an acquisition of control.

Other Measures

The Proposals contain other measures, including:

  • amendments to the rules dealing with foreign exchange gains or losses;
  • amendments to the Regulations dealing with computation of foreign accrual tax in relation to foreign affiliates that form a consolidated group in a foreign jurisdiction;
  • relevant to domestic spin-off transactions, new rules for computing "safe income" of a foreign affiliate;
  • amendments to the "fresh start" rules where an active business carried on by a foreign affiliate becomes passive;
  • rules for computing policy reserves in a foreign affiliate's insurance business;
  • revisions to the rules in the 2004 Proposals dealing with immigration of a foreign affiliate to Canada; and
  • amendments to address defects in the SEP computation rules in situations involving circular shareholdings and nil overall net surplus in the relevant foreign affiliate group.

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.

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Registration
Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:
  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.
  • Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.
    If you do not want us to provide your name and email address you may opt out by clicking here
    If you do not wish to receive any future announcements of products and services offered by Mondaq you may opt out by clicking here

    Terms & Conditions and Privacy Statement

    Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

    Use of www.mondaq.com

    You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

    Disclaimer

    Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

    The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

    Registration

    Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

    • To allow you to personalize the Mondaq websites you are visiting.
    • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
    • To produce demographic feedback for our information providers who provide information free for your use.

    Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

    Information Collection and Use

    We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

    We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

    Mondaq News Alerts

    In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

    Cookies

    A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

    Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

    Log Files

    We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

    Links

    This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

    Surveys & Contests

    From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

    Mail-A-Friend

    If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

    Emails

    From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

    *** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

    Security

    This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

    Correcting/Updating Personal Information

    If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

    Notification of Changes

    If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

    How to contact Mondaq

    You can contact us with comments or queries at enquiries@mondaq.com.

    If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.

    By clicking Register you state you have read and agree to our Terms and Conditions