Fresh on the heels of a number of recent court decisions,1 and based on recommendations made by the Advisory Panel on Canada's System of International Taxation,2 Budget 2012 proposes an assortment of anti-surplus stripping measures aimed at discouraging certain foreign affiliate investments (referred to as "foreign affiliate dumping transactions" or "FADTs") by Canadian corporations controlled by non-residents, which the Government asserts inappropriately erode Canada's corporate tax base. However, as discussed in further detail below, the proposed amendments contain a "business purpose" exception designed to keep "legitimate" transactions outside of their purview.
By way of background, the Income Tax Act (Canada) (the "Tax Act") generally affords a deduction with respect to interest expenses incurred by a Canadian taxpayer for purposes of making an equity investment in a "foreign affiliate" (which generally includes any foreign corporation in which the Canadian taxpayer (and entities related to the Canadian taxpayer) have an equity interest of at least 10%),3 despite the fact that income of the affiliate may, in many cases, be repatriated from the foreign affiliate as "exempt surplus", free of Canadian income tax. In addition, while the Tax Act has, for some time, contained a specific anti-avoidance provision4 designed to prevent surplus extractions arising from the transfer or other contribution to a Canadian corporate taxpayer by a non-resident shareholder of shares of a "connected" Canadian corporation,5 no similar rule exists where the transferred or contributed property is foreign corporation stock. The proposed FADT measures are intended to discourage foreign-owned corporate groups from undertaking these and other similar transactions in circumstances where the primary motivating factor is a Canadian "tax benefit"6 (including those benefits described above) and the net economic benefits to Canada are modest.
The centerpiece of the proposed FADT measures is new section 212.3 of the Tax Act which, where applicable, will operate to deem a dividend to have been paid by a Canadian taxpayer (referred to as the "corporation resident in Canada" or "CRIC") to its foreign parent to the extent of any non-share consideration given (or obligations assumed) by the CRIC in relation to a FADT (which is defined to include share investments and certain indebtedness,7 along with capital contributions, in any foreign entity that is (or becomes as a result of the FADT or the series of the transactions that includes the FADT), a "foreign affiliate" of the CRIC). Any such deemed dividend will be subject to non-resident withholding tax levied under Part XIII of the Tax Act at a rate of 25%, unless reduced by virtue of an applicable tax treaty.8
New proposed section 212.3 of the Tax Act will also apply in
conjunction with certain other amendments to the Tax Act, including
amendments to the thin capitalization rules in subsection
18(4) (which generally operate to limit the amount of interest expense that a Canadian corporation may claim with respect to indebtedness owing to "specified non-residents") and the "paid-up capital" and contributed surplus computational rules in section 84, such that any paid-up capital or contributed surplus increases that would otherwise have arisen from an impugned FADT are effectively disregarded.
Finally, Budget 2012 indicates that a variety of changes to various supporting provisions of the Tax Act will be made to ensure a comprehensive application of the new section 212.3 principles.9
As indicated above, the new FADT measures are not intended to apply to foreign affiliate investments that may reasonably be viewed as having been undertaken by the relevant CRIC, instead of being undertaken (or retained) by the non-resident parent or another non-resident entity in the corporate group, primarily for bona fide purposes other than to obtain a tax benefit. To that end, the new measures contain a list of factors that will be given "primary" consideration for purposes of making this determination. These factors include, among others: (a) the degree of present and (expected) ongoing connection between the foreign affiliate's business activities and those of the CRIC (or other members of the CRIC's Canadian group, if any), as compared with those of any non-resident corporation in the corporate group; (b) the degree to which the CRIC was instrumental in the decision to make the investment, and the decision-making authority that the CRIC's senior officers, residing and working principally in Canada, possessed and exercised in connection with the investment decision (again, as compared to their counterparts at any non-resident corporation in the group); (c) any restricted participation entitlement that may exist in respect of the CRIC's share investment in the subject foreign affiliate, insofar as earnings and growth entitlements are concerned (e.g., a preferred share investment as opposed to a common share investment); and (d) the extent to which senior officers of the foreign affiliate are "functionally accountable" to senior officers of the CRIC who reside and work principally in Canada. The Government acknowledges that the formulation of the applicable "business purpose" test is not straightforward. As a consequence, the Government has invited stakeholders to submit comments on the operative considerations identified in Budget 2012 before June 1, 2012.
In the absence of the above-noted business purpose exception, the new rules will apply to any FADT that occurs on or after March 29, 2012. Limited grandfathering may be available in relation to certain FADTs entered into between arm's length parties before that date, provided that, among other things, the parties were obligated to complete the subject transaction pursuant to the terms of a written agreement that was entered into before March 29, 2012 and the transaction occurs prior to 2013.
1 See, for example, The Queen v. Collins & Aikman Products Co. et al., 2010 FCA 251 and Copthorne Holdings Ltd. v. The Queen, 2011 CSC 63.
2 The Advisory Panel on Canada's System of International Taxation (2008) identified certain types of foreign affiliate "dumping" transactions as being abusive (in particular, transactions that reduce the Canadian tax base without providing any meaningful economic benefit to Canadians).
3 See the definition of a "foreign affiliate" in subsection 95(1) of the Tax Act.
4 Section 212.1 of the Tax Act.
5 Paid-up capital may generally be returned to a non-resident shareholder free of withholding tax under Part XIII of the Tax Act.
6 As defined in subsection 245(1) of the Tax Act.
7 Excluding, for instance, certain amounts owing by the foreign affiliate to the CRIC that arose in the ordinary course of the CRIC's business and that are repaid within a commercially reasonable period.
8 For example, under the Canada-United States Income Tax Convention (1980), as amended, the withholding tax rate on qualifying dividends may be as low as 5%.
9 Including, for example, changes to section 128.1 of the Tax Act in the context of certain corporate immigration transactions.
The foregoing provides only an overview. Readers are cautioned against making any decisions based on this material alone. Rather, a qualified lawyer should be consulted.
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