On August 14, 2012, the Minister of Finance released for consultation draft legislative proposals (the August 14 Proposals) to implement income tax measures proposed in the March 2012 federal Budget (the Budget Proposals). The government has invited comments by September 13, 2012. It is expected that the government will then introduce these measures into Parliament in the autumn 2012 session.
Included in the Budget Proposals was a sweeping and aggressive set of proposals to dramatically change the rules relating to the acquisition, ownership and financing of foreign affiliates (FAs) (generally meaning foreign companies in which the Canadian shareholder has at least a 10% interest) by foreign-controlled Canadian companies. This was done in an effort to deter Canadian subsidiaries of foreign-based multinational groups from making investments in non-resident corporations that are (or become) FAs of the Canadian subsidiary in situations where these investments can result in inappropriate erosion of the Canadian tax base, referred to as "foreign affiliate dumping". As indicated in the Explanatory Notes to the August 14 Proposals, such erosion can arise because of the exempt treatment of most dividends from these FAs in combination with the interest deductions on debt incurred to make such investments or the ability to extract corporate surplus from Canada free of non-resident dividend withholding tax (WHT). The government views the result of this planning as inappropriate, particularly when undertaken without providing any significant economic benefits to Canada.
For a detailed discussion of the Budget Proposals, including the foreign affiliate dumping rules (the FA dumping rules) as originally proposed, please click here to access our Budget 2012 Blakes Bulletin.
Generally, the FA dumping rules apply where a corporation resident in Canada (a 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 be deemed to have paid a dividend to its parent (subject to the new election discussed below). The deemed dividend is subject to WHT, even though no amount is actually extracted from Canada. Where the form of consideration consists of shares of the CRIC, the paid-up capital (PUC) of such shares will be automatically suppressed.
While the August 14 Proposals generally give effect to the Budget Proposals, there are significant changes to the FA dumping rules. Some of the major changes to the FA dumping rules are:
- most significantly, extension of the rules to certain investments made by a CRIC in the shares of another CRIC where such shares derive more than 50% of their value from FA shares;
- introduction of an election to allow a CRIC to reduce a deemed dividend that would otherwise arise under the rules by reducing its PUC in certain circumstances (the PUC suppression election);
- introduction of a rule to "reinstate" PUC previously reduced as a result of a PUC suppression election in limited circumstances (the PUC reinstatement rule) to allow the distribution of FA shares and certain other property by a CRIC as a return of capital free of WHT in some cases;
- elective relief for loans made by a CRIC to an FA with the election resulting in deemed interest income in the CRIC at a baseline rate; and
- modest relief for limited types of corporate reorganizations and other internal transactions.
While some of these changes are intended to be relieving, and appear to respond to submissions from the tax and business communities, other new (and not previously announced) measures expand the scope of these rules and raise new issues to be considered and managed. In addition, the relieving provisions do not appear to go far enough in some cases. Foreign multinationals that are considering acquiring Canadian targets with FAs or that already have Canadian subsidiaries that own or will acquire FAs should carefully consider the impact of these rules on such acquisitions as well as the ongoing funding of such FAs.
The FA dumping rules generally apply to transactions that occur after March 28, 2012, subject to:
- limited grandfathering for transactions that occur before 2013 between arm's length parties which are obligated to complete the transactions under written agreements entered into before March 29, 2012; and
- a transitional election to have essentially the version of the rules contained in the Budget Proposals apply to transactions which occurred between March 29, 2012 and August 13, 2012.
The new FA dumping rules are complex and far-reaching. This bulletin provides a high-level, non-exhaustive summary of these rules, focussing on the significant changes to the Budget Proposals and the impact of these changes on common commercial transactions. We also discuss a new change to the upstream shareholder loan rules that was not contained in the Budget Proposals.
Expansion of the Meaning of Investment in a Subject Corporation
Under the Budget Proposals, an "investment in a subject corporation" included not only an acquisition of shares of the subject corporation but also a capital contribution, a loan or acquisition of debt, or the acquisition of options or other interests in the subject corporation. The August 14 Proposals significantly broaden the scope of "investment in a subject corporation" made by a CRIC in three respects:
Extension of Maturity/Redemption Date
A CRIC will be considered to have made an investment in a subject corporation where the maturity date of a debt obligation owing by a subject corporation to the CRIC is extended. An investment will also arise if the redemption or buy-back date of shares is extended.
The Explanatory Notes state that each extension would result in a new investment to which the FA dumping rules could apply, in addition to the initial investment in the debt or shares (if made after March 28, 2012). While this new measure is presumably intended to preserve the integrity of the rules, it seems to provide for a harsh result given that no incremental funding results from such an extension.
Benefits Conferred on FAs
The new rules deem any transaction or event under which a "benefit" is conferred on the subject corporation by a CRIC to be a capital contribution, and therefore, an "investment in a subject corporation". The Explanatory Notes state that this provision is intended to be interpreted and applied in a fashion similar to that of the shareholder benefit conferral rule, though the precise meaning of this in some fact patterns is not entirely clear. It seems a "benefit" could arise if the CRIC engages in a transaction that transfers value downstream to its FAs, for example, a forgiveness of debt, a downstream guarantee or the CRIC bearing expenses properly borne by the FA without reimbursement.
Indirect Acquisitions of FAs
In a significant expansion of the Budget Proposals, the FA dumping rules may now even apply to acquisitions of some Canadian target companies.
This change will deem an acquisition by a CRIC of shares of another CRIC to be an "investment in a subject corporation" where the fair market value (FMV) of all shares of FAs owned directly or indirectly by the other CRIC exceeds 50% of the total FMV of all properties owned by the other CRIC, determined without reference to debt obligations of any Canadian corporation in which the other CRIC has a direct or indirect interest (the >50% test).
A typical structure used by a foreign purchaser (Foreign Purchaser) to acquire a Canadian target company (Canadian Target) is for Foreign Purchaser to incorporate a Canadian acquisition company (Canco). Foreign Purchaser capitalizes Canco with sufficient equity (or a combination of interest-bearing debt and equity that does not exceed the debt-to-equity ratio under the thin capitalization rules) to enable Canco to acquire the shares of Canadian Target. Canadian Target then amalgamates with Canco to form Amalco (alternatively, Canadian Target is liquidated into Canco). Under existing law, a step-up (or "bump") in the tax cost of non-depreciable capital property owned by Canadian Target is available upon such amalgamation or liquidation in some circumstances.
This structure is often used in acquisitions of Canadian multinationals by foreign buyers to facilitate a post-closing reorganization to extract the FAs of Canadian Target from Canada without Canadian tax. Specifically, the bump enables Amalco to distribute the FA shares without recognizing any gain or loss on the disposition; the distribution may be effected by way of return of PUC of Amalco (the PUC created as a result of Foreign Purchaser's equity investment in Canco) free from WHT.
The ability to extract the FA shares post-acquisition in a tax-efficient manner becomes more important with the introduction of the FA dumping rules. Retaining the FAs under Canada could result in additional costs in the form of: (i) WHT on immediate or future deemed dividends where the FAs are equity-funded by Canco, and/or (ii) Canadian tax on interest at a "high" prescribed rate where the FAs are debt-funded by Canco and the PLI election described below is made. New rules contained in the August 14 Proposals will affect the manner in which Canco is held and is capitalized with the purchase price, in order to enable a tax-efficient extraction of the FA shares post-acquisition.
If the shares of Canadian Target in the typical acquisition structure meet the >50% test, Canco will be deemed to have made a separate investment in the underlying FAs of Canadian Target. Canco will thus be deemed to have paid a dividend to Foreign Purchaser in an amount equal to the portion of the purchase price that "can reasonably be considered to relate to" the deemed investments in the FAs of Canadian Target (subject to (i) the new PUC supression election discussed below and (ii) any portion of the purchase price satisfied with Canco shares).
The phrase "can reasonably be considered to relate to" is not defined. It suggests that a reasonable allocation of the purchase price paid by Canco for the indirectly acquired FA shares is required to determine the amount of the deemed dividend. The Explanatory Notes state that in the absence of specific factors that indicate otherwise, it would be expected that the most reasonable way to allocate the consideration would be on a pro-rata basis based on the FMV of the underlying assets indirectly acquired. As a practical matter, the valuation of the underlying FAs may not be a straightforward exercise, as the overall deal price covers the entire (Canadian and foreign) business of Canadian Target.
In determining whether Canadian Target meets the >50% test, while debts of Canadian corporations in which the Canadian Target has a direct or indirect interest are to be ignored in computing the total FMV of Canadian Target's properties, any debts of the FAs will affect their value. While a third-party valuation will be the best way to make the determination, this will not be practical in all situations. In addition, the exercise will involve a certain amount of risk in "close to the line" cases.
A broad anti-avoidance rule deems the >50% test to be met at the time Canadian Target is acquired even if the test was in fact not met at that time, if as part of the "series of transactions", property owned directly or indirectly by Canadian Target (other than FA shares) is disposed of. This broad rule is not only intended to address situations where Canadian Target "stuffs" itself with non-FA assets, but also where the Foreign Purchaser intends to retain Canadian Target's FAs while divesting Canadian Target's Canadian business assets. However, it has no de minimis or "ordinary course of business" exception, which could be problematic.
The deemed dividend that would otherwise arise as a result of the acquisition by Canco of the shares of Canadian Target (with consideration other than Canco shares) may be avoided or reduced where the PUC suppression election described below is available.
The PUC Suppression Election
The PUC suppression election is available where a CRIC has only one class of shares issued and outstanding or where it demonstrates that an amount of PUC arising from transfers of cash or other property to it can be traced to an investment in FAs (including indirect investments through the acquisition of a Canadian Target that meets the >50% test). In addition, all shares of the CRIC not owned by the parent must be owned by persons dealing at arm's length with the CRIC.
Where the PUC suppression election is available, a CRIC and its parent may jointly elect to treat the dividend otherwise deemed to paid by the CRIC as a reduction of its PUC to the extent of the lesser of the deemed dividend and its PUC. Perhaps surprisingly, the foreign parent (which would not ordinarily be filing returns in Canada) must sign the election (as well as the other joint elections described below).
The PUC suppression election should be available in the typical acquisition structure unless Canco is held indirectly by Foreign Purchaser through one or more Canadian holding companies. Since such Canadian holding companies are persons who do not deal at arm's length with Canco and who own shares of Canco not owned by the Foreign Purchaser, the PUC suppression election will not be available where one or more such Canadian holding companies exist in the structure. The PUC suppression election will also not be available where Canco has multiple shareholders within the corporate group.
In order to completely eliminate the immediate deemed dividend in the typical acquisition structure, the portion of the purchase price attributable to the FMV of the shares of Canadian Target's FAs will need to be funded by way of equity investment by Foreign Purchaser in Canco (with debt funding limited to the portion of the purchase price attributable to Canadian Target's Canadian/non-FA assets).
While a PUC suppression election will avoid an immediate deemed dividend and WHT on the direct or indirect acquisition of FAs, the reduction of a CRIC's PUC could give rise to a deemed dividend (and resulting WHT) in the future when assets of the CRIC are distributed to the parent as a return of capital, unless the property distributed on such return of capital qualifies under the new PUC reinstatement rule discussed below.
The PUC Reinstatement Rule
The PUC reinstatement rule allows PUC that has been reduced as a result of a PUC suppression election to be "reinstated" when certain subsequent distributions are made in the form of a return of PUC. Such subsequent distributions must be distributions of FA shares acquired on the initial investment, property substituted for such FA shares (e.g., other securities received in exchange for the FA shares) or proceeds from the disposition of such FA shares or substituted property, where such proceeds are distributed within 30 days of the disposition.
While the current wording of the PUC reinstatement rule does not appear to support its application to an indirect acquisition of FA shares, Department of Finance officials have indicated informally that the PUC reinstatement rule is intended to be available to such an indirect acquisition, and that corresponding changes will be made to the draft legislation when it is introduced into law. Assuming such changes are made, the PUC reinstatement rule should apply to "reinstate" the PUC previously reduced under the PUC suppression election immediately before the distribution of FA shares to Foreign Parent by way of return of PUC. The distribution will therefore be free of WHT provided that Canco is sufficiently capitalized with equity by ForeignParent as described above.
However, for the PUC reinstatement rule to apply, the extraction
of FA shares (including post-acquisition) must be by way of return
of CRIC's PUC. For example, there will be no PUC reinstatement
in the typical acquisition structure if the FA shares are
transferred to another entity in the Foreign Purchaser group as a
repayment of debt owing by Canco to the other entity. This could
mean extra steps and less flexibility in rationalizing Canadian
Target's FAs in multiple jurisdictions within the Foreign
Purchaser group structure post-acquisition.
Furthermore, the PUC reinstatement rule would appear to be available only where the taxpayer previously made the PUC suppression election. PUC that was suppressed automatically because shares of the CRIC were provided as consideration for the acquisition) cannot be reinstated.
Exceptions to the FA Dumping Rules
The Budget Proposals contained a sole exception to the FA dumping rules where an investment met a "business purpose" exception. The proposals included a list of specific factors to be given "primary consideration" in determining whether the business purpose exception was met.
The business and tax communities made submissions to Finance to the effect that certain types of transactions would be caught by the FA dumping rules even though they would not erode the Canadian tax base or violate the policy rationale underlying such rules.
The August 14 Proposals responded in part to these submissions by including three exceptions to the FA dumping rules:
- the "pertinent loans or indebtedness" (PLI) exception,
- exceptions for certain corporate reorganizations; and
- an exception for strategic business expansions.
The first two categories are new in these proposals and while they offer some measure of relief, as is discussed below, they fail to carve-out all situations in which there is no threat to the Canadian tax base. The third category represents a generally unfavourable evolution of the business purpose exception.
Pertinent Loans or Indebtedness
The definition of "investment" in the Budget Proposals included both loans and other acquisitions of debt owing by a subject corporation. The rules provided an exception for an amount owing or acquisition made in the ordinary course of the business of the CRIC.
The August 14 Proposals maintain the latter exception and add an important new exception. The new exception applies where a debt obligation is a PLI. A PLI is an amount owing by a subject corporation to a CRIC that arose after March 28, 2012 that was not already carved-out under the ordinary course of business exception described above, provided that the CRIC and its parent have made a joint election in respect of all amounts owing to the CRIC by such subject corporation. The election is permanent and must be made in writing on or before the filing due date of the CRIC for its taxation year that includes the day on which an amount first became owing to the CRIC (after March 28, 2012). PLIs result in income of at least a baseline amount of interest as described below.
A CRIC looking to take advantage of this exception will therefore have to carefully monitor its interaction with its FAs to ensure that the deadline to file the joint election is not missed.
Companion Rule to PLI Exception – New Upstream Shareholder Loan Exception
Subject to a few narrow exceptions, under current rules, a Canadian corporation will generally face adverse tax consequences if it makes loans to its foreign shareholder and other non-Canadian members of a corporate group. The August 14 Proposals contain a previously unannounced companion rule to the PLI exception described above that will allow a CRIC that is controlled by a non-resident corporation to make a loan after March 28, 2012 to its parent or another non-resident corporation within the group where the CRIC and the parent jointly elect in respect of all loans and indebtedness owing by the borrower corporation. The election is made on a borrower-by-borrower basis, is permanent, and must be made in writing on or before the filing due date of the CRIC for its taxation year that includes the day on which such amount first became owing. This new rule applies whether or not the CRIC has any FAs.
Baseline Interest Rate on PLIs and Upstream Shareholder Loans
PLIs and upstream shareholder loans taking advantage of the new exception will be subject to a new rule that deems the interest earned by the CRIC on the amount owing to be no less than the greater of a prescribed interest rate and the interest cost of any amount borrowed by the CRIC (or another Canadian resident not dealing at arm's length with the CRIC) that directly or indirectly funds the PLI or upstream shareholder loan. Essentially this means that loans structured to take advantage of these rules should generally have an interest rate no less than the baseline rate.
The prescribed rate (which is a floating rate that is set quarterly and is currently 5%) is the same rate as that payable by taxpayers on late-paid taxes; it is 4% higher than the rate generally prescribed in respect of interest payable between taxpayers to avoid the deemed conferral of a benefit or as a measure of a fair return on capital. In some cases, foreign transfer pricing rules may not allow a full deduction of interest set at this "high" prescribed rate.
The FA dumping rules contained in the Budget Proposals did not contain an explicit mechanism to allow for corporate reorganizations and other internal transactions that do not fundamentally result in any incremental investment in or change in ultimate ownership of FAs.
The August 14 Proposals remedy this partially by introducing a number of exceptions to the FA dumping rules where the investment in a subject corporation is an acquisition of shares of the subject corporation:
a. from a related CRIC or as a result of an amalgamation among related CRICs;
b. upon an exchange of certain shares or convertible debt;
c. as a result of certain rollovers on a transfer of FA shares to another FA, reorganization of an FA's capital or foreign merger; and
d. as a result of certain liquidations of an FA, FA share redemptions or FA dividends.
The exceptions in paragraph (a) are subject to an anti-avoidance
rule which provides that the relevant CRICs must not be dealing
with each other at arm's length at all times during the course
of the series of transactions or events that includes the
acquisition of the subject shares. This ensures that the exceptions
only apply to truly internal corporate reorganizations.
The exceptions in paragraphs (b) – (d) do not apply where the shares of the subject corporation are preferred shares, unless the subject corporation is wholly owned by the CRIC. The exceptions in paragraph (d) do not apply to the extent that any debt is assumed by the CRIC in respect of a liquidation, redemption or dividend, as the case may be.
While these internal reorganization/distribution exceptions are a welcome change to the FA dumping rules, they do not go far enough. For example, where a non-convertible debt of a subject corporation is repaid by issuing shares, the exception will not apply; this is inappropriate because such a transaction does not give rise to any incremental investment in the subject corporation. In such a circumstance, it may be possible to fit within the exceptions by first adding a conversion feature to the debt and then effecting the exchange.
Strategic Business Expansions
The Budget Proposals contained a business purpose exception to the FA dumping rules that included certain enumerated factors to be given "primary consideration" when determining whether the exception was met. These factors were generally perceived by the business and tax communities to be unrealistic, and concerns were expressed that there was considerable uncertainty in how to interpret the factors.
The August 14 Proposals narrow the exception by turning the list of factors into a list of conditions, all of which must be met. In general, the conditions look to whether:
- the business activities of the FA are more closely connected to the business activities of the CRIC (and related Canadian corporations) as compared to the business activities of the parent (and any other non-resident corporation in the group);
- the principal decision-making authority in respect of the making of the investment was made by officers of the CRIC, the majority of whom are resident and work principally in Canada; and
- such officers will continue to have ongoing principal decision-making authority and whether their performance evaluation and compensation will be based on the results of the operations of the subject corporations to a greater extent than the performance evaluation and compensation of any officers of a non-resident corporation outside of the subject corporation and its subsidiaries but within the broader corporate group.
The Explanatory Notes include an example where a CRIC is owned by a foreign private equity fund – which assumes that the CRIC is controlled by the foreign corporate general partner of the fund – and in one iteration, in the example, the test in this exception is satisfied. Still, given the practical realities of the way in which most multinational corporate groups are managed, it will likely be difficult for a CRIC with a foreign corporate parent to be comfortable that it meets all of these conditions in a wide variety of cases.
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.