Canada: Minister Of Finance (Canada) Releases Revised Budget Proposals

The March 29, 2012 federal budget (Budget 2012) proposed amendments to a number of international tax measures contained in the Income Tax Act (Canada) (Act) (for a full discussion of Budget 2012, see McCarthy Tétrault's article dated March 29, 2012 Harper's First Majority Government Budget — Tax Changes Include Targeted Measures to Close Perceived Loopholes). On August 14, 2012, draft legislation (Revised Proposals) was released, which contained revisions to the foreign affiliate (FA) "dumping" rules that were originally introduced in Budget 2012, new rules for certain non-resident shareholder loans, as well as details on the thin capitalization, partnership and "bump" proposals that were in Budget 2012.

FOREIGN AFFILIATE "DUMPING" RULES

1. Background

Budget 2012 significantly curtailed investments in FAs by foreign-controlled Canadian corporations with the introduction of the FA dumping rules. The FA dumping rules were introduced in response to the report of the Advisory Panel on Canada's System of International Taxation (Panel), which characterized certain FA dumping transactions as abusive in that they reduce the Canadian tax base without providing any significant economic benefit to Canada. The Panel described the general effect of these dumping transactions as avoiding Canadian withholding tax that would otherwise be payable if the foreign-controlled Canadian corporation had paid an amount to its parent corporation as a dividend.

The Budget 2012 version of the FA dumping rules was widely criticized for deterring Canadian subsidiaries of foreign-based multi-national groups from making investments in non-resident corporations. The technical notes (Technical Notes) accompanying the Revised Proposals expressly state that the rules were designed to deter such investments. In particular, the FA dumping rules target investments, such as purchases of, and subscriptions for, shares of an FA, capital contributions and loans to an FA and acquisitions of shares of a Canadian corporation, the assets of which are primarily shares of an FA.

2. Operative Provisions

Subsection 212.3(1) provides that subsection 212.3(2) — the main operative provision — applies to an investment in a non-resident corporation (Subject Corporation) made at any time (Investment Time) by a corporation resident in Canada (CRIC) if:

  1. the Subject Corporation is immediately after the Investment Time, or becomes as part of a transaction or series of transactions or events that includes the making of the investment, an FA of the CRIC;
  2. the CRIC is at the Investment Time, or becomes as part of a transaction or event or series of transactions or events that includes the making of the Investment Time, controlled by a non-resident corporation (Parent); and
  3. neither subsections 212.3(12) nor 212.3(13) applies in respect of the investment.

Subsection 212.3(12) contains what is commonly referred to as the more closely connected business activities exemption, whereas subsection 212.3(13) contains the exception in respect of certain corporate reorganizations. Each of these rules is discussed in detail below. The condition set out in (ii) above has been expanded from the original version of this rule, which only applied where the CRIC was, at the time of the investment, controlled by the Parent.

An investment is defined as an investment in a Subject Corporation made by a CRIC that is:

  1. an acquisition of shares of the Subject Corporation by the CRIC;
  2. a contribution of capital to the Subject Corporation by the CRIC, which is deemed to include any transaction or event under which a benefit is conferred on the Subject Corporation by the CRIC;
  3. a transaction under which an amount becomes owing by the Subject Corporation to the CRIC, other than an amount owing that arises in the ordinary course of the business of the CRIC and that is repaid, other than as part of a series of loans or other transactions and repayments, within 180 days of the day the amount becomes owing or where the amount owing is a pertinent loan or indebtedness (PLI);
  4. any acquisition of a debt obligation of the Subject Corporation by the CRIC from another person, other than a debt obligation acquired from a person with which the CRIC deals at arm's length at the time of the acquisition, provided the acquisition is made in the ordinary course of the business of the CRIC or where the debt obligation is a PLI (as defined below);
  5. an extension of the maturity date of a debt obligation owned by the Subject Corporation to the CRIC or the extension of the redemption, acquisition or cancellation date of shares of the Subject Corporation owned by the CRIC;
  6. an acquisition by the CRIC of shares of another corporation resident in Canada, of which the Subject Corporation is an FA, if the total fair market value of all the shares that are owned directly or indirectly by the other corporation and are shares of FAs of the other corporation exceeds 50% of the total fair market value (determined without reference to debt obligations of any Canadian corporation in which the other corporation has a direct or indirect interest) of all of the properties owned by the other corporation; and
  7. an acquisition by the CRIC of an option in respect of, or an interest in, or for civil law a right in, shares of, an amount owing by (other than an amount excluded from (iii) above), or a debt obligation of (other than a debt obligation excluded from (iv) above), the Subject Corporation.

A PLI means an amount owing by the Subject Corporation to the CRIC if:

  1. the amount became owing after March 28, 2012;
  2. the amount is not an amount owing that arose in the ordinary course of the business of the CRIC and that is repaid, other than as part of a series of loans or other transactions and repayments, within 180 days of the day the amount became owing, or a debt obligation acquired in the ordinary course of the business of the CRIC from a person with which the CRIC deals at arm's length at the time of the acquisition; and
  3. the CRIC and the Parent jointly elect in writing in respect of all amounts that became owing after March 28, 2012, by the Subject Corporation to the CRIC, and file an election with the minister on or before the filing due date of the CRIC for its taxation year that includes the day in which any such amount first became owing.

Any PLI will be subject to the new interest imputation rules set out in section 17.1. Section 17.1 will require the CRIC to include in its income a deemed amount of interest for each year the loan is outstanding. Section 17.1 is discussed in detail below under the heading "Loans to Non-Residents."

The Revised Proposals expand the definition of investment (from the Budget 2012 version) to include the extension of the maturity date of a debt obligation or the extension of the redemption, acquisition or cancellation date of shares and, likely to be the most significant for foreign multi-nationals acquiring Canadian corporations, the acquisition of shares of another Canadian-resident corporation by the CRIC if at least 50% of the value of the other Canadian corporation is attributable to FA shares. On a first read, it would seem that the latter provision could apply to transactions commonly referred to as "bump and runs," where FAs are distributed to foreign parent corporations without incurring Canadian income tax. This issue is discussed in more detail below under the heading "Paid-Up Capital Suppression Election."

Of significance to the acquisition of shares of a Canadian corporation is subsection 212.3(10), which provides that for purposes of determining if an acquisition by the CRIC of shares of another corporation resident in Canada will come within the ambit of section 212.3, the condition is deemed to be satisfied at the time of the acquisition if:

  1. any property, owned directly or indirectly by the other corporation (other than shares of FAs of the other corporation), is disposed of, after the time of the acquisition, directly or indirectly by the other corporation as part of a series of transactions or events that includes the acquisition and at any time that is subsequent to the time of the acquisition and that is within the series, the condition in paragraph 212.3(8)(f) (the valuation condition) would have been satisfied had the acquisition occurred at the subsequent time; and
  2. the fair market value of properties owned directly or indirectly by the other corporation is not to be taken into account more than once in determining whether the condition in paragraph 212.3(8)(f) is satisfied.

Two adverse tax consequences will arise where subsection 212.3(2) applies. First, the CRIC will be deemed to have paid a dividend to the Parent equal to the fair market value of any transferred property (other than shares of the CRIC), obligation assumed, or benefit conferred by the CRIC that relates to the investment. Second, where the paid-up capital of the CRIC's shares increases due to the investment, that increase is deemed to be nil. This will have both present and future withholding tax implications in that the deemed dividend will be immediately subject to withholding tax, and future distributions from the CRIC are more likely to be paid in the form of dividends, as opposed to tax-free returns of capital, due to the reduction in paid-up capital.

3. Exceptions to the FA Dumping Rule

As previously noted, subsection 212.3(1) excludes from the application of subsection 212.3(2) transactions to which subsection 212.3(12) or (13) apply. The more closely connected business activities exemption in subsection 212.3(12) will apply if the CRIC demonstrates that all of the following conditions are met:

  1. the business activities carried on by the Subject Corporation and all other corporations in which the Subject Corporation has, at the Investment Time, an equity percentage (as defined in subsection 95(4)), are at the Investment Time, and are expected to remain, on a collective basis more closely connected to the business activities carried on in Canada by the CRIC (or by a corporation resident in Canada with which the CRIC does not, at the Investment Time, deal at arm's length) than to the business activities carried on by any non-resident corporation (other than the Subject Corporation or any corporation in which the Subject Corporation has an equity percentage) with which the CRIC, at the Investment Time, does not deal at arm's length;
  2. officers of the CRIC had and exercised the principal decision making authority in respect of the making of the investment and a majority of those officers were resident and worked principally in Canada at the Investment Time; and
  3. at the Investment Time, it is reasonably expected that officers of the CRIC will have and exercise the ongoing principal decision-making authority in respect of the investment, a majority of those officers will be resident, and will work principally, in Canada, and the performance, evaluation and compensation of the officers of the CRIC who are resident, and work principally, in Canada will be based on the results of operations of the Subject Corporation to a greater extent than will be the performance, evaluation and compensation of any officer of a non-resident corporation (other than the Subject Corporation or corporation controlled by the Subject Corporation) that does not deal at arm's length with the CRIC.

The foregoing represents a significant change from the Budget 2012, which contained a list of factors to consider when determining if the more closely connected business activities exemption would apply. If nothing else, it seems that this change will add some certainty for taxpayers, but this is likely to provide little comfort given the onerous conditions that must be satisfied.

Notwithstanding the foregoing, the more closely connected business activities exemption will not apply where subsection 212.3(14) applies. Subsection 212.3(14) provides that subsections 212.3(12) and paragraph 212.3(13)(c) do not apply to an acquisition of shares of a Subject Corporation by a CRIC if, having regard to all terms and conditions of the shares and any agreement in respect of the shares, the share may not reasonably be considered to fully participate in the profits of the Subject Corporation and any appreciation in the value of the Subject Corporation, unless the Subject Corporation is a subsidiary wholly-owned corporation of the CRIC.

The exemption for corporate reorganizations in subsection 212.3(13) provides that subsection 212.3(2) does not apply to an investment in a Subject Corporation made by CRIC if the investment is an acquisition of shares of the Subject Corporation:

  1. from another corporation resident in Canada to which the CRIC is, immediately before the Investment Time, related and that is, at no time that is within the series of transactions or events that includes the making of the investment and that is before the Investment Time, dealing at arm's length with the CRIC;
  2. that arises as a result of an amalgamation under subsection 87(1) of two or more corporations to form the CRIC if all of the predecessor corporations are, immediately before the amalgamation, related to each other and none of the predecessor corporations deals at arm's length with another predecessor corporation in any time that is within the series of transactions or events that includes the making of the investment and that is before the Investment Time; or
  3. in which the shares are acquired by the CRIC in an exchange to which subsection 51(1) applies, as consideration for a disposition of shares to which subsection 85.1(3) applies, in the course of a reorganization of the capital of the Subject Corporation to which subsection 86(1) applies, as a result of a foreign merger (as defined in subsection 87(8.1)) under which the Subject Corporation was formed, on a liquidation and dissolution to which subsection 88(3) applies, on a redemption of shares of another non-resident corporation that is, immediately before the Investment Time, an FA of the CRIC, or as a dividend in respect of the shares of another non-resident corporation that is, immediately before the Investment Time, an FA of the CRIC.

For the purposes of this rule, "related" and "arm's length" are determined without reference to paragraph 251(5)(b).

The foregoing is a welcome change, since Budget 2012 did not contain an exemption for corporate reorganizations and other internal transactions that do not alter or change the level of investment in or ultimate ownership of the FA group. Any transaction to which paragraph 212.3(13)(c) (set out in (iii) above) would otherwise apply is subject to the application of subsection 212.3(14) (discussed above). Further, subsection 212.3(13) does not apply if subsection 212(15) applies. Subsection 212(15) applies to an investment in a Subject Corporation made by CRIC that is an acquisition of shares of the capital stock of the Subject Corporation in a transaction to which subsection 88(3) applies, on a redemption of shares of another non-resident corporation that is, immediately before the Investment Time, an FA of the CRIC or as a dividend in respect of the shares of another non-resident corporation that is, immediately before the Investment Time, an FA of the CRIC to the extent of the lesser of:

  1. the total of all amounts each of which is the amount of a debt obligation assumed by the CRIC in respect of the liquidation and dissolution, redemption or dividend, as the case may be; and
  2. the fair market value of the shares at the Investment Time.

Consequently, subsection 212.3(2) may apply to certain reorganizations to the extent of any debt assumed by the CRIC.

4. Paid-Up Capital Suppression Election

The paid-up capital suppression election effectively allows a CRIC and its Parent to elect to reduce the paid-up capital of the CRIC shares so as to avoid the deemed dividend that would otherwise arise pursuant to subsection 212.3(2). In particular, subsection 212.3(5) provides:

  1. that the amount of the dividend deemed to have been paid by the CRIC, and to have been received by the Parent, is to be reduced by the lesser of:
    1. the amount that would otherwise be deemed to be paid and received as a dividend, and
    2. either, where there is only one class of shares issued at the Investment Time, the amount of paid-up capital in respect of that class or where the CRIC demonstrates that amount of paid-up capital in respect of one or more classes of its capital stock arose from one or more transfers of property to the CRIC, the total of all amounts of that paid-up capital in respect of a class of shares of the CRIC; and
  2. in computing the paid-up capital in respect of any class of shares of the CRIC at any time that is at or after the Investment Time, there is to be deducted the amount determined under (i) above in respect of that class.

Based on the foregoing, where there is only one class of shares issued, a CRIC may acquire shares of an FA and reduce the paid-up capital of a class of shares by the amount of that investment without triggering a deemed dividend. However, where there is more than one class of shares issued by the CRIC, to benefit from the paid-up capital suppression election, the CRIC must trace and link the creation of the paid-up capital to the property it received and used to make the investment in the FA. This could prove to be an onerous requirement and, at the very least, will be an administrative burden.

Subsection 212.3(4) provides that subsection 212.3(5) applies if:

  1. paragraph 212.3(2)(a) applies to an investment in a Subject Corporation made by a CRIC;
  2. either there was only one class of issued and outstanding shares of the capital stock of the CRIC at the Investment Time or the CRIC demonstrates that an amount of paid-up capital in respect of one or more classes of the capital stock of the CRIC arose from one or more transfers of property to the CRIC, which property was issued by the CRIC to make the investment to which paragraph 212.3(2)(a) applies;
  3. at the Investment Time, all the shares of the CRIC that were not owned by the Parent were owned by persons who were dealing at arm's length with the CRIC; and
  4. the CRIC and the Parent jointly elect, in writing under subsection 212.3(4), in respect of the investment and file the election with the minister of national revenue on or before the filing due date of the CRIC for its taxation year that includes an Investment Time.

An accompanying rule in subsection 212.3(6) ensures that the reductions of paid-up capital that arise as a result of paragraphs 212.3(2)(b) and 212.3(5)(b) do not produce an inappropriate result where subsections 84(3), (4) or (4.1) subsequently treat the corporation as having paid a dividend on shares that have been subject to a paid-up capital reduction as a result of a share redemption, acquisition, cancellation or reduction of paid-up capital.

Where a CRIC and its Parent have elected to reduce the paid-up capital of the CRIC's shares under subsection 212.3(5), in certain cases the paid-up capital can then be reinstated in advance of a return of capital. Specifically, subsection 212.3(7) provides that if, in respect of an investment in a Subject Corporation made by a CRIC that is an acquisition of shares (acquired shares) of the Subject Corporation, an amount is required by paragraph 212.3(5)(b) to be deducted in computing the paid-up capital in respect of a class of shares of the CRIC and the CRIC reduces, at a time subsequent to the Investment Time, the paid-up capital in respect of the class, then the paid-up capital in respect of the class is to be increased, immediately before the subsequent time, by the least of:

  1. the amount of the reduction of the paid-up capital at the subsequent time;
  2. the amount, if any, by which the amount required by paragraph 212.3(5)(b) to be deducted, in respect of the investment, in computing the paid-up capital in respect of the class exceeds the total of all amounts required to be added under subsection 212.3(7) to the paid-up capital of the class in respect of a reduction of paid-up capital made before the subsequent time; and
  3. an amount that if the property distributed on the reduction of the paid-up capital is the acquired shares, or property substituted for the acquired shares, is equal to the fair market value of the acquired shares, or the portion of the fair market value of the substituted property that may reasonably be considered to relate to the acquired shares, as the case may be, at the subsequent time, the CRIC demonstrates that it has received after the Investment Time and no more than 30 days before the subsequent time as proceeds from the disposition of the acquired shares or as the portion of the proceeds from the disposition of property substituted for the acquired shares that may reasonably be considered to relate to the acquired shares or if none of the foregoing applies, is equal to nil.

As stated in the Technical Notes, the main purpose of subsection 212.3(7) is to allow a CRIC to extract an investment in a Subject Corporation, without tax consequences, to the extent of the initial amount of paid-up capital that arose on or in connection with the investment. Therefore, through the combined operation of subsections 212.3(4), (5) and (7), transactions known as "bump and runs" may still be effected.

5. Accompanying Provisions

Lastly, there are a number of rules that are designed to ensure the proper application of section 212.3. In particular, subsection 212.3(11) provides that, for the purposes of both section 212.3 and the corporate immigration rule contained in paragraph 128(1)(c.3), a CRIC that is controlled by more than one non-resident corporation is deemed not to be controlled by any such corporation that controls another non-resident corporation that controls the CRIC, unless the application of subsection 212.3(11) would result in the CRIC not being controlled by any non-resident corporation. Subsection 212.3(16) contains "continuity" rules that apply to amalgamations under subsection 87(11) and windings-up under subsection 88(1). Subsection 212.3(17) contains an anti-avoidance rule that targets situations where a CRIC uses a "good" FA as a conduit to make an investment in a "bad" FA. For this purpose, a good FA would be an FA an investment in which the CRIC would meet the more closely connected business activities exemption. Lastly, subsection 212.3(18) contains "look-through" rules for partnerships that effectively deem each member of the partnership to have entered into any transaction entered into by the partnership itself, in proportion to the fair market value of the member's direct and indirect interest in the partnership. This rule, along with section 95.1(1), also applies for the purposes of the corporate immigration rule contained in paragraph 128.1(1)(c.3).

In addition to the foregoing, paragraph 128.1(1)(c.3) was also added to deter certain corporate immigrations, the results of which would be similar to an FA dump. Paragraph 128.1(1)(c.3), similar to section 212.3, may result in a deemed dividend and/or a reduction of paid-up capital where the immigrating taxpayer is a corporation that was, immediately before the immigration, controlled by a non-resident corporation (NRC) and the immigrating corporation owned, immediately before the immigration, shares of NRCs that, immediately after the immigration were or became as part of the same series, FAs of the immigrating corporation. Like subsection 212.3(b), subsection 128.1(3) ensures that reductions of paid-up capital that arise as a result of paragraph 128.1(1)(c.3) do not produce an inappropriate result where subsections 84(3), (4) or (4.1) subsequently treat the immigrating corporation as having paid a dividend on shares which have been subject to a paid-up capital reduction.

6. Coming Into Force

Section 212.3 applies in respect of transactions and events that occur after March 28, 2012, with two exceptions. First, transactions in progress on March 29, 2012, are grandfathered, unless a party to the transaction can choose not to complete the transaction due to changes to the Act. Second, taxpayers may elect to have the version of the rules set out in Budget 2012 apply for transactions that occurred before August 14, 2012.

LOANS TO NON-RESIDENTS

The Revised Proposals contain a significant addition to Budget 2012, as they introduce a new exception from the FA dumping rules for certain loans made by a CRIC to its foreign affiliates and a new exception to the existing shareholder debt rules for certain loans made by a CRIC to a related or connected NRC.

These new exceptions apply where there is an amount owing that generally meets the definition of PLI (described above).

The effect of the joint election is that all amounts that become owing by the Subject Corporation to the CRIC after March 28, 2012, are covered by the election.

Once an amount owing is a PLI, it is not subject to the FA dumping rules in proposed subsection 212.3(2), the deemed dividend rule in subsection 15(2), or the deemed interest rule in subsection 17(1). Instead, a new deemed interest rule in proposed subsection 17.1 will apply to require the income inclusion to the CRIC of an amount at least equal to the prescribed rate plus 4%, which would be 5% based on the current prescribed rate. However, if the CRIC (or certain non-arm's length persons or partnerships) directly or indirectly funds the PLI by incurring debt obligations, the amount of interest payable on such debt obligations will be included in the CRIC's income, if greater than the amount based on the prescribed rate. The reference to indirect funding is intended to address the situation where, for example, another corporation resident in Canada borrows money, makes an equity contribution to the CRIC, and the CRIC makes a loan to a NRC. The amount included in income as deemed interest is net of any interest actually charged on the PLI.

The exception for PLI may be of benefit to a CRIC if the interest rate charged on a loan or other indebtedness (e.g., due to transfer pricing considerations) is not significantly different than the deemed interest under proposed subsection 17.1. It should be noted, however, that the prescribed rate (currently 1%) is set quarterly, based on the three month Government of Canada Treasury bill rate, so that it may fluctuate significantly in the future. Further, it is 4% higher than the deemed interest rule under subsection 17(1).

The PLI election may facilitate cash pooling and other intercompany debt for foreign multi-nationals with Canadian subsidiaries without incurring Canadian withholding tax. Currently, subsection 15(2) deems the amount of any loan or indebtedness made by a CRIC to a related or connected NRC to be a dividend paid by the CRIC that is subject to Canadian dividend withholding tax of 25%, which rate is generally reduced under most of Canada's tax treaties to 15%, or 5% in some cases.

These new rules apply generally to loans made or indebtedness incurred after March 28, 2012. It is not clear whether the PLI election can be made where pre March 29, 2012, loans are repaid and new ones are made. It appears that the PLI election cannot be revoked, so careful consideration should be given to whether it should be made in respect of a particular NRC, since all future indebtedness of such NRC will be subject to the new interest imputation rule.

THIN CAPITALIZATION RULES

The thin capitalization rules generally deny the deduction by a CRIC of interest payable to specified non-residents (a non-resident owning shares representing more than 25% of the votes or value of the CRIC and any other non-resident who does not deal at arm's length with such shareholder) to the extent that a debt-to-equity ratio is exceeded (currently 2:1). The current rules do not take into account debt owed by partnerships of which a CRIC is a member. Further, the disallowed interest expense retains its character as interest for withholding tax purposes. The Canadian withholding tax rate is 25% for interest payable to a person that is not dealing at arm's length with the payer, which rate is generally reduced under most of Canada's tax treaties to 10% and is reduced to 0% under the Canada – U.S. tax treaty. The thin capitalization rules are intended to protect the Canadian tax base from erosion through excessive interest deductions in respect of debt owing to specified non-residents.

Budget 2012 proposed a significant expansion of the application of the thin capitalization rules by:

  1. limiting the deduction of interest paid to specified non-residents by reducing the permitted debt-to-equity ratio to 1.5:1, effective for taxation years that begin after 2012;
  2. extending the rules to include debts owed by partnerships of which a CRIC is a member, effective for taxation years that begin after March 28, 2012;
  3. including in a CRIC's income, where the permitted debt-to-equity ratio of the CRIC in a partnership of which it is a member is exceeded, the portion of the deductible interest of the partnership that exceeds the allowable debt-to-equity ratio, effective for taxation years that begin after March 28, 2012; and
  4. deeming interest that is disallowed under the rules to be a dividend that is subject to Canadian withholding tax of 25%, which rate is generally reduced under most of Canada's tax treaties to 15%, or 5% in some circumstances.

Budget 2012 also proposed a relieving change to prevent double taxation in certain circumstances where a loan was made to a CRIC by a controlled foreign affiliate (CFA), where the interest received by the CFA is included in the CRIC's income in the year or a subsequent year under the foreign accrued property income rules. This change is effective for taxation years that end after March 28, 2012.

The Revised Proposals for the thin capitalization rules are generally consistent with Budget 2012. Some highlights are discussed below.

Firstly, in computing equity for thin capitalization purposes, contributed surplus that arose in connection with an investment to which the FA dumping rules apply will not be included.

Secondly, the rules computing a CRIC's share of debts of partnerships in which it is a member take into account multiple tiers of partnerships and determine a partner's share of the debts of a partnership by reference to its "specified proportion", as defined in proposed subsection 248(1), generally to mean the partner's share of the income of the partnership. Where the specified proportion is not determinable (e.g. because the fiscal period of the partnership ends after the partner's year-end), the partner's share of the debts of a partnership is determined by reference to the relative fair market value of its interest in the partnership.

Finally, the rules for treating disallowed interest as a dividend for withholding tax purposes contain a new anti-avoidance rule, applicable after August 14, 2012, to ensure that the deemed dividend rules cannot be avoided by transferring a debt obligation. Specifically, interest that is payable by a CRIC at the time of a transfer to which subsection 214(6) or subsection 214(17) applies will be deemed to have been paid by the CRIC to the non-resident immediately before the transfer.

PARTNERSHIP INTERESTS AND THE SECTION 88 BUMP

Under section 88, a taxable Canadian corporation (acquirer) that acquires another taxable Canadian corporation (target) may increase the tax cost of non-depreciable capital property up to fair market value on the winding-up of the target into the acquirer or a vertical amalgamation of the target with the acquirer. Non-depreciable capital property includes shares of subsidiaries and partnership interests. Thus, intangibles, depreciable property, resource property and income property are not eligible for the "bump."

A common technique to effect a transfer of ineligible property held by a target to a non-resident or tax-exempt person was to have the target transfer the ineligible property to a partnership on a tax-deferred basis prior to the acquisition of control of the target by an acquirer. The acquirer could then bump the tax cost of the partnership interest, as eligible property, and sell it without incurring any tax. If the purchaser were a non-resident or tax-exempt person, it could generally wind-up the partnership without being subject to any Canadian tax.

Budget 2012 ended this planning by denying the bump in respect of a partnership interest to the extent the fair market value of the partnership interest is attributable to accrued gains on ineligible property held by the partnership directly or indirectly through other partnerships, regardless of when the ineligible property was acquired by the partnership. Budget 2012 also warned that other amendments would be made to end the avoidance of tax through the use of partnerships that held ineligible property. These new bump denial rules generally apply after March 28, 2012, with limited transitional relief for winding-ups and amalgamations occurring before 2013, where an acquirer acquired control of target before March 29, 2012, or was obligated before such date to acquire control of a target and had the intention before that date to amalgamate with, or wind-up, the target.

In addition to providing details on the foregoing amendments, the Revised Proposals introduce two new anti-avoidance rules to address certain transfers of property that occur either before or after the acquisition of control by an acquirer of a target, where such transfers occur as part of a transaction or event or a series of transactions or events in which control is acquired.

Firstly, new paragraph 88(1)(e) applies where:

  1. before the acquisition of control, there has been a tax-deferred disposition of property under subsection 97(2), or of an interest in a partnership under section 85; and
  2. a partnership holds ineligible property directly or indirectly through one or more partnerships.

In such case, the fair market value of the target's partnership interest is reduced by the fair market value of such ineligible property for the purpose of computing the bump under paragraph 88(1)(d), effective generally to dispositions on or after August 14, 2012, subject to transitional rules similar to that referred to above, but with reference to August 14, 2012, instead of March 29, 2012. This anti-avoidance rule appears to ensure that the tax cost of the partnership interest is not increased where ineligible property is acquired by the partnership prior to the acquisition of control.

Secondly, new subsection 97(3) applies where:

  1. after the acquisition of control, there has been a disposition of property to a partnership by a taxpayer;
  2. the partnership acquires ineligible property or an interest in a partnership that holds ineligible property; and
  3. the target is the taxpayer or has, before the disposition, an interest in the taxpayer.

In such case, the tax deferral under subsection 97(2) will not apply to the disposition by the taxpayer to the partnership, effective generally to dispositions made after March 28, 2012. This anti-avoidance rule appears to apply where the partnership does not have ineligible property at the time the test in new subparagraph 88(1)(d)(ii.1) is applied, but subsequently acquires such ineligible property, which may then be distributed free of Canadian tax on a subsequent wind-up of the partnership.

Interestingly, the Technical Notes confirm that new subparagraph 88(1)(d)(ii.1) will not apply to look through a taxable Canadian corporation held by a partnership even if such corporation holds ineligible property.

TRANSFER OF PARTNERSHIP INTERESTS

Currently, subsection 100(1) prevents a taxpayer from obtaining a capital gain (50% inclusion rate) on the sale of a partnership interest to a tax-exempt person where a sale of the assets of the partnership would have given rise to ordinary income (100% inclusion rate). In the absence of this rule, a taxpayer could transfer income assets to a partnership on a tax-deferred basis in exchange for a partnership interest, sell the partnership interest to a tax-exempt person, realizing only a capital gain. As noted above, the tax-exempt person could then wind-up the partnership and acquire the income assets on a tax-free basis.

Budget 2012 extended the application of subsection 100(1) to transfers of partnership interests to non-resident persons, except where the partnership used all of its property in carrying on a business through one or more permanent establishments in Canada (in such a case, a subsequent wind-up of the partnership would not be on a tax-free basis). Budget 2012 also extended the application of subsection 100(1) to certain indirect transfers to tax-exempt and non-residents persons. Finally, Budget 2012 warned that other amendments would be made to end the avoidance of tax through the use of partnerships holding income assets. These changes generally apply to dispositions of partnership interests made on or after March 29, 2012, subject to transitional relief for arm's length dispositions before 2013 where a taxpayer was obligated to make the disposition.

As in the case of the similar rules regarding subsection 88(1) and partnership interests, the Revised Proposals expand the application of subsection 100(1).

Firstly, where a partnership holds property indirectly through one or more partnerships, the partnership interests are looked through for purposes of determining which portion of the capital gain is attributable to non-depreciable capital property.

Secondly, the list of persons or partnerships subject to subsection 100(1) is expanded to include not only non-resident persons, but a partnership or trust (other than a mutual fund trust), where a tax-exempt or non-resident person is a direct or indirect member or beneficiary. Look-through rules apply in determining indirect members or beneficiaries and the portion of the gain that is subject to subsection 100(1), subject to a de minimus exception of 10% or less of the gain. These changes generally apply on August 14, 2012, subject to transitional relief for certain arm's length transactions completed before 2013.

Finally, the Revised Proposals contain an anti-avoidance rule that is intended to ensure that subsection 100(1) applies where partnership interests are created or changed in a way that is economically equivalent to a direct disposition of a partnership interest. The anti-avoidance rule generally applies on August 14, 2012, subject to transitional relief as noted above.

CONCLUSION

In addition to the items discussed above, the Revised Proposals contains many other measures addressing corporate income tax and international tax matters that were introduced in Budget 2012. The Revised Proposals were released for further consultation; although it is understood that certain of the revisions to Budget 2012 are in direct response to comments that had been made by interested parties. The government intends to finalize the legislation as soon as possible.

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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