The Department of Finance (Canada) released draft legislation (the "Proposals") on August 14, 2012 which amend provisions of the Income Tax Act (the "Act") originally announced as part of the 2012 Budget. Of significance are new provisions now known as the foreign affiliate dumping rules that could cause adverse tax consequences to many transactions involving Canadian corporations with foreign subsidiaries. The Proposals apply to a broad range of domestic and international transactions and particularly affect transactions where a foreign controlled Canadian corporation makes an "investment" in its foreign subsidiary.
We encourage Canadian corporations that are part of a foreign based multi-national enterprise ("MNE") and that have foreign investments to review their current and planned transactions to minimize the impact of the Proposals.
The Proposals generally apply to transactions and events that occur after March 28, 2012 ("Budget Day"). As the Proposals differ from those released on Budget Day, an election may be available to have the original proposals apply where the event or transaction occurred between March 29, 2012 and August 13, 2012. Further, transactions may be grandfathered if they were in progress at the time the proposals were first announced.
The Foreign Affiliate Dumping Rules
The Proposals generally apply where a corporation resident in Canada (known as a "CRIC") that is controlled by a non-resident corporation (the "FP") makes an "investment" in a foreign affiliate (the "FA") of the CRIC. A foreign affiliate is generally a corporation not resident in Canada where the Canadian corporation, together with related persons, owns directly or indirectly at least 10% of the shares of any class.
There are exceptions to the Proposals including a Canadian connection exception and certain reorganization and distribution exceptions. In the case of a loan by the CRIC to a FA, the Proposals will generally not apply to certain loans made in the ordinary course of business or where the interest rate on the loans is not less than a prescribed quarterly rate (currently 5%).
Where the Proposals apply, the result is that (1) a dividend will be deemed to have been paid by the CRIC to the FP at the time of the investment, and (2) where paid-up capital ("PUC") is created in shares of the CRIC and such increase in PUC can reasonably be considered to relate to the investment in the FA by the CRIC (such as where the FP transfers its foreign subsidiary to the CRIC), the PUC of the shares of the CRIC will be reduced.
The amount of the deemed dividend is generally the fair market value of the investment made by the CRIC to the FA. A deemed dividend will trigger Canadian withholding tax of 25% (subject to a reduction, pursuant to an applicable tax treaty, to typically 5% or 15%).
A PUC reduction reduces the availability of future returns of capital made by the Canadian corporation that can generally be distributed to its non-resident shareholders free of Canadian withholding tax. Certain provisions in the Proposals allow for an election to reduce the PUC of the CRIC thereby avoiding deemed dividend treatment and for the possibility of a PUC reinstatement where the FA has made certain distributions to the CRIC or from the disposition of the FA.
There are two main exceptions to the application of a deemed dividend or PUC reduction. The first involves a "more closely connected" test, the purpose of which is to allow a Canadian subsidiary of a foreign MNE (the CRIC) to invest in foreign affiliates in circumstances where the investment would have been made even if the CRIC was not foreign controlled.
For the exception to apply, the CRIC must demonstrate that it is investing in a business where that business is more closely connected to the CRIC's business than that of any other non-resident members of the MNE. Furthermore, Canadian resident officers of the CRIC must exercise principal decision-making authority and the performance evaluations and compensation of the Canadian officers of the CRIC must be based on the results or operations of the FA to a greater extent than the performance evaluations and compensation of any officer of a non-arm's length non-resident corporation (other than the FA).
The Proposals also exclude the acquisitions of shares of the FA through certain reorganization and distribution transactions such as the acquisition of shares of a FA made by a CRIC from a related Canadian resident corporation and certain specified types of transactions such as share exchanges, foreign mergers and liquidations and certain distributions.
What is an Investment?
The definition of investment for purposes of these rules is extremely broad and will encompass many common domestic and international transactions. Investments can include:
- an acquisition of shares of the FA by the CRIC;
- a contribution of capital to the FA by the CRIC even if no shares are taken back and includes any benefit conferred on the FA by the CRIC;
- any loan or debt issued by the CRIC to the FA or the acquisition of a debt obligation of the FA by the CRIC except for certain loans and indebtedness made in the ordinary course of business or where the interest rate on such loans or indebtedness is not less than a prescribed rate;
- the extension of the maturity date of a debt obligation owing by the FA to the CRIC;
- the acquisition of an option or interest in the capital stock or debt obligation of the FA by the CRIC; or
- an "indirect investment" in another CRIC as described below.
The following examples of an "investment" demonstrate the breadth of the application of the Proposals:
- The FP carries on business through a Canadian subsidiary corporation (the CRIC) that it controls and through foreign subsidiaries in other countries. The FP transfers the shares of the foreign subsidiaries to its CRIC in exchange for shares of the CRIC. The Proposals will generally deny the increase in the PUC of the shares of the CRIC that would normally have resulted from the contribution of foreign corporation shares to a Canadian subsidiary. The PUC reduction reduces the amount that the CRIC can distribute to the FP free of withholding tax. If the FP also took back debt in exchange for the shares of the foreign subsidiaries, then the result would generally be a dividend deemed to be paid by the CRIC to the FP in the amount of the debt. The deemed dividend would be subject to Canadian withholding tax.
- An "indirect investment" may also be subject to the
Proposals. For example, where a CRIC acquires shares of any
Canadian-resident target corporation (the
"Target") which owns shares of a FA (the
"Target FA"), if the fair market value
of the Target FA is more than 50% of the fair market value of the
Target as a whole, the amount of the purchase price will be a
deemed dividend to the FP subject to withholding tax.
An example of an "indirect investment" is where a TSX-listed corporation ("Pubco") invests in the resources sector outside Canada and the majority of its value is held in such foreign subsidiaries. Assume that more than 50% of the fair market value of Pubco is attributable to these foreign subsidiaries. As part of a share offering, IPO or private placement, a foreign controlled Canadian corporation (the "Purchaser" who is the CRIC in this example) subscribes for shares of Pubco. If the Purchaser acquires or holds more than 10% of the shares of any class of Pubco, the Proposals could apply to deem a dividend to be paid by the Purchaser to its foreign parent or to reduce the PUC of the shares of the Purchaser.
- A benefit conferred on the FA by a CRIC is deemed to be a capital contribution, and therefore, an "investment" for purposes of the Proposals. An example where this might arise is where the foreign controlled CRIC guarantees a loan owing by the FA to a third-party financial institution. If insufficient consideration is paid by the FA to the CRIC for the guarantee, then the guarantee could be considered a benefit conferred on the FA by the CRIC. In this example, a dividend of an amount equal to the fair market value of the guarantee (less any guarantee fee) could be deemed to be paid by the CRIC to the FP and subject to Canadian withholding tax.
Status of Proposals
Finance has asked for submissions from stakeholders regarding these proposals. We understand that several interested groups have made submissions. Accordingly, there may be more changes to the Proposals before they come into force.
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.