Much of a detailed and technical nature has been written about the new so-called Foreign Affiliate Dumping Rules. But what, in plain English, are these rules about? Who is affected? The purpose of this blog is not to provide a detailed discussion of these rules but merely to enable the non-tax advisor to recognize when the rules might apply and so to seek the appropriate tax advice.
Simply stated, these rules target foreign corporations that finance other foreign corporations through Canadian subsidiaries. Advisors should therefore look for Canadian corporations with both: (i) a foreign controlling shareholder; and, (ii) investment (debt or equity) in a foreign affiliate.
If this description fits and no exemption is available then the primary effect of these rules is to deem, in effect, the amount of the investment to be a taxable dividend payable by the Canadian subsidiary to its foreign parent. Alternatively, that amount is applied to reduce stated capital—in tax parlance, paid-up capital—and so to reduce the amount available to be distributed as a non-taxable return of capital in future. In either case, the end result is the application of Canadian withholding tax.
While the relevant rules surrounding potential exemptions—as set out in the October 15, 2012 draft legislation—are detailed and extensive, the general tenor is to exempt investment by a Canadian subsidiary in a foreign affiliate if the transaction is not entered into primarily for tax planning purposes. Further discussion of these exemptions is beyond the scope of this blog.
The following is a typical structure targeted by the new rules. A Canadian-resident corporation (CanCo) purchases shares of a foreign affiliate from its foreign parent (ParentCo). CanCo does not pay ParentCo and, instead, the amount of the purchase price becomes an interest-bearing debt. CanCo now has an interest deduction to apply against other income. CanCo does not, however, have an offsetting income inclusion if the foreign affiliate pays only dividends and those dividends are paid out of after-tax profits. The result is a net tax benefit to CanCo. In addition, ParentCo will be exempt from Canadian withholding tax on those interest payments if ParentCo resides in the U.S. (Canada's tax treaty with the U.S. exempts interest payments from the 5% or 10% withholding tax otherwise applicable to dividends).
In this situation, the Foreign Affiliate Dumping Rules would apply to re-characterize the amount of the purchase price for which CanCo is indebted to ParentCo as a taxable dividend. This deemed dividend would arise at the time of the share purchase. At that time, then, ParentCo would be subject to Canadian withholding tax on that amount at the (typical treaty-reduced) rate of 5%. Conversely, CanCo would be denied deductions on future interest payments since the debt obligation would not exist for Canadian tax purposes.
Taking the above example further, there may be situations in which the Canadian corporation is ultimately controlled (for example) by a German corporation which flows interest through a U.S. affiliate able to shelter that interest income from U.S. income tax. Distributions of that interest by the U.S. affiliate to the German parent would then be exempt from U.S. withholding tax pursuant to a treaty exemption similar to that arising under Canada's treaty with the U.S.
Other examples of affected structures as described by Canada's Department of Finance on March 29, 2012 are as follows:
- a Canadian subsidiary acquires shares of a foreign affiliate using that subsidiary's own funds (a mechanism is then available for the foreign parent to extract earnings from the Canadian subsidiary without attracting Canadian withholding tax otherwise applicable to dividends);
- a Canadian subsidiary acquires treasury shares of a foreign affiliate, either by using that subsidiary's own funds or by using borrowed funds, when that subsidiary's foreign parent (or another foreign member of the corporate group) already owns shares in that foreign affiliate;
- a Canadian subsidiary acquires shares of a foreign affiliate from a foreign subsidiary of the foreign parent; and
- a Canadian subsidiary acquires shares of a foreign affiliate from an arm's length party at the request of the foreign parent.
Notwithstanding these specific examples, Canadian advisors should be vigilant for any structures that follow the basic pattern described in the second paragraph, above. If the basic pattern fits then Canadian tax counsel must be consulted to determine whether the rules do indeed apply and, if so, whether an exemption or other solution is nevertheless available.
The Foreign Affiliate Dumping Rules received first reading in the Commons on October 18 and apply retroactively to investments made after March 28, 2012—subject to limited grandfathering for pre-existing contractual commitments.
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.