Canada: Fall Tax Update

The month of October saw more proposed federal tax legislation than most people would have thought possible – roughly 1,400 pages. Most of this new legislation is included in a Notice of Ways and Means Motion ("NWMM") tabled on October 24, which reintroduces changes that have been proposed previously on a variety of occasions with a number of refinements and adjustments. The government also introduced Bill C-45 on October 18.

Bill C-45 will enact a significant number of the income tax initiatives announced in the March 29, 2012 federal budget.

Some of the proposed changes embodied in both Bill-C45 and the NWMM will require actions in advance of deadlines in 2013 and others will have a significant effect on the planning of new transactions. This update provides an overview of a selection of the key developments and their potential impact.

Bill C-45

Bill C-45 will implement several significant aspects of the March 29, 2012 federal budget, including the following:

  • Foreign Affiliate Dumping Rules
    These rules are intended to prevent foreign-based corporate groups from artificially loading up their Canadian affiliates with debt to generate tax shelter in Canada, or from indirectly extracting earnings from Canada without actually paying a dividend and incurring withholding tax.
    The foreign affiliate dumping rules contain numerous traps that may affect any number of transactions involving a foreign-controlled Canadian corporation that has foreign subsidiaries. A particularly controversial aspect of the rules is the application in the M&A context where a foreign corporation establishes a Canadian corporation to acquire shares of another Canadian corporation that has material investments in foreign affiliates.
  • Partnership Amendments
    Two separate amendments are proposed targeting various transactions involving partnerships that were perceived to be abusive. The first amendment places significant limits on the ability to "bump" the cost of the partnership held by a Canadian target in an acquisition, and the second expands the scope of an existing anti-avoidance rule where a partnership interest is sold to a tax exempt or non-resident purchaser.
    The first rule should be considered in any acquisition of a Canadian target that owns its assets through a partnership structure where a "bump" may be important. The second rule potentially applies to a broad category of transactions involving dispositions of partnership interests. It can cause a capital gain realized by a Canadian individual or other taxable investor on a sale or redemption of an interest in a partnership to be effectively taxed at a higher rate if a tax exempt or non-resident person (or certain trusts or partnerships of which a tax exempt or non-resident person is a beneficiary or partner) acquires an interest in the partnership from the Canadian investor or from the partnership as part of the same series of transactions.
  • Thin Capitalization Amendments
    Canada's thin capitalization rules are being amended to limit the deductibility on interest by a Canadian corporation to certain non-resident shareholders where the relevant debtto- equity ratio exceeds 1.5 to 1 from the current 2 to 1. The amendments will also extend the application of the rule to loans made by these non-resident shareholders to certain partnerships and deem interest that is subject to these rules to be treated as a dividend for withholding tax purposes.


The NWMM is a comprehensive package of legislation which implements a variety of previously announced technical amendments. The NWMM includes amendments affecting reorganizations of and distributions from foreign affiliates, the taxation of non-resident trusts and their beneficiaries and the taxation of investors in offshore fund investment property. The amendments also include rules affecting "foreign tax credit generator" transactions, real estate investment trusts, mergers of mutual funds, tax bumps in respect of shares of foreign affiliates, securities lending arrangements, and include a new reporting regime for tax avoidance transactions. Of particular relevance to Canadian multi-nationals are the upstream loan and hybrid surplus rules discussed in greater detail below:

  • Upstream Loan and Hybrid Surplus Rules
    These proposed rules radically alter two significant aspects of Canada's foreign affiliate system. First, a Canadian parent will include an amount in income in respect of certain loans made by a foreign affiliate to the Canadian parent or certain other non-arm's length persons commencing in August 2013 (subject to a limited grandfathering for loans in existence before August 19, 2011). Second, the income tax consequences of the sale of a foreign subsidiary are radically altered in a way that may make it prohibitive to distribute the proceeds of the sale to Canada.

Other Developments

Additional recent developments in Canada's tax legislation that are not contained in Bill C-45 and the NWMM include:

  • Stapled Securities Amendments
    This proposed legislation targets certain issuances of "stapled securities" which the Department of Finance believes contravene the rules originally announced in 2006 to tax income trusts in a manner similar to corporations.
  • Joint Venture Policy
    Canada Revenue Agency announced in June 2011 that it was ending its administrative practice allowing a taxpayer to defer the recognition of income from joint ventures in certain circumstances. Canada Revenue Agency has issued a number of further statements since June 2011 regarding this change in policy which are potentially relevant to members of existing joint ventures and any person forming or investing in a joint venture in the future.


Originating in the March 29, 2012 federal budget, legislation is proposed in Bill C-45 that is aimed at preventing foreign-based corporate groups from artificially loading up their Canadian affiliates with debt to generate tax shelter in Canada, or from indirectly extracting earnings from Canada without actually paying a dividend and incurring withholding tax. While these objectives may be reasonably clear, the proposed rules are not. The "Foreign Affiliate Dumping Rules", as they are being called, are full of inconsistencies and pitfalls, and their scope extends far beyond these two situations. Nevertheless, it appears that the government is determined to introduce the rules despite serious concerns that have been raised about them. Canadian corporations that are controlled by a non-resident corporation – or that are being acquired by a non-resident corporation – will need to pay close attention to these rules if they themselves have foreign affiliates. In some cases they will find themselves with serious problems in continuing to conduct their ordinary business activities or even in complying with existing commitments.

The Rules

Two elements must be present for the Foreign Affiliate Dumping Rules to come into play: there must be a Canadian corporation that is controlled by a foreign corporation (this is being called a "CRIC"), and the CRIC must itself have one or more foreign affiliates. For these purposes, control most often will mean ownership of more than 50% of the CRIC's voting shares. A foreign affiliate will exist where the CRIC and related parties hold 10% or more of a class of shares of a foreign corporation.

Where these conditions are satisfied, any investment in a foreign affiliate by a CRIC will be treated as a dividend by the CRIC to its controlling shareholder and subject to withholding tax, unless it fits into an exceptionally narrow range of safe harbours. Among these, a loan to a foreign affiliate can be carved out by an election to recognize a minimum amount of interest income on the loan in Canada – but not if the loan was made before March 29, 2012. An investment in a foreign affiliate will be excepted if it meets a very high threshold of connectedness to the CRIC's Canadian business activities. While undoubtedly this safe harbour will be available in some cases, the threshold is so high and so vague that many will be uncertain that the protection is available even in cases where it clearly should be. As a final safe harbour, in some cases it is possible to reduce the "paid-up capital" of the CRIC's shares instead of recognizing a deemed dividend. Paid-up capital is the tax equivalent to stated capital. Because paid-up capital in many circumstances can be distributed to shareholders free of tax, this provision may operate more as a deferral of tax than a safe harbour. And in any case, due to the technicalities of the rule the paid-up capital reduction alternative will not always be available, even where the CRIC has significant paid-up capital.

The Foreign Affiliate Dumping Rules extend to transactions that are at most indirect investments in foreign affiliates. Principal among these, if a CRIC acquires shares of another Canadian corporation that has more than 75% of its assets in foreign affiliates, that share purchase can be treated as an investment by the CRIC in those foreign affiliates and trigger the application of the rules. The CRIC need hold only 10% of the other Canadian corporation for this to be a problem.

Extensions of the maturity date of a loan to a foreign affiliate are treated as a new investment in the foreign affiliate, even if the original loan or a previous extension was subject to these rules. While there are rules to exclude reorganization transactions from the FA Dumping Rules, they are incomplete and a reorganization that does not involve any new investment can be caught.

While these rules deem investments in foreign affiliates to be dividends paid to the CRIC's foreign shareholder, no credit is provided for this taxation. The assets remain in the CRIC and if they are distributed to the foreign parent in the future, there will be tax again. In many other respects as well, the rules pay little regard to concepts of fairness. Similar transactions may have materially different results, and pitfalls that serve little apparent policy purpose abound.

The Impact on Existing CRICs

Under these rules, a CRIC will have to exercise extreme caution in connection with any foreign investment it proposes to make, or in dealing with any foreign affiliates it already owns. This will apply even if control of the CRIC is indirect, through a series of corporations. Although the problem that the rule is intended to address arises in the context of a closely held corporate group, the more than 50% control threshold that has been chosen for CRIC status will catch many situations that are far from that.

A CRIC will also need to verify that any Canadian corporation in which it makes a material share investment does not derive 75% or more of its value from non-Canadian subsidiaries.

A CRIC that has existing loans or advances to foreign affiliates must take great care in dealing with those loans, and it must take equal care in dealing with any debt the foreign affiliate may have to other persons. In making any advances to foreign affiliates in the future, it must remember to take particular steps that are now required to prevent those loans from being treated as distributions by the CRIC to its controlling shareholder.

Reorganizations or other internal transactions involving a CRIC or its foreign affiliates will have to be examined carefully to determine whether they are subject to these rules. In many cases there will not be a problem, but this cannot be taken for granted.

For some CRICs the biggest issue under these rules will be problems that arise because of their existing obligations or arrangements. If a CRIC has a funding commitment to a foreign affiliate joint venture company agreed to before these rules were known, for example, there is virtually no exception from the rules in recognition of this pre-existing commitment. The rules will apply unless the JV activities have the requisite high level of connectedness to the CRIC's Canadian business, meaning the CRIC will face a deemed dividend tax each time it makes an investment in accordance with the commitment, unless a paid-up capital reduction can be made instead.

Similar problems may arise under shareholder agreements. Where the CRIC is party to a buysell, shotgun or similar provision in a shareholders' agreement of a foreign affiliate, funding a purchase under those provisions may well bring the FA Dumping Rules into play. This may put the CRIC at a disadvantage relative to the other shareholders.

Where the penalty tax applies, the rate will be 5% of the deemed dividend where the CRIC's shareholder is in one of many of the countries with which Canada has a tax treaty. However, the tax may be as much as 25% of the deemed dividend in other circumstances.

The Impact on Canadian M+A

Recent years have seen a significant number of M+A transactions involving the acquisition of Canadian corporations with foreign operations (typically mining companies). Where the purchaser is not Canadian, the standard form of transaction is for the purchaser to acquire the Canadian target through a Canadian purchasing company, combine the two Canadian corporations to step-up the tax cost of the shares of the target's foreign subsidiaries and transfer those shares out of Canada. The FA Dumping Rules are intended to accommodate these transactions, but the relief provided is narrow and it cannot be taken for granted that this will be the case.

Many M+A transactions do not involve the "buy, bump and run" described in the last paragraph. In many transactions this simply isn't appropriate from a business perspective, while in some cases foreign law or other considerations may prevent the step up of the tax cost of the subsidiary shares or the tax-effective extraction of those shares from Canada. In these cases, the FA Dumping Rules have the potential to be highly problematic. Further investment in the foreign operations will be caught if it flows through Canada. Financing of the investment by the Canadian company out of its own resources also may be caught. This may require that alternative arrangements be made to cut Canada out of further participation in the foreign affiliate group.

By having this effect, the FA Dumping Rules are likely to make it a more difficult choice to use Canada as a group holding company in many cases. The degree of connection required between Canadian operations and the foreign operations in order for further investment in foreign operations by the Canadian company to avoid the FA Dumping Rules is such that in many cases there will be a material risk of tax exposure. Additional investment will need to bypass Canada, and in this case retaining management in Canada may be inappropriate.

In any case, if financing for the acquisition of a company that will become a CRIC is intended to involve borrowings in Canada, the FA Dumping Rules will be of great potential relevance and will need to be considered carefully. And given ambiguities and omissions in the rules, in many situations it may be difficult to be sure whether or to what extent the rules apply.


The Foreign Affiliate Dumping Rules are not nuanced. They assume any investment in a foreign affiliate by a CRIC is a tax avoidance ploy and provide only limited routes to safety. Foreign groups that currently have CRICs and foreign investors looking to acquire Canadian companies with foreign operations will need to pay close attention to these rules. It is critical to understand the scope of the rules as they apply to the particular circumstances in order to establish appropriate governance protocols. Otherwise, they may apply unexpectedly to existing Canadian groups and in the context of new acquisitions. And it will be equally important in undertaking any transactions to which these rules may have bearing to ensure that the many pitfalls that may compound the consequences of their application are taken into account. Further, because neither the scope nor the effect of the application of these rules is intuitive, at least until there is greater familiarity with their workings it will be important to consider their application to any investments in or other transactions affecting a CRIC or its subsidiaries.


The March 29, 2012 federal budget proposed two measures that target transactions involving partnerships. The measures were included in the August 14, 2012 draft legislation and will generally be effective from March 29, 2012.

The first measure will generally deny the tax "bump" in respect of a partnership interest to the extent that the accrued gain in respect of the partnership interest is reasonably attributable to the amount by which the fair market value of the partnership assets (other than non-depreciable capital property) exceed their tax cost. The second measure proposes to expand in a number of ways the current rule that effectively re-characterizes a capital gain on the disposition of a partnership interest to a tax exempt as an income gain to the extent that the accrued gain in respect of the partnership interest is reasonably attributable to accrued gains on partnership property other than non-depreciable capital property. These two measures are discussed in greater detail below.

The Bump Limitation Rule

Where available, the tax bump allows a qualifying Canadian corporate buyer of a Canadian corporate target to "push-down" its tax cost in the target shares to increase, or "bump", the tax cost of the target's non-depreciable capital property upon an amalgamation with or wind-up of the target. In the case of a non-resident buyer, it will generally incorporate a Canadian corporation to acquire the target shares in order to, among other things, obtain the tax bump.

The bump is only available in respect of non-depreciable capital property - generally shares of subsidiaries or other corporations, partnership interests and land that is not held as inventory. Other types of property - depreciable property, resources property, eligible capital property (e.g., goodwill) and inventory - are not eligible for the bump.

The amount of the increase or bump in the cost of any particular non-depreciable capital property is limited to the unrealized gain in respect of the property at the time that the buyer acquired control of the target. The proposed bump limitation rule will reduce the amount of the tax "bump" in respect of a partnership interest to the extent that the accrued gain in respect of the partnership interest is reasonably attributable to the amount by which the fair market value of the partnership assets (other than non-depreciable capital property) exceed their tax cost.

The proposed amendments also include anti-avoidance rules aimed at preventing the avoidance or manipulation of the new bump limitation rule.

Sales of Partnerships to Tax-Exempts or Non-Residents

A taxpayer is generally only required to include in income one-half of its capital gain (referred to as the "taxable capital gain") from the disposition of capital property.

However, subsection 100(1) of the Income Tax Act (Canada) provides that where a taxpayer sells a partnership interest to a tax-exempt person and realizes a capital gain, the amount of the taxpayer's taxable capital gain is deemed to be one-half of the amount of the capital gain attributable to accrued gains on non-depreciable capital property plus 100% of the remainder of the capital gain. This results in a 100% inclusion rate to the extent that the accrued gain on the partnership interest is attributable to accrued gains on depreciable property, resource properties, goodwill or inventory of the partnership.

The proposed amendments broaden subsection 100(1) in a number of ways.

First, subsection 100(1) is expanded to also apply where a taxpayer disposes of a partnership interest to a non-resident person, unless immediately before and immediately after the acquisition by the non-resident, the partnership uses substantially all of the partnership's property in carrying on business through one or more permanent establishments in Canada.

Second, subsection 100(1) is expanded to apply on a sale of a partnership interest to a partnership that has direct or indirect tax-exempt or non-resident members and to a sale of a partnership interest to a trust resident in Canada (other than a mutual fund trust) that has direct or indirect tax-exempt beneficiaries. The proposed amendments are intended to apply only to the extent of the percentage of the gain attributable to a tax-exempt or non-resident person. In addition, there is a de minimis exception from the application of subsection 100(1) where the rule would otherwise apply to only 10% or less of the gain on the disposition of a partnership interest.

Finally, the amendments include anti-avoidance rules that result in the application of subsection 100(1) where there is no direct disposition of a partnership interest, but there is a dilution, reduction or alternation of the partnership interests for the purposes of avoiding the application of subsection 100(1).


Canada's thin capitalization rules currently apply to limit the deductibility of interest expense of a Canadian resident corporation in respect of debt owing to "specified non-resident shareholders" and non-resident persons that do not deal at arm's length with such shareholders, where the amount of such debt exceeds two times the aggregate of the equity contributed by such nonresident shareholders and the retained earnings of the corporation. A specified non-resident shareholder for purposes of these provisions is a non-resident shareholder who, either alone or together with persons with whom the shareholder does not deal at arm's length, owns or has a right to acquire shares of the Canadian corporation representing 25% or more of its votes and fair market value. These rules do not currently apply to partnerships or trusts.

In December 2008, the government-mandated Advisory Panel on Canada's System of International Taxation (the "Advisory Panel") made a number of recommendations relating to the thin capitalization rules, including reducing the debt-to-equity ratio from 2:1 to 1.5:1 to make the rules more consistent with actual Canadian industry ratios and with the equivalent legislation in other countries, and to extend the rules to partnerships, trusts and Canadian branches of non-resident corporations. The Advisory Panel also noted that interest expense that is not deductible under the thin capitalization rules maintains its character as interest for both domestic and tax treaty purposes, which could allow U.S. investors to inappropriately reduce their Canadian withholding tax liability as a result of the general exemption from withholding tax on related party interest under the Canada-U.S. Tax Treaty, and recommended that the government review the treatment of non-deductible interest under the thin capitalization rules to address these concerns.

In response to these recommendations, the March 29, 2012 federal budget proposed a number of significant changes to the thin capitalization rules, which were included in the August 14, 2012 draft legislation. In general, as described below, the amendments reflect the recommendations of the Advisory Panel, although they do not currently adopt the recommendation that the thin capitalization rules be extended to trusts and Canadian branches of non-resident corporations.

One of the key changes reflected in the proposed amendments is a reduction in the debt to equity ratio applicable for purposes of the thin capitalization rules from 2:1 to 1.5:1, effective in respect of taxation years that commence after 2012. Corporations will therefore need to take steps to bring their debt to equity capitalization for purposes of the rules in line with this reduced limitation before the new limitation becomes applicable in 2013.

The proposals also extend the application of the thin capitalization rules to debts of partnerships of which a Canadian resident corporation is a member. These rules provide that, for purposes of calculating a corporation's debt to equity ratio for taxation years that commence on or after March 29, 2012, each member of a partnership is deemed to owe to the partnership's creditors that member's "specified proportion" of the debts owed by the partnership, and to have paid any interest on the debt that is deductible by the partnership with respect to such amounts. A corporate partner's share of the debts of a partnership, or its "specified proportion" thereof, is based on its proportionate share of the income or loss of the partnership, determined by reference to the last fiscal period of the partnership ending before the partner's taxation year end, and is therefore not (necessarily) based upon its proportionate capital contributions made to the partnership. If the specified proportion of a partner is not determinable, such as, for example, because the first fiscal period of the partnership ends after the partner's year end or the corporation becomes a partner after its last fiscal period has ended, the corporate partner's share of the debts of the partnership is determined by reference to the relative fair market value of its interest in the partnership. The deeming rule can apply through multiple tiers of partnerships to allocate partnership debt to a Canadian resident corporate partner of the top-tier partnership in the chain. The proposed amendments may also apply to back-to-back loans made to a partnership, although the application of the rules in these circumstances is unclear.

Where a Canadian resident corporate partner's debt to equity limitation is exceeded by virtue of the allocation to it of partnership debt on this basis, the partnership is not denied an interest deduction, but instead the corporate partner is required to include in computing its income for purposes of the Income Tax Act (Canada) (the "Tax Act") an amount equal to the excess interest deduction, determined by applying the thin capitalization limit to the corporate partner. This calculation is to be made taking into account the partnership debt allocated to the partner. The source of this income inclusion is determined by reference to the source against which the interest is deducted at the partnership level.

One of the most significant changes to the thin capitalization provisions contained in the proposed amendments is that disallowed interest will be re-characterized, and deemed to be a dividend, for non-resident withholding tax purposes. This re-characterization rule, which was likely introduced as a result of the elimination of withholding tax on related-party interest paid to residents of the United States entitled to treaty benefits under the Canada-U.S. Tax Treaty, will generally deem interest (other than compound interest) that was paid by a corporation resident in Canada, or by a partnership of which the corporation is a member, to a non-resident person to be a dividend paid by the Canadian resident corporation, and not to have been paid by the corporation or the partnership as interest, to the extent that the interest is not deductible or, in the case of the debt of the partnership, an amount is included in computing the income of the corporation, because the thin capitalization limitation is exceeded.

An election may be made to designate disallowed interest expense for purposes of the recharacterization rule to particular interest payments made a non-resident lender in the taxation year; under this provision, the Canadian resident corporation may allocate recharacterized interest to the latest interest payments made in the taxation year, thereby deferring the withholding tax remittance date. For the purposes of this dividend withholding rePage characterization rule, any interest that is payable after the end of the year is deemed to be paid immediately before the end of the year, so that the withholding and remittance obligations in respect of the deemed dividend cannot be deferred beyond year end by accruing (and not paying) the interest. In these circumstances, the withholding tax remittance date will be the 15th day of the month following the corporation's year end. In addition, where a debt is transferred by the non-resident to a Canadian resident corporation (in circumstances where subsection 214(6) or (7) of the Tax Act would apply to deem a payment of interest to have been made), the Canadian resident corporation will be deemed to have made a payment of the unpaid interest to the non-resident lender immediately prior to the transfer.

In light of the dividend re-characterization rule in the proposed amendments, which represents a substantial change in Canadian tax policy, Canadian resident corporations that may be or become subject to the thin capitalization rules will need to carefully monitor their debt to equity capitalization ratios on an ongoing basis, having regard to foreign exchange fluctuations where relevant, to ensure that they do not become subject to unanticipated withholding tax liabilities. This may be particularly relevant in circumstances where the corporation has a shortened taxation year, such as on an acquisition of control.

The dividend re-characterization rule applies to taxation years ending after March 28, 2012, and the provision is therefore currently in effect. A transitional rule applies in respect of taxation years that include the budget announcement date, March 29, 2012, pursuant to which the recharacterized dividend is pro-rated based on the number of days in the taxation year following that date. The proposed amendments do provide relief from penalties for failure to withhold and remit tax on a timely basis in respect of interest that is re-characterized as a dividend; however, this relieving provision is not available if the interest payment would, absent the recharacterization rule, have been subject to withholding tax.

Finally, the proposed amendments to the thin capitalization rules include a relieving provision that can apply to reduce the potential for double taxation in circumstances where a controlled foreign affiliate of a Canadian resident corporation makes an interest bearing loan to the corporation. In the absence of the relieving provision, in this case the interest may be included in computing the foreign accrual property income ("FAPI") of the foreign affiliate, and thus taxable on a current basis to the Canadian resident corporation, but the deductibility of the interest so included may be denied under the thin capitalization rules. The amendments address this potential for double taxation by permitting a corporation to deduct interest that would otherwise be disallowed under the thin capitalization rules to the extent that an amount in respect of the interest is included in the corporation's income as FAPI.


On August 19, 2011, the Department of Finance released draft legislation related to the taxation of foreign affiliates ("FAs"). A revised version of these rules is included in the NWMM. The proposals cover a broad range of issues and include certain significant changes in tax policy. The following discusses the controversial proposed amendments relating to hybrid surplus and upstream loans.

Dividends paid by a FA to a Canadian corporation are generally not subject to tax in Canada to the extent that they are paid from the "exempt surplus" of a FA. Dividends paid from "taxable surplus" are taxable in Canada but an effective credit (in the form of a grossed-up deduction) is provided for foreign taxes paid in respect of the taxable surplus. Exempt surplus generally includes an FA's income from an active business carried on in a country with which Canada has concluded a tax treaty or tax information exchange agreement and taxable surplus includes income from an active business carried on in other countries and foreign accrual property income ("FAPI"). When FA shares that are "excluded property" are sold by another FA of the Canadian taxpayer, one-half of the gain is included in exempt surplus and one-half in taxable surplus. If the foreign tax paid on the gain is less than the Canadian tax that would be paid on a capital gain realized by the Canadian taxpayer, the repatriation of the taxable surplus portion of the gain will generally be taxable in Canada but the exempt surplus portion of the gain could be repatriated without the incurrence of any Canadian tax. Since there is no economic incentive to repatriate taxable surplus, the Canadian government traditionally allowed FAs to pay up dividends from the exempt surplus portion of the gain on the sale of foreign affiliate shares and "lend up" the taxable surplus portion of such gain while deferring indefinitely the payment of taxable surplus dividends. This allowed Canadian multinationals to reinvest the proceeds from the sale of a foreign subsidiary in the Canadian economy instead of abroad. There are two aspects of the amendments dealing with foreign affiliates that prohibits this practice: a new category of surplus (hybrid surplus) and rules to tax upstream loans.

Hybrid Surplus

The new "hybrid surplus" is effectively a combination of exempt and taxable surplus: one-half of any distribution from hybrid surplus is exempt, and the other half is taxable with a grossed-up deduction for any underlying taxes. An FA's hybrid surplus is generally defined to include any capital gains (other than those relevant in computing FAPI) that arise on the disposition of FA shares and partnership interests and is reduced by any capital losses (that are not relevant in computing FAPI) that arise on such dispositions and by any income or profits taxes reasonably considered to relate to amounts included in hybrid surplus. Dividends are generally considered to be paid out of hybrid surplus after exempt surplus and before taxable surplus, but after both those surplus accounts if so elected.

Under the new hybrid surplus rules, an FA can no longer distribute the exempt dividend portion of a capital gain on the disposition of FA shares without also distributing the taxable dividend portion of the gain. Thus, if the foreign tax paid on the gain is less than the Canadian tax that would be imposed on such a gain, the new rules may cause a Canadian taxpayer to defer the repatriation of the full amount of an FA's gain on the sale of shares of another FA.

The hybrid surplus definition applies generally after 2012 for all dispositions.

Upstream Loans

The amendments also include a new anti-avoidance regime designed to prevent the deferral of Canadian tax in situations where an FA's low-taxed taxable surplus or low-taxed hybrid surplus is repatriated via "upstream loans". Although these rules were included to complement the "hybrid surplus" rules discussed above, these rules potentially apply to a much broader category of transactions. In addition, although the rules only apply to loans and other indebtedness, the explanatory notes warn that the general anti-avoidance rule will apply to any other types of transactions that are designed to circumvent the policy of the upstream loan provisions.

The rules include an amount in the income of a Canadian taxpayer where the Canadian taxpayer, a person not dealing at arm's length with the Canadian taxpayer (other than a "controlled foreign affiliate" as defined in section 17) or a partnership with the Canadian taxpayer or such a non-arm's length person as a member receives a loan from or becomes indebted to a FA of the Canadian taxpayer or a partnership in which the FA is a member. Exceptions include, among other things, loans or indebtedness that are repaid within two years, indebtedness that arises in the ordinary course of a business and loans made in the ordinary course of a money lending business (where certain conditions are met).

The rules also include transitional relief for loans or indebtedness that existed prior to August 19, 2011. Such loans or indebtedness will not be considered to have arisen until August 19, 2014 and, as such, if they are repaid by August 19, 2016, there will be no income inclusion in respect of such amounts under the upstream loan rules.

The amount included in the income of the Canadian taxpayer is equal to the specified amount of the loan or indebtedness. Where the FA is wholly-owned (whether directly or indirectly) by the Canadian taxpayer, the specified amount is equal to the full amount of the loan or indebtedness. In other cases, the specified amount will be determined based on the taxpayer's equity interest (by reference to its surplus entitlement percentage) in the relevant FA. A deduction is provided where a loan or indebtedness that gave rise to an income inclusion is repaid in a subsequent year and the repayment is not part of a series of loans or other transactions and repayments.

The upstream loan rules also include a reserve mechanism that is intended to allow a taxpayer to claim an offsetting deduction to the extent that if dividends had been paid, instead of the loans being made, the taxpayer would not have been taxable because of sufficient surplus balances and in some cases Canadian tax being previously paid in respect FAPI. The rules allow a taxpayer to take into account surplus balances of all affiliates in the chain of FAs that includes the creditor FA. The amount of the reserve claimed in a taxation year is included in income in the following taxation year, requiring the taxpayer to claim a reserve again in that following year unless the loan is repaid.

The upstream loan proposals generally apply after August 19, 2011 (subject to the transitional relief discussed above for loans that existed prior to August 19, 2011).


On July 25, 2012, the Department of Finance released draft legislation implementing rules originally announced in July 2011 targeting "stapled security" transactions. The draft legislation is largely consistent with the July 2011 announcement. The purpose of the proposed legislation is to eliminate the benefits of two types of "stapled security" structures, which in the Department of Finance's view, circumvented the rules announced in 2006 to tax income trusts similarly to corporations (the "SIFT Rules"). Although there are relatively few stapled security structures targeted by these rules in the market, the Department of Finance was concerned that they would become more popular.

Prior to the introduction of the SIFT Rules, income trusts were entitled to a deduction for income that was made payable to their unitholders and typically paid no entity level tax.

Two securities will be deemed "stapled" under the proposed rules where they are required to be traded or transferred together, one or both of the securities is listed, and the securities are issued by:

  • the same entity, be it a partnership, corporation or trust,
  • an entity and an entity in which it holds a 10% or greater interest (a "subsidiary"), or
  • a real estate investment trust ("REIT") or a subsidiary of the REIT and any other entity.

A "security" is defined to mean a liability, share, partnership or trust interest or a right to control the voting rights of a share.

The first type of stapled security structure targeted by the proposed rules involves a publiclytraded share of a corporation (or unit of a partnership or trust) that trades together with a debenture or other liability issued by the corporation or by one of its subsidiaries. Absent the proposed rules, the issuer of the debenture deducted the relevant interest to reduce or eliminate its taxable income. The holders of the debentures were generally indifferent to receiving the interest, since they were also the equity holders. Additionally, interest received by non-resident or tax-exempt holders on the debentures was generally not subject to Canadian withholding or income taxes. The proposed rules eliminate the tax advantage of the structure by denying the interest expense on the debenture.

The second structure targeted by these rules involves a REIT that leases property to a corporation or other entity whose shares or units are traded with the units of the REIT (the "Lessee"). A qualifying REIT is not subject to the SIFT Rules and pays no tax where it distributes all of its income to its unitholders. To qualify for REIT status, the REIT needs to satisfy certain tests regarding its properties and revenues. Prior to the stapled security rules, the Lessee would deduct the rent paid to the REIT, and the REIT would deduct the amount of the lease payments when they were distributed to the unitholders. The Department of Finance also suggests that these stapled security structures allowed the REIT to circumvent the restrictions on the types of property a REIT can own and sources of revenue a REIT can earn. The proposed rules deny the Lessee's deduction for any lease payment or other amount paid to the REIT, and do not reduce the amount received by the REIT. The application of the proposed rules in these circumstances can therefore result in double tax.

The proposed "stapled security" rules do not apply to all jointly-traded securities. The proposed rules do not apply where each of the reference securities is a share, or where each of the reference securities is a liability. The definition of "security" under the rules does not include a right to acquire a share. Therefore, convertible debentures or similar offerings should generally be excluded. However, "security" does include a right to vote the shares of a corporation. The proposed rules could therefore apply to a public debt issuance where the note holders or security trustee has the right to vote shares pledged as security in certain circumstances. This result does not appear to be intended.

The application of the proposed rules to stapled securities can only be eliminated where the securities are permanently and irrevocably separated. An anti-avoidance rule applies where an entity's securities become "unstapled" and then "re-stapled" at a subsequent time to include in the entity's income the amounts that would have been non-deductible by the entity under the proposed rules during that "unstapled" period.

The proposed rules include some transitional relief for entities that had stapled securities outstanding on July 21, 2011. For entities with stapled securities outstanding prior to October 31, 2006 (when the SIFT Rules were announced), the stapled securities rules will begin to apply on July 1, 2016. For entities with stapled securities issued between October 31, 2006 and July 21, 2011, the rules generally came into force on July 20, 2012. The transitional relief will be lost if there are changes to the terms of the securities. Accordingly, issuers that qualify for the transitional relief will need to carefully consider any amendments to the terms of the stapled securities to ensure that the relief is not prematurely lost.

Separately, the July 25 draft legislation includes some further refinements to the SIFT Rules, including that SIFT Trusts, which previously paid quarterly tax instalments, are now required to remit on a monthly instalment basis, similar to corporations.

Comments to the proposed rules were required to be made by September 25, 2012, and it is possible that some amendments could be forthcoming in the near future.


The March 22, 2011 federal budget included rules to eliminate the tax deferral potentially available to a corporate partner of a partnership (the "Partnership Anti-Deferral Rules"). By way of example, prior to these rules, a corporation with a December 31st year-end that was a partner of a partnership with a January 31st fiscal period was generally not taxable on its share of the partnership's January 31, 2010 income until its December 31, 2010 tax year, even though substantially all of the income was earned by the partnership in calendar 2009. This deferral is no longer available for corporate partners that together with related or affiliated persons have a greater than 10% interest in a partnership. Under the Partnership Anti-Deferral Rules, the corporate partner in the above example was required to include in its December 31, 2011 income its share of the partnership income for the "stub period" between February 1, 2011 and December 31, 2011 and its share of the partnership income for fiscal period ending January 31, 2011. Recognizing that taxing a corporation on 23 months of partnership income in one year was unfair, the Partnership Anti-Deferral Rules permit the corporation to realize the 2011 "stub period" income over a five-year period.

The Canada Revenue Agency ("CRA") previously had a longstanding administrative practice to allow a member of a joint venture with a separate fiscal period to compute its income from the joint venture in a similar manner to partnerships. As a result of the Partnership Anti-Deferral Rules, CRA announced an end to this administrative practice in June 2011. Members of joint ventures are now required to include their share of income from a joint venture that is realized during the member's taxation year regardless of the joint venture's fiscal period. CRA has agreed to provide members of a joint venture that previously calculated their income in accordance with its administrative policy transitional relief to effectively realize over a five-year period the "stub period" income for the member's first post-March 22, 2011 taxation year (the "2011 Stub Income") similar to the transitional relief in the Partnership Anti-Deferral Rules. Although the change to the joint venture policy is premised on the Partnership Anti-Deferral Rules, CRA's recent statements provide a number of important differences between the treatment of partnerships and joint ventures that need to be considered by current and prospective joint venture members.

Under the Partnership Anti-Deferral Rules, a corporate partner of a partnership with a different year-end to the partnership may include in income its pro-rated share of the partnership's income for each fiscal period in the corporate partner's taxation year. A similar formulaic approach is not available for joint ventures. A member of a joint venture is required to determine the actual amount of income earned during its taxation year. In addition, for 2012 and later years, CRA will not permit a member of a joint venture to estimate its joint venture income for purposes of filing its return and then re-file the return once the actual information is known. This has the potential to cause significant administrative difficulties for joint ventures with members having multiple year-ends. If possible, corporate members of joint ventures with different year-ends may consider requesting that their fiscal years be aligned to ease this complexity.

CRA will generally provide transitional relief to allow a joint venture member to claim a reserve to effectively include 15% of the 2011 Stub Income in its 2012 taxation year, 20% in 2013, 2014 and 2015, and 25% in 2016, including 2011 Stub Income earned through multi-tier joint ventures. This transitional relief is not available for corporate joint venture members in respect of dividend income received by the joint venture from Canadian corporations or foreign affiliates, or income that would otherwise have been included in the participant's income absent the new rules.

The transitional relief in the Partnership Anti-Deferral Rules permit a corporation to continue to claim a reserve in respect of its 2011 Stub Income where it transfers its interest in the partnership to a related or affiliated corporation. Conversely, a joint venture member that transfers its interest to any person will be immediately taxable on any income that was previously subject to the transitional relief. In other words, if a joint venture member claimed the transitional relief in its 2011 return and transfers its interest to a wholly-owned corporation in 2012, the joint venture member will be required to bring the entire 2011 Stub Income into its 2012 income. This is an important distinction to the Partnership Anti-Deferral Rules, and it will present practical difficulties to corporate groups that wish to reorganize their joint venture interests.

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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