Thin Capitalization Rules
Following on the expansion to the thin capitalization or "thin cap" rules in the 2012 federal budget (described in Osler's Budget Briefing 2012), Budget 2013 proposes to further expand the scope of these rules to debts of Canadian-resident trusts and to those of certain non-resident corporations and trusts. Canadian-resident trusts and non-resident corporations and trusts that are members of partnerships would also be allocated their "specified proportions" of partnership debts.
In general, the thin cap rules deny the deduction of interest paid by a Canadian-resident corporation to certain non-resident shareholders of the corporation or non-resident persons that do not deal at arm's length with such shareholders to the extent that a 1.5:1 debt-to-equity ratio is exceeded (determined under specific rules in the ITA). Interest that has been denied under the thin cap rules will be deemed to have been paid as a dividend by the Canadian-resident corporation.
Currently, the thin cap rules apply only to debts of Canadian-resident corporations (directly or as a member of a partnership). Budget 2013 proposes to extend the thin cap rules to apply to debts of Canadian-resident trusts. The existing thin cap rules would be modified in several respects to take into account the differences between a trust and a corporation.
Where an amount of interest of a Canadian-resident trust is not deductible because of the application of the extended thin cap rules, Budget 2013 proposes that the trust may designate all or a portion of such amount as having been paid to the non-resident recipient as a beneficiary of the trust, and not as interest. This would allow the trust to deduct the designated payment in computing its income under the ITA, but the designated payment would be subject to non-resident withholding tax (and, in certain cases, an additional tax on "designated income" of the trust).
Budget 2013 introduces the concept of a "specified non-resident beneficiary" of a trust, which generally includes a non-resident beneficiary of the trust who, either alone or together with non-arm's length persons, has an interest as a beneficiary under the trust with a fair market value that is at least 25% of the fair market value of all interests as a beneficiary under the trust. Similar to the rules for determining whether a person is a specified shareholder of a corporation, certain deeming rules would cause a person to be deemed to hold interests in a trust or to have exercised rights in respect of interests in a trust for the purposes of the specified non-resident beneficiary definition. Additionally, where the amount of income or capital of the trust that the person may receive depends on an exercise of (or the failure to exercise) a discretionary power, that power is deemed to have been exercised (or failed to have been exercised).
The equity of a Canadian-resident trust will generally include contributions by specified non-resident beneficiaries and a proxy for trust retained earnings. Specifically, Budget 2013 proposes that the "equity amount" will be the amount by which (a) the total of (i) all equity contributions (defined as transfers of property to the trust in exchange for interests or rights to acquire interests as beneficiaries of the trust, or transfers of property to the trust by beneficiaries for no consideration) made by specified non-resident beneficiaries (measured on the basis of the average of all such contributions before each month of the year) and (ii) the "tax-paid earnings" of the trust for the year (measured as the taxable income of the trust less the federal and provincial tax payable by the trust for the year), exceeds (b) the total of all amounts paid or payable by the trust to specified non-resident beneficiaries (measured on the basis of the average of all such amounts before each month of the year), except to the extent the amounts are included in the beneficiaries' income under the ITA or are subject to non-resident withholding tax.
Recognizing that trusts may not have complete historical records enabling them to determine their "equity amounts", Budget 2013 proposes that an existing trust will be able to elect to determine its "equity amount" on Budget Day based on the fair market value of its assets less the amount of its liabilities at the beginning of Budget Day. This deemed trust equity would be deemed to have been contributed by the trust's beneficiaries in proportion to the relative fair market values of their beneficial interests on Budget Day. Contributions, tax-paid earnings and distributions on or after Budget Day would be added to (or subtracted from) the trust's "equity amount" for purposes of the thin cap rules.
Non-Resident Corporations and Trusts
Budget 2013 also proposes to extend the thin cap rules to non-resident corporations and trusts that have otherwise deductible interest expense under the ITA (e.g., because they carry on business in Canada through a branch). Under the proposals, the Canadian banking business of an authorized foreign bank would be excluded.
For purposes of the application of the thin cap rules to non-resident corporations and trusts, Budget 2013 proposes a 3:5 debt-to-asset ratio to parallel the 1.5:1 debt-to-equity ratio used for Canadian resident corporations. More specifically, the "equity amount" of a non-resident corporation or trust is defined as being 40% of the amount by which the cost of the non-resident's properties used or held in the course of carrying on business in Canada or, in the case of a corporation or trust that elects to be taxed on its net income under the ITA rather than being subject to non-resident withholding tax on its gross rental income, generally, its Canadian real property (in either case, measured on the basis of the average of all such amounts for each month of the year) exceeds the total of its liabilities other than, generally, debts that are owed to specified non-residents (measured on the basis of the average of all such amounts for each month of the year). In measuring the cost of a non-resident's properties for this purpose, partnership interests are excluded.
Although the proposals are not limited on their face to non-resident corporations and trusts that carry on activities the income from which is taxable in Canada under the ITA and any applicable tax treaty, that is their effect, since only such non-resident corporations and trusts should have interest expense that would otherwise be deductible under the ITA. Non-resident trusts and corporations that may be subject to the extended thin cap rules should review any applicable tax treaty to determine whether relief may be available.
All the thin cap proposals apply to taxation years that begin after 2013 and will apply to existing as well as new borrowings.
The non-resident trust rules of the ITA provide that where property is contributed by a Canadian resident taxpayer to a non-resident trust, the trust may be deemed to be a resident of Canada for most purposes of the ITA. These and related rules are proposed to be amended in response to the Federal Court of Appeal decision in The Queen v. Sommerer1. In that case, the Court held that a trust attribution rule of the ITA did not apply in circumstances where the trust acquired property in exchange for fair market value consideration. The attribution rule applies to attribute to a Canadian resident taxpayer income from property held by a trust in circumstances where the taxpayer has effective ownership of the property. Such effective ownership arises where the property can revert to the taxpayer, or the taxpayer has influence over the trust's dealings in respect of the property. Budget 2013 first proposes to restrict the application of the trust attribution rule to trusts resident in Canada determined without regard to the non-resident trust rules. Second, the non-resident trust rules are proposed to be amended so as to apply where a Canadian-resident taxpayer maintains effective ownership of property held by a non-resident trust, as described above for purposes of the trust attribution rule. Any transfer or loan of the property made directly or indirectly by the taxpayer, regardless of any consideration exchanged, will be treated as a transfer of restricted property by the taxpayer for purposes of the non-resident trust rules. The result will generally be to cause the taxpayer to be treated as having made a contribution to the non-resident trust, so that the non-resident trust will be deemed to be a resident of Canada in accordance with the non-resident trust rules. Finally, the provision of the ITA that prevents a trust from distributing property to a beneficiary on a tax-deferred basis where the property is subject to the trust attribution rule, is proposed to be extended to apply to the effectively owned property that is subject to these proposals.
These proposals apply to taxation years ended on or after Budget Day.
International Tax Evasion and Aggressive Tax Avoidance
Specified Foreign Property
A Canadian-resident that owns "specified foreign property" (including, generally, certain funds or property situated, deposited or held outside Canada and certain interests in non-resident entities and indebtedness owed by non-resident persons) with a cost in excess of $100,000 must file a Foreign Income Verification Statement (Form T1135). Budget 2013 proposes to extend the normal reassessment period for a taxation year of a taxpayer by three years if the taxpayer has failed to report income from a specified foreign property on its annual tax return, and the Form T1135 was not filed on time, or a specified foreign property was not identified, or was improperly identified, on the Form T1135.
In addition, Budget 2013 proposes to revise Form T1135 to require more detailed information regarding specified foreign property. These proposals apply to the 2013 and subsequent taxation years.
Information Requirements Regarding Unnamed Persons
Tax legislation allows the Minister of National Revenue (the Minister) to require any person to provide information or documents for the purposes of tax administration or enforcement. However, before issuing a requirement to a third party to provide information relating to unnamed persons, the Minister must first obtain a court order.
The current rules contemplate that the Minister may obtain this order on an ex parte basis - without notifying the third party of the application. The rules also provide the third party with specific rights to seek a review of the issuance of the court order. Parties have successfully challenged requirements relating to unnamed persons in cases such as Minister of National Revenue v. RBC Life Insurance Company, where it was found that the third party requirements were invalid because the Minister had failed to make full and frank disclosure in obtaining the ex parte order.2 On the basis that such challenges "significantly delay the obtaining of the information and consequently the audit and tax reassessment process", Budget 2013 proposes to eliminate the ex parte nature of the Minister's application as well as the ITA provisions that set out specific rights of review. This proposal is effective on the day the enacting legislation receives Royal Assent.
International Electronic Funds Transfers
Budget 2013 proposes to amend the ITA and the ETA to require certain financial intermediaries to report to the Canada Revenue Agency (CRA) international electronic funds transfers of $10,000 or more. These requirements are intended to mirror current requirements in the Proceeds of Crime (Money Laundering) and Terrorist Financing Act. Reporting will be required beginning in 2015.
Stop International Tax Evasion Program
Budget 2013 proposes that the CRA will launch a program under which it will pay rewards to individuals that provide information to the CRA that leads to the collection of outstanding taxes due in respect of major international tax non-compliance. Rewards would be paid of up to 15% of federal tax collected if the information results in total additional assessments or reassessments exceeding $100,000 in federal tax.
Budget 2013 reaffirms the intention of the Canadian government to pursue an intergovernmental agreement with the United States that would enhance the sharing of tax information under the Canada-United States Income Tax Convention. According to Budget 2013, this agreement would include provisions which "support" the Foreign Account Tax Compliance Act ("FATCA") rules passed by the United States Congress in 2010. The FATCA rules, which begin to become effective starting on January 1, 2014, represent a sweeping new paradigm for the enforcement of tax transparency by the United States. Under the FATCA regime, a wide range of direct and indirect U.S. payments made to non-U.S. financial institutions (and certain other non-U.S. entities) will be subject to a new 30% U.S. withholding tax unless the financial institution agrees to report extensive information about its U.S. account holders and owners to the IRS. The FATCA rules are extraordinarily complex and invasive in scope.
To date, the United States has signed intergovernmental agreements with the United Kingdom, Mexico, Ireland, Denmark, and Switzerland to clarify and simplify the application of FATCA to entities in those countries. In November 2012, the United States announced that it is working with more than 50 countries worldwide in negotiating FATCA intergovernmental agreements, including Canada. Budget 2013 indicates that Canada and the United states are negotiating a reciprocal agreement that would include a commitment by Canada and the United States to work with other trading partners to adapt the terms of this agreement to build a broader based common multilateral framework for the automatic exchange of tax information among partnering countries.
Budget 2013 notes that the Government has been largely unsuccessful in challenging perceived "treaty shopping" in court, a likely reference to cases such as MIL Investments, Prevost Car and Velcro. Budget 2013 states the Government intends to consult on measures that would "protect the integrity of Canada's tax treaties while preserving a business tax environment that is conducive to foreign investment", promising to release a consultation paper to provide stakeholders with an opportunity to comment on possible measures. No specific measures are proposed in Budget 2013.
Footnotes1 2012 FCA 207.
2 2013 FCA 50, argued by Osler's Mahmud Jamal, Hemant Tilak, Pooja Samtani and David Mollica.
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