In response to a perceived increase in the use of offshore investment structures to avoid Canadian income tax, the Department of Finance first introduced complex tax legislation that governs the treatment of direct or indirect investments in certain foreign entities by Canadian taxpayers (the FIE Rules) in 2001. A fifth draft of the proposed legislation was released in July 2005 and, although this legislation has not yet come into force, the rules are intended to apply for taxation years beginning after 2002.
The FIE Rules are an anti-deferral mechanism designed to prevent Canadian taxpayers from earning passive income offshore without paying Canadian tax. In the absence of these rules, Canadians could potentially invest in offshore corporations which do not pay Canadian tax on investment income as it is earned. The Canadian investor would only pay Canadian tax when he or she sold or received a dividend on the shares of the offshore corporation.
The FIE Rules deny the benefit of this tax deferral, and generally catch equity or equity-like investments in foreign entities that earn passive investment income. However, determining whether the rules apply in any particular circumstance is a complex exercise. The FIE Rules assume that all non-resident entities are FIEs, unless it can be shown that the entity is not. Grossly simplified, an entity will not be a FIE if the value of its investment property makes up less than half of the value of the entity, or if the entity's principal business is not an investment business.
If the rules do apply to the investment, the taxpayer becomes subject to one of three income imputation rules.
Prescribed Rate of Return Method
The default means of calculating income is the prescribed rate of return method. The amount of income a taxpayer must include is determined by multiplying the sum of the actual cost (and any income previously taxed as a result of the FIE Rules) at the end of each month by a prescribed interest rate. The current rate, which will be in effect from January 1, 2006 to March 31, 2006, is 5%. Amounts included by this method are added to the cost of the interest, thereby reducing any capital gain or increasing any loss that may arise on a future disposition.
In some instances, the taxpayer may elect to be governed by one of two other income imputation rules if information and certain other requirements are met.
The first of these two rules is the mark-to-market regime. This method relies on the annual increase or decrease in the fair market value of the interest. A taxpayer may elect to use the mark-to-market method only if the interest has a "readily obtainable fair market value" at all times in the taxation year. Simply stated, the interest must be listed and actively traded on a prescribed stock exchange, or include conditions that require its redemption or retraction at a fixed arm's length market price. An election must be made for the first year in which the FIE Rules apply to the particular investment. Once the election is made, the mark-to-market rules continue to apply as long as the interest is a FIE, and continues to have a readily obtainable fair market value.
The second of these two regimes is the accrual method, which allows the taxpayer to look through to the actual income or loss of the foreign entity and take into account only the holder's portion of that income or loss. The income or loss must be calculated using Canadian rules. This method can only be used if the mark-to-market regime is inapplicable and other stringent conditions are met.
Due to the complexity of the FIE rules, many taxpayers will invest in non-resident entities without knowing whether or not the rules apply. It is only upon careful review of a particular situation that the impact of the rules can be confirmed.
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