A fifth draft of the proposed FIE legislation, amending the Income Tax Act ("ITA"), 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.
In a prior issue of the Tax Bulletin, we assessed the general impact of the FIE rules, which operate as an anti-deferral mechanism designed to prevent Canadian taxpayers from earning passive income offshore without paying Canadian tax. In particular, the article focused on the income imputation rules that apply to foreign investments caught by the rules. Where the rules apply, an investment in a FIE will be taxed under one of three methods: the prescribed rate of return regime, the mark-to-market regime, or the accrual regime.
The proposed FIE rules are applicable to a taxpayer who holds a participating interest in a FIE that is not an "exempt interest" of the taxpayer. Among other things, the definition of "exempt interest" includes an interest in an FIE whose interests are publicly traded on a foreign stock exchange of a country in which the FIE is resident. In order to qualify as an "exempt interest" under this provision, the following criteria must be satisfied:
- the foreign entity must be at arm's length with the taxpayer;
- the foreign entity must be resident in a jurisdiction with a prescribed stock exchange, as defined by the regulations to the ITA; and
- there must be identical interests in the entity listed on the prescribed stock exchange.
If all three requirements are met, a Canadian investor will only pay Canadian tax when he or she sells the interest or receives a distribution from the foreign company. If the requirements are not met, one of the three income imputation methods listed above will be applied to determine tax payable on the interest.
Whether a company is resident in any particular jurisdiction will be a factual determination based upon an assessment of how and where it is managed and controlled, as well as the specific provisions of any applicable tax treaty.
It should be noted that the above exemption will only be applicable where the taxpayer had no "tax avoidance motive" for the acquisition of the interest. Although the proposed rules explicitly define the term, its practical application to any given set of facts is exceptionally complex. The proposed rules provide that a taxpayer has a tax avoidance motive if it is reasonable to conclude that the main reasons for owning the interest are either that:
- the taxpayer has deferred or reduced the tax payable from the investment property; or
- the taxpayer has derived a tax benefit attributable to the investment property.
In determining whether these requirements are met, the rules provide for a number of factors to consider including:
- the nature of the foreign entity;
- the form and terms of the interest in that entity;
- other interests in other entities that the taxpayer may have;
- the relationship between the entity in which the taxpayer has an investment and other entities;
- the extent to which the affected entities are subject to taxation on their income and gains;
- the extent to which income and gains of the entity are distributed in the year in which such income is earned or realized or in the following year; and
- the amount of tax that would have been payable by taxpayer if the taxpayer had earned the income or realized the profits from the investment property.
The proposed rules also provide for two circumstances where a tax avoidance motive will not be present. The first is where the taxpayer owns an interest in an entity that distributes all of its income. This exclusion will apply only where the FIE, and all other FIEs that it owns, allocates income and gains to holders within 120 days of its year end, and provided also that the amount is included in the holder's income annually. The second is the acquisition of a "Regulated Investment Company" or a United States "Real Estate Investment Trust" provided the Canadian taxpayer includes any amounts received in income.
Despite the complex definition of the term "tax avoidance motive", arguably a more significant problem with the exemption is that there are a limited number of countries with prescribed stock exchanges. Currently, exchanges in 25 counties are listed, most of them in Europe. Many important countries in Asia and Latin America are not included. Therefore, in order to escape the scope of the FIE rules, a taxpayer must be careful to ensure that their offshore investments fall within the exemption's geographical limitations.
The prescribed stock exchanges are:
- Australia: The Australian Stock Exchange
- Austria: The Vienna Stock Exchange
- Belgium: Euronext Exchange (formerly the Brussels Stock Exchange)
- Denmark: The Copenhagen Stock Exchange
- Finland: The Helsinki Stock Exchange
- France: Euronext Exchange (formerly the Paris Stock Exchange)
- Germany: The Frankfurt Stock Exchange
- Hong Kong: The Hong Kong Stock Exchange
- Italy: The Milan Stock Exchange
- Japan: The Tokyo Stock Exchange
- Ireland: The Irish Stock Exchange
- Israel: The Tel Aviv Stock Exchange
- Mexico: The Mexico City Stock Exchange
- Netherlands: Euronext Exchange (formerly the Amsterdam Stock Exchange)
- New Zealand: The New Zealand Stock Exchange
- Norway: The Oslo Stock Exchange
- Singapore: The Singapore Stock Exchange
- South Africa: The Johannesburg Stock Exchange
- Spain: The Madrid Stock Exchange
- Sweden: The Stockholm Stock Exchange
- Switzerland: The Zurich Stock Exchange
- United Kingdom: The London Stock Exchange
- United States:
a. the American Stock Exchange
b. the Boston Stock Exchange
c. the Chicago Board of Options
d. the Chicago Board of Trade
e. the Cincinnati Stock Exchange
f. the Intermountain Stock Exchange
g. the Midwest Stock Exchange
h. the NASDAQ
i. the New York Stock Exchange
j. the Pacific Stock Exchange
k. the Philadelphia Stock Exchange
l. the Spokane Stock Exchange
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.