Copyright 2008, Blake, Cassels & Graydon LLP

Originally published in Blakes Bulletin on Tax, September 2008

On July 14, 2008, the Minister of Finance released draft legislation that included a number of tax measures originally proposed in the 2008 federal budget, as well as a number of previously announced tax initiatives (the July 14th Proposals). Included were proposals dealing with (i) the calculation of income and capital gains of a foreign affiliate and (ii) the currency in which such amounts were to be determined. One of the key components of these proposals is a "carve out rule" that excludes from foreign accrual property income (FAPI) certain capital gains or losses and income or loss that accrued prior to a non-resident corporation becoming a foreign affiliate of a Canadian taxpayer. A great deal of controversy ensued when previous version of these proposals released on October 2, 2007 (the October 2007 Proposals) significantly restricted the scope of this "carve-out rule" by limiting its application only to a non resident corporation that dealt at arm's length with the Canadian taxpayer prior to becoming a foreign affiliate. This change was retroactive and restricted the scope of existing paragraph 95(2)(f) of the Income Tax Act (the Act) which deals with capital gains and losses as well as proposed paragraph 95(2)(f.1) of the Act which deals with other income and losses. The July 14th Proposals return the scope of carve-out rule to its original breadth.

The rules contained in proposed paragraphs 95(2)(f) to (f.15) of the Act represent a substantial overhaul of the way that income and capital gains of a foreign affiliate are to be calculated and what currency should be used. In addition to reinstating the broader ambit of the carve-out rule, this regime represents a reconfiguration of rules that had been previously proposed. In the explanatory notes accompanying the July 14th Proposals, the Department of Finance described these rules as containing the following three main components:

  1. The "main rule" found in proposed paragraph 95(2)(f) of the Act which provides that (i) capital gains and capital losses of a foreign affiliate from the disposition of property and (ii) income or loss from a property, from a business other than an active business or from a non-qualifying business are to be determined, except as otherwise provided in the foreign affiliate rules contained in the Act and except to the extent that the context otherwise requires, as if the foreign affiliate was a taxpayer resident in Canada.

  2. The "carve-out" rule contained in new paragraph 95(2)(f.1) of the Act which provides that, in computing an amount other than the main rule, there is not to be included any portion of any amount that can reasonably be considered to have accrued before the corporation became a foreign affiliate of the taxpayer.

  3. The "reading rule" contained in proposed paragraph 95(2)(f.11) of the Act which provides some specific guidelines as to how the main rule is to be applied.

The main rule is essentially the same as that set out in existing paragraph 95(2)(f) of the Act and the previous version of the proposed paragraph 95(2)(f.1). The version of paragraph 95(2)(f) contained in the July 14th Proposals also makes it clear that this rule is to be overridden in circumstances where other provisions of the foreign affiliate rules provide otherwise. This should be of assistance, particularly as the provisions of the Act relating to foreign affiliates contain a number of proposed rules dealing with how fluctuations in foreign currency affect the computation of FAPI and other amounts of foreign affiliates in various specific situations.

As discussed above, the most significant change in the July 14th Proposals is to the carve-out rule which has the effect of excluding from the calculation of FAPI, certain capital gains or capital losses or income or loss that generally accrued before the relevant corporation became a foreign affiliate of a Canadian taxpayer. The version of this rule that was included in the October 2007 Proposals would have denied the benefit of the carve-out rule to a foreign affiliate which was a "relevant non-arm's length entity" of the taxpayer prior to such company becoming a foreign affiliate. The introduction of the "relevant non-arm's length entity" concept significantly restricted the carve-out protection particularly for multinational corporations that had decided to move non-Canadian subsidiaries underneath a Canadian subsidiary.

There was much opposition to this restriction of the scope of the carve-out rule particularly since it would have had retroactive effect. Some multinational corporate groups had moved non-resident subsidiaries under their Canadian corporate subsidiaries relying on the breadth of the carve-out rule as it was prior to October 2007 Proposals. The Joint Committee on Taxation of the Canadian Bar Association and the Canadian Institute of Chartered Accountants included this issue in the submission that it made with respect to the October 2007 Proposals. As a consequence of the controversy, paragraphs 95(2)(f) to (f.2) of the Act were left out of the draft legislation when it was introduced as Bill C-28 on November 21, 2007.

Under the July 14th Proposals, the "relevant non-arm's length entity" concept has been replaced by an exception to the carve-out rule for property that would have been owned by or a business carried on by a "specified person or partnership". This concept is significantly narrower than the "relevant non-arm's length entity" approach. A "specified person or partnership" includes only persons who did not deal at arm's length with the taxpayer if such persons were resident in Canada. This change will be welcomed by multinational companies that have reorganized, or plan to reorganize, their corporate groups by moving non-Canadian corporations underneath their Canadian subsidiaries.

The July 14th Proposals have increased the breadth of the carve-out rule in another way. Under the October 2007 Proposals, the carve-out rule would not have applied to dispositions of "designated taxable Canadian property". This term was defined as taxable Canadian property where the gain would not be exempt from Canadian tax under an applicable tax treaty. Under the July 14th Proposals, paragraph 95(2)(f) of the Act no longer excludes property of a foreign affiliate that would be "designated taxable Canadian property" from being eligible for the relief offered by paragraph 95(2)(f) of the Act.

Although the regime contained in paragraphs 95(2)(f) to (f.15) of the Act as proposed in the July 14th Proposals involves a significant number of new provisions, many of the concepts were already present in earlier proposals. The version in the July 14th Proposals largely involves a reorganization of the concepts that were already covered in existing paragraph 95(2)(f) of the Act and previously proposed paragraphs 95(2)(f.1) and (f.2) of the Act.

Although the reworked version of these provisions is welcome, the foreign affiliate rules are still largely in a state of flux as they have been since significant changes were originally included in December of 2002. The complexity of the foreign affiliate rules is fairly daunting to begin with. The myriad of promised changes since 2002 and the various comfort letters released by the Department of Finance have only added to the level of uncertainty that already surrounds the application of the foreign affiliate rules to the foreign subsidiaries of Canadian corporations. It is hoped that the long-awaited version of the revised foreign affiliate proposals will bring some clarity to the current uncertain state.

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