Last year, Canada's controversial 2007 spring budget1 effectively posted a notice to the tax havens of the world: Tell us, through tax information exchange agreements, about the undisclosed income dishonest Canadians are hiding in your banks and trust companies and you will be rewarded with investment by honest Canadians, motivated by tax incentives we will give them; but refuse and we will impose punitive tax on honest Canadians who venture near your shores. (For prior coverage, see Doc 2007-6959 or 2007 WTD 55-1.)
The second legislative leg of that carrot and stick approach2 to inducing TIEAs was announced July 14 with draft amendments to the foreign affiliate regulations that would provide tax exemptions (the carrot) to Canadians who carry on business in TIEA countries.3
The first leg (the stick component) was enacted in December 2007 in the form of rules (which may not come into effect for several years) that will immediately tax profits — whether or not repatriated — that are earned in countries that have failed to effectuate TIEAs with Canada within five years of being invited to do so. Following is a brief review of Canada's new approach to TIEAs.
Analysis
Since 1976, tax treaties have been the keys that unlock the effects of a European-style participation exemption or territorial tax system for Canadian multinationals operating abroad. A territorial tax system exempts the parent company from home-country tax on dividends received from its foreign subsidiaries. But in accordance with the March 2007 budget and the draft regulations issued July 14, another type of treaty — a tax information exchange agreement — will also swing open the doors to the home-country tax exemption. And that will potentially be effective this year.
Under the current rules (often referred to as the foreign affiliate system or the exempt surplus system), a Canadian corporation does not pay any permanent tax on dividends it receives out of the exempt surplus of a foreign affiliate.4 For purposes of these rules, a nonresident corporation is a foreign affiliate if a Canadian entity owns 10 percent or more of the shares of any class of the nonresident corporation.5 The exempt surplus is the after-tax active (or deemed active) business profits of an affiliate that is resident in a designated treaty country (DTC), provided that those profits are earned in that or any other designated treaty country.6 Exempt status requires residency in the DTC for purposes of the treaty between Canada and the DTC, and as understood under Canadian domestic law (based on mind and management). A DTC under current domestic law, and since the introduction of the system in percent, by both votes and value, of the affiliate and it does not have certain affiliated party nexus to the affiliate. The underlying exemption from permanent tax arises under paragraph 113(1)(a) of the ITA. 1976, is a country with which Canada has a comprehensive income tax treaty7 in force.
Thus, because Canada has no treaties with pure tax havens (such as Bermuda, the Cayman Islands, and the British Virgin Islands), the profits of foreign subsidiaries that are based there or earned there do not qualify as exempt surplus. Instead, they are classified as taxable surplus8 and are treated, on repatriation, much like dividends received by U.S. or U.K. corporations from foreign subsidiaries — namely, they are taxed on a gross-up and credit basis.9
The flip side of this system — in which the foreign affiliate is a controlled foreign affiliate, or CFA, meaning that it is controlled by the relevant Canadian shareholder, by that shareholder and certain other unaffiliated Canadians or affiliated nonresidents, or by certain unaffiliated Canadians10 — is that passive or deemed passive income (foreign accrual property income)11 of a CFA is immediately taxed through attribution12 in the hands of the Canadian shareholder (whether corporate or noncorporate).
The adverse part of the new rule (immediate attribution of
active business profit) will arise when a CFA has earned income
from a nonqualifying business that is connected to the earning
of income in a nonqualifying country.13 A nonqualifying country
is one with which Canada has no tax treaty and that has failed
to enter into a TIEA with Canada within 60 months after Canada
has ''sought by written invitation to enter into
negotiations for a comprehensive tax information exchange
agreement.'' In principle, the effective-date rules are
such that it appears unlikely that any country will be a
nonqualifying country until 2014. Indeed, at this point, there
have been no announcements by the Canadian government regarding
TIEA negotiations.
The favorable aspect of the system will arise when a country
that does not have a tax treaty with Canada enters into a TIEA
that has been brought into force. In particular, the July 14
draft proposals would extend the entire current exempt surplus
system to countries with which a TIEA has come into force. That
would be effectuated through the simple mechanism, set out in
draft revised subsection 5907(11), of including as a designated
treaty country a country with which ''a comprehensive
tax information exchange agreement, in respect of that
sovereign jurisdiction . . . has entered into force and has
effect.'' The draft would make that applicable
beginning this year, and for proposed new subsection
5907(11.11), the effective date would be the beginning of the
tax year of the foreign affiliate in which a TIEA comes into
force — conceptually, as early as January 1 of this
year.
Commentary
In some ways, it is difficult to know what to make of this TIEA development. For example, although more than 15 months have elapsed since the project was announced in March 2007, and although hardly a week goes by without word of countries entering into TIEAs, there has not been, as already noted, any indication from the Canadian government that it has even started negotiating TIEAs, let alone entering into any. Further, following the April 25 release of an interim report by the government-appointed Advisory Panel on Canada's System of International Taxation that clearly signals that the panel favors extending the exempt surplus system to all countries,14 there has been speculation in Canadian circles that the lifespan of the TIEA system might in fact be quite short. Finally, it is difficult to come to terms with the philosophical underpinnings of the carrot and stick approach inherent in this initiative in the context of a mature and developed country such as Canada. But only time will tell what effect it actually has on the foreign operations of Canadian-based multinationals.
Footnotes
1 The March 2007 budget had proposed severe restrictions on the deductibility of financing costs related to foreign acquisitions. However, those proposals were withdrawn by the government two months later amid controversy, and the government instead announced a different restriction in this area, specifically regarding double-dip financings. That provision was later enacted as new section 18.2 of the Income Tax Act, Canada, as amended in December 2007 as part of Bill C-28.
2 See Lorne Saltman, ''The Carrot and the Stick: Canada's Approach to TIEAs,'' Tax Notes Int'l, Dec. 3, 2007, p. 951, Doc 2007-24515, or 2007 WTD 237-12.
3 Legislative Proposals and Explanatory Notes relating to the Income Tax Act, the Excise Act, 2001, and the Excise Tax Act, Department of Finance, Ottawa, Canada, July 14, 2008.
4 It may pay a potentially fully refundable tax, under Part IV of the act, on such dividends if it does not own more than 10 percent, by both votes and value, of the affiliate and it does not have certain affiliated party nexus to the affiliate. The underlying exemption from permanent tax arises under paragraph 113(1)(a) of the ITA.
5 That status also may arise with as little as a 1 percent ownership if certain affiliated parties own at least 9 percent (subsections 95(1) and 95(4) of the ITA).
6 Technically, such earnings are considered to be exempt earnings, a component of exempt surplus, under section 5907(1) of the Income Tax Regulations. Note that Canada has tax treaties with 86 countries.
7 Section 5907(11) of the Income Tax Regulations refers to a ''comprehensive agreement or convention for the elimination of double taxation on income.''
8 Technically, such profits comprise taxable earnings, a component of taxable surplus, under section 5907(1) of the Income Tax Regulations.
9 This actually involves grossed-up deductions of foreign taxes calibrated to give the effect of a credit, in accordance with paragraph 113(1)(b) and (c) of the ITA and relevant provisions under the Income Tax Regulations.
10 Subsection 95(1) of the ITA.
11 Id.
12 Section 91 of the ITA.
13 These notions were added to the definition of FAPI by Bill C-28.
14 For a detailed discussion, see Nathan Boidman, ''Reforming Canada's International Tax: An Interim Report,'' Tax Notes Int'l, May 19, 2008, p. 613, Doc 2008-9581, or 2008 WTD 100-9.
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