Canada: Budget 2018: Cross Border Tax Planning Measures Targeted

Last Updated: March 6 2018
Article by Michel M. Ranger

Budget 2018 introduced several international tax measures designed to address certain transactions through which taxpayers are potentially able to either strip surplus out of Canada free of tax or earn passive property income offshore while deferring or, in some cases, avoid altogether, Canadian taxation. 

Cross-Border Surplus Stripping using Partnerships and Trusts

Paid-up capital in respect of shares ("PUC") is a valuable tax attribute, particularly for non-residents with Canadian subsidiaries.  Unlike dividends, PUC can be returned by a Canadian corporation to its foreign shareholders free of Canadian withholding tax at any time and generally without regard to the level of the corporation's earnings.  PUC is also one of the components in the computation of the "equity amount" in respect of a corporation for purposes of the Canadian thin capitalization rules. Generally, interest that is paid or payable by a Canadian corporation on debt owing to certain non-arm's length non-residents, that exceeds 1.5 times the equity amount of the corporation, will not be deductible and, in most cases, will be re-characterized as a dividend subject to withholding tax.  As a result, the higher the equity amount in respect of shares of a Canadian corporation held by certain non-residents, the higher the amount of related-party interest-bearing debt that can generally be used to repatriate funds from Canada in the form of deductible interest, which, in the case of interest paid to related US residents, would be paid free of Canadian withholding tax. 

Generally, the PUC in respect of shares of a Canadian corporation is equal to the amount that the corporation has received as consideration for the issuance of such shares.  The starting point for the computation of PUC is the amount that is added to the stated capital account of a corporation that is maintained for the shares in question.  Normally, such amount will be equal to the cash amount paid for the shares or the fair market value of any property transferred to the corporation in consideration for the issuance of the shares.  Such amount is then adjusted pursuant to various rules contained in the Income Tax Act (Canada) (the "Tax Act"). 

One such rule, contained in section 212.1 of the Tax Act, is an anti-avoidance rule that is meant to prevent a non-resident shareholder of a Canadian corporation from using certain tax exemptions applicable to the sale of shares of a corporation, which are generally contained in Canada's numerous bilateral tax treaties, to artificially increase PUC, or strip surplus out of a Canadian corporation on a tax-free basis, using certain non-arm's length transactions.  A typical example would involve a non-resident shareholder of a wholly-owned Canadian corporation (the subject corporation), with shares having PUC of $20 but a fair market value of $100, forming a new Canadian corporation (the purchaser corporation) to which it would transfer the shares of the subject corporation, generally on a tax-free basis pursuant to most of Canada's bilateral tax treaties, for shares of the purchaser corporation (alternatively, the transaction could be structured such that, in addition to shares, the purchaser corporation would issue a non interest-bearing promissory note to the non-resident shareholder, which can be repaid at any time free of Canadian withholding tax).  Often, the subject corporation and the purchaser corporation would subsequently be amalgamated.  But for the application of section 212.1, this would have resulted in a step-up in the PUC of the shares held by the non-resident shareholder from $20 to $100.  However, the application of section 212.1 to such non-arm's length transfers prevents this step-up in PUC from occurring by limiting the amount of PUC of the shares of the purchaser corporation to the amount of PUC of the shares of the subject corporation (i.e., $20 in our example above).  In addition, where non-share consideration is also paid by the purchaser corporation to the non-resident shareholder, the PUC of the shares of the purchaser corporation will be reduced by the amount of such non-share consideration and, if the amount of the non-share consideration exceeds the PUC of the shares of the subject corporation, the amount of such excess will be deemed to be a dividend paid by the purchaser corporation to the non-resident shareholder.

While section 212.1 applies to situations where shares of a corporation resident in Canada are transferred to another corporation resident in Canada, it does not address situations involving a transfer of shares of a Canadian resident corporation to other types of holding vehicles, such as a partnerships or trusts, or where interests in a partnership or a trust (that may themselves own shares of a Canadian resident corporation) are transferred by a non-resident person to a Canadian resident corporation. As noted in Budget 2018, this "gap" in the rules could, subject to the application of the general anti-avoidance rule, allow a non-resident shareholder of a Canadian resident subject corporation to form a partnership, transfer the shares of the subject corporation to the partnership, and then transfer the partnership interest to a newly formed wholly-owned Canadian resident purchaser corporation, and achieve the result that section 212.1 seeks to prevent.   

Budget 2018 proposes to address the perceived "gap" by amending the Tax Act to add a comprehensive "look-through" rule for partnerships and trusts that will allocate the assets, liabilities and transactions of a partnership or trust to its members or beneficiaries, respectively, based on the relative fair market value of their interests such that, for purposes of applying section 212.1, a transfer by a non-resident person of an interest in a partnership which, in turn, owns shares of a Canadian resident corporation will be treated as if the non-resident person transferred the shares of the Canadian resident corporation directly.

A rule similar to section 212.1 applies in the context of corporate immigrations. In this regard, Budget 2018 also proposes amendments to the corporate immigration rules to prevent the use of partnerships and trusts to circumvent the application of the corporate immigration anti-avoidance rule.

Although no detailed legislative proposals were tabled with the release of Budget 2018, once the amendments are enacted, the measure will apply to transactions occurring on or after February 27, 2018.

Finally, in addition to PUC, contributed surplus is also one of the components of the computation of the "equity amount" in respect of a corporation for purposes of the Canadian thin capitalization rules.  There are certain provisions in the Tax Act that allow a corporation to convert contributed surplus into PUC on a tax-free basis.  Budget 2018 proposes specific amendments to the Tax Act that will exclude any contributed surplus that arose at a time when a corporation was a non-resident of Canada from the "equity amount" in respect of a corporation, as well as any contributed surplus that arose in connection with a disposition to which section 212.1 applies.

Foreign Affiliate Rules Tightened

Budget 2018 is also proposing certain modifications to the foreign affiliate rules in the Tax Act.  The two principal proposed changes are in response to the implementation of certain structures that essentially circumvent the rules requiring that foreign accrual property income ("FAPI") of a controlled foreign affiliate of a Canadian taxpayer be taxed on an accrual basis in the hands of the Canadian taxpayer.  For these purposes, FAPI generally includes all income from property of a passive nature, and specifically includes income from an "investment business", which is defined for these purposes as a business, the principal purpose of which is to derive income from property.  However, the definition of an investment business specifically excludes certain businesses that would otherwise be considered to be an investment business where certain conditions are met, including that the affiliate carrying on the business employ more than five full-time employees in the active conduct of that business (referred to as the "six employee test").  The rationale behind this exception is that, if an affiliate's investment business activities are so significant that they require more than five full-time employees, the affiliate's business should be considered to be an active business and, therefore, income derived from that business should be excluded from FAPI. 

Budget 2018 identified ways (each referred to in Budget 2018 as "tracking arrangements") in which Canadian taxpayers may be circumventing the application of the FAPI rules and thereby avoiding Canadian taxation of an affiliate's income on an accrual basis.  "Tracking arrangements" involve taxpayers pooling their business assets in a common affiliate and implementing some form of tracking arrangement, either through the equity interests in the affiliate or through contractual arrangements, to retain control over the assets contributed and the return on such assets. 

Tracking Arrangements

The primary "tracking arrangement" identified in Budget 2018 involves different foreign affiliates, presumably carrying on the same or similar investment businesses, which, when considered separately, would not warrant employing more than five full-time employees.  Since the six employee test is applied on a business-by-business basis, as opposed to an affiliate by affiliate basis, none of these affiliates' businesses, considered separately, would be able to qualify for the exception to the investment business definition.  However, if the affiliates were to pool all of their financial and other assets together in a common foreign affiliate, which then carries on the cumulative investment activities previously carried on by the separate corporations (and which, when aggregated, can now justify employing more than 5 full-time employees), taxpayers could take the position that the affiliate is carrying on a single investment business with more than five full-time employees and, therefore, claim that the business was excluded from the definition of investment business (and thus the resulting income of the affiliate was not FAPI).

Budget 2018 proposes to introduce a rule that, for the purposes of the investment business definition, would deem specific activities carried on by a foreign affiliate to be a separate business carried on by the affiliate where the income attributable to the specific activities accrues to the benefit of a specific taxpayer under what is referred to in Budget 2018 as a "tracking arrangement".  As a result, each deemed separate business of the affiliate would need to satisfy the more than five full-time employee test on its own in order for the deemed separate business not to constitute an investment business.

No draft implementing legislation was released with Budget 2018 in respect of the foregoing proposals and, therefore, it is not known how the Department of Finance will define what constitutes a "tracking arrangement" for these purposes.  This measure is intended to apply to taxation years of foreign affiliates that begin on or after February 27, 2018.

Controlled foreign affiliate status

Budget 2018 also suggested that Canadian taxpayers may be circumventing the application of the FAPI rules by using tracking arrangements to ensure that a foreign affiliate that is earning FAPI is not a controlled foreign affiliate of the Canadian taxpayer.  As previously noted, only FAPI of a controlled foreign affiliate of a Canadian taxpayer is subject to tax on an accrual basis in the hands of the Canadian taxpayer.  For these purposes, a foreign affiliate will be considered a controlled foreign affiliate of a Canadian taxpayer if the Canadian taxpayer controls the foreign affiliate, or would control the foreign affiliate if the Canadian taxpayer held all of the shares of the foreign affiliate that are held by (i) the Canadian taxpayer; (ii) persons with which the Canadian taxpayer does not deal at arm's length; (iii) any four other persons that are resident in Canada; and (iv) any non-resident persons that do not deal at arm's length with the persons in (iii). 

Budget 2018 suggested that certain groups of Canadian taxpayers are using "tracking arrangements" to avoid controlled foreign affiliate status.  Pursuant to such tracking arrangements, a group of Canadian taxpayers, presumably all of whom deal at arm's length, once again collectively pool their assets in a single foreign affiliate and each Canadian taxpayer would retain control over its assets contributed and any returns from those assets would accrue exclusively to such Canadian taxpayer's benefit.  Provided the group of Canadian taxpayers is sufficiently large such that none of the Canadian taxpayers controls the foreign affiliate, each separate Canadian taxpayer can potentially take the position that the foreign affiliate is not a "controlled foreign affiliate" of that Canadian taxpayer.  As a result, by artificially diluting control of a foreign affiliate, but not actually relinquishing any control of a particular business that is carried on by that foreign affiliate and that is generating FAPI, a Canadian taxpayer may effectively be able to avoid having FAPI taxed in its hands on an accrual basis, even though the Canadian taxpayer has retained full economic control over the assets of the business (and the income stream from those assets) that are generating the FAPI. 

To address this type of planning, Budget 2018 proposes a rule that would deem a foreign affiliate of a Canadian taxpayer to be a controlled foreign affiliate of the Canadian taxpayer if FAPI attributable to activities of the foreign affiliate accrues to the benefit of the Canadian taxpayer under a "tracking arrangement". As in the case of the changes proposed in Budget 2018 in respect of the investment business definition, no proposed implementing legislation accompanied the release of the Budget. This measure is intended to apply to taxation years of a foreign affiliate that begin on or after February 27, 2018.

Other measures affecting foreign affiliates

Where the principal purpose of a business carried on by a foreign affiliate is to derive income from trading or dealing in indebtedness, the income from that business is generally treated as FAPI of the affiliate. Similar rules apply to income of an affiliate derived from an investment business.  Each of these rules contains an exception to the FAPI characterization of income for certain regulated foreign financial institutions; however, only the exception in respect of the "investment business" definition includes a minimum capital requirement.  In order to ensure consistency, Budget 2018 proposes to add a similar minimum capital requirement to the trading or dealing in indebtedness rules.  This measure will apply to taxation years of a foreign affiliate that begin on or after February 27, 2018.

In addition, Canadian taxpayers with foreign affiliates are currently required to file a Form T1134 in respect of each of its foreign affiliates within 15 months after the end of the taxpayer's taxation year.  Budget 2018 proposes to significantly reduce this timeframe by more closely aligning a Canadian taxpayer's T1134 reporting requirement with the general filing due-date for the Canadian taxpayer by requiring the Forms to be filed within six months after the end of the taxpayer's taxation year.  For many Canadian multinational corporations, this reduced timeframe could prove to be a challenge, given that some of the information pertaining to its foreign affiliates may not be available within 6 months of the Canadian taxpayer's year end, and the focus of such Canadian multinationals is likely to be on completing their Canadian domestic tax filing obligations.  This measure will apply to taxation years of a Canadian taxpayer that begin after 2019.

Finally, Budget 2018 contended that audits in respect of foreign affiliates are generally time consuming and they often involve issuing requirements for information located in foreign jurisdictions, as well as requesting information from a foreign jurisdiction that is tax treaty or TIEA partner.  A three-year extended reassessment period currently exists in respect of assessments made as a consequence of a transaction involving a taxpayer and a non-resident with whom the taxpayer does not deal at arm's length.  Although this three-year extension currently applies to many transactions involving foreign affiliates, it does not apply to all income associated with a foreign affiliate.  As a result, Budget 2018 proposes to extend the reassessment period for a Canadian taxpayer by three years in respect of income arising in connection with a foreign affiliate of the Canadian taxpayer.

This measure will apply to taxation years of a Canadian taxpayer that begin on or after February 27, 2018.

The foregoing provides only an overview and does not constitute legal advice. Readers are cautioned against making any decisions based on this material alone. Rather, specific legal advice should be obtained.

© McMillan LLP 2018

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Michel M. Ranger
Similar Articles
Relevancy Powered by MondaqAI
Aird & Berlis LLP
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Aird & Berlis LLP
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions