Canada: Proposed Technical Amendments To The FAPI And Foreign Affiliate Rules

Last Updated: September 21 2000

Eric Lockwood, Michael J. Maikawa and Nick Pantaleo of PricewaterhouseCoopers LLP, Toronto, review and analyze the proposed changes announced by the Department of Finance on November 30,1999, on the proposals dealing with foreign corporations held through partnerships in which a corporation resident in Canada or a foreign affiliate of a corporation resident in Canada is a member.

Introduction

On November 30, 1999, the Department of Finance released a package of proposed technical amendments to the Income Tax Act.1 The proposed amendments are intended to correct or clarify the application of existing income tax provisions, implement measures that had already been announced, or deal with other situations that require a legislative policy response.

Among the proposed technical amendments are changes to the foreign accrual property income (FAPI) and foreign affiliate rules, found in subdivision i of division B of the Act and in regulation 5900. Most of these changes deal with the holding of a foreign corporation through a partnership where one or more members of the partnership are corporations resident in Canada or foreign affiliates of corporations resident in Canada. This article will review and analyze these proposed changes. As well, it will review other significant proposed changes to the FAPI and foreign affiliate rules.

Foreign Corporations Held Through Partnerships

The proposed amendments to deal with shares of a foreign corporation held through a partnership can be summarized as follows:

  • proposed2 section 93.1: determination of foreign affiliate status and the amount of dividend deemed to have been received by a member of a partnership;
  • proposed subsection 93(1.2): capital gain/dividend conversion election in respect of a disposition of a foreign affiliate held by a partnership;
  • proposed subsection 93(2.1): loss limitation rules;
  • amendments to regulation 5905: surplus entitlement adjustments; and
  • other proposed amendments.3

Determination Of Foreign Affiliate Status

Current Issues

The FAPI and foreign affiliate rules in the Act do not specifically address the status of a foreign corporation held by a partnership. However, it is the position of the Canada Customs and Revenue Agency (herein referred to as "the CCRA") that if shares of a foreign corporation are held through a partnership and the requisite ownership tests are met, the foreign corporation would be a foreign affiliate of the partnership but not a foreign affiliate of the members of the partnership.4

A foreign affiliate5 of a taxpayer resident in Canada means a non-resident corporation in which the taxpayer’s equity percentage6 is not less than 1 percent and the equity percentage in the foreign corporation of persons related to the taxpayer is not less than 10 percent. Equity percentage is the sum of the taxpayer’s direct equity percentage7 in the foreign corporation and the direct equity percentage in the foreign corporation held by another corporation in which the taxpayer has an interest. The direct equity percentage in a foreign corporation is determined by the number of shares of the corporation owned by a particular person. The CCRA takes the position that shares of a foreign corporation held through a partnership are owned by the partnership and not by the members. Hence, the foreign corporation cannot be a foreign affiliate of the members of the partnership.

The CCRA’s position appears to have merit.

A partnership is not a legal person or entity and is not subject to tax.8 However, subsection 96(1) of the Act provides that where a taxpayer is a member of a partnership, the taxpayer’s income and various types of losses for a taxation year or the taxpayer’s taxable income earned in Canada for a taxation year, as the case may be, is to be computed as if the partnership were a separate person resident in Canada. Subsection 96(1) goes on to specify that income or loss is to be computed as if each partnership activity, including the ownership of property, were carried on by the partnership as a separate person and a computation were made of the amount of

  • each taxable capital gain and allowable capital loss of the partnership from the disposition of property, and
  • each income and loss of the partnership from each other source or from sources in a particular place,

for each taxation year of the partnership. Since subsection 96(1) provides for the computation of income as if the property were owned by the partnership, it appears that the foreign affiliate status of a foreign corporation held through a partnership should be determined with respect to the partnership.

Further, a corporation resident in Canada is permitted certain deductions under section 113 in respect of dividends received on a share "owned by it of the capital stock of a foreign affiliate of the corporation [emphasis added]." Generally, under partnership principles, each partner has some form of ownership interest in the underlying assets of the partnership and no partner may treat partnership property as his or her own.9 Accordingly, if all the shares of a foreign corporation are held through a partnership, arguably no partner can own the requisite number of shares of the corporation to make it a foreign affiliate of the partner. Rather, each partner would have an undivided interest in all the shares held through the partnership that is equal to the partner’s interest in the business carried on through the partnership.10

The CCRA’s position is not free from doubt and has been challenged by certain writers.11

In addition, it has been suggested that where a foreign affiliate of a taxpayer is a member of a partnership that holds all the shares of a foreign affiliate, subsection 96(1) should have no application because no computation of income or taxable income earned in Canada is involved.12

The most significant result of the CCRA’s position is that a corporation resident in Canada is not eligible to claim any deductions under section 113 in respect of dividends paid by a foreign corporation whose shares are held through a partnership in which the taxpayer is a member. Further, if a foreign affiliate of the taxpayer is a member of the partnership, its share of dividends paid by the foreign corporation would be FAPI.13 Finally, the rollover provisions found in paragraphs 95(2)(d.1) and (e.1) would not be applicable because a necessary condition is that a taxpayer have a surplus entitlement percentage in the relevant foreign affiliates of not less than 90 percent. According to regulation 5905(13), surplus entitlement percentage is computed only in respect of a corporation resident in Canada. Therefore, surplus entitlement percentage is indeterminate in respect of a partnership.14

Proposed Subsection 93.1(1)

Proposed subsection 93.1(1) deems shares held by a partnership, at any particular time, to be owned by the members of the partnership in a proportion equal to that proportion of the number of shares that the fair market value of the member’s partnership interest is of the fair market value of all members’ interests in the partnership at that time. This deeming rule applies for determining whether a non-resident corporation is a foreign affiliate of a Canadian resident company, but only for the purposes of proposed subsection 93.1(2) and sections 93, 113, and 95 to the extent that section 95 is applicable in applying those provisions.

In certain circumstances, it may be difficult to value a member’s partnership interest. Nevertheless, this approach is probably the most reasonable for determining whether a foreign corporation held through a partnership is a foreign affiliate of a corporation resident in Canada. An alternative approach would be to allocate ownership of the shares of the foreign corporation in proportion to a member’s share of the income or loss of the partnership for its fiscal period that includes the particular time. However, this approach would mean that the foreign corporation could lose its foreign affiliate status with respect to a particular member in a year if no income were allocated (or allocable) to that member. This could happen, for example, where, under the partnership agreement, another member is entitled to be allocated a certain amount or type of income before the particular member is allocated its share of any remaining amount, if any. The loss of foreign affiliate status in a particular year would mean the loss of exempt and taxable surplus (including underlying foreign tax) of the foreign corporation.

Proposed Subsection 93.1 (2)

Proposed subsection 93.1(2) allocates to the members dividends received by a partnership from a foreign affiliate of a corporation resident in Canada. Under proposed paragraph 93.1(2)(a), where a dividend is paid to a partnership at any time, each member of the partnership is deemed, for purposes of sections 93 and 113, to have received the proportion of the partnership dividend that the fair market value of the member’s interest in the partnership is of the fair market value of all members’ interests in the partnership at that time.

Under proposed paragraph 93.1(2)(b), the proportion of the dividend deemed by paragraph (a) to have been received by a member is deemed to have been received in equal proportions on each affiliate share that is property of the partnership at the time the dividend is paid. Proposed paragraph 93.1(2)(c) deems each share referred to in proposed paragraph (b) to have been owned by the member. Together, paragraphs (b) and (c) deem a taxpayer to have received a dividend on a share owned by it in order to meet the condition in section 113, but only in respect of the amount deemed to have been received under proposed paragraph 93.1(2)(a).

In calculating the amount deductible by a member of the partnership under section 113, proposed paragraph 93.1(2)(d) limits the deduction to the amount included in the member’s income pursuant to subsection 96(1) in respect of the dividend received by the partnership.15 The purpose of proposed paragraph 93.1(2)(d) is to limit the deduction to the member to its share of the partnership dividend as determined by the partnership agreement.

Analysis Of Proposed Subsections 93.1(1) And (2)

Determining the Amount of Dividend Received by Members

The calculation in proposed paragraph 93.1(2)(a) implies that the percentage of income allocated to a particular member is equal to that member’s percentage interest in the value of the entire partnership. This may not always be the case. Partnership agreements often provide for allocations of partnership income that are not necessarily uniform. This practice is particularly common in the real estate industry where, for example, partners may not all wish to experience the same level of commercial risk with respect to the partnership business. Some partners may have a preferential entitlement to current partnership income; others may be particularly interested in long-term growth. It is problematic in these circumstances to base the allocation of dividends from an affiliate on the relative fair market value of partnership interests, and such an allocation could produce anomalous results.

For example, suppose that Canco1 and Canco2 are partners in a partnership, P. P owns, among other commercial interests, all of the share capital of a foreign affiliate, FA. The partnership agreement allocates to Canco2 all of the dividends received on the shares of FA by P. Assume that the partnership interests are of equal value.

If P receives a dividend of $1,000 from FA, pursuant to subsection 96(1), Canco2 will be allocated $1,000 as a dividend from FA. Proposed paragraph 93.1(2)(a), however, will deem Canco2 to have received only $500 from FA. Consequently, even though the surplus of FA will be reduced by $1,000, Canco2 will be able to recognize only $500 as a dividend from FA’s surplus for purposes of computing a deduction under section 113. The balance of the dividend allocated to Canco2 will be fully taxable.

It is submitted that the result illustrated above is not appropriate. Furthermore, because of the limitation contained in proposed paragraph 93.1(2)(d), there will be a loss of surplus whenever the amount allocated pursuant to subsection 96(1) differs from the amount computed under proposed paragraph 93.1(2)(a). To illustrate, assume in the previous example that the partnership agreement between Canco1 and Canco2 instead requires partnership income to be allocated on a 60/40 basis. Canco1 will be allocated $600 of the $1,000 affiliate dividend and Canco2 the balance. Canco2 is limited by proposed paragraph 93.1(2)(d) from deducting more than $400 under section 113, and Canco1 can deduct only $500 owing to the allocation imposed by paragraph 93.1(2)(a). Thus, $100 of surplus is lost to the members and that amount will be taxable in the hands of Canco1.

The approach in proposed paragraph 93.1(2)(a) is also not consistent with other provisions, in particular proposed subsection 93(1.2). This new provision extends the dividend election rules to situations where a partnership disposes of shares in a foreign affiliate. Proposed subsection 93(1.2) links the amount that a partner can designate to the taxable capital gain allocated to it under subsection 96(1). Thus, the ability to use available surplus to reduce a capital gain is indirectly based on the actual allocation formula of the partnership agreement.

Furthermore, the approach adopted is not consistent with public statements by the Department of Finance. At the 1997 Association de planification fiscale et financičre round table, the Department of Finance stated:

For purposes of section 113 of the Act, in cases where a partnership receives a dividend from a foreign corporation, each of the partners would be deemed, under the proposed changes, to have received a proportion of the dividend equal to that proportion of the partnership’s income to which he is entitled.16

If there is a policy concern that artificial partnership allocations may be used to create unintended benefits for partners, recourse is available to the provisions in subsections 103(1) and (1.1).

In summary, the allocation of affiliate dividends in proposed paragraph 93.1(2)(a) should be based on the terms of the partnership agreement and should be consistent with the portion of the affiliate dividend allocated to a member by subsection 96(1). The possible wording could be as follows:

For purposes of sections 93 and 113 and any regulations made under section 93 and 113, each member of the partnership is deemed to have received the proportion of the partnership dividend that is included in its income pursuant to subsection 96(1) or would be included pursuant to subsection 96(1) if that provision were applicable.

Deemed Dividend: Net or Gross?

As discussed above, proposed subparagraph 93.1(2)(d)(i) limits the amount that a corporation resident in Canada may claim under section 113, in respect of a dividend deemed to have been received from a foreign affiliate of a partnership. The amount deductible cannot exceed the amount included in income pursuant to subsection 96(1) in respect of the dividend. In ordinary circumstances, paragraphs 96(1)(f) and (g) provide that the income or loss allocated to each partner is that partner’s share of the net income or loss, after applicable expenses, from any source in a particular place. Consequently, proposed subparagraph 93.1(2)(d) may be interpreted to restrict the deduction available under section 113 to only the net dividend, after expenses, rather than the gross amount.

This result conflicts with the flowthrough nature of a partnership and is inconsistent with the CCRA’s policy in respect of dividends received by a partnership from a taxable Canadian corporation. Paragraph 4 of Interpretation Bulletin IT-138R17 states that a partnership receiving dividends from a taxable Canadian corporation may allocate to each partner that partner’s share of gross dividends received by the partnership and also its share of any applicable expenses. Thus, the subsection 112(1) deduction is available to a corporate partner on its share of the gross dividend received by the partnership. Furthermore, the rule in subsection 112(3.1), in respect of a loss on a share held by a partnership, is directed at gross dividends received by members. This also appears to be the intent of proposed subsections 93(2.1), (2.2), and (2.3) (see the discussion below).

There is no apparent policy reason why a dividend received from a foreign affiliate through a partnership should be treated differently. Otherwise, a taxpayer that invested indirectly in a foreign affiliate through a partnership would be taxed differently than it would have been had it incurred the expenses itself and invested directly in the foreign affiliate. For greater certainty, it would be preferable if proposed paragraph 93.1(2)(d) read as follows:

Where the corporation resident in Canada is a member of the partnership, the amount deductible by it under section 113 in respect of the dividend referred to in paragraph (a) shall not exceed the portion of the amount of that dividend included in its income pursuant to subsection 96(1).

Similar wording should be adopted for proposed subparagraph 93.1(2)(d)(ii).

Effective Date

Proposed section 93.1 is effective for dividends received after November 30, 1999. Proposed subsection 93.1(1) contains no language that otherwise limits its application to particular periods of time. Therefore, it appears that the intention is for proposed subsection 93.1(2) to operate only for dividends paid after November 30, 1999, and for proposed subsection 93.1(1) to apply retrospectively whenever subsection 93.1(2) is operative. If this interpretation is correct, the surplus characterization of dividends paid after November 30, 1999 with respect to any particular member should be determined under part LIX of the Regulations for the period during which the foreign affiliate of the partnership is a foreign affiliate of the member pursuant to proposed subsection 93.1(1).

It is understood that the intention is for the proposed changes to operate as indicated above. However, on the basis of the wording of these provisions, this interpretation is not free from doubt. The application date for certain proposed changes to the regulations is not consistent with this view. For example, the revisions to regulation 5905 (discussed below) are effective after November 30, 1999. There appears to be no mechanism to give effect to reorganizations involving foreign affiliates held through partnerships before that time; consequently, the potential exists for anomalous results if proposed subsection 93.1(1) is intended to apply in the manner set out above.

Furthermore, because the application date of proposed section 93.1 generally, and proposed subsection 93.1(1) in particular, is based on there being a dividend received, the status of a foreign affiliate of a partnership is unclear in situations where no dividend has been received. For example, proposed subsection 93(1.2), intended to extend the dividend election to foreign affiliates held through a partnership, is one example of a provision that may not function appropriately. The preamble to this subsection requires that a foreign affiliate of a partnership be a foreign affiliate of a Canadian resident corporation. For this to be the case, proposed subsection 93.1(1) would need to be operative, but it is not clear if it is in the absence of dividends.

The policy intent would be clearer if proposed section 93.1 were applicable retroactive to 1972, except that subsection 93.1(2) would not apply for dividends received before December 1, 1999.

Proposed Subsection 93(1.2)

The election under subsection 93(1) permits part or all of the proceeds of disposition on the sale of a foreign affiliate by a corporation resident in Canada or by another foreign affiliate to be treated as a dividend received from the foreign affiliate whose shares are being sold. When a foreign affiliate of a corporation resident in Canada disposes of shares of another foreign affiliate that are excluded property, subsection 93(1.1) will apply to deem subsection 93(1) to apply automatically. The mechanics of the election are in regulation 5902. Proposed subsection 93(1.2) provides a similar election in circumstances where the shares of a foreign affiliate being disposed of are held through a partnership.18 Consequential amendments are proposed to regulation 5902 to accommodate an election under proposed subsection 93(1.2).

Proposed subsection 93(1.2) specifies that the election cannot be greater than four-thirds of the taxable capital gain from the disposition of shares of a foreign affiliate of a member that is a corporation resident in Canada or a foreign affiliate of a corporation resident in Canada.19 Proposed subsection 93(1.3) is similar to subsection 93(1.1) and applies where a foreign affiliate is a member of a partnership that disposes of a share of a foreign affiliate that is excluded property.20

Proposed subsection 93(1.2) differs from subsection 93(1) in that the former provision limits the elected amount to the capital gain allocated to the member; under subsection 93(1), the maximum elected amount is proceeds of disposition.21 In certain circumstances, it may be desirable to elect an amount in excess of the amount of the capital gain in order to avoid the loss of surplus. Figure 1 illustrates how holding a foreign affiliate through a partnership could result in a disadvantage as compared to holding the foreign affiliate directly.

If FA1, a foreign affiliate of Canco, sold FA2 to a third party for proceeds of F $1,000, subsection 93(1.1) would deem a subsection 93(1) election to have been made22 to reduce the proceeds of disposition by the lesser of the amount of the capital gain and the net surplus of FA2. In this case, the proceeds would be reduced by F $500. As a result, FA1 would be deemed to have received an exempt surplus dividend of F $500. However, subsection 93(1) allows an election to be made for up to F $1,000. In these circumstances, Canco likely would elect to reduce the proceeds by F $1,000 in order to transfer all of the exempt surplus in FA2 to FA1. However, if FA2 were owned by a partnership of which FA1 was a member and the entire gain on the disposition of FA2 were allocated to FA1 under the partnership agreement, by virtue of proposed subsection 93(1.2), the elected amount would be limited to F $500 and F $500 of surplus would be lost.

Filing Deadlines

The filing deadline for an election to be made under proposed subsection 93(1.2) depends on whether the member of the partnership ("the disposing corporation") is the Canadian corporation or a foreign affiliate. If the disposing corporation is the Canadian corporation, the relevant year is the taxation year of the corporation in which the fiscal period of the partnership in which the disposition was made ends. For example, if the disposition occurred on June 1, 2000, the partnership has a June 30 fiscal year-end, and the corporation has a December 31 year-end, the filing deadline for the proposed subsection 93(1.2) election is six months from December 31, 2000, or June 30, 2001. If the disposing corporation is a foreign affiliate, the relevant year for determining the filing deadline is the taxation year of the corporation that includes the end of the taxation year of the foreign affiliate that, in turn, includes the last day of the fiscal period of the partnership in which the disposition was made. For example, assume that (1) the disposition occurred on June 1, 2000, (2) the partnership has a June 30 year-end, (3) the foreign affiliate has a January 30 year-end, and (4) the Canadian corporation has a December 31 year-end. The filing deadline for the proposed subsection 93(1.2) election would be six months from December 31, 2001, or June 30, 2002.

Proposed Subsection 93(2.1)

Subsection 93(2) provides that any loss from the disposition of a share of a foreign affiliate, by either a Canadian resident corporation or a foreign affiliate, is reduced by the cumulative total of any exempt dividend before the date of disposition. "Exempt dividend" is defined in subsection 93(3) and generally means, in the case of a corporation resident in Canada, any dividend received out of exempt surplus or taxable surplus that was deductible by virtue of paragraph 113(1)(a), (b), or (c). Where the dividend was received by a foreign affiliate, the amount of exempt dividend is any dividend previously received out of exempt or taxable surplus, net of any income or profits tax paid by the foreign affiliate in respect of the dividends received. The definition is being modified to apply for the purposes of proposed subsections 93(2.1) to (2.3).

Similarly, proposed subsection 93(2.1) denies a capital loss on the disposition of a share held by a partnership. The subsection applies whether the member of the partnership is a corporation resident in Canada or a foreign affiliate of a corporation resident in Canada. However, the rule does not apply in respect of a foreign affiliate where the share disposed of would be excluded property if the foreign affiliate partner had held the share directly.23

Specifically, proposed subsection 93(2.1) reduces the amount of allowable capital loss by three-quarters of the exempt dividends received on the share by

  • the particular corporation resident in Canada,
  • a foreign affiliate of the particular corporation,
  • another corporation related to the particular corporation, or
  • a foreign affiliate of a corporation resident in Canada that is related to the particular corporation,

to the extent that those exempt dividends have not already reduced a capital loss or an allowable capital loss under subsection 93(2) and proposed subsections 93(2.1) to (2.3).

Proposed subsection 93(2.2) was added to similarly limit losses where the loss occurs on the disposition of an interest in a partnership that has a direct or indirect interest in shares of a foreign affiliate. Proposed subsection 93(2.3) is similar to proposed subsections 93(2.1) and (2.2) but covers the situation where a partnership disposes of an interest in another partnership that has a direct or indirect interest in shares of a foreign affiliate.

Surplus Entitlement Adjustments

If the surplus entitlement percentage24 of a Canadian corporation in respect of a particular foreign affiliate changes,25 the surplus, deficit, and underlying foreign tax balances of the affiliate and all other affiliates in which the particular affiliate has an equity percentage may need to be adjusted to ensure that the appropriate balances are carried forward. The rules for adjusting these balances are found in regulation 5905. In addition, surplus entitlement percentage is important because a corporation resident in Canada must have a surplus entitlement percentage of at least 90 percent in order to qualify for rollover treatment on certain mergers and liquidations that involve foreign affiliates.26

As a result of the new election under proposed subsection 93(1.2), consequential amendments are proposed to regulations 5905(2)(a), 5905(6)(a), and 5905(8). Moreover, proposed regulation 5905(14) applies where the number of shares of a foreign affiliate of a corporation resident in Canada deemed to be owned by a person under proposed subsection 93.1(1) increases or decreases. Finally, in determining equity percentage, surplus entitlement of a share, and the surplus entitlement percentage for purposes of most sections in regulation 5900, proposed regulation 5905(15) deems each member of the partnership to own that proportion of the number of the shares held by the partnership that the fair market value of the member’s interest in the partnership is of the fair market value of all the members’ interests in the partnership.

Proposed regulations 5905(14) and (15) are intended to apply after November 30, 1999. This suggests that the surplus balances of a foreign affiliate held through a partnership cannot be adjusted to reflect changes in ownership before that date. This rule will lead to unintended results. For example, suppose that partnership P owned 10 percent of foreign affiliate FA during year 1. During subsequent years, P gradually acquired all of the shares of FA. Absent proposed regulations 5905(14) and (15), it appears that regulation 5905(1) would not apply to adjust the surplus of FA, relative to any member, and thus an inappropriate overstatement of surplus would result. It appears that proposed regulations 5905(14) and (15) should apply on the same basis as proposed subsection 93.1(1).

Other Proposals

Synthetic Cost Base Grind Where Pre-Acquisition Dividends Received by Partnership

Proposed subsection 92(4) may apply to adjust the proceeds received by a corporation resident in Canada or by a foreign affiliate of a corporation resident in Canada on the disposition of all or part of its interest in a partnership. This provision will apply if the partnership received a dividend from a foreign corporation that was deductible in whole or in part by the member under paragraph 113(1)(d) as a pre-acquisition dividend or would have been so deducted if the member had been a corporation resident in Canada.

To illustrate the apparent policy reason for this provision, assume that the shares of a foreign affiliate of a corporation resident in Canada are held through a partnership of which the corporation is a member and the affiliate pays a dividend out of its pre-acquisition surplus to the partnership.27 If the dividend is allocated to the member, the member’s cost base of its partnership interest will increase by the amount of the dividend28 and the eventual distribution of the dividend to the member will reduce the cost base of the partnership interest29 by the same amount. In addition, assuming that all other technical amendments are otherwise applicable, the partner will receive a deduction under paragraph 113(1)(d) for the pre-acquisition dividend paid by the foreign affiliate, but the pre-acquisition dividend will have no net effect on the cost base of the partnership interest. In the absence of this provision, taxpayers may be able to strip out unrealized gains within foreign affiliates. If the partnership interest were sold thereafter, the cost base of the partnership interest would not be reduced by the pre-acquisition dividend received by the member.

Therefore, proposed subsection 92(4) is necessary to increase the member’s proceeds of disposition by the amount that was deducted under paragraph 113(1)(d) (net of foreign withholding taxes). The amount added to the member’s proceeds does not include amounts previously added under proposed subsection 92(4) or amounts that were previously deemed to be a gain under proposed subsection 92(5) (see below). If only a portion of the member’s interest in the partnership is disposed of, the deemed proceeds under proposed subsection 92(4) are reduced in the same proportion.

Similarly, if the partnership disposes of the share of the foreign affiliate, proposed subsections 92(5) and (6) deem the member to have a gain equal to the amount of pre-acquisition dividends previously deducted by the member, net of foreign withholding taxes. This amount is also reduced by any amount added by virtue of proposed subsection 92(4) to a member’s proceeds on the disposition of a partnership interest.

Flowthrough of FAPI Adjustments to the Cost Base of a Foreign Affiliate

Proposed subsection 91(7) applies where a foreign affiliate is acquired by a Canadian resident corporation from a partnership of which the Canadian resident corporation or a non-arm’s-length corporation was a member. If during the time the partnership held the foreign affiliate, the partnership reported FAPI in respect of the foreign affiliate, there would be a corresponding increase in the cost base of the shares of the foreign affiliate held by the partnership by virtue of paragraph 92(1)(a). Similarly, there would be a reduction in the cost base of the shares held by the partnership by virtue of paragraph 92(1)(b).30 Under proposed subsection 91(7), any amount that has been added or deducted under subsection 92(1) in computing the cost base of the shares held by the partnership is deemed to have been added or deducted in respect of the Canadian corporation that acquires the shares of the foreign affiliate. This deeming rule is necessary to allow the corporation to receive a deduction under subsection 91(5) in respect of dividends from taxable surplus that have previously been included in income as FAPI.

Similar to existing subsection 91(6), subsection 91(7) does not allow for flowthrough of subsection 92(1) cost base adjustments if the shares of the foreign affiliate are acquired by another foreign affiliate of the Canadian resident corporation. This restriction could result in taxable surplus being subject to Canadian tax in the future.

The effect of some of the above changes in respect of foreign corporations held through a partnership is illustrated in the following example.

Example

Facts

  • Canco1 owns 100 percent of a foreign corporation, FA1. FA1 is a controlled foreign affiliate31 of Canco1.
  • Canco2 and FA1 each have a 50 percent interest in a partnership, P.
  • Canco1 and Canco2 are unrelated.
  • P owns 100 percent of another foreign corporation, FA2. FA2 is a controlled foreign affiliate of P.
  • FA2 earns FAPI of $1,000 in year 1, on which it pays foreign tax of $200. FA2 has no other income.
  • FA2 pays a dividend of $800 in year 2.
  • All of Canco1, Canco2, FA1, FA2, and P have a December 31 taxation or fiscal year-end.

Results for P

  • Pursuant to subsection 96(1), for purposes of computing a member’s income for a taxation year or the taxable income earned in Canada for a taxation year, P is considered to be a separate person resident in Canada with a December taxation year-end. P is also considered to be carrying on each partnership activity, including the ownership of property, as a separate person.
  • In computing its income for year 1, P will include its share (that is, 100 percent) of FA2’s FAPI of $1,000.32 P is entitled to a deduction of $526,33 for a net inclusion in income of $474.
  • P’s cost base in the shares of FA2 is increased by $474 pursuant to paragraph 92(1)(a).
  • In year 2, P receives an $800 dividend from FA2. For purposes of subsection 91(5), regulation 5900(3) will be amended to deem the dividend to be paid from taxable surplus. Therefore, P claims a deduction of $474 and the remaining income is $326. The cost base of the FA2 shares held by P is reduced by $474 under paragraph 92(1)(b).

Canco2

  • FA2 is a foreign affiliate of Canco2 by virtue of proposed subsection 93.1(1).34
  • By virtue of paragraph 12(1)(l), Canco2 includes in income for year 1 its share (that is, 50 percent) of FA2’s FAPI included in computing P’s income under subsection 96(1) of $1,000 less its share of P’s subsection 91(4) deduction of $526, or $237. The cost base of Canco2’s partnership interest in P is increased by this amount, pursuant to subparagraph 53(1)(e)(i).
  • In year 2, Canco2 includes in income its share of P’s income of $326, or $163. The cost base of Canco2’s partnership interest is increased accordingly. The total cost base increase for years 1 and 2 is $400. Canco2 includes in income its share of the dividend received by P from FA2 under paragraph 12(1)(l) and subsection 96(1).
  • Proposed subsection 93.1(2) deems Canco2 to have received a dividend from FA2 of $400; however, this amount is not included in Canco2’s income because proposed subsection 93.1(1) does not apply for purposes of section 90.35 By virtue of proposed subsection 93.1(1), the dividend will be from taxable surplus, and Canco2 will be entitled to a deduction of $163 under paragraph 113(1)(b).36 Thus, Canco2’s net income for year 2 is nil.
  • If P should remit the dividend proceeds to the partners, Canco2 would reduce its partnership cost base by the $400 received.

FA1

  • If subsection 96(1) is not applicable because FA1 (and not Canco1) is a member of the partnership, FA1 will not have any income inclusion (that is, its share of P’s FAPI) in year 1.

Under this scenario, in year 2, FA1’s share of the dividend paid by FA2 to P will be $400. The dividend should not be FAPI, since the dividend will be deemed to have been paid by another foreign affiliate (see proposed subsection 93.1(1)). The dividend will increase FA1’s taxable surplus and underlying foreign tax balances by $400 and $100, respectively (see proposed subsection 93.1(2)). In the absence of proposed subsections 93.1(1) and (2), FA1’s share of the dividend would be FAPI.

  • If subsection 96(1) applies, FA1 would have an income pickup of $237 in year 1, which should be considered FAPI of FA1.

In year 2, FA1 would be allocated its share of P’s income of $163 (similar to Canco2), but this amount should not be FAPI.37 Proposed paragraph 93.1(2)(a) should deem FA1 to have received its share of the gross dividend of $400. Therefore, the taxable surplus and underlying foreign tax balances of FA1 are updated accordingly.

  • If P were to distribute the dividend proceeds to the partners, FA1 would reduce its partnership cost base by the $400 received.38
  • When FA1 pays a dividend to Canco1, it will reduce its taxable surplus and underlying foreign tax balances accordingly.

Canco1

  • If subsection 96(1) does not apply to FA1, Canco1 will not have any income until it receives a dividend from FA1. The dividend of $400 will be from taxable surplus and will be included in income under section 90. Canco1 will be entitled to a deduction of $163 under paragraph 113(1)(b), leaving Canco1 with net income of $237.
  • If subsection 96(1) did apply, Canco1 would report FA1’s FAPI of $237 pursuant to subsection 91(1) in year 1. The cost base of the shares of FA1 would be increased by the same amount under paragraph 92(1)(a). When FA1 pays a dividend of $400 to Canco1, Canco1 would claim a deduction of $237 under subsection 91(5) and a deduction of $163 under paragraph 113(1)(b), and hence would not report any additional income.

The above conclusions are summarized in figure 2 for the case in which subsection 96(1) applies to FA1. Although the application of subsection 96(1) to FA1 is unclear, the wording of proposed subparagraph 93.1(2)(d)(ii) and paragraph 93(1.2)(b) suggests that the Department of Finance considers subsection 96(1) to apply.

Other Proposed Changes To The Fapi And Foreign Affiliate Rules

Addition of New Subsections 85.1(5) and (6)

These proposed provisions would extend the share-for-share exchange rollover provisions in section 85.1 to share-for-share exchanges involving foreign corporations. These proposals were promised by the minister of finance in a news release issued in April 1999.39 Similar to section 85.1, proposed subsection 85.1(5) will deem the vendor to have transferred its existing shares at cost. This amount will also be the cost of new shares received. Proposed subsection 85.1(6) parallels the provisions found in subsection 85.1(2). These new provisions will apply to exchanges occurring after 1995. Taxpayers may request a reassessment of their 1996, 1997, and 1998 taxation years by writing to the relevant CCRA tax centre.

This provision will be a relief for Canadian taxpayers (particularly individuals) who hold an interest in foreign corporations. However, some care will need to be taken if a taxpayer ("vendor") transfers shares of a foreign corporation ("FC1") that is a foreign affiliate of the vendor for shares of another foreign corporation ("FC2") that is not a foreign affiliate of the vendor after the transfer. In these circumstances, the surplus balances, if any, of FC1 computed in respect of the vendor will be lost.

Surplus might be preserved, however, if the proposed provision allowed the vendor to transfer the shares of FC1 at an amount that was greater than the adjusted cost base of the shares but less than the fair market value of the shares. This could be accomplished by replacing the term "adjusted cost base" in proposed paragraph 85.1(5)(a) with the term "relevant cost base." The meaning of relevant cost base, currently in subsection 95(4)40 and applicable only for purposes of section 95, would have to be extended to apply to subsections 85.1(5) and (6). This would enable a vendor to trigger a gain on the transfer of the shares of FC1 so that a subsection 93(1) election could be filed to use the surplus, if any, of FC1 in respect of the vendor.

Changes to Paragraphs 95(2)(g) and (h)

The proposed change to paragraph 95(2)(g) is intended to expand the relief from FAPI where foreign currency gains or losses are realized on the settlement of debts owing between foreign affiliates or between a foreign affiliate and a non-arm’s-length non-resident corporation. As proposed, paragraph 95(2)(g) will now exclude from FAPI such foreign currency gains or losses whether they are incurred on income or capital account. Moreover, existing paragraph 95(2)(h) will be incorporated into paragraph 95(2)(g) and will apply when the foreign affiliate redeems, cancels, or acquires its own shares.41

Paragraph 95(2)(g), however, will now apply only to a debt obligation other than a specified debt obligation42 and to a share of the capital stock of a foreign affiliate other than a mark-to-market property.43 It is not clear from the technical notes why the exclusion for a specified debt obligation or a mark-to-market property is necessary for purposes of paragraph 95(2)(g). Nor is it clear if these exclusions are intended to apply only to a foreign affiliate that is either a financial institution or a foreign affiliate of a financial institution.

The terms "specified debt obligation" and "mark-to-market property" are broadly defined in section 142.2. For example, it appears that almost any type of debt obligation would be a specified debt obligation unless paragraph (c) or (d) of the definition applied. In many situations, paragraph (c) would not apply since the exclusions refer to, for example, an income bond and an income debenture. Paragraph (d) refers to an interest in an instrument, which may not always exist as evidence of a debt obligation between foreign affiliates. Moreover, the exclusion in paragraph (d) is dependent on the issuer of the debt being related or not dealing at arm’s length with the lender, or the lender having a significant interest in the issuer. This exclusion may not apply, for example, where a foreign affiliate that is a controlled foreign affiliate and a qualified foreign corporation44 lends funds to another qualified foreign corporation when the lender is not related to, or does not hold a significant interest in, the borrower.45 From a tax policy perspective, there does not appear to be any reason why this would be an appropriate result.

It would have been desirable if the changes to paragraph 95(2)(g) had ensured that FAPI could not arise in circumstances where a foreign currency gain or loss occurs on the transfer of a debt to another foreign corporation. As proposed, paragraph 95(2)(g) will still apply only on the settlement of a debt.

Finally, foreign affiliates will often try to mitigate foreign exchange exposures by entering into hedging transactions. The proposed changes to paragraph 95(2)(g) do not deal with hedging transactions. The income tax treatment of hedging gains and losses in foreign affiliates can produce asymmetrical results.46

Foreign Accrual Property Losses

At present, FAPI of a foreign affiliate in a particular year is reduced by certain losses, defined in regulation 5903, incurred in the year or in the five preceding taxation years. The proposed amendments to regulation 5903 and the description of f in the definition of FAPI in subsection 95(1) provide that FAPI will be reduced for losses (that is, foreign accrual property losses or "FAPLs") incurred in the three taxation years following and the seven taxation years preceding the year.47 The carryover of FAPLs will therefore mirror the carryover of non-capital losses for domestic tax purposes.

The effective date for the proposed change to description F in the definition of FAPI in subsection 95(1) is the taxation year of a foreign affiliate that begins after November 30, 1999. However, the effective date for proposed regulation 5903 (except for proposed regulation 5903(2)(b)) is the taxation year of a foreign affiliate that begins after 1998. Proposed regulation 5903(2)(b) applies to foreign affiliate taxation years that begin after 2000. Why changes to these related provisions have different effective dates is not clear.

Regulation 5907(1.3) provides that an amount paid by a particular foreign corporation to another corporation in respect of the use of a loss of the other corporation in the computation of a group’s foreign tax liability will be considered foreign accrual tax.48 Proposed regulation 5907(1.4) ensures that the amount paid will be foreign accrual tax to the extent that the amount paid is in respect of a FAPL. This new provision eliminates an opportunity for taxpayers to shelter FAPI of a foreign affiliate with active business losses of another foreign affiliate where both are members of the same tax group for foreign tax purposes. Proposed regulation 5907(1.4) applies to taxation years that begin after November 30, 1999.

Conclusion

The proposals announced on November 30 include a mixture of changes that in certain circumstances will tighten the FAPI and foreign affiliate rules and in other circumstances will provide some relief to taxpayers.

In particular, the proposed amendments to deal with foreign corporations held through a partnership in which a corporation resident in Canada or a foreign affiliate of a corporation resident in Canada is a member are welcome changes. Partnerships are used for a number of commercial ventures, and the absence of these rules, combined with the CCRA’s position noted earlier, was a large gap in the Canadian FAPI and foreign affiliate regime.

Nevertheless, the proposed partnership provisions are complicated, and no doubt this article has not identified all the anomalies that could arise. Some of the concerns and observations raised in this article have been communicated to the Department of Finance, and it is hoped that some, if not all, suggestions will be accepted. In the meantime, taxpayers and advisers need to exercise care in applying these new provisions.

Footnotes:

* This article originally appeared in Canadian Tax Foundation's Canadian Tax Journal publication.

1 Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as "the Act"). Unless otherwise stated, statutory references in this article are to the Act.

2 "Proposed" refers throughout the article to sections contained in Canada, Department of Finance, Legislative Proposals and Explanatory Notes Related to Income Tax (Ottawa: the department, November 1999), issued with Canada, Department of Finance, Release, no. 99-102, November 30, 1999.

3 See J. Douglas Bradley, "Foreign Affiliates: A Technical Update," in Report of Proceedings of the Forty-Second Tax Conference, 1990 Conference Report (Toronto: Canadian Tax Foundation, 1991), 43:1-26, for an analysis of the problems of holding foreign corporations through a partnership. Some of the recommendations suggested by Bradley are included in the proposals announced by the Department of Finance.

4 See, for example, CCRA document nos. 9821495, December 15, 1998, and 9722165, August 28, 1998; and "Revenue Canada Round Table," in Report of Proceedings of the Fortieth Tax Conference, 1988 Conference Report (Toronto: Canadian Tax Foundation, 1989), 53:1-188, question 11, at 53:36-37.

5 "Foreign affiliate" is defined in subsection 95(1) of the Act.

6 Defined in subsection 95(4).

7 Defined ibid.

8 It is beyond the scope of this article to review the principles of partnership law and the taxation of partnerships in detail. For such a discussion, see, for example, Peter McQuillan and James Thomas, Understanding the Taxation of Partnerships, 4th ed. (North York, Ont.: CCH Canadian, 1999); Douglas S. Ewens, "Tax Issues Affecting Partnerships," in Report of Proceedings of the Forty-Ninth Tax Conference, 1997 Conference Report (Toronto: Canadian Tax Foundation, 1998), 8:1–85; and David J. Thompson, "The Partnership as a Separate Person: Opportunities and Pitfalls," in Corporate Tax Planning in a Changing Business Environment, 1994 Corporate Management Tax Conference (Toronto: Canadian Tax Foundation, 1994), 5:1-21.

9 See, for example, the discussion in Ewens, supra footnote 8, at 8:26, on ownership of partnership property.

10 The CCRA’s position seems to accept this proposition. See, for example, CCRA document no. 9235140, November 26, 1992; document no. rrrr154 in TaxPartner (Scarborough, Ont.: Carswell) (CD-ROM database); and "Revenue Canada Round Table," supra footnote 4.

11 For example, see Thompson, supra footnote 8, at 5:11-12.

12 See Ewens, supra footnote 8, at 8:14; and Bradley, supra footnote 3, at 43:18.

13 It is generally accepted that FAPI of a foreign affiliate should be computed in accordance with Canadian tax principles. Accordingly, it follows that for purposes of computing FAPI of a foreign affiliate that is a member of a partnership, subsection 96(1) would be applicable. Hence, a foreign corporation that is a foreign affiliate of the partnership would not be a foreign affiliate of the member, and the member’s share of dividends paid to the partnership would be FAPI.

14 It appears that, notwithstanding the position of the CCRA, the rollover provisions found in subsection 85.1(3) and in paragraphs 95(2)(c), (d), and (e) would apply where a foreign corporation is a foreign affiliate of a partnership. These provisions require that the foreign corporation be a foreign affiliate of a "taxpayer." It is submitted that for these purposes, while a partnership is not generally a "taxpayer," the term may apply to a partnership where the term is relevant in computing income. This is because a partnership’s income is calculated as if the partnership were a "person." "Taxpayer" is defined in section 248 to mean "any person whether or not liable to pay tax" (see Thompson, supra footnote 8, at 5:5).

15 See proposed subparagraph 93.1(2)(d)(i). Subparagraph 93.1(2)(d)(ii) applies a similar approach to dividends allocated to a member of a partnership that is a foreign affiliate of a corporation resident in Canada.

16 CCRA document no. 9M19020, October 10, 1997.

17 Interpretation Bulletin IT-138R, "Computation and Flow-Through of Partnership Income," January 29, 1979.

18 Paragraph 93(1.2)(d) deems, for the purposes of section 113, the disposing corporation to have owned the share on which the deemed dividend was received.

19 The ratio 4:3 is presumably based on the presumption that taxable capital gains are 75 percent of capital gains. In the February 2000 federal budget, the minister of finance proposed that taxable capital gains will be reduced to 662/3 percent of capital gains for dispositions occurring after February 27, 2000. Presumably, the ratio in proposed paragraph 93(1.2)(a) will have to be changed accordingly.

20 Regulation 5902(6) determines the elected amount where subsection 93(1.1) applies. Amendments to regulation 5902(6) make the regulation applicable for purposes of proposed subsection 93(1.3) in similar circumstances.

21 However, an election under subsection 93(1.1) is limited to the lesser of the amount of the capital gain and the net surplus of the affiliate being disposed of (see regulation 5902(6)).

22 Assuming that the shares of FA2 were excluded property.

23 It is proposed that this exception be added to existing subsection 93(2). Presumably, by not denying a capital loss in circumstances where the shares disposed of are excluded property, the Department of Finance is attempting to eliminate circumstances where surplus balances could potentially be duplicated. However, a loss arising on the sale of shares of a foreign affiliate that are excluded property might be denied by virtue of one of the stop-loss provisions found in section 40 of the Act.

24 Defined in subsection 95(1) and regulation 5905(13).

25 For example, because of an increase in the amount of the shares owned, directly or indirectly, in a foreign affiliate or because of the redemption of shares of a foreign affiliate held directly or indirectly by a corporation resident in Canada.

26 See paragraphs 95(2)(d.1) and (e.1).

27 Although the foreign corporation may also be a foreign affiliate of the partnership, the dividend will not reduce the cost base of the shares held by the partnership because subsection 92(2) applies only to a corporation resident in Canada or a foreign affiliate of a corporation resident in Canada.

28 See subparagraph 53(1)(e)(i).

29 See subparagraph 53(2)(c)(v).

30 A deduction is available under paragraph 92(1)(b), by virtue of subsection 91(5), for dividends received by the partnership from taxable surplus. For this purpose, regulation 5900(3) is being amended to clarify that all dividends received by a partnership from a foreign affiliate of the partnership are deemed to be from taxable surplus.

31 "Controlled foreign affiliate" is defined in subsection 95(1).

32 See subsection 91(1).

33 Pursuant to subsection 91(4), the deduction is calculated as the amount of the foreign tax paid by FA2 on the FAPI of $200 multiplied by the "relevant tax factor" (defined in subsection 95(1) as being 2.63).

34 Even if Canco2’s interest in P were 60 percent, it appears that Canco2 would not be required to report any of FA2’s FAPI under subsection 91(1). It also appears that FA2 would not be a controlled foreign affiliate of Canco2, for the purposes of subsection 91(1), because proposed subsection 93.1(1) is not relevant for that provision. Subsection 93.1(1) is relevant only for the purposes of "subsection (2), sections 93 and 113 (and any regulation made under those sections) and section 95 to the extent that section is applied for the purposes of those provisions [emphasis added]." Accordingly, proposed subsection 93.1(1) cannot be extended to result in the inclusion of income under subsection 91(1). In any event, this would be double-counting FA2’s FAPI.

35 Ibid.

36 The deduction under paragraph 113(1)(b) would be based on the underlying foreign tax applicable to Canco2’s share of the dividend (that is, $100) multiplied by the relevant tax factor minus 1 (that is, 1.63).

37 Aside from the fact that to include this amount in FAPI would result in double-counting, since FAPI was reported in year 1, technically, to the extent that this amount is included in FAPI by virtue of clause A in the FAPI definition in subsection 95(1), it should be deducted by virtue of new clause H in the definition.

38 FA1’s cost base of its partnership interest in P is determined in accordance with paragraph 95(2)(j) and regulation 5907(12).

39 Canada, Department of Finance, Release, no. 99-035, April 15, 1999.

40 "Relevant cost base" of a property is defined to mean the adjusted cost base or such greater amount, not exceeding fair market value, that a taxpayer may claim.

41 The exclusion from FAPI of foreign exchange gains arising on the redemption by a foreign affiliate of its own shares is presumably in response to the MacMillan Bloedel case (The Queen v. MacMillan Bloedel Limited, 99 DTC 5454 (FCA)), where a Canadian corporation successfully argued that a capital loss arose on the redemption of a class of its shares that were denominated in US dollars.

42 Defined in subsection 142.2(1).

43 Defined ibid.

44 Defined in the proposed changes to paragraph 95(1)(g).

45 Furthermore, owing to what appears to be a technical anomaly, it is not clear if the "significant interest" exception (defined in subsections 142.2(2) and (3)) is available for specified debt obligations. Although the term "significant interest" appears in the definition of specified debt obligation, it is defined only for purposes of the mark-to-market property definition.

46 See, for example, CCRA document no. 9729790, November 21, 1997.

47 Proposed subsection 152(6.1) gives the minister the authority to issue a reassessment, as would be necessary in these circumstances.

48 Defined in subsection 95(1).

The information provided herein is for general guidance on matters of interest only. The application and impact of laws, regulations and administrative practices can vary widely, based on the specific facts involved. In addition, laws, regulations and administrative practices are continually being revised. Accordingly, this information is not intended to constitute legal, accounting, tax, investment or other professional advice or service.

While every effort has been made to ensure the information provided herein is accurate and timely, no decision should be made or action taken on the basis of this information without first consulting a PricewaterhouseCoopers LLP professional.

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