Global Tax Alert | 17 July 2013
Canada issues draft technical amendments on foreign affiliates and other measures
On 12 July 2013, Canada's Department of Finance released draft legislation containing a range of proposed amendments to the federal Income Tax Act (the Act) and Income Tax Regulations (the Regulations) applicable mainly in relation to investments in foreign affiliates.
Many of the proposals are in response to issues taxpayers and their representatives have brought to the department's attention. Interested parties are invited to provide comments on the draft legislation by 13 September 2013.
Various effective dates would be applicable, depending on the particular measure.
This Tax Alert describes only a selection of more significant elements in these proposals.
Many of the measures announced are intended to implement comfort letters that remain outstanding, or are otherwise intended to be relieving or clarifying in various respects. However, this package also includes certain measures that are intended to tighten up the system.
Foreign accrual property income
Foreign accrual property income (FAPI) is attributed annually based essentially on a relevant shareholder's “participating percentage” in respect of a controlled foreign affiliate (CFA) at the end of the CFA's taxation year. The determination of FAPI is based on the application of general income characterization principles, as well as a number of specific recharacterization rules, some of which can recharacterize what would otherwise be “income from property” into “income from an active business” (i.e., the rules in paragraph 95(2)(a)), and others that can recharacterize what would otherwise be “income from an active business” into “income from a business other than an active business” (i.e., the “base erosion” rules in paragraphs 95(2)(a.1) to (b)).
A number of significant changes would be made to many of these rules:
- • Under current rules, no FAPI would be attributed to a shareholder if it disposes of its interest in the CFA before the end of the CFA's taxation year. Moreover, the FAPI of a CFA generally does not include items that arose before it became a foreign affiliate of the relevant taxpayer (given paragraph 95(2)(f.1)). Thus, if one taxpayer disposes of its interest in a CFA to another taxpayer before the CFA's year end, there is somewhat of a gap, in that FAPI that has already arisen would not be attributed to either taxpayer. To close this gap, it is proposed that a CFA's taxation year would be deemed to have ended if a relevant taxpayer's “surplus entitlement percentage” in respect of the affiliate decreases, subject to certain exceptions.
- • The rules in clause 95(2)(a)(ii)(D) can apply to recharacterize what would otherwise be “income from property” into “income from an active business” where a borrower foreign affiliate pays interest that relates to an investment in the shares of another foreign affiliate. Under current rules, both affiliates must be resident and subject to income taxation in the same country. It is proposed that this “same country requirement” be eliminated, such that the rules would accommodate a broader range of cross-border acquisition financing transactions.
- • The active business income recharacterization rules in subparagraph 95(2)(a)(i) would also be expanded somewhat to cover income from activities that are directly related to an active business carried on by the particular affiliate, as opposed to by another relevant foreign affiliate as under the current rules. Depending on the circumstances, such income may already be covered by the definition of “income from an active business,” which includes certain income from property that pertains to or is incidental to the affiliate's active business.
- • A number of changes would be made to the “base erosion” rules, but these would be mainly of a very technical nature (including to address concerns under current rules in relation to inter-affiliate services). One change with more substantive implications would be the introduction of new subsection 95(3.2), which would permit a foreign affiliate to sell to a relevant Canadian taxpayer goods that are produced by another foreign affiliate (rather than by the selling affiliate), in a country other than where the selling affiliate is based, under specified contract manufacturing arrangements.
Partnerships and hybrids
- • Section 93.1 and related provisions were introduced a number of years ago in order to address the interaction of the foreign affiliate rules with partnerships. These rules would be revised in various respects, including to clarify the treatment of dividends flowing through tiered partnerships, as well as to better accommodate structures that involve certain cross-chain financial arrangements.
- • The active business income recharacterization rules in subparagraph 95(2)(a)(i), as well as those in clause 95(2)(a)(ii)(D), would also be revised to accommodate arrangements and structures that include partnerships.
- • Subsection 91(4) of the Act provides for deductions that may be taken to offset FAPI inclusions where a relevant foreign affiliate has paid or is deemed to have paid “foreign accrual tax” (FAT). In some cases, however, a FAPI-earning foreign affiliate may be a fiscally transparent entity (FTE) under relevant foreign tax laws, such that it would be its shareholder(s) rather than the FTE that would have to pay any applicable foreign tax. A number of changes would be made to the relevant definitions and Regulations, and new supporting rules would be introduced, in order to ensure that FAT can arise in such circumstances.
- • A new characterization rule (section 93.2) would also be introduced for certain Australian trusts, deeming them to be nonresident corporations for various purposes. It should be emphasized that this rule would be limited to certain Australian trusts, at least for the time being.
- • In addition, a new characterization rule (section 93.3) would be introduced to deem “equity interests” in corporations that do not have traditional share capital to be “capital stock” for various purposes. This rule would ensure that such corporations can be regarded as foreign affiliates — and as controlled foreign affiliates — given that the definition of “equity percentage” requires the ownership of capital stock. For certain types of corporations, the effect of this measure may be merely to clarify the application of the Act, but for other corporations the effect may be to give rise to FAPI attribution that was previously inapplicable.
A number of changes would be introduced to the various rules in the Act that apply to corporations engaged in international shipping. The two main features of these rules are subsection 250(6), which deems a qualifying corporation to be resident where it is incorporated, even if managed in Canada, and the new definition of “international shipping,” which is relevant for purposes of paragraph 81(1)(c) and subsection 250(6). The various proposed changes to this regime are generally intended to make it more flexible and to better reflect the structures of modern shipping organizations.
In particular, the changes would achieve the following objectives:
- • Provide for the use of trusts and partnerships, both as holding entities and as operating entities in a shipping group
- • Lower the ownership threshold that is required for certain purposes to 25% in order to accommodate a broader range of shipping group structures
- • Allow “back office” services to be provided by an entity in a shipping group to another entity that is part of the group
- • Broaden the activities that would be considered part of international shipping by making it clear that ships operated under a pooling arrangement would qualify, as well as activities such as accounting and marketing that are incidental to or pertaining to the operation of such ships
On the other hand, the definition of “international shipping” will also specifically exclude various activities that are not generally associated with traditional forms of shipping and the operation of ships, such as offshore storing or processing of goods, fishing, laying cable, salvaging, towing, tug-boating, offshore oil and gas activities (including exploration and drilling activities), dredging and bareboat chartering, other than a bareboat charter to a group entity.
Other foreign affiliate measures
The proposals also include certain additional measures relating directly or indirectly to foreign affiliates, including the following:
- • A number of refinements would be made to the income imputation rules in section 17, which are mainly clarifying or relieving.
- • New subsection 87(8.3) would block the rollover otherwise applicable under subsection 87(4) in relation to a “triangular” foreign merger in circumstances that parallel those in which subsection 85.1(4) currently blocks a rollover under the share-for-share exchange rule in subsection 85.1(3).
- • Certain refinements would be made to Regulation 5907(1.1) in order to accommodate surplus computations in the increasingly prevalent context of cross-border consolidated groups of foreign affiliates, and so-called “multiple entry” consolidation.
A few more measures should be noted:
- • The application of the rules in the Act in relation to partnerships is an area that seems to keep getting refined. In addition to the measures referred to above, the proposals would introduce rules to ensure that determinations of “taxable Canadian property” that involve ownership thresholds are to be made at the partnership level, rather than the partner level.
- • The “functional currency” rules would also be revised in various respects — but mainly to make them more accessible to taxpayers having short taxation years.
- • Finally, section 241 of the Act, which governs the sharing of confidential taxpayer information, would be revised by adding a new subsection (9.5), intended to permit a government official (i.e., a Canada Revenue Agency officer) to provide taxpayer information to a law enforcement officer of a domestic or foreign police organization when the official has reasonable grounds to believe that the information will afford evidence of a listed offence, including offences relating to the corruption of a foreign official, terrorism, criminal organizations and various other serious offences.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP (Canada), Toronto
- • Derek Alty
+1 416 943 3860
- • Yi-Wen Hsu
+1 416 943 5310
- • Mark Kaplan
+1 416 943 3507
- • Heather Kerr
+1 416 943 3162
- • Terry McDowell
+1 416 943 3600
- • Trevor O'Brien
+1 416 943 5435
- • Linda Tang
+1 416 943 3421
- • Andy Tse
+1 416 943 3024
Ernst & Young LLP (Canada), Montreal
- • Albert Anelli
+1 514 874 4403
- • Angelo Nikolakakis
+1 514 879 2862
- • Nicolas Legault
+1 514 874 4404
- • Nik Diksic
+1 514 879 6537
Ernst & Young LLP (Canada), Calgary
- • Karen Nixon
+1 403 206 5326
- • Mark Coleman
+1 403 206 5147
Ernst & Young LLP (Canada), Vancouver
- • Eric Bretsen
+1 604 899 3578
Ernst & Young LLP, Canadian Tax Desk, New York
- • Andrea Lepitzki
+1 212 773 5415
EYG no. CM3650