Revised Canadian proposals affecting foreign affiliates.
The Canadian Department of Finance released a revised package of technical amendments on February 27, 2004. The package is a revised version of the draft legislation originally released on December 20, 2002, and reflects consultations and discussions with taxpayers, as well as with professionals groups such as Tax Executives Institute and the Joint Committee on Taxation of the Canadian Bar Association and the Canadian Institute of Chartered Accountants.
The draft legislation addresses a number of technical problems with the Income Tax Act that have accumulated during the last several years. Many of the proposed amendments to the foreign affiliate rules address problems with the legislation that was introduced in 1995, when the rules were last significantly amended. Many of the amendments implement changes of a relieving nature that were "promised" to tax payers or their representatives in a series of so-called comfort letters.
Significantly, however, the December 2002 draft legislation also contained proposals that were not expected, and threatened to adversely affect reorganizations of foreign affiliates occurring after that date. The February 2004 version of those particular proposals is much less negative, and thus is welcome. At the same time, the Department of Finance took the opportunity to revise almost every reorganization provision and to introduce several new rules, many of which are extremely complex and could have unforeseen consequences.
This article addresses the most significant provisions of the February 2004 draft legislation.
The Global Section 95 Election
If a taxpayer wishes to apply certain relieving changes retroactively to a taxation year commencing after 1994, an election may be available to do so. If the changes are part of the global section 95 election or "global election", however, then under the December 2002 draft legislation, making that election may cause other proposals to apply retroactively, which could have negative consequences for some taxpayers. The global election entails the retroactive application of a large number of the foreign affiliate amendments contained in the technical bill, many of which deal with completely unrelated issues. This aspect of the technical bill has been subject to much criticism.
In the February 2004 draft legislation, Finance responded to this criticism by "unbundling" some of the provisions from the global election and creating separate elections to apply those provisions retroactively.
The decision whether to make the election (or the unbundled elections) will still involve significant analysis. The election is required to be filed by the due date for the taxpayer's return that includes the date when the legislation receives Royal Assent. If a taxpayer chooses unwisely, the 2004 draft legislation provides a three-year window for the taxpayer to revoke the election retroactively.
Reorganizations and Other Transactions
Some of the 2002 proposed amendments to the foreign affiliate rules were unexpected and could have had a significant effect on common transactions. The following is a summary of those proposals and the other significant proposals affecting reorganizations.
1. Transfers of Foreign Affiliates Within an Arm's-Length Group. The first proposed change related to certain transfers of shares of a foreign affiliate to other foreign affiliates or certain non-arm's-length persons. In many cases, the proposal (in proposed subsection 93(1.4) of the Act) would have deemed the shares transferred to be outside the definition of"excluded property." Consequently, any gain realized by an affiliate on the disposition of the shares (in excess of the amount eligible for a section 93 deemed dividend election) would create foreign accrual property income (FAPI), which is taxed immediately in the hands of the Canadian shareholder if the affiliate is a controlled foreign affiliate. In addition, draft regulations released in 2002 would have restricted the amount of surplus eligible for the section 93 deemed dividend in these circumstances. Draft regulation 5902(7) would have prevented the taxpayer from accessing the surplus balances of lower-tier affiliates owned by the affiliate that was the subject of the disposition.
According to the explanatory notes, the proposals were intended to prevent taxpayers from utilizing internal reorganizations to create additional surplus or an increase in the tax basis of shares in circumstances in which the shares transferred would continue to be part of the group and thus continue to have surplus balances in respect of the taxpayer or a non-arm's-length party. Unfortunately, however, the proposals had more severe consequences than required to achieve those objectives.
There are many circumstances unrelated to Canadian taxation where it is necessary or advisable to transfer the ownership of foreign affiliates within a related group. After December 20, 2002, many taxpayers were forced to put such internal reorganizations on hold pending a determination of the effect of the new rules and a reconsideration of the draft legislation by the Department of Finance. Others were forced to proceed with transactions with very little information concerning the likely tax consequences.
The February 2004 proposals provide that such transactions will not create FAPI unless the taxpayer so elects, which may be prudent if the transaction is taxable in the local jurisdiction and foreign taxes will offset the FAPI inclusion. Instead, the Department introduced complex surplus suspension rules in proposed new paragraphs 95(2)(c.1)--(c.6). Any gain on the sale of shares that are excluded property to a "specified purchaser" will be suspended until such time as the shares are disposed of by the specified purchaser or the purchaser ceases to meet the definition of specified purchaser. The suspended gain is the amount by which the fair market value of the shares exceeds their tax basis and the amount of surplus that is eligible for a section 93 election.
The definition of specified purchaser has been expanded in the 2004 proposals. It generally includes other foreign affiliates, any person who does not deal at arm's length with the taxpayer, and certain trusts and partnerships.
There are extremely complex rules designed to limit the circumstances in which the gain may become "unsuspended." For those taxpayers who sell part of a foreign affiliate with the intention of retaining some interest in the purchaser or the business, the rules may be so restrictive that the taxpayer may never be able to access the surplus associated with the sale.
The proposed rule to limit the surplus available for a section 93 deemed dividend election has been dropped in the February 2004 proposals. The section 93 deemed dividend rules, however, have been completely revised and require careful analysis.
2. Sales of Other Property. Another startling change in the 2002 draft legislation applied to dispositions of excluded property. The regulations currently contain a rule forestalling the recognition of surplus where capital property used in an active business is transferred to another foreign affiliate and the transfer is eligible for rollover treatment under the local tax law. The 2002 draft legislation would have significantly broadened this rule to extend its application to (1) all dispositions (other than certain rollover transactions), including dispositions to arm's-length purchasers, and (2) all excluded property (including shares of another foreign affiliate and inventory), not only capital property used in carrying on an active business. The proposed rule would not apply if the gain or loss were included in an amount that was taxable under foreign law in computing the affiliate's earnings from an active business carried on by it.
There were numerous issues with the proposed rule, which appeared to prevent surplus recognition in numerous circumstances, including:
* the sale of an affiliate by a holding company to an unrelated purchaser, whether or not subject to tax; and
* the sale of inventory by a US LLC or other disregarded entity in the ordinary course of its business.
In response to criticism, the Department of Finance virtually abandoned these proposals in the February 2004 package. They have been replaced by proposed paragraphs 95(2)(17.3)--(f.9), which parallel the surplus suspension rules described above, and will generally apply to the sale of the assets of a business to other affiliates or non-arm's-length persons, other than such sales occurring in the ordinary course of business.
Income and gains arising from dispositions of excluded property other than foreign affiliate shares to specified purchasers will be suspended (not included in exempt or taxable earnings of an affiliate) until the property is no longer owned by the specified purchaser or the purchaser ceases to meet the definition of specified purchaser. Similar complex rules restrict the ability to "unsuspend" the surplus. If the taxpayer chooses to recognize the income or gain, it will be included in FAPI rather than suspended, which the taxpayer may wish to do if the transaction is taxable in the local jurisdiction and there is sufficient foreign tax to offset the FAPI inclusion.
3. FAPI Loss Suspension. The 2004 legislation includes new FAPI loss suspension rules in paragraphs 95(2)(h)--(h.5) that parallel the surplus suspension rules described above for dispositions of property other than excluded property, depreciable property, or eligible capital property.
4. Section 93 Elections. The 2004 proposals contain extensive changes to section 93 and related regulations. Section 93 provides for an election, which applies automatically in some circumstances, to treat a portion of the proceeds of disposition of a foreign affiliate as a dividend from exempt or taxable surplus rather than as proceeds of disposition.
Complex rules have been introduced to determine the amount of surplus available for a section 93 election by consolidating all of the surplus and deficit accounts of the affiliate that is disposed of and all lower-tier affiliates. Under the current rules, deficits are not relevant to the calculation in a number of circumstances. The regulations governing the recomputation of the surplus accounts of affiliates after a section 93 election is made have also been completely revised and are very complex.
5. Other Reorganization Changes. Numerous other changes are proposed to the reorganization provisions, most of which are of a restrictive nature. The changes are much broader in the 2004 version than the 2002 version. These include:
* numerous changes to specific reorganization provisions to prevent the creation of surplus on mergers, liquidations, share redemptions, dividends-in-kind, returns of capital, and other transactions, unless the taxpayer elects FAPI treatment of the income or gain;
* the introduction of a peculiar anti-avoidance rule in subsection 95(3.8) that may apply to prevent surplus recognition if a taxpayer elects to realize FAPI on certain transactions and the affiliate is not a controlled foreign affiliate, depending on the motivation of the taxpayer for making the election;
* the reduction of surplus pools where a section 87 or 88 "bump" is claimed in respect of shares of a foreign affiliate (and in the 2004 version, the reduction of bump room where the affiliate has previously paid dividends); and
* the requirement to reduce surplus of a parent affiliate on the dissolution of a subsidiary affiliate that has a deficit (the deficit formerly disappeared).
A number of generally relieving changes are also proposed:
* the paragraph 95(2)(d.1) and (e.1) rollovers for certain foreign mergers and liquidations of certain affiliates into other affiliates will be extended to non-capital property;
* paragraph (e.1) will be clarified by deleting the words suggesting that the two affiliates must be resident in the same country (though the Canada Revenue Agency had not interpreted the paragraph as imposing that requirement, the words are ambiguous);
* the definition of "disposition" will be amended retroactively to provide that the cancellation of shares on a foreign merger for no consideration (and similar transactions) will not be considered to be a disposition of the shares; and
* a long overdue change to the calculation of taxable surplus where a foreign affiliate continues into Canada (though there is also a new restriction on crediting foreign taxes if none would be payable on an actual disposition).
Relief for Tax Rate Reductions
On a positive note, the Department of Finance finally proposes to take into account the recent reduction in Canadian tax rates in determining whether FAPI of affiliates and taxable surplus dividends from affiliates will be subject to tax in Canada. The definition of "relevant tax factor" will be amended to reduce the previous 38-percent tax rate by the general rate reduction for the year as provided in section 123.4.
Currently, FAPI and taxable surplus dividends are taxed in Canada to the extent the foreign tax relating to those amounts is less than 38 percent. For 2002, the target rate will be 35 percent, declining to 33 percent in 2003 and 31 percent in 2004. This change will lessen the concern about potential FAPI and facilitate the repatriation of dividends from certain moderately taxed affiliates. The amendment was moved out of the technical bill and included in another legislative amendment package in October 2003.
Financing Foreign Affiliates
A number of significant changes are proposed in the financing area. While most of these changes were anticipated and are relieving in nature, certain problems remain.
1. Hedging of Investments in Affiliate Shares. One highly anticipated change was not originally included in the 2002 technical bill. In many cases, Canadian taxpayers borrow in a foreign currency to invest in equity of foreign affiliates. This provides a natural hedge whereby any gain on the share investment relating to currency fluctuations is offset by a corresponding loss on the repayment of the debt (and vice versa). The taxpayer may not be hedged for Canadian tax purposes, however, if currency fluctuations result in a loss on the share investment. The loss is denied to the extent that the taxpayer has received exempt dividends on the shares; the gain on the debt is taxable.
Department of Finance officials confirmed in a comfort letter that they would recommend an amendment to eliminate the denial of the loss in these circumstances but did not include the amendment in the 2002 draft legislation. The 2004 draft includes a proposal to reduce the loss denial by the amount of the foreign exchange gain arising in the year of the loss denial on an obligation issued to acquire the share or the redemption, acquisition, or cancellation of shares issued to acquire the share or a gain on an agreement to hedge the taxpayer's foreign exchange exposure in respect of the share. The provision may apply retroactively if the taxpayer so elects, but is not part of the global election.
The amendment is welcome but is fairly narrow, since it appears that there may be no relief if the related gain does not arise in the same year as the loss on the shares. In addition, there is no relief available if the gain is realized by one Canadian corporation and the loss is realized by another. For example, in most so-called Tower structures used to finance U.S. subsidiaries, the third-party debt is held by a partnership of the Canadian taxpayer and a related company. The US LLC (which ultimately finances the taxpayer's US operations), however, is held by another related Canadian company (a Nova Scotia unlimited liability company). Therefore, upon unwinding the Tower structure, any potential loss on the shares of the LLC would be realized by the Nova Scotia ULC, whereas the gain on the debt would be realized by the partnership.
2. Hedging of Currency Exposure by Foreign Affiliates. The 2002 draft legislation finally addressed the treatment of hedging transactions relating to foreign currency fluctuation. A series of amendments will treat the hedging transaction similarly to the underlying transaction that is the subject of the hedge, assuming that it can be identified. Previously, income, gains, and losses on hedging transactions were generally considered to create FAPI income, gains, and losses. The changes made to these proposals in the 2004 version were not substantial, despite suggestions that the rules be changed to include a broader variety of hedging transactions.
Most of the changes to the rules governing inter-affiliate loans and any related hedging transactions are part of the global election. A taxpayer is not able to make the election on a selective basis and eliminate FAPI arising in some affiliates, while leaving FAPI losses unaffected in other affiliates. The "all or nothing" approach makes sense in the context of the financing amendments, which are related.
3. Loans to Holding Companies. It may be that none of the foreign affiliate provisions has been more problematic than the "holding company rule" in clause 95(2)(a)(ii)(D) of the Act. The rule is generally intended to deem the interest income of a lender (the first affiliate) arising from a loan to a holding company (the second affiliate) to be active business income rather than FAPI where:
* the second affiliate uses the funds to buy shares of another affiliate (the third affiliate) resident in the same country;
* the second and third affiliates are both subject to taxation in that country;
* the shares of the third affiliate are excluded property;
* the interest expense is "relevant" in computing the income of a group of corporations resident in that country, typically under a consolidated filing or group relief system; and
* the shares of relevant group companies are excluded property.
The 2002 proposals attempted to address two of the many problems with the rule, with less than complete success: the subject-to-taxation requirement (which was a problem for flow-through entities such as LLCs) and the requirement that all the relevant group companies meet the excluded property test (which was a problem if there were any dormant affiliates in the group or ones earning small amounts of FAPI).
While the proposals adequately addressed these issues in some circumstances, the method for addressing the problem with the excluded property test (a proposed consolidated income test) created many more problems. The uncertainty surrounding the proposed test merely added to the existing uncertainty already inherent in the requirement that the interest paid or payable by the second affiliate be "relevant" in computing the earnings of a group of affiliates. It is clear from a review of the CRA interpretation letters on this subject that this test is not an easy one to meet given the requirements of the various tax systems to which the rule must apply.
The proposals were part of the global election package, which greatly complicated the decision whether to make the election.
Department of Finance officials have been convinced that many of these restrictive requirements are not required and have completely revamped the rule. Most significantly, the requirement that the interest be relevant in computing the income of a group of affiliates has been removed, as has the excluded property test for other group companies. The foreign tax treatment of the interest expense will no longer be relevant. In addition, the amendments may apply retroactively if the taxpayer elects, but are no longer part of the global election. The new requirements of the rule are, as follows:
* The taxpayer must have a qualifying interest in the first affiliate or be related to it (relaxation of the test applicable to all the provisions of paragraph 95(2)(a));
* The second affiliate must be related to the taxpayer and the first affiliate;
* The debt relates to the acquisition of the third affiliate;
* The shares of the third affiliate are excluded property and the taxpayer has a qualifying interest in the third affiliate or is related to it:
* The second and third affiliates are resident in the same country; and
* The second and third affiliates are subject to taxation in that country (or their direct or indirect shareholders are subject to taxation on all or substantially all of the affiliate's income).
The new rule clarifies the consequences if some of these requirements are not met for a period of time during a particular year. The interest income of the first affiliate for that period will not be deemed to be active business income, not all income for the year.
The Department of Finance has also introduced new regulations to require any deficit created in the second affiliate by the interest expense to be pushed down to the third affiliate or other another affiliate in which the second affiliate has an equity interest. The rules are quite complex, but there is no detrimental effect if the lower-tier affiliates do not have sufficient earnings to absorb the deficit; no FAPI will arise in such cases and the remaining deficit will revert to the second affiliate.
Investment Business Test: Greater Than 5 Employees
The income from an "investment business" or business of earning income from property such as interest, rent, royalties, etc., is included in FAPI unless the exceptions contained in the definition can be met. These exceptions will be relaxed.
One of the exceptions relates to businesses that employ more than five employees full time in the active conduct of the business. This exception is amended in two respects. First, the exception will now be available for income earned by a partnership even if the affiliate that is a member of the partnership is a limited partner, as long as the partner meets the definition of a "qualifying member" of the partnership (generally a partner actively engaged in the partnership business or a similar business, or having a ten-percent interest in the partnership). Second, the exception will be broadened to allow the greater-than-five-employee test to be met by contracting for the services of a broader array of individuals, including employees of a qualifying member of a partnership and employees of a "qualifying shareholder" of an affiliate (generally a ten-percent interest). The 2004 draft legislation expands this further by allowing the employees to be provided by "designated corporations" and "designated partnerships."
The changes are welcome, but do not address many of the problems associated with the greater-than-five-employee test, including employees provided by joint venture partners and circumstances where one business is carried on in multiple entities for legal reasons. It is unclear why the Department of Finance continues to impose such strict limitations on this exception to the investment business definition.
The Fresh Start Rules
When the foreign affiliate rules were amended in 1995, many businesses that had been considered to be active businesses were reclassified as investment businesses or businesses giving rise to income from a business other than an active business (a FAPI business). The fresh start rules were intended to provide for a deemed disposition of property of the business and a deemed reacquisition of that property, with the income, gains, and losses being included in surplus for the final year of active business status, and the income from the FAPI business being computed in subsequent years by reference to the new tax basis of the assets of the business. Unfortunately, the rules were flawed in many respects.
The 2002 technical bill contained a series of amendments designed to address these flaws. Taxpayers have the option to apply these amendments on a retroactive basis by making a "Fresh Start Section 95 Election." This election is similar to but separate from the global election.
The 2002 proposals also introduced a similar rule to apply in circumstances where a business was a FAPI business in a particular year and becomes an active business in a subsequent year (the reverse fresh start rule). For example, a business may cease to be an investment business if a sixth employee is hired. The proposals provided that there would be a deemed disposition of property of the business, resulting in the inclusion in FAPI of all accrued income and gains in the last year that the business is a FAPI business.
The reverse fresh start rule was subject to significant criticism. The rule would create FAPI without an actual disposition of the property and therefore without any offsetting foreign tax. In the February 2004 proposals, Finance responded by deferring the recognition of the FAPI income, gains, or losses until such time as there is an actual disposition of the property. As a quid pro quo, however, Finance introduced a new rule to defer recognition of any surplus arising from the regular fresh start rule until the time of an actual disposition of the property. The latter rule will not apply retroactively, even if a fresh start election is made.
Controlled Foreign Affiliate Definition
The 2004 proposals include a number of amendments that were not included in the original proposals. For example, the Department of Finance has introduced a revised definition of "controlled foreign affiliate" seemingly designed to address the decision of the Federal Court of Appeal in Silicon Graphics Ltd. v. The Queen, 2002 DTC 7112, and hence ensure that control by a group of shareholders for this purpose does not require a connection between those shareholders. The proposals also include potentially far-reaching new rules to look-through the ownership of holding companies, trusts and partnerships for the purpose of applying the definition.
While many of the changes to the draft legislation released on February 27, 2004, are welcome, the changes are complex and extensive. Taxpayers should exercise caution in pursuing any transaction involving foreign affiliates until the implications of the changes are fully analyzed.
Finance has asked for comments on the legislation by the end of April 2004. It is likely that further changes will be made before the legislation is introduced as a bill. If taxpayers have not already done so, they should begin to analyze transactions undertaken by their affiliates after 1994 to determine whether the global election, the fresh start election, and a number of freestanding elections should be made.
SANDRA SLAATS is a partner in the Toronto office of Deloitte & Touche LLP, focusing on the development and implementation of international tax strategies. She received her Bachelor of Laws degree from the University of Toronto and a Masters of Law (Taxation) from Osgoode Hall Law School. From 1987 to 1990, Ms. Slaats was employed as a Tax Policy Officer with the Canadian Department of Finance, and is currently a member of the Joint Committee Working Group on the foreign affiliate proposals.
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|Date:||Mar 1, 2004|
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