Canada - English

FA Dumping Rules - Some Important Tweaks - by Heather O'Hagan 

Global Tax Adviser


October 23, 2012


Heather O'Hagan
Toronto, International Corporate Tax


Federal Bill C-45, which implements some of the 2012 federal budget tax measures, contains some important modifications to the foreign affiliate (FA) dumping proposals. Among other things, Bill C-45 introduces the concept of a "qualifying substitute corporation", relaxes the paid-up capital (PUC) suppression rules and the pertinent loans or indebtedness rules, and modifies the indirect investment rules in a foreign affiliate, all of which alleviate some of the harsher results of these rules.

There are also minor modifications to the controversial business purpose test exception (in subsection 212.3(16)) but these changes do little to alleviate the practical concern and uncertainty in demonstrating that this exception has been met.



The FA dumping rules are intended to curtail the use of Canada's foreign affiliate system where the relevant Canadian company is controlled by a non-resident corporation. In general, the FA dumping rules will apply where a foreign-controlled corporation resident in Canada (called a CRIC) makes an investment in a foreign affiliate. For this purpose, an investment in a foreign affiliate is very broadly defined.


If a foreign-controlled CRIC makes an investment in a foreign affiliate, generally one of two results will take place. First, the CRIC will be deemed to have paid a dividend to its non-resident parent equal to the fair market value of any property transferred (excluding shares of the CRIC itself), obligation assumed, or benefit conferred by the CRIC that is considered to be related to the foreign affiliate investment. Second, if the PUC of the CRIC's shares is otherwise increased because of the foreign affiliate investment, that increase will be deemed not to have occurred.


Both of these results will create withholding tax implications, either at the time that the investment in the foreign affiliate is made by the CRIC as a result of the deemed dividend rule, or in the future on the payment of a dividend because there is insufficient PUC in the CRIC to support a return of capital.


For details, see TaxNewsFlash-Canada 2012-31, "FA Dumping Proposals Ease Burden of Rules".


Bill C-45 Modifications


"Qualifying substitute corporation" elections
The concept of a "qualifying substitute corporation" (QSC) is a key component of a new election that is available to a CRIC to alleviate some of the harsher results of the FA dumping rules (subsection 212.3(3)). Under the previous version of the rules, a dividend that was deemed to be paid by a CRIC to its non-resident parent would have been ineligible for the reduced 5% treaty withholding tax rate if the parent did not directly own the shares of the CRIC. The new election now allows the dividend to be deemed to be paid by one or more qualifying substitute corporations. By making a QSC election to allocate the dividend to a top-tier Canadian corporation in the group, the reduced treaty withholding tax rate should become available.


A qualifying substitute corporation is a corporation resident in Canada that is controlled by the same non-resident corporation (the Parent) that controls the CRIC, and whose shares are owned by the Parent or by another non-resident corporation that is related to the Parent. The qualifying substitute corporation must also have at least some direct or indirect ownership of the shares of the CRIC.


If there is an investment in a foreign affiliate such that the rules create a deemed dividend, the election must allocate the full amount of the dividend between the CRIC and qualifying substitute corporations. The election also allows the dividend to be deemed to be paid to a related non-resident corporation that is controlled by the Parent, which also ensures that the lower treaty rate will be available where there is more than one level of non-resident corporations that control the CRIC.


The ability to access the lower treaty rate of withholding tax was one of the recommendations made by the Joint Committee on Taxation of The Canadian Bar Association and The Canadian Institute of Chartered Accountants (Joint Committee) in its September 13, 2012 submission on these rules.


PUC suppression rules
In the draft legislation released in August, the ability to suppress PUC rather than have a deemed dividend arising from an investment in a foreign affiliate was an elective provision that was restricted to CRICs with only one class of shares, or with more than one class of shares where the PUC of a particular class was directly traceable to the investment in the foreign affiliate.


The PUC suppression rules now apply automatically if the election mentioned above is made, but only if certain other conditions are also met (subsections 212.3(6) and (7)). The Parent and the related non-resident corporation, if applicable, to which amounts have been allocated under the election must own shares of every class of the CRIC and any qualifying substitute corporations. As well, the allocation of amounts under the election must result in the maximum amount of cross-border PUC reduction. So, the highest amount allocated under the election should be attributed to shares of the CRIC or of a qualifying substitute corporation with the highest amount of cross-border PUC.


The PUC suppression rules can still apply to a CRIC if no election is made, but only if the CRIC has one class of shares, or has more than one class where the PUC of a particular class is traceable to a specific transfer of property to the CRIC that was then used to make the investment in the foreign affiliate. As well, shares of the CRIC that are not owned by the Parent must be owned either by a related non-resident, or an arm's-length third party.


If any portion of a dividend is not offset by a PUC reduction, it will continue to be treated as a dividend subject to withholding tax.


The Joint Committee recommended that PUC suppression should be a default position rather than an elective one, which is the path that has been followed with these new provisions.


Indirect investments in foreign affiliates
The indirect investment rule caused significant issues when it was added to the August draft legislation. This rule ensures that the FA dumping rules will apply where a CRIC acquires shares of another Canadian target corporation which already owns a foreign affiliate group. If the value of the foreign affiliate group made up more than 50% of the value of the Canadian target corporation, this indirect investment was caught by the rules.


The revised rules have increased the foreign affiliate value threshold to 75%, but otherwise the indirect investment rule remains essentially the same (paragraph 212.3(10)(f)). The Explanatory Notes confirm that the computation of the value is based on the proportionate equity interest in the foreign affiliate group held by the Canadian target corporation. The Explanatory Notes also confirm that the CRIC must reasonably allocate the consideration paid for the Canadian target corporation to the shares of each foreign affiliate in the group in order to determine the appropriate consequences of the rules.


The Joint Committee raised a number of questions regarding the indirect acquisition rule, including whether the 50% threshold was appropriate, whether an investment in a Canadian target by a CRIC ought to be exempted where the Canadian target uses the proceeds in its Canadian business operations, and whether Canadian public companies ought to be carved out of the rules altogether. The new rules have only addressed the first of these concerns and have not made any changes with respect to the latter two questions.


Pertinent loans or indebtedness
Under the August draft legislation, the election to treat a loan to a foreign affiliate as a "pertinent loan or indebtedness" only applied if the loan was made after March 28, 2012. The election then applied prospectively to all loans between the CRIC and that particular foreign affiliate.


The election to treat a loan as a "pertinent loan or indebtedness" must now be made on a loan-by-loan basis (subsection 212.3(11)). As well, the election will now also be available if the loan was outstanding prior to March 29, 2012 and its term is extended beyond that date. However, the rules in section 17.1 that now create a deemed interest inclusion in respect of a "pertinent loan or indebtedness" apply to taxation years ending after March 28, 2012. Therefore if the election is made in respect of a loan that was outstanding prior to March 29, 2012, there will be an imputed interest charge on the loan for the period in the taxation year that is before, as well as after, that date.

The election under subsection 15(2.11) to treat a loan as a "pertinent loan or indebtedness" must also now be made on a loan-by-loan basis, rather than in respect of all loans made by a CRIC to a particular non-resident. It is interesting to note that this election under the new rules in subsection 15(2.11) still only applies to amounts that become owing after March 28, 2012. There is no ability to elect in respect of loans that were outstanding prior to that date.


Corporate reorganizations
New exceptions in paragraph 212.3(18)(c) allow certain Canadian reorganizations, such as amalgamations, reorganizations of share capital, and exchanges of convertible property, that would otherwise have triggered the indirect acquisition rule in paragraph 212.3(10)(f) to be excluded from its application.


Business purpose test
One of the Joint Committee's biggest concerns raised in its submission was the business purpose test exception now in subsection 212.3(16). Because of the strict requirements needed in order to fall into this exception to the rules, we expect taxpayers to have difficulty meeting all of the required conditions.


One of the recommendations made by the Joint Committee in this regard was to eliminate the requirement that the officers of the CRIC who had decision-making authority in respect of the investment had to be resident and working in Canada. This recommendation was the only change made to the business purpose test. The rules now allow the decisions of corporate officers of the CRIC to be counted in the application of the test even if they are not residents of Canada. Their activities can now be included as part of the investment decision-making process if they are residents of, and working in, a country where a controlled foreign affiliate of the CRIC is located if that affiliate's business activities are closely connected to those of the foreign affiliate that is subject to the rules.


However, despite this change, there are still a number of strict requirements that will need to be met if this test is to apply.


For more information, contact your KPMG adviser.





Information is current to October 23, 2012. The information contained in this publication is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. For more information, contact KPMG’s National Tax Centre at 416.777.8500.


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