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Finance Releases Foreign Affiliate Draft Legislation 

Global Tax Adviser


July 16, 2013


Heather O'Hagan and Dave Beaulne
Toronto, International Corporate Tax


The Department of Finance released draft legislation on July 12, 2013 relating to among other things, the taxation of foreign affiliates, non-resident corporations without share capital, and the foreign currency election. Most of the changes included in the draft legislation are relieving in nature and deal with specific issues that taxpayers have raised over the years, some of which have previously been addressed by Finance in various comfort letters. However, there are also some significant new tightening rules that could impact foreign affiliate groups. Below is a summary of some of the more significant changes included in the draft legislation.

Stakeholders have until Friday September 13, 2013 to provide comments on the draft legislation.


Stub period accrual of FAPI
The rules in subsection 91(1) that impute foreign accrual property income (FAPI) of a controlled foreign affiliate (CFA) to a Canadian taxpayer have always applied where that taxpayer has a participating percentage in the CFA at the end of the CFA's taxation year. Accordingly, if the shares of the CFA are sold prior to the end of its taxation year, such that the taxpayer no longer has a participating percentage at year-end, no FAPI imputation would arise in respect of the CFA's taxation year that included the sale.


New subsection 91(1.1) now requires FAPI imputation for a CFA in which a Canadian taxpayer's surplus entitlement percentage (SEP) has decreased in the year. The decrease in SEP forces the CFA to have a deemed year-end at that time. As a result, the rules in subsection 91(1) will apply to impute FAPI of the CFA up to the time of its deemed year-end, as the taxpayer would now have a participating percentage in the CFA at the end of its (deemed) taxation year.


There is one narrow exception to this new rule in subsection 91(1.2). Where a Canadian taxpayer's decrease in a CFA's SEP is the same as a connected Canadian taxpayer's increase in SEP in the same CFA, the deeming rule will not apply. In order to be connected there has to be ownership of at least 90% of each class of shares of the taxpayers in question.


These new rules apply as of July 12, 2013. Accordingly, any decrease in the SEP of a CFA from now on will impact potential FAPI accruals.


Significant amendments for FAs held through partnerships
There has never been a comprehensive set of rules in the Act that deal with foreign affiliates held by partnerships. Section 93.1 allows taxpayers to look through a partnership to an underlying foreign affiliate, but only for certain purposes - for example to allow a Canadian taxpayer to claim a section 113 deduction in respect of dividends paid by a foreign affiliate to a partnership in which the Canadian taxpayer is a member. The current list of provisions to which section 93.1 applies is quite limited, and the partnership look-through rules have never broadly applied to the foreign affiliate measures contained in section 95.


Amongst other changes, one of the new provisions to which the partnership look-through rules will now apply is section 233.4, which contains the information reporting requirements for foreign affiliates. As a result, a Canadian taxpayer will now have to file form T1134 "Information Return Relating To Controlled and Not-Controlled Foreign Affiliates" for foreign affiliates held by a partnership in which it is a member.


Application of partnership look-through rule to clause 95(2)(a)(ii)(D)
Section 93.1 is also amended to provide a new set of rules for purposes of applying clause 95(2)(a)(ii)(D). This clause allows for the recharacterization of interest on loans made by a financing foreign affiliate to a second foreign affiliate where the funds are used to acquire shares of a third foreign affiliate. The new measures in subsection 93.1(4) allow the recharacterization rules to apply where the loan is made to a partnership that owns the third affiliate. This is accomplished by deeming the partnership to be "a non-resident corporation without share capital" and the members' interests in the partnership to be "equity interests" in the hypothetical corporation - both these terms are defined in new section 93.3 (see commentary below). There is also a deemed residence rule for the hypothetical corporation.


Partnership deemed to be a "taxpayer" for certain FA rules
New subsections 93.1(5) and (6) provide some welcome rules to deal with foreign affiliates that are owned through partnerships, but again, only for certain measures in section 95.


Generally, a partnership that owns the shares of a foreign affiliate is considered a "taxpayer" under the foreign affiliate provisions in the Act, but only for purposes of computing its income, as is stipulated in subsection 96(1). So, for example, if a Canadian corporation owns a partnership that owns a CFA that earns property income, the partnership is required to include FAPI in its income and that income is then included in the Canadian member's income. This can be particularly problematic where the income from property would be recharacterizable if the partnership were instead a foreign or domestic corporation.


The rules in these two new subsections are similar to the current rules contained in paragraph 95(2)(n). Paragraph 95(2)(n) imputes foreign affiliate and qualifying interest status between two foreign affiliate chains that are each owned by related Canadian companies. However, that paragraph does not apply where one of the chains is owned by a partnership and the other is owned by a Canadian corporation. These new measures fill that gap and create a related party test by deeming the partnership in question to be a corporation, and the members of the partnership to own shares based on the relative value of their partnership interests.


If a Canadian corporation (Canco), or one of its foreign affiliates, is a member of a partnership, and based on the deeming rule Canco and the partnership would be related, any foreign affiliate of Canco in which it has a qualifying interest is now deemed to be a foreign affiliate of the partnership in which the partnership has a qualifying interest.


These rules apply only in respect of the specific provisions listed in subsection 93.1(6). These provisions are:


  • Paragraph (b) of part A of the FAPI definition, which excludes foreign affiliate dividends from FAPI
  • The determination of whether a foreign affiliate's property is considered excluded property for purposes of the FAPI inclusion for capital gains in part B of the FAPI definition
  • The recharacterization rules in subparagraph 95(2)(a)(ii) - this amendment could provide relief in the context of financing structures that use partnerships, and
  • Paragraph 95(2)(g), which deems foreign exchange gains and losses to be nil in respect of certain loan and share transactions between foreign affiliates.


Coming-into-force measures
New subsections 93.1(4), (5) and (6) apply to foreign affiliate taxation years that end after July 12, 2013. However taxpayers can elect retroactive application of subsections (5) and (6) back to taxation years that end after 2010, but the election will apply to all foreign affiliates of the taxpayer.


Non-resident corporations without share capital deemed to have shares
There are many types of entities created under the laws of foreign jurisdictions that Canada finds difficult to apply our foreign affiliate rules to, either because the entity does not have the defining characteristics of a Canadian-equivalent corporation, partnership or trust, or because it does have the characteristics of a corporation but does not have capital that is divided into what we would call "shares". The new rules in section 93.3 are meant to alleviate this second category of uncertainty. The Explanatory Notes specifically refer to US LLCs as being one type of non-resident corporation that does not have capital divided into shares.


The new rules will deem a non-resident corporation that does not have capital divided into shares to have 100 issued shares of each class, based on identical rights and obligations of its ownership interests. Each owner will be deemed to own a proportionate interest based on the relative values of all equity interests in that class.


KPMG observations
These new provisions could have significant foreign affiliate implications. Not only will these rules become relevant in determining whether a non-resident corporation is a foreign affiliate of a Canadian taxpayer based on the equity percentage owned in each class of shares, but they will also impact the treatment of distributions made to its owners. Remember that all pro-rata distributions on a class of shares of a foreign affiliate are deemed to be dividends under the rules in subsection 90(2). It will therefore be very important to determine whether the non-resident corporation does in fact have more than one class of shares based on the characteristics of its equity interests.


Section 93.3 applies to taxation years of non-resident corporations that end after 1994, presumably on the basis that these rules are aimed at clarifying existing law. However, taxpayers can elect prospective treatment such that the rules will only apply to such taxation years that end after July 12, 2013.


Foreign accrual tax broadened to encompass transparent entities
The definition of "foreign accrual tax" (FAT) in subsection 95(1), which represents foreign tax that can offset a FAPI inclusion, has always been problematic when dealing with transparent entities such as US LLCs. The definition requires that the foreign affiliate itself (i.e. the LLC) pay the foreign tax, or that the foreign tax be paid by another foreign affiliate but only in respect of a dividend received from the first foreign affiliate.


Transparent entities do not pay tax on their income; rather it is the member that picks up its share of the income of the transparent entity and pays the applicable foreign tax on that income. As a result, foreign tax paid by a member of a transparent entity in respect of its allocation of income does not qualify as FAT unless there is distribution made in the year by the entity to which the foreign tax could be attached.


The changes to the FAT definition will now allow foreign tax paid by a "shareholder affiliate" to qualify as FAT as long as the shareholder affiliate is liable for the tax under the laws of the foreign jurisdiction, and as long as the transparent affiliate, and any other foreign affiliate that has an equity percentage in it, do not have more than five members.


New Regulations 5907(1.091) and (1.092) incorporate similar changes in respect of foreign tax payments and refunds for surplus purposes.


These changes generally apply to taxation years of a foreign affiliate that end after 2010.


FA residency requirement eliminated under clause 95(2)(a)(ii)(D)
As indicated above, the rules in clause 95(2)(a)(ii)(D) allow for the recharacterization of interest on loans made by a financing foreign affiliate to a second foreign affiliate where the funds are used to acquire shares of a third foreign affiliate. Certain conditions have to be met in order for these provisions to apply, including the requirement that the second and third affiliates be resident in the same country and be subject to tax (or their members be subject to tax) in that same country.


These two requirements have now been replaced with one - that the second and third affiliates be subject to tax (or their members be subject to tax) in a country other than Canada. There is no longer a residency requirement for either affiliate, which should provide more flexibility in structuring share acquisitions within foreign affiliate groups. However, consequential changes are made to the surplus regulations and, in order to obtain exempt surplus treatment for such recharacterized income, it will be necessary for the second and third affiliates to be resident in a designated treaty country (although not necessarily the same one).


The amendments to clause 95(2)(a)(ii)(D) apply to foreign affiliate taxation years that end after July 12, 2013.


Functional currency election deadline amended
Two significant changes have been made to the functional currency rules in section 261.


The first relates to the timing of making the election to switch from being a Canadian dollar tax reporter to a functional currency tax reporter. Based on current rules, a corporation must file the election at least six months before the end of its first taxation year to which section 261 will apply. So for a corporation with a December 31st year-end, the election had to be filed before June 30th of the year to which the rules were intended to first apply. However, if the election was filed prior to June 30th but there was an acquisition of control (or some other form of reorganization that resulted in a deemed year-end) after June 30th, the election would not have been valid for the taxation year that ended on the acquisition of control as it was not filed 6 months before that year-end (assuming the corporation maintained a calendar taxation year). As well, it was not possible to file the election for a corporation whose taxation year was less than 6 months - for example for a newly-incorporated company.


In order to reduce the impact of these results, the election filing deadline has now been shortened to 60 days after the start of the first functional currency taxation year. This could require more diligence in ensuring that companies wishing to make the election do so within this shortened period of time, but it also provides additional flexibility to make the election for companies with short taxation years.


The other significant change in the functional currency rules deals with amalgamations of functional currency companies. The amendments now allow a new corporation that is formed as a result of an amalgamation of predecessor corporations that have the same functional currency, to have the same functional currency as the predecessors apply without having to make an election.


Both of these amendments apply to taxation years that begin after July 12, 2013.


Other miscellaneous changes


Foreign mergers
Subsection 87(8.3) is a new anti-avoidance rule applicable to foreign mergers. Previously, the rules in subsection 85.1(4), which prevent the transfer of shares of a foreign affiliate by a Canadian taxpayer to another foreign affiliate on a tax-deferred basis in cases where the transferred shares are ultimately sold to an arm's length person, could have been avoided by instead using the foreign merger rules. The new provision creates a taxable foreign merger where the merger is part of a series of transactions resulting in the sale of the merged company's shares to an arm's length person or partnership. This subsection applies for foreign mergers that occur after July 12, 2013.


Australian trusts
New section 93.2 imports foreign affiliate status to certain Australian business trusts in which a CFA of a Canadian corporation has a beneficial interest. In particular, new section 93.2 will deem the Australian trust to not be a trust and to instead be a non-resident corporation for certain purposes and only when certain conditions are met. New section 93.2 comes into force on July 12, 2013 and on an elective basis will come into force on January 1, 2006.


Taxable Canadian property (TCP)
Changes to the definition of TCP import a partnership look-through test, but only to paragraph 248(1)(e) of the definition which deals with shares of public companies, mutual fund corporations, and mutual fund trusts.


Base erosion rules
There are also a handful of relieving changes to the so-called "base erosion" rules. The base erosion rules generally treat as FAPI certain business income of a foreign affiliate that has a close connection to Canada. Some of these changes are based on long-outstanding comfort letters and have significant retroactive application.


For more information, contact your KPMG adviser.






Information is current to July 16, 2013. 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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