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Welcome Changes to FA Dumping Rules 

Global Tax Adviser


August 28, 2013


Heather O'Hagan
Toronto, International Tax News


The Department of Finance released a 26-page package of amendments to the foreign affiliate (FA) dumping rules in section 212.3 on August 16, 2013. These are the first revisions to the rules since they were enacted into law in December 2012 as part of Bill C-45. For the most part, the changes are relieving in nature and are intended to fix issues that have been identified by taxpayers (including the Joint Committee in its September 2012 submission). However, it appears that Finance has also made some tightening changes which are meant to plug what it perceived to be "loopholes" in the rules. The relieving changes generally apply back to the inception of the rules, that is to transactions that occur after March 28, 2012. The tightening changes generally apply prospectively to transactions that occur on or after August 16, 2013.

The following article highlights some of the more significant changes to the FA dumping rules. Finance invites stakeholders to comment on the draft legislation by October 15, 2013.


Application of rules under subsection 212.3(1)


The FA dumping rules currently apply where a corporation resident in Canada (a "CRIC") makes an "investment" in a particular non-resident corporation (a "Subject Corporation") at any time (the "investment time") and:


  • The subject corporation is, immediately after the investment time, or becomes as part of a transaction or event or series of transactions or events that includes the making of the investment, a foreign affiliate of the CRIC
  • The CRIC is, at the investment time, or becomes as part of a transaction or event or series of transactions or events that includes the making of the investment, controlled by a foreign corporation (a "Foreign Parent"), and
  • None of the exceptions to the rules apply.


Because of the difficulty in determining when a series of transactions starts and ends, many foreign affiliate investments made by a CRIC prior to a foreign parent acquiring control of the CRIC were at risk of being swept into the rules even though the making of the investment had nothing to do with the acquisition of control.


Proposed amendments
In apparent response to these concerns, Finance is modifying the second condition above such that an investment in a subject corporation will only be caught if one of three additional conditions is met:


  • At the investment time, Foreign Parent and all non-arm's length parties own shares of the CRIC that give the holders at least 25% of its overall votes, or 25% of its overall value
  • The CRIC's investment in the Subject Corporation is an acquisition of preferred shares as contemplated in subsection 212.3(19)
  • An arrangement is entered into in connection with the investment whereby a person other than the CRIC (or a related person) has a material risk of profit or loss in respect of a property that relates to the investment.


KPMG observations
It is common for a foreign parent to acquire a "foothold" in a target in order to assess the appropriateness of a greater investment. In public companies, this foothold often takes the form of an acquisition of 5% to 19.9% of the public company's shares (for example, Canadian public companies conducting mining operations in foreign jurisdictions). Under the current version of the rules, there is a risk that, if the investment in the subject corporation is made by the CRIC during the period of time when the foreign parent holds a foothold interest in the CRIC, the investment could be caught by the FA dumping rules if the foothold interest is viewed as part of a series of transactions in which the foreign parent acquires control of the CRIC. These changes should remove the risk of the FA dumping rules applying to investments by the CRIC in its foreign affiliate group that are made while a Foreign Parent owns foothold interests of less than 25% in the CRIC, even if there is a subsequent acquisition of control of the CRIC that is part of the same series.


Furthermore, these changes also appear to provide more flexibility to private equity groups that own a CRIC through a fund structure. For example, if a CRIC is owned by a limited partnership in which a group of unrelated persons have invested, it could be the case that the partnership's general partner (often a non-resident corporation) controls the CRIC even if its percentage ownership in the partnership is nominal. The FA dumping rules would then have applied to any investments by the CRIC in its foreign affiliate group. As a result of these changes, this structure may now escape the application of the FA dumping rules where the general partner does not own at least 25% of the votes or value of the CRIC on a look-through basis. However, it should be noted that the deemed control rules outlined below will now have to be taken into consideration in determining whether a CRIC is foreign controlled, and which foreign entity exercises that control.


Timing of deemed dividend under paragraph 212.3(2)(a)
The amendments will deem a dividend arising from the application of the rules to be paid by the CRIC to Foreign Parent at the "dividend time" rather than at the "investment time". Dividend time is a new term defined in subsection 212.3(1.1). This change is meant to give more appropriate results where the CRIC is not controlled by Foreign Parent at the investment time but subsequently becomes so controlled as part of a series. In such a case, through the operation of the "dividend time" concept, the dividend will now be deemed to arise at the earlier of the time of that acquisition of control and 180 days after the investment time. Where the CRIC is controlled by Foreign Parent at the investment time, "dividend time" is the same as "investment time". One particular benefit of this change to the timing of the deemed dividend is that it allows better access to lower withholding tax rates under the terms of a treaty.


Changes to QSC election and PUC offset rules


Currently, under subsection 212.3(3), a taxpayer can elect to allocate what would otherwise be a dividend deemed paid by a CRIC to its Foreign Parent to instead be deemed paid by the CRIC and one or more other Canadian corporations in the group ("qualifying substitute corporations") on their respective cross-border share classes, and to be received by Foreign Parent and certain other non-resident corporations. The rules in subsection 212.3(7) then apply automatically to reduce paid-up capital ("PUC") balances of those cross-border share classes by the amount of the dividend allocations in the election. This PUC reduction provided a deferral of withholding tax, at least until such time as an actual distribution was made that would otherwise have relied on the existence of PUC.


Proposed amendments
A number of significant changes have been made to these provisions.


PUC offset
The PUC offset rule in subsection 212.3(7) is now no longer tied to an election made under subsection 212.3(3), but rather applies automatically anytime a deemed dividend arises under paragraph 212.3(2)(a). The rules now look to the total amount of cross-border PUC attributable to shares of the CRIC or a qualifying substitute corporation ("QSC") that are owned by Foreign Parent or a non-arm's length non-resident corporation.


If the deemed dividend is greater than the total cross-border PUC balance, the PUC of each of the applicable classes of shares is reduced to nil, and the amount of the dividend is reduced accordingly. If the deemed dividend is less than this total PUC balance, the dividend is reduced to nil, and the PUC reduction is allocated to classes of shares owned by Foreign Parent or a non-arm's length non-resident corporation to produce the greatest total reduction of PUC in respect of shares owned by Foreign Parent or the non-arm's-length non-resident.


The rules also require that the CRIC file a prescribed form with the CRA no later than the 15th day of the month following the month that includes the dividend time. The CRIC must provide the amounts of cross-border PUC attributable to each class of shares immediately before the dividend time and the ownership of those shares, and the amounts of the PUC reductions to each of the classes.


KPMG observation
Because the PUC offset rule now applies automatically, taxpayers do not have the flexibility to choose to retain PUC and pay withholding tax on a deemed dividend instead. This could affect thin capitalization calculations that previously relied on PUC balances. However, the new rules now seem to be less complicated than before, and eliminate the need to file an election where the dividend is less than the amount of cross-border PUC. On the other hand, a prescribed form must still be filed and the filing deadline is fairly tight, so taxpayers will need to take care to ensure that it is not forgotten.


QSC election
Because the QSC election is no longer required in order to have a PUC reduction apply, the requirement to file an election is now limited to cases where a deemed dividend continues to arise after the application of subsection 212.3(7). The election allows the entire dividend to be deemed to be paid by the CRIC or a QSC, and to be received by Foreign Parent or a non-arm's length non-resident corporation.


The amendments also broaden the definition of qualifying substitute corporation ("QSC") in subsection 212.3(4), which currently requires the corporation to be controlled by Foreign Parent, amongst other conditions. The definition now allows the corporation to be controlled by a non-arm's-length non-resident corporation as well. This should potentially allow more corporations to be included in the election and in the PUC offset rules above.


PUC reinstatement rule broadened


The PUC reinstatement rules in subsection 212.3(9) allow, in certain circumstances, cross-border PUC that had been subject to a reduction under either paragraph 212.3(2)(b) or (7)(b) to be increased at a subsequent time when there is an actual distribution of property that would otherwise reduce PUC. The PUC reinstatement measures apply where the original investment made by the CRIC which caused the FA dumping provisions to apply was either:


  • An acquisition of the shares of a Subject Corporation under paragraph 212.3(10)(a)
  • A contribution of capital to the Subject Corporation under paragraph 212.3(10)(b), or
  • An indirect acquisition of the Subject Corporation's shares under paragraph 212.3(10)(f).


The PUC increase is available at the subsequent time if a CRIC or a QSC distributes property as a return of capital that is either:


  • Shares of the Subject Corporation
  • Property traceable to proceeds received from a disposition of the Subject Corporation' s shares (as long as the distribution is made within 180 days from the time of the disposition), or
  • Property traceable to a dividend or return of capital received in respect of the Subject Corporation's shares (as long as the distribution is made within 180 days from the time of the receipt of the dividend or return of capital).


Proposed amendments
The PUC reinstatement rules have been amended in three ways.


First, the rules now also allow a PUC reinstatement if the CRIC or the QSC reduces PUC as a result of a redemption, acquisition or cancellation of its shares.


Second, the rules have been expanded to allow for PUC reinstatement where the original investment that caused the FA dumping rules to apply was one to which paragraphs 212.3(10)(c), (d), or (e) applied. These paragraphs essentially relate to investments that are debts owing by a Subject Corporation. As a result, if the CRIC or a QSC receives amounts that relate to the repayment of, or the disposition of, such a debt and distribute those amounts, PUC reinstatement can apply. However, the 180-day requirement for the distribution still applies.


It is interesting to note that the payment of interest to the CRIC in respect of such a debt can also result in PUC reinstatement if that interest is then on-distributed by the CRIC as a return of capital, or is traceable to the redemption or cancellation of the CRIC's shares.


Third, a restriction on these rules is being modified and expanded to apply not only in respect of distributions by a CRIC that are traceable to proceeds of disposition of the Subject Corporation shares, but also to amounts received as dividends or returns of capital from the Subject Corporation, or as repayments or dispositions of debts, or interest payments, as outlined above.


This restriction on PUC reinstatement applies to transactions that occur on or after August 16, 2013.


KPMG observation
The wording of this provision appears unclear. According to the Explanatory Notes, this rule requires that the property received by the CRIC must be traceable to an original investment that gave rise to the FA dumping rules in the first place. The Notes go on to say that there will be no PUC reinstatement where the original investment was one to which an exception applied, such as the business purpose exception in subsection 212.3(16) or one of the reorganization rules in subsection 212.3(18). However, the wording of the legislation itself may imply that this provision may have a more narrow scope.


Deemed control of a CRIC
Finance is proposing a tightening amendment to the special rules for determining control of a CRIC in subsection 212.3(15). This subsection now includes a rule relating to group control. It provides that a CRIC will be deemed to be controlled by a Foreign Parent where a related group of non-resident corporations is in a position to control the CRIC. Where this is the case, the member of the group that has the highest direct equity percentage in the CRIC will be the entity that is deemed to control the CRIC. If more than one member has the same direct equity percentage, the CRIC can determine which member will be deemed to be the controller.


Pertinent loans or indebtedness


Currently, if an election is filed to treat a loan made by a CRIC to a subject corporation as a pertinent loan or indebtedness ("PLOI"), that loan would not be considered an investment under paragraphs 212.3(10)(c) or (d) and the FA dumping rules would not apply. Subsequently, the PLOI could (subject to the general anti-avoidance rule) be converted into shares of the subject corporation and qualify for one of the reorganization exceptions in subsection 212.3(18).


Proposed amendments
New subsection 212.3(18.1) now prohibits the reorganization exceptions from applying to property received by a CRIC as a repayment or settlement of a PLOI. Thus, an acquisition of shares of a subject corporation on a conversion of a PLOI will now constitute an investment to which the FA dumping rules will apply.


This new rule only applies prospectively to transactions occurring on or after August 16, 2013.


Other amendments to reorganization exceptions


Currently, amalgamations of two or more corporations to form a CRIC fit into the reorganization exceptions to the FA dumping rules under subparagraph 212.3(18)(c)(ii) where the amalgamation would otherwise cause an indirect investment in a subject corporation under paragraph 212.3(10)(f).

However, a concern arises where a CRIC owns shares of a predecessor corporation that is part of an amalgamation where the new corporation formed on the amalgamation is not the CRIC itself, but is a corporation described in the indirect acquisition rule in paragraph 212.3(10)(f). In this case, the reorganization exception would not currently apply as the amalgamation takes place at a level below the CRIC.


Finance is amending subparagraph 212.3(18)(c)(ii) to allow such amalgamations to fit into the reorganization exceptions.


Debt conversions
The reorganization exception in paragraph 212.3(18)(d) applies to conversions of debts or similar instruments into shares of a subject corporation held by a CRIC. The conditions for entitlement to this exception are being tightened such that they will now only apply to a bond, debenture or note (i.e., not to all debt obligations) and only where subsection 51(1) would apply if the debt instrument conferred on the holder the right to make the conversion.


Amendments to thin capitalization rules
Finance has proposed amendments to the definition of "outstanding debts to specified non-residents" in subsection 18(5) to ensure that the thin capitalization rules do not impede the ability of a foreign parent that controls a CRIC to use debt to finance the CRIC if the CRIC in turn uses the borrowed funds to make an investment in a subject corporation in the form of an advance for which PLOI treatment has been elected. As the CRIC would already be accruing interest on the PLOI investment at a rate that matches the rate on the loan from Foreign Parent, it was perceived to be unfair to further penalize the CRIC by potentially denying an interest deduction on the borrowing from the non-resident under the thin cap rules.


For more information, contact your KPMG adviser.






Information is current to August 28, 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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