Foreign Affiliate Rules Now Set — Take Action to Manage Their Impact
Canadian multinationals may need to act now that the Department of Finance has released long-awaited legislation that provides the latest, and likely final, version of the proposed tax rules affecting foreign affiliate members of Canadian corporate groups.
The legislation is making its way through Parliament, and although not yet formally enacted into law, it is considered to be substantively enacted for purposes of International Financial Reporting Standards (IFRS) and Canadian Accounting Standards for Private Enterprises (ASPE). (See TaxNewsFlash-Canada 2012-39, “Tax Accounting Update — Finance Clears the Slate”.)
Once the applicable technical bills receive Royal Assent, the clock will start ticking on the time available for making the vast number of elections contained in almost 1,000 pages of pending legislation.
The legislation includes several key provisions that have changed significantly since the last version of the proposals was released. The legislation also brings into law measures that could have a significant impact on foreign affiliate reorganizations and the computation of surplus in foreign affiliate groups. This TaxNewsFlash-Canada highlights these changes and their potential impact on Canadian multinationals with foreign affiliates.
Application of rules remains unchanged
The definition of “specified debtor” includes Canco and any non-arm’s length person other than a controlled foreign affiliate. However, to be considered a controlled foreign affiliate in this case, the affiliate must be controlled by Canadian residents. The definition also includes partnerships of which the taxpayer or a non-arm’s length person is a member.
The rules still contain an exception for loans made in the ordinary course of the creditor’s business as long as arrangements are made for repayment of the loan within a reasonable period of time.
Any amount of the loan that would have been deductible as an exempt surplus or taxable surplus dividend if it had instead been paid as a dividend to the Canadian corporation (e.g., Canco) by the applicable lending foreign affiliate (e.g., Lender FA) is generally deductible under these rules. A deduction is also available for Lender FA’s hybrid surplus, provided that the foreign tax rate applicable to that surplus is greater than the Canadian capital gains tax rate.
The new measures clarify that the surplus (and deficit) balances in respect of all affiliates in the chain of ownership between the lender FA and the Canadian corporation (i.e., upstream surplus) can be included in this computation, as can surplus balances of other foreign affiliates in which the lender FA has direct or indirect ownership (i.e., downstream surplus).
New measures now also allow deductions for the cost base of the lender FA's shares, or such other relevant foreign affiliate in the chain that is held directly by the Canadian corporation. This cost-base deduction is not available, however, if the specified debtor is a non-resident corporation. Previously taxed foreign accrual property income (FAPI) will also be eligible as a deduction if the cost-base deduction is not otherwise available.
Definition of “specified amount” amended
New repayment period and foreign exchange relief for loans
outstanding on August 19, 2011
The revised coming-into-force measures now provide grandfathered loans with a five-year repayment period. If a loan that was entered into prior to August 19, 2011 remains outstanding on August 19, 2014, it will be deemed to be a new loan issued on that date. The loan then becomes subject to the regular two-year repayment period, and must be repaid by August 19, 2016 to avoid being subject to the rules described above.
New transitional measures have also been introduced to deal with foreign exchange exposure when such grandfathered loans are repaid. These measures only apply to grandfathered upstream loans that are repaid before August 19, 2016, and only in certain situations where a Canadian borrower realizes a foreign exchange capital gain or loss equal to the lender foreign affiliate’s related capital loss or gain arising from the repayment.
in Explanatory Notes
Foreign Tax Credit Generator Rules
The original version of these rules, released in August 2010, was broadly worded and did not require any tracing between the jurisdiction where the FAPI was earned and the jurisdiction governing the issuer of the hybrid instrument. As such, the rules could have applied to any foreign affiliate in any jurisdiction if there was a hybrid instrument in place somewhere in the corporate group.
· Has the Canadian company (Canco) included FAPI in its income in respect of a particular foreign affiliate (FAPI-FA) which has been offset by some level of foreign tax paid by FAPI-FA?
· Is there a hybrid instrument in place somewhere in the foreign affiliate group?
· Is the “specified owner” of the hybrid instrument either Canco (or a partnership of which Canco is a member) or any foreign affiliate of Canco?
· Is the issuer of the hybrid instrument either FAPI-FA or another foreign affiliate of Canco that either owns shares in FAPI-FA or is owned by FAPI-FA?
· Is the owner of the hybrid instrument considered to own fewer shares of the issuer foreign affiliate (or to have a different allocation of partnership income) under its relevant foreign tax law than it is considered to own (or be allocated) under Canadian tax law?
Essentially, in order for these rules to apply, the issuer of the hybrid instrument must be in the same chain of ownership as the foreign affiliate that is earning FAPI.
To determine whether the foreign tax credit generator rules apply to this REPO example, you must answer the following questions:
· Has Canco included FAPI in its income in respect of a particular foreign affiliate which has been offset by some level of foreign tax?
Yes — US Finco.
· Is there a hybrid instrument in place somewhere in the foreign affiliate group?
Yes — Between Canco and US Subco.
· Is the “specified owner” of the hybrid instrument Canco or one of its foreign affiliates?
Yes — Canco.
· Is the issuer of the hybrid another foreign affiliate of Canco that is in the same ownership chain as US Finco?
Yes — US Subco.
· Is the owner of the hybrid instrument (Canco) considered to own fewer shares of US Subco under U.S. tax law than under Canadian tax law?
Yes — Under U.S. tax law, Canco owns no US Subco preferred shares but under Canadian tax law, Canco owns 100% of US Subco preferred shares.
Because the answer to all of these questions is yes, the foreign tax credit generator rules will deny the deduction of any U.S. tax paid by US Finco in respect of its FAPI to Canco.
affiliate “funding” rules
If the funding provisions apply, the application of the rules is expanded and FAPI-FA can be outside the chain of ownership where the hybrid instrument resides.
Foreign affiliate dumping rules
An investment in a foreign affiliate includes:
· The acquisition of shares of, or a capital contribution to, the foreign affiliate by the CRIC.
· A loan made to the foreign affiliate by the CRIC, or the acquisition by the CRIC of an amount owing by the foreign affiliate. In this case, short-term loans that arise in the ordinary course of the CRIC’s business, or “pertinent loans or indebtedness”, are not included as investments.
· The extension of the maturity date of a debt obligation owing by the foreign affiliate to the CRIC, or of the redemption, acquisition or cancellation date of shares of the foreign affiliate owned by the CRIC.
· The acquisition of shares of another Canadian-resident corporation by the CRIC if at least 75% of the value of the other Canadian corporation is attributable to foreign affiliate shares (the indirect acquisition rule). The previous version of the rules contained a 50% test.
Consequences of the proposed
Both of these results will create withholding tax implications, either at the time the CRIC makes the investment in the foreign affiliate as a result of the deemed dividend rule, or in the future on the payment of a dividend because the CRIC has insufficient PUC to support a return of capital.
“Qualifying substitute corporation” election
If the QSC election is made, the PUC of the qualifying substitute corporation’s shares is automatically reduced by the amount of the deemed dividend. If no QSC election is made, this reduction is applied to the cross-border PUC, if any, of the CRIC. Effectively, cross-border PUC is reduced to the extent possible before a deemed dividend will arise. If a deemed dividend still arises, the QSC election deems the dividend to have been paid by the QSC, and received by either the QSC’s non-resident parent corporation or another related non-resident corporation, such that reduced tax treaty withholding tax rates can be accessed.
Other amendments to rules
New exceptions also 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 referred to above, to be excluded from its application.
For further details of the FA dumping rules, see TaxNewsFlash-Canada 2012-31, “FA Dumping Proposals Ease Burden of Rules”.
Foreign affiliate distributions
All pro-rata distributions made by a foreign affiliate are now treated as dividends from a Canadian tax perspective, regardless of their treatment under foreign law. However, certain elections may be made to instead treat a distribution as a reduction to the cost base of the shares in the foreign affiliate or a return of paid-up capital.
to reduce cost base
This election can now be filed up to 10 years after its original due date, as long as the taxpayer can demonstrate that the original determination not to file was made using reasonable efforts, and that it is “just and equitable” to allow for late-filing.
to return paid-up capital
If this election is to be made, it will be imperative that the foreign affiliate’s paid-up capital be calculated to ensure that it is sufficient to allow for a reduction equal to the amount of the distribution.
Other foreign affiliate measures
As a reminder, the technical bills that are currently making their way through Parliament contain a host of other foreign affiliate amendments that:
· Apply an anti-avoidance rule to deem exempt earnings to instead be classified as taxable earnings where there is a disposition of property between non-arm’s length persons and the disposition would be an “avoidance transaction” under GAAR
· Introduce the concept of hybrid surplus, which is created where a foreign affiliate realizes a capital gain (or loss) on the disposition of shares of another foreign affiliate (or a partnership interest) that would not otherwise be included in FAPI
· Affect foreign affiliate liquidations and mergers, including absorptive mergers, that in certain cases can apply on a tax-deferred basis
· Change some of the stop-loss provisions in the Income Tax Act to ensure that losses realized on the disposition of excluded property of a foreign affiliate are not stopped for surplus and other purposes
· Ensure that foreign accrual capital losses (FACL) are only deductible against foreign accrual capital gains
· Extend the carryforward period for foreign accrual property losses (FAPL) to 20 years (from five years), and introduce a three-year carryback
· Limit “bump” room in respect of the shares of a foreign affiliate on an acquisition of control where their fair market value does not exceed the total of their cost base and the “good” surplus of the affiliate (i.e., exempt surplus and grossed-up foreign tax, both of which can be returned to Canada tax-free)
· Apply “fill-the-hole” surplus rules, which require deficits in upper-tier foreign affiliates to be “filled in” with surpluses from lower-tier affiliates before tax deductible dividends can be paid to Canada.
We can help
Your KPMG adviser can help you assess the effect of these tax changes, and point out ways to ease their impact. We can also keep you abreast of the progress of these proposals as they make their way into law and help you bring any concerns you may have to Finance’s attention.
Information is current to December 6, 2012. The information contained in this TaxNewsFlash-Canada 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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