Up a CRIC without a ...

By Eric Lockwood

On May 10, 2012 we hosted a webcast on the Foreign Affiliate Dumping (FAD) proposals (if you missed the webcast see our Tax Memo “Canadian federal budget targets Canadian subsidiaries of foreign multinationals” for background on these proposals).  Clearly, the proposals are targeted at new investments made by foreign-controlled Canadian corporations in foreign affiliates.  However, they are very broadly worded. There is another aspect of the proposals touched on during the webcast that I would like to comment on in this note; namely the extent to which the proposals, as drafted, appear to prevent a Canadian corporation from managing its current foreign affiliate structure.

The FAD proposals are invoked if a foreign-controlled Canadian corporation makes an investment in a foreign affiliate and the exception for bona fide purpose is not met.  The definition of “investment” is broad and includes:

• An acquisition of a  share
• A contribution to capital
• An acquisition of a debt or a transaction under which an amount became owing, unless the debt or the amount owing arose in the ordinary course of business

This would appear to bring the FAD proposals into play if Canco makes a loan to an FA to help it with a short-term working capital shortfall, or if Canco makes a contribution to the capital of an FA that needs to restructure its debt.  What about the common practice of Canco incurring expenses on behalf of FA and charging them down through an intercompany account?

Basic restructuring may also be an issue.  Suppose Canco transfers the shares of FA to a new FA Holdco.  This should normally be a rollover under subsection 85.1(3). However, Canco would have an “investment” in the shares of FA Holdco and perhaps the FAD proposals would rise up to bite. Similarly, suppose Canco liquidates FA Holdco and acquires shares of FA as a consequence.  Or, FA Holdco and FA merge.  Or, Canco amalgamates with another Canadian company or liquidates into its parent.

In the examples above, if the FAD proposals apply, the consequence would be a deemed dividend paid to the foreign parent with the consequent withholding tax implications.

Hopefully, none of this is intended and the Department of Finance will clarify the rules.  However, the wording of the current bona fide purpose exception does not give much comfort. 

And the result is that foreign-controlled Canadian multinationals that are trapped in these rules are trapped indeed.  They are largely frozen in place as far as managing their foreign affiliate investments is concerned.  We can expect this stasis to last for months before we see revised proposals.  In the meantime, what are taxpayers to do?

PwC will file a submission to the Department Finance.  Other groups will also.  We encourage you to consider filing a submission if your company is adversely affected by these proposals.

 

As always, we look forward to your comments.

Enhancing the Competitiveness of Canada’s International Tax System (Part 8)

By Wally Conway:

I’m back - after a great vacation in sunny Sicily where there were lots of good food, wine and beaches!

Up to now I have been talking about ways to enhance the competitiveness of Canada’s international tax rules by moving to a full exemption system for taxing foreign business profits, including capital gains and losses arising on the sale of shares of foreign affiliates that are essentially carrying on or earning income from an active business.

I now want to start to look at how to improve Canada’s foreign accrual property income (“FAPI”) regime.

Briefly, here are the Canadian rules:

• FAPI of a controlled foreign affiliate of a taxpayer for a particular year is subject to Canadian taxation on an accrual basis;
• It’s included in the taxpayer’s income for tax purposes in the year in which the affiliate’s taxation year ends; and,
• The taxpayer is permitted to claim Canadian tax relief for any foreign income taxes paid by the affiliate in respect of the portion of the FAPI that is included in the taxpayer’s income.

Essentially, the objective of the FAPI regime is to establish a sort of fiscal unity between the taxpayer and a controlled foreign affiliate to prevent the use of a foreign company to avoid Canadian tax on passive types of income and income from Canadian-source activities. This ensures that the Canadian tax base is not inappropriately eroded. In this respect, it is clear that FAPI should not include active business income of the affiliate that is derived from a foreign business carried on through a permanent establishment in a foreign country.

However, sometimes the line between what is active business income versus FAPI is not always clear. Worse, the broad scope of some of the FAPI rules can result in income that should be treated as active being treated instead as FAPI. This has a negative impact on the competitiveness of Canadian companies globally and on Canada’s markets. 

The Advisory Panel on Canada’s System of International Taxation recommended in its December 2008 final report that the FAPI rules be reviewed to ensure they are properly targeted and do not impede bona fide business transactions and the competitiveness of Canada’s businesses.

In subsequent postings, I will take a closer look at some of the current FAPI rules, including the so-called “base erosion” rules, to see how they can be improved to ensure that foreign source active business income is better determined and not included in FAPI, yet remains robust enough to protect Canada’s tax base.

What are your thoughts on FAPI? How would you like to see the rules change? Leave your thoughts below.

Is the Elephant Finally Out of the Room?

By: Nick Pantaleo

The comments started coming in not long after the Minister stood up in the House of Commons and the budget papers became available. 

“Happy now?” someone emailed.  “Looks like you guys got what you wanted,” another observed. Others asked, “Is this really what the Panel recommended?”

The comments were in response to the foreign affiliate dumping proposals announced in the March 29th federal budget. The budget papers pointed out (3 times) that the proposals were based on recommendations made by the Advisory Panel on Canada’s System of International Taxation, of which I was a member.

Actually, the Panel’s recommendations in question focussed on debt dumping, something Finance Minster Jim Flaherty specifically requested us to consider. In the international tax context this refers to borrowings by foreign-controlled Canadian companies to invest in foreign affiliates whereby the interest is deductible in computing taxable income but dividends are not taxable. The Panel concluded that such transactions are not a good thing if they are tax-motivated and there are no economic benefits for Canada.

The proposals go farther than what the Panel recommended by deeming such investments to be a deemed dividend even when they are not financed with debt. No doubt this is to make the debt dumping aspect of the proposals more robust and prevent creative tax planners from replacing non-debt financing with debt financing in the future.

It also looks like the proposals are intended to stop transactions that create paid-up capital in perceived abusive circumstances.

Taxpayers and tax advisors will be looking to the government to provide more clarity around the proposals, particularly how the business purpose exception is intended to operate. While the government has promised to consult with the tax community, to this observer their position is clear: they don’t believe the benefits of such structures to Canada are worth the cost of an actual or possible erosion of the Canadian tax base.

The proposals will be discussed and debated in the coming weeks, including whether the government’s hypothesis is correct, whether it is possible to get clarity around the business purpose exception and other issues.
Aside from that important discussion, the proposals raise (at least) three questions in my mind.

First, while the proposals seem directed, in part, to the extract of earnings of a Canadian subsidiary free of withholding tax, would this be a problem if the earnings could be loaned to the foreign parent at a reasonable rate of interest? Withholding tax would still be deferred but the interest income would add to, not erode, the Canadian tax base.

Second, while the proposals grandfather existing structures (although any future change is subject to the new rules), why is there is no grandfathering under the upstream loan proposals for loans existing when those proposals were introduced on August 19, 2011? After all, the upstream loan proposals are intended to deal, in part, with loans made by foreign affiliates of foreign-controlled Canadian companies to other foreign affiliates or to related non-resident companies.

Also, while the foreign affiliate dumping proposals are based on the Panel’s recommendations, the upstream loan proposals are not and it is difficult to view upstream loans as having a more damaging impact on Canada’s tax base than debt dumping. Hopefully, the government will reconsider at least this aspect of the upstream loan proposals.

Finally, since the proposals are based on the Panel’s recommendations, it seems to me that the government should agree with the Panel that there are economic benefits to continue to permit Canadian-controlled companies to deduct interest on funds borrowed to invest in foreign affiliates. If that is the case, then that proverbial elephant I wrote about in a previous posting  is finally out of the room.

That being the case, are there any remaining hurdles for Canada to move to a full exemption system? Time will tell.

Loan from FA and Thin Cap – Budget Proposal

By: Melanie Huynh

Currently, interest paid by a Canco to a controlled foreign affiliate (CFA) could be subject to the thin capitalization rule in 18(4).  This may result in a denial of some or all of Canco’s interest expense, while the interest income earned by the CFA is taxed in Canada as FAPI, giving rise to double taxation.

Under the March 2012 budget proposal, Canco’s interest deduction is not denied, but only to the extent that the FAPI, net of related deduction under 91(4), is included in Canco’s income. Although the proposal is welcome, further fine tuning is needed to properly address the double taxation issue.

For example, under the proposal the net FAPI must be included in the income of the same Canco that has the interest expense.  This means the rule will only give the intended result if loans are made to the lowest tier Canco. To illustrate, assume Canco1 owns Canco2 which owns CFA, and CFA makes an interest bearing loan to Canco1. Because CFA’s FAPI is included in Canco2’s income and not Canco1, the proposal will not apply to Canco1 which will continue to be subject to the denial rule in 18(4). Presumably such a result is unintended.

Another concern with the budget proposal is that it does not provide relief for taxes paid (including any Canadian withholding tax) in respect of the FAPI. In the above example, assume the loan is made to Canco2 and say there is a 25% Canadian withholding tax paid and no further tax in CFA’s home country. Under this scenario Canco2’s FAPI will be completely offset by a 91(4) deduction. The proposal does not assist Canco2, however, because its net FAPI inclusion is nil. Canco2’s interest expense remains fully subject to the denial rule in 18(4). This is an unfair result considering that if the CFA were a Canadian company there would be no tax leakage for the group.

Given the above concerns, if Canco1 in the example is a public company it may be beneficial to make the loan from CFA to Canco1.  This is the current practice for most taxpayers anyway because, as a public company, the loan is unlikely to be caught by the rule in 18(4).

I am sure there are other tricks and traps with this proposal as we work through the rule – want to share yours?

Budget 2012 – Jobs, Growth and Long-term Prosperity

By: Wally Conway

The Honourable Jim Flaherty has finally tabled the Harper Government’s budget. As expected, the budget focus was on creating Canadian jobs, economic growth, and returning to balanced budgets. To meet its medium term goal of eliminating budgetary deficits, the federal government is relying on measures such as growing its revenue, protecting its tax base and reducing government operating expenditures.

By promoting Canadian economic growth, some of the budget measures would grow Canadian jobs and government revenues. The Harper government expects to grow jobs and government revenues by creating a Canadian business operating environment which would be globally competitive and attract new business investment to Canada. The proposed measures are designed to improve business operating conditions by supporting research, education and training, reducing investment inhibiting regulations and expanding access to foreign markets through expanding international trade and tax agreement networks.

By proposing new tax rules that are designed to curtail tax avoidance achieved through widely used international tax planning techniques, some budget measures would protect against tax revenue losses.  The proposals would deal with tax base erosion achieved through thinly capitalized Canadian subsidiaries of non-residents, the sale of shares of related foreign corporations to Canadian subsidiaries, secondary adjustments associated with international transfer pricing assessments and the packaging of non-capital property of a Canadian corporation in a partnership prior to a sale to non-residents. Measures affecting Canadian individuals are also proposed. Together these tax measures could have significant positive government revenue impact.

Finally, some budget measures propose to reduce government operating expenditures by some $5.2 billion annually. Nonetheless, government expenditures are expected to grow by over 6% from last year. Expenditures are expected to grow further in future years. Consequently, we can expect to see more attempts at revenue growing and tax base protecting in future year’s budgets of the types that are in this year’s budget. As well, current tax expenditures (perceived entitlements of taxpayers) may become tax base broadening targets of budgets of future years.

It is clear that the path to balanced budgets lies in sustainable economic growth. If the Harper government wishes to create a globally competitive business operating environment capable of attracting the new business, it needs to be more analytical and strategic in development of its actions plans. Canada must compete globally. To do so effectively, Canada must become more strategic in its efforts. This sort of strategic effort appeared to be lacking in the budget.

Any Harper government strategy must include an evaluation of the strengths and weaknesses of Canada and its global competitors. Canada must use its strengths to exploit the weaknesses of its competitors. To the extent that Canadian weaknesses are being exploited by its competitors, those weaknesses need to be eliminated. The elimination of weaknesses and the building of strengths is where the government needs to direct its efforts. Canada’s resources and efforts need to be focused on actions that will produce the most effective results. Results of actions must be measured and evaluated. A good plan today is better that a perfect plan that is too late.

 

Is it time for Canada to change its tax revenue mix?

By: Nick Pantaleo

Budget watch 2012 has focused primarily on speculation over the amount and scope of government spending cuts to reverse budget deficits.

We have seen this movie before – in the mid to late 90s when the federal government and certain provinces drastically cut spending. This led to years of budget surpluses and reduced debt and service costs. For those in need of a reminder, I refer you to an excellent video produced by the MacDonald Laurier Institute at http://www.macdonaldlaurier.ca/the-canadian-century-video/.

Lost Opportunity

 By Eric Lockwood

When considering investments in foreign affiliates, private corporations have a difficult decision to make:  whether to hold such investments directly and thereby potentially benefit from the capital dividend account provisions; or to hold them indirectly through a foreign holding company and take advantage of the many commercial and foreign tax benefits such structures afford.

Budget 2012 – Encouraging the commercialization of intellectual property in Canada

By: Wally Conway

Canada provides generous tax support to encourage research and development (R&D) in Canada. Still, the government and other economic pundits lament that despite this support Canada continues to lag other countries in innovation and productivity.

Why?

What would you like to see in the federal budget — take our poll

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Enhancing the Competitiveness of Canada’s International Tax System (Part 7)

By: Wally Conway

If not exemption, how about a rollover? 

In our previous post, Nick identified possible impediments to Canada providing a tax exemption in respect of gains arising on the sale of shares of foreign affiliates earning active business income.

Is there another alternative to the current system - for example, a system that would not include restrictions on upstream loans or the need to maintain a new “hybrid surplus” account while still respecting the current policy objectives? Or a system that would not be viewed by some as giving an undue advantage to companies with foreign versus domestic investments? How about a rollover for capital gains earned directly or indirectly on the sale of interests in foreign and domestic entities earning active business income?