Enhancing the Competitiveness of Canada’s International Tax System (Part 10)

By: Nick Pantaleo

Yes, Virginia, there is FAPI

“Nick, there is no such thing as FAPI.”

That was the surprising reaction I got from an unimpressed partner a number of years ago when, as a young practitioner, I rushed into his office with the news that I thought one of our clients had a “FAPI” issue.

But that was a long time ago. My girls were still just a twinkle in my eyes; hockey season started on time; Septembers were still exciting for Blue Jay fans; Canada Trustco referred to a FAPI, not a GAAR case; and I was younger than Nat Boidman.

Then came the 1995 changes which tightened and expanded the FAPI regime by adding to the base erosion rules and introducing the investment business definition. Suddenly, foreign affiliate planning and compliance became a lot more challenging and complicated.

In his last post Wally argued that Canada’s base erosion rules have really not stood the test of time and like certain other countries have done, they need to be carved back to ensure that they do not adversely affect today’s global operations of Canadian companies. But, what about the investment business definition – has it stood the test of time?

Looking back

As a refresher, in 1991, the Tax Court of Canada in Canada Trustco Mortgage Company v. The Minister of National Revenue, concluded that a business carried on by a foreign affiliate for the purpose of earning interest income was an active business. Hence, the interest was income from an active business and not FAPI. In response, this is what was defined as an investment business: a business where the principle purpose of which is to derive income from property (such as interest, rents, royalties and dividends from non-foreign affiliates), as well as income from the insurance or reinsurance of risk, the factoring of accounts receivable, or the disposition of certain properties known as investment properties. Income from an investment business is FAPI.

There is an exception in the definition for a business of regulated financial institutions (including insurers, and traders and dealers in securities or commodities), real estate developers, leasing and licensing companies and money lenders provided the business is conducted principally with persons dealing at arm’s length with the foreign affiliate and employs more than 5 full-time employees.

The Advisory Panel on Canada’s System of International Taxation, of which I was a member, heard a lot about the complexity of the FAPI system generally and, in particular, the difficulties taxpayers have in meeting the exception to the investment business definition. For example, although it parallels the domestic investment business test, the more than 5 full-time employee requirement is somewhat arbitrary and perhaps not as suitable for foreign affiliates. The Panel also referred to difficulties meeting the test when activities such as real estate development, leasing, and the management of global businesses are carried out for non-tax reasons through more than one foreign affiliate.

The definition has gone through various amendments, mostly relieving, but the changes have not eliminated some of the inherent certainties such as, for example, whether royalties or licensing fees derived from intangible and other property are caught if the affiliate has created or developed the underlying property.

Is there a better alternative to the investment business definition?

Brian Arnold in his book, Reforming Canada’s International Tax System: Toward Coherence and Simplicity, recommends that the definition be dropped and that the FAPI definition be expanded to include specific sources of passive income. The Advisory Panel did not go that far, instead recommending that the scope of the definition be more properly targeted and clarified to eliminate the above problems and uncertainties to ensure it does not impede bona fide business transactions.

Part of the challenge is that the Canadian FAPI regime applies to all foreign affiliates, regardless of where they are located or the level of foreign tax they are subject to; the CFC regime for many other countries is restricted to income earned in low-tax jurisdictions. Arnold suggests that a “designated jurisdiction approach” should be considered to, among other things, simplify the regime and he offers a couple of approaches.

Conceptually, I like our system.

At its core, the Canadian tax treatment of income earned abroad by foreign affiliates as FAPI or as active business income is not dependent on the level of foreign tax the income is subject to. This is an important competitive feature of the Canadian system. To do otherwise would mean limiting, for example, the application of paragraph 95(2)(a), something that would ignore how Canadian companies conduct their global operations. It is why section 18.2, since repealed, made no sense.

However, this comes at a cost. We need to deal with more complexity in the FAPI rules because they need to be robust, especially so if Canada moves to a full exemption system. More on this topic in my next post.

Thoughts? Comment? Leave them below.

Reflections on the Summer of "O" Twelve

By: Nick Pantaleo

It has been awhile since my last posting. Can you blame me? It has been a great summer!

But, the opening of the Canadian National Exhibition, the start of the U.S. Tennis Open, Labour Day and seeing kids getting ready for school are signs that summer is coming to an end.

Time for a brief look back and some reflections.

Summer heroes

For many, the summer focus was on the Games and the many incredible athletic performances including those of Phelps and Bolt (again) and the Canadian women’s soccer team.

Not being a super summer Games fan, I was content with taking more time off to play more golf than in previous summers, taking some short road trips with Lori and the girls and making what has become for me an annual trip to Wimbledon in June. Unfortunately, my presence this year did not help the Canadian pros. Nestor, Raonic, Wozniak – saw them all play and they all lost. Fortunately, I stayed away from watching Felip Peliwo and Eugenie Bouchard and they went on to claim the Boys and Girls Championships – quite the feat for Canadians to hold these titles in the same year!!

I loved seeing Federer walk away with the Gentlemen’s title for the seventh time and reclaiming the number one ranking – I guess all veterans like to see other veterans do well. But, was Lori peeved when he announced that he would pass on the Rogers Cup. She still bought me a Federer cap though – black, with white lettering.

Rain and Canadian efficiency

Speaking of the Rogers Cup, I got rained on there as well as at Wimbledon.

There isn’t much to do during rain delays at a tennis match except drink and watch the rain fall.

At Wimbledon you get to experience their ritual for keeping the grass courts dry, which consists of about 7-8 teenagers at each court quickly scurrying to remove the net, posts and chairs and then rolling a tarp across the court. It takes about 5 minutes at most. It takes the same number of people about 10-15 minutes to reverse everything once word is given from some higher authority to get the matches going again.

In contrast, when it began to rain on the asphalt court of the semi-final match at the Rogers Cup, the court was cleared in no time. However, when the rained stopped, it took 30-40 minutes for about 40 people, using towels and 13 large blow dryers on wheels, to dry the court!!

Foreign Affiliate dumping proposals (round two) and contingency fees

I thought Finance was quick in getting out another version of the proposed FA dumping proposals following the June 1st deadline for comments (see PwC’s commentary).

In a previous posting and an article for the Tax Executive Institute’s June newsletter, I was critical that the proposals announced in the March budget were overreaching and lacked clear alternatives and safe harbours. In particular, original proposed subparagraph 212.3(5) was the only way out of the rules and its application would have caused considerable administrative and compliance issues for the CRA and taxpayers.

The revised proposals are better, I believe. The paid-up-capital offset and re-instatement rules and the new elective 17.1 regime should provide taxpayers with clearer alternatives for many situations. Also, there is less riding on new proposed 212.3(12), which replaced proposed 212.3(5) and although it is suppose to offer a practical exception where the Canadian resident corporation is the base for the strategic business expansion, I suspect there will be some uncertainty as to its application, at least initially.

Finance was also busy launching consultations on Contingency Fees and the Scientific Research and Experimental Development tax incentive program. It will be interesting to see how this one develops. Professional firms as well as taxpayers have an important stake in the outcome. I expect to have more to say on this in a future posting.

However, the promised “Hoover” bill of foreign affiliate amendments has yet to be seen.

About Time You Say?

The CRA’s Rulings Directorate is (finally) taking the task of replacing outdated Interpretation Bulletins and will be reaching out to the entire tax community for help. The CRA is planning to make the bulletins available online as folios and has already updated some of them.  

This is the right thing for the Agency to do. In a 2011 submission, PwC urged the CRA to put processes and resources in place to update all bulletins on a regular basis so that all taxpayers would have greater certainty in complying with the Income Tax Act (see our submission). Kudos to new Director General, Mickey Sarazin for leading this herculean task.

And finally.....

After almost 5 years with PwC and 26 years at the Department of Finance, Wally Conway decided to retire. Yes, he is giving all of this up to enjoy and work on his properties in Quebec!!

Wally brought to PwC and our clients a deep knowledge and history of recent and past legislative developments that extended into almost every area of the corporate income tax landscape. In doing so, Wally helped us to better understand Canadian tax policy and to engage Finance officials about legislative changes.

I benefitted most from Wally’s advice, insight and friendship. I will miss our road trips, his desire for “early” lunches and dinners and his hearty laugh that could be heard at the other end of the floor!

Wally has left behind some more thoughts on how to improve, in particular, the Canadian international tax system. I will do my best to continue with his multi-part series.

Wally, many thanks for your years of service and all the best for a long, happy and healthy retirement!

What if...you were stuck with the CRA?

Listen to  this episode of Tax Tracks where Rick Biscaro, a former CRA Director, walks through a few “sticky situations” with the CRA.

 

What have you encountered in dealing with the CRA? Have you been in a sticky situation?

Sneak peak:
In the next episode, Sharon Gulliver – a former CRA officer – discusses what to do and what not to do when being audited by the CRA.

What would you like us to talk about next? Leave your thoughts and comments below.

Enhancing the Competitiveness of Canada’s International Tax System (Part 9)

By: Wally Conway

A New Approach to Tax Base Protection

The Canadian Income Tax Act includes certain provisions commonly referred to as the base erosion rules. These are rules are intended to prevent the shift of Canadian income to foreign jurisdictions by having a Canadian company establish a foreign affiliate. The foreign affiliate is to serve as a captive property procurement, insurance, financing or services company in a manner whereby a Canadian resident (usually the Canadian company or non-arm’s length person) incurs deductible charges from the affiliate and the resulting income is taxed in a foreign jurisdiction, often at a lower tax rate.

The Advisory Panel on Canada’s System of International Taxation in its December 2008 final report noted that Canada’s current base erosion rules are considered by many Canadian businesses as being too broad and prevent them from taking full advantage of global supply chains they have built up to support their global operations.

As Canadian companies expand globally, they acquire intellectual know-how, service and manufacturing capabilities in foreign jurisdictions, that they want use globally, in the most productive and cost-efficient manner possible. Providing their Canadian operations with access to such acquired capabilities, even in a manner that meets accepted transfer pricing guidelines, can run afoul of Canada’s base erosion rules.

Conceptually, base erosion rules should not apply to income that is derived by a foreign affiliate from active business operations carried on in a permanent establishment in a foreign country. Otherwise, the result is that such foreign active business income is inappropriately included in foreign accrual property income (FAPI) of the affiliate. This is contrary to the tax policy underlying the foreign affiliate rules. It also precludes such foreign affiliates from competing in the Canadian market place and the Canadian market place from benefiting from that competition.

The Advisory Panel recommended that the scope of Canada’s base erosion rules be reviewed to ensure they do not impede bona fide business transactions and the competitiveness of Canadian businesses.

A number of countries, including Australia and even the U.S., have or are considering the scope and necessity of their base erosion rules.  More recently, the UK has stated that its CFC rules will only include profits that have been artificially diverted from the UK.

In the March 29th federal budget, the government promised that amendments would be made to the base erosion rules to alleviate the tax cost to Canadian banks of using excess liquidity of their foreign affiliates in their Canadian operations as well as ensuring certain securities transactions undertaken in the course of a bank’s business are not inappropriately caught by these rules.

This is a very positive development for foreign operations of Canadian banks and a step in the right direction in re-evaluating Canada’s base erosion rules. But more work is needed to ensure that the global operations of Canadian companies in other industries are also not adversely affected by Canada’s base erosion rules.

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.

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.

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?”

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.

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.

Enhancing the Competitiveness of Canada’s International Tax System (Part 5)

By: Wally Conway

Taxation of Capital Gains from sale of Shares of Foreign Affiliates

In my last post (Part 4), I discussed the Canadian taxation of capital gains arising on the sale of foreign active business assets owned directly by Canadian corporate taxpayers and indirectly through foreign affiliates. I proposed that Canada adopt a territorial approach, similar to what I proposed for foreign active business income earned directly or indirectly by such taxpayers.

Time now to look at the taxation of capital gains arising on the sale of shares of a foreign affiliate.