Copyright 2008, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Tax, December 2008
Introduction
In the aftermath of the Canadian government's attempt to restrict the deduction of so-called "double dip" interest, the government established the Advisory Panel on Canada's System of International Taxation. Briefly, the mandate of the Panel was to recommend ways to improve the competitiveness, efficiency and fairness of Canada's system of international taxation. In a report released on December 10, 2008, the Panel made a number of recommendations to change the rules applicable to the taxation of inbound and outbound investment, withholding taxes and compliance matters.
The report is available at www.apcsit-gcrcfi.ca/07/index-eng.html. The Panel's report contains information and analysis supporting the recommendations. This bulletin describes only the important recommendations and considers the implications for taxpayers if the recommendations become law and speculates as to the possibility of the recommendations becoming law.
The bulletin focuses on those recommendations where changes are recommended. However, those recommendations proposing that Canada retain significant existing taxation policies are mentioned. Our review is organized under the headings Outbound Investment, Inbound Investment and Compliance Issues.
Outbound Investment
Canada has a mixed credit and exemption system for taxing foreign investments made by Canadian residents. Regarded as a whole, the recommendations relating to outbound investment would expand the exemption system used to tax dividends received by Canadian corporations from foreign affiliates. No changes to the credit system of taxation of income earned from a foreign branch operation are recommended. Some simplification of the rules applicable to the accrual and credit system for taxation of passive income earned by controlled foreign corporations (the foreign accrual property income, or "FAPI", rules) is suggested.
The exemption system currently in place exempts Canadian corporations from taxation on dividends received from foreign affiliates when the dividends are attributable to income from an active business earned in a country with which Canada has a tax treaty or a tax information exchange agreement (a TIEA). Such exempt dividends are said to be paid from "exempt surplus". Dividends received from active business income earned in other countries are subject to a credit system for underlying foreign tax. Thus, such dividends are taxable to the recipient corporation to the extent the underlying foreign tax rate is lower than the Canadian tax rate. Such taxable dividends are said to be paid from "taxable surplus".
The Panel proposes that the exemption system be expanded to cover all active business earned by a foreign affiliate. A companion recommendation would eliminate the provisions of the Income Tax Act (the Tax Act) that recharacterize active business income that is earned in a country that has no tax treaty or TIEA with Canada as FAPI. The principal basis for the Panel's recommendation, and of other recommendations described below, is that taxpayers plan around the existing rules and there would be little revenue loss from adopting the broader exemption system.
The implications of the foregoing expansion of the exemption system would be profound. Much Canadian tax planning effort is devoted to creating foreign structures to ensure that taxable surplus that has been subject to a low rate of foreign tax is not distributed to Canada while exempt surplus is distributed. Such planning may involve the use of so-called "mixer" corporations that take advantage of a provision of the Tax Act that specifies that a foreign affiliate is deemed to distribute exempt surplus before taxable surplus is distributed. The need for this type of planning would be curtailed for most Canadian corporations. The exception would be where a Canadian corporation has an investment in a non-controlled foreign affiliate – not subject to the FAPI regime – that earns passive income. In this case, the foreign affiliate would accumulate taxable surplus from its passive income. To bring all income within a full exemption system, the Panel believes that consideration should be given to extending the FAPI rules to passive income of a non-controlled foreign affiliate. This would present obvious compliance issues for taxpayers who may not have access to the information necessary to compute the FAPI of a non-controlled foreign affiliate.
The Tax Act contains an inter-affiliate payment rule that recharacterizes passive income of a foreign affiliate – such as interest, rents and royalties – as active business income where the passive income was received from another foreign affiliate that deducted the item in question in computing its active business income. If the recipient affiliate is resident in a treaty/TIEA country, then the passive income will be exempt surplus. If not, it will be taxable surplus. The Panel's recommendations do not suggest amending these provisions. The elimination of the treaty/TIEA requirement for the recipient affiliate would mean that a broader range of countries will be suitable jurisdictions in which to locate such financing affiliates.
The Panel's report seems to suggest that the elimination of the treaty/TIEA distinction among countries would eliminate the need to track separate surplus pools. As pointed out above, this is not necessarily correct where a non-controlled foreign affiliate earns passive income. This may be a relatively rare situation and might be ignored in favour of the simplicity of a system that does not require tracking of surplus pools. There would be transitional issues relating to existing pools of taxable surplus. The Panel suggests that there be no carry over of taxable surplus – all dividends would be exempt following implementation of the proposed system. A more important policy consideration in tracking surplus will be in the context of dispositions of shares of foreign affiliates and is related to another recommendation of the Panel that is discussed in the following paragraph.
The Panel has recommended that there be an exemption from Canadian tax on the disposition of shares of foreign affiliates that are excluded property. Generally, shares are excluded property if 90% or more of the fair market value of the affiliate's assets are used in an active business or are investments in other foreign affiliates whose shares are excluded property. The extended exemption would include dispositions of excluded property shares by other foreign affiliates. In effect, this amounts to a recommendation that Canada adopt a form of "participation exemption" that is found in the tax law of other countries, including a number of members of the EU. Such an exemption from Canadian tax may eliminate the need for offshore holding company structures that are commonly used by Canadian corporations to hold foreign operating subsidiaries.
The participation exemption proposal and the expansion of the non-surplus-tracking dividend exemption proposal are obviously related. There seems little point in continuing to tax capital gains arising on the sale of the shares of a foreign affiliate if the gain could be avoided by reducing the value of the affiliate by paying an exempt dividend prior to the sale. However, if the shares to be sold are not excluded property, then there may be a need to continue to track surplus – which is similar to the dividend stripping rules relating to the sale of shares of a Canadian corporation in section 55 of the Tax Act – unless a different method is used for excluding the portion of the gain related to underlying excluded property.
In a recommendation that will undoubtedly prove popular with taxpayers, the Panel has recommended that interest expense incurred on debts used to finance foreign affiliates should not be subject to special restrictions and that the prohibition on the deduction of interest expense related to "double-dip" financing found in section 18.2 of the Tax Act should be repealed. In many circumstances, taxpayers have found ways to avoid the provisions of section 18.2, often using "hybrid" financial instruments that are treated for tax purposes as debt in the issuer's country of residence and equity to the holder in Canada.
There are a number of recommendations where the Panel has suggested retention of existing provisions with amendments to better target the provisions or to simplify their application. In some cases, further study is recommended.
While indicating that the FAPI regime should remain, it is suggested that amendments be made to ensure that the "base erosion" rules do not impede bona fide business transactions. The "base erosion" rules treat what would otherwise be active business income of a foreign affiliate as FAPI where the income is deducted in computing Canadian source income and include rules that characterize as FAPI income of a foreign affiliate from the insurance of Canadian risks of, or from the re-selling of goods into Canada to, non-arm's-length Canadian persons. The Panel suggests that certain of these rules should be retained – such as the insurance of Canadian risks – and others – such as the sale of goods – should not be retained. In the same vein, income of a foreign affiliate from an "investment business" as defined in the Tax Act is deemed to be FAPI. There are exceptions to this definition. In the view of the Panel, certain of these exceptions should be broadened to ensure that "true" active businesses are not brought within the FAPI provisions. An example of a business inappropriately characterized as an investment business is a real estate business that is carried on in multiple entities for business reasons. Each of the entities may be considered to be carrying on an investment business but, if the business was being carried on in one entity, it would not be an investment business.
Speculating which, if any, of the foregoing recommendations will be accepted by the government is a risky proposition. However, we will make some observations. The extension of the exemption regime to all active business income seems to make sense. If the figures used by the Panel are accurate, then there would be little revenue loss. In fact, encouraging the distribution of such earnings to Canada may encourage investment in Canada. Eliminating one surplus pool – taxable surplus – would be a desirable result, as it would reduce the complexity of the system. Some of the Panel's ideas for improvement in the methodology to characterize excluded property would be highly desirable to prevent inappropriate characterization of shares of a foreign affiliate as excluded or non-excluded property as a result of the cascading effect of relatively small levels of excluded or non-excluded property several tiers down in a foreign affiliate structure. Current rules create very difficult compliance issues for taxpayers. One recommendation that may be difficult for the government to accept is to provide a full exemption for gains on the sale of shares of a foreign affiliate that are excluded property. Looking at existing surplus stripping provisions in the Tax Act applicable in a domestic – section 55 of the Tax Act – and in a foreign context – exempt and taxable surplus, there is a clear distinction in the Tax Act between the tax free transfer of taxed earnings as dividends and the realization of appreciation in value on the sale of shares. The only basis for accepting this recommendation may be enhancing competitiveness of Canada's international tax system. Finally, repeal of the rules against the deduction of double-dip interest under section 18.2 may be logical since, as noted, there are a number of structures that avoid these rules while providing a double dip. Rumours have circulated that some pressure for the introduction of section 18.2 came from the U.S. government. If true, repeal of section 18.2 may be difficult in the face of U.S. opposition.
Inbound Investment
While the Panel's recommendations on outbound investment would generally provide relief to Canadians investing internationally, the recommendations for the changes to the taxation of non-resident investment in Canada are mixed.
Thin Capitalization
The principal focus of the Panel's recommendations is Canada's thin capitalization rules. Currently, these provisions limit the deduction of interest expense by Canadian corporations on loans from significant (25% or more) non-resident shareholders where the debt to equity ratio of the shareholder's investment exceeds 2 to 1. The Panel suggests three changes.
The first recommendation is that the debt to equity ratio for non-resident shareholder debt be reduced from 2 to 1 to 1.5 to 1. The actual increase in a non-resident shareholder's investment in share capital of a Canadian corporation required to meet this lower ratio may be higher than appears to be the case. The Canadian thin capitalization rules permit retained earnings to be counted as equity. Some calculations show that a non-resident shareholder currently investing at a 2 to 1 ratio of debt to equity would have to increase its share capital investment by 20% of the current amount of share capital plus 20% of the corporation's retained earnings.
The Panel makes a comment, as opposed to a recommendation, concerning the withholding tax treatment of interest expense disallowed under the thin capitalizations rules. Under the recent Fifth Protocol to the Canada-U.S. Income Tax Convention, interest expense paid after 2009 between related persons will be exempt from withholding tax. The Panel is concerned that this exemption from withholding tax could create an incentive for U.S. shareholders to set up thinly capitalized Canadian holding corporations to convert the distribution of amounts that would otherwise be dividends subject to withholding tax into interest that is not subject to withholding tax. The non-deductibility of interest paid by the holding company against tax-free dividend income received by the holding company may be a non-issue. On the other hand, in Canada's other current tax conventions the rate of withholding tax applicable to interest is usually 10% while the rate applicable to dividends to significant shareholders is 5%, so at present this will be an issue only in a Canada-U.S. context.
Canada's existing thin capitalization rules apply only to Canadian corporations. The Panel recommends that theses rules be extended to non-resident persons carrying on business in Canada through a branch, a partnership or a trust following consultations with taxpayers. The ability to operate in Canada other than through a Canadian corporation can result in substantial advantages for a non-resident. Highly levered branch operations carried on in Canada by corporations located in countries such as Luxembourg have been used in some cases. When combined with a favourable tax treaty and the Canadian courts' current reluctance to overturn "treaty shopping" arrangements, such branch structures can be very tax efficient.
There will be a number of conceptual issues that would have to be addressed in implementing thin capitalization rules in a non-corporate context. The Tax Act does contain a provision that applies thin capitalization rules to branches of foreign banks. Section 20.2 essentially restricts debt financing of a foreign bank's Canadian branch assets based on the branch's GAAP financial statement to 95% – including third party debt. While bank branches are specialized businesses, some of the concepts used could have broader application. Such concepts might include the use of GAAP and branch books to determine amounts used as the bases for determining thinly capitalized branches – which would be in line with the existing accounting-based corporate thin capitalization rules – and whether advances made by a head office to a branch would be recognized as debt for Canadian tax purposes – perhaps a stretch. In applying the thin capitalization rules to partnerships and trusts, an issue that will have to be addressed is whether, as is currently the case for corporations, the thin capitalization rules would apply at the entity level and affect Canadian resident and non-resident owners. In the case of a partnership, this may not be the case since the non-resident may lever its investment in the partnership and such debt should be part of the thin capitalization calculation.
The Panel suggests that third party debt of Canadian entities that is guaranteed by a significant owner should continue to not be included as related party debt for purposes of the thin capitalization rules. However, it is suggested that the current inclusion of "back-to-back" loans made by a significant non-resident shareholder on condition that an intermediary on-lend the amount to a Canadian corporation be broadened to include all indebtedness between the significant shareholder and the intermediary where the amount has been loaned or transferred directly or indirectly to the Canadian business. If the rules on back-to-back loans are to be reviewed, it would be useful to review both the on-lending of foreign sourced funds by a Canadian corporation that is not thinly capitalized and the direct lending of foreign funds to lower tier Canadian subsidiaries. While the Canada Revenue Agency (the CRA) has administrative policies that exempt some such loans to such subsidiaries from the application of the back-to-back loan rules, some legislative direction would be useful.
We are not aware that the government is concerned with the existing 2 to 1 debt to equity ratio for thin capitalization introduced in 2001 and so it is not clear that this will be a priority. On the other hand, as pointed out by the Panel, the extension of the thin capitalization rules to business entities other than corporations has been suggested before and, if the definitional issues can be addressed, we would not be surprised to see developments proceed in this area.
Other Matters
With an exemption system for dividends received from an active business of a foreign affiliate and the ability to deduct interest expense on amounts borrowed to acquire shares of foreign affiliates, Canada can be an attractive jurisdiction in which to hold foreign investments. This has led to transactions referred to by the Panel as "debt dumping". These arrangements involve a Canadian subsidiary of the foreign parent borrowing money to acquire shares of another foreign subsidiary of the parent. The acquisition of the other foreign subsidiary has no relationship to the Canadian subsidiary's business, the principal purpose being to create a Canadian interest deduction possibly funded by tax-free exempt surplus dividends received from the acquired affiliate. The Panel has recommended that such debt dumping transactions be curtailed but in a manner that ensures that bona fide business transactions are not affected. How to identify a bona fide transaction within a global business may be a challenge. This issue could be made easier if offending debt dumping transactions were limited to the acquisition by the Canadian subsidiary of debt-like preferred shares of a related foreign affiliate. Such arrangements have been challenged by the CRA using existing anti-avoidance provisions such as subsection 95(6) and the General Anti-Avoidance Rule. There is only limited Canadian jurisprudence addressing such arrangements (see Univar Canada Ltd. v. The Queen) and, in that 2005 decision, the CRA was not successful. The Panel suggests two alternative approaches. One approach would be to treat a portion of the acquisition price of the foreign subsidiary as a deemed dividend under a modified surplus stripping rule. Another more complex approach would seek to deny interest expense. In any case, the Panel recommends that the government carefully study these alternatives before acting.
The Panel does not see the need for Canada to enact further laws to restrict treaty shopping and the use by third country investors to invest in Canada through treaty countries. The Panel believes that existing rules and jurisprudence – particularly case law developing internationally – are sufficient to counter treaty abuse. A very powerful tool to counter treaty abuse would be the introduction of "Limitation on Benefits" articles in tax conventions as recently added to the Canada-U.S. Tax Convention by the Fifth Protocol.
The final inbound recommendation of the Panel is to encourage continued reduction of withholding taxes on a bilateral basis through the tax treaty process. However, from a tax revenue perspective, the Panel suggests that reduction in corporate tax rates should take precedence over reductions in withholding taxes.
Compliance Issues
Non-Resident Withholding
A recommended amendment would simplify the withholding regime in respect of services provided in Canada. Currently, payments made to non-residents for services rendered in Canada are subject to a 15% withholding tax on account of the non-resident's final Canadian tax liability. Similarly, non-resident employers are subject to Canadian withholding obligations in respect of services rendered in Canada by their non-resident employees. While there is a system of waivers in respect of withholding obligations in certain circumstances administered by the CRA, obtaining such waivers can be a lengthy and frustrating process, and the CRA's published guidelines often preclude the issuance of a waiver even when it is clear there is no ultimate tax liability. The Panel recommends moving to a system of certification similar to the U.S. system. Under such a system, the payer would be relieved of its withholding obligation on receipt of a certificate from the non-resident containing prescribed information, provided that the payer had no reason to believe that the information was not correct.
A second recommended amendment deals with withholding requirements on the disposition of taxable Canadian property. When a non-resident disposes of certain property, the gain on which is subject to Canadian tax, a purchaser is required to withhold and remit to the CRA a portion of the purchase price on account of the non-resident's ultimate tax liability. The amount that must be withheld can be reduced if a certificate – known as a "section 116 certificate" – is obtained from CRA by the non-resident. As is the case with reductions in withholding for services rendered in Canada, obtaining section 116 certificates can be a protracted process. In theory, recent amendments to the Tax Act have eliminated the requirement to withhold where the non-resident vendor would not be subject to Canadian tax on a gain as a result of a tax treaty. However, the purchaser is required to establish that the vendor is resident in the treaty country – a question of foreign law that is made more difficult if a limitation on benefits article such as that found in the Canada-U.S. Income Tax Convention is included in other tax treaties – and that the vendor's gain on the sale of the property would not be subject to Canadian tax under the treaty – which will often involve difficult valuation issues relating to the relative values of property underlying a security. Further, these recent amendments do not provide the purchaser with a "due diligence" defence in circumstances where it is ultimately determined that the purchaser erred in concluding the transaction was treaty exempt. The Panel recommends a certification process whereby the non-resident vendor would certify to the purchaser that the gain on the sale of the property is not subject to Canadian tax under a treaty, and the purchaser would be absolved of liability where it relies on such a certificate. It may require a change in the government's mindset to accept that a non-resident's word is an adequate substitute for the section 116 certificate process. One way to proceed might be to restrict a vendor certification process only to vendors resident in a treaty country that would permit Canada to enforce collection procedures in the foreign country where the certification is not correct and treaty relief was not available. An example of such a provision is paragraph XXVI.4 of the Canada-U.S. Income Tax Convention.
In a closely related recommendation, the Panel recommends that purchasers should not be required to withhold tax on the acquisition of any publicly traded security. This would be accomplished by including all publicly traded securities in the definition of "excluded property". Publicly listed shares of corporations and units of mutual fund trusts are currently included in the definition of excluded property but other securities that trade publicly are not included, such as interests in partnerships. It is worth noting that many publicly traded partnerships in Canada contain requirements that only Canadian residents can be partners, so the extension of the definition may have limited application. However, it is possible that the government would accept the expansion of the definition of excluded property to include all publicly traded securities because, in many cases, it is practically impossible for a purchaser of a publicly traded security to know whether the vendor of the security is a non-resident.
Transfer Pricing
The Panel makes a number of recommendations to improve compliance issues associated with transfer pricing. In the case of transactions between a taxpayer and non-arm's-length non-residents, which would include transfer pricing issues, the period for reassessment is extended from the normal four-year period to seven years. However, the provision of the Tax Act that permits a taxpayer to waive a statutory reassessment period requires that the waiver be filed within that normal four-year period. As a result, if the transfer pricing dispute arises in years five through seven, then the taxpayer and the CRA have no ability to file and accept a waiver. There appears to be no reason for this disconnect between the extended reassessment period and the period during which a waver can be filed. The Panel recommends that the period for filing a waiver be extended to match the seven-year reassessment period. There are other circumstances in which the normal four-year reassessment period may be extended. Presumably, it would be appropriate to amend the Tax Act to permit the filing of a waiver at any time that a matter is open for reassessment.
The Panel suggests that appeals and objections in respect of matters referred to competent authorities should automatically be held in abeyance. Currently this practice is followed by the CRA only in certain cases.
Another recommendation would change the rules in the Tax Act that require large corporations to pay one-half of any tax in dispute. A recommendation of the Panel would see this requirement modified in transfer pricing cases on the basis that tax may have been paid in the foreign jurisdiction on the amounts disputed by the CRA. It will be interesting to see whether the government will accept this recommendation, since acceptance on the basis of hardship in transfer pricing cases may lead to other equally worthy taxpayers expecting relief – particularly in the current economy. The better legislative initiative (and one which would be more consistent with global norms) would be to eliminate the requirement to pay taxes in dispute in all cases.
A number of other suggestions of issues that merit further study and to improve the efficiency of the CRA's operations were made by the Panel but are not discussed here. Interested readers are referred to the Report at the link given above.
It will be interesting to see which, if any, of the Panel's recommendations are incorporated into legislative initiatives in the upcoming federal budget, scheduled for January 27, or in other future proposed amendments.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
