Canadian Foreign Affiliates — New Draft Rules
January 22, 2010
Marc G. Darmo
Gabrielle M.R. Richards
On December 18, 2009, Canada’s Minister of Finance released draft regulations relating to the taxation of Canadian multinationals with foreign affiliates. This release deals with some of the proposals announced in 2001, 2002, 2004 and 2007; not included, however, are the anticipated changes to the foreign affiliate rules for mergers and other reorganizations that were proposed in 2004. These changes will be the subject of a separate release, to be issued in the near future. The public has until February 15, 2010 to provide comments to the Department of Finance.
Summary of Proposed Regulations
The following is a summary of the various proposed provisions of Part LIX of the regulations to the Income Tax Act:
- Partnerships – New section 5908 contains a number of provisions relating to the computation of surplus and deficit accounts of foreign affiliates held by partnerships, including rules to reflect the provisions of section 93.1 of the Act. In addition, section 5902 and portions of section 5905 are amended to deal with elections under section 93(1.2) of the Act in respect of partnership dispositions of foreign affiliate shares.
- Foreign Accrual Property Losses (FAPL) – Section 5903 is amended to reflect the three-year carry-back of FAPL and extension of the FAPL carry-forward period from five years to 20 years, effective on the dates previously announced, as well as changes to its computation to reflect paragraph 95(2)(f) of the Act and to ensure no duplication of FAPL within a corporate group. New subsection 5907(1.4) ensures that an amount paid by a particular foreign affiliate to another corporation will be considered foreign accrual tax only to the extent that the amount is in respect of an FAPL of a controlled foreign affiliate of a "relevant person or partnership" in respect of a taxpayer.
- Acquisition of Control and "Bump" Rules – New rules were added to section 5905 to reflect the interaction of the winding-up "bump" under paragraph 88(1)(d) of the Act and the computation of foreign-affiliate surplus balances. These rules limit the "bump" to the extent that the Canadian subsidiary being wound up (or vertically amalgamated) has received tax-deductible dividends after the acquisition of control by its Canadian parent out of exempt or taxable surplus earned before the acquisition of control. These rules will apply to windings-up that began, and amalgamations that occurred, after February 27, 2004 — except for those where the acquisition of control occurred after December 18, 2009. In that case, new subsection 5905(5.4) will apply instead (as discussed below).
On an acquisition of control that generally occurs after December 18, 2009, new subsection 5905(5.2) will apply in a manner similar to paragraph 111(4)(c) of the Act. It will reduce the exempt surplus balance of the top-tier foreign affiliate to the extent the aggregate of the "tax-free surplus balance" of the affiliate and the adjusted cost base of the shares of the affiliate exceeds the fair market value of the shares at the time of acquisition of control. "Tax-free surplus balance" is generally the aggregate of the exempt surplus of the foreign affiliate and any other foreign affiliates in which it has an interest plus the grossed-up amount of underlying foreign tax (i.e., taxes paid by such foreign affiliates in respect of taxable surplus). A special ordering rule ensures that the adjusted cost base of the shares referred to in the computation under subsection 5905(5.2) is determined after taking into account any adjustments under paragraph 111(4)(c) of the Act.
The new "bump" limitation rules in subsection 5905(5.4) (with amended paragraph 88(1)(d)(ii) of the Act) ensure that the "bump" will only be available to the extent the fair market value of the foreign affiliate’s shares at the time of acquisition of control exceeds the aggregate of the "tax-free surplus balance" of the affiliate (described above) and the adjusted cost base of the shares of the affiliate immediately before the winding-up. Effectively, if subsection 5905(5.2) has applied to a foreign affiliate on an acquisition of control, no "bump" should be available in respect of the shares of the affiliate on a subsequent winding-up or amalgamation.
- February 27, 2004 Proposals – A number of features previously introduced to deal with the computation of deficits of foreign affiliates, such as "deficit levitation" rules, "interest push-down" rules and "surplus consolidation" rules, are replaced with a new "fill-in-the-hole" rule, applicable where a share of a foreign affiliate is acquired after December 18, 2009. The rules in new subsection 5905(7.1) to (7.7) will apply to ensure "blocking deficits" are not circumvented; that is, deficits in upper-tier affiliates would need to be filled with surpluses from lower-tier affiliates before the upper-tier affiliate can distribute tax-deductible dividends to its Canadian corporate shareholders. Effectively, the exempt surplus balance of the lower-tier affiliate and the exempt deficit balance of the upper-tier affiliate are reduced, a result comparable to what would have occurred had a dividend been paid by the lower-tier affiliate, immediately before the transactions, from its "tax-free surplus balance" (discussed above), to the extent necessary to "fill the hole" in the upper-tier affiliate. In keeping with the notional dividend concept, the new rules provide for increases in the adjusted cost base of shares of lower-tier affiliates, as if the deemed dividend had been reinvested in shares. These new cost base adjustments are reflected in amendments to the Act, in particular, paragraph 53(1)(d) and new subsection 92(1.1).
- Permanent Establishments – A comprehensive definition of "permanent establishment" is added in section 5906 to ensure a common definition for the foreign affiliate rules.
- Foreign Oil and Gas Levies – New section 5910 deems certain oil and gas levies to be income taxes paid by a foreign affiliate.
- Other Changes – The non-taxable portion of gains from the disposition of eligible capital property, and the non-deducted amounts in respect of eligible capital property, are included in "exempt earnings" and "exempt loss." Further, the foreign tax consolidation rules in subsection 5907(1.1) are modified. Finally, consequential changes to the regulations (primarily in section 5907) reflect the amendments that flow from legislation enacted in December 2007, such as the calculation of amounts in particular currencies.
Foreign Affiliate Elections
The Budget 2007 legislation included six individual elections to effect the retroactive application of selected provisions and a revocable "global election" that permitted taxpayers to have all amendments apply retroactively. The deadlines for these elections were extended in June 2008 by 18 months, resulting in a December 31, 2009 deadline for taxpayers with calendar taxation years. This deadline is being maintained in the December 18, 2009 proposals, with the scope of the revocation option being broadened from the global election to include the six individual elections, all of which can now be revoked by the filing-due-date for the taxpayer’s taxation year that includes December 14, 2010 (i.e., June 30, 2011 for a taxpayer with a calendar taxation year).